Please read the following Scenario: Elisa McRay was recently hired as cost analy

Question

Please read the following Scenario:

Elisa McRay was recently hired as cost analyst by Medlab Medical Supplies Inc. One of Elisa's first assignments was to perform a Net Present Value analysis for a new warehouse. Elisa performed the analysis and calculated a Present Value Index of 0.75 the plant manager, Mark, is very intent in purchasing the warehouse because he believes that more storage space is needed. Mark asks Elisa into his office and the following conversation takes place:

Mark: Elisa, you are new here aren't you?

Elisa: Yes, sir.

Mark: Well, Elisa, let me tell you something. I'm not at all pleased with the capital investment analysis that you performed in these new warehouse. I need that warehouse for my production. If I don't get it, where are am I going to place our output?

Elisa: Hopefully with the customer, sir.

Mark: Now don't get smart with me.

Elisa: No, really, I was being serious. My analysis does not support constructing a new warehouse. The numbers don't lie, the warehouse does not meet our investment return targets. In fact, it seems to me that purchasing a warehouse does not add much value to the business. We need to be producing product to satisfy customer orders, not to fill a warehouse.

Mark: Listen, you need to understand something. The headquarters people will not allow me to build the warehouse if the numbers don't add up. You know as well as I that many assumptions go into your Net Present Value Analysis. Why don't you relax some of your assumptions so that the financial savings will offset the cost?

Elisa: I'm willing to discus my assumptions with you. Maybe I overlooked something.

Mark: Good. Here is what I want you to do. I see in your analysis that you don't project greater sales as a result of the warehouse. It seems to me, if we can store more goods, then we will be able to manufacture more goods, which will mean we will have more to sell. Thus, logically a larger warehouse translate into more sales. If you incorporate this into your analysis, I think you will see that the numbers will workout. Why don't you work it through and come back with a new analysis. I am really counting on you on this one. Let's get off to a good start together and see if we can get this project accepted.

Please make sure that within your text you mention in detail:

1. What is your advise to Elisa? Why? (Please elaborate)

2. Is Mark correct on his assumption that a large warehouse will bring more sales? Why or Why not?

3. What will happen for each accounting period when production is increased but stored not sold? Describe the effect in the balance sheet and the income statement for the excess production period and the sales period. Hint, the accounts you want to look at are: Inventory, Cost of Goods Sold, Depreciation Expense.

Explanation / Answer

1. In the current situation Elisa has to make market research of the product they are dealing in. The demand of the product has to be taken into consideration. All this have to be taken into consideration while making the project report to make appropriate assumptions and estimated value of sale purchase and other expenses. Also she needs to get more details regarding investment in warehouse to ensure the vaibility of making investment in warehouse.

2. No Mark is not correct on his assumptions that large warehouse will bring more sales. They are many other external and internal factors that are required to be considered before making assumptions regarding the increase in sale. There may be less demand of the product than its supply which leads to inventory building. There should be excess production capacity of the machines to make more product to increase the sale. Also they are many other factors which has to be taken into consideration before making assumptions for increase in sales.

3. When production increases but remains unsold it will lead to increase in inventory and inventory holding cost increases. Higher closing inventory leads to higher profits in income statement and in next accounting period the profits will be lower due to increased opening inventory. Cost of goods sold will be higher as production increases and leads to decrease in profits as there is no balance between demand and supply. Production is more and sale is less. Depreciation amount of the machine should be taken at higher rate because due to more production wear and tear of the machine is higher. This leads to lower profits and also the value of the machine will be reduced at higher rate due to extra wear and tear.

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