Financial Management: Marginal Costing Capital Budgeting (Case Study Sample)

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Financial Management
Case Summary
Kate took an early retirement at the age of 58 after working for a financial service company for 30 years in Germany. She received a lump sum after-tax payment of €570,000 from her employee and needs to assess the viability of a venture. Kate is contemplating a new career as a retailer dealing with coated nuts imported from the US. She requires a financial plan to assess the viability of the proposed venture. ‘Only Nuts Inc.’, a US producer of coated nuts offers Kate exclusive rights to sell their products in exchange of upfront payments of these rights. She has an estimate of costs accruing from operations, which include expenses on freight, refrigerators for preserving stock, rent of a small industry room, web development, and the buying price of stock. Kate has already incurred sunk costs in market research and established a projection of sales over the next five years, which are cash inflows to the venture. Costs for the above study do not factor in the review; Kate cannot recover them irrespective of the investment option selected. The study also identified the average selling price of a pound of coated nuts in the German market in addition to costs accruing from packaging and shipping of products within the country. Additionally, the research identifies the cost of using credit cards to receive payments for sales made over the internet. Furthermore, Kate has an estimate of the annual wage bill and believes that it is essential to outsource funds to support establishment and operations of the new venture. Noted is the difference in the use of standard units of measurement; the Germans use € and kilogram (kg) and $ and pounds (lb.) for the Americans in valuation of currency and measurement of mass respectively. The researcher will convert dollars into euro and pounds into kilograms to standardize the metrics for analyzing the viability of the proposed venture. At the current conversion rate, $1 is equivalent to €0.95 and 1 lb. is equal to 0.453592 kg. These are some of the assumptions of the review.
Break-even analysis
Marginal costing complements the decision making process of Kate in analyzing viability of the proposed retail venture. The technique will only consider variable costs (V.C.) when establishing the cost of sale of a unit of coated nuts and overlooks fixed costs (F.C.). Kate should expect to incur marginal production cost per unit for freight, packaging and shipping, credit card commissions, and boxes and decorative papers. The difference between these variable costs and turnover yields contribution, which helps in covering fixed costs accruing to the venture. The principal of marginal costing is that periodic fixed cost of the retail business will remain the same over the forecast period irrespective of the sales volume. Sale of additional units of coated nuts should subsequently yield increase in turnover, variable costs, and profit contribution; the converse would result from a decrease in output. Fixed costs, such as rent, special refrigerator, part-time wages, and website development do not have an effect on the volume of output. A benefit credited to the use of the technique is simplicity in operations and avoids either over or under absorption of accruing overheads. Furthermore, it does not apportion fixed costs, which happens frequently on arbitrary basis, and information derived complements the decision-making process.
An application area of the marginal costing concept is in preparation of a break-even analysis for the venture. A break-even analysis with cost and revenue estimates will enable Kate to establish the amount of turnover required to cover all accruing costs without making a profit. Table 1 below shows the process of computingCITATION Eny05 \p 8 \l 1033 (Enyi 8).
Option 1
Table SEQ Table \* ARABIC 1: Online Sales option contribution
Contribution= Sales turnover-Total variable expenses.
At the break-even-point, the total number of coated nuts sold by the retailer should cover accruing fixed and variable expenses.
Table SEQ Table \* ARABIC 2: Break-Even-Point Online Sales
The total number of coated nuts that the retailer should sell to cover the above fixed costs and variable costs in table 2 is 709 kilograms; at this level, Kate will not make a profit or loss. The contribution level for the venture is constant over the years. However, the break-even-point reduces for year 2 to 5, as indicated in table 3 below, due to a decrease in fixed costs.
Table 3: Break-even-point Option 1, year 2 to 5
The break-even-point for option 1 reduces from 709 to 428kgs, and this is due to elimination of non-recurrent fixed costs, which are the cost of purchasing a special refrigerator and the three-month deposit for the small industrial room.
Option 2
Table 4: Online Sales + Gustav opportunity option contribution
The contribution margin yielded from investing in online sales and Gustav opportunity provides more contribution per kilogram as compared to only focusing on the former venture and overlooking the latter. Kate should consider pursuing both options to safeguard maximization of the retirement benefits.
Table 5: Break-Even-Point Online Sales + Gustav option
Furthermore, the break-even-point in option 2 above is less than in option 1. This signals to Kate that she has to stock more than 398 kilograms of coated nuts to make a profit after covering all accruing fixed and variable costs in option 2 and 709 kg for option 1. From this, it is apparent that option 2 stands to maximize Kate’s retirement benefits.
Table 6: Break-even-point Option 2, year 2 to 5
The break-even-point for year 2 to 5 reduces to 254 units down from 398 kilograms in year 1. This offers Kate an opportunity for establishing the optimal monthly level of stock for coated peanuts required to cover all fixed and variable costs and attain a predetermined profit margin. Furthermore, the break-even-point for the second and subsequent years in option 2 is less than the 428 in option 1; this makes the former venture attractive as compared to the latter.
An assumption underlying the use of the technique is possible classification of fixed and variable costs and their designated range in addition to the level of production. Moreover, the unit variable costs estimated by Kate should remain constant over the review period and they should have a direct relationship with the volume of output. The fixed cost of the venture should also stay constant over the 5-year review period irrespective of the level of activity and inventory changes should be insignificant to safeguard the analysis from impairment. Another assumption is that the technological requirements of the venture will not change and the selling price will not fluctuate over the forecasted period. Moreover, stock levels of coated nuts should remain constant at the pre-established level to match the estimated demand.
Preparation of a cost volume and profit (CVP) analysis can further complement the decision-making process; it examines relationships between expenses, output, and profitability. The technique complements financial planning activities, such as: establishing the effect of changes in product mix and production methods, viability of special sales promotion initiatives, and the effect of price changes on profitability. Furthermore, CVP offers another method for computing the break-even-point of the retail venture. This analysis technique factors in changes in the business environment that affect generation of revenue and accruing costs. An increase in prices in future, for example, may prompt Kate to offer customers a sales discount; CVP establishes the effect of such actions on the contribution sales ratio, which measures the rate of profit generation of a venture. Additionally, it factors in the effect of inflation on the forecasted costs and acknowledges possibility of a drop in overhead expenses due to efficient placement of orders with other suppliers who offer better terms. Moreover, it offers an opportunity for analyzing the effect of changing the product mix of coated nuts as a strategy, as is the case with the Gustav investment option. The CVP and break-even-analysis complement short run operational decisions, such as ensuring that inventory levels are at optimal levels to achieve objective of the business plan. Additionally, both techniques can assist Kate in determining viability events in relation to future operations while making short-term tactical decisions.
Budget forecast
Budget planning and control will assist the researcher in quantifying plans of the retail venture so as to enable Kate achieve her wealth maximization objective in the 5-year period. A master budget will quantify all accruing incomes and expenditures of the venture, which incorporates production and non-production budgets CITATION Pri13 \l 1033 (Price Waterhouse Coopers). The sales budget will indicate the volume of coated nuts sold over the 5-year based on the forecast data gathered from the market research and the established re-ordering period. The production budget will provide a forecast of import of finished goods from a manufacturer in the US based on their monthly stock level policy. The direct labor budget forecast the human capital requirements essential in meeting the requirements of the venture in the period under review. The factory overhead budget will have a forecast of Kate’s fixed and variable costs for the 5-year period of operations. Non-production budgets, on the other hand, will comprise costs on administration, selling and distribution, and capital expenditure. These will assist in preparation of the income statement and balance sheet for the forecast period. Preparation of a projected balance sheet will enable Kate to establish changes in the future financial...