As the financial consultants of Catawba Industrial Company our aim is to determine the best course of action to pursue with respect to the introduction of the new proposed light weight compressor. This course of action must remain within the production capacity restrictions the company faces.
The company will continue to produce the standard compressor to satisfy the requirements for the automatic paint system and the demand that currently exists for this product. Introduce Light Weight Compressor:
The company will introduce the new light weight compressor to replace the standard unit in the automatic paint system and to satisfy any demand that might exist through industrial distributors. Mixed Proposal:
The company will continue to produce ten standard units necessary for the automatic paint system. After the demand is met for the automatic paint system, the new light weight compressor will be produced and sold to meet the projected demand.
Criterion: To maximize future cash flows
When deciding the best alternative, the company should choose the one that will maximize future cash flow. Cash flows are cash transactions that either cause the company to spend or receive actual monetary units. The decision may change the level of operation, meaning it will affect both costs and revenues; therefore, the decision should maximize the net difference between the two. This will allow for the highest possible profit within the production capacity of the warehouse. The company cannot change what has happened in the past, therefore must focus on cash flows that affect the company in the future. Lastly, cash flow is the only factor that the company can influence in the short run. If this is managed properly, in the long run net income will follow the trend of cash flows.
The following table explains what cost accounts are relevant to the decision criterion. The costs are relevant because they differ under one set of conditions than they would be under another.
(Variable)There are two components to direct labour, hours and wages. Since the required hours for the light weight compressor is less than the standard, the variable cost per unit is going to change. (100 hours for standard, 62.5 hours for light weight)
(Variable)The light weight compressor can be produced on new numerical control machinery, so it requires less materials then the standard unit. Therefore, the variable cost per unit will change depending on what compressor is produced. Other Direct Charges
(Variable)Since other direct charges consist of material handling, if materials decrease, the amount of materials to handle will decrease as well. Other Mfg Overheard
(Variable)A simplifying assumption was used because there is no direct indication of the relevance of this cost. However, the exhibits show that the cost differs between the two compressors, so the assumption was made that it is a relevant cost. A sensitivity analysis will be performed to show the effects, in case this assumption is incorrect. Depreciation (Partial)
(Fixed)This is a one-time cost for the company rather than the variable charge indicated in the two exhibits provided. $218,000 is relevant because it is a necessary future cash outflow if the company chooses to manufacture the light weight compressors. Non-Relevant Costs
Depreciation per UnitDepreciation is not a cash flow, but is an allocation of historical cash flows. Depreciation is a sunk cost that has occurred in the past when the purchase of capital equipment occurred. A sunk cost is a cost that cannot be recovered therefore is not relevant in your decision making process Extra Hardware and HoistsThe company already installed these improvements, therefore they are historical costs and do not affect the future decision. SalesSales expenses are actually a set fixed cost but are...