Kilgors Case study: Investment in a new wine variety

Following the success of two earlier innovations, Kilgors management had considered a potential investment in a new wine blend, designed to attract the Chinese consumer.  They had found that the Chinese market was a significant area of growth.  For example, other winemakers, such as Penfolds, were not able to meet demand for some of their high-end wines like Grange Hermitage, even with dramatic price increases. For Kilgors, this was a relatively untapped international market that demanded attention.  The R&D manager, who was also Kilgors senior wine-maker, was asked to pull together a budget proposal for this new product development project.

At the same time Kilgors management were reviewing the need to replace equipment in the winery, as the old equipment was at the end of its useful life. The senior winemaker had mentioned the potential for new flexible bottling system that would enable them to adapt more readily to changing consumer demand for the different wine varieties.  He explained how he had seen the new bottling system in action and had visited a Singapore food manufacturing company who was currently installing this state of the art equipment.  He said it would enable Kilgors to operate more on a demand-driven basis and switch wine production according to updated rolling forecasts.  The other managers thought this proposed investment linked nicely with the R&D investment idea being floated, as introducing a new wine blend would impact on the winery’s current throughput capacity.

They asked the senior accountant to generate a capital budget that would enable them to evaluate the NPV of the flexible bottling system against standard machine replacement.  This as important as the two projects was quite different.  For example, the initial outlays for the two options were significantly different, with the new technology being a lot more costly.  The flexible bottling system also required $1.5 million investment in training on the new equipment comprising, flying Kilgors key wine makers and production managers to France to train for several weeks with the equipment experts.  However, the proposed system also provided cost savings, such that the wastage was minimised, cutting the cost per litre of wine by $3.00.  The machinery didn’t require as many operators, thus cutting the direct labour costs overtime.  Similarly variable overheads were reduced with the new technology.  Due to the enhanced safety features of the flexible bottling system, the insurance premiums were lower, thus reducing the fixed overheads.  Table 1 provides an overview of the information gathered by the accountant.

 

Table 1: Winery Bottling Equipment – Capital Investment Options 

	Replacement Bottling Equipment	Flexible Bottling System
Project life	10 years	10 years
Initial Outlay	$10 million	$43.5 million
Employee training costs	Nil	$1.5 million
Selling price per litre	$20	$20
Direct wine cost per litre	$6.00	$5.00
Direct labour per litre of wine	$8.00	$7.00
Variable overhead per litre	$4.00	$3.00
Fixed Overhead	$1.5 million	$1.2 million
Expected Volume (per annum)	1,800,000 litres	1,950,000 litres

Marginal Tax Rate: 32%; Discount Rate: 10%

Required: 

 

1. What factors do you consider important for the budgeting process?  In your response, make sure you outline the strategy of Kilgors (differentiation or cost leadership) and what is important for Kilgors to achieve their mission? 

(4 marks)

 

2. To date, you have studied more traditional forms of budgeting (i.e. incremental adjustments to the budget each year to determine next year’s budget). Rather than take a traditional approach to budgeting would more contemporary approaches, such as zero-based budgeting, be suitable for the R&D department to use?  Explain why or why not and the approach you would take to budgeting for Kilgors proposed R&D investment. 

 

(4 marks)

3. Calculate the NPV of the two proposed investments.  Which option should Kilgors adopt?  Explain why?

                                                                                                                                (6 marks for NPV calculation)

                                                                                                                                (6 marks for Explanation)