Jerry Burnside, controller of Pitts Industries, Inc., tells you about a meeting of sev- eral top managers of the firm. The topic discussed was the introduction of a new product that had been undergoing extensive research and development. Burnside had thought the product would be brought out in the coming year, but the managers decided to give it further study. The product is expected to have a market life of ten years. Sales are expected to be 30,000 units annually at $90 per unit. The following unit costs were presented by Jamie Barker, manager of the division that would produce and sell the product. Materials Direct labor Overhead (manufacturing) Selling and administrative expenses $10 17 30 12 Total costs $69 Barker went on to point out that equipment costing $3,000,000 and having an ex- pected salvage value of $100,000 at the end of ten years would have to be purchased. Adding the $900,000 that had already been spent on research and development brought the total outlay related to the new product to $3,900,000. Depreciation of $300,000 per year would reduce taxes by $120,000 (40% rate). The $21 per-unit profit margin would produce $630,000 before taxes and $378,000 after taxes. The net return would then be $498,000 annually, which is a rate of return of about 4%, far below the 14% cutoff rate. Barker concluded that the product should not be brought out. Burnside tells you that Barker is a strong believer in "having every product pay its way." The calculation of the manufacturing overhead cost per unit includes exist- ing fixed costs of $600,000 allocated to the new product. Additional cash fixed costs are $200,000 per year. Selling and administrative expenses were also allocated to the product on the basis of relative sales revenue. Commissions of $4 per unit will be the only incremental selling and administrative expenses. Required: 1. Prepare a new analysis. 2. Explain the fallacies in Barker's analysis.
Jerry Burnside, controller of Pitts Industries, Inc., tells you about a meeting of sev- eral top managers of the firm. The topic discussed was the introduction of a new product that had been undergoing extensive research and development. Burnside had thought the product would be brought out in the coming year, but the managers decided to give it further study. The product is expected to have a market life of ten years. Sales are expected to be 30,000 units annually at $90 per unit. The following unit costs were presented by Jamie Barker, manager of the division that would produce and sell the product. Materials Direct labor Overhead (manufacturing) Selling and administrative expenses $10 17 30 12 Total costs $69 Barker went on to point out that equipment costing $3,000,000 and having an ex- pected salvage value of $100,000 at the end of ten years would have to be purchased. Adding the $900,000 that had already been spent on research and development brought the total outlay related to the new product to $3,900,000. Depreciation of $300,000 per year would reduce taxes by $120,000 (40% rate). The $21 per-unit profit margin would produce $630,000 before taxes and $378,000 after taxes. The net return would then be $498,000 annually, which is a rate of return of about 4%, far below the 14% cutoff rate. Barker concluded that the product should not be brought out. Burnside tells you that Barker is a strong believer in "having every product pay its way." The calculation of the manufacturing overhead cost per unit includes exist- ing fixed costs of $600,000 allocated to the new product. Additional cash fixed costs are $200,000 per year. Selling and administrative expenses were also allocated to the product on the basis of relative sales revenue. Commissions of $4 per unit will be the only incremental selling and administrative expenses. Required: 1. Prepare a new analysis. 2. Explain the fallacies in Barker's analysis.
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Using the Capital Budgeting
Transcribed Image Text:7-45 Jerry Burnside, controller of Pitts Industries, Inc., tells you about a meeting of sev-
eral top managers of the firm. The topic discussed was the introduction of a new
new product product that had been undergoing extensive research and development. Burnside
had thought the product wouid be brought out in the coming year, but the managers
Analyzing a
decided to give it further study.
The product is expected to have a market life of ten years. Sales are expected to
be 30,000 units annually at $90 per unit. The following unit costs were presented by
Jamie Barker, manager of the division that would produce and seli the product.
Materials
$10
Direct labor
17
Overhead (manufacturing)
Selling and administrative expenses
30
12
Total costs
$69
Barker went on to point out that equipment costing $3,000,000 and having an ex-
pected salvage value of $100,000 at the end of ten years would have to be purchased.
Adding the $900,000 that had already been spent on research and development
brought the total outlay related to the new product to $3,900,000.
Depreciation of $300,000 per year would reduce taxes by $120,000 (40% rate).
The $21 per-unit profit margin would produce $630,000 before taxes and $378,000
after taxes. The net return would then be $498,000 annually, which is a rate of return
of about 4%, far below the 14% cutoff rate. Barker concluded that the product should
not be brought out.
Burnside tells you that Barker is a strong believer in "having every product pay
its way." The calculation of the manufacturing overhead cost per unit includes exist-
ing fixed costs of $600,000 allocated to the new product. Additional cash fixed costs
are $200,000 per year. Selling and administrative expenses were also allocated to the
product on the basis of relative sales revenue. Commissions of $4 per unit will be the
only incremental selling and administrative expenses.
Required:
1. Prepare a new analysis.
2. Explain the fallacies in Barker's analysis.
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