Case 202- Morgan Components

It was June 2004, and Sean O'Fearna's eyes kept wandering back to the small plaque hanging on the wall in his office in Stuttgart, Germany. Sean was director of the European Interior Components Product Line Team (PLT) at Morgan Components. He had just come out of a meeting with Asiacar purchasing managers and what at one time had been the company's most promising panel contract in Europe was threatening to turn into the biggest loss-maker of the year.

Sean had to decide whether to meet Asiacar's demands for a price reduction of 25 percent on the door panels for a new model due to be launched in 2005. Asiacar was one of the biggest car manufacturers in the world. If he gave Asiacar what they were asking for, the profitability of the project would be seriously damaged, and so, perhaps, would his reputation as a manager. If he refused to comply with Asiacar's request, the plant in Clondalkin, Ireland, would go back to working at low capacity and there would have to be severe cutbacks in the workforce. Very likely the plant would have to be closed. The Asiacar contract had been awarded in May 2003, and the first parts were due to be delivered in January 2005. That meant that there were six months left, and a substantial proportion of the investment and launch expenditures had already been made or committed.

Asiacar was expecting an immediate answer.

Sean looked at the plaque. It had been given to him by his colleagues at Clondalkin when he was transferred to Stuttgart. Sean had been the manager of the Clondalkin plant for three years and in that time had substantially improved its profitability. The contract with Asiacar had saved the plant from closure. The plaque said:

To Sean, a distinguished son of Clondalkin, who has done so much for our town, for the factory, and for our families.

From the workers and managers at the factory Clondalkin, 1 April, 2004

Morgan Components' global organization

Morgan Components was one of the world's largest manufacturers of automobile components. It produced chassis, air-conditioning units, electronic components, exterior components (lights, bumpers, grilles), interior components (dashboards, door and instrument panels) and engine components.

In 2003, it had made sales of close to €1 billion and losses of €913 million.[2] It had more than 84 plants in 25 countries, and 55.000 employees.

Morgan Components was formed in 1996 as a spin-off from one of the biggest world car manufacturers. In 2004, more than 80% of its sales still came from this manufacturer. Customer diversification was a priority and it was expected to be achieved through international growth or through the acquisition of business with other customers. In the last three years, the sales diversification policy had failed to achieve its objectives.

Morgan Components in Ireland

Morgan Components had four plants in Ireland, three of which had been acquired in Janaury 2004 from Plasticom, a rival manufacturer. These acquisitions brought in new door and instrument panel technology, and increased the group's business with Asiacar. This manufacturer had an auto plant in the UK, which together with the favourable conditions offered by Ireland made it an attractive location.

Morgan Components had its operations organised so that the plants produced what the PLT at European headquarters in Stuttgart assigned them, according to profitability, unused capacity and strategic fit criteria. There were PLTs for each region of the world and used product line; internally, each PLT was organised by customers. PLTs took care of all aspects of sales (bid preparation and presentation, customer relationship management and project progress monitoring) and had bottom line responsibillity for each project.

The Clondalkin plant

The Clondalkin plant was one of the three plants that Morgan Components has acquired in 2004 from Plasticom. It manufactured exclusively door panels for cars and trucks. The original management team had been kept on at the plant, with the exception of the sales team, as sales had been centalized in Stuttgart.

Clondalkin was a small town of 12.000 inhabitants close to Dublin. It had commerce, farming and some industry. Morgan Components was the third largest employer in the city.

In 2004, the Clondalkin plant had 14.000 m² of floor area and 176 employees, of whom 122 were manual workers, 12 were supervisors, 34 were administrative staff and 8 were managers. The plant had the capacity to produce 200.000 panels per year. In 2002 it had lost an important customer and so in 2003 it had been working at 60% capacity. A large proportion of the workforce was specialised, and under the previous ownership everything possible had been done to preserve jobs, even when business was slow. Morgan Components had a more aggressive policy when it came to maintaining plants at a low capacity for extended periods.

In the rest of Europe, Morgan Components had six more plants capable of producing panels. It was a number considered high by Morgan Components officials.

Sean

Sean O'Fearna was born in Clondalkin in 1972. He studied engineering at the University of Loughborough, in the UK, and in 1997 earned an MBA from a European business school. He started to work for Plasticom in the purchasing department, from where he was promoted to various positions of responsibility until in 2000 he became plant manager at Clondalkin. From being the least profitable of the three plants in Ireland, Clondalkin became the best in terms of financial performance, return on investment, quality, and employee turnover. Morgan Components was highly impressed with Sean's management, and in March 2004 he was offered the job of director of the Interior Components PLT in Stuttgart.

Sean was married and had three children. He was very satisfied with the way his career had progressed so far and saw his integration in Morgan Components as a great opportunity. A proportion of Sean's pay, 35%, was variable and depended on the achievement of a number of objectives, the most important of which was the profitability of the projects for which he was responsible, measured as the projects' accounting profit and internal rate of return.

The Asiacar panels contract, March 2003

In January 2003, Asiacar invited the Clondalkin plant to tender for the contract to co-design and produce the front door panels for a new model of automobile due to be launched in May 2005.[3] The expected volume was 300.000 units, distributed over five years. Winning this contract would assure the plant's viability, and Sean and his team did their best to prepare a competitive bid.

The Clondalkin plant won the contract in March 2003 at a unit price of €90 and a cost of €79.2, which was the result of dividing the manufacturing costs (except for the investment in moulds) over the entire project life by the expected 300.000 units (see Exhibit 202.1). Asiacar would provide the initial design, produced by the door panel supplier for the new model in Japan,[4] and the Clondalkin plant would adapt that design to the European market. Production would have to start in January 2005. If the model was a success, the contract would be extended on similar terms.

Asiacar would pay for the moulds, which would remain its property throughout the life of the contract.[5] The expected investment in moulds was €5 million; Asiacar would pay 40% of the total upon signing the agreement and the rest at start of production. Gross margin [6] was expected to be €4.2 million (16% of sales) and did not indude factory overheads. The expected profits [7] of the project, after deducting factory overheads, was €3.2 million (12% of sales). Although Plasticom guidelines demanded a minimum profit of 14%, in view of the plant's low capacity utilisation the unit price of €90 was accepted.

The Asiacar panels contract, June 2004

In January 2004. Morgan Components bought Platiscom's three Irish plants and started to introduce its own management systems. By March 2004, it had completed its analysis of the profitability of the projects currently under way, in the light of the group's cost structure and its new profitability threshold.

Exhibit 202.2 shows the expected costs of the Asiacar door panel project according to the Morgan Components costing system. The manufacturing cost categories were similar to those used by Plasticom, but the new total manufacturing cost included a charge for general corporate overheads. Also, the standard labour cost was slightly higher, at €16 per unit rather than £15. As a result, the original expected profit of €3.2 million disappeared to be replaced by a €225.000 loss.

Executives of Morgan Components questioned the feasibility of a project that failed to pass any of the thresholds. Morgan Components' financial situation was delicate, and the rules for project acceptance were very strict. However, Sean defended the intrinsic return of the original bid, despite the apparent loss under the new costs system. He argued that the bid has been made without the corporate support of Morgan Components and that therefore the charge for general corporate overheads was irrelevant for judging its profitability. Likewise, he maintained that the standard costs used by Plasticom were better adapted to the actual plant than those imposed by Morgan Components. Lastly, he added that they could not possibly withdraw from the agreement without seriously damaging their relationship with Asiacar. Sean's bosses at Morgan Components had no choice but to accept his arguments, but they reminded him that in future all new contracts would have to yield a return on sales of at least 12%. Sean was satisfied, and pushed ahead with the planned investment and project launch.

The Asiacar revival plan

Asiacar's market share had been shrinking in recent years. The company's financial situation was weak, and there was strong pressure to regain profitability. One of the emergency measures taken was to start up the Asiacar revival plan: a set of drastic measures including a cut in the number of suppliers and major cost reductions.

Every employee in the organisation was aware of the importance of this plan for the company's survival.

The phone call

In June 2004, a few weeks after he convinced the management of Morgan Components that the door panel project was viable, Sean received a phone call from Asiacar executives. They asked whether they could count on Morgan Components to help them put into effect the Asiacar revival plan' in the door panel contract. They demanded a reduction of 25% on the target price, which would thus drop from €90 to €67.50 per unit. If Morgan was unable to meet this request, the contract would be given to the Japanese supplier who had been manufacturing door panels for the Japanese version of the new model since 2003. Asiacar hoped not to have to take that step.

Asiacar regarded the price reduction as a special collaboration by its manufacturing partner, and was willing to allow part of the price reduction to be offset by reducing elements of design, manufacturing and quality of materials. They also encouraged Morgan Components to improve its manufacturing processes and cut variable costs by increasing the initial investment.

Sean analysed Asiacar's proposal. Although it would still be possible to take legal action against them for breach of contract, the PLT's legal team advised against it as it would sour relations with a strategic customer. Nor was it clear how much of the investment could be recovered, or when. At the same time, Sean met with his sales team to discuss whether Asiacar's threat to transfer the manufacturing to its Japanese supplier was credible, with only six months to go before starting production. Although it was possible, technically speaking, it would entail major risks as the moulds would need to be adapted and the process would take weeks, if not months. Sean guessed that the price offered by the Japanese supplier could not be much lower than that offered by Morgan Components. In addition, the Japanese supplier would face an additional transportation cost in the region of €4 per unit. Taking all of this together, it was difficult to know whether the Japanese supplier represented a real alternative or just pressure tactics.

Project status

In June 2004, the Clondalkin plant had already purchased project-specific equipment for €980.000. Sean estimated its resale value at next to nothing. Equipment remaining to be purchased amounted to €270.000, to make up the budgeted total of €1.25 million. Development costs incurred to date amounted to €680.000, with only €70.000 of the budgeted €750.000 remaining. Likewise, a large part of the investment in moulds had already been committed. As the moulds belonged to Asiacar, the invested amount would be recovered in full.

If the terms imposed by Asiacar were accepted, the job would be a loss-maker for Morgan Components as the revenue obtained from a unit price of €67.50 would not cover the full cost of almost €91. As Exhibit 202.3 shows, the losses would amount to €7 million.

Sean knew that part of those losses were not real, but merely reflected the impact of the overhead allocation. The impact on the Panel PLT's income statement, however, was real enough. And it was by that income statement that Sean and his team would be evaluated.

Possible measures

Reduce feature

One alternative would be to redesign the panel to eliminate some parts or replace them with cheaper ones. This would require a considerable investment in product and process redesign, and might mean having to find new suppliers to make sure that deadlines were met.

First, the project would need engineers to make changes. Sean estimated it would take around 750 engineer-hours. Those hours would be supplied by central engineering services at a standard cost of €60 per hour. Those resources were unlikely to be employed in any other productive activity in the short term. For accounting purposes, however, the central engineering services would bill these hours to the Clondalkin plant, and the cost would be added to the overall development cost. There would be no other significant additional costs.

Sean estimated that with these changes they would be able to cut the per-unit costs of raw materials by €6,75. The savings would be substantial as materials accounted for almost half of the total cost of the panel. However, they would have to work against the clock to adapt the design in the time available. All the changes might not be ready for January 2005, and they might need more than the estimated 750 engineer-hours.

Invest in equipment to reduce scrap

The engineering team considered the possibility of introducing a new quality control process to increase quality and reduce scrap. The new process required a new machine which cost €180.000. Product and process designers considered that per unit raw material costs would be reduced by €2,70, although direct labour would increase by €1,60 per unit.

Although this option was appealing, common sense said that if part of problem had been investing too much before the project started, increasing the investment still further would have to be assessed very carefully. What if the model did not sell as well as expected and the expected sales volume never materialized?

In-house production

A third alternative, compatible with either of the previous two, was to make some of the components planned to be made by outside suppliers in the Clondalkin plant and so capture the margin on those operations. Sean was thinking specifically of a small component, the X-27, to be manufactured by an external supplier.

Morgan Components had a policy of not manufacturing any components in-house that were not considered strategic, either in terms of technological input, potential to provide competitive advantage or need to retain control over critical processes. The X-27 could not be considered a strategic component: its technology was basic, it did not generate a competitive advantage and the chosen supplier was very reliable. The price agreed with the supplier was €6,20 per unit. A preliminary study suggested that the X-27 could be manufactured in the Clondalkin plant using equipment already available. The labour required would be minimal, as the item could be manufactured while other processes were in set-up. On that basis, the variable manufacturing cost would be €4,20 per unit. On the other hand, around €240.000 would have to be invested in a braiding and assembly unit.

If the X-27 was produced in Clondalkin, the supplier was very likely to go out of business. Although it was not a key supplier, it had always worked satisfactorily for the Clondalkin plant and had given good service. In the past it had helped the plant out on more than one occasion, when it had problems with the supply chain. Sean knew that he could put the same pressure on his suppliers as Asiacar had out on them. His suppliers were weaker and would not be able to take the strain.

Risks

If they had lost the contract, they were unlikely to recover either the €980.000 invested in project-specific equipment or the €680.000 spent on launching costs. Moreover, if they did not win another contract soon, the Clondalkin plant would have to be restructured, which would mean firing 45 workers. Apart from the social problems which would cause in a small town like Clondalkin, the cost of compensation would be far from negligible: around €30.000 per worker.

On the other hand, if they accepted the price cut that Asiacar was asking for, even with all the improvements described above, the project would still make a loss. And that loss would affect Sean's salary and the salary of his team, as well as his professional reputation.

The decision

Sean decided to devote the day to thinking about the problem. First, he needed to consider the relevant criteria for a decision of this kind. On the economic side he needed to clarify which costs were relevant and which costs were merely accounting illusions, as one of his professors used to say when they were analyzing cases at the business school. Things seemed much simpler on the blackboard than they turned out to be in real life. Sean took pencil and paper, avoiding looking at the plaque this time.

[1] Source: Palencia, L. and Fernandez. A. (2004) 'Morqan Components', lESE Business Schoool Cases, Copyright © 2004 IESE. Reproduced with permission from IESE Publishing.

[2] Including restructuring charges and goodwill amortization of €647 million

[3] At the time of the invitation to tender, the plants in Ireland, which still belonged to Plasticom pared bids and submitted them directly to customers.

[4] The Japanese company had already developed the new model in Japan, where it had exclusive manufacturing rights.

[5] The customer retained ownership of the moulds, so that if there were any kind of problem threatened production, they could change supplier reasonably quickly and so continue manufacturing.

[6] Gross Margin, GM = revenues - variable costs - direct project costs.

[7] Profit = revenue - variable costs - direct project costs - factory overheads.

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