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Stryker Corporation: In-sourcing PCB

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Stryker Corporation: In-sourcing PCBs In late May 2003 executives in Stryker Corporation’s Instruments business were actively considering a change in their sourcing strategy for printed circuit boards (PCBs), a key electronic component of many of Stryker Instrument’s medical products. Currently, Stryker purchased PCBs from a small number of contract manufacturers.

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. In recent years, the performance of some contract manufacturers had been unsatisfactory with respect to quality, delivery and/or responsiveness and Stryker had repeatedly found itself looking for new suppliers. More generally, contract manufacturers tended to operate on thin margins with scant capital. Bankruptcies were not uncommon, and even without bankruptcy, a financially weak supplier was simply less reliable.

Given recent events and the shaky appearance of several current suppliers, Stryker Instruments had resolved to address the issue. Stryker Instruments’ manufacturing managers studied three options for improving the situation. Option #1 was to maintain the current basic sourcing policy for PCBs, but with important modifications. Specifically, it would protect against future disruptions by acquiring safety stocks of key materials and instituting dual sourcing of all electronic assemblies. Option #2 would boost reliability by establishing a partnership with a single supplier, one of the current group of contract manufacturers. That company would become Stryker Instruments’ sole supplier of PCBs and establish a stand-alone facility for supplying them. The partnership and increased business from Stryker was expected to strengthen the supplier, further boosting its reliability. Option #3 was for Stryker Instruments to manufacture its own PCBs in its own facility near company headquarters in Kalamazoo, Michigan. Once such a facility was up and running, it might be expanded to supply PCBs to other Stryker businesses as well.

Of the three alternatives, Option #3 promised the highest degree of control over quality and delivery. From that perspective, it was most the attractive. But it also required the largest capital outlay and the largest increment to Stryker’s headcount and payroll. Whether it offered an adequate return on investment was a question that had to be carefully studied. If Stryker Instruments wanted to proceed with the investment, it would have to obtain numerous approvals. Stryker Corporation’s capital budgeting procedures required specific business and financial analyses of proposed expenditures. The financial analyses included studies of outlays, costs, profitability, risks, and shareholder returns. More specifically, estimates of net present value (NPV), internal rate of return (IRR) and payback period all had to be prepared before a project could receive funding. ________________________________________________________________________________________________________________ Senior Lecturer Timothy A. Luehrman prepared this case. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Copyright © 2007, 2008 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.

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Stryker Corporation: In-sourcing PCBs

Stryker Corporation Stryker Corporation was a leading provider of specialty medical and surgical products with 2002 revenues and operating profits of $3.0 billion and $507 million, respectively. The corporation’s divisions included Orthopaedic Implants, Medical and Surgical Equipment (MedSurg), Rehabilitative Medical Services, and International Sales. Summary operating and financial data for Stryker as a whole are presented in Exhibit 1.

MedSurg had 2002 sales of $1.1 billion, an increase of 13% over 2001, which came from three major business units. Stryker Endoscopy produced video-imaging and communications equipment and instruments for arthroscopic and general surgery. Stryker Medical produced hospital beds and other patient-handling equipment along with emergency medical service products. Stryker Instruments produced surgical instruments, operating room equipment and interventional pain control products. Stryker Instruments operated manufacturing facilities in Michigan, Puerto Rico and Ireland and recorded global revenues of approximately $430 million in 2002. PCBs were used in virtually all of Instruments’ key products and platforms, sometimes in more than one application. They were contained, for example, in instrument consoles, footswitches, handpieces, chargers, docks, and monitors. Stryker had considered in-house manufacturing of PCBs before – a proposal had been developed as recently as 2001, but had not been executed. In 2003, as supplier reliability continued to cause concern, the idea was once again receiving serious study.

The Proposal An in-sourcing strategy had been studied in various forms so far and the proposal might change further before implementation. In its current version the proposal called for the construction of a new building with 30,000 square feet of space on eight acres owned by Stryker in Kalamazoo, Michigan. Site preparation, construction and improvements were expected to cost $3,030,000. This sum did not include architectural and engineering fees of $278,000. Furnishings and nonmanufacturing equipment would cost $126,000. Communication equipment and IT infrastructure would cost an additional $210,000. The building would be ready for manufacturing equipment by April 1, 2004.

The proposed facility would manufacture all of the various types of PCBs required by Stryker Instruments and hence require many kinds of manufacturing equipment. Stryker Instruments’ managers and engineers were already familiar with the requisite manufacturing processes and had prepared detailed specifications for the needed equipment, including descriptions of equipment, software, and related systems by model and manufacturer; specific configurations and options to be included on the systems; quantities for each type; and installed costs. The total budget for about 70 separate categories of equipment was $2,643,258. Equipment was to be installed and ready for testing by the end of the second quarter of 2004. Actual production would begin the third quarter of that year.

As Stryker Instruments began producing its own PCBs, it would transition out of supplier agreements with third parties. This would happen fairly quickly: production transfers would take place product by product and the transition would be complete by the end of 2005. Accordingly, for part of 2004-05, Stryker would be manufacturing some PCBs while still buying some from outside suppliers. Beginning in 2006, all PCBs would be produced in-house. Exhibit 2 shows Stryker Instruments’ anticipated expenditures on PCBs for the period 2004-2009 under the old sourcing strategy using contract manufacturers, including growth in volume and expected increases in the 2

Stryker Corporation: In-sourcing PCBs

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suppliers’ prices. Exhibit 2 also shows the anticipated production schedule for the new facility as currently proposed. Stryker’s manufacturing costs were divided into three main categories: materials, variable costs and fixed costs. Materials costs were estimated by product and based on actual costs reported under existing supplier agreements, adjusted for expected price increases. These are presented in Exhibit 2 for the new facility’s anticipated production volume. Fixed costs were estimated by period for more than 30 categories, including wages and salaries, overtime, benefits, training, depreciation, building and equipment maintenance, office supplies, etc. Certain fixed costs would be incurred beginning in the first quarter of 2004, even before the start of production. A summary of expected fixed costs, including inflation and wage increases, is shown in Exhibit 2. Similarly, estimated variable costs for more than 20 categories including wages, overtime, shipping supplies, scrap, etc., also are summarized in Exhibit 2. Variable costs would begin to be incurred in the third quarter of 2004. Of the combined fixed and variable costs shown in Exhibit 2, roughly half represented employee compensation and benefits; by 2006 the facility was expected to employ 56 people. The building would be depreciated on a straight-line basis over 30 years.1 Capital equipment would be depreciated straight-line over seven years. IT equipment and other furnishings would be depreciated over 3 years. These depreciation charges are included in the fixed costs summarized in Exhibit 2. Also included are expected maintenance expenditures for both the building and equipment, but not additional capital spending. Manufacturing volumes contemplated for 2009 represented 100% of the facility’s rated capacity.

Finally, the project would benefit from terms of trade established with suppliers of certain PCB components and materials. About 60% of the materials purchased by Stryker for manufacturing PCBs would qualify for generous payment terms of net 120 days. Even better, the 120 days did not commence until Stryker actually took a given component from its stock. In effect, the supplier owned the component until that point, even though Stryker had physical possession of it. Further, the fact that payment was not due for 120 days meant that Stryker typically would be paid for finished goods by its customers before it was required to pay its materials supplier. Under existing arrangements with contract manufacturers, the contract manufacturer benefited from this arrangement rather than Stryker. Indeed, under the existing policy, Stryker paid its contract manufacturers much more quickly—in 15 to 60 days, depending on the contract, for an average of about 30 days. Exhibit 3 presents a calculation of the anticipated change in accounts payable associated with the new sourcing strategy.

In its various financial analyses Stryker would apply a 36% tax rate. The company generally used a hurdle rate of 15% for net present value calculations (for projects deemed riskier than usual a higher rate would apply). Exhibit 4 presents selected capital market data as of May 2003.

1 Architectural and engineering fees were not depreciated as part of the building, but rather expensed .

3

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Stryker Corporation: In-sourcing PCBs

Exhibit 1 Stryker Corporation—Selected Financial and Operating Data for Stryker Corporation (figures in US$ millions, except employees)

2002

2001

2000

Net sales Gross profit RD&E expense SG&A expense Operating profit Net interest expense Net earnings

$3,012 1,898 144 1,187 521 41 $329

$2,602 1,637 144 1,000 454 66 $255

$2,289 1,473 124 898 417 98 $211

Cash & marketable securities Working capital Net property, plant & equipment Capital expenditures Depreciation & amortization Total assets Long-term debt (including current portion) Stockholders' equity Dividends Number of employees

$38 444 519 139 186 2,838 502 1,521 $24 14,045

$50 460 444 162 172 2,439 723 1,072 $20 12,839

$54 380 378 81 169 2,441 1,013 866 $16 12,084

Source: Stryker Corporation 2006 Annual Report. Historical figures have been restated to reflect the adoption of SFAS 123R.

4

2004

Source:

1,252,888

Fixed costs 1,712,087

459,200

Variable costs

Stryker Corporation documents and Casewriter estimates.

Total Stryker manufacturing cost

-

Manufacturing costs for Stryker facility Materials

-

10,237,918

PCB Purchases assuming transition to in-sourcing

Decrease in purchases from contract manufacturers

10,237,918

2004

252,000

Projected PCB Purchases under current sourcing

Annual Data: 2004–2009

Total Stryker manufacturing cost

252,000

7,847,541

1,862,524

1,668,764

4,316,253

6,438,252

3,799,665

10,237,918

2005

252,000

9,553,963

2,139,445

1,668,927

5,745,591

11,773,605

-

11,773,605

2006

604,044

374,444

10,498,507

2,239,932

1,336,177

6,922,397

14,363,798

-

14,363,798

2007

604,044

374,444

11,706,178

2,324,005

1,421,416

7,960,757

16,518,368

-

16,518,368

2008

1,712,087

1,252,888

13,650,762

2,412,930

1,525,709

9,712,123

20,152,409

-

20,152,409

2009

604,044

374,444

252,000

Fixed costs

459,200

-

2,559,479

2,559,479

229,600

-

10,237,918

10,237,918

Q1

2005

229,600

229,600

-

2,559,479

2,559,479

2004

Total

-

-

2,559,479

2,559,479

Q4

2004

Materials

-

2,559,479

2,559,479

Q3

2004

Variable costs

Manufacturing costs for Stryker facility

-

2,559,479

PCB Purchases assuming transition to in-sourcing

Decrease in purchases from contract manufacturers

2,559,479

Q1

Projected PCB Purchases under current sourcing

Q2

2004

Stryker Corporation—Selected Cost Projections under Different Sourcing Policies

Quarterly Data: 2004–2005

Exhibit 2

2,116,473

417,256

392,701

1,306,515

1,707,479

852,000

2,559,479

Q2

2005

2,563,512

535,412

523,232

1,504,869

2,171,293

388,186

2,559,479

Q3

2005

2,563,512

535,412

523,232

1,504,869

2,559,479

-

2,559,479

Q4

2005

-5-

7,847,541

1,862,524

1,668,764

4,316,253

6,438,252

3,799,665

10,237,918

2005

Total

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Exhibit 3

Stryker Corporation: In-sourcing PCBs

Stryker Corporation—Effect on Accounts Payable, Out-sourcing vs. In-sourcing of PCBs

2004

2005

2006

2007

2008

2009

Old A/P = 30 days of CM purchases

841,473

841,473

967,694

1,180,586

1,357,674

1,656,362

New A/P = 120 days of 60% of Materialsa

841,473

851,425

1,133,377

1,365,514

1,570,341

1,915,816

-

9,953

165,683

184,928

212,667

259,454

Change in A/P, new vs. old

Source: Casewriter estimates. aA/P assumed to be the same under both policies during 2004.

Exhibit 4

Stryker Corporation—Contemporaneous Interest Rate Data

Yield (annual %) on Selected US$ Bonds at May 31, 2003

U.S. Treasury Bonds 1-year 5-year 10-year 20-year Corporate Obligations Short-term 90-day commercial paper Long-term Moody’s Aaa Moody’s Baa

Source: U.S

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