ABC Company - Research Paper Example

? ABC Company Cedar roofing and siding shingles are recognized all over the world for their attractive nature and beauty they add to homes. It is for this reason that they are on high demand from new homeowners and construction companies. There are a number of companies in the US that deal with Cedar roofing and siding shingles. Therefore ABC Company is operating in a very competitive market. However, the demand for these products is still high owing to the high rate of upcoming real estate ventures. Besides facing competition from other companies that deal with cedar in making roofing and siding shingles, ABC also faces competition from products made of iron and clay, which are operating in the same market. However, cedar products have a higher competitive advantage over similar products in the market made of iron or clay. The main disadvantage of cedar roofing and siding products is the attached price, which might lead to potential buyers resolving for cheaper iron products. ABC Company is therefore likely to maintain its growth with minimal deviation either downwards or upwards. These deviations may be because of the harsh economic times forcing many homeowners to prefer cheaper iron products or clay products for their roofing and siding. Environmental conservation movements are also affecting the industry negatively (Sparrow Exteriors, 2013). These conservation policies are in turn making the cost of raw materials for cedar roofing tiles to be more expensive. Indulging into a new project such as building the dollhouse could be a viable solution for the company to meet its target goal of $3 million in the next three years. ABC Company’s Cash Flow Cash Flow from operating activities Cash paid to customers Sales 1,200,000 Dividends 100,000 Cash 70,000 (50,000) 20,000 Accounts receivable 120,000 (180,000) (60,000) 1,280,000 Cash Payments to Suppliers Cost of goods sold 800,000 Beginning AC payable 250,000 Ending AC payable (210,000) 40,000 (840,000) Cash Payments to Employees Units produced 80,000 Labor Payment per unit 2.80 (224,000) Cash Payments for operating expenses Equipment 100,000 Selling and administrative expenses 250,000 (350,000) Cash Payments for Income Tax Beginning Income Tax payable 40,000 Ending Income tax payable (10,000) (30,000) Net cash flow from operating activities (164,000) Analysis of ABC Co.’s Cash Flow A company’s operating cash flow indicates the revenue generated from doing business over a specified period less the operating expenses (Howell & Bain, 2008). This is an important process since it helps a company determine whether the business has a healthy financial position between the one given on paper and the one that is applicable in practice. From the results of ABC’s operating cash flow, the company is experiencing a negative cash flow. Although this is normal sometimes, it is still a cause for alarm to the company management. The situation indicates that the company is spending more money than it is receiving. This is a common phenomenon with new companies, however, the situation is dangerous if persistent over the long run (Lerner, 1995). There are several reasons for a negative cash flow but the main causes include poor debt collection, high operating costs, and bad business decisions. In the case of ABC Company, there are three likely reasons for the negative cash flow. These are high costs of goods sold which mostly consists of purchases. The other reason is poor debt collection, the company’s accounts statement indicates that the net accounts receivable were still very high with a small margin having been collected compared to the previous period’s accounts. The third reason is the nature of the company, with a 25% growth in sales it means the company is a fast growing company, which results into significant increase in the company’s working capital. To improve the cash flow situation at ABC, the company needs to reduce its spending and increase its sales (Laughlin, Bebbington, & Gray, 2001)However, the best option in this situation will be to increase its sales as targeted by management. In this case if the $3 million target is reached and the rate of operations is maintained, it would mean that the business could the business will be making an approximate cash flow of more than $1.5 million. The other options that will aid in achieving this situation are creating a strict budget that the company should follow throughout its operations (Laughlin, Bebbington, & Gray, 2001). Finally, the company should ensure that they collect all or higher percentage of their accounts receivable. The cash flow at the company cannot be used to finance the new project. This is because of the negative nature of the current cash flow. The company is spending too much money on its current operations. This in turn means that it is not able to make enough money to finance additional operations or projects. Therefore, the proposed project will have to be financed through other means. The best option the company has for financing the new product is through equity financing. Debt financing could have been a viable choice if the status of the company showed a positive cash flow (Lerner, 1995). However, the situation indicate that the company would not be able to pay off the interest rates that would amount from debt financing, therefore, its better if the company tries equity financing. Besides, the reason for not having a positive cash flow to set off the debt, there are other several advantages of using equity financing. These advantages include: Low risk compared to loans Profits are not channeled into loan repayments There is more cash at hand to finance more activities Investors do not have to be paid back their investment in the event the business or project fails (Edgett & Jones, 1991). Using the provided details on the product’s costs in terms of overhead the unit price for the current product is give as follows Materials cost 1.30 Labor 2.80 Selling expense 0.20 Factory overhead 1/ (40000/80000) 2.00 Fixed selling exp. 2.39 Fixed overhead 4.95 Total cost 13.64 The total cost that will be used for the expansion product without incorporating fixed costs will be as follows Labor 4.00 Material cost 5.60 Selling expense 0.20 Factory overhead 1.00 Total cost 10.80 When the new product is manufactured, the selling expense fixed cost will remain increase since the number of products being manufactured will have increased by 5,000. Therefore the new selling expense fixed cost will be = 85,000 ? 2.39 = $203,150 Since the company had an extra, 5,000 machine hours that will be used for the new product it means that the factory overhead fixed costs will remain the same. This is because the company uses machine hours to set overhead fixed costs and since there will be no expansion in the machine hour with the new products, it also means there will be no changes in the factory overhead fixed costs. Basing on the fact that the new products absorbs some of the selling expense fixed costs the new resulting fixed per unit will be as follows: = (198,000/45,000) = 4.40 The cost for producing each unit has reduced by = (4.95-4.40) = $0.55 Therefore, the total cost for producing the current product will reduce to = (13.64 – 0.55) = $13.09 For a 40 percent gross margin on the new product the company can set the selling price at Initial cost = 10.80 Cost including fixed costs = (10.80 + 4.40 + 2.39) = 17.59 40% margin = (0.40 ? 17.59) + 17.59 New selling price = 24.63 To find out the contribution margin for each product and the break-even points for the product we carry out the following calculation. First, we identify the sales mix percentage Current product (85000/80,000) ?100 = 94.12% New product (5000/85000) ?100 = 5.88% Sales mix of the products Current product New Product Selling price 14.50 24.63 Variable cost 5.30 10.80 Percentage mix 94.12% 5.88% Total fixed cost 401,203 Contribution margin for the product Current product New Product Selling price 14.50 24.63 Variable cost (5.30) (10.80) Contribution margin 9.20 13.83 Units of sales mix required to reach break-even point Break-even point of units of sales mix = Total Fixed Cost ? Weighted Average contribution margin per unit Weighted average contribution margin per unit of sales mix Current Product contribution margin ? current product sales mix percentage Add New Product contribution margin ? new product sales mix percentage = Weighted average unit contribution Current product New Product Selling price 14.50 24.63 Variable cost (5.30) (10.80) Contribution margin 9.20 13.83 Percentage mix x 94.12 5.88 8.66 0.81 Total: weighted average unit contr. 9.47 Break-even point in units of sale mix 401,203 ? 9.47 = 42,365.68 Number of units for each product at break-even point Current Product New Product 94.12% 5.88% 42365.68 42365.68 Number of units at break-even 39,875 2,491 Break-even point Current Product New product Number of products 39,875 2,491 Price per unit 14.50 24.63 Sales 578,187.50 61,353.33 Break-Even Point $639,540.83 year Investment ($) Cash Flow ($) Present factor at 12% PV 0 42000 1 (42000) 1 15000 0.8929 13392.86 2 13000 0.7972 10363.52 3 10000 0.7118 7117.80 4 10000 0.6355 6355.18 5 6000 0.5674 3404.56 NPV (1366.08) The resulting NPV for the new project with a 12 percent rate of return will be negative. = -$1,366.08 Straight-line depreciation is the most used depreciation method by majority business in financial accounting. The method distributes the cost of an asset to equal values over the life span of the product (Merrit , 2013). Putting in mind that straight-line depreciation expense is equally distributed for each year of the investment life cycle; it can be seen as a fixed cost. It is an expense since it reduces the value of a fixed asset. For the case of products variable costs, depreciation does not affect them since it is a fixed cost; however, it affects the average cost of the product since it is incorporated in the fixed costs. This also applies in the case of profit, since the depreciation expense is equally distributed for each year; the profit for each year is also reduced by a uniform amount. Depreciation does not require cash to be spent (Merrit , 2013). Therefore, depreciation only affects the profit for each year but does not affect the cash. It is therefore irrelevant to indicate depreciation on cash flow statements. Purchasing the new equipment will not be a very viable option for ABC Company. Putting into consideration the cash flows generated from the new equipment and the net present value of money, the resulting value is negative. A negative Net Present Value means the project is likely to generate negative cash flows over its life span. This therefore, indicates a strain on the company’s budget and an alarming increase in company costs. Conclusion After reviewing ABC’s financial situation, it is clear that the company is likely to meet its set target in three years’ time. However, the company is also faced with a number of risks. The first being its nature of operating cash flow. The company needs to take up the necessary precautions in order to avoid a consistent situation such as the one it is in right now. The other risk the company is facing is its choice of finance for the new project. If the company resolves to using debt or equity, financing it will still face a number of risks. In the case of debt finance, the company faces the risk of accumulating more costs because of interest. Further, if the company fails to reach its targets and the overall business fails, then the company could lose everything in repaying loans. The other risk is with equity financing, with current situation of the company, it is likely to have a rough time convincing investors to put in their money. The third risk involves purchasing of the new project’s equipment. After assessing the projected cash flows from the project, it is evident that it is not a viable business venture. However, since the cash flow only reflects at fixed cost there is a high chance when all costs are considered the new equipment could of great benefit to the company. Being the company’s controller, my objective is to create a strict budget and assess all the employees towards the project so that I can ensure everything goes according to the set budget limits. The CEO should undertake the new project. After carefully consideration of its profit margin and the costs involved, the project is likely to help the company meet its target. References Edgett, S., & Jones, S. (1991). New product development in the financial service industry: A case study. Journal of Marketing Management, 7(3), 271-284. Howell, P., & Bain, K. (2008). The economics of money, banking and finance: A European text (4th ed.). Harlow: Prentice Hall. Laughlin, R., Bebbington, J., & Gray, R. (2001). Financial accounting: practice and principles (6th ed.). New York: Cengage Learning. Lerner, J. (1995). Venture Capitalist and the Oversight of Private Firms. The Journal of Finance, 301-318. Merrit , C. (2013). The Straight-Line Depreciation Method & Its Effect on Profits. Retrieved from Business and Entrepreneurship: http://yourbusiness.azcentral.com/straightline-depreciation-method-its-effect-profits-9166.html Sparrow Exteriors. (2013). cedar shake and roofing shingle. 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