Harold Blank, Vice President of Manufacturing for Herr Foods,Inc., was contemplating a capital investment that could improveproduction; however, this operations decision would force severalof his recently hired employees into new jobs as positions wereeliminated by automation.

Herr Foods took pride in achieving the highest quality in theirfinished products. Their top product line was potato chips, and thefinal physical inspection was a critical step. That was whenseveral employees identified and removed around 75% of thediscolored or burned chips before packaging. So, when Harold wasintroduced to the opti-scanner machine, which claimed to do thesame step more effectively than humans, he was intrigued, but notconvinced.

COMPANY HISTORY

In 1946, Jim Herr purchased Verna’s Potato Chips Company inLancaster, Pennsylvania, for $1,750. The company’s assetsincluded:

two iron kettles (each holding 100 pounds of lard),

a potato slicer for threepotatoes,

a peeler that held 10 pounds ofpotatoes, and

a 1938 Dodge panel truck.

At 21 years old and with a $1,750 loan, Jim distributed potatochips in a wax paper bag to small grocery stores and other foodoutlets in southeastern Pennsylvania.  He and his wife,Miriam, worked long hours in front of the hot kettles perfectingtheir recipes and product quality. Building a customer base wasequally difficult as there were similar operations selling potatochip products in Pennsylvania and Maryland.

In 1951, a fire destroyed the company. Jim, a religious man,believed God would lead them to a new location. They purchased asmall farm in Nottingham—ideally located near the mission churchwhere his family was active and closer to their distributionarea.  With all of his available resources and help fromthe local bank, Jim reestablished Herr Foods and expanded the scopeof its operations.

Nottingham—located in Chester County about 50 miles southwest ofPhiladelphia and 50 miles north of Baltimore—was a greatlocation.  Even though it was in a rural area, nearly 50%of America’s population lived within a 500-mileradius.  The county itself had one of the highestper-capita incomes in the state and was one of the fastest-growingcounties in the Philadelphia area.  Jim found that thepeople practiced good moral and ethical standards, were religious,and provided a dependable and stable work force.

Over the years, Jim and Mim’s faith and commitment to fair andethical business practices paid off.  Jim was a man ofhis word.  A simple handshake often closed manycomplicated agreements between customers andsuppliers.  Jim always made good on his promises andnever forfeited on a debt obligation.  If someone wasunethical in his business practice with him, Jim was compassionateand not vindictive.  This was not a sign of weakness, butan effort to reflect his Christian testimony in all areas of hisbusiness.

Herr Foods grew and prospered.  Currently, there were600+ loyal employees and over 150 sku product lineclassifications.  Herr’s operated in a 10-state regionbetween Massachusetts, Ohio, and Virginia, with 20 distributioncenters and its own fleet of vehicles to distribute its products toretailers.  Revenues were approaching $100 million peryear for this family-owned business with potato chips accountingfor about 60% of revenues.  

The same values that Jim practiced in running the business werestill evident as the second generation had assumed ownership andoperation of the business.  Jim’s three sons, Jim, Ed,and Gene; his daughters, June and Martha; and his son-in-law,Daryl, were all active in the business and espoused the same strongChristian values and beliefs.  Son Jim stated, “I’veagreed with my father’s philosophy of running the company tomaintain a culture of integrity, fairness, and opportunity; tostress quality products and service; and to continue the growth ofthe company.”  

OPERATIONS

Given that there were 30 snack-food companies in Pennsylvaniaalone—along with large national companies like Frito Lay andNabisco—having any level of success and growing market share wasquite an accomplishment for Herr’s.  In addition to theextensive potato-chip product line, the company produced pretzelsand other snack foods.  Each line offered a variety ofproducts with varying sodium, fat, nutrients, and packagingspecifications.  The company also distributedcomplementary product lines such as salsas, dips, and meatsnacks.

Pretzel production had recently flourished.  Threehundred pounds of dough are mixed every 8 minutes and fed onto fourdifferent conveyer lines.  After the dough—either plainor sour—was blended into 10-pound sections, it was fed through apretzel die to form its shape.  Depending upon thepretzel, 600 to 2,000 pounds per hour were baked in each of fourovens.  The operation runs 24 hours per day, Mondaythrough Friday noon.  On Friday afternoon, the equipmentwas cleaned.   

The tortilla/corn line produces both corn and tortillachips.  Two lines ran continuously at a rate of about2,000 pounds of product per hour.  The corn was soakedfor 8 to 10 hours and then cooked for 2 minutes to form a lumpy,creamed texture.  The product was cut on a sheeter andsent to a fryer for 15 seconds.  The hot chip runsthrough a tumbler where seasoning was applied. One day per week,onion rings were produced in this assembly area.  Onionrings were actually dehydrated potato flakes that were fried andcovered with onion seasoning.

Cheese curls and popcorn represent smaller productlines.  For cheese curls, moisture was removed from cornmeal, seasoning was applied, and the product was baked for 1 minuteto create a puff. About 1,000 pounds were produced perhour.  For popcorn, yellow gourmet kernels were airpopped, small and unpopped kernels are removed, and the remainingkernels were seasoned.

The potato chip line was the biggestoperation.  Twenty tractor trailer loads of potatoesarrive every day with 50,000 pounds of potatoes pertruck.  Each truck was hydraulically lifted to a45-degree angle to dump the potatoes.

Potatoes were dropped into a washer, scrubbed, and sent by waterflume to three slicers.  They were sliced at 24 slicesper inch in less than 1 second.  They then go to thevegetable oil vats where they were cooked between 3 and 5 minutesat about 325° F.  Four pounds of potatoes made 1 pound ofpotato chips.  Around 56,000 pounds of potatoes per hourwere processed through five fryer ovens 16 hours a day.

After they were dried and salted, a conveyor belt transports thechips past a final inspection point where four employees identifyand remove overcooked or green chips.  Managementestimated that these employees found and removed 75% of thedefective chips, and defective chips represented about 0.5% of theentire output.  With this inspection, only about 10 to 15defective chips out of about 10,000 will reach the finalpackage.

Various stages along the conveyer belt sized the chips beforethey reached a packing machine, with smaller chips going to thesmaller packages.  The tortilla chips, popcorn, cheesecurls, and potato chips were packaged by weight using a bucketprocess to accumulate the product.  The product droppedinto a waiting bag.  Seven million bags of potato chipsof various sizes were produced per month along with a similarquantity of other products.  The production process wasalmost entirely automated until the bags were placed in cartons forshipment.   

Cartons of all the product lines were stacked by type in thewarehouse. The entire warehouse inventory rotated out on afirst-in-first-out basis 3 times per week.  The inventoryturnover rate was critical for a product sensitive to freshnesswith about a 10-week shelf life.

Automation

From the time the potatoes were dumped off the truck until thepackages of finished product were boxed, there was virtually nohuman contact during potato chip production.  Minimumpersonal contact with the food was desirable from a healthperspective; however, the lack of observation and interaction was aquality control concern.  Management had always seen theimportance of personal inspection to insure that defective productswere identified and removed.  Harold was concerned thatautomation would replace the only stage—a critical stage—wherepeople have an impact on quality.

Herr Foods’ top priority was quality.  Ideally,customers should not find even one chip that was defective in anyway.  Inspectors removed chips that are green, black, anddark brown or have black and gray spots.  The green chipsresulted when the potatoes did not have the proper sugar content,often found in unripe potatoes.  Black or dark brownchips occurred when the chips cook too long in the hotoil.  Black, gray, and hard spots were caused in thecolder months when potatoes bruise in shipment.

Since Herr Foods prints “Satisfaction Guaranteed or Your MoneyBack” on each package, the company made every effort to avoidreturns.  The company’s products have obviously met theconsumer satisfaction test as only about 3 out of 100,000 bags ofproduct were returned.

The new system could easily replace the existingsystem.  A 20-foot conveyer belt was used for theinspection process where two employees on both sides of the beltsearch for defective chips.  This section of theproduction line would be removed and replaced with a 5-foot beltmoving at 60 miles per hour, followed by the opti-scanner, whichtook another 5 feet and, finally, a 10-foot conveyer belt moving atthe original speed of 3 miles per hour toward the sorting andpacking operations.

The opti-scanner spread out the chips and passed them under anoptical sensor that recognized discolored chips.  Aschips were scanned, a blast of air blew defective chips ontoanother belt moving at a 90-degree angle where they weredisposed.

The opti-scanner manufacturer was convinced that quality willnot suffer because of automation, but significantly improved theprocess of detecting and discarding defective chips from thecurrent rate of 75% to a 95% success level.  However, theautomated process would also lose about 1 good chip for every 4 badchips.  As the bad chips were blown off the conveyerbelt, an occasional good chip would be blown away along withit.  The manual inspection system also lost some goodchips, but the amount was insignificant.  About 2.5defective chips of every 10,000 chips would be missed throughmanual inspection; about 12 good chips of every 10,000 would berejected by the opti-scanner.

While the manufacturer’s claims seemed impressive, Harold stillhad some significant concerns regarding this new technology andpotential risks.  He was not aware of any other regionalsnack food companies that were planning on making this investmentand only national companies like Frito Lay seemed to have the meansto consider taking a risk of this magnitude on such unproventechnology.

Cost

The new opti-scanner machine would cost $75,000; shipping,installation, and testing would be an additional$20,000.  It would cost $5,000 to dismantle the existingconveyer belt and prepare the area for the new system. To avoiddisrupting production, management wanted to install the newsystems—about a 16-hour process—over the next holiday weekend usingexisting maintenance personnel with technical staff from themanufacturer.  The life expectancy of the opti-scannerwas five years for capital investment purposes with a zero salvagevalue.  The opti-scanner would probably incur anadditional $1,200 per year in maintenance and insurance costs.

With the machine, the company would not need the 4 inspectorsemployed on each of 2 shifts.  These people worked 40hours per week and received $10 per hour.  The companyassumed benefit costs of an extra 25%.  The evening shiftpay differential was an extra $0.50 per hour.

Harold had informed the staff of the company’s policy to notterminate employees due to automation.  Affectedemployees would be reassigned to other jobs within thecompany.  However, Harold believed that these positionscould be eliminated within 6 months through attrition andreductions in new hires, which would be a savings to thecompany.

Inspectors tended to be the most recent hires.  Whilethe work can be monotonous, it was critical for ensuring productquality.  The position experienced a higher turnover ratethan other positions. The average employee stayed about 6 months to1 year; then, 3 out of 4 transfer to other positions and 1quits.  It costs about $300 per employee in hiring andtraining.

The inspector position also determined which employees provedcapable of more skilled and technical positions.  Thecompany had only a limited number of entry-level positions of thisnature, and these positions provided a natural training ground.

To justify the acquisition to top management, the machine mustgive the company a payback of three years orless.  Harold believed the labor savings and qualityimprovement would easily justify and give a satisfactory return onthe investment.  However, given the tight margins on allthe product lines, a capital investment could impact cash flow,which may hurt the company’s credit rating and decrease its workingcapital.

Since the company was privately held, top management probablyneeded to borrow money to finance this capitalacquisition.  Their long-standing association with thearea banking community had allowed them to qualify for the lowestrate of 8.25% for this capital project. The company could alsofinance the equipment purchase from corporateearnings.  Last year, company owners earned a rate ofreturn of 14% on book equity.  For planning purposes,Harold assumed that 80% of the opti-scanner would be funded by debtwith the remaining funds coming from retainedearnings.  Their current corporate tax rate is 40%.

CORPORATE CULTURE AND PHILOSOPHY

Jim Herr had always been a deeply religious man and believedthat the corporate culture and philosophy should be grounded inChristian values and ethics.  Maintaining the highestlevels of integrity, reputation, and excellence of Herr Foods inthe eyes of customers, employees, suppliers, and other stakeholderswas critical.  Therefore, every significant decision topmanagement made must pass a test.

Required:

Discuss various types of capital budgeting methods available toHarold to help him in his decision. Suggest to Harold whatmethod(s) he should use in making the decision.

Evaluate this capital acquisition proposal and recommend acourse of action.