Cornell Management Simulation
Table of Contents
I. SALES AND MARKETING ANALYSIS 3
A. Current Market 3
B. Marketing Opportunities 4
II. RESEARCH & DEVELOPMENT ANALYSIS 5
A. Current Situation 5
B. New Product Opportunity 5
C. Limit on R&D Expenditures 6
III. OPERATIONS ANALYSIS 6
A. Current Situation 6
B. Operations Opportunities 8
IV. FINANCING ANALYSIS 9
A. Current Situation 9
B. Financing Opportunities 9
C. Bankruptcy 10
APPENDIX A: HISTORICAL FINANCIAL REPORTS 11
You and your teammates are about to take over the management of a newly spun-off company
that produces and sells DC/AC Power Inverters. Even though the power inverter market has
shown great promise, the company’s previous management team was unable to obtain the
profit and growth objectives set by the Board of Directors, so the Board dismissed that
management team and hired your team to take over operations of the company.
Your management team is tasked with setting this company on a successful strategic path,
achieving both profit and growth from your operations. Your objective is to be the best
competitor in the marketplace. Success will be measured in terms of the growth in your
company’s stock price over the period in which you manage the company. This business case
provides you with an overview of your new company and the industry in which you will
The Power Inverter
Growth in the demand for clean, renewable energy has led to the emergence of new
technologies for generating power from multiple sources such as wind and solar. With this
evolution has come an ever-increasing need for products to support the technology and to
make power available for everyday use. One of the most ubiquitous components of any
renewable energy system is the DC/AC Power Inverter.
Most electrical power systems, whether they use mechanical generators, wind turbines, or
solar cells, produce direct current (DC) electricity, which can be stored in batteries. However,
most household products that use electricity, such as appliances, computers, and TVs, use
alternating current (AC) electricity. A power inverter is an electronic component that converts
DC power into conventional AC power, and it is a critical piece of any renewable energy system.
Your company currently produces and sells two types of
power inverters to manufacturers who integrate the
inverters in their products, which are then sold to
customers. The first is the Mechanical Power Inverter
(MPI), which is used with nearly all types of small electric
generators. MPIs are often used on construction sites and
in facilities such as hospitals and warehouses, where fossil
fuel-powered generators provide electricity in remote
areas or backup power in the event of an outage. MPIs can
also be found in many manufacturing facilities, where companies have begun to harness the
excess mechanical motion that occurs in their manufacturing processes to generate electricity.
In these settings, electrical power is stored in large battery banks and numerous power
inverters convert the DC current to AC current for use in the plant.
The second product line is the Wind Power Inverter
(WPI). This inverter is designed for use with small to
medium sized wind turbines of up to 100kw power
capacity. Wind has huge variability in its speed and
duration, which presents significant challenges in
using it as a power source. This is amplified by the
physics of wind power – doubling wind speed leads to
an eightfold increase in power for a constant
geometry wind turbine. Because of this, turbine
components must be able to adapt to very wide
ranges and variability of loads, and for that reason, inverters for use with wind turbines are
more sophisticated and complex than mechanical power inverters. Your company’s WPI uses
newer technology and higher quality materials than the MPI to solve these challenges. The
market for the WPI is growing quickly as more businesses are taking advantage of government
subsidies and tax incentives for installing wind turbines on their properties. These small threebladed turbines can be seen cropping up on all sorts of properties, from commercial office
buildings to manufacturing facilities to family farms and ranches.
Functional Area Analysis
While the prior management team was separated from the company as part of the spin-off,
their divisional managers and staff were retained, and they are eager to contribute to the
turnaround of the company’s fortunes. At the request of the board and to aid you and your
team as you take over the management, specialists from each of the functional areas of the
company – Sales and Marketing, Research and Development, Operations, and Finance – have
prepared an analysis of their respective area, outlining the current state and opportunities for
I. SALES AND MARKETING ANALYSIS
A. Current Market
The power inverter market is a global market filled with opportunities. We have identified two
market sectors: Commercial and Home Energy. Our company has been selling only in the
commercial sector, which includes facilities for manufacturing and construction as well as
buildings such as hospitals and schools. Home Energy, a market we have not yet tried to
penetrate, includes single-family homeowners and small farms and ranches. While we feel
confident that our MPI and WPI are well suited for use in the home energy market, we have
focused only on the commercial sector, where our relatively small sales force has been able to
generate revenue by selling a large volume of products to a fairly small number of customers.
The Mechanical Power Inverter is used extensively in the commercial sector, and last year the
company sold over 1.8 million MPIs, accounting for $110 million in sales. Wind Power Inverters
are not yet as common in the Commercial sector, and our revenue for WPI was $45 million last
year, with just under 500,000 units sold.
Sales representatives call on customers, demonstrating products, dealing with customer
problems and taking orders. Without sales reps, it is doubtful that any sales would be
forthcoming. For the past two years, 15 sales representatives have tried to cover the demand,
but that is insufficient. At least 25 sales reps are necessary to adequately cover the
Commercial sector. We are confident that additional sales reps would lead to greater sales.
Advertising helps create demand for our products and enhances customers’ awareness of our
brand. The advertising budget last year in the Commercial sector was $1 million total. This is
well below the minimum we believe necessary to attract the attention of potential customers.
At least $3 million should be spent on MPI and $5 million on WPI advertising.
Our prices last year for the MPI and WPI product lines were $60 and $90 per unit, respectively.
We believe the demand for the MPI is sensitive to price and that a large price increase would
severely decrease demand for the product, even if accompanied by increased advertising and
higher innovation ratings. Demand for the WPI is less sensitive to price than MPI and more
sensitive to innovation and advertising.
B. Marketing Opportunities
In addition to competitive pricing, increased advertising, and improved product innovation,
additional sales can be obtained two different ways. First, we can hire additional sales
representatives for the Commercial sector, and second, we can begin selling our products in the
Home Energy sector.
Additional sales representatives
The cost of hiring and training a new sales rep is $10,000. There is no cost associated with firing
a sales rep. Note: while adding sales reps enhances our ability to sell our products, carrying
multiple products decreases the effectiveness of sales reps in each market sector (because the
sales reps are less specialized). Relatively speaking, sales reps carrying one product are more
effective than sales reps carrying two or three products.
Selling in the Home Energy sector
In order to enter the Home Energy sector, it is necessary to establish agreements with
wholesale distributors and retail installers and to set up a sales office to manage those
relationships. We have looked into the situation and estimate that it would cost $200,000 per
year for a sales manager, clerical help, space and utilities to operate in this sector, in addition to
sales reps’ salaries and expenses. We believe that at least 20 sales reps need to be hired in
order to cover the Home Energy sector, although we can start with many fewer and build to
that number over time.
In terms of advertising, we would have to spend at least $3 million on MPI and $5 million on
WPI to effectively launch our products into the Home Energy sector. The sales volume we
could realize in the Home Energy sector depends not only on the number of sales reps, but also
on the relative prices, advertising, and the innovation level of our product compared to our
competitors. While highly uncertain, we believe the unit sales volume could eventually grow to
about 50-60 percent of the Commercial sector over the next several years, depending on the
level of investment we make in developing the market.
II. RESEARCH & DEVELOPMENT ANALYSIS
A. Current Situation
While advertising can create valuable positive perceptions of a product in customers, the
ultimate measure lies in product performance. Products such as ours are tested regularly by the
Consumer Products Laboratory, and the reports, which detail Innovation Awareness compared
to our competition, are available to our existing and potential customers. Innovation Awareness
can be improved only by investing in research and development. Over the past two years, very
little has been spent on R&D, with only $1.2 million spent last year. To be competitive in the
MPI and WPI markets, we believe that annual expenditures on R&D will have to be in the
neighborhood of $5 million and $8 million, respectively. In the long run, of course, we will
have to spend whatever is necessary to maintain an innovation advantage over our
B. New Product Opportunity
We do not currently carry a power inverter for use in
photovoltaic (solar) energy systems. The specific
requirements of photovoltaic power conversion will
require more advanced features than those found in the
MPI or WPI. We believe that with a major research and
development effort, we could have a Solar Power Inverter
(SPI) ready to sell in as little as two years. If we decide to
pursue this new product opportunity, we will need to
spend a total of $20 million on research and development
for the SPI in order to turn our concept into a marketable product.
The SPI market is likely to be relatively small at the outset (about 600,000 – 800,000 units);
however, the rate of growth could be high. The ultimate size depends, in part, on the overall
innovation level of the products being sold and the marketing effort being put behind them.
It is our anticipation that this product could sell at a high price, with demand likely to be
significantly more sensitive to innovation level than to price. Introductory prices should be in
the range of $140 – $170 per unit. Additional spending in SPI R&D above the $20 million initial
investment will result in continuing improvement of its innovation level (and justification for
higher prices, naturally).
C. Limit on R&D Expenditures
Total R&D expenditures in each year cannot exceed the greater of (a) the total R&D
expenditures the previous year or (b) 10% of last year’s sales revenues. Currently, the limit is
$15.483 million. The simulation interface will display your spending limit.
III. OPERATIONS ANALYSIS
A. Current Situation
We have a relatively new plant that has operated on a two-shift basis for several years. The
initial capacity of the plant was 1,600,000 units per shift per year, but we have lost effective
capacity each year as a result of physical depreciation. This year our capacity is estimated to be
1,441,000 units per shift (in other words, running two shifts, we will make 2,882,000 units this
year). It is expected that capacity will decrease by one percent per year as equipment
depreciates. The simulation interface will display your capacity per shift each year.
All three products can be produced with the same equipment, but we lose effective capacity if
we produce more than one product (due to the change-over costs which accompany multiple
product production). If only one product is produced, our full capacity is available. If two
products are produced, the effective capacity is 98%, and if three products are produced, the
effective capacity is reduced to 96% of the nominal capacity.
All products shipped must meet minimum specifications, and the percentage of goods
produced which do not meet specifications (the “reject rate”) is an important metric in our
operations. A high reject rate is very costly because the labor and material costs embodied in
the items rejected are not recoverable.
Without investment, the reject rate will increase every year. Machinery wears with usage and
its ability to produce products that fall within specified tolerances decreases. Parts need
replacement as they become worn and employees need continuous training in maintenance
and operation processes. Two years ago the reject rate was 15% and last year that percentage
rose to 16%.
For several years the factory has employed two shifts of 625 workers each. Last year the
prevailing wage rate was $15.75 per hour on the first shift, including fringe and direct
overheads. Second shift workers get paid a 10% premium and the third shift gets paid a 20%
The first and second shifts can be scheduled to work overtime, and they will be paid an
overtime premium of 10% over their base wage rate. Each shift can work a maximum of 15%
overtime, so if the company is operating with one shift, that shift can work up to a maximum of
1.15 times its capacity. If the company is operating with two shifts, each can work a maximum
of 15% overtime, making the maximum production for two shifts equal to 2.3 times the one
shift capacity. There is no overtime possible for three shifts since process improvements and
maintenance is performed on the weekends, when the plant is idle.
Any fractional shift scheduled above the overtime limit has to be paid a full shift’s wages. For
example, scheduling 0.8 shifts will result in paying the first shift its entire wages, even though it
is idle 20% of the time and produces only 80% of its capacity. Scheduling 1.3 shifts will result in
paying two shifts (since it’s above the 1.15 maximum), even though the second shift will be idle
70% of the time and produce only 30% of that shift’s capacity.
The simulation interface will display the number of units that will be produced by whatever
shifts are scheduled.
One unit of materials is used in the production of one unit of MPI. Two units of materials are
used in the production of one unit of WPI. If and when SPI is produced, three units of materials
will be used in the production of each unit. Material costs are expected to increase at the rate
of inflation. Your average manufacturing cost per unit is displayed in the simulation interface.
Warehouse and shipping costs
Each year, you pay warehousing costs on any inventory left in storage. Commercial shipments
are made in volume through regular routes served by preferred vendors, with an average cost
of $3.00 per unit. The more diverse distribution network in the Home Energy sector requires
more expensive shipping, estimated at $4.00 per unit.
Managerial salaries, support staff wages, and office operating and occupancy costs totaled
$3.309 million last year, and it is expected that these costs will rise at the rate of inflation.
B. Operations Opportunities
Several opportunities are available in the operations area:
Shift additions or deletions
To create products to sell, you assign a number of shifts to run for the year. Depending on
demand for our products, it may be necessary to change the number of shifts being used from
the current level of two. The costs of hiring an additional shift or laying a shift off are
substantial, making it important to consider the long run needs for labor in adding or
subtracting shifts. The cost of adding a shift is $850,000 to screen ($100 each) and train (two
weeks pay) 625 workers. Termination costs for a shift are three weeks pay, or $1,181,250 at the
current wage level. The costs of adding or terminating a shift are proportional to the number of
workers per shift.
Every year the reject rate naturally increases by about 2% as machines get older and more worn
out. In order to offset that expected increase and improve the reject rate over time, it is
necessary to spend money on Process Improvement. Every $1 million you invest in Process
Improvement will decrease the reject rate by about 1%. In other words, you must spend about
$2 million on Process Improvement each year just to offset the natural increase in the reject
rate. The impact of Process Improvement investment decreases as your reject rate goes down
(it’s harder to make improvements in your process as you get closer to perfection). Your
operations team can put those funds to work quickly, so the reject rate improves the year in
which Process Improvement expenditures are made.
The limit that can be spent on Process Improvement each year is based upon plant capacity.
Your spending limit and an accurate projection of the impact on reject rate will be provided in
the simulation interface.
To offset the effects of physical depreciation and support firm growth, it is possible to expand
our plant to add production capacity. There is, however, a one-year lag between when the
capacity expansion is ordered (and paid for) and when it is available for use. The cost of
capacity additions is made up of two elements: (1) a fixed cost of $900,000 each time capacity
is added plus (2) a variable cost of $55 per unit of capacity per shift. For example, if 200,000
units of capacity had been added in year one, the total cost would have been $900,000 + ($55 x
200,000) = $11.9 million. The following year, if three shifts were operating, total output would
be 600,000 units greater than if the capacity were not added (200,000 per shift x 3 shifts). In
addition to capital costs, the addition of each 10,000 units of capacity results in the hiring of 3
Because of the high fixed cost associated with capacity expansion, it is better to add a lot of
capacity all at one time rather than a number of smaller expansions in multiple years.
IV. FINANCING ANALYSIS
A. Current Situation
We currently have 10 million shares of common stock outstanding with a book value of $7.00
per share. Our company’s current bond rating is BB.
The company borrowed $5 million from its bank two years ago. It rolled-over those notes at the
beginning of last year and paid interest at the rate of 9.9%. These notes are due at the
beginning of the current year.
Last year the company experienced an unanticipated cash shortage and incurred a Bank
Overdraft of approximately $2.6 million to meet the shortage. Interest on the Bank Overdraft
balance at the end of each year is 8% above the company’s regular one-year interest rate. For
example, given the current interest rate for a BB-rated company of 7.33%, the interest rate on
the outstanding Bank Overdraft to be paid in this year will be 15.33%, resulting in an interest
payment of $406,000. The simulation interface provides you with pro forma (projected)
financial statements. Your projected interest expense for next year is shown on the income
B. Financing Opportunities
One Year Bank Notes
The company has access to funds from several banks on a one-year
note basis, and the interest rate is tied to the company’s bond rating.
The banks will not lend to companies with a bond rating below BB. If
the company’s bond rating falls below BB, the only sources of new
capital are Bank Overdraft (which is very expensive) or new stock
There is a limit to the amount of debt which can be placed at one
time, which is based on your asset level and operating income. The
total debt limit this year is $8.973 million. The simulation interface
will display your debt limit each year.
It is perhaps more appropriate to call the Bank Overdraft a problem
rather than an opportunity. The Bank Overdraft is drawn upon in a given year if the sum of the
beginning cash position plus the cash flow from operations plus the net proceeds from
conventional lending activities and new stock issuance falls short of the year’s cash needs. It is
very expensive to obtain funds through this channel and it should be avoided by using careful
cash flow forecasting and less expensive forms of capital. Excessive use of Bank Overdrafts can
result in bankruptcy.
New Stock Issuance
Additional shares of stock can be issued to a maximum of 20% of the existing shares
outstanding. The flotation costs associated with a new stock issue are $1 million fixed cost plus
5% of the gross proceeds. Thus, for example, if 1 million shares had been issued last year at a
price of $7 per share, the net proceeds to the company would have been $5.65 million ($7
million in gross proceeds minus $1.35 million in flotation costs). While shares can be issued at
any time without limit, remember that each additional share dilutes the company’s earnings
per share (EPS), other things equal. EPS is an important statistic in investors’ share price
determination, as is the growth in earnings and investors’ assessment of each company’s
Shares are sold at the beginning of the decision year; thus the cash proceeds from sales are
available during the year, and the sale price will be the ending stock price from the prior year.
Dividends and Stock Repurchases
Cash distributions can occur in two forms – dividends and stock repurchases. There is no tax
incentive reason to differentiate between cash dividends and stock repurchases; both capital
gains and dividends are subject to personal taxes at the same rate. Investors appear to value
companies that pay dividends at somewhat higher value than those that don’t, but if the
company’s stock is selling below its “intrinsic value,” then stock repurchases would create value
for the remaining shareholders. Given the company’s poor cash flow performance since the
spinoff, no dividends have been declared, and the Board of Directors has issued a press release
to the investor community informing them that dividend policy would come from the
recommendation of the new management team on a going-forward basis. A restrictive
covenant in the line of credit agreement with the bank (that provides for overdraft financing if
necessary) prohibits the payment of a cash dividend or the repurchase of shares if Total Equity
falls below $20 million. Put another way, the simulation interface will force you to reduce your
dividend or share buyback if the total amount requested exceeds this constraint.
If it appears that a firm will be unable to meet its debt obligations, it can be forced into
bankruptcy. Bankruptcies are likely to occur when the value of a firm’s Bank Overdrafts become
large relative to the value of its inventories. In the event of a bankruptcy, a company will
undergo a Chapter 11 reorganization whereby the firm’s debt is converted into equity and the
firm continues to operate. In effect, the firm repays the debt with newly-issued equity shares,
and the firm’s original stockholders end up owning a smaller proportion of the firm.
APPENDIX A: HISTORICAL FINANCIAL REPORTS
Cash $2,467 $0
Accounts Receivable 12,287 12,725
Inventories 19,222 26,458
Current Assets 33,976 39,184
Land, Plant & Equipment (net) 60,030 51,882
Total Assets 94,006 91,066
Bank Overdraft 0 2,648
One-Year Bank Notes 10,000 5,000
Accounts Payable 8,905 6,910
Total Liabilities 18,905 14,558
Total Equity 75,101 76,508
Shares Outstanding 10,000,000 10,000,000
Sales $149,490 $154,826
Cost of Goods Sold 120,119 135,171
Gross Profit 29,371 19,655
Advertising 900 1,000
Research & Development 1,100 1,200
Other Selling, General & Administrative 12,637 13,746
Process Improvement 720 1,000
Operating Income 14,014 2,709
Interest Expense 911 476
Income Taxes 4,848 826
Net Income 8,255 1,407
Earnings Per Share $0.83 $0.14
Beginning Inventories 100 0 Production 1,856 619
Units Available 1,956 619 Unit Sales 1,782 473 Ending Inventories 174 146 Cost / Unit Available $47.32 $75.68 Cost of Goods Sold 84,323 35,796 Ending Inventory Value 8,210 11,012 2020 2021
Reject Rate 15% 16%
Average Capacity/Shift 1,477 1,455