ABC Coatings, Inc.: equipment replacement analysis.(Instructor's Note)

Maheshwari, Sharad ; McLain, P. Michael ; Stretcher, Robert 等

INSTRUCTORS' NOTES

ABC Coatings, Inc. is a very small business with turnover approximately $10 million according to its income statement. The overall profit is very small, approximately 1.5% of sales. Hence, the company is trying to find ways to improve productivity and profit margins. Modernizing the old labor intensive plant with a computer controlled new plants is one of the options under considerations. The students have to find out if the new plant is a good option financially.

The solution of this case would demonstrate to the students that technology based decisions made without financial considerations can be incorrect. Many corporations reported problems after much touted IT projects. Among others, these problems included not realizing profitability gains as expected. That is, the new technology may not be the answer to all the problems of a given business.

The calculations in this case are very straight forward. Students have to calculate overall saving from the new system. That is, the total cost differential between old and new systems is to be calculated. The costs involved in the calculations will be labor, utility, cleanup, interest and depreciation cost. Total cost differential between old and new systems will also include depreciation tax shield allowed for the new equipment. The system decision will be based on the present value of the saving over the life of new plant compared to the total investment on the new plant.

COST AND OTHER CALCULATIONS

The steps in calculations to justify the new systems:

* Labor cost.

* Benefit cost.

* Utility cost (in this case cost differential is provided.)

* IT support cost for new plant.

* Expected clean-up cost.

* Interest cost for the new plant financing.

* Depreciation cost for the new plant.

* Depreciation tax shield for the new plant.

* Annual savings (loss) from the new plant.

* Net present value of the savings over the life of the new plant.

* Compare net present value of the saving with capital cost of the new plant.

* Recommendation.

The labor cost calculations are presented in the Tables 1 and 2. The hourly workers cost is calculated based on 2000 hours and the salary rate. The benefit cost is calculated as 30% of the total salary paid for hourly workers and 40% of total paid for yearly salaried workers. The overall payroll cost is the sum of salaries paid and benefits cost incurred.

The utility cost differential is given as $18,000 per year ($1500 per month). The new plant is using more mechanized machine and will use slightly more electricity. Similarly, new plant will have an additional cost of $25,000 per year for the IT support. This cost is not incurred in the old systems. The chemical spills are part of the process and hence, company incurs cleanup cost. The new plant is cleaner and is expected to lower the overall cleanup cost. Table 3 shows the calculations for cleanup cost. Expected cost of cleanup is calculated by multiply probability with cleanup cost.

The cost of debt financing for new plant, depreciation and depreciation tax shield are calculated next. These calculations only apply to the new plant, as the old plant is fully paid and depreciated. Table 4 shows these costs. The interest cost is based on the simple yearly interest at the rate of 8%. The cost of new plant is $2,850,000.00. Therefore, yearly interest cost will be $228,000.00 ($2,850,000*.08=$228,000.) The straight-line depreciation method is used for the new plant for its useful-life of 10 years. The yearly depreciation cost will be $285,000.00 ($2,850,000/10 = $285,000.00.) Depreciation tax shield is saving of corporate income tax, hence, calculated as depreciation multiply corporate tax rate. The yearly depreciation tax shield will be $99,750.00 ($285,000*0.35=$99,750.)

The overall savings from the new system is to be calculated next. Total costs of the old and new systems are shown in the Table 5.

The new plant will save company $372,750 annually. It is assumed that the company will realize these saving each year over the life of the loan. The justification of the new plant will be based on the fact if net present value of the saving is more than the cost of the plant. The net present value at 8% over 10-year is calculated by multiplying PVIFA(r,n) factor with the annual savings (Excel formulae can be used as well.) PVIFA(8%,10) is 6.710081 and saving rate is $374,750 per year. The net present value of this saving will be $2,501,183 (6.710081*374,750). This is less than the cost of the new plant $2,850,000. Therefore, this plant investment is not justified despite the substantial savings in the labor cost.

Sharad Maheshwari, Hampton University

P. Michael McLain, Hampton University

Robert Stretcher, Sam Houston State University Table 1: Yearly Labor Cost in the Old Plant Cost (Hourly Type of Worker Number or Salaried) Pallet Movers (Hourly) 5 $10.00 Machine Operators (Hourly) 12 $15.00 Line Workers (Hourly) 10 $16.00 Subtotal (Hourly Workforce) 27 Supervisors (Salaried Yearly) 3 $85,000.00 Schedulers (Salaried Yearly) 3 $45,000.00 System Operators (Salaried Yearly) 0 $75,000.00 Subtotal (Salaried Workforce) 6 Benefit (Hourly Worker (30%)) Benefit (Salaried Worker (40%)) Total Payroll Cost 33 Type of Worker Payroll Pallet Movers (Hourly) $100,000.00 Machine Operators (Hourly) $360,000.00 Line Workers (Hourly) $320,000.00 Subtotal (Hourly Workforce) $780,000.00 Supervisors (Salaried Yearly) $255,000.00 Schedulers (Salaried Yearly) $135,000.00 System Operators (Salaried Yearly) $0.00 Subtotal (Salaried Workforce) $390,000.00 Benefit (Hourly Worker (30%)) $234,000.00 Benefit (Salaried Worker (40%)) $156,000.00 Total Payroll Cost $1,560,000.00 Table 2: Yearly Labor Cost in the New Plant Cost (Hourly Type of Worker Number or Salaried) Pallet Movers (Hourly) 2 $10.00 Machine Operators (Hourly) 5 $15.00 Line Workers (Hourly) 5 $16.00 Subtotal (Hourly Workforce) 12 Supervisors (Salaried Yearly) 2 $85,000.00 Schedulers (Salaried Yearly) 1 $45,000.00 System Operators (Salaried Yearly) 1 $75,000.00 Subtotal (Salaried Workforce) 4 Benefit (Hourly Worker (30%)) Benefit (Salaried Worker (40%)) Total Payroll Cost 16 Type of Worker Payroll Pallet Movers (Hourly) $40,000.00 Machine Operators (Hourly) $150,000.00 Line Workers (Hourly) $160,000.00 Subtotal (Hourly Workforce) $350,000.00 Supervisors (Salaried Yearly) $170,000.00 Schedulers (Salaried Yearly) $45,000.00 System Operators (Salaried Yearly) $75,000.00 Subtotal (Salaried Workforce) $290,000.00 Benefit (Hourly Worker (30%)) $105,000.00 Benefit (Salaried Worker (40%)) $116,000.00 Total Payroll Cost $861,000.00 Table 3: Expected Cleanup Cost Old System Type of Cleanup Cost Probability Expected Cost Major $10,000,000 1.00% $100,000 Minor $50,000 100.00% $50,000 Total $150,000 New System Type of Cleanup Cost Probability Expected Cost Major $10,000,000 0.10% $10,000 Minor $10,000 100.00% $10,000 Total $20,000 Table 4: Interest and Depreciation Cost Type Rate Cost Interest Cost 8.0% $228,000 Depreciation (10 yr Straight line) 10.0% $285,000 Depreciation Tax Shield (35% Corp Tax Rate) 35.0% -$99,750 Table 5: Total Cost Schedule of Old and New Systems Type of Cost Old System New System Overall Payroll $1,560,000 $861,000 Utility $0 $18,000 IT Support $0 $25,000 Cleanup $150,000 $20,000 Interest $0 $228,000 Depreciation $0 $285,000 Depreciation Tax shield $0 -$99,750 Total $1,710,000 $1,337,250 Savings from the New Plant $372,750