PLEASE READ CAREFULLY AND FOLLOW THE INSTRUCTIONS GIVEN AT THE BOTTOM OF THE PAGE

The Case

You are a Senior Consultant for the professional service firm, BUSI 2083 LLP. Your firm specializes in providing a wide variety of internal business solutions for different clients. It is your final week on the job and a Manager asks you for some help prior to your departure. Eager to leaving a lasting impression, you start reading the background information provided by the Manager.

Lesley Donovan is the controller for the East division of Explorer Ltd. Jason Conner, head of plant engineering, has just left Donovans office after presenting three alternatives for submission in the capital expenditure budget for the fiscal year 2014. The budget is due to the CEO in two days and therefore Donovan realizes that time is of the essence.

Conner has outlined the following alternatives to replace an outdated milling machine:

build a general purpose milling machine;

buy a special purpose numerically controlled milling machine; or

buy a general purpose milling machine.

Explorer Ltd. is a well-established company. The company was set up about 30 years ago by two brothers Dan and Kevin Thompson, in Huntsville, Ontario, to produce accessories for the automobile industry. The Central division continues to serve the auto industry, and is the largest division in the company with sales of $35 million annually. Dans son is now head of this division. Kevin is still active in the company and is the Chief Executive Officer (CEO). His office is located in Toronto.

The parts division supplies seals to the mining and petrochemical industry from a plant in Toronto. This division is only ten years old and until 2010 was highly profitable. As a result of the downturn in the sector of the economy, sales in 2012 were only $12 million.

The East division, located in Scarborough, is the engineering division. Full-time employees tend to work approximately 2,000 hours in the division. Regular product lines include industrial fans, industrial cooling units, and refrigeration units for industrial users. The division is highly capital-intensive and sales tend to be directly related to general economic conditions.

Each division runs independently and performance is based upon budgeted return on investment. Bonuses are paid if the budget target is achieved. Annually, each division prepares a detailed budget submission to Kevin, outlining expected profit performance and capital expenditure requests. The milling machine proposal is part of the capital expenditure request.

The 2013 pro forma income statement for East division is set out below:

Sales	$22,364,000
Cost of Goods Sold	$14,760,240
Gross Profit	$7,603,760
Selling and General Administrative Costs	$3,578,760
Allocated Costs (based on sales)	$1,677,300
Income Before Income Taxes	$2,347,700
Return on Sales 10.5%
Return on Investment 8.5%
Investment (Historical Cost)	$27,626,118

Jason Connor has pointed out to Donovan that the existing machine is not only outdated but maintenance costs are becoming prohibitive. Jason also noted that maintenance costs of new general purpose machines are only $26,000 while special purpose machines can save an additional $14,000 in maintenance. Also there would be a significant savings in insurance as the price for a general purpose machine would drop to $3,000 while a special purpose machine would be 67% higher than the general purpose machine. The machine has no market or salvage value and he is sure that its book value is now zero. The trouble is that he doesnt know which proposal is best for the company. In addition to the cost and revenue date provided, Connor provided comments on each alternative below:

Build a general purpose machine:

This machine can be built by East division. The division is below capacity at present as a major contract has just been completed. The division could thus produce the machine without affecting revenue-producing activity, but it will take six months to complete. The machine is expected to last five years and have no salvage value because removal costs will probably equal selling price.

Connor believes that the division has the technical expertise to undertake the work. In 2012, the division produced a specialized drilling machine that has proven very successful. Connor pointed out that David Williams, chief engineer, loves the design challenge of new machines. Donovan sat down with Connor and produced the following cost estimates:

Material and parts	$55,000
Direct labour (DL$)	$90,000
Variable overhead (50% of DL$)	$45,000
Fixed overhead (25% of DL$)	$22,500
TOTAL	$212,500

Donovan argues that this job should also bear a proportion of administrative costs; she suggests $12,000.

Buy a special purpose machine: The advantage of this special purpose machine is that only one operator is required and output per hour could increase by 25%. In addition, maintenance costs are significantly reduced because microchip circuitry is employed. Connor points out that this machine is state-of-the-art and would probably mean that new work could be taken on. A numerically controlled machine required extensive training of operators. In total, 26 weeks are spent in the suppliers factory located in Florida. While the training is going on, the supplier provides an operator to work the machine without charge. Expected costs of this training period including hotel, per diem, and travel will cost $3,000 per week, excluding the operators labour which is set at $15 per hour. The machine costs $625,000, and the supplier guarantees the salvage value of $25,000 at the end of five years. It is available immediately. It is estimated the machine can generate sales of $243,750 annually at full capacity and require $19,500 in direct materials cost. While the direct material costs are equivalent, the level of sales for the general purpose machine are $48,000 lower than the special purpose machine.

Buy a general purpose machine: The purchase price of this machine is $295,000 and cost levels associated with the machine are expected to be the same as the general purpose machine built by the company because the technology is similar. The salvage value of the machine net of removal costs, is estimated to be $5,000 in five years. It can be delivered immediately.

General comments

The required rate of return for this investment class has been set at 8% by Kevin Thompson.

Required

Prepare the budget submission to Kevin.

Evaluation

Final Exam: Major Case Analysis will be marked in its entirety out of 100. The following rubric indicates the criteria students are to adhere to, and their relative weights to the assignment overall.

Activity/Competencies Demonstrated	% of Total Grade
Identification and Analysis of Issues (90%)
a. Issue identification	/5
b. Identification of Key Success Factors	/10
c. Identification of Alternatives	/5
d. Quantitative Analysis	/40
e. Qualitative Analysis	/30
Recommendation (10%)
a. Recommendation on course of action	/5
b. Circumvention of Potential Problems	/5
Total	/100

PLEASE COMPLETE REQUEST USING THE FOLLOWING INSTRUCTIONS.

.

First prepare two column statements for cash in and cash out.

One for General Purpose and one for Special Purpose.

How to prepare this:

Write sale in two column (given)

Then deduct all variable costs

(Dont take fixed costs. Supervisors salary also a fixed cost).

Read question carefully you will get sale figure there.

In variable costs you will find:

Operators (2,000 Hrs X $15)

Insurance

Maintenance

Direct materials

Variable OH (50% of direct labor)

These will give you total variable costs

(For special purpose sales are same as General purpose but VC differ. Operator cost is 26 week means half year, variable OH half year, insurance also differ but direct material same in both cases. Maintenance also differ, Read the text carefully)

If you deduct these variable costs from sales, you will positive cash for both General Purpose and Special Purpose. This will tell you which one is better.

Now come to NPV analysis:

By now you already got positive cash for General purpose and special purpose. This is for 5 years at 8% discount rate find amount (use table 2)

First Find cost:

Building General Purpose: take all variable costs (given in the question)

Building special purpose: cost of machine + Training costs for 26 weeks

Buying General purpose: Only buying cost

Dont deduct salvage value

For cost no need to use table just show cost as minus

Now take salvage value and find NPV in two Buy Special Purpose and Buy General purpose