Engineering Economy

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QUESTION
 
 
 
Case Study1
Elroy had been with Barnes Machine Company a year since finishing a BS in industrial
engineering (IE). Barnes had been in business for over 50 years, but the company had only recently
moved from Detroit to Gainesville, Georgia. The public reason for the move was the economics
of the old facility. Privately, based on comments he had heard, Elroy believed a shift to nonunion
labor was a larger motive.
Elroy’s boss is the production supervisor, Mr. Hill. Because the plant and the workforce are new,
Elroy has been conducting time-and-motion studies to establish new production standards. While
these were clearly needed, Elroy was impatient to apply other IE tools he had studied.
One Friday, Mr. Hill asked Elroy to attend a 10 a.m. meeting on Monday. Monday morning, Elroy
was surprised to join not only Mr. Hill and John Blackburn, the head of manufacturing engineering,
but also Mr. Simkins, the head of marketing and several others from sales and marketing. Most
surprising was the attendance of the company’s CEO, Mr. Barnes, Jr.
The meeting’s purpose was to consider a request for proposal (RFP). As Mr. Simkins quickly
pointed out, the request came from one of Barnes’s most significant customers. The problem, and
the reason for the special meeting, was that a successful bid would exceed current production
capabilities. Mr. Simkins, in summarizing, said, “Fortunately Mr. Barnes was farsighted enough
to have our new facility built with room for expansion.”
Mr. Hill agreed: “I see no reason why we should not bid on this proposal. Of course, as John
pointed out, we will need new production capability. While this RFP calls for a four-year delivery
plan, the total number of parts has not been specified. Since Simkins believes the data will be
available before the final proposal deadline, I suggest that we examine the economics of the various
manufacturing alternatives. To that end, I intend to have Elroy here start that study immediately.”
Mr. Barnes ended the meeting with, “I’m sure that not bidding won’t hurt our other business with
them, but they have been a steady customer since my father started the company and I really would
like to help them. Besides, whenever we have added new manufacturing capacity, Simkins has
managed to sell it to someone. So, whatever you do, Hill, don’t let Elroy be too pessimistic. Let’s
get on with it. I expect a preliminary evaluation in a week. By the way, John, don’t forget about
all that extra equipment we have stored from the old plant. You may find something there that will
help keep the cost down.”
During the next several days, Elroy met several times with Mr. Hill and John Blackburn. John,
who had joined the company after it moved, drove to a warehouse in Atlanta to inspect the stored
equipment. In a meeting Wednesday, John said that only a new engine lathe would be required.
Hill said, “If that’s all we need to bid this job, Mr. Barnes will be very pleased. After all, what will
it cost, 15 or 20 thousand?”
“We can probably find one in that price range, Mr. Hill,” John said, “but if we are going to consider
this as a long-term investment that Mr. Simkins will market for us, I think we should seriously
consider one of the automated systems that have become available in the past few years.
Remember, this type of equipment usually lasts a long time. I am sure that it will still be serviceable
long after we complete this contract.”
1 Adapted from “Cases in Engineering Economy 2nd Edition”.
2
“OK, John, your point is well made,” Mr. Hill replied. “Elroy see what you can find that will do
the job. Check with John on the specs but take a close look at the economics for us.”
During the next few days, Elroy found that there were basically 3 different possible machine types
that would do the job ranging from the traditional manual engine lathe to a computer-controlled
lathe. From the manufacturers, he obtained the information contained in Table 1.
Table 1. Cost Data
Machine Type
Purchase
Cost
Annual Maintenance
Cost per Machine
A. Manual $20,000 $2,750
B. Semiautomatic $45,000 $6,250
C. Automatic $100,000 $8,250
The company works 40 hours per week (there are 52 weeks in a year), hint: use this information
to calculate labor cost and number of machines required (the number of machines must be an
integer number). The company pays labor costs based on the hours that the machines are used
(hint: you should calculate the machine-hours required for the production runs). Machine A would
require a full-time operator. A single operator could service two of Machine B, and Machine C
would require no operator at all. After consulting with John about the skill level required, Elroy
checked with accounting and found that an operator would be paid at $14 an hour (hint: you should
estimate the labor hours needed to calculate the labor cost). Accounting had indicated that they
would try to classify the equipment in the 5-year life category for tax depreciation purposes.
Mr. Hill, John, and Elroy decided that the analysis should be based on production runs of 40,000
pieces per year. When Elroy checks with accounting, he finds that they can make the analysis
based on 4 years and effective income tax rate is 25%. They estimate that each machine will have
a salvage value of 20% of initial purchase cost at the end of four years. Marketing tells him that
the sale price per piece is expected to be $4.50.
Elroy noted that each of the machines has a different production rate and he decided to ignore
setup cost for each machine. Elroy summarized the production rate and variable cost in Table 2.
Table 2. Production Data
Machine
Type Production Rate (Pieces/Hour) Variable Cost/Piece
A. 6 $1.30
B. 10 $2.50
C. 20 $3.20
In previous economic studies of capital purchases, Elroy has been told to use a MARR of 15%. He
believes that he should do the same here.
Accounting had indicated that that the War-Eagle Bank had offered a loan of up to $20,000 and
they would use $20,000 loan for any machine with APR of 9% and repayment would be made in
3 equal annual payments.
Friday afternoon Elroy sits down to begin his analysis. He knows that everyone at the meeting
next Monday will expect him to have an answer and that it is very likely that his report will
determine whether Barnes responds to the RFP.
3
Assume that you work in the same position that Elroy has and answer the following questions.
Questions
1. Perform a spreadsheet analysis that shows after tax cash flows over a 4-year period and find the
net present value (NPV) for each machine option. According to the NPV criterion, what would be
your decision? 50 pts
2. Find the IRR for each machine option. According to the IRR criterion, what would be your
decision? Show your analysis on spreadsheet (incremental analysis etc.). 10 pts
3. Elroy wants to show how changes in the variables can affect the NPV of the investment project
of machine type B. Perform a sensitivity analysis varying the variable cost, annual maintenance
cost, price per piece and salvage value. Assume that each of these variables can deviate from its
base-case expected value by ±10%, ±20%, and ±30%. Make a table showing all your NPVs for
each change and the base case scenario. 15 pts
4. Based on your results from question 3, plot the sensitivity diagram (NPVs vs change on
variables). Write a short conclusion about the sensitivity analysis performed. 15 pts
5. Elroy wants to know the break-even point of demand for each machine. Explain your procedure
shortly. Note: do not change the number of machines. 10 pts
*Submit an excel and word or pdf documents in a zip file. Mac users need to save the
spreadsheet as xls or xlsx.

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