Bus 222 Profit Planning and Control Case 9.1 Case 9.

2 Reading 9-14 to 9-17

Decision Making Under Uncertainty

Profitability Analysis 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 Highlights Exquisite Foods Inc. sells premium foods Current contribution margin ratio is 65% Introducing new product-Souffles for Microwaves Target dual-career families Three different strategies for promotion
Television and magazine advertising 25% off coupons in Sunday newspaper $0.50 mail-in rebate coupons

Strategy one
Hire a marketing consultant Prepare a 30-second video commercial and magazine Ads Target evening working market and career-minded individuals Net 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 $230,000 Margin

$225,688

$253,500

Other selection criteria

Long term goals (strategy) vs. short term benefits
TV 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 Skateboards b. 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 Unit

Total revenue Cost Molded Plastic Hinges, Latches handle Direct Labor Variable Mfg OH Relevant SG&A Total Relevant Cost Contribution Margin Direct Labor Hour CM per Hour Tackle Boxes Mfg (per unit) Buy (per unit) $86.00 $86.00 $68.00 $8.00 $9.00 $18.75 $6.25 $11.00 $53.00 $33.00 1.25 $26.40 n/a n/a n/a n/a $4.00 $72.00 $14.00 n/a n/a Skateboards Mfg (per unit) $45.00

$5.50 $7.00 $7.50 $2.50 $3.00 $25.50 $19.50 0.5 $39.00

Variable Overhead Per Unit

Direct Labor Hrs OH/DLH Total OH Total Variable OH Variable OH per Hr Variable OH per Unit Tackle Boxes $18.75 / $15.00 = 1.25 hrs $12.50 / 1.25 = $10.00 $12.50 x 8,000 = $100,000 $100,000 - $50,000 = $50,000 $50,000 / $10,000 = $5.00 $50,000 / 8,000 = $6.25 Skateboards $7.50 / $15.00 = 0.5 hrs

$50,000 / $10,000 = $5.00 $5.00 x .5 = $2.50

Product Mix for Maximum Profitability

Total Direct Labor Capacity = 8,000 x 1.25 hrs = 10,000 hrs
Tackle Boxes = 8,000 2/5 Skateboards

8,000

Tackle Boxes = 8,000 2/5 (17,500) Tackle Boxes = 1,000 units

1,000 0 0

17,500
Units of Sales for Skateboards CM per Hr = $39.00

20,000

Product Mix with Improved Margin

Tackle Boxes Volume Unit CM New Margin Volume Unit CM Old Margin Mfg 1,000 $33.00 $33,000 8,000 $33.00 $264,000 Buy 9,000 $14.00 $126,000 0 $0.00 $0 Skateboards Mfg 17,500 $19.50 $341,250 0 $0.00 $0 $264,000 $500,250 8,000 Total 27,500

Improved Margin

$236,250

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 Sportways 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 sheet The income statement Tax 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 LEASE The Balance Sheet

Cash / Debt / Lease (90% rule and GAAP tests (SFAS No. 13)) Assets and Liabilities Liquidity Ratios
Current ratio = current assets/current liabilities Quick or acid test ratio = (current assets inventory)/current liabilities

Leveraged Ratios
Debt Ratio = Total Liabilities / Total Assets Debt to Equity Ratio = Long Term Debt / Total Equity Times Interest Earned Ratio = EBIT / Interest EBITDA Coverage Ratio = (EBITDA + Lease Payments) / (Interest + Principal + Lease Payments)

BUY OR LEASE The Income Statement

Depreciation Expense Depreciation Expense and Interest Expense Rental Expense
Less than the combined interest and depreciation expense resulting from a leveraged purchase (borrow to purchase)

BUY OR LEASE Tax Issues

Accelerated Depreciation can reduce taxes
At least two types of companies don't benefit from accelerated depreciation: companies in capitalintensive 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 LEASE Fleet 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 LEASE
THE "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 lease Future market for the equipment Company's borrowing costs NAL 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 LEASE Its 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?