When a competitor develops and introduces a superior product, that is less costly to manufacture and even many times usable and durable, Hans Thorborg, the general manager of the German plant of Precision Worldwide, Inc.(PWI), and his team have to decide to math the competitor’s product. When to do so, how to price or what sustainable competitive advantage they need to adopt during the next strategic period, given that they hold a large inventory, which is now inferior product.
PWI is confronted not only with a substitute product that is both cheap and durable; Compared to PWI’s steel rings, the plastic rings being produced by Henri Poulenc is both cheaper and lasts longer. PWI is also facing the risk of earning the ire of its customers if it manufactures but selectively introduces the cheaper plastic rings in areas where it faced with the ‘plastic’ competition.
Hans Thorborg may open many alternatives decisions as the following: Stay out of plastic rings. However, continue to sell steel rings and do not manufacture/sell plastic rings do not seem like a feasible decision because for its survival PWI will have to plan strategically and keep with competition. It is just an issue of time, when to sell plastic ring.
Stop selling steel ring. It may be a necessary action need to take, but when is the earliest stop date is a concern. Otherwise, sell steel ring until plastic ring available and dispose of remaining steel ring and steel inventory, or stay out of plastic ring until all steel ring inventory is sold.
Manufacture more steel rings with excess labor in the Summer.
Do or do not sell plastic rings only in France and continue to sell steel rings in other markets.
In order to make good pricing decisions, Hans needs to identify what are the relevant costs in both steel and plastic ring and compare their contributing margin (CM). As the note in Table A, “OH was allocated on the basic of direct labor cost, and the variable OH costs amounted to 80 cents per direct labor dollar,” the allocated fixed OH cost is not relevant and the CM of plastic and steel rings is $1,214.45(90%) and 674.40(50%) respectively (Exhibit1.)
We can easy see that the plastic rings is less variable cost and higher CM than that of steel ring. As a result, plastic ring is more contributing forward to cover the fix cost, given that the plastic total cost is less than that of steel, so plastic ring is more profitable.
However, if the rings are produced in the summer, PWI will have a huge saving cost. The reason of having this huge saving cost is that special steel will become a sunk cost if it does not use in summer, so the direct material uses as free cost, and that the direct labor will decrease because in policy states “employing excess labor (70% of regular wage) on various make work projects rather than laying worker off.”
Consequently, the OH will decrease as well as direct labor cost(Exhibit2.) Moreover, there will be the effect of unequal lives on these relative contributions, that is, the steel rings have four times replacement frequency more than plastic’s, so the equivalent contribution of steel rings is much higher (Exhibit3.) However, the price of steel rings should drop to have a competitive price, and the Exhibit 4 is shown the minimum price, $551.20, at which selling the existing steel rings can reach; Assuming that plastic rings sell for $1,350.00 and equivalent contribution of steel are equal that of plastic ring.
For the 15,100 finished steel rings that will still be on hand in September will be used up based on the estimates of periodic and regular consumption. Assume that sales continued at the current rate of 690 rings per week, the estimation is shown in Exhibit 5, that is 5,5 months to sell the finished steel rings and 18 months to sell all of them. In order to sell as quick as possible the steel rings, Hans needs to mark down the remaining inventory to the minimum price calculation above and give more discount when customers buy the large volume.
What is the maximum loss if all steel rings were scrapped in September? The maximum loss, $433,589, will be the difference between contribution margin of steel and plastic rings (Exhibit6.)
The actions Hans Thorborg should take is that continue selling steel rings till mid-September, then introduce plastic rings in France at least. Also, he needs to determine how long steel rings can be sold in all markets, but keeping in mind competitive pressures and potential loss of customer goodwill. It is possible for him continuing to sell steel rings for six months after mid-September, so this will allow him to deplete existing inventory of finish rings. Also, he needs to start retooling, reengineering the production lines for the plastic rings, so reduce the cost of plastic rings, and be able to compete with Henri.
Exhibit 1: Relevant Cost and Contribution Margin of Plastic Rings and Steel Rings
|100 Plastic Rings |100 Steel Rings | |Selling Price |$1,350.00 |$1,350.00 | |Material Cost |$17.65 |$321.90 | |Direct Labor Cost |$65.50 |$196.50 | |Overhead Rate |0.80 |0.80 | |Direct Overhead |$52.40 |$157.20 | | | | | |Total Variable Cost |$135.55 |$675.60 | |Contribution Margin,$ |$1214.45 |$674.40 | |Contribution Margin,% |90 |50 | |
Exhibit 2: New contribution margins if PWI products in summer
|100 Plastic Rings |100 Steel Rings No Labor Saving |100 Steel Rings with Labor Saving | |Selling Price |$1,350.00 |$1,350.00 |$1,350.00 | |Material |$17.65 |$0.00 |$0.00 | |Direct Labor |$65.50 |$196.50 |$137.55 | |Variable Overhead Rate/DirectLabor Rate |0.80 |0.80 |0.80 | |Direct Overhead |$52.40 |$157.20 |$110.04 | | | | | | |Incremental Cost |$135.55 |$353.70 |$247.59 | |Contribution Margin,$ |$1,214.45 |$996.30 |$1,102.41 | |Contribution Margin,% |90 |74 |82 | |Exhibit 3: Effect of unequal lives
|100 Plastic Rings |100 Steel Rings Variable Cost |100 Steel Rings Opportunity Cost | |Selling Price |1,350 |1,350 |1,350 | |Variable Cost |135.55 |675.60 |247.59 | |Contribution |1,214.45 |674.4 |1,102.41 | |Replacement frequency |1 |4 |4 | |Equivalent Contribution |1,214.45 |2697.6 |4409.64 | |
Exhibit 4: Minimum steel ring price can reach
|100 Plastic Rings |100 Steel Rings Variable Cost |100 Steel Rings Opportunity Cost | |Equivalent Contribution |1,214.45 |1,214.45 |1,214.45 | |Replacement Frequency |1 |4 |4 | |Contribution Margin,$ |1,214.45 |303.61 |303.61 | |Total variable Cost |135.55 |675.60 |247.59 | |Minimum price |1,350 |979.21 |551.20 | |
Exhibit 5: Estimation periodic of finishing inventory
| | | | | |Item |Rings |# Ring Selling /Week |Weeks of Inventory |Months of Inventory | |Previous Finished Rings |15100 |690 |22 |5.5 | |Raw Steel |34500 |690 |50 |12.5 | |Total |49600 |690 |72 |18.0 | |
Exhibit 6: The maximum potential loss
|Steel Rings |Plastic Rings |Difference | |Number of Rings Sold |49600 |12400 | | |Selling Price/100 rings |1350 |1350 | | |Revenues |669600 |167400 | | |Cost: | | | | |Convert 34500 steel rings at $247.59/100rings |85,418.55 | | | |Manufacture 12400 plastic ring at $135.55/100 rings | |16808 | | | | | | | |Contribution Margin,$ |584181.45 |150592 |433589.45 | |