Question

Each year, Worrix Corporation manufactures and sells 3,300 premium-quality multimedia projectors at $12,300 per unit. At the current production level, the firm’s manufacturing costs include variable costs of $2,800 per unit and annual fixed costs of $6,300,000. Selling, administrative, and other expenses (not including 15% sales commissions) are $10,300,000 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 $2,100,000. The variable costs per unit are $2,300 for rework and $2,800, 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 $12,300,000 for new equipment (including installation cost) and $3,300,000 for training. The firm currently inspects all units before shipment. Patti believes that current appraisal costs of $600,300 per year and $53 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 $1,300, 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. Existing Process

Existing Process
Particulars	Unit	Cost	Y1	Y2	Y3	Total
Sales	3300	12300	40,590,000	40,590,000	40,590,000	121,770,000
Manufacturing Cot	3300	2800	9,240,000	9,240,000	9,240,000	27,720,000
				-	-	-
Gross Margin			31,350,000	31,350,000	31,350,000	94,050,000
Fixed Cost			6,300,000	6,300,000	6,300,000	18,900,000
				-	-	-
Selling and Admin Exp			10,300,000	10,300,000	10,300,000	30,900,000
Commission 15%			6,088,500	6,088,500	6,088,500	18,265,500
Repair work						-
Fixed Cost			2,100,000	2,100,000	2,100,000	6,300,000
Rework 40%	1,320	2300	3,036,000	3,036,000	3,036,000	9,108,000
Repair 15%	495	2800	1,386,000	1,386,000	1,386,000	4,158,000
Total Cost			29,210,500	29,210,500	29,210,500	87,631,500
Net Income			2,139,500	2,139,500	2,139,500	6,418,500
%			5.3%	5.3%	5.3%	5.3%

2. New Process

New Process
Particulars	Unit	Cost	Y1	Y2	Y3	Total
Sales	2640	12300	32,472,000	32,472,000	32,472,000	97,416,000
Manufacturing Cot	2640	2747	7,252,080	7,252,080	7,252,080	21,756,240
Saving			(600,300)	(600,300)	(600,300)	(1,800,900)
Gross Margin			25,820,220	25,820,220	25,820,220	77,460,660
Fixed Cost			4,100,000	4,100,000	4,100,000	12,300,000
Training			3,300,000			3,300,000
Selling and Admin Exp			10,300,000	10,300,000	10,300,000	30,900,000
Commission 15%			4,870,800	4,870,800	4,870,800	14,612,400
Repair work						-
Fixed Cost			2,100,000	2,100,000	2,100,000	6,300,000
Rework 0%			-	-	-	-
Repair 5%	132	1300	171,600	171,600	171,600	514,800
Total Cost			24,842,400	21,542,400	21,542,400	67,927,200
Net Income			977,820	4,277,820	4,277,820	9,533,460
%			3.0%	13.2%	13.2%	9.8%

3. New Process Outlay:

Equipment 12.3 mn and training 3.3 mn. Total 15.6 mn.

4. IRR is 28.2%

5. It is better to invest.