Two Questions 3 - Essay Example

Question In 2006, Tom Lopez became head of Consumer Products research (CPR) and began a number of project development projects. Although the grouphad good ideas that lead to the introduction of several promising products at the start of 2008, Lopez was criticized for poor cost control. The financial performance reports for CPR under his leadership were consistently unfavorable. Management was quite concerned about cost control because profits were low, and the company’s cash budget indicated that additional borrowing would be required throughout 2008 to cover out-of-pocket costs.

Because of his inability to exert proper cost control, Lopez was relieved of his responsibilities in 2008, and Gabriella Garcia became head of Consumer Products Research. Garcia vowed to improve the performance of CPR and scaled back CPR’s development activities to obtain favorable financial performance reports.Compare the performances of Lopez and Garcia in the role as head of Consumer Products Research. Did Garcia do a much better job, thereby making her deserving of the promotion? Why or why not?

In terms of profit, Garcia did a better job than Lopez as a result of scaling back the project development. When profits are low and management is looking to cut costs, spending significant amounts of money on research and development is not the appropriate tactic. R&D is expensive and, as the timeline of two years from project initiation to implementation under Lopez demonstrates, there is no return on investment reflected in the financial statements until well after the products are brought to market.

During times of low profit margins, development has to be scaled along with cost initiatives to keep management and investors satisfied. Even though Lopez developed good ideas, his efforts at cost control failed because there was no actual cost cutting and no immediate impact on revenues. While it could be argued that, given enough time, Lopez’s management would have yielded greater profits at lower costs. Management’s focus on profitability, however, precluded the company’s ability to focus on R&D to the extent that Lopez intended.

Garcia, however, reduced—but did not eliminate—development while simultaneously focusing on cutting the costs related to current market offerings. This had an immediate impact on the company’s profitability and management was no-doubt pleased with the results. The issue here was time. It does take time to develop innovative products and bring them to market. This effort, however, cannot be the sole focus unless the company is currently in a strong financial position and can absorb the R&D costs until the new products are in place.

Simply stated, the company could not afford Lopez’s approach to development projects. Management was looking for cost controls because it desired maintenance and increase of profits; something that is accomplished by limiting R&D and focusing on current processes to increase internal efficiencies. This Garcia did well and, without completely cutting all development, positioned the company to maintain acceptable profit levels while still investing in the future by employing innovation.Question 2:In response to a significant increase in energy costs in the spring of 2000, American Energy Systems of Hutchinson, Minnesota, introduced a stove that uses dry-shelled corn as a fuel.

Depending on the size of the house and weather conditions, tests indicated that heating an average house requires 15-30 bushels of corn per month. The stove sold for $2,170 and, with corn then at a historical low cost of $2 a bushel, heating with corn was ten times cheaper than gas or heating oil and seven times cheaper than electricity.Assuming that corn stove has a life of ten years, do you feel comfortable making this decision using only the payback capital budgeting model? Why or why not?

No, I would not feel comfortable making this decision using only the payback capital budgeting model. The reasons for my position include short- versus long-term capital use, the stability of several commodity markets, and the likelihood of switching costs. First, from a short-term perspective, the corn heating system is a good deal. For a relatively low initial investment, and assuming that the system remained a superior performer at the savings level shown here, the consumer would be assured of lower heating costs.

There is no basis, however, to think that this would reasonably continue. To make this decision based on an historically low price of corn, does not consider the long-term likelihood of market price moves. Second, the savings equation depends upon three independent commodity variables; the cost of petrochemicals, the cost of electricity, and the cost of corn. While the cost of fossil fuels has risen in this scenario, those prices fluctuate. In the past decade, oil prices have been as low as $10/bbl.

and as high as $140/bbl. Electricity, depending on the method of generation (coal, hydro, or nuclear) has remained relatively stable. Corn is at a historic low. For the method of corn heating to be viable, this relationship would have to remain constant—and it is highly unlikely that it will. Corn prices will return to median levels unless the demand for corn (in part due to the adoption of the corn stove) could drive the prices much higher. When taken in combination, there is no reasonable assurance that corn will stay low while oil stays high.

Thus, the corn stove heating system could work very well for the first two years and then become the same—or higher—than the other methods. There is too much uncertainty in the commodities market to make me feel comfortable switching to corn heat. Finally, there would be switching costs involved even if the corn stove were to be completely adaptable to the ducting and furnace systems in the home. Once the oil or electric furnace is removed, and given the likelihood that one of those methods might become cheaper in the future, implementing a new oil stove or electric furnace would be much more expensive that the corn stove.

Accordingly, I would not use a simple capital budgeting model to determine the propriety of making this change.