Case Liquid Chemical Liquid Chemical. Ltd. sells a range of highegrade chemical products throughout the Pacic North, west from its main plant in Vancouver, British Columbia. The company's products, because of their chemical properties, call for careful packaging. The company has always emphasized the special properties of the containers used. Liquid Chemical had a special patented lining made from a material known as GHL, and the Company operated a department specially to maintain its containers in good condition and to make new ones to replace the ones that were past repair. Tom Walsh, the general manager, had for some time suspected that the rm might save money and get equally good service by buying its containers outside. After careful inquiries, he approached a rm specializing in container production, Packages, Inc., and obtained a quotation on the special containers. At the sametime he asked Amy Dyer, the controller, to let him have an upetoedate statement of the cost of operating the Container Department. Within a few days, the quotation from Packages, Inc. came in. They were prepared to supply all the new containers required, running at the rate of 3,000 a year, for $600,000 annually. The contract would run for a term of ve years, and thereafter would be renewable from year to year. lfthe number of containers required increased, the contract price would be increased proportions ally. Additionally, if the above contract was agreed upon, Packages, Inc. proposed to carry out maintenance work on the containers for a sum of $1 75000 annually on the same contract terms. Tom Walsh compared these gures with the cost data prepared by Amy Dyer covering a year's operations of the Container Department. Dyer's analysis is as follows: Direct material (GHL) $ 75.000 Direct material [other] 125,000 Direct labor 350,000 Departmental overhead: Department manager's salary $80,000 Rent 17,000 Depreciation of machinery 60,000 Maintenance of machinery 13,500 Other overhead 63,000 233,500 $783,500 Allocation of general administrative overhead from entire factory 69,500 Total cost of Container Department for one year Walsh '8 conclusion was that no time should be lost in closing down the Container Depart ment and entering into the contract offered by Packages, Inc. However, he felt bound to give the manager of the department, Jake Duffy, an opportunity to question this conclusion before he acted on it. Walsh called Duffy in and put the facts before him, at the same time making it clear that Duffy's own position was not in jeopardy. Even if Duffy's department were closed down, there was another managerial position shortly becoming vacant to which Duffy could be moved without loss of pay or prospects. Jake Duffy looked thoughtful, and asked for time to think the matter over. The next morning Duffy asked to speak to Walsh again, and said he thought there were a number of considerations that ought to be borne in mind before his department was closed down. "For instance," Duffy said, \"what will you do with the machinery? It cost $480,000 four years ago, but you'd be lucky Liquid Chemical 481 482 Chapter 11 Capital Investments if you got $80,000 for it now, even though it's good for another ve years. Then there's the stock of GHL we bought a year ago. That cost us $300,000. At the rate we're using it now, it'll last us another three years. We used up about a quarter of it last year. But it'll be tricky stuff to handle if we don't use it up. We bought well, paying $1,500 a ton for it. You couldn't buy it today for less than $1,800 a ton. But you wouldn't have more than $1,200 a ton left if you sold it, after you'd covered all the handling expenses.\" Tom Walsh thought that Amy Dyer ought to be present during this discussion. He asked her to come in and then reviewed Duffy's points. \"I don't much like all this conjecture," Dyer said. "I think my gures are pretty conclusive. Besides, if we are going to have all this talk about 'what will happen if,' don't forget the problem of space we're faced with. We're paying $27,500 a year in rent for a warehouse a couple of miles away. If we closed Dutly's department, we'd have all the warehouse space we need without renting.\" "That's a good point," said Walsh, "though I must say, I'm a bit won'ied about the employees if we close the Container Department. I don 't think we can find room for any of them elsewhere in the rm. I could see whether Packages, Inc. can take any of them. But some of them are getting on in years. There's Walters and Hines, for example. They've been with us since they left school many years ago. Their severance pay would cost us $10,000 a year each, for ve years." Duffy showed some relief at Walsh's comment. "But I still don't like Amy's gures," he said. \"What about this $69,500 for general administrative overhead? You surely don't expect to re anyone in the general ofce if I'm closed down, do you?" "Probably not," said Dyer, "but some one has to pay for these costs. We can't ignore them when we look at an individual department, because if we do that with each department in turn, we'll wind up by convincing ourselves that general managers, accountants, secretaries, and the like, don't have to be paid. And they do, believe me." \"Well, I think we've thrashed this out pretty fully,\" said Walsh, \"but I've been wondering about the possibility of perhaps keeping on the maintenance work ourselves. What are your views on that, Duffy?" \"I don't know,\" said Duffy, \"but it's worth looking into. We shouldn't need any machinery for that, and I could hand the management over to a department supervisor. You'd save about $20,000 a year there. You'd only need about oneefth of the employees, but you could keep the oldest. You wouldn't save any space, so I suppose the rent would be the same. I shouldn't think the other overhead expenses would be more than $26,000 a year. " "What about materials?\" asked Walsh. \"We use about 10 percent of both GHL and other materials on maintenance," Duffy replied. \"Well, I've told Packages, Inc. that I'd let them know my decision within a week,\" said Walsh. \"I'll let you know what I decide to do before I contact them." N ates i. Liquid Chemicals tax rate is 40%, and its afterstax hurdle rate is 10%. ii. The company uses straight-line depreciation for tax purposes. The depreciation expense in each of the next four years is $60,000. The equipment will be fully depreciated at the end of that period. iii. Liquid Chemicals annual net revenue is $2,000,000. Required Prepare a net present value analysis of quuid Chemicals three alternatives. Use a veyear time horizon. You don't have to make additional assumptions (regarding ination rates, for example) beyond the information provided in the case