Question

Consider the following scenario: An engineering firm is considering switching from a manual to an automated machine for quality control. Under the current process:

1. Manual inspection:
   1. Works earn $35/ hour, inspect 7 items per hour and need 16 inspectors total, working 8 hours per shift and 200 shifts a year
   2. There is a false negative of 15%, so the company actually pays workers $25/hr and sets aside $10/hr to cover cost of poor quality (considered a regular business expense)
2. Proposed automated inspection:
   1. Capital cost of machine is $17million (it is available in 2 months)
   2. Cost of shipping machine would be $50,000
   3. Installation/modifications of machine into warehouse is $130,000
   4. Operating costs are estimated to be “minor”
   5. Inspection cost for management to observe machine prior to purchase is $5,000
   6. Automated process has a false negative rate of 2%

For both processes:

1. The firm sells 170,000 items a year at $75 each
2. Use a planning horizon of 4 years and a corporate MARR of 12%
3. Do not consider taxes in the analysis

-Based on the above considerations, what should the company do and why? Show calculations.

Answer 1

Solution:

Manual Inspection : Working-1

Expected sales in units a year =170000 at $ 75 per unit

False Negative rate is 15%

	Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
	Sales (175,000*75)		12,750,000	12,750,000	12,750,000	12,750,000	A
Less	Capital cost	-	-	-	-	-	B
Less	Labour Cost		(640,000)	(640,000)	(640,000)	(640,000)	C	=-(8*200*16*25)
Less	Sales lost due to false negative		(2,250,000)	(2,250,000)	(2,250,000)	(2,250,000)	D	=(12750000)*15/85
	Net Cash Flows	-	9,860,000	9,860,000	9,860,000	9,860,000	E=A-B-C-D
	Discount Factor at 12%	1	0.8929	0.7972	0.7118	0.6355	F
	PV of Net Cash Flows	-	8,803,571	7,860,332	7,018,153	6,266,208	E*F
	NPV if manual inspection is done	29,948,265

Automated Inspection: Working -2

Capital Cost of the machine	17,000,000
Cost of shipping	50,000
Installation/modification	130,000
Pre purchase inspection	5,000
Total Capital Outlay	17,185,000

False Negative Rate is 2%

Cash Flow Analysis of Automated Inspection-Working 3

	Particulars	Year 0	Year 1	Year 2	Year 3	Year 4
	Sales (175,000*75)		12,750,000	12,750,000	12,750,000	12,750,000	A
Less	Capital cost	(17,185,000)		0	0	0	B
Less	Labour Cost (for 2 months)		(106,667)				C
Less	Sales lost due to false negative		(591,837)	(591,837)	(591,837)	(591,837)	D
	Net Cash Flows	(17,185,000)	12,051,497	12,158,163	12,158,163	12,158,163	E=A-B-C-D
	Discount Factor at 12%	1	0.8929	0.7972	0.7118	0.6355	F
	PV of Net Cash Flows	(17,185,000)	10,760,265	9,692,413	8,653,940	7,726,733	E*F
	NPV	19,648,351

Hence the COmpany should continue with manual inspection as it gives a higher NPV

Note that the value of false negatives during inspection has been assumed based on the sales value as cost of the units are unavailable.