Question

Cost benefit analysis for the Long Engineering Company

       The Long Engineering Company (LEC) has decided to install a network system to help their technical support engineers (five of them who earn an average of $100,000 each per year) to deliver better customer service including: mail out sales and other literature, answer phone calls for technical assistance and log and forward repair requests using an alpha-numeric paging system that will be part of the new network system. Currently all company technical manuals and are in physical format, but will need to be scanned and converted to electronic readable form. There are about 3000 pages of technical literature. The initial feasibility study estimated that there would be savings in various areas including: (1) there are currently four clerical staff, two of these would no longer be needed ($60,000 per year each), and (2) Reduced long distance toll bills of $1,500 per month for calls to field support staff regarding repair requests. It was also expected that there would be an increase in sales of $400,000 per year because of improved customer service, with a gross profit rate of 40%. The company typically uses a cost of money (discount rate) of 20% for these types of projects.

Ten months ago, our company’s IT consultant/vendor gave us the following proposal, and we

prepared an Excel spreadsheet (see separate handout) showing a Net Present Value of $257,605

for the project: "Our system will provide a full LAN configuration for your customer support services area covering the major areas of functionality required including: call logging by customer or inquirer, recording of nature of request and nature of response, access to all company technical literature online, and automatic message forwarding to hand-held devices of field service persons where necessary. The cost of the system includes the required file server and six workstations, laser printer and WAN communications adapter ($150,000). The software provided will include the necessary LAN operating system (Windows), and applications software to meet the functionality requirements mentioned above ($175,000). Existing staff should be able to handle the new system with additional training, as the entire system will be very user friendly with a low learning curve and should be easily administrated by one of the existing engineers, only absorbing 20% of his time. We do recommend that you budget for at least one week of training for each of your employees each year to gain and maintain the skills necessary to achieve full benefit from this system. It will also be necessary to budget for conversion of the company's technical literature at an estimated cost of $5 per page. A maintenance contract is available if you wish at a cost of 15% of the initial cost of the hardware, and a similar contract is available for the software. Training costs typically amount to $2500 per week, per employee."

Assignment:

The financial situation of the company has changed substantially in the last 10 months, so your manager

wants you to make changes to the previous Excel spreadsheet so as to present a more conservative

analysis by including the following changes:

1. Assume that the engineer/supervisor who will be administering the system will have to devote 50% of his time the 1^st year, 40% the 2^nd year, 30% the 3^rd year, and 20% the 4^th and 5^th years of the analysis. Hint: It is customary in business to allocate the portion of a resource's cost/salary in direct relationship to the % of time it devotes to the project.
2. Assume that the anticipated sales increase will be only $200,000 the 1^st year, $300,000 the 2^nd year, and $400,000 the remaining 3 years of the study.
3. Assume the gross profit rate will only be 20% throughout the study.
4. If the new Net Present Value (NPV) is negative, your manager wants you to make changes to the software initial cost until the NPV turns to zero (0) for the project. That will indicate the new, lower, price which we may want to negotiate for with the vendor if we don’t want to lose money on this project.   

Please turn in a printed copy of the revised version of the spreadsheet in class on Thursday, January

31th, 2019; be sure to include your name. The NPV of the project should be Zero, and the new

software cost should be highlighted?

1 Long Engineering Company-Vendor Proposal Analysis 3 Proposal Data 4 Increased sales 5 Discount Rate 6 Hardware Maintenance 7 Software Maintenance 8 Gross Margin 9 Weeks per Year 10 Assistant Salary 11 Engineer Salary 12 13 NPV 14 15 16 Year 17 Initial Costs 18 Hardware 19 Software 20 Data Conversion 21 People, Supervisor 22 Training Costs 23 24 25 Hardware Maintenance 26 Software Maintenance 27 People, Supervisor 28 Training 29 Total Costs 30 31 Initial Benefits 32 33 Recurring Benefits 34 Increase Profit 35 Wage Saving 36 Phone Bill Saving 37 Total Benefits 38 400,000 Staff assistants 2 15% 15% Training for Assistants ( Data Conversion Cost of Training Training weeks Initial Training for Staff (weeks) Initial Training for Engineers (weeks) 15,000 2,500 60,000 100,000 2 257,605 150,000) 175,000) 15,000 Recurring Costs (22,500)(22,500) (22,500) (22,500) (22,500) (26,250)(26,250) (26,250) (26,250) (26,250) (20,000)(20,000) (20,000) (20,000) (20,000) (29,423) (29,423) (29,423) (29,423) 8.173) (98,173) 340,000)(98,17 173 8.173) (9 160,000 120,000 18,000 298,000 160,000 160,000 160,000 160,000 120,000 120,000 120,000 120,000 18,000 18,000 18,000 18,000 298,000 298,000298,000298.000 39 Net Cash Flow 40 NPV 340,000) 199,827 257,605 166,522 99.827 199.827 199,827 199,827 138,769 115,641 96,367 80,306 42 43

Answer 1

Ans:

Basic Information
Gross Profit	20% of sales		Hardware cost	150,000
Supervisor Salary Allocated			Software Cost	175,000
Year			Data Conversion Cost	15000
1	40%		Engineer Salary	$100,000
2	30%		Training cost per Year	$29,423
3	20%		Discounting Rate	20%
4	20%		Hardware Maintenance	15%
5	20%		Software Maintenance	15%
Incremental sales
1	$200,000
2	$300,000
3	$400,000
4	$400,000
5	$400,000

a) Computation of Net Present Value

Particulars	Amount ($)
	0	1	2	3	4	5
Initial Investment
Hardware cost	$150,000
Software Cost	$175,000
Data Conversion Cost	$15,000
Recurring Cost
Hardware Maintenance		$22,500	$22,500	$22,500	$22,500	$22,500
Software Maintenance		$26,250	$26,250	$26,250	$26,250	$26,250
People ,Supervisor cost		$40,000	$30,000	$20,000	$20,000	$20,000
Training Cost		$29,423	$29,423	$29,423	$29,423	$29,423
Total Cost	$340,000	$118,173	$108,173	$98,173	$98,173	$98,173
Recurring Benefits
Increased profit		$40,000	$60,000	$80,000	$80,000	$80,000
Wages Saving		$120,000	$120,000	$120,000	$120,000	$120,000
Phone Bill Saving		$18,000	$18,000	$18,000	$18,000	$18,000
Total Benefits		$178,000	$198,000	$218,000	$218,000	$218,000
Incremental Benefits	-$340,000	$59,827	$89,827	$119,827	$119,827	$119,827
Present Value Factor @ 20%	1	0.83	0.69	0.58	0.48	0.40
Present Value	-$340,000	$49,856	$62,380	$69,344	$57,787	$48,156
Net present Value	-$52,477

So if the software cost is decreased by $52,477 then the NPV of the project become Zero and the cost of Software becomes $122,523.