Do Porter’s five force analysis ( GuitarPro case)
GuitarPro Inc.
INTRODUCTION
GuitarPro Inc., a manufacturer of high-quality guitars. was founded in 2005 by Mia Bach, a well-known musician and a great ambassador for arts and culture in her home town. After completing an MBA program at a local university. Ms. Bach decided to combine her love Of music with her newly acquired business skills and started GuitarPro Inc. (“GuitarPro”). She defined GuitarPro’s mission as producing high quality acoustic guitars at reasonable prices. Ms. Bach’s motto is “a world without music is like a world without sunshine!” Given her reputation in the musical world, Ms. Bach quickly developed business contacts with some of the most important guitar retailers in North America. In 2016, the company employed 190 production workers and generated annual revenues of approximately
GuitarPro is a relatively small player in a much larger and very concentrated North American industry operating mainly in the United States. Guitar market retail sales in the United States at the end of 2015 were approximately Sl.2 billion with acoustic guitars making up $696 million of that total. This is up from the 2008 recessionary period SShere the market for all leisure goods. including musical instruments. dropped significantly. The guitar manufacturing market in the United States is highly concentrated with the top töur manufacturing companies (Fender. Gibson, Taylor, and Martin) accounting for an estimated 79.7 percent of industry revenue. Approximately 1 1,300 people were employed in the acoustic and electric guitar manufacturing industry in the United States in 2015.
GuitarPro’s guitars are sold to retailers across North America. While Mia Bach •s original vision was to produce many different guitars at various price points and “ith a wide range of specifications, competitive pressures have förced GuitarPro to specialize in its most popular guitar, the model XI 50. In over the last two years, GuitarPro has only produced X 150 guitars. From the beginning, GuitarPro marked up the X 150 model by 20 percent on full cost. GuitarPro’s guitars have been rated very highly in terms of quality and have received consistent reviews on par with similar guitars produced by other North American manutilcturers. However, the company currently faces fierce competition from Korean manufacturers ‘*ho have kept costs low. Even though customers continue to care about the quality of the instruments they purchase, the low prices oflZ:red by Korean make Koreanmade guitars a significant competitive threat.
A second source of pressure on prices is the arrival in North America of “big- box” discount retailers of musical instruments and supplies (e.g.. The Guitar Center). These big-box stores carry a large inventory to satisfy “even the most demanding customer” at very competitise prices and have forced several smaller independent retailers who have been long-time customers of GuitarPro out of business. So far, Ms. Bach has resisted pressure on prices by arguing GuitarPro’s products are of much higher quality than those typically sold at big-box stores; however. these higher prices are becoming more and more difficult to sustain.
During a recent meeting of the management team, Anna Jones, GuitarPro•s Vice President of
Sales and Marketing, announced a new customer, Virtual Music Inc. (VMI) would be joining the GuitarPro family. Virtual Music Inc. is a new market entrant with discount big-box stores in the 25 largest cities in the United States and Canada and is continuing to expand. The main problem is that V MI will not want to pay more than $1,900 per X 150 guitar which is equivalent to a markup of 10 percent over cost. I Ms. Bach was not sure about current customers’ response when they learn that a discount price was given to VMI, Unless production capacity is increased, the company is not able to produce enough guitars to fill both the VMI order and the orders of other regular customers. Ms. Bach was uncertain about increasing production capacity and its impact on the profitabilityof VMI ‘s order and current operations.
MANAGEMENT TEAM
Ms. Bach has surrounded herself with excellent people over the last ten years. Her two key managers are Mr. Smith, the COO, a 42-year-old engineer with a deep love for music, and Mr. Harris, the CFO, a 63-year-old CPA with significant financial and managerial accounting experience. Both have been with the company since its creation. Mr. Smith oversees production, quality control, and the hiring of production employees while Mr. Harris oversees most financial responsibilities, including accounts receivable and payable, relationships with lenders, payroll, cash flow management, etc. Ms. Bach expects to sell the company to Mr. Smith when she retires in 10 years. Mr. Harris plans to retire two years from now and Ms. Bach has asked him to help her find a replacement CFO.
To address declining sales, Ms. Bach also recently hired Ms. Jones as VP Sales and Marketing. Ms. Jones’s main task is to identify and recruit new customers in North America and Europe. Ms. Bach created this new position given new customer acquisition has become more and more difficult in recent years. Since the industry is sensitive to changes in economic conditions, the 2008 financial crisis has made it more difficult to attract new customers. Ms. Jones has 20 years of experience in marketing musical instruments and she has been working hard to obtain new orders since joining the company. She has been using her contacts to better penetrate the North American market and develop new potential customers in Europe.
Over the last three years, Ms. Bach has also been using her business school knowledge to design compensation plans to motivate the management team, For instance, Mr. Smith receives a bonus when the quantity of waste in the production process is below 2 percent. Typically, the percentage of waste can be as high as 4 percent in this industry. However, with the use of computer-aided design and manufacturing (CAD/ CAM), the level of waste ranges between 1.8 percent and 2.5 percent. Mr. Harris receives a bonus based on the annual profitability of the firm. A bonus system was also offered to Ms. Jones tied to the retail value of new business she brings in. New business is defined as any new customer that has not purchased guitars from GuitarPro in at least the last three years. These bonuses could represent up to 20 percent of the compensation of these managers, which is consistent with the industry average.
Assume all dollar amounts mentioned in the case are in Canadian dollars and that the companyhas an effective hedging strategy against foreign exchange risk.
2
MARKET FOR GUITARS
Guitar sales belong to the broad retail musical instrument industry. Recent growth in the guitar sales in North America has been slow at approximately 1.8 percent per year or less. Given there is very little room for growth, pressure to maximize gross margin by keeping manufacturing costs low has been significant. Most of this pressure now comes from guitar manufacturers in Asia and especially in Korea. Prior to the 1970s, Japanese-made guitars such as Yamaha or Ibanez were very popular in North America since they were well-priced and of good quality. During the 1970s, manufacturing costs skyrocketed in Japan as real estate, fuel, raw mate- rials and transportation costs all increased dramatically. Japanese manufactures then moved most manufacturing to Korea where wages and other costs tended to be significantly lower. Today, Korean manufacturers provide quality entry-level guitars at relatively low prices and continue to pose a significant challenge to North American guitar producers.
GuitarPro made the choice several years ago to focus on production of its most popular XI 50 guitar model. The X 150 is a midrange dreadnought-style six- string guitar. Dreadnoughtstyle acoustic guitars can range in price from $150 for an entry-level model to more than $10,000 for a collector’s edition. The X 150, at a price of just under $2,000, is considered a midrange model of good quality and has sold very well over time. Given low growth potential in the industry, GuitarPro must control manufacturing costs of the X 150 if it wants to continue to competein this market.
Recent changes to GuitarPro’s customer base have also put pressure on price.
Specifically, the arrival of big-box discount music stores, such as V MI in North America. has changed the retail landscape. Retailers such as V MI offer a wide range of musical instruments. including guitars, as well as a wide variety of music-related products. Like Walmart. these bigbox music stores use a centralized purchasingand inventory system allowing them to purchase larger volumes of products thatare then distributed to all of their stores. Due to larger volumes purchased, storeslike VMI often request discounts and tuvorable purchasing terms which put significant pressure on manufacturers like GuitarPro to reduce prices. Many of the smaller local retailers that have been long-time customers of GuitarPro have recently closed since they are not able to compete in terms of price and variety with big-box music stores. As GuitarPro loses more and more of these long-time customers, the pressure to attract a big-box store like VMI as a customer has increased as well.
PRODUCTION PROCESS
Mr. Smith is in charge of production, quality control and the hiring of production employees. He has also recently implemented a significant capital project with the objective of reducing the need for skilled labour by increasing the use of automated production equipment in the factory. The primary reason why Korean manufacturers are able to sell at such low prices is due to the relatively low wages paid to skilled employees. GuitarPro must pay much higher wages in the United States to attract and retain skilled employees since demand for their skills is higher than the supply. Mr. Smith believes that automating the production process has facilitated a significant reduction to wages while maintaining quality standards, since many skilled employees could be replaced with non-specialist production employees that are trained to run the automated equipment but are not necessarily trained to hand-craft guitars.
Under the current production process, several skilled employees continue to be responsible for the initial selection of the wood to be used for the guitar neck and body as well as for evaluating the quality of the products at various points in the pro- duction process. The cutting. sanding. and much of the assembly of the guitar is done using automated equipment and is overseen by production workers. Once the body has been cut, molded, thinned and braces have been added where necessary, the pieces of the body are glued together and the neck is added. Tuners, frets, the bridge and pickups made of plastic or aluminum are added, the guitar is stringed and is then ready for inspection. The inspection process requires a skilled employee to ensure that good quality and sound have been achieved with every guitar produced.
While the demand for musical instruments is cyclical, Mr. Smith manages pro- duction at GuitarPro at relatively constant levels each month. By producing levels higher than demand in the slow months, GuitarPro can meet the larger demand in September (beginning of the music class year) and December (the holiday season). To better understand the costs to produce and sell the X 150 model,Mr. Harris collected the information presented in Table l .
Based on current levels of demand, GuitarPro produces 1,000 units of X 150 guitars per month, although the recently acquired automated production equipment allows for a maximum production capacity of 1,200 units of Xl 50 guitars per month. Current variable costs of each X 150 guitar are $1,310 while total monthly fixed costs of production are $417,000. Over the last few years, the company has reduced its markup from 20 percent to 15 percent on full cost due to competitive pressures on price, yielding an average selling price of $1 ,986 per unit.
TABLE I
Variable and fixed costs
For each Xl 50 guitar produced, the company incurs the following variable production costs:
Type Of cost Cost per unit
Direct materials SS25
Direct labour
Variable overhead costs $325
Sl.310
The variable overhead cost includes items such as maintenance of the equipment, electricity used torun the equipment, and materials handling costs. These costs vary with the volume of production. The monthly fixed overhead costs of production are $41 7,000, which includes of depreciation and other fixed overhead costs including insurance, heat, light. andwater, etc. All selling, general and administrative expenses are fixed.
4
NEW CUSTOMER, SPECIAL PRICE
The announcement by Ms. Jones of the potential deal with VMI was good news for the management team. To further examine the options. Ms. Bach called a meeting and asked Ms. Jones to present details of the tentative agreement with VMI (see Table 2).
TABLE 2
Draft agreement with VMI on Xl 50 sales
The tentative agreement between Ms. Jones and VIVII is as follows:
l. VNII will pay Sl.900 per guitar.
2. VMI will commit to purchase 500 units of X ISO guitars per month over the first year ofthe agreement and VMI has the
Option to increase its monthly purchases by 1 50 units per month in each year for the remaining five years Of the contract. Thus. at the end of year 6 of the contract. GuitarPro could be producing and selling as many as I .250 units to VMI.
3. This initial contract will be fora period or six years. with an option to renew ror an additional four yearsaner that.
At the meeting, a debate broke out between Ms. Jones and Mr. Harris, theCFO, about V MI’s demand to pay no more than $1,900 per X 150 guitar, a mark-up of 10 percent over cost. Mr. Harris argued markups had already beendecreased by 5 percent over the last few years. Furthermore, he argued that if they give this price break to V Ml, all of GuitarPro’s other customers will ask for the same deal and that could have a very negative impact on firm profits. Ms. Jones insisted that the firm must adapt to changes in the competitive landscape and reduce prices to survive. Given the relatively low growth in the industry, these adjustments are necessary. Mr. Smith argued that this new order would push the company above current production capacity and, thus, some orders from current customers ‘,sould go unfilled if this new contract was accepted. After 30 minutes of heated debate, Ms. Bach intervened and encouraged the management team to identify specific options for consideration. After careful consideration, the team hasdeveloped several options that are summarized in Table 3.
After receiving the list of options to consider, Ms. Bach asked Mr. Harris toanalyze the four options and make a recommendation.
TABLE 3
Options discussed by management
Option I Reject the VMI contract and continue to actively seek new business at the current selling price of Sl ,986 per unit. No new employees or equipment are required underthis option. Since there is no guarantee that GuitarPro will be successful in securing new customers, the number of units sold under option I remains at 1,000.
Option 2 Accept the VMI new business and produce at current maximum capacity of 1,200 units per month. GuitarPro will produce 500 units for sale to VMI each month and the other 700 units will be sold to customers With the best long-term relationship with GuitarPro over the years. No new employees or equipment are required under this option, and all customers will pay S 1,900 for the X 150 guitars.
Option 3 Accept the VMI new business and acquire new production equipment that will increase capacity to 2,400 units per month. Adding this new equipment requires significant additional floor space. Luckily, additional space has become available in the building adjacent to GuitarPro’s production facility. This space is owned by Bach’s current landlord who is willing to lease it to GuitarPro for six years with an option to renew. Under this option, fixed costs will increase by $395,000 per month. The monthly fixed costs include the S50,000 of depreciation of the new equipment, the lease cost and indirect manufacturing costs such as insurance, heat, light, and water services for the newly leased building. The cost of the equipment is $6,000,000, it has a useful life of 10 years and no residual value at the end. The company uses a discount rate of 5 percent on its investment decisions. The variable cost per unit is not affected under this option. GuitarPro does not expect to have difficulties hiring the additional production employees required to run the new equipment under this option. No additional skilled employees are required. Under this option, all customers will pay $1,900 for the Xl 50 guitars. Assume that cash flows are equal to profit plus amortization multiplied by (l — tax rate) and that the tax rate is 25%, the CCA rate is 20% (category 8).
Option 4 Accept the VN’II new business and produce I ,200 units, using the current automated equipment. Outsource production of the remaining 300 units to a smallmanufacturer of stringed instruments owned by a former GuitarPro employee. eost ofthe outsourced units would increase to S 1,785. However, the outsourcepartner cannot produce more than 300 units per month for GuitarPro due to capacity constraints. Under this option, all customers will pay Sl ,900 for the X 150 guitars.
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