IBM1000 Case #4 Chapter 6 - Everything and Nut's

1. Calculate P. Nutt’s current volume.

To calculate P. Nutt’s current production volume, let's break down the information provided:

1. Current Roasting Machine Output:

• The machine produces 10 lbs. every 15 minutes.
2. Hourly Production:
• Since there are 4 intervals of 15 minutes in an hour, we calculate the hourly output as:
10 lbs. × 4 = 40 lbs. per hour
3. Daily Production:
• Assuming an 8-hour workday, the daily production capacity is:
40 lbs. / hour × 8 hours = 320 lbs. per day
4. Weekly Production:
• Assuming a 5-day workweek, the weekly production capacity is:
320 lbs. / day × 5 = 1,600 lbs. per week
5. Current Utilized Volume:
• Mr. Nutt is operating at 85% of his current capacity.
• Therefore, the actual current volume being produced and sold is:
1,600 lbs. / week × 0.85 = 1,360 lbs. per week

P. Nutt’s current production volume is 1,360 lbs. per week.

2. What are the capacity options that P. Nutt needs to consider.? What are the fixed and variable
costs? What is the indifferent point for the identified options? What are the implications of the
indifference point?

Step 1: Identify the Capacity Options for P. Nutt

P. Nutt has two capacity options for expanding his business:
1. Option 1: Retain the Current Roasting Machine
▪ Capacity: 1,600 lbs. per week.
▪ Annual Production Capacity:
1,600 lbs. / week × 52 weeks = 83,200 lbs. per year
▪ This option limits Mr. Nutt to a maximum of 83,200 lbs. per year.
2. Option 2: Purchase the New Roasting Machine
▪ New Machine Capacity: 2,500 lbs. per hour.
▪ Weekly Capacity (assuming 40 - hour workweek):

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 2,500 lbs. / hour × 40 hours = 100,000 lbs. per week
▪ Annual Production Capacity:
100,000 lbs. / week × 52 weeks = 5,200,000 lbs. per year
▪ This option significantly increases production, allowing P. Nutt to meet potential wholesale
demand and projected retail growth.

Step 2: Determine Fixed and Variable Costs for Each Option

Option 1: Current Roasting Machine
• Fixed Costs: $18,500 annually.
• Variable Costs: $60,000 annually for labor and other operating expenses.
• Raw Peanut Cost: $1.40 per lb., as Mr. Nutt buys peanuts through a distributor.
Option 2: New Roasting Machine
• Fixed Costs:
▪ Current fixed costs of $18,500.
▪ Additional fixed costs for the machine financing: $2,895 per month, totaling $34,740
annually.
▪ Total Fixed Costs: 18,500 + 34,740 = 53,240 USD annually
• Variable Costs:
▪ Current variable costs: $60,000 annually.
▪ Additional labor and operating costs with the new machine: $70,000.
▪ Total Variable Costs: 60,000 + 70,000 = 130,000 USD annually
• Raw Peanut Cost: $1.00 per lb. (direct purchase from growers in bulk).

Step 3: Set Up Cost Equations for Each Option

Let Q represent the production volume (in lbs.) per year.
1. Total Cost for Option 1 (Current Machine):
o Equation:
Total Cost = Fixed Costs + Variable Costs + Raw Peanut Cost
o Fixed Costs: $18,500
o Variable Costs: $60,000
o Raw Peanut Cost: $1.40 per lb.
o Total Cost (Option 1):
Total Cost = 18,500 + 60,000 + (1.40 × Q)
2. Total Cost for Option 2 (New Machine):
o Equation:
Total Cost = Fixed Costs + Variable Costs + Raw Peanut Cost
o Fixed Costs: $53,240

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 o Variable Costs: $130,000
o Raw Peanut Cost: $1.00 per lb.
o Total Cost (Option 2):
Total Cost = 53,240 + 130,000 + (1.00 × Q)

Step 4: Calculate the Indifference Point

The indifference point is the production volume Q at which the total costs of both options are equal. At
this production level, Mr. Nutt would be indifferent between the two options, as the total cost would
be the same.

Set the total cost equations for both options equal to each other:
18,500 + 60,000 + (1.40 × Q) = 53,240 + 130,000 + (1.00 × Q)
Now, solve for Q:
1. Combine like terms: 78,500 + 1.40Q = 183,240 + 1.00Q
2. Move all terms involving Q to one side and constants to the other side:
1.40Q − 1.00Q = 183,240 − 78,500
3. Simplify: 0.40Q = 104,740
4. Solve for Q: Q = 104,740 / 0.40 = 261,850 lbs. annually

Indifference Point: The indifference point is 261,850 lbs. per year. At this production volume, both
the current machine and the new machine would have the same total cost.

Step 5: Interpret the Implications of the Indifference Point

The indifference point helps Mr. Nutt decide when investing in the new machine becomes cost-
effective.
1. If Demand Exceeds 261,850 lbs. Annually:
▪ The new machine becomes more economical due to its lower variable costs and the bulk
purchasing savings on peanuts ($1.00 per lb. instead of $1.40 per lb.).
▪ This investment would support both current and anticipated future demand, potentially
allowing for business expansion.
2. If Demand Stays Below 261,850 lbs. Annually:
▪ Keeping the current machine is more economical since the fixed costs are lower.
▪ If demand doesn’t grow as expected, purchasing the new machine could lead to unnecessary
financial strain due to higher fixed costs (loan repayment and additional labor expenses).

Conclusion: The indifference point (261,850 lbs. annually) provides a production threshold that helps
Mr. Nutt make an informed decision. If demand projections suggest he will meet or exceed this

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threshold, investing in the new machine is financially beneficial. However, if demand remains below
this level, maintaining the current machine setup would be the more cost-effective choice.

3. Draw the decision tree for purchasing the Peanut Roasting Machine. If Mr. Nutt does not
invest in the machine, does he need to worry about the different demand scenarios? Why or why
not?

Step 1: Set Up Decision Points and Demand Scenarios

The decision tree will have two main branches stemming from Mr. Nutt’s decision to either purchase
the new machine or not purchase the new machine. Each branch then considers various demand
scenarios with associated profits or costs based on anticipated demand levels.

Decisions:
1. Invest in New Roasting Machine
2. Do Not Invest in New Roasting Machine

Demand Scenarios (for each decision branch):

Based on the case study, we’ll use three main demand levels:
1. Low Demand: 4,000 lbs. per week (208,000 lbs. annually)
2. Medium Demand: 15,000 lbs. per week (780,000 lbs. annually)
3. High Demand: 20,000 lbs. per week (1,040,000 lbs. annually)
Each scenario affects the revenue and costs and, thus, the expected profit.

Step 2: Calculate Expected Profits for Each Scenario Under Both Decisions
We’ve previously calculated the expected profits for each demand level with the new machine:

With New Machine:

1. 4,000 lbs./week Demand: Expected Profit = $440,760
2. 15,000 lbs./week Demand: Expected Profit = $2,156,760
3. 20,000 lbs./week Demand: Expected Profit = $2,936,760

Without New Machine:

If Mr. Nutt does not invest in the new machine, he is limited to producing up to 1,600 lbs. per week
(83,200 lbs. annually). Therefore:
• Any Demand Above 1,600 lbs./week: He cannot meet this demand, leading to missed sales
opportunities and potential revenue loss.

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Assuming that demand beyond this level remains unserved, he would only make profits based on his
maximum production capability:
• Profit from 1,600 lbs./week demand (annual production of 83,200 lbs.):
▪ Revenue = 83,200 lbs. × $4.00 per lb. = $332,800
▪ Total Costs (fixed: $18,500 + variable: $60,000 + raw peanut cost of $1.40 per lb.):
18,500 + 60,000 + (1.40 × 83,200) = 18,500 + 60,000 + 116,480 = 194,980
▪ Expected Profit Without New Machine (at 1,600 lbs. / week):
332,800 − 194,980 = 137,820

Step 3: Draw the Decision Tree

Decision tree is structured:

1. Decision Node (Root): Mr. Nutt’s choice to either:
o Purchase the New Machine
o Do Not Purchase the New Machine
2. If Purchasing the New Machine:
o Branches into three chance nodes for demand levels:
▪ Low Demand (4,000 lbs. / week) with expected profit: $440,760.
▪ Medium Demand (15,000 lbs. / week) with expected profit: $2,156,760.
▪ High Demand (20,000 lbs. / week) with expected profit: $2,936,760.
3. If Not Purchasing the New Machine:
o Only one outcome as Mr. Nutt is capped at 1,600 lbs. / week capacity:
▪ Expected Profit: $137,820.

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Step 4: Determine if Mr. Nutt Needs to Worry About Demand Scenarios Without the New
Machine
If Mr. Nutt chooses not to invest in the new machine, he does not need to worry about the higher
demand scenarios (15,000 lbs. or 20,000 lbs. weekly) for the following reasons:

1. Capacity Limitation: His current machine limits him to 1,600 lbs. per week (83,200 lbs.
annually). He physically cannot meet demand beyond this level with his current setup.
2. Opportunity Cost of Lost Sales: While he might lose sales opportunities, this is a known trade-
off if he chooses to avoid the fixed costs and operational adjustments involved with a new
machine.
3. Financial Stability: With his current setup, he maintains a predictable profit margin without
taking on additional debt or variable costs.

Conclusion: If Mr. Nutt does not invest in the new machine, he only needs to operate within his
existing production constraints and therefore does not need to worry about demand levels beyond
1,600 lbs. per week. This choice, however, would limit his growth potential and ability to capture
larger wholesale opportunities.

4. Calculate the expected value for the various capacity options.

Step 1: Define Demand Scenarios and Probabilities

The case study provides several possible demand levels. We’ll assume hypothetical probabilities for
each scenario:

1. 4,000 lbs./week Demand – Probability: 0.4

2. 15,000 lbs./week Demand – Probability: 0.35
3. 20,000 lbs./week Demand – Probability: 0.25

Step 2: Calculate Annual Revenue for Each Demand Scenario

• Wholesale price per lb.: $4.00

• Annual Production for each demand level:

1. 4,000 lbs./week: 4,000 lbs. / week × 52 weeks = 208,000 lbs. annually
2. 15,000 lbs./week: 15,000 lbs. / week × 52 weeks = 780,000 lbs. annually
3. 20,000 lbs./week: 20,000 lbs. / week × 52 weeks = 1,040,000 lbs. annually

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 • Revenue for each demand level:
1. 4,000 lbs./week: 208,000 lbs. × 4.00 = 832,000 USD
2. 15,000 lbs./week: 780,000 lbs. × 4.00 = 3,120,000 USD
3. 20,000 lbs./week: 1,040,000 lbs. × 4.00 = 4,160,000 USD

Step 3: Calculate Total Costs for Each Demand Scenario

Total costs include fixed costs, variable costs, and the cost of raw peanuts (purchased at $1.00/lb when
buying in bulk with the new machine).
With New Machine (Fixed and Variable Costs):
• Fixed Costs: $53,240 annually
• Variable Costs: $130,000 annually
• Raw Peanut Cost: $1.00 per lb.
Total Costs by Demand Level:
1. 4,000 lbs./week (208,000 lbs. annually):
o Raw peanut cost: 208,000 × 1.00 = 208,000 USD
o Total Cost: 53,240 + 130,000 + 208,000 = 391,240 USD
2. 15,000 lbs./week (780,000 lbs. annually):
o Raw peanut cost: 780,000 × 1.00 = 780,000 USD
o Total Cost: 53,240 + 130,000 + 780,000 = 963,240 USD
3. 20,000 lbs./week (1,040,000 lbs. annually):
o Raw peanut cost: 1,040,000 × 1.00 = 1,040,000 USD
o Total Cost: 53,240 + 130,000 + 1,040,000 = 1,223,240 USD

Step 4: Calculate Net Profit for Each Demand Scenario

Net Profit = Revenue - Total Cost
1. 4,000 lbs. / week Demand:
o Revenue: $832,000
o Total Cost: $391,240
o Net Profit: 832,000 − 391,240 = 440,760 USD
2. 15,000 lbs. / week Demand:
o Revenue: $3,120,000
o Total Cost: $963,240
o Net Profit: 3,120,000 − 963,240 = 2,156,760 USD
3. 20,000 lbs. / week Demand:
o Revenue: $4,160,000
o Total Cost: $1,223,240
o Net Profit: 4,160,000 − 1,223,240 = 2,936,760 USD

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Step 5: Calculate Expected Value
The expected value (E.V.) is the sum of each profit outcome multiplied by its probability.
EV = (440,760 × 0.4) + (2,156,760 × 0.35) + (2,936,760 × 0.25)
1. 4,000 lbs. / week Demand: 440,760 × 0.4 = 176,304
2. 15,000 lbs. / week Demand: 2,156,760 × 0.35 = 754,866
3. 20,000 lbs. / week Demand: 2,936,760 × 0.25 = 734,190
Total Expected Value (E.V.): 176,304 + 754,866 + 734,190 = 1,665,360 USD

Final Answer: Expected Value

The expected value for purchasing the new roasting machine, given the various demand scenarios, is
$1,665,360 USD. This value represents the average expected annual profit, considering the probabilities
of each demand level.

5. What is the worst possible financial outcome for Mr. Nutt? The best possible financial
outcome? What other factors, core competency, strategic flexibility, etc., should P. Nutt consider
when making his decision?

1. Worst Possible Financial Outcome

The worst-case scenario involves purchasing the new peanut roasting machine but experiencing low
demand. In this case:
1. Fixed Costs Increase:
o Current fixed costs are $18,500 annually.
o With the new machine, fixed costs increase to $53,240 annually (which includes the
$2,895 / month loan payment).
2. Variable Costs Increase:
o Current variable costs are $60,000 annually.
o Variable costs will rise by $70,000, making the new annual variable cost $130,000.
3. Low Demand Scenario (4,000 lbs. per week):
o Weekly sales of 4,000 lbs. mean approximately 208,000 lbs. per year.
o Revenue:
▪ Wholesale price for peanuts: $2.00 per 500-gram bag (equivalent to $4.00 per lb.).
▪ Annual revenue at 4,000 lbs. / week:
4,000lbs. / week × 4.00 (price per lb.) × 52 weeks = 832,000USD annually
4. Costs:
o Total Annual Costs:
▪ Fixed costs: $53,240

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 ▪ Variable costs: $130,000
▪ Raw peanut cost at $1.00 per lb. (for 208,000 lbs. annually):
208,000 lbs. × 1.00 = 208,000 USD
▪ Total costs: 53,240 + 130,000 + 208,000 = 391,240 USD
5. Profit/Loss:
o Revenue: $832,000
o Total costs: $391,240
o Net profit: 832,000 − 391,240 = 440,760 USD
In this low-demand scenario, Mr. Nutt would still be profitable but with the risk of not achieving
expected returns due to the high initial investment in the machine.

2. Best Possible Financial Outcome

The best-case scenario would involve Mr. Nutt achieving his maximum demand projection of 20,000
lbs. per week within the first year after acquiring the new machine. In this scenario:
1. Production and Sales at Full Capacity:
o Weekly sales of 20,000 lbs. translate to 1,040,000 lbs. annually.
2. Revenue:
o Annual revenue for 20,000 lbs. / week (at $4.00 per lb.):
20,000 lbs. / week × 4.00 USD per lb. × 52 weeks = 4,160,000 USD annually
3. Total Costs:
o Fixed costs: $53,240
o Variable costs: $130,000
o Raw peanut cost at $1.00 per lb. (for 1,040,000 lbs. annually):
1,040,000 lbs. × 1.00 = 1,040,000 USD
o Total costs:
53,240 + 130,000 + 1,040,000 = 1,223,240 USD
4. Profit:
o Revenue: $4,160,000
o Total costs: $1,223,240
o Net profit: 4,160,000 − 1,223,240 = 2,936,760 USD
In the best-case scenario, Mr. Nutt could achieve a significant profit with the new machine if demand
reaches 20,000 lbs. per week.

3. Other Factors Mr. Nutt Should Consider

A. Core Competency

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 • Quality of Roasted Peanuts: Maintaining quality is essential to retain existing customers and
attract new ones. The new machine must not compromise the taste, freshness, or texture that
his customers enjoy.
• Customer Loyalty: The aroma of freshly roasted peanuts draws in customers. He should
ensure that the new machine does not alter this appeal.
B. Strategic Flexibility
• Scalability: The new machine allows Mr. Nutt to increase production capacity significantly,
enabling him to respond to higher wholesale demand and potential expansion.
• Cost Efficiency: Buying raw peanuts in bulk at $1.00 per lb. (versus $1.40 per lb. currently)
reduces production costs, which can enhance profitability, especially at higher volumes.
C. Market and Demand Analysis
• Demand Consistency: Assess if there is a stable, long-term demand for 20,000 lbs. weekly, or
if it is seasonal. Market research or securing advance contracts with distributors could help
minimize risks.
• Competition: Evaluate the potential impact of competitors entering the market, as they might
capture a portion of the demand.
D. Financial Risk and Loan Obligation
• Loan Repayment: The $2,895 monthly payment represents a fixed commitment. He should be
confident in his ability to meet this obligation, even during low-demand periods.
• Break-Even Analysis: Knowing the exact point where he breaks even will help him determine
the viability of the investment.

Summary
• Worst Outcome: Achieving only 4,000 lbs. / week demand, resulting in a smaller profit
margin due to high fixed costs.
• Best Outcome: Achieving 20,000 lbs. / week demand, leading to substantial profitability.
• Other Considerations: Mr. Nutt should focus on maintaining product quality, securing
flexible and scalable production capabilities, assessing consistent demand, evaluating
competition, and planning for financial commitments. These factors will aid in making a well-
informed decision on whether to purchase the machine.

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