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Thompson Tools: The Entrepreneur’s Dilemma
“You won’t believe what just happened!” Alyssa Thompson shouted when you answered your phone. “It may be the opportunity of a lifetime, but I’ll need your help running the numbers to see what I’m getting myself into.”
It seemed Alyssa was fated to go into a business related to rock climbing. She was born in Estes Park, Colorado, and had grown up challenging herself to ascents on the sheer rock walls in Rocky Mountain National Park.
You and Alyssa became friends as freshmen when you attended Maryville University. While Alyssa majored in Marketing, you majored in Accounting. You shared an interest in the outdoors, taking long hikes on the trails outside of St Louis and free climbing the cliffs along the Missouri River.
After three years, Alyssa decided to return to Colorado and complete her studies in Maryville’s On-Line program. During the Summer break, she secured an internship position at an established company that specialized in retail mountaineering equipment. She worked in the department that organized and operated rock-climbing tours. While there she developed the idea that led to her current business opportunity. A critical tool for rock climbers is the piton, a device like a flat spike that the climber hammers into crevices in the rock wall in order to attach support lines. These tools need to be strong enough to be driven into the rocks and removed numerous times. That strength comes at the expense of added weight, which is a significant issue for climbers, since they typically carry many pitons.
She shopped her employer’s store looking for lightweight pitons, but could only find ones made of steel. She asked the owner why none of the pitons were made of titanium, or some other lightweight alloy. He replied that they tried a titanium product from Russia, but it was very expensive and of low quality. He told her if she could reliably obtain titanium pitons at the right price and quality, he would be willing to buy them.
Alyssa began to research the potential to produce high quality pitons from titanium. It turned out to be less complicated than she anticipated, and, after several tries, she designed one that would take advantage of titanium’s superior strength, while weighing significantly less than the standard steel product. Then she identified a company in the Denver area that did drop forging, the key to the production process. She made inquiries and learned the company had excess capacity and could produce the product in volumes she believed she could sell. Within weeks, Thompson Tools (consisting entirely of Alyssa) was in business, purchasing titanium bars and having them delivered to the forge, where they were converted into the finished product and delivered to the retail store in Denver.
Alyssa’s trial order was for 1,000 units, but soon she had a reorder rate of 1,000 units per month. The retailer paid her $11.00 per piton. The raw material cost of the titanium came out to $1.50 per piton, and the forge charged her $9,000 to make and pack an order of 1,000 pitons. Clearly, she was not making any money. In fact, a minimum wage job would have paid her more. However, what mattered to her was the proof of her concept - she could successfully design and sell her product. The start up risk had been low, and she now had her own business.
Three phone calls changed the landscape. First, she received a call from the owner of the Denver retailer. He told Alyssa he was impressed with her product and made the following offer: “If you give me an exclusive supplier arrangement for two years, I will guarantee you a purchase volume of 4,000 units per month at $10.50 per piton for the length of the contract”. “Actually, I think it could be 10% higher, but I’m only willing to guarantee 4,000”. Her elation at the offer quickly evaporated because the $10.50 price would only cover her current unit costs. She wasn’t sure if the forge would grant her a cost break because of the extra volume, or, more importantly, if the forge had the available capacity to quadruple production.
The second phone call was from the owner of the forge. He had decided to close the forge and move to Florida. He asked if she was interested in taking over the forge. She felt her jaw drop, but quickly recovered and said she might be interested, but would need some operating data first.
She learned that the forge had thrived making titanium implants for hip and knee replacements, but that business had shifted to China. In fact, the owner of the forge admitted that for the last few months Alyssa had been his only customer. He operated a forge with a minimum crew of six, each able to operate all the equipment in the forge. Her current volume of 1,000 units required only one week of labor. She asked if the workers could produce more than 1,000 units per week, and the owner speculated “about 1,100 units”. She realized she would need all six workers if her demand increased to 4,000 units per month.
The workers were paid wages of $60,000 each, including benefits like holiday and vacations. Operating costs (fuel, property taxes, insurance, maintenance, and utilities) totaled $60,000 last year. Alyssa estimated administration costs to be around $500 a month, or $6,000 per year. Finally, the forge owner offered to sell the forge for $25,000, IF Alyssa agreed to retain all six of the forge workers at their current salary. Alyssa would depreciate the forge over 10 years using Straight Line depreciation.
The third phone call was to her father. She explained the offer to him; She would quit school to devote 100% of her time to running the business. While he had misgivings, he agreed to gift Alyssa the purchase price, since the cost of the forge would be offset by what he was paying for Alyssa’s tuition and dorm expenses. And, he wanted to encourage Alyssa’s entrepreneurial ambitions.
Alyssa realized this could be a once in a lifetime opportunity. She had guaranteed demand. She would forego a salary for at least the first year.
Registration for the Fall term is fast approaching. She must decide!
She decided to call you for an objective opinion. You understand her love for the outdoors, and she remembered that you received an “A” in ACCT 211. She is confident you can advise her in this matter.
1. Based on the retailer’s offer, calculate Alyssa’s revenue, contribution margin and operating income for both the retailer’s baseline offer, and the 10% increase. Present the data in a Contribution format Income Statement for Alyssa’s first year of operation. (30 pts)
(I suggest you start with unit data; then calculate the annual data.)
2. Which costs are variable, and which costs are fixed? (10 pts)
3. What is the relevant range for the forge? (10 pts)
4. Is Direct Labor variable or fixed, and why? (10 pts)
5. Calculate her breakeven units. (10 pts)
6. Calculate her Margin of Safety units (for both baseline and 10% increase). (10 pts)
7. What is your advice to Alyssa? Should she stay in school and complete her degree, or should she throw caution to the wind and go into the mountain climbing equipment business? Explain your answer. (10 pts)
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