JointsOrtho – Expansion of New Plant Analysis

Modupe Sarratt, Dawn Capers, Cheja Tucker, Tamarra Grant

MGMT. 640 Group Project

JOINTSORTHOExecutive Summary

Overview

JointsOrtho has been manufacturing and distributing various orthopedic medical devices for

older adults. The United States has been facing an aging problem, and a large number of people

of the entire population are getting older each day. Approximately, more than 10,000 Americans

each day turns to age 65, which is an alarming situation for society and it is estimated that by the

year 2050, 89 million Americans will fall into this category of older age. This situation is an

opportunity for companies manufacturing various orthopedic medical devices, and our company

“JointsOrtho” can take benefit from this situation. The management of JointsOrtho is aiming to

set up their own manufacturing plant for this purpose as it will be beneficial in the long term.

JointsOrtho has been offering a wide range of products, including cardiac and diabetic care and

items for hip and knee replacements. They can exploit this opportunity by providing quality

products and services at reasonable costs to customers.

Problem

JointsOrtho has been generating higher revenues and the cash cycle of the company is small,

which means it is collecting its cash from the revenues in a short span of time. It also possesses

idle working capital for managing operations of the company. It would be practicable to open the

new warehouse, as well as, assist in generating revenue. The company’s financial statements can

be used to analyze the company’s current and past performance and formulate policies for the

future. It is of high concern that the facts and empirical data used for the financial data should be

accurate. A small mistake in recording the transaction of the company can have a very large

impact on the financial performance of the company.

JOINTSORTHO

JointsOrtho (JO) New Plant & New Product

Background to the financial plan for a new plan (New Facility) and Full Hip (New Product)

The financial plan is to increase revenue with manufacturing a new product for the new

plant or facility that will be distributed throughout the United States. The process of building a

new plant is a big project that involves a considerable amount of capital for investment decisions,

thus will cost the company a lot of money. In order for the expansion process to begin, the

members of JointsOrtho (JO) will target the workforce of Delaware to set up a new plant for the

remanufacturing of a full hip replacement. Each full hip replacement device will be sold

throughout the United States at a cost of $36,750 each, which includes shipping and handling.

The projected sales for these devices are expected to be between 1,000 and 1,200 hips, per

month. The project classification includes the site selection, the cost to buy a new facility, and

the hiring of new workers in order to analyze if the new facility (new plant) will breakeven with

manufacturing the new product within the first 12 months of the financial forecast.

Purpose Statement

The goal of this assignment is to analyze the financial state of JointsOrtho. As financial

managers, we will analyze if JointsOrtho should decide to expand. By illustrating probable

financial situations, we can determine if this organization will break even in twelve months and

if JointsOrtho should open an additional facility to produce new hip replacements. In order to

answer these questions, we will critically analyze the total value of money, three types of project

risks, risk/return of opening a new facility, and use the transactional information provided to

JOINTSORTHOconclude if opening a new facility is the best financial decision to make based on the

organization’s state.

Site Selection & Opportunity Cost (OC) for buying new plant

JointsOrtho (JO) is a company that develops two main products, which are medical

devices and hip and knee replacements. To increase the wealth of JO, the financial plan is to add

the production cost for full hip replacements for an aging population turning the age of 65, which

is estimated to be 10,000 people each day. JO, like any other firm enjoys the period of rapid

growth that enables them to introduce a new plan, a new product, and new technology for an

innovative marketing strategy in relation with the opportunity cost to buy a new plan.

Opportunity cost is an advantage for the additional stock that goes into the manufacturing of

medical devices. In accordance with Investopedia, is decision to provide some additions to stock

to measures project for risk (“Variable Cost,” 2016).

Site Selection

To start with a new plant for the expansion, the members of JointsOrtho will target the

Delaware workforce and the aging population to select the new facility that will tend to grow at

the same rate as the economy. The economy of the expected growth of the population turning 65

each day is 10,000 people, which is estimated to be 89 million people by the year 2050.

Therefore, a large facility is necessary for selecting a site in a major shopping landmark. The

new plant or facility has 41,000 square feet of space and is designed to JointsOrtho specifications

as the JointsOrtho/Full Hip Replacement Center.

The new plant is conveniently located at the intersection of interstate I-95 North and

route 4, which is about two miles before Delaware Stadium. The site is tailored to fit the firms

JOINTSORTHOneeds for manufacturing at minimal cost, where the rental cost should be $9 per square foot.

This site offered the greatest opportunity to cater to affluence customers and the trend indicates

the rapid expansion of the local economy with the retiree population from the University of

Delaware and the state stadium has already endorsed a development of 300 luxury retirement

condominiums three miles from the site.

Opportunity cost for buying new plan

The opportunity cost is the difference between rent and buy. To rent for a year lease is $9

per square foot multiplied by 41,000 square feet times 12 months plus the security deposit, and to

buy is $9 per square foot multiply with 41,000 square feet plus down payment plus tax and

settlement (finance).

Opportunity Cost for buying rent or buy decision:

Space 41000 Square feet Rental $9 per square foot Option to buy 6% Tax

12 months’ Compute for Rent Versus Decision to Buy: 41000 @ $9

Security ($9*41000) $369,000 Down payment: 41000*9*4 =$1476000

January 369,000 Tax: 6% of (41000@$9) = $22140

February 369,000 Settlement (Interest rate 3%) =$11070

March 369,000

April 369,000

May 369,000

June 369,000

July 369,000

August 369,000

September 369,000

October 369,000

JOINTSORTHONovember 369,000

December 369,000

APR cost of rent ($9*41000 + 12*369000) $4,797,000

Cost to buy (1476000 + 22140 + 11070) = $1,509,120 Opportunity Cost: ($4,787,000 - $1,509,120) = 3,277,880

Analyzing cost for manufacturing Full Hip Replacements

Hip replacement refers to the process in which a damaged hip joint is surgically replaced

with an artificial implant. Patients require differing degrees of replacements, such as total or

partial implants, and new hips are made from plastic, ceramic and metal. However, not all

implants are safe, and some can cause serious complications, JointsOrtho is going to be an expert

in manufacturing full hip replacement device that will be sold throughout the United States at a

cost of $36,750 each, including shipping and handling. Sales are expected to be between 1000

and 1200 hips per month.

Opportunity cost for manufacturing new product

Weekly cost to manufacturing Hip replacement and hire workers

Activities Weekly cost (40 hours)

15 Molding Specialists ($18/hr.) $10,800

10 Machine Specialist ($16/hr.) 6,400

5 Cleaning & Maintenance ($13/hr.) 2,600

10 Shipping & Receiving ($17/hr.) 6,800

3 Shift supervisors ($20/hr.) 2,400

1 Administrative/Human Resources ($15/hr.) 600

1 Plant manager salary ($6000/per month) 1,500

Weekly cost $31,100

Yearly cost for 12 months (= * 52 weeks) $1,617,200

JOINTSORTHOJointOrtho’s financial concepts is intended to reconstruct Hip replacement devices with “zero

risks for the rate of return” is fundamental for capital budgeting decisions and is the financial

plan for the opening of a new manufacturing plant. Per Parrino & Kidwell, capital budgeting is

“investment decisions” made to evaluate the three types of project risks, Risk/Return, fixed and

variable cost, the total value of money, and the breakeven analysis for the first 12 months

(Parrino and Kidwell, 2009).

Project Risks to the new plantThe three types of project risks for zero risks include (a) creating an efficient network of

statewide distributors, (b) considering the means for obtaining sufficient shelf space and

promotion at the retail level, and (c) assessing product acceptance by consumers.

Creating an efficient network of statewide distributors for estimating manufacturing cost:

JointsOrtho must build relationships with all the Orthopedic Practices throughout the United

States that will accept to use their new products for being their key distributors before JO can

define the markets for hip replacements. The cost for recruiting distributors is allowing the

Orthopedics to set up the price of hip replacements in their individual state for variable costs of

five years for the device and depreciation set up for ten years. In between the variable cost and

the depreciation is fixed cost for five years to analyze the cost and profit for investment

appraisals. The benefit of analyzing the risk is to avoid waste with direct material cost and parts

that are directly used to make hip replacements, and to separate the indirect labor for the cost of

the new plant.

JOINTSORTHO Obtaining sufficient shelf space and promotion at the retail level:

JointsOrtho will need to conduct a systematic tracking of data to study the product request by the

Orthopedics Practice throughout the United States to compare the cost of activities in processing

orders and the nature by which hip replacements is used to determine if costs maybe out of

control. This will need to be determined in order to investigate the operation and management of

their product for depreciation, discount, and defectiveness for the return policy.

Assessing product acceptance by consumers is the product cost for preparing financial statement:

The product quality of the hip replacement will be a major factor in overcoming risk/return for

consumer satisfaction because it is the full cost for manufacturing overhead to launch for

discount and coupon programs while introducing consumers to try upgrading the product for

higher sales. Also, assessing our product for acceptance will include appraisals to invest in our

product by participating in health and medical events at the retail levels to provide consumers

with an incentive, which will help lower the risk of dissatisfied customers to a small percentage.

Risk/Return for Capital Budgeting

The concept of risk /return is a research and evaluation strategy for financial operations and

management of production for marketing and sales to create the best approach for the best

practice to analyze the cost of the new plant for the direct cost of manufacturing the product.

The importance of risk and return “is asset or sale variance relationship for plausible risk-averse”

such as, the cost of plant and the production of product association for the allocation of rate per

units for each product manufactured to the rental cost per square feet by using the common

measurements of; Net Present Value (NPV), Internal Rate of Return (IRR), and Time Value of

Money (TVM) (Henkel, 2009). According to Investopedia, “opportunity cost is the cost of an

JOINTSORTHOalternative in order to pursue a certain action” (“Variable Cost,” 2016). Therefore, opportunity

cost is the benefit of weighing the pros and cons for an alternative action. Unfortunately, there is

no real formula for determining opportunity cost, since the plant/product will provide us with

different measures of value. In its simplest terms, however, one would describe opportunity cost

simply as the difference in return between the cost of a new plant and the production of the new

product. Let’s assume risk-free government bond yielding 6%, in this situation the opportunity

cost is 3% (3% new plant - 6% new product). According to the journal of finance “it is well

known that under certain circumstances the internal rate of return and the present value criteria

for capital budgeting analysis can give conflicting recommendations as to the projects that

should be included in the discounting rate in making of correct capital budgeting decisions”

(Dudley, 2011). To illustrate, the way to reduce risk for high return is the allocation of cost for

the product (full hip) and the production to the cost of the plant (facility) for operation.

Net Present Value for 12 months or the first year for producing full hip for productNPV 12 Months Production Cost of Capital

12 Months # of Days Each Price

Amount of manufacture products Monthly Cash Output

January 31 $ 36,750.00 1000 $ 1,139,250,000 February 28 $ 36,750.00 1000 $ 1, 290,000,000 March 31 $ 36,750.00 1000 $ 1,139,250,000 April 30 $ 36,750.00 1000 $ 1,102,500,000 May 31 $ 36,750.00 1000 $ 1,139,250,000 June 30 $ 36,750.00 1200 $ 11,025,000,000.00 July 31 $ 36,750.00 1200 $ 11,392,500,000.00 August 31 $ 36,750.00 1200 $ 11,392,500,000.00 September 30 $ 36,750.00 1200 $ 11,025,000,000.00 October 31 $ 36,750.00 1200 $ 11,392,500,000.00 November 30 $ 36,750.00 1200 $ 11,025,000,000.00 December 31 $ 36,750.00 1200 $ 11,392,500,000.00

JOINTSORTHOFixed and variable cost for evaluating internal rate of return (IRR) for operating

expensesFixed cost and variable costs are used for the rate of return and is the cause-and-effect

between the number of hours used to produce 1000 to 1200 hip replacements and the level of

maintenance required for finished products. Cost pool is the tracing cost for the direct cost of the

designed hip replacement and the fixed costs for readiness of the shipping products. Cost

allocation is the indirect cost for the variable used to design the cost of estimation for equipment

maintenance of the cost of goods manufactured and the cost of goods sold. It was noted that

“variable costs are those cost that vary depending on volume of production for increase or

decrease” (“Variable Cost,” 2016). In this case, the production varies from 1000 to 1200 hips

remain the same for 12 months, and the fixed cost such as rent will remain the same regardless

whether production increases or decreases. Indirect or direct costs of labor for cost pool is

assigning cost allocation to the product for accounting, such as variable cost include material

costs or labor costs necessary for completing a product for sale that may include packaging and

shipping, and increase revenue and expenses. Likewise, fewer products decrease revenue and

expenses for breakeven purposes.

Break-Even Analysis

Breaking-Even Analysis for leverage can be calculated with comparing Account Rate of

Return (ARR) with Internal Rate of Return (IRR) for the weighted average of pros and cons for

the advantage and disadvantage is considered the break-even point. Break-even point can be

defined in numerous ways, such as, in term of EBIT for IRR or in term of payback method for

ARR. ARR and IRR are similar for payback method, and capital budgeting for an option to

accept or reject a project under General Accepted Accounting Principle (GAAP) or to accept or

JOINTSORTHOreject a project under Financial Accounting standard Board (FASB) (Parrino and Kidwell, 2009).

The advantages and disadvantages for ARR and IRR can be summarized as follows:

The Accounting Rate of Return (ARR)It is sometimes called the book rate of return. This method computes the return on a capital

project using accounting numbers such as, the project’s net income (NI) and book value (BV)

rather than cash flow data. The most common definition is given in this equation:

First, the ARR is not a true rate of return. ARR simply gives us a number based on average figures from the income statement and balance sheet.

It ignores the time value of money.

There is no economic rationale that links a particular acceptance criterion to the goal of maximizing shareholders’ wealth.

Internal Rate of Return (IRR) The IRR is an important and legitimate alternative to the NPV method.

The NPV and IRR techniques are similar in that both depend on discounting the cash flows from a project.

When we use the IRR, we are looking for the rate of return associated with a project so we can determine whether this rate is higher or lower than the firm’s cost of capital.

The IRR is the discount rate that makes the NPV to equal zero.

When the IRR and NPV Methods Disagree The IRR and NPV methods can produce different accept/reject decisions if a project

either has unconventional cash flows or the projects are mutually exclusive.

On the other hand, decisions made based on the project’s NPV are consistent with the goal of

shareholder wealth maximization. In addition, the result shows management the dollar amount

by which each project is expected to increase the value of the firm. For these reasons, the NPV

JOINTSORTHOmethod should be used to make capital budgeting decisions. Capital Budgeting is the practice

that the managers used for payback method for ongoing capital projects and post audits on all

completed capital projects. Managers should also conduct ongoing reviews of capital projects in

progress that challenge the business plan, including the cash flow projections and the operating

cost assumptions. Management must also evaluate people responsible for implementing a capital

project.

The rule for decision is summarize as follow:

Decision Rule: IRR > Cost of capital -> Accept the project.

IRR < Cost of capital -> Reject the project.

Capital Budgeting in Practice

Some key advantages are as follows:

Intuitively easy to understand.

Based on the discounted cash flow technique.

Easy to calculate and understand for people without strong finance backgrounds.

A simple measure of a project’s liquidity.

Evaluating the Payback Rule The standard payback period is widely used in business.

It provides a simple measure of an investment’s liquidity risk.

The greatest advantage of the payback period is its simplicity.

It ignores the time value of money.

It does not adjust or account for differences in the overall, or total, risk for a project, which could include operating, financing, and foreign exchange risk.

The biggest weakness of either the standard or discounted payback methods is their failure to consider cash flows after the payback.

JOINTSORTHOSummary of Payback Method

Decision Rule: Payback period ≤ Payback cutoff point -> Accept the project.

Payback period > Payback cutoff point -> Reject the project.

Key Disadvantages

1. With nonconventional cash flows, IRR approach can yield no or multiple answers.

2. A lower IRR can be better if a cash inflow is followed by cash outflows.

3. With mutually exclusive projects, IRR can lead to incorrect investment decisions.

Most common version does not account for time value of money.

Does not consider cash flows past the payback period.

The Break-Even analysis is broken down as follows:

Fixed Costs include:

State Withholding Tax: 5.55%Social Security: 3.75%Medicare: 1.45%Employee Health & Dental Insurance: 2% = $2,925Unemployment: 4%

1. Using 2080 hours for a 40 hour work week over the course of one year15 of the workers will be paid at the rate of $18/hour for 40 hours per week (molding specialists)

$18.00*2080 = $37,440/year*15 employees = $561,600/ Fringe Benefits Cost = $33,264/year per employee Total Fringe Benefits: $498,960

10 of the workers will be paid at the rate of $16/hour for 40 hours per week (machining specialists)

$16.00*2080 = $33,280*10 employees = $332,800/ Fringe Benefits Cost = $29,568/ per employee Total Fringe Benefits: $295,680

5 of the workers will be paid at the rate of $13/hour for 40 hours per week (cleaning and maintenance)

$13.00*2080 = $27,040*5 employees = $135,200/ Fringe Benefits Cost = $24,024/per year Total Fringe Benefits Cost= $120,120

10 of the workers will be paid at the rate of $17/hour for 40 hours per week (shipping and receiving)

$17.00*2080 = $35,360*10 employees = $353,600/ Fringe Benefit Cost = $31,416/employee Total Fringe Benefits = $314,160

JOINTSORTHO3 shift supervisors will be paid at the rate of $20/hour for 40 hours per week

$20.00*2080 = $41,600*3 employees = $124,800/ Fringe Benefit Cost = $36,960/ Total Fringe Benefits: $110,880

1 plant manager will be paid a salary of $6,000 per month $6000*12= $72,000/year Fringe Benefits Cost = $63,959/per year

1 administrative/human resources person at the rate of $15/hour for 40 hours per week $15.00*2080 = $31,200/ Fringe Benefits Cost = $27,720/year

Total Yearly Cost of all employees = $1,611,200

Total Yearly Cost Fringe Benefits: $1,495,438

2. Pay your salary of $6,000/month = $72,000/year; Fringe Benefit Total Cost: $63,959

3. Borrow $6,000,000.00 for building with 10 year mortgage at 10% annum

Monthly payment for Building = $50,000/month

4. Order for raw materials = $1,000,000/ year

5. Fringe Benefits - 15 days of Paid Time Off, 8 Paid Holidays, 6 Paid Sick Days = 232 days/ per employee

Margin Ratio = Sales - Variable Costs                 Sales

Sales:1.200 Hip Replacements: $600,000Cash: + $44,100,000                           = $44,700,000

= $44,700,000 - $7,000,000 = 84.3%

Break Even = Fixed Cost_______           Price-Variable Cost

Price per Unit: $36,750

Variable Cost per Unit (Based on selling 1,200 units): $5,833.33

Total Fixed Cost: $8,076,408.20

$8,076,408.20   = 261.23 units X 36,750 units

$36,750 - $5,833.33

Break Even Point in Sales Dollars = $9,600,200.50

JOINTSORTHOConclusion

The company’s products are need based and mostly dependent on age factor. The USA

market is filled with growth opportunities for the company as a very large population resides

with age more than 65 years. On the other hand, the expected sales and calculated expenses show

that the company will not only achieve its break-even point but will also earn the profit of

$42,690,151 dollars. The company’s expansion is expected to produce many job opportunities

which will cost the company but per the expected return, the company will manage to cover its

expenses and earn profit. In view of the financial statements, the company’s total assets value

49,827,563 dollars against the liability which means that the company can easily repay its

liabilities in case of bankruptcy. Hence, it is suggested that the company should expand its

operations as the facts and figures show that the company will easily manage to earn profit.

JOINTSORTHO References

Dudley, C. L. (2011). A note on reinvestment assumptions in choosing between net present and internal

rate of return. The Journal of Finance, 27(4), 907-915

Investopedia. (n.d). Variable Cost. Retrieved 2016-11-30 Retrieved from

http://www.investopedia.com/terms/v/variablecost.asp?lgl=no-infinite

Henkel, J. (2009). The risk-return paradox for strategic management: disentangling true and spurious

effects. Strategic Management Journal, 30(3), 287-303

Ortho Image: retrieved from http://orthoinfo.aaos.org/figures/A00377F03T.jpg

Parrino, R. & Kidwell, D. S. (2009). Fundamentals of Corporate Finance. The fundamental of Capital

Budgeting. John Wiley & Sons. Inc. UMUC customized edition.

Plant Image: retrieved from http://www.inc.com/magazine/201311/nadine-heintz/inside-a-factory-

makeover.html