AirTech was established in 2000 to manufacture and distribute quality ventilation equipment targeted at original equipment manufacturers for industrial and commercial fans. Over the ensuing years AirTech has built its brand on a reputation for superior products, dependable service, competitive pricing, and engineering expertise focused on design of custom fans. By early 2008 AirTech had grown to US$20 million in revenues and launched an aggressive growth plan expanding plant and installing a state-of-the-art automated warehousing facility. Within a year the recession hit and sales stagnated for four years. In early 2013 in search of growth AirTech entered the residential ventilation market with standard fans and blowers for bathroom exhaust, kitchen range hoods and laundry ventilation. Instead of selling to original equipment manufacturers, these fans and blowers were sold to major wholesalers for distribution in Canada and the US. This initiative had limited success. But, as a result of their expansion into the residential sector and AirTech's reputation for quality ventilation solutions, a major US retailer in the home improvement and building market, Home Depot, recently approached AirTech to design a heavy duty yet attractive ceiling fan for use in basement renovations where air circulation is often poor. The fan would be sold by Home Depot in the US exclusively under its own brand. From an initial meeting with Home Depot's product category manager, Carlos Batista, AirTech's Marketing VP, Sam Carlyle, learned that the retail price for this ceiling fan should be about US$150 and that customers would expect the product to carry a one year warranty. Carlos explained Home Depot's approach to warranty claims to Sam, "We simply replace all products returned in the warranty period with new products -- from you at no cost to us -- without any question. We will dispose of the products, recycling as much as we can. If you'd like to have them back, we'll ship them to you, but you pick up the tab for that. Based on past experience with products in this line, you should expect a 3% warranty return rate." Batista revealed that their marketing group had surveyed customer requirements for the fan's features and functionality. The information from the survey is provided in Exhibit 1. Batista told Sam, "Home Depot requires a 30% gross profit margin. We expect you to pay for all transportation, customs and handling costs. We handle our own internal distribution, so that's not a worry to you in this contract. We've estimated demand and are willing to offer a contract for 40,000 of these units over the next 2 years. We may need up to 15% more per year depending on how the economy improves. At the end of the two year contract, we'll both reevaluate the contract, but it's likely that redesign will be required because we'll attract competition. I think that we'll acquire the units in lots of 10,000, which should reduce your transportation, handling and customs costs. We'd like to receive delivery at the end of quarters one and three. Given that we're ordering half a year's requirements and have to carry the inventory, we'll pay you for our purchases 90 days after delivery. That way we're both sharing some of the carrying costs." Sam expressed interest in the opportunity and promised to get back to Carlos within the next two weeks. After returning from the meeting with Batista, Sam Carlyle shared Home Depot's requirements with AirTech's Product Development Director, Arjun Patel, stressing that the company had to meet customer requirements while not sacrificing AirTech's reputation for quality. Sam told Arjun, "Boy we have to worry about everyone's margins in this deal-- Home Depot has a 30% gross profit margin requirement and I'm held responsible for a 7% return on sales for the residential line. That 7% is after all the products in the line share marketing and administration costs. I expect the charge for marketing and administration cost in total to be the same as last year, about 20% of AirTech's selling price. Although this may sound like an arbitrary allocation we have, if fact, done research on recent new product releases and found that incremental spending for the initial marketing materials and then the follow-on sales initiatives over the life of the product are real. Also, we think that the 3% warranty return rate is a bit high given our focus on quality, but we do expect it be about $4 per unit. With all these complexities on this order do you think we can develop this product profitably? On one hand I am worried about diluting our brand with this Home Depot deal, but on the other it may be an opportunity to expand sales into a new market." Arjun took in Sam's information and requested a day or two to think about it and gather a little information. After a few days of investigation, Arjun and Sam met again to share what they had learned. Arjun told Sam, "After brainstorming with my team, we decided that this basement fan could use the same technology and production facilities that we use on our laundry and bath ventilation fans. That line is new and so far, competitors haven't gotten anything out there that is as good as our products. We feel that we've got another two years before that happens. But basement fans pose special problems and move lots more air than bath and laundry fans. So my group will need a US$200,000 budget for designing and testing for basement conditions." Sam acknowledged Arjun's budget and replied, "I've done a little digging into the cost of transportation, handling and customs; those costs should total US$50,000 per shipment. I've tested out the payment terms with Finance and found out that we're generating enough cash flow to manage the 90 days without difficulty, but my product group will be charged 1% of the product's sales revenue for carrying charges, so that increases my return on sales from 7 to 8% to cover it. My real question is whether we can design to customer specifications and give everyone the margin they need." Arjun had recently attended an executive education program on financial analysis of entrepreneurial ideas and learned about a concept, target costing, that he thought might be tried on this new product. As he explained to Sam, "What I learned is that target costing is a product innovation and profit management process. It's based on the notion that both the selling price for a product and the required return on sales are determined by others and are not under our control. That's just like this new product proposed by Home Depot. Target costing manages what you can control, namely, the cost of the product. It has tools that help design products at costs that maintain margins, satisfy customers, and can be manufactured. If we apply target costing principles, hopefully we'll be able to sell this new fan to Home Depot." "Okay," Sam replied. "I'm game to try this target costing process if it's not going to slow us down. Do you have any material on it that you can share?" "Sure," Arjun replied, "I'll make you a copy of the reading I got in my training course." Arjun sent him a copy of the Target Costing Note.

Provide cost analysis should Air Techproceed with this initiative?What recommendations would you make that might impact theprofitability of this initiative?

Exhibit 1 - Summary of Customer Survey Results Feature Survey Score (10 point scale with 10 high and 1 low importance) Silent operation 9 Variable speed 7 Low maintenance 6 Appearance 5