THE NEW LINE PROJECT
In March 2005, Juan Navarro -recently hired as Development Manager at Herramientas Industriales, S.A.- needed to study the investment in a new line of tools for home use intended to complement the company's range of products. His analysis was the culmination of a long process of technical and market research that had cost the non negligible sum of 135,000 euros. He was due to make his recommendation to the management committee the following day.
The company manufactured professional tools for workshops. Ten years ago it had successfully entered the market for tools for domestic use too. At the beginning it was hard for the company to get a space for itself in the hardware stores and hypermarkets channel, but finally after considerable effort it managed to adequately position itself in this market. However, it had underestimated two facts. The first was that the domestic or DIY (Do It Yourself) market assigned significant value to the aesthetic design of the tools. The second was that it was essential to offer a full range of the most commonly used DIY tools.
Once the company realised the importance of design, it launched a new line of products better suited to consumers' tastes, thus helping revitalise the declining sales at the time. However, given the urgency, the launching was restricted to a too narrow line. The typical consumer looks for a pack of basic tools, but the line the firm had launched was clearly insufficient. They were therefore considering supplementing the existing range with new tools sharing the same design aesthetics. While, on one hand, this new extension to the line would increase sales of the insufficient line of modern design tools, it would also cause significant cannibalisation of the line of old-design tools. After thorough market research, the marketing department in the DIY division came up with the figures shown in Table 1.
TABLE 1
Data in thousands of euros
|
Year
|
1
|
2
|
3
|
4
|
|
Sales of the extension of the modern line
|
754
|
812
|
828
|
828
|
|
Sales of pre-existing modern line without the extension
|
2,189
|
2,189
|
2,032
|
1,819
|
|
Sales of pre-existing modern line with the extension
|
2,208
|
2,313
|
2,285
|
2,129
|
|
Sales of old line without the extension
|
349
|
276
|
202
|
135
|
|
Sales of old line with the extension
|
310
|
209
|
157
|
85
|
The general manager felt that it was not necessary to take into account the cannibalisation of existing products when analysing the project. "Every man for himself," he said. "The cannibalised product has to do the best it can." There was no precedent of an increase in sales in the existing modern line by launching an extension to the line, so there was certain disagreement in the company about how to factor this into the investment analysis, if indeed it should be at all.
All the tools in the old line had a gross margin of 29% on sales, while the gross margin on the modern line tools was 33% on sales.
During the first year of the extension of the line's launch it would require special discounts for the distribution channels estimated at 10% of sales, together with a fixed cost for brochures and merchandising materials of around 50,000 euros.
Juan Navarro was not quite sure how to act with respect to the investment. Manufacturing the extension of the line would need moulds and machinery requiring an investment of around 300,000 euros. This amount would be depreciated at a rate of 65,000 euros a year in the first two years and 40,000 euros a year over the following three years. The line extension would use the existing facilities currently used for the production of the remainder of the modern and of the old line. The operations manager said that if the new line was launched it would have to justify the use to be made of existing facilities with its profitability. These facilities had a book value of 859,000 euros and a replacement value of 1,034,000 euros. It was estimated that the line extension would use more or less 37% of them. This capacity was currently sitting idle, but there were other divisions in the company that were planning new launches that would use these facilities to some extent. Therefore, the operations manager concluded that whoever was going to use these facilities would have to pay for them both as an investment as well as for the corresponding part of the depreciation, bearing in mind that the annual depreciation of these assets came to 186,000 euros.
Moreover, the company was in a period of expansion, and although general overheads are assumed to be fixed costs, the controller pointed out that general overheads had for many years been between 8% and 9% of sales. The logical conclusion of this reasoning was that all investment projects should be allocated such percentage of sales as a cost attributable to them. However, the company's project managers were frontally opposed to this, each maintaining that this growth in general overheads with sales was not attributable to their project, but to the overall growth of the company. If only their project was carried out -they said- there would be no increase in general overheads. The controller admitted grudgingly that what the project managers were saying was perhaps true.
Another point to take into account came from working capital. In the DIY line, once established, working capital tended to be around 20% of sales. However, at the start of the lifetime of a new line, things were different. More credit had to be given to the distribution channel. Inventory management was more chaotic at the start of production of the new line. Historical data suggested that it was normal for working capital to reach 25% of sales in the first year of launch of a new DIY product, subsequently falling to 22% in the second year and stabilising at 20% after the third year.
If it was necessary to liquidate the already existing fixed assets in four years' time, their liquidation value would be around 100,000 euros. The liquidation value of the new investments in four years' time was estimated to be around 45,000 euros.
The company avoided like the plague anything that looked like long-term debt, so all its projects were financed with equity. The company was entirely owned by the Méndez family and Felipe Méndez -its founder- was a man of fixed ideas. "If I can't get a 25% return on my money," he said, "I'd rather spend it. I have no need to invest my money in things that don't give me this kind of return."
With all this going round in his head, Juan Navarro readied himself for an analysis of the investment that would enable him to make a recommendation as to whether the investment was attractive or not. He knew the general manager was waiting to see how he undertook this analysis in order to judge his technical ability. The finance manager had been cautious about expressing his views on the issues he raised a few days ago about the project analysis. The controller and the operations manager were reputed figures within the company and would defend their positions vehemently. Project managers tended to defend to the hilt anything that represented a potential boost to the chances of their project going ahead and frontally opposed anything that might hold it back. They were expecting to find out how the analysis would treat the use of the idle capacity that was going to be used by the expansion of the DIY tools line. Juan Navarro did not want to make a fool of himself at the meeting the following day -the first important meeting since he recently joined the company- thus he dusted down the cases he had studied while taking his MBA a couple of years ago at a prestigious business school in Madrid. As usual, no case was exactly like the situation he was facing but some of them could offer some ideas relevant to the difficult decision he had to make.
Note: The company tax rate was 30%.