Case 26 Abstract

Cooper laboratories is a major producer of medical equipment, drugs and is a leader in ultrasonic medical equipment. Ten years ago, health insurers implemented a payment system based on what they think a specific medical service might cost. Hence, Cooper is motivated to cut costs by reducing expenses, especially since it has been a topic for politicians and law-makers. The company is discussing pushing their ultrasonic machine SONICA as well as looking at three possible options; As Is, Price Increase, and Expand.

Case Context

SONICA

• Cooper Laboratorys Ultrasonic machine used in gallbladder surgery, cost $200,000.

• Reduces operation time by 5 min lowering the cost from $1200 to $200.

• 40 machines are currently sold per year with no marketing expenses.

• Sales will increase to 170 by year 3 only to hospitals that perform at least 100 operations per year.

Three Options:

1. As Is no increase in capacity or price change, yearly production 50

• This will create excess demand

2. Price Increase no increase in capacity, yearly production 50 price would be increased, this option is limited to 5% price increase in year 1

• Reduce excess demand by raising the price. Potentially lose sales

3. Expand No change in price buy expand capacity to accommodate the expected growth in demand

Six-Month Expansion:

• $7.5% million

• 7% cost of capital 26% tax-rate

• capacity raised to 210 machines

• 7-year project life

  • All equipment cost except 3 Machines

• 3 machines leased for $60,000 a year

(8 payment lease with first due immediately)

• Straight-line 5-year accumulated depreciation

Marketing expenses for expansion:

Year 1 = $860,000

Year 2 = $265,000

Year 3 = $90,000

OPERATION COST CONSIDERATIONS

Year 1 - VC per unit = $125,000

Year 2 - = $118,000

Year 3 = $115,000 economies of scale is presumed for each year after

Maintenance & Supervisory labor = $310,000

Fixed-Cost = $245,000

Administrative Salaries = $150,000

Computer value with 6-year life = $400,000 with significant amount of excess capacity

Reorganization will save Cooper $150,000 annually

MARKETING CONCERNS

• Advertise heavily in trade journals

• Attend medical conventions

• Make quality brochures to give to sales reps

If Cooper decides to expand:

Marketing Expenses: Year 1 = $860,000

Year 2 = $265,000

Year 3 = $ 90,000

8. Note that Cooper uses 7% required rate of return to evaluate the Sonica investment, and the hospitals that may use Sonica are assumed to use 7%. Does this make financial sense in view of the fact that the same piece of equipment is being evaluated? Explain.