Charles Bradshaw, president and owner of Wellington Metal Works, had just returned from a trip to Europe.1 While there, he had toured several plants using robotic man- ufacturing. Seeing the efficiency and success of these companies, Charles became convinced that robotic manufacturing is the wave of the future and that Wellington could gain a competitive advantage by adopting the new technology.
Based on this vision, Charles requested an analysis detailing the costs and bene- fits of robotic manufacturing for the material handling and merchandising equip- ment group. This group of products consists of such items as cooler shelving, stock- ing carts, and bakery racks. The products are sold directly to supermarkets.
A committee, consisting of the controller, the marketing manager, and the pro- duction manager, was given the responsibility of preparing the analysis. As a starting point, the controller provided the following information on expected revenues and expenses for the existing manual system:
1 This case is based, in part, on David A. Greenberg, "Robotics: One Small Company's Experience," in CostAccounting for the 90's (Montvale, NJ: National Association of Accountants, 1986): pp. 57-63.
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Percentage of Sales |
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Sales
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$400,000
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100%
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Less: Variable expensesa
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228,000
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57
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Contribution margin
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$172,000
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43
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Less: Fixed expensesb
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92,000
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23
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Income before income taxes
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$ 80,000
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20
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a. Variable cost detail (as a percentage of sales): Direct materials, 16%
Direct labor, 20%
Variable overhead, 9%
Variable selling, 12%
b. Of the total, $20,000 is depreciation; the rest is cash expenses.
Given the current competitive environment, the marketing manager thought that this level of profitability would likely not change for the next decade.
After some investigation into various robotic equipment, the committee settled on an Aide 900 system, a robot that has the capability to weld stainless steel or alu- minum. It is capable of being programmed to adjust the path, angle, and speed of the torch. The production manager was excited about the robotic system because it would eliminate the need to hire welders, which was so attractive because the mar- ket for welders seemed perpetually tight. By reducing the dependence on welders, better production scheduling and fewer late deliveries would result. Moreover, the robot's production rate is four times that of a person.
It was also discovered that robotic welding is superior in quality to manual welding. As a consequence, some of the costs of poor quality could be reduced. By providing better-quality products and avoiding late deliveries, the marketing man- ager was convinced that the company would have such a competitive edge that it would increase sales by 50 percent for the affected product group by the end of the fourth year. The marketing manager provided the following projections for the next 10 years, the useful life of the robotic equipment:
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Year 1
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Year 2
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Year 3
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Years 4-10
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Sales
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$400,000
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$450,000
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$500,000
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$600,000
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Currently, the company employs four welders, who work 40 hours per week and 50 weeks per year at an average wage of $10 per hour. If the robot is acquired, it will need one operator who will be paid $10 per hour.
Because of improved quality, the robotic system will also reduce the cost of direct materials by 25 percent, the cost of variable overhead by 33.33 percent, and variable selling expenses by 10 percent. All of these reductions will take place immediately after the robotic system is in place and operating. Fixed costs will be increased by the depreciation associated with the robot. The robot will be depreciated using MACRS. (The manual system uses straight-line depreciation without a half-year convention and has a current book value of $200,000.) If the robotic system is acquired, the old system will be sold for $40,000.
The robotic system requires the following initial investment:
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Purchase price
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$380,000
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Installation
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70,000
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Training
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30,000
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Engineering
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40,000
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At the end of 10 years, the robot will have a salvage value of $20,000. Assume that the company's cost of capital is 12 percent. The tax rate is 34 percent.
Required
1. Prepare a schedule of after-tax cash flows for the manual and robotic systems.
2. Using the schedule of cash flows computed in Requirement 1, compute the NPV for each system. Should the company invest in the robotic system?
3. In practice, many financial officers tend to use a higher discount rate than is jus- tified by what the firm's cost of capital is. For example, a firm may use a dis- count rate of 20 percent when its cost of capital is or could be 12 percent. Offer some reasons for this practice. Assume that the annual after-tax cash benefit of adopting the robotic system is $80,000 per year more than the manual system. The initial outlay for the robotic system is $340,000. Compute the NPV using 12 percent and 20 percent. Would the robotic system be acquired if 20 percent is used? Could this conservative approach have a negative impact on a firm's ability to stay competitive?