Question

An existing turning operation in an small parts manufacturing plant is currently generating 25% scrap. The value of the scrap including material, labor and overhead costs is $20.00/unit. The current rate of process is 2000 units / month of both good an bad product. The existing equipment was purchased 5 years ago for $500,000. Current operating costs are $20,000 per year. The equipment's market value currently is $150,000. It has 4 more years of life remaining.

A quality improvement team has determined that the scrap rate can be reduced to 7% if new tooling and major overhaul work could be performed and some of the major components be replaced. The improvements would also reduce the annual operating costs to $15,000 per year.

If the organization requires a 20% IRR what is the maximum that could be spent on the equipment to reduce the scrap rate?

Answer 1

Calculation of Total Cost under both the options
Particulars	Current	After Overhaul
Total Units	2000	2000
% of Scrap Units	25%	7%
No of Scrap Units	500	140
Value of Scrap /Unit	20	20
Value of Scrap /Month	10000	2800
Value of Scrap/Yr	120000	33600
Operating Cost	20000	15000
Total Cost	140000	48600
Benefit/Yr	140000-48600
	91400			2.5887
Factor @ 20%	(1/1.2)+(1/1.2)^2+(1/1.2)^3)+(1/1.2)^4))			91400
	2.5887			236607.18
Present Value of Benefit for 4 yrs
	91400*2.5887
	$236,607
So the maximum amount that can be spent on equipment is the amount of benefit we get from the overhaul ie $236607