HERR FOODS OPTI-SCANNER ACQUISITION DECISION DILEMMA Harold Blank, Vice President of Manufacturing for Herr Foods, Inc., was contemplating a capital investment that could improve production; however, this operations decision would force several of his recently hired employees into new jobs as positions were eliminated by automation. Herr Foods took pride in achieving the highest quality in their finished products. Their top product line was potato chips, and the final physical inspection was a critical step. That was when several employees identified and removed around 75% of the discolored or burned chips before packaging. So, when Harold was introduced to the opti-scanner machine, which claimed to do the same step more effectively than humans, he was intrigued, but not convinced. Could this new technology replace humans and the job they had successfully performed for almost 50 years? How would employees respond if they knew they would be reassigned because of automation? COMPANY HISTORY In 1946, Jim Herr purchased Vernas Potato Chips Company in Lancaster, Pennsylvania, for $1,750. The companys assets included: two iron kettles (each holding 100 pounds of lard), a potato slicer for three potatoes, a peeler that held 10 pounds of potatoes, and a 1938 Dodge panel truck. At 21 years old and with a $1,750 loan, Jim distributed potato chips in a wax paper bag to small grocery stores and other food outlets in southeastern Pennsylvania. He and his wife, Miriam, worked long hours in front of the hot kettles perfecting their recipes and product quality. Building a customer base was equally difficult as there were similar operations selling potato chip products in Pennsylvania and Maryland. In 1951, a fire destroyed the company. Jim, a religious man, believed God would lead them to a new location. They purchased a small farm in Nottinghamideally located near the mission church where his family was active and closer to their distribution area. With all of his available resources and help from the local bank, Jim reestablished Herr Foods and expanded the scope of its operations. Nottinghamlocated in Chester County about 50 miles southwest of Philadelphia and 50 miles north of Baltimorewas a great location. Even though it was in a rural area, nearly 50% of Americas population lived within a 500-mile radius. The county itself had one of the highest per-capita incomes in the state and was one of the fastest-growing counties in the Philadelphia area. Jim found that the people practiced good moral and ethical standards, were religious, and provided a dependable and stable work force. Over the years, Jim and Mims faith and commitment to fair and ethical business practices paid off. Jim was a man of his word. A simple handshake often closed many complicated agreements between customers and suppliers. Jim always made good on his promises and never forfeited on a debt obligation. If someone was unethical in his business practice with him, Jim was compassionate and not vindictive. This was not a sign of weakness, but an effort to reflect his Christian testimony in all areas of his business. Herr Foods grew and prospered. Currently, there were 600+ loyal employees and over 150 sku product line classifications. Herrs operated in a 10-state region between Massachusetts, Ohio, and Virginia, with 20 distribution centers and its own fleet of vehicles to distribute its products to retailers. Revenues were approaching $100 million per year for this family-owned business with potato chips accounting for about 60% of revenues. The same values that Jim practiced in running the business were still evident as the second generation had assumed ownership and operation of the business. Jims three sons, Jim, Ed, and Gene; his daughters, June and Martha; and his son-in-law, Daryl, were all active in the business and espoused the same strong Christian values and beliefs. Son Jim stated, Ive agreed with my fathers philosophy of running the company to maintain a culture of integrity, fairness, and opportunity; to stress quality products and service; and to continue the growth of the company. OPERATIONS Given that there were 30 snack-food companies in Pennsylvania alonealong with large national companies like Frito Lay and Nabiscohaving any level of success and growing market share was quite an accomplishment for Herrs. In addition to the extensive potato-chip product line, the company produced pretzels and other snack foods. Each line offered a variety of products with varying sodium, fat, nutrients, and packaging specifications. The company also distributed complementary product lines such as salsas, dips, and meat snacks. Pretzel production had recently flourished. Three hundred pounds of dough are mixed every 8 minutes and fed onto four different conveyer lines. After the dougheither plain or sourwas blended into 10-pound sections, it was fed through a pretzel die to form its shape. Depending upon the pretzel, 600 to 2,000 pounds per hour were baked in each of four ovens. The operation runs 24 hours per day, Monday through Friday noon. On Friday afternoon, the equipment was cleaned. The tortilla/corn line produces both corn and tortilla chips. Two lines ran continuously at a rate of about 2,000 pounds of product per hour. The corn was soaked for 8 to 10 hours and then cooked for 2 minutes to form a lumpy, creamed texture. The product was cut on a sheeter and sent to a fryer for 15 seconds. The hot chip runs through a tumbler where seasoning was applied. One day per week, onion rings were produced in this assembly area. Onion rings were actually dehydrated potato flakes that were fried and covered with onion seasoning. Cheese curls and popcorn represent smaller product lines. For cheese curls, moisture was removed from corn meal, seasoning was applied, and the product was baked for 1 minute to create a puff. About 1,000 pounds were produced per hour. For popcorn, yellow gourmet kernels were air popped, small and unpopped kernels are removed, and the remaining kernels were seasoned. The potato chip line was the biggest operation. Twenty tractor trailer loads of potatoes arrive every day with 50,000 pounds of potatoes per truck. Each truck was hydraulically lifted to a 45-degree angle to dump the potatoes. Potatoes were dropped into a washer, scrubbed, and sent by water flume to three slicers. They were sliced at 24 slices per inch in less than 1 second. They then go to the vegetable oil vats where they were cooked between 3 and 5 minutes at about 325 F. Four pounds of potatoes made 1 pound of potato chips. Around 56,000 pounds of potatoes per hour were processed through five fryer ovens 16 hours a day. After they were dried and salted, a conveyor belt transports the chips past a final inspection point where four employees identify and remove overcooked or green chips. Management estimated that these employees found and removed 75% of the defective chips, and defective chips represented about 0.5% of the entire output. With this inspection, only about 10 to 15 defective chips out of about 10,000 will reach the final package. Various stages along the conveyer belt sized the chips before they reached a packing machine, with smaller chips going to the smaller packages. The tortilla chips, popcorn, cheese curls, and potato chips were packaged by weight using a bucket process to accumulate the product. The product dropped into a waiting bag. Seven million bags of potato chips of various sizes were produced per month along with a similar quantity of other products. The production process was almost entirely automated until the bags were placed in cartons for shipment. Cartons of all the product lines were stacked by type in the warehouse. The entire warehouse inventory rotated out on a first-in-first-out basis 3 times per week. The inventory turnover rate was critical for a product sensitive to freshness with about a 10-week shelf life. Automation From the time the potatoes were dumped off the truck until the packages of finished product were boxed, there was virtually no human contact during potato chip production. Minimum personal contact with the food was desirable from a health perspective; however, the lack of observation and interaction was a quality control concern. Management had always seen the importance of personal inspection to insure that defective products were identified and removed. Harold was concerned that automation would replace the only stagea critical stagewhere people have an impact on quality. Herr Foods top priority was quality. Ideally, customers should not find even one chip that was defective in any way. Inspectors removed chips that are green, black, and dark brown or have black and gray spots. The green chips resulted when the potatoes did not have the proper sugar content, often found in unripe potatoes. Black or dark brown chips occurred when the chips cook too long in the hot oil. Black, gray, and hard spots were caused in the colder months when potatoes bruise in shipment. Since Herr Foods prints Satisfaction Guaranteed or Your Money Back on each package, the company made every effort to avoid returns. The companys products have obviously met the consumer satisfaction test as only about 3 out of 100,000 bags of product were returned. The new system could easily replace the existing system. A 20-foot conveyer belt was used for the inspection process where two employees on both sides of the belt search for defective chips. This section of the production line would be removed and replaced with a 5-foot belt moving at 60 miles per hour, followed by the opti-scanner, which took another 5 feet and, finally, a 10-foot conveyer belt moving at the original speed of 3 miles per hour toward the sorting and packing operations. The opti-scanner spread out the chips and passed them under an optical sensor that recognized discolored chips. As chips were scanned, a blast of air blew defective chips onto another belt moving at a 90-degree angle where they were disposed. The opti-scanner manufacturer was convinced that quality will not suffer because of automation, but significantly improved the process of detecting and discarding defective chips from the current rate of 75% to a 95% success level. However, the automated process would also lose about 1 good chip for every 4 bad chips. As the bad chips were blown off the conveyer belt, an occasional good chip would be blown away along with it. The manual inspection system also lost some good chips, but the amount was insignificant. About 2.5 defective chips of every 10,000 chips would be missed through manual inspection; about 12 good chips of every 10,000 would be rejected by the opti-scanner. While the manufacturers claims seemed impressive, Harold still had some significant concerns regarding this new technology and potential risks. He was not aware of any other regional snack food companies that were planning on making this investment and only national companies like Frito Lay seemed to have the means to consider taking a risk of this magnitude on such unproven technology. At the same time, Harold knew the importance of being at the leading edge of product innovation and processes but at what cost? Cost The new opti-scanner machine would cost $75,000; shipping, installation, and testing would be an additional $20,000. It would cost $5,000 to dismantle the existing conveyer belt and prepare the area for the new system. To avoid disrupting production, management wanted to install the new systemsabout a 16-hour processover the next holiday weekend using existing maintenance personnel with technical staff from the manufacturer. The life expectancy of the opti-scanner was five years for capital investment purposes with a zero salvage value. The opti-scanner would probably incur an additional $1,200 per year in maintenance and insurance costs. With the machine, the company would not need the 4 inspectors employed on each of 2 shifts. These people worked 40 hours per week and received $10 per hour. The company assumed benefit costs of an extra 25%. The evening shift pay differential was an extra $0.50 per hour. Harold had informed the staff of the companys policy to not terminate employees due to automation. Affected employees would be reassigned to other jobs within the company. However, Harold believed that these positions could be eliminated within 6 months through attrition and reductions in new hires, which would be a savings to the company. Inspectors tended to be the most recent hires. While the work can be monotonous, it was critical for ensuring product quality. The position experienced a higher turnover rate than other positions. The average employee stayed about 6 months to 1 year; then, 3 out of 4 transfer to other positions and 1 quits. It costs about $300 per employee in hiring and training. The inspector position also determined which employees proved capable of more skilled and technical positions. The company had only a limited number of entry-level positions of this nature, and these positions provided a natural training ground. To justify the acquisition to top management, the machine must give the company a payback of three years or less. Harold believed the labor savings and quality improvement would easily justify and give a satisfactory return on the investment. However, given the tight margins on all the product lines, a capital investment could impact cash flow, which may hurt the companys credit rating and decrease its working capital. Since the company was privately held, top management probably needed to borrow money to finance this capital acquisition. Their long-standing association with the area banking community had allowed them to qualify for the lowest rate of 8.25% for this capital project. The company could also finance the equipment purchase from corporate earnings. Last year, company owners earned a rate of return of 14% on book equity. For planning purposes, Harold assumed that 80% of the opti-scanner would be funded by debt with the remaining funds coming from retained earnings. Their current corporate tax rate is 40%. CORPORATE CULTURE AND PHILOSOPHY Jim Herr had always been a deeply religious man and believed that the corporate culture and philosophy should be grounded in Christian values and ethics. Maintaining the highest levels of integrity, reputation, and excellence of Herr Foods in the eyes of customers, employees, suppliers, and other stakeholders was critical. Therefore, every significant decision top management made must pass a testsomething like a What would Jesus do? approach. Was the action in the best interest of all parties concerned? If not, what additional actions would make things right? Were we being a good steward of our resourcesboth financial and otherwise? Did this action meet the highest ethical and integrity standards? Harold knew it was important that any decision be made in light of the companys basic philosophy and system of values. Was the time right to automate the inspection process? Required: If the case is presented in a more directed format, the following questions may help to lead the discussion. 1. Identify the critical issues Harold faces in purchasing an opti-scanner. 2. Discuss various types of capital budgeting methods available to Harold to help him in his decision. Suggest to Harold what method(s) he should use in making the decision. 3. Evaluate this capital acquisition proposal and recommend a course of action. 4. Identify other areas of concern regarding this acquisition and how they might impact the final decision. 5. Given that Herr Foods, Inc. is a company based on Christian principles, how, if at all, will this corporate culture and philosophy impact the decision process? 6. Which of the inspection methods does Herr Foods, Inc. want to go with and is the method consistent with company policy?