Administrative Overhead A proportion of general administrative overhead is

Administrative overhead a proportion of general

This preview shows page 32 - 36 out of 40 pages.

Administrative Overhead : A proportion of general administrative overhead is allocated to the container department. Is this cost proportional to the number of employees in the container department? Apparently the answer is yes, and in this case it is not the best estimate because it is not considering the real administrative resources consumed by the container department. Quality of Outsource Services : Quality issues are always important when a company is considering outsourcing some services. In this case, it is assumed that Packages, Inc. will perform maintenance and/or make containers with a quality at least as good as Liquid Chemical’s quality. Due to the importance of quality, Liquid Chemical Co. should carefully evaluate Package Inc.’s ability to meet quality requirements imposed by Liquid Chemical. Container Contract Terms : Does Packages Inc. have the ability to meet Liquid Chemical’s future container needs? Time Horizon and Inflation : Is the price locked in for five years regardless of inflation? Employees : The effect of eliminating some employees may have a detrimental effect on the morale of remaining employees.
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7-33 Solutions 7.65 continued Incremental Cash Flow—Alternative A: Make Containers and Perform Maintenance Year of Operation 0 1 2 3 4 5 Buy GHL $ (240,000) Tax Savings on Purchase 96,000 Cash Flow on Purchase $ (144,000) Other Materials $ (500,000) $ (500,000) $ (500,000) $ (500,000) $ (500,000) Labor: Super- visor (50,000) (50,000) (50,000) (50,000) (50,000) Labor: Workers (450,000) (450,000) (450,000) (450,000) (450,000) Rent: Ware- house (85,000) (85,000) (85,000) (85,000) (85,000) Maintenance (36,000) (36,000) (36,000) (36,000) (36,000) Other Expenses (157,500) (157,500) (157,500) (157,500) (157,500) Manager’s Salary (80,000 ) (80,000 ) (80,000 ) (80,000 ) (80,000 ) Total Costs $(1,358,500) $ (1,358,500) $ (1,358,500) $ (1,358,500) $ (1,358,500) Tax Savings 543,400 543,400 543,400 543,400 543,400 Cash Flow due to Costs $ (815,100) $ (815,100) $ (815,100) $ (815,100) $ (815,100) Tax Effects of Depreciation $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ -- Tax Effects of GHL Costs $ 80,000 $ 80,000 $ 80,000 $ 80,000 $ -- Total Cash Flow $ (675,100) $ (675,100) $ (675,100) $ (675,100) $ (959,100) Discount Rate 10% Factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209 PV $ -- $ (613,727) $ (557,934) $ (507,213) $ (461,102) $ (595,526) NPV $ (2,735,502) (See Following Page for Considerations)
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Solutions 7-34 7.65 continued Considerations: Under this alternative, GHL consumption is 40 tons per year. At the end of Year 4 the GHL stock is zero, and a purchase of 40 tons is necessary. At that time, the price will be $6,000 per ton. There is no cash outflow due to GHL consumption from Year 1 to Year 4, just “accounting” expenses because the product is in stock. Due to these GHL expenses, there is tax savings of $80,000 per year (= 40 tons X $5,000/ton X 40%) from Year 1 to Year 4. It uses straight-line depreciation, resulting in depreciation expense of $150,000 per year (= $1,200,000/8 years). It generates a cash inflow of $60,000 per year (= $150,000 X 40%) from Year 1 to Year 4 because the book value of the machinery at the beginning of Year 1 is $600,000.
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7-35 Solutions 7.65 continued Incremental Cash Flow—Alternative B: Make Containers and Buy Maintenance Year of Operation 0 1 2 3 4 5 Buy GHL $ (120,000) Tax Savings on Purchase 48,000 Cash Flow on Purchase $ (72,000) Other Materials $ (450,000) $ (450,000) $ (450,000) $ (450,000) $ (450,000) Labor: Super- visor (50,000) (50,000) (50,000) (50,000) (50,000) Labor: Workers (360,000) (360,000) (360,000) (360,000) (360,000) Rent: Ware- house (85,000) (85,000) (85,000) (85,000) (85,000) Maintenance (36,000) (36,000) (36,000) (36,000) (36,000) Other Expenses (92,500) (92,500) (92,500) (92,500) (92,500) Manager’s Salary (80,000) (80,000) (80,000) (80,000) (80,000) Maintenance Contract (375,000 ) (375,000 ) (375,000 ) (375,000 ) (375,000 ) Total Costs $(1,528,500) $ (1,528,500) $ (1,528,500) $ (1,528,500) $ (1,528,500) Tax Savings 611,400 611,400 611,400 611,400 611,400 Cash Flow due to Costs $ (917,100) $ (917,100) $ (917,100) $ (917,100) $ (917,100) Tax Effects of Depreciation $ 60,000 $ 60,000 $ 60,000 $ 60,000 $ -- Tax Effects of GHL Costs $
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