Finished Inventory is much too High!! - Analysis III (Conclusion)

By Eli Schragenheim

This is a case study by Eli Schragenheim that he has allowed me to publish here. Your goal is to analyze the current situation, comment the proposals and develop what you believe are the best strategy and tactics for the company to pursue. The first post is the current situation. (If you are interested in such business cases and their analysis I recommend Eli's book, "Management Dilemmas". The book has many different case studies for you to work through. Eli gives his analysis which he does not claim to be the best possible - nevertheless they are thought provoking.

 

Our Improved Proposal

1. Build a central warehouse with finishing capabilities in the US (currently half the business)
2. Using the Theory of Constraints distribution solution maintain a maximum of 1 weeks inventory for clients in the US and Germany (nearly 80% of the business). 
   NB. Clients forecast for next week’s consumption is accurate.
3. Allow these clients to reduce their commitment to Lisbon Motors inventory from 4 weeks to 1 week (or eliminate this commitment entirely).
   Clients can change to new models without having to pay for 4 weeks of inventory they now don’t need.
4. Introduce penalties if a required motor is not immediately available at the client. (This penalty should be high enough to discourage competitors).

With such an offer Lisbon Motors should be able to...

1. Maintain the loyalty of existing clients – the clients no longer have to pay for about 4 weeks of stock when they go through a model change,
2. New models can actually be introduced more quickly,
3. Shortages of motors no longer occur – as guaranteed by the penalties.

Would this allow Lisbon Motors to “steal” clients from their competitors? Would a 15% increase in sales be a conservative estimate for gains Lisbon-Motors will make in their market? 15% more sales in a stable market would increase Lisbon Motors’ share of the Global market from 11 to 12.7% - will competitors even notice? Would a 1% price premium relative to competitors be justified and not stop the 15% growth? Might the answer to all these questions be a clear “YES”?

What are the Costs and Benefits of our Improved Proposal?

A. Benefits:

1. 1% higher average price (Germany, Eastern Europe and the US) or about 1m$.
   The other markets (Asia) need to be considered – does Lisbon Motors want to compete there?
2. The remote central warehouse in the US needs only 2-3 months inventory. Because only 4 basic models need to be stocked inventory requirements will be further reduced. More than 20m$ of cash will be set free and Lisbon Motors makes a 1m$ savings in interest expense (5% assumed).
3. Since uncompensated scrapped material is no longer an issue the company saves 2.5m$.
4. 15% growth results in 18m$ more sales of which more than 8m$ of margin remains after deducting materials costs. Since no additional operating expenses are necessary to produce this volume (Lisbon Motors has plenty of capacity) all of this 8m$ goes to the bottom line. Will the much better service cause the 15% growth?
5. There will be savings in transportation costs because of the many fewer scrapped motors – 9% of the 12m$ transportation costs or about 1m$.
6. The total of these benefits comes to: 13.5m$.

B. Added Costs:

1. There is an added investment of .5m$ due to the necessary engineering changes to the production process.
2. Renting a US warehouse and the necessary production (finishing) facilities could be up to 1m$
3. Hiring more expensive direct labour in the US (for finishing) means the additional labour cost is not 960k$, but more like 1.5m$
4. Lost margin because of higher materials costs of up to 3m$/year.
5. The total of these added costs comes to: 6.0m$.

C. The Net Benefit:

The net benefit comes, conservatively, to 7.5m$ annually (however, if the new offer is really attractive to Lisbon Motor clients much more seems to be possible)! Net profit increases from 2.5m$ (on 120m$ sales) to 10m$ on 138m$ sales. Return on sales increases from 2.1% to 7.2%.

D. Were the Criteria Met?

1. The new offering must be difficult for competitors to copy.
2. It must give new added value to clients
   Otherwise continued price pressure will undermine any cost improvement
3. Clients must understand and appreciate the value of the new offer
4. The offer must be good enough to lead to additional sales
5. Must show significant improvement to the bottom line improvement even with a conservative assessment
6. The offer must not add significant risk
   There is some risk because the investment must be made and the US warehouse needs to be committed to, for at least some period of time before savings and added income are realized. However, in Europe there is no need to commit to a warehouse and there is usually a way to test the new offering without having to invest in the engineering test.

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