Automated Inspection Investment Under an Optimistic Vendor Case
Calder Precision Parts is evaluating a $2.4 million automated inspection and ERP-integration project. The vendor's business case shows $620,000 per year in combined labor and scrap savings over a five-year life and a simple payback under four years. Calder's cost of capital is 9%. Finance's own estimate adds $180,000 of implementation and training expense in year zero, which the vendor case omits. The plant controller warns that roughly half the savings depend on the vendor's scrap estimate, which assumes defect rates fall from 4.1% to 1.2%; Calder's sister plant reached only 2.6% two years after a similar installation. Nobody trusts a residual value, though the equipment could probably be sold for $150,000 in year five. The COO favors the project because a competitor announced a similar line.
1. Compute NPV, IRR, and payback on finance's numbers, then explain why the payback figure misleads in this case.
Read the worked answer
Finance's numbers, discounted at 9%:
- Year 0 outflow: $2,400,000 + $180,000 = $2,580,000.
- Five-year annuity factor at 9%: (1 - 1.09^-5) / 0.09 = 3.8897.
- PV of savings: $620,000 x 3.8897 = $2,411,600.
- PV of residual: $150,000 x 0.6499 = $97,500.
- NPV = $2,509,100 - $2,580,000 = about -$71,000.
- IRR is roughly 8.0%, below the 9% hurdle.
- Simple payback: $2,580,000 / $620,000 = about 4.2 years.
Payback misleads for three reasons. It ignores the time value of money, treating $2.4 million spent today as equal to savings received in years three through five. It stops counting at 4.2 years, so it cannot see that the project never clears the hurdle rate over its full life. And it is flattered by the vendor's assumption of flat savings from day one, when real savings ramp as lines are converted and operators learn the equipment.
A payback under four years sounds decisive but answers a different question than whether the project beats the cost of capital. Here it does not, by a narrow margin that the scrap assumption will decide.
2. Rerun the analysis using the sister plant's demonstrated defect rate and state what the sensitivity means for your recommendation.
Read the worked answer
Split the savings by confidence before rerunning. Assume about $310,000 is labor and throughput, reasonably well understood, and $310,000 is scrap, which depends on defects falling from 4.1% to 1.2%, a 2.9-point drop.
At the sister plant's 2.6%, the drop is 1.5 points, or 1.5 / 2.9 = about 52% of the scrap benefit:
- Scrap savings: about $160,000
- Total annual savings: about $470,000
- PV of savings: $470,000 x 3.8897 = about $1,828,200
- NPV = $1,828,200 + $97,500 - $2,580,000 = about -$654,000
At demonstrated performance the project destroys roughly $650,000 of value. That is not a marginal miss inside the error bars; it is the difference between a defensible capital request and a bad one.
The implication for the recommendation: do not answer yes or no on the vendor's framing. Either the vendor prices to the demonstrated outcome, or it accepts contractual risk for the defect-rate assumption. Also ask what the model looks like with a two-year ramp to 2.6%, since the sister plant did not reach that rate immediately - which is worse still. The single variable that decides this project should be the variable the vendor is made to warrant.
3. What price or structural change would make this a sound decision, and which non-financial arguments should be accepted or rejected?
Read the worked answer
The break-even price is the most useful number in the meeting. The project is NPV-neutral when the year-0 outflow equals $2,509,100, so with $180,000 of training the equipment price would need to fall to roughly $2.33 million, about a 3% concession. At the sister plant's scrap rate, no realistic price cut rescues it, so price alone is not a general answer.
Arguments that can legitimately justify proceeding:
- Off-book quality costs. Warranty, rework, and customer scorecard penalties may be real and uncounted. Quantify them before claiming them.
- A staged pilot on one line is a real option. It buys defect-rate evidence for a fraction of $2.4 million and preserves the ability to stop. Price the pilot as the decision, not the project.
- Capacity or labor availability constraints that make the line uneconomic without automation.
Arguments to reject:
- The competitor announcement. That is competitive framing applied to a capital decision; the rival's hurdle rate, subsidies, and quality baseline are unknown, and matching an announcement is not a strategy.
Contract terms that shift risk: milestone payments tied to measured defect rate at 6 and 12 months, a scrap-performance guarantee with clawback, and a savings ramp written into the model rather than assumed away.