Roverco plc manufactures and markets a house-cleaning robot. At present, it is in the middle of a project to develop a voice-controlled robot from a laboratory prototype. The prototype was built from a patent which the company acquired for £50,000. The inventor agreed to accept payment in five equal installments, three of which have now been paid.
At a recent board meeting, it was revealed that sales of Roverco’s standard product had taken an unforeseen downturn and that this would have a knock-on effect on profitability and liquidity. This situation is partly due to increased competition from Housemouse Ltd, a dynamic new entrant to the market which specializes in the application of the very latest technology to its products. Also, Roverco’s two long-established rivals, Cleanbot plc and Nomess plc, have been competing on price for the last year or so. Roverco decided against joining in the price war, hoping that it would soon be over. However, the market has responded positively to the price reductions, with increased orders going to Cleanbot and Nomess, causing Roverco to lose market share.
During the meeting, there was a heated discussion concerning the voice-controlled robot project. The project manager presented a financial statement (shown below) and reported that progress was slower than expected due to snags with the voice-recognition system. In connection with this, he recommends that a specialist electronic engineer be employed for the duration of the project, which he estimates will now continue for the next 18 months. The salary would be £28,000 p.a. on a fixed-term contract basis. Without this additional appointment, it is very doubtful that the project will be completed.
Project manager’s financial statement
|Costs to date||42.000|
|Estimated costs for completion of project:|
|Final payment for patent||20.000|
|Gross salaries of two development engineers||75.000|
|Gross salary of new engineer||42.000|
|Materials and equipment (including M4411)||19.000|
|Total cost of project||263.000|
|Budgeted cost of project||218.000|
|Requested increase in budget||45.000|
Following this, the finance director shocked the meeting into silence by proposing that the project be abandoned. She justified this course of action by pointing out that Roverco’s share price had been falling slowly but steadily for the last three months and that in her regular meeting with share analysts from the big City firms, scheduled for next month, she feels it would be wise to issue a profits warning. The effect of this would be a steeper fall in the share price which, in turn, would make the company more vulnerable to a takeover bid. However, to avoid this, she believes the downward profit trend can be quickly reversed by abandoning the voice-controlled project and putting the savings of £221.000 into price cuts on the existing product range.
The chairman is not sure what to do. He postpones the discussion for one week and asks you for advice. You ascertain the following information:
- Market research costing £35.000 was commissioned for the project. This predicted that the optimum price/volume relationship was a selling price of £999, creating sales of 6.000 robots a year. The product life cycle was estimated as four years, at which point a major redesign would be needed to remain competitive.
- Roverco’s accountant has estimated that the new production facility fixed assets for the voice-controlled robot will cost £900.000 and will have a resale value of £400.000 after four years. Other fixed overhead costs of £340.000 p.a. will be incurred; these are caused solely by this product and include depreciation of £90.000 p.a. for the production facility. The variable cost of producing each robot will be £917.
- A special miniature hydraulic mechanism will be used in the robot’s production. Roverco has a stock of 9.000 of these left over from a previous product. They were originally bought at a ‘bargain price’ of £9 each (the current market price is £15 which is included in the £917 total variable cost). They could probably be sold as a job lot for £45.000. Roverco has no other use for these items.
- If the project is abandoned, two development engineers will have to be made redundant at a cost to Roverco of £18.000 each.
- Some specialized voice-control testing equipment could be sold for £8.500 in its present condition, or for £2.500 at the end of the project. The rest of the equipment has no resale value.
- A £6.000 order (order no. M4411) for bespoke electronic components was placed last month for delivery in two months’ time; three months’ credit is normally allowed by the supplier. A legal contract was signed for this order which Roverco is not able to cancel.
- The project overheads of £65.000 include £15.000 for depreciation of the buildings used for product development and a general administration charge of £3.000 (nominally for services from the rest of the company). They also include £17.000 as a proportion of the project manager’s pay.
Identify the relevant cash flows and advise the chairman whether, on purely financial grounds, the project should continue or be abandoned. Support your calculations with clear statements as to why particular items have been included or excluded and state any assumptions that you make.