1) Arbitrage is the act of simultaneously buying

Precision Worldwide, Inc.In late May 2004, Hans Thorborg, the general manager of the German plant of PrecisionWorldwide, Inc. (PWI), scheduled an afternoon meeting with his sales manager, accountant, anddevelopment engineer to discuss the introduction by the French firm Henri Poulenc (a competitor) ofa plastic ring substitute for the steel retaining rings presently used in certain machines sold byPrecision Worldwide. The plastic ring, new to the market, not only had a much longer life than thePWI steel ring but also apparently had a much lower manufacturing cost. Thorborg’s problemstemmed from PWI’s large quantity of steel rings on hand and the substantial inventory of specialsteel that had been purchased for their manufacture. After a thorough survey, he had found that thespecial steel could not be sold, even for scrap; the total book value of these inventories exceeded$390,000.For nearly 90 years PWI had manufactured industrial machines and equipment for sale innumerous countries. The particular machines involved in Thorborg’s dilemma were made only atthe company’s plant in Frankfurt, Germany, which employed more than one thousand people. Thedifferent models were priced between $18,900 and $28,900 and were sold by a separate salesorganization. Repair and replacement parts, which accounted for a substantial part of the company’sbusiness, were sold separately. As with the steel rings, these parts could often also be used on similarmachines manufactured by competitors. The company’s head office was in Toledo, Ohio, U.S.A. Ingeneral, plants outside the United States were allowed considerable leeway in administering theirown affairs; the corporate headquarters, however, was easily accessible by telephone, email, orduring executive visits to the individual plants.In the late 1990s, competition had increased. Japanese manufacturers, with low-priced spareparts, had successfully entered the field. Other companies had appeared with lower-quality andlower-priced machines. There was little doubt that future competition would be more intense.The steel ring manufactured by PWI had a normal life of about two months, depending upon theextent to which the machine was used. A worn-out ring could be replaced in a few seconds, andalthough different models of the machines required from two to six rings, the rings were usuallyreplaced individually as they wore out.The sales manager, Gerhard Henk, had learned of the new plastic ring shortly after its appearanceand had immediately asked when PWI would be able to supply them, particularly for sale tocustomers in France, where Henri Poulenc was the strongest competition faced by PWI. Bodo________________________________________________________________________________________________________________Eisenbach, the development engineer, estimated that the plastic rings could be produced by midSeptember. The necessary tools and equipment could be obtained for about $7,500. Eisenbach hadinitially raised the issue of the steel-ring inventories that would not be used up by September. Henkbelieved that if the new ring could be produced at a substantially lower cost than the steel ones, theinventory problem was irrelevant; he suggested that the inventory be sold, or if that was impossible,thrown away. The size of the inventory, however, caused Thorborg to question this suggestion. Herecalled that the size of the inventory resulted from having to order the highly specialized steel inlarge amounts so that a mill would be willing to handle the order.Henk reported that Henri Poulenc was said to be selling the plastic ring at about the same price asthe PWI steel ring; since the production cost of the plastic ring would be much less than the steel, heemphasized that PWI was ignoring a good profit margin if it did not introduce a plastic ring. As themeeting concluded, it was decided that the company should prepare to manufacture the new ring assoon as possible but that until the inventories of the old model and the steel were exhausted, theplastic ring would only be sold in those markets where it was offered by competitors. It wasexpected that the new rings would not be produced by any company other than Henri Poulenc forsome time, and this meant that no more than 10% of Precision Woldwide’s markets would beaffected.Shortly after this, Patrick Corrigan, from the parent company in Ohio, visited Frankfurt. During areview of company problems, the plastic-ring question was discussed. Although the ring was only asmall part of the finished machines, Corrigan was interested in the problem because the companywanted to establish policies for the production and pricing of all such parts that, in total, accountedfor a substantial portion of PWI’s revenues. Corrigan agreed that the company should proceed withplans for its production and try to find some other use for the steel; he then said, “If this does notseem possible, I would, of course, expect you to use this material and produce the steel rings.”A few days after Corrigan’s visit, both Eisenbach and Henk came in to see Thorborg. Eisenbachcame because he felt that since tests had indicated that the plastic ring had at least four times thewearing properties of the steel ring, it would completely destroy demand for the steel ring. Heunderstood, however, that the price of the competitive ring was high, and he felt that the decision tosell the plastic ring only in markets where it was sold by competitors was a good one. He observed,“In this way we will probably be able to continue supplying the steel ring until stocks, at least ofprocessed parts, are used up.”Henk still strongly opposed sales of any steel rings once the plastic ones became available. If steelrings were sold in some areas, he argued, while plastic rings were being sold elsewhere, customerswho purchased steel rings would eventually find out. This would harm the sale of PrecisionWorldwide machines—the selling price of which was many times that of the rings. He producedfigures to show that if the selling price of both rings remained at $1,350.00 per hundred, theadditional profit from the plastic rings (manufactured at a cost of $279.65 per hundred versus the$1,107.90 per hundred for steel rings) would more than recover the value of the steel inventory, anddo so within less than a year at present volume levels. Thorborg refused to change the decision of theprevious meeting but agreed to have another discussion within a week.Anticipating this third meeting and also having Corrigan’s concern in mind, Thorborg obtainedthe data displayed in Table A from the cost accounting department on the cost of both plastic andsteel rings.Thorborg also learned that the inventory of special steel had cost $110,900 and representedenough material to produce approximately 34,500 rings. Assuming that sales continued at thecurrent rate of 690 rings per week, without any further production, some 15,100 finished rings wouldbe left on hand by mid-September. Thorborg then recalled that during the next two or three monthsthe plant would not be operating at capacity; during slack periods, the company had a policy ofemploying excess labor (at about 70% of regular wages) on various make-work projects rather thanlaying workers off. He wondered if it would be a good idea to use some of this labor to convert thesteel inventory into rings during this period.Table A100 Plastic Rings100 Steel RingsMaterialDirect laborOverheadaDepartmentalAdministrative$ 17.6565.50$321.90196.50131.0065.50393.00196.50Total (cost)$279.65$1,107.90aOverhead was allocated on the basis of direct labor cost.It was estimated that the variableoverhead costs included here were largely fringe benefits related to direct labor and amounted to80¢ per direct labor dollar or about 40% of the departmental amounts.QuestionWhat action should Hans Thorborg take? Why?