Auditing Assignment: Financial Analysis For Business Scenarios

Question

Task:

Accounting Assignment Instructions:

Cost-Volume-Profit Analysis
Assume that you are an accountant from an accounting firm. A local firm, WotsWot Pty Ltd, is considering whether or not to expand its business and is asking you for advice. According to the information given below and the current business and economic environment, you are required to write a report to the owners of WotsWot Pty Ltd and provide recommendations.

Information:
The firm sells wotsits to its customers within the local community, and has observed the demand function:

q = 25 000 – 250p

They are currently operating at full capacity, and selling wotsits for $55 each. They face fixed costs of $150 000 and variable costs of $30 per wotsit. If they expand their business to capture a state-wide market, they predict that in the first year the demand function will change to:

q = 60 000 – 600p

However, to meet the demands of the larger market, they will be forced to move premises. The only location available at this time would result in an increase in their fixed costs by $270 000 excluding any possible financial cost, but this would enable them to quadruple their existing capacity. They would be forced to employ more staff, and would use the opportunity to take advantage of advances in technology to provide an improved product. This would decrease the variable cost of each wotsit to $27. They might also need to increase or decrease the price of each wotsit if they operate the business state-wide.

The following is the key financial information of WotsWot Pty Ltd as at 30th June 2020:

Current assets: $658 000 Non-current assets: $1 127 000

Current liabilities: $395 500 Non-current liabilities: $560 000

Requirements:
1. Your report needs to include necessary graphs/calculations to assist your explanations, which can be part of the report or the appendices.

2. When writing the report, you need to follow the short report format with the following sections (please refer to textbook P564):

• Introduction
• Earning capacity
• Financial stability and risks
• Management changes
• Conclusion
• Recommendations

3. You need to consider both financial information and non-financial information when giving recommendations.

4. You need to research widely to support the arguments and recommendations in your report.

5. You need to include appropriate references (either footnote or Harvard style) and a bibliography or a reference list at the end of the report if necessary.

Answer

Introduction
WotsWot Pty Ltd, analyzed in this accounting assignment, is a firm currently operating in the local community and selling wotsits. The entity is planning to expand its business to the state-wide market. The company has formulated the estimated cost and capacity and developed the demand function after properly analyzing the current situation in the market. Through expansion, the quantity demanded of the product will increase, and accordingly, the company has to change its pricing policy and production methods and capacity.

Earning Capacity
The current selling price of the company is $55 and the variable cost is $30 thus the company is earning at $25 per unit sold. The company is having a good profit margin in the product and should plan for expansion as in this market the earning capacity of most of the business have fallen and also the demand function is showing low demands (Brown et al. 2017). In the current situation, the company is operating at its full capacity of 11250 units, and thus for any further expand production capacity needs to be increased which involves an investment of funds. The current level of profit is not the maximum profit that the company is earning given the demand function the company is operating. It can be seen that if the product is further increased from $55 to $65 the demand for the product will reduce to 8750 units only but at this level, the company would be able to generate more profits. The profit will increase from the current level of $131,250 to $156,250 leading to a net increase of $25000. Thus, in the given situation the company would increase its profitability without any change in the production method or capacity but by just changing its pricing and production policy. The company is not operating at the most efficient capacity but focused on the highest capacity rather than the highest profitability.

As per the expansion plan, the company would require to invest in new premises which will increase the administrative and other expenses leading to an increase in the fixed cost by more than double at $420,000 from the earlier cost of $150,000. Due to economies of large-scale production, the operating expense will reduce from $30 to $27. Thus, the profitability per unit will increase. This burden of the huge fixed cost comes with a benefit of increasing the production capacity of the company by fourfold that is the company will be able to produce 4 times its maximum capacity now being 11250. The new capacity will be 45000 units which will help the company to meet increased demand in the state-level market. As per the profitability analysis, it can be seen that with this improved capacity and the new demand equation the company will be able to earn more profits even if the same level of units is sold in the overall state market (Shuli 2011). The company will have to increase its price to $82 from $55. This will increase the profit by approx $42750 from the current level.

In the new market also, the company should not work at 100% capacity and operate at most efficient levels. It can be observed that given the new demand equation if the company wants to sell at highest capacity of 45000 units than the price should be set at $25 which is lower than the variable cost of the company of $27 thus the company will start bearing losses of approx $510,000. The most efficient level of production and sales will be 21000 units with the selling price of $65 per unit. At this level the company will be able to generate the highest profits of around $378,000, any increase or decrease in price or quantity will lead to a reduction in the profit of the company.

Financial Stability and Risks
Since the economic conditions are currently not favorable and the flow of funds has lowered the undertaking of any new liability would not be preferred. In the given situation the company is having positive prospects for future growth and the profitability will increase. The drawback of this plan is an increase in the fixed cost which constitutes the fixed burden on the profits of the company and does not depend on the units sold, thus in any adverse condition due to which the demand equation changes the company would continue to bear the fixed cost which would affect the disposable profits in the hands of the company (Chen & Gong 2019).

The movement to the new premises will also require funds to be invested by the company. In the current situation, the current assets are sufficient to cover the current liabilities but the company is already having huge noncurrent liabilities, the capital of the company is coming as $829,500. Thus, the scope of getting fresh funds from long term liabilities is there but only for a limited amount. The company should also avoid taking a huge burden of liabilities and finance charges which will negatively impact the profitability and increase pressure on the working capital (Chen & Gong 2019). Thus, this may hamper the stability and increase the amount of risk for various stakeholders of the company.

Management Changes
The management of the local and state-level business are two different things and management needs to change its approach and thus new management would be required with the already existing team so manage the new business horizon. This may lead to conflict between the existing and new management over some issues which would hamper the smooth running of the company. Proper systemized management procedures should be adopted (Cohen, S. & Karatzimas 2017).

Conclusion
The new expansion policy of the company is very promising and if the expectations remain good will help the company is generating a good amount of profits. The various challenges are required to be addressed by the company like increase fixed costs and arranging the funds for expansion in the most cost-effective manner.

Recommendations
The company should continue to do a market study and develop the current demand equation as this keeps on changing and accordingly change its pricing and production limit. The source of funds should be generated from internal sources that would be most effective for the company.

References
Brown, J. L., Fisher, J. G., Peffer, S. A., & Sprinkle, G. B 2017, The effect of budget framing and budget-setting process on managerial reporting, Journal of Management Accounting Research, vol. 29, no.1, pp. 31.

Charles, T.S 2012, Cost Accounting: A Managerial Emphasis, Pearson Education

Chen, A., & Gong, J 2019, Accounting comparability, financial reporting quality, and the pricing of accruals. Accounting assignment Advances in Accounting, Incorporating Advances in International Accounting, vol. 45.

Cohen, S. & Karatzimas, S. 2017, Accounting information quality and decision-usefulness of governmental financial reporting: Moving from cash to modified cash, Meditari Accountancy Research, vol. 25, no. 1, pp. 95-113.

Shuli, I 2011, Earnings management and the quality of the financial reporting. Perspective of Innovation in Economics and Buisness (PIEB), vol. 8, no. 2, pp. 45- 48.

Appendix
Current Demand Function

Demand Function after Expansion

Current Financial Position