Straight Supply Straight Supply is a major supplier of medicalcomponents to large pharmaceutical corporations. Bonnie Straight isa second generation CEO of the company founded by her father fortyyears ago. Originally established in Moorhead, Minnesota, Bonniemoved the company operations to Denver ten years ago so she couldsee the mountains from her office window. The Denver locationproved profitable for Straight Supply as the company could takeadvantage of a larger pool of labor and find and train skilledemployees to assemble quality products efficiently. The locationalso made it easier for shipping around the country as manytrucking companies were looking for loads out of the Denver area.Additionally, Bonnie could more easily take advantage of businessand medical conferences. An unexpected benefit of beingheadquartered in Denver was the close proximity to Colorado Springsand the many Christian organizations based in the area like Focuson the Family. Bonnie became an active contributor to several ofthese organizations and was invited to serve on the board of someof them. Her work in the medical supply area also providedopportunities to help worthwhile causes through the donation ofmedical supplies and materials to these organizations. At least tenpercent of company profits were donated to Christian organizationsevery year. One of Straight Supply’s most successful products is aninsulin-monitoring pump, which monitors and measures insulinconcentrations and automatically injects insulin into diabeticpatients. Due to the technical nature of this pump and its criticalfunction, exacting standards are needed in its design andmanufacture. There are several critical components requiring highlyskilled labor and the finest quality materials. Recently, acompetitor, began promoting a similar insulin monitoring and pumptype product. One of the large pharmaceutical companies, which hasbeen a major customer of Straight, indicated that they were givingserious consideration to the competitors product. This customerwanted to give Straight Supply every opportunity to continuebusiness with them since they have a good relationship, which hasexisted over a number of years, however, business is business.Bonnie learned that the competing product was close in quality, butdefinitely lower in price. While this other insulin pump did nothave as long a history for product reliability, the competingcompany had introduced several successful medical products over thelast few years. There was every indication that the competitor’sinsulin pump could reach the quality standards required by thesemajor companies at a favorable price. Straight anticipated that ifthey wanted to remain a product leader in the insulin monitoringpump product area and maintain their current customer base, theywere going to have to make their product more competitive. Giventhat competitors were able to offer a similar quality product at alower price meant that Straight would have to consider lower itsselling price. However, at the same time, they wanted to maintainas much of the profit margin as possible as this was a criticalproduct to the overall success of the company. Bonnie realized thatthey were going to have to reduce production costs. Given that thecompany had produced this product for some time, they had prettymuch taken advantage of the learning curve phenomena. Allproduction efficiencies and the resulting cost savings had prettymuch been incorporated into the current cost of the product and itwould be difficult to introduce additional efficiencies of costsavings into the production process. Material costs were somewhatout of their control as they had to rely on other suppliers toprovide materials and additionally, material costs was not thatgreat of a component of the total costs of the product. When itcame to overhead costs, the company used activity based costing toattempt to get as accurate a measure as possible of appropriateindirect costs to allocate to this particular product line. Whilethere is never a guarantee of complete accuracy with the allocationprocess, top management believed that their costing procedure wasreasonable. This process of determining total costs was furtherconfirmed by an independent consulting firm which recommended andimplemented their current cost allocation system. Outsourcing wasquickly becoming the only option for production of this product.The production process was fairly labor intensive, involving askilled workforce to insure that the critical intricacies andcomponents of the product were properly assembled. Straight haddepended on some of their most talented work force to assemble thisimportant product. Naturally, the labor cost on a per part basiswas relatively high due to many factors. The product was made inthe Denver plant, which also had a high cost of living, and thedemand for qualified employees was critical which resulted in ahigher wage rate. Also, well-trained technically skilledindividuals were needed in many disciplines, which also demanded ahigher wage rate. The employees working for Straight were some ofthe more dependable with a greater number of years working at thecompany which added to the labor costs. The potential forconsiderable cost savings in labor was available if the productcould be assembled overseas. Straight identified a medical supplycompany in India that apparently employed a highly skilled workforce with appropriate training in the assembly of similarproducts. The labor rate was considerably lower, enough so, thatthe product could be shipped to India and back by air for just theassembly process and money could be saved. Before making anycritical decisions of this nature, Bonnie thought it best toconduct a financial analysis of alternative proposals for afive-year time period. The choice for Straight Supply in thissituation was to either continue production in Denver or have theproduct assembled in India. The production and finance departmentscame up with some critical cost factors to aid in the decisionprocess. At the Denver plant, 25 employees worked on this specificproduct. Their average wage rate including benefits is $30 perhour. Employees at the Denver plant are able to produce 75 of theinsulin pumps per hour on an eight-hour shift for 250 days in theyear. Indirect costs related to the production of the insulin pumpwere allocated to the product at 180 percent of the direct laborcosts. Wage rates will increase at 6 percent per year. The cost toship the product to their pharmaceutical customer in Chicago was$0.75 per item and that shipping cost would increase 4 percent peryear. If the insulin pump were no longer assembled in Denver, inaddition to a reduction in the labor force, there would be animmediate one-time reduction in capacity related costs of $120,000.For this current year, the anticipated annual demand was equal tothe current production capacity. If Straight Supply maintains itsmarket share with existing customers, there should be a 10%increase in demand for this product for each of the next fiveyears. The annual increase in demand could actually have been 20%;however, top management thought it better to estimateconservatively given the potential increase in competition.Additional employees would need to be hired at the Denver plant tokeep up with demand. Each insulin pump sold for $100 this year withthe price forecasted to increase at five percent per year over thenext five years. Increases in working capital directly associatedwith the product have been equal to 12 percent of the total salesrevenue figure. In India the wage rate was only $10.50 per hour,and each employee could assemble an average of two insulin pumpsper hour. Given this was a new production process at the Indialocation, learning curve efficiencies could apply to the insulinpump and it was expected that production levels would increase 15%per year over the next three years before leveling out in thefourth and fifth years. Also, the hourly rate would increase at 10%per year for each of the next five years. The management at theIndia plant promised to hire enough skilled workers to meet theproduction demand every year. Round trip shipping cost to and fromIndia would be at $5.00 per item with that rate increasing at 4%per year. The additional shipping requirement will increase theproduction time by one week. To maintain its just-in-time inventoryphilosophy Straight Supply will need to begin the production of theinsulin pump one week earlier so the final product will beavailable to the customer at the agreed upon delivery date.Starting the production process one week sooner will create aninitial cost increase of $260,000 for the earlier ordering ofrequired materials. In completing capital budgeting projects,Straight Supply has used a weighted average cost of capital processto determine a correct discount rate and then add a premiumdepending on perceived additional risk factors. The basic discountrate for this year is 14.8%. If a new product is being considered arisk premium of 2.5% is added. If there is a change in a domesticlocation a risk premium of 1.5% is added. A project involving aninternational element results in a risk premium of from 3.0% to6.0% depending upon a number of factors including politicalstability, economic security, language and cultural differences,and governmental factors. ?

Required: 1. Evaluate the two proposed alternatives regardingthe insulin pump.