Question

BTS has decided that they wish to bid and sell a large telephone communications system to a major business customer. What is similar about the industry and the business is that the vendor selling a system gets substantial follow-on business in later years by making changes and alterations to that system. The marketing department wants to take an incremental approach to the bid, basically treating it as a capital budgeting project. They propose selling the system at or below its direct cost in labor and materials (the incremental cost) to ensure getting the follow-on business. BTC has projected the value of that business by treating future sales less direct costs as cash inflows.
They maintain that the initial outlay is the direct cost to install the system, which is almost immediately paid back by the price. Future cash flows are then the net inflows from the follow-on sales. These calculations have led to an enormous NPV and IRR for the sale viewed as a project.
Both support and criticize this approach

Answer 1

The approach is basically to sell the system at cost and then earn firm cash flows continuously over the next few years.

There are both pros and cons to the approach.

Pros:

1. If the system fetches the Cash Flows from the client then this would be a positive NPV project, and a net cash positive to the firm.

2. Selling the system at a margin (profit) might make the price too high for their major customer, and this could lead to either this deal not happening at all, which would have some ripple effects.

3. As long as the marginal costs are covered, from a costing point of view there is no risk in selling it at cost, since the sunk cost should not form a part of a Capital Budgeting decision.

Cons:

1. If the projected future cash flows are much lower, that scenario needs to be worked out, as that could lead to this project not being NPV positive.

2. Even though future costs of software are being recovered as Maintenance, software generally makes profit in two stages:

i. Implementation fee - with a higher margin, because it takes more time and effort to implement it and integrate it properly into the client's system.

ii. Maintenance Fee - For maintenance activities and incremental changes if any.

3. Currently it looks like the firm is not making money from the implementation , and if the cost of implementation shoots up (more hours of technical guys involved) , then it would make it an unprofitable deal.