Question: Kilgore Manufacturing, Inc. (KMI) is a small manufacturing company in the St. Louis area that produces components used in the aerospace industry. James Kilgore, the president and owner of KMI, started the company five years ago. Although business has been reasonably steady for the last two years, KMI has yet to establish any long-term relationships with major aerospace contractors. This is important, because small companies like KMI only get business as subcontractors to the large aerospace manufacturing companies that win major contracts, many of which are with the federal government.

In the aerospace business, after the federal government awards a new defense project to the major aerospace contractors, these companies, in turn, send out a request for subcontractor bids to smaller companies like KMI for specific work related to the project. Often, the subcontract goes to the company with the lowest bid for the required work. Cost overruns in federal government contracts are commonplace, but are becoming increasingly less accepted. In their desire to win subcontracts from the major aerospace companies, some subcontractors submit unreasonably low bids to perform the work on specific aspects of a major project. Recently, the federal government has been cracking down severely on the major contractors, who in turn have demanded more accountability from their subcontractors. More and more contracts between the major contractor and its subcontractors are including harsher penalties for low production levels, late deliveries, cost overruns, and other failures by the subcontractors to meet the promises.

Jim Kilgore has just learned that a new defense contract has been awarded to one of the major aerospace contractors. A certain system in the project requires one of the components produced by KMI, a relay switch manufactured by only three other companies in the U.S. After finding out about the new contract, Jim Kilgore held a strategy meeting with Tim Reynolds, vice-president of manufacturing, and Bill Shelton, plant manager.

Jim: "I don't know if you have heard yet, but a new contract has been awarded to Avionics, Inc. The good news for us is that our R-7 relay switch plays a big role in the project. I think this is the opportunity we have been waiting for. One of my contacts in Washington has given me enough information to estimate that the project will require at least 600 R-7 relay switches per day. But, my guess is that the subcontract will be awarded to the company that can provide the largest number of relay switches per day at the lowest cost to the government. Fortunately, our current contracts for the R-7 are about to run out so that we could devote the entire line of production to this new contract with Avionics. What do you think of this possibility, Bill?"

Bill: "We can easily meet the 6O0-per-day quota. Our production data over the past two years show an average daily production run of around 635 relay switches per day when we're running at full capacity."

Jim: "That's well and good, Bill, but we also need to know something about the amount of variability in daily production levels. In this new subcontract, we have to specify a guaranteed minimum level of daily production in addition to an average or typical daily production level. The government is really serious about contractors and subcontractors meeting their obligations. On those days we fall short of the guaranteed minimum, a $5,000 penalty is assessed!. I know it is steep. However, we do want to play the game. I want this contract; it's the break we've been looking for to get in solid with one of the key aerospace manufacturers. We can't afford, however, to lose money on this contract."

Bill: "Well, let's see what we know. Over the past two years, our lowest daily production run was 494 units and the highest was 768 units. In fact, if I remember right, the actual distribution of daily production levels is described fairly well by a normal distribution with a mean of about 635 units and a standard deviation of about 40 units."

Tim: "So there are definitely days when we are unable to make 600 units. If we were to bid 600 units, we would be hit with the $5,000 penalty from time to time. What sort of profit margin can we expect from Avionics. Jim?"

Jim: "I don't think that's going to be a problem. As best we can tell, our competitors are pretty close to us in terms of their production capabilities and production costs. As a result, I think we can maintain our usual profit margin of $3.80 per relay switch. It really boils down to who can produce the most relay switches daily. But we have to be very careful with our bid. Bid too low on the guaranteed minimum daily number of units and we lose the contract to one of our competitors; bid too high and we get the contract, but we lose our shirts in penalties."

Tim: "Let me make sure I understand the situation. Suppose, for example, that we were to guarantee a minimum daily production level of 600 units, but we fell short, say 5% of the time. Then, by my calculations, we would net an average daily profit of $2,163."

Jim: " How did you come up with that figure?"

Tim: "Well, each day's production level will be different and there is no way we can predict when we will fall short of the guaranteed bid level, but we can still talk in terms of averages. Going back to my example, suppose we fall short 5% of the time. We would incur the $5,000 penalty about once in every 20 days which averages out to $250 per day. If we actually average 635 relay switches per day, then over a typical 20-day period we would produce about 12,700 relay switches. At a $3.80 profit margin, the average profit for a 20-day period would be $48,260, which comes to $2,413 per day. After subtracting the $5,000 penalty for one day out of the twenty, our average net daily profit over the 20 days drops to $2,163."

Bill: "Where did the 5% figure come from?"

Tim: "I just made it up for the example. It should be pretty close to correct, but I'm not sure."

Jim: "Good job! That's a great example of how to think through this problem. Of course, everything depends on how often we fall short and that is determined by our guaranteed bid level.

Tim: "You know, one way we could cut out some of the penalty costs would be to stockpile relay switches on those days that we produce more than the guaranteed bid level."

Jim: " I had already thought of that but then found out from Avionics that we have to turn over our entire production to them each day. Besides, we don't have the space for inventory."

Bill: " And we can't use any overtime to meet the minimum when we are just short because we will be operating 24 hours a day with our three shifts. If we borrow a little from the next day's production to meet the minimum, we stand a higher chance of not meeting the minimum the next day."

Jim: "That's right. So in our calculations to come up with a guaranteed minimum daily level of production, we need to assume that we sell everything we produce each day, that we cannot stockpile or create a stand-by inventory, and that we can't use any overtime or borrow from later production to avoid a penalty. The good news is the deadline for submitting a bid is approximately three months away."

Bill: "Great! A new worker in the plant suggested some changes to our R-7 production process during one of our quality circle meetings last week. I think the idea is a winner. These changes would result in a more complicated production process with a steep learning curve for the workers, it could eventually lead to higher production levels. Here's the best part. We can do it with only minor modifications to our current equipment and it will cost practically nothing to make the changes! We could implement the new procedure in less than a week's time."

Jim: "This could be what we need to pull off this deal. Bill, start making the necessary changes. We'll monitor production levels for the next 60 production days. If the new process works as you suggest, we should see higher production in the second 30-day cycle. If so, we'll make our bid based on the new process; otherwise, we'll switch back to the old procedure and base our bid on the data from the past two years."

Tim: "Getting back to profits again, how much profit do we really need to make in order to pursue this contract?"

Jim: "I can't overemphasize the importance of this contract to us. If we are awarded the contract and do a good job, it could lead to a long-term relationship with Avionics and would certainly enhance our reputation with other major aerospace companies. We can't afford to lose money on this contract. I'd be willing to break even just to get these non-monetary benefits, but we can not. I’ll tell you what, if we could just make $1000 per day on this job, the accountants and I would be happy. Bill, report back in 60 days to let us know how the new production plan is working. The three of will assess the situation at that time and develop the bid proposal."

The data for the first 60 days of production under the new manufacturing process implemented at KMI is collected and available for our analysis. This database contains

1. month of production day,
2. date of the month for that production day and
3. number of units produced on that day.

Please answer the following questions based on the above data and the data provided in the Kilgore.xls file.

Calculate the guaranteed minimum daily production level under the existing production process that will result in an average net daily profit of $1,000, the amount needed by KMI. Show all your work.

Price: $2.99

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