Gringotts Ltd manufactures a product known as the Nimbus 500. A large number of other companies also manufacture the Nimbus 500 and the market price of the Nimbus 500 is forecast to be £220 during 2014. Market demand for the Nimbus 500 is highest towards the end of the year. Customers prefer to place the orders with manufacturers who are able to deliver Nimbus 500s immediately from their inventory.
A summarised version of Gringotts Ltd's balance sheet at 31 December 2013 is shown below.
Summarised balance sheet of Gringotts Ltd as at 31 December 2013
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£
Plant and equipment (net) 780,000
Inventory 80,000
Recievables 125,000
Cash at bank 30,000
Payables (20,000)
Net assets 995,000
Share capital 100,000
16% loan from shareholders 500,000
Retained earnings 395,000
Capital 995,000
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During 2014, Gringotts Ltd is committed to:
- Repaying £125,000 of the 16% loan from shareholders in June
- Paying £40,000 interest on the loan in June and £30,000 interest in December
- Paying interest on its bank overdraft at a rate of 5% per quarter on the balance outstanding on the last day of each quarter
- Incurring fixed overhead costs (excluding depreciation) at a rate of £200,000 per quarter (all such costs are paid in the month in which they are incurred)
- Incurring variable production costs at a rate of £100 per Nimbus 500 (75% of these costs are paid for in the month they are incurred and 25% in the month after they are incurred).
Gringotts Ltd's accounting policies include
- Providing for depreciation at a rate of 5% per quarter on the net book value (i.e. cost less depreciation) of plant and equipment outstanding at the end of each quarter;
- Valuing inventory (or 'stock') at a standard production cost of £160 per Nimbus 500.
In early January 2014, Gringotts Ltd's executives meet in order to discuss commercial strategy for the coming year. The sales director advocates an aggressive strategy (Strategy 1), involving new investment, high inventories and an expansion of sales. The finance director advocates a conservative strategy (Strategy 2) involving no new investment, minimising inventories and the adoption of a 'tight' credit policy on sales.
Relevant details concerning the two strategies are described in the following section.
Strategy 1
- In January, acquire new production equipment at a cost of £360,000.
- Offer 60% (by sales value) of customers, 2 months' credit and require the rest to pay immediately.
- Make sales at a rate of 900 Nimbus 500s per month (quarters 1 and 2) and 1,100 Nimbus 500s per month (quarters 3 and 4).
- Produce at a rate of 1200 units per month (quarters 1 and 2) and 1100 units per month (quarters 3 and 4).
- A review of outstanding debts at the end of 2014 is forecast to result in a bad debt write-off totalling £64,000 (all relating to quarter 4 sales)
Strategy 2
- Continue the existing credit policy of offering 50% (by sales value) of customers 1 month's credit and require the rest to pay immediately.
- Make sales at a rate of 800 Nimbus 500s per month (quarters 1 and 2), 1,000 Nimbus 500s per month (quarter 3) and 1,100 Nimbus 500s per month (quarter 4).
- Produce at a rate of 850 Nimbus 500s per month (quarters 1 and 2) and 1,000 Nimbus 500s per month (quarters 3 and 4).
- A review of outstanding debts at the end of 2014 is forecast to result in a bad debt write-off totalling £10,000 (all relating to quarter 4 sales).
Requirements:
Note: In preparing your answer you may assume that cash is held on current account where it earns no interest and any cash deficit requirement is satisfied by drawing down on the overdraft facility.
a) Prepare a cash-flow budget and a profit budget for Gringotts Ltd on the basis of Strategy 1. The budgets should be split into quarterly intervals showing cash-flow and profit forecasts for each individual quarter.
b) Prepare a cash-flow budget and a profit budget for Gringotts Ltd on the basis of Strategy 2. The budgets should be split into quarterly intervals showing cash flow and profit forecast for each individual quarter.
c) Compare and contrast the two sets of budgets you have prepared in answer to requirements a) and b). Advise Gringotts Ltd's management on the relative merits of the two alternative strategies. Advise which strategy should be adopted and why.