Question

Landry Grass (LG) is a manufacturer of artificial grass for sport, landscape, and playground applications. LG is divided into three main divisions, sport, landscape, and playground - and each division is treated as a profit centre. LG's strategy is to deliver the most dynamic and innovative range of artificial grass, meeting the highest performance standards and producing customized solutions for a wide range of customers.

Bill Withers, the newly appointed VP of Accounting for the sports division, considers a new machine that has been developed. The new machine is an upgraded version of LG's existing machine, used to manufacture artificial grass for soccer fields. Bill is not sure if it makes sense to buy the new machine, since the old machine was only purchased 2 years prior. However, the annual cost savings proposed by the manufacturer of the new machine seem attractive. Bill is especially interested in investigating the new machine because his annual bonus is tied to LG's net income, and any cost reductions will benefit him as well as the company.

The initial cost of the new machine is $200,000 and it has a useful life of 7 years. There is an initial set up cost of $7,000, which is required to integrate the machine with the existing equipment. At the end of 7 years, the machine has a salvage value of $24,000.

Bill knows that the has to accurately estimate the cost savings from the new machine. The new machine is more automated and will save 2,000 direct labour hours per year. The labour rate is $16 per hour. Bill knows that the new machine will be more expensive to run and estimates increased power and maintenance costs of $250 per month. The existing machine has a contribution margin of $330 per unit.

Currently, LG's artificial grass is sold to local schools, universities, and soccer clubs. A soccer team announced plans to sponsor a club in a city only 100km away from LG. This requires a higher grade of grass but the production process is similar to the type of grass LG currently produces. The higher grade grass could only be produced with the new machine Bill is considering.

LG has the available capacity to produce the higher grade grass in addition to it's regular grass. It would cost LG $.50 per sq. meter to supply the higher grade grass. and 7,000 sq. meters would be needed. Bill estimates the sales price of this grass would be $50,000 and believes the sale would take place in 2 years.

Bill knows the machine is a good strategic fit for LG, as more sports teams will need grass. He is not sure if it makes sense to replace a machine that was only purchased 2 years prior. LG paid $100,000 for the existing machine and is depreciating it on a straight line basis over it's estimated useful life. The existing machine's book value is $60,000 and LG could sell it today for $25,000, realizing a $35,000 loss.

Before Bill prepares his report to management, he considers the estimated labour hour savings. He wonders how the analysis would change if the labour hours savings was increased by 10%. The estimate could have a significant impact on the final decision because it is an annual number. He knows 2,000 is a reasonable estimate provided by operations, but decides to increase it by 10% to make sure the new machine is purchased.

LG has a required rate of return of 12%.

REQUIRED

Prepare the report that Bill would submit to his manager recommending whether LG should purchase the machine to make higher grade turf. Round your calculations to the nearest dollar.

Answer 1

Cost of new machine = 200,000

Salvage value = 24,000

Depreciation for 7 years = 176000

Depreciation per year = 25,143 approx

Installation cost borne = 7000

Total apportioned cost per year = 25143 +1000 = 26,143

Power and maintenance costs per year = 250*12 = 3000

Labour money saved due to new machine = Labour hours saved * Labor rate per hr

= (2000 * 110%) * 16 = 35,200

Net of savings less expenses = 35200 - ( 26143 + 3000) = 6057

Yes, the new machinery should be purchased.