ESET-212 Lecture Notes - Lecture 3: Oil Heater, The Automatic, Stationary Engineer
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Skinner Industries from Conway, North Carolina has found an exclusive market in supplementary equipment to support the ever increasing motor sports market. In the last ten years, the company has filed for patents on the portable fuel dispenser, power lug nut remover, and the removable transparent windshield protector. Each of these items is critical when the race car drivers have to make a pit stop during a race. When seconds count, having the best available equipment can mean millions in prize dollars and sponsorship support.
Sherry Skinner has always been a big fan of motor sports having grown up in Conway, North Carolina and going with her dad to many races during her youth. Sherry wanted to be a part of the action of motor sports, but since this was a male dominated sport, she knew it could not be as a driver, member of the pit crew or working in the engine shop. While the sport does have a few female drivers, Sherry did not want to be a token, and she felt her gifts and talents could be better utilized in other venues.
Sherry loved engineering, and went to Duke for her engineering degree. After excelling in college, she had her choice of jobs at major companies around the country. However, Sherry passed up the prestige jobs and went back to her roots in Conway. She decided to start her own company and use her talents to develop unique products that could be used in the motor sports arena. Sherry knew that it would be hard to compete against the big boys and major automobile corporations when it came to the race cars, however she thought there could be a market in supplementary equipment items.
Growing up with the sport, Sherry always enjoyed the action on pit row. Races were often won or lost on how quickly the pit crew got tires changed and fuel added to the car. Sherry reasoned correctly that this part of the race would be a good place to start developing products. The two most critical activities during a pit stop were changing tires and adding fuel. Any equipment or product design which could enhance these activities would certainly have instant appeal.
After a great start to the company, Sherry took the company public nine years ago when Skinner Industries was just three years old. 1,200,000 shares of common stock were issued at a price of $10 per share through the mid-Atlantic regional exchange.
The company has continued to prosper and enjoy a good growth rate as the motor sports craze has mushroomed. In 20x3 the Skinner Industries growth rate in earnings was 6% and in 20x4 the growth rate was 5%. Sherry does not want the company to become too large, as she still likes the feeling of a âdown homeâ business with the boys. At the same time, the business is virtually guaranteed to grow just because of the motor sport market itself.
Sherry is happy with the current 5% growth rate and to support that projection she is planning on a $3,000,000 capital expansion program in 20x5. She is currently close to capacity with many of the operations and without the continued expansion the desired growth could be in jeopardy.
So far, Sherry has been able to maintain a reasonable increase in long-term assets without having to initiate subsequent issues of stock. She would like to continue funding growth through both the company profits and with favorable bank loans. Ideally, the company wants to maintain a target equity ratio of 70% of the total capital structure which includes long-term liabilities plus equity. Currently, the cost of borrowing is 11.5% before taxes. Sherry has also determined that the cost of equity is 13%.
When Sherry started the business, she was able to work out an attractive lending agreement for $5,000,000 in long-term bonds with a 15 year maturity. Part of the agreement with the bank was that Sherry establishes a sinking fund that would have to match the $5,000,000 in bonds one year prior to maturity. This provision would guarantee the bank collateral on the bonds but allow Skinner to earn some interest on marketable securities. As of the end of the current year, that fund has grown to $3,000,000 and Sherry is planning on adding $1,000,000 in each of the next two years. The bank also required that Sherry establish an appropriated retained earnings account equal to the amount of the collateral sinking funds so that she would be limited in the amount of dividends that could be declared and paid in any given year.
To supplement some of the recent expansion, Sherry had funded the increase in long-term assets with additional long-term notes. This funding has grown to $2,000,000 at the end of the current year. The financial institution providing these funds has identified some constraints on potential dividend payments based on the overall financial performance of Skinner. The company must maintain a current ratio of at least 1.20, a times interest earned ratio of at least 3.0, and a debt ratio no greater than 60%.
While the company is growing and there continues to be a need for capital expansion, Sherry also recognizes the need for dividends, and has established a once a year dividend payment at the end of the year. The investors seem to like their dividend bonus that comes in early February just before the start of racing season. Many of the investors are value conscious and want a return on their investment from both dividends and stock price appreciation. Since this is a regional company focusing on a very specific market, a large number of investors are motor sport fans from the mid-Atlantic area. Sherry has always believed in a significant dividend, last year it was $700,000, and the dividend yield is over 6.0%. The company has also maintained a pretty consistent dividend payout ratio through 20x3.
While everything seems to be going right for the company, with a reasonable growth rate in an exploding market plus an attractive dividend, Sherry is puzzled on why the market price of the stock at around $8 7/8 seems so low. Perhaps the overall economy, which is struggling and filled with uncertainty, is causing the price decline. Also, Sherry believes that the job market in North and South Carolina has suffered with many textile and similar jobs going overseas. In an effort to support the price of the stock and maintain the confidence of the investors, Sherry thinks it is important to retain and possibly even increase the current dividend per share for 20x4.
Sherry has just received the financial statements as of December 31, 20x4 without the inclusion of a 20x4 dividend payment. She needs to determine what annual dividend payment the company should make for 20x4. She also wanted to see what happened last year so she obtained the income statement and balance sheet from 20x3 along with the balance sheet figures at the end of 20x2. The corporate tax rate is 40%.
| Skinner Industries | |||
| Income Statement | |||
| As of December 31 | |||
| Dollars in $1,000s | |||
| 20x3 | 20x4 | ||
| Sales | 23,500 | 26,150 | |
| Cost of Goods Sold | 14,700 | 16,990 | |
| Depreciation | 1,750 | 1,840 | |
| Gross Margin | 7,050 | 7,320 | |
| Operating Expenses | 2,850 | 2,900 | |
| Operating Income | 4,200 | 4,420 | |
| Financing Expenses | 1,300 | 1,370 | |
| Net Income Before Tax | 2,900 | 3,050 | |
| Taxes | 1,160 | 1,220 | |
| Net Income | 1,740 | 1,830 | |
| Skinner Industries | |||
| Balance Sheet | |||
| As of December 31 | |||
| Dollars in $1,000s | |||
| 20x2 | 20x3 | 20x4 | |
| Cash | 950 | 1,000 | 800 |
| Marketable Securities | 2,260 | 2,750 | 3,000 |
| Accounts Receivable | 4,000 | 4,130 | 4,850 |
| Inventory | 8,300 | 8,640 | 9,570 |
| Total Current Assets | 15,510 | 16,520 | 18,220 |
| Long-Term Assets (net) | 17,500 | 18,380 | 20,360 |
| Total Assets | 33,010 | 34,900 | 38,580 |
| Accounts Payable | 6,200 | 6,270 | 7,050 |
| Accruals | 1,500 | 1,530 | 1,600 |
| Short-Term Notes Payable | 4,500 | 5,000 | 5,500 |
| Total Current Liabilities | 12,200 | 12,800 | 14,150 |
| Long-Term Liabilities | 6,250 | 6,500 | 7,000 |
| Total Liabilities | 18,450 | 19,300 | 21,150 |
| Common Stock | 12,000 | 12,000 | 12,000 |
| Retained Earnings - Appropriated | 1,700 | 2,250 | 3,000 |
| Retained Earnings - Unappropriated | 860 | 1,350 | 2,430 |
| Total Equity | 14,560 | 15,600 | 17,430 |
| Total Liabilities & Equity | 33,010 | 34,900 | 38,580 |
1. What amount should Sherry declare in dividends for 20x4? Identify what factors influenced your decision and how they helped you in determining the dividend amount.
INSOURCING/OUTSOURCING
Rentex Motor Drives is a division of a large U.S. manufacturer of industrial machinery and equipment. The parent company makes circulating pumps, high-capacity cooling fans, and compressors. Rentex Motor Dnves manufactures the electric motors that power much of this machinery and equipment. Rentex has a world-wide customer base and sells motors not only to its parent company, but also to other customers across the globe â some of whom are direct competitors of Rentex's parent company.
Recently the company developed an electric motor assembly that will be a key component in a new circulating pump being manufactured and sold by one of Rentex's sister companies. The circulating pump will be sold to the manufacturers of oil-fired burners used for home heating. Each circulating pump will require a single electric motor assembly.
Rentex must now decide whether or not it should outsource or internally manufacture the motor assembly. To help with the analysis, a cross-functional team has been formed. Members of the team have been assigned the responsibility of analyzing from a total cost perspective whether or not Rentex should outsource or internally manufacture the electric motor assembly.
A European supplier that produces motors for a number of Fortune 500 companies has submitted a detailed proposal to Rentex for building the subassembly. However, confounding this analysis is an internal bias against outsourcing the motor, particularly since there is a strong union presence within Rentex's facilities. Furthermore, management at Rentex believes that the electric motor assembly design might be adapted in the future to enable its use in new applications in the chemical processing industry, thereby representing a future growth opportunity.
As an initial step the cross-functional team has gathered the required information to guide the firm's decision process.
Outsourcing Costs
Unit Costs: Rentex's marketing group estimates that volumes for the motor assembly are:
| Year 1 | 5,500 units |
| Year 2 | 6,250 units |
| Year 3 | 7,000 units |
The European supplier of electric motors has quoted a price of $105 per unit, FOB ex-works, 1&2 with 5% price decreases per year for Year 2, and again for Year 3. Remember â the Year 3 price decrease is based off the Year 2 figure). The team assumes these price decreases are due to productivity improvements from higher volumes, the positive effects of learning at the supplier, and greater operating efficiencies. These prices have not been negotiated and the purchasing team believes that negotiation may lead to a lower unit price. If the new line of circulating pumps is successful, it is estimated that the life of the product cycle will be six years, reaching a peak of 8,000 units in Year 4, with a 10% reduction per year in volume after that as the product reaches the end of its life. It is estimated that the product will be completely phased out at the end of Year 6.
Shipping, handling, and receiving: Shipping, handling, and receiving costs at the buyer are estimated to be $15 per unit and should remain constant.
Tooling: The supplier has stated that it will cost $30,000 to fabricate the tooling and fixtures required to produce the electric motor. Rentex's policy is to assume ownership of tooling, so Rentex is responsible for the tooling costs. It's estimated that the tooling will have a usable life span of at least 6 years, with proper preventive maintenance (which the supplier has agreed to perform at no additional cost). The purchasing team plans to allocate the tooling costs evenly over the first three years.
Quality-related costs: The team has decided to include quality-related costs in its outsourcing calculations. During the investigation of the supplier, a team member collected data on the process that would likely produce the motors. The team estimates that the supplier's defect level, based on process measurement data, is 1,000 parts per million (ppm). Rentex's quality assurance department estimates that each supplier defect will cost Rentex $1,750 in direct nonconformance costs. Unfortunately, with quality problems there are always hidden costs that are difficult, if not impossible, to model.
Supplier capacity/safety stock: The team has concluded the supplier has available capacity to satisfy Rentex's current and near-term requirements for the motor. To mitigate supply chain risk, Rentex plans to hold one month's worth of the assembly as safety stock. The team assumes that this is a new cost each year.
Insourcing Costs
Rentex's cost engineering department has provided the following per unit cost estimates for internally manufacturing and assembling the motors during Year 1 of a three-year planning cycle:
| Direct labor | $19.75 | Cost of receiving components | $4.25 |
| Direct materials | $35.25 | Supplemental factory supplies | $2.15 |
| Transfer profit 3 | $21.75 |
Initial tooling and line modification costs: The start-up costs (including tooling) to modify existing production lines and equipment to accommodate production of the new motor will be $42,000, which will be spread out evenly over the first three years.
Depreciation expense: Depreciation expense on production equipment and tooling is considered a noncash item and is not included in the insourcing analysis.
Engineering design costs: Engineering costs to design, develop, and improve the production process will be $75,000 and will be spread evenly across the first three years of production.
Factory and corporate overhead: Overhead is allocated at 180% of direct labor costs.
Cost increases: In Years 2 and 3, management expects a 2% annual increase in direct material costs and a 3% increase in direct labor rates. (This increase is compounded so the increase in Year 3 costs is based off Year 2 cost figures).
Quality-related costs: The team estimates that Rentex's finished electric motor quality defects to be 2,500 ppm. Rentex's quality assurance department estimates that each defect costs the company $1,500 in nonconformance costs.
Preventive maintenance costs: Rentex's maintenance manager estimates that preventive maintenance of the production equipment required to produce the motors will cost $15,000 in Year 1, and will increase at the rate of 3% per year thereafter.
NOTES:
1. FOB (free on board) vessel means the supplier is responsible for transportation charges to the port in China.
2. Buyer is responsible for the cost and delivery of goods from the seller's location.
3. Transfer profit is the internal profit from selling to another unit in the company. This company views its units as profit centers, so profit must be included. Furthermore, the supplier has included profits in its quoted price.
Calculate the total cost per year for insourcing and outsourcing. Also calculate the cost per unit.
