Purchasing and Production Managers - Essay Example

Corporate Finance Introduction United Metal is considering an alternative proposal of buying components from Amalgamated Components. These componentsare at present being manufactured in house by United Metals. The proposal assumes a saving of $96000 during a period of eight years, which is remaining useful life of machinery purchased by United Metals a year ago the purpose of manufacturing of such components. An effort has been made in this write up to evaluate both the in-house manufacturing and buying proposals in order to arrive at proper recommendations to be made to United Metals. a) Critical evaluation of arguments of purchasing and production managers Purchasing Manger’s arguments 1. The argument of the purchasing manger that there would be savings of $96000 over a period of eight years holds no grounds. First of all it is not clear whether manager is arguing the saving in absolute terms (net cash flow) or in terms of profits. The manger has calculated the savings of $96000 as under: Cost of own manufacturing (including capital cost of machine) 0.95p per pc. Purchase price of component 0.83p per pc. Margin 0.12p per pc. Total Production 100000 pc. Saving per year (0.12 * 100000) $ 12000 Saving for 8 years $ 96000 The calculations of purchasing manager are absolutely wrong, as he is taking total cost of manufacturing of the present in- house activity and comparing it with only cost of purchasing the component from Amalgament Components. Manufacturing costs and purchasing price are altogether incomparable costs. He has altogether ignored the many expenses required to be added to the cost of purchases to make it comparable to manufacturing cost, like depreciation on Scanner of $8000, freight inward, assembling cost of the product, salaries of administrative and selling staff and many other assembling, administrative, selling expenses, and even the taxation outflows. 2. The suggestion of selling the machinery is absolutely illogical. The machinery was purchased only one year back for $45000 and selling only for $5000 is no good suggestion, considering the fact that the firm would suffer a loss to the tune of $35000 after taking into account capital allowance for two years. If at all machinery is to sold, it should be done at a time when the proposal of buying the component actually start bringing profits, as the machinery has got few alternative uses as per production manager. 3. The argument about only 60% use for current 4 years of warehouse holds grounds when $50000 is planned to be spent on extension of warehousing facilities after the fourth year, particularly when a capital allowance can be claimed @ 4%. The matter needs serious consideration while evaluating the buying option. Production Manager’s arguments 1. The argument of production manager that present machinery holds 8 years of useful life, and also machinery could be used for alternative purposes as well are valuable arguments from the point of view United Metals, particularly when the machinery could be sold only for a meager sum of $5000 . Under such circumstances there is no point in selling the machinery and incur losses from such sale. The alternative buying proposal of components can be still be considered taking into account other merits of the proposal, if any. 2. The assumption of production manager of the saving of $7000 for 8 years, on basis of which he discounted the benefit at 12% appears as vague calculations. His stated version of 20% as current cutoff rate may hold grounds, but there are no revenue figures available to verify this rate. 3. The idea of production manager to fit a variable dimension sensor to one of machines in sub assembly holds ground if United Metal needs to have a check on the quality of the product. Of course, this would mean initial outlay of cash flow to the tine of $8000 for United Metal, if the buying proposal is adopted. The argument that expenditure on sensor is unnecessary even after capital allowance for tax purposes is baseless if the buying scheme is adopted. After all 25% of capital allowance is big incentive and huge tax saving approach. 4. The maintenance of additional stockholding because of delivery in not less than a batch of 30000 components would definitely put pressure on the cash outflows of United Metals. These arguments of production manager are positive and conservative in approach. 5. So far as transfer of Chief operator to another department at the same $8000 per year salary is concerned, the matter does not hold any ground as the issue is not going to bring in an opportunity cost issue to be considered for the proposal.. b) Important issues and factors required for financial analysis 1. The buying proposal of components needs a consideration from the point of incremental net present value of cash flows during its evaluation. The proposal is worth only when it augments the present value of future cash flows of United Metals. 2. The argument of savings of $96000 needs a serious consideration while evaluating the positive points of buying proposal, though there are serious doubts that there would be such saving on adoption of the proposal. 3. The issue of sale of existing machinery at low value of $5000 when the machine can be used for alternative purposes as per production manager needs an extensive in depth study while making a decision about the closure of manufacturing of components. 4. The Amalgamated Components will enter into one year contract, though renewable, with United Metals for the supply of component. This is a very serious issue. At the time of renewal of contract after one year, Amalgament Component may propose such issues like increase in price, purchase of bigger batch than of 30000 components, and others. This issue will definitely destroy the profitability calculations of United Metals if remained unconsidered. Thus time period of contract is the utmost important issue before taking a final decision. 5. Additional cost of $8000 of sensor is a matter that will put pressure on cash outflow. The matter needs a serious consideration even though capital allowance is available from taxation point of view. 6. Stocking of additional components only for the sake of entering into a contact for supply of component is purely a case of dictation of terms from the supplier. As there is no additional price incentive for such stocking, the matter should be given a due consideration while evaluating the proposal. 7. After four years United Metals would be required to invest in the extending the warehousing facilities. This is a matter of utmost importance keeping in view the fact that capital allowances of only 4% is available on industrial buildings, and hence requires a serious consideration. C) Financial Appraisals and Recommendations As stated above an appraisal statement need to be prepared to show how much United Metals be benefited cash flow wise before taking a decision about of buying proposal from Amalgamated Components. Accordingly following is the statement that depicts incremental present values of future cash flows if the proposal is adopted: Incremental NPV of Cash Flows under component buying from Amalgamated Components Notes 1. Sale of old machine is considered as inflow of sale value of $5000, but loss of $30000 is not considered as this is not a cash outflow. 2. Net Inflow that will increase is considered on the assumption of savings of $96000 over 8 years, even though the writer does not agree with such cash inflow as stated in above in this write up. However the calculations of inflow are made as under: Manufacturing Cost per piece (including depreciation/ capital cost) 0.95 Less Purchase price of component 0.83 Depreciation/capital cost 0.05 0.88 Assumed cash savings per piece 0.07 Assumed cash saving per year on production 100000 pcs. (100000*0.07) $7000 3. Terminal cash inflow is taken as written value of Capital Expenditure made on extension of warehouse after reducing the capital allowance allowed for tax purposes at the rate of 4% till 8th year. 4. Additional stock required to maintain purchases batch wise. The outflow is shown in the first year on the assumption that United Metals will maintain additional stock throughout. 5. Saving of $96000 for eight years or $ 12000 is treated as additional income and taxable additional income is calculated after deducting the capital allowance @ 25% on purchase of Sensor and 4% on extended warehouse facility made after 4th year. The tax is calculated at the rate of 35% of assumed taxable savings or profits. Recommendations The above financial analysis clearly shows that the buying proposal will contribute negative cash flows during a period of eight years, when both inflows and outflows are considered. This is even after the fact that a terminal cash inflow is assumed at the end of 8th years on the extension of warehouse facility after 4th year. This terminal inflow is calculated at written down value after considering the terminal allowance. The Net present value of net cash flows is calculated taking the 20% p.a. as discounting rate. As net cash flow as well as NPV of cash flow is negative, it is certain that the acceptance of proposal is not going to add anything to the kitty of United Metals. Under such circumstances, it is recommended that United Metal should continue with existing arrangement of in-house manufacturing of components and avoid incurring of losses and depletion of cash flows by entering into buying contract with Amalgamated Components. Read More