BU.220.620 Economics for Decision Making

Spring 2012

Prof. Mario Macis

Homework 2

Custom Limousines (Mario Macis and Scott Masten)

Custom Limousines Co. ("Custom") buys Cadillac Escalades from General Motors and converts them into limousines, a process that takes about six months per limousine. Currently, Custom buys 24 cars per month at $44,000 each. The terms of their purchase agreement with GM requires payment in full upon delivery from GM.

Recently, Custom proposed the following change in their purchase agreement with GM: Custom would continue to pay GM $44,000 per vehicle but would defer payment for six months. If GM agreed to the deferred payments, Custom promised to increase their purchases of Escalades.

As the person at GM responsible for this account, you must assess whether it is in GM's interest to accept this proposal. To do so, you make a number of inquiries and obtain the following information:

1. According to Tetsuya Lee in project analysis, GM currently uses a discount rate (internal interest rate) of 10% per year.

2. John Nichols in financial control reports that he estimates the marginal cost per Escalade to be $40,400. He cautions that actual cost depends on how many cars are sold; if more are sold, the per unit cost will be lower since the very large design and tooling (machinery) costs for the Escalade will be spread over more units.

3. Max Quandt in production says the marginal cost is between $29,000 and $34,000 depending on the output per month. He notes that the rate of total output affects the efficiency of quality control efforts, labor costs (overtime versus regular time), and so on. However, small changes in output, such as 10 cars per month, do not affect marginal costs.

4. The amount by which Custom will increase purchases if their proposal is accepted is unknown, but John Ramirez, Custom's manager of operations, says the increase would be "substantial," maybe as much as five more Escalades per month.

5. Jennifer Smith, a colleague in marketing, reports that Ford, Mercedes Benz, Chrysler, and now Infiniti all sell to companies who do limousine work. These companies compete directly with Custom. Further, Smith reminds you that GM also sells vehicles to Fleet Ltd., a company that also converts Escalades into limousines.


QUESTIONS:

1. Consider Nichols' $40,400 marginal cost estimate. Do you find it convincing? Why or why not?

2. Given the discount rate of 10% per year, how much profit in a typical month would be lost on current sales of 24 cars per month if payments were deferred for six months?

3. In evaluating the potential gains from the proposal, you have two unknowns, the marginal costs of production (somewhere between $29,000 and $34,000) and the potential increase in purchases by Custom — maybe as many as five vehicles units per month — if the deferment is accepted.

3a. If you decide to use $34,000 as your working estimate of marginal costs, what increase in Custom's purchases would be necessary for the proposal not to reduce GM’s profits on this account?

3b. If marginal costs were lower (e.g., $16,000), would this make Custom's proposal more or less attractive? Why?

4. The reminder from Jennifer Smith that G.M. also sells Cadillacs for limousine conversion to Fleet Ltd. is troubling. You realize that your "breakeven analysis" in Question 3a may not be correct. Why?