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Cost analysis by continental medical supplies

Question:

Kelly McClung was recently hired as a cost analyst by Continental Medical Supplies Inc. One of Kelly's first assignments was to perform a net present value analysis for a new warehouse. Kelly performed the analysis and calculated a present value index of 0.75. The plant manager, I. M. Madd, is very intent on purchasing the warehouse because he believes that more storage space is needed. I. M. Madd asks Kelly into his office and the following conversation takes place.

I. M.: McClung, you're new here, aren't you? Kelly: Yes, sir. I. M.: Well, McClung, let me tell you something. I'm not at all pleased with the capital investment analysis that you performed on this new warehouse. I need that warehouse for my production. If I don't get it, where am I going to place our output? Kelly: Hopefully with the customer, sir. I. M.: Now don't get smart with me.

Kelly: No, really, I was being serious. My analysis does not support constructing a new warehouse. There is no way that I can get the numbers to make this a favorable investment. In fact, it seems to me that purchasing a warehouse does not add much value to the business. We need to be producing product to satisfy customer orders, not to fill a warehouse. I. M.: Listen, you need to understand something. The headquarters people will not allow me to build the warehouse if the numbers don't add up. I know as well as you that many assumptions go into your net present value analysis. Why don't you relax some of your assumptions so that the financial savings will offset the cost?

Kelly: I'm willing to discuss my assumptions with you. Maybe I overlooked something. I. M.: Good. Here's what I want you to do. I see in your analysis that you don't project greater sales as a result of the warehouse. It seems to me, if we can store more goods, then we will have more to sell. Thus, logically, a larger warehouse translates into more sales. If you incorporate this into your analysis, I think you'll see that the numbers will work out. Why don't you work it through and come back with a new analysis. I'm really counting on you on this one. Let's get off to a good start together and see if we can get this project accepted.

What is your advice to Kelly?

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