Issues in Accounting Education Vol. 15, No. 2

May 2000

Component Technologies, Inc.: Adding FlexConnex Capacity

Julie H. Hertenstein

ABSTRACT: Component Technologies, Inc. (CTI) manufactures components usedinelectronicdevices.CTIisconsideringaddingmanufacturingcapacityfor FlexConnex to meet increased future demand. CTI’s manufacturing planning staffidentifiesthreeoptionstomeetthisdemand.Thestaffperformspreliminary financialanalysestoevaluatewhethertoconductdetailedplanningforandevalu- ation of each of the three options. During their analysis, they consider which discount rate is more appropriate: the 20 percent rate, which the corporate fi- nance manual states is the hurdle rate for capital investments, or 10 percent, which the staff believes is closer to the corporate cost of capital. They experi- mentwithbothdiscountrates,andtwotimehorizons.Thiscaserequiresyouto calculate net present values (NPVs) and to analyze the effect of different dis- count rates and time horizons. It also asks you to consider the effect of other financialandnonfinancialissuesonyouranalysis.

BACKGROUND

n 1993, Component Technologies, Inc. (CTI)1 manufactured compo- nents, such as interconnect

components, electronic connectors, fi- ber-optic connectors, flexible intercon- nects, coaxial cable, cable assemblies, andinterconnectsystems,usedincom- putersandotherelectronicequipment. CTI’s global marketing strategy pro- ducedsignificantgrowth;CTIwasnow oneofthreemajorsuppliersinitsmar- ket segments. Major customersin-

of FlexConnex could continue to in- crease 10 percent per year as applica- tions of computer technology extended into industrial products and consumer products such as automobiles and appliances.

Planning Meeting

At a meeting of his staff, Tom Richards, director of manufacturing planning, stated that they needed to plan to bring additional capacity for FlexConnex online in about two years.

cludedotherglobalcompanies,suchas

IBM,HP,Hitachi,andSiemens.These companies, in turn, manufacturedand marketed their productsworldwide.

FlexConnex, one of CTI’s largest selling products, was very profitable (see Exhibit 1). The Santa Clara, Cali- fornia plant that manufactured the FlexConnex component was projected to reach its full capacity of 75 million units in 1994. With sufficient capacity tomeetdemand,CTIexpecteditssales

1 This case is based on decisions faced by an actual company. Component Technologies, Inc. is a disguised name. Other facts have been changed for instructional purposes.

Julie H. Hertenstein is an Associate Professor at Northeastern University.

Theauthor gratefully acknowledges Marjorie B. Platt and H. David Sherman for their helpful comments, and research assistants Janet Sutherland and Zheng Yang for their contributions.

EXHIBIT 1

FlexConnex Cost Analysis Sheet Santa Clara Plant, 1993

PlantCapacity:75 millionunits

SellingPrice/Unit:$0.85

VariableCost/Unit:$0.255

FixedManufacturingCost:$9.5 million annually (includes $2.5 million depreciation)

Estimated Plant Profitability at Capacity:
Revenue / $63,750,000
Variable Cost / 19,125,000
Fixed Manufacturing Cost / 9,500,000
Plant Profitabilitya / $35,125,000

a Excludes interest expenses and corporate selling, general and administrative expenses.


He suggested that they begin by proposing possible alternatives. The staff quickly identified three promis- ing alternatives:

1.The Santa Clara plant had been designed for future expansion. Ad- ditional space was available at the site, and new production capacity could be easily integrated into the existing production processes as long as compatible manufacturing technologies wereemployed.

2.CTI owned a plant in Waltham, Massachusetts that manufactured a product line that was being phased out. Some existing equip- ment in the Waltham plant was compatible with the Santa Clara plant’s manufacturing technology and could be converted to the pro- duction of FlexConnex. Half of the Waltham plant would be available in 1994, and the remainder in 1996.

3.CTI could build a greenfield plant2 in Ireland, close to its major Euro- peancustomers.Toattractsuchin- dustries, the Irish government would make a site available at low cost. A new technology currently being Beta-tested3 by an equip-ment manufacturer could be used to equip thisplant.


2 The term “greenfield plant” is commonly used to refer to a brand new plant built entirely from scratch, as contrasted with the expan- sion, conversion, refurbishment, or renova- tion of an existing plant.

3 A “Beta-test site” refers to equipment being testedusinganactualworkloadatacustomer site. Beta-test is often the final testing phase before the equipment is released ascommer-

ciallyavailabletocustomers.Acustomerwho consentstobeaBeta-testsiteagreesnotonly touseequipmentthatisnotfullytested(thus being, in the American vernacular, a “guinea pig”), but also to provide the vendor detailed feedbackonoperationsandproblemsencoun- tered.Inreturn,theequipmentmanufacturer often provides incentives such as financial discounts,extraon-sitevendorpersonnel,etc.

Tombelievedthatthesethreewere promising proposals. To ensure CTI could bring additional, profitable, FlexConnex capacity online in two years, Tom felt that they should begin developing plans for these alterna-tives.Nonetheless,hewantedthestaff to keep an open mind to additional al- ternatives even as they evaluated these three. As the discussion started to wind down, Gracie Stanton, an en- gineer, said that she had asuggestion.

Gracie:Beforewespendourtimedevel- oping these three alternatives in detail, I’d like to get a rough feel for the poten- tial profitability of each alternative. We shouldn’t waste our time developing de- tailed plans for an alternative if there is no chance it will ever show a positive NPV.

Tom: Good point, Gracie. Let’s breakup intothreegroups,anddoback-of-the-en- velopecalculationsbasedonwhatwecur- rently know about each alternative. Gracie, would you head up the Santa Clara group, since you were part of the engineeringteamforthatplant?Edward Lodge, how about Waltham?Ian Townsley, could you and your folks take a look at Ireland? To start, what are the factsandassumptionsabouteachfacility?

Gracie:Well,there’senoughspaceatthe SantaClarasitetoproduceanadditional 30 million units annually. I expect it would cost about $23 million to expand this plant, and bring its total capacityto 105 million units. Of the $23 million,we would spend $5 million to expand the building, and $18 million for additional equipmentcompatiblewithSantaClara’s existing manufacturing process. All $23 millionwouldprobablybespentin1994, andtheplantwouldbereadyforproduc- tion in1995.

Iassumethatthesellingpriceperunit will remain at its current level; further, sincethesamemanufacturingtechnology will continue to be used, the variable

manufacturingcostwillremainthesame asweshowonthe1993SantaClaraCost AnalysisSheet[Exhibit1].Expandingthe existingplantwouldallowsomefixedmanu- facturing costs, like the plant manager’s salary,tobesharedwiththeexistingfacil- ity,soIestimatethattheadditionalfixed manufacturingcosts,excludingdeprecia- tion, will be $2.1 million annuallybegin- ningin1995.In1997,thesefixedcostswill riseto$2.4millionandremainatthatlevel fortheforeseeablefuture.

Edward: Well, the Waltham plant is smallerthanthespaceavailableinSanta Clara,soIthinkitscapacitywillbeabout 25 million units. It will require renova- tions to adapt the plant to manufacture FlexConnex, say, about $2 million, and approximately$12millionforequipment. Half of this would be spent in 1994, and halfin1996.Initialproductionwouldbe- gin in 1995; half of the 25-million-unit capacityshouldbeavailablein1995;two- thirds in 1996; the remainder in1997.

SincetheWalthamplantwillusethe same technology as Santa Clara, we can assumethatthevariablemanufacturing costs will be the same as Santa Clara’s. Sellingpriceswillalsobethesame.How- ever,sinceWalthamwillbeastand-alone faculty,itsfixedmanufacturingcosts,ex- cludingdepreciation,wouldbesomewhat higher: $2.4 million annually beginning in1995.In1997,however,fixedcostswill increase to $2.6 million annually, where I expect them to remain for the foresee- ablefuture.

Ian: I just visited the Beta-test site for the manufacturing equipment using the newtechnologythatIproposeweusefor thegreenfieldplant.ThereIlearnedthat the economic size for a plant using this technology to manufacture a product such as FlexConnex is about 70 million units, so I propose that we prepare our estimates for Ireland based on a 70-mil- lion-unit capacity plant. Of course, this will cost more, since it is much larger thanothersites.WiththehelpoftheIrish

government, an appropriate site can be obtainedforabout$1million.Abuilding large enough to produce 70 millionunits can probably be built for about $10 mil- lion, and equipping the facility with the new technology equipment will cost about $50 million. Most of this would be spent in 1994, although as much as 10 percent might be spent before the end of 1993toacquireandpreparethesite.The plant would begin production in 1995; someareasoftheplantwouldnotbecom- plete, however, and as much as 20–25 percent of the investment would remain to be spent during1995.

Although FlexConnex’s worldwide selling price will be the same as for the other facilities, the new equipment will lowerthevariablemanufacturingcostto

$0.195perunit.Theefficiencyofthisnew plantwillhelpkeepfixedmanufacturing costs down, as well, but since thefacility willbesolarge,fixedmanufacturingcosts, excluding depreciation, would be higher than the other two facilities: $2.8million annuallybeginningin1995,risingto$2.9 million annually beginning in1999.

Tom:Theseassumptionssoundlikerea- sonable first cuts to me. Let’s just start with a five-year analysis, 1994 through 1998, using the discount rate of 20 per- cent,whichthecorporatefinancemanual states is the hurdle rate for capital in- vestments. For simplicity, let’s assume all cash flows occur at the end of the re- spective year. Discount everything to today’s dollars, that is, as of the end of 1993. And, consistent with corporatepolicy, we’ll do a pretax analysis; we’ll ask the corporate finance staff to evalu- ate the tax implicationslater.

Afewminuteslater,thebuzzingof the small groups died down, and the tapping on the laptop keyboards had ceased.

Tom: Well, what have you learned from this first glance?

Edward: The Waltham site looks promising.

Ian: Not Ireland.

Gracie: This is odd. The Santa Clara plant is right on the margin, and that surprisesmesincetheexistingmanufac- turing facility is one of CTI’s most prof- itable, and we get further economies of scale by expanding that plant. I wonder if the discount rate we are using is too high. At the “Finance forManufacturing Engineers” seminar I attended recently, we discussed the problems associated with using a discount rate that was too high.Theprofessorstatedthattherewas a sound theoretical basis for using a dis- count rate that approximated the company’scostofcapital,butmanycom- panies“addedon”estimatesforrisk,cor- porate charges, and other factors that were less well grounded. Based on what I learned in that seminar, I tried to esti- mate CTI’s actual cost of capital; it was about 10 percent. I wonder what would happen if we used 10 percentinstead?

Tom: With these laptops and spread- sheetprograms,that’seasyenough;let’s check itout.

A few seconds later.... Gracie: Now, that’s better! Edward: Ours too.

Ian: Well, at least we’re moving in the rightdirection.Butitdoesn’tmakesense to me that a facility with lower variable cost per unit, and lower average fixed cost per unit at capacity, shows a nega- tive NPV when the others are positive. We checked our calculations; what’s the story?CoulditbethatIrelandwouldnot even be up to capacity production in five years because the plant is sobig?

Gracie:Maybe,butourplantsarebeing penalized,too;afterall,eventhoughthey reachcapacityinthefirstfiveyears,they will presumably continue to produce FlexConnex. Although there is constant technological change in this industry, there is a reasonable probability that

demand for FlexConnex will remain strong for at least 10 years.

Ian: Well, then, let’s look at each of the three plants over a ten-year period, us- ing Gracie’s 10 percent discount rate.

Later....

Edward:Aha!Walthamcontinuesto improve.

Gracie: However, Santa Clara has you beat now!

Ian: I’ve got bad news for both of you!

Questions:

1.Preparethemanufacturingstaff’scal- culationsforthethreealternatives:

a.In the first set of calculations, the staff used a discount rate of 20 percent, a five-year time horizon, and ignored taxes and terminal value. What is the relative attractiveness of these threealternatives?

b.In the second set, they useda

10percent discount rate. What happens to the NPV of

each alternative? What hap- pens to their relative attrac- tiveness? Why?

c.In the third set, they changed the time horizon to ten years, butkeptthe10percentdiscount rate. Why does Ian say he has “bad news” for theothers?

2.In addition to reducing costs, the new technology proposed for the greenfield plant would increase manufacturing flexibility, which would enable CTI to respond more quicklytocustomersandtoprovide themmorecustomfeatures.Should these factors be considered in the analysis? If so, how would you in- corporatethem?

3.Should other factors be taken into consideration in choosing the loca- tionoftheFlexConnexplant?Ifso, what arethey?

4.Should Tom Richards continue to develop more detailed plans forthese three alternatives? If not, which should be eliminated? Are there other alternatives that his staff should consider? If so, what arethey?