Suggested Solution
MEMORANDUM
TO: Robyn Que
FROM: Lauren Lent
DATE: October 16, 20XX
REGARDING: Repair or Replace Equipment, and Financial Statement Presentation
Thank you for the opportunity to address some important issues at BBQ. I have considered your concerns, and have analyzed data related to the issues
Repair or Replacing of Equipment
As you are aware, we are having problems with some of our manufacturing equipment. This equipment needs to be either replaced or repaired. In light of the current economic turndown, I recommend that we consider the most affordable alternative in the short-term. This would mean getting the equipment repaired, which would require a one-week plant shut-down. We could easily get this work done during our annual plant shut down in December. Since sales are soft, and technology changes are anticipated, I believe it would be best to continue to use our current equipment, and begin to plan for a major investment in updated equipment once the new technology is available.
Financial Statement Impact
The impact of the repairs on net income will depend on whether the repairs are considered to be part of normal maintenance, or whether they are considered to extend the life of the equipment.
Normal repairs are expensed as incurred; repairs that extend the life of equipment are capitalized and expensed over the useful life of the repairs. They may be considered “betterments”. In our case, the repairs will not increase the useful life beyond the original expectation, so they should be expensed. This will lower net income by approximately $75,000 for the current year. In evaluating net income, it would be prudent to consider net income earned from operations versus net income after unusual items.
Financing Alternatives
Financing for repairs may be difficult as banks are hesitant to lend money to small businesses due to the current economic slow down. Since repairing the equipment will cost much less than replacing, it will be easier to obtain the smaller amount required. We could consider issuing bonds or issuing shares to raise the required money. Bonds would require regular interest payments, and a stated future repayment date of the principal amount. Shares would not require regular payments, and would not even require repayment, but shareholders would expect to earn a share of profits. A third alternative is to maximize internal cash management in order to avoid the need for additional financing.
We should be able to handle the cost of repairs if we can collect our ageing accounts receivable. This might involve factoring our receivables by selling them to another company at a discount. I recommend that we use this alternative so that we can cover the cost of these repairs with short-term methods and avoid long-term debt or shareholder obligations.
Absorption vs. Variable Costing
I have discussed the change in costing methods with Sandy. The main difference between variable and absorption costing is that variable costing treats all fixed manufacturing costs as period expenses, whereas absorption costing allocates fixed manufacturing costs to products. If there is unsold inventory on the balance sheet at the end of the period, some fixed costs will be absorbed by this inventory and will be deferred on the balance sheet until the products are sold.
The unusual variances you see are due to increased levels of unsold inventory, and should reverse next year if we cut production to
