Problem
A technology firm plans to manufacture a new fitness watch. It plans to sell the watch for a price of $150. It will sell the watches for 6 consecutive years. The projected costs of manufacturing 15,000 watches in a single year are given as follows.
Direct materials (variable) 400,000
Direct labor (variable) 450,000
Manufacturing overhead:
Variable portion 100,000
Fixed portion 90,000
Selling and administrative costs:
Variable portion 250,000
Fixed portion 100,000
The above costs should be considered as expenses beginning in year 1. In addition to these costs, the firm will purchase new machining equipment at a cost of $500,000 in year 0. This equipment will be depreciated for tax purposes according to the 7-years MACRS schedule. At the end of 6 years, the equipment will have a salvage value of $40,000.
The firm will borrow $300,000 in order to finance this equipment. It will borrow the amount at 8% interest and repay the loan in 4 annual installments.
The firm's MARR is 18%. Tax rate is 38%.
The firm needs to decide whether to deliver the watches itself or hire a third-party logistics provider to deliver and transport the watches. The following explains the additional costs for each option.
Option 1: If the firm delivers the watches itself, it will purchase 5 trucks in year 0 at a cost of $80,000 per truck. These trucks are depreciated according to the 5-year MACRS schedule. At the end of 6 years, each truck can be salvaged for $15,000 per truck. Beginning in year 1, the firm will also pay $110,000 per truck in each of the 6 years for operations and maintenance and labor. Option 1 also requires the firm to invest $65,000 in a working capital fund, which will be fully recoverable at the end of 6 years.
Option 2: If the firm hires a third-party logistics provider, it will pay an annual fixed cost of $450,000 plus $15 for every watch that it produces, beginning in year 1. These annual fixed and variable costs are in addition to those listed above. The firm will not need to purchase any trucks or invest in a working capital fund if it selects option 2.
If the firm sells 15,000 watches in each year for 6 years, what is the net cash flow for each option? Based on a net present worth analysis, should the firm choose option 1 or option 2?
The marketing team believes the firm will sell more than 15,000 watches in each year. Assume the firm will sell the same number of watches in each year. What is the break-even point between option 1 and 2? In other words, what is the minimum number of watches that the firm would need to sell in each year to incentivize it to switch from one option to the other option?