Reference no: EM132993154
Question - Spring Corporation is a manufacturer of a Jigger, which it sells in the intermediate market. The following information is available about the Jigger (revenue and costs are provided on a per unit basis):
Revenue $125.00
Manufacturing costs:
Material $45.00
Labour 16.00
Manufacturing overhead 30.00
Total Manufacturing costs $91.00
Annual volume, in units 24,000
Machine hours available (annual) 14,000
The product is produced using production equipment referred to as M1. The $16.00 per unit labour cost represents the cost of the employee to run the machine (M1). Manufacturing overhead costs are approximately 40% fixed, based on the budgeted capacity of 24,000 units. Each unit requires 0.4 hours of machine time.
Spring is considering the purchase of new equipment, M2, that has a capital cost of $3,500,000. This machine would produce a second product, the Gizmo. This product will require .80 hours of time on M1 and 1.10 hours on M2. The demand for the Gizmo is increasing, but Spring would be the dominant producer in the field. The product is distinct from the Jigger and the demand for that product would not change.
Company management estimates that revenue for the new product will be $475.00 per unit. Variable overhead costs on the M2 are expected be the same per machine hour as on M1. The direct material cost for the Gizmo is $125.00 per unit. The hourly labour rate for the machine operator will be the same as the hourly labour rate for the operator of M1.
The maximum machine hours available on M2 is 8,750 hours per year. There will be no increase in fixed costs. All administrative costs are considered fixed. Sales commissions equal 5% of sales on the Jigger and it is anticipated that this commission rate would apply to the Gizmo as well.
The new machine is classified as a class 8 asset for tax purposes. The CRA requires that assets in this class be written off using the declining balance method at a CCA rate of 20%.
Management is uncertain as to the demand for the Gizmo. Conservatively, they have estimated that demand in the first two years will be 6,500 units. They expect demand to increase to 10,000 units for years 3 to 5.
It is anticipated that the machine will have a useful life of 5 years. For purposes of a conservative evaluation, the company has assumed the residual value will be $350,000. The CCA class will remain open. The company's combined corporate tax rate is 25% and it requires a 11% return, after tax, on projects with the level of risk associated with the Gizmo.
The vice president of marketing has indicated that unless the M2 is purchased, the company's ability to compete in the target market segment will be impeded. She feels the company has an opportunity to become a market leader in the field. The president is concerned that if the equipment is purchased, it will take the company into new markets where it has not competed before. He is also worried that if the company is not able to fill all of the orders for the Jigger, the customers may look elsewhere for this product.
Required - Prepare a report to the president. The report should include a supported recommendation for the proposed acquisition of M2, as well as any relevant qualitative issues.