This case uses a marginal analysis of several options that will solve a problem. It takes revenue and expenses that are affected by the problem and ignores those that are not affected. It’s a common way to focus on the impact of a decision without information that can cloud the issue.
This should not be confused with an income statement even though it is in the same format. A full profit and loss statement includes all revenue, direct production expenses that lead to a gross margin, general and administrative expenses, and taxes. This analysis is likely to have you choosing a solution based on the lowest cost. Revenue is a factor in terms of how supply chain activities affect it.
Read the case, and review the analysis spreadsheet. Focus on the forecast first with emphasis on the financial impact of quality issues on a company’s sales over and above the scrap, rework, and product replacements that poor quality creates.
Note that each option’s spreadsheet has the exact same rows. Rows are populated with values when they apply to the option and are blank when they do not apply. This preempts management questions at presentation time. “Where’s (fill in the blank)?” has sidetracked many a presentation to management.
You are the Director of Purchasing at Endurance Products, Inc. Endurance produces and distributes compact, attractively priced exercise equipment. The company’s mission is:
Outperform the competition through successful partnerships while maintaining effective communication, consistency, superior service, and honest, active marketing programs. Stamina Products Inc. will continue to pursue excellence. Whether it’s the design of our equipment or our exceptional customer service, we are truly dedicated to building a healthier, stronger you.
You supervise production of the Endurance folding exercise bike with a built-in heart rate sensor. The bike, which has a suggested retail price of $98.00 at Walmart, Amazon, QVC, and various other outlets, is popular among apartment dwellers and others with limited space for storing exercise equipment. The gross margin on the bike, 35%, isn’t spectacular; but it’s a profitable product that will contribute more as sales grow because there will be no incremental G&A expenses tied to growth for the foreseeable future.
The product requires simple assembly by the consumer. The frame is ready to use after the pedal box, the seat, and the handles with sensors and the heart rate monitor are attached. Total time to unpack and assemble the bike is 25 minutes for most buyers.
Price, which is significantly lower than competitors’ folding bikes, is Endurance’s competitive advantage for this product. However, consumers of fitness equipment demand quality even at the low end of the market.
Endurance shipped 82,400 folding bikes in the fiscal year that just ended on January 31, very close to its forecast. An increase in the upcoming year is unlikely due to some recent quality issues that must be addressed, so a volume increase is not in this year’s forecast.
Demand was distributed evenly month by month with one exception. New Year’s resolutions caused January to account for 20% of a year’s total sales. Timing of shipments for January sales always is the key to capitalizing on the demand spike. Retail outlets are preoccupied with holiday related sales through December 25th. They do not want to add inventory until then; but when December 26th arrives, they want three weeks of steady delivery to match demand.
Endurance ships approximately 6,000 units per month February through December. It ships just over 16,000 at the end of December and into January. The company analyzed the costs and risks of matching production to demand and decided to produce at a constant monthly rate instead. Bikes are packaged and stored in a nearby warehouse. The growing inventory is depleted when the January demand spike occurs. The warehouse space costs $0.25 per square foot per month plus $0.10 per square foot for utilities. To date, Endurance has not used more than 30% of the facility’s 50,000 square feet of space.
All parts of the bike are imported from non-US suppliers to be packaged and shipped from Endurance’s Indiana operation. The only assembly performed in Indiana is attaching the heart monitor to the hand handles. Endurance packed those two parts separately and had consumers join them, but that process proved challenging for many users. Providing the pre-assembled handle-monitor part preempted warranty claims, eliminated the need to have a tech service team, and increased customer satisfaction as shown in sellers’ product ratings.
Frames, hand handles, and the pedal assemblies are made in Mexico. Frames and handles are made by The Permaneo Company in a former auto parts factory outside of Mexico City. Pedal assemblies are made by Aguante Enterprises of Ciudad Juárez, a joint venture of The Permaneo Company and El Paso’s Might-Could Enterprises. Both businesses have been reliable, low cost providers.
The heart rate sensor was made in China through January of 2019; but after six months of 25% tariffs with no end in sight, Endurance decided it no longer could absorb the extra import cost on such a tight margin product. Several potential suppliers bid on the contract; and a Malaysian company, Ketahanan Industries, won the business.
The change to Ketahanan Industries as the source for heart rate sensors has not met expectations. Ketahanan produced the assembly for $5.50 per unit, $1.00 less than the next lowest cost bidder. Shipping cost is $1.00 per item, the same as it was when it was shipped from China. The problem is that nearly 4% of the sensors stopped working within 90 days of use. The failure rate had been less than 2% when they were made in China. Endurance replaces failed sensor units at no charge.
Because online reviews are disproportionately filed by dissatisfied customers, the folding bike’s ratings fell. On Amazon, for example…
Table 1: Ratings of online reviews
|Rating||Before Ketahanan||After Ketahanan|
Marketing data suggests that high and low ratings influence sales either positively or negatively by 10% of the year’s forecast.
Endurance has the right to deduct the cost of defects identified through its packaging process; but because bikes can be stored in the warehouse for up to 11 months before they’re sold and it will take time after that for sensors to fail in the field, there is no provision for recovering the cost of items that fail months after delivered.
As the director of Purchasing, you will lead the team that will recommend the course of action Endurance will take to address this supplier induced quality issue. The team will consider the following three options.
- Stock replacement parts and add one person to the customer service team to handle the complaint calls, package replacements with directions, and quickly ship them to customers.
- Shipping the replacement part costs $12.00.
- Customer service reps earn $15/hour including benefits.
- Take the business to the company that bid $6.50 when you selected Ketahanan Industries.
- You can expect to get a failure rate reduction to 2.5%.
- You will continue to replace failed parts at the lower failure rate with a part time customer service rep who works 20 hours/week.
- Make the sensors yourself using space in the warehouse currently used for storage. Facts about this option:
- This will require a 3400,000 capital expenditure for equipment plus $10,000 for installation and testing before the operation goes live.
- Inbound shipping cost will be eliminated.
- The highly automated production process will require only 4 full time employees who will earn $20/hour including the cost of benefits which adds 25% to the hourly wage rate.
- The failure rate will be under 1%.
- The operation will take 50% of the warehouse space leaving room to store packaged bikes until annual sales exceed 110,000 units. Then Endurance will have to acquire another 20,000 square feet of warehouse space, the minimum available at any given time.
- Each spreadsheet has a question at the top of the page. It asks, “What will this scenario do to the product’s reputation?” All are set to a default of “Neutral” in cell B1. Which option is best when all of them are set to neutral?
- Now choose a response (Neutral, Positive, or Negative) for each option based on what you read in the case, and respond to the following:
- Explain why you chose as you did.
- Based on how you assigned an impact to the product’s reputation, which option is the best one? Why?
- Compare options 1 and 2. What was the impact of changing to the more expensive supplier? Why did that happen?
- If your CFO tells you that the primary goal for the next year is to conserve cash, which option will you recommend? Why?
- If there are no financial restrictions, which option will you recommend to management? Why?
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