Reference no: EM132592679

Outsourcing was quickly becoming the only option for production of this product. The production process was fairly labor intensive, involving a skilled workforce to insure that the critical intricacies and components of the product were properly assembled. Straight had depended on some of their most talented work force to assemble this important product. Naturally, the labor cost on a per part basis was relatively high due to many factors. The product was made in the Denver plant, which also had a high cost of living, and the demand for qualified employees was critical which resulted in a higher wage rate. Also, well-trained technically skilled individuals were needed in many disciplines, which also demanded a higher wage rate. The employees working for Straight were some of the more dependable with a greater number of years working at the company which added to the labor costs. The potential for considerable cost savings in labor was available if the product could be assembled overseas.

• Straight identified a medical supply company in India that apparently employed a highly skilled work force with appropriate training in the assembly of similar products. The labor rate was considerably lower, enough so, that the product could be shipped to India and back by air for just the assembly process and money could be saved.

• Before making any critical decisions of this nature, Bonnie thought it best to conduct a financial analysis of alternative proposals for a five-year time period. The choice for Straight Supply in this situation was to either continue production in Denver or have the product assembled in India. The production and finance departments came up with some critical cost factors to aid in the decision process.

• At the Denver plant, 25 employees worked on this specific product. Their average wage rate including benefits is $30 per hour. Employees at the Denver plant are able to produce 75 of the insulin pumps per hour on an eight-hour shift for 250 days in the year. Indirect costs related to the production of the insulin pump were allocated to the product at 180 percent of the direct labor costs. Wage rates will increase at 6 percent per year. The cost to ship the product to their pharmaceutical customer in Chicago was $0.75 per item and that shipping cost would increase 4 percent per year.

• If the insulin pump were no longer assembled in Denver, in addition to a reduction in the labor force, there would be an immediate one-time reduction in capacity related costs of $120,000.

• For this current year, the anticipated annual demand was equal to the current production capacity. If Straight Supply maintains its market share with existing customers, there should be a 10% increase in demand for this product for each of the next five years. The annual increase in demand could actually have been 20%; however, top management thought it better to estimate conservatively given the potential increase in competition. Additional employees would need to be hired at the Denver plant to keep up with demand.

• Each insulin pump sold for $100 this year with the price forecasted to increase at five percent per year over the next five years. Increases in working capital directly associated with the product have been equal to 12 percent of the total sales revenue figure.

• In India the wage rate was only $10.50 per hour, and each employee could assemble an average of two insulin pumps per hour. Given this was a new production process at the India location, learning curve efficiencies could apply to the insulin pump and it was expected that production levels would increase 15% per year over the next three years before leveling out in the fourth and fifth years. Also, the hourly rate would increase at 10% per year for each of the next five years. The management at the India plant promised to hire enough skilled workers to meet the production demand every year.

• Round trip shipping cost to and from India would be at $5.00 per item with that rate increasing at 4% per year. The additional shipping requirement will increase the production time by one week. To maintain its just-in-time inventory philosophy Straight Supply will need to begin the production of the insulin pump one week earlier so the final product will be available to the customer at the agreed upon delivery date. Starting the production process one week sooner will cause an initial cost increase of $260,000 for the earlier ordering of required materials.

• In completing capital budgeting projects, Straight Supply has used a weighted average cost of capital process to determine a correct discount rate and then add a premium depending on perceived additional risk factors. The basic discount rate for this year is 14.8%. If a new product is being considered a risk premium of 2.5% is added. If there is a change in a domestic location a risk premium of 1.5% is added. A project involving an international element results in a risk premium of from 3.0% to 6.0% depending upon a number of factors including political stability, economic security, language and cultural differences, and governmental factors.

Question 1: Evaluate the two proposed alternatives regarding the insulin pump by providing NPV, IRR, MIRR, PAYBACK, DISCOUNTED PAYBACK, AND PI.