NoFat manufactures one product, olestra, and sells it to large potato chip manufacturers as the key ingredient in nonfat snack foods, including Ruffles, Lays, Doritos, and Tostitos brand products. For each of the past three years, sales of olestra have been far less than the expected annual volume of 125,000 pounds. Therefore, the company has ended each year with significant unused capacity. Due to a short shelf life, NoFat must sell every pound of olestra that it produces each year. As a result, NoFat's controller, Allyson Ashley, has decided to seek out potential special sales offers from other companies. One company, Patterson Union (PU) - a toxic waste cleanup company- offered to buy 10,000 pounds of olestra from NoFat during December for a price of $2.20 per pound. PU discovered through research that olestra has proven to be very effective in cleaning up toxic waste locations designated as Superfund Sites by the US Environmental Protection Agency. Allyson was excited, noting that "This is another way to use our expensive olestra plant!"
- The annual costs incured by NoFat to produce and sell 100,000 pounds of olestra are as follows:
- Variable costs per pound:
- Direct Materials $1.00
- Variable Manufacturing Overhead $0.75
- Sales Commissions $0.50
- Direct Manufacturing Labor $0.25
- Total fixed Costs
- Advertising $3,000
- Customer hotline service $4,000
- Machine set-ups $40,000
- Plant machinery lease $12,000
In addition, Allyson met with several of NoFat's key production managers and discovered the following information:
*The special order could be produced without incurring any additional marketing or customer service costs
*NoFat owns the aging plant facility that it uses to manufacture olestra
*NoFat incurs costs to set up and clean its machines for each production, run, or batch, of olestra that it produces. The total set-up costs shown in the previous table represent the production of 20 batches during the year.
*NoFat leases its plant machinery. The lease agreement is negotiated and signed on the first day of each year. NoFat currently leases enough machinery to produce 125,000 pounds of olestra.
*PU requires that an independent quality team inspects any facility from which it makes purchases. The terms of the special sales offer would require NoFat to bear the $1,000 cost of the inspection team.
5. Assume that NoFat pays for all costs with cash. Also, assume a 10-percent discount rate, a 5 year time horizon, and that all cash flows occur at the end of the year. Using an NPV approach to discount future cash flows to present value,
A) Calculate the NPV of accepting the special sale with the assumed positive relevant profit of $10,000 per year (i.e., the special sales alternative).
B) Calculate the NPV of downsizing capacity as previously described
C) Based on the NPV of parts a and b, identify and explain which of these two alternatives is best for NoFat to pursue in the long-term.