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In the Pieles de La Garriga case study we have to decide whether we are going to accept the offer of Comerpiel and under which conditions. In order to make our decision we have to consider some criteria. The criteria that I identified as the most important are the lack of capacity for the first month if we decide to take the whole order, the profit or loss, the risk that Comerpiel will back out the contract, and the strategic implications of our decision.
None of the alternatives is perfect. So we have to decide which of the criteria are the most important and to choose the alternative that satisfies them the most. For me, the most important criteria are the strategic implications and the maximum profit that we can make. I don't think that the risk is so high and the problem with the capacity can be solved if we pay some overtimes.
So, I chose to accept the whole order of Comerpiel (to produce both the small and the large bands) and to ask for a price 5% higher than the suggested. By choosing a price 5% higher we can earn much more profits and at the same time we reduce he financial risk.
The first thing I am going to do concerning the analysis is to define the problem that we are facing (I consider myself in this case as a partner of Pedro). Basically we have to make a decision. We have to decide if we are going to accept the offer of Comerpiel and the conditions of the agreement. The conditions have to do with the products that we will have to deliver (small bands, large bands or both) and the price of these products.
The next step is to choose the criteria that we are going to take into consideration. In my opinion, the most important criteria are the following (their order does not indicate their importance):
I am going to start with the capacity of the machine and the capacity of the rest of the factory. As we know, if we order the machine now (which is the end of August) it will take approximately two weeks to be delivered and start working (without taking into consideration any possible delays). That means that we will have approximately two weeks time to produce the first delivery. That delivery (at the end of September) consists of the 30% of the total amount and if we choose to produce both the small and the large bands it will take us about 18 working days to produce it (if we assume that each day has 8 working hours).
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Considering the total capacity of the factory, I don't think that we will have any problems since even if we accept the whole order there is still going to be extra capacity (according to Pedro).
The next criterion I am going to discuss is the profit or loss we expect to make from this order. The earnings from the order depend on the following factors:
1. The price that we are going to sell the products. As we know, Beatriz (manager of Comerpiel) suggested $35 for the large bands and $14 for the small bands. Whatsoever, according to Pedro, it might be possible to achieve prices which are even 10% higher.
2. The products that we will decide to produce. We can decide to produce small bands, large bands or both.
3. The products that Comerpiel will be willing to buy. There is a possibility that Comerpiel is going to stop buying our products if the hats and the gloves that they are selling do not do well in the market. There are many possibilities there. They might want to stop buying only the small bands, only the big ones or both. Furthermore, there are many times during the year that they can stop buying. Of course, the later they choose to stop buying, the better the financial results are.
In calculating the costs of production we also have to make certain assumptions:
1. The cost for producing the bands is 13,49 for the small ones and 30,76 for the large ones.
2. In the case that we want to produce both the small and the large bands, for the first month 3 more workers will have to operate the machine during the weekends or the afternoons. They will have to work for 8 extra eight hour shifts and they will be paid 60 euros per day. These workers will only do the special finishing. The rest of the production procedure will be done during the ordinary shifts, as we have enough capacity to do it.
3. Taking the worst case scenario I consider the value of the machine after the production of the order practically zero. So we shouldn't calculate any depreciation costs.
4. In case Comerpiel decides that they don't need more bands, they will inform us when we will have produced half of the bands needed for the monthly delivery. That is the average of the worst case scenario (to inform us when we will have produced the whole delivery) and the best case scenario (to inform us before we start producing).
In exhibit 2 I present the profit/loss for all the cases that I explained under the assumptions that I made.
I would also like to analyze the risk that we are taking by accepting the order. As we can see from the results in exhibit 2, if Comerpiel cancels the order during the year we might have significant losses (up to 200.000 euros). That is a lot of money for us since all the profits of the rabbit pelt division per year is about 750.000 euros (in order to calculate this, I used the margins for the two types of bands and I assumed that we produce 50% small bands and 50% large bands).
The last criterion is the strategy. To be more specific, I mean the strategic implications that there would be if we "disappoint" Comerpiel by not accepting the order (or accepting part of it). The last thing that we want is Comerpiel to give that order to another company. Our cooperation with Comerpiel is a strategic mater for us because they help us to enter the world of furs.
Considering all the criteria that we have, we must now decide what we are going to do.
As we can see from the exhibit 2, producing only the small bands is no profitable at all. So, we should forget about that option.
If we produce only large bands the risk is less, comparing it with the risk of producing both. Of course, in case Comerpiel eventually really wants to buy the whole quantity of both the small and the large bands, we might lose a lot of profit. Furthermore, by not choosing to produce the small bands we might lose some of the trust of Comerpiel.
If we choose to produce both the small and the large bands the first problem we are going to face is the insufficient capacity (this is going to cost us some overtimes).On the other hand we take a strategically better decision and we can make very big profits if Comerpiel follows the terms of the agreement. Of course, it is a more risky decision because we can end up with a lot of losses. But how probable is that Comerpiel will cancel the order? And if they cancel it, is it going to be during the first months? I believe that Comerpiel is a very reliable partner of ours and they seem to know very well what they are doing. So, I think it is quite improbable that they will stop buying our products, especially in the first months.
One way to reduce the financial risk of producing both the small and the large bands is to increase the price. On the other hand, by increasing the price we add another risk. We add the risk of Comerpiel considering the price very high and choosing another producer. So if we increase the price we should be very careful of how much we are going to increase it.
After taking into consideration all the criteria and the alternatives that I described, I concluded that the best option is to accept the whole order of Comerpiel (for both the large and the small bands) and sell it 5% higher than Beatriz suggested. As we can see from exhibit 2, it is quite a financially risky decision (but not as risky as without increasing the price). The main reasons why I would be willing to take that risk are that it is a strategically better move and also because I believe that the probability that Comerpiel will back out the contract is relatively small.
Number of eight hours shifts needed to complete the deliveries.
Small bands Large bands Both
Total amount: 27 35 62
30% 8 10 18
20% 5 7 12
Profit/loss for all the alternatives described.
In case we produce only the small or only the large bands:
Time they stop buying Suggested price
Price +5% Price +10%
Produce only small bands Don't buy at all -120705 -120705 -120705
Stop buying in October -95880 -89580 -83280
Stop uying in November -113055 -102555 -92055
Stop buying in December -88230 -71430 -54630
Don't stop buying -44700 -23700 -2700
Produce only large bands Don't buy at all -152280 -152280 -152280
Stop buying in October -96080 -85580 -75080
Stop uying in November -109880 -92380 -74880
Stop buying in December -53680 -25680 2320
Don't stop buying 24800 59800 94800
Large Don't buy Stop buying Stop buying Stop buying Don't stop
at all in October in November in December buying
Suggested price Don't buy at all -213705 -188880 -206055 -181230 -137700
Stop buying in October -157505 -133400 -150575 -125750 -82220
Stop uying in November -171305 -147200 -164375 -139550 -96020
Stop buying in December -115105 -91000 -108175 -83350 -39820
Don't stop buying -36625 -12520 -29695 -4870 38660
Price +5% Don't buy at all -213705 -182580 -195555 -164430 -116700
Stop buying in October -147005 -116600 -129575 -98450 -50720
Stop uying in November -153805 -123400 -136375 -105250 -57520
Stop buying in December -87105 -56700 -69675 -38550 9180
Don't stop buying -1625 28780 15805 46930 94660
Price +10% Don't buy at all -213705 -176280 -185055 -147630 -95700
Stop buying in October -136505 -99800 -108575 -71150 -19220
Stop uying in November -136305 -99600 -108375 -70950 -19020
Stop buying in December -59105 -22400 -31175 6250 58180
Don't stop buying 33375 70080 61305 98730 150660
In case we produce both the small and the large bands: