LOOK FORWARD PIPE & TUBE, INC.[1]

If we do decide to produce the 10- and 12-inch pipe internally, it could solve our overstaffing problem, Anna Holub, owner of Look Forward Pipe & Tube, Inc. (LFPT), remarked to the plant manager. Im reluctant to lay anyone off. Its not the right thing to do if it can be at all avoided.

THE FIRM

Anna Holub had no intentions of starting her own firm back in 1998 when she graduated from college. She started working for WorkHardFederer Pipe, a company based in Norman, Oklahoma. This firm had a quote by a great tennis player, Roger Federer, as a moto: There is no way around hard work. Embrace it. You have to put in the hours because theres always something which you can improve. Anna found other quotes by Federer including: When you do something best in life, you dont really want to give that up and for me its tennis. For Anna, it was her understanding of the manufacturing side of the piping business and in May of 2004, she decided to start her own pipe company.[2] She recognized that in order to be successful, she needed marketing and financial expertise. By her own admission, Anna made many mistakes during the first 18 months, but nonetheless, the business surged ahead. By the third year, it was clear not only that the company would be successful, but that it had the potential to prosper.

And prosper it has. LFPT operates on 14 acres and employs 31 people. In fiscal year 2008, sales totaled nearly $25 million despite a nationwide recession and the highly competitive nature of the piping business.

Anna attributes her success to two factors: service and dedication to quality. She often tells her employees, If we achieve quality, the quantity will take care of itself. The company also provides exceptional service. LFPT keeps an unusually large volume and selection of inventory at all times and maintains a relatively large fleet of trucks. As a result, the company can fill an order quite quickly. Such fast delivery means that distributors LFPT sells to--many of whom are nationally known wholesalers of building materials--are able to keep their inventory low.

A PROBLEM OF SIZE

The vast majority of LFPTs sales come from drainage pipe, which is mainly used in various sewer systems. The pipe comes in a variety of sizes, and sales depend in part on customers perceiving the company as a full-line producer. That is, a sales person is more likely to win an account if a distributor knows that a producer can promptly deliver various sizes of pipe. Typically, this means that a manufacturer can quickly meet orders for the most commonly used sizes of pipe. These include pipe with diameters of 3 inches, 6 inches, and 8 inches.

Sometimes, however, a distributor is interested in 10-inch and 12-inch pipe. LFPT has never produced these sizes internally because Anna feels that annual sales volume is too low to justify the start-up cost. If a customer requests such pipe, LFPT typically buys it from a competitor who manufactures the desired sizes. Anna has not analyzed whether this is a good policy, and she thinks now is the time to do so, especially given the firms staffing situation.

As she sees it, there are two main advantages to producing the 10-inch and 12-inch pipe internally. First, LFPT avoids the expense of buying the pipe from another firm. LFPT pays 45 cents per pound for this pipe plus another 2 cents per pound in distribution costs to get the pipe to LFPT customers. Unit selling price is 56 cents per pound. A second advantage is that the companys staffing problem would be helped.

Though dollar sales have increased slightly in the last two years, Anna recognizes that the firm is overstaffed by two employees. Sales simply arent sufficient to keep all the production workers busy full time. She thinks this could continue, given the state of the economy. In its entire history, the firm has never cut any workers hours, let alone lay off someone. Anna decided that she wont start now.

ANNAS ESTIMATES

Anna cant be certain of what future sales of the 10-inch and 12-inch pipe will be. She finds it helpful to think in terms of scenarios. She has devised a set of estimates shown in Exhibit 1.

In addition, two sales people complained that accounts were lost when distributors learned that LFPT does not produce 10-inch and 12-inch pipe internally. These distributors were concerned that LFPT would not be able to fill orders quickly. As a result, these sales people argued, the entire account was lost and not just the orders for 10-inch and 12-inch pipe.

Anna is unsure what to make of this lost order argument. If the sales personnel are correct, then LFPT could nearly double the figures shown in Exhibit 1. For the time being, she decides to ignore the possibility that orders have been lost. She wants time to investigate the claims of the sales personnel who, she believes, have a strong incentive to inflate any loss.

The most inexpensive equipment that is capable of producing the quality that Anna desires costs $600,000 and can generate 2 million pounds of pipe per year. For the purpose of analysis, Anna will assume straight-line depreciation to zero salvage value over the eight-year life of the project. The market value of the equipment after eight years is expected to be $180,000 before taxes. Ms. Holub also determined that the investment in net working capital will be the same regardless of whether LFPT makes or buys the 10-inch and 12-inch pipe.

THE ACCOUNTANTS ESTIMATES

The firms accountant, Don Carlione, has developed a set of numbers that, in his view, strongly indicates in-house production is a losing proposition. (See Exhibit 2.) Mr. Carlione estimates it will cost 54.3 cents per pound to produce the 10-inch and 12-inch pipe internally. He notes that LFPT can purchase the same pipe for 45 cents per pound from another manufacturer and incurs another 2 cents per pound to get the pipe to LFPTs customers. Thus, Don argues, internal production results in a 7.3 cent per pound loss, or $87,600 per year assuming 1.2 million pounds of pipe.

As Anna scans these figures, she smiles as she notices that Don used Annas sales estimates and annual sales probabilities. She wonders, though, how accurate the accountants numbers really are. For one thing, the estimates are based on the most likely sales figure and do not consider the other sales possibilities. In addition, Anna questions the appropriateness of including depreciation, given that it is a non-cash item. For these and other reasons, she decides to reconsider the analysis.

Anna is comfortable with many items listed in Exhibit 2. She believes it is quite reasonable, for example, to assume material costs will be 32 cents per pound. And, yes, the project would use two laborers and will require plant space and supervisory personnel. Yet the firm has significant excess space and the equipment could be operated in an area of the factory that Anna believes would otherwise be vacant for the foreseeable future. In addition, Anna believes that the firms plant manager could easily supervise the project without affecting his efficiency in other areas.

Anna then reflects further on her staffing situation. Although it may not be good business, she is quite comfortable with her decision not to terminate any employees. Ms. Holub realizes that at most, LFPT will be over-staffed for three years, since two workers are scheduled to retire at that time. And there is the possibility that sales will increase sufficiently over the next three years so that all the staff would be fully utilized. If this does happen, of course, new workers would have to be hired (but no new supervisors) if the project were implemented. Anna estimates there is only a 20 percent chance that this would happen in any year. Considered from a different angle, there is an 80 percent chance in each of the next three years that the two laborers used in the project will not be productively employed somewhere else in the firm.

1. The accountants estimates in Exhibit 2 use the most likely sales projection in Exhibit 1 for each year. Is this appropriate?