Problem Statement
How to grow the business since sales plateau existed for almost 20 years despite continuous profits? This is what Wayne Swisher had been concerned for several years.
In early 1996, Wayne Swisher received a certified letter from a major national retail merchandise chain, inquiring about a private branding arrangement for SMC’s line of riding mowers. Wayne had to decide whether or not to accept the proposal as well as the next step to grow SMC.
The Private-label Proposal
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Contract: A 2-year contract which could be automatically extended on a year-to-year basis, with price and other terms negotiable then. Also can be terminated by any party with a 6-month notice.
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Product: Minor changes based on Ride King
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Order: An annual order of approximately 8,200 units, a sample order of 700 standard riding mower units to be delivered in Jan1997.
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Price: FOB; 5% discount on SMC’s manufacturer’s list price for its standard model; Reorders will be at the same price
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Marketing: SMC did not need to make any promotion effort to either the chain or the consumers. In addition, the private label relationship with the chain should be held confidential.
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Negotiable Inventory holding & payment term: The chain would carry inventories in its regional warehouse. However, only until the mowers were shipped to a company store, or only when they had been in a regional warehouse for 2 months, would title be transferred and would the 45 days’ payment term start to take effect.
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Warranty: SMC’s standard warranty would be required for all mower parts. SMC was expected to bear any labor costs resulting from warranty work at $22 per hour. Replacement parts would be sold to the chain at present price point and shipped FOB factory.
Proposal evaluation
To facilitate our analysis with limited information, the following reasonable assumptions are taken:
- Unit sales without cannibalization, selling prices and costs (except the additional costs mentioned in the case) of Ride King would remain the level of 1995.
- Ignore the impact of decreasing unit fixed cost with expanded production volume.
- Recognize sales in late 1996, though the sample order of 700 was to be shipped and sales were to be recognized in 1997
- Assume consistent cannibalization rate among two-year contract period (=300 cannibalized annually/8,200 annually)
- Average the one-time costs of $10000~12000, i.e. $11,000, and the costs are expensed when accepting the proposal.
- Assume SMC could well arrange production and avoid excess OT work for PL/Ride King over the minimum of 2100 units/year.
- Assume the new mowers under proposal (“PL”) occupied the same capacity as Ride King did.
- Assume after negotiation, title can be transferred upon shipment from SMC.
Sales Analysis (Table A)
Total Ride King Sales, both the original and those from Private Label proposal (“PL”), would be 4,874, 12,100 and 12,100 units for year 1996~1998 respectively, with net increase of 674, 7,900 and 7,900 after cannibalization.
Financial Analysis
- Additional income per unit (Table B)
* As stated in Assumption b), united fixed cost is overstated. Hence, gross profit of the proposal would be slightly higher.
Hence, the proposal would bring an additional per unit income of $42.25 (gross profit of 6.5%) if within the 10,000 capacity with a single 40-hour-per-week shift and an additional income of $16.25 (i.e. GP of 2.5%) if over capacity with overtime work.
- Capacity Analysis (Table C)
Assume SMC could manage to arrange a smooth production without significant fluctuation to counter the seasonal delivery. Hence, production volume could be consistent with sales volume as shown in Table A.
Hence, in 1996, as total production volume still under capacity, no overtime work for PL needed. While for both 1997 and 1998, 2,100 units of PL would be produced with overtime work.
- Incremental Income (Table D)
Based on the assumption and calculation above, total incremental income can be derived as follows. The proposal would generate an extra net profit before tax for SMC of $11,098, $88,850 and $88,850 in year 1996, 1997 and 1998 respectively. On the base of year 1995, the sharp increase in sales by 178% would bring in a 21% increase in net profit before tax.
Table D
For detailed information on Additional Financial Expenses, please see the Table F as follows:
(To simply analysis of AR financing cost, we ignore cannibalization of the sample order, and use the same selling price and payment term of PL's for the small quantity of cannibalized Ride King. Also, we ignore the inventory financing cost for 1996.)
In order to gauge the risks associated with the terms and conditions of the proposal, SMC tried to analyze the sensitivity of the sales and profits to the changes of terms and conditions in payment terms, inventory costs, interest rates and cannibalization volume.
To illustrate the point clearer, the breakeven point of each terms and condition is calculated with other situation held constant.
Sensitivity No Additional Profit
Payment terms -65% 114 days
Extra holding inventory -131% 3,700 units
Interest rate -196% 14.3%
Cannibalization volume -22% 1,690 units
Because all these conditions above are unlikely to happen, SMC can be rather confident that the proposal is quite favorable in making profits.
Evaluation of the proposal
Just like a coin has two sides, the proposal also has pros and cons. SMC can benefit from the private label proposal from six aspects.
- SMC can enjoy the increase in sales and profits after accepting the proposal. The details can be seen in the following table:
* % increase versus those in 1995
If SMC accepted the proposal, its sales could rocket up almost 178% in 1997, compared to sales in 1995. It profits could be increased by 21% in 1997, compared to those in 1995. The proposal posed a good opportunity to SMC to increase sales and profits.
- SMC could also benefit from stable demands for its products in the next two years. The private proposal would offer stable orders to SMC.
- SMC could fully utilize its currently idle production capacity. Without acceptance of this private label proposal, the idle manufacturing capacity is 5,800 units per annum, more than 50% of total capacity. The high opportunity cost incurred could not be neglected.
- Furthermore, SMC could utilize this opportunity to make entry into the most important retail distribution channel: national retail merchandise chains, which currently accounts for 24% of the national market.
- Moreover, this proposal could provide an extra benefit of free test market! In fact, SMC remains a regional manufacturer of riding mowers for almost half a century. Its sales had plateaued for a decade while industry as a whole embraced record increase in recent years. SMC could take this precious chance to survey customer reaction across US to its unique mid-engine products with the help of the mass merchandise distributor’s strength of marketing without even using any of SMC’s scarce valuable marketing resources.
- Additionally, this new challenge would be a best learning opportunity for SMC when it operates on a scale twice the size of current operation. SMC could learn how to cope with the production within or even exceeding full capacity. For example, stretched manufacturing would lead to unprecedented pressure for purchasing department, warehouse management, logistics, etc.
On the other hand, SMC should look at the other side of coin and analyze the cons of the private label proposal as well.
- Upon adopting the proposal, SMC would contribute more than 50% of its capacity for Ride King to one single private label mower production. Furthermore the improvement of SMC’s own brand could be limited by the remaining 42% production capacity. Limited capacity could hamper the introduction of new product, say missing the good timing, or could lead SMC to miss the good chance to grow current brand, say if demand for current brand increased.
Other than capacity, the proposal also put pressure on SMC’s other resources, such as financial budget, labor, general management, etc. Private label production would consume a certain part of the limited and valuable corporate resources.
- Moreover, accepting proposal to manufacture private brand and distribute the private brand through other channels might lead to potential conflict with its traditional distributors. Although the chain’s outlets were located in metropolitan areas, there would be some overlap in trade areas with SMC’s current dealers. SMC, a small concern, relies heavily on its regional dealers to promote its products to consumers. Such a bold move might lead to certain percentage of independent dealers to drop the SMC line.
- The less profitable Private Label could cannibalize 300 units of the sales of more profitable Ride King annually in 1997 and 1998. What is more, the cannibalization rate could be higher than estimated 300 units a year.
- Additionally, SMC had to bear the risks associated with the private label plan. Accepting the proposal is confronted with two uncertainties. One is that the mower producer had committed two third of its current capacity to one single distributor. Once there was no renewal of the contract, it would be difficult to develop another comparable buyer. The other is that the contract would be terminated midway, i.e. one party is entitled to break the deal with a six-month notice beforehand at any time. Furthermore, although the total sales and output would expand almost twice, the increase in profits will not keep the same pace with the increase of the sales.
- Finally, SMC should consider other potential costs. For example, sudden expanded production might lead to quality insurance challenges. The product liability claims might eat up the minute increase in profit from the contract. Plus, the warranty costs would $22 per labor hour.
Alternatives:
- Alternative 1: Accept the proposal and, in the long run, develop own brand based on the experiences of private label production:
SMC should incorporate the consideration of the following elements when accepting the offer.
- Firstly, during negotiation with the mass distributor, SMC should try its best to make the contract terms more favorable. Albeit its bargaining power is somewhat limited, as a reliable provider of a highly differentiated mower product, SMC had some say on the some part of the contract. To negotiate to transfer title upon shipment by SMC would be very reasonable and fair. Holding inventory of an average of 2,100 units in the chain’s regional warehouse under SMC’s title would be very unfavorable to SMC, given PL’s high average monthly inventory financing cost of ~$4.61 per unit per month and even higher AR financing cost of ~$4.89 per unit. Although SMC would not hold a big chance for this as in title transfer, still Wayne could try as 15-day could save SMC an AR financing cost of ~$19,310 a year.
- Secondly, in order to enhance its own brand and strengthen its own brand product, SMC should make this deal only as a short run option. Production of private label can only be regarded as a temporary way to improve SMC’s sales and profits, and is not a reliable one in the long run. To develop its core competency, SMC has to emphasize on improving its own brand image and establishing its own national distribution channel.
Further actions should be taken if SMC decides to accept the proposal:
A improve its current product mix.
In its four core products, Kits makes up to 8.2% of its annual sales yet offer zero profits. With the coordination among its relevant functional area within the firm, SMC could gradually drop the whole product line of Kits if it could not improve its profitability.
B Hire more temporary labor to avoid excessive overtime work
Since the firm scaled up its production, it should hire temporary labor with
adequate training to ensure the on-time delivery and quality control. Excessive overworking for a long period might causes the decrease in both workers’ productivity and production quality. Of course, SMC should reach a good trade-off between the costs to hire extra hands and the improvement in productivity and quality.
C Establish nationwide distribution network
Unsatisfied being a regional riding mower provider, SMC should take the chance of free market test provided by the private label proposal to help establish its own national distribution network. Western part of United Sates poses great new chance for SMC.
D Diversification of product lines
It is important for SMC to build more consumers-oriented mower in addition to its current farm mower offering. For example, mowers used in cutting the grass in garden offer great potential for SMC since SMC are already quite specialized in movers used by farmers. The change in product orientation would help it to capture different market niche and widen its target customer base.
- Alternative 2: Reject the proposal and concentrate on the development of own brands:
On the other hand, SMC should consider further actions to develop alternative strategies if it rejects the proposal to produce the private label.
A Launching of new product: Trim Max.
If rejecting the offer, the company could put more of its limited resources to the launch of Trim Max as a strategic move, widening its product line of trail-movers under the Swisher name. But the firm will possibly be confronted with some uncertainties, such as poor sales of Trim Max.
B Improving profitability of Kits or discontinue it
Among SMC’s four core products, Kits makes up to 8.2% of SMC’s annual sales yet offers zero profits. With better coordination among its relevant functional areas within the firm, SMC could examine closely the root causes of the unprofitability of Kits and try to eliminate the non-value added portion of the value chain. If SMC cannot improve Kits’ profitability at last, it should consider dropping the production of Kits at all.
C Establishing nationwide distribution network
Upon rejection of the offer, in the long run, SMC should put its efforts on establishing national distribution network for its product mix, especially Trim Max, the new introduction to the market. As we mentioned earlier, the western part of United Sates is untouched yet. SMC could try to push the distribution channel toward the western part.
D Diversifying product lines
The advent of the new product, Trim Max, would no doubt improve the product diversification. Furthermore, SMC should expand the newly introduced products and reduce the reliance on its old flagship product, the Ride King, which was designed in the 1950s.
E More advertising
Obviously, the introduction of the new product should be fully assisted by full-scale advertisements and vigorous promotions. SMC can promote its products in the current geographic scope of distribution channel to expand the sales. Furthermore, SMC could consider vigorously promoting its product to the untouched part, the western part of US, and help to set up the national distribution channels.
Final decision:
After delving into all the pros and cons of the two alternatives, Wayne believes that SMC should adopt this private label proposal with eyes on the long-term development of own brand.
Major reasons:
For SMC, the benefits are comprised of both direct and indirect contributions.
- Direct cost saving and profit generation,
A excess capacity utilization
The most important reason to accept this offering is that SMC can make a full use of its capacity and make more profit. As we have explored previously, SMC has around 60% of idle capacity which comprised a potential opportunity costs. In addition, analyzing from economics’ angle, we find that total fixed costs of SMC’ s products remain unchanged with the utilization of idle capacity. The additional revenue arising from the sales of private label may possibly increase profits in SMC.
B Profitability
In 1996, sales can increase by 15.2% and net profits would boost by 3.74% after accepting the proposal. In the next two years, the sales and net profits will be rocketed to 178.3% and 20.59%, respectively, comparing with those in 1995.
- Indirect benefits on regarding the production of private label as a stepping stone to promoting SMC’s own brand
A Accumulation of profits to finance future development
The increased profit aroused from the contract could be accumulated as retained earning to finance the company’s future expansion. This is especially true, when SMC is of such a small scale (market share is less than one percent). It would be quite difficult to fully expand after sales and profits had plateaued for more than a decade. At this stage, private label production could provide SMC with necessary profits, which could finance future development.
B Accumulation of operational experience
The firm can get much precious experience on operating business on a larger scale and in full capacity. The experience includes management, marketing, operation and technology experience. All of these experiences should be considered as a preparation for great leap in the future.
One afternoon in early 1996, Wayne Swisher, satisfied with his analysis about the current and future development of SMC, was confident that SMC could both benefit from the private label proposal, the birds at hand, and stay in track with the long-term development of SMC’s own brand. The funds, raised by utilization of excess capacity and the production of private label, and the experiences learned from production in full capacity, could assist SWC to step further to fully develop its own brands in the long run.
Case 4 Swisher Mower Group 4 /
