Custom-widget Manufacturer to Increase Prices by 30%
Case Type: business turnaround; improve profitability.
Consulting Firm: Kaiser Associates first round full time job interview.
Industry Coverage: industrial equipment.
Case Interview Question #01165: Our client is Osterley Industrial Inc., a manufacturer and retailer of high end, made to order, custom metal widgets based in the United States. Osterley Industrial has been generating losses for 3 years. To turn around the business, the company’s board recently named a new CEO.
Osterley Industrial’s new CEO has hired our consulting firm to help him understand why the company has been unprofitable and to provide some suggestions that would help the company return to profitability. How would you go about it? What recommendations would you make to the new CEO?
Additional Information:
The new CEO provides the following information to our consultants:
* Average monthly sales (2016): $225,000
* Cost of Goods Sold (COGS): 64% of sales
* Selling, General, and Administrative Expenses (SG&A): $81,000
* Interest and Other Expenses: $15,000
Possible Answers:
Question #1: Please calculate the company’s average monthly losses.
Possible Answer:
Profits/Losses = Revenue – Cost = $225,000 – ($225,000 * 64% + $81,000 + $15,000) = -$15,000
Question #2: It takes on average, 3 months to produce a custom-widget. The process requires a great deal of highly-skilled manual labor. Osterley uses a cost-plus pricing mechanism to set prices. Based on the custom specs required by each individual client, Osterley first calculates the total cost to produce the widget by estimating the expected labor and raw material costs and then multiplies the total cost by 1.5 to calculate the retail price. The average price of a widget is $25,000. 100% of Osterley’s sales are made-to-order and are delivered immediately once the widget reaches finished goods inventory.
The overall industry for custom widgets is relatively small and has been growing at a very slow pace. Osterley’s booked revenue has increased by 3% per year. Osterley is the leader in the industry and typically sells at the highest prices. Market studies show that Osterley’s raw material and labor costs are similar to the company’s competitors. Osterley is known for having the best widget designers; however, the industry has never wanted to pay extra for design services, which is why the company makes all of its revenues by selling the widgets. Although Osterle’s widgets last longer than the competition, there are many customers who do not buy their widgets at Osterley because they are “too pricey”.
Based on this information, please provide three reasons as to why Osterley may be losing money?
Possible Answer:
a. Increases in SG&A. Widget designers may have become too expensive. At the current level, the company would require higher sales in order to cover its SG&A costs AND make a profit.
b. Company may not be fully capturing the value generated by the widget designers in the widget’s price. Cost-plus-pricing method might be leaving money on the table.
c. Company is too highly levered and cannot cover the high interest expenses.
Question #3: From looking at the company’s sales data, you discover that Osterley has been generating $250,000 in new orders per month. Osterley’s accountant explains to you that Osterley cannot book a sale until the widget has been produced AND shipped to the customer. You also discover that the factory has been producing per month on average $225,000 worth of orders, which is the same amount that the company’s income statement shows in sales per month. You also uncover from customer interviews that customers across the board are complaining about missed delivery times, although some customers were much more “frustrated” than others.
Given that the company has been generating more orders than what it has been producing for 36 straight months, what do you think has happened to those orders?
Possible Answer:
If the number of orders coming in the system is higher than the number of orders leaving the system, that means that the company has a backlog of orders that is increasing every month.
Question #4: Assuming the company has been producing on average $225,000 worth of widgets per month and receiving $250,000 worth of orders per month for 36 months, how large is the backlog? If Osterley sold $225,000 in new orders today, how long will be the delay in months?
Possible Answer:
a. Backlog: $25,000 per order * 36 months = $900,000 of orders.
b. Delay: It would take Osterley $900,000 / $225,000 per month = 4 months to cover the backlog.
Question #5: How much would the company earn if it was able to expand capacity to$ 250,000 worth of orders per month?
Possible Answer:
* Average monthly sales: $250,000
* Cost of Goods Sold (COGS): $250,000 * 64% = $160,000
* Selling, General, and Administrative Expenses (SG&A): $81,000
* Interest and Other Expenses: $15,000
* Profits/Losses: $250,000 – ($160,000 + $81,000 + $15,000) = -$6,000
Question #6: From a conversation with the plant manager, you find out that expanding capacity is very difficult because skilled widget designers are hard to find and new machinery would not increase the capacity. Outsourcing is also not possible because Osterley does not trust the quality and reliability of other manufacturers and are too expensive for Osterley to be able to make the necessary margin to cover its costs.
Based on all the previous information, please advise the CEO as to what to do next. Please explain and detail your assumptions. Please show the potential impact of your recommendations.
Possible Answer:
a. The best option for Osterley at this point is to raise prices given that it cannot expand capacity and that it’s not capturing the value of its valuable widget designers. The assumption here is that there is a large % of Osterley customers that are not price sensitive and would still purchase widgets from Osterley at a much higher price.
b. For example, if Osterley increases prices by 30% and 22% of customers do not purchase widgets due to the price increase, Osterley would have roughly the same revenues ($25,000 * 130% = $32,500, 9 * 78% = 7, $32,500 * 7 widgets = $227,500), but much lower costs of goods sold ($16,000 * 7 = $112,000 vs. $16,000 * 9 = $144,000). With this price increase, the company could swing to a $19,500 monthly profit, despite losing some customers.
* New price: $25,000 * (1 + 30%) = $32,500
* Number of widgets sold: 9 * (1-22%) = 7
* Average monthly sales: $32,500 * 7 = $227,500
* Cost of Goods Sold (COGS): $16,000 * 7 = $112,000
* Selling, General, and Administrative Expenses (SG&A): $81,000
* Interest and Other Expenses: $15,000
* Profits/Losses: $227,500 – ($112,000 + $81,000 + $15,000) = $19,500
c. Osterley could also consider trying to reduce some of its SG&A costs and interest costs.