Question 1 Relevant Costing

The Claypot division of Housewear Products Inc. makes ceramic pots that are used to hold large decorative plants. During 2012, the division produced 10,000 pots and incurred the following costs:

Unit-level materials costs (10,000 ® $15)                                                $150,000

Unit-level labor costs (10,000 ® $20)                                                           200,000

Unit•level overhead costs (10,000 ® $16)                                                 160,000

Depreciation expenses on equipment*                                                         30,000

Other manufacturing overhead**                                                                  36,000

*The equipment was purchased for $170,000 and has a current book value of $140,000, remaining useful life of four years, and a $20,000 salvage value at the end of its useful life. If the company does not use the existing equipment, it can be leased to another company for $20,000 per year for the next four years.

**Includes supervisors' salaries and rent for manufacturing plant.

Required:

The division is considering replacing the equipment used to manufacture its ceramic pots. Replacement equipment can be purchased at a price of $240,000. The new equipment, which is expected to last 4 years and have a salvage value of $40,000, will reduce unit-level labor costs by 40 percent.

(a) Assuming the division desires to maintain its production and sales at 10,000 ceramic pots per year, prepare a schedule that shows the relevant cost of operating the existing equipment versus the cost of operating the new equipment for a four year time period.

(b) Should the existing equipment be replaced based upon your quantitative analysis? Explain your answer.

(c) Discuss several other qualitative and/or quantitative factors that could influence the decision whether to replace the old equipment with the new equipment at this time. Be as specific as possible.

Question 2 Budgeting

Linda Johnson and Torn Scott recently graduated from Northeastern University. After graduation they decided not to work for their previous coop employers but, rather, to start their own small business hoping they could have more flexibility in their personal lives for a few years. Linda's family has operated Mexican restaurants and taco-trucks for the past twenty years, and Linda noticed there were no taco-truck services in the Boston, close to Northeastern. To reduce the amount they would need for an initial investment, they decided to start a business operating a taco-cart rather than a taco-truck, from which they would cook and serve traditional Mexican styled street food.

They started their business on September 1, 2012. The first thing they bought was a used tacocart for $15,000. This cost, along with the cost for supplies to get started, a business license, and street vendor license brought their initial expenditures to $20,000. Five-thousand dollars came from personal savings they had accumulated by working on coop assignments during college, and they borrowed $15,000 from Linda's parents. They agreed to pay interest on the outstanding loan balance each month based on an annual rate of 6 percent. They will repay the principal over the next few years as cash becomes available. They were able to rent space in The Camden Street parking lot near Northeastern's campus, believing that the students would welcome their food as an alternative to the typical fast food that was currently available in the student center.

After two months in business, September and October, they had average monthly revenues of $20,000 and out of pocket costs of $16,000 for rent, ingredients, paper supplies, and so on, but not interest. Torn thinks they should repay some of the money they borrowed, but Linda thinks they should prepare a set of forecasted financial statements for their first year in business before deciding whether or not to repay any principal on the loan. She remembers a bit about budgeting from the managerial accounting course she took and thinks the results from their first two months in business can be extended over the next 10 months to prepare the budget they need.

They estimate the cart will last at least five years, after which they expect to sell it for $5,000 and move on to something else in their lives. Linda agrees to prepare a forecasted (proforma) income statement and balance sheet, along with a cash budget for their first year in business, which includes the two months already passed.

Required:

a. Prepare the annual pro forma financial statements (income statement and balance sheet) that you would expect Linda to prepare based on her comments about her expectations for the business. Assume no principal will be repaid on the loan. The accounting period begins on September 1, 2012 through August 31, 2013.

b. Prepare a cash budget for the year for the period September 1, 2012 through August 31, 2013. Would Linda and Tom be able to afford upgrading their taco cart to a taco truck at an additional cost of $45,000?

c. Review the financial statements and cash budget prepared above. What are some reasons that the actual results may not appear the same as the budgeted financial statements?