Question

Cupid Company sells boxes of chocolates. They currently offer two different types, heart shaped and cupid shaped. They sell 8,750 cupid shaped boxes for $18.75 and 10,000 heart shaped boxes for $15.00 each. Cupid Company has $18,000 of fixed costs (non-plant). Both boxes currently have an extremely manual manufacturing process. The cupid shaped box costs $7.50 each to make, comprised of $1.50 in variable overhead, $2.10 in direct materials, direct labor cost $8.15 per hour and it takes employees 28.72 minutes per box. The heart shaped box costs $6.00 each to make, comprised of $1.50 in variable overhead, $1.58 in direct materials, $8.15 per hour for direct labor; it takes employees 21.5 minutes per box.

One of the employees, Venus, proposed a cost savings plan. Her plan was to purchase a new chocolate picking machine, which would cut direct labor by 40%. The machine costs $785,000 and would last the company 6 years with a $20,000 salvage value. They would be able to sell the machine at the end of six years for $35,000.

Venus was discussing her plan with a co-worker, Aphrodite. Aphrodite believed that sales were currently constrained by available space and labor. She believed that in addition to reducing labor costs, Cupid Company would also be able to increase sales of each style by 5%. Additionally, she proposed a new product be offered; chocolate flower bouquets. The company would be able to see 3,200 units at $30 each. The cost would be $10.50 per bouquet, comprised of $1.50 in variable overhead, $7.00 in direct materials, $8.15 per hour for direct labor and it takes employees 14.73 minutes per bouquet. Additionally, fixed costs would increase by $5,000.

Cupid Company's desired rate of return is 15%, has a 30% tax rate and they use straight-line depreciation for all plant assets. All numbers provided are pre-tax.

How much could the company spend on the equipment and earn a $100,000 NPV just Venus' plan?

Answer 1

Cupid Company can invest $100,000 on the equipment as the NPV of cash inflows (including the sales proceeds) is higher than 100,000 as explained below.

Venus' plan will reduce the labor costs as shown below:

Reduction in labor cost	Labor hours Original (In Mins)	Reduced labor hours	Cost per hour	Labor cost
Heart shaped	28.72	17.23	8.15	2.34
Cupid Shaped	21.5	12.90	8.15	1.75

Total cost after these savings:

	Heart shaped	Cupid Shaped
Total Cost before purchasing	7.50	6.00
Variable OH	1.50	1.50
Direct Materials	2.10	1.50
Direct Labor	2.34	1.75
Total Cost After purchasing	5.94	4.75
Savings Per unit (a)	1.56	1.25
Sales in Units (b)	8,750	10,000
Total savings ( a*b)	13,644.05	12,477.50

NPV Calculation:

Reduction in cost	Heart shaped	Cupid Shaped	Total Savings	PV Factor	NPV
Year 1	13,644.05	12477.5	26,121.55	0.8696	22,715.30
Year 2	13,644.05	12477.5	26,121.55	0.7561	19,750.50
Year 3	13,644.05	12477.5	26,121.55	0.6575	17,174.92
Year 4	13,644.05	12477.5	26,121.55	0.5718	14,936.30
Year 5	13,644.05	12477.5	26,121.55	0.4972	12,987.63
Year 6	13,644.05	12477.5	26,121.55	0.4323	11,292.35
Year 6 (Sale proceeds)			35,000.00	0.4323	15,130.50
				NPV of cash inflows	113,987.51