Dessert Dilemma – A Capital Case Study

Should General Mills Make or Buy?
Case prepared by General Mills, Inc.
Introduction
Paul looked up at his computer monitor, confused about what to do next. Every time he thought things were settled with Project Morrison, the marketing or operations team would throw a curve-ball, leading to a complete revaluation of everything he had done to date.
As a Research & Developmen guy and the Project Manager in the Desserts unit of Baking Products, Paul played a key role in developing the financial rationale and understanding the long-term impact of any new product launch for the division. Specifically, the Desserts team had been working on Project Morrison — a new 3 flavor SKU microwavable dessert mix in a plastic bowl that would allow you to add water, heat for three minutes, and eat. Research and Development tests had scored incredibly high on taste, and there were no similar products on the market. Paul felt it was a great idea, but there was a lack of consensus on the team about exactly how successful it would be.
The Market
The Baking Products division was in a tough situation, with two major competitors (Duncan Hines and Pillsbury Baking) and some smaller private label players. Duncan Hines was owned by a private equity firm, which had been behaving unpredictably since acquiring it three years earlier. Pillsbury Baking was owned by Smuckers, who had been investing heavily in brand-building. The overall Baking category was declining by 1-2% per year, so having a big new product win was going to be key to the division’s success — for the current fiscal year and beyond. Margins had eroded from $5.00 per case to $4.00 per case over the past few years as trade spending had increased, and innovation was seen as the best way to reverse this trend.
The Situation
From the beginning of the project, it was assumed that the product would be manufactured at General Mills’ plant in Avon, Iowa. The technology needed to create a microwavable bowl dessert was not readily available on the open market, and would warrant a significant investment. Already, $500,000 had been spent on the long-lead feasibility study at Avon, and a capital expenditure of another $4,850,000 would be required for the equipment to produce the product. Assuming no unforeseen setbacks, the product was scheduled to hit the market in June 2016.
Then everything changed. Bob, the contract manufacturing liaison for the Baking Division, announced at the weekly new product meeting that he had just gotten off the phone with Atlantic Choice, a contract manufacturing/packaging facility located in NJ. Atlantic Choice had quietly been developing this same microwavable bowl technology, and offered their services to GMI. While Bob had never used this company for co-pack before, Atlantic Choice promised they could have the product in-market by October 2015, much sooner than would be possible in-house. The capital cost for contract was also significantly less than an internal option, requiring only $1,500,000 in additional capital by GMI for a packaging system. The initial COGS quote on a cost per case basis was higher than the expected internal costs (see Exhibit A). Bob expressed his concern that if GMI didn’t tie down this external capacity and use it, a competitor — or even worse, private label — could gain access to this technology and flood the market with a similar product before General Mills.
Product Development and Operations have provided the following cost estimates:
Ingredients: $3.40 per case
Manufacturing: $4.50 per case
Packaging: $2.60 per case
Logistics: $0.75 per case
Finance reminded Paul that the effective tax rate was 26% of earnings before taxes.
Operations stated that the equipment has a 10 year life expectancy with no salvage value. After that, the equipment will need to replaced.
The meeting had ended with Consumer Insights providing their PreVu estimate (see Exhibit B) for the expected size of market. PreVu predicted sales of 2,000,000 cases per year, growing at a rate of 3% per year. Marketing has set the price to the trade at $20.10 per case. Margins for this new product will significantly exceed margins typical of the category.
The Decision
The pressure was mounting for Paul to develop and analyze the financials, and to present his recommendation to the team. By the end of the following week the engineers at the plant would run out of the long lead capital that had been approved. For the growth project to move forward, Paul knew it had to have at least a 20% IRR of free cash flow to exceed internal hurdles. Paul needed to finish to submit a Capital Project workbook quickly for the final recommended solution.
As he read over the last email from his manager (see Exhibit C), he knew he would have to quickly answer the following questions:
Ø What is the recommended course of action: produce internally or externally?
Ø What assumptions were made in developing the recommended solution?
Ø What business, strategic and financial risks are associated with the recommended solution?
He developed an Excel workbook based upon the data available. and started re-reading back through the chain of emails that had been passed around by the team. It was going to be a long night….

Exhibit A
From: Atlantic Choice
To: Bob, Contract Manufacturing, Baking Division
Subject: Project Morrison Price Quote
Date: 17 January 2015
Bob,
We are excited at the possible opportunity to work with General Mills on this great new product launch. Per our conversation, Atlantic Choice will source all ingredients and make the product (see quote below). Contract term is 10-years. We can discuss the exclusivity clause further at a later time.
General Mills will also buy and install the packaging equipment at Atlantic Choice by the agreed upon date.
Annual Volume 1,800,000 cases
Ingredients/Manufacturing $15.50/case
.

From: Senior Project Manager, Avon Plant
To: Engineering Liaison, Baking Division
CC: Paul, Financial Analyst, Baking Division
Subject: Project Morrison Final CPA
Date: 13 January 2015
Left you a voicemail yesterday — am still waiting to hear back on the project approval progress in Minneapolis. The $500,000 of capital funding we approved for the feasibility study runs out at the end of the month, and as I said, it’s really important we keep the ball rolling on getting the $4,800,500 Final Capital Project approved. If I have to release my resources on this and then re-assemble the team, it’ll add another month or two into the startup and get us into the back of the queue with operations for our next round of testing. If we want this project to be fully automated, and not require any additional manpower at the plant, it’s critical that we done ample testing throughout the project development.
Please give me a call back and let me know what the holdup is.
From: Supply Chain Decision Support Analyst — Baking Products
To: Paul, Project Manager, Baking Division
Subject: Morrison COGS, etc
Date: 14 January 2015
I’ve got a couple of things for you.
1) I heard back from Abby, the AFOM (Assistant Financial Operations Manager) at the Avon plant. Apparently, they’ve run a very basic test with the feasibility equipment. The current COGS assumption for manufacturing/packaging/ingredient is pretty accurate, based on the line rates they feel they can achieve ( $11.25 per case), plus or minus 5%. About a dollar of this is an allocation for general plant costs. Depreciation is not included in the figure.
2) Logistics wants to have more detailed costing before they commit to a number. The best I could get out of them was to use the frosting number from Avon, which is $0.75 per case. They won’t have time to look at this more carefully for a couple of weeks; with the new hours-of-service legislation going into effect and the volatility in fuel prices, it sounds like they’re pretty overworked.
Exhibit B
From: Consumer Insights Manager
To: Marketing Manager
Subject: Project Morrison PreVu Estimate
Date: 11 January 2015
Basis yesterday’s meeting, I am assuming that we’re going with the high consumer spending scenario ($20MM for launch year including slotting allowances, $9MM thereafter). Please find attached the Preview estimate (+/- 20%) for Project Morrison.
We assume that there will be minimal cannibalizations of other products.

Marketing Inputs
Cons. Spending ($MM) $20 initially, $9 thereafter
Price to the trade: $20.10 per case

Annual Volume (MEQCs)
Midpoint 2,000
High 2,200
Low 1,800
Sales should grow at an annual rate of 3%, assuming that our price to the trade does not increase.

From: Marketing Manager
To: Business Unit Director
Subject: Project Morrison Size of Business Estimate
Date: 12 January 2015
Though CI has come back with a PreVu estimate for Project Morrison, we do not believe their estimate fully takes into account the potential of this launch. Specifically, we strongly believe that the volume will be significantly higher. This project will be unique to the market and to the dessert shelf, and clearly represents a unique eating occasion.
Since we have never had great luck with the accuracy of PreVu in the past, our own analysis of the market and similar product turn levels show volume estimates as follows:

Marketing Inputs
Cons. Spending ($MM) $20 initially, $9 thereafter

Annual Volume (MEQCs)
Midpoint 3,000
High 3,300
Low 2,700
We predict annual growth in sales at 10%. Assuming that our price to the trade does not increase.
Exhibit C
From: Finance Manager, Baking Division
To: Paul, Project Manager, Baking Division
Subject: Project Morrison Size of Business Estimate
Date: 12 January 2015
Paul,
It sounds like you have your hands full with this project. I just got off the phone with our Product Sales Manager, and the sales force is definitely pushing us to get this product on the shelf as soon as possible. Sales will be behind this launch 100%, which will definitely help up to move a lot of cases. They are hearing rumblings of a major new product offering by Duncan Hines and are concerned that if we wait till June 2017 to launch it will be too late. That being said, we need to justify this launch on sound fiscal and business rationale, and not speculation.
We are predicting a 2% annual increase in COGS (no including depreciation).