Question

the chief engineer for Portland Purifiers, a maker of industrial water filters with major (and patentable) improvement over current market offerings. she estimates that the development of the product launch cost half a million dollars, including tooling the manufacturing line. the last product launch cost about $200,000 in marketing and promotion costs. she thinks the product would sell for about $50,000 and should sell 75 units in year 1, 140 in year 2, and then level out at 200 per year. contribution margins is 40 percent. should the company continue with this project? what do you need to know about the company in order to understand its decision to go or not go ahead? what is the payback period?

Answer 1

Development costs of the product is estimated at half a million dollars i.e. $ 500,000 and assuming that marketing and promotion costs for product is same as last launched product cost i.e. $ 200,000.

Therefore initial cost of product would be $ 500,000 + $ 200,000 = $ 700,000

Product selling price will be $ 50,000

Contribution Margin of product is 40 %

Therefore product contribution is $ 20,000 ($50,000×40%)

1st year contribution is ($ 20,000×75 units) $ 1,500,000

2nd year contribution is ($ 20,000×140 units) $ 2,800,000

3rd year and onwards contribution is $ 4,000,000

($ 20,000×200 units)

Payback period of the project is in 1st year itself i.e

$ 700,000 ÷ $ 1,500,000 = 0.4667 years

Therefore company should continue the project as it has very good contribution margin and contribution of the product which results very good payback period i.e. in 1st year itself.

We would like to know about the company in order to understand it's decision to go or not go ahead is company's costs of capital, expected return on investment, market of the product, sources of fund to investment in the project etc. These are the major factor on the basis of which the company can decide whether to go or not to go ahead.