1. Calculate operating income per customer in each year — Microdot Inc sells and distributes computer networking equipment its overall margin sales
Computer Science & ITGeneralWorked Solution
Microdot Inc. sells and distributes computer networking equipment; its overall margin on sales is 10%. Microdot has customers of two kinds: low and high volume. Low volume customers on average generate sales for $5,000 per year and the average tenure is four years. High-volume customers on average generate sales for $18,000. Their average tenure is seven years but they require an initial investment of $8,000 (comprised mostly of legal fees paid to lawyers to review the long-term contract and upgrades in the software to allow customers to place purchase orders online). Assume a 12% required rate of return.
Required
1. Calculate operating income per customer in each year.
2. Microdot estimates the value of each kind of customer by calculating the customer’s projected NPV over the total expected time of the contract. Use the operating incomes calculated above to compute the value of each kind of customer.
3. Indicate which type of customer is more profitable for Microdot Inc.
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SOLUTION
1. The operating income per customer in each year is calculated as follows:
Year 1
Low Volume
High Volume
Sales
$5,000
$18,000
Net margin 10%
$ 500
$ 1,800
Other identifiable costs
$ 0
($ 1,143)
Operating income of each customer
$ 500
$ 657
Year 2 and Beyond
Low Volume
High Volume
Sales
$5,000
$18,000
Net margin 10%
$ 500
$ 1,800
Other identifiable costs
$ 0
$ 1,143
Operating income of each customer
$ 500
$ 657
2.
To determine the value of each kind of customer, an assumption is needed: required rate of return. If the average net margin is 10%, then it is reasonable to assume that minimum is required. However, to provide for contingencies, it is normal that the required rate of return is slightly higher than the average return, so in this case it is also reasonable to assume a discount rate of 12%.
Low-Volume Customer
Low-Volume Customer
Low-Volume Customer
High-Volume Customer
High-Volume Customer
High-Volume Customer
Total Present Value
Present Value Discount Factors At 10%
Cash Flows
Total Present Value
Present Value Discount Factors At 10%
Cash Flows
Initial Investment
$ 0.00
1.000
$ 0
($8,000)
1.000
($8,000)
Cash inflows (at year-end):
Year 1
$454.50
0.909
$500
$1,636.20
0.909
$1,800
Year 2
$413.00
0.826
$500
$1,486.80
0.826
$1,800
Year 3
$375.50
0.751
$500
$1,351.80
0.751
$1,800
Year 4
$341.50
0.683
$500
$1,229.40
0.683
$1,800
Year 5
$1,117.80
0.621
$1,800
Year 6
$1,015.20
0.564
$1,800
Year 7
$ 923.40
0.513
$1,800
Net present value
$1,584.50
$ 760.60
3.
From the NPV calculations in requirement 2, it is clear that low-volume customers are more profitable. However, if the initial investment of high-volume customers can be slightly reduced, they will be more profitable.