Question 2

Two proposals for manufacturing a new product have been proposed to the board of directors of 'Salamis' Ltd. Market research indicates that there is strong demand for the product.

Proposal 1: The company will acquire plant costing 900,000. Fixed expenses (other than depreciation) would amount to 570,000 per annum and variable expenses per unit would be 350.

Proposal 2: The company will acquire plant costing 800,000. Fixed expenses (other than depreciation) would amount to 240,000 per annum and variable expenses per unit would be 400.

In both cases the plant is expected to last five years and to have no scrap value. The straight-line method of depreciation is considered appropriate. The finished product will be marketed for 500 per unit irrespective of the level of sales. The forecast level of demand is 6,000 units per annum. The working capital requirement amounts to 50,000 under each proposal.

Required:

(a) For each proposal calculate the break-even position in units each year.

(b) Demonstrate and explain which proposal carries the minimum risk to the business.

(c) For each proposal calculate the contribution and the expected profit.

(d) State which proposal should be accepted and give your reasons including a commentary on both risk and return considerations.

(e) 'Contribution analysis described in the text books is too simplistic and it is of little relevance to management'. How far do you agree with this statement?