WILL BILL MILL & DRILL?

A case by Prof Sridar Natarajan

Sri Castings was established by Bill in December 2007 with an investment
of Rs. 5 Million. Its objective was to manufacture and sell raw castings for
an ancillary supplier to the automobile industries in Tamil Nadu. The plant
was located on two acres of land acquired on a long-term concessional
lease rental of Rs. 100,000 a month
The machinery was purchased and installed in a record period of 3 months
and its first batch of castings itself was found acceptable by the ancillary Brake Drums Ltd. As Mr. Phadke, GM, Materials of Brake Drums Ltd.
stated, Sri Castings was the first company in BDLs 5 years of existence
whose samples were found to meet BDLs stringent quality requirements
in the first shipment itself.
With a relentless commitment to quality and a supportive client, Sri
Castings posted good results better than expected in the financial year
2008-09, ending with a profit of Rs. 10 lakhs. It was during the annual get
together at BDL that Bill broached the subject of getting additional casting
orders to supply. Sri Castings was working only one shift now, which was
resulting in an inefficient utilization of his Electric Arc Furnace. Additional
orders could result in a better utilization of the Furnace, which could work
for 16 hours instead of 8. Bill would be willing to pass on some of the
benefits of the better utilization to BDL in terms of better prices.
In May 2009, Sri Castings got additional orders from BDL that promised a
doubling of their turnover and a sixty percent increase in profits. Bills
employee strength grew to 50; he hired a full-time Production Manager, a
Metallurgical Engineer from a reputed Engineering College in Coimbatore.
Knowing that handling of volumes would bring with it possibilities of
quality problems, he also hired a full-time Quality Assurance supervisor.
Once again, Bills commitment and hard work paid off. He closed 2009-10
with a turnover of Rs. 21 million and a profit of Rs. 1.7 million. Not only
did he better his estimates, he also increased his ROI by 4.8%.
Not surprisingly, in the annual get-together for 2010, it was Mr. Phadke
who broached the topic for additional orders to Sri Castings. Bill, he said
(they were now on first-name terms), would you be interested in a new
order? We are on the lookout for a raw casting supplier for a smaller
drum. Would I be able to handle it without additional investment,
asked Bill? Afraid not, Bill. This is a slightly complicated product. But the

margins would be fairly attractive! Could I get back to you on this,

Phadke? Maybe a week?
In a weeks time Bill got back in the negative. Sorry, Phadke, but I want
to consolidate the scrap sourcing this year. I wont have time for a
complicated product. No hard feelings? Not at all. In fact, I am happy
to note that you are consolidating. Maybe I will get some benefit out of
your consolidation, eh? Yeah, maybe, came the answer with a smile.
There was definitely a lot of mutual respect between the two.
It was during his scrap consolidation travel that he came across this
advertisement for the sale of a machine shop Rs. 1.65 million for the
entire machinery on an as-is-where-is basis. The advertisement
triggered off a thought process hitherto never considered. Should he start
machining his castings? He was not sure of the answer, but, trusting his
instincts he went and visited the Shop. The machines were both good and
in good condition it would easily have a useful life of 5 years; the records
were maintained professionally. He was convinced that Rs. 1.65 million
for the entire machinery was a good bargain.
He returned and had a first round of discussions with Mr. Murali, his
Production Manager, who was immediately excited about the prospect.
With his confidence now strengthened, Bill immediately sent a proposal to
BDL requesting that he send them machined castings instead of raw
products. His proposal clearly provided details of the machine shop that
he was planning to acquire in order to service BDL. This was July 2010.
After several rounds of discussions between Phadke and Bill, the MD of
BDL agreed to meet Bill to discuss and finalize the proposal. Though it
was a good 3 months after the advertisement had been released, Bill was
in regular touch with the Shop and ensured it was still available a task
which required a lot of persuasion and cajoling.
The meeting with the MD was very productive. Mr. Shome, the MD, was
very supportive, on the one hand, but equally down-to-earth on the other.
It so happens Mr. Bill that we are actually planning to offload some of our
internal machining activities, so your timing is perfect! However, you
need to consider the following points before we finalize the deal.
a. The machining unit has to be a separate entity, as it was against
the policy of BDL to have the same supplier perform the casting
and the machining.

b. The machining charges would be a percentage of the cost of the

castings. This meant that if the foundry became more efficient,
the machining charges would have to reduce!
c. The initial contract would be for a period of 5 years commencing
1 April 2011, after which they would reconsider the arrangement
Mr. Bill promised to revert after re-considering his workings.
Bill and Murali sat down with their calculators and data sheets (Annexure
1). A separate entity meant additional fixed costs. Also, Bill noted that
the orders from BDL would only require 50% of the capacity of the
Machine Shop. Could he get orders from the other ancillary suppliers?
He went back to Phadke, his friend and well-wisher who introduced him to
three more companies that were already getting their castings machined
outside. Mr. Bill visited these companies and, after speaking to the
owners, was convinced that he would be able to utilize his machines at
least 70% of the capacity in the first year itself. The companies he met
assured him of the orders, providing he was competitive in his pricing. His
experience with BDL told him that he was very cost effective in his
operations.
Having accounted for the revenue side of the projections, Bill and Murali
worked out the costs based on the following assumptions:

The company could be setup in the Sri Castings campus, which

had an area of 20,000 square feet that was unused. Consequently,
there would be no cost for land.

For the first two years, Murali would be totally in-charge of the
production activities of both Sri Castings and the new company.
While the time spent on the new plant could affect the production of
the existing castings in terms of contribution loss of around Rs. 5
lakhs in the first year and Rs. 7 lakhs in the second year, Bill felt it
was worth it.

The fixed costs for the new plant was estimated to be as follows:
o Salary of machine operators: Rs. 70,000 p.m.
o Salary of other personnel:
Rs. 30,000 p.m.
o Other overheads:
Rs. 50,000 p.m.

o Interest costs:

Rs. 10,000 p.m.

The new plant will be depreciated using the SLM.

The tax rate is 30%.

The castings planned to be produced by Sri Castings in the coming 5

years are shown below.
*Picture source - Internet

The casting weights and materials are shown below.

Component

Weight

Material

SC-120

20kgs

SG Iron

SC-220

20 kgs

Grey Iron

SC-1425

25 kgs

SG Iron

SC-2425

25 kgs

Grey Iron

SC-1430

30 kgs

SG Iron

SC-2430

30 kgs

Grey Iron

SC-1635

35 kgs

SG Iron

SC-1640

40 kgs

SG Iron

The prices of Grey Iron and SG Iron in Rs. per ton are expected to
vary as given below.

Material

2011-12

2012-13

2013-14

2014-15

2015-16

Grey Iron

18,000

19,000

20,000

21,000

21,500

SG Iron

20,000

21,000

22,000

23,000

23,500

The estimate of production of castings at Sri Castings for the next 5

years is as given below.
Units per year

Component

2011-12

2012-13

2013-14

2014-15

2015-16

SC-120

4,000

4,000

4,200

4,200

4,500

SC-220

3,000

3,200

3,200

3,500

3,500

SC-1425

6,000

6,000

6,000

6,000

6,000

SC-2425

5,000

5,500

6,200

6,500

7,000

SC-1430

6,000

6,500

7,000

7,500

8,000

SC-2430

6,000

5,500

5,500

5,200

4,000

SC-1635

5,000

5,000

5,500

5,500

5,500

SC-1640

5,000

6,000

6,500

6,500

7,000

Sri Castings charges BDL at the rate of the raw material cost + a
40% increase to take care of fixed costs and profit margin.

Bill felt that if the machining charges were more than 7% of the cost
of the product, BDL would not accept their proposal. However, he
was positive that if he charged 5% of the product cost as his
machining charges, he would be a very profitable venture and his
investment would be giving him his desired return of 20%.

Advise Bill on his investment proposal. Should he start this venture?

Should he charge 5% of the product cost as his charges? Will he
generate his return of 20%?

ANNEXURE 1 - DATA SHEET FOR INVESTMENT IN MACHINE SHOP

Table 1: Machine cost details
Machine

Numbers

Operations
executable

Cost (Rs.)

CNC M/c

One

Milling
Turning
Shaping

800,000

Lathe (Manual)

Two

Turning

480,000

Drilling Machine

One

Drilling
Tapping
Chamfering

75,000

Grinder

One

Grinding

35,000

Tooling

260,000

Additional fixed

350,000

assets
Total (funded 50% internally and 50% through a 5year Term Loan of 12% interest)

2,000,000