CHEMCO is a chemical manufacturing company that has been successful in research and development. It has built its reputation by exploiting its excellent research staff’s ability to develop new and useful products. The firm has been able to capitalize on being an innovator, reaping the high profits that result from being first with a product and facing little initial competition. The company has promoted new products strongly obtaining an identification with them that has carried over into longer term market dominance in many cases. A recent new product, PRIMEBEEF, seems to have remarkable effects as cattle feed additive. It results in a higher proportion of high grade beef.
Having been involved in many new product introductions, CHEMCO has learned to deal with the market uncertainties of new products. Therefore, when the initial market tests for PRIMEBEEF were successful, capacity planning became an issue, CHEMCO developed flexible capacity plans that took account of contingencies. The potential market was large but not certain. It was known that competitors were already attempting imitations. Therefore, part of the strategy was to expand output as soon as possible to establish CHEMCO’s market position was to expand output as soon as possible to establish CHEMCO’s market position. The capacity planning issues were centered in plant size and the expandability of a small plant, should that be the decision. After making market estimates, CHEMCO decided on a 10 year planning horizon.
Marketing predictions could be framed in several scenarios that were structured as follows:
1) Demand would be high initially, product identification would be successful, and demand would remain high. Probability = .60
2) Demand would be high in the initial two years, but competition would be so keen that demand would be low thereafter (third through tenth years) Probability = .10
3) Demand would be initially low and would remain low. The product would never be very successful. Probability = .30.
From the above three scenarios, CHEMCO noted that the probability of an initial (first two years) high demand was p = .70 which formed the basis for a capacity strategy that would start with a small plant that could be expanded after two years if demand was in fact high during the initial period.
Two basic capacity strategies were based on the market predictions. Alternative 1 – build a large plant costing $ 3 million. Alternative 2 – build a small but expandable plant initially costing $ 1 million. If initial demand is high, decide within two years whether or not to expand the plant at a cost of $2,200,000. This decision involved risks also because even if initial demand is high (p =.70), the probability is only p = .60 that it will be high thereafter. Therefore, the conditional probability that demand will be following a decision to expand is p = .60 / .70 = .86.
Estimates of annual income were made under the assumption of each demand pattern as follows:
1) A large plant high volume would yield $1million annually in cash flow.
2) A large plant with low volume would yield only $ 100,000 annually because of high fixed costs and inefficiencies.
3) A small plant with low demand would be economical and would yield annual cash income of $ 300,000.
4) A small plant, during an initial period of high demand, would yield $450,000 per year, but this yield would drop to $400,000 yearly in the long run because of competition. (The market would be larger than under c, but would be divided up among competitors).
5) If the small plant were expanded to meet sustained high demand, it would yield $700,000 cash flow annually and would be less efficient than a large plant built initially.
6) If the small plant were expanded but high demand was not sustained, estimated annual cash flow would be $50,000.
Analysis and Decision:
CHEMCO decided that the capacity planning program was definitely risky and that careful analysis should be made attempting a decision. The president of the company stated that they wished to preserve CHEMCO’s historical record of maintaining an 18 percent before tax return on investments. It also raised the questions of whether or not the company had all information it needed and whether there were other strategies that should be considered. What analysis should be made? What should CHEMCO do?
Considering alternatives (4) and (5) above, a smaller plant with a provision to expand seems to be viable, reasonable revenue earning without affecting its market share.