Strathclyde Graduate Business School
Resit Coursework
International Finance & Decision Making
BAF_7_IFD
Business
2018-19
7
2
The Case of Morden Engineering
Last year Morden Engineering purchased new machinery for £45000 for use in manufacture
of a part used in manufacturing the final product. The cu
ent level of output is XXXXXXXXXXitems
per year and the production will last another eight years. The direct manufacturing cost per
unit is 50 pence and the raw material input costs another 40 pence per unit.
Clyde Engineers, a competitive manufacturer of the above part, has developed new
technology to manufacture the part and has offered to supply Morden Engineering at 83
pence per unit on one year renewable contract basis.
As a part of contract it has also offered to fulfil the entire requirement of Morden Engineering
ut each batch of supplies would consist of no less than 30000 items.
Morden Engineering Purchasing Manager believes that the offer is very attractive. In the
departmental meeting he argues that, with cost of own manufacturing running at 95 pence
per unit which, of course, includes the capital cost of machine, the savings will total £96000
over 8 years. He, therefore, proposes that the indigenous manufacturing should be
completely stopped, sell the machinery purchased only last year and accept the Clyde
Engineers offer.
The Production Manager, who was responsible for decision of buying and installing the
machinery last year, has just come back after attending a Short Course on Project Appraisal
in a prestigious Business School. He asserts that apart from problems of quality control and
security of supplies, there is no economic case for purchasing the part from Clyde
Engineers. To support his assertion he argues that machinery is virtually new and still has an
economic life of eight years, and being of specialised nature has no alternative uses and
could be sold only for £5000 in the market. With capital allowance at 25 per cent on declining
alance method on plant and machinery its cu
ent book value is £40000, and if sold in the
market now would result in a loss of £35000. He claims that this initial loss of £35000
combined with an annual savings of £7000 over next eight years will give a return on 'buy
ather than make' of only 12 per cent whereas the company's required rate of return is
estimated at 20 per cent.
He reinforces his claim by pointing out that this was a highly conservative analysis since
other serious problems have been ignored. The parts produced by the Clyde Engineers
using new technology may vary in length by 4 mm, which may not cause a quality problem in
the final product but would not only involve some redesign in the subassembly but also need
supplementing the subassembly with another machine costing £8000. Even allowing for the
tax allowances on the new machine, this in his view represents an unnecessary expenditure.
The corporation tax rate cu
ently is 25 per cent.
Furthermore the supply of large batches of the part by Clyde Engineers would cause an
average stockholding of 15000 parts throughout the year as against the cu
ent stocks of two
weeks supplies of materials and the finished part, and ten per cent more of warehouse
space would be occupied.
The operator on the machine cannot be made redundant for another eight years as specified
in his contract. The only alternative is to transfer him to another department at his cu
ent
salary of £8000 per annum against the advertised post of an operator at £7000 per annum.
The Purchasing Manager considered the problem of operator as a minor but perceived the
increase in inventory as a real issue. The warehouse is only 60 per cent utilised and an
3
extension of the warehouse is planned only in another four years’ time. This would cost
£50000 and the expected life of warehouse extension is estimated at 25 years for
depreciation purposes. Since the use of this capacity would not involve any cash outlay, the
Purchasing Manager maintains that cost of inventory could be ignored. He claims that he
could be spending just £8000 and would be saving £96000 which is an excellent opportunity.
Assume yourself as the Chairperson of the meeting, with your recently acquired knowledge
of project appraisal as a part of your course; you will need to resolve the stalemate. Clearly
you will need to clarify the issues involved and a
iter which manager is co
ect and what
decision is in the best interest of Morden Engineering.
To help you to do your job effectively, we believe that you may need to find answers at least
to the following questions:
i. Evaluate (critically) the arguments utilized by the Purchasing and the Production
Managers to support their cases. Which is co
ect? (If either of two!)
(15 marks)
ii. What do you believe are the important issues involved and which factors should (or
should not) be taken into account while doing financial analysis?
(20 marks)
iii. What should be the decision of Morden Engineering? Support your recommendation
with financial appraisal.
(50 marks)
iv. What are the possible risks of adopting your recommendation? What other
alternatives might be considered by Morden Engineering?
(15 marks)
(Total 100 marks)
Submission Date: Monday 8th April 2019
Slide 1
1
Morden Engineering
y
Shashi Kuma
Abstract of the Case
• Case is based on make versus buy decision faced
y Morden Engineering.
• Switch from Manufacture to Purchase will:
– Affect costs
– Have personnel implications
– Release a recently purchased machine
– Require some additional capital expenditure
– Change the amount of stocks held; and
– Hence the space required
– Have consequential tax considerations
Abstract of the Case
• A debate between production and purchasing
managers emanated about the importance and
elevance of these issues
• Your precious judgement needed on which
manager is co
ect; and
• What decision Morden Engineering should
take?
Learning Objectives of the Case
• Provide practice in structuring problem formulating
decisions in financial language;
• Practice the use of DCF techniques in decision making
and problem solving;
• Help clarify the difference between cash flows and
accounting numbers in context of decision making;
• Help identifying the items and cash flows that are
elevant or not relevant to the decision using with o
without rule;
• Help understand the concepts of net incremental cash
flows, sunk costs, opportunity costs, problem boundaries,
and the cost of capacity; and
• Help understand the importance of co
ect treatment of
tax in a project appraisal.
The Managers Arguments
• Depreciation
• Profits versus cash flow:
• Book Losses:
• Why value of old machine has fallen so
sharply?:
• Was the original decision to buy the machine was
ad?
• Book versus market values:
• Inventory:
• Opportunity costs
Relevant Factors
• Cost Savings:
• Chief Operator:
• Purchase of New Machine:
• Working Capital:
• Warehouse Extension
• Old Machine
Risks and Alternatives
• Contract renewal price:
• Reversibility of the decision:
• Alternative suppliers: Are there other suppliers,
the competition between them.
• Buy-in new technology: