A financial analysis of Terror Tubes

Category: Accounting

Terror Tubes, a manufacturer of high-performance automotive exhaust systems, is realising reduced profits as costs relating to their standard exhaust line are increasing. Increased lead and delivery times caused by this increased demand may have a negative impact on Terror Tubes' image regarding their custom built systems which may lead to loss of sales. If the standard systems can't be produced to meet demand they may lose the new contract. A systematic and continuous identification and elimination of waste can lead to increased efficiency, improved productivity and enhanced competitiveness. Generally, companies that work towards the elimination of waste in the manufacturing process realise the following benefits; lower raw material stock and associated holding cost, reduced work-in-process, and lower finished goods inventories; higher levels of product quality; increased flexibility and ability to meet customer demands; lower overall manufacturing costs; and increased employee involvement (Canel et al, 2000).

After a brief overview of the high performance exhaust market this paper will discuss Terror Tubes' current production processes, the effect of the new contract with Super Car on Terror Tubes' operations, and identify the operational decisions required under current conditions for the company's operations to run effectively. Finally the paper will discuss the effect the move to producing standard systems has had on the company's financial structure.

The high performance exhaust market is driven by professional drivers and other car enthusiasts who wish to maximise the power of their vehicle while improving the look and sound of the car. Fabricators of high performance exhaust systems use pre-fabricated components such as baffles, hangers, mounts, mufflers and catalytic convertors which they assemble with the fabricated header pipes, collector pipe, downpipe and tailpipe to complete the system. To make these pipes in accordance with the design specification they will cut, bend and weld various sized pipes to make up the complete system. There are various metals used and these metals require different welding techniques. There are many after-market options available for standard types of engines, but there is also demand for purpose built exhaust systems for special cars and engines.

Terror Tubes uses a combination of manufacturing processes in their facility. The custom built systems are made to order and have a high level of customer consultation, design and specification and also a wide variety of components and materials are used. This is a low volume, high variety (intermittent) manufacturing process. The standard exhaust systems are made to stock. This is a high volume, low variety (continuous) process. The new contract with Super Car has had many effects on Terror Tubes' operations. There has been loss of productivity due to increased work-in-process, lead times and delivery times are increasing, planned production during normal work hours has not been achieved resulting in more overtime. Raw materials inventory and work-in-process inventory have increased.

Terror Tubes is currently operating with poor forecasting and poor production planning which will result in long lead times. These problems in turn have led to poor delivery performance and high inventory. There are many opportunities that Terror Tubes should consider in regards to their daily operating decisions. These opportunities include improving accuracy of forecasting, reducing batch sizes, implementing a just-in-time (JIT) philosophy, project management for better production planning and control, improving productivity, re-engineering the custom exhaust fabrication process, revising the factory layout and considering outsourcing. Another important factor in the improvement of productivity is improved management of staff. Job satisfaction is an important antecedent to having productive workers, so any improvement in the working environment, especially in the factory environment at Terror Tubes where tasks are repetitive but critical for product quality, should be taken into consideration (Ross, 1994).

With demand for the standard systems steadily increasing, the original forecast given by Super Car is no longer working. Stank et al (1996) and Cahon et al (2002) emphasise the importance of sharing information between customers and suppliers. McCarthy and Golicic (2002) stated forecasting has a substantial impact on supply chain performance. Improvement in customer service performance, such as shorter lead times, improved inventory availability and better response to fluctuation in demand, was found. Also, improvements in cost and capital were found which could be related to reductions in safety stock. Terror Tubes should work with Super Car to develop a better understanding of the market and develop a more accurate forecast. This would include studies of various factors that may contribute to the increase or decrease of demand. For example, the relationship between the sales of second hand V8 cars in the Sydney region and the demand of high performance exhaust systems.

With more accurate forecasts, Terror Tubes will be able to implement a JIT philosophy. Gupta and Brennan (1995) argue that with JIT implementation a company can reduce inventory, lead-times and increase productivity. It provides cost-effective production and delivery of the necessary parts, in the right quantity, at the right time and place, while using a minimum of facilities, equipment, materials, and human resources (Voss and Robinson, 2002). In consultation with their suppliers, Terror Tubes can arrange for the different sized pipes for the standard systems to be delivered in lot sizes at specified times. The supplier should cut to length all the pipes for the standard systems as they do not change. This will remove the need for the utilisation of the pipe cutting machine which can then be used for the custom built systems only. Suppliers of the pre-fabricated components such as the baffles can also deliver in lot sizes relative to the batch quantity of the standard systems. This will reduce the raw materials inventory. JIT seeks to eliminate all sources of waste which do not add value to the production process.

In partnership with Super Car, Terror Tubes can decide on the ideal lot, or batch size, that will be produced during normal production time. Super Car will then order their standard systems in this lot size, which will be their economic order quantity. By managing batch sizes inventory will be reduced. Batch sizes will allow for higher planned capacity utilisation. With batch sizes known, Terror Tubes can order the custom cut pipe to arrive just before it is required, reducing the raw materials inventory. The pre-fabricated accessories such as the catalytic convertors can be stored close to the end of the manual fabrication line to reduce assembly time. With a standard bill of materials for each system, the correct amount of accessories and fasteners needed for the assembly can be planned ahead.

Terror Tubes can also reduce lead times and work-in-process inventory by re-engineering the custom exhaust fabrication process. Though the increased demand for the standard systems may be increasing costs, it may be that the custom built systems are not being managed adequately and it is this problem that is manifested in increased costs of the standard line. Babu (1999) and Ong (1997) argue that in a make to order environment, the details about product specification become gradually known during the development, design and process planning phases. This effect makes production scheduling less accurate, and frequently causes revisions of operations schedule during fabrication. Further difficulties arise at Terror Tubes because of the presence of multiple machine and capacity constraints. Information Technology can support the process by managing the order to delivery cycle. An introduction of a computer aided productivity management system is suggested.

Improved productivity can be achieved through reduction of production costs, higher production yields, improvement of production throughput, and reduced work in process (Lager, 2002; Terwiesch and Bohn, 2001). A computer aided productivity management system will aid in production planning and control with the application of concepts of project management. Benefits will be realised when the demand management and capacity management are operating in a unified way. Fox and Spence (1998) advocate a multi-project scheduling system which will assist in the allocation of scarce resources to activities in order to be sure that multiple projects are completed by their due dates. Project Management can be very useful as an effective approach for increasing flexibility in production planning and control activities. This project management will include monitoring and controlling the projects on their progress to assess how they are performing against the project plan and intervention where necessary to bring them back in line with the project plan. It is noted that a skilled project manager may be required to be hired at an additional cost.

By outsourcing some tasks of the fabrication of the standard systems to specialist companies, Terror Tubes may focus better on their custom built systems, and reduce the increased costs associated with the new line, such as increased overtime and increased work-in-process lying around the factory. Terror Tubes can assess the productivity of their current processes and undertake outsourcing actions if outside producers can provide comparable services to the same quality or better. Resources can be reinvested in more technical processes. For example, Terror Tubes could outsource the welding of the steel pipe. Ten Raa and Wolff (2001) find a positive association between the rate of outsourcing and productivity growth. Outsourcing can boost profitability in three ways. Labour, productivity and warehouse rent (Jiang et al, 2006) can be reduced. The use of outsourcing will provide Terror Tubes with the flexibility to engage outside help only when they need it, for as long as they need it. This will reduce their overtime penalty rates. Productivity will increase as Terror Tubes can concentrate on the more profitable custom built systems. Though the increase in sales of the standard systems has meant the company has had to rent warehouse space, with other actions being employed to make the operations run effectively, the need for permanent warehouse space may be made redundant.

The factory layout will have a significant impact on the performance of a manufacturing system (Thompkins et al, 1996). Functional grouping of core competencies into specific areas accelerates certain aspects of the production. A complete review of factory layout may be required in collaboration with all staff on the floor. This may highlight problems such as bottle-necks in the fabrication process and non-value-adding tasks. A time in motion study may also be beneficial. In consultation with all the floor staff, the company needs to answer questions such as: Are there unnecessary steps in the process? Does work flow from one machine to another? Where does work-in-process inventory get piled up? Is the work flow generally in one direction? Are the machines used efficiently? Does product get moved more often than necessary? Are operators utilising waiting time efficiently? Can operators use all the machinery?

As well as affecting operations, the new contract with Super Car has also, affected the company's financial structure. The new contract has added cost at every step of the supply chain. Increased inventory costs - raw material, goods in process, finished product - impact on cash flow. Increased inventory has increased fixed costs with the need for rented warehouse space. Planned production during normal working hours has not been achieved. Without proper production planning, labour costs have increased due to the need for more overtime. The standard systems should be fabricated in normal time and if any overtime is required it should be used to fabricate the custom built systems as they have a better margin. Overall conversion cost of product is higher than budgeted. All this extra cost is eroding the profit margin.

Terror Tubes needs to meet the increased demand of Super Car without increasing costs or lead times. With a combination of intermittent and continuous manufacturing processes the manufacturing process itself must be reviewed to identify the value adding process steps from the non-value adding process steps. The non-value adding processes need to be reduced. With more accurate forecasts and improved production planning Terror Tubes should be able to improve productivity, reduce work-in-process, reduce lead times, and reduce the need for overtime. Where overtime is required, it should not be used to fabricate the standard systems; only the custom systems should be produced in overtime as they have a better margin. By determining batch quantities for the standard systems and better control over production planning by project managing the process, raw materials inventory can be reduced by receiving cut-to-length pipe and pre-fabricated accessories in correct order quantities at the right time. A JIT philosophy should be implemented to aid the project management. This will alleviate the production planning problems caused by the custom built systems' planning uncertainties. JIT will yield increased efficiencies and performance excellence throughout the company. Terror Tubes should also determine if there is any part of the fabrication process that could be outsourced. Outsourcing can reduce labour costs, increase productivity and potentially eliminate the need for warehouse space. A review of the factory layout in partnership with the floor staff may provide further ways to improve work flow, machine utilisation and productivity. Once these decisions have been actioned, Terror Tubes should enjoy increased profit margin as pressure is eased by reducing costs at every step of the supply chain.