Baker Adhesives
Case 37 – Baker Adhesives Adhesives Background/Facts This case is about Baker Adhesives which is a small company that manuactures specialty adhesives in !ewark" !#$ The setting is #une o %&&' %& &'$$ Ba Bake kerr Adh dhes esiv ives es wa was s a mo mode dest st co comp mpan any y o oun unde ded d by (o (oug ug Baker)s ather who was a chemist and believed in le*ible production syst sy stem ems$ s$ Ba Bake kerr Adh dhes esiv ives es ha had d re rece cent ntly ly o ora raye yed d in into to in inte tern rnat atio iona nall markets with a sale to !ovo" a Bra+ilian toy manuacturer$ Alissa ,oreno was a sales manager and needed to meet with (oug to discuss the recent results$ -oing into the meeting (oug is e*cited at the prospects o ind i ndin ing g ne new w ma mark rket ets$ s$ As .$ .$$ $ ma manu nua act ctur urin ing g co cont ntin inue ues s to mi migr grat ate e overseas" he is under intense pressure to ind new markets$ This recent sale sa le to !o !ovo vo ha had d be been en a i ina nanc ncia iall bo boos ostt to Ba Bake kerr Adh dhes esiv ives es$$ Th The e company compa ny was able to easily meet the order and in act it reed up some raw material the company had in inventory$ The purpose o the meeting was to inali+e details on a new order rom !ovo that was to be 0&1 larger than the original order$ 2hen th 2hen the e me meet etin ing g st star arte ted" d" ,o ,ore reno no hi hitt Ba Bake kerr wi with th th the e ba bad d ne news ws immediately$ The problem was that since !ovo order was denominated in Bra+ilian" the payment rom !ovo had to be converted into .$$ dollars at the current e*change rate$ *change rates had changed since the time Baker Adhesives and !ovo had agreed on a price" the value o the payment was now substantially lower than anticipated$ This was going to hurt proit$ o obviously Baker was concerned and wanted to know kn ow wha hatt co coul uld d be do done ne"" so th they ey co coul uld d co cont ntin inue ue to do bu busi sine ness ss internationally$ Analysis/(ecision This de This deal al wa was s in init itia ialllly y th thou ough ghtt to be a go good od i ina nanc ncia ialllly y o orr Ba Bake ker r Adhesives$ Although" ater actoring in e*change rates" this was not the case$ 4n the original order" order" !ovo was charged 5&6" 5&6"33$3 33$3& & B89 or their purchase$ Ater the e*change o currency rom B89 to .$$ dollars" Baker Adhesive was estimated to receive :6"375$%6 ;5&6"33$3& < $ 6'3'=$ This means that Baker Adhesive brought in :00">'7$&' less rom
their deal with !ovo than was e*pected$ Baker Adhesives should have researched e*change rate risk$ To manage the e*change?rate risk o their deal with !ovo" Baker Adhesive could have hedged in the orward market or hedged in the money market$ 4n order to hedge in the orward market" Baker Adhesive would have to make a deal in which the bank would provide Baker Adhesive a guaranteed e*change rate or the uture e*change o currencies ;orward rate=$ These contracts speciied a date" an amount to be e*changed" and a rate$ The bank ee would be built into the rate$ Then by securing a orward rate or the date o a oreign?currency? denominated cash low" Baker Adhesive could eliminate any risk due to currency luctuation$ For Baker Adhesive" this meant that the anticipated uture inlow rom the sale to !ovo could be converted at a rate that would be known today$ The second way to manage risk is hedging in the money markets$ This would allow Baker Adhesive to make any currency e*changes at the known current spot rate$ To do this" Baker Adhesive would need to convert uture e*pected cash lows into current cash lows$ This is done on the money market by borrowing @today in a oreign currency against an e*pected uture inlow or making a deposit @today in a oreign account to be able to meet a uture outlow$ By hedging one o these two ways" Baker Adhesive could continue to do business and e*pand internationally$
Baker Adhesives .&73 BA8 A(D4 4n early #une o %&&'" (oug Baker met with his sales manager Alissa ,oreno to discuss the results o a recent oray into international markets$ This was new territory or Baker Adhesives" a small company manuacturing specialty adhesives$ .ntil a recent sale to !ovo" a Bra+ilian toy manuacturer" all o Baker Adhesives) sales had been to companies not ar rom its !ewark" !ew #ersey" manuacturing acility$ Dowever" as .$$ manuacturing continued to migrate overseas" Baker would be under intense pressure to ind new markets" which would inevitably lead to international sales$ (oug Baker was looking orward to this meeting$ The recent sale to !ovo" while modest in si+e at 5"%5& gallons" had been a signiicant inancial boost to Baker Adhesives$
The order had used up some raw?materials inventory that Baker had considered reselling at a loss a ew months beore the !ovo order$ Furthermore" the company had been running well under capacity and the order was easily accommodated within the production schedule$ The purpose o the meeting was to inali+e details on a new order rom !ovo that was to be 0&1 larger than the original order$ Also" payment or the earlier !ovo order had Eust been received and Baker was looking orward to paying down some o the balance on the irm)s line o credit$ As Baker sat down with ,oreno" he could tell immediately that he was in or bad news$ 4t came uickly$ ,oreno pointed out that since the !ovo order was denominated in Bra+ilian real ;B89=" the payment rom !ovo had to be converted into .$$ dollars ;.:= at the current e*change rate$ -iven e*change rate changes since the time Baker Adhesives and !ovo had agreed on a per?gallon price" the value o the payment was substantially lower than anticipated$ ,ore disappointing was the act that !ovo was unwilling to consider a change in the per?gallon price or the ollow?on order$ Translated into dollars" thereore" the new order would not be as proitable as the original order had initially appeared$ 4n act" it would not even be as proitable as the original order had turned out to be due to a rise in some o Baker Adhesives) costsG This case was prepared by Associate Hroessor ,arc 9ipson$ 4t was written as a basis or class discussion rather than to illustrate eective or ineective handling o an administrative situation$ Copyright I %&&7 by the .niversity o irginia (arden chool Foundation" Charlottesville" A$ All rights reserved$ To order copies" send an e?mail to salesJdardenpublishing$com$ !o part o this publication may be reproduced" stored in a retrieval system" used in a spreadsheet" or transmitted in any orm or by any meansKelectronic" mechanical" photocopying" recording" or otherwiseKwithout the permission o the (arden chool Foundation$
?%Adhesives ,arket .&73 The market or adhesives was dominated by a ew large irms who provided the vast bulk o adhesives in the .nited tates and in global markets$ The adhesive giants had international manuacturing and sourcing capabilities$ ,argins on most adhesives were uite slim since competition was ierce$ 4n response" successul irms had developed ever more eicient production systems which" to a great degree" relied on economies o scale$ The ocus on scale economies had let a number o specialty markets open or small and technically savvy irms$ The key to success in the specialty market was not the eicient manuacture o large uantities" but iguring out how to easibly and economically produce relatively small batches with distinct properties$ 4n this market a good chemist and a le*ible production system were key drivers o success$ Baker Adhesives had both$ The business was started by (oug Baker)s ather" a brilliant chemist who let a big company to ocus on the more interesting" i less marketable" products that eventually became the staple o Baker Adhesives) product line$ 2hile Baker)s ather had retired some years ago" he had attracted a number o capable new employees and the company was still an acknowledged leader in the specialty markets$ The production acilities" though old" were readily adaptable and had been well maintained$ .ntil Eust a ew years ago" Baker Adhesives had done well inancially$ 2hile growth in sales had never been a strong point" margins were generally high and sales levels steady$ The company had never employed long?term debt and still did not do so$ The irm had a line o credit rom a local bank" which had always provided suicient unds to cover short?term needs$ Baker Adhesives currently owed about :5&"&&& on the credit line$ Baker had an e*cellent relationship with its bank" which had been the company)s bank rom the beginning$ !ovo Lrders The original order rom !ovo was or an adhesive !ovo was using in the production o a new line o toys or its Bra+ilian market$ The toys needed to be waterproo and the adhesive" thereore" needed very speciic properties$ Through a mutual riend" ,oreno had been introduced to !ovo)s purchasing agent$ 2orking with (oug Baker" she had then negotiated the original order ;the basis or the pricing o that original order is shown in *hibit 5=$ !ovo had agreed to pay shipping costs" so Baker Adhesives simply had to deliver the adhesive in 00?gallon drums to a nearby shipping acility$
The proposed new order was similar to the last one$ As beore" !ovo agreed to make payment 3& days ater receipt o the adhesives at the shipping acility$ Baker anticipated a iveweek manuacturing cycle once all the raw materials were in place$ All materials would be secured within two weeks$ Allowing or some le*ibility" ,oreno elt it would be about three months rom when the order was agreed upon to the receipt o payment rom !ovo$ That was" in act" about the length o time it took or the original order$ For this reason" ,oreno e*pected $
?3? .&73 receipt o payment on the new order" assuming it was agreed upon immediately" somewhere around eptember 0" %&&'$ 2hereas a third o the raw materials continued to be materials Baker Adhesives had in e*cess supply ;those the company had considered selling o= and the rest were on hand" about a uarter o the materials needed to be purchased" and their cost had recently risen by 5&1$ *change 8isks 2ith her newound awareness o e*change rate risks" ,oreno had gathered additional inormation on e*change rate markets beore the meeting with (oug Baker$ The history o the dollar?to?real e*change rate is shown in *hibit %$ Furthermore" the data in that e*hibit provided the most recent inormation on money markets and an estimate o the e*pected uture ;eptember 0" %&&'= spot rates rom a orecasting service$ ,oreno had discussed her concerns about e*change rate changes with the bank when she had arranged or conversion o the original !ovo payment$5 The bank" helpul as always" had described two ways in which the bank could mitigate the e*change risk rom any new orderM Dedge in the orward market Banks would oten provide their clients with guaranteed e*change rates or the uture e*change o currencies ;orward rates=$ These contracts speciied a date" an amount to be e*changed" and a rate$ Any bank ee would be built into the rate$ By securing a orward rate or the date o a oreign?currency? denominated cash low" a irm could eliminate any risk due to currency luctuations$ 4n this case" the anticipated uture inlow o real rom the sale to !ovo could be converted at a rate that would be known today$ Dedge in the money markets 8ather than eliminate e*change risk through a contracted uture e*change rate" a irm could make any currency e*changes at the known current spot rate$ To do this" o course" the irm needed to convert uture e*pected cash lows into current cash lows$ This was done on the money market by borrowing today in a oreign currency against an e*pected uture inlow or making a deposit today in a oreign account so as to be able to meet a uture outlow$ The amount to be borrowed or deposited would depend on the interest rates in the oreign currency since a irm would not wish to transer more or less than what would be needed$ 4n this case" Baker Adhesives would borrow in real against the uture inlow rom !ovo$ The amount Baker
Though Baker Adhesives had a capable accountant" (oug Baker had decided to let Alissa ,oreno handle the e*change rate issues arising rom the !ovo order until they better understood the decisions and tradeos that needed to be made$ $ 5
?6? .&73 would borrow would be an amount such that the !ovo receipt would e*actly cover both principal and interest on the borrowing$ Ater some discussion and negotiation with the bank and bank ailiates" ,oreno was able to secure the ollowing agreementsM Baker Adhesives) bank had agreed to oer a orward contract or eptember 0 at an e*change rate o &$6%%7 .:/B89$ An ailiate o the bank" located in Bra+il and amiliar with !ovo" was willing to provide Baker with a short?term real loan" secured by the !ovo receivable" at %'$01 ;annual eective rate=$ ,oreno was initially shocked at this rate" which was more than three times the $01 annual eective rate on Baker)s domestic line o credit$ Dowever" the bank described Bra+il)s historically high inlation and the recent attempts by the government to control inlation with high interest rates$ The rate they had secured was typical o the market at the time$ The ,eeting 4t took (oug Baker some time to get over his disappointment$ Dowever" i international sales were the key to the uture o Baker Adhesives" Baker reali+ed he had already learned some important lessons$ De vowed to put those lessons to good use as he and ,oreno turned their attention to the new !ovo order$
?0*hibit 5 BA8 A(D4 !ovo Hrice Calculation on 4nitial Lrder 9abor ,aterials ,anuacturing overhead Administrative overhead Total costs ,arkup ;1= Cost plus markup in dollars Conversion ;.:/B89= Cost plus markup in reals Amount ;gallons= Nuoted price per gallon .&73 '"&&& 3%"0&& 6"&&& %"&&& 66"0&& 3"7& 6"37& &$6'3' 5&6"330 5"%5& '$%3 !otesM The e*change rate used in the calculation was obtained rom the 2all treet #ournal$ Lverhead was applied based on labor hours$ The raw materials e*pense was based on the original cost ;book value= o the materials$ The rounded price o B89 '$%3 per gallon was used in negotiations with !ovo$ Thus" or the inal order !ovo was billed a total o '$%3 O 5"%5& P B895&6"33$3&$ $
?'*hibit % BA8 A(D4 *change 8ate and ,oney ,arket 4normation *change 8ates or 8eal as o #une 0" %&&' ;.:/B89= Bid on real Ask or real Consensus orecast bid or eptember 0" %&&' Consensus orecast ask or eptember 0" %&&' tandard (eviation o ,onthly *change 8ate Changes %&&0 Qear to date %&&' 4nterbank 8ates Bra+il .$$ .&73 &$63' &$63& &$6%3% &$6%6' 3$3'1 '$031 57$6&1 0$&&1 Bid on 8eal (ollar alue o 8eal ;.:/B89= &$0&&& &$6&& &$6'&& &$66&& &$6%&& &$6&&& &$3&& &$3'&& &$36&& &$3%&& &$3&&& 5/5/%&&0 %/5/%&&0 3/5/%&&0 6/5/%&&0 0/5/%&&0 '/5/%&&0 7/5/%&&0 /5/%&&0 >/5/%&&0 5/5/%&&' %/5/%&&' 3/5/%&&' 6/5/%&&' 0/5/%&&' 5&/5/%&&0 55/5/%&&0 5%/5/%&&0 '/5/%&&'
