TTE compatible batteries

Our client is TTE, an IT distributor who deals in spare parts but also manufactures laptop batteries that are compatible with most major brands (HP, Lenovo, Dell). Hewlett Packard have approached our client to produce a compatible battery for their new model of laptop, set to come out at the end of the year. The battery should be priced much lower than the original model to constitute a cheaper alternative. TTE has also pre-ordered a significant quantity of the new battery model (Original Equipment Manufacturer model or OEM) , to have in stock when the new HP model is released. They have now approached us to understand the pros and cons of accepting HP’s request. 

Identify the problem

Candidate: ‘Can we understand that the list of pros and cons will determine whether TTE will invest in the new HP product?’. 

Interviewer: Yes, they would like to determine whether they should invest and what the commercial strategy should be if they decide to do so.

Candidate: So really what we need to determine is whether TTE’s investment in the HPE batteries would be profitable and if yes recommend next steps?

Interviewer: Yes

Build the structure

Candidate: In assessing the profitability of the new venture I would like to examine the potential revenue stream from the main sales channels, B2B and B2C versus the costs of the investment, which include both the variable and fixed costs of producing the new compatible and the loss of profit from the cannibalization of revenue from OEM batteries.

Lead the analysis

Candidate: Since TTE has a significant investment in the OEM batteries I would like to start on the costs side and consider the risk of cannibalization and whether this can be mitigated as well as any additional costs of production and potential synergies

I would like to start by understanding what TTE’s investment is in the new HP batteries.

Interviewer: TTE has invested $500m in OEM batteries representing 10 million batteries and they can be sold at a mark-up of 10%.  

Candidate: The biggest risk given the investment in OEM would be that of cannibalization. I would like to hypothesize that TTS will lose at least 30% from sales of OEM.

$550m x 1.1 = $550 m in profit for OEM

0.3 x $550m = $16.5m cost of cannibalization

Candidate: Next I would like to look at production costs for the compatibles - can you tell me anything about the cost structure and potential synergies, given that TTE already produces compatibles, as well as how many batteries TTE would be expected to produce 

Interviewer: Sure! The variable cost of producing one compatible battery is $30 and HP estimates they can be marked up at 30%. HP has ordered 5m units which can be produced in TTE’s current factories by ramping up production with no additional fixed costs.

Candidate: Thank you! So the total cost of the investment would be that of the variable costs plus the cost of cannibalization:

(5m x $30) + 16.5m = $165m

Next, I would like to look at the revenue side and calculate the total potential revenue. HP has said according to their market research the batteries can be marked up at 30%

This means $30 x 1.3 = $39 - we can approximate to $40 per battery

$40 x 5m = $200m revenue

However, I would like to understand the different revenue streams and capabilities that TTE as well as the market size for compatibles, to determine whether this revenue would be achievable. I would like to hypothesize that since brand is important to consumers, most sales will be B2B Can you tell me anything about the B2B compatibles market and TTE’s business capabilities?

Interviewer: TTE sells mainly to consumers (B2C) and controls a relatively low percentage of the B2B market for compatibles which is estimated at $30bn:

Candidate: Ok so let's calculate the market penetration TTE would need to achieve:

200m/30bn = 0.66 market penetration 

This seems feasible based on the B2B market alone so there is no need to look at the breakdown of the B2C market.

Finally, do we know anything about the ROI which TTE expects on this project?

Interviewer: Indeed, TTE expects at least 20% ROI for this stage of the project

Candidate: Therefore we can calculate this as:

Profit from investment/Cost of investment x 100

So $200m - $165m/165m x 100 =  21% 

So the investment would yield the expected ROI

I believe I can move to the final recommendations

Recommendation 

Candidate: I recommend that TTE invest in producing the HP batteries for the following reasons.

First, the investment meets the profitability criteria of TTE, with a 21% expected ROI (vs. 20% required). TTE is already equipped to produce compatibles so there would be no additional fixed costs associated with ramping up production so TTE can also achieve economies of scale, for example in negotiating better deals with suppliers of materials for larger quantities.

Secondly, TTE would be required to capture a relatively small size of the B2B compatibles market, at 0.66%, which should be feasible considering TTE’s current market position. 

Finally, from a future perspective, the margins for private label compatible batteries are significantly higher and offer a higher profit ratio than OEM, which would mean the same profit can be made by selling fewer items, reducing additional costs such as warehouse space.

The potential risks are the lack of a strong B2B division of TTE since the majority of sales come from the consumer segment (given more time I would like to further analyse the potential costs associated with ramping up B2B sales in the future).