An Analysis of the Outsourcing Proposal of Fleet Ltd - Essay Example

DECISION-MAKING IN BUSINESS By + Table of Contents DECISION-MAKING IN BUSINESS 3 Part A 3 An Analysis of the Outsourcing Proposal of Fleet Ltd 3 Part B 7 Strategic Option 1A Cash Flow 7 Strategic Option 1B Cash Flow 9 Strategic Option 1C Cash Flow 10 Workings for the Cash Flows 12 Net Present Value for Strategic Option 1A 12 Net Present Value for Strategic Option B 13 Net Present Value for Strategic Option C 13 Payback Period for Strategic Option A 13 Payback Period for Strategic Option B 13 Payback Period for Strategic Option C 14 Accounting Rate of Return for Strategic Option A 14 Accounting Rate of Return for Strategic Option B 14 Accounting Rate of Return for Strategic Option C 14 Internal Rate of Return for Strategic Option A 14 Internal Rate of Return for Strategic Option B 15 Internal Rate of Return for Strategic Option C 15 A Report Appraising the Capital Investment Decision Facing Peaches Plc. Board of Directors 15 Reference 19 DECISION-MAKING IN BUSINESS Part A An Analysis of the Outsourcing Proposal of Fleet Ltd This paper is going to give an analysis of the outsourcing proposal put forward by Fleet Ltd and both the financial and non-financial effects of the same. Fleet Ltd appointed a new chief executive in the year 1995 when the company was headed for a big financial loss. The new chief executive removed the levels of hierarchy, decentralized the organization and focused on the core competencies of the business which were selling and buying. It is this decision of the new chief executive that led to the development of the philosophy of outsourcing. Fleet Ltd intends to outsource the non-activities of the company. This is because these kinds of activities require people working in the forefront of the industry and Fleet Ltd happens to have no such personnel among its staff. These activities are equally impossible to achieve in-house and therefore the outsourcing proposal would be very efficient in consideration of this argument. In this company, anything that is not buying and selling is a potential candidate for outsourcing. The intended services to be outsourced include distribution, quality control, packaging, design, security and cleaning activities. Fleet also wants to abolish its information technology (IT) department and outsource the services for the same. The question which then arises is whether the outsourced activities would result in significant improvements for the company or not. If outsourcing is to be carried out, it should be to enhance the profitability of Fleet Ltd so as for it to make the same gains that it used to make in 1980s and 1990s or even much better. Any likelihood of the occurrence of a loss as a result of outsourcing should render the whole idea obsolete and other options put into considerations in order to avoid the financial crisis awaiting Fleet Ltd. Outsourcing of distribution would reflect in the reduction of the size of the distribution staff from 250 to 3. The financial effect of this is that Fleet Ltd will reduce the amount of money that it uses to pay the current distribution staff. This means that there will be enough money available after the retrenchment of the 247 employees. This money can be channeled towards investment for the company, something that will definitely result in profits for the company. The outsourcing of distribution will therefore give Fleet Ltd a financial gain rather than a financial loss. On this understanding, it is clear that outsourcing of distribution is an effective idea and it is for the profitability advantage of Fleet Ltd. However, the non-financial impact will be the creation of job insecurity for the distribution staff that is likely to be retrenched. Fleet Ltd intends to outsource its IT needs as the projects of its IT department overrun its budget. The arrangements for the setting up of the IT department are also done in an informal manner. However, the IT department is against this idea of outsourcing the company’s IT needs obviously due to the job insecurity issues that are likely to emerge. Fleet Ltd has nevertheless outsourced Results Ltd for its IT needs at a fixed price of 250,000 pounds per year for an initial contract of three years. The outsourcing of Results Ltd will have a huge financial loss for Fleet Ltd. This is because of the many expenses that will be incurred for the outsourcing of Results Ltd. Having paid Results Ltd 250,000 pounds per year (which can be translated to 750,000 pounds for 3 years), Fleet Ltd will also have to pay a lump sum of 20,000 pounds for Charles Smith, an IT department staff who has agreed to take an early retirement. This is to be added into his pension scheme. Fleet Ltd will equally have to appoint a contract manager at a pay of 50,000 pounds per year, an amount that will sum to 150,000 pounds for the three years of service. It will also have to pay the rental for the building housing the IT department at a value of 30,000 pounds for the three years that it was bound to pay. Fleet Ltd stands to lose 100 million pounds, the amount of money that it used to buy computers that were estimated to serve it for the next three years. This will bring the total expenditure of Fleet Ltd with the outsourcing of Results Ltd at 100,950,000 pounds. Fleet Ltd will only have gained 30,000 pounds for the resale of the IT equipment bought the previous year and 22,000 pounds for the leasing of the building housing the IT department for the three years that it would lease it. Fleet Ltd will also save money on the consumables in the IT department which are estimated to be 18,000 pounds for the next 3 years. It will equally save 81,000 pounds, an amount that would have been paid for overheads for the IT department for the next three years. So the outsourcing of Results Ltd will incur Fleet Ltd more expenses than the income it would have gained. The total expenditure being 100,950,000 pounds and the total money gained being 151,000 pounds. Fleet Ltd will incur an expenditure of 9,994,000 pounds being the deductions of the total expenditure from the money gained. If not outsourcing of Results Ltd had been done, Fleet Ltd will have spent 18,000 pounds for consumables for its IT department for three years, a rental of the building housing the IT department of 30,000 pounds for the three years, 81,000 pounds for overheads for IT departments for the next three years and a total salary of 900,000 pounds for its 10 IT department staff for the next three years as well. This means that the total expenses of Fleet Ltd, in the absence of outsourcing, would be 1,029,000 pounds. This is in comparison to 9,994,000 pounds that would have been spent in the event of outsourcing. The company would also not have lost the 100 million pounds that it used to buy computers estimated to serve it for three years at a loss since the current price is indicated to be 30,000 pounds. With this financial analysis, it is absolutely clear that outsourcing of IT needs for Fleet Ltd is a misguided idea as it will cause the company more losses than profits. This will actually head it to the financial crisis foreseen by the company in 1995. The organization’s dream of having only world class core activities will remain to be a dream in paper only as it will be impossible to practically achieve it given its financial condition. The Fleet Ltd has a desire for world class support in its non-core activities like IT, the desire outweighs its financial capabilities and pursuing it will only be a step towards inviting a financial catastrophe to Fleet Ltd. Fleet Ltd needs to take into account various factors before making a decision to pursue outsourcing. One of the factors is its financial position at the moment. Fleet Ltd needs to consider whether it has acquired the financial stability required to do outsourcing. If it does not have the financial capacity, it will be needless to try it out as it will be attracting losses. Fleet Ltd equally needs to consider the cost-benefit analysis of outsourcing. It needs to ask itself a fundamental question of whether outsourcing will enhance its business profitability or not. If outsourcing increases the company’s profitability, then it should be undertaken and if not, then it should not be considered at all. Lastly, Fleet Ltd should consider the job security of its employees before outsourcing any services. It should weigh the value of outsourcing to the value of losing some of its employees. If the value of outsourcing will prove to be more important, then it should pursue it. I would recommend that Fleet Ltd outsources the distribution services and not its IT needs. This is because the outsourcing of distribution will give the company an increase in its financial profits unlike the outsourcing of IT needs which will give the company financial losses. With the outsourcing of quality control, packaging, design activities, security and cleaning, the company will have to put into consideration the factors discussed above before making a decision of either outsourcing or not. Though the outsourcing philosophy advanced by the newly appointed chief executive is a great idea, it will have to be considered carefully before it is pursued. The desire to have world-class support by organizations is an excellent one but it has to be employed after doing a cost-benefit analysis of the same. Organizations ought to undertake outsourcing services if their positive effects outweighs their negative effects. Any mistake with the cost-benefit analysis will result in a major financial crisis to an organization. It is therefore of crucial importance for Fleet Ltd to do a cost-benefits analysis of the intended outsourcing before carrying it out in order to avoid a major financial crisis instead of the profits that the company longs to make in its business. Part B Strategic Option 1A Cash Flow Strategic Option 1A Cash Flow Statement as at……… INDIRECT METHOD OPERATING ACTIVITIES Net profit Demolishion cost ADJUST NON-CASH ITEMS Add depreciation of additional manufacturing unit Add back amortization of patents Add depreciation of high end manufacturing non-current assets Cash flow from operating activities INVESTING ACTIVITIES Acquisition of patents Purchase of additional manufacturing unit Purchase of land for relocation Disposal of land Sale of non-current manufacturing assets Cash flow from investing activities FINANCING ACTIVITIES Finance for launch of product Interest for launch and establishment of product Additional working capital Cash flow from financing activities Total cash flows (65,700 +22,500-12,500) Add opening cash flow balance Closing cash flow balance In thousand pounds 53200 (500) 3000 5000 6000 65700 (5000) (6000) (3000) 3000 500 (12,500) 24,000 (2700) 1200 22,500 75,700 0 75700 Strategic Option 1B Cash Flow Strategic Option 1B Cash Flow Statement as at…….. DIRECT METHOD OPERATING ACTIVITIES Pre-payment of lease cost Annual lease payments (800,000*10) Cash flow from operating activities INVESTING ACTIVITIES Acquisition of additional manufacturing unit Acquisition of high end manufacturing non-current assets Cash flow from investing activities FINANCING ACTIVITIES Working capital Finance for launch of the product Interest for launch and establishment of the product Cash flow from financing activities Total cash flows(-2200-8000+22500) Add opening cash balance Closing cash flow balance In thousand pounds (1400) (8000) 2200 (2000) (6000) (8000) 1200 24,000 (2700) 22,500 12300 0 12,300 Strategic Option 1C Cash Flow Strategic Option 1C Cash flow statement as at……… INDIRECT METHOD OPERATING ACTIVITIES Net profit Add depreciation of non-current assets upgrade Cash flow from operating activities INVESTING ACTIVITIES Upgrade of non-current manufacturing activities Cash flow from investing activities FINANCING ACTIVITIES Finance for launch of product Interest for launch and establishment of the product Working capital Cash flow from financing activities Total cash flows (28500+4000+22500) Add opening cash flow balance Closing cash flow In thousand pounds 24,500 4000 28,500 4000 4000 24000 (2700) 1200 22,500 55000 0 55000 Workings for the Cash Flows W1 Depreciation of additional manufacturing unit 2000/10=200 p.a In 10 years = 200 *10=2000M pounds W2 Amortization of patents 5000/10=600 p.a In 10 years=500*10=5000M pounds W3 Depreciation of high end manufacturing non-current assets 6000/10=600 p.a In ten years= 600*10=6000M pounds W4 Finance for launch of product If 12.5% = 300 100% =? 100/12.5*300=2400*10=24M W5 Interest payment in arrears 10 years – 1 year=9 years Interest = 300* 9=2.7M Net Present Value for Strategic Option 1A PV=Closing cash flows/ (1 + discount rate) = 75700000/ (1 +0.125) =67,289,000 NPV=PV-Cost of investment = 67289000-12500000 = 57789000 pounds Net Present Value for Strategic Option B PV= Closing cash flow / (1 + Discount rate) = 12300/ (1+ 0.125) =10933000 NPV=PV-Cost of investment =10933000-(-8000000) =1,8933,000 pounds Net Present Value for Strategic Option C PV=Closing cash flow/ (1+ Discounting rate) =55000000/ (1+1.125) =48889000 NPV=PV – Cost of investment =48889000-4000000 =44889000 pounds Payback Period for Strategic Option A PBP=Initial investment cost/Annual operating savings = 12500/6570 =2 years Payback Period for Strategic Option B PBP=Initial investment cost/ Annual operating savings =8000/2200 = 3.6 years Payback Period for Strategic Option C PBP=Initial investment cost/Annual operating savings =4000/2850 =1.4 years Accounting Rate of Return for Strategic Option A ARR=Average accounting profit/Average investment =5320/1250 =4.3 years Accounting Rate of Return for Strategic Option B ARR=Average accounting profits/Average investments =4120/8000 =5.15 years Accounting Rate of Return for Strategic Option C ARR=Average accounting profit/average investment =2450/400 =6.1 years Internal Rate of Return for Strategic Option A NPV=Cash flow of A/ (1+r)^n 54789000=75700000/(1+r)^10 (1+r)^10=75700000/54789000 1+r=1.033 r=0.033 IRR=3.3% Internal Rate of Return for Strategic Option B NPV=Cb/ (1+r)^n 18933000=1230000/ (1+r)^10 (1+r)^10=12300000/18933000 1+r=0.96 r=-0.04 IRR=-4% Internal Rate of Return for Strategic Option C NPV=Cc/ (1+r)^n 48885000=55000000/ (1+r)^10 (1+r)^10=48885000/55000000 1+r=0.99 r=-0.01 IRR=-1% A Report Appraising the Capital Investment Decision Facing Peaches Plc. Board of Directors This report is going to assess the value of the capital investment decisions facing Peaches Plc. Board of directors. This will be based on the analyzed cash flow statement, the payback period of initial investment, the accounting rate of return of the strategies, the internal rate of return of the strategies and the net present value of the strategies to be considered for implementation. Peaches Plc. Board of directors should consider implementing strategic option 1A that will involve the buying of a patent worth 5 million pounds. This is evidenced from the cash flows of strategic option 1A that are higher as compared to the two other strategic options. The company shall therefore be able to easily to convert current to cash when needed. Potential investors always do keep in mind the liquidity levels of particular firms before they can invest their cash in particular projects. Therefore the firm will attract potential investors, as many as possible, who shall finance the operations of the firm through the buying of company shares, bonds and even debentures. This investment will enable the company to be solvent throughout its life hence enabling it to escape bankruptcy score under the Z score. This shall therefore make good the competition of Apple’s iPhone and other competitors in the market providing the same products. This is because it is able to sustain itself in the market despite pressure and stiff competition from Apple’s iPhone and other potential competitors. The payback period for this strategic option 1A also cites the significance to implement the strategy. The strategy shall take a shorter period to pay back the initial investment as compared to the other strategies. This clearly suggests that the firm is likely to make huge profits or returns if it upholds strategic option 1A. Potential investors will also be interested in putting their funds in that particular project since their initial investment will be able to be returned at a faster rate. This is unlike the other strategic options which will take a longer period of time to pay back their initial investment. This will therefore mean that after the implementation of strategic option 1A, the company and its investors will start receiving profits as compared to implementing the other two strategic options. Strategic option 1A has a positive internal rate of return as opposed to strategic option 1B and strategic option 1C. This favorable and higher internal rate of return gives strategic option 1A an upper hand for implementation in the investment decisions that shall be made by its board of directors. It will enable the company to acquire more assets that will increase its profitability index and give the company financial freedom. This would not be the case if the company implements the other two strategic options. The accounting rate of return of strategic option 1A takes a lesser time of 4.3 years as compared to strategic option 1B that takes 5.15 years and strategic option 1C that takes 6.1 years. This gives the company a good reputation in the financial markets. Financial institutions such as banks will be more than willing to loan the company since its financial statements is quite attractive. Potential investors too will be willing to buy shares of the company since the financial statements of the company are less risky hence giving them security and high expectations to make good returns. This is unlike the strategic option 1B and strategic option 1C whose implementations would portray riskier financial statements. This will keep away potential investors since they will fear that the company will run insolvent and hence be declared bankrupt. This will lead to liquidation of the company’s assets to pay its debtors hence making potential investors ran into losses. The expectations of the company to be financially secure and make good returns will be severely dwindled. Among the three types of categories of investors that we have, a higher percentage tend to be risk averse as compared to those who are risk takers and risk neutral. Therefore, if a company’s financial statements and other accountings analyzed calculations under the accounting standards indicate that the company will make losses, a higher percentage of investors will keep off from such type of investment. They will instead opt for other investments that will give them good returns. Some may even prefer buying shares from your competitors at your expense. Therefore, the board of directors of Peaches Plc needs to implement strategic option 1A that will portray a good financial picture of the firm. If the board of directors opts for the other strategies, they may face a threat to their employment when it comes to the annual general meeting. Shareholders will vote out the board of directors since they made a decision that affected the company financially and even led them to losses. This will highly affect the decision making power of those individuals who are holding posts as directors after they are kicked out. Potential competitors and even the other minor competitors in the industry go through the liquidity position of their fellow competitors. They do this so as to find loopholes so as to keep their fellow competitors out of the market and gunner a higher percentage of the market share and good appreciation from the consumers of their products (Kepner, Charles H., Tregoe, Benjamin B., 1965). The potential competitors can do this strategy by highly lowering the prices of their products below the market price. This will force the board of directors of Peaches Plc to pass a regulation to lower the prices of their products too. This will make the company incur severe losses in the process and be unstable in the market place. Consequently, the company will move from the safe zones of the Z score to the grey zones hence indicating bankruptcy. The company will go insolvent and subsequently be liquidated. To avoid all these, the board of directors of Peach has to carefully make investment decisions in a wise manner through the involvement of investment managers who shall advise them on the policy to implement. The board of directors should therefore implement strategic option 1A as compared to strategic option 1B and strategic option 1c. Reference Kepner, Charles H., Tregoe, Benjamin, B.(1965) The rational manager: A systematic approach to problem solving and decision making. McGraw-Hill. Read More