Finance-QA258 Online Services
Part 1: New Product Introduction
Chemical Company A is evaluating the market introduction of a new product in the year 2018. The introduction of the new product would need some capital expenditures and management would like to know if the investment makes financial sense.
Management has asked a specialized consulting company to evaluate the market potential of the product and the consultants have just now finished their work to the full satisfaction of the management. Based on a detailed analysis of the market trends, the consulting company is expecting a relative short life cycle of four years for the product. Starting in 2018, the product will generate annual sales (=cash ins) of USD 55 (all figures in 000) until the year 2021. Management feels that these figures are realistic.
The fee of the consulting company to develop the market data is USD 10. As management is satisfied with the analysis of the consultants, the chemical company will definitely have to pay this amount towards the end of year 2017.
Besides the mentioned investment in the consulting study of USD 10, the chemical company would need to invest USD 100 at the end of year 2017 for the new machinery. The supplier has offered the installation as a turnkey project and guarantees the price. The machinery is supposed to hold a total of four years. At the end of the four year period, the machine would be worthless. It would then be removed by the supplier without any additional costs to the chemical company.
The machine would be operated by the personnel of the supplier during the whole four year period. For the planned sales volume, the supplier has offered to operate the machinery for annual operating costs (=cash outs) of USD 10. This amount contains all costs for direct material, labor, maintenance…. No other operating costs will be incurred for the chemical company during the whole four year period.
Unfortunately, the chemical company is known in its industry for its large corporate overhead. Even though the company entered a major cost cutting initiative in recent years and will be decreasing costs significantly in the future, the corporate head office with central departments like legal, human resources and finance is still very large. In order to pay for these overhead departments, the controller of the company has decided to allocate overhead costs based on net sales figures. Each product has to contribute with 2% of its net sales volume for covering the overhead costs. Even though the proposed project is very small compared to the overall size of the company and will definitely not have any incremental impact on the corporate overhead, the 2% rule will still apply according to the controller. Based on the planned annual net sales of USD 55, the controller is planning to charge an annual amount of USD 1.1 in case the new product is introduced.
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The weighted average cost of capital (after tax) of the chemical company is 6%. As a result, the discount factors for each of the year of operations are as follows
2018 2019 2020 2021
0.9434 0.8900 0.8396 0.7921
The tax rate of the chemical company is 50% over the whole planning horizon.
Based on current tax regulations, the company has to apply straight line depreciation over the four year life time of the machinery. Depreciation will start in the year when the first sales are realized.
Please determine if the company should undertake this project from a financial standpoint. In case you feel that information is missing, please feel free to make any additional assumptions. Explicitly clarify your assumptions about what to include or exclude in the calculations.
Part 2: Product Costing
Chemical Company A is currently using a full absorption costing system, allocating all overhead costs to the products. In recent times, the marketing department has tried to convince the Corporate Controller to implement a direct costing system throughout the company, removing the cost allocations. As a consultant, you have been asked to provide an outside opinion about the implementation of a direct costing system.
2.1. Please provide a short memo to the controller, convincing him or her why the implementation of a direct costing approach might add value to the company. Keep in mind that the chemical industry is characterized by large fixed assets and, as a result, significant depreciation expenses in the income statement. Provide specific disadvantages of the current approach and advantages of the direct costing approach for a chemical company.
2.2. The company currently maintains 15 global manufacturing sites and 75 sales companies in different countries around the globe. Currently, each manufacturing site determines the full absorption cost of each product and bills these costs – incl. a margin – to the different sales companies. As a result, some products cannot be sold in certain markets as the transfer prices exceed the market prices in these markets. Could the direct costing approach help in this situation? Please explain.
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