Make or Buy Decisions

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Make or Buy Decision

Jumeirah Full Service Car Wash

Jumeirah Full Service Car Wash is about to start its car wash business. The owner is Nasser El Adly, a retired taxi driver. The car wash is strategically located on a busy street that separates an affluent suburban community from a middle-class community. It has two highly sophisticated washing chambers. Each chamber can provide anything from a basic two-star wash and rinse to a five-star luxurious bath. It is all “touchless”, that is there are no brushes to potentially damage the car. Outside each chamber there is also a 400 horse-power vacuum. Nasser likes to joke that these vacuums are so strong that they will pull the carpet right out of your car if you aren’t careful.

However, Nasser has some important decisions to make before he can open the car wash. First, he knows there is only one drive-through car wash about 10 minutes away. It is attached to a petrol station. It charges 20 Dirham for a basic wash and 15 Dirham if you also buy at least 30 liters of petrol from the station. It is a “brush” type wash with rotating brush heads. There is also a self-serve car wash a 15-minute drive away from Nasser’s location. He knows that both these locations have long lines, which is one reason why he decided to build a new car wash.

Nasser is planning to offer three levels of wash service – Basic, Deluxe, and Premium. The Basic is all automated; it requires no direct intervention by employees. The Deluxe is also all automated, except that at the end two employees will wipe down the car and put some wax on the windscreen so that any dust or water will not stick to it. The Premium level will include all the services of the Deluxe, plus a special wax after the machine wax all over the car’s body, and two employees will vacuum the car, wipe down the entire interior, and wipe the inside of the windows. To offer the Premium service, Nasser will have to hire a couple of “car wash specialists” to do the additional pampering.

Based on the data he received from the local authorities, Nasser has pulled together the following estimates for his prospective car wash business:

Per Unit (AED)Total (AED)

Direct materials per Basic wash0.90

Direct materials per Deluxe wash2.40

Direct materials per Premium wash3.30

Direct labor per Basic washN/A

Direct labor per Deluxe wash1.20

Direct materials per Premium wash7.20

Variable overhead per Basic wash0.30

Variable overhead per Deluxe and Premium wash0.60

Variable administrative overhead – all washes0.30

Annual Fixed wash chamber overhead350,000

Annual Fixed administrative overhead390,000

The estimated total number of washes of any type is 45,000. Nasser has invested AED 1,200,000 in assets for his business. He would like a return on investment (ROI) of 20%.

Required:

  1. Identify the issues that Nasser must consider in deciding on the price of each level of service of his car wash business. Also, discuss what issues he should consider in deciding on what levels of service to offer.

Nasser is trying to become a market entrant with two competitors. The location of the car wash is ideal since it shall cater to customers both from affluent background and those who would prefer the less expensive alternatives. Nasser is therefore thinking ahead when deciding to give more options when customers would require a car wash.He needs to assess his customer base and analyze how much would the middle class community be willing to pay. The prices offered by him need to be competitive because of the alternatives present in the area not too far away from his own business. He would therefore require to actively market his services in order to gain a competitive advantage and this cost will have to be absorbed into the service cost charged to the customers. In the present situation Nasser is offering three types of car washing services.

  • Basic Wash:
  • An all automated service that requires no direct intervention by employees.
  • Estimated variable cost of service per unit (AED):
  • Direct Materials 0.90
  • Direct Labor N/A
  • Variable Overhead 0.30
  • Variable Administrative overhead 0.30
  • Total variable cost is AED 1.50 /wash
  • Since this service is also provided by another competitor who charges a reasonable price of 20 Dirham for a basic wash and brings it down further with to 15 Dirham if you also buy at least 30 liters of petrol from the station. This car wash has the advantage over Nasser’s basic wash service as customers would be attracted to a place where there is an easy provision of fuel. As cars would line up to get their fuel tanks filled it would be just a complimentary service that the competitor would provide at a low cost making the option very attractive. Since Nasser does not have a petrol station adjacent to his business he will have to keep the cost lower than the ones being provided by the competitor there in order to attract customers, making full use of its edge of automated process in contrast to the competitors brush cleaning service and self-service and the ease of provision by avoiding long queues at his competitors end and the nearer distance from the 15 minute away other competitor.
  1. Deluxe Wash:
    • The Deluxe is also all automated, except that at the end two employees will wipe down the car and put some wax on the windscreen so that any dust or water will not stick to it.
    • Estimated variable cost of service per unit (AED):
    • Direct Materials 2.40
    • Direct Labor 1.20
    • Variable Overhead 0.60
    • Variable Administrative overhead 0.30
    • Total variable cost is AED 4.50 /wash
    • This is a service where Nasser has a competitive edge over his competitors. However he needs to ascertain if they would be willing to purchase this service that is more expensive than the basic wash.Nasser could play at the heart of the customers by addressing that the additional cost is due to the great quality of service provision, cost of the wax used and the labor cost of the employees’ administering it and adding a ‘personal touch’ to the service. It is possible that customers might not consider this worth their money and seek out the cheaper alternative and Nasser might have to offer discounts or customer loyalty coupons to make this offer more attractive.
  2. Premium Wash:
    1. The Premium level will include all the services of the Deluxe, plus a special wax after the machine wax all over the car’s body, and two employees will vacuum the car, wipe down the entire interior, and wipe the inside of the windows. To offer the Premium service, Nasser will have to hire a couple of “car wash specialists” to do the additional pampering.
    2. Estimated variable cost of service per unit (AED):
    3. Direct Materials 3.30
    4. Direct Labor 7.20
    5. Variable Overhead 0.60
    6. Variable Administrative overhead 0.30
    7. Total variable cost is AED 11.40 /wash
    8. This is one of the most expensive of the offers by Nasser’s car wash and its acceptance by the customers’ needs to be evaluated. This service will be welcomed by the affluent neighborhood and Nasser needs to focus all his attention to marketing it to the customers from that area. This service also sets him apart from his customers and the inclusion of specialists to do the job would showcase how much importance Nasser places in the quality control of service provision. Nasser is going over and above at providing exceptional car wash services by the wax treatment and the cleaning of the interior and this is something not provided by his competitors. It is important that these service upgrades do not outweigh the cost for the consumer and do not result in the loss of the service in the long term.

Since Nasser is providing three different services he will need to ascertain the prices being set at such a level to create a market niche for him, incur customer loyalty and provide profitability. He can try to promote the least expensive service first and then try to sell the customers up to a higher level of service when they drive in to receive it.In the beginning of his business it is wise for him to introduce an introductory price to attract customers and offer discounts for additional services. Since humans are creatures of habit they are likely to come back to him if his services are good and his popularity will soar through word of mouth. Loyalty cards can be introduced to encourage customers to keep using his services and he can offer promotions and coupon books with the option of advance booking for additional washes.

  1. Nasser estimates that out of the total 45,000 washes, 20,000 will be Basic, 20,000 will be Deluxe, and 5,000 will be Premium. Using the Cost-plus pricing, advice Nasser about the prices for each type of wash that Nasser should charge to achieve his 20% desired ROI.

Solution:

Budgeted Units = 45,000

Annual Fixed wash chamber overhead per Unit=350,000/45,000

=AED 7.78 /unit

Annual Fixed administrative overhead per Unit =390,000/45,000

= AED 8.67

Total Fixed cost per Unit =7.78 + 8.67

= AED 16.44 /Unit

Investment made = AED 1,200,000

ROI Required 25 %

Budgeted Units =45000 Units

Desired ROI per Unit = (1,200,000 x .25)/45000

= AED 6.67/Unit

Desired Selling price achieving a ROI of 25%

Basic Wash

Deluxe

Premium

Direct Materials

0.90

2.40

3.30

Direct Labor

-

1.20

7.20

Variable overhead

0.30

0.60

0.60

Variable adminitrative overhead

0.30

0.30

0.30

Variable Cost per Unit (AED)

1.50

4.50

11.40

Fixed Price /unit

16.44

16.44

16.44

Desired ROI per Unit

6.67

6.67

6.67

Desired Selling price/Unit

24.61

27.61

34.51

  1. During the first year, instead of selling 45,000 washes, Nasser sold 43,000 washes. He was quite accurate in his estimate of total number of washes in the first year, but he was way off on the types of washes that he sold. He sold 3,000 Basic, 31,000 Deluxe, and 9,000 Premium. His actual fixed expenses were as estimated and his variable cost per unit was as estimated. Comment on Nasser’s actual net income and his actual ROI.

Solution:

Revenues

Units

Selling price

Total

Basic

3,000

24.61

73,830

Deluxe

31,000

27.61

855,910

Premium

9,000

34.51

310,590

Total Revenues

1,240,330

Variable Expenses

Basic

3,000

1.5

(4,500)

Deluxe

31,000

4.5

(139,500)

Premium

9,000

11.4

(102,600)

Total Variable Expenses

(246,600)

Contribution Margin

993,730

Fixed Expenses

Annual Fixed wash chamber overhead

(350,000)

Annual Fixed administrative overhead

(390,000)

Net Income

253,730

Actual Return on Investment = 253,730/1,200,000

= 21.14 %

  1. Nasser was using a traditional approach to allocate overhead. He was allocating overhead equally to all three types of washes, even though the Basic wash is considerably less complicated and uses very little of the technical capabilities of the machinery. Advise Nasser as to what should Nasser do to determine more accurate cost per wash for each type of wash? How will this affect his pricing and, consequently, his sales?

Clearly the traditional approach of allocating costs is incorrect in Nasser’s business as he is providing three difference types of services but allocating costs equally amongst them despite their differences in service and quality. The basic wash does not use much more complex capabilities of the equipment. The equipment is expensive and the overhead depreciation would be a big portion of the allocated fixed cost. Therefore the accuracy of the product cost would significantly improve with activity based costing approach. The earlier approach has resulted in product costs and prices that were too high for the basic wash and too low for premium. Allocation of overhead using labor would change the pricing and the type of services wanted will shift based on the value the consumer finds the best. Such an approach could potentially lower his sales but increase his profitability per wash.

Fujairah Watering Systems

Fujairah Watering Systems (FWS) is a private company providing the products and services needed to irrigate farms, parks, street side trees, commercial projects and private homes. It has a centrally located factory in Fujairah that manufactures the products it retails through retail outlets across the nation. It also maintains a division that provides installation and warranty servicing across seven emirates.

The mission of FWS is to manufacture quality parts that can be used for effective irrigation projects that also conserve water. By that effort, the company hopes to satisfy its customers, provide rapid and responsible service, and serve the community and the employees who represent them in each community.

The company has been growing rapidly, so management is considering new ideas and new markets to help the company continue its growth and maintain a high quality of its products.

One of its products is in high demand at home and abroad. The company mass-produces a special connector unit that it normally sells for AED12.00. It sells approximately 35,000 of these units each year. The variable cost for each unit is AED6.90. A company in Canada would like to buy 15,000 of these units at AED7.80 per unit. The production of these units is near full capacity at FWS, so to accept the offer from the Canadian company would require temporarily adding another shift to its production line. To do this would increase variable manufacturing costs by AED0.90 per unit. However, variable selling costs would be reduced by AED0.60 a unit.

Another local irrigation company has asked for a special order of 2,000 of the connectors. To meet this special order, FWS would not need an additional shift, and the irrigation company is willing to pay AED9.30.

Required

FWS is seeking your advice on the following issues:

  1. What are the consequences for FWS if it agrees to provide the 15,000 units to the Canadian company? Would it be wise to accept the “special order”?

Acceptance of the Canadian offer for the purchase of 15,000 units would have the following implications on the variable costs of FWS if an additional production line is added.

Variable manufacturing costs would increase by AED 0.90 per unit.

Variable selling costs would be reduced by AED 0.60 a unit.

If accepted

AED

Selling price/Unit

7.80

Units Required

15,000

Total Revenue

117,000

Current Variable Cost/unit

6.90

Change in Manufacturing Cost

0.90

Change in Selling Cost

(0.60)

New Variable Cost/Unit

7.20

Total Costs for 15,000 Units

(108,000)

Net Income/(Loss)

9,000

Since the acceptance of the order results in a Net income of 9,000 Dirhams it would be profitable for FWS to entertain this order.

  1. Should FWS accept the special order from the local irrigation company?

The local irrigation company has asked for a special order of 2,000 of the connectors which would not require an additional shift, and the irrigation company is willing to pay AED 9.30

If accepted

AED

Selling price/Unit

9.30

Units Required

2,000

Total Revenue

18,600

Current Variable Cost/unit

6.90

Total Costs for 2000 Units

(13,800)

Net Income/(Loss)

4,800

Since this proposal also results in a positive net income for FWS and does not require additional efforts of adding an extra production line it should be accepted.

  1. What would be the consequences of accepting both special orders?

Even though both the orders result in a profitable result for FWS, the organization needs to consider the implications of their acceptance of both. The order by the Canadian company would require additional resources for the new production line and changes would be required to the additional setup. The company needs to ensure that its employees do not lose focus of their main goal of being the market leaders and do not work tirelessly on just one product. The company would be working at an over capacity and should be aware that the labor cost would also need to compensate its workers for all the hard work that they are doing. Taking both of these orders would require greater working hours and machine working and company needs to make sure It has ample facilities to take up huge orders of this kind. There should be a cost benefit analysis of just focusing on the production of this one item instead of spending resources on the research on the innovation for an even better product.

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