Sunk Costs and Supply Chain Rescue

Nadia Clarke

Picture this. It is exactly twelve weeks before the holiday launch of your flagship product. You have got a three thousand unit pre order locked in with a massive urban logistics client, a strict delivery deadline of November fifteenth, and then, boom. Your primary casting supplier in Taiwan gets hit with sudden power grid rationing. Your custom structural aluminum chassis is delayed by six full weeks. Suddenly, you are staring down a forty thousand dollar per week late penalty, and even worse, a thirty percent contract cancellation risk. That is a cool one point three five million dollars in profit just vaporizing. What do you do?

Nadia Clarke

This is the exact scenario VoltGlide faced with their next generation heavy duty electric cargo scooter, the VG four Atlas. With their gross margin sitting at fifteen hundred dollars per scooter, they could not just sit and take the hit. So, they looked for a savior, and they found one in Monterrey, Mexico. Sierra Madre Casting. Sierra Madre says, yes, we can build the tooling and deliver all three thousand chassis on time by November fifteenth. But, there are two major catches. First, their base price is two hundred sixty dollars per unit, compared to Taiwan's two hundred twenty dollars. And second, they need a hundred fifty thousand dollars upfront to construct a brand new die cast mold. For a growing company, writing a check for a hundred fifty grand on the spot is a massive cash flow killer. So, Sierra Madre offers a classic lifeline. A tooling amortization agreement.

Nadia Clarke

Instead of billing that hundred fifty thousand dollars upfront, they offer to spread, or amortize, the cost of production tooling across an agreed volume of parts. Specifically, they set a tooling amortization quantity of six thousand units. To make the math work, they calculate and specify the tooling cost per unit of finished product manufactured. In this case, that is a twenty five dollar adder, which they call the cost of finished part manufactured, or CFPM, adder. So, instead of paying a hundred fifty thousand dollars on day one, VoltGlide pays zero upfront. But, the purchase price for those initial units jumps from two hundred sixty dollars to two hundred eighty five dollars per chassis. It sounds like a perfect win, right? You preserve your cash, you hit your November launch, and your customer is happy. But there is a massive catch hidden deep in the contract. The true up clause. Sierra Madre is not a bank. They want their hundred fifty thousand dollars one way or another. If VoltGlide decides to pull the plug after that initial three thousand unit run and go back to their cheaper supplier in Taiwan, the true up clause kicks in. They have to pay a lump sum bill for the remaining three thousand unamortized units, which comes out to seventy five thousand dollars, due within thirty days.

Nadia Clarke

Now, if you are a procurement manager, seeing a seventy five thousand dollar penalty landing on your desk feels like a massive failure. It looks like a classic mistake. Your natural reaction, which I see all the time, is loss aversion. You think, well, to avoid paying that seventy five thousand dollar penalty, we just have to stick with Mexico for the next three thousand units until the tooling is fully paid off. But, this is where the classic financial trap closes shut. Let us actually do the marginal math here.

Nadia Clarke

If VoltGlide stays with Mexico for the full six thousand units to avoid the true up bill, they pay two hundred eighty five dollars per unit. Six thousand units times two hundred eighty five dollars is one point one one million dollars. Now, let us look at the alternative. What if they switch back to Taiwan after that first run and willingly pay the seventy five thousand dollar true up penalty? For the first three thousand units, they pay Mexico eight hundred fifty five thousand dollars. Then they pay the seventy five thousand dollar true up bill. Then, they buy the remaining three thousand units from Taiwan at their cheaper base rate of two hundred twenty dollars, which costs six hundred sixty thousand dollars. If you add those three numbers up, eight hundred fifty five thousand, plus seventy five thousand, plus six hundred sixty thousand, you get, one point five nine million dollars. By choosing to pay the penalty and switching back, VoltGlide actually saves one hundred twenty thousand dollars!

Nadia Clarke

It seems counterintuitive, but it is the sunk amortization principle in action. Amortized tooling is not a variable production cost. It is a deferred capital liability. Once you commit to that first run, that hundred fifty thousand dollars is a sunk cost. You owe it no matter what. The only thing that matters for your next run is the actual marginal unit price difference, which is two hundred sixty dollars in Mexico versus two hundred twenty dollars in Taiwan. Because Taiwan is forty dollars cheaper per unit, making the switch easily pays for the penalty and drops real cash back to your bottom line.

Nadia Clarke

So, let me leave you with a question for your own operation. When you analyze dual sourcing alternatives, are you treating amortized tooling as a variable cost of goods sold, or are you tracking it as the deferred balance sheet liability it actually is? Think about it. Talk to you next time.