91Ó°ÊÓ

Phish Corporation is the largest manufacturer and distributor of novelty ice creams across the East Coast. The company's products, because of their perishable nature, require careful packaging and transportation. Phish uses a special material called ICI that insulates the core of its boxes, thereby preserving the quality and freshness of the ice creams. Patrick Scott, the newly appointed \(\mathrm{C} 00\), believed that the company could save money by closing the internal Packaging department and outsourcing the manufacture of boxes to an outside vendor. He requested a report outlining Phish Corporation's current costs of manufacturing boxes from the company's controller, Reesa Morris. After conducting some of his own research, he approached a firm that specialized in packaging, Containers Inc., and obtained a quote for the insulated boxes. Containers Inc. quoted a rate of \(\$ 700,000\) for 7,000 boxes annually. The contract would run for five years and if there was a greater demand for boxes the cost would increase proportionately. Patrick compared these numbers to those on the cost report prepared by Reesa. Her analysis of the packaging department's annual costs is as follows: After consulting with Reesa, Patrick gathers the following additional information: i. The machinery used for production was purchased two years ago for \(\$ 430,000\) and was expected to last for seven years, with a terminal disposal value of \(\$ 10,000\). Its current salvage value is \(\$ 280,000\). ii. Phish uses 20 tons of ICl each year. Three years ago, Phish purchased 100 tons of ICI for \(\$ 400,000 .\) ICI has since gone up in value and new purchases would cost \(\$ 4,500\) a ton. If Phish were to discontinue manufacture of boxes, it could dispose of its stock of ICI for a net amount of \(\$ 3,800\) per ton, after handling and transportation expenses. iii. Phish has no inventory of other direct materials; it purchases them on an as-needed basis. iv. The rent charge represents an allocation based on the packaging department's share of the building's floor space. Phish is currently renting a secondary warehouse for \(\$ 27,000 ;\) this space would no longer be needed if the contract is signed with Containers Inc. v. If the manufacture of boxes is outsourced, the packaging department's overhead costs would be avoided. The department manager would be moved to a similar position in another group that the company has been looking to fill with an external hire. vi. Phish has a marginal tax rate of \(40 \%\) and an after-tax required rate of return of \(10 \%\). 1\. Sketch the cash inflows and outflows of the two alternatives over a five- year time period. 2\. Using the NPV criterion, which option should Phish Corporation select? 3\. What other factors should Phish Corporation consider in choosing between the alternatives?

Step by step solution

01

Determine Costs of In-House Production

Calculate the annual costs for maintaining the Packaging department by evaluating costs for machinery, ICI, direct materials, rent, and overhead. For machinery cost, use depreciation which involves subtracting the terminal disposal value from the initial purchase cost and dividing by its lifespan: \( \text{Depreciation per year} = \frac{430,000 - 10,000}{7} \). For ICI, no new purchase price is needed since existing stock is used.

02

Determine Costs of Outsourcing

From the provided contract, Containers Inc. costs are \( \$700,000 \) annually for packaging 7,000 boxes, with a potential increase if demand changes. Calculate the total contractual cost over five years: \( \text{Total cost} = 700,000 \times 5 \).

03

Evaluate Savings and Benefits from Outsourcing

Consider benefits such as no longer needing the filler ICI stock, freeing up the secondary warehouse rental space (\\(27,000), and overhead savings from the Packaging department closure. Calculate the net revenue from selling 20 tons of ICI at \\)3,800 per ton: \( \text{Net revenue} = 20 \times 3,800 \).

04

Calculate Net Present Value (NPV) for In-House and Outsourcing

Determine cash flows from in-house savings and outsourcing costs, calculating their NPVs at the company's post-tax discount rate of 10%. Use NPV formula: \[ \text{NPV} = \sum \frac{C_t}{(1+r)^t} \]where \( C_t \) is the net cash flow at time \( t \) and \( r \) is the discount rate.

05

Compare In-House vs. Outsourcing NPVs

Compare the NPVs calculated in Step 4 to decide which option offers a higher financial benefit over the five years. Select the one with the greater NPV.

06

Consider Additional Factors

Beyond quantitative analysis, evaluate qualitative factors like potential outsourcing risks, impact on product quality, employee morale, and reliance on external vendors. Also, reassess strategic alignment with company goals.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Outsourcing Decision

When a business evaluates whether to outsource a part of its operation, it involves strategically deciding if hiring an external provider is more beneficial than performing the task in-house. In the case of Phish Corporation, the decision revolves around outsourcing the packaging of ice creams to Containers Inc. This decision-making process should look beyond immediate cost comparisons and include a detailed cost-benefit analysis. When considering outsourcing:

• Examine both direct and indirect costs related to continuing in-house operations.
• Compare these to the known costs of outsourcing to assess potential savings.
• Assess the qualitative benefits of outsourcing, such as improved focus on core activities and elimination of specific operational risks.

It's important to evaluate if the external service provider can meet or exceed the current quality and reliability standards. In Phish Corporation’s scenario, comparing the internal packaging department costs against the fixed quote from Containers Inc. provides a more comprehensive view of which option offers a better financial scenario over a specified period.

Net Present Value (NPV)

Net Present Value (NPV) is a critical financial metric used to assess the profitability of an investment. It calculates the difference between the present value of cash inflows and the present value of cash outflows over a period of time, considering a specified discount rate. For Phish Corporation, the NPV helps determine whether outsourcing the packaging department is financially more advantageous.When calculating NPV, follow these steps:

• Identify the net cash flows for each year for both in-house operations and outsourcing.
• Apply the discount rate to each cash flow to determine its present value. For Phish, an after-tax discount rate of 10% is used.
• Sum the present values for all periods to arrive at the NPV.

The general formula for NPV is:\[ \text{NPV} = \sum \frac{C_t}{(1+r)^t} \]where \( C_t \) represents cash flow at time \( t \) and \( r \) is the discount rate. A positive NPV indicates the investment would result in a net gain, while a negative NPV suggests a net loss. For Phish Corporation, it's crucial to select the option with the higher NPV, signaling a better financial return.

Cost-Benefit Analysis

A cost-benefit analysis is a method used to evaluate the overall value for money of a project or decision by comparing all associated costs and benefits. In the case of Phish Corporation, this analysis was required to determine whether to continue with in-house packaging or switch to outsourcing. The analysis involves:

• Listing all direct and indirect costs associated with both current operations and outsourcing options, such as materials, labor, and overhead expenses.
• Identifying quantifiable benefits such as cost savings from eliminated overheads, revenue from selling stocks of unused materials, and potential space rental savings.
• Evaluating non-quantifiable factors like changes in product quality, employee morale, flexibility, and strategic alignment.

For Phish, potential annual savings from eliminating warehouse rental costs and overheads, alongside revenue from selling unused ICI stock, weigh heavily in the final decision. By effectively applying cost-benefit analysis, companies can make informed financial decisions, ensuring that the benefits outweigh the costs, leading to enhanced long-term profitability.