Advanced Cost Management Project

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Elon Motors produces electric automobiles. In recent years, they have been making all components of the cars, excluding the batteries for each vehicle. The company’s leadership team has been considering the ways to reduce the cost of producing its cars. The leadership team considered various options and believes Elon Motors could reduce the cost of each car if it produces the car batteries instead of purchasing from the current vendor, Avari Battery Company.

Currently, the cost of each battery is $325 per unit. Elon Motors feels that it could greatly reduce the cost if the production team makes each battery. To produce these batteries, the company will need to purchase specialized equipment. Cost of the new equipment is $1,570,000 with salvage value of $70,000 and a useful life of 10 years.

Currently, Elon Motors purchases 3,000 batteries per year, and expects that the production will remain the same for the coming 10-year period. To make batteries, Elon Motors has provided below the relevant data about the proposed project.

Purchase of direct materials at a cost of $125 per battery produced.
Employing three production workers to make the batteries. Each worker likely works for 2,080 hours per year and makes $25 per hour. In addition, health benefits will amount to 20% of the workers’ annual wages.
The variable manufacturing overhead costs are estimated to be $25 per unit.
Because there is currently unused space in the factory, no additional fixed costs would be incurred if this proposal is accepted.
Cost of capital (hurdle rate) has been determined to be 10% for all new projects, and the current tax rate of 30% is anticipated to remain unchanged.
The pricing for the company’s products as well as number of units sold will not be affected by this decision.
Elon Motors uses straight-line method to depreciate the equipment.
Required Items

Based on the above information and using the provided Excel template (Files), calculate the following items for the proposed equipment purchase.
Annual cash flows over the expected life of the equipment
Payback period
Accounting rate of return
Net present value
Internal rate of return
Modified Internal rate of return

 

Sample Solution

Analyzing Elon Motors’ Battery Production Proposal

We can analyze the feasibility of Elon Motors producing their own batteries using the provided information. While an Excel template isn’t available here, we can outline the calculations needed for each required item.

Annual Cash Flows:

  1. Equipment Cost: This is a negative cash flow in year 0, equal to $1,570,000.
  2. Salvage Value: This is a positive cash flow in year 10, equal to $70,000.
  3. Savings per Battery: ($325 – $125) = $200 per battery.
  4. Annual Savings: Savings per battery * Number of batteries (3,000) = $600,000.
  5. Labor Cost per Worker: 2,080 hours/year * $25/hour = $52,000/year
  6. Total Labor Cost: $52,000/worker * 3 workers = $156,000/year
  7. Health Benefits: $156,000 * 20% = $31,200/year
  8. Total Labor Cost with Benefits: $156,000 + $31,200 = $187,200/year
  9. Total Annual Operating Costs: Labor + Variable Overhead ($25/unit * 3,000) = $187,200 + $75,000 = $262,200
  10. Annual Cash Flow (Year 1-9): $600,000 (Savings) – $262,200 (Operating Costs) – Depreciation (explained later)
  11. Depreciation: (Cost – Salvage Value) / Useful Life = ($1,570,000 – $70,000) / 10 years = $150,000/year

Payback Period:

This is the number of years it takes to recover the initial equipment cost ($1,570,000) from the annual savings. We can calculate this by iteratively adding the annual cash flows until the sum is equal to or greater than the initial cost.

Accounting Rate of Return (ARR):

This is a profitability metric that uses the average annual profit over the project’s life. We can calculate the average annual profit by subtracting the total annual operating costs from the annual savings and then averaging that amount over the 10 years.

Net Present Value (NPV):

This considers the time value of money and calculates the present value of all future cash flows (including the initial equipment cost) using the company’s hurdle rate (10%).

Internal Rate of Return (IRR):

This is the discount rate that makes the NPV of the project equal to zero. It essentially tells you the actual profitability of the project considering the time value of money.

Modified Internal Rate of Return (MIRR):

This variation of IRR considers the cost of capital (10%) for borrowing money to fund the project and the reinvestment rate for the project’s cash flows.

Using a spreadsheet:

An Excel spreadsheet is ideal for these calculations as it allows for easy automation and visualization of the results. However, with the formulas provided, you can calculate each value manually as well.

By analyzing these results, Elon Motors can decide if producing their own batteries is a financially viable option.

 

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