A Company is considering two different solutions to an issue it is experiencing with its Richland product line’s obsolete manufacturing equipment. The equipment has historically refined its V1 components, adding additional features that convert the V1 into the V2, a higher margin component. However, the processing generally destroys about 15% of the V1 components (discovered during quality inspection just before packing) and, because of the manufacturing equipment’s age and frequent malfunction, that percentage is beginning to rise.
the company is considering the following two solutions and must select one of these paths forward:
Solution A: Invest in a new piece of equipment that will convert the V1 into the V2 at not only a faster pace (25/hour versus the old machine that converted at the rate of 20/hour), but also would decrease the defects from 15% to 10%. Part of the appeal of this solution is that the company believes it can increase sales in the next fiscal year by entering into a new geographic market if only its capacity could handle it. Right now, they are selling all V2s produced, and could sell all V2s produced with the new machine.. The cost of the new machine is $1,100,000 and they would need to spend $55,000 at the end of each year in maintenance to keep it in pristine condition over its 7-year useful life. At the end of 7-years, the company expects zero salvage value on the equipment. the company’s cost of capital is 10%.
Solution B: The company has a strong market for its V1 product. It can elect to not replace the manufacturing equipment that converts the V1 to the V2 and then sell all of its V1 product to a handful of key customers. The V1 manufacturing equipment is fairly new, requiring only $5,000 in maintenance each year. Current yields are 35 V1s/hour.
the company runs two 8-hour shifts that each operate five days a week, 52 weeks/year. The unit costs for the two products are as follows:
Revenue Direct Material Direct Labor
V1 $50 $14 $11
V2* $72 $8 $4
Incremental DM and DL added to convert V1008 to V2008.
Using the above information, answer the following two questions. For the purpose of this analysis, ignore taxes
1) Using the “Incremental Cost Approach” in your analysis, which solution should the company select? Show your calculations. Keep in mind the concept of relevant costs. You may attach an Excel spreadsheet with your numeric analysis if you wish
2) the company’s VP of Sales has expressed concern about losing long-term customers should they discontinue the V2 line. Others have brought up issues that the company’s management team had not considered. Regardless of your answer to number 1 above, assume that the analysis does NOT point to elimination of the V2 line. How sensitive do you think your analysis could be to the following risks (explain how this risk could impact your decision)
A) The company’s cost of funds after year one escalates to 13% driven by a tightening of the credit market.
B) The “new market” for V2 is projected to be significantly higher than company’s capacity.
C) company’s CEO is compensated based on total revenue.