Question

Each year, Worrix Corporation manufactures and sells 3,600 premium-quality multimedia projectors at $12,600 per unit. At the current production level, the firm’s manufacturing costs include variable costs of $3,100 per unit and annual fixed costs of $6,500,000. Selling, administrative, and other expenses (not including 15% sales commissions) are $10,500,000 per year.

The new model, introduced a year ago, has experienced a flickering problem. On average, the firm reworks 40% of the completed units and still has to repair under warranty 15% of the units shipped. The additional work required for rework and repair caused the firm to add additional capacity with annual fixed costs of $2,300,000. The variable costs per unit are $1,200 for rework and $1,700, including transportation cost, for repair.

The chief engineer, Patti Mehandra, has proposed a modified manufacturing process that will almost entirely eliminate the flickering problem. The new process will require $12,500,000 for new equipment (including installation cost) and $3,500,000 for training. The firm currently inspects all units before shipment. Patti believes that current appraisal costs of $600,500 per year and $55 per unit can be eliminated within 1 year after the installation of the new process. Furthermore, if the new investment is made, warranty repair cost per unit are estimated to be only $2,800, for no more than 5% of the units shipped.

Worrix believes that none of the fixed costs of rework or repair can be saved and that a new model will be introduced in 3 years. This new technology would most likely render obsolete the equipment the company purchased a year ago.

The accountant estimates that warranty repairs now cause the firm to lose 20% of its potential business.

Required:

1. What is the total required initial investment cost (cash outlay) associated with the new manufacturing process?

2. What is the total expected change (i.e., increase or decrease) in cost of quality over the next 3 years from using the new manufacturing process being proposed?

3. Based solely on financial considerations, should Worrix invest in the new process? Specifically: (a) What is the cumulative (i.e., 3-year) estimated change in pretax cash flow assuming the new system is implemented? (b) What is the estimated payback period for the proposed investment? (c) What is the estimated pretax internal rate of return (IRR) for the proposed investment? (Use the built-in IRR function in Excel to answer this question.) (Round your "IRR" answer to 2 decimal places.)

Answer 1

1. What is the net investment cost associated with the new process? 1, Net investment cost associated with the new process $12,500,000 Cost of new equipment and installation 53,500,000 $16,000,000 Training cost Net investment cost 2. What is the net financial benefit (over the next three years) from using the new process 2. Net financial benefit (over the coming three years) from using the new process Quality cost if no change is made: Rework $1,200 3,600 X 40% x 51,728,000 $1,700 $918,000 3,600 X 15% X $600,500 $198,000 aisal (fixed) Inspection (variable) 12,600 X $55 Foregone contribution margin from lost sales $12,600 Selling price per unit 10,710 3,100 less selling at 15% less variable cost $7,610 X Contribution margin per unit Production and sales volume 3,600 + (1- opportunity cost) 80% 4,500 Production and sales volume 3,600) 6,849.000 Lost sales (units $900 Total current cost of quali $10,293,500 ear Quality cost of the new process: $630,000 $9,663,500 S2,800 Warranty repairs 4,500 X 5% X Savings from the new process each year Life of the proposed investment $28,990,500 Estimated savines over thre ear period Appraisal and inspection cost, Year 1: $600,500 Fixed $798,500 Variable $198,000 3,600 X Total savings over three-year period $28,192,000 28990500-798500 3. Based on financial information, should Worrix use the new process? 3. Yes-the $16,800,000 cost of the new process and the expected benefits net to a positive $41,939,250 over the coming three-vear period. The pattern of pre-tax cash flows for this investment opportunity is as follows: Year Amount 16,000,000) 0 $8,865,000 (9663500-798500 $9,663,500 S9,663,500 Thus, the payback period for this proposed investment is 1.8 years(28192000/16000000 its internal rate of return (IRR) is approximately 34.06%, as shown below: IRR = 34.06% IRR(B92:B95) Formula is used