Dry Dock
Universal Exports (UE) is a large sea freight company, operating a fleet of 46 freight ships. UE moves freight globally but does the bulk of its business serving transatlantic routes between Europe and South America. UE has been successful in recent years as the market for shipping to and from South America has steadily grown.
Regulations and necessities around maintenance require that ships are routinely dry docked, with UE dry docking their vessels a minimum of once every 24 months. Dry docking will also occasionally be required for unexpected damage, including storm damage and collisions.
Dry docking, along with the maintenance which occurs there, is a significant expense; costing UE an average of $850k per vessel per docking. However, over the past couple of years, UE has noted that the dry dock they outsource this work to in South America has been progressively more unreliable in making their facilities available for UE when required and has frequently conducted substandard maintenance, leading to delays and occasional breakdowns.
To deal with the problem, UE’s management is considering making an investment to bring the whole process of dry docking in-house. We have been engaged to advise whether they should go ahead with these plans, as well as the specific form they should take. We have been instructed that a minimum requirement for the plan to go forward is that the initiative should pay for itself within 10 years.
No complex analysis of the wider industry is required. Rather, we are addressing the simple question of whether to carry out an essential activity in-house or to outsource that activity.
Analysis
To begin, we need to establish whether the project is viable at all. Thus, we should find its cost, compare this to the current arrangements and then establish whether savings are sufficient to recoup investment over the specified 10 year period.
Additional information
The candidate should ask for additional information to establish the cost of bringing dry docking and maintenance in-house.
The candidate should be asked to brainstorm before you share additional information
The candidate can be given the following information upon request:
There are two options for bringing dry docking and maintenance in-house:
Option 1
UE can lease a dry dock facility and run it themselves, employing their own maintenance staff.
Option 2
UE can purchase its own dry dock facility outright, then employ staff and run it themselves – just as in Option 1.
Additional information:
· Each dry dock can accommodate only one ship at a time.
· Ships are dry docked for an average of two weeks each time.
· UE will need capacity to be able to dry dock ships for the repair of unexpected damage, but we do not need to consider these costs, as they will be covered by the ships’ insurance.
The candidate should be shown EXHIBIT 1
Initial Capacity Check
Before we go further and assess in-housing options, we should check that a single dry dock facility will indeed have the capacity to accommodate UE’s large fleet.
46 ships with mandatory servicing once every 24 months means 23 ships per annum to dry dock.
Dry docking averages 2 weeks.
23x2 weeks = 46 weeks per year
This means that a single dry dock will be used at near capacity, but still have some spare capacity to be able to accommodate unplanned repair work where needed.
Costs
Existing Outsourcing
Average of $850k cost per ship for 23 ships per year
Annual cost = 850k x 23 = $19.55m
Cost over 10 years = $195.5m
In-House Option 1
Labour costs = $3m
Maintenance equipment costs = $0.5m
Components for maintenance = $5m
Annual lease of dry dock = $7.5m
Total annual cost = $16m
Total cost over 10 years = $160m
$160m < $195.5m
Therefore, the investment would be returned in under 10 years.
Thus, this option is financially viable.
In-House Option 2
One-time investment to purchase dry dock = $75
To this, we add the following per annum costs:
Labour costs = $3m
Maintenance equipment costs = $0.5m
Components for maintenance = $5m
Maintenance of dry dock = $1m
Total per annum cost = $9.5m
Therefore:
Total cost = cost of dry dock + (per annum cost x 10)
Total cost = $75m + $95m = $170
$170 < $195.5
Therefore, the investment would be returned in under 10 years
Thus, this option is financially viable.
Choosing How to Proceed
The candidate should conduct an analysis of the potential costs and benefits of pursuing the various options available to UE.
In-House Option 1
Pros
· Shorter period to break even on investment
· More flexibility if the idea of in-housing dry-docking does not work as planned
Cons
· If in-housing dry-docking is a success, then the company will not own the facilities
· Cost of leasing is likely to increase in the future due to the growing shipping market in the region
In-House Option 2
Pros
· By owning a dry dock facility, UE would have taken possession of a valuable asset, which might increase in value as the shipping market in that region grows
· Removes vulnerability to changes in rates or terms of leasing – or the cancellation of that lease – by facility owners
Cons
In-house dry docking might well not work in practice – notably because UE has no previous experience in this area and would have to successfully recruit all the relevant staff etc – UE might be stuck with an asset holding no utility for them, and which might well end up being re-sold for less than its purchase price.
Maintain the Current Outsourcing Arrangement
It must be remembered that, just because the options for bringing dry-docking in-house are viable, this does not mean that they necessarily should be pursued.
Pros
· An upfront investment will not be required
· Allows the company simply to get on with its core business of moving freight
Cons
· The standard of the dry-docking service might degrade further
· Recent and possible future problems around delays and unreliability might cause UE to lose customers and/or develop a bad reputation
Recommendation
The candidate can opt to recommend any of these options so long as they provide a solid supporting rationale.
One possible recommendation is the following:
Universal Exports should pursue in-house Option 2, where they purchase their own dry dock facility.
Our quantitate analysis has shown that this is financially viable, with costs being returned within 10 years.
Attempting to bring dry docking in-house admittedly has some risk of failure. However, by maintaining the status quo, UE already risks the service from their existing dry dock becoming worse - whilst even the existing level of dysfunction might harm their brand.
The dry dock is unlikely to significantly devalue after purchase in the face of a growing shipping market in the region. Indeed, the dry dock may gain value – so even if the in-housing project does not work out, we should not lose out on the cost of the dry dock.
