Question 1

In the context of 'Vision 2027', the new management is considering purchase of environmentally friendly equipment. Based on the information given in Appendix Q1.1 Below , answer the following question.

a. Using the information in Table 1, and your knowledge of relevant costs, calculate the increase/decrease in operating profit for the company if the fixed-wing drones were discontinued.

b. For each of the four fixed overheads, give a reason why you decided in (a) that the overhead is relevant or irrelevant.

• c. Based on your analysis of relevant and non-relevant costs:

i. Amend the operating statement in Table 1 to provide the total profitability of the drones as well as the profitability of each drone.

ii. Explain the main reason for the change you propose in (c) (i) above.

d. Using the information in Table 2, and your knowledge of relevant costs, calculate the difference in profit over the next five years between keeping and replacing the old machine.

e. Evaluate the response of the managing director to the proposed new machine.

Appendix Q1.1: Proposal to replace equipment

Mr. Jordan plans to introduce new environmentally friendly technology to manufacture drones for the toy market. The current product ranges consist of three types of drones manufactured from two specialist machines in a UK factory that produces no other toys.

The following information on sales and expenses for the past month has now become available.

Table 1: Operating statement

		Drones
		Total	Fixed-wing	Fixed-wing hybrid	Multi-rotor
Sales		845,000	180,000	420,000	245,000
Less: variable expenses	354,000	93,000	160,000	101,000
Contribution	491,000	87,000	260,000	144,000
Less: fixed overheads
	Marketing	102,000	18,000	58,000	26,000
	Deprecation of equipment	116,000	36,000	48,000	32,000
	Line supervisors' salaries	34,000	11,000	12,000	11,000
	Factory overheads	169,000	36,000	84,000	49,000
	Total fixed overheads	421,000	101,000	202,000	118,000
Net operating profit (loss)	Total70,000	Total(14,000)	Total58,000	Total26,000

Mr Jordan is concerned about the losses shown by the fixed-wing drones and wants a recommendation as to whether the line should be discontinued.

The following information is relevant to the fixed overhead figures above.

1. The two specialist machines used to produce each of the three drones currently have no resale value.
2. The company has no other use for the capacity now being used to produce fixed-wing drones.
3. If the fixed-wing drones were discontinued, both line supervisors responsible for its manufacture would no longer need to be employed by the company.
4. The marketing expense for each line of drones is exclusively for those drones.
5. Factory overheads are general and fixed common costs that are allocated based on sales.

Proposal of new machine and other new information

After consultation with the production manager, Mr Jordan is considering the purchase of a new machine. The new machine will comply with new environmentally friendly technology and will cut scrap and rework rates (the cost of remedying manufacturing problems), resulting in substantial savings in materials and labour costs. A production manager has gathered the following information concerning the old machine and the proposed new one.

Table 2: Information for replacing old machine

Old machine				Proposed new machine
Original cost		125,000		List price new		150,000
Remaining book value	90,000		Expected life		5 years
Remaining life		5 years		Disposal value in five years	0
Disposal value now	50,000		Annual variable operating expenses	220,000
Disposal value in five years	0		Annual revenue from sales	500,000
Annual variable operating expenses	265,000
Annual revenue from sales	500,000

During the initial discussion about the proposal to replace the machine, the first response, from the Board of Directors was that the company had already made an investment in the old machine, so the business had no choice until their investment has been fully recovered as it is now just a 'sunk cost'. Mr Jordan went on to say that a further reason for not purchasing the new machine was that the disposal of the old machine would result in a 'loss' of 40,000.