Lesley Donovan is the controller for the East division of Explorer Ltd. Jason Conner,
head of plant engineering, has just left Donovan’s office after presenting three
alternatives for submission in the capital expenditure budget for the fiscal year 2014.
The budget is due to the CEO in two days and therefore Donovan realizes that time is
of the essence.
Conner has outlined the following alternatives to replace an outdated milling
machine:
1. build a general purpose milling machine; 2. buy a special purpose numerically controlled milling machine; or 3. buy a general purpose milling machine. Explorer Ltd. is a well-established company. The company was set up about 30 years
ago by two brothers Dan and Kevin Thompson, in Huntsville, Ontario, to produce
accessories for the automobile industry. The Central division continues to serve the
auto industry, and is the largest division in the company with sales of $35 million
annually. Dan’s son is now head of this division. Kevin is still active in the company
and is the Chief Executive Officer (CEO). His office is located in Toronto.
The parts division supplies seals to the mining and petrochemical industry from a
plant in Toronto. This division is only ten years old and until 2010 was highly
profitable. As a result of the downturn in the sector of the economy, sales in 2012
were only $12 million.
The East division, located in Scarborough, is the engineering division. Full time
employees tend to work approximately 2,000 hours in the division. Regular product
lines include industrial fans, industrial cooling units, and refrigeration units for
industrial users. The division is highly capital-intensive and sales tend to be directly
related to general economic conditions.
Each division runs independently and performance is based upon budgeted return on
investment. Bonuses are paid if the budget target is achieved. Annually, each division
prepares a detailed budget submission to Kevin, outlining expected profit
performance and capital expenditure requests. The milling machine proposal is part
of the capital expenditure request.
The 2013 pro forma income statement for East division is set out below:
Sales $22,364,000 Cost of Goods Sold $14,760,240 Gross Profit $7,603,760 Selling and General Administrative Costs $3,578,760 Allocated Costs (based on sales) $1,677,300 Income Before Income Taxes $2,347,700 Return on Sales – 10.5% Return on Investment – 8.5% Investment (Historical Cost) $27,626,118 Jason Connor has pointed out to Donovan that the existing machine is not only
outdated but maintenance costs are becoming prohibitive. Jason also noted that
maintenance costs of new general purpose machines are only $26,000 while special
purpose machines can save an additional $14,000 in maintenance. Also there would
be a significant savings in insurance as the price for a general purpose machine
would drop to $3,000 while a special purpose machine would be 67% higher than the
general purpose machine. The machine has no market or salvage value and he is
sure that its book value is now zero. The trouble is that he doesn’t know which
proposal is best for the company. In addition to the cost and revenue date provided,
Connor provided comments on each alternative below:
1. Build a general purpose machine:
o This machine can be built by East division. The division is below
capacity at present as a major contract has just been completed. The division
could thus produce the machine without affecting revenue-producing activity,
but it will take six months to complete. The machine is expected to last five
years and have no salvage value because removal costs will probably equal
selling price. o Connor believes that the division has the technical expertise to
undertake the work. In 2012, the division produced a specialized drilling
machine that has proven very successful. Connor pointed out that David
Williams, chief engineer, loves the design challenge of new machines.
Donovan sat down with Connor and produced the following cost estimates: Material and parts $55,000 Direct labour (DL$) $90,000 Variable overhead (50% of DL$) $45,000 Fixed overhead (25% of DL$) $22,500 TOTAL $212,500 o 2. Donovan argues that this job should also bear a proportion of
administrative costs; she suggests $12,000. Buy a special purpose machine:
The advantage of this special purpose machine is that only one operator is
required and output per hour could increase by 25%. In addition, maintenance
costs are significantly reduced because microchip circuitry is employed.
Connor points out that this machine is state-of-the-art and would probably mean that new work could be taken on. A numerically controlled machine required
extensive training of operators. In total, 26 weeks are spent in the supplier’s
factory located in Florida. While the training is going on, the supplier provides an
operator to work the machine without charge. Expected costs of this training
period including hotel, per diem, and travel will cost $3,000 per week, excluding
the operator’s labour which is set at $15 per hour.
The machine costs $625,000, and the supplier guarantees the salvage value of
$25,000 at the end of five years. It is available immediately. It is estimated the
machine can generate sales of $243,750 annually at full capacity and require
$19,500 in direct materials cost. While the direct material costs are equivalent,
the level of sales for the general purpose machine are $48,000 lower than the
special purpose machine.
3. Buy a general purpose machine:
The purchase price of this machine is $295,000 and cost levels associated with
the machine are expected to be the same as the general purpose machine built
by the company because the technology is similar. The salvage value of the
machine net of removal costs, is estimated to be $5,000 in five years. It can be
delivered immediately. General comments
The required rate of return for this investment class has been set at 8% by Kevin
Thompson.
Required
Prepare the budget submission to Kevin.

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