Bus 222 – Profit Planning and Control

1. 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

2. Case – 9.1 Decision Making Under Uncertainty Exquisite Foods, Inc.

3. 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

4. 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

5. 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

6. 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

7. Most profitable marketing alternative

8. 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

9. Case 9-2 Profitability Analysis Sportway, Inc.“Wholesale sporting equipment distributor”

10. 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.

11. Options • BAU - Continue to Make tackle boxes (8,000 annually) • Reexamine product mix to maximize profit • Make Skateboards • Make/Buy Tackle boxes

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

13. Contribution Margin Per Unit

14. Variable Overhead Per Unit

15. 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 Product Mix for Maximum Profitability 8,000 Units of Sales for Tackle Boxes CM per Hr = $26.40 1,000 0 0 17,500 20,000 Units of Sales for Skateboards CM per Hr = $39.00

16. Product Mix with Improved Margin

17. 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

18. Reading 9-14 to 9-17 Buy or Lease

19. 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

20. BUY OR LEASEThe 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)

21. BUY OR LEASEThe 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)

22. BUY OR LEASETax Issues … Accelerated Depreciation can reduce taxes At 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.

23. 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

24. 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 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

25. 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?