Chat with us, powered by LiveChat M14: CASE STUDY 2 ASSIGNMENT EVALUATING A NEW TECHNOLOGY ALTERNATIVE • Concepts Illustr | Office Paper
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M14: CASE STUDY 2 ASSIGNMENT

EVALUATING A NEW TECHNOLOGY ALTERNATIVE

• Concepts Illustrated: Replacement Analysis, Incremental analysis, sensitivity analysis, breakeven
analysis, and risk analysis.

1. BACKGROUND
Air Technology Corporation manufactures several types of disks that are used in the construction of turbine
engines. When the company built its Denver, Colorado, plant to manufacture the disk, two hydraulic presses
were expected to meet all the forging requirements in the original design. The forging process required that
each type of disk be processed through a preliminary shaping (or preform) die, a final forge-shaping die, and
surface machining. As demand levels increased, the company’s product-flexibility requirements and the need to
change product mix to meet demand schedules induced down times for tooling (die) changes that were greater
than anticipated. Increased demand also led to an increase in inventory levels, specifically work-in-process pieces
in the preform stage, in order to meet all product-mix needs. Additionally, it was projected that increasing
demand levels could cause the plant’s forging capacity to be exceeded.

One alternative to the capacity problem was to subcontract part of the forging. Another alternative was to buy
a third press, of a smaller and different design, that could forge the preforms faster than the current presses.
This press could not make final forgings, however. A comparison had to be made to determine if it was better
to continue current operations with the addition of a subcontractor or to invest in a third forging press that
would handle preforms and use the current forging presses for final forgings.

2. DESCRIPTION OF THE DISK-MANUFACTURING PROCESS
The company receives nickel and titanium raw materials in specifically dimensioned cylindrical shapes. These
pieces weigh from 40 to 450 pounds. Upon arrival, the materials are tested for quality, and each piece is issued
a unique identity code and placed in storage.

For the first step in the manufacturing process, raw material is measured for proper size. If the cylinder is too
tall, it is machined to specifications (area a in Fig.1). It is then cleaned with solvent and placed in an oven to be
heated. Once the material has attained a prescribed temperature, it is sprayed with a boron nitride lubricant
(area b). The lubricant enhances forgeability and prevents material from sticking to the forging dies. It then
moves to one of the forging presses (area c)

2.1 THE FORGING OPERATION

Under the original design, forging is performed by one of two hydraulic, 8000-ton, single action presses. The
raw material is placed in a vacuum load lock chamber and preheated to 2000°F. It is then moved by an
automated manipulator to the forging chamber where it is processed. The raw material is now called a preform.
The preform is removed from the dies by the automatic manipulator and placed in an exit lock chamber where
argon or nitrogen is used to cool the part. Once cooled, the preform is grit blasted and visually inspected (area

M14: CASE STUDY 2 ASSIGNMENT

d). The shape of the final product will dictate the thickness of the preform, with a particular thickness being
suitable for a series, or “family,” of final products. All preform thicknesses are processed from a single flat set
of dies.

The preform is then taken to a vertical turning lathe (area a), where a centering dimple is machined into the
preform. This dimple is used in the final forging process to ensure that the preform is centered in the die. This
allows even material flow during the actual forging process. Additionally, any forging excess material, or flash,
is removed and any rough edges are blended before the part leaves this station.

Figure 1: Current plant layout with two forging presses

At this point, if the preform’s final forging is not imminent, it will be sent to storage. If the preform’s final forging
is scheduled soon, it will return to the spray lube station (area b) where it will be heated and lubricated for final
forging. These processes are repeats of those given the raw material. The preform is then returned to the forge
(area c), where a final shape die is now in place, and the part is processed. Upon completion of this final forging
operation, the disk is within 0.06 inches of final machined dimensions. Once the final forging is cooled, it is grit
blasted (area d) and sent for heat-treatment preparation.

g-Nondestructive testing

f-Automated turning system

a-Vertical turning lathe

e-Heat treatment

c-Forging press
b

d

Lubrication

spray

Grit blast

: Automatic guided vehicle track

M14: CASE STUDY 2 ASSIGNMENT

2.2 THE HEAT-TREATMENT OPERATION

The final forging then returns to the vertical turret lathe (area a) where a hole is drilled in the center of each
disk. The hole relieves stress during the heat-treatment process. Once drilling is finished, any sharp edges, burrs,
or flashing are removed, and an air grinder is used to smooth and blend all edges and surface flaws remaining.
Once prepared, the disk is transferred to heat treatment (area e).

For heat treatment, the disks are placed on grids, and support rings are inserted under each part. These rings
prevent material sag during the heating cycle and critical in maintaining disk flatness. The disks are placed in
high-temperature furnaces, to meet the part-specific temperature and duration requirement, and, once cycled,
are removed and cooled in an oil quench. The disks then go through low-temperature stabilization and
precipitation hardening to set the metallurgical properties of the part. The part is then allowed to attain room
temperature before being sent to its machining processes.

2.3 THE TURNING OPERATION

The heat-treated disk is sent back to the vertical turret lathes (area a), where a test piece of material is removed
from the center of the disk. This piece is marked to identify it with its parent disk, and then sent for materials
analysis. The outside diameter and datum surfaces are then machined. The datum surface is used as a reference
on the automated turning system (area f). The outside diameter machining establishes the disk concentricity.
The automated turning system is a computer-controlled machining process that produces the part’s final “sonic
shape,” the name given the disk when it is prepared for ultrasonic finishing. This finishing is then performed,
and the part is checked for dimensional accuracy, flatness, and, concentricity. It is then sent to final testing
(area g).

2.4 THE FINAL TESTING AND INSPECTION

In nondestructive testing, each disk is given a high-frequency sound inspection that checks the internal
consistency of the material. The disk is then chemically cleaned to remove any residue from the ultrasonic
machining and given an acid-solution wash to remove a specified amount of material from the entire surface of
the disk. The disk is next sprayed with a fluorescent penetrant. The disk is the washed, dried, and given an
extensive black-light illumination inspection to identify any remaining flaws. After nondestructive testing, the
part is prepared for shipment. (The steps beyond final forging are identical for each alternative.)

3. DESCRIPTION OF INVESTMENT ALTERNATIVES
Last year, the demand schedule did not require the forging process cell to operate at full capacity. Projected
demands could exceed current plant forging capacity, however. The following two courses of action were
proposed to handle the projected demands.

1. Subcontract the forging requirements overflow to a local vendor. This subcontractor can produce the
same type of forgings, but preforms will cost 10% more than the preforms produced in-house, and final
forgings will cost 75% more. Therefore, it is feasible to use this subcontractor only for preforms, not for
final forgings.

M14: CASE STUDY 2 ASSIGNMENT

2. Purchase a third forging press to handle the increasing requirements. A newly developed forging press
is available for purchase. The new press has an automatic manipulator arm that is faster than those on
the current presses.

As a result of its design differences, the new press can forge faster with lower operating and maintenance costs.
These advantages pertain only to the preform process, however. At the increased specifications required by final
forgings, the new press cannot perform as well as the current presses. Thus, under this alternative, the new
press would handle preform requirements only, and the current presses would handle final forgings. The
proposed layout is shown in Fig.2

3.1 EXPECTED DISK DEMAND

During the previous year, the plant produced about 8000 disks. Recently, a foreign producer has announced
that it is entering this manufacturing field and will be competing for future contracts within the next 3 to 5 years.
With this new information, the home office has projected that demand will peak in the third year after increasing
as follows: 9400 in year 1, 10,500 in year 2, and 13,000 in year 3. Beyond year 3, demand is most likely to
remain at the 13,000 level. These estimates represent the most-likely estimates with the actual demand varying
in either direction.

Figure 2: Proposed forging process layout with the third press

3.2 CURRENT PRESS PRODUCTION CAPABILITIES

The forging presses are scheduled for either production or maintenance, 24 hours a day and 335 days a year.
The other 30 days per year are devoted to research and development use. In the past, the forging presses
required 1.5 days of tooling set-up time for each different forging run. Final forging runs were made in batches
of 50 to 200 parts, depending on the scheduled demand for the part. No policy changes are currently planned

Preform lube line “B” department

Gatorizing
Line “C”

department

Grit blast
Line “D”

department

Third press

Current two presses

: Automatic guided vehicle track

M14: CASE STUDY 2 ASSIGNMENT

for batch sizing in scheduling, even with increasing demand. Last year, preform forging runs were made 8 times,
with an average of 1000 preforms per run. Therefore, with just production time, maintenance time, set-up time,
and current scheduling policies, the current presses produced preforms at an average rate of 27.384 minutes
per preform and final forgings at an average rate of 67.474 minutes per final forging. With the two current
presses, the total annual press minutes available are calculated to be

2 presses ´ 335 days ´ 24 hours/day ´ 60 minutes/hour = 964,800 minutes/year.

3.3 ECONOMIC CONSIDERATIONS

3.3.1 SUBCONTRACTOR ALTERNATIVE

For the projected demand at the most likely level, the subcontractor is needed to handle 1140
preforms in year 2, and 9800 in each year thereafter. Under this alternative, the costs for preform
forging are as follows.

Most-Likely Projection

Year 1 Year 2 Year 3-10

Preform demand 9,400 10,500 13,000

In-house preform capacity 9,400 9,360 3,200

No. of subcontract units 0 1,140 9,800

In-house cost (@ $205/part) $1,927,000 $1,918,800 $656,000

Subcontractor cost (@
$225/part)

0 256,500 2,205,000

Total preform cost $1,927,000 $2,175,300 $2,861,000

M14: CASE STUDY 2 ASSIGNMENT

3.3.2 PURCHASE-NEW-PRESS ALTERNATIVE

The new press, in addition to being faster than the current presses, will incur minimal set-up costs,
as it will always be configured for preforms (no tooling time). The new press will produce preforms
at an average rate of 20 minutes per preform and will handle all preform processing requirements.
The associated annual costs and resultant savings when compared with the subcontractor option are
as follows.

Most-Likely Projection

The difference in the current in-house cost of $205 per part and the new-press cost of $175 per part
is the result of reduced power consumption and an elimination of set-up and tear-down times,
prorated on a per-part basis.

The new press will cost $3,000,000. It has a 10-year service life and is considered a 7-year MACRS
property. Its salvage value at the end of service life is expected to be 10% of the original cost. The
dies from the current presses will fit the new forge, so this alternative will not incur additional tooling
costs.

3.3.3 OPERATING AND MAINTENANCE COST

Indirect costs are charged on a per-finished-part basis, so there will be no difference in overhead
charge for the two alternatives. Because the forging process is automated, there are no projections
for increased operator or maintenance personal, as the current staff should easily be able to monitor
one more machine. Note that the operating and maintenance (O&M) cost does not include power
expenses as they are reflected in the variable cost above. Although the two alternatives require
different mixes of spare parts, the budget allocation for the two alternatives is the same. The
remaining costs for maintenance supplies and equipment insurance are rated on an hourly basis and
are charged as $20 per operating hour. When the new press handles all preforming, it causes the
forging cell’s totals of machine operating hours to be reduced in years 1 and 2 therefore, reducing
the O&M costs to a level below the current two-press configuration. In year 3 and beyond, all
preformings are to be done on the new press. This causes the operating hours to exceed those
available using the subcontractor option, creating an increase in O&M costs. These comparative costs
are as follows.

Year 1 Year 2 Year 3-10

Subcontractor cost $1,927,000 $2,175,300 $2,861,000

New press cost (@ $175/part) 1,645,000 1,837,500 2,275,000

Comparative savings $282,000 $337,800 $586,000

M14: CASE STUDY 2 ASSIGNMENT

Year Required Operating Time (Hours) Incremental
Savings

Subcontractor Option New Press Option

Preforms Final Preforms Final

1 3,815 8,190 3,135 8,190 $13,600

2 3,800 9,150 3,500 9,150 6,000

3 1,300 11,325 4,335 11,325 -60,700

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10 1,300 11,325 4,335 11,325 -60,700

3.3.4 INVENTORY COSTS

Inventory level is considered to be dependent upon forging cell organization but independent of
demand. The average raw material cost is $3520 per disk. The plant currently, and under the
subcontractor option, projects a need for 2500 disks for work in progress (WIP). Preforms are held
as WIP to facilitate the final forging scheduling (precluding inadvertent interruptions created by an
insufficient supply of preforms to meet final forging requirements), and this volume was primarily
established because of the limited number of preform forging runs. Under the new-press option,
since it is a more responsive set-up, lead time for final forging can be reduced, and the inventory
level can be reduced, by a most-likely estimate of 10% (250 units), to 2250 parts. This indicated that
the new-press option expects to release working capital of $880,000 (a one-time inventory reduction,
$3520´250). The current inventory carrying-cost rate is known to be about 15% of the unit cost.
Therefore, the new-press purchase results in an annual savings of $132,000 in inventory holding
costs.

3.3.5 TAX RATES AND COST OF CAPITAL

The company has a combined income tax rate of 38.6% and must pay property taxes at a rate of
1.95% on the remaining book value to the local township. The cash required for the purchase of the
new press could either be obtained from funds that are available for investment in equipment or it
could be borrowed. Since sufficient internal funds are available, the borrowing option is not
considered at this time.

The current firm’s investment policy does not go into detail on how to deal with a possible project
risk, but the firm’s Capital Expenditure Review Committee (CERC) has used the following criteria for
any project to be considered for implementation.

M14: CASE STUDY 2 ASSIGNMENT

• No investment project will be considered if it is not likely to produce at least an 18% rate of
return on the after-tax cash flows.

• The NPW of the cash flows, using the worst case, must be no less than 15% of the project
outlay.

This last criterion is considered to be a method by which the CERC hopes to measure risk in a less
formal fashion. That is, when cash flows are computed assuming the least favorable events, likely
resulting in a negative net cash flow, this net cash flow should not be more than 15% of the cost of
the project.

Questions:

a) Based on the information on demand and resource requirements in Section 3.1 and 3.2, and on the
assumption that final forgings have priority over preforms, compute the remaining preform capacity for
each year form Year 1 to Year 10. Also compute the excess capacity or additional preform capacity
required in each year.

b) Assume that the demand projections are accurate, proposed inventory reductions can be made, and a
15% inventory holding rate is appropriate. Develop incremental cash flows, and compute the present
value of adopting the third press, using the company’s MARR of 18% and a 10-year planning horizon.
Also compute the internal rate of return and comment on whether the option is acceptable.

c) Assume a worst-case scenario, namely that the demand does not increase over the planning horizon.

Re-compute the incremental cash flows for the forging cell and compute the new present value.
Comment on the savings created by reduced processing time combination with lower total operating
hours.

d) Variability in Demand. Recall that the major factor that initiated this equipment acquisition was a

projected increase in demand. Because the demand projections are speculative in nature, the risk
involved in these alternatives need to be assessed. To account for the extreme variations in disk
demand, three estimates of the annual demand level are specified: a most-likely demand, which is the
same as before; an optimistic (high) demand; and a pessimistic (low) demand. Recall that the O&M
cost varies directly with the press hours allocated and the press hours are, in turn, dependent on the
level of disk demand. Recompute the preform and final forging press hours according to the low-and
high-demand levels. With the assumption that the inventory reduction of 250 units is still valid, compute
the after-tax cash flows under the high-and low-demand scenarios. Compute the corresponding NPWs
for the two cases and comment.

M14: CASE STUDY 2 ASSIGNMENT

Year Demand (No. of Disks)

Low Most-Likely High

1 8,500 9,400 9,700

2 9,800 10,500 11,000

3 11,000 13,000 13,500

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10 11,000 13,000 13,500

e) Degree of Inventory Reduction. The raw material cost of $3520 per disk unit, when considered in
volume of parts produced or held in inventory, is extremely large when compared to the $3,000,000
purchase price of the new forging press. Therefore, it is important to examine the impacts of inventory-
reduction level and holding-cost variations on the NPW calculation. In the previous analysis, the projected
inventory reduction was 250 units, and the inventory holding-cost savings was 15% of the cost of those
250 units ($880,000). In the past, Air Technology Corporation also had a history of overestimating the
savings potential of new equipment. The level of inventory-reduction savings also varies as a function of
carrying cost. This variation has been fairly well established for other product lines, but it is not as
predictable for this new production process. For the purpose of sensitivity analysis, examine the impact
on incremental NPW, when inventory reductions range from 0 to 500 units and the carrying-cost saving
vary simultaneously from 0% to 18%. Do this by plotting incremental NPW v.s. amount of inventory
reduction for each level of carrying-cost savings at 0%, 6%, 12%, 15% and 18%. Then compute the
break-even inventory reduction at each of the five levels of carrying-cost savings. Comment on the
sensitivity of decisions on the two parameters.

f) Assume that the demands in Year 1, Year 2 and Year 3-10 are random variables with triangular
distributions between their respective pessimistic and optimistic values with the peaks at their most-likely
values. The previous demand variability analysis viewed demand as a single factor that had pessimistic,
most-likely, and optimistic estimates. Then, we treated this variable response as if the annual demand
rates were perfectly correlated (for example, a low-demand requirement in year 1 is followed by 9 more
years of relatively low demand, resulting in a net present value that falls in the low end of the spectrum).
As stated previously, a more realistic view is that annual demand will vary from year to year. To gain
insight into the effects of this correction, the simulation model was developed under the two extremes-
no demand correlation (independently sampled annual demands) and perfect demand correlation (a
single 0-1 random number was used to generate three inverse triangular variates, with the third being
used repeatedly for years3-10). To gain insight into the effects of this correlation, perform risk simulation
under two extremes-no demand correlation (independently sampled annual demands) and perfect
correlation (a single 0-1 random number is used to generate three inverse triangular variates, with the
third being used repeatedly for years3-10). Do this by first fixing the inventory reduction level at 250 and
use 5 replications, of 200 iterations each, for each of the two conditions. Estimate the expected value
and the variance of NPW and also estimate P (NPW £ 0). Comment on the result.

M14: CASE STUDY 2 ASSIGNMENT

Hints/Suggestions for Case 2

Part (a): Note that the current capacity available for preform in minutes in any year is equal to the total
capacity (in minutes) minus capacity allocated to final forging (= demand for the product for that year*
average minutes per final forging). So, dividing the result by average minutes per preform will give you
available capacity for preform in units of production.

Part (b) and (c): Remember to work with incremental cash flow (new press over subcontract) and treat
savings (due to process improvement including reduction of operation hours, and reduction in inventory
carrying cost) as positive cash flows in the incremental cash flow analysis. Also, do not forget that there is a
working capital release in Year 0 (due to reduction of WIP inventory level) that needs to be recovered later.

Part (d): Remember that after you re-compute the preform and final forging hours, you need to re-compute
the O&M savings under different scenarios as in the Table in Section 3.3.3. Based on the data given, show
that for the subcontractor option, the in-house operating-minutes per perform is about 24.361 minutes, and
the in-house operating minutes per final form is 52.277 minutes. Then you can use the following table to
prepare the O&M savings for various scenarios.

Hours actually
forging
preform in-
house with the
subcontract
option

New-press
forging hours

Hours saved O&M savings

Low demand ____ ____ ______ ______

____ ____ ______ ______

____ ____ ______ ______

Most-likely
demand

(as previously
computed):

3815 3135 680 13600

3800 3500 300 6000

1300 4335 (3035) (60700)

High demand ____ ____ ______ ______

____ ____ ______ ______

____ ____ ______ ______

M14: CASE STUDY 2 ASSIGNMENT

Part(e): This part should be a straightforward sensitivity analysis.

Part(f): We will discuss Risk Simulation, particularly, how to generate random variates form a triangular
distribution, the number of replications, and the number of iterations, etc. We will also discuss how to use
EXCEL to do these tasks, particularly to make as many iterations as 200. If you have software like @Risk or
Crystal Ball and know how to use them, you may also use either one to perform the simulation (please talk
to me if you are interested in using @Risk or Crystal Ball for this case study). If you don’t have the software,
you can try using DATA/Table command in EXCEL Otherwise it may be tedious to do 200 iterations for each
of the 5 replications. In this case, you may want to reduce the number of iterations to a manageable number,
but still get reasonable estimates of the expected values and variances of NPW If for each of the 5
replications.

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