Precision Worldwide, Inc. Recommendations: Precision Worldwide, Inc. (PWI) should cease production of their steel rings, proceed towards production of the new plastic rings, and scrap any unused or unsold steel inventories in conjunction with the availability of the new plastic ring product. The sooner the company is able to sell plastic rings, the sooner they will be able to realize the increased profit margins associated with that product.
The introduction of the plastic ring from one of PWI’s competitors changes the dynamic of the market for this type of product as any end users of these rings will immediately see the merit of purchasing that said rings in plastic instead of steel. Any delays in making the plastic rings available could jeopardize PWI’s business relationship with buyers of the major assemblies that are also produced by PWI. The risk of losing buyers of major assemblies is too great to justify prolonged sales of the inferior steel rings once the plastic product is available.
PWI should make every effort to reduce waste when disposing of raw steel inventory and finished goods. To facilitate this process, PWI may implement a 15% price reduction on steel rings until the beginning of September which will provide for increased sales for 14 weeks. The company will not make use of 70% wages during this time period due to the fact that the company will not be producing additional steel rings between May and September 2004. The projected loss to the company if remaining steel inventory is liquidated and scrapped-out at $0. 00 is approximately $278,192. 0 (see below).
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Total cost of Steel Inventories| $390,000. 00 | Cost of Raw Steel| $110,900. 00 | Cost of Steel Finished Goods| $279,010. 00 | | | Inventory projected on-hand by Mid-September| | (=15,100 rings/100*1,107. 9)| $167,292. 90| | | Total Scrap forecast| | (=Raw Steel Cost + Mid-Sep inventory projections)| $278,192. 90 | The above values give no credit to additional sales that may be projected as a result of discounting the steel rings. Once the plastic product is available in September, the company will discontinue availability of steel entirely.
The chart below takes into account a comparison between 14 weeks of projected sales at a discount of 15% and assuming sales increase by 15% during that period as well as normal sales during the same period on steel rings. We are projecting a possible increase in sales of 15% to correlate with the discounting of steel product. 14 Weeks of Sales| Normal Pricing| Discount of 15%| | | | 690 units per week| $9,315. 00| $7,818. 00| 794 units per week| N/A| $9,111. 15| Based on current sales of steel, the company makes profits of approximately $86,865. 8 on an annual basis. The annual sales for plastic rings will be approximately $384,041, assuming the sales rate of plastic rings is comparable to the sales rate of steel rings (Chart 1).
If the loss of $278,192. 90 is expensed at the end of year of sales of $384,041, the resulting net profit will be $105,848. 68 which is more than 22% higher net profit than the company can realize in a full year of normal steel sales (Chart 2).
Calculations: Incremental Analysis Chart 1: Incremental Analysis| | Steel Rings| Plastic Rings| Incremental| |
Selling Price| 1,350. 00| 1,350. 00| = 0| Incremental Revenue| Cost| 1,107. 90| 279. 65| = 828. 25| Incremental Cost| Profit| 242. 10| 1,070. 35| = 828. 25| Incremental Profit| Manufacturing Analysis Chart 2: Units| Steel Rings| Plastic Rings| | 6. 9 Per week| 1,670. 49| 7,385. 42| | 52 weeks| 86,865. 48| 384,041. 58| | Minus Sunk Costs (scrap)| | -278,192. 90| | Profit| 86,865. 48| 105,848. 68| | Increase in Profit| | | 18,983. 20| Table A-1 compares the cost of plastic and steel rings per 100.
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The table excludes the overhead cost that is allocated to administrative costs, which is a non-manufacturing cost that isn’t easily traceable to the production of rings. Same as above, manufacturing overhead cost is 80% of direct labor that results in a reduction to $52. 40 ($65. 50*. 8) for plastic and $157. 20 ($196. 50*. 80) for steel. Table A-1 Plastic Rings vs. Steel Rings Per 100| | | | Plastic Rings| Unit Cost| Steel Rings| Unit Cost| Material| $ 17. 65| | $321. 90| | Direct labor| 65. 50| | 196. 50| | Overheada| | | | | Departmental| $52. 40| | $157. 20| | Total (cost)| $135. 55| $1. 6| $675. 60| $6. 76| Assuming that the company doesn’t produce any more steel rings, Table A-2 uses cost supplied by the case study and illustrates that the raw material being a sunk cost, administrative cost removed and manufacturing overhead reduced. Table A-2 | For 100 Steel Rings| Unit Cost| Material (sunk)| $(321. 90)| | Direct labor| $196. 50 | | Overheada| | | Departmental| $157. 20 | | Total Cost- Sunk Cost| $353. 70 | $3. 54 | Conclusions: When presented with the above information, PWI has little choice but to abandon current steel production, liquidate current inventories as quickly s possible and begin the production and sale of plastic rings.
This will result in a loss to the company of approximately $110,990 in raw material and approximately $167,292. 90 in finished goods totaling approximately $278,282. 90. This loss is acceptable due to the fact that sunk costs should not be taken into consideration when making future business decisions, this course of action will ensure the least amount of risk to the company’s reputation, and this loss can be recouped in approximately 37 weeks (278,292. 0 divided by 1,070 divided by 6. 9) at current rates of sale. Furthermore, the loss of scrapping steel inventories is a one-time event; subsequent years’ sales will be far higher than previous years’ sales due to increased margins in plastic rings, thus further justifying this course of action. Assumptions: * Current steel inventories are valued at $390,000 which is inclusive of both raw material and finished goods. Of the $390,000, $110,990 is in raw material and $279,110 is in finished goods. From the date of the decision (May 31, 2004) until production of plastic rings is on-line (September 1, 2004) there are approximately 14 weeks of production and sales opportunity. *
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A 15% reduction in the price of steel rings will result in a 15% increase in sales providing for weekly sales of 794 rings per week (690 x 1. 15) for 14 weeks totaling 11,116 rings. * At the end of May, the company has approximately 25,000 steel rings on-hand (690×14+15,100).
* Assumes continued labor costs to produce the plastic rings, thus avoiding the reduction of 70% of regular wages. There is a risk to the company in converting all rings to plastic where only 10% of customers are currently demanding plastic rings. * There is a risk of less demand for plastic rings due to 4 times the wear of steel. * It is important to introduce plastic rings to the market because the competition is offering plastic rings at a lower cost. As an example, other companies are offering low-priced and low-quality machines resulting in increased future competition. * There will be a cost of $7,500. 00 for tools and equipment to manufacture the plastic rings, which will be taken as a depreciate expense over time.
