Financial Management the Universal Direction

Financial Management

The Universal Direction Assistance (UDA) Project

Comparing Quantitative and Qualitative Methods

Automobile manufacturers face mature market and increased foreign competition. The costs of production continue to climb, while the American economy puts the squeeze on the consumer. Margins are shrinking as manufacturers struggle to maintain their current marketshare, let alone increase it. Automobile engineering has reached a point where there is little that can be done to improve on design. Cars are efficient, high performance, and ergonomically correct. Anything the consumer wants as far as comfort is concerned is already available. The following will explore GMC's latest attempt to capture a shrinking market.

There are several ways to compete in a market that has reached maturity and may be on the road to decline in the future. The first is to offer comparable products at a lower price. However, due to the costs involved in automobile manufacturing, there is only so low that one can go before they are taking losses. Price competition has been tough for the past several years, with Asian manufacturers flooding the American market with low priced vehicles.

The second way to compete in a market that has reached maturity is to offer a better product. The base product is the automobile. Design has been almost over-engineered in this respect and there is almost nowhere to go. Manufacturers then have to look at add-ons and value-added concepts to attract new customers. This is exactly what GMC has decided to do with their Universal Direction Assistance (UDA) Project. The following will explore several scenarios regarding the release of this new and innovative product.

The Universal Direction Assistance (UDA) project is one of the latest attempts to find gadgets that will increase sales. The UDA is a Global Positioning System (GPS) that is currently offered on GMC models. Competitors also have similar systems available, which may dilate the market potential for GMC. The UDA will help customers get roadside assistance when they need it. The UDA increases customer convenience and safety by having someone there before they need it. In the instance of a crash, this technology could save their life. If they are unconscious, the system will alert help. Roll-out will be slow as the technology needs to be developed for each new area in which it is introduced.

Competitors already have this technology available and have had for several years. The benefit to this is that product has already achieved market acceptance and is becoming standard on automobiles. GMC will not have to spend the money to introduce the customer to this type of product. The technology already has wide acceptance.

However, there are many more disadvantages to being second to market. The most important factor is that the competition already has established brand equity with this type of technology. In marketing, being first has its advantages. People tend to remember the first of anything more than they will remember subsequent models. Systems such as the UDA are already associated with other automobile manufacturers. GMC will have to establish product differentiation in order to win some of the competition's market share. This is a difficult position to be in and GMC will have to work hard to establish its name with this type of system. Marketing studies indicate that the UDA is likely to be accepted by customers who purchase GMCs in the next four years. Results of the marketing survey also indicated that the UDA system would increase overall purchase of GMS vehicles in the next four years. This is the purpose of a value-added product such as the UDA. The following will present the results of an analysis to determine if the UDA project will add enough value to the existing lines and if it is likely to result in additional income from automobile sales.

The Current Situation

There are costs and benefits to every project and this one is no different. There is now single magic formula that will tell us whether to go ahead with the project or not. Projects such as this are capital intensive, and there are many variables that simply cannot be accounted for. In the end, it is the customer who will decide. All we can do is to give it our best shot and to make our best guess as to what the outcome will be. There are many different ways to look at project valuation. The following will discuss the major factors that are expected to influence the success or failure of the UDA project.

At the onset, this project produced conflict among upper management. GMC has a policy of spreading the costs of any one project among the various divisions, whether they are directly involved or not. This represents good risk management practices and assures that the costs of the project will not cause undue hardship for the division that will head the project. In this case, the Director of the Gadget division has submitted a proposal that raises an objection to his division sharing the costs of the project, just as anyone else. He wishes for his division to be excluded from their responsibility of cost sharing.

The first issue to be addressed in this analysis is to respond to this request. The first reaction to this proposal is from a team perspective. The organizational culture at GMC is such that it works hard to maintain a feeling of team among its various divisions. The rules regarding cost sharing are clear and universal. Sharing costs helps to develop a sense of teamwork among the various divisions. All of the divisions have something at stake in the success or failure of the project. This helps to foster helping behavior among the various divisions.

The proposal by the director of the Gadget division is not in line with team thinking. His proposal did not state any legitimate reasons why his division should be excluded from sharing a portion of the risk for this project. His move appears to be self-serving and protectionist. If he is allowed to be excluded from cost sharing then it will soon follow suit with other divisions as well. Soon GMC would have no one willing to share the costs of the project and there would be no way to fund it.

In his defense, the concerns of the manager of the Gadget Division are founded on the idea that his division is small, as compared core manufacturing divisions. Cost sharing will have a greater impact on his division than on some of the more well-funded divisions. The impact of the cost sharing would be minimal for the manufacturing divisions. However, for the Gadget Division, that impact could mean much lower returns for the project and a potential loss for his division.

The Gadget Division cannot be separated from the corporate whole. Excluding one division would be like cutting off an arm. However, others may see the move to exempt the Gadget Division from its responsibilities as discriminatory. This could jeopardize the support of other division managers for the project. The financial analyst is to weigh the total costs against the total benefits of the project. Among these costs are tangible costs and benefits for the division. There are also tangible costs and benefits for the organization as a whole.

However, decisions within an organization are not always based on the tangible costs alone. There are intangible costs in every decision as well. For instance, a loss of organizational support represents a cost is not tangible, but it can still have a dramatic impact on the success or failure of the project. The real question is whether allowing the Gadget Division to be excluded from the costs will have a negative impact on the rest of the project. In order to answer this, one might want to get the opinions of other division managers in order to respond correctly.

Every division of the company is important. It is difficult to separate any one division from the organization as a whole. However, there are certain divisions that are more important than others. The automobile is the core product. Without this core product all of the other divisions, including Gadgets, would not exist. Gadgets represents a value-added product that does not have the ability to exist outside of the core product line. Extras increase the value of the core product line, but do not replace it and are not independent of it. However, the core product can exist without the value-added lines such as Gadgets.

Gadgets is a secondary division and is recognized that the complaints of the manager are valid points. However, Gadgets would not be needed if the core product were not produced. If Gadgets does not share its portion of the burden, then more will be placed on the core divisions, such as manufacturing, It is important to make certain that core products are not jeopardized by increased overhead expenses. One cannot risk the survival of the organization for the sake of a single part.

Currently, Gadgets has an important role to play in building sales and in recovering from several shocks to the market. It is hoped that the value added by the UDA system will help to increase sales of the core product. The division manager of Gadgets has a valid point in regards to the overall impact on the Division's profits. He had a valid reason for requesting this exception to the rules. It may at first appear that the Gadget Division manager is acting out of self-interest and protectionism. However, it may be that he truly does have the best interests of the entire organization in mind.

If Gadgets fails to produce a product that will increase sales of the core product then the entire organization may be in jeopardy. If the exclusion is allowed, then the Gadget Division would have more money at their disposal for better research and development. The Gadget Division has to get it right the first time. Therefore it seems reasonable to allow the Gadget Division to be excluded from the normal cost sharing practices of the company. The Gadget Division realizes the importance of this project and wishes to make certain that their. Although this move may serve to alienate other Division managers, it is felt that this move will be necessary However, if the rationale for this decision is carefully disclosed, then the negative reactions are likely to be less intense.

In order to lessen the blow to other divisions it is the decision of the analyst that it would be unfair to allow the Gadget Division to accept no risk for the project. However, it is also recognized that since the division is disproportionately small, as compared to other divisions that make up the core manufacturing divisions, they will be allowed to share a smaller portion of the risk than company policy dictates. This will allow them to sink more money into research and development, without allowing them to avoid their responsibilities to the organization as a whole.

It may at first appear that the Gadget Divisions Manager's response is an attempt to avoid company policy. However, when one analyzes the situation more closely it appears that the proposal does have the best interests of the company in mind. Corporate overhead is a concern for the entire plant. Organizational goals should be at the forefront of everyone's concern. The UDA project is of utmost importance to the success of the core product line. It is expected to give GMC a considerable advantage over those that do not offer such services, and will put them on at least an equal footing to competitors that already have similar technology in place.

The Gadget Division manager does have the best interests of the project in mind. This decision will require an exception to corporate policies. These policies were supposed to be fair and equitable to all divisions involved. As written, each division shares the same percentage of the burden. However, as the Gadget Division's manager pointed out, this would be equitable if it were proportionate to the relative size of all of the divisions. The Gadgets Division contributes value added projects that help to enhance the core products. As such, they run on a much smaller budget than divisions that specialize in the actual manufacture of automobiles.

If they are made to share the same percentage as the other divisions then they are actually sharing a larger portion when one considers their size. This factor was not considered when the policy was adopted. It may be a good idea to review this policy in the past to make certain that it is still a valid approach to cost sharing across the company. However, for the time being, the Gadget Division will be allowed to share half of the normal percentage of the burden.

Break-Even Analysis

There are many factors that must be considered in determining whether to undertake a project. There are several different approaches to the problem and no right or wrong answer. Every analyst has their own favorite method for determine the future value of a project. There are several quantitative approaches that one can use. However, it is not all about the numbers. Even if a project appears to be profitable from an analytical perspective, it may still fail if certain more subjective factors are not considered.

We mentioned the fact that the automobile market has reached maturity and that several other competitors have already beaten GMC to the introduction of similar products. These factors and others will have a major impact on the outcome of this project. These factors are difficult to analyze because there are simply too many variables to factor into a reasonable guess as to what will happen. Therefore, the quantitative analysis will have the greatest weight in this analysis.

The most common analysis technique is to analyze the potential return on the investment (ROI). This techniques tells us at which point will the company start making money and how much will they make, if the circumstances hold true. Risk analysis is the opposite of ROI. Using this philosophy every project has a foreseeable and predictable financial risk. Risk analysis involves measuring the potential risk against the potential gain of the project. The idea is to avoid risk and take the route that has the highest potential gains. Both of these analysis approaches involve the use of Break even analysis.

The first factor in determining the break even point for the UDA project is the effect of the UDA project on core product lines. It is the general consensus that the UDA will result in an annual after tax cash flow of $25 million dollars. When one extrapolates these figures over the entirety of the project it amounts to $100 million dollars. This estimate considers the scenario where the product is well-received by the public and that expected sales quotas are met.

One of the key financial considerations for this project is where the production will take place. GMC already owns a suitable building for production of this product. The building was purchased twenty years ago for $40 million dollars and has a current value of $10 million. After the completion of the project this building will be sold for $6 Million. The building has been valued using a straight line depreciation from the time of purchase.

The cost for using this building, minus overhead, represents a fixed cost. Equipment will cost $180 Million dollars, but will have no re-sale value at the end of the project. This makes the net expenditure for he use of the building (-$186 million). This assumes that there will be no major repairs needed on the building due to its setting vacant for so many years. Currently, this building represents a liability from many perspectives. The company has to maintain insurance on the building, yet gains no revenues for its use. It is liability and will soon begin to dilapidate if actions are not taken to prevent its further decline. Using this building would transfer these numbers from the liability side to the revenue side of the equation.

Now let us examine the most commonly considered production revenues and costs for the duration of the project. If market predictions are correct, it can be expected that 1.5 million units will be sold over the first two years and that 1 million will be sold over the last two years of the project due to the entry of even greater competition into the marketplace. However, several competitors already have this technology, so this is not expected to be a factor. The total cost per unit will be $700 for the first two years of the project. During the second two years, the unit price is expected to drop to $500 per unit due to introduced competition. Let us take a look at how these projections look by examining the following table.

UDA Project Revenue Statement

Years

Income Statement

Net sales

Cost of goods sold

Net Operating Income

400,000,000)

Operating expenses

Net Income

400,000,000)

In sufficient data was provided to estimate operating expenses and variable costs. Therefore, they were not included in these figures. Many of these factors cannot be accurately determined for the purposes of quantitative analysis. There are many factors that could affect these costs such as wages, health care costs, fuel costs, and utility costs. It is expected that operating costs will reduce the net income considerably from those shown. However, it will reduce it at a uniform rate, so that it will not affect the final analysis of the project.

Now let us see what the additional $25 Million in Sales does to these projections. In addition we will cost-average the $180 Million in equipment expenses over the four years of the project. The effect of the $6 million for resale of the building is negligible in this case.

Income

Years

Income Statement

Net sales

Cost of goods sold

Net Operating Income

375,000,000)

Operating expenses

Net Income

420,000,000)

As one can see his revenue does not change our analysis considerably. The project is still at a loss. The Gadget Division would not be able to sustain such as loss. In addition, the additional $25 Million in additional car sales would not be credited to the Gadgets Division, but would be considered income for the Vehicle Sales Division. Therefore the additional & 25 million in sales would not be considered in this project This analysis represents what is considered to be the most likely course that the situation will take based on marketing analyses of customer preferences. One must remember that there are already substitute projects available on the market. However, GMC has established brand equity and this will help to boost sales, even though a similar product is already on the market. Let us assume that the price of the UDA falls to $600 instead of $500.

Best Case Scenario

Years

Income Statement

Net sales

Cost of goods sold

Net Operating Income

275,000,000)

Operating expenses

Net Income

320,000,000)

As one can see, this still does not mean profit and the project would appear to be a no go. The problem in this scenario is that in this particular case the costs remain constant, while the number of units sold and the revenue produced fall over the same time period.

It is standard procedure to conduct worse case scenario analysis. However, it is easy to predict what the result will be in this case. The primary concern in the worst case scenario is that the losses will be so great that they will have a negative impact on the profitability of the corporation as a whole. Losses of this scale may negate any increases in revenue from other divisions. One must consider the effects of the project on the well-being of the entire organization, and in this case there is some concern.

Worst Case Scenario

Years

Income Statement

Net sales

Cost of goods sold

Net Operating Income

475,000,000)

Operating expenses

Net Income

520,000,000)

In any of these scenarios, it would be recommended that the project not be undertaken, even if it means a small loss of potential revenue in other divisions. However, there are other things to consider in the analysis and this only represents the most common valuation method.