The framework and relevant criteria
Which elements will enable us to appraise each one of these alternatives and to take a decision and set up an action plan ? In other words, what are the criteria which constitute the framework of the issue and that we have to take into account in the analysis ? Let’s focus on the three main important ones.
First of all, is the company Pieles de la Garriga able to manufacture the expected quantity of rabbit bands within the schedule defined by Comerpiel ? Pieles de la Garriga is facing an unusual demand in terms of production volume. Will the firm be able to meet this demand ? The order alone (see Exhibit 1 : 1.12 million euros estimated as potential revenue) amounts to 75% of sales revenue Pieles de la Garriga makes with Comerpiel today (1.5 million d’euros). In addition to the buying of an indispensable machine to satisfy the finition criteria demanded by the customer, are today’s output capacities of the company sufficient or does the firm have to increase its daily production working time ? If it is the case, what will be the financial impacts of such choices ? To the contrary, associated with the production in the weeks to come, will the company’s available stocks be sufficient to supply Comerpiel ?
Secondly, profitability : will the contract generate profit ? In order to know it, we have to analyze the costs and potential gains of each alternative, basing our study on the data we have as well as some assumptions, in particular the price that Pieles de la Garriga should adopt. Besides, is it financially more interesting to bid for the whole contract or to bid partially ? In other words, is profit proportional to sales ?
Finally, what the risk the company incurs if Pedro Saez decides to bid for the contract ? First, if the company wins the bid, it will increase its dependence towards Comerpiel, which is already its biggest customer to date. Comerpiel accounts for 60% of the rabbit pelt division’s sales to the fur garment and accessory market, which totals sales of 2.5 million Euros out of the 8.8 million Euros sales in the overall rabbit pelts division. Every other things being equal, if Pieles de la Garriga wins the bid, it would make more than 72% of its fur garment and accessory sales with Comerpiel (see Exhibit 1 : 1.5 million + 1.12 million estimated as potential revenues, out of the total 3.62 million Euros in fur garment), which would become then an even more important client, enjoying a strong commercial pressure and negotiation power.
Also, Pieles de la Garriga has to take into consideration the time factor in its analysis. The company has to manufacture a high volume of goods in a short period of time (at least for the first delivery planned for the end of september) and order (as well as receive) a new machine before starting manufacturing any band. As a consequence, the risk not to be able to meet the deadlines is real and may have repercussions regarding the continuation of the contract and future business relationships with Comerpiel.
Moreover, if Pedro Saez decides to bid for only one stream of the RFP, he has to be aware of the underlying risks. The main data being that Comerpiel considers selling the hats at 15 Euros and gloves at 10 Euros, which means (if we assume equivalent production costs for both hats and gloves), a greater margin on gloves, that is to say on small bands. To bid only on large bands is still possible but it can constitute a business risk. The economic analysis will help us see whether the question is relevant or not.
In addition, we should ask ourselves how to take in account in our final decision the risk that Comerpiel might not hold to its agreement and might cancel the contract ? By keeping in mind this risk at all stages of the analysis, this element will help us choose the most adequate pricing model that the company should adopt.
Finally, a last consideration : Pieles de la Garriga is also confronted with the risk to lose its major customer if it does not win the bid. Can it afford to lose such an important customer ? Moreover, can it afford not to bid for the contract ? What would happen if Comerpiel decided to sign with a competitor ? Undoubtedly there would have strong consequences in the business between Pieles de la Garriga and its customer.
Let’s perform a quantitative analysis of the project with a strong focus on the issues of profitability and output capacity, while taking into account the transversal risks cited above.
Analysis
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Production capacity : In order to meet the type of finish Comerpiel wants, Pieles de la Garriga has to order a new production machine. If the company orders it now, the machine will be delivered in two weeks. As a consequence, out of 22 days of production per month, let’s consider that the company has no more than 11 days of production in September. However, the firm is required to manufacture and deliver 6,000 large bands and 9,000 small bands by the end of September. The firm carries a stock of dyed pelts sufficient to cover three months of sales. Let’s assume that this stock is equally composed of small bands and large bands. Will the company be able to manufacture the quantity required by Comerpiel within 11 days ? Let’s set up the appropriate equations :
L = number of days to produce large bands
S = number of days to produce small bands
Number of cycles per hour (data given) = 2
Number of large bands processed simultaneously (data given) = 36
Number of small bands processed simultaneously (data given) = 70
(8*2) * 36 * L = 6000 ➔ L = 11 days
(8*2) * 70 * S = 9000 ➔ S = 8 days
Thus the number of days necessary to meet Comerpiel’s demand is 19 days. But the company has only 11 days available. Therefore it faces a bottleneck in September (note that this bottleneck only affects the last stage of the production process because the stocks at our disposal prevent us from any risk of reaching under output capacity). For the following months, given that there are 22 working days available per month, the machine capacity is sufficient.
How to face this issue ? Not to manufacture the required quantity and postpone it to October can not be considered. Pieles de la Garriga’s proven reliability in meeting its commitments has contributed to make it become Comerpiel’s main supplier. Damaging the company’s credibility would be equivalent to jeopardizing its future business relationship with its customer. A possible solution would be to work overtime during the last two weeks of September. Of course, the underlying assumption would be that such a solution is feasible, that is to say is accepted by the employees themselves. Exhibit 2 shows the calculation of the additionnal costs of such a project. If during the last two weeks of September the company paid its employees twice as much as it would normally do (pessimistic assumption because Exhibit 3 shows that employees would not work twice as much), the additionnal cost of working overtime would be about 35,400 Euros. Let’s bet that the financial gesture made by Pedro Saez will help convincing the employees.
What we see in Exhibit 3 is that if the employees work 13 hours and a half in September instead of the normal 8 hours per day, the company will be able to manufacture and deliver Comerpiel at the end of September. As for the following months, the bottleneck disappears : if working 8 hours per day, the company will manufacture the expected monthly quantities.
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Profitability : Increase the output capacity by buying a new machine and working overtime is necessary, but so far nothing tells us whether the overall project is profitable or not. However we should keep in mind that Pieles de la Garriga’s main objective, as a private firm, is to make as much money as possible.
What does Exhibit 1 show ? That the essential parameter in the project profitability calculation is price. If the company bids for the whole scope of the contract with a price equal to that of asked by Beatriz Elizalde (third column), net profit (before tax) equals almost to zero (4,700 Euros). To the contrary, if the firm bids with prices 10% above those asked by Beatriz Elizalde (first column), then the project becomes profitable and profit would reach 116,700 Euros. Most certainly the risk to bid with a 10% higher price is substantial, but Pedro Saez seems quite confident that he can win the deal with such a price, given the good relationship he has fostered with Comerpiel. By the way, does he really have the choice ? Undoubtedly not. If he wants to make money, to increase the price is its sole recourse. In particular, he has to cope with costs which can not be cut down : the purchase of the machine and the overtime hours costs, both indispensable prerequisites to be able to manufacture. Therefore, his capacity of action is small.
Another risk to take into account regarding profitability is the one that Comerpiel does not hold to its agreement and cancels the contract for business or strategic reasons. In its forecast profitability calculation, Pieles de la Garriga has to weigh this element. Exhibit 1 shows three different possible scenarios : a cancelation at the end of September, October or November. If the company bids with the prices suggested by Comerpiel and this latter breaks the deal at any of the above dates, Pieles de la Garriga will have lost money. If it bids with prices 10% higher than the ones suggested, it will lose money only if Comerpiel breaks the deal at the end of September. If Comerpiel breaks the contract in October or November, then Pieles de la Garriga will have earned money. What does it mean ? Under this assumption, the contract breakeven point will occur in October, when the company have produced about 20,000 bands, both small and large (15,000 produced in September & about 5,000 produced in October – see the production planning in Exhibit 3).
What do we learn from this information ? We learn that if Pieles de la Garriga bids with the suggested price, not only it will make little money but also it will be exposed to lose money for sure if Comerpiel does not hold to its agreement and cancels the contract before the end. This information shows that Pieles de la Garriga should bid with a higher price in order to minimize its financial exposure.
Another solution to consider in order to protect the company against the risk Comerpiel cancels the contract would be to increase substantially its prices in the beginning of the contract and to decrease them proportionnally during the rest of the contract. This solution would not affect profit (neither increase nor decrease it, the average profit would remain the same) but it would rather protect Pieles de la Garriga more against a breach of contract at the beginning, around September or October. The company would make more money at the very beginning and its losses would be reduced if the worst happened. Nevertheless, such a practice is not likely because it is not easy to justify from a business perspective. If the advantage for Pieles de la Garriga is obvious, that of Comerpiel is not. Would Comerpiel accept such a clause, in addition to higher prices than the ones suggested ? Its seems to be too many conditions. We have to keep in mind that Pieles de la Garriga is not the client but the supplier.
Finally, the analysis of profitability allows us to see that if Pieles de la Garriga bids for part of the RFP, which means that it bids for small bands only or large bands only (but not for both), profitability varies substantially. Again, if the company made a bid for small bands with suggested prices, it would lose a lot of money (44,700 Euros - see Exhibit 1) and if it made a bid for large bands with suggested prices, it would earn little money (24,800 Euros). With 10% higher prices than those suggested, biding for small bands only is still not profitable (-2,700 Euros) but biding for large bands is very interesting (94,800 Euros).
The sole advantage of of these two solutions is not to have to work overtime. Normal working days of 8 hours would be enough to manufacture the required quantities. However, the purchase of a new machine remains necessary and weighs on the expected profitability of these solutions.
The question that may arise at this stage of our consideration would be to know whether Pieles de la Garriga bids for the whole contract or just for the large bands. The difference in profit is about 21,900 Euros (116,700 – 94,800) but in the second solution the company keeps its current output pace and does not have to implement any additional workload. However, the assumed margin of Comerpiel is higher on small bands than on large bands (see page 2). Can Pieles de la Garriga afford not to bid for small bands ? Pedro Saez is confronted with both an economic and strategic choice.
Action plan & conclusion
I would recommend that Pieles de la Garriga bid for the whole request for proposal launched by Comerpiel, first because of the following strategic reasons :
- To begin, after one year and a half penetrating the rabbit pelt fur garment and accessory market, Pieles de la Garriga is about to sign its biggest deal, which accounts in itslef for half the sales made by the fur garment division (2.5 million Euros – see page 1). The opportunity is too enticing not to be played, above all for a new company which started in the business few months ago and which aims at growing more and building a strong reputation in this market ;
- If this deal with Comerpiel increases the company’s dependence towards iths main customer, it increases as much, if not more, Comerpiel’s dependence towards its main supplier Pieles de la Garriga. So risks are shared. By signing such a deal, Comerpiel would make 80% of its total purchases with Pieles de la Garriga (1.5 million Euros + 1.23 million Euros – compared with 70% currently). The latter would then become a key partner for Comerpiel.
Furthermore, as concerns the contract profitability, it is maximum when :
- Pieles de la Garriga bids for both large and small bands ;
- Pieles de la Garriga bids with higher prices than the ones suggested by Comerpiel.
Bid only for large bands would avoid working overtime and facing administrative and potential social issues but would entail a net profit loss of 21,900 Euros (116,700 – 94,800). Regarding the option with 10% prices, one the one hand it includes a business risk (though identified and calculated) but on the other hand assures that the firm will minimize the effect of an anticipated breach of contract.
Thus I would recommend the following action plan :
- Bid for the whole RFP in order to make as much net profit as possible ;
- Pass the order for the new production machine ;
- Communicate internally with management, shopfloor and personnel representatives in order to schedule and implement overtime workload in september ;
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Make a proposal with higher prices than suggested by Beatriz Elizalde by about 11% on both small and large bands (see prices in Exhibit 1, second column) so as to keep a security margin in anticipation of the negotiations to come ;
- Not go below prices higher by 9-10% than those proposed by the customer.
To sum up, the rabbit pelt fur garment and accessory division of Pieles de la Garriga is young and has to cope with an increasing competitive market, where demand skyrockets. If Pedro Saez, a young and ambitious manager, eager to make proof of his management skills and abilities to his father, wants to develop business and to make his division grow fast, he has to take actions equal to his personal and professional ambitions. Of course, the move is hasardous, like all business decisions, but at least, this analysis will have helped identify the potential threats.
