Case Study- November 2016
You are a buyer at McFly Enterprises. Your engineering team has approached you to buy a flux capacitor for their new time machine. Although this product is new to the marketplace, your marketing team seems to think they can sell 50,000 in the first year of production. In the second year, they project 80,000, and 90,000 in the third year. Potentially, sales grow by another 10% in the two years beyond that. Although you are a bit skeptical based on how overly optimistic your marketing team has been in the past, you move forward in quoting the business.
In reviewing the drawings, you see that the part has quite a bit of copper in it. You turn to your internal cost estimators to understand more about the “should cost” of this part. They advise that about 30% of the value is copper. Due to very tight technical specifications, the manufacturing process must be highly automated. This means that labor makes up only 15% of the cost in most markets (this depends on whether the supplier is in a mature market or a development market). The remainder is overhead and other.
You receive offers from the following suppliers. It should be noted that in order to normalize their proposals, you told them to assume $2.90 per pound. (Note: Take a look at historical rates of copper. One site to review them is: http://www.metalradar.com/lme-prices/copper/. Typically they are shown in metric tonnes.
Brown Enterprises has offered you a price of $48.23 per unit. They will give you a reduction of 5% per year for each of 3 years. They require an investment of $1.2M. They are willing to bear the risk for copper fluctuation. In their review with engineering, it seems that they will require a small deviation from what is shown on the drawings. In addition, your engineering team will have to compress their testing/validation requirements to achieve the proposed launch timing. This launch timing is critical because it is expected that your competition is working on a similar product that will launch 6 months after McFly’s. You need to beat them to market to achieve market penetration and brand recognition. Brown Enterprises has been an exceptional supplier in the past. Engineering loves them. Historical quality is rated at 95 on a scale of 100. Their delivery has also been very good and there are responsive to your manufacturing team. The delivery score is 96. They will produce in Japan. Their price is fixed assuming that foreign exchange does not vary by more than 10%.
Tannen Corp has given you a very competitive offer of $38.50. They are only looking for an up front investment of $895,000. Because the price is so competitive, they have asked McFly to share in the copper risk. The price would need to be adjusted quarterly for copper fluctuation. In return, they are offering productivity of 3% per year in years 2, 3 and 4. Engineering is a bit skeptical of their proposal. It appears to meet timing, but if there are any issues found during the development testing, launch will be delayed. They also need $100k in additional testing costs (incurred by McFly). This supplier has been satisfactory in both technical and quality (score: 80). They have also had some recent delivery issues that have dropped their score to 70. They produce in China. They will take any foreign exchange risk.
Parker-Wilson has provided a very, very thorough proposal. They always have exceptional technical and quality performance. They spend money on high-tech capital equipment to ensure that they do not have quality spills. Their quality is impeccable. They score a 99 on 100 point scale. Delivery is 95. Their quoted price is $43.00. They have offered 5% productivity in years 2,3, 4, and 5. Required investment is $1.2M. They would like to share the copper risk, splitting the indexation 50/50 on a quarterly basis. They will produce in Texas, and they can meet timing requirements.
Lastly, you have an offer from Strickland, LLC. They have quoted a price of $40.90 per unit for 5 years. They require $750,000 in investment. Copper must be indexed at McFly’s risk. Their proposal meets timing requirements. Historical technical performance is good. Quality is very good. They deliver flawlessly. They produce in Indiana.
So it seems there are 4 viable options. What do you recommend?
For reference, your cost of capital is 10%.
Please show the NPV of the 4 options. Provide a thorough rationale about why you are recommending who you are recommending.
By the way, Supplier Relations just advised that Tannen has just hit the radar as being a “Yellow” risk due to recent merger and acquisition activity that might have overextended them.