Capacity Planning and Financial Appraisal - Coursework Example

Capa Planning and Financial Appraisal Capa Planning Given Data Sales per quarter = 40,000 pieces of all 5 products. Available hours = 560 hrs. per quarter. Resource requirement (minutes per product): Work centre A: 2.5 Work Centre B: 3.5 Work Centre C: 1.5 Capacity Calculation Based on the above data, the capacity requirement on each work centre was worked out, and the results are shown in table 1. CALCULATIONS Load Workcentre A Workcentre B Workcentre C Sales Qty x Work Content 100000 140000 60000 No. of resources needed =Load/Capacity 2.976190476 4.166666667 1.785714286 Actual Resources provided (Management Decision) 4 5 3 Table 1 Capacity Requirement From Table 1, it can be seen that the following are the requirements of the three work centres Work Centre A: 4 Work Centre B: 5 Work Centre C: 3 Assumptions made in Capacity Calculation 1. The available number of working hours is given as 560. Since the given data pertains to working hours, it is assumed that this takes care of all breaks and interruptions to work, such as lunch and refreshment breaks. 2. The set up time for the production of the parts is assumed to be zero. In other words, it is assumed that the production of these parts will not require any set up. This assumption is justified because each workcentre is independent and is continuously running a single operation. This means that apart from one initial setup and possibly minor adjustments in between, the workcentres should run without any set up once they are started. 3. The utilization of the workcentres is assumed to be 100%. This assumption ignores any machine downtime for various reasons such as breakdown, power failure, lack of materials or labour, and planned maintenance. (Vorne industries, 2008) However, the actual number of machines planned for procurement is higher than the calculated number by a substantial amount in the case of each type of workcentre. This has occurred partly due to rounding off of fractional requirements. Where the rounding off involved marginal increases, as in the case of Workcentres A and C, the rounding off has been carried over to the next higher figure. Because of this, there is enough in-built cushion in the calculated figure to take care of lower utilization. 4. Interference or waiting times have been assumed to be zero. Interference and waiting times can arise because of unbalanced line in which some of the machines have less capacity than others causing a pile up at these centres. Waiting times can also occur when disparate products are being scheduled one at a time, and the schedules fail to take care of piling of jobs at the same time at a workcentre, causing some of the parts/products to wait. In the present case, there is a continuous production of five different products with the same processing times. Although this could lead to scheduling problems because of changeover from one product to another, in this particular case, it is unlikely to happen because all products take the same time to process. Moreover, there is sufficient cushion available in the capacities due to rounding off, to take care of any waiting time. Financial Viability Check The financial viability of the new plant is to be checked using the IRR method. The Operations Director (OD) has set a criterion for selection of projects based on the IRR of the project. According to this criterion, projects having an IRR of more than 30% are to be accepted, while those having IRR equal to or less than 30% are to be rejected. In order to test the present proposal the IRR was calculated using the data from the above capacity calculations, and additional data regarding the cost of manufacture and the cost of the workcentres. Given Data Revenue and Manufacturing Cost Selling price per piece = €50. Cost (Labour + Material) per piece = €40 Contribution Margin per piece = €10. Indirect costs are assumed to be nil, and hence the above cost is also the profit per piece. Cost of Workcentres The cost of workcentres and the total investment required are shown in Table 2. Equipment type Workcentre A Workcentre B Workcentre C Quantity Required 4 5 3 Cost per set of equipment 550000 220000 130000 Total Investment Required 2200000 1100000 390000 Table 2 Total investment required on all cost centres = 2,200,000 + 1,100,000 + 390,000 = 3,690,000 Profits and cashflows Profit per piece = €10 Number of pieces sold per quarter = 40,000. This figure is held steady over a period of five years. Hence annual profit for a period of five years = 10 x 4 x 40,000 = €1,600,000 for each year. This figure is the same for all the five years. The cash flows (outflow on account of investment in year 0, and inflow on account of profit for each of the five years) are shown in Table 3. Cash Flows Period 0 1 2 3 4 5 Purchase of Equipment -3690000 Profit 1600000 1600000 1600000 1600000 1600000 Table 3 The IRR for the project was calculated using MS-Excel. The IRR was found to be 32.9%. Since this is more than the threshold value of 30% fixed by the Operations Director, the project will be accepted. Assumptions 1. The given costs are only those of direct material and direct labour. There are bound to be other costs, including indirect manufacturing costs, selling costs, and administrative costs. These have been ignored. Since the calculated IRR value of 33% is only substantially higher than the threshold value of 30%, it is unlikely that consideration of the additional costs would change the decision. Hence ignoring these costs may not matter as far as the final decision is concerned. 2. No detail has been given about other related capital expenditure such as costs of installation, and these have been ignored. Inclusion of these costs will further push up the cash outflow in year 0, and thus bring down the IRR. However, it is unlikely that installation costs would be high enough to bring the IRR below the threshold level, and hence change the decision. In view of this, there will be no change in the decision to accept the project even if these costs are considered. IRR Method IRR is the rate of discount which gives a Net Present Value of zero. (Mcmenamin, 1999, p. 371) Net Present Value is the present value of all present and future cash flows (inflows and outflows), and is obtained by discounting the actual cash flows over a period of time at a certain rate. Thus IRR is the rate at which the present value of all present and future cash outflows and inflows is equal to zero. From this it is evident that an accurate estimate of the future cash flows expected to be generated from the project is critical to the correct computation of IRR. One of the problems with IRR is that it assumes that any surplus generated during the life of the project will be reinvested, and will yield the same return as the other investments. Thus IRR presupposes that enough avenues for reinvestment of available surplus will be available, and that these avenues will provide the same return as the basic project. (Polimeni, Handy & Cashin, 1993, p.157) Another problem with IRR, and indeed various other methods of investment appraisal, is that it ignores the risk factor. Estimates made about the returns likely to be generated by a project are assumed to be firm. In reality a number of external and internal factors may cause these estimates to change. Some of these are discussed in the following sections. Because of this, a more accurate assessment of an investment proposal should ideally take into consideration the various risk factors that are associated with a project. Current trends in investment appraisal techniques are tending towards provision for various systematic and non-systematic risks. (Holland, Ott & Riddiough, 2000, p. 33) These issues have a bearing on the discussion that follows regarding the Assumptions that are made in calculating the capacity and financial viability of this project, in the light of the global developments since 2008, and the current outlook. Viability of the proposal under current commercial climate The calculation of the economic and commercial viability of the proposal as above involves a number of assumptions, many of which may not be realistic under the current commercial conditions. Selling prices The input costs as well as the selling prices are assumed to remain constant over a period of five years. Most commodities are facing severe competition from emerging economies, and low cost countries, such as Mexico and China. In the face of such competition many manufacturers are either outsourcing their manufacturing operations or relocating production facilities to lower cost locations. The assumption that increased transportation and shipping costs coupled with increasing labour costs are rendering the outsourcing strategy less attractive has been negated by facts. (Sloane, 2010) Under such conditions, the assumption that selling prices will remain constant over the next five years is not very realistic. Prices are likely to face severe downward pressure. Manufacturing Costs The costs of several raw materials are likely to go up. Although this might sound paradoxical against the background of predicted fall in selling prices, this is very likely on account of two factors. Oil prices are likely to be pushed up once the economic recession ends. At the same time, the expansionary policies adopted by most countries as a stimulus to the economy are likely to result in inflation, pushing up costs and wages. (Makinen, 2008) Thus both the assumptions of prices and costs remaining constant are unrealistic given the current economic conditions, and margins are likely to fall considerably over the next five years. As Sloane (2010) observes, companies could assume that the strategies that they formulated could be valid for at least two to three years in the past. This is no longer true, and companies have to be constantly vigilant and review their strategies very frequently. In view of this, it is not very likely that the assumptions of stable costs and prices will hold over a period of five years. Interest Rates The choice of discount rates plays an important part in determining the relative merits of different projects, and in decision making regarding the acceptability of individual projects. (Liu, Rettenmaier & Saving, 2004) Interest rates have an impact on the financial analysis, and the decisions made based on them, because the discount rates used for calculating NPV, and benchmarking IRR for acceptance, are dependent on the cost of capital, which in turn is a function of the prevailing interest rates. According to the Macro Trader.Com (2010), interest rates are likely to remain static in the short-term up to the end of 2010. However, the long-term outlook for interest rates is definitely an increasing one as credit risk is likely to be higher. This means that the assumption of a static interest rate for the next five years is not realistic. What are the implications of this for the current proposal? Since the OD has assumed a cut-off rate of 30%, which is very high, the likelihood of the IRR going below the prevailing cost of capital, even with increased interest rates, is very low. However, the benchmarking against the current interest rates would have yielded a certain level of profitability, and this will certainly get reduced. Because of this, the criteria that impelled the OD to set a cut-off rate of 30% for IRR might shift to prompt a higher cut-off rate, which could for example be 35%. Exchange Rates Foreign Exchange Rates are volatile and movement in exchange rates between various currencies might be in any direction. The British Pound has weakened against the US dollar, and has reached very low levels against the Euro. The US dollar is no longer considered as safe as it used to be. (Barclays Commercial, 2009) The implications of all these for the proposed projects will again be on costs, and to some extent on selling prices. If the company buys from, or sells to, foreign countries, the impact on prices and costs is obvious. Even if the company does not have commercial transactions in any foreign country, the costs and selling prices of its competitors will be affected, and hence the company will also be indirectly affected. Cost of Capital The cost of capital is a function of the risk free interest rate and the risk perception associated with each type of investment. (Dayananda, Irons, Harrison, Herbohn & Rowland, 2002, p. 118) As discussed earlier, credit risk is likely to be higher in future, raising the cost of debt capital. In addition, the higher levels of uncertainty and volatility that are likely to prevail in the market might also increase the required rate of return. The movement of these values can be in either direction, but will impact the decision by altering the cut-off value for acceptable IRR values. References 1. Barclays Commercial (October 12, 2009) Interest and Exchange rate Outlook. Retrieved on March 24, 2010 from http://docs.google.com/viewer?a=v&q=cache:XiZi-yMw7wAJ:www.business.barclays.co.uk/BBB/A/Content/Files/Interest_and_Exchange_Rate_Outlook.pdf+exchange+rate+outlook+2010&hl=en&gl=in&pid=bl&srcid=ADGEESjR6rShHnOybxlWijVSMn8VevMAn1wFgFJPcTEmY8dIA9f7FXAeKnhM1DJfBt5sdGC1eWMSRjd_pLRxln4_u8mVTytqlk_4Zh63V1DKJabW0-AJCK_wBzrpHCBctcLbjD-ESKzn&sig=AHIEtbQDuhUZCPiKTtDctQ9ILIjK5CXhUA 2. Dayananda, D., Irons, R., Harrison, S., Herbohn, J., & Rowland, P. (2002). Capital Budgeting: Financial Appraisal of Investment Projects. Cambridge, England: Cambridge University Press. 3. Holland, A. S., Ott, S. H., & Riddiough, T. J. (2000). The Role of Uncertainty in Investment: An Examination of Competing Investment Models Using Commercial Real Estate Data. Real Estate Economics, 28(1), 33. 4. Liu, L., Rettenmaier, A. J., & Saving, T. R. (2004). ‘A Generalized Approach to Multigeneration Project Evaluation’. Southern Economic Journal, 71(2), 377+. 5. Makinen, G.E. (August 22, 2008). CRS Report for Congress: Current Economic Conditions and Selected Forecasts. Retrieved on March 24, 2010 from http://italy.usembassy.gov/pdf/other/RL30329.pdf 6. Mcmenamin, J. (1999). Financial Management: An Introduction. London: Routledge. 7. Polimeni, R.S., Handy, S.A., and Cashin, J.A. (1993). Schaum’s Outline of Theory and Problems of Cost Accounting. New York: McGraw-Hill. < http://books.google.co.in/books?id=WLJtZfo08DYC&printsec=copyright&source=gbs_pub_info_s&cad=3#v=onepage&q=&f=false> 8. Sloane, E. (February 3, 2010).U.S. Manufacturing Slides in Cost-Competitiveness Study. Managing Automation. Retrieved on March 24, 2010 from http://www.managingautomation.com/maonline/news/read/U_S__Manufacturing_Slides_in_Cost_Competitiveness_Study_33263 9. The Macro Trader.Com (Januray 13, 2010). Global Interest rate Outlook. Retrieved on March 24, 2010 from http://www.themacrotrader.com/2010/01/13/global-interest-rate-outlook/ 10. Vorne industries (2008). The Fast Guide to OEE. Retrieved on March 24, 2010 from www.vorne.com/pdf/fast-guide-to-oee.pdf Read More