HARSH ELECTRICALS – ANALYZING COST IN SEARCH OF PROFIT

On the chilly evening of 6th November, 2013 Mr. Madhusudhan Gupta, the founder of Harsh Electricals,
was in deep contemplation as he began going through the financial records of his firm. Mr. Gupta
couldn’t help but noticed again and again how the profits of Harsh Electricals had dwindled over the
years as the firm had started losing out on its dominant position in the market due to burgeoning
competition along with a surge in manufacturing and servicing costs. Harsh Electricals, which till now
acted as a specialist supplier of home appliances to various retailers in states of Andhra Pradesh,
Maharashtra and Karnataka was struggling to stay afloat due to surge in core-activity costs amidst
increasing intensity of competition. Out of sheer complacency, he had completely overlooked these
factors which got reflected in the firm’s profitability. After few tumultuous years, he was convinced that
the business needed a paradigm shift and could visualize the prosperity of his business in manufacturing
of quality appliances than supplying the over-supplied one. With his fingers on the calculator and the path
of Harsh Electricals’ new venture on his mind Mr. Gupta began to extract all the possible information
from the relevant data available to ascertain the viability of his new venture.
Harsh Electricals: The Beginning

Mr. Gupta hailed from Nanded, a small town in Maharastra, the second most populous state of India,
where his family owned retail and wholesale supplies Agency that dealt with electrical goods and home
appliances. For the initial years he single-handedly managed the procurement process of his family
business. But Mr. Gupta’s great aspirations and ambitions were limited by Nanded. Being a small town,
Nanded had a small market size with narrow exposure. The petite market had no power to quench Mr.
Gupta’s or any other like-minded entrepreneur’s thirst for success and the want to expand the business
and take it to new heights.

His entrepreneurial journey took a new turn in 2008 when he decided to move to Hyderabad, the then
capital of undivided Andhra Pradesh, a state in southern India. Hyderabad was witnessing its growth
story. From a rock city to an IT hub, it was undergoing major transformations. The surge in population
had led to booming demand for all kinds of goods and services. Due to its connectivity, infrastructure and
geography, Hyderabad had become one of the well established markets for electrical and electronic goods
in southern India. Hence, Mr. Gupta decided to shift his base from Nanded to Hyderabad.
After moving to Hyderabad, one of the steps that kick-started Mr. Gupta’s journey was his thorough door-
to-door market research. During his first stint as the procurement manager he observed the plethora of
private label brands that existed in the electrical goods and home appliances industry but remained
anonymous to the end users. He noticed a parallel state of affairs prevailing in the regional air cooler
marke tof the state because of the vast geographical stretch between the manufacturer and retailers due to
concentration of large number of manufacturers at Hyderabad and the ever increasing number of retailers
across the state. Many products and brands were not reaching the retailers due to huge bargaining power
of the distributors in the value chain. Mr. Gupta decided to bridge the gap between manufacturers and
retailers by engaging himself as a middleman. He travelled across 23 districts of undivided Andhra
Pradesh to establish a client base for his business. His business acumen, honesty and unusual negotiation
skills aided him in securing at least one large retailer from each of these districts. He was always upfront
with his clients, and believed that mutually supportive long-term supplier relationship was the best way to
achieve improvement in quality.
On assurance of the retailers, Mr. Gupta invested INR 800,000 in the form of equity to begin his business-
to-business (B2B) trading concern registered under the name of ‘Harsh Electricals’ on the 1st of April,
2008. Initially the entity dealt with supplying electrical goods and home appliances such as Air Coolers,
Fans, Hand Grinders, to all these retailers. Subsequently the product portfolio was expanded to include a
commendable range of quality approved Electric Home Appliances, Ceiling Fans, Table Fans, Wall Fan,
Electric Geysers, Room Coolers, and Exhaust Fans.

Page | 1
The Rise & Fall of Trade

The performance of Harsh Electricals for the financial year 2008-09 was exceptional. The sales reached
almost INR 4 million and post-tax profit touched 0.65 million (See Exhibit 1). The return was
overwhelming on an equity investment of INR 0.8 million. The splendid financials provoked Mr. Gupta
to start expanding his business to a few neighboring states like Maharashtra and Karnataka in the fiscal
year 2009-10 itself. The hard work of the promoter endorsed Harsh Electricals as one of the major
suppliers of electrical goods to many retailers of Andhra Pradesh, Maharashtra and Karnataka. The
growth story continued in 2010-11 as the firm experienced overwhelming financial performance.
However, the celebratory period was short lived as the financial performance declined in the fiscal years
2011-12 and 2012-13.
The decline in the net profit margin was attributed to increase in marketing and servicing cost during
those years. In fact there were a lot of grievances received by the retailers from their customers with
respect to the air coolers and other home appliances being supplied by Mr. Gupta. Further, owing to
tremendous competitive pressure from the market Harsh Electricals had to increase its marketing and
promotional expenses to sustain its competitive advantage amidst rising number of competitors. The firm
had also experienced a sharp rise in the selling and distribution expenses after entering into the
neighboring states, and there was a surge in the post sales repairs and replacement cost due to inferior
quality of products supplied by some of the manufacturers. The inadvertent inclusion of substandard
products in the product mix had shaken the strong affiliation of Harsh Electricals with its customers and
posed a serious challenge to the firm’s current core competencies.
The plunge in profits and cash flow compelled Mr. Gupta to review the market so that he could identify
the aspects of market priority, product structure and bring the required core competencies back to the
firm. Based on market mapping, Mr. Gupta brought into being that the quality of product demanded and
expected by the retailers was far away from the quality supplied by the manufacturers in the air cooler
market. The divergence of product excellence created a high discontentment towards few manufacturers.
Many customers even questioned several products’ cost effectiveness. Mr. Gupta could see the presence
of few manufacturers of air coolers in Hyderabad who were quality cognizant and their products could
only soothe the demand of 30%-40% of the state populace interested in buying superior products. This
insight helped Mr. Gupta discover the potential that lied ahead in the market. He could visualize a big
market opportunity for the manufacturers provided the products were appealing to customers, sold with
an assurance of good quality and promised a better life than its peers. He believed that air coolers
manufactured with superior manufacturing performance, continuous improvement and change will bring
back the competitiveness of the firm, lead to more productivity, capture quality and as well as efficiency
features.
The Manufacturing Decision
Mr. Gupta was certain that his good reputation in the market will be able to attract the retailers again
towards his product and Harsh Electricals could be a big name in the region of its operation. He
recognized the potential of a striking surplus in manufacturing of air coolers. Primary research conducted
by him revealed that average profit to the manufacturer from the sale of a standard air cooler priced
around INR. 2300 was approximately 15%. This provided huge incentive to Mr. Gupta who was aiming
to start his own manufacturing unit for producing air coolers with high quality assurance. With the large
network of retailers in hindsight, Mr. Gupta could think of selling 4,000 to 4,500 coolers smoothly in a
year though the number may climb up to 5,000 units a year. In fact the air cooler business was seasonal in
nature; hence Harsh Electricals had to operate for a maximum period of six month in a year.
Harsh Electricals wanted to position the product differently for a mildly higher price. The differentiation
was to be made on fragility and cooling capacity. Air coolers came in three different variants: plastic,
fiber and iron. Plastic air coolers were very fragile and did not have a favourable image amongst the
customers. Iron coolers, though had longer life, were not favored by people living in the sub-temperate

Page | 2
zone around Hyderabad. Hence, Mr. Gupta thought of manufacturing fiber air coolers exclusively. Sales
in the residential air cooler market were narrowly tied to three factors: cost, life and the cooling capacity
of air cooler. But only the manufacturers knew that high air cooling capacity was only possible without
compromising on the cost i.e., competitive priorities such as cost and quality had a positive relationship
with each other. The competitive strategy of Harsh Electricals would be to manufacture fiber air coolers
with high cooling capacity at a competitive price. Mr. Gupta was almost sure that the product of Harsh
Electricals would generate high economic value to its customers (EVC).
Mr. Gupta was in no doubt that to run his show resourcefully, he needed the help of some bright,
experienced and ingenious talent to organize and manage work processes in innovative and efficient ways
to compete in the market. In addition to skill and experience, the person was required to have high level
of spirit, commitment and potential to take his business a long way without compromising with the value
system of Harsh Electricals. During the autumn of 2013 Mr. Gupta had an opportunity to meet Mr.
Nagesh, a skilled mechanical labor in the industry, at a party organized by an air cooler manufacturer on
the eve of Dussehra1. Nagesh, with little more than 10 years of experience in the cooler manufacturing
sector, was managing two assembly lines 2 simultaneously in a manufacturing unit while making sure that
they synchronize seamlessly. Since Mr. Gupta was desperately looking for an individual with such skills
and qualities for setting up the manufacturing unit, he seized the opportunity and shared his mind without
further delay. Both of them agreed to meet over dinner on 18th of June 2013 at Hotel Paradise in
Hyderabad.

After two long hours of conversation on the dinner table both the gentlemen built a consensus for
manufacturing two different models of fiber air cooler – a STANDARD model and a BALENO model at
the beginning. The standard model would look sturdy and was to come with a water capacity of 60 liters.
The cooler was intended to have a powerful air flow with air delivery of 1100 cubic meters/ hour. The
Baleno model was designed even more powerful with air delivery of 1500 cubic meters/ hour and a tank
that could store water up to 80 liters. The Baleno model could be considered as first of its kind in the fiber
air cooler segment; it was designed to compete with Iron made heavy desert coolers and for consumers
living closer to the tropic.
During the conversation Mr. Gupta could notice all the qualities and competencies in Nagesh that he was
looking for his business. He also found Nagesh discontented with the quality of work output he was
delving with, and the meager salary that he was getting for his hard work. Based on the proficiency and
expectations of Nagesh, Mr Gupta made up his mind to offer an annual package of INR 6, 00,000to pull
Nagesh to his side. Mr Gupta was almost sure that INR 6, 00,000, a hike of fifty percent over current pay,
would be suitable to both the parties. But the pay and allowances were to be finalized in the next round of
meeting scheduled over a weekend on 7thNovember, 2013 at his office where Nagesh was asked to bring
his ideas and numbers to the table.
Manufacturing of Coolers – The Investment & Cost Information

The coolers were to be manufactured through a process called progressive assembly. Assembly line
would have workers to complete a specific task on the product as it continues along the production line
rather than complete a series of tasks. Assembly lines had been a commonly used method of producing
complex products like automobiles, computers, electronic items and home appliances etc. Most of the
assembly lines for these complex products were progressive lines and were designed for a sequential
organization to minimize the motion of workers. Exhibit 2 presents the progressive assembly line for
manufacturing of air coolers. The progressive line was supposed to increase efficiency by maximizing the
labour output (productivity) relative to the cost of labor.

1
A famous festival in India symbolizing the triumph of good over evil
2
Body assembly, and Motor-blade-panel assembly

Page | 3
Mr. Gupta, after a proper due diligence, concluded that a firm like Harsh Electrical had to be equipped to
manufacture forty coolers per day at full capacity if it had to meet the seasonal need of 4000 to 4500
coolers. In order to build the capacity, Harsh Electricals would have to enter into a three years lease
agreement with a local real estate developer for designing the workshop on 1200 square feet commercial
area. A good negotiator like Mr. Gupta could certainly be able to get the property at lease rental of INR 8
per square foot per month though the rate could go as high as INR 9 per square foot per month. Mr. Gupta
planned to allocate 150 square feet of the area for his office and the rest to utilize for the workshop. Rent,
being a contractual expense, was to be paid even if the production did not take place in a particular
month. The rental agreement was expected to have a strong clause for security deposit of around INR
80,000 by the tenant to secure the property owner from any distressful event. Additionally, the firm also
planned to acquire fixed assets worth INR 500,000 including machineries like conveyor belt and a tool kit
for each worker to ensure that the assembly line ran efficiently to achieve maximum capacity. Exhibit 3
presents the details of the fixed assets such as the cost, life and the salvage value of the assets.
The manufacturing cost of producing an air cooler consisted of primarily raw materials, labour and other
manufacturing expenses. The raw material component cost would represent a major chunk of
manufacturing cost of an air cooler. Exhibit 4presents the raw material cost details and required inventory
holding of the raw materials. The raw material components and their cost was to remain fixed for
production of each unit of cooler hence the total cost of raw material of Harsh Electricals was likely to
change with total volume of production. With high volume of production the total raw material cost was
to increase proportionately and in the low volume scenario the total raw material cost was expected to be
low. The firm could avail 15 days credit from the suppliers on 40% of the raw materials and remaining
raw materials were to be procured on cash. Mr. Gupta chose to follow a moderate working capital policy
and decided not to park funds unreasonably in illiquid current assets. Inventory management was to be
based on Fixed-Order Quantity System. Under this system, a firm reordered only when a stock reached
the minimum limit set earlier by the firm. This was done to free up workshop space and loosen the cash
flow.
The labour cost in manufacturing air coolers had two components: fixed and variable was expected to
exhibit two different patterns, i.e., fixed and variable labour costs. The salary of Nagesh, being for
management of the manufacturing floor, was not to bear any relation with the volume of air cooler
production. In order to run the assembly line for producing 40 units, Harsh Electricals would require
employing five casual workers on daily basis. As per employment regulation of the state, the casual
workers were to be paid at least INR 200 per day for 8 hours of employment. The labour time and cost
involved in manufacturing coolers were expected to vary with the variation of models. While the Standard
model was expected to consume 60 minutes of assembly line labour, the Baleno Model was to capture 72
minutes. Therefore the number of casual workers to be employed was an outcome of the daily production
schedule.
Besides the run labour, Harsh Electricals had to appoint a staff member for setting up machines before
each production run and handling the materials. The employee would be offered a monthly salary of INR
6,000 for the sixth months of production season. Harsh Electricals had also to outsource some services
that included transportation of raw materials and drilling bits on the body of the cooler. In order to avoid
botherations Mr. Gupta thought of approaching suppliers for a door step service of raw materials at an
additional cost of 0.5% of the cost of raw materials towards the freight. Door step services were evolving
and gaining popularity those days because of convenience and cost effectiveness. Similarly, few local
agencies known for drilling bits were charging INR 10 for drilling on one cooler irrespective of the
variation of models. All the fixed costs, i.e., the costs that had to be paid irrespective of the number of
units produced, were to be paid on a monthly basis, and the drilling bit and run labour were to be paid on
a fortnight basis or as per the credit arrangement.
To establish the total energy consumption of Harsh Electricals, Mr. Gupta focused on facility-level
consumption to determine a facility’s energy consumption. The kilowatt hour (kWh) cost of electricity for

Page | 4
commercial purpose was fixed by the then state government at INR10 per unit3 and Harsh Electricals was
supposed to be charged for 1000 units minimum for month even when the production would not take
place during non-seasonal part of the year. Monthly power consumption for the factory lighting, computer
and office lighting were estimated as given in Exhibit 5. In order to provide a safety cushion against the
unforeseen contingencies, Mr. Gupta decided to go for the workshop insurance that might cost around
INR 25,000 for the first year and would subsequently be renewed annually. The firm would also have to
pay for the wires, screws, bushes, nuts and bolts, and oiling of the machinery employed on the production
floor. The total cost to be incurred on these items in particular to manufacture a volume of 5000 coolers
was estimated to be INR 45,000 though the exact amount could be known at the time of production. The
amount was expected to go up by INR 5,000 with every 1000 subsequent units. Despite the fact that the
amount appeared to be on the higher side and unconvincing, the industry experience was different as most
often consumables like thick rubber bush, packing materials and wires that reduce the noise of an air
cooler were shifting the cost to upside.
Mr. Gupta could find a ready money of INR 1.2 million in his account to put as an equity investment for
the upcoming venture. The assets were financed using the equity and no debt financing was planned since
its requirement was not felt. However, need be he planned to raise the additional amount required for
working capital either through a revolver4 loan or from a private money lender. While revolving credit
was available at 14% per annum the private lenders were free to charge any rate as high as 60% but Mr.
Gupta thought of managing to get the rate as low as possible to 24% from a close source because of his
credibility in the market. Even though financing through private lenders was expensive, many small
entrepreneurs preferred it as the money was available on call and there were no transaction costs
associated with the funding. Hence, it was a flexible choice for the firm to borrow money from the market
instead of banks.
Harsh Electricals – The Marketing Strategy
By the end of July 2014 the firm was anticipating to sell 4000 air coolers. Mr. Gupta paid special
attention to the pricing so that his products can penetrate the air cooler market. In search for an “optimum
price” for his products he considered various key factors, like pinpointing the target customer,
competitor’s pricing, relationship between price and quality, etc. After a thorough market mapping he
decided that the air coolers manufactured by Harsh Electricals should be sold above the prevailing
manufacturer’s price of INR 2300 because of the differentiation strategy. This, he believed, would help
him in sending strong messages to the consumers and assist his firm in positioning the brand of “Harsh
Electricals” in the minds of the retailers and consumers. Thus, with a premium pricing strategy to reflect
the exclusiveness of his air coolers, he decided to sell the Standard model for INR 2500 and the Baleno
model for INR 3000 to the retailers. The manufacturer’s price was mapped per se to make the products
available to customers at INR 3500 and INR 4000 for Standard and Baleno model respectively allowing a
margin of 25 -30% to the retailers. The sales mix of the two models Normal and Baleno were expected to
be in the proportion of 4:1. Mr. Gupta also planned on having 60 air coolers of Normal model and 10 of
Baleno made to meet any unforeseen demand during the off-season.
As a differentiator, Harsh Electricals had planned to follow a liberal credit policy by allowing a credit
period of 14 days to its customers, against the industry benchmark of 10 to 12 days. For the delicate
relationships maintained by Mr. Gupta with individual retailers, he expected none of the customers would
default in terms of payment days baring few exceptions. All the air coolers assembled were dispatched on
the same day and no work-in-progress inventory for the coming day. The firm also had to bear an
additional cost of INR 10 per cooler as distribution cost which was not usually recovered from the
retailers as a market practice. He also expected that the tax rate levied on SMEs would not change

3
One unit is 1 kWh is the amount of energy used by a 1kW (1000 watt) electric heater for 1 hour
4
Revolver is an arrangement for a line of credit with financial institutions that allows the entity to withdraw, repay,
and again redraw the amount sanctioned at any point of time till the arrangement expires.

Page | 5
drastically anytime soon in the foreseen future. Along with this he anticipated that his firm would earn a
minimum interest of INR 8,000 on the funds that were parked in the bank after the season was over.
The Preparation
With Mr. Nagesh to his side and a major gap in the air cooler market in South India, Mr. Gupta
premeditated to wind up his trading concern and setting up a manufacturing unit in January, 2014,
provided the product profitability were encouraging to support his manufacturing decision. Mr Gupta had
finally realized that for his new venture to thrive, he will have to assess the costs accurately and with due
diligence so that he can avoid repeating past mistakes. Before the second round of discussion with
Nagesh, Mr Gupta started accumulating the costs as his mind mused on the profitability of the models if
they were to be sold at INR 2500 for Standard and INR 3000 for the Baleno model. He was wondering on
the minimum number of coolers that were to be sold by Harsh Electricals for safeguarding itself from
losses. Mr Gupta, in the trading business, had earned profit as high as INR 8, 59,846 in the previous years
and was wondering what should be the volume of sales to achieve the same level of profit in 2014. Gupta
was murmuring what if the revenue and profit are not attainable……..?

Page | 6
EXHIBIT 1 – INCOME STATEMENT OF HARSH ELECTRICALS
2008-09 2009-10 2010-11 2011-12 2012-13
Sales 3,960,000 4,560,000 5,052,000 4,335,000 4,050,000
COGS 2,991,000 3,285,000 3,713,220 3,208,000 3,120,000
Gross Profit 969,000 1,275,000 1,338,780 1,127,000 930,000
Marketing expenses 96,000 156,000 170000 186,000 175,000
General and Administrative 66,000 72,000 73000 75,000 84,000
expenses
Replacement and service cost 22,000 56,000 64000 93,000 151,000
EBITDA 785,000 991,000 1,031,780 773,000 520,000
Depreciation and Amortization 54,000 54,000 54,000 54,000 54,000
EBIT 731,000 937,000 977,780 719,000 466,000
Interest 0 0 0 0 0
PBT 731,000 937,000 977,780 719,000 466,000
Tax 87,720 112,440 117,334 86,280 55,920
Net Income 643,280 824,560 859,846 632,720 410,080
Source: Company Records

EXHIBIT 2- PROGRESSIVE ASSEMBLY LINE

Page | 7
EXHIBIT 3 – FIXED ASSETS

Asset Cost Life (years) Salvage Value

Plant and Machinery 320,000 5 20,000

WorkshopFurniture and Fixtures 40,000 10 NIL
Office Furniture and Fixtures 60,000 10 NIL
Computer & Software 80,000 5 NIL

EXHIBIT 4 - RAW MATERIAL COMPONENTS, COST AND INVENTORY HOLDING

PERIOD

Cost for Cost for Inventory Credit Period

Standard Baleno Holding period (No. of
Raw Material Component Model Model (No. of Days) Days)
Body 650 830 1 0
Motor 500 630 10 14
Pump 90 110 10 14
Blade, Clamp & Wiring 168 205 10 14
Pipe, Water Distributor & Panel Set 190 210 10 0
Diverter 110 110 10 0
Packing (Carton &Labeling) 40 50 10 0
Wheel(Set) 30 40 10 0
Total 1778 2185 - -

EXHIBIT 5- MONTHLY POWER CONSUMPTION

Item Peak Load Consumption Off Season Consumption

(in kWh or Units) (in kWh or Units)
Plant & Machinery 1 units per Standard cooler+ 10 units (For Maintenance)
1.5 Units per Baleno Model+
10 units For Maintenance
Factory Lighting 300 100
Personal Computer 50 20
Office Lighting 100 40

Page | 8