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On March 23, 2005, Boris Kikely, president of MBM Tool & Machine (MBM), a tier 2 aerospace company located in Vaughan, Ontario, was reviewing his profit/loss statements from the previous month. He was upset to discover yet another report from his vice-president of Finance and Administration, indicating that costs for outsourced chemical processing have been escalating and, in addition, there were continuous quality problems with the company that MBM had contracted to perform chemical processing. He realized that this situation had definitely gone on long enough and it was time that MBM stopped dragging its feet on a decision to insource chemical processing.
The Aerospace Industry in Ontario
In 2005, among the companies in the Ontario aerospace Industry, there were about 45 CNC Precision machining shops manufacturing product primarily for the following Tier 1 or Original Equipment Manufacturing customers (T1-OEM): Goodrich Aerospace, Bombardier Aerospace, Messier-Dowty, and Boeing Aerospace. These four customers controlled and directed the sourcing of product for approximately 85-90% of procured product. Quality is paramount for the T1-OEM customers. As such, these customers controlled all process steps along each products value chain. Indeed, the T1-OEM controlled where each machine shop was to have its products chemically processed in order for product to meet final expectations
Chemical Processing
In 2005 in Ontario, T1-OEM customers had only certified 3 suppliers to perform chemical processing. Therefore, most machine shops were forced to seek chemical processing abroad: US, Quebec, and even in some cases as far away as Europe. This usually presented logistical problems and cost premiums associated with transportation. To establish a new chemical processing company in Ontario required about 18 months of permissions and approvals from both Government and customers. In the end, even if successful, this did not guarantee work for the processing company.
MBM Tool and Machine
Boris Kikely opened MBM in in the summer of 1967. Initially scrambling and taking any type of work he was presented, Kikely would travel from customer to customer seeking work and developing relationships. By 2005, MBM had evolved from a small mom-pop type company into a mid-size enterprise with sales of about $17 Million CAD per year, and gross profit margins ranging from 25 to 30%.
The business focused on complex mid-to-larger size components and assemblies Exhibit 1 provides a sample of the complexity of the typical component’s value chain.
The Current Process
After incurring much trouble with local chemical processing companies (quality, delivery and pricing issues), MBM had, for the last couple of years, outsourced most of its chemical processing work to a
company in Montreal. Although the chemical processing was done fairly well, MBM questioned the quality of the work and was forced to inspect all product received from the chemical processing supplier. Indeed, product was not delivered to the expected high quality standards.
MBM purchased about $5 Million in chemical processing services a year representing about 40% of all of its annual expenses. To support the movement of product to the chemical processing suppliers, MBM purchased a truck at a cost of $45,000 and hired two drivers at a cost of $25 per hour, specifically with the task of moving product between Vaughan and Montreal on a daily basis (6 days a week, assume 12 hour work days per driver, with the operating cost for the truck at $.52/Km. Each driver driving about 600km/day, not included in the processing spend value).
Insource Processing
Kikely realized that MBM would not be able to repatriate all processing and as such, he focused his effort on out-sourced process steps 14-22 in Exhibit 1, representing about 75% of all chemical processing costs. In order to set up a processing line, MBM would be responsible for environmental and customer approval of the new facility. Total fixed costs associated with building the processing facility:
1. Building Expansion: $2.5 Million
2. Approvals and Certifications: $500 Thousand
3. Processing Equipment: $1.5 Million Variable costs:
1. Labour: 9 people at $15/hr (assume 3 person per shift, 24 hr operation, 300 days)
2. Chemicals: $250/Hr (assume 300 days a year, 24 hours per day)
3. 1 Maintenance worker at $30/hr, 8 hour shift, 300 days a year
4. Drivers—Assume the drivers are reassigned, with cost to driver reduction the vehicle only.
The company would still require the driver and the truck for the balance of outsourced processing requirements. However the truck would be required to operate, on average only 6 hours, or driving only 600km per day. Most of the remaining outsourced operations are performed locally.
In addition to the added labor costs, Kikely knew that running a new chemical processing plant would dramatically increase the plant's hourly consumption of energy and gas. Based on the CFO’s estimates, the new facility would likely consume an additional $15.00 of electricity and $7.50 of gas every hour that it was running. Further, MBM would have to properly dispose of used chemicals at a cost of $35 per cubic meter, where the company was generating, on average, 1 cubic meter of waste chemicals per hour.
With this new investment, Kikely expected on-time delivery to customers to improve to over 90%, and quality to exceed 98%. Furthermore, he saw the addition of the new facility to be a positive move in the quest to win new orders and contracts.
Kikely estimated that the chemical facility needed to run 300 days/year (6 days a week, 24 hours per day, for 50 weeks). Kikely assumed the facility needed to operate at 80% efficiency to meet his current demand needs.
Decision
As Kikely looked through all of the information that he and his team had collected regarding this investment, he had several concerns. He questioned whether the building of a new chemical processing plant was the right choice. Kikely believed that insourcing chemical processing was the right move for MBM; it was a good step toward growth and would help the company improve its control of the quality of its products. However, he also knew that he would need to make a strong case to his investment partners to gain approval for this major investment expense. He wanted to ensure that he had convincing quantitative and qualitative arguments for the investment.
Questions
1. Qualitative Analysis:
a. Provide a review of the industry giving thought to the following: Continued outsourcing, Insourcing, or company acquisition. Please discuss the pros/cons of each of the above.
2. Quantitative Analysis:
a. Determine the annual costs for insourcing product at MBM.
b. Assess MBM’s payback on the new Facility—In Years, how long before the facility is paid off. Assuming that Kikely has a payback requirement of 3 years on any capital investments, does the investment meet this objective
3. As opposed to building a chemical processing plant from scratch, if Kikely had the opportunity to purchase an existing chemical processing company for $6 Million dollars, with operating costs 30% less than those projected to be spent at MBM, should Kikely buy the company instead of constructing the new facility? Please provide your supporting information
4. In 2008, the government is lobbying to impose new environment regulations that, if passed, will results in $1 Million in increased annual costs in for all processing facilities. Assess how this annual expanse may change your assessment above (keep in mind that if you opt to not construct or buy a facility, processing suppliers will pass on 50% of the fee to you, as its primary customer.
(Base on this case, mostly the assignment is to answer those 4 questions according the given information)
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