It is hoped that the value added by the UDA system will help to increase sales of the core product. The division manager of Gadgets has a valid point in regards to the overall impact on the Division's profits. He had a valid reason for requesting this exception to the rules. It may at first appear that the Gadget Division manager is acting out of self-interest and protectionism. However, it may be that he truly does have the best interests of the entire organization in mind.
If Gadgets fails to produce a product that will increase sales of the core product then the entire organization may be in jeopardy. If the exclusion is allowed, then the Gadget Division would have more money at their disposal for better research and development. The Gadget Division has to get it right the first time. Therefore it seems reasonable to allow the Gadget Division to be excluded from the normal cost sharing practices of the company. The Gadget Division realizes the importance of this project and wishes to make certain that their. Although this move may serve to alienate other Division managers, it is felt that this move will be necessary However, if the rationale for this decision is carefully disclosed, then the negative reactions are likely to be less intense.
In order to lessen the blow to other divisions it is the decision of the analyst that it would be unfair to allow the Gadget Division to accept no risk for the project. However, it is also recognized that since the division is disproportionately small, as compared to other divisions that make up the core manufacturing divisions, they will be allowed to share a smaller portion of the risk than company policy dictates. This will allow them to sink more money into research and development, without allowing them to avoid their responsibilities to the organization as a whole.
It may at first appear that the Gadget Divisions Manager's response is an attempt to avoid company policy. However, when one analyzes the situation more closely it appears that the proposal does have the best interests of the company in mind. Corporate overhead is a concern for the entire plant. Organizational goals should be at the forefront of everyone's concern. The UDA project is of utmost importance to the success of the core product line. It is expected to give GMC a considerable advantage over those that do not offer such services, and will put them on at least an equal footing to competitors that already have similar technology in place.
The Gadget Division manager does have the best interests of the project in mind. This decision will require an exception to corporate policies. These policies were supposed to be fair and equitable to all divisions involved. As written, each division shares the same percentage of the burden. However, as the Gadget Division's manager pointed out, this would be equitable if it were proportionate to the relative size of all of the divisions. The Gadgets Division contributes value added projects that help to enhance the core products. As such, they run on a much smaller budget than divisions that specialize in the actual manufacture of automobiles.
If they are made to share the same percentage as the other divisions then they are actually sharing a larger portion when one considers their size. This factor was not considered when the policy was adopted. It may be a good idea to review this policy in the past to make certain that it is still a valid approach to cost sharing across the company. However, for the time being, the Gadget Division will be allowed to share half of the normal percentage of the burden.
There are many factors that must be considered in determining whether to undertake a project. There are several different approaches to the problem and no right or wrong answer. Every analyst has their own favorite method for determine the future value of a project. There are several quantitative approaches that one can use. However, it is not all about the numbers. Even if a project appears to be profitable from an analytical perspective, it may still fail if certain more subjective factors are not considered.
We mentioned the fact that the automobile market has reached maturity and that several other competitors have already beaten GMC to the introduction of similar products. These factors and others will have a major impact on the outcome of this project. These factors are difficult to analyze because there are simply too many variables to factor into a reasonable guess as to what will happen. Therefore, the quantitative analysis will have the greatest weight in this analysis.
The most common analysis technique is to analyze the potential return on the investment (ROI). This techniques tells us at which point will the company start making money and how much will they make, if the circumstances hold true. Risk analysis is the opposite of ROI. Using this philosophy every project has a foreseeable and predictable financial risk. Risk analysis involves measuring the potential risk against the potential gain of the project. The idea is to avoid risk and take the route that has the highest potential gains. Both of these analysis approaches involve the use of Break even analysis.
The first factor in determining the break even point for the UDA project is the effect of the UDA project on core product lines. It is the general consensus that the UDA will result in an annual after tax cash flow of $25 million dollars. When one extrapolates these figures over the entirety of the project it amounts to $100 million dollars. This estimate considers the scenario where the product is well-received by the public and that expected sales quotas are met.
One of the key financial considerations for this project is where the production will take place. GMC already owns a suitable building for production of this product. The building was purchased twenty years ago for $40 million dollars and has a current value of $10 million. After the completion of the project this building will be sold for $6 Million. The building has been valued using a straight line depreciation from the time of purchase.
The cost for using this building, minus overhead, represents a fixed cost. Equipment will cost $180 Million dollars, but will have no re-sale value at the end of the project. This makes the net expenditure for he use of the building (-$186 million). This assumes that there will be no major repairs needed on the building due to its setting vacant for so many years. Currently, this building represents a liability from many perspectives. The company has to maintain insurance on the building, yet gains no revenues for its use. It is liability and will soon begin to dilapidate if actions are not taken to prevent its further decline. Using this building would transfer these numbers from the liability side to the revenue side of the equation.
Now let us examine the most commonly considered production revenues and costs for the duration of the project. If market predictions are correct, it can be expected that 1.5 million units will be sold over the first two years and that 1 million will be sold over the last two years of the project due to the entry of even greater competition into the marketplace. However, several competitors already have this technology, so this is not expected to be a factor. The total cost per unit will be $700 for the first two years of the project. During the second two years, the unit price is expected to drop to $500 per unit due to introduced competition. Let us take a look at how these projections look by examining the following table.
UDA Project Revenue Statement
Cost of goods sold
Net Operating Income
In sufficient data was provided to estimate operating expenses and variable costs. Therefore, they were not included in these figures. Many of these factors cannot be accurately determined for the purposes of quantitative analysis. There are many factors that could affect these costs such as wages, health care costs, fuel costs, and utility costs. It is expected that operating costs will reduce the net income considerably from those shown. However, it will reduce it at a uniform rate, so that it will not affect the final analysis of the project.
Now let us see what the additional $25 Million in Sales does to these projections. In addition we will cost-average the $180 Million in equipment expenses over the four years of the project. The effect of the $6 million for resale of the building is negligible in this case.