2024 – Lesley Donovan is the controller for the East division of Explorer Ltd Jason Conner head of plant

Lesley Donovan is the controller for the East division of Explorer Ltd. Jason
Conner, head of plant engineering, has just left Donovan’s office after presenting three
alternatives for submission in the capital expenditure budget for the fiscal year 2014. The
budget is due to the CEO in two days and therefore Donovan realizes that time is of the
essence. Conner has outlined the following alternatives to replace an outdated milling
machine: (1) build a general purpose milling machine; (2) buy a special purpose numerically
controlled milling machine; (3) buy a general purpose milling machine.
Explorer Ltd. Is a well-established company. The company was set up about 30
years ago by two brothers Dan and Kevin Thompson, in Huntsville, Ontario, to produce
accessories for the automobile industry. The Central division continues to serve the auto
industry, and is the largest division in the company with sales of $35 million annually. Dan’s son
is now head of this division. Kevin is still active in the company and is the Chief Executive Officer
(CEO). His office is located in Toronto.

The parts division supplies seals to the mining and petrochemical industry
from a plant in Toronto. This division is only ten years old and until 2010 was highly profitable.
As a result of the downturn in the sector of the economy, sales in 2012 were only $12 million.

The East division, located in Scarborough, is the engineering division. Full time
employees tend to work approximately 2,000 in the division. Regular product lines include
industrial fans, industrial cooling units, and refrigeration units for industrial users. The division
is highly capital-intensive and sales tend to be directly related to general economic conditions.

Each division runs independently and performance is based upon budgeted
return on investment. Bonuses are paid if the budget target is achieved. Annually, each division
prepares a detailed budget submission to Kevin, outlining expected profit performance and
capital expenditure requests. The milling machine proposal is part of the capital expenditure
request.

The 2013 pro forma income statement for East division is set out below:

Sales $22,364,000
Cost of Goods Sold 14,760,240
Gross Profit 7,603,760
Selling and General Administrative Costs 3,578,760
Allocated Costs (based on sales) 1,677,300

Income Before Income Taxes $2,348,220
Return on Sales – 10.5%
Return on Investment – 8.5%
Investment (Historical Cost) $27,626,118

Jason Connor has pointed out to Donovan that the existing machine is not
only outdated but maintenance costs are becoming prohibitive. Jason also noted that
maintenance costs of new general purpose machines are only $26,000 while special purpose
machines can save an additional $14,000 in maintenance. Also there would be a significant
savings in insurance as the price for a general purpose machine would drop to $3,000 while a
special purpose machine would be 67% higher than the general purpose machine. The machine
has no market or salvage value and he is sure that its book value is now zero. The trouble is that
he doesn’t know which proposal is best for the company. In addition to the cost and revenue
date provided, Connor provided comments on each alternative below:

1) Build a general purpose machine:

This machine can be built by East division. The division is below capacity at
present as a major contract has just been completed. The division could thus produce
the machine without affecting revenue-producing activity, but it will take six months to
complete. The machine is expected to last five years and have no salvage value because
removal costs will probably equal selling price.

Connor believes that the division has the technical expertise to undertake the
work. In 2012, the division produced a specialized drilling machine that has proven very
successful. Connor pointed out that David Williams, chief engineer, loves the design
challenge of new machines. Donovan sat down with Connor and produced the following
cost estimates:

Material and parts $55,000
Direct labor (DL$) 90,000
Variable overhead (50% of DL$) 45,000
Fixed overhead (25% of DL$) 22,500
TOTAL $212,500
Donovan argues that this job should also bear a proportion of administrative
costs; she suggests $12,000.

2) Buy a special purpose machine:

The advantage of this special purpose machine is that only one operator is
required and output per hour could increase by 25%. In addition, maintenance costs are
significantly reduced because microchip circuitry is employed.

Connor points out that this machine is state-of-the-art and would probably
mean that new work could be taken on. A numerically controlled machine required
extensive training of operators. In total, 26 weeks are spent in the supplier’s factory located
in Florida. While the training is going on, the supplier provides an operator to work the
machine without charge. Expected costs of this training period including hotel, per diem,
and travel will cost $3,000 per week, excluding the operator’s labor which is set at $15 per
hour.

The machine costs $625,000, and the supplier guarantees the salvage value of
$25,000 at the end of five years. It is available immediately. It is estimated the machine can
generate sales of $243,750 annually at full capacity and require $19,500 in direct materials
cost, which is equivalent to the general purpose machine.

3) Buy a general purpose machine:

The purchase price of this machine is $295,000 and cost levels associated with
the machine are expected to be the same as the general purpose machine built by the
company because the technology is similar. The salvage value of the machine net of
removal costs, is estimated to be $5,000 in five years. It can be delivered immediately.

General comments: The required rate of return for this investment class has been set at 8%
by Kevin Thompson.

Required:

Prepare the budget submission to Kevin.