The demand for one of Parsons products has increased over the last few years and, despite the extensive use of overtime and weekend working, the company has been forced to sub-contract some of its production to other producers. Last year Parson's bought in 200,000 units out its total sales of 800,000 units at an average cost per unit of £8.00. It is anticipated that the demand faced by Parsons will increase by 10 per cent next year. Unless the company invests in additional production capacity the need for subcontracting will increase by a further 80,000 units. Demand is expected to continue to increase at a rate of 10 per cent per annum for the subsequent five years before levelling off from year six onwards. It is anticipated that the product will be withdrawn from the market after 10 years.
Discussions with its suppliers indicate that it will be possible to increase the level of sub-contracted production. It should be possible to do this on the same terms as agreed for the 200,000 units currently being purchased.
It is anticipated that the final selling price charged by Parsons for this product will remain at £12.00 for the next ten years. The company anticipates that it could make a profit from selling the product at this price even if it has to rely completely on output produced by its sub-contractors.
The company's production facility was acquired some time ago and is now fully depreciated for tax purposes. However, it is assumed that with regular maintenance it can be used for another ten years at least.
The company has been considering investing in a new and enlarged production facility. This would allow the company to meet all of its sales requirements for the next ten years as well as reducing the costs of production. A plant capable of producing 1,500,000 units would cost £10 million. This would have to be depreciated for tax purposes on straight-line basis over eight years, even though its anticipated working life would be more than 10 years. It is estimated that after the ten years it would have a resale value of about £1.20 million. The production facility would be located in the same building as its existing machinery. It would account for 20 per cent of the floor space in the building whereas the current production occupies 15 per cent. There is considerable spare capacity in the building and it is considered to be unlikely that the company will have any alternative use for this over the next ten years.
The company's production manager has produced the following estimates of costs per unit, but the finance director is not fully confident of his ability to identify the relevant costs.
Current Proposed
Labour expenses £1.50 £0.85
Raw materials 2.50 2.30
Depreciation 1.05 1.45
Maintenance costs 0.20 0
Other costs 0.30 0.20
Costs of space* 0.60 0.80
Direct overheads 0.10 0.15
General overheads 0.06 0.09
Overall costs per unit £6.31 £5.84
* The company's accounting system allocates a standard cost per square metre for the space used.
The company follows a policy of holding stocks of the final product at the start of each year equivalent to 10 per cent of the anticipated unit sales for that year. For expected sales of 800,000 units this would imply holding 80,000 units. Given the current production constraint the units held for stock have been purchased from the company's sub-contactors. The company also holds raw materials equivalent to five per cent of its annual production requirements. Expected sales of 800,000 units consequently required an overall investment in stocks of the finished product and raw materials of £715,000. The growth of sales and the investment in the new production facility would have an impact on the level of stocks. (The company's debtors and creditors can be assumed to cancel each other out.)
If the tax rate is 30 per cent and the required rate of return is 11 per cent.
Is it in the shareholders' interest to continue to sub-contract the growing demand for the product or invest in the production facilities required to produce the product internally? Determine the net present value of the investment, its IRR, and payback period, specifying your key assumptions, and provide an interpretation the outcomes.
Discuss some of the possible risks of both sub-contracting and investing in the new production facilities.