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At a meeting of his staff, Tom Richards, director of manufacturing




20-4 Component Technologies, Inc.: Adding;FlexConnex Capacity;In 2002, Component Technologies, Inc. (CTI)I. manufactured components, such as interconnect components;electronic connectors, fiber-optic connectors, flexible interconnects, coaxial cable, cable assemblies, and;interconnect systems, used in computers and other electronic equipment. CTI's global marketing strategy produced;significant growth, CTI was now one of three major suppliers in its market segments. Major customers included;other global companies, such as illM, HP, Hitachi, and Siemens. These companies, in turn, manufactured and;marketed their products worldwide.;FlexConnex, one of CTI's largest selling products, was very profitable (see Exhibit 1). The Santa Clara, California;plant that manufactured the FlexConnex component was projected to reach its full capacity of 75 million units in;2003. With sufficient capacity to meet demand, CTTexpected its sales of FlexConnex could continue to increase 10;percent per year as applications of computer technology extended into industrial products and consumer products;such as automobiles and appliances.;PLANNING MEETING;At a meeting of his staff, Tom Richards, director of manufacturing planning, stated that they needed to plan to bring;additional capacity for FlexConnex online in about two years. He suggested that they begin by proposing possible;alternatives.Thestaffquicklyidentifiedthreepromisingalternatives:.;1. The Santa Clara plant had been designed for future expansion. Additional space was available at the site, and;new production capacity could be easily integrated into the existing production processes as long as compatible;manufacturingtechnologieswereemployed..;2. CTI owned a plant in Waltham, Massachusetts that manufactured a product line that was being phased out.;Some existing equipment in the Waltham plant was compatible with the Santa Clara plant's manufacturing;technology and could be converted to the production of FlexConnex. Half of the Waltham plant would be;available in 2003, and the remainder in 2005.;3. CTI could build a greenfield plantZin Ireland, close to its ~jor European customers. To attract such industries;the Irish government would make a site available at low cost. A new technology currently being Beta-tested3 by;an equipment manufacturer could be used to equip this plant.;Torn believed that these three were promising proposals. To ensure cn could bring additional, profitable;FlexConnex capacity online in two years, Tom felt that they should begin developing plans for these alternatives.;Nonetheless, he wanted the staff to keep an open mind to additional altematives even as they evaluated these three.;As the discussion started to wind down, Gracie Stanton, an engineer, said that she had a suggestion.;Gracie: Before we spend our time developing these three alternatives in detail, I'd like to get a rough feel for the;potential profitability of each alternative. We should11'twaste our time developing detailed plans for an alternative if;there is no chance it will ever show a positive NPV.;Source: Issues in Accounting Education, by Julie H. Hertenstein, May 2000, Vol. 15 Issue 2, p. 257-261;I Thiscaseis basedondecisionsfacedby anactualcompany.ComponentTechnologies,Inc.,is a disguisedname.;Other facts bave been changed for instructional purposes.;2The term "greenfield plant" is commonly used to refer to a brand new plant built entirely.from scratch, as;contrasted with the expansion, conversion, refurbishment, or renovation of an existing plant.;3A "Beta-test site" refers to equipment being tested using an actual workload at a customer site. Beta-test is often;the final testing phase before the equipment is released as commercially available to customers.A customer who;consents to be a Beta-test site agrees not only to use equipment that is not fully tested (thus being, in the American;vernacular, a "guinea pig"), but also to provide the vendor detailed feedback on operations and problems;encountered. In return, the equipment manufacturer often provides incentives such as financial discounts, extra;on-site vendor personnel, etc.;20-9;Tom: Good point, Gracie. Let's break up into three groups, and do back-of-the-envelope calculations based on what;we currently know about each alternative. Gracie, would you.head up the Santa Clara group, since you were part of;the engineering team for that plant? Edward Lodge, how about Waltham? Ian Townsley, could you and your folks;take a look at Ireland? To start, what are the facts and assumptions about each facility?;Gracie: Well, there's enough space at the Santa Clara site to produce an additional 30 million units annually. I;expect it would cost about $23 million to expand this plant, and bring its total capacity to 105 million units. Of the;$23 million, we would spend $5 million to expand the building, and $18 million for additional equipment;compatible with Santa Clara's existing manufacturing process. All $23 million would probably be spent in 2003, and;the plant would be ready for production in 2004.;I assume that the selling price per unit will remain at its current level, further, since the same manufacturing;technology will continue to be used, the variable manufacturing cost will remain the same as we show on the 2002;Santa Clara Cost Analysis Sheet [Exhibit 1]. Expanding the existing plant would allow some fixed manufacturing;costs, like the plant manager's salary, to be shared with the existing facility, so I estimate that the additional fixed;manufacturing costs, excluding depreciation, will be $2.1 million annually beginning in 2004. In 2006, these fixed;costs will rise to $2.4 million and remain at that level for the foreseeable future.;Edward: Well, the Waltham plant is smaller than the space available in Santa Clara, so I think its capacity will be;about 25 million units. It will require renovations to adapt the plant to manufacture FlexConnex, say, about $2;million, and approximately $12 million for equipment. Half of this would be spent in 2003, and half in 2005. Initial;production would begin in 2004, half of the 25-million-unit capacity should be available in 2004, two-thirds in;2005, the remainder in 2006.;Since the Waltham plant will use the same technology as Santa Clara, we can assume that the variable;manufacturing costs will be the same as Santa Clara's. Selling prices will also be the same. However, since Waltham;will be a stand-alone faculty, its fixed manufacturing costs, excluding depreciation, would be somewhat higher: $2.4;million annually beginning in 2004. In 2006, however, fixed costs will increase to $2.6 million annually, where I;expectthemto remainfor the foreseeablefuture..;Ian: I just visited the Beta-test site for the manufacturing equipment using the new technology that I'propose we use;for the greenfield plant. There I learned that the economic size for a plant using this technology to manufacture a;product such as FlexConnex is about 70 million units, so I propose that we prepare our estimates for Ireland based;on a 70-million-unit capacity plant. Of course, this will cost more, since it is much larger than other sites. With the;help of the Irish government, an appropriate site can be obtained for about $1 million. A building large enough to;produce 70 million units can probably be built for about $10 million, and equipping the facility with the new;technology equipment wilt' cost about $50 million. Most of this would be spent in 2003, although as much as 10;percent might be spent before the end of 2002 to acquire and prepare the site. The plant would begin production in;2004, some areas of the plant would not be complete, however, and as much as 20-25 percent of the investment;would remain to be spent during 2004.;Although FlexConnex's worldwide selling price will be the same as for the other facilities, the new equipment will;lower the variable manufacturing cost to $0.195 per unit. The efficiency of this new plant will help keep fIxed;manufacturing costs down, as well, but since the facility will be so large, fixed manufacturing costs, excluding;depreciation, would be higher than the other two facilities: $2.8 million annually beginning in 2004, rising to $2.9;millionannuallybeginningin 2008..;Tom: These assumptions sound like reasonable first cuts to me. Let's just start with a five-year analysis, 2003;through 2007, using the discount rate of 20 percent, which the corporate finance manual states is the hurdle rate for;capital investments. For simplicity, let's assume all cash flows occur at the end of the respective year. Discount;everything to today's dollars, that is, as of the end of 2002. And, consistent with corporate policy, we'll do a pretax;analysis, we'll ask the corporate finance staff to evaluate.the tax implications later.;A few minutes later, the buzzing of the small groups died down, and the tapping on the laptop keyboards had ceased.;Tom: Well, what have you learned from this first glance?;20-10;Edward: The Waltham site looks promising.;Ian: Not Ireland.;Gracie: This is odd. The Santa Clara plant is right on the margin, and that surprises me since the existing;manufacturing facility is one of CTI's most profitable, and we get further economies of scale by expanding that;plant. 1wonder if the discount rate we are using is too high. At the "Finance for Manufacturing Engineers" seminar I;attended recently, we discussed the problems associated with using a discount rate that was too high. The professor;stated that there was a sound theoretical basis for using a discount rate that approximated the company's cost of;capital, but many companies "added on" estimates for risk, corporate charges, and other factors that were less well;grounded. Based on what I learned in that seminar, I tried to estimate CTI's actual cost of capital, it was about 10;percent.l wonder what would happen if we used 10 percent instead?;Tom: With these laptops and spreadsheet programs, that's easy enough, let's check it out.;A few seconds later,...;Gracie: Now, that's better!;Edward: Ours too.;Ian: Well, at least we're moving in the right direction. But it doesn't make sense to me that a facility with lower;variable cost per unit, and lower average fixed cost per unit at capacity, shows a negative NPV when the others are;positive. We checked our calculations, what's the story? Could it be that Ireland would not even be up to capacity;production in five years because the plant is so big?;Gracie: Maybe, but our plants are being penalized, too, after all, even though they reach capacity in the first five;years, they will presumably continue to produce FlexCoDl1ex.Although there is constant technological change in;this industry, there is a reasonable probability that demand for FlexCoDl1exwill remain strong for at least 10 years.;Ian: Well, then, let's look at each of the three plants over a ten-year period, using Gracie's 10 percent discount rate.;Later.....;Edward: Aha! Waltham continues to improve.;Gracie: However, Santa Clara has you beat now!;Ian: I've got bad news for both of you!;QUESTIONS;1. Prepare the manufacturing staffs calculations for the three alternatives;a. In the fIrst set of calculations, the staff used a discount rate of 20 percent, a fIve-year time horizon, and;ignored taxes and terminal value. What is the relative attractiveness of these three alternatives?;b. In the second set, they used a 10 percent discount rate. What happens to the NPV of each alternative? What;happens to their relative attractiveness? Why?.;c. In the third set, they changed the time horizon to ten years, but kept the 10 percent discount rate. Why does;Ian say he has "bad news" for the others?;2. In addition to reducing costs, the new technology proposed for the greenfield plant would increase;rnanufacturing flexibility, which would enable eTI to respond more quickly to customers and to provide them;more custom features. Should these factors be considered in the analysis? If so, how would you incorporate;them?;3. Should other factors be taken into consideration in choosing the location of the FlexCoDl1explant? If so, what;are they?;4. Should Torn Richards continue to develop more detailed plans for these.three alternatives? Hnot, which should;be eliminate a? AIe there other alternatives that his staff should consider? If so, what are they?;20-11;EXHIBIT 1 FlexConnex Cost Analysis Sheet;Santa Clara Plant, 2002;Plant Capacity: 75 million units;Selling PricelUnit: $0.85;Variable CostlUnit: $0.255;Fixed Manufacturing Cost: $9.5 million annually (included $2.5 million depreciation);Estimated Plant Profitability at Capacity;Revenue $63,750,000;Variable Cost;Fixed Manufacturing Cost*;Plant Profitability $35,125,000;*Excludes interest expenses and corporate selling, general and administrative expenses


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