XYZ Foods is considering producing a new candy, Tira-Tira. XYZ has spent two years and P450,000 developing this product. XYZ has also test marketed Tira-Tira, spending P100,000 to conduct consumer surveys and tests of the product in 25 states. Based on previous candy products and the results in the test marketing, management believes consumers will buy 4 million packages each year for ten years at 50 cents per package. Equipment to produce Tira-Tira will cost XYZ P1,000,000, and P300,000 of additional net working capital will be required to support Tira-Tira sales. XYZ expects production costs to average 60% of Tira-Tira’s net revenues, with overhead and sales expenses totaling P525,000 per year. The equipment has a life of ten years, after which time it will have no salvage value. Working capital is assumed to be fully recovered at the end of ten years. Depreciation is straight-line and XYZ’s tax rate is 45%. The required rate of return for projects of similar risk is 10%. A. What is the initial investment from this project? B. What is the NPV of this investment? Should XYZ Foods produce this new candy? C. Suppose that competitors are expected to introduce similar candy products to compete with Tira-Tira, such that peso sales will drop following the first-year. What is the maximum drop in sales annually from this product for year 2 onwards and still make this a viable investment?
Cost-Volume-Profit Analysis
Cost Volume Profit (CVP) analysis is a cost accounting method that analyses the effect of fluctuating cost and volume on the operating profit. Also known as break-even analysis, CVP determines the break-even point for varying volumes of sales and cost structures. This information helps the managers make economic decisions on a short-term basis. CVP analysis is based on many assumptions. Sales price, variable costs, and fixed costs per unit are assumed to be constant. The analysis also assumes that all units produced are sold and costs get impacted due to changes in activities. All costs incurred by the company like administrative, manufacturing, and selling costs are identified as either fixed or variable.
Marginal Costing
Marginal cost is defined as the change in the total cost which takes place when one additional unit of a product is manufactured. The marginal cost is influenced only by the variations which generally occur in the variable costs because the fixed costs remain the same irrespective of the output produced. The concept of marginal cost is used for product pricing when the customers want the lowest possible price for a certain number of orders. There is no accounting entry for marginal cost and it is only used by the management for taking effective decisions.
XYZ Foods is considering producing a new candy, Tira-Tira. XYZ has spent two years and P450,000 developing this product. XYZ has also test marketed Tira-Tira, spending P100,000 to conduct consumer surveys and tests of the product in 25 states.
Based on previous candy products and the results in the test marketing, management believes consumers will buy 4 million packages each year for ten years at 50 cents per package. Equipment to produce Tira-Tira will cost XYZ P1,000,000, and P300,000 of additional net working capital will be required to support Tira-Tira sales. XYZ expects production costs to average 60% of Tira-Tira’s net revenues, with overhead and sales expenses totaling P525,000 per year. The equipment has a life of ten years, after which time it will have no salvage value. Working capital is assumed to be fully recovered at the end of ten years.
A. What is the initial investment from this project?
B. What is the NPV of this investment? Should XYZ Foods produce this new candy?
C. Suppose that competitors are expected to introduce similar candy products to compete with Tira-Tira, such that peso sales will drop following the first-year. What is the maximum drop in sales annually from this product for year 2 onwards and still make this a viable investment?
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