Problem
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 could 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:
Identify which alternative should be selected and support your decision. Provide calculations to support reasoning.