The Director of the European Interior Components Product Line Team of Morgan Components Company, Sean O’Fearna is facing a difficult decision. He needs to respond to the price reduction request on a door panel project, which would take-off in six months. The initial contract was signed at a price of 90 euros between Asiacar and Plasticom. Morgan Components took ownership of the contract, as it acquired the Clondalkin plant of Plasticom.
The project was seen infeasible by Morgan Components executives, even before the price reduction. Therefore, first a unit based cost breakdown analysis was applied. It was observed that with the current production processes, the minimum price that Morgan Components could afford was 80 euros. Then the possible process improvements and cost reduction alternatives were analyzed and redesigning the door panel to reduce its features was identified as a must. The other two alternatives of reducing scrap and in-house production of X-27 had their own shortcomings like high initial investments and going against company policies, and therefore should only be applied if the price was restricted to very low levels. (e.g. at 73 euros Alternative of reducing features should be supported by reducing scrap to maintain profitability. For all the price levels below 72 euros, all three measures should be taken)
Then, the auto industry was analyzed with regards to the purchasing regimes in the first years of a new launched product. The outcome was that even a failure product driven to market by Asiacar would necessitate Asiacar to buy at least 30,000 units of door panels in total. (A moderate success would result in the purchase of 100,000 to 200,000 units and a real success would take the sales number of Morgan Components up to 300,000 units.) In the light of this analysis a comparison of worst case scenarios were made. The result showed that even in the worst case scenario of going on with the Asiacar contract, Morgan Components would be better off than canceling the contract.
Moreover, a series of arguments were prepared for Sean O’Fearna to present his seniors within Morgan Components to convince them on this argument and get permission to go on with Asiacar contract. Financial situation and the diversification policy of Morgan Components, under capacity production of the Clondalkin Plant and the importance of Asiacar as a client were among these.
Then a price range was provided to Sean O’Fearna before his negotiations with Asiacar. He should keep the price at a level between 75 to 81 euros not to forgo the contract, while maintaining profitability. To be able to achieve this, the credibility of the Japanese supplier threat was argued and the risk of changing suppliers for Asiacar was quantified as 5 to 7 euros. Besides, counting on the fact that Clondalkin had the rights to redesign the door panels for Europe up to now, and Asiacar had already invested 2 million to Clondalkin redesigns, the Japanese threat was further diluted. However, these arguments would not mean much without Sean being able to put them clearly on the table during negotiations.
Therefore a clear negotiation action plan was outlined in order for Sean to persuade Asiacar to carry on with the contract at a price level of 78, which would reduce the risk on Morgan Components and may even provide a profit of 1.8 million euros in the best case scenario, while, on the other hand, providing Asiacar a savings potential of 3.6 million euros.
Problem Statement & Alternatives
The main problem Sean O’Fearna is facing in the Morgan Components Case Study is that he needs to give a response to the 25% price reduction request of Asiacar. This reduction is requested on a door panel contract, for which some investments are already made and the process is to be started in six months. Sean is concerned about the potential losses that may arise after this price reduction, and the potential risks of canceling the whole contract.
First of all Sean needs to decide on whether to carry on with the contract or cancel it right away, analyzing the cost structure of the door panels. Moreover, he may need to choose a way to modify his production processes to reduce his costs. Afterwards, if he decides to carry on with the contract, he will need to decide on a minimum price that he may afford and come up with a price range, mutually acceptable for both Asiacar (AC) and Morgan Components (MC).
Since Sean himself is not in a position in the organizational structure of MC to decide on such a critical issue all by himself, he will need to discuss the upcomings with his own superiors, before starting a negotiation with AC. In this context, he has to identify the strengths of his arguments that he should draw on during his dialogues with both MC executives and AC representatives.
All the decisions Sean needs to take are constrained in five main criteria, all of which will be taken into consideration to provide a framework for the analysis.
First of all is the risk of canceling the contract right away. Since some investments has already been made and considering the Clondalkin Plant running with 60% capacity currently, quitting the contract will require firing some workers and in total incurring a non-recoverable loss of 3 million euros.
Second important aspect is the profitability of the AC contract. Taking into account the potential risks contained within the structure of the contract, the cost structure of the door panel production should be re-analyzed to determine the maximum potential profit and potential losses that may occur at the end of the contract period.
Third criterion is the MC organizational structure and corporate strategy. The organizational structure will affect the decisive ability of Sean himself and the possibility of that a certain modification in the cost allocation structure of the contract may be applied. Moreover, alternative cost cutting methods should be analyzed with regards to the strategies of the company.
The fourth key point is AC as a company and its current condition. The relations of MC with AC and the significance of AC to MC as a strategic client have important impact on the decisions of both Sean and the senior management of MC, who are seeking for diversification. Furthermore, the Japanese Supplier threat put forward by AC should be analyzed in the context of AC being in weak financial situation and currently running a revival plan.
Finally, Sean and his relationship with the Clondalkin Plant and the Clondalkin town should regularly be considered during analysis, in the sense that he may not yet be able to think unbiased from MC’s side, since he has worked for long years at Clondalkin before MC bought the plant.
Analyses of Alternatives in the Framework of Relevant Criteria:
1. To carry on with Asiacar contract or to cancel it right away
The first issue to observe before making this decision for Sean is to figure out the losses the company is going to face. It is clearly stated in the case that the company is going to lose 3 million euros if the contract is cancelled now. So, Sean needs to check the alternative of going on with the contract and analyze the profitability of it, in order to make a net comparison.
To have a better judgment of the profitability of the door panel contract, Sean first needs to analyze the costing methods of Plasticom and MC. He needs to spot out the Two main differences are in the labor costs and the corporate overheads. Assuming that wages might have been increased after the factory was bought by MC in order to increase motivation and gain worker loyalty. Moreover, since the wages might as well rise in the following five year contract period, the increased labor cost approach seems conservative, but logical. On the other hand, the corporate overheads are only an allocated portion of MC headquarters’ costs; they have no direct relation with this contract alone and do not affect the potential positive cash flows. As Sean convinced MC executives not to consider the corporate overheads to carry on with the project before, they definitely will not be included in the analyses for such a critical decision of canceling the contract.
The next step in the analysis of costs should be to decide whether AC is going to buy 300,000 units in the following five years and how the purchases will be distributed over years. It can be certainly understood from Sean’s doubts, that in the AC contract there’s no restriction for AC to buy 300,000 door panels. Also, big manufacturing companies tend to transfer market risks on to the supplier as a procurement strategy. It is often the case that if the product of a main company does not sell in the market, it is the supplier who suffers because of not being able to compensate initial investments.
Therefore, it is crucial to analyze costs on per-unit base and to carefully differentiate variable costs and fixed costs. Exhibit-1 shows the recommended cost structure per unit door panel. The reason that indirect labor, maintenance and factory overheads were incurred as variable is that these costs tend to change with the volume of production and would disappear if there were not door panel production. Even factory overheads are allocated on to projects according to production volumes.
So, it is obvious from Exhibit-1 that Sean cannot afford to carry on with the contract at a price of 68 euros per panel unless a cost reduction in the production process is made. Then, the decision of going on with the contract depends on the next decision step, which is;
2. To choose which alternative cost reduction methods to implement
Sean has three alternative ways to reduce production costs of door panels. First of which, – now on to be called Alternative-1 – is to reduce the features of the panel design. Alternative-2 is to reduce scrap and Alternative-2 is to produce X-27 in-house. All possible combinations and outcomes of these process improvements are given in Exhibit-2. As it is seen, the Alternatives 2 and 3 are inefficient to reduce the cost below the 68-euro level. Their effect is more adequate when combined with Alternative-1.
On the other hand, the Alternatives 2 and 3 bring some shortcomings with them. First of all, Alternative-3 requires a non-strategic component to be manufactured in-house and may cause a supplier to go out of business. This is both against two critical criteria; MC corporate policies and Sean’s relations with Clondalkin. Moreover, both Alternative 2 and 3 require an increase of initial investments. This increases the risk undertaken by MC with regards to the fact that the amount of purchase and its distribution over the years is ambiguous. Exhibit-3 presents possible procurement regimes that may be followed by AC according to the success level of their new car model. A summary of Exhibit-3 may be that while a successful or moderately successful model would create a purchase of over 100,000 units of panels, the failure of AC would mean sales of below 100,000 units for MC, but particularly not below 30,000.
This analysis enables us to compare worst-case scenarios and make a distinct comparison between canceling the contract and going on with it. Exhibit-4 demonstrates this comparison. According to this, it is clear that even if AC’s new model is a failure, MC would be better off by continuing with the contract with minimum condition of implementing cost reduction Alternative-1 is met. Sean should do everything he can to keep this contract, in order to minimize Clondalkin’s losses.
3. Affordable Price Range and the Effect of Price on Cost Reduction Alternatives
Graph at Exhibit-5 illustrates the variation in breakeven points of the AC contract with different cost reduction alternatives at different price levels. This graph is essential in several ways: First, the minimum affordable price for MC is 72 euros, assuming that it is the probability to sell more than 300,000 units with this contract is very low. It also reveals the cons and pros of the alternative cost reduction methods. For example, if the price level is restricted to a level of 72 euros or below by AC, then the trade-offs of Alternatives 2 & 3 are less important compared to the profitability increase they bring and both should be implemented immediately. If a price of 73 euros may be negotiated with AC, then the implementation Alternative-3 may be postponed or completely dropped due to its shortcomings and only Alternative 1 and 2 would be enough together to bring MC to a breakeven at 300,000 units. At even higher price levels, alternatives 2 and 3 lose their significance and MC may carry on the contract only with Alternative-1.
However, can the price reduction request of 25% be negotiated with Asiacar? Is the Japanese threat credible? What are the arguments and strengths that Morgan Components has in hand to increase the requested price to a higher level? How important is this contract and the relationships with Asiacar for both Morgan Components and Sean himself? All these questions and more need to be answered in order to come up with a down to earth action plan that can be applied immediately to get Sean and Morgan Components out of this situation without any significant losses.
In the light of the analysis made, my recommendation for Sean O’Fearna is to go on with the Asiacar contract with whatever means possible. This outcome is also supported by the criterion of Sean’s relationship with Clondalkin plant. He, having a strong reputation within Clondalkin, would not want to put the plant at risk by continuing at a capacity of 60% and not making decent profits.
On the other hand, considering the organizational structure of Morgan Components, Sean is not at a position to take such a critical decision on his own. He needs to convince the senior executives of Morgan Components about carrying on with the contract. However, at this point, his strong relations with Clondalkin my turn out to be a disadvantage for him. Morgan Components executives, knowing Sean’s strong tie to Clondalkin may respond to this proposal biased. Therefore, Sean needs to support his arguments with fact, especially the data presented in the exhibits of this report, which clearly show that canceling the contract brings the worst possible outcome.
Moreover, Sean must emphasize on the corporate vision of Morgan Components. Being 80% dependent on only one firm and being very eager about their diversification policy, creating new businesses with Asiacar has high importance of Morgan Components. Asiacar is not a completely new client for Morgan Components and the three plants of Plasticom were acquired by Morgan Components mainly to increase businesses with Asiacar. When compared to the 1.2 billion euro sales size of Morgan, the 27 million euro potential of this contract may seem small at first sight.
However, at this crucial period where Morgan is trying to minimize its losses by all means, letting Asiacar down with this contract would put both current and future businesses of Morgan with Asiacar at stake. In addition to that the Asiacar contract will increase the capacity usage of the Clondalkin plant significantly from 60% to 90%. Clarifying all these critical aspects should get Sean the necessary permissions to start negotiations with Asiacar to continue business with them.
The next step for Sean should be to analyze the possibility of negotiating the requested price of 68 euros with Asiacar. Greatest threat for Morgan Components is the possibility that Asiacar may transfer its supply to a Japanese supplier, which is currently supplying door panels for the Japanese version of the same Asiacar model. Nevertheless, if the nature of automotive industry is analyzed, it will be seen that most of the main manufacturers apply Just-In-Time production procedures, or even if not, they try to minimize their inventory by pressurizing suppliers with tight deadlines and minimum delivery lots. Supplying from Japan to a manufacturer in UK, other than bringing an additional logistics cost of 4 euros, is extremely risky for the manufacturer in the sense that it may increase lead-times and cause inventory pile-ups. Although it is difficult to quantify such a risk, Sean’s target price during his negotiations with Asiacar should definitely be higher than 72 euros.
In that case, what should be the target price for Sean during his negotiations with the Asiacar representatives? Looking at Exhibit-3 again, aiming a price that would breakeven at 300,000 units is far too risky for Morgan Components. On the contrary, trying to achieve a profit even if Asiacar’s new product fails would be too opportunistic and may cause an unpleasant response of direct change of supplier on the Asiacar side. Therefore, targeting a price range that would arrive at a breakeven at moderate success would be my suggestion. This price range may be deducted from Exhibit-5, and falls between 75 euros and 81 euros.
Furthermore, the Clondalkin plant contains a key advantage regarding the Asiacar contract. Clondalkin is not a just a plant that is to produce a given design; Asiacar has provided Clondalkin the initial design and the redesign of the door panel and the necessary adaptations of the design for the European market is carried by the Clondalkin plant. Why is this issue so important? Because of the two vital criteria for Asiacar: Time restrictions and the necessary initial investments. First of all, there are only eight months left for the product launch of Asiacar, which is on May 2005. This means that the first samples of the door panels for the try-outs should be delivered to Asiacar at the latest by January 2005. Thus, the new supplier needs to redesign the product for European Markets, produce the mold, and start the production within 6 months. Would Asiacar take such big risk?
Besides, Asiacar has provided 2 million euros of a total of 5 million euro investment on the redesign of the door panels. Now Asiacar has two possible option, which I recommend Sean to emphasize clearly during the negotiations: Asiacar is either going to provide the remaining 3 million euros and wait until Clondalkin completes the molds and then transfer them to Japan, or come down to accept a mutual agreement for with Morgan Components
In order to be able to build on this argument without being offensive, my recommendation is that Sean should follow such an action plan: First he should mention that Morgan Components wants to support the revival plan of Asiacar and ready for sacrificing to an extent to maintain a sustainable relationship. However he should stress on the fact that pressurizing Morgan Components for a price reduction to 68 euros would result in the shut down of the whole company. He should support this by the data provided in Exhibit-6, which is the re-structured version of the cost breakdown in Exhibit-1. Exhibit-6 will show Asiacar that below 81 euros, Morgan Components will theoretically not make profits for this contract. Moreover, reducing the price down to 81 euros would mean a potential saving of 2.7 million euros for Asiacar. He should also underline the risks and additional costs of working with a Japanese supplier and mention that a 68 euro price from a Japanese supplier would mean the exact same cost to Asiacar to buy the panels at a 73 euro price from Morgan.
Setting his minimum and maximum clearly to 73 and 81 euros, then Sean may start releasing the handles again. Depending on the reactions of the Asiacar representative, he may restate the importance of being an Asiacar supplier for Morgan Components and approach with the favor of going below 81 euros with the following conditions being guaranteed: More future contracts starting form 2005 and the renegotiation of the door panel prices at the end of 2005.
Even after that, if Asiacar keeps insisting on very low price levels, the issue of having the current design in hand and having already expended the 2 million design fund should be raised, but without being offensive or destructive. The objective must be keeping the price in range of 75 to 81 euros.
If Sean may apply my recommendation completely, he should come out of the Asiacar negotiations, with a price of around 78 euros. Having this price settled and implementing a redesign on the panel to reduce features (Cost Reduction Alternative-1), Morgan Components may expect a profit of nearly 1.8 million euros within the next five years, if the project is a complete success. Moreover, since the initial investments will be recovered after 170,000 units, the risk will be also minimized.
Within very tight deadlines and such stressful conditions, following such a structured action plan may not be very easy for Sean O’Fearna to apply, however, with the above given key points in mind he should be able to achieve the outcome to save his professional reputation, Clondalkin Plant’s future and moreover, to provide a decent profit for his new company, Morgan Components.