Having difficulty with this case study on Budgeting!
“There are 8,264 different types of errors you can make in a printing job,” Jim Crandall has been heard to say. “And over the years I guess I’ve made nearly every one twice over.” Crandall is the owner of Letter Perfect Press, a company with annual sales of nearly $8 million. The firm does a wide range of printing, including annual reports, or*ganizational brochures, and personal printing jobs such as wedding invitations. He purchased the firm in 1976 when there were 16 employees and the business occupied 10,000 square feet. Now, 20 years later, there are 65 employees, and the business occupies 35,000 square feet. Crandall stresses quality printing and has even been known to redo projects that customers were perfectly satisfied with. He feels strongly that “if it’s not as good as we can do, we redo it.” The Problem
Crandall now faces a decision about replacing a printing press, the Miller, named after its manufacturer. Though the machine is 15 years old, this is not necessarily “ancient” for equipment of this sort. Still, the Miller has required substantial maintenance time the last few years. As a result, not only have mainte*nance costs been increasing, but the machine’s down (maintenance) time has been increasing as well. Though the Miller has been able to achieve its production target of $500,000 of sales per year, Crandall is certain this volume will not be maintained. Exhibit 1 shows estimates of the annual sales he expects from the Miller over the next seven years. After reviewing these figures, he even wonders if they aren’t a bit generous, especially in the later years.
Crandall is “nearly certain” the machine should be replaced and has nar*rowed the choice to two models: the Akiyama, which is made in Japan, and the German-manufactured Heidelberg. With a decision like this there are often fac*tors other than cost that influence the choice. Will the machine be expertly in*stalled? It is vital that a press be firmly level because the error tolerance in a typ*ical job is in thousandths of an inch. Does a manufacturer offer professional assistance in press operation? A new piece of equipment requires employee re*training, and it is necessary that a producer offer operator assistance during the first few weeks after a sale. Does a manufacturer offer prompt and reliable main*tenance support? The equipment must be examined twice a year to minimize the chance that problems will arise, and if a malfunction does occur, Crandall wants the machine repaired as quickly as possible.
The technical support of each firm is excellent and Crandall feels these factors are about equal. Nor is there much to choose from on the basis of an*nual operating costs; see Exhibit 2. For example, two workers are required to run either press. An operator feeds the ink and paper into the machine, while a pressman adjusts the equipment for the type of printing being done. The Heidelberg, though, because it is a bit bigger and more expensive, will require more space, increase the firm’s annual insurance premium, and cost somewhat more to maintain. These increases, however, are relatively small. Heidelberg versus Akiyama
The real differences involve each machine’s contribution to annual sales and the purchase price. The Akiyama is essentially a modern replacement of the Miller. Purchase of the Akiyama in effect allows Letter Perfect to maintain sales at current lev*els.
The Heidelberg does everything that the Akiyama can do and more. The most sig*nificant difference is that the Heidelberg can be run at a much faster speed than the Akiyama. This is important because customers frequently want their orders filled very quickly. Virtually all presses can be run at faster rates, but the Heidelberg’s speed is legendary in the graphics business. At present Letter Perfect’s ca*pacity to fill quick orders in-house is limited relative to the number of requests re*ceived. Orders are often farmed out to another graphics company, mainly as a ser*vice to Letter Perfect’s customers, and Letter Perfect only breaks even on this type of business.
If the Heidelberg is purchased, all work of this sort could be done in-house. In addition, Crandall would more heavily promote the firm’s ability to take quick orders, and that service should increase annual sales. The Heidelberg’s sales figures in Exhibit 1 include estimates of annual quick-order sales. Crandall is less confident about these predictions, however, since they involve estimates of future sales increases.
The costs of the 2 machines including installation are as follows: the Akiyama is $400,000 and the Heidelberg is $880,000. Both manu*facturers provide the same guarantee and offer free operator assistance during the first four weeks after the sale.
As Crandall reflects on the choice, a number of difficulties come to mind. If he stays with the Miller he will likely use it for the remainder of its economic life, 7 years. He is also likely to keep the Akiyama that long as well at which time he would replace it. The Heidelberg is a different story, however. If pur*chased, Letter Perfect would probably use this press for its entire useful life, estimated to be 25 years. And Crandall is unclear whether or how to incorporate this longer period into the analysis.
Crandall thinks it is reasonable, based on conversations with used-equipment brokers and his own expertise, that the current after-tax market value of the Miller is $45,000, and that the Akiyama’s after-tax market value in seven years will be $120,000. He is unsure, though, what the value of the Heidelberg will be at that time. This press has only been manufactured for three years and there is virtually no data on its resale value. Crandall believes, however, that the cost of this machine new will rise by 4 percent a year. Another Problem
The second problem involves Letter Perfect’s project evaluation technique. For all equipment decisions, both large and small, Letter Perfect has used the payback method. Crandall likes the payback for two reasons. First, it is simple and easy to use. Letter Perfect’s management must make numerous equipment-related deci*sions during the course of a year, and convenience is an important factor. Crandall also views a project’s payback as a measure of the project’s risk. He views a short payback as an indication of relatively low risk.
Crandall has asked Denise Molton to help him in the evaluation. Molton has an undergraduate degree in marketing and an MBA in finance. A recent hire, she divides her time between sales and finance, and she has already contributed im*portant ideas to the firm’s marketing and finance policies.
When they meet, Crandall hands Molton a list of questions he wants an*swered.
- Is payback an appropriate evaluation tool for all projects?
- Is it necessary to estimate the market value of the Heidelberg in 7 years given that it would probably be used for 25 years?
- Use whatever financial techniques are appropriate to evaluate which, if ei*ther, of the two printing presses should be purchased.
Back at her office, Molton reflects on some issues she thinks are relevant to her assignment. She decides that a 40 percent tax rate is appropriate, but she is a bit unclear on what discount rates to use. Molton is comfortable using a 10 per*cent after-tax rate to evaluate a simple cost-reduction project. She realizes that the printing presses involve sales projections and, thus, are projects of higher risk. She also thinks that the Heidelberg is a riskier investment than the Akiyama. Her first reaction is to use a 12 percent after-tax rate on the Akiyama and a 14 percent rate on the Heidelberg.
EXHIBIT 1: Annual Sales Estimates for Each Press
EXHIBIT 2: Estimated Annual Operating Costs of Each Press
Pension fund (2)
Welfare benefits (3)
Payroll taxes (4)
Fire & sprinkler insurance
1. One operator at $29,984 per year plus one pressman at $35,527
2. Five percent of labor.
3. Health, disability and life insurance premiums.
4. Social Security and unemployment insurance.
5. Charge for space occupied by each machine.
* These figures do not include material costs, which are 10 percent of sales. From United States