Last year, the demand schedule did not require the forging process cell to operate at full capacity. Projected demands could exceed current plant forging capacity, however. The following two courses of action were proposed to handle the projected demands. 1. Subcontract the forging requirements overflow to a local vendor. This subcontractor can produce the same type of forgings, but preforms will cost 10% more than the preforms produced in-house, and final forgings will cost 75% more. Therefore, it is feasible to use this subcontractor only for preforms, not for final forgings.

2. Purchase a third forging press to handle the increasing requirements. A newly developed forging press is available for purchase. The new press has an automatic manipulator arm that is faster than those on the current presses. As a result of its design differences, the new press can forge faster with lower operating and maintenance costs. These advantages pertain only to the preform process, however. At the increased specifications required by final forgings, the new press cannot perform as well as the current presses. Thus, under this alternative, the new press would handle preform requirements only, and the current presses would handle final forgings.

During the previous year, the plant produced about 8000 disks. Recently, a foreign producer has announced that it is entering this manufacturing field and will be competing for future contracts within the next 3 to 5 years. With this new information, the home office has projected that demand will peak in the third year after increasing as follows: 9400 in year 1, 10,500 in year 2, and 13,000 in year 3. Beyond year 3, demand is most likely to remain at the 13,000 level. These estimates represent the most-likely estimates with the actual demand varying in either direction.

The forging presses are scheduled for either production or maintenance, 24 hours a day and 335 days a year. The other 30 days per year are devoted to research and development use. In the past, the forging presses required 1.5 days of tooling set-up time for each different forging run. Final forging runs were made in batches of 50 to 200 parts, depending on the scheduled demand for the part. No policy changes are currently planned for batch sizing in scheduling, even with increasing demand. Last year, preform forging runs were made 8 times, with an average of 1000 preforms per run. Therefore, with just production time, maintenance time, set-up time, and current scheduling policies, the current presses produced preforms at an average rate of 27.384 minutes per preform and final forgings at an average rate of 67.474 minutes per final forging. With the two current presses, the total annual press minutes available are calculated to be 2 presses 335 days 24 hours/day 60 minutes/hour = 964,800 minutes/year.

For the projected demand at the most likely level, the subcontractor is needed to handle 1140 preforms in year 2, and 9800 in each year thereafter. Under this alternative, the costs for preform forging are as follows. Most-Likely Projection Year 1, Year 2, Year 3-10 Preform demand 9,400 10,500 13,000 In-house preform capacity 9,400 9,360 3,200 No. of subcontract units 0 1,140 9,800 In-house cost (@ $205/part) $1,927,000, $1,918,800, $656,000 Subcontractor cost (@$225/part) 0, 256500, 2205000 Total preform cost $1,927,000, $2,175,300, $2,861,000

The new press, in addition to being faster than the current presses, will incur minimal set-up costs, as it will always be configured for preforms (no tooling time). The new press will produce preforms at an average rate of 20 minutes per preform and will handle all preform processing requirements. The associated annual costs and resultant savings when compared with the subcontractor option are as follows.

Year 1, Year 2, Year 3-10 Subcontractor cost $1,927,000, $2,175,300, $2,861,000 New press cost (@ $175/part) 1645000 1837500, 2275000 Comparative savings $282,000, $337,800, $586,000

The difference in the current in-house cost of $205 per part and the new-press cost of $175 per part is the result of reduced power consumption and an elimination of set-up and tear-down times, prorated on a per-part basis. The new press will cost $3,000,000. It has a 10-year service life and is considered a 7-year MACRS property. Its salvage value at the end of service life is expected to be 10% of the original cost. The dies from the current presses will fit the new forge, so this alternative will not incur additional tooling costs.

Indirect costs are charged on a per-finished-part basis, so there will be no difference in overhead charge for the two alternatives. Because the forging process is automated, there are no projections for increased operator or maintenance personal, as the current staff should easily be able to monitor one more machine. Note that the operating and maintenance (O&M) cost does not include power expenses as they are reflected in the variable cost above. Although the two alternatives require different mixes of spare parts, the budget allocation for the two alternatives is the same. The remaining costs for maintenance supplies and equipment insurance are rated on an hourly basis and are charged as $20 per operating hour. When the new press handles all preforming, it causes the forging cells totals of machine operating hours to be reduced in years 1 and 2 therefore, reducing the O&M costs to a level below the current two-press configuration. In year 3 and beyond, all preformings are to be done on the new press. This causes the operating hours to exceed those available using the subcontractor option, creating an increase in O&M costs. These comparative costs are as follows.

Inventory level is considered to be dependent upon forging cell organization but independent of demand. The average raw material cost is $3520 per disk. The plant currently, and under the subcontractor option, projects a need for 2500 disks for work in progress (WIP). Preforms are held as WIP to facilitate the final forging scheduling (precluding inadvertent interruptions created by an insufficient supply of preforms to meet final forging requirements), and this volume was primarily established because of the limited number of preform forging runs. Under the new-press option, since it is a more responsive set-up, lead time for final forging can be reduced, and the inventory level can be reduced, by a most-likely estimate of 10% (250 units), to 2250 parts. This indicated that the new-press option expects to release working capital of $880,000 (a one-time inventory reduction, $3520250). The current inventory carrying-cost rate is known to be about 15% of the unit cost. Therefore, the new-press purchase results in an annual savings of $132,000 in inventory holding costs.

The company has a combined income tax rate of 38.6% and must pay property taxes at a rate of 1.95% on the remaining book value to the local township. The cash required for the purchase of the new press could either be obtained from funds that are available for investment in equipment or it could be borrowed. Since sufficient internal funds are available, the borrowing option is not considered at this time. The current firms investment policy does not go into detail on how to deal with a possible project risk, but the firms Capital Expenditure Review Committee (CERC) has used the following criteria for any project to be considered for implementation.

No investment project will be considered if it is not likely to produce at least an 18% rate of return on the after-tax cash flows. The NPW of the cash flows, using the worst case, must be no less than 15% of the project outlay. This last criterion is considered to be a method by which the CERC hopes to measure risk in a less formal fashion. That is, when cash flows are computed assuming the least favorable events, likely resulting in a negative net cash flow, this net cash flow should not be more than 15% of the cost of the project.

QUESTIONS

a) Based on the information on demand and resource requirements in Section 3.1 and 3.2, and on the assumption that final forgings have priority over preforms, compute the remaining preform capacity for each year form Year 1 to Year 10. Also compute the excess capacity or additional preform capacity required in each year. b) Assume that the demand projections are accurate, proposed inventory reductions can be made, and a 15% inventory holding rate is appropriate. Develop incremental cash flows, and compute the present value of adopting the third press, using the companys MARR of 18% and a 10-year planning horizon. Also compute the internal rate of return and comment on whether the option is acceptable. c) Assume a worst-case scenario, namely that the demand does not increase over the planning horizon. Re-compute the incremental cash flows for the forging cell and compute the new present value. Comment on the savings created by reduced processing time combination with lower total operating hours. d) Variability in Demand. Recall that the major factor that initiated this equipment acquisition was a projected increase in demand. Because the demand projections are speculative in nature, the risk involved in these alternatives need to be assessed. To account for the extreme variations in disk demand, three estimates of the annual demand level are specified: a most-likely demand, which is the same as before; an optimistic (high) demand; and a pessimistic (low) demand. Recall that the O&M cost varies directly with the press hours allocated and the press hours are, in turn, dependent on the level of disk demand. Recompute the preform and final forging press hours according to the low-and high-demand levels. With the assumption that the inventory reduction of 250 units is still valid, compute the after-tax cash flows under the high-and low-demand scenarios. Compute the corresponding NPWs for the two cases and comment

e) Degree of Inventory Reduction. The raw material cost of $3520 per disk unit, when considered in volume of parts produced or held in inventory, is extremely large when compared to the $3,000,000 purchase price of the new forging press. Therefore, it is important to examine the impacts of inventoryreduction level and holding-cost variations on the NPW calculation. In the previous analysis, the projected inventory reduction was 250 units, and the inventory holding-cost savings was 15% of the cost of those 250 units ($880,000). In the past, Air Technology Corporation also had a history of overestimating the savings potential of new equipment. The level of inventory-reduction savings also varies as a function of carrying cost. This variation has been fairly well established for other product lines, but it is not as predictable for this new production process. For the purpose of sensitivity analysis, examine the impact on incremental NPW, when inventory reductions range from 0 to 500 units and the carrying-cost saving vary simultaneously from 0% to 18%. Do this by plotting incremental NPW v.s. amount of inventory reduction for each level of carrying-cost savings at 0%, 6%, 12%, 15% and 18%. Then compute the break-even inventory reduction at each of the five levels of carrying-cost savings. Comment on the sensitivity of decisions on the two parameters. f) Assume that the demands in Year 1, Year 2 and Year 3-10 are random variables with triangular distributions between their respective pessimistic and optimistic values with the peaks at their most-likely values. The previous demand variability analysis viewed demand as a single factor that had pessimistic, most-likely, and optimistic estimates. Then, we treated this variable response as if the annual demand rates were perfectly correlated (for example, a low-demand requirement in year 1 is followed by 9 more years of relatively low demand, resulting in a net present value that falls in the low end of the spectrum). As stated previously, a more realistic view is that annual demand will vary from year to year. To gain insight into the effects of this correction, the simulation model was developed under the two extremesno demand correlation (independently sampled annual demands) and perfect demand correlation (a single 0-1 random number was used to generate three inverse triangular variates, with the third being used repeatedly for years3-10). To gain insight into the effects of this correlation, perform risk simulation under two extremes-no demand correlation (independently sampled annual demands) and perfect correlation (a single 0-1 random number is used to generate three inverse triangular variates, with the third being used repeatedly for years3-10). Do this by first fixing the inventory reduction level at 250 and use 5 replications, of 200 iterations each, for each of the two conditions. Estimate the expected value and the variance of NPW and also estimate P (NPW 0). Comment on the result.

Year Required Operating Time (Hours) Incremental Savings Subcontractor Option New Press Option Preforms Final Preforms Final 1 3,815 8,190 3,135 8,190 $13,600 2 3,800 9,150 3,500 9,150 6,000 3 1,300 11,325 4,335 11,325 -60,700 10 1,300 11,325 4,335 11,325 -60,700 Year Demand (No. of Disks) Low Most Likely High 8,500 9,700 2 9,800 11,000 9.400 10,500 13,000 11,000 13,500 3 10 11,000 13,000 13,500 Year Required Operating Time (Hours) Incremental Savings Subcontractor Option New Press Option Preforms Final Preforms Final 1 3,815 8,190 3,135 8,190 $13,600 2 3,800 9,150 3,500 9,150 6,000 3 1,300 11,325 4,335 11,325 -60,700 10 1,300 11,325 4,335 11,325 -60,700 Year Demand (No. of Disks) Low Most Likely High 8,500 9,700 2 9,800 11,000 9.400 10,500 13,000 11,000 13,500 3 10 11,000 13,000 13,500