December 2004 Examiner's Solution

Case Solution 1
1. Prepare an assessment of the two options under consideration and make a recommendation to the directors on the
preferred option.

(26 marks)

Assessment of Lightair 3000 Option

Year Demolition Scrap Purchase and Annual Insurance Overhaul Net Cash Discount Factor Present Values
Installation Operating Costs Outflows

£ £ £ £ £ £ £ £ £

0 20 000 −5 000 70 000 85 000 1 85 000

1 20 000 3 000 23 000 0.926 21 298

2 21 000 3 000 24 000 0.857 20 568

3 22 050 3 000 25 050 0.794 19 890

4 23 153 3 000 8 000 34 153 0.735 25 102

5 24 310 3 000 27 310 0.681 18 598

6 25 526 3 000 28 526 0.630 17 971

7 8 000 26 802 3 000 37 802 0.584 22 076

23 0503

Assessment of Cleanayr 100 Option

Year Demolition Scrap Purchase and Annual Operating Insurance Net Cash Outflows Discount Factor Present Values
Installation Costs

£ £ £ £ £ £ £ £

0 20 000 −5 000 45 000 60 000 1 60 000

 1 35 000 22 000 2 000 59 000 0.926 54 634

2 22 880 2 000 24 880 0.857 21 322

3 23 795 2 000 25 795 0.794 20 481

4 24 747 2 000 26 747 0.735 19 659

5 25 737 2 000 27 737 0.681 18 889

6 26 766 2 000 28 766 0.630 18 123

7 6 000 27 837 2 000 35 837 0.584 20 929

234 037

Conclusion:

On the basis of a lower NPV, the Lightair 3000 System is the recommended option. Note that it is the lower cost option that is preferred –
that with the lower NPV.

2. Any investment appraisal process involves the identification of key investment factors. Identify four key investment
factors.

(4 marks)

Identification of key investment factors:

 Capital investment.
 Operating cash flows.
 Investment life.
 Cost of capital.

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December 2004 Examiner's Solution

Case Solution 2
1. Compute the break-even level of activity on the basis of last year's results.

(7 marks)

Computation of Contribution Margin/Unit

£ £

Total Sales Revenue 1 200 000

Less: Variable Costs

Direct materials 120 000

Direct labour 420 000

Variable manufacturing overheads 72 000

– Sales commission 24 000

– Carriage 60 000

696 000

Total Contribution Margin £504 000

Contribution Margin/Unit £8.40

Fixed Costs

Fixed Manufacturing Costs 210 000

Selling & Distribution 70 000

Administrative Expenses 148 400

£428,400
 Break-even Activity level =

= 51 000 Sweaters

2. Carry out a quantitative assessment of the two separate options suggested by the Marketing Director and make a
recommendation on which of these options will meet the objective set out by the Chief Executive.

(16 marks)

Option (a)

Assessment

Sales (78 000 × £18) 1 404 000

Less: Variable Costs

Total Variable Costs £696 000

Original Volume 60 000

Therefore, Variable Cost/Unit = £11.60

Total Variable Costs/78 000 sweaters 904 800

Total Contribution Margin 499 200

Less: Fixed Costs

Fixed Manufacturing Costs 210 000

Selling & Distribution 110 000

Administrative Expenses 148 400

468 400

468 400
 Net Profit 30 800

Option (b) Review only incremental business from Exellis sales

Assessment

Sales (40 000 × £14) 560 000

Less: Variable Costs

Original Variable Cost/Unit £11.60

Adjustments:

Extra Packaging Cost £3.00

Saving in Sales Commission −0.40

Saving in Carriage −£1.00

Revised Variable Cost/Unit £13.20

Total Variable Costs/40 000 sweaters 528 000

Total Contribution Margin 32 000

Less: Fixed Costs

Website Contribution 7 000

7 000

7 000

Incremental Net Profit 25 000

Current Net Profit 75 600

Revised Net Profit 100 600

Recommendation:
 Option (a) results in a significant deterioration in profitability in the next financial year. Only Option (b) will create the level of profitability
desired by the Chief Executive.

3. The Cost–Volume–Profit Analysis approach has a number of assumptions. Outline these assumptions and indicate whether
they constrain the usefulness of the approach.

(7 marks)

The assumptions underlying Cost–Volume–Profit Analysis include the following:

1. All costs are identifiable as either variable of fixed costs.

2. All costs behave in a linear manner with respect to output levels.
3. Sales price per unit remains unchanged.
4. Sales mix will be maintained precisely as budgeted.
5. All production is sold and, hence, there is no inventory.

These assumptions do restrain the usefulness of the model in real world situations. However, the analysis of cost behaviour is useful in
many decision-making problems.

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