Question

TENALPINA TOOLS:
THE ENTREPRENEUR’S DILEMMA

“You would not believe what just happened!” Giulia shouted when her father answered the phone. “It may just be the opportunity of a lifetime; I just need to work through the numbers to see what I’m getting myself into.”

Background

It seemed that Giulia was fated to go into a business related to rock-climbing. She loved challenging herself to ascents on sheer rock walls and liked to tell her friends that she was born to it. It might be more precise to say, however, that she was born near it.

Giulia Ferrato was born in Pieve di Cadore, in the foothills of Italy’s beautiful Dolomite Mountains. The region is famous for its Alpine skiing resorts like Cortina, but she was more interested in the mountains in the other seasons. The Dolomites are filled with sheer rock cliffs that are covered with ledges and caves. When she was a young girl, Giulia was on a drive with her father and he pointed out some of the caves on a nearby mountain. “Those were used by soldiers during the war as lookouts and gun emplacements,” he told her. She asked how the soldiers got there. “They climbed up, I suppose,” he replied. From that time on, Giulia was fascinated with climbing those sheer rock walls.

As a teenager, Giulia spent two summers with her uncle and aunt in London. Thus, by the time she left for university, she was proficient in four languages: Italian, English, French, and German. After receiving a degree in engineering, Giulia returned to Italy and got a job as a manufacturing design engineer at Indesit, the multinational Italian appliance manufacturer.

She considered her time at Indesit as a stop along the way to her long-term goal. She longed to start her own business, just as her parents had done. With that goal in mind, she absorbed whatever relevant knowledge she could in that job and scrupulously saved. After five years, Giulia left Indesit to get an entrepreneurship-focused MBA in the United States. At the time, her father told her that he would provide her the “equivalent cost” of the MBA to start a business right then and get some “applied knowledge” instead of the degree. Giulia demurred, saying she would rather spend her own money for the MBA first, seeking business opportunities while pursuing her degree.

Between the first and second years of her MBA program, Giulia took an internship at a well- established company that specialized in retailing mountaineering equipment, both online and in a large store in Denver. She worked for a part of the business that organized and operated mountain-climbing tours. While there, she developed the idea that led to her current business. A critical tool for rock climbers is the piton, a device like a flat spike that the climber hammers into crevices in the rock wall in order to attach support lines. These tools need to be strong enough to be driven into rocks and removed numerous times. That strength comes at the expense of added weight, which is a significant issue for climbers since they typically carry many pitons.

She shopped her employer’s store looking for lightweight, high-strength pitons, but could only find ones made of steel alloys. She asked the owner why none of the pitons were made of titanium or a similar metal. He replied that there used to be a titanium product from Russia, but it was very expensive and not very high quality. He told her that if he could reliably get titanium pitons at the right price and quality, he would be happy to buy them.

When she returned from her internship at the end of the summer, she began to research the potential to produce high-quality pitons from titanium. It turned out to be less complicated than she had anticipated. She was able to design a piton that would take advantage of titanium's superior tensile strength while weighing significantly less than the standard steel alloy product. She also found a company that did drop forging, an integral part of the production process, within 30 miles of her school. She discovered that the company had excess capacity and could produce the product in volumes Giulia believed she could sell. Within weeks, TenAlpina Tools (consisting entirely of Giulia) was in business, purchasing titanium alloy bars and having them delivered to the forge, where they were converted into the finished product and shipped to Denver.

Product and Process
Figure 1 illustrates typical pitons. Pitons have three critical features:

The blade is the portion that is driven into cracks and fissures in the rock wall. It needs to be relatively thin and strong.

The head is the opposite end from the blade, where the piton is struck by a “wall hammer” to drive it into the rock.

The eye is a round aperture beneath the head that serves as a connection point for attaching climbing lines and for removing the piton. For removal, a short cable is attached to the eye at one end and to a similar eye in the hammer at the other. Through a series of short swings of the hammer, the piton is then worked out of the wall. The connection to the cable keeps the freed piton from flying off into the air and down the mountain.

For a piton to be made from a single piece of metal, it must be hammered into shape. This is not greatly different in concept from the old blacksmithing process, but uses complex and powerful equipment. Figure 2 shows the typical drop-forge and rolling operations. The forge used by Giulia’s supplier involved the following steps:

The metal bars were cold rolled and flattened through a high-pressure extrusion process to flatten the blade end and leave a thicker end for the head and the eye ring. The resulting slug was cut off the bar.

The slug was placed in a furnace and heated to a temperature well in excess of 1,000 degrees Fahrenheit.

The hot slug was removed by a worker using long tongs and placed on the anvil (fixed table portion) of a drop-forge hammer. The anvil held a mold (called the die) with a cavity the shape of the bottom half of the piton. The hammer, containing a matching die, was then fired to strike the slug several times rapidly with a force of up to 20 tons.

The formed piton was removed using the tongs and dropped into a vat of water to cool.

The cooled piton was then taken to a drilling station where the eye, which still had a membrane of titanium where the hole should be, was bored out and smoothed.

The piton was then “de-burred” and buffed on a polishing wheel in order to remove any remaining metal “flash” at the seams where the upper and lower dies had met.

The finished piton was bagged and boxed for shipping.

The Growth Opportunity

Giulia’s original trial order was for 1,000 units, but soon she had a reorder rate of 1,000 per month. The retailer paid Giulia $11.00 per unit for the pitons and absorbed the shipping costs. The forge charged her $9,000 to make and pack an order of 1,000 pitons. After accounting for material waste and recovery, the cost of the titanium alloy bars was $1.45 per piton. Clearly, she was not making much money on the business. In fact, a minimum wage job would have provided more income. However, what mattered to Giulia was the proof of concept—she could successfully design and sell her own products. The start-up risk and capital requirements had been low and now she had her own business.

Giulia had been thinking about ways of increasing profits, including an idea for a new product line, when a quick series of surprise events changed the landscape. First, she received a call from her single customer. He told her that he had been impressed with the quality and design of her product and proposed the following offer: “If you give me an exclusive supplier arrangement for two years, I will guarantee you a purchase volume of at least 4,000 units per month at $10.50 per unit for the length of the two-year contract. I have to tell you, however, I think demand could be about 10% higher, but I will not commit to that for the length of the contract.”

Her elation at that offer quickly evaporated because the $10.50 price would barely cover her current unit costs. She also knew that even four times the current purchase quantity would not qualify her to move to the next level of volume discounts on material. She wasn’t even sure that her contract manufacturer had the available capacity to quadruple production for her, nor whether he would give her a price break for that extra volume.

The second surprise came when she contacted her contract manufacturer to make those inquiries. Before she could even raise the questions, he interrupted her to say that he had been meaning to call her. He had just decided to close down his business and retire. He asked if she wanted to buy the company. She felt her jaw drop open but quickly refocused and told him that she might be interested. First, she said, she would need some operating data from him. He agreed to provide what he could and suggested that she come to the factory to talk about it.

Giulia learned a few things even before getting to the quantitative data. First, the owner, Stanley Kowalchek, was 66 years old and his wife wanted them to spend most of the year at their second home in Clearwater, Florida. Both of his children were grown and had no interest in the business. His business had thrived in the 1990s while he was the exclusive forged parts supplier to a company that made medical implants, mostly for hip and knee replacements. However, that business had changed and his customers had begun to shift contract production to China. In fact, for the last three months, Giulia had been his only customer.

Giulia also learned that Stanley had been operating with a minimum “skeleton” crew of six workers. They were all capable of working any of the equipment, and, because of the low demand, they were required to move from work station to work station to fill Giulia’s orders. Even so, Stanley told her, her volume of 1,000 units consumed only about one week of labor capacity per month. She quickly realized that she would need all six, then, if her demand increased to 4,000 units per month.

The laborers were paid wages that totaled $57,500 per year each, including benefits, holiday and vacation pay, and so forth. For six workers, that totaled $345,000. Given that it would take a month to make 4,000 units and 12 months to make the full 48,000 units, labor cost per unit would be $7.19. Stanley told her that occupancy costs (lease costs for the building and maintenance and utilities costs other than electricity) totaled $33,000 for the last year. The equipment takes a beating, so it needs to be replaced regularly, but Stanley assured Giulia that it was all in good working order and in the middle of its useful life. Depreciation on the equipment was $14,355 last year.

Stanley appeared to be fairly cost conscious. For example, he kept track of the supplies used in the plant daily. He was able to tell Giulia that the cost of supplies for the last order of 1,000 pitons he made for her was $110.00. He was also very focused on energy consumption and had metered all of the production equipment. He used this to monitor KwH usage. However, he still received only a single electric bill. For last month, when the only production was 1,000 units for Giulia, the bill was $1,908. However, two months back he had made 1,300 units for her, since one order had spanned the end of one month and the beginning of the next. The bill that month was $1,962.

Some comments Stanley made led Giulia to believe that he no longer considered the business a “going concern” and that he was simply looking to sell the assets. He would be disposed to sell them all to a single party, especially if the buyer would be inclined to keep his long-time workers employed. Based on some quick internet research, Giulia concluded that the purchase price for all the business assets would be under $100,000.

Giulia realized that this could be a once-in-a-lifetime opportunity. She had guaranteed demand. No matter what she decided, she knew that she would not take a salary for at least the first year, but if she were operating the forge she would incur some administrative costs that would average about $600 per month related to the various duties associated with payroll, property management, and other issues. She needed to think about how her fledgling business would be affected if she absorbed the operation of the forge, both immediately and in the future. She decided to call her father to talk it through with him after doing some preliminary thinking about the situation.

My Question:

I need some help making sense of the case posted above and also the steps for the various calculations I need to do to analyze the business alternatives in this case. The calculations, I think focus mainly on:

- Calculating breakeven, in units or dollars, for all 3 business alternatives explained in the case (the current business situation, alternative 1 of buy forge, and alternative 2 of buy forge plus 10%)

- Also, I think some cost estimation needs to be done here, preferably using the High-Low method of cost accounting. (I think the entrepreneur's utilities is one of the things to use this cost estimation method on)

- Finally, some recommendations for the decision the entrepreneur should take

(This is a case problem in Managerial Accounting)

Answer 1

Answer -

Firstly,All the information which she gathered till now is relevant for Giulia’s next move.

Other Contextual information and the data that Giulia needs to be seeking is

Although she concluded the business assets price to be under $100,000 but she needs to know for how much actually the owner, Stanley Kowalchek is ready to sell the assets.
She should also seek the data for selling and distribution expenses which could be incurred.
She should know the balance leasing period of the manufacturing entity.
She should compare all these costs like labour, maintenance , etc with the market rates.
She should research and analyse the future demand of the pitons because current order is only for 2 years.
She should work out the break-even period , because currently she will be at loss if she buys the business assets completely. So she should assess in how many years can she recover her initial costs.
A brief calculation is also provided below , which shows that currently the deal is not profitable. But based on the future demands , it can turn out to be profitable. So, Giulia must basically research and find out the future demand for the product.