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Introduction
Galaxy Micro Systems is in the middle of deciding what kind of contract it will tie up with a national franchiser for three years service warranty. There are two alternatives; one is a lump sum contract paid out at the onset. The other is combination of a smaller fixed sum and an installment payment schedule spread over three years. Both schemes appear to be acceptable to Galaxy but there are parameters that need to be defined to make the decision. There is also a significant potential sale that needs to be assessed as it will influence the whole sales picture.
Assumptions have to be made with the best possible estimates regarding sales volumes and probabilities. Comparisons of costs have to be made over a three year period. The best estimate of sales volume will determine what contract will be selected.
Decision Problem
Galaxy needs to decide between two pricing scheme: one is fixed cost and the other is variable. The former specifies $770,000 as the one-time lump sum price for a 3 year period regardless of the number of work station unit sold in the first year. For the unit service of $80, this amounts to 9,625 units sold in the first year. Clearly, if Galaxy can confidently forecast that sales over this number of units, then this lump sum contract would be advantageous. The disadvantage is that the 18% hurdle cost would immediately take effect and would apply for the next three years. To compare apples to apples, we can compare the future values (Future Value of a Single Amount (Explanation), n.d) of the two alternatives using the hurdle rate.
The second option is a variable scheme where various sales targets from regional offices are given probabilities of being achieved. In this scenario, there is a factor that affects the probabilities for the regional sales. There is a long-standing customer who is an early user of the product who was satisfied enough to indicate interest in buying 1,500 units but for some reasons, it cannot yet commit to a buying date. Consequently, Galaxy management sees only a 60% for this to happen. It is seen as a big influence in coming sales as the long-standing customer is the first user of the proto-type. The probability is just a “sentiment”. Decisions have to be made on how to make turn this into more certainty. As it stands now, we can immediately assign an expected monetary value to this by multiplying 60% by 1,500 units which gives 900 units.
The product launch is only two months away and the promotional literature has to be printed in a week. Galaxy has to decide on how to portray the involvement of the long-standing customer.
The major purchase creates a critical risk for marketing and somehow also for product development (Critical Risks and Problems, n.d.), because the market is still monitoring the status of the product. Regional sales are expected to respond depending on the event of purchase pushing through. There are probabilities associated by the regional sales for both scenarios of the major purchase materializing or not.
For the major purchase pushing through, these are the targets, probabilities and estimated monetary value (Sharma, 2015) of sales:
UNITS % SALE ESTIMATED UNITS
Regional sales 1 2,000 20% 400
Regional sales 2 3,000 40% 1,200
Regional sales 3 4,500 40% 1,800
TOTAL 3,400
The same table can also be shown for the case of the major purchase not pushing through:
UNITS % SALE ESTIMATED UNITS
Regional sales 1 1,000 40% 400
Regional sales 2 2,500 40% 1,000
Regional sales 3 4,000 20% 800
TOTAL 2,200
The mean values for these two opposing scenarios would reveal the probable sales volumes, which would be
ESTIMATED UNITS
Regional sales 1 400
Regional sales 2 1,100
Regional sales 3 1,300
TOTAL REGIONAL SALES 2,800
Galaxy offered a refinement to the forecasting approach using fractiles for the go or no-go scenarios for the major purchase, as follows:
FRACTILE UNITS
5% 1,900
25% 2,500
50% 3,000
75% 4,000
95% 5,500
This will need to be compared to the previous assessment of sales forecasts.
Decision Alternatives and Evaluation
As it stands at the moment, the best assessment for the major purchase pushing through is 60%, which is not good enough as the basis for launching the product. This is a critical risk for the business as a withdrawal of the long-standing customer would forever hound the product’s reputation. The customer had 6 months using the product and whatever reason it has for purchasing or not will be considered seriously by future prospects. The prudent decision should be to settle first this critical sale to its logical conclusion. All activities regarding the product should be held in abeyance until the customer has categorically decided to purchase or not. In the event that it did not, then a general review of the business should be made to determine how to move forward on this major setback.
The decision analysis (Bodily et. al., 1998) approach for this case involves examining probability scenarios of a critical risk event which is the major purchase. We thus have three possible counter-offers to the franchiser with respect to the decision of the long-time customer.
60% will purchase
100% will purchase
Will not purchase
60% Chance of Major Purchase
We can still use the current estimates to compare the variable-cost service contract with the fixed cost contract but we since they have different payment schedules, we need to compare their future costs using the company’s hurdle rate of 18% at the end of the 3rd year.
For the fixed-cost contract of $770,000, the 3rd year cost factor is 1.64 which makes it $1,265,135.
Major purchase 900 units
Regional sales 2,800 units
TOTAL 3,700 units
The contract value would be:
Up-front payment $70,000
Payment $296,000 ($80 x 3,700)
TOTAL $366,000
The payment would be divided into 3 at the end of each year. The future cost is computed as follows.
PAYMENT FACTOR (18% pa) VALUE (end of 3rd yr)
Up-front $70,000 1.64 $115,012
1st payment $98,667 1.39 $137,383
2nd payment $98,667 1.18 $116,427
3rd payment $98,667 1.0 $ 98,667
TOTAL $467,489
In the variable scheme, there is an annual minimum payment per year of $250,000. This is 2.5 times that of the estimated payments and should be nullified or adjusted to somewhere lower than $98,667.
The future value of the fixed-contract is 2.7 times that of the variable-cost contract which immediately shows the variable contract as the far better option. The equivalent value for the fixed-contract would be $467,489 divided by 1.64, which will be $285,054.
The lump sum contract value of $770,000 requires a sales volume of at least 9,625 units to be viable for Galaxy. This figure is at more than two and a half times of the estimates of the total sales in the first year which is 3,700. This pricing scheme is too favorable for the national franchiser.
For this scheme to be viable for Galaxy, the value should be below the expected sales for the first year. The value may be smaller but the risk is lower for the franchiser because it is a guaranteed payment up front. This can be 20% below the lump-sum payment of $285,054 which would be $228,043.
With a 60% chance of making the major purchase, Galaxy can get back to the franchiser with two equivalent offers.
Offer A: One-time Lump Sum Up-front of $228,043
Offer B:
Up-front of $70,000
Estimated payment of $98,667 after each of the 3 years
Minimum annual payment of $78,934 (80% of estimate)
100% Chance of Major Purchase
Major purchase 1,500 units
Regional sales 3,400 units
TOTAL 4,900 units
The contract value would be:
Up-front payment $70,000
Payment $392,000 ($80 x 4,900)
TOTAL $462,000
PAYMENT FACTOR (18% pa) VALUE (end of 3rd yr)
Up-front $70,000 1.64 $114,800
1st payment $154,000 1.39 $214,060
2nd payment $154,000 1.18 $181,720
3rd payment $154,000 1.0 $154,000
TOTAL $664,580
The future value of the fixed-contract is 1.16 times that of the variable-cost contract which immediately shows the variable contract as still the better option.
The equivalent value for the fixed-contract would be $664,580 divided by 1.64, which will be $405,232. A further discount of 20% for early payment would set it at $324,185.
With a 100% chance of making the major purchase, Galaxy can get back to the franchiser with two equivalent offers.
Offer A: One-time Lump Sum Up-front of $324,185
Offer B:
Up-front of $70,000
Estimated payment of $154,000 after each of the 3 years
Minimum annual payment of $123,200 (80% of estimate)
The estimated 4,900 units sold tallies just above the midrange of Jansen’s forecasting format showing it as optimistic which is acceptable for this scenario.
No Major Purchase
Major purchase 0 units
Regional sales 2,200 units
TOTAL 2,200 units
The contract value would be:
Up-front payment $70,000
Payment $176,000 ($80 x 2,200)
TOTAL $246,000
PAYMENT FACTOR (18% pa) VALUE (end of 3rd yr)
Up-front $70,000 1.64 $114,800
1st payment $82,000 1.39 $134,480
2nd payment $82,000 1.18 $ 96,760
3rd payment $82,000 1.0 $ 82,000
TOTAL $428,040
The future value of the fixed-contract is 1.79 times that of the variable-cost contract which immediately shows the variable contract as still the better option.
The equivalent value for the fixed-contract would be $428,040 divided by 1.64, which will be $261,000. A further discount of 25% for early payment risk would set it at $195,750. This is a higher discount because of the less optimistic view with the loss of the major purchase.
With the loss of the major purchase, Galaxy can get back to the franchiser with two equivalent offers.
Offer A: One-time Lump Sum Up-front of $195,750
Offer B:
Up-front of $70,000
Estimated payment of $82,000 after each of the 3 years
Minimum annual payment of $49,200 (60% of estimate)
The estimated 2,200 units sold tallies just below the midrange of Jansen’s forecasting format showing it as pessimistic which is acceptable for this scenario.
Conclusions and Recommendation
The decision of the long-standing customer is the most critical aspect of this case as it will dictate the next moves of the business. There may be findings that can show that the product is not yet ready for the market. The product launch may need to be postponed until there is certainty.
If there are no such findings to withdraw the product, there can be three counter proposals for service warranty that Galaxy can prepare based on the major purchase’s chances of sale 60%, 100% and 0%. All of them should remove the minimum annual payment of $250,000 because it is too far from estimates. The future value method was used to compare the fixed and variable price schemes. The $770,000 fixed-price format will also have to be lower in all cases to be equivalent to the variable-price estimates.
The major purchase and no-major purchase estimates both conform to Jansen’s forecasting format.
References
Bodily, S. E., Carraway, R.L., Frey, Jr., S.C. & Pfeifer, P.E. (1998). Quantitative business analysis: Text and cases. Boston: Irwin/McGraw-Hill.
Critical Risks and Problems. (n.d.). Center for Business Planning. Retrieved May 4, 2016 from http://www.businessplans.org/2mba/2mba11.html
Future Value of a Single Amount (Explanation). (n.d.). Accounting Coach. Retrieved May 4, 2016 from http://www.accountingcoach.com/future-value-of-a-single-amount/explanation/4
Sharma, R. (2015, September 6). Expected Monetary Value (EMV): Parameters of Decision. Bright Hub Project Management. Retrieved May 4, 2016 from http://www.brighthubpm.com/risk-management/48245-calculating-expected-monetary-value-emv/
