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Straight Supply is a major supplier of medical components to large
pharmaceutical corporations. Bonnie Straight is a second generation CEO
of the company founded by her father forty years ago. Originally
established in Moorhead, Minnesota, Bonnie moved the company operations
to Denver ten years ago so she could see the mountains from her office
window.
The Denver location proved profitable for Straight Supply as the
company could take advantage of a larger pool of labor and find and
train skilled employees to assemble quality products efficiently. The
location also made it easier for shipping around the country as many
trucking companies were looking for loads out of the Denver area.
Additionally, Bonnie could more easily take advantage of business and
medical conferences.
An unexpected benefit of being headquartered in Denver was the close
proximity to Colorado Springs and the many Christian organizations based
in the area like Focus on the Family. Bonnie became an active
contributor to several of these organizations and was invited to serve
on the board of some of them. Her work in the medical supply area also
provided opportunities to help worthwhile causes through the donation of
medical supplies and materials to these organizations. At least ten
percent of company profits were donated to Christian organizations every
year.
One of Straight Supply’s most successful products is an
insulin-monitoring pump, which monitors and measures insulin
concentrations and automatically injects insulin into diabetic patients.
Due to the technical nature of this pump and its critical function,
exacting standards are needed in its design and manufacture. There are
several critical components requiring highly skilled labor and the
finest quality materials.
Recently, a competitor, began promoting a similar insulin monitoring
and pump type product. One of the large pharmaceutical companies, which
has been a major customer of Straight, indicated that they were giving
serious consideration to the competitors product. This customer wanted
to give Straight Supply every opportunity to continue business with them
since they have a good relationship, which has existed over a number of
years, however, business is business.
Bonnie learned that the competing product was close in quality, but
definitely lower in price. While this other insulin pump did not have as
long a history for product reliability, the competing company had
introduced several successful medical products over the last few years.
There was every indication that the competitor’s insulin pump could
reach the quality standards required by these major companies at a
favorable price.
Straight anticipated that if they wanted to remain a product leader
in the insulin monitoring pump product area and maintain their current
customer base, they were going to have to make their product more
competitive. Given that competitors were able to offer a similar quality
product at a lower price meant that Straight would have to consider
lower its selling price. However, at the same time, they wanted to
maintain as much of the profit margin as possible as this was a critical
product to the overall success of the company.
Bonnie realized that they were going to have to reduce production
costs. Given that the company had produced this product for some time,
they had pretty much taken advantage of the learning curve phenomena.
All production efficiencies and the resulting cost savings had pretty
much been incorporated into the current cost of the product and it would
be difficult to introduce additional efficiencies of cost savings into
the production process. Material costs were somewhat out of their
control as they had to rely on other suppliers to provide materials and
additionally, material costs was not that great of a component of the
total costs of the product.
When it came to overhead costs, the company used activity based
costing to attempt to get as accurate a measure as possible of
appropriate indirect costs to allocate to this particular product line.
While there is never a guarantee of complete accuracy with the
allocation process, top management believed that their costing procedure
was reasonable. This process of determining total costs was further
confirmed by an independent consulting firm which recommended and
implemented their current cost allocation system.
Outsourcing was quickly becoming the only option for production of
this product. The production process was fairly labor intensive,
involving a skilled workforce to insure that the critical intricacies
and components of the product were properly assembled. Straight had
depended on some of their most talented work force to assemble this
important product. Naturally, the labor cost on a per part basis was
relatively high due to many factors. The product was made in the Denver
plant, which also had a high cost of living, and the demand for
qualified employees was critical which resulted in a higher wage rate.
Also, well-trained technically skilled individuals were needed in many
disciplines, which also demanded a higher wage rate. The employees
working for Straight were some of the more dependable with a greater
number of years working at the company which added to the labor costs.
The potential for considerable cost savings in labor was available if
the product could be assembled overseas.
Straight identified a medical supply company in India that apparently
employed a highly skilled work force with appropriate training in the
assembly of similar products. The labor rate was considerably lower,
enough so, that the product could be shipped to India and back by air
for just the assembly process and money could be saved.
Before making any critical decisions of this nature, Bonnie thought
it best to conduct a financial analysis of alternative proposals for a
five-year time period. The choice for Straight Supply in this situation
was to either continue production in Denver or have the product
assembled in India. The production and finance departments came up with
some critical cost factors to aid in the decision process.
At the Denver plant, 25 employees worked on this specific product.
Their average wage rate including benefits is $30 per hour. Employees at
the Denver plant are able to produce 75 of the insulin pumps per hour
on an eight-hour shift for 250 days in the year. Indirect costs related
to the production of the insulin pump were allocated to the product at
180 percent of the direct labor costs. Wage rates will increase at 6
percent per year. The cost to ship the product to their pharmaceutical
customer in Chicago was $0.75 per item and that shipping cost would
increase 4 percent per year.
If the insulin pump were no longer assembled in Denver, in addition
to a reduction in the labor force, there would be an immediate one-time
reduction in capacity related costs of $120,000.
For this current year, the anticipated annual demand was equal to the
current production capacity. If Straight Supply maintains its market
share with existing customers, there should be a 10% increase in demand
for this product for each of the next five years. The annual increase in
demand could actually have been 20%; however, top management thought it
better to estimate conservatively given the potential increase in
competition. Additional employees would need to be hired at the Denver
plant to keep up with demand.
Each insulin pump sold for $100 this year with the price forecasted
to increase at five percent per year over the next five years. Increases
in working capital directly associated with the product have been equal
to 12 percent of the total sales revenue figure.
In India the wage rate was only $10.50 per hour, and each employee
could assemble an average of two insulin pumps per hour. Given this was a
new production process at the India location, learning curve
efficiencies c
ould apply to the insulin pump and it was expected that production
levels would increase 15% per year over the next three years before
leveling out in the fourth and fifth years. Also, the hourly rate would
increase at 10% per year for each of the next five years. The management
at the India plant promised to hire enough skilled workers to meet the
production demand every year.
Round trip shipping cost to and from India would be at $5.00 per item
with that rate increasing at 4% per year. The additional shipping
requirement will increase the production time by one week. To maintain
its just-in-time inventory philosophy Straight Supply will need to begin
the production of the insulin pump one week earlier so the final
product will be available to the customer at the agreed upon delivery
date. Starting the production process one week sooner will create an
initial cost increase of $260,000 for the earlier ordering of required
materials.
In completing capital budgeting projects, Straight Supply has used a
weighted average cost of capital process to determine a correct discount
rate and then add a premium depending on perceived additional risk
factors. The basic discount rate for this year is 14.8%. If a new
product is being considered a risk premium of 2.5% is added. If there is
a change in a domestic location a risk premium of 1.5% is added. A
project involving an international element results in a risk premium of
from 3.0% to 6.0% depending upon a number of factors including political
stability, economic security, language and cultural differences, and
governmental factors.
Required:
1. Evaluate the two proposed alternatives regarding the insulin pump.
2. Based upon your evaluation identify which alternative should be selected and support your decision.
3. Identify some non quantitative factors which might be critical in this decision making situation.
4. Based on both your quantitative analysis and non quantitative
issues identify which alternative should be selected and support your
decision.
5. How does the consideration of an international opportunity complicate this decision making process?
6. Explain and give an illustration if possible on how the capital
budgeting process will be incorporated into your business plan?
