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Finance report on Menstrie & Co



MENSTRIE & CO.

Just over a year ago, Menstrie & Co purchased new machinery for £45,000 for use in the

manufacture of a particular component. The total direct manufacturing costs for these

components are £50,000 per year with raw materials costing a further £40,000. The

current level of output is some 100,000 items per year. Menstrie & Co expect to continue

making the final product in which these components are incorporated for another 8 years.

Stirling Components, one of Menstrie & Co's regular suppliers, has developed a new

method of producing the component in question and has offered to supply Menstrie's

entire needs under a renewable one­year contract at a cost of 83p per piece.

Menstrie & Co's Purchasing Manager believes this offer to be most attractive. With the

cost of own manufacture running at 95p per piece (including the capital cost of the

machine), he argues that the savings wills total £96,000 over 8 years. He is therefore

suggesting that Menstrie should axe this particular manufacturing operation, sell their

recently purchased machinery and accept Stirling's offer.

The Production Manager, however, who was responsible for the original decision to install

the new machinery, is claiming that problems of quality control and security of supply

aside, there is still no economic case for purchasing rather than manufacturing. The

machinery, though virtually new and having a useful remaining life for some 8 years, has

few alternative uses and could be sold for some £5,000. Since its current book value is

£40,000, this would result in a loss of £35,000. The Production Manager, proud of his

recently acquired grasp of discounting techniques, pointed out that this initial loss of

£35,000 followed by annual savings of some £7,000 for 8 years gave a return on the 'buy

rather than make' idea of only some 12%, while the company's current cost of capital was

20%.

He pointed out that even this, however, was a highly conservative analysis, since it

ignored three other serious problems:

1) The components produced by Stirling's new process could vary in diameter by up to 2

mm. While this in no way distracted from the quality of the final product in which these

components were incorporated, it did mean that Menstrie would have to fit a variable

dimension sensor to one of the machines used in sub­assembly, and this would cost

£8,000.

2) While Stirling's delivery service was good, they would not deliver batches of less than

30,000 items, and this implied an average stockhold of 15,000 items throughout the year.

This was a substantial increase over the 2 weeks' supply of both raw materials and

components currently held in stock, and would occupy an additional 10% of the total

warehouse space.

3) The only alternative job which the Production Manager could offer his chief operator

was one currently being advertised at £7,000 per year in another department. Because of

the chief operator's contract with the company, he would have to be transferred at his

present salary of £8,000.

The purchasing manager felt the problem with the chief operator was trivial and that the

inventory question was a "red herring". The warehouse was only 60% utilised, and on the

basis of current plans, no additional space would be required for another 4 years when an

extension costing £50,000 was planned. Since the use of this capacity involved no cash

outlays, the Purchasing Manager argued that the cost of inventory could be ignored. As

far as he could see, spending £8,000 to save £96,000 looked a pretty good deal.

At this stage, it was becoming clear that someone would need to act as arbiter in this

dispute. A judgement was needed on which issues were important, which manager was

correct, and what decision Menstrie & Co should take.

REQUIRED

(a) Critically evaluate the arguments used by the purchasing and production managers.

Which (if either) is correct? 20%

(b) What are the important issues in this situation, and which factors should (and should

not) be included in the financial analysis? 20%

(c) What should Menstrie & Co do? Back up your recommendation with a financial

appraisal. 40%

(d) What are the risks of following your recommended action? What alternatives might

Menstrie & Co consider? 20%

NOTE

A number of approaches could be taken to the performance of the financial analysis.

A suggestion for students is to find the NPV of making and compare this with the NPV of

buying.

2000 words





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