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PRODUCTION PLANNING AT VIKTOR LENAC SHIPYARD
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9B04D019
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
Giorgio Sinkovic and Professor David M. Currie prepared this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 2004, Ivey Management Services Version: (A) 2009-10-09
As the late afternoon sun descended over Mount Ucka, Ivana Boric sat down to prepare the production plan for the coming year at Viktor Lenac Shipyard. It was late May 2003, and the choppy seas caused by the Yugo wind from the southeast reminded her of the turbulent times facing Viktor Lenac. Recent expansion had increased fixed costs beyond the level that could be supported by the current volume of sales, jeopardizing Viktor Lenac’s future. If management could not discover ways to increase profits from current operations, the shipyard could default on loans and be forced to seek bankruptcy protection. Boric’s supervisor, the manager of production for the shipyard, suggested that she explore ways to improve Viktor Lenac’s profitability by changing the mix of products. From her training as an engineer, Boric realized that there were several ways to improve profitability: training employees, using more modern technology and changing production processes. However, some of these methods required a long time to implement and show results, while others involved significant expenditures of funds at a time when cash was tight. She hoped that by changing the mix of products it would be possible to realize a quick improvement in profits without incurring a large outlay of funds.
MODERNIZATION AT VIKTOR LENAC
Viktor Lenac (pronounced LEN-atz) was one of two shipyards in Rijeka, a city of 200,000 people, located on the north coast of Kvarner Bay, between the Istrian Peninsula and the eastern Adriatic coast of Croatia. Founded in 1896 as Lazarus Shipyard, Viktor Lenac was renamed for a Croatian hero of the Second World War and became one of Yugoslavia’s important shipyards in the four decades of the Yugoslav Federal Republic. Croatia became an independent country in 1991, when it and Slovenia seceded from the Yugoslav Federal Republic. Serbia opposed the secession, which led to brief military confrontations in 1991 and 1995 and caused a crisis in the Croatian shipbuilding industry. Foreign companies, who were major purchasers from Croatian shipyards, hesitated to spend millions of dollars to purchase a new ship that might require two years to complete. Because Viktor Lenac specialized in repairs, it survived the crisis better than most of its
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sister yards. Repairs took weeks rather than years and didn’t require the significant cash commitment that accompanied building a new ship. Viktor Lenac was the only profitable large Croatian shipyard in the 1990s. Following independence, Croatia began an effort to modernize and move toward a market economy. The effort included privatizing firms previously owned by the government. Attracted by the shipyard’s profitability, a consortium of investors from Italy and the United States purchased a 65 per cent stake in Viktor Lenac in 1993. The remaining 35 per cent was distributed to current and former employees. In 1996, the new owners decided to modernize the shipyard to improve productivity and expand product offerings. The number of employees grew to 1,200 in 2001, from 500 in 1995. Modernization was financed by an $80 million1 loan package from the International Finance Corporation (part of the World Bank Group) and several private banks. The first phase of expansion began in 2000, but immediately experienced delays and cost overruns. Because of the delays, the shipyard did not yet have the cranes, steel workshops and other equipment appropriate for new building. High fixed costs caused the yard to lose its competitive advantage in repairs, which were the heart of Viktor Lenac’s business. Neither of these situations would improve until productivity increased, which would result from the second phase of the modernization program. Unfortunately, the second phase was still in the future, pending the outcome of negotiations between lenders and the Croatian government.
THE SHIPBUILDING INDUSTRY
In 1999, shipbuilding worldwide was a $30 billion industry. The manufacturing facility in which a ship is built is called a shipyard, and shipyards around the world specialized in various aspects of shipbuilding: repair, conversion, newbuilding and drilling platforms. Viktor Lenac traditionally emphasized repairs, but one of the justifications for the recent expansion was to enable the company to become a full-service shipyard with capabilities in multiple areas. Each activity had a different impact on Viktor Lenac’s operating income, which management termed “contribution” and defined as revenues less direct production expenses.
Repairs
Ships need repair for a variety of reasons. First, insurance policies, international safety regulations and port regulations require regular maintenance, which includes check-ups of the ship’s important functions — vessel integrity, the propulsion system, environmental protection and safety. Second, the natural effect of salt water is that animal and vegetable matter accumulate on a ship’s hull, which can reduce the ship’s speed and lead to deterioration of the hull. Painting the hull with anticorrosive, antivegetative paint requires that the ship be docked out of the water. Third, repairs may be necessary on an emergency basis if the engine fails, if there is a fire on board, if the hull is damaged or if some other event renders the ship unsafe or unable to operate. Ship owners estimate the yearly cost of maintenance at approximately one per cent of the purchase price of the vessel. Because the average life of a ship is 25 years, the worldwide market for repairs is about 25 per cent of the market for new construction. Because of the size of the market and Viktor Lenac’s history as a repair yard, many executives (particularly those with long experience with the company) favored emphasizing repairs as part of the company’s strategy. Viktor Lenac had spent many years earning the trust
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All monies in US$ unless otherwise specified.
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
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of clients because of its expertise in bidding contracts. It was impossible to know beforehand the total cost of repairs because the true extent of damage may not be discovered until repairs are begun. Some shipyards purposely bid low prices to lure clients, then changed work orders to secure higher prices. Viktor Lenac’s reputation for quality work and honest negotiations had secured the trust of numerous clients.
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
The marketing department told Boric that it had received a variety of contracts from regular customers to repair up to 40 ships this year. If approved by management, each contract would contribute approximately a half million dollars to Viktor Lenac’s operating income (see Exhibit 1).
Conversions
Conversion is an alternative to constructing a new ship. A frequently used method is to convert a passenger ship into a transport. In other situations, a transport of one type is converted to a different type. For example, if the demand for oil increases while the demand for livestock declines, owners will need more tankers and fewer livestock carriers. Owners may have to wait two years or more for a new ship, but often it is possible to convert an existing ship to one purpose from another in half the time. The saving in delivery time helps offset the cost of converting because it returns a ship to active service when it might otherwise be idle. Several of the newer executives at Viktor Lenac proposed entering the market for conversions as part of the company’s strategy. They pointed out that each conversion would help the company diversify its product offerings and provide a much higher contribution to profits than repairs (see Exhibit 1). The marketing department had contracts for up to four conversions over the coming year, but the contracts were not yet approved by Viktor Lenac management.
Newbuilding
Construction of a new ship was called newbuilding and could require two years or more to complete. Newbuilding consisted of:
• • • •
Bidding, including the preliminary design that becomes part of the contract Detailed design, including material specification for the 25,000 items that are part of the ship Production, composed of two stages — vessel production and outfitting the vessel Trial and delivery
Because of the high cost and the need to meet complex contract specifications, both the purchaser and the shipyard appoint one or more persons each to represent their interests. These representatives observe the production process from beginning to end and verify compliance with the contract to the satisfaction of both parties. Unlike repairs, the client and the shipyard agree on the price and exactly what work is to be accomplished before signing the contract. In almost all cases, the client wants a turnkey ship that is ready for immediate use upon delivery. The new owners of Viktor Lenac were particularly keen to enter the newbuilding market. The managing director stressed the importance of newbuilding if Viktor Lenac wanted to be a player in the global market. The director of finance pointed out the lower contribution of only $1.6 million for each new ship (see Exhibit 1), but the engineers responded that the expertise gained from newbuilding would benefit the company in the long run. The marketing department thought that it could secure contracts for no more than
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two ships for the coming year. Both contracts would be for tugboats rather than for transports because Viktor Lenac did not yet possess the expertise to compete in the transport market.
Drilling Platforms
Oil and gas reserves frequently are located on the ocean floor rather than on dry land. Exploring and extracting oil or gas must be done from a platform that provides housing for the crew as well as allowing drilling at depths of several hundred meters. Platforms in shallow water have a component called an “offshore jacket,” which is the superstructure of the platform. The jacket is constructed using technology and resources similar to those of shipbuilding. Viktor Lenac produced offshore jackets in the 1980s but left the market to focus on repairs. It would be possible to reenter the market by partnering with an Italian firm, Rosetti Marino s.p.a., which had expertise in constructing the platform’s production module. Each jacket would provide a contribution of $3.1 million (see Exhibit 1). Because Viktor Lenac was new to the market, it could reasonably expect to produce only two offshore jackets in the next year.
Resources for Production
Boric had anticipated questions involving production, so she had asked the production manager to identify which stages in the production process or which resources used were likely to limit production. The production manager identified four possible tight spots: steel, corrosion protection, dock capacity and labor hours (see Exhibit 2).
Steel
The basic raw material in all shipyard activities is steel, which must be cut into correct shapes, then welded to other components. Viktor Lenac purchased steel from the Czech Republic, one of the few countries in Eastern Europe producing steel of sufficiently high quality for shipbuilding. Because it was necessary to order and ship steel in advance of the year’s production, the amount of steel available this year was limited to 5,500 tons.
Corrosion Protection
A ship’s components must be protected against corrosion and the accumulation of vegetative matter. Recent modernization included constructing an enclosed building in which anticorrosive, antivegetative paint could be applied to components. Because of the paint’s potentially harmful effect on the environment, the circulation system in the building prevents vapors and wastage from being released into the atmosphere or the harbor. The building had a capacity of 500,000 square metres of anticorrosion paint annually and could not be expanded without a significant investment of money and time.
Dock Days
Any of the procedures involving a ship’s hull must be completed in a dry dock so laborers have external and internal access to the complete hull. Viktor Lenac had two docks that could accommodate ships of the
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
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size in which Viktor Lenac specialized. Because national holidays limit operation of the yard, the docks could be open no more than 350 days during the year, so total dock capacity was 700 days. The second dock was part of the recent modernization program, and there were no plans for erecting a third dock during the second phase
Labor Hours
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
Shipbuilding requires knowledgeable, well-trained workers with skills in metalworking, welding and electronics. Recent hiring had depleted the pool of experienced labor in the Rijeka area. Croatia’s labor force was not considered mobile because Croatians tended to reside for life in the region of their birth. Therefore, it would be difficult to attract workers from the country’s other shipyards. Viktor Lenac’s human resources department thinks that it would be possible to replace departing workers over the coming year by drawing on Rijeka’s existing labor pool, but it would be difficult to train new workers to meet standards required by modern shipbuilding. As a result, there was a limit of four million labor hours available over the coming year.
THE DECISION
It was apparent to Boric that strategic as well as financial considerations would influence the decision about what to produce over the coming year. Although the production manager’s instructions did not include consideration of strategy, she realized that the most important concern was keeping the firm in business. The existing production plan, which continued Viktor Lenac’s traditional emphasis on repairs, would lead to a contribution of approximately $17 million. A contribution of approximately $30 million was necessary to cover fixed expenses, such as administration, marketing and debt service. Boric wondered if it would be possible to improve the contribution by changing the mix of contracts that management would accept. Boric next turned her attention to the resources and processes used to generate the contribution. Which if any, of the constraints might prevent Viktor Lenac from achieving a contribution sufficient to cover fixed expenses? If it was possible to obtain more of that resource, what price would Viktor Lenac be willing to pay? What would be the implications for Viktor Lenac if the contribution was not sufficient to cover fixed expenses?
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Exhibit 1 CONTRACTS AVAILABLE AND CONTRIBUTION PER CONTRACT (in US$)
Authorized for use only by Christopher ODowd in MS 4343 at University of Texas at San Antonio from Aug 27, 2014 to Dec 19, 2014. Use outside these parameters is a copyright violation.
Contract Repair Conversion Offshore jacket Newbuilding
Source: Company files.
Contracts Contribution Available per Contract 40 4 2 2 520,171 5,014,710 3,098,844 1,600,150
Exhibit 2 RESOURCES USED BY EACH CONTRACT Steel Corrosion Dock (tons) Protection Days 170 1,100 418 300 5,700 48,000 4,200 10,000 9 83 20 Labor Hours 47,645 731,000 170,609 100,426
Contract Repair Conversion Offshore jacket* Newbuilding
* Offshore jackets do not require Dock Days. Source: Company files. 