Reference no: EM13923437

 

Prepare the income statement and the statements of cash flow for 2011 through 20145

Background

MartinCo is a small company that has been in the Martin family for several generations. In 2011, Mr. Martin added a new business line selling an exclusive and unique image processing sensor that he had developed. For the last years, the business unit had done quite well, exceeding Mr. Martin' and the Board of Director's expectations. Given that MartinCo had never worked in the image processing industry, the project had originally been viewed as extremely risky with several of the board members recommending against it. Even so, the project had prevailed and the business unit had done well.

Recently, Mr. Martin had received inquiries from a major Photography and Imaging firm (Canikon, Inc.) to exclusively use his image processing sensor or to purchase the rights to the sensor outright with the intent of getting a larger manufacturer to produce the product. Mr. Martin is faced with a dilemma. Should he choose to keep the rights to his product, he will have to ramp up production to meet the demands of Canikon. Alternatively, should Mr. Martin chooses not to expand his image processing business unit to meet Canikon's propositions, Canikon could independently develop a similar sensor and cut him out of the market altogether. Mr. Martin is loath to give up the rights to his designs and brand and realizes that he might have to do so if the numbers don't fall out well for his product.

Mr. Martin wants to compile a report for the business unit that will give him some insight into its present operation and potentially a better understanding of whether an expansion would be a feasible undertaking.

A big concern that Mr. Martin has is that Canikon intends to, and would be able to significantly underprice his present product and cost structure. Canikon is currently a leading distributor in the Photography and Imaging industry. Hence, the company has the ability to source a larger manufacturer to produce a similar type of sensor and would able to bring economies of scale to bear that Mr. Martin would have difficulty achieving.

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Product Development and Initial investments

Mr. Martin invested significant time and expense in the development of his unique Image Processing Sensor. He went through extensive development, testing, consumer feedback, promotional giveaways and effort before proposing the product and business line to the board members. All in all he had produced one hundred and fifty units before even having a fully functional production line. Mr. Martin presented his ideas to the board at the 2^nd quarter Board of Directors meeting of 2010. Although there was some hesitation, the Board of Directors approved the project and expected the purchase of equipment to be finalized with plans to have the sensors to run off the lines and delivered to the distributors starting on January 1^st, 2011.

Mr. Martin understood the risk that he was taking. The market was not well known to him, but he felt that he had a good product that he could sell at a premium for the first years. He was worried about his costs, but felt that he could bring those down if his sales were high enough. He

knew that he could not run the business unit if he could not reduce the $670 production cost to

produce the first unit. Particularly, Mr. Martin aims to get the price to $600 or below within five

years. Had he known that he would be approached by Canikon when he started out and that he

would possibly be forced to get the price below $400, he might have given up there and then and

moved on to some other venture!

For the project, MartinCo invested $120,000 in equipment that was installed on site. The

machinery has been depreciated according to the 7-year MACRS schedule. A vehicle, which

depreciated according to the 3-year MACRS schedule, had to also be purchased for $25,000.

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Sales

Since the start of the Image Processing business unit, MartinCo has seen steady growth in the sales of its sensors. Besides the 150 units that had been produced and given away before 2011 for market testing purposes, MartinCo had increased its sales from 500 units in the first year to 1200 units in 2014.

Year	2011	2012	2013	2014	2015
Unit Sales	500	760	910	1150	1200
Price	$650.00	$600.00	$580.00	$570.00	$570.00
Revenues	$ 325,000.00	$ 456,000.00	$ 527,800.00	$ 655,500.00	$ 684,000.00

Initially, the MartinCo was able to sell the sensors at the price of $650/unit. Nonetheless, this

price has decreased to $570 per unit by 2014. Revenues had increased significantly over the five

years from $325,000 to over half a million dollars.

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Operating (i.e. Indirect) Costs

MartinCo distributes its indirect cost to the business units, so the Image Processing unit is responsible for its component of operating costs. For the first five years, the unit's indirect costs have been specified according to the following table.

Year	2011	2012	2013	2014	2015
Operating Costs	$ 78,600	$ 103,000	$ 114,000	$ 127,000	$ 140,000

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Raw Materials

Mr. Martin was also able to compile the yearly raw material costs paid to the supplier since the

time the project was developed. Upon further analysis, Mr. Martin recognizes that the per-unit costs of raw materials are closely related to the number of sensors produced. Nonetheless, the raw material costs for the first five years are shown in the following table.

Year	2010	2011	2012	2013	2014
Raw Materials	mce_markernbsp;    88,000.00	mce_markernbsp;    122,670.00	mce_markernbsp;    135,240.00	mce_markernbsp;    134,550.00	mce_markernbsp;    138,000.00

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Direct Production Costs

Due to the uniqueness of his image processing sensor, Mr. Martin has very closely monitored the direct production costs because of his concern with the high initial cost to produce the first prototype. Since then, Mr. Martin has invested much of his time in mentoring and training the production crew to help them become more efficient.

From his accounting data, Mr. Martin has been able to calculate that his total production costs

have increased from $136,328 to $259,637 over the past 5 years. Yearly sales/production has

however increased significantly in the same time period. By dividing the total direct labor costs

by the units produced, Mr. Martin is able to determine his average yearly unit cost. The average

per unit labor cost has decreased steadily from about $273/unit to about $216/unit. These

numbers are a great improvement over the $670 that it cost him to produce the first unit. Since

the operating or fixed costs are not included in this number, Mr. Martin concludes that there is

clearly a learning factor taking place, although he has not managed to figure out what to make of

these values.

Year	2011	2012	2013	2014	2015
Unit Sales	500	760	910	1150	1200
Production Costs	$ 136,328.17	$ 173,706.36	$ 203,507.66	$256,285.53	$259,637.01
Avg. Prod. Cost/Unit	mce_markernbsp;    272.66	$ 228.56	$ 223.63	$222.86	$216.36

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Interest and Taxes

MartinCo borrowed $60,000 to finance the venture to be repaid over 5 years at 6% interest. MartinCo's tax rate is 29% of taxable income and ordinary income. Tax rate is 15% for capital gains.

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Expansion

During the 2nd quarter of 2015, a buying agent for the Canikon approached Mr. Martin. The

buying agent proposed an exclusive selling agreement where Canikon would purchase all of Mr.

Martin' Image Processing Sensors. Given the expanse of Canikon, a dramatic increase in sales is

expected for the business unit.

The buying agent was willing to commit to a 5 year purchase agreement with steadily increasing

sales from 3000 units in 2016, to 4200 units in 2020.

Year	2016	2017	2018	2019	2020
Unit Sales	3000	3600	4000	4200	4200
Price	$385.00	$385.00	$385.00	$385.00	$385.00
Revenues	$1,155,000	$1,386,000	$1,540,000	$1,617,000	$1,617,000

To allow for an operating and profit margin for Canikon, a fixed per-unit price of $385 paid by

the company to MartinCo would be a condition of the agreement. Mr. Martin is particularly

worried about the expansion at this point since he is unsure whether this would still allow him to

breakeven. After gathering additional information, Mr. Martin notes that:

• He would have to estimate future costs to meet the demands of Canikon by relying on information that he was able to gather from the first five years of operations.
• He would have to replace the existing equipment. Mr. Martin estimates that he could get $38,000 in salvage for his existing machinery if he chooses to expand.

• He would also need new equipments valued at $260,000 to be able to meet Canikon's demands.

• Like the old equipment, the new machines would depreciate according to a 7-year MACRS schedule.

• For the expansion, Mr. Martin could get a loan of $100,000 at a 6% interest rate repayable over 5 years.

• Following the 2015 production lot, Mr. Martin expects a 4% annual rate of reduction in the per-unit cost of raw materials.

• His tax rates would remain unchanged.