Wermers Industries Incorporated has developed a new drill press, model LS-88, that is designed to offer superior performance to a comparable drill press sold by Wermers's main competitor. The competing drill press sells for $31,000 and needs to be replaced after 1,000 hours of use. It also requires $6,000 of preventive maintenance during its useful life. Model LS-88's performance capabilities are similar to the competing product with two important exceptions-it needs to be replaced only after 2,000 hours of use and it requires $7,000 of preventive maintenance during its useful life.From a value-based pricing standpoint what is model LS-88's economic value to the customer over its 2,000 hour life?

A) $62,000
B) $36,000
C) $67,000
D) $43,000

Question

Princy Rajoria · Accepted Answer

Final Answer : C, Explanation :  The economic value of Model LS-88 is the sum of its purchase price and the net present value (NPV) of the savings associated with longer life and lower maintenance cost compared to the competing product.The purchase price of Model LS-88 is not given in the problem statement, so we need to calculate it as follows:If the competing product sells for $31,000 and needs to be replaced after 1,000 hours of use, its effective cost per hour is $31,000/1,000 = $31/hour.Over the same 1,000 hours of use, the competing product also requires $6,000 of preventive maintenance, which adds another $6/hour to its effective cost per hour.Therefore, the effective cost per hour of the competing product is $31 + $6 = $37/hour.If Model LS-88 needs to be replaced only after 2,000 hours of use and requires $7,000 of preventive maintenance during its useful life, its effective cost per hour is:Purchase price + NPV of savings = Effective cost per hour x Hours of usePurchase price + NPV of savings = $37 x 1,000 + $7,000Purchase price + NPV of savings = $44,000Purchase price + NPV of savings = Effective cost per hour x 2,000Therefore, the effective cost per hour of Model LS-88 is ($44,000/2,000) = $22/hour.The economic value of Model LS-88 to the customer is then the sum of the purchase price and the NPV of savings:Economic value = Purchase price + NPV of savingsEconomic value = $44,000 + $7,000Economic value = $51,000However, the problem asks for the economic value over the full 2,000-hour life of Model LS-88, not just the first 1,000 hours when the competing product needs to be replaced.Since Model LS-88 can last for the full 2,000 hours without replacement, we can calculate its economic value over this period as follows:Economic value = Purchase price + NPV of savings for 2,000 hoursEconomic value = Purchase price + [(Savings per hour x Hours of use)/ (1 + Discount rate)^t]where:Savings per hour = Effective cost per hour of competing product - Effective cost per hour of Model LS-88Savings per hour = $37/hour - $22/hour = $15/hourDiscount rate = 10%t = 0 (i.e., present value)Economic value = Purchase price + [(15 x 2,000)/ (1 + 0.10)^0]Economic value = Purchase price + $30,000Given that the purchase price of Model LS-88 is not disclosed, we cannot determine its economic value precisely. However, we know that it must be at least $51,000 (the economic value over the first 1,000 hours) plus some additional value over the second 1,000 hours due to the longer life of Model LS-88.Since the savings per hour of Model LS-88 ($15) remain constant over the whole useful life, the additional economic value over the second 1,000 hours will simply be 15 x 1,000 = $15,000.Therefore, the minimum economic value of Model LS-88 over its full 2,000-hour life is:Economic value = $51,000 + $15,000Economic value = $66,000Thus, the closest answer is C) $67,000.

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