Indian Electricals Limited

INDIAN ELECTRICALS LIMITED In May 1964, the Management of Indian Electricals Limited was faced with a question of whether or not to accept a trial order placed by one of their clients for manufacture and supply of 250 Stationery Vending Machines. From a comparatively small beginning in the 1930’s the Company had steadily grown to its present status of a Public Limited Company with a share capital of Rs.1.25 crores. The Company was engaged in two major activities: 1. Manufacturing of a wide range of products, 2. Selling plant and equipment imported from its foreign principals. The manufacturing activities covered plant and machinery, industrial equipment for various industries, transmission gears and control panels. In the field of selling, the Company represented over 200 foreign principals supplying a diversity of plant and equipment. The important products imported were construction equipment and a complete range of industrial machinery including control and automatic equipment. The company was representing Bolten & Co., London, for automation equipment. Bolten & Co. was trying to sell Stationery Vending Machines to a client in India through direct negotiation. Sample machines were supplied by them to the client who had expressed keen interest in buying a large number of these machines. The only reason why it could not do so was the shortage of foreign exchange availability in India. Bolten & Co. were considering the possibility of manufacturing these machines in India. While Bolten & Co. had been approached by a few Indian parties, who were keen to collaborate with them on such a project, they preferred that Indian E1ectrica1s Limited should undertake manufacture and selling of these machines. Accordingly, negotiations were commenced about this proposal. As there was only one client in India for these machines, Bolten & Co. proposed that Indian E1ectrica1s Limited sell directly. Bolten & Co. requested the client to get in touch with the Indian E1ectricals Limited. In January 1964, Indian E1ectrica1s Limited received a letter from the client informing about its decision to place an order for 250 machines. The letter also referred to an earlier discussion of the client with Bolten & Co in which the following points were made. a. With a view to developing the production of the Stationery Vending Machines in India, it was intended to place a token Development Order for a few machines with Bolten & Co, which should be manufactured in India. The Development Order may be placed in instalments and may be spread over a period of time. b. On a rough estimate, the client planned to install about 1000 Stationery Vending Machines during the Third Five Year Plan (ending 31 March 1966) and about 5000 machines during the Fourth Five Year Plan. However, there was no commitment that these machines would be purchased from any one particular source. The management was concerned about the following aspects of the enquiry: 1. Relatively small size of the initial order and 2. The cost of making the necessary tools for this order. The following letter was written in order to explore the possibility of increasing the size of the initial order and the possibility of the client providing a licence to the Indian Electricals Limited for importing the necessary tools, since it might be cheaper to import the tools rather than to make them in India.

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January 20. 1964 The Director. (Client) New Delhi Dear Sir, We thank you for your letter dated 26th December 1963, addressed to our office at New Delhi. We note from your letter that you have decided to place an order for 250 nos Stationery Vending Machines on us. A considerable amount of special tooling is required, if machines with interchangeable parts and of a quality at par with that of imported machines are to be made in India. A reasonable price can be quoted only if the order size is about 1000 machines or more. We would also be interested in knowing whether you would be in a position to provide us import licence for the necessary specialised tooling. On receipt of your reply and after having had an opportunity to inspect the sample machine, we shall look further into the possibility of manufacturing the machines. Yours faithfully Sd/ (For Indian Electricals Ltd) The management was aware that it would be difficult to import the tools and it started a study of technical and financial implications of making the tools in its own factory. The Works Manager who had recently visited the factory of Bolten & Co. had sent the following report about the technical and financial aspects of producing the tools in India. REPORT ON VISIT TO BOLTEN & CO LONDON 13.1.64 - 17.1.64 Stationery Vending Machines Visited Bolten & Co. on 13.1.64. Studied in particular the Stationery Vending Machines proposed to be made in India for the Indian client. Bolten & Co. have made only 300 nos. of this unit so far. They indicate a manufacturing cost of £ 28 Ex-works and tooling cost of £ 6,000.1 They have designed the tools based on a total production quantity of 5,000 nos. Bolten & Co., will supply detailed drawings, material specifications and process sheets. The tools are straightforward ones and should not present any technical problems to us. They use a large number of standard tools for notching, bending, etc.The design is simple and there should be no serious manufacturing difficulties. A royalty of 5% should be allowed for Bolten & Co. The tooling cost may be distributed over 1 The prevailing exchange rate: £ 1 = Rs.12 2

2,000 units for the tools in India. The selling price as mentioned to the client includes "Mechanism for Change Giving." This item is not fitted on the sample already available with us. Drawings for the mechanism are being dispatched by Bolten & Co. -Works Manager Finally, when the cost estimates were prepared, the cost of tooling plus the other equipment turned out to be Rs 6.18 lakh. This estimate was much higher than expected. Its implication was that an order size of less than 2000 machines may be unremunerative. The details of these estimates are given in Exhibits 2 and 3. In view of this, the Works Manager decided to find out the cost of importing tools from Bolten & Co. On his request, Bolten & Co. submitted their cost estimate for manufacturing the tools as £17,250. This cost was higher than the tools used by their own workers, due to the specialised nature of tools required for the low-skilled Indian workers. Soon after these estimates were prepared, the Delhi Office of Indian E1ectrica1s learnt that Bolten & Co. was considering manufacture of these machines with other parties, that it would be difficult to get an import licence from the client, and that it was not possible to increase the size of the initial order. The relevant letter is reproduced below: Dated: 2.5.1964 Instruments Division Bombay Office Indian Electricals Ltd Sub: Stationery Vending Machines Please refer to the correspondence on the above subject resting with your letter dated 4.4.1964. Mr. R.N. Mehra of Delhi Office met Mr. B.N.Singh of the Purchasing Department of the clients for Stationery Vending Machines. During the meeting, the case of Stationery Vending Machines was also discussed. It was found that in addition to the letter of 31st March, which Mr. Davies has written to the Director (client), New Delhi, some other correspondence has also passed between Mr. Davies of Bolten & Co and the client. In this letter, it has been mentioned that Bolten & Co. are negotiating with two parties in India for the manufacture of Stationery Vending Machines in India. It is also stated that one of the parties has already sent its Deputy Production Manager to U.K. for discussion and analysis of what would be involved in the manufacture of machines in India. We hope that a copy of this letter is available with you and that you are aware of the negotiations with the other party. It was also found during the meeting that the letter dated 20th January 1964, written by the General Manager, Manufacturing to the Director (client), New Delhi, has not been replied. This was because of the correspondence with Bolten & Co. that has all along given the impression to the client that the machines will be made in India. In our letter dated 27th February, it was mentioned that an indent has been placed on Purchasing Department by the user department of the client for 250 machines at a price of Rs.1,680 each. Mr. Mehra found that the estimates are based on a proposal submitted by Bolten & Co., to the client in which Indian prices on the basis of 250 machines each were given. The client is likely to place an order for 250 machines at this price. As is already on record with you, the total requirement of Stationery Vending Machines 3

during the Third Five Year Plan is 1000. During the discussions yesterday, it was found that it is not possible for the client to place an order for 1000 machines straightaway and the order for 250 machines is to be considered a development order. It is our feeling that if we like to develop this line it would be possible to work out a basis for amortization of the special tools required for the manufacture of Stationery Vending Machines. The client is definitely aware of the cost of tooling involved in this case. We shall thank you kindly to acknowledge receipt of this letter and to let us know whether you would like us to do anything fresh on the matter. In particular, we would like to know whether it has been decided to manufacture these machines at our factory; if not, whether negotiations with Bolten & Co. are still going on. 2 This is important in view of the fact that the enquiry for these machines is expected shortly, and because in our future contacts with the client, we should be able to give definite information on our standpoint on the case. Sd/ (For Instruments Division, Delhi Office) A copy of the above letter was sent to Bolten & Co. asking for their comments. As of May 1964, no comments had been received. According to the Works Manager, the reluctance on the part of the client to increase the order size implied that it wanted to invite tenders again to obtain lower prices for the subsequent orders and possibly to develop an alternative vendor. He felt that the chances were 75 percent that tenders would be called again and that Indian Electricals would be required to quote a price lower than Rs l,680 per machine on the second bid. In view of this likelihood, the Management felt that the investment of Rs.6.18 lakh in tooling was not justified.

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Instruments Division sold much other equipment to this client. In view of this, the Instruments Division felt that an acceptance of this order would increase their goodwill with the client. 4

EXHIBIT 1 INDIAN ElECTRICALS LIMITED HIGHLIGHTS

1962-63 1961-62 (Rupees in Lakhs) 1.

Sales, Completed Contracts, Servicing and Service Fees

687.90

489.40

2.

Other Income

30.10

22.14

3.

Profit before Depreciation, Development Rebate & Taxes

62.10

53.90

4.

Profit before Taxes

46.10

38.90

5.

Provision for Taxes

23.80

20.10

6.

Profit after Taxes

22.10

17.20

7.

Total Dividend Distributed

19.40

15.10

8.

Gross Block

188.80

142.50

9.

Net Block

126.80

98.20

270.80

163.40

Per Equity Share (Rs.)

14.92

13.90

11.

Number of Shareholders

6,926

5,102

12.

Number of employees

2,342

2,010

1010

Shareholders' Equity (Net North) Total

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EXHIBIT 2 INDIAN ELECTRICALS LIMITED Cost Estimate of Stationery Vending Machine without Change Giving Mechanism Following is the estimated net ex-factory cost per machine based on the sample unit we have. 1.

Material Cost

Rs. 58.31 per machine

2.

Labour and overheads for manufacturing components (including set up)

Rs.224.37 per machine

3.

Labour and overheads for assembly (including set up)

Rs. 84.32 per machine

4.

Electroplating (sub-contactor’s charges)

Rs. 92.25 per machine --------------------------Rs.459.25 per machine

5.

Depreciation of tools (Rs.5,79,145 / 2000Machines)

Rs.289.58 per machine

6.

Product overheads at 15%

Rs.112.35 per machine

Grand Total of Cost per Machine

Rs.861.18 per machine

NOTES: 1. The cost per machine had been arrived at by totalling the material and direct labour cost, adding to this a certain proportion of the overhead costs like rent, depreciation, administration and development costs. In recent years, when the company decided to export fuse units it found that prices based on the above method of costing were not competitive in the overseas market. This led them to analyze the cost structure more carefully and separate the variable and fixed costs of manufacturing the product. Similar analysis was not done in the case of the vending machine but from the recent experience with the fuse units the Works Manager indicated that for practical purposes the composition of item Nos. 2, 3 and 6 would be as follows: a) Item Nos. 2 and 3: 30 per cent of this cost was variable and 70 per cent was fixed. The fixed cost was largely an allocated cost and was not escapable. b) Item No.6: These were the general research and development costs incurred by Indian Electricals Ltd., which were allocated to its own line of manufactured products on a pro-rata sales revenue basis. No specific development costs were envisaged for Stationery Vending Machines. 2. The works manager estimated that the cost of the Change Giving Mechanism would be about Rs.89/- per machine.

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EXHIBIT 3 INDIAN ELECTRICALS LIMITED Dated March 4, 1964 Indian Electricals investment in tooling for the stationery vending machine, to be made in India: Jigs, fixtures, tooling for bar work, etc. Press Tools

Rs. 1,14,745 Rs. 4,64,400 ----------------Total Tooling Rs. 5,79,145 ----------------An approximate composition of this cost was as follows: Material cost Direct Labour

Rs. 50,000 Rs. 90,000

Allocated Overhead costs (Depreciation, Rent, General Administration, etc.)

Rs. 4,39,145 --------------Rs.5,79,145 ---------------

Other Equipment Equipment for assembly shop Equipment for storage and handling

Rs. 24,000 Rs. 15,000 ----------------Rs. 39,000 -----------------The investment of Rs. 6,18,145 in tools and equipment would suffice for producing 2,000 machines. In case Indian Electricals is required to produce at a rate higher than 1000 machines per year, then one additional capstan and 5 presses would need to be purchased. Some increase in the labour force would also be necessary. The details of the cost of machines and wages to be paid are as follows: Landed cost of the imported machines (including duty of 50%)

Rs. 3,70,000

Further, the following labour force would have to be added: Machine Shop 2 persons Assembly 2 persons ----4 ----The wages (all inclusive) per person would be Rs.9/- per day. Total investment for producing more than 1000 nos. per year would be Rs.9,88,145.

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NOTES 1.

There was sufficient idle capacity in the Tool Room to manufacture these tools, both in terms of labour and machinery. However, the capacity in the Tool Designing Department was limited. Diverting this capacity for designing tools for the Stationery Vending Machine would involve a sacrifice in the switchgear manufacturing programme because of the delay in getting the necessary tool designs from the Tool Design Department. This would result in a sacrifice of sales worth Rs.750,000/- of switchgear products. The contribution from these products (sales value less variable manufacturing costs) was 44 per cent of the sales value. These variable manufacturing costs were primarily the material costs and did not include any of the overheads like depreciation of machines or tools.

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Management had not established a minimum rate of return to be earned on each investment. However, a post-tax return of 10% was considered satisfactory. 3. The tooling cost would not be materially altered because of the ‘change giving mechanism’.

Indian Electricals Limited Issues to be considered in the case 1. Read all the exhibits and relevant information carefully and apply these to your solution. 2. Should Indian Electricals Ltd (IEL) accept this order? 3. What time-frame should be considered for this decision? 4. How should the profit be computed for this order? Should it be for 250 machines only? 5. Is IEL justified in its stand that an order of less than 1000 machines is unprofitable? Should it insist on import licence as a precondition? 6. Do IEL have a threat from the competitors? 7. What are the relevant short-term and long-term costs and revenues for different scenarios? How do you project these? What price do you charge for the machine for the initial order and possible subsequent orders?

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