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The Importance of Demand and Costs in Starting a Manufacturing Business

George is an independent inventor. His usual manner of operation is to invent some new device, obtain a patent on it, then license out the technology to companies that manufacture it under their own brand name. His income is derived by obtaining royalties on each unit of the devices sold by the licensee. When George invents a tabletop device that produces large quantities of hydrogen from water, he knows he has a winner and decides to produce the device himself. The demand for cheap and convenient sources of hydrogen is high in all chemistry labs – from high school and college labs to industrial and government labs. So he takes a large portion of his life savings and uses it to create a company called Electrolytic Solutions, LLC. Note that at the time he begins this venture, George has applied for a patent. Electrolytic Solutions begins assembling the hydrogen-producing devices. While interest in the devices is high among scientists he shows it to, actual sales lag. George decides that he should approach major chemical companies that produce chemical feedstocks to see if they would back his device. Each of the companies he approaches earns substantial revenue providing hydrogen gas to customers in the chemical industry. He is open-minded about how he can work with these companies – he is willing to license his technology to them for their own production of the devices, or to provide them with an equity share in his company in order to obtain investment finance from them, or even to sell the technology to them outright.

George approaches two major producers of commercial hydrogen gas (hydrogen gas is important in producing a whole range of products, and demand for it is high both for small scale production in laboratories, and large scale production in manufacturing). Engineers at both of these large companies are impressed with George’s technological achievement. They see value in having a tabletop hydrogen generating device. The engineers in both these companies report their enthusiasm for the device to higher levels of management, and in one case, they are asked to write a business case to present to a senior level new product selection committee. But in both instances, higher level managers kill the initiative on two grounds: first, their existing customers see no value in the devices; and second, pro forma income projections suggest that sales of the devices will not generate enough revenue to make them worthwhile. Nine months into the effort, George runs out of cash. He considers declaring bankruptcy when one of his licensees for another product, Salvation Enterprises, offers to buy him out. The buy-out covers George’s start-up costs ($450,000). George considers himself lucky because he is able to recover his investment, although he makes no profit. After three years of operation, Salvation Enterprises makes $10 million in annual profits from the device. Their principal market is high school and college laboratories in the US. They have received inquiries about their products from universities overseas. More interesting, they are conducting discussions about selling their product to the R&D laboratories of major chemical companies in ten countries. If these discussions lead to sales, Salvation’s revenue from these devices can increase five-fold in two years.

This case study is designed to test your capacity to integrate a wide range of business knowledge and insights. Use whatever resources are at your disposal to answer the following questions. If you need to know more about the industrial uses of hydrogen, check this out on the Internet. If you don’t remember your lessons on patents, trademarks, copyrights, and trade secrets, look these topics up on the Internet.

1. Clearly, George is inexperienced in business. While his technical capabilities are solid (he has made a good living inventing new technologies for a number of years), his business skills are weak. What factors should George have considered before deciding to manufacture the hydrogen producing devices himself? (Your answer should be about one page long, single space. Be thorough in your discussion.

2. Up until now, George has made a good living licensing out his technology and living off of royalties. If you were a consultant educating him on the technology licensing process, what are risks and opportunities associated with this process that you would explain to him?

3. This case study illustrates the type of phenomenon that Clayton Christensen describes in his book, The Innovator’s Dilemma. This is evident in the last two paragraphs of the case study.

a. As Salvation Technology’s success ultimately demonstrated, there is a market for the tabletop hydrogen-producing device. Using Christensen’s research findings as the basis of your response, explain why middle and senior level managers are reluctant to adopt disruptive technologies. Show how this reluctance manifests itself in this specific case.

b. Christensen points out that at the earliest stage of the introduction of a disruptive technology, it is difficult to see how it is a threat to a major competitor’s ongoing business. He illustrates this view convincingly with examples from the disk drive, mechanical shovel, and steel industries. Describe briefly (in one page, single space) how the disruptive technology of mini-mills was not viewed as a competitive threat to major US steel producers, and how gradually mini-mills were able to take over high-end, high-margin steel production. Then create a parallel scenario (using Christensen’s theory) showing how Salvation Technology’s production of the tabletop hydrogen device can ultimately present the big hydrogen producers with a competitive threat.
 

The Importance of Demand and Costs in Starting a Manufacturing Business

There are many factors which must have been on George’s checklist before deciding to start manufacturing the product (Lindgren, 2017). The first factor which he should have considered is the demand for the product or the supply gap that is there must be a large size of the unsatisfied market in which the product manufacturer intends to launch the product. Luckily, in this case, the demand was very high for the product. The cheap and safe source of hydrogen was required by school, colleges, universities and government labs. The second essential factor is the setup and running costs or the fixed and variable costs. Establishing a manufacturing plant is a costly proposition. It involves licenses, equipment, customized machines, and expert technical know-how. George did not ponder upon all these factors and jumped to the conclusion of production. He should also have researched that if there are any other manufacturers and how well are they performing in terms of production, operations, and profits. Also, it is necessary to assess the process of the production to be adopted for the product manufacturing and to understand the technical implications of the same. The choice of product to be manufactured decides the cost of the machinery and labor. This further decides the amount of capital required for starting the business. The third crucial factor which George missed out was his own inexperience of running a business, lack of production process knowledge and scarcity of required professional and technical qualifications (GALEA, 2017). Being technically solid does not guarantee success in production. Had George been a seasoned and well-experienced businessman he would have chalked out a strategic development and expansion plan keeping in mind the stages at which funding would be required. George must have analyzed before foraying into production the cost factor. This was the major reason for the failure of his startup. It even leads him on the verge of bankruptcy. He did not determine beforehand the amount he would invest out of his own pocket. Assessing and ensuring the source of funds is the backbone of any production operation. The fourth factor which did not get George’s enough attention was the seed capital or the initial investment source. He risked all his life’s savings and invested in the business which was not a sensible decision. Apart from these major investments, there are other costs also involved in retail cost per individual unit, raw material cost, logistics, and marketing etc. In manufacturing, everything cannot be made (Otten, Krenzler & Daduna, 2015). Some of the less important things are to be outsourced. Proper knowledge of what is to be outsourced is also necessary. It also helps in reducing the fixed cost and the quality remain the same. Another factor is the production capacity and system. Had George kept it on a low scale i.e. as a small scale production and understood the production process in and out maybe he could have attracted more investors as the risk would have been small (Kachanova, 2016). Conducting a market survey would also have provided him the first-hand information. He would have come to know about the need for the product, expected the price per unit, market competition, etc. Gathering of data regarding the investments required, profits generated, break-even points attained could have helped him boost his project. Studying the government policies with respect to the production is also required to see if any subsidy or grant is provided in the field of choice. It can act as a boost in terms of capital investment and may lower down the risk factor. Last is the feasibility of giving any idea a shape. Sometimes plans look good on paper but are difficult to put into practice. Even after spending $450,000 and nine months of his life he gained nothing. He ultimately got a buy-out offer and took the same. Apart from this, the opportunity cost he paid is also high (Aksaray & Thompson, 2017). 

Assessing Competition and Production Capacity

As a consultant, they would have explained George about both, the opportunities as well as the risks. The first opportunity is the royalty of the company. Royalty is a sum of the amount paid by the licensee to the licensor for the use of technology/product licensed to him (Symeonidou & Bruneel, 2017). It could be paid per product sold, or lump sum or as a percentage of total sales. It is a continuous source of income for the owner. It is an additional kind of income or profitability with very little investment. The second opportunity for the licensor is that it is a jump card for making an entry into the foreign markets. It helps in circumventing all the legal formalities and helps to enter the foreign markets. There are so many trade barriers and tariffs accompanied by numerous taxes and legal bindings which make it practically impossible for an individual to launch its product in the foreign market (Wang, Tseng & Liang, 2016). The third opportunity is that it requires a very low amount of capital requirements. It is a very cost-effective route of getting the product into the market. The licensor does not have to spend on manufacturing, packaging, marketing, logistics and hefty salary bills. The fourth advantage which the licensor enjoys is that he does not have to worry about the market knowledge, industry or the existing trends as he enters the market with an established organization. Lastly, if there are any discrepancies in the product they get removed as the owner does not have the required infrastructure and resources which the organization has. It creates a reverse flow of the information as it provides new insights to the licensor about his own product. However, with opportunities, risks are also associated with this. The first risk is the total loss of the technology (Chowdhury, Jeon & Ramalingam, 2017). At times the idea or the product licensed is in its crude or early stage. The organizations act clever and make changes in the product and claim it to be its own production. The second risk which is an aftereffect of the first risk. Once the owner loses the ownership of the product, it is followed by the loss of intellectual property if the product is not patented by the owner. The most common example of such infringement happens in case of the software industry. Another risk associated with this is that the license period is usually limited. Once the terms of the agreement are over, the licensee may turn out to be your competitor. He has got all the required information the production of the product. He can offer competitive prices for the same product. Sometimes it happens that the agreement is entered into but the production does not start. In such a case there are no royalties to payouts for an indefinite amount of period. Also, there is the very limited scope of participation for the owner because when a company is investing in the product a huge amount it becomes its discretion how to produce and at what price to sell. The licensor becomes overly dependent on the licensee for every development and promotion of the product as he has given all the rights to the company. In such a context he has a very limited say. But after the analysis, it can be deduced that technology licensing has more advantages than disadvantages. 

Advantages and Risks of Technology Licensing based on Clayton Christensen's The Innovator's Dilemma

The book named The Innovator's Dilemma by Clayton Christensen explains that in spite of doing everything right how successful and leading organizations lose their market shares and leadership to the extent of failing in business. Using Clayton’s findings in the book the case study will explain why the middle and senior level managers did not show interest in George’s product. The first reason they produced was that their existing customers did not see any value in the product. Clayton describes disruptive technologies as an innovation leading to the creation of a product which creates a new market for itself, a valuable network and improving itself over the period of time. Thus it replaces the product in the market and disrupts the market too. The managers did not want to adopt the product because it was a disruptive innovation. It has its own disadvantages and potential threats to the organization. First of all, it competes with the existing product which they are selling. It is comparatively cheaper, simpler and easy to operate as compared to other products in the market. They want to continue with the sustainable technology because it focuses on the present customers. It is more comfortable and easier to continue producing what they are currently producing rather than setting up a new plant with all the fresh investments. Another disadvantage is that it creates a new consumer class and market in the already existing market. It leads to the division of the target segment and eventually overriding their customers. PCs replacing mainframe computers, memory cards replacing floppy disks are the common examples of the disruptive technologies. It also forces the organizations to change their focus from the existing products and mainstream customers to the less profitable with small market size and simpler products. It is not a favorable proposition for the big companies as it affects their performance trajectories. Even if they agree to focus on this, the investors do not show any interest in investing. The second reason they put forward was that the sales of the tabletops will not produce enough revenue thus making it not worth the investments. However, it can be seen that George’s product has full potential and traits of becoming a successful product. It is also said that the organizations must not be fixed to the grounds. They must keep on finding new opportunities. Their reluctance to invest in the product became an opportunity for the Salvation Enterprises. They made $10 million in their annual profits after working for more than a couple of years and discussions are going on for selling their product to the chemical companies of  10 big countries. Salvation enterprises proved that analyzing the product, features and market analysis combined with a push can make difference. Sometimes even if the companies try adopting the disruptive technologies the technology is so rapidly changing that at times it becomes practically impossible to implement the process of adoption of disruptive technology. This overshooting of technology in the mainstream markets is a big problem for the managers. Big companies rather than selling what they make should make what sells. The success of aviation enterprises is in itself a proof of the same. At times focusing on customers’ needs is also profitable. Another possible reason for the reluctance of the senior level managers is that they are not authorized to do so. It means that in spite of the fact they find it a good project, the management or the board of directors do not approve of the same. As far as the middle management is concerned they are so comfortable with the sustainable technologies that they do not want to venture into the new ideas or simply speaking they do not want to come out of their comfort zones. They are bound by the knowledge which the organization and management have gathered over the period of time. It makes no sense to them to discard that knowledge. Same is the attitude of the sales team of any organization. Likewise, they are also reluctant to adopt the products generat4d through the adoption of the disruptive technologies. 

The mini-mills worked at the microeconomic levels of productions and did not aim bigger in the beginning. They understood the point that why some of the big producers have stagnated in terms of profits and en-cashed the point which led the successful companies to lose their growth and ultimately fail. The big iron ore steel producers used iron ore for steel production. They used big furnaces, castings and rolling machines for finished products. It was a huge investment for setting up a mill close to 10 billion dollars. Apart from the initial investments the licenses, required technical manpower, and ongoing recurring expenses like salary bills, trade tariffs, etc. On the other hand, the advantages minimills had over them were that they were using recycled steel, junk cars, and industry scrap as their raw material. They can produce with less labor and in small batch quantities. This gave them an added cost advantage of 20% to 25%. The mini-mills became technologically viable in the 1960s and their market was concrete reinforcement rebar market. Steel required for rebar is so easy that anyone can make it without much of a problem. They were a great success as the product required no specifications for burying it in cement. However, the quality produced was uniformly bad and the only perfect market for this crummy product was rebar market which procured it for concrete reinforcement market. Similarly, from rebar market to structural steel, they grew like anything and today they control a major part of the steel market in America ("Connotation and Selection of Disruptive Technologies that Lead Industrial Change", 2017). They rose to their success by making their foundations strong. Big industries collapsed because they did not pay attention to the less profitable piece of business. 

In the earlier question, it has been seen that how the hydrogen tabletops have succeeded and performed well in local and international markets. Any product which is new to the market Moreover, R & D companies of major chemical companies are planning to research on this. If all of this goes according to the plan the Hydrogen tabletops can be a huge success like the mini-mills and they will replace the existing products as these tabletops are cheap, simpler and easy to operate and they will create a separate market and group of consuming for them. These changes will ultimately lead to the clean sweep of the existing products in the market which is expensive, difficult to use & operate. The hydrogen table top can help the company to expand themselves in the markets. It will be more of a customer-oriented product and when people get what they need that commodity sells at a great speed as compared to buying what is available in the markets 

References

Aksaray, G., & Thompson, P. (2017). Density Dependence of Entrepreneurial Dynamics: Competition, Opportunity Cost, or Minimum Efficient Scale?. Management Science. https://dx.doi.org/10.1287/mnsc.2016.2710

Chowdhury, S., Jeon, J., & Ramalingam, A. (2017). Property rights and loss aversion in contests. Economic Inquiry. https://dx.doi.org/10.1111/ecin.12505

Coccia, M. (2017). Disruptive Technologies and Competitive Advantage of Firms in Dynamic Markets. SSRN Electronic Journal. https://dx.doi.org/10.2139/ssrn.2960190

Connotation and Selection of Disruptive Technologies that Lead Industrial Change. (2017). Chinese Journal Of Engineering Science, 19(5), 9. https://dx.doi.org/10.15302/j-sscae-2017.05.002

Debrulle, J., & Maes, J. (2015). Start-ups' Internationalization: The Impact of Business Owners' Management Experience, Start-up Experience and Professional Network on Export Intensity. European Management Review, 12(3), 171-187. https://dx.doi.org/10.1111/emre.12050

GALEA, S. (2017). On the Production of Useful Knowledge. The Milbank Quarterly, 95(4), 722-725. https://dx.doi.org/10.1111/1468-0009.12296

Kachanova, L. (2016). A system approach to management of the technological process of production and application of fertilizers. Vestnik Orelgau, 2(59), 103-112. https://dx.doi.org/10.15217/issn1990-3618.2016.2.103

Lindgren, L. (2017). Integrated Design of Material, Manufacturing, Product, and Performance. Procedia Manufacturing, 7, 53-58. https://dx.doi.org/10.1016/j.promfg.2016.12.016

Otten, S., Krenzler, R., & Daduna, H. (2015). Models for integrated production-inventory systems: steady state and cost analysis. International Journal Of Production Research, 54(20), 6174-6191. https://dx.doi.org/10.1080/00207543.2015.1082669

Symeonidou, N., & Bruneel, J. (2017). Determinants, causal connections, and outcomes of corporate technology licensing: a systematic review and research agenda. R&D Management, 47(4), 620-636. https://dx.doi.org/10.1111/radm.12278

Wang, K., Tseng, C., & Liang, W. (2016). Patent Licensing in the Presence of Trade Barriers. The Japanese Economic Review, 67(3), 329-347. https://dx.doi.org/10.1111/jere.12098

Wang, L., & Mukherjee, A. (2014). Patent Protection, Innovation and Technology Licensing. Australian Economic Papers, 53(3-4), 245-254. https://dx.doi.org/10.1111/1467-8454.12030

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