Financial Controls in Project Management Activities

Objective

Complete hands-on exercises to apply cost control techniques

Cost Budgeting

Activity (1)

Robots R Us estimates to invest the following in a project to make sophisticated robotic toys for children.

Design$90 million

Engineering$110 million

TOTAL$200 million

The total cost of the project is $200 million of which $40 million is invested by the company in cash and the balance $160 million is obtained through a bank loan. It is agreed that the loan principal will be repaid by 5 equal end of year payments of $32 million. The interest on the loan is 10 percent per annum and will be paid at the end of the year based on the remaining balance of the loan.

The company estimates that its sales will be 100,000 robotic toys per year. The anticipated selling price is $700 per robotic toy and sales are expected to grow at 20,000 robots per year. The anticipated operating and maintenance costs are $50 million the first year and, due to production efficiencies, it is expected t decrease by $3 million per year. The effective tax rate is 40.%. The design and engineering costs are capitalized and the depreciation of the equipment manufactured to produce the robotic toys is based on MACRS.

For tax purposes, under MACRS, the equipment is depreciated over six calendar years and the percentages are as follows:

Year Percent

120.00

232.00

319.20

411.52

511.52

6 5.76

Required

  1. Prepare a statement showing the cash flows for the business.
  1. Compute the net present value (NPV) and determine if the project is feasible.
  1. Compute the internal rate of return (IRR) of the project.
  1. What additional factors may have to be taken into account in deciding whether to go ahead with the project?
  1. Would you recommend the project? Why or why not?

Solution to parts (1) and (2)

All numbers in 000’s

Outflow* / Additional
Outflow** / After tax
Net inflow*** / Depreciation
Cash savings**** / Salvage
Value of
Equipment
***** / Net Cash / Discount
@15% / Present
worth
Yr 0
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6 / (40,000) / (32,000)**
(32,000)
(32,000)
(32,000)
(32,000) / 2,400
14,520
26,640
38,760
50,880 / 16,000
25,600
15,360
9,216
9,216
4,608 / 34,680 / (40,000)
(13,600)
8,120
10,000
17,976
62,776
4,608 / 1.0
.87
.756
.658
.572
.497
.432 / (40,000)
(11,832)
6,138
6,580
17,976
31,200
1,990

Net present value 12,052

WORKINGS FOR PARTS (1) AND (2)

* Note 1

Cash paid for equipment= (200,000)

Loan obtained=160,000

Net cash outflow=40,000

** Note 2

Additional outflow is the principal repayment on the loan $32,000 per year. (You do not get a tax saving on this)

***Note 3

Please see workings below

(All numbers in 000s)

Inflow
(Sales) / Outflow
(Operating costs) / Outflow
(Interest on loan) / Net inflow / After tax inflow
Tax @ 40%
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6 / 70,000
84,000
98,000
112,000
126,000 / (50,000)
(47,000)
(44,000)
(41,000)
(38,000) / (16,000)
(12,800)
(9,600)
(6,400)
(3,200) / 4,000
24,200
44,400
64,600
84,800 / 2,400
14,520
26,640
38,760
50,880

**** Note 4

To get cash savings from MACRS depreciation you multiply the depreciation by the tax rate.

Depreciation Tax @40%Cash savings due to tax

Yr 140,0000.416,000

Yr 264,0000.425,600

Yr 338,4000.415,360

Yr 423,0400.49,216

Yr 523,0400.49,216

Yr 611,5200.44,608

*****Note 5

First you have to compute profit from sale of equipment

Market value $50,000

Book value$11,520

Profit on sale$38,480

Tax on profit @40%$15,392

Second you now have to compute net cash inflow from sale

Salvage value $50,000

Less tax$15,392

Net cash collected$34,680

Solution to part (3)

Outflow* / Additional
Outflow** / After tax
Net inflow*** / Depreciation
Cash savings**** / Salvage
Value of
Equipment
***** / Net Cash / Discount
@32% / Present
worth
Yr 0
Yr 1
Yr 2
Yr 3
Yr 4
Yr 5
Yr 6 / (40,000) / (32,000)**
(32,000)
(32,000)
(32,000)
(32,000) / 2,400
14,520
26,640
38,760
50,880 / 16,000
25,600
15,360
9,216
9,216
4,608 / 34,680 / (40,000)
(13,600)
8,120
10,000
17,976
62,776
4,608 / 1.0
.757
.573
.434
.329
.249
.189 / (40,000)
(10,303)
4,660
4,348
5,921
15,662
870

Net present value (18,842)

To compute IRR you have to find a discount rate that generates a negative net present value. Now, we have a positive net present value at 15% i.e., 12,052 and a negative net present value, i.e., (18,842) at 32%. If you see the graph below, for a change of 17% the net present value changes by a total of 30,894. If we take the distance from 15% to the point at which NPV is 0 as X, then

X / 17 = ( 12,052 \ 30,894) times 17

X = 6.63

Hence the rate of return where NPV is 0 is 15 plus 6.63. The IIRR is 21.63%.

This is the exact rate of return of the project.

Solution to part (4)

The additional factors that have to be taken into account to decide whether to go ahead with the project are:

Financial

How accurate are the projected numbers? How sensitive is the project to even a 5 percent decrease in anticipated revenue or increase in projected costs?

Technological

Is there any possibility of new technology that could make our system and products obsolete?

Economic

Is there a chance of a recession that could adversely affect the projected numbers? This include the possibility of inflation and interest rate hikes

Legislative

Does this project create waste that is difficult to dispose of in the traditional way? Is there a chance of environmental legislation that could adversely affect waste disposal? Are there any other legislation that the company should be concerned about?

Competitors

Who are the key competitors? What are the competitors doing that could adversely affect this business?

Ethical

Is there any possibility that existing work force and personnel could be laid off as a result of this project? What are the social costs to the community in such a case?

Activity (2)

The QQQ Manufacturing Company prepared a budget for manufacturing overhead for the month of January 200X. The budget is shown below:

QQQ Manufacturing Company

Manufacturing overhead static budget

January 200X

Production in units / 90,000
Variable Overhead:
Power
Repairs
Payroll
Miscellaneous
Total Variable Overhead / $2,700
4,500
63,000
9,000
79,200
Fixed Overhead
Superintendence
Factory rent
Maintenance
Indirect labor
Depreciation of equipment
Miscellaneous
Total Fixed Overhead
TOTAL OVERHEAD / $8,000
10,000
3,000
5,000
12,000
4,000
42,000
$121,200

At the end of the month it was determined that only 80,000 units were produced.

Required:

Question 1

Prepare a static budget showing the variances between actual and budgeted numbers.

QQQ Manufacturing Company

Manufacturing Overhead Performance Report

January 200X

Budget / Actual / Variance
Units / 90,000 / 80,000 / 10,000
Variable Overhead
Power
Repairs
Payroll
Miscellaneous / $2,700
4,500
63,000
9,000 / $2,500
4,200
56,800
8,500 / $ 200 F
300 F
6,200 F
500 F
Total Variable Overhead / 79,200 / 72,000 / 7,200 F
Fixed Overhead
Superintendence
Factory rent
Maintenance
Indirect labor
Depreciation
Miscellaneous / 8,000
10,000
3,000
5,000
12,000
4,000 / 8,500
10,000
2,500
5,200
12,000
4,300 / 500 U
0
500 F
200 U
0
300 U
Total Fixed
Overhead / 42,000 / 42,500 / 500 U
TOTAL OVERHEAD / $121,200 / $114,500 / $6,700 F

Solution

The chart above is called a static budget performance report. Here, you compare actual performance with the static budget. In evaluating this performance report, managers would first compare the actual production to the budgeted production to determine if there is a difference, and, if so, why the difference occurred. The results show that, during January, the company produced 10,000 fewer units than anticipated. This might have been a planned reduction due to an unexpected reduction in sales, or it might have been a production shortfall due to problems in the factory. If the former is the case, no management action is necessary. If the latter occurred, management should take action because of the failure in effectiveness.

Required

Question 2

What is your opinion of this report? Is this report meaningful, why or why not?

Solution

The report is not meaningful. It is highly unlikely that, for any given period, actual production will coincide exactly with budgeted production. Thus, a single static budget is usually useful only for planning but not for controlling. To be meaningful, the company has to “flex” the static budget and prepare a flexed budget.

Required

Question 3

Prepare a flexed budget, compute the variances and comment.

Solution

QQQ Manufacturing Company

Manufacturing Overhead Performance Report

January 200X

Budget / Actual / Variance
Units / 80,000 / 80,000 / 0
Variable Overhead
Power @ .03
Repairs @ .05
Payroll @ 0.70
Miscellaneous @ 0.10 / $2,400
4,000
56,000
8,000 / $2,500
4,200
56,800
8,500 / $ 100 U
200 U
800 U
500 U
Total Variable Overhead / 70,400 / 72,000 / 1,600 U
Fixed Overhead
Superintendence
Factory rent
Maintenance
Indirect labor
Depreciation
Miscellaneous / 8,000
10,000
3,000
5,000
12,000
4,000 / 8,500
10,000
2,500
5,200
12,000
4,300 / 500 U
0
500 F
200 U
0
300 U
Total Fixed
Overhead / 42,000 / 42,500 / 500 U
TOTAL OVERHEAD / $121,200 / $114,500 / $2,100U

The flexed budget shows that the performance, overall is actually unfavorable. Managers use a technique called variance analysis to determine who is responsible. For the variable overhead the variances can be broken down into (a) spending variance and (b) efficiency variance. Generally, the department supervisors will be responsible for spending variance and the factory manager will be responsible for efficiency variance. However, an unfavorable spending variance is not necessarily the fault of the supervisor. States may have increased electricity charges etc hence increasing the total spending of the departmental managers.. Similarly, efficiency variances may not always be attributable to the production manager. It could be due to no fault of the manager. Hence, both variances are broken down into (a) controllable and (b) uncontrollable. Managers are held responsible for the controllable components only.

1