See attached file.
The manager of Crafts needs to have information about how switching to level production will affect the company's profits and loan need.
Assumptions for pro formas and the cash budget.
Switching to level production will not affect Sales, Accounts Receivables, Long-term Debt, or Net Plant and Equipment. You can take those numbers from the pro forma statements given in the case. Use information in the case for COGS (65.1% of Sales), Tax Rate (34%) and interest expense and income (annual rates adjusted for monthly periods).
The lower COGS represents the savings on labor costs. The additional storage and handling costs associated with level production of $115,000 can be spread evenly over the year and added to the $200,000 per month of operating expense.
Assume the company makes an $88,000 tax payment in March, and tax payments based on the 1993 tax expense of $139,000 in four installments (e.g., 35, 35, 35, and 34 thousand) in April, June, September and December. These payments will reduce Accrued Taxes on the pro forma balance sheet.
Long-term Debt payments are $25,000 in June and December.
Inventory is a little tricky. Under level production it will grow substantially during the early part of the year. For any month Ending Inventory is Beginning Inventory plus Production less COGS of Sales in that month.
Net sales. The alternative production scenario will not influence sales. So net sales will be the same as in the seasonal production scenario.
Cost of goods sold Under level production, savings in overtime wages ($225,000) and direct labor ($265,000) reduce the percentage of cost of goods sold to sales from 70% to 65.1%.
Operating expense. The level production scenario will incur an additional $115,000 of storage and handling costs and are accounted for as operating expenses.
Interest expense. Since the company has the policy of repaying its debts promptly (within 30 days), interest expense for each month is the amount of interest the company owes on the debts outstanding during the previous month. These debts basically consists of two parts: long-term debt and notes payable . Long-term debt is relatively stable ( a $25,000 payment is to be made every June and December) and interest rate is 9.625% (compounded annually). The amount in notes payable will depend on how much money the company has to borrow to support its production each month. If sales during any particular month exceed the need for cash, notes payable will be zero and any additional earnings will accumulate in the cash balance. Interest rate for notes payable under $2 million is 9% per annum.
Interest income. Interest income for each month is 4% per annum on the cash balance of the previous month.
Taxes are calculated at 34%.
Cash. Cash balance has to meet the minimum required balance of $200,000 each month. Any shortage will result in borrowing from the bank while any surplus will cause interest income to increase.
Accounts Receivable. Accounts receivable is directly connected with sales, and as sales remain the same under both production plans, so does the value in accounts receivable.
Inventory. The calculation of inventory is connected with both sales and production volume. Each month , the excess of production over sales will stay in inventory, and immediately starts accumulating during January 1994 (Figure 2).
Net plant and equipment is identical to the seasonal production strategy.
Accounts payable. Under level product production, accounts payable will be even for each month since the payment for material and other production inputs will be even for each month of the year. The number is derived by taking the monthly average of total accounts payable for 1994.
Notes payable. This number is what the company had to borrow to reconcile the balance sheet.
Accrued taxes. Accrued taxes is derived from tax payment/credit each month. A tax credit will decrease the balance, while a tax payment has the opposite effect.
Long-term debt will remain the same.
Shareholders' equity includes any net profit/loss from the previous month.
The solution explains how to calculate the effect to profits for switching to level production