96 Case 16 Great White Hall Flatland Views has advertised for proposals to build a new community center, but the city council cannot agree on how to evaluate the submitted proposals. The request for proposal (RFP) specified that respondents had to meet certain basic needs, although optional items could be included. The RFP also asked that each respondent calculate a benefit/cost (B/C) ratio using a discount rate of 12%. The RFP did specify the approximate size of each optional facility and the use that could be expected (and the value of such use in dollars per hour). The RFP stipulated that the council would select a package of facilities based on estimated construction costs and B/C ratios.

Since this package might not match any proposal, the council could issue a new RFP. However, if a new RFP is issued, only respondents to the first RFP may respond. The council’s intent is to provide an incentive for participation in the first RFP. Instead of a second RFP, the council could choose to simply negotiate with one of the original bidders. Three firms responded to the RFP, but they used different assumptions on how to calculate the ratio as well as including different options within their proposals.

Their construction materials and associated lives are similar, but their designs differ substantially. The proposals can be summarized as follows. Tightfisted Proposal Averell Johnson, the conservative patriarch of the city’s construction community, has proposed a bare-bones facility (see Table 16-1). Assuming 50 years of use and end-of-period Case 16 Great White Hall 97 cash flows, his proposal has a B/C ratio of __.1 His proposal also assumes that construction expenditures are all made at the start of the construction period. Table 16-1 Tightfisted Proposal Construction: 1 year:

96case 16 Great White Hall Flatland Views Has Ad

96 Case 16 Great White Hall Flatland Views has advertised for proposals to build a new community center, but the city council cannot agree on how to evaluate the submitted proposals. The request for proposal (RFP) specified that respondents had to meet certain basic needs, although optional items could be included. The RFP also asked that each respondent calculate a benefit/cost (B/C) ratio using a discount rate of 12%. The RFP did specify the approximate size of each optional facility and the use that could be expected (and the value of such use in dollars per hour). The RFP stipulated that the council would select a package of facilities based on estimated construction costs and B/C ratios.

Since this package might not match any proposal, the council could issue a new RFP. However, if a new RFP is issued, only respondents to the first RFP may respond. The council’s intent is to provide an incentive for participation in the first RFP. Instead of a second RFP, the council could choose to simply negotiate with one of the original bidders. Three firms responded to the RFP, but they used different assumptions on how to calculate the ratio as well as including different options within their proposals.

Their construction materials and associated lives are similar, but their designs differ substantially. The proposals can be summarized as follows. Tightfisted Proposal Averell Johnson, the conservative patriarch of the city’s construction community, has proposed a bare-bones facility (see Table 16-1). Assuming 50 years of use and end-of-period Case 16 Great White Hall 97 cash flows, his proposal has a B/C ratio of __.1 His proposal also assumes that construction expenditures are all made at the start of the construction period. Table 16-1 Tightfisted Proposal Construction: 1 year: $2.5 million Annual operation: Gym: $120,000 City offices: $190,000 Annual benefit: Gym: 60 hours/week at $200/hour Major Projects Proposal The proposal that has been supported by the “town and gown†crowd includes a small auditorium/theater and a library as well as the gym (see Table 16-2).

Major Projects Inc. has evaluated the proposal over 30 years of use for the benefits and for a 12-month term for the construction phase. Major Projects has assumed end-of-period cash flows, but they have analyzed the construction phase as 12 months—each with an equal share of the construction expenditures. Their calculated B/C ratio is ___.1 Table 16-2 Major Projects Proposal Construction: 12 months: $4.8 million Annual operation: Gym: $110,000 City offices: $165,000 Library: $450,000 (mostly salaries) Theater: $65,000 Annual benefit: Gym: 60 hours/week at $200/hour Library: $0.5 million in improved education Theater: 16 hours/week at $450/hour 1 The omitted B/C ratios for each facility are not necessary for the rest of the case.

The “easiest†option is to calculate them. Cases in Engineering Economy 2nd by Peterson & Eschenbach 98 Energy Breakthrough Proposal The third proposal (Table 16-3) is from a new firm that specializes in the design and construction of energy-efficient structures. They based their B/C ratio, _____, on assumptions of 40 years of use and costs and benefits that flow continuously over that time (distributed rather than end-of-period cash flows). Table 16-3 Energy Breakthrough Proposal Construction: 1 year: $3.9 million Annual operation: Gym: $ 65,000 City offices: $100,000 Theater: $15,000 Annual benefit: Gym: 60 hours/week at $200/hour Theater: 16 hours/week at $450/hour The Council’s Solution Overwhelmed by the responses, the city council has decided to hire you as a consultant.

Your contract requires you to calculate comparable ratios, to recommend a package of facilities, and to recommend a contractor. Options 1. The problem can be simplified by specifying that all projects assume end-of-period cash flows except for construction costs, which could be specified to occur before construction begins. This may or may not be the best assumption. 2.

The problem can be simplified by limiting it to the calculation of the omitted B/C ratios. 3. The problem can be simplified by reducing the scope of the consultant’s contract to constructing valid comparisons of the three proposals. 90 Case 14 Northern Gushers Northern Gushers Drilling has developed a lease on the North Slope of Alaska over the last five years. They have drilled 16 production wells evenly spaced over the four square miles of the lease tract.

Every well’s production declines over time, so to maintain a “steady†total flow new wells are drilled. Specifically, total production from the existing wells will decline at 17% per year if no new wells are drilled. All wells have been directionally drilled from the gravel drill pad, which also contains a processing facility (see Figure 14-1). Figure 14-1 Field Arrangement Case 14 Northern Gushers 91 This processing facility separates water and natural gas from the crude oil stream. By reducing the pressure from formation to atmospheric levels, the volatile gases are removed from the oil.

The oil is then dehydrated to remove water before transfer to the pipeline. As shown in the flowchart of Figure 14-2, a small portion of the natural gas is used to power the facility. Then most of the natural gas and all the water are repressurized and reinjected into the formation. This reinjection avoids the environmental problems of flaring the gas or surface disposal of contaminated water. It also helps maintain the pressure in the oil formation to increase total recovery.

Figure 14-2 Processing Flow Chart The timing of new wells has been planned to maintain a steady flow of about 20,000 barrels of oil per day (BOPD). This flow rate is the “shipping space†on the Great Northern Pipeline that has been allotted to Northern Gushers parent company. Fluctuations in Cases in Engineering Economy 2nd by Peterson & Eschenbach 92 production are matched with the shipping space by buying, selling, and trading with other shippers at about the tariff’s cost per barrel. A second consideration has been maximizing total recovery by distributing new wells over the leased tract. Thus, each of the 16 wells has helped maintain current production and also increased total recovery from the field.

Now Northern Gusher is facing a different problem. The entire leased tract has been covered by the 16 wells. New wells will be drilled “in-between†existing wells and will therefore have less impact on total recovery from the field. Each new well will increase production now by 2000 BOPD and increase the decline rate by 1%. Since each well costs about $2 million to drill and $1.75 million to tie into the production facilities, the management of Northern Gushers must justify this decision to their parent company by identifying the rate of return on the required capital investment.

Additional capital is required every 7 years to do a well work-over for $1.25 million. Abandonment costs in the final year of production amount to 10% of the initial drilling and facility costs. The abandonment costs are required by state agencies to return the land to its initial condition. Currently, the tariff for transportation through the pipeline is $5.25 per barrel, and another $3.75 per barrel is required to ship it to market. The incremental annual operating and maintenance cost for the field is $200,000 for each new well.

At this point, Northern Gusher must decide whether to initiate planning and construction for Well 17. This particular well could come on line next year with an estimated production rate of 2000 BOPD once tied into existing separation facilities. By next year, Northern Gusher’s total production rate will fall to 18,000 BOPD. The production of the 16 wells is declining at 17% per year. With the new well added in, the higher production rate results in a field decline rate that is 1% higher at 18% per year.

For simplification, the new decline rate can be assumed to begin as soon as the new well is drilled since the field will be producing at a higher rate almost from the start. While more wells will be drilled in the future, economic analysis of Well 17 is done without considering them. Oil production at the facility will be closed down (the field will be shut-in) when the total field production reaches 500 BOPD. At that production rate, it is no longer economic to operate the field. Because some of the oil produced by Well 17 would have been produced in later years by nearby wells, the incremental “production rate†with Well 17 versus without Well 17 will be negative in later years.

This sign change in the cash flows can result in multiple rates of return, so that is an additional concern of management. The value of oil has varied dramatically over the last six years, from a low of $18 per barrel to a high of $140 per barrel, back down to $22 per barrel and then back up to the Case 14 Northern Gushers 93 current level of $45 per barrel. Because of this vast uncertainty, your boss has given you guidelines of $30 per barrel and a horizon of 20 years for the initial analysis. Should Well 17 be added now, and how much additional oil will be produced? What is the incremental rate of return on this investment?

Options 1. If management demands an internal rate of return of 15% on investments, can Well 17 be justified now or at a later date? If now, when can well 18, 19, and so on be justified? Each of these later wells will have a similar effect on the total decline rate for the field. Specifically, assume that each well increases the decline rate by 1%.

2. Rather than considering the price of oil to be “fixed†at its current level, consider the impact of a higher or lower inflation rate for oil than for the economy as a whole. 77 Case 10 The Cutting Edge by E. R. (Bear) Baker, IV University of Alaska Anchorage Elroy had been with Barnes Machine Company a year since finishing a BS in industrial engineering (IE). Barnes had been in business for over 50 years, but the company had only recently moved from Detroit to Gainesville, Georgia.

The public reason for the move was the economics of the old facility. Privately, based on comments he had heard, Elroy believed a shift to nonunion labor was a larger motive. Elroy’s boss is the production supervisor, Mr. Hill. Because the plant and the workforce are new, Elroy has been conducting time-and-motion studies to establish new production standards.

While these were clearly needed, Elroy was impatient to apply other IE tools he had studied. One Friday, Mr. Hill asked Elroy to attend a 10 a.m. meeting on Monday. Monday morning, Elroy was surprised to join not only Mr. Hill and John Blackburn, the head of manufacturing engineering, but also Mr.

Simkins, the head of marketing and several others from sales and marketing. Most surprising was the attendance of the company’s CEO, Mr. Barnes, Jr. The meeting’s purpose was to consider a request for proposal (RFP). As Mr.

Simkins quickly pointed out, the request came from one of Barnes’s most significant customers. The problem, and the reason for the special meeting, was that a successful bid would exceed current production capabilities. Mr. Simkins, in summarizing, said, “Fortunately Mr. Barnes was farsighted enough to have our new facility built with room for expansion.†Cases in Engineering Economy 2nd by Peterson & Eschenbach 78 Mr.

Hill agreed: “I see no reason why we should not bid on this proposal. Of course, as John pointed out, we will need new production capability. While this RFP calls for a five- year delivery plan, the total number of parts has not been specified. Since Simkins believes the data will be available before the final proposal deadline, I suggest that we examine the economics of the various different manufacturing alternatives. To that end, I intend to have Elroy here start that study immediately.†Mr.

Barnes ended the meeting with, “I’m sure that not bidding won’t hurt our other business with them, but they have been a steady customer since my father started the company and I really would like to help them. Besides, whenever we have added new manufacturing capacity, Simkins has managed to sell it to someone. So whatever you do, Hill, don’t let Elroy be too pessimistic. Let’s get on with it. I expect a preliminary evaluation in two weeks.

By the way, John, don’t forget about all that extra equipment we have stored from the old plant. You may find something there that will help keep the cost down.†During the next several days, Elroy met several times with Mr. Hill and John Blackburn. John, who had joined the company after it moved, drove to a warehouse in Atlanta to inspect the stored equipment. In a meeting Wednesday, John said that only a new engine lathe would be required.

Hill said, “If that’s all we need to bid this job, Mr. Barnes will be very pleased. After all, what will it cost, 15 or 20 thousand?†“We can probably find one in that price range, Mr. Hill,†John said, “but if we are going to consider this as a long-term investment that Mr. Simkins will market for us, I think we should seriously consider one of the automated systems that have become available in the past few years.

Remember, this type of equipment usually lasts a long time. I am sure that it will still be serviceable long after we complete this contract.†“OK, John, your point is well made,†Mr. Hill replied. “Elroy see what you can find that will do the job. Check with John on the specs, but take a close look at the economics for us.†During the next few days, Elroy found that there were basically four different possible machine types that would do the job ranging from the traditional manual engine lathe to a computer-controlled lathe with robotic load/unload and tolerance checks.

From the manufacturers, he obtained the information contained in Table 10-1. Case 10 The Cutting Edge 79 Table 10-1 Cost Data Machine Type Purchase Cost Annual Maintenance Cost A. Manual $18,000 $1,350 B. Semiautomatic 27,000 2,430 C. Automatic 64,000 4,250 D.

Automatic with robotic load/unload 120,000 14,400 Machines A and B would each require a full-time operator. A single operator could service two of Machine type C, and Machine type D would require no operator at all. After consulting with John about the skill level required, Elroy checked with accounting and found that an operator would be paid at $14.29 an hour. A 25% incentive is added to base pay for employees on the second or third shifts. In addition, fringe benefits would run 63% of base pay, and manufacturing overhead would be assigned at a rate of 47% of the operator’s direct pay.

Accounting had indicated that they would try to classify the equipment in the 5-year life category for tax depreciation purposes. Mr. Hill, John, and Elroy decided that the analysis should be based on production runs of 1000 pieces due to uncertain availability of storage space. Elroy noted that each of the machines has a different production rate and setup procedure. Each manufacturer claims an expected life of about one million pieces.

John pointed out that the machines all use the same cutting technique, which implies that the tool and material costs should be about the same. Elroy summarized this in Table 10-2. Cases in Engineering Economy 2nd by Peterson & Eschenbach 80 Table 10-2 Production Data Production Rate Material + Tool Machine Setup Cost (Pieces/Hour) Cost/Piece A $ 750 6 pieces $0.50 B pieces 0.50 C pieces 0.50 D pieces 0.50 John pointed out that there is a part currently purchased from an outside vendor that could be produced on this equipment. He estimates the setup cost to be about the same and the production rates to be approximately twice as many pieces per hour for Machine A, about 50% greater for Machine B, and remaining about the same for Machines C and D.

Machine tool and material cost would run about $0.70 a unit. When Elroy checks with accounting, he finds that they purchased about 7,000 of the parts last year. Marketing expects that to increase to 8,000 parts this year and remain steady for a while. Accounting tells him that the average cost per purchased part is $4.26. In previous economic studies of capital purchases, Elroy has been told to use an interest rate of 15%.

He believes that he should do the same here. Friday afternoon Elroy sits down to begin his analysis. He knows that everyone at the meeting next Monday will expect him to have an answer and that it is very likely that his report will determine whether or not Barnes responds to the RFP.

.5 million Annual operation: Gym: 0,000 City offices: 0,000 Annual benefit: Gym: 60 hours/week at 0/hour Major Projects Proposal The proposal that has been supported by the “town and gown†crowd includes a small auditorium/theater and a library as well as the gym (see Table 16-2).

Major Projects Inc. has evaluated the proposal over 30 years of use for the benefits and for a 12-month term for the construction phase. Major Projects has assumed end-of-period cash flows, but they have analyzed the construction phase as 12 months—each with an equal share of the construction expenditures. Their calculated B/C ratio is ___.1 Table 16-2 Major Projects Proposal Construction: 12 months: .8 million Annual operation: Gym: 0,000 City offices: 5,000 Library: 0,000 (mostly salaries) Theater: ,000 Annual benefit: Gym: 60 hours/week at 0/hour Library:

96case 16 Great White Hall Flatland Views Has Ad

96 Case 16 Great White Hall Flatland Views has advertised for proposals to build a new community center, but the city council cannot agree on how to evaluate the submitted proposals. The request for proposal (RFP) specified that respondents had to meet certain basic needs, although optional items could be included. The RFP also asked that each respondent calculate a benefit/cost (B/C) ratio using a discount rate of 12%. The RFP did specify the approximate size of each optional facility and the use that could be expected (and the value of such use in dollars per hour). The RFP stipulated that the council would select a package of facilities based on estimated construction costs and B/C ratios.

Since this package might not match any proposal, the council could issue a new RFP. However, if a new RFP is issued, only respondents to the first RFP may respond. The council’s intent is to provide an incentive for participation in the first RFP. Instead of a second RFP, the council could choose to simply negotiate with one of the original bidders. Three firms responded to the RFP, but they used different assumptions on how to calculate the ratio as well as including different options within their proposals.

Their construction materials and associated lives are similar, but their designs differ substantially. The proposals can be summarized as follows. Tightfisted Proposal Averell Johnson, the conservative patriarch of the city’s construction community, has proposed a bare-bones facility (see Table 16-1). Assuming 50 years of use and end-of-period Case 16 Great White Hall 97 cash flows, his proposal has a B/C ratio of __.1 His proposal also assumes that construction expenditures are all made at the start of the construction period. Table 16-1 Tightfisted Proposal Construction: 1 year: $2.5 million Annual operation: Gym: $120,000 City offices: $190,000 Annual benefit: Gym: 60 hours/week at $200/hour Major Projects Proposal The proposal that has been supported by the “town and gown†crowd includes a small auditorium/theater and a library as well as the gym (see Table 16-2).

Major Projects Inc. has evaluated the proposal over 30 years of use for the benefits and for a 12-month term for the construction phase. Major Projects has assumed end-of-period cash flows, but they have analyzed the construction phase as 12 months—each with an equal share of the construction expenditures. Their calculated B/C ratio is ___.1 Table 16-2 Major Projects Proposal Construction: 12 months: $4.8 million Annual operation: Gym: $110,000 City offices: $165,000 Library: $450,000 (mostly salaries) Theater: $65,000 Annual benefit: Gym: 60 hours/week at $200/hour Library: $0.5 million in improved education Theater: 16 hours/week at $450/hour 1 The omitted B/C ratios for each facility are not necessary for the rest of the case.

The “easiest†option is to calculate them. Cases in Engineering Economy 2nd by Peterson & Eschenbach 98 Energy Breakthrough Proposal The third proposal (Table 16-3) is from a new firm that specializes in the design and construction of energy-efficient structures. They based their B/C ratio, _____, on assumptions of 40 years of use and costs and benefits that flow continuously over that time (distributed rather than end-of-period cash flows). Table 16-3 Energy Breakthrough Proposal Construction: 1 year: $3.9 million Annual operation: Gym: $ 65,000 City offices: $100,000 Theater: $15,000 Annual benefit: Gym: 60 hours/week at $200/hour Theater: 16 hours/week at $450/hour The Council’s Solution Overwhelmed by the responses, the city council has decided to hire you as a consultant.

Your contract requires you to calculate comparable ratios, to recommend a package of facilities, and to recommend a contractor. Options 1. The problem can be simplified by specifying that all projects assume end-of-period cash flows except for construction costs, which could be specified to occur before construction begins. This may or may not be the best assumption. 2.

The problem can be simplified by limiting it to the calculation of the omitted B/C ratios. 3. The problem can be simplified by reducing the scope of the consultant’s contract to constructing valid comparisons of the three proposals. 90 Case 14 Northern Gushers Northern Gushers Drilling has developed a lease on the North Slope of Alaska over the last five years. They have drilled 16 production wells evenly spaced over the four square miles of the lease tract.

Every well’s production declines over time, so to maintain a “steady†total flow new wells are drilled. Specifically, total production from the existing wells will decline at 17% per year if no new wells are drilled. All wells have been directionally drilled from the gravel drill pad, which also contains a processing facility (see Figure 14-1). Figure 14-1 Field Arrangement Case 14 Northern Gushers 91 This processing facility separates water and natural gas from the crude oil stream. By reducing the pressure from formation to atmospheric levels, the volatile gases are removed from the oil.

The oil is then dehydrated to remove water before transfer to the pipeline. As shown in the flowchart of Figure 14-2, a small portion of the natural gas is used to power the facility. Then most of the natural gas and all the water are repressurized and reinjected into the formation. This reinjection avoids the environmental problems of flaring the gas or surface disposal of contaminated water. It also helps maintain the pressure in the oil formation to increase total recovery.

Figure 14-2 Processing Flow Chart The timing of new wells has been planned to maintain a steady flow of about 20,000 barrels of oil per day (BOPD). This flow rate is the “shipping space†on the Great Northern Pipeline that has been allotted to Northern Gushers parent company. Fluctuations in Cases in Engineering Economy 2nd by Peterson & Eschenbach 92 production are matched with the shipping space by buying, selling, and trading with other shippers at about the tariff’s cost per barrel. A second consideration has been maximizing total recovery by distributing new wells over the leased tract. Thus, each of the 16 wells has helped maintain current production and also increased total recovery from the field.

Now Northern Gusher is facing a different problem. The entire leased tract has been covered by the 16 wells. New wells will be drilled “in-between†existing wells and will therefore have less impact on total recovery from the field. Each new well will increase production now by 2000 BOPD and increase the decline rate by 1%. Since each well costs about $2 million to drill and $1.75 million to tie into the production facilities, the management of Northern Gushers must justify this decision to their parent company by identifying the rate of return on the required capital investment.

Additional capital is required every 7 years to do a well work-over for $1.25 million. Abandonment costs in the final year of production amount to 10% of the initial drilling and facility costs. The abandonment costs are required by state agencies to return the land to its initial condition. Currently, the tariff for transportation through the pipeline is $5.25 per barrel, and another $3.75 per barrel is required to ship it to market. The incremental annual operating and maintenance cost for the field is $200,000 for each new well.

At this point, Northern Gusher must decide whether to initiate planning and construction for Well 17. This particular well could come on line next year with an estimated production rate of 2000 BOPD once tied into existing separation facilities. By next year, Northern Gusher’s total production rate will fall to 18,000 BOPD. The production of the 16 wells is declining at 17% per year. With the new well added in, the higher production rate results in a field decline rate that is 1% higher at 18% per year.

For simplification, the new decline rate can be assumed to begin as soon as the new well is drilled since the field will be producing at a higher rate almost from the start. While more wells will be drilled in the future, economic analysis of Well 17 is done without considering them. Oil production at the facility will be closed down (the field will be shut-in) when the total field production reaches 500 BOPD. At that production rate, it is no longer economic to operate the field. Because some of the oil produced by Well 17 would have been produced in later years by nearby wells, the incremental “production rate†with Well 17 versus without Well 17 will be negative in later years.

This sign change in the cash flows can result in multiple rates of return, so that is an additional concern of management. The value of oil has varied dramatically over the last six years, from a low of $18 per barrel to a high of $140 per barrel, back down to $22 per barrel and then back up to the Case 14 Northern Gushers 93 current level of $45 per barrel. Because of this vast uncertainty, your boss has given you guidelines of $30 per barrel and a horizon of 20 years for the initial analysis. Should Well 17 be added now, and how much additional oil will be produced? What is the incremental rate of return on this investment?

Options 1. If management demands an internal rate of return of 15% on investments, can Well 17 be justified now or at a later date? If now, when can well 18, 19, and so on be justified? Each of these later wells will have a similar effect on the total decline rate for the field. Specifically, assume that each well increases the decline rate by 1%.

2. Rather than considering the price of oil to be “fixed†at its current level, consider the impact of a higher or lower inflation rate for oil than for the economy as a whole. 77 Case 10 The Cutting Edge by E. R. (Bear) Baker, IV University of Alaska Anchorage Elroy had been with Barnes Machine Company a year since finishing a BS in industrial engineering (IE). Barnes had been in business for over 50 years, but the company had only recently moved from Detroit to Gainesville, Georgia.

The public reason for the move was the economics of the old facility. Privately, based on comments he had heard, Elroy believed a shift to nonunion labor was a larger motive. Elroy’s boss is the production supervisor, Mr. Hill. Because the plant and the workforce are new, Elroy has been conducting time-and-motion studies to establish new production standards.

While these were clearly needed, Elroy was impatient to apply other IE tools he had studied. One Friday, Mr. Hill asked Elroy to attend a 10 a.m. meeting on Monday. Monday morning, Elroy was surprised to join not only Mr. Hill and John Blackburn, the head of manufacturing engineering, but also Mr.

Simkins, the head of marketing and several others from sales and marketing. Most surprising was the attendance of the company’s CEO, Mr. Barnes, Jr. The meeting’s purpose was to consider a request for proposal (RFP). As Mr.

Simkins quickly pointed out, the request came from one of Barnes’s most significant customers. The problem, and the reason for the special meeting, was that a successful bid would exceed current production capabilities. Mr. Simkins, in summarizing, said, “Fortunately Mr. Barnes was farsighted enough to have our new facility built with room for expansion.†Cases in Engineering Economy 2nd by Peterson & Eschenbach 78 Mr.

Hill agreed: “I see no reason why we should not bid on this proposal. Of course, as John pointed out, we will need new production capability. While this RFP calls for a five- year delivery plan, the total number of parts has not been specified. Since Simkins believes the data will be available before the final proposal deadline, I suggest that we examine the economics of the various different manufacturing alternatives. To that end, I intend to have Elroy here start that study immediately.†Mr.

Barnes ended the meeting with, “I’m sure that not bidding won’t hurt our other business with them, but they have been a steady customer since my father started the company and I really would like to help them. Besides, whenever we have added new manufacturing capacity, Simkins has managed to sell it to someone. So whatever you do, Hill, don’t let Elroy be too pessimistic. Let’s get on with it. I expect a preliminary evaluation in two weeks.

By the way, John, don’t forget about all that extra equipment we have stored from the old plant. You may find something there that will help keep the cost down.†During the next several days, Elroy met several times with Mr. Hill and John Blackburn. John, who had joined the company after it moved, drove to a warehouse in Atlanta to inspect the stored equipment. In a meeting Wednesday, John said that only a new engine lathe would be required.

Hill said, “If that’s all we need to bid this job, Mr. Barnes will be very pleased. After all, what will it cost, 15 or 20 thousand?†“We can probably find one in that price range, Mr. Hill,†John said, “but if we are going to consider this as a long-term investment that Mr. Simkins will market for us, I think we should seriously consider one of the automated systems that have become available in the past few years.

Remember, this type of equipment usually lasts a long time. I am sure that it will still be serviceable long after we complete this contract.†“OK, John, your point is well made,†Mr. Hill replied. “Elroy see what you can find that will do the job. Check with John on the specs, but take a close look at the economics for us.†During the next few days, Elroy found that there were basically four different possible machine types that would do the job ranging from the traditional manual engine lathe to a computer-controlled lathe with robotic load/unload and tolerance checks.

From the manufacturers, he obtained the information contained in Table 10-1. Case 10 The Cutting Edge 79 Table 10-1 Cost Data Machine Type Purchase Cost Annual Maintenance Cost A. Manual $18,000 $1,350 B. Semiautomatic 27,000 2,430 C. Automatic 64,000 4,250 D.

Automatic with robotic load/unload 120,000 14,400 Machines A and B would each require a full-time operator. A single operator could service two of Machine type C, and Machine type D would require no operator at all. After consulting with John about the skill level required, Elroy checked with accounting and found that an operator would be paid at $14.29 an hour. A 25% incentive is added to base pay for employees on the second or third shifts. In addition, fringe benefits would run 63% of base pay, and manufacturing overhead would be assigned at a rate of 47% of the operator’s direct pay.

Accounting had indicated that they would try to classify the equipment in the 5-year life category for tax depreciation purposes. Mr. Hill, John, and Elroy decided that the analysis should be based on production runs of 1000 pieces due to uncertain availability of storage space. Elroy noted that each of the machines has a different production rate and setup procedure. Each manufacturer claims an expected life of about one million pieces.

John pointed out that the machines all use the same cutting technique, which implies that the tool and material costs should be about the same. Elroy summarized this in Table 10-2. Cases in Engineering Economy 2nd by Peterson & Eschenbach 80 Table 10-2 Production Data Production Rate Material + Tool Machine Setup Cost (Pieces/Hour) Cost/Piece A $ 750 6 pieces $0.50 B pieces 0.50 C pieces 0.50 D pieces 0.50 John pointed out that there is a part currently purchased from an outside vendor that could be produced on this equipment. He estimates the setup cost to be about the same and the production rates to be approximately twice as many pieces per hour for Machine A, about 50% greater for Machine B, and remaining about the same for Machines C and D.

Machine tool and material cost would run about $0.70 a unit. When Elroy checks with accounting, he finds that they purchased about 7,000 of the parts last year. Marketing expects that to increase to 8,000 parts this year and remain steady for a while. Accounting tells him that the average cost per purchased part is $4.26. In previous economic studies of capital purchases, Elroy has been told to use an interest rate of 15%.

He believes that he should do the same here. Friday afternoon Elroy sits down to begin his analysis. He knows that everyone at the meeting next Monday will expect him to have an answer and that it is very likely that his report will determine whether or not Barnes responds to the RFP.