GREAT LAKES PIPE & TUBE, INC. “If we do decide to produce the 10- and 12-inch pipe internally, it could solve our overstaffing problem,” Mark Rubin, owner of Great Lakes Pipe & Tube, Inc. (GLPT), remarked to Vinny Patricko, the plant manager. “I’m reluctant to lay anyone off or even cut back hours. It’s not good business and it’s not the right thing to do if it can be at all avoided.”

THE FIRM Mark Rubin had no intentions of starting his own firm in 1972. Since graduating from college in 1964, he had worked for ML Pipe, a company based in Youngstown, Ohio. In January 1972, the company decided to relocate to New Jersey, and Rubin went also. Rubin and his wife were quite unhappy in Virginia, mainly because they felt so distant from their relatives, nearly all of whom were located around Youngstown. In May of 1972, he decided to move back to Youngstown and start his own pipe company.

Rubin felt he understood the manufacturing side of the piping business “inside and out.” He recognized, however, that in order to be successful, he needed marketing and financial expertise. By his own admission, Rubin made “many mistakes” during the first 18 months, but nonetheless, the business surged ahead. By the third year, it was clear not only that the company would be successful, but that it had the potential to prosper.

And prosper it has. GLPT operates on 14 acres and employs 31 people. In fiscal year 1991, sales totaled nearly $25 million despite a nationwide recession and the highly competitive nature of the piping business.

Rubin attributes his success to two factors: service and dedication to quality. While many firms are concerned with the quantity of pipe they produce, right from the start Rubin was dedicated to manufacturing the best quality of pipe possible. He often tells his employees, “If we achieve quality, the quantity will take care of itself.” The company also provides exceptional service. GLPT keeps an unusually large volume and selection of inventory at all times and maintains a relatively large fleet of trucks. As a result, the company can fill an order quite quickly. Such fast delivery means that distributors GLPT sells to--many of whom are nationally known wholesalers of building materials--are able to keep their inventory low.

A PROBLEM OF SIZE

The bulk of the firm’s sales come from PVC pipe, which is mainly used in residential and commercial plumbing and government sewer systems. This pipe comes in many different sizes, and sales depend in part on customers viewing the firm as a “full-line producer.” That is, a salesman is more likely to win an account if a distributor is convinced that the manufacturer can promptly deliver various sizes of pipe as needed. This typically means that a producer can quickly fill orders for the most commonly used sizes of PVC pipe; that is, pipe with diameters of 3 inch, 6 inch, and 8 inch.

Sometimes, however, a distributor is interested in 10-inch and 12-inch pipe as well. GLPT has never produced these sizes internally because Rubin feels that annual sales volume is too low to justify the start-up cost. If a customer does request such pipe, GLPT will typically buy it from a competitor who does manufacture the desired sizes. Rubin has never carefully analyzed whether this is a good policy, and he thinks now is the time to do so, especially given the firm’s staffing situation.

As he sees it, there are two main advantages to producing the 10-inch and 12-inch pipe internally. First, GLPT avoids the expense of buying the pipe from another firm. GLPT pays 45 cents per pound for this pipe plus another 2 cents per pound in distribution costs to get the pipe to GLPT customers. Unit selling price is 56 cents per pound. A second advantage is that the company’s staffing problem would be helped.

Though dollar sales have increased slightly in the last two years, the increases have not kept up with inflation. Rubin realized six months ago that the firm is overstaffed by two employees. The orders simply aren’t there to keep all the production workers busy full time. He thinks this could continue, given not only the state of the economy but also the increase in industry competition.

In its entire 29-year history, the firm has never been forced to even cut any worker’s hours, let alone lay off someone. And Rubin has decided that he won’t start now.

RUBIN’S ESTIMATES

Rubin can’t be certain, of course, what future sales of the 10-inch and 12-inch pipe will be. He finds it helpful to think in terms of scenarios, and he has devised a set of estimates shown in Exhibit 1.

In addition, two salespeople complained that accounts were lost when some distributors learned that GLPT does not produce 10-inch and 12-inch pipe internally. Apparently, these distributors were concerned that GLPT would not be able to fill orders as quickly as they would like. As a result, these salesmen argued, the entire account was lost and not just the orders for 10-inch and 12-inch pipe.

Rubin is unsure what to make of this “lost order” argument. If the sales personnel are correct, then GLPT could nearly double the figures shown in Exhibit 1 by producing the 10-inch and 12-inch pipe in-house. While he can believe that some sales have been lost, Rubin finds it hard to believe that the volume is anywhere near what the salespeople claim. For the time being, he decides to ignore the possibility that orders have been lost. He wants time to investigate the claims of the sales personnel who, he believes, have a strong incentive to inflate any loss.

The most inexpensive equipment that is capable of producing the quality that Rubin desires costs $600,000 and can generate 2 million pounds of pipe per year. For the purpose of analysis, Rubin will assume straight-line depreciation to zero salvage value over the eight-year life of the project. (Ideally, you should use MACRS depreciation). The market value of the equipment after eight years is expected to be $180,000 before taxes.

THE ACCOUNTANT’S ESTIMATES

The firm’s accountant, Abe Komansky, has developed a set of numbers that, in his view, “strongly indicates” in-house production is a “losing proposition.” (See Exhibit 2.) Komansky estimates it will cost 54.3 cents per pound to produce the 10-inch and 12-inch pipe internally. He notes that GLPT can purchase the same pipe for 45 cents per pound from another manufacturer and incurs another 2 cents per pound to get the pipe to GLPT’s customers. Thus, Komansky argues, internal production results in an 7.3 cent per pound loss, or $87,600 per year assuming 1.2 million pounds of pipe.

As Rubin scans these figures, he smiles as he notices that Komansky used Rubin’s sales estimates and annual sales probabilities. He wonders, though, how accurate the accountant’s numbers really are. For one thing, the estimates are based on the “most likely” sales figure and do not consider the other sales possibilities. In addition, Rubin questions the appropriateness of including depreciation, given that it is a non-cash item. For these and other reasons, he decides to rethink the figures the accountant has compiled.

Rubin is comfortable with a number of the items listed in Exhibit 2. He believes it is quite reasonable, for example, to assume material costs will be 32 cents per pound. And, yes, the project would use two laborers and will require plant space and supervisory personnel. Yet the firm has significant excess space and the equipment could be operated in an area of the factory that Rubin believes would otherwise be vacant for the foreseeable future. In addition, Rubin believes that the firm’s plant manager could easily supervise the project without affecting her efficiency in other areas.

Rubin then reflects further on his staffing situation. Although it may not be good business, he is quite comfortable with his decision not to terminate any employees. Rubin realizes that at most, he will be over-staffed for three years, since two workers are scheduled to retire at that time. And there is the possibility that sales will increase sufficiently over the next three years so that all the staff would be fully utilized. If this did happen, of course, new workers would have to be hired (but no new supervisors) if the project were implemented. Rubin estimates there is only a 20 percent chance that this would happen in any year. Looked at from a different angle, there is an 80 percent chance in each of the next three years that the two laborers used in the project could not be productively employed somewhere else in the firm.

Rubin uses a 12% cost of capital for all projects. GLPT has a marginal tax rate of 36%.
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EXHIBIT 1

Rubin’s Estimate of the Probability Distribution of Annual Sales of 10-inch
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and 12-inch Pipe, Years 1 - 8 (in thousands of pounds).*

------------------------------------------------- Annual Sales Probability 900 lbs. .20 1,200 .50 1,800 .30

*These estimates do not consider the possibility that in-house production may increase sales (see case)

EXHIBIT 2
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Accountant’s Estimate of Annual Cost of Producing
10 inch and 12 inch Pipe In-House

1. Raw materials $384,000 2. Distribution cost 24,000 3. Direct labor 40,000 4. Indirect labor 8,000 5. Pension and welfare 6,720 6. Payroll taxes 4,800 7. Utilities 8,000 8. Repairs and maintenance 7,000 9. Space 6,600 10. General factory 18,000 11. Depreciation 75,000 12. Lost interest 72,000 $654,120 Unit cost 54.5 cents - 654,120/1,200,000
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Description of the above items: 1. 32 cents per pound times 1.2 million pounds per year. 2. 2 cents per pound times 1.2 million pounds per year. 3. Two workers at $20,000 per year each. 4. 20 percent of item 3. This is mainly the project’s share of supervisory salaries. 5. 14 percent of items 3 plus 4. This includes the firm’s contribution to the employee’s pension fund. 6. 10 percent of items 3 plus 4. This is mainly for social security and unemployment insurance. 7. The project’s share of electricity, heat, water, etc. 8. Annual maintenance and repair on the equipment. 9. The project’s share of the factory space occupied by the equipment and the two workers. 10. The project’s share of items like property taxes, corporate fees, secretarial support, etc. 11. Based on the cost of the equipment: $600,000/8 12. Lost interest on the $600,000 used to purchase the equipment: .12 x $600,000 where .12 is the project’s after-tax discount rate.

Scenario Analysis

The purpose of this exercise is to evaluate the sensitivity of investment decisions to management uncertainty concerning input variables. For the Great Lakes Pipe and Tube, Inc. take the base case analysis and test the sensitivity of the investment decision to each one of the following assumptions. Change one assumption at a time.

1. Rubin was concerned about the fact that the accountant may have ignored inflation in his analysis. While the first year costs are correct, Rubin believes the accountant has simply forgotten about the effects of inflation on the project cash flows after the first year. The accountant’s estimate of direct labor cost reflects the terms of the current labor market conditions. Rubin believes, however, that at the end of three years, inflation will start pushing labor costs higher. His expectation is that total labor costs including benefits would increase annually at the rate of inflation of 3 percent, starting in the fourth year of the project. Rubin believes raw material costs will increase with inflation (at 3%) in every year of the project. He also expects the unit cost of purchased pipe (at 45 cents in the first year) to increase annually at the rate of inflation during the life of the project. Recalculate the NPV of the project, adjusting the cash flows for expected inflation.

2. Assume that there is an alternative use of the space in which the proposed pipe manufacturing project will be located. The Gross Present Value of the alternative project is $200,000. The net present value of the alternative project is $20,000.

3. Assume that the two laborers who were going to be employed for the project in the first three years have both decided to retire immediately.

4. Assume that the market value of the equipment is expected to be $250,000 before taxes (instead of $180,000 in the base case scenario).

5. Assume that the current supplier responded to the news that Great Lakes planned to start its own production by cutting the unit cost of pipes to 42 cents per unit.