Bus 222 – Profit Planning and Control

Case – 9.1 Decision Making Under Uncertainty

Case – 9.2 Profitability Analysis

Reading 9-14 to 9-17 Buy or Lease

Group 3

Ajay Aggarwal

Nidhi Jain

Qingwei Meng

Thomas Giap

Case – 9.1

Decision Making Under Uncertainty

Exquisite Foods, Inc.

Case 9-1 Decision Making Under Uncertainty

Case HighlightsExquisite Foods Inc. sells premium foodsCurrent contribution margin ratio is 65%Introducing new product-Souffles for

Microwaves Target dual-career families Three different strategies for promotion

Television and magazine advertising25% off coupons in Sunday newspaper$0.50 mail-in rebate coupons

Strategy one

Hire a marketing consultantPrepare a 30-second video commercial

and magazine AdsTarget evening working market and

career-minded individualsNet contribution margin $230,000

Strategy two Offer 25% off coupons in Sunday newspaper 15% redemption rate Hire a marketing consultant Calculations:

– Average expected sales $695,000– Contribution margin (65%) $451,750– Relevant cost $226,063

• Redemption cost $26,063• Hiring cost $5,000• Distribution cost $195,000

– Net contribution margin (contribution margin-relevant cost) $225,688

Strategy three Offer $0.50 mail-in rebate coupon Hire a marketing consultant to create a one-sixth page,

one-color rebate coupon Prepare 500,000 packages Redemption rate 10% Calculations:

– Average expected sales $490,000– Contribution margin (65%) $318,500– Relevant cost $65,000

• Redemption cost $25,000• Printing and attaching cost $35,000• Hiring cost $5,000

– Net contribution margin (contribution margin-relevant cost) $253,500

Most profitable marketing alternative

Strategy One Two Three

Net contribution

Margin $230,000 $225,688 $253,500

Other selection criteria

Long term goals (strategy) vs. short term benefitsTV ads will probably create long term brand awareness while rebate/coupon focus on short term sales, and may even lose long term sales

Objectives of the product promotion, product/brand awareness, short term and long term sales, overall cost reductions

Market share Competition Return on investment (ROI) Effects on other products (product mix) Behavioral, legal and implementation issues

Case 9-2 Profitability Analysis

Sportway, Inc.“Wholesale sporting equipment distributor”

Case Highlights Sportway Inc. is currently using plastic

department to manufacture molded fishing tackle boxes

Sportway can make 8,000 units of tackle boxes.Sportway believes that they can sell 12,000 of tackle boxes.

Maple Products offered to supply 9,000 units of tackle boxes at $68.00 price per unit.

Bart Johnson suggested to make better use of plastics department by making skateboards

Bart Johnson believes that Sportway can sell 17,500 units of skateboards.

Options

1. BAU - Continue to Make tackle boxes (8,000 annually)

2. Reexamine product mix to maximize profit

a. Make Skateboardsb. Make/Buy Tackle boxes

Objective

To determine which product or products Sportway, Inc should manufacture and/or purchase to maximize profitability and show the associated financial impact

Contribution Margin Per UnitSkateboards

Mfg (per unit) Buy (per unit) Mfg (per unit)Total revenue $86.00 $86.00 $45.00Cost $68.00

Molded Plastic $8.00 n/a $5.50Hinges, Latches handle $9.00 n/a $7.00Direct Labor $18.75 n/a $7.50Variable Mfg OH $6.25 n/a $2.50Relevant SG&A $11.00 $4.00 $3.00

Total Relevant Cost $53.00 $72.00 $25.50

Contribution Margin $33.00 $14.00 $19.50

Direct Labor Hour 1.25 n/a 0.5CM per Hour $26.40 n/a $39.00

Tackle Boxes

Variable Overhead Per UnitTackle Boxes Skateboards

Direct Labor Hrs $18.75 / $15.00 = 1.25 hrs $7.50 / $15.00 = 0.5 hrsOH/DLH $12.50 / 1.25 = $10.00

Total OH $12.50 x 8,000 = $100,000

Total Variable OH $100,000 - $50,000 = $50,000Variable OH per Hr $50,000 / $10,000 = $5.00 $50,000 / $10,000 = $5.00Variable OH per Unit $50,000 / 8,000 = $6.25 $5.00 x .5 = $2.50

Product Mix for Maximum Profitability

Units of Sales for Skateboards

CM per Hr = $39.00

Uni

ts o

f Sal

es fo

r T

ackl

e B

oxes

CM

per

Hr

= $

26.4

0

20,000

8,000

17,500

1,000

Total Direct Labor Capacity = 8,000 x 1.25 hrs = 10,000 hrs

Tackle Boxes = 8,000 – 2/5 Skateboards

Tackle Boxes = 8,000 – 2/5 (17,500)

Tackle Boxes = 1,000 units

0 0

Product Mix with Improved Margin

SkateboardsMfg Buy Mfg Total

Volume 1,000 9,000 17,500 27,500

Unit CM $33.00 $14.00 $19.50

New Margin $33,000 $126,000 $341,250 $500,250

Volume 8,000 0 0 8,000

Unit CM $33.00 $0.00 $0.00

Old Margin $264,000 $0 $0 $264,000

Improved Margin $236,250

Tackle Boxes

Strategic Factors How is the long term demand – skate board as well as tackle boxes

Outsouring tackle boxes manufacturing– Reliability ( on time, quality, order to shipping time)– Single sourcing ( higher bidding, solvency, not able to meet the orders)– Flexibility- quickly adapt to market needs– Maple supplying tackle boxes to Sportway’s competitors.– Are there any other supplier which have more capacity to produce tackle

boxes

Skateboard manufacturing– Customer demographics are different- promotion policies and brand image– Labor skills/resources requirements- learning curve, training, new

equipments, unkowns– High risk product- Safety, Warranty and Insurance – Existing supplier increases the supply, or new entrants

Reading 9-14 to 9-17

Buy or Lease

BUY OR LEASE

Things to consider….

The balance sheetThe income statementTax issues Fleet flexibility The "true cash cost" of leasing vs. owning

For decades, the lease vs. purchase decision has been among the most complex analyses in modern finance

BUY OR LEASEThe Balance Sheet …

Cash / Debt / Lease (90% rule and GAAP tests (SFAS No. 13))

Assets and LiabilitiesLiquidity Ratios

Current ratio = current assets/current liabilitiesQuick or acid test ratio = (current assets – inventory)/current liabilities

Leveraged RatiosDebt Ratio = Total Liabilities / Total AssetsDebt to Equity Ratio = Long Term Debt / Total EquityTimes Interest Earned Ratio = EBIT / InterestEBITDA Coverage Ratio = (EBITDA + Lease Payments) /

(Interest + Principal + Lease Payments)

BUY OR LEASEThe Income Statement …

Depreciation Expense Depreciation Expense and Interest

Expense

Rental ExpenseLess than the combined interest and

depreciation expense resulting from a leveraged purchase (borrow to purchase)

BUY OR LEASETax Issues …

Accelerated Depreciation can reduce taxesAt least two types of companies don't benefit from accelerated depreciation: companies in capital-intensive industries that may be subject to the Alternative Minimum Tax and companies in the red that don't need the tax reduction.

The generous tax deferral available for the upcoming years should be considered in a lease vs. purchase decision.

BUY OR LEASEFleet Flexibility …

Mission Critical Equipment with certainty about its permanent usefulness – Owning is better than Leasing

Examples of mission critical equipment include critical components of an assembly line or production facility, equipment necessary for power generation, oil rigs for petroleum companies, and other items generally inseparable from business operations.

Easily shed surplus equipment because the business grew, shrank, or changed its plans

New Technologies Encourage businesses to shed obsolete equipment. Easier on leased equipment because the "risk" of obsolescence is borne by the leasing company

BUY OR LEASETHE "TRUE CASH COST" OF LEASING VS. OWNING…

Cash is a constraint …frequently the decision is between borrowing and leasing. Leasing is a substitute for debt financing

Terms and conditions of a leaseFuture market for the equipmentCompany's borrowing costsNAL net advantage of leasing

NAL = PV cost of owning – PV cost of leasing • Comparison of leasing with an equivalent loan• Comparison of the present value (PV) of leasing with the

PV of buying and borrowing (the recommended method)• Comparison of the internal rate of return implicit in the lease

contract with the cost of borrowing

BUY OR LEASEIt’s Your Choice… really!

For large companies, most often the decision to lease or buy is driven by balance sheet considerations and by cash on hand

Public companies are sensitive to heavy emphasis on reported profitability

For private companies, tax considerations, fleet flexibility, and the true "cash cost" often carry stronger weight than earnings management

QUESTIONS?