The candidate should begin by asking any relevant clarificatory questions, before structuring their approach to the case.
Recall that:
Profit = Revenues – Costs
The candidate should analyse these components in sequence.
Recall that:
Revenue = Volume x Price
Thus, the candidate will need values for both price and the number of chips required nationally.
The candidate should begin to ask structured questions to move towards these values.
The total number of dogs in the UK is approximately 12m
Average canine life expectancy is 8 years
94% of dogs are licenced
The government is prepared to pay £15 each for the new chips
Thus, we have a value for the price (£15), but must still estimate the number of chips required.
The candidate might make this estimation via multiple different methods. Here, we will use the replacement concept.
To begin, we assume that the number of dogs in the UK has remained constant.
To maintain stable numbers, the number of new dogs each year must equal the number which die.
We calculate this number as follows:
Replacement Rate = Population/Lifespan = 12m/8 = 1.5m new dogs per year
94% of these dogs will be licenced in accordance with the law
1.5 x 0.94 = 1.41m new licences per year
We can round this to 1.4m new chips required per year from the start of the programme
Note that dogs which have already been licenced are not covered by the new legislation, so need not be considered.
We can now plug our values for volume and price into the equation above.
Revenue = Volume x Price
Revenue = 1.4m x 15
Revenue = £21m
The candidate should now move on to consider costs. They should begin by asking structured questions to gain more information on aspects of costs; including fixed and variable costs of chip production, the costs of any investments required and the cost of licencing any proprietary technologies.
Chips will cost Stratos £4 each to manufacture (with this including labour, raw materials and other costs).
To produce these additional microchips alongside their current contracts, Stratos will have to increase the size of their production facilities.
Stratos can lease a unit adjacent to their current production line for £750k per year.
This new production line will also require new equipment to be purchased at a cost of £6m.
A few different location technologies can be used to make chips that are compliant with the new legislation. However, all are proprietary and will require both an initial lump payment plus an additional licencing payment for each chip manufactured.
Stratos has two options to licence locator technology:
Cartograph
Will require a lump payment of £500k and per-unit licencing fee of £1
Transpose
Will require a lump payment of 250k and a per-unit licencing fee of £2
The candidate will need to make calculations as to the different cost components.
Cost to manufacture = number of chips x unit cost
Cost to manufacture = 1.4m x 4 = £5.6m per annum
Cost of new facility = rental cost + equipment cost
Cost of new facility = 750k + 6m = £6.75m in year one
Total production costs = 5.6m + 6.75m = 12.35m
These will need to calculated for both possible providers:
Cartograph
Cost to licence tech = lump sum + (unit fee x number of units)
Cost to licence tech = 500k + (1 x 1.4m) = £1.9m
Transpose
Cost to licence tech = lump sum + (unit fee x number of units)
Cost to licence tech = 250k + (2 x 1.4m) = £3.05m
The candidate should note that, at the volumes required here, Cartograph is the cheaper option and thus the one that should be engaged if production goes ahead.
Total Costs in Year One
Total Costs = production costs + licencing costs
Total Costs = 12.35m + 1.9m = 14.25
Now that the candidate has values for both revenues and costs, they can calculate Stratos’s projected profits for year one of the dog microchip contract.
Year One Profit = Revenues – Costs
Year One Profit = 21m – 14.25m
Year One Profit = £6.75m
The candidate should enquire about the wider market Stratos finds itself in. In particular, the candidate should seek information on Stratos’s competitors, their market shares, possible sources of advantage over Stratos and the overall probability of Stratos winning the contract.
Stratos has four other competitors which are capable of bidding for the government contract.
All have roughly equivalent market share in this space and all have an equivalent chance (approximately 20%) of winning the government contract.
However, if Stratos invests £1m to lobby government ministers, they believe that they can raise their chances of securing the contract to as much as 75%.
In order to decide on the best course of action here, the candidate should compare the expected profits with and without lobbying.
Expected Profit Without Lobbying
(6.75 x 20%) + (0 x 80%) = £1.35m
Expected Profit With Lobbying
(6.75 - 1) x 75% + (-1) x 25% = £4.06m
The expected profit with lobbying is higher. Thus, Stratos should opt to invest in lobbying government ministers to help secure the deal.
The candidate should provide a brief, structured recommendation advising Stratos on how to proceed.
If the legislation requiring the new microchip type for dogs is passed, Stratos should attempt to win the government contract to provide these chips as the expected profits will be £4.06m in year one, with further profits in subsequent years.
In doing so, Stratos should licence locator technology from Cartograph, as this minimises licencing costs and so boosts profits.
They should also invest in lobbying government ministers to increase their chance of winning the contract rather than one of their competitors. This move boosts expected profits.
The candidate should also note any potential risks or other issues which might need to be considered before going forward.