Module 9 Management Accounting Project

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Question #2 30 marks

The Luna Mining Company (LMC) was incorporated in 1973 to develop mineral deposits in
Canadas north. In 2004, the company discovered a promising quartz ore body in the
Northwest Territories just outside the town of Carlsbad. Preliminary sampling indicated high
concentrations of several valuable minerals including gold, silver and platinum. In 2005, a
mineshaft was constructed along with a processing plant and administrative offices. The mines
development lead to the economic revival of the town of Carlsbad. During 2005, twenty new
homes, a sixty-unit trailer park and several new businesses were established.

Mining and processing operations began in January 2006 and have continued without
interruption since that date. During 2013, the company removed 1.2 million tons of ore from the
mine; this level of production is expected to continue for the next twenty-five years. Overall, the
company hopes to earn a 15 per cent pretax profit on sales although this has not been met in
recent years. The cost of transporting personnel and materials between Carlsbad and the
closest railway link during the summer months has become prohibitive. Furthermore, the
northern isolation of Carlsbad has resulted in a high turnover of production and administrative
personnel.

The process of extracting valuable minerals begins with the removal of ore from the ground by
drilling and blasting the underground ore body. The raw unrefined ore must then be
transported to the surface and crushed so that the particles are no greater than 1/60 of a
centimeter in diameter. The crushed ore is then ready to enter the refining process. The total
cost of mining and crushing the ore amounts to $30.65 per ton.

In order to extract the usable minerals, the crushed ore is passed through three distinct
processes: amalgamation, electrolysis and purification (see Exhibit 1). In the first stage, called
amalgamation, mercury is added to the unrefined ore. The mercury combines with the valuable
minerals forming a compound that is drawn off. This compound is then heated causing the
mercury to vaporize, leaving a residue that is 30 per cent gold, 60 per cent silver, and 10 per
cent platinum. One ounce of residue is obtained for every 3 tons of ore placed in the process.
The vaporized mercury is condensed and reused the next day. The total cost of the
amalgamation process is $13.51 per ounce of residue recovered. Each year the company
must invest an additional $280,000 to replace mercury lost during the recovery process.

The second process is called electrolysis. In this process, the residue from the amalgamation
process is cast into thick slabs that are hung in large vats of acid. When an electric current is
passed through the vat, pure gold is transferred to separate plates. When the gold plates and
acid are removed from the vat, silver is recovered from the bottom of the vat. When the acid is
filtered for reuse the next day, platinum is removed. The total cost of the electrolysis process is
$9.60 per ounce of residue placed in the vat.

Module 9 Management Accounting Project
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At this point, the gold plates are 99.9 per cent pure and can be sold on world markets. The
current market price for gold is $400.00
1
per ounce but mine officials are aware that future
prices may rise or fall from this level depending on the state of the world economy. During the
past three months, the price has ranged from $350 to $420 per ounce.

The silver can be sold after electrolysis for $4.60 per ounce or it can be further purified.
Purification costs are $1.30 per ounce of pure silver, which can be sold for $6.00 per ounce
(both the $6.00 and $4.60 prices have remained relatively stable during the past year and
management expects no significant changes during the next year). This purification process
reduces the volume of the silver product by 20 per cent.

The platinum can be sold after electrolysis for $430.00 per ounce or further purified and sold
for $550.00 per ounce. Purification results in a 10 per cent reduction in the volume of platinum.
The total cost of purification is $48.60 per ounce of pure platinum.

During the winter, food and supplies are brought to the mine and the town of Carlsbad from the
town of Fargo on a winter road built over the frozen tundra and lakes. Fargo is LMCs closest
link to a railway line. Once the supply trucks are emptied, processed minerals are loaded for
shipment to outside markets. The total cost of winter road transportation was $3 million in
2013. This cost was split equally between LMC and residents of Carlsbad. During the spring,
summer and fall periods, all shipments between Fargo and the mine site have to be made by
floatplane and helicopter. LMC spent a total of $5.5 million on these flights during 2013. No
figures were available on summer transportation expenditures for local businesses and
residents.

The high cost of transporting supplies and personnel to the mine site and getting processed
minerals to the outside market is of great concern to the management of LMC. They are now
considering the option of building a railroad from Carlsbad to Fargo. Preliminary studies have
indicated that construction of the railroad would cost $75 million and that a train (engine, box
cars, caboose and a passenger car) would cost an additional $15 million. With the railroad,
LMC would be able to charge the residents of Carlsbad for freight and passenger fares for trips
to and from Fargo. It is estimated that the revenue collected from freight and passenger fares
would amount to $570,000 per year. The operating and maintenance costs (not including
interest and depreciation) for the railroad would be $240,000 and $140,000 per year
respectively. LMC expects the railroad and train to last for 25 years with no salvage value at
the end of that time. Money to finance the purchase of the train and construction of the railroad
would be borrowed at a rate of 10 per cent per annum. The CCA rate for the railroad and train
are set at 4 per cent and 10 per cent respectively and LMC would depreciate the fixed assets
for financial reporting purposes using the straight-line method. Management believes that the
railroad would eliminate the need for summer airfreight and winter roads between Carlsbad
and Fargo. Also, administrative costs ($1,250,000 in 2013) would be reduced by 25 per cent
because LMC would no longer have to pay large isolation bonuses to key personnel.

1
Despite current gold, silver or platinum prices you are to use the prices as stated in this case. They are
intentionally different from current world prices.
Module 9 Management Accounting Project
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Transportation costs from Fargo to outside markets would remain at approximately $3.3 million
next year. The effective corporate tax rate is 40 per cent.

If construction were to begin in the summer of 2014, the railway would be ready for use by
January 2015. Before such a railroad could be built, LMC would have to obtain permission
from the Territorial government and the town councils of Carlsbad and Fargo. It appears that
some opposition may exist to this proposal from some members of the councils and various
levels of government. Everyone is concerned about the impact of the railroad on the caribou
calving grounds. On the other hand, building the railroad would create new employment
opportunities in both towns and stimulate growth throughout the region. LMC has petitioned
the federal government for a 50 per cent subsidy to offset the costs of building the railroad and
buying the train. Early indications are that this request may be approved if approval is obtained
from all other concerned parties.

Should the subsidy be granted, LMC would receive all revenue and incur all operating and
maintenance costs of the railroad and train. However, only the cost of the railroad and train
after the subsidy would be subject to depreciation and capital cost allowance.

Required:

a) Determine the optimal yearly production plan for the ore processed by the Luna Mining
Company (9 marks).

b) Analyze the economic feasibility of building the railroad, and outline arguments the
company could present to the municipal town councils, the territorial government and the
federal government in order to acquire permission to build the railroad and receive the 50
per cent subsidy (12 marks). (Assume that product prices remain at the 2013 levels.)

c) Prepare a budgeted income statement before taxes for LMC for 2015, and determine the
pretax profit on sales percentage (6 marks). Assume the following:
i) Current price levels remain unchanged.
ii) The federal government grants LMC a 50 per cent subsidy for the railroad and train
capital costs.
iii) The railroad is fully operational by January 2015.
iv) LMC continues to process 1.2 million tons of ore per year following the optimum
yearly production plan that you determine in part (a) above.

d) Explain how long-term uncertainty concerning the prices of precious metals would affect
the following: (3 marks)
i) the capital budgeting decision of LMC
ii) the request for a government subsidy


Module 9 Management Accounting Project
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Exhibit 1 LMCs budgeting and control process
Luna Mining Company
Summary of Mineral Processing

Process Input Output Process cost Market price
of output
1. Amalgamation 3 tons ore
mercury
1 oz. residue
mercury
$13.51/oz. of
residue
$280,000/year
for mercury
N/A
N/A
2. Electrolysis 1 oz.
residue
.3 oz. pure gold
.6 oz. raw silver
.1 oz. raw
platinum
$9.60/oz. of
input
$400/oz. pure
gold
$4.60/oz. raw
silver
$430/oz. raw
platinum
3. Purification 1 oz. raw
silver
.8 oz. pure silver $1.30/oz. of
output
$6.00/oz. of
pure silver
4. Purification 1 oz. raw
platinum
.9 oz. pure
platinum
$48.60/oz. of
output
$550/oz. of
pure platinum

Summary of marks for Question #2
a) Optimal yearly production plan 9
b) Economic Feasibility Analysis 12
c) Budgeted income statement 6
d) Discuss uncertainty with prices of precious metals 3

Total 30