Capital Budget Recommendation
Category : Articles
Running Head: CAPITAL BUDGET RECOMMENDATION
Capital Budget Recommendation
ACC 543/Managerial Accounting and Legal Aspects of Business
University of Phoenix
May 18, 2009
Capital Budget Recommendation
Guillermo Furniture is a company that manufactures mid-grade and high-end sofas. In order to keep up with the growing economy, Mr. Guillermo has to make some production changes within his business. The job of the new accountant is to differentiate the capital budget evaluation techniques and explain how the differences help make a recommendation. After looking at the data sheets the accountant will be able to give a recommendation of the best budget evaluation that will provide the greatest return. This paper will discuss some of the analytical techniques used to evaluate major investment opportunities.
Differentiate among the various capital budget evaluation techniques.
If Guillermo is trying to increase the company??™s return; he should consider all the possible budget techniques. He could update the equipment to high tech production or he could become a chain distributor for the mid-grade products instead of a manufacturing all the furniture. If the company update to a more computerized business, the production could increase by 50 %, the direct material per unit would remain the same while the labor rate would increase. Of course, the workers would have to be more skilled and experienced to handle the new equipment which would increase the labor rate to 40 dollars per hour. When looking at the labor rate however, the cost per hour and the amount of hours worked would still be more beneficial when upgrading to the high tech equipment. The cost to pay the technicians is 40 per hour, but the technicians will only have to work 4 hours per unit compared the current 20 hours per unit for 15 dollar per hour. The current labor cost is 300 dollars per unit. If Mr. Guillermo upgrade to high tech then the total labor cost would reduce to 160 dollars per hour. The direct cost per unit will decrease 10% from the current direct cost therefore; the company will be able to reduce the selling price to become more compatible to other competitors.
If Guillermo decides to become a distributor, the amount of production for both mid-grade furniture and high-end furniture is going to increase by 50 %, but the price per unit will be reduced by 10%. The direct material for high-end furniture is going to remain the same, but for the Mid-grade there are no material costs or labor time for brokered units because they will not be manufactured from Guillermo??™s company. The direct cost for mid-grade furniture will depend on the net FOB (free on board) destination including shipping. The direct cost for high-end will decrease from $700 to $410.
When looking at the overhead for the year, the wages come to 45,000 dollars higher because the equipment will need maintenance throughout the year. The utilities will increase if the company production is upgraded to high-tech. If Guillermo decide to become a broker the utilities will drop from 9,000 dollars a year to 4,500 because the mid-grade furniture will no longer be in production in Sonora, the mid-grade furniture will come for overseas. The benefits included in the overhead will drop because the labor decreases. However, the insurance will increase by 12,000 dollars due to adding on to the building for high-tech production. It is important not to ignore the property taxes increase. There is no way to get around paying property tax. The more money spent, the larger the amount of taxes the company will have to pay. The property taxes will be three times as much because the value on the building and the equipment used for production will increase. The depreciation will increase on a straight line basis. On a good note, the supplies expense is miscellaneous and do not vary.
Explain how the different techniques would help make a recommendation.
? While looking at the data sheet, the accountant noticed the broker??™s direct cost for the mid-grade furniture will vary based on the FOB. This cost is estimated to be $360 dollars per unit, but the cost depends on the destination. Even though the production amounts for the mid-grade are the same in both the high-tech production and the broker cases, the direct cost of shipping for the broker??™s mid-grade furniture decreases the profit to 59 dollars per unit which makes the product margin 65,041 a year in the broker??™s case. However, upgrading to high tech production allows the profit to be 159 dollars per unit which makes the product margin for high tech production to be 910,706.
Recommend a course of action.
The recommendation for Guillermo furniture is to upgrade to high tech production. The net margin of the high-tech would give the greater return. If the net margin was 910,760 minus the overhead (-697,531) the net income will be 213,175. After taxes (-89,534) the net income will be 123,641. However, the broker??™s net margin was 678,026 minus the cost of overhead (-612,985) the net income before taxes would be 65,041, after taxes (-27,317) the net income would be 37,724. The profit is 85,917 dollar difference.
Once Guillermo purchase a capital asset, the company will be committed to the investment for an extended period of time. If the market drops or turn sour, Guillermo??™s company will be stuck with the consequences. However, given the information on the data sheet, it is best for the company to invest in becoming more high tech. Of course, the overhead will be more expensive than becoming a broker, but the profit will be well worth the investment. It is best not to focus on revenue but on the cost of operation. The main focus should be to reduce operating cost. Guillermo need not make decision by focusing only on revenue or only on cost. Rather the decision should be based on an analysis of the interactions of revenue, cost, and volume of sales that would be generated as cost and pricing strategies are altered (Edmonds, 2007).
Edmonds, T. P. (2007). Fundamental financial & managerial accounting concepts. New York: McGraw-Hill.