Case Study: Lily Tulip

Problem Statement: Lily-Tulip has ordered four machines designed to manufacturer their patented extruder foam cups, effectively tripling this capacity. Doug Smith, vice-president of sales, must decide if all or any of the machines should be converted to produce the coextruded foam cups that were recently developed by the company. Pertinent Facts: Industry and Market information: • The disposable cup industry serves the fast food, convenience store, and restaurant markets with hot and cold beverage containers. • Lily-Tulip is the second largest supplier of disposable cups to the food service industry in the United States and the largest in Canada. • The three largest competitors held over 50% market share between them, with the remainder split among hundreds of suppliers, none of whom was thought to hold more than a 5% market share. • Lily-Tulip has market share of approximately 15% with current production of paper (wax coated) and extruded foam cups. Table 1 identifies market share by product line and cup size. • Cup sizes ranged from 8 ounces to 48 ounces and were used to hold hot and cold beverages. • Generally, smaller cups were for hot beverages and the larger sizes for cold.
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A trend had emerged towards larger cups for hot beverages, primarily in the convenience store market. Table 2 presents 1984 industry demand.

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While it is considered that the fast food and convenience store markets have matured, growth in cup usage is expected to mirror growth in the general population (1984 U.S. population growth rate was 0.89%i).

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The industry has significant excess capacity due, in part, to the introduction of foam technology and a general slowing of the growth in demand for disposable cups.

Product Information: • There are six variations in cup models: Paper (Wax coated), Paper (Poly coated), Foam, Plastic, Extruded Foam, and Lily-Tulip’s new Co-extruded Foam (which is yet to be introduced). • Only variations based on foam technology are suitable for both hot and cold beverages. varieties. • Lily-Tulip management believes that, within a given technology, no competitor has a distinct cost advantage (as related to all manufacturing and distribution costs but excluding marketing and administrative costs). • • Extruded Foam cups are a patented design of Lily-Tulip. Co-extruded foam cups are a Lily-Tulip design expected to receive patent protection. • Co-extruded foam cups are made with less polystyrene and more air. As a result, the co-extruded foam cups may be produced at costs equal to, or less, than all Table 3 identifies product characteristics of the most common

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other varieties (Table 4). Co-extruded foam cups weigh less than extruded foam cups. • Lily-Tulip declares superior product attributes for it’s extruded foam and coextruded foam cups including: better graphics, a lip that allows for tighter lid fit, and a moderate transmission of heat (as opposed to too much for poly coated paper and none for foam). Lily-Tulip alleges that this may reduce user discomfort as the user can tell when a beverage is too hot to drink without burning hands or lips. • Lily-Tulip’s co-extruded foam cups claim even better graphics, lower cost, and the availability to produce in larger sizes. Lily-Tulip specific Information: • The new machines will have the ability to triple Lily-Tulip’s extruder foam capacity. • It would be more cost effective to convert the new machines to co-extruder foam production prior to installation. • Lily-Tulip has the ability to convert their extruded foam capacity to co-extruded foam. • Lily-Tulip has plant capacity and financial resources allowing for an aggressive expansion of production, if desired. Alternative Solutions: There appears to be three natural alternatives to choose from. The easiest to implement would require the least change. Accordingly, the first alternative would be to

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retain the current production capabilities of paper and extruded foam products while increasing the capacity of extruded foam production by introducing the new machinery. The second alternative also suggests that Lily-Tulip retain the current production capabilities of paper and extruded foam products. Differing from the first is that the new machinery would be converted to produce co-extruded foam cups prior to installation. For final consideration, retain current production capabilities of paper products, convert new machinery to co-extruded foam production (prior to installation), and shift existing extruded foam production capabilities to co-extruded foam as soon as feasible. Decision: The cost of the new machinery need not be factored into the alternatives presented as the equipment has already been ordered and, in effect, represents a sunk cost. While the first option is the easiest to implement, it provides the least in long-term benefits to the company. Retaining paper cup production is wise as it does not risk alienating or losing any current related customers. The machinery used in the production of paper cups cannot be used for other types of cups and no additional investment is required in order to maintain current levels of production and / or sales. The cost of producing co-extruded cups is reported to be the same as the paper (wax coated) cups (Table 4). The switch from paper (wax coated) cups to co-extruded cups should occur concurrent to consumer demand. Choosing to use the new machines for the original production intent (extruded foam cups) does not add modification costs; however, it excludes the company from effectively leveraging the new technology (co-extruded foam) it has developed. The benefits that co-extruded foam cup production may offer to

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Lily-Tulip are substantial (included in the review of subsequent options) and prevention of their realization is sufficient reason for rejecting this first alternative. The second option recommends the retention of paper cup production for the reasons already noted. Maintaining existing extruded foam production would allow LilyTulip to avoid retrofitting current machinery. Lily-Tulip would also be able to continue servicing existing extruded foam accounts without disruptions. Modifying the new

machines to produce co-extruded foam cups would permit Lily-Tulip greater entry into the growing larger size (32 & 48 ounce) cold beverage cup market (Table 1). Extruded foam and co-extruded foam cups are noted to maintain rigidity longer than paper cups and have a tighter lid fit. Extruded foam and co-extruded foam cups are suitable for both cold and hot applications. As noted, co-extruded foam cups may be manufactured at production costs similar to paper cups and lower than extruded foam cups (Table 4). The combination of a superior product, at a similar cost, would present Lily-Tulip with significant acquisition opportunities as an alternative for paper (wax coated) cup users. The final alternative, which Doug Smith should recommend, maintains elements of the second while adding that Lily-Tulip should convert extruded foam production to co-extruded foam as soon as able. Assuming the superior co-extruded product could be sold at the current price of extruded cups, the profit margin would be substantially greater. Upon substituting extruded foam cups with co-extruded, the manufacturing

savings alone represents an opportunity cost of $1.125 million annually (based on current production levels, Table 5). Co-extruded cups are superior in that they offer better graphics and are lighter (which may result in lower weight-based shipping expenses). For hot beverage

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applications, the moderate transmission of heat adds yet another reason for customers to choose co-extruded rather than purely foam cups. Consumers would benefit from better awareness of beverage heat (avoiding burns to hands and mouth) while the manufacturer and retailer could avoid potential liability suits resulting from personal injury. Co-extruded cups may be produced in the larger sizes currently served by inferior offerings. Analysis performed in Table 6 identifies that 32 and 48 ounce cups represent over 70% of cold cup demand and over 57% of total cup demand. Lily-Tulip currently services this market only through their production of paper (wax coated) cups. As the exclusive producer of co-extruded cups, Lily-Tulip would be well positioned to increase their share of this growing market. At a 15% penetration, approximately equal to that which Lily-Tulip enjoys within the industry, additional sales of co-extruded cups would add profits of $13.5 million annually (Table 7). Implementation and Control: Lily-Tulip should follow Doug Smith’s recommendation and approve modifications to new machinery, prior to installation, in order to produce co-extruded foam cups. Extruded foam cup production should be converted as co-extruded foam manufacturing is established and product substitution sales agreements with customers are executed. Lily-Tulip should commence marketing co-extruded cups as replacements to all other cup technologies (as they are suitable for both hot and cold beverages). This effort would be applicable to current customers and those served by competitors. Lily-Tulip should reduce their marketing efforts on paper cups and transfer resources to co-extruded foam.

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As Lily-Tulip offers co-extruded foam cups to current and competitor paper cup customers, the company should reduce the production of paper cups to match declining demand. Paper cup manufacturing would be reduced gradually and, as occurring,

resources could be redirected to the production of co-extruded cups. Eventually, demand may decrease to the point that Lily-Tulip may determine that it is no longer feasible to produce paper cups. competitors. Lily-Tulip should utilize the added capacity that the new machines represent by increasing their market share. The company should aggressively solicit large wholesale accounts (including, convenience stores such as 7-11 and fast-food retailers). Lily-Tulip should market the co-extruded cups as a superior product (citing greater rigidity, tighter lids, and heat transference). Lily-Tulip should emphasize the better graphics that could be customized to the seller. Manufacturing costs for co-extruded cups are equal to wax coated paper cups and significantly lower than all other cup technologies. For large acquisitions, Lily-Tulip could effectively price match co-extruded foam cups to prices of inferior products (Table 8). Even when matching prices of all other technologies, LilyTulip would be able to generate profits across all cup sizes. While this would reduce margins, overall profitability would grow as a result of the greater volume. After all current and immediately acquired accounts have been effectively converted to co-extruded foam cups, Lily-Tulip should explore using excess capacity to produce their patented co-extruded cups for competing cup manufacturers. This would require selected agreements, likely starting with smaller companies who service customers Lily-Tulip is not supplying or is not interested in acquiring agreements with. If this occurs, the machinery used could be sold to smaller

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Lily-Tulip should also explore patent licensing agreements with other cup producers. Naturally, acquiring the business of competitor's customers is preferable. When attempts have been unsuccessful, receiving revenue from competitor sales is acceptable. Lily-Tulip should extend the use of the co-extruded technology to additional applications such as plates, bowls, and other food service products. This will generate additional revenue streams and maximize efficiencies. Lily-Tulip must not forget that it was product advancements from their research and development activities that created the competitive advantage. To this end, the company must return a portion of the profits realized to R&D in order to maintain product superiority and fund future advancements.

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Appendices: Table 1: 1984 Cup Industry Market Share %
8 oz Hot 12 oz. Hot n/a 10 75 n/a n/a 15 12 oz. Cold 60 n/a 25 n/a 10 5 16 oz. Hot n/a n/a 85 n/a n/a 15 16 oz. Cold 60 n/a 25 n/a 10 5 20 oz. Hot n/a n/a 85 n/a n/a 15 20 oz. Cold 70 n/a 10 5 10 5 32 oz. Cold 75 n/a 10 5 10 n/a 48 oz. Cold 80 n/a n/a n/a 20 n/a

Competitive Paper (wax coated) Paper (poly coated) Foam Plastic Lily-Tulip Paper (wax coated) Extruded Foam

n/a 15 70 n/a n/a 15

Table 2: 1984 Cup Industry Units (100 Millions) 8 oz. Type of usage Hot Cold 25 n/a 12 oz. 20 5 16 oz. 10 15 20 oz. 5 55 32 oz. n/a 150 48 oz. n/a 30

Table 3: 1984 Cup Technology Technology Paper (wax coated): Paper (Poly coated): Foam: Extruded Foam: Description Paper is first printed, then cut, then formed, then wax coated. Paper is first printed, then cut, then formed, then polystyrene coated. Polystyrene is molded, then printed. Polystyrene is extruded as a sheet, then printed, then formed by heat shrinkage around a mandrel. Lily-Tulip has patents on this product. Multiple layers of polystyrene (with different percentages of air) are co-extruded as a sheet, then formed by heat shrinkage around a mandrel. Lily-Tulip expects to receive additional patents on this product. Hot Cold X X X X X X

Co-extruded Foam:

X

X

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Table 4: Lily-Tulip Profitability Analysis

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Table 5: Product Exchange Analysis

Table 6: Lily-Tulip Demand Analysis

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Table 7: Larger Size Sales Analysis

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Table 8: Price Match Analysis

Endnotes: i Historical U.S. Population Growth, NPG Facts & Figures. Available at http://www.npg.org/facts/us_historical_pops.htm . Accessed on 9/24/10.

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