The Super Project is a new instant dessert based on a flavored, water-soluble, agglomerated powder. There will be four different types of dessert to be offered but General Foods Corporation believes that 80% of sales will be from the chocolate flavored dessert. General Foods has many different product lines produced in the United States as there foreign operations were under a separate division. Some of the different U. S. product lines are Post, Kool-Aid, Maxwell House, Jell-O, and Birds Eye.
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The capital investment project for Super was a $200,000 investment, involving $80,000 for building modifications and $120,000 for machinery and equipment. The adjustments would be made to an existing building, where Jell-O was manufactured. The agglomerator machine that was used for the Jell-O product was not running at the full capacity to produce the dessert and therefore the cost of the machine was not included in the cost of the project. The $120,000 for machinery and equipment is based upon the packaging machinery.
The powdered dessert was a significant and growing segment of the total dessert market according to Nielsen, as it was 25. 3% of the market share. General Foods was in hope that Super would be able to capture 10% of the total dessert market. 80% of this expected Super volume would come from growth of the total market share or growth in the powders segment, while 20% would come from erosion of Jell-O’s sales. For the capital budgeting procedure, General Foods’ Accounting and Financial Manual identified four categories that capital investment project proposals; 1) safety and convenience, 2) quality, 3) increased profit, and 4) other.
Super happened to fall under the third category of increasing the profits for General Foods. Estimates of payback and return on funds employed were required for each such project in which it required a $50,000 or more of new capital funds and expense before taxes. Payback period is the length of time before the project repays for the investment. As you can tell General Foods uses some unique methods in determining if the investment is worth implementing or not. General Foods has given us three different options of the basis they will use.
One, an Incremental basis, two, a Facilities-Used basis, and three, a fully allocated basis, all of which we will go into more detail about. We have come up with another option to value the expected profitability, the Net Present Value Method. Once we figure out which of these options we are going to use we must figure out if we will include the test market expenses, which are the sunk costs, the overhead expenses, the Erosion of Jell-O, and the allocation of charges for the use of excess capacity.
So the problems are which one of our four options do we use to value the Super Project and do we accept or reject the Super Project. Alternatives The first three alternatives used were, Incremental Basis, Facilities-Used Basis, and Fully Allocated Basis. These alternatives were set up by General Foods and would be selected using the company’s Return on Fund Employed (ROFE) method along with payback period. The company had different requirements as far as ROFE and payback period.
They were set up for every new project, and if the project met these requirements they would be implemented. The only problem with these methods is that ROFE and payback period are very inefficient ways of determining the quality of a project. Both ROFE and payback period don’t take into account the time value of money, making some projects more attractive because without time value of money, projects will appear as good investments in the short term but actually be bad in the long term.
Besides the inefficient ways of determining the projects in ROFE and payback period, General Foods alternatives were also not the greatest ways to determine a projects worth. First off, there was Alternative 1, Incremental Basis. This alternative was passed on an ROFE and payback period basis, with an ROFE of 63% and a payback period of 7 years. Unfortunately, these numbers do not show all the facts incorporated with alternative 1. One of the major problems with Alternative 1 is that it does not take into effect opportunity cost by using Jell-O machinery and facilities on Super instead of Jell-O.
Alternative 1 also incorporates the original marketing cost of super into the project costs. These marketing costs should not be included because they should actually be considered as sunk costs. Alternative 2, facilities used basis, is slightly better than Alternative 1. In alternative 2, opportunity cost is incorporated by allocating the Super Project some facilities costs prorate with Jell-O. This increases the amount of capital used to $453 from $200 million to cover the costs of losing production of Jell-O.
However, though opportunity cost is included for alternative 2, the sunk costs of pre-marketing efforts of Super are still included, when they should not be. Alternative 3, fully allocated basis, is the most complete and correct alternative listed by Sanberg. It takes into account both the Incremental and Facilities-Used basis. However, this alternative includes the test marketing expenses, which as mentioned above are sunk costs and should be excluded from the valuation. The corporate controllers’ memo is a reply about the Super Project.
The controller questions whether we will be better off in the aggregate. He also doubts some different ROFE figure of the Super project is irrelevant. He thinks the way of allocated production is not very clear to describe the total situation of Super Project. He says that he sees very little value in looking at the Super Project. The last alternative that General Foods could use to value the Super Project is the Net Present Value Method (NPV) and it will be discussed below.