Question

A company is considering two mutually exclusive proposals, X and Y. Proposal X will require the purchase of machine X, for Rs 1,50,000 with no salvage value but an increase in the level of working capital to the tune of Rs 50,000 over its life. The project will generate additional sales of Rs 1,30,000 and require cash expenses of Rs 30,000 in each of the 5 years of its life. Proposal Y will require the purchase of machine Y for Rs 2,50,000 with no salvage value and additional working capital of Rs 70,000. The project is expected to generate additional sales of Rs 2,00,000 with cash expenses aggregating Rs 50,000. Both the machines are subject to written down value method of depreciation at the rate of 20 per cent. Assuming the company does not have any other asset in the block of 20 per cent; has 12 per cent cost of capital and is subject to 35 per cent tax, advise which machine it should purchase? What course of action would you suggest if Machine X and Machine Y have salvage values of Rs 10,000 and Rs 25,000 respectively?

Answer 1

The best production method initially is Method 1, and it remains the most economical option even if labor costs double, making it the most cost-effective choice regardless of increased labor costs.

Step-by-step explanation:

To determine the best production method, we need to consider both capital and labor costs. With labor costing $100/unit and capital costing $400/unit, the total costs for each method are as follows: Method 1 (50 labor units, 10 capital units) totals $9,000; Method 2 (20 labor units, 40 capital units) totals $18,000; and Method 3 (10 labor units, 70 capital units) totals $29,000.

Thus, Method 1 is the most cost-effective initially. If the labor cost doubles to $200/unit, the total cost for each method becomes: Method 1 is $14,000, Method 2 is $16,000, and Method 3 is $21,000; making Method 1 still the most cost-effective option.

In scenarios where labor costs increase significantly, a firm may seek to use more capital-intensive production methods. However, based on the given costs, remaining with Method 1, which is more labor-intensive, continues to be the most economical choice despite the increased labor costs.