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Read the following case carefully and answer the question that follows.
China Dolls
________________________________________________________________________
Jeffrey Cheong picks up the folder marked URGENT which his secretary had just
placed on his table and looks at its contents. The folder contains letters from two of his
major clients, KiKi and Houida. Both KiKi and Houida, two European fashion houses
were HCFs first customers and have been with HCF since its inception. They were
writing to Jeffrey to inform him that they may be looking to China to contract
manufacture for them as the prices are very competitive.
Jeffrey stares out of his window in contemplation. He is in a dilemma. Loss of its major
two clients would be disastrous to HCF. As it stands now, HCF has been experiencing
falling margins and profits over the last few years as evidenced in the financial statements
enclosed. Loss of KiKi and Houida would mean that HCF will now be incurring losses.
(see Appendix 1)
As soon as his other clients hear of this new development, they too would be taking
similar steps. Jeffrey realises he has to review his strategy quickly if he wants to retain
the present clientele. He knows the inevitable. During the late 1990s and into the early
21st century, China has made inroads into the textile industry and is forecasted to grow
further. Following the relaxation of trade barriers, many of the European and American
fashion houses are now looking at importing clothes from China at very low prices. This
is mainly due to its low operating costs. This had a massive negative impact on many
companies operating at higher cost base elsewhere. The previous adverse perception of
Made in China labels has slowly changed as China now manufactures clothes that are
of higher quality at substantially lower operating costs. If Jeffrey wants to survive in this
industry, he too must consider moving his operations to China.
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and womens clothes. It had no difficulty meeting the demand of the fashion houses as
Peter had recruited several European-trained Malaysian designers to join his team.
By the late 1970s, HCFs turnover had reached RM 10 million. Over the ensuing five
years since its inception, HCF had managed to add two more European fashion houses to
its customer base. HCFs talented designers were providing inputs toward the
development of the ready-to-wear designs and were well received by the fashion houses.
HCF was now faced with a problem. The factory located in Penang is no longer big
enough to cope with the production capacity. Peter quickly sourced a large plot of land in
mainland Penang Butterworth and began building a new much larger state-of-the-art
factory to cater for the growing demand.
In July 1980, HCF opened its new factory in Butterworth. Peter, now the Managing
Director of HCF decided not to shut down the Penang island factory but operated both
factories. HCF now employed between 80 100 employees, mostly tailors in the Penang
factory, while the Butterworth factory employed about 300 employees.
HCF continued to experience growth in sales throughout the early 1980s to mid 1990s,
charting annual sales of around RM 100 million. Its customer base had also increased,
drawing in customers from Europe as well as America. Profits were also riding high.
HCF opened two more factories. In 1990, it opened its third factory in Jitra, Kedah. The
factory had a capacity of producing 1 million garments a year with a staff strength of 300
employees. In 1995, due to ever increasing demand for its clothes, HCF decided to open
its fourth factory with a production capacity of 2 million garments a year. This time it
looked to Thailand as labour is very cheap. HCF set up a wholly owned subsidiary Haute
Couture (Thailand) Pte. Ltd to operate the Chieng Mai based factory. It recruited a total
of 500 employees.
In 1997, Malaysia was facing a financial crisis, with foreign exchange market volatility
being the main issue. Manufacturers with foreign customers were unable to honour their
contract price as exchange rates fluctuated. HCF was caught unaware. HCF has to tender
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for contract six months before the delivery of the consignment. Fluctuations in the
exchange rates made it impossible to predict the cost of material that HCF has to
purchase from the fashion houses. HCF found itself selling its garments at very low
margins for the first time. 1998 saw HCF suffering its first loss since its inception. Many
of its competitors also suffered losses and some even had to cease manufacturing. In a bid
to survive the financial tsunami that had hit Malaysia, Peter Tan consolidated HCFs
position by deciding to cut operating costs. HCFs major cost apart from the cost of
imported material was labour cost. Peter Tan made the decision to shut down the Penang
factory, much to the dissent of his father. HCF was still able to meet the demand while
still operating the other three factories in Butterworth, Jitra and Chieng Mai. He also
decided to shift as much of the production to Chieng Mai as the labour cost was a quarter
of the labour cost incurred in the Malaysian factories. Moreover, HCF was facing labour
shortage problems in Malaysia, as many of the labour force were moving to the cities for
better prospects. As a result of this consolidation exercise, about 300 of HCFs employees
were made redundant, many of whom have been with HCF since its inception.
Over the next few years, its profitability increased gradually and HCF slowly pulled itself
out of the loss making situation. HCF managed this difficult feat because of its customer
base as well as its reputation for high quality clothes which commanded premium prices
with its customers. The financial crisis had not affected Europe much and as such,
demand for the clothes continued.
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Further, the European fashion houses would supply the material for the clothes as they
want to maintain the quality of the output. HCF purchases the material, source for
appropriate accessories locally and produces the clothes. The fashion houses would
contract for a specific quantity of a specific design at a specific quality to be delivered
at a specific time. Any variation outside the contract stipulation will have to be borne by
HCF itself.
Usually the contracts are for delivery of clothes one season ahead. This means that
summer clothes will have to be delivered by the beginning of spring. HCF will sell the
manufactured clothes at a contracted price. The fashion houses allow HCF to tender for
the contract price based on the design, quantity and price of materials supplied. The
contract tendering process usually takes place about six months before the due date for
the delivery of a seasons batch.
HCFs Customers
HCF manufactures ready-to-wear clothes for a number of European and American
fashion houses. Its clothes are well-sought after for its modern designs and high quality
finishing. HCFs customers have remained loyal over the last three decades, although its
major feat was the securing of two major American fashion houses as its customers
within the last 5 years. All of HCFs clothing is manufactured under the customers own
label.
The customers of HCF can be analysed as follows:
(2008 figures)
Customer
Turnover
% Sales
(RM million)
KiKi
Houida
McCaffery
Jesse
Freuline
Elegance
TommyH
Balli
Zubri
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32.0
21.0
17.4
9.4
8.3
11.3
8.0
6.5
6.1
120.0
26.7%
17.5%
14.5%
7.8%
6.9%
9.4%
6.7%
5.4%
5.1%
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HCFs Shareholders
HCF was successfully listed in early 2007 and at the end of 2008, its shares were held as
follows:
% Shareholding
Tan Boon Kheong
Peter Tan
Daniel Tan
Elaine Tan
Beverly Tan
Elvis Lee
Lee Teck Choon
Adrian Lim
Employee-held shares
Public-held shares
19%
25%
10%
5%
5%
3%
2%
2%
4%
25%
100%
The company has 57 million shares in issue at a par value of RM 1 each. The share price
at the time of floating was RM 2.50 per share. Market price as at 31 st December 2008 was
RM 1.80 per share.
HCFs Board of Directors and Key Personnel
Board of Directors
Tan Boon Kheong Founder Chairman and first Managing Director
Tan Boon Kheong is the founder chairman of HCF Bhd. He started the company as a
business venture for his son, Peter Tan who had returned from Europe as a newly
qualified designer. He retired as Managing Director in 1980 but kept a close personal
interest in the company he founded with his hard-earned money. The Board of Directors
still look upon him for valuable advice in managing the company. He still retained his
19% shareholding in the company and is a director of the company
Peter Tan Current Chairman
Peter Tan, the eldest son of Tan Boon Kheong is the brains behind the success of HCF. As
a newly trained designer in the 1970s, he was the inspiration behind the setting up of
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HCF. With his contacts with the various fashion houses in Europe he managed to secure
good contracts on behalf of HCF. HCF grew from strength-to-strength under his
leadership. He took over from his father as Managing Director / Financial Controller in
1980 and continued to lead HCF until his retirement in early 2009. He still sits on the
Board of Directors as the chairman. He holds 25% shareholding. He is also the Managing
Director of the Thailand operations
Daniel Tan Financial Controller
Daniel Tan is the youngest of the Tan children. He has held the position since 1990, when
he returned as a qualified accountant from the United Kingdom. He took over the role
from his brother Peter Tan, when the latter was bogged down with too much work as a
Managing Director. Prior to his return, he worked in the United Kingdom for one of the
largest audit firms in the country. He is considered to be a whizz in finance and has a
good working relationship with his brother, Peter Tan and the rest of the employees of
HCF.
Daniel Tan also has a good working relationship with HCFs bankers and has helped HCF
secure / renegotiate loans and extend credit arrangements whenever needed. He is
concerned about HCFs present situation, as he feels that HCF will be unable to meet the
situation in the same manner it resolved its previous setbacks.
Elaine Tan Sales & Marketing Director
Elaine, sister to Peter and Daniel has worked with the company for the last 15 years. Prior
to her joining HCF, she worked for a large departmental store in Kuala Lumpur as the
Chief Purchasing Manager. Her role was to secure clothes for the departmental store. At
HCF, she has the challenging task of maintaining a relationship with all of HCF
customers the fashion houses from Europe and American. The designers from these
fashion houses are said to be very temperamental. Her time is taken up negotiating and
securing contracts with these fashion houses. She now has her hands full with the present
situation, trying to keep the customers from cancelling crucial contracts. She sits on the
Board of Directors.
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staff. He has successfully introduced improved working conditions and total quality
management skills to the employees. He is a certified TQM operator.
Current Position
Having read the two letters form KiKi and Houida, Jeffrey quickly called for a
management meeting with his key personnel to discuss possible strategies to address the
situation HCF is currently facing.
During the brainstorming session, Elaine the Sales and Marketing Director proposed
that HCF considers moving its manufacturing to China. This way, HCF would be able to
still retain KiKi and Houida as its customers and supply the clothes at lower prices. She
also proposed that HCF shuts down its existing plants in Butterworth, Jitra and Chieng
Mai.
Teoh Chin Teh Factory Operations Director, on the other hand was not interested in
closing own the Malaysian operations completely. He argued that if HCF were to
completely close down the Malaysian operations, a large number of employees will have
to be retrenched. Many of them have been with HCF for more than 10 years.
He suggested two alternative options. Firstly expand manufacturing operations to China
to focus on contracts from fashion houses, while retaining the Malaysian operations to
develop HCFs own label, to be marketed to the Malaysian and Asean market. Secondly,
he suggested that HCF completely pull-out from the activity of contract manufacturing
since the remaining customers may also pull out on hearing the news that KiKi and
Houida had pulled out. He suggests that HCF concentrate on developing HCFs own label
by producing out of the Malaysian operations.
Jeffery reiterated that no clothes manufacturer should ignore Chinas influence and that
HCF needs to have a strategy with China. According to his research almost 30% of the
European fashion houses are now selling Made in China labels. If HCF were to
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continue retaining its current customer base, it has to consider moving operations to
China. Daniel Tan was assigned to research into the possibility of expansion into China.
After several weeks of research, Daniel came up with the following information:
Proposal to expand to China
The management team had discussed two possible ways of expanding into China:
Setting up its own factory in China that is large enough to manufacture clothing
for its existing customers.
The first option would require HCF to invest a large sum of money in China. Currently
HCF does not have sufficient funds to finance this expansion. HCF would have to look
for alternative sources of funds. Therefore, this option will not be possible without the
full support of the Board of Directors of HCF. Peter Tan, the current Chairman of HCF is
keen with this option as he feels HCF would lose its independence should it consider a
joint venture. However, the option of expanding into China on its own would require
careful consideration.
Daniels research had produced the following information:
Cost of building a factory (fully equipped) RM 15 million
Net present value (over 5 years) RM 6.3 million
Cost of capital used 8% p.a.
The new factory would be able to manufacture at a similar capacity as its current
operations in Butterworth, Jitra and Chieng Mai in total. The new factory would be ready
in about 18 months.
The second option however would require a much shorter period to become operational.
Elaine is in favour of this option. By entering into a joint venture with an existing
Chinese manufacturer, HCF would be able to service its customers in about 6 months
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instead of waiting for 18 months for the factory to be ready. Daniel contacted several
Chinese clothing manufacturers who had large factory operations with excess capacity.
After evaluating all the proposals, he short-listed Celestial Clothes as a possible partner.
Celestial Clothes has been manufacturing since 1995 for several British High-Street
stores and is interested in penetrating the European market. It has already established
itself as a high quality clothes manufacturer.
The joint venture proposal would be a 70/30 profit share with Celestial Clothes taking
70% stake. Both HCF and Celestial Clothes would form a separate company under the
joint venture agreement. Celestial Clothes would need to build an annexure to its current
factory to cater for this new venture as HCFs want the manufacturing activities to remain
separate from Celestial Clothes existing business. The total cost of this expansion is
estimated to be equivalent to RM 8 million with HCFs investment at RM 2.4 million.
Celestial Clothes would be able to manufacture almost one and a half times HCFs
current manufacturing capacity. If HCFs Board of Directors agrees to the joint venture
proposal, Celestial Clothes will immediately proceed to build the annexure and begin
manufacturing in 6 months time. Daniel has provided details of the cash flow this joint
venture company would provide over the next five years. The calculations are provided in
Ringgit equivalent, using forecast exchange rates.
(RM millions)
HCFs share of
Post tax inflow
2009
2010
2011
2012
2013
0.4
1.8
2.5
4.1
5.6
Since the joint venture proposal has a higher risk than HCF running its own operations,
Daniel is proposing using a higher risk factor of 12% to evaluate this proposal. There is
also a risk of the Chinese currency fluctuating against the Ringgit over the next 5 years as
the forecasted exchange rates cannot be assured. Daniel expects the above cash flow may
further be affected by a 5% negative variation if exchange rates move over the next 5
years.
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still operate out of the factories in Butterworth and Jitra, while closing down the Cheing
Mai factory.
Jeffrey is concerned with the demand for HCFs own label in Malaysia and Asean region.
HCF is a relatively unknown company in this region. It has always been manufacturing
for the European and American fashion houses, then again under the fashion house labels
rather that under its own label. Venturing into this business would be an uphill task,
creating a brand of its own. HCF will have to price its products relatively low to penetrate
the market. Advertising costs would also be high as HCF creates its brand. There are
uncertainties present in this option.
Jeffrey feels that HCF may not have sufficient demand to sustain its existence. He
estimates the uncertainties to be:
Probability
30%
70%
High success
Low success
With the help of Elaine Tan the Sales and Marketing Director, Jeffery developed the
following targets for the next five years.
2009
2010
2011
2012
2013
70
29.5%
100
32%
130
33%
140
35%
(RM million)
Sales Revenue
50
Ave Gross Margin % 28%
Fixed costs are estimated to be RM 30 million for the Malaysian factories. Advertising
costs is estimated at RM 2.1 million per annum. Retrenchment costs of shutting down the
Chieng Mai factory is estimated at RM 1.8 million.
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Appendix 1
Haute Couture Fashions Bhds
Income Statement and Balance Sheet
(Consolidated Group Accounts)
Income Statement
Year ended
30 September 2008
RM 000
th
Revenue
Cost of Goods sold
Gross Profit
Operating Costs
Operating Profit
Finance Cost
Operating Profit after financing
Taxation
Operating Profit for the period
120,000
77,250
42,750
38,150
4,600
1,300
3,300
858
2,442
Balance Sheet
As At
30th September 2008
RM 000
Fixed Asset (net)
Current Assets
Inventory
Trade Receivables
Cash / Short-term investments
Current Liabilities
Trade Payables
Tax Payable
Bank Overdraft
Net Tangible Assets
Financed by :
Paid up share capital
Share Premium Account
Retained Earning
Long Term Loan
(repayable in 2011)
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33,413
36,375
28,420
43,865
376
72,661
21,634
39,734
361
61,729
13,904
858
3,058
17,820
7,250
3,399
1,643
12,292
54,841
88,254
49,437
85,812
57,000
10,500
16,254
57,000
10,500
13,812
4,500
88,254
4,500
85,812
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Appendix 2
European Fashion Industrys Foray into Asia
Europe has always been in the forefront of high fashion. Designers from France and Italy
have inspired and dominated the fashion scene since the 1950s. As the world and
especially Europe crawled out of the doom of World War II, many were anxious to bring
normalcy into their life. The post World War II era saw many people becoming much
more fashion conscious and many fashion houses such as Christian Dior, Armani, Gucci
etc. sprouted like mushrooms overnight to meet this growing demand.
Haute Couture the French word for high fashion have been widely accepted as the
official term used by many European fashion houses to define their craftsmanship. These
fashion houses held proud to their designs and craftsmanship and enjoyed a constant
demand for their one of a kind designs. They prided themselves to the fact that their
designs were limited editions and that customers were willing to pay a great deal of
money to be seen wearing them.
By the mid 1960s many more similar fashion houses had joined this very competitive
and lucrative market. However, it was during the same the period, the euphoria of the
post World War II need to be fashionable had settled to a more practical level. Clothing
manufacturing began to make inroads into the fashion industry and consumers were being
distracted and lured into this new fashion market. The clothing manufacturers, often
contracted by High Street retailers to supply ready-to-wear clothes made it possible for
clothes to be available at a fraction of the Haute Couture prices and yet be fashionable.
Customers soon realised that fashion need no longer be costly. Demand for haute
courtier began to nose-dive as a result and many of the fashion houses started recording
their first losses. This trend continued for several consecutive years and threatened the
continued existence of the once powerful haute courtier industry.
In a bid to survive, several fashion houses decided to consolidate their position by
branching out to ready-to-wear as a new market segment while still maintaining the
haute couture segment. Their aim was to make ready-to-wear much more fashionable
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than High Street labels and at the same making them available to everyone. They began
sourcing for suitable clothing manufacturers who would be able to produce very high
quality clothes at reasonable prices so that they could penetrate and capture a portion of
the ready-to-wear market. The trend during the early 1970s was to look outside Europe
for the manufacture of clothes as the operational cost of maintaining factories in Europe
had risen sharply, especially labour cost. The rise of trade unions during the late 1960s
had resulted in the labour force holding employers to ransom while demanding for better
pay and working conditions. Thus many European companies were now either
establishing manufacturing bases in countries with much lower labour and overhead costs
or sourcing manufacturers based in these countries to contract manufacture for them.
Asia, otherwise known as the Far East to the Europeans became their area of interest.
Land was in abundance, and labour was cheap, without the threat of trade unions.
Additionally, Asia was welcoming foreign currency inflow with open arms.
Required:
Jeffrey convenes a Board of Directors meeting to inform them of the latest developments
and put forth the strategic options identified by his management team. The strategic
issues were discussed by the Board and it was agreed that a consultant would be
appointed to advise the Board on which direction HCF should take. You are the
consultant appointed by HCFs Board.
Prepare a report that prioritises, analyses and evaluates the issues facing HCF, and
make appropriate and specific recommendations. Be sure to justify your
recommendations clearly.
Allocation of marks:
Issues faced by HCF
2 marks
Analyses
7 marks
Recommendations
5 marks
4 marks
Overall
Total:
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2 marks
20 marks