THE FIRM

And prosper it has. LFPT operates on 14 acres and employs 31 people. In fiscal year 2008, sales totaled nearly $25 million despite a nationwide recession and the highly competitive nature of the piping business.

A PROBLEM OF SIZE

Sometimes, however, a distributor is interested in 10-inch and 12-inch pipe. LFPT has never produced these sizes internally because Anna feels that annual sales volume is too low to justify the start-up cost. If a customer requests such pipe, LFPT typically buys it from a competitor who manufactures the desired sizes. Anna has not analyzed whether this is a good policy, and she thinks now is the time to do so, especially given the firms staffing situation.

As she sees it, there are two main advantages to producing the 10-inch and 12-inch pipe internally. First, LFPT avoids the expense of buying the pipe from another firm. LFPT pays 45 cents per pound for this pipe plus another 2 cents per pound in distribution costs to get the pipe to LFPT customers. Unit selling price is 56 cents per pound. A second advantage is that the companys staffing problem would be helped.

Though dollar sales have increased slightly in the last two years, Anna recognizes that the firm is overstaffed by two employees. Sales simply arent sufficient to keep all the production workers busy full time. She thinks this could continue, given the state of the economy. In its entire history, the firm has never cut any workers hours, let alone lay off someone. Anna decided that she wont start now.

ANNAS ESTIMATES

Anna cant be certain of what future sales of the 10-inch and 12-inch pipe will be. She finds it helpful to think in terms of scenarios. She has devised a set of estimates shown in Exhibit 1.

In addition, two sales people complained that accounts were lost when distributors learned that LFPT does not produce 10-inch and 12-inch pipe internally. These distributors were concerned that LFPT would not be able to fill orders quickly. As a result, these sales people argued, the entire account was lost and not just the orders for 10-inch and 12-inch pipe.

Anna is unsure what to make of this lost order argument. If the sales personnel are correct, then LFPT could nearly double the figures shown in Exhibit 1. For the time being, she decides to ignore the possibility that orders have been lost. She wants time to investigate the claims of the sales personnel who, she believes, have a strong incentive to inflate any loss.

The most inexpensive equipment that is capable of producing the quality that Anna desires costs $600,000 and can generate 2 million pounds of pipe per year. For the purpose of analysis, Anna will assume straight-line depreciation to zero salvage value over the eight-year life of the project. The market value of the equipment after eight years is expected to be $180,000 before taxes. Ms. Holub also determined that the investment in net working capital will be the same regardless of whether LFPT makes or buys the 10-inch and 12-inch pipe.

THE ACCOUNTANTS ESTIMATES

The firms accountant, Don Carlione, has developed a set of numbers that, in his view, strongly indicates in-house production is a losing proposition. (See Exhibit 2.) Mr. Carlione estimates it will cost 54.3 cents per pound to produce the 10-inch and 12-inch pipe internally. He notes that LFPT can purchase the same pipe for 45 cents per pound from another manufacturer and incurs another 2 cents per pound to get the pipe to LFPTs customers. Thus, Don argues, internal production results in a 7.3 cent per pound loss, or $87,600 per year assuming 1.2 million pounds of pipe.

As Anna scans these figures, she smiles as she notices that Don used Annas sales estimates and annual sales probabilities. She wonders, though, how accurate the accountants numbers really are. For one thing, the estimates are based on the most likely sales figure and do not consider the other sales possibilities. In addition, Anna questions the appropriateness of including depreciation, given that it is a non-cash item. For these and other reasons, she decides to reconsider the analysis.

Anna is comfortable with many items listed in Exhibit 2. She believes it is quite reasonable, for example, to assume material costs will be 32 cents per pound. And, yes, the project would use two laborers and will require plant space and supervisory personnel. Yet the firm has significant excess space and the equipment could be operated in an area of the factory that Anna believes would otherwise be vacant for the foreseeable future. In addition, Anna believes that the firms plant manager could easily supervise the project without affecting his efficiency in other areas.

Anna then reflects further on her staffing situation. Although it may not be good business, she is quite comfortable with her decision not to terminate any employees. Ms. Holub realizes that at most, LFPT will be over-staffed for three years, since two workers are scheduled to retire at that time. And there is the possibility that sales will increase sufficiently over the next three years so that all the staff would be fully utilized. If this does happen, of course, new workers would have to be hired (but no new supervisors) if the project were implemented. Anna estimates there is only a 20 percent chance that this would happen in any year. Considered from a different angle, there is an 80 percent chance in each of the next three years that the two laborers used in the project will not be productively employed somewhere else in the firm.

EXHIBIT 1

Annas Estimate of the Probability Distribution of Annual Sales of 10-inch

and 12-inch Pipe, Years 1 - 8 (in thousands of pounds).*

Annual Sales Probability 900 lbs. .20 1,200 .50 1,800 .30

*These estimates do not consider the possibility that in-house production may increase sales (see case)

EXHIBIT 2

Accountants Estimate of Annual Cost of Producing 10 inch and 12 inch Pipe In-House

1. Raw materials $384,000

2. Distribution cost 24,000

3. Direct labor 40,000

4. Indirect labor 8,000

5. Pension and welfare 6,720

6. Payroll taxes 4,800

7. Utilities 8,000

8. Repairs and maintenance 7,000

9. Space 6,600

10. General factory 18,000

11. Depreciation 75,000

12. Lost interest 72,000

$654,120

QUESTION

2. (a) What is the opportunity cost (sacrifice) of using two workers to produce the 10-inch and 12-inch pipe internally? In other words, how should the workers costs be accounted for in the analysis?

(b) How, if at all, should the items in Exhibit 2 be adjusted to get the incremental cash flows of the project? (see template for hints)