Question

Boston Metal Company (BMC), a small manufacturer of fabricated metal parts, must decide whether to compete to become the supplier of transmission housings for Gulf Electric. Gulf Electric produces transmission housings in its own in‐house manufacturing facility, but it has almost reached its maximum production capacity. Therefore, Gulf is looking for an outside supplier. To compete, BMC must design a new fixture for the production process and purchase a new forge. The available details for this purchase are as follows:

• The new forge would cost $125,000. This total includes retooling costs for the transmission housings.

• If BMC gets the order, it may be able to sell as many as 2,000 units per year to Gulf Electric for $50 each, and variable production costs (such as direct‐labor and direct‐material costs) will be $15 per unit. The increase in fixed costs, other than depreciation, will amount to $10,000 per year.

• The firm expects that the proposed transmission‐housings project will have about a five‐year project life. The firm also estimates that the amount ordered by Gulf Electric for the first year will also be ordered in each of the subsequent four years. (Due to the nature of contracted production, the annual demand and unit price would remain the same over the project after the contract is signed.)

• The initial investment can be depreciated on a MACRS basis over a seven‐year period, and the marginal income‐tax rate is expected to remain at 40%. At the end of five years, the forge is expected to retain a market value of about 32% of the original investment. BMC’s MARR is known to be 15%.

What Makes BMC Managers Worry:  BMC’s managers are uneasy about this project because too many uncertain elements have not been considered in the analysis:

• If it decides to compete for the project, BMC must invest in the forging machine in order to provide Gulf Electric with samples as a part of the bidding process. If Gulf Electric does not like BMC’s samples, BMC stands to lose its entire investment in the forging machine.

• If Gulf likes BMC’s samples, but feels that they are overpriced, BMC would be under pressure to bring the price in line with those of competing firms. Even the possibility that BMC would get a smaller order must be considered, as Gulf may use its overtime capacity to produce some units in‐house instead of purchasing the entire number of units it needs. BMC is also not certain about the variable‐ and fixed‐cost projections.

Recognizing these uncertainties, the managers want to assess a variety of possible scenarios before making a final decision. Put yourself in BMC’s management’s position mentally, and describe how you might address the uncertainty associated with the project. In doing so, perform a sensitivity analysis for each variable and develop a sensitivity graph.

Annual Revenue (X)	Probability	General Inflation Rate (Y)	Probability
$15,000	0.20	3%	0.25
$25,000	0.50	5%	0.50
$35,000	0.30	7%	0.25

Answer 1