FOSTER’S MARKET CASE

1.What are the two capacity options that Robbie needs to consider? What are their fixed and variable costs? What is the indifference point for the two options? What are the implications of the indifference point?

The two capacity options that Robbie has are: Keep buying the roasted coffee from the supplier. This option won’t have fixed costs but it will have variable costs of $ 3 per pound. Second option is to buy the roaster equipment. This option will have fixed costs of $35,000 and a variable cost of $ 1.60 per pound. The indifference point are those that are going to indicate to the financial manager the level of where the utility operation from the two capacity options is equal. Indifference point formula: total cost of buying from the supplier equals total cost of investing in roaster equipment. $3 per pound= $1.60 per pound + $ 35,000 (equipment cost) Indifference point=$3 per pound - $1.60 per pound / $ 35,000 = 25,000 pounds.

So in this case, the option 1 is more profitable when the production is below 25,000 pounds, on other hand option 2 will be more profitable if the production is above 25,000 pounds. The fixed cost will be spread out through more pounds to sell, so there will be a time where the fixed costs will be covered.

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2.Draw the decision tree for the roaster decision. If Forster’s does not invest in the roaster, does Robbie need to worry about the different demand scenarios outlined above? Why or why not?

Yes, because all scenarios are equal.

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3.Calculate the expected value for the two capacity options. Keep in mind that, for the roaster option, any demand above 14,400 pounds will generate revenues of only $2.90 a pound. Update the decision tree to show your results.

Option 1 (Continue buying from the local supplier) :

EV = 14,400 X ($7-$3) = $57,600

Option 2 (Buying a roaster) :

Low demand = 18,000 - 14,400 = 3,600

Medium demand = 25,000 - 14,400 = 10,600

High demand = 35,000 - 14,400 = 20,600

EV low demand = [14,400 x ($7-$1.60) + 3,600 x ($2.9-$1.60)] - $35,000 = $ 47,440

EV Medium demand = [14,400 x ($7-$1.60) + 10,600 x ($2.9-$1.60)] - $35,000 = $ 56,540

EV High demand = [14,400 x ($7-$1.60) + 20,600 x ($2.9-$1.60)] - $35,000 = $ 69,540

Overall EV for option 2 = 33.33% x 47,440 + 33.33% x 56,540 + 33.33% x 69,540 = $ 57,834

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4.What is the worst possible financial outcome for Forster’s? The best possible financial outcome? What other factors— core competency, strategic flexibility, etc.—should Robbie consider when making this decision?

The worst possible outcome is that Robbie invests in the new roaster and the demand low which will give a profit of $47,440. The best possible result is that Robbie invests in the roaster and the demand is high which will give a profit of $69,540. However, if demand estimates are reasonably accurate, Robbie should make money regardless of the decision he makes. If you invest, it can increase its flexibility to produce and sell coffee. In addition, possibly this can make your business more competitive. On the other hand, it can limit your budget to invest in other things related to this business.

Also, if selling coffee is the core competency of the company, then roasting coffee would be a significant strategic realignment.

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