Management Accounting and Financial Planning
Management Accounting and Financial Planning Main Assignment 2: Case Study and Questions. Fosters Construction Ltd Foster’s Construction Ltd: Organizational Background Fosters Construction Ltd (FCL) is a privately owned company with revenue of £20 million per annum, and 200 employees. The company has been operating for 24 years and is well established in the market-place. However, despite a national rate of 4 per cent per annum over the last few years (which is expected to continue), a general economic downturn has seen FCL’s nominal revenue reduce at a rate of about 3 per cent per annum.
The company’s main activity is the construction of large industrial buildings. It also provides maintenance services, mainly for those buildings which it has constructed. FCL has a large investment in construction machinery, and has always kept up with the latest technology in the industry. The company has concentrated on developing a corporate image as an innovative, technologically advanced construction firm, and many of the managers of FCL consider that this corporate image has been a major factor in securing large, competitive contracts in the past. FCL is subject to corporation tax at 35 per cent, payable twelve months after year end, and a system of 25 per cent writing down allowance on capital assets.
FCL’s Formal Capital Investment System An investment in construction equipment is central to the operations of FCL, the organization has, over many years, developed a detailed system by which capital investment proposals are considered. The summary sheet in Exhibit 1 is taken from the firm’s capital investment procedures manual, and outlines the formal process for capital investment decision-making within FCL.
The Current CI Decision: Purchase of a Replacement Crane The construction site manager (CSM) has recently submitted a CI/12 application for the purchase of a new crane. The new asset would replace an existing crane which is ten years old, and which requires major maintenance in order to meet required safety standards. The CSM has indicated in the January budget-setting around that the firm would need to spend money maintaining the old crane, but had not at that stage been aware of any replacement options. It had previously been expected that the existing crane would see out its remaining useful life, to be replaced by a more modern crane (the Auto-Lift II, or ‘AL II’). The AL II is technologically more advanced than the firm’s existing crane, and is able to lift much larger loads. The new crane would cost £345 000, which is considerably more than the original £195 000 cost of the existing crane.
The CSM consulted with the site accountants, and put forward the following information in the CI/12 application:
1. Description: purchase of an AL II crane to replace an existing crane which is in need of major maintenance.
2. Cost projections: purchase price = £345 000; annual running cost = £60 000. It is expected that the AL II crane would have a £30 000 scrap value at the end of its useful life in ten years’ time.
3. Projected time-scale; available for purchase from Allied Importers Ltd in one month’s time. Purchase price payable on 31 March – the last day of FCL’s financial year for taxation purposes. The site accountants and the CSM had agreed that no further information was necessary, as the CI proposal qualified as a ‘replacement of existing asset’ Class I investment.
The CSM’s CI/12 application has now been considered by the director of CI, who feels uneasy about recommending the AL II crane purchase for funding approval. The director of CI has called a meeting of concerned parties to discuss the CI application.
Fosters Construction Ltd Capital Investment Procedures – Summary Capital investment (CI) is defined as ‘any major expenditure on purchasing, construction or upgrading capital assets, the benefits from which will accrue over several years.
1. In early January of each year the CI budget is determined. The total amount of available funds for CI expenditure is determined by the directors, based on what they consider the company can afford.
2. Later that month, divisional managers meet to discuss forthcoming CI requirements, and the budget allocated across divisions. Managers must present their proposed CI requirements under the following three headings: (i) essential replacement of existing assets (Class 1); (ii) strategic expansion (Class 2); (iii) safety and regulatory expenditure (Class 3). The final allocation across divisions is a decision taken jointly by the CEO and the director of CI.
3. Throughout the year, access to funds for investment requires the submission of a standard form CI/12 – Capital Expenditure Application. The information normally required with such as submission includes: (i) a description of the proposed investment; (ii) motivation for the investment, i.e. what will the investment achieve for the company; (iii) financial projections of the cost of the investment; (iv) projected future financial benefits of the investment; (v) key success indicators for the investment (used for assessing the riskiness of the project and for subsequent post audit); (vi) a projected time-scale for completion of the investment. However, proposed Class 3 projects may dispense with items (iv) and (v), and those in Class 1 may dispense with items (ii), (iv) and (v).
4. The CI/12 form is assessed by the director of CI, who has the following options: (i) accept the proposal and forward it to the CEO for financing approval; (ii) refer the proposal back for further refinement; (iii) reject the proposal. CI proposals will be assessed with regard to the net present value (NPV) and payback period (PP) of the proposed project, although Class I projects will be considered as ‘cost minimization exercises’, since there is already an accepted need to continue with current operations and assets, and Class 3 projects are not required to meet financial criteria.
5. All CI projects are assessed within a ten-year planning horizon, i.e. investment effects beyond this ten-year horizon are considered uncertain, and are ignored.
6. If approved, a CI proposal is then allocated funds from the annual budget. A project supervisor is then assigned, and this person is responsible for the implementation and reporting of the CI project. 7. In due course, some selected CI projects will be subject to post audit by the director of CI.
The Meeting Participants
The following people are present at the meeting to discuss the AL II purchase proposal;
• Sonya Carson (SC) Director of CI. Sonya is new to this position, and is familiarizing herself with the technical nature of the firm’s operations. She has an undergraduate economics degree and is considered competent, if perhaps a little over-ambitions. However, many longer-serving organizational members doubt Sonya’s ability to make good decisions regarding investment in an industry about which she currently knows little. For this reason, her appointment to the position of Director of CI was controversial.
• Julian Done (JD) Construction Site Manager (CSM). Julian has worked in the construction industry for 15 years, progressing through the ranks to become CSM two years ago. He is considered to be competent in his job, but is perceived as uncompromising and confrontational. Julian has no time for ‘the head office bosses’, and his outspoken manner at meetings has often met with disapproval from the CEO.
• Franc Silvero (FS) CEO of Foster’s Construction Ltd. Franc came to FCL seven years ago when the construction industry was in a boom period. Received much accolade for record sales levels when he first joined the firm as Contracts Director, and so has continued to implement the policies which had met with success in the past. Franc is now perceived as conservative, and often resists movement towards new areas of business operations. He has a construction background, and sometimes feels uncomfortable with his new managerial role as CEO.
• Henry Morton (HM) Engineering Manager. Henry has an engineering degree and has worked in the trade for eight years, joining FCL three years ago. Henry is often called to give advice on the technical and operating implications of capital asset purchases, as well as their probable maintenance costs. Henry keeps up-to-date on innovation and new technology in the construction industry, and in his opinion is well respected. However, Henry has is the past been frustrated in several attempts to introduce advanced technology into FCL’s construction equipment, and blames this on the conservative approach of Franc Silvero.