The case discusses an Australian based company, Southern Star Ltd, which specializes on the skateboard manufacturing both junior and senior ones. The company has a strong position in the market with a stable revenue and income growth. At the same time, the firm is highly dependent on seasonal fluctuations and sells the most of its produced goods in the spring and summer months.
Southern Star has obtained a new opportunity to sell its products internationally. As described in the case, the company has an option to sign a long-term contract with an Indian customer that will significantly influence the company’s sales and production volume. The firm will have to double its manufacturing in the second half of the following year and extent its production capacity by four times in the next two years. The potential risks and benefits of the Indian option will be discussed, along with evaluating how the contract will influence the company’s profits in the future. In addition, an alternative option of relocating the company’s production to India will be reviewed. Finally, the paper will be concluded with a suggestion on whether the company’s management should accept this order and sign the contract or not.
The decision on the Indian contract should consider internal and external aspects, which will be faced by Southern Star Ltd in case it accepts the order. Internal aspects are predominantly referred to the additional relevant costs and investments necessary to maintain a higher production level. External aspects are the risks, which occur due to operating in the international marketplace.
The most crucial financial issue is related to a significant investment that is needed to obtain a new building for the skateboard manufacturing. If the company decides to accept the order, it will have to produce twice as many goods since the second half of the following year. However, its budgeted production for this period amounts to 5,200 skateboards (2,400 junior and 2,800 senior ones) since July 2013, and the total capacity of the building is constrained to total 8,000 skateboards per month. Therefore, the company will not manage to produce its budgeted volume, and the Indian order in this building as the production volume has to be equal to 10,400 units in the following year and twice as much in the next two years.
In order to comply with the required sales volume, including the Indian order, for the next three years, Southern Star Ltd will have to obtain a considerably larger building (with at least three times as much capacity as the current one) and, thus, make a significant investment. This order could be analyzed as a separate project, where the decision is made on the basis of positive NPV (net present value), payback period and other financial ratios. The company’s management needs to consider the investment volume, cost of financial resources and net profits coming from the order separately from its current production and sales activities.
It is significant to evaluate the Indian order based on the relevant costs borne by the company if it signs this contract. All of the direct costs are relevant for each additionally produced unit of skateboards. They are: direct material costs (wood, wheels, and speed control system), direct labor costs, and manufacturing overhead costs (variable part). Besides, such variable costs as commission payments and distribution (variable component), which are dependent on the sales volume in dollars and units respectively, are also relevant for the order.
As the Indian order requires a significant increase in the production volume, it is also essential to consider an increase in fixed manufacturing overhead costs stepwise. More manufacturing staff will require more managing employees to maintain processes in the company. Moreover, the company will have to spend a certain amount of funds in order to find more workers, both manufacturing and managing ones, that is additional costs associated with human resource seeking and management.
Fixed research and development, marketing, and distribution costs are not relevant as the company is selling the order to one customer, who does not need any additional improvements in products or advertising companies aligned for it. However, it is crucial to take into account that transportation costs should occur as products have to be delivered across the ocean to India. The company’s management should discuss the transportation issue with the customer in order to define the cost-bearing side.
External risks of the new order appear from the note that the Indian customer does not sign the contract for three years for a certain amount of consumption and fixed prices. No one can ensure the company that skateboard prices and demand volume will not fluctuate in the following years significantly. In addition, there is no information on further sales opportunities for the company’s production after the discussed three years. Increasing the company’s capacity by three-four times requires more market research and assurance of the future market conditions and profits.
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From the international perspective, the company has an alternative option of opening a new production facility in India. This option seems to be a preferred one as it requires lesser investment and lower production costs for the project. However, it is essential to consider other financial and non-financial issues. Some international risks, such as country risk or foreign exchange fluctuations, may influence the company’s profitability level and even threaten its stability. Financial managers of Southern Star Ltd should review the Indian tax regulations, country financial position, local legislation (especially related to income repatriation opportunities and nationalization), costs of necessary resources and availability of investment funds before making a final decision on the production relocating to India.
Signing the Indian contract obviously requires more research on the financial and non-financial risks, which can occur for Southern Star Ltd within this project. It can be considered a good chance for the company to expand its production and markets on the international level. However, it also bears significant risks.
The company’s management should decide whether it is ready to take such risks and initiate extending the business in the following year. They should explore other markets and opportunities as well in order to ensure future profits after the Indian contract expires. If the market research shows that the company’s products will have stable demand overseas, Southern Star Ltd should take this order.
The company could also find a compromising way of expansion. There is an option to increase its manufacturing facilities in the following year with the purpose of covering only the current contract with an Indian customer. This will provide the company with time and opportunity to get better knowledge of the Indian market and business environment. Subsequently, the company can initiate a second step of the expansion. At the end of the following year, it can analyze the Indian order’s outcomes and build a manufacturing plant in India if conditions are satisfying, and profits generated by the project overweight its risks.