R.U. Redddie Report. Optimal distribution plan for plant in St. Louis and in Denver with the project NPV

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Frederick Watson
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1 Jeanne Yi-Chun Hsieh Chinenye Nwangwu R.U. Redddie Report Memo The R.U. Reddie Corporation which manufactures clothing for stuffed cartoon animals has projected the market demand in the following years to be substantially greater than current plant capacity. To be more profitable, the company is considering opening a new plant to produce more units to satisfy the market demand. Two specific locations for the new plant are under consideration: St. Louis and Denver. The two locations have its own specification in terms of market demand, labor, environmental regulations and different level of proximity to the suppliers. Nevertheless, the most important factors for R.U. Reddie Corp are the combination of production cost and shipping cost for each option. The company wants to know between St. Louis and Denver, which one is a better location to achieve its objective of minimizing the total variable costs. Model Description We built a linear model using the data gathered for R.U.Reddie which indicates different production costs, plant capacity and the road mileage between the cities. The objective of our model was to minimize total variable costs, which are the combination of production cost and transportation costs, while satisfying the market demand. We ve built 2 models, one for Denver and one for St. Louis, incorporating 20 variables and 9 constraints for each one. We ve also compute the NPV for each alternative, using the COGS derived from our linear model to evaluate the new plant project. Optimal distribution plan for plant in St. Louis and in Denver with the project NPV From our analysis, in the scenario where the new plant locates in St. Louis, the calculated NPV is $585,630 and the optimal distribution plan for R.U. Reddie and the corresponding COGS is: In Year 1, the COGS is expected to be $5,935,500 The plant in Boston should produce 300,000 units, among which 80,000 should be kept to satisfy Boston market and 220,000 units should be shipped to Denver. The plant in Cleveland should produce 400,000 units, among which 200,000 should be kept to satisfy Cleveland market and 200,000 units should be shipped to Chicago. The plant in Chicago should produce 500,000 units, among which 170,000 should be kept to satisfy Chicago market and 330,000 units should be shipped to Denver. The plant in St. Louis should produce 500,000 units, among which 440,000 should be kept to satisfy St. Louis market and 60,000 should be shipped to Denver. From Year 2 to Year 10, The annual COGS is expected to be $6,689,500 The plant in Boston should produce 200,000 units, among which 140,000 should be kept to satisfy Boston market and 60,000 units should be shipped to Denver. The plant in Cleveland should produce 400,000 units, among which 260,000 should be kept to satisfy Cleveland market and 140,000 units should be shipped to Chicago. 1

2 Jeanne Yi-Chun Hsieh Chinenye Nwangwu The plant in Chicago should produce 500,000 units, among which 290,000 should be kept to satisfy Chicago market and 210,000 units should be shipped to Denver. The plant in St. Louis should produce 900,000 units, among which 500,000 should be kept to satisfy St. Louis market and 400,000 should be shipped to Denver. In the scenario where the new plant locates in Denver, the calculated NPV is $419,740 and the optimal distribution plan for R.U. Reddie and the corresponding COGS is: In Year 1, the COGS is expected to be $5,790,000 The plant in Boston should produce 300,000 units, among which 80,000 should be kept to satisfy Boston market and 220,000 units should be shipped to St. Louis. The plant in Cleveland should produce 400,000 units, among which 200,000 should be kept to satisfy Cleveland market and 200,000 units should be shipped to St. Louis. The plant in Chicago should produce 500,000 units, among which 370,000 should be kept to satisfy Chicago market, 20,000 units should be shipped to St. Louis and 110,000 units shipped to Denver. The plant in Denver should produce 500,000 units, and all of the produced units should be kept in Denver to satisfy Denver market. From Year 2 to Year 10, The annual COGS is expected to be $6,606,250 The plant in Boston should produce 200,000 units, among which 140,000 should be kept to satisfy Boston market and 60,000 units should be shipped to St. Louis. The plant in Cleveland should produce 400,000 units, among which 260,000 should be kept to satisfy Cleveland market and 140,000 units should be shipped to St Louis. The plant in Chicago should produce 500,000 units, among which 430,000 should be kept to satisfy Chicago market and 70,000 units should be shipped to St. Louis. The plant in Denver should produce 900,000 units, among which 670,000 should be kept to satisfy Denver market and 230,000 should be shipped to St. Louis. Recommendation Based on our finding above, we can conclude that St Louis would be the best location to build the new plant. This recommendation is based on the fact that St Louis yielded higher NPVs in the base case; therefore building the new plant in St Louis is more profitable than building in Denver. 2

3 Plant in St Louis Shipping cost (per mile) $ Revenue (per outfit) $ City Capacity Y1 Capacity Y2~ Boston Cleveland Chicago St. Louis Denver City Y1 demand Y2-10 demand Building&Equipment cost Fix cost production costs/unit Land B&E&L Boston $9,500 $600 $3.80 $500 Cleveland $7,700 $300 $3.00 $400 Chicago $8,600 $400 $3.25 $600 St. Louis $12,100 $550 $3.05 $1,200 Denver $37,900 $1,850 $2,700 $40,600 Mileage Plant\Market Boston Cleveland Chicago St. Louis Denver Boston ,000 1,200 2,000 Cleveland ,400 Chicago 1, ,000 St. Louis 1, Denver 2,000 1,400 1, Production Plan (Y1) Plant\Market Boston Cleveland Chicago St. Louis Denver Capacity Boston <= 400 Cleveland <= 400 Chicago <= 500 St. Louis <= >= >= >= >= >= Production Plan (Y2-10) Plant\Market Boston Cleveland Chicago St. Louis Denver Capacity Boston <= 400 Cleveland <= 400 Chicago <= 500 St. Louis <= >= >= >= >= >= Total Demand Total Revenue Annual Production cost Shipping cost COGS Y $13,600 $5, $ $5, Y2-Y $16,000 $6, $ $6, $12,625

4 Plant in St Louis Tax rate 40% WACC 11% Terminal Value 50% 0f PP&E & Land Land $ Investment in PP&E $ 10, Number of years 10 StraightLine Depreciation rate 0.10 Salvage Value $ 5, Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 SALES REVENUE $ - $ 3, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, COGS $ - $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, GROSS PROFIT $ - $ 1, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, SG&A $ - $ $ $ $ $ $ $ $ $ $ EBITDA $ - $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, DEPRECIATION $ - $ $ $ $ $ $ $ $ $ $ EBIT $ - $ $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, INTEREST EXPENSE $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - TAXABLE INCOME $ - $ $2, $2, $2, $2, $2, $2, $2, $2, $2, INCOME TAX EXPENSE $ - $ $ $ $ $ $ $ $ $ $ NET INCOME $ - $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, CAPITAL EXPENDITURE $ 11, $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - NOPLAT $ - $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, Operating Cashflow $ - $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, Financing Cashflow $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - CAP EXPENDITURE $ 11, $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - Investing Cashflow $ (11,600.00) $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - UFCF $ (11,600.00) $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, TV $ 5, PV CFs $ $ 1, $ 1, $ 1, $ 1, $ $ $ $ $ PV TV $ 2, ENTERPRISE VALUE $ 12, NPV $ IRR 8% Larger than the WACC so this is a good project

5 Plant in Denver Shipping cost (per mile) $ Revenue (per outfit) $ City Capacity Y1 Capacity Y2~ Boston Cleveland Chicago St. Louis Denver City Y1 demand Y2-10 demand Building&Equipment cost Fix cost production costs/unit Land Boston $9,500 $600 $3.80 $500 Cleveland $7,700 $300 $3.00 $400 Chicago $8,600 $400 $3.25 $600 Denver $10,800 $750 $3.15 $800 St. Louis $12,100 $550 $3.05 $1,200 Mileage Plant\Market Boston Cleveland Chicago St. Louis Denver Boston ,000 1,200 2,000 Cleveland ,400 Chicago 1, ,000 Denver 2,000 1,400 1, Production Plan (Y1) Capacity Plant\Market Boston Cleveland Chicago St. Louis Denver <= 400 Boston <= 400 Cleveland <= 500 Chicago <= 500 Denver >= >= >= >= >= Production Plan (Y2-10) Capacity Plant\Market Boston Cleveland Chicago St. Louis Denver <= 400 Boston <= 400 Cleveland <= 500 Chicago <= 900 Denver >= >= >= >= >= Total Demand Total revenue Annual Production cost Shipping cos COGS Y $13,600 $5, $ $5, Y2-Y $16,000 $6, $ $6, $12,396

6 Plant in Denver Tax rate 40% WACC 11% Terminal Value 50% 0f PP&E & Land Land $ 1, Investment in PP&E $ 12, Number of years 10 StraightLine Depreciation rate 0.10 Salvage Value $ 6, Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 SALES REVENUE $ - $ 3, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, $ 5, COGS $ - $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, GROSS PROFIT $ - $ 2, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, $ 3, SG&A $ - $ $ $ $ $ $ $ $ $ $ EBITDA $ - $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, DEPRECIATION $ - $ $ $ $ $ $ $ $ $ $ EBIT $ - $ $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, INTEREST EXPENSE $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - TAXABLE INCOME $ - $ $2, $2, $2, $2, $2, $2, $2, $2, $2, INCOME TAX EXPENSE $ - $ $ $ $ $ $ $ $ $ $ NET INCOME $ - $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, CAPITAL EXPENDITURE $ 13, $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - NOPLAT $ - $ $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, Operating Cashflow $ - $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, Financing Cashflow $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - CAP EXPENDITURE $ 13, $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - Investing Cashflow $ (13,300.00) $ - $ - $ - $ - $ - $ - $ - $ - $ - $ - UFCF $ (13,300.00) $ 1, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, $ 2, TV $ 6, PV CFs $ 1, $ 1, $ 1, $ 1, $ 1, $ 1, $ $ $ $ PV TV $ 2, ENTERPRISE VALUE $ 13, NPV $ IRR 8% Larger than the WACC so this is a good project

7 CASE R. U. REDDIE FOR LOCATION The R. U. Reddie Corporation, located in Chicago, manufactures clothing specially designed for stuffed cartoon animals such as Snoopy and Wile-E-Coyote. Among the popular products are a wedding tuxedo for Snoopy and a flak jacket for Wile-E-Coyote. The latter is capable of stopping an Acme Rocket at close range... sometimes. For many sales, the company relies upon the help of spoiled children who refuse to leave the toy store until their parents purchase a wardrobe for their stuffed toys. Rhonda Ulysses Reddie, owner of the company, is concerned over the market projections that indicate demand for the product is substantially greater than current plant capacity. The most likely projections indicate that the company will be short by 400,000 units next year, and thereafter 700,000 units annually. As such, Rhonda is considering opening a new plant to produce additional units. BACKGROUND The R. U. Reddie Corporation currently has three plants, which are located in Boston, Cleveland, and Chicago, respectively. The company s first plant was the Chicago plant, but as sales grew in the Midwest and Northeast, the Cleveland and Boston plants were built in short order. As the demand for wardrobes for stuffed animals moved west, warehouse centers were opened in St. Louis and Denver. The capacities of the three plants were incrementally increased to accommodate the demand. Each plant has its own warehouse to satisfy demands in its own area. Extra capacity left over was used to ship product to St. Louis or Denver. The new long-term forecasts provided by the Sales Department were both good news and bad news. The added revenues would certainly help Rhonda s profitability, but the company would have to buy another plant to realize the added profits. Space is not available at the existing plants, and the benefits of the new technology for manufacturing stuffed animal wardrobes are tantalizing. These factors motivated the search for the best location for a new plant. Rhonda has identified Denver and St. Louis as possible locations for the new plant. RHONDA S CONCERNS A plant addition is a big decision. Rhonda started to think about the accuracy of the data she was able to obtain. She had market, financial, and operations concerns. Market. The projected demands for years 2 through 10 show an annual increase of 700,000 units to a total of 2,000,000 units for each year. She had two concerns here. First, what if the projections for each city were off plus or minus 10% equally across the board? That is, total annual demands could be as low as 1,800,000 or as high as 2,200,000, with each city being affected the same as the others. Second, the marketing manager expressed a concern over a possible market shift from the Midwest and Northeast to the West. Under this scenario, there would be an additional demand of 50,000 units in St. Louis and 150,000 units in Denver, with the other cities staying at the most likely demand projections. Financial. Rhonda realized that the net present value (NPV) of each alternative is an important input to the final decision. However, the accuracy of the estimates for the various costs is critical to determining good estimates of cash flows. She wondered if her decision would change if the COGS (variable production plus transportation costs) for each option was off by 10%. That is, what if the variable production costs and transportation costs of St. Louis are 10% higher than estimated while the variable production costs and transportation costs for Denver are 10% lower than estimated? Or vice versa? Further, what if the estimate for fixed costs is off by 10%? For example, suppose St. Louis is 10% higher while Denver is 10% lower, or vice versa. Would the recommendation change under any of these situations? Operations. The ultimate location of the new plant will determine the distribution assignments and the level of utilization of each plant in the network. Cutting back production in any of the plants will change the distribution assignments of all plants. Since there will be excess capacity in the system with a new plant under the assumption of the most likely demand projections, the capacity of the Cleveland plant could be cut in year 2 and beyond. Suppose Cleveland cuts back production by 50 (000) units a year from year 2 and beyond. Will this affect the choice between Denver and St. Louis? What is the impact on the distribution assignments of the plant? Further, there are some nonquantifiable concerns. First, the availability of a good workforce is much better in Denver than St. Louis because of the recent shutdown of a beanie baby factory. The labor market is much tighter in St. Louis and the prognosis is for continued short supply in the foreseeable future. Second, Denver metropolitan area has just instituted strict environmental regulations. Rhonda s new plant would adhere to existing laws, but the area is very environmentally conscious and more regulations may be coming in the future. It is very costly to modify a plant once operations have begun. Finally, Denver has a number of good suppliers with the capability to assist in production design (new wardrobe fashions). St. Louis also has suppliers but they cannot help with product development. Proximity to suppliers with product development capability is a plus for this industry. continued

8 continued DATA The following data have been gathered for Rhonda: a. The per-unit shipping cost based on the average ton-mile rates for the most efficient carriers is $ per mile. The average revenue per outfit is $8.00. b. The company presently has the following capacity constraints: CAPACITY 1 (i) Boston 400 (ii) Cleveland 400 (iii) Chicago 500 c. Data concerning the various locations is as follows: MOST MOST LIKELY ANNUAL LIKELY DEMAND 1 CURRENT COSTS FIXED VARIABLE DEMAND 1 AFTER BUILDING & COSTS PRODUCTION CITY 1ST YEAR YEARS 2 10 EQUIPMENT 1,2 (SGA) 1,3 COSTS/UNIT LAND 1 Boston $9,500 $600 $3.80 $500 Cleveland , Chicago , St. Louis Denver d. New plant information: ANNUAL FIXED VARIABLE BUILDING & COSTS PRODUCTION ALTERNATIVE EQUIPMENT 1 (SGA) 1,3 COSTS/UNIT LAND 1 Denver $12,100 $550 $3.15 $1,200 St. Louis 10, e. The road mileage between the cities is: BOSTON CLEVELAND CHICAGO ST. LOUIS DENVER Boston 650 1,000 1,200 2,000 Cleveland ,400 Chicago 300 1,000 St. Louis 850 Denver 1 In 000s. 2 Net book value of plant and equipment with remaining depreciable life of 10 years. 3 Annual fixed costs do not include depreciation on plant and equipment.

9 f. Basic assumptions you should follow: Terminal value (in 10 years) of the new investment is 50% of plant, equipment, and land cost. Tax rate of 40%. Straight-line depreciation for all assets over a 10-year life. R. U. Reddie is a 100% equity company with all equity financing and a weighted average cost of capital (WACC) of 11%. Capacity of the new plant production for the first year will be 500 (000) units. Capacity of the new plant production thereafter will be 900 (000) units. Cost of goods sold (COGS) equals variable costs of production plus total transportation costs. There is no cost to ship from a plant to its own warehouse. There is a production cost, however. g. R. U. Reddie operations and logistics managers determined the shipping plan and cost of goods sold for the option of not building a new plant and simply using the existing capacities to their fullest extent (Status Quo solution): Questions Year 1 COGS $4,692,000 Boston to Boston 80 Boston to St. Louis 320 Cleveland to Chicago 80 Cleveland to Cleveland 200 Cleveland to St. Louis 120 Chicago to Chicago 290 Chicago to Denver 210 Years 2 10 COGS $4,554,000 Boston to Boston 140 Boston to St. Louis 260 Cleveland to Cleveland 260 Cleveland to St. Louis 140 Chicago to Chicago 430 Chicago to St. Louis 70 Your team has been asked to determine whether or not R. U. Reddie should build a new plant and, if so, where it should be located. Your report should consist of six parts. 1. A memo from your team to R. U. Reddie indicating your recommendation and a brief overview of the supporting evidence. 2. Model the location decision as a linear model. The objective function should be to minimize the total variable costs (production plus transportation costs). The variables should be the quantity to ship from each of the plants (including one of the alternative new plants) to each of the warehouses. You should have 20 variables (four plants and five warehouses). You should also have 9 constraints (four plant capacity constraints and five warehouse demand constraints). See the addendum for hints. You will need two models one for Denver and one for St. Louis. 3. Use the Linear Programming Solver or the Transportation Method Solver in OM Explorer to solve for the optimal distribution plan for each alternative (i.e., Denver and St. Louis). 4. Compute the NPV of each alternative. Use the results from the linear models for the COGS for each alternative. Hint: Your analysis will be simplified if you think in terms of incremental cash flows. Create an easy-toread spreadsheet for each alternative. 5. Do a sensitivity analysis of the quantitative factors mentioned in the case: Forecast errors (across the board and market shift), errors in COGS estimate, and errors in fixed cost estimates. Do each factor independent of the others and use the most likely projections as the base case. Summarize the results in one table. 6. Use the analysis in (5)to identify the key quantitative variables that determine the superiority of one alternative over another. Rationalize your final recommendation in light of all the considerations R. U. Reddie must make. ADDENDUM Here are some hints for your model. a. The capacity constraint for Boston would look like this: 1B-B 1B-CL 1B-CH 1B-D 1B-SL 400 The variable B-CH means Boston to Chicago in this example. You will need a total of four capacity constraints, one for each of the existing sites and one for the alternative site you are evaluating. Remember that the new site will have a capacity limit of 500 in the first year, and 900 in the second year. b. The demand constraint for Boston would look like this: 1B-B 1CL-B 1CH-B 1D-B 140 The Denver location alternative is depicted in this example (D-B represents the number of units produced in Denver and shipped to Boston). You will need a total of five demand constraints, one for each warehouse location. Notice that the demand constraints have signs to indicate that exactly that quantity must be received at each warehouse. continued

10 continued c. There is no need to put three zeros after each demand and capacity value. Define your variables to be thousands of units shipped. Remember to multiply your final decisions and total variable costs by a thousand after you get your solution from the model. d. Since the capacity and demand changes from year 1 to year 2, you will have to run your model twice for each location to get the data you need. You will also need to run the model and spreadsheets multiple times to do part (5) of the report.

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment

CHAPTER 11. Topics. Cash Flow Estimation and Risk Analysis. Estimating cash flows: Relevant cash flows Working capital treatment CHAPTER 11 Cash Flow Estimation and Risk Analysis 1 Topics Estimating cash flows: Relevant cash flows Working capital treatment Risk analysis: Sensitivity analysis Scenario analysis Simulation analysis