Plastic rings have been introduced to the market by one of our competitors. The new rings have a longer life and a lower cost to manufacture. Industrial Grinders needs to decide when is the appropriate time to switch over to making plastic rings. Analyzing the Facts
Industrial Grinders manufactures industrial machines, which are sold by a separate company, and they manufacture parts which are sold by them. They have inventory on hand valued at $93,000, made up of special steel worth $26,400 and manufactured steel rings valued at $66,600. Steel rings have a normal life of about two-months. Industrial Grinders is a well established company and has been around nearly 70 years. Plastic Rings have recently been introduced to the market by a French firm, Henri Poulenc. The new rings have four times the wearing properties of the steel ring, and can be manufactured at a lower cost. It is expected that the plastic rings would not be produced by any other company other than Henri Poulenc for some time, and this meant that no more than 10% of Industrial Grinder’s market would be affected. Poulenc is our strongest competitor in the French market.
Development engineer estimates that plastic rings could be produced in three and a half months, with the necessary tools and equipment obtained for about $1,800. The next two or three months the plant would not be operating at capacity; during slack periods, the company had a policy of employing excess labor (at about 70% of regular wages) on various make-work projects rather than laying the men off. This time could possibly be used to convert the steel inventory into rings. Generating /Evaluate Alternatives
1.The company could prepare to manufacture the plastic rings as soon as possible but that until the inventories of the steel rings and the manufactured steel currently in inventory were exhausted the plastic ring would only be sold in those markets where it was offered by competitors.
This alternative would leave slightly under 50,000 steel rings to sell. At the current sales pace of 690 per week it would take us close to 72 weeks years to exhaust all of the steel rings. During that time frame it would be reasonable to expect that plastic rings would be manufactured as the standard ring by not only us but our competitors, therefore eliminating the demand for steel ring. We also should take into account that our plastic ring sales of 69 per week in France would mean additional time needed to exhaust our steel ring sales. The special steel in inventory would be manufactured into steel rings. The next few months are usually a slow down time for Industrial Grinders and they are able to employ excess labor at 70%. This will reduce the labor cost and some of the indirect expenses that are directly related to labor costs, therefore creating a higher profit on the recently manufactured steel rings. This savings would allow us the flexibility to offer a discount on the sales price of the steel rings to our customers. We could phase in the process of preparing our machines to start making the plastic rings. We would need to invest $1,800 for the necessary tools and equipment to start producing the plastic rings. During the next 6 months we should begin marketing the plastic rings and educate our customers on the improved benefits of the plastic rings.
2.The company could stop making steel rings, dispose of the special steel inventory ($26,400), sell what steel rings are currently in inventory and start making plastic. In this way we will be able to continue supplying the steel rings until stocks, at least of processed parts of slightly under 25,300, are used up. Using current sales pace of 690 per week it would take us close to 37 weeks to exhaust the inventory of manufactured steel rings. We would incur the loss of the $26,400 for disposing of the special steel, but the profit made by selling the plastic rings would more than make up for the loss. We could use the slow down period to do a change over process on the machines to start making the plastic rings.
We would need to invest $1,800 for the necessary tools and equipment to start producing the plastic rings. During the next three months we should begin marketing the plastic rings and educate our customers on the improved benefits of the plastic rings. The profit made on the plastic rings would allow us to offer a discount on the sales price for the steel rings to offset the risk of our customers finding out that we are selling plastic at the same price as our steel, risking them buying our machines.
3.Throw away all inventory and start making plastic rings. As with alternative 2 we could use the slow down period to do a change over process on the machines to start making the plastic rings. We would need to invest $1,800 for the necessary tools and equipment to start producing the plastic rings. During the next three months we should begin marketing the plastic rings and educate our customers on the improved benefits of the plastic rings. This alternative would leave us with zero rings to sell to our current customers leaving us at a disadvantage, both from a financial perspective and a customer service perspective. This alone makes this not a viable alternative.
4.The company could continue to make steel rings and set up to manufacture plastic rings as soon as possible, selling both in the future. This alternative assumes that there are a significant portion of our market that will not embrace the plastic rings. Given the fact that it has four times the wearing properties, this is an unlikely assumption. The demand for steel is likely to decline so we would be faced with eliminating the steel line in the near future.
5.The company could take a “do nothing” approach and continue to make only steel rings. This alternative would leave us at a competitive disadvantage. Customers will likely demand the plastic rings once they are informed that they have four times the wearing properties of the steel ring. This has the inherent risk of eliminating our line of sales for parts which is a substantial part of our company’s business leaving us to only machine sales. This alone makes this not a viable alternative. Decision Criteria
While generating and evaluating my alternatives above, I have concluded that only alternative 1 and 2 are viable options and need to be compared in my decision criteria. Improve profitability
Alternative 2 will be most profitable. As shown in Table A, the cost to produce the plastic ring is much less than the cost to produce steel rings.
It is probable that we will sell less individual rings because the plastic rings have four times the wearing properties but the decreased cost will more than make up for the reduction in sales. We can then market to areas that we currently do not have a presence. Increase sales market share
The introduction of the plastic ring will most likely increase our market share. Alternative’s 1 and 2 will have the best chance of achieving this, however alternative 2 will achieve this in a more expedient manner Maintain customer satisfaction
The best customer satisfaction will be achieved through alternatives 1 and 2, both allow for our current customers to purchase steel rings until they have decided if they should want to convert to plastic.
Preferred Alternative and Action Plan
Alternative 2 will improve profitability more than alternative 1 because it will allow us to begin selling our plastic rings, which have a much lower cost to produce as shown in Table A, sooner than if we were to manufacture the special steel on hand. The plastic rings will most likely be the preferred product by our customers therefore leaving us with steel rings that may never get sold. Keeping the current inventory of steel rings allows us to satisfy our customers that may take a while to convert to the plastic ring. Alternative 2 also will allow us to keep employee moral up by not asking them to produce steel rings at a reduced labor but would be able to focus their efforts in making sure we are ready to manufacture plastic rings.
It also would allow us to perform some testing of our own on the plastic rings to make sure they meet our high quality standards. Producing the plastic rings sooner rather than later, would allow us to introduce the product to all of our markets, much of which is outside the area where French firm, Henri Poulenc has already introduce the rings, therefore increasing our market share. Final Thoughts
Our reading titled Relevant Costs and Revenue can be applied directly to this case study. In the discussion of whether revenues and costs were relevant , I found it very clarifying when stated that it is meaningless to discuss whether a cost or revenue is relevant or irrelevant unless a decision has been specified and in order to perform a correct economic analysis of a decision problem you must identify and include all relevant revenues and cost, therefore determining the effects of our decision choice on cash. In preparation for writing this paper, before reading Relevant Costs and Revenue, I spent some time on this paper going in circles trying to determine the overhead allocation that would be applicable to each of my options. I have concluded that the overhead would remain the same so long as at least one product was manufactured, so it is irrelevant to the decision of which type of ring we are producing. I am focusing only on the parts division and not the manufacturing of the machines. It is also true that the plastic rings will be a substitution product for the steel rings because plastic will cannibalize sales of the steel market. In my analysis, I will assume that Industrial Grinders will continue to produce the same volume of plastic rings as they did steel rings therefore having inventory to sell to our new markets that will be gained from being first in the market place to introduce plastic rings. Therefore, as shown in Table C, increasing our contribution margin to $198,803 for plastic rings compared to $83,531 for steel rings. I relate this concept to the failure tolerant leader readings. If after the introduction of the plastic rings to our markets, we find out that the demand is not there, then we would scale down production to meet our demands, reducing our variable cost.
If I were to look only at the contribution margin for the plastic rings compared to the steel rings (table C), taking into account that the sales would decrease because of their wearing properties then I would have continued to recommend the steel rings. We need to take into account the other aspects for choosing this alternative, which includes market growth and customer service. It was very interesting to me to apply this to a manufacturing situation. My career has been primarily Healthcare. I provide contribution margin analysis on every productline that the hospital does or is considering to provide. There are only a few times when the fixed costs change. As long as we are providing services to our patients the fixed overhead usually remains the same. I have also learned from our readings that even in my Healthcare analysis, there are times when considering the opportunity costs should also be taken into account.
Costs100 Plastic Rings100 Steel Rings100 Steel Rings @ 70% labor Material$4.20$76.65$76.65
Variable Cost100 Plastic Rings100 Steel Rings
Total Variable Cost32.28160.89
Per Unit Contribution Margin100 Plastic Rings100 Steel Rings 12% discount on revenue100 Plastic Rings
Volume at 690
Contribution Margin $49,700$83,531$198,803