This case is designed to show the interconnection between operations management, markets and strategic cost management. The central integration point in this case is the relationship between the selection of an operations/production strategy and its impact on profitability. The case deals with the proposed acquisition of Creative Designs by Hammond Cards. The two companies have different manufacturing operations and different customer profiles. Hammond produces simple and standard-sized greeting cards that are packaged in sets of 20 cards to a package. Hammond’s business model is low margin high volume. In contrast, Creative Designs specializes in so-called studio cards. These are highend greeting cards sold individually at retail. Creative’s production operations are optimized for high margin-moderate volume production.
Since the two production operations have essentially the same production steps, Hammond is hoping to exploit the synergy by sharing the peak demand across the two plants and to transfer best practices between plants. It also hopes to exploit the different distribution channels and customer segments that Creative will bring and thus smooth out seasonal demand fluctuations and allow efficient management of inventory.
The students are asked to take the role of consulting team hired by the CEO of Hammond to make certain that the expected benefits from the merger will be forthcoming. The case requires students to evaluate the operations of both Hammond and Creative. By analyzing cycle time, demand fluctuations, capacity bottlenecks, and quality management they are expected to form a judgment about the potential benefits from the merger. It turns out that though the plan to offload excess demand from Hammond to Creative is a good idea, it needs several modifications to be effectively implemented. To test the profit impact of the joint operations, the strategic cost analysis uses a new order from a customer as a test case to determine which of the two plants is best suited to produce the cards and which customer is the most profitable for this particular design. The answers are counter intuitive. Even though the Hammond plant is cheaper for production and the Creative customer less expensive to serve, the high prices commanded by Creative customers means selling to them regardless of the production site. The case has both separable discipline specific as well as integrative learning objectives that include understanding the need for a balance between operational efficiencies, cost efficiencies, and customer service costs in increasing profitability.
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Gregory Hammond founded Hammond Cards, Inc. 1951. The company, located in a suburb of Chicago, IL grew to become a major provider of greeting cards sold through traditional channels – card store chains, bookstores, pharmacy chains and supermarkets. By industry standards, Hammond was small, with annual revenues less than 1% of industry leader Hallmark. The company produced all of its cards in a single manufacturing plant that was located adjacent to the company headquarters. Over the years, Hammond sales grew to roughly 10 million cards per year but growth had slowed in recent years, perhaps due to the proliferation of online e-cards.
In an effort to stimulate growth, Hammond management was exploring potential acquisitions of other card companies. Creative Designs was one of Hammond’s potential acquisition targets. Creative Designs was a privately-held greeting card company with a complementary set of offerings and a focus on different markets. Founded in New Jersey in 1986, Creative Designs was a smaller, niche player in the high-end card market. The company headquarters and manufacturing operations were located in a single facility just outside of Newark, NJ.
Wendy Hammond, daughter of the founder and current President of Hammond Cards, had entered into discussions with Creative Designs’ owners to discuss an acquisition of the company. The owners were amenable to the sale and had provided Hammond with significant amounts of data about their business and operations during the early part of the “due diligence” process. Wendy was intrigued by what they had learned. She believed that the proposed acquisition of Creative Designs would provide numerous opportunities for her company. There were, of course, some simple scale economies that could be extracted from the combination of the two businesses. For example, such a consolidation would allow cross-selling of the two distinct lines of greeting cards to the combined set of existing customers and new customers who might be brought into the mix by the wider variety of products.
The Product Lines and Markets
Hammond Cards manufactured and sold a wide range of greeting cards, but they were all basically simple, standard-sized cards. All of Hammond’s sales were packaged in sets – 20 cards to a package. This allowed the retailers the choice to sell boxed sets (e.g., a set of Christmas cards) or open the package and vend them one at a time. This approach was a factor that differentiated Hammond from most of the industry’s big players.
Another dimension of product differentiation was price. Hammond’s cards were targeted at priceconscious buyers. Sales and distribution of Hammond’s cards was straightforward and a relatively low portion of total annual expenses. Sales were either direct to large chain stores (e.g., K-Mart, Wal-Mart, Walgreens) or to major wholesale/distribution operations.
In contrast to Hammond Cards, Creative Designs specialized in so-called studio cards. These were high-end greeting cards which were sold individually at retail. Creative Designs had not participated in the big-store supply chain. The majority of Creative Designs cards were sold through smaller specialty shops and chains (stationery, cards, gifts, etc.)
Improvement Opportunities Created by the Merger
Before Wendy went any further with the acquisition talks, she felt that she needed to have better insights into the opportunities offered by the combined organization other than simple scale economies in sales and administration. One intriguing opportunity was the potential ability to address several of Hammond’s operations and profitability challenges by leveraging the combined capabilities of Hammond’s current operations and the acquired Creative Designs operations. The greeting card production operations at the two companies were quite similar. In fact, for most of the production process, they even used the same kind of machines in the same way with the same, unionestablished pay rates. The obvious point of difference was printing. Hammond used printers that could print the entire foreground or background of a card surface in one operation. These machines also used less expensive ink and operated with fewer laborers per machine. The required class of labor was also less expensive.
Wendy hoped that effective integration of the two operating environments would allow the company to do the following: Improve their ability to accommodate seasonality of their business and, thus, better match supply and demand; Enable more efficient management of inventory and facilitate better control over inventory costs; Address product quality issues at both Hammond and Creative designs; Provide an environment that was conducive to process improvement and implementation of new operating concepts and policies. Finally, by reducing waste and improving process efficiency, lessen overall costs as a percentage of revenues and increase the bottom line. Wendy engaged the services of Olin Consulting, Inc. to help her examine the potential outcomes associated with the merger.
The Operations Analysis
Wendy first directed the team to Bob Martin, Vice-President of Operations at Hammond Cards. Hammond and Martin had previously discussed the shortcomings of Hammond’s current operations infrastructure. Based upon these new discussions, Martin constructed an operating plan for the merged operations.
Operations @ Hammond Cards
Martin’s hope was that the proposed acquisition of Creative Designs (CD) could provide additional production capacity and flexibility that would allow him to address Hammond’s major concerns. In addition, Martin believed that the smaller scale of the CD operations would allow him to utilize that facility as a learning laboratory for new production methods. His objective relative to the laboratory concept was to implement new production methods at Creative Designs and then to migrate those methods to the larger scale Hammond operations at some later date. Martin said:
“We’ve been operating at or near capacity for some time at Hammond Cards. This places a lot of stress on our machinery, our managers and our production workers. As a result, we’ve been reluctant to make major changes to the operation. Mostly we just try to keep pace with demand and hope that the machinery holds up – and that our quality is acceptable. If we go forward with this acquisition, I plan to off-load (transfer) some of our demand over to the Creative Design facility. My analysis indicates that, unlike us, they’re operating at far less than full capacity. They also run a much smaller operation, which makes them a great learning laboratory. We can pilot new production methods at Creative Designs and then migrate those methods to the larger scale operations at Hammond after working out any issues that may arise. This way, we avoid the risks associated with bringing new, untested processes into our main operating environment.”
The Production Environment @ Hammond Cards
Martin and his team presented the consultants with the following production data. Hammond Cards operated one production shift that worked 5 days per week. Hammond was required to conform to union rules – the workday was 7:30 – 4:30 with a one-hour (unpaid) lunch break and two (paid) 15-minute breaks. The union prohibited overtime or second shifts, which was fine with Hammond management, given their concerns with cost management. Current production operations utilized virtually all of the available space in the Hammond plant. Consequently, Martin could not add machines to the system and had to manage within the constraints of current resource availability – both machines and human resources. The greeting card design process was outside of Martin’s direct control and was not considered to be a significant production constraint. The consultants were, therefore, directed to the five-step process that began with template cutting and concluded with a bar-code scan and packaging operation. In between these operations, the cards proceeded through 2 separate printing steps and a folding/UPC pricing code step.
The Process @ Hammond Cards
In order to facilitate the consultant’s analysis, Martin produced a detailed description of the process steps, production times, and machine as well as human resource allocation at the various steps.
Template cutting: The template cutting process cuts paper stock into the correct size(s) for card production. This batch process requires 1 minute to align the stock on the cutting machine. The stock placed onto the cutting machine is sufficient for 100 cards. Following alignment, it takes 48 seconds of cutting time per batch of 100. There are two workers and two template-cutting machines dedicated to this process.
- Printing 1: The first printing step prints the background colors for the card. There are 4 machines and 4 workers at this process step. Each machine requires 2.5 seconds of processing time per card.
- Printing 2: The second printing step prints the foreground colors for the card. There are 5 machines and 5 workers at this process step. Each machine requires 3.15 seconds of processing time per card.
- Fold and affix UPC code: Step #4 involves the folding and placement of pricing (UPC) codes on the cards. This is a highly automated step that utilizes machinery that both folds the card and prints the UPC codes. There are 2 machines and 2 workers at this production step. Each machine processes a card every 1.2 seconds.
- Bar code scan and package for shipment: This final step involves scanning bar codes and packaging the cards for shipping. A single machine scans the cards and packages the cards for shipping. There are 2 of these machines and 2 workers at this production step. Each machine processes a card every 1.1 seconds.
Operations at Creative Designs
Martin also provided the consultants with production data for Creative Designs. Creative Designs operated one production shift that worked 5 days per week. CD’s workers belonged to the same union as Hammond’s employees. Not surprisingly, the workday was 7:30 – 4:30 with a one-hour (unpaid) lunch break and two (paid) 15-minute breaks. As with Hammond Cards, the union prohibited any use of overtime or second shifts. Martin intended to keep the work days and hours the same at the two plants, in order to avoid any workforce issues surrounding working conditions, pay scales, etc. As was the case with Hammond Cards, current production operations at CD utilized all of the available space. Martin could not add machines to the CD system and would have to meet all of Creative Design’s demand and any production transferred from Hammond Cards with the resources currently available at Creative Designs. As was the case with Hammond Cards, the design process was not considered to be a significant production constraint. Therefore, the consultants were again directed to focus on the process that began with template cutting and concluded with a bar-code scan and packaging operation. In between these operations, the cards proceeded through 4 separate printing steps and a folding/packing step. The CD production system required four printing steps due to the print technology used at CD, which required multiple prints to achieve multi-colored card products.
The Process @ Creative Designs
In order to facilitate the consultant’s analysis, Martin produced a detailed description of the process steps, production times, and machine as well as human resource allocation at the various steps.
- Template cutting: CD utilizes the exact same template cutting process and machines as Hammond cards. This machinery cuts paper stock into the correct size(s) for card production. This batch process requires 1 minute to align the stock on the cutting machine. The stock placed onto the cutting machine is sufficient for 100 cards. Following alignment, it takes 48 seconds (.8 minutes) of cutting time per batch of 100. There is one worker and one template-cutting machine dedicated to this process.
- Printing 1: The first printing step prints the background colors for what will become the interior portion of the card. There are 2 machines and 2 workers at this process step. Each machine requires 2 seconds of processing time per card.
- Printing 2: The second printing step prints the foreground colors for the interior portion of the card. There are 2 machines and 4 workers at this process step. Each machine requires 1.5 seconds of processing time per card.
- Printing 3: The third printing step prints the background colors for what will become the exterior portion of the card. There are 2 machines and 2 workers at this process step. Each machine requires 1.6 seconds of processing time per card.
- Printing 4: The fourth printing step produces the foreground colors for the exterior portion of the card. There are 3 machines and 6 workers at this process step. Each machine requires 2.4 seconds of processing time per card.
- Fold and affix UPC code: Step #6 involves the folding and placement of pricing (UPC) codes on the cards. This is a highly automated step that utilizes machinery that both folds the card and prints the UPC codes. There are 2 of these machines and 2 workers at this production step. Each machine processes a card every 1.4 seconds.
- Bar code scan and package for shipment: This final step involves scanning bar codes and packaging the cards (20 cards per package) for shipping. A single machine scans the package and packages (20 cards per package) the cards for shipping. CD utilizes older technology than Hammond Cards for this process. The CD process requires .25 minutes (15 seconds) of set-up time per 20 cards and 25 seconds of processing time per 20 cards. There are 2 machines and four workers at this final production step.
Both Hammond Cards and Creative Designs assumed a 20-day per month, 240-day per year production horizon. Martin instructed the consultants to use this assumption in their analysis. Demand for Hammond Cards was somewhat seasonal (See Exhibit #1). As noted in Exhibit #1, Hammond Cards followed a level production strategy, with the production rate set at 42,000 units per day. Martin believed that the 42,000-card daily production rate was placing too much stress on the Hammond production system. He was unsure of his plant’s current capacity utilization level but he was sure that it was too high – maybe even approaching 100%. His goal was to maintain level daily production but to do so at a production rate that translated to capacity utilization in the 84-86% range. He believed that this was achievable if he maintained level production at Hammond Cards but set the production rate to 37,000 cards per day, regardless of demand for the month. His plan called for producing 37,000 units per day every month at Hammond. If Hammond’s average daily demand for a given month was greater than 37,000, he would produce 37,000 at Hammond and schedule the excess (difference between that month’s average demand and 37,000) production at Creative Designs. His tour of Creative Designs operations suggested that there was significant unused or idle capacity in their operations to absorb this additional demand. He saw this idle capacity as the answer to the excessive demands currently placed on the Hammond Cards operations.
Demand for Creative Designs products was also seasonal (See Exhibit #2). Creative Designs followed a modified ‘chase demand’ strategy, opting to produce product as needed in a given month but with a fixed daily rate for the month. For example, the daily production rate in February, when the monthly demand was 240,000, would be set at 12,000 per day (12,000 per day x 20 days per month = 240,000). CD management would recalculate the daily production each month, based upon orders received for delivery in that month. Martin planned to leave that system in place but, as noted above, would transfer some of Hammond’s demand to the Creative Design operation.
Historical data also suggested that Hammond’s current production strategy resulted in excess finished goods inventory. Since cards were a seasonal item, this excess inventory would be stored, sold at a discount or destroyed as worthless. By lowering the production rate at Hammond, Martin hoped to reduce this excess inventory. He hoped that this reduction in inventory would also help him to better meet customer demands for shorter lead times. Hammond’s current lead-time was 16 days. Martin hoped that a reduction in the production demands placed on the system, and resulting reduction in inventory, would also allow him to better meet customer expectations for on-time delivery (lead time), which were now in the 6-8 day range.
Creative Designs took pride in its reputation for delivering high quality products to its customers. To that end, the company had instituted methods to ensure product quality. Creative Designs’ workers were responsible for inspecting product at their workstations and for taking corrective action when necessary to ensure a high quality product. These corrective actions included additional work to fix the defect or, if necessary, destroying the card. There were no designated inspectors at Creative Designs – it was ‘everyone’s job’. The workers considered themselves to be, at least in part, artisans. As such, they took great pride in the finished product and were very selective about product quality. If the acquisition went ahead, Martin hoped to leverage that pride and commitment to create more robust quality practices both at Hammond Cards and Creative Designs.
Hammond Cards had a similar approach to quality, but, given their higher levels of production, the workers had less time for inspection. However, Martin remained confident that Hammond was producing quality products. “Our numbers indicate that very few products come back to us from the customer for production defects. We’re proud of that fact. It tells us that we produce a quality product and that our procedures are catching most defects that do occur in the production process. However, I’d like to have a more systematic approach to quality. I believe that this will be essential for me if, as planned, I have responsibility for two plants in the future. I’ve read about quality management practices and process control. I know that many firms are now pursuing six sigma quality management practices. I’m not sure that we’re ready for six sigma but I’d sure like to see us operating at the 3-sigma level of quality associated with total quality management (TQM) practices. Creative Designs has very few returns. I’d like
us to learn from them. More than just learn from their current practices, I’d like to use their smaller operations as my laboratory for new management practices. The first two management practices that I’d like to explore at CD are process management consistent with TQM and the adoption of leaner inventory systems – something on the idea of JIT. After we prove these methods at CD, I’ll move them to the higher volume operations here at Hammond Cards. I see this strategy of learning (at CD) and knowledge/skill transfer (to Hammond) as essential to the improvement of our operations.” The consultants asked Martin if he had any data related to quality. He again noted the low rate of returns but said that he had little else that he could share. He did have some data from the template cutting processes at both Hammond Cards and Creative Designs. He explained that this was a crucial step in the process.
“Mistakes in template cutting can affect product quality and cause problems later in the process. For example, a poorly cut card could appear unattractive to customers or be difficult to fit into an envelope. Inaccurate sizing of the card could also result in production problems at later job steps. For example, a card that was too small could ‘drift’ in the printing process, which created misaligned or uneven printing. On the other hand, a card that was too big could jam some of the other machinery – something the operators found very annoying. We use the same machinery at both plants for template cutting, which is to our advantage. One of our most popular card sizes is a 9-inch by 5-inch card that requires a cut of 18 inches by 5 inches. Once folded, this becomes the 9 by 5 card. I have some data from both the Hammond (Exhibit #3) and the CD (Exhibit #4) template cutting processes. I don’t know if this is helpful for you, but you’re welcome to take what I have. Both sets of data are samples from the long cut (18 inches) of that 9 by 5 card. The specification for the long cut on that card is 18 inches plus or minus 0.02 inches. Our process engineers tell us that we won’t compromise the printing or jam the other machines if we stay within those specification limits.”
The Profitability Analysis
Wendy sent the consultants to Lucy Canella, Controller at Hammond Cards to begin the profit management investigation. As noted earlier, there was already a plan in place to combine sales and administrative activities for the two firms in order to reduce costs and gain some scope and scale advantages. Canella had overseen the collection of source data on the two production facilities and had also assembled her projections for the combined sales function and administrative function. She had performed a preliminary ABC analysis of sales and administration. She had also performed a preliminary cost driver analysis for the production plants. However, with plenty of work already on her plate, she decided that the consultants should complete that task. In the end, she wanted to provide Wendy Hammond with a report that took all of this data, analyzed it, and provided recommendations related to the potential plusses and minuses of combining the two businesses.
Production Cost Data for Hammond Cards and Creative Designs
Canella provided the consultant with the data in Exhibit 5. Three principal forms of direct materials were involved in the production of greeting cards: card stock, ink and envelopes. Both Hammond and Creative Designs purchased card stock in sheets pre-sized for their template cutting machines. The ink for the printing machines at Hammond was a bit less expensive than the ink used in the printers at Creative Designs. Both companies bought pre-made envelopes. Since both companies rent their facilities, plant and equipment asset values are relatively low. Total assets at both companies are roughly equal to twice the gross book value of PPE.
The book values of the production assets did differ between the two companies. As mentioned earlier, Hammond used more expensive printing machines. These machines performed more printing on a single pass. They were also more economical in that they used less expensive ink, used less labor, and allowed the use of a lower pay grade of laborer. The Creative Designs plant needed two of its less sophisticated printers to ink each side of a greeting card. Other machines were quite similar across the two companies, but, again, Creative Designs employed machines that were less complicated and needed more labor support. The details related to the machinery for the two plants appear in Exhibit 6.
Sales and Administrative Data for the Two Businesses
Lucy told the consultants that Hammond sold big orders to big customers while Creative Designs was focused on small orders to small customers. Nonetheless, she said, the basic nature of the sales activity and administrative tasks was about the same. Even the salary for each salesperson and each administrative support person was about the same across the two companies.
“I have done a basic ABC analysis for the combined sales force, distribution activity, and administrative support. I’ve labeled this analysis as Exhibit 7. I did not include the executive personnel in this analysis because, by contract, those costs would be independent of the business activity over the first couple of years after any acquisition”.
Cost Drivers for Production at the Two Plants
Lucy Canella provided the consultants with Exhibit 8. She explained the content as follows: “I’m interested in having you put together an ABC cost analysis of the production process steps at each of the two plants. To this end, I have analyzed the cost drivers that relate the shared costs to each process step. Total variable overhead can be assigned to each process step as a function of the percentage of machines found at each process step. Building rent, heat and other occupancy costs can also be distributed to each step as a function of number of machines. Plant personnel costs other than direct labor can be divided up among the steps by the percentage of direct laborers working in each step. That is, those costs are a function of direct laborer headcount. Finally, there is no need to allocate machine depreciation. These costs can be matched directly since each machine is uniquely associated with only one process step.” Lucy felt that it was important to use cost drivers that reflected the underlying causes when allocating costs from the process steps to actual products. She explained: “Since both factories currently process in very standard ways, we could probably use the number of cards processed at each step and get a good measure of general production cost right now. However, since specific designs and production requirements differ from one card style to another, I
want to use better drivers to capture the cause-effect relationships. For example, the cost of cutting out cards on the template cutter is really not a function of number of cards of output. It is really related to the number of card stock sheets fed into the template cutting process.”
A Future Product Design
Lucy had one last issue she wanted to bring to the attention of the consultant team. During the acquisition discussions, the Hammond management team had been shown the design of a proposed new, more complicated card line. Currently, both plants produced standard cards with the characteristics shown in Exhibit 9A. This new card would fit into a standard size envelope, but used two folds and, consequently, more paper. It also featured a more vibrant multicolored graphic design. Data contrasting this proposed design to the current standard design is given in Exhibit 9B. If the merger went through, it is unlikely that this card design would be put into production in the near term. However, the existence of this design prompted Lucy to consider how the various portions of a new, combined company might work together to improve profits overall. “If we sold this card to Hammond’s current customers, we could probably get a price of $0.65 per card. Through Creative Designs’ sales market, it could probably sell at $0.90 per card. There are other differences between selling to a Hammond customer and selling to a Creative Designs customer, as I have summarized in Exhibit 10. However, it is unclear to me not only to whom we should market the card, but where we should produce it. This may be a good example to use to examine how the two organizations could combine forces to improve profits.”
You are to assume the role of a member of the Olin Consulting Group. Wendy Hammond wants your group to evaluate and opine on two issues. One is to assess the operations-based benefits achievable through the acquisition. The second is to explore the profit improvement opportunities inherent in combining the two firms. The focus here would be on the cost and profit implications of the utilization of resources inherent in the ways the businesses were currently run, examining the potential to improve bottom-line outcomes.
The Consultant’s Operations Analysis Assignment
On the operations side, Wendy Hammond wants the Olin group to provide an independent evaluation of Martin’s plan. Your report should include an assessment of current operations, an evaluation of the Martin’s proposed plan, and, where appropriate, suggestions for improving upon the plan. Assume that Wendy Hammond has provided your group with the following additional guidance as you begin your analysis of the operations at Hammond Cards, Inc. and Creative Designs. Her instructions state that your evaluation of Bob Martin’s plan should include, but not be limited to:
- An assessment of Hammond and CD’s current production capabilities.
- An evaluation of Martin’s plan to level Hammond Card production at 37,000 and shift additional demand to Creative Designs.
- An evaluation of Martin’s plan to use Creative Designs as a learning laboratory for the combined operations.
- An assessment of current quality management practices and an evaluation of Martin’s plan for quality improvement in the combined operations.
- A general evaluation of the operations strategy and potential impacts that may or may not have been addressed by Martin and Hammond.
The Consultant’s Profitability Analysis Assignment
Wendy asked Lucy Canella to set the parameters for the profitability assessment. Ms. Canella then provided the guidelines listed below. On the financial side, the report should specifically address the following points:
Provide a determination of the break-even point, in greeting cards sold, for EACH of the two companies. Based on the results, as well as any other information about the companies, provide your characterization of the business model at each of the two companies. Add any relevant comments or state any pertinent assumptions, as you see fit. Provide a table similar to Exhibit 7 for the 5 process steps at the Hammond plant. What is your reaction to the information revealed by this table? Provide a table similar to Exhibit 7 for the 7 process steps at the Creative Designs plant. What is your reaction to the information revealed by this table? Assume that the two companies merge. Use the table information from Exhibit 7 and from items #2 and #3 above (without any further adjustments!). Determine the expected margin (before general administration expense) from producing an average-sized order from a current
- Hammond customer for the proposed complex card:
- Producing the cards in the Hammond plant.
- Producing the cards in the Creative Designs plant.
Repeat item #4 for an average order from a current Creative Designs customer. Evaluate the proposed acquisition from a profit improvement perspective. Are there actions you would have to take to ensure that the profit potential from the acquisition is realized? If so, what actions would you take and what impact would they have on the overall profitability of the combined business? Explain your rationale and cite any evidence you believe to be relevant.
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