Case Study Cam Ltd

8/12/2019 Case Study Cam Ltd

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1. Introduction

This report attempts to assess the economic feasibility of two suggestions for

addressing the Managing Directors concern regarding low capital utilization at the

budgeted profit level of $ 108,000. Suggestion made by the Operations Director

specifies a need to find an alternative supplier to hold the companys inventory from

which they can directly pull at a moments notice. Suggestion of the Sales Director, on

the other hand, involves the launch of an intensive advertising campaign with a hope to

boost sales in the following year. Recommendation on course of action is made based

on, among other things, the comparison of relative potential profitability of different

plans using four measurements, namely break-even point, margin of safety, net profit

and return on capital employed (ROCE).

The main report is divided into two parts. The first part includes calculations and

interpretation of four measurements. The second part presents a sensitivity analysis for

each of alternative plans.

2. Main report

2.1 Financial analysis

The assumptions underlying my calculation and interpretation of four key performance

indicators are as follows:

- All output is turned into sales revenue

- Each product sells for only one price (i.e. no discount for bulk purchases)

- Costs can be classified accurately as either fixed or variable costs- Changes in activity are the only factors that affect costs

- Cost-Volume-Profit relationships are linear over the relevant range of production

and sales

- Economies of scale and reactions of competitors are all ignored

The table below illustrates the effect of proposed changes in budgeted data on the key

performance indicators (KPI). A detailed calculation can be found in Appendix A.

TABLE 1: Key performance indicators (KPI)


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KPI ORIGINAL BUDGET OD'S SUGGESTION SD'S SUGGESTION

Break-even point (BE) $200,000 $182,383 $255,556

Margin of safety (MOS) 54.5% 58.5% 47.2%

Net Profit (NP) $108,000 $113,000 $102,800

Return on capital employed (ROCE) 18.0% 20.5% 16.6%

Regarding to the Operations Directors suggestion,projected variable costs increase by

$5,000 without an associated rise in sales. In this case, the contribution earned would

be $5,000 less than the amount suggested by original budget. However, as the

budgeted fixed costs decrease by $10,000, net profit would actually increase by $5,000,

from $108,000 to $113,000. Following the implementation of Sales Directorsproposition, expected sales revenues rise by 10%, resulting in a proportionate $24,200

increase in variable costs. Contribution, in this case, will go up by $19,800. This rise is

less than offsets the $25,000 increase in fixed costs and net profit will decrease by

$5,200, from $108,000 to $102,800.

Break-even point can be defined as the point where total contribution equals fixed costs.

Operations Directors plan, which incurs lower fixed costs, would result in a lower break-

even point and also a higher margin of safety than the companys original budget. Two

outcomes are expected conditional on the implementation of Operations Directors.

First, the company would need to sell fewer products in order to cover its fixed costs.

Second, there will be lower risk that a decline in expected sales will result in a net loss.

Under Sales Directors alternative, because a higher amount of fixed costs is required to

be covered, the break-even point is reached later than in the original budget- at sales

revenue of $255,556 rather than at $200,000. The Margin of safety is also lower for

Sales Directors alternative, suggesting a higher risk of incurring losses on sales drop.

From my calculation, Operations Directors plan has a ROCE of 20.5% versus 16.6% for

Sales Directors suggestion. A comparison between these figures with the one from

original budget (18%) suggests that Operation Directors plan makes a better use of the

companys capitalrelative to other alternatives. Operations Directors plan introduces a

better way to manage the inventories level, making sure the company will not build up

unnecessary stock, while Sales Directors proposition implies a rise in the amount, and

possibly the length of credit that the company can offer to its customers.


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2.2 Sensitivity analysis

Sensitivity analysis focuses on how a result will be changed if the original estimates

regarding sales volume, total fixed cost and variable costs change. With regard to the

Operations Directors alternative, sensitivity analysis answers questions such as what

the performance indicators will be if:

1. Variable materials cost increases by 10% and other fixed costs decline by 20%

(i.e. $10,000) (scenario 1)


(i.e. $10,000) (scenario 2)

3. Variable materials cost increases by 5% and other fixed costs decrease by15% (i.e. $7,500) (scenario 3)


(i.e. $5,000) (scenario 4)

The table 2 below answers these questions:

TABLE 2: Sensitivity analysis for Operations Directors suggestion

OD'S SUGGESTION SCENARIO 1 SCENARIO 2 SCENARIO 3 SCENARIO 4

$ $ $ $ $

Sales 440,000 440,000 440,000 440,000 440,000

Less Variable costs:

Materials 105,000 105,500 115,000 105,000 105,000

Labour 142,000 142,000 142,000 142,000 142,000

247,000 247,500 257,000 247,000 247,000

Contribution 193,000 192,500 183,000 193,000 193,000

Contribution Margin Ratio 44% 44% 42% 44% 44%

Less Fixed costs:

Selling and Admin 40,000 40,000 40,000 40,000 40,000

Other 40,000 40,000 40,000 42,500 45,000

80,000 80,000 80,000 82,500 85,000

Net profit 113,000 112,500 103,000 110,500 108,000

Capital employed 550,000 550,000 550,000 550,000 550,000

Key performance

indicatorsOD'S SUGGESTION SCENARIO 1 SCENARIO 2 SCENARIO 3 SCENARIO 4

Break-even point (BE) $182,383 $182,857 $192,350 $188,083 $193,782Margin of safety (MOS) 58.5% 58.4% 56.3% 57.3% 56.0%


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Net Profit (NP) $113,000 $112,500 $103,000 $110,500 $108,000

Return on capital

employed (ROCE)20.5% 20.5% 18.7% 20.1% 19.6%

The column labelled Scenario 2 shows that increasing variable material costs further by10% will decrease profit 8.8%, from $113,000 to $103,000. The column labelled

Scenario 3 shows that decreasing fixed costs further by 10% will decrease profit 4.4%,

from $113,000 to $108,000. Thus net profit, as well as other performance indicators, is

highly sensitive to changes in variable materials.

Performing a similar sensitivity analysis on the variables in Sales Directors alternative,

we have the following results:

1. At the same level of extra fixed costs ($25,000), 0.5% further rise in sales will

increase profit 15% (scenario 1)

2. At the same level of extra fixed costs ($25,000), 5% drop from Sales Directors

expected sales level will reduce profit 2.7% (scenario 2)

3. At the same level of expected sales, 20% reduction in extra fixed costs that will

be incurred increases profit 4.8%, from $102,800 to $107,800 (scenario 3)

4. At the same level of expected sales, 20% increase in extra fixed costs that will

be incurred reduces profit 4.8%, from $102,800 to $97,800 (scenario 4)

TABLE 3: Sensitivity analysis for Sales Directors suggestion

SD'S SUGGESTION SCENARIO 1 SCENARIO 2 SCENARIO 3 SCENARIO 4

$ $ $ $ $

Sales 484,000 486,200 462,000 484,000 484,000


Materials 110,000 110,500 105,000 110,000 110,000Labour 156,200 142,000 142,000 156,200 156,200

266,200 252,500 247,000 266,200 266,200

Contribution 217,800 233,700 215,000 217,800 217,800

Contribution Margin Ratio 45% 48% 47% 45% 45%

Less Fixed costs:

Selling and Admin 40,000 40,000 40,000 40,000 40,000

Other 75,000 75,000 75,000 70,000 80,000

115,000 115,000 115,000 110,000 120,000

Net profit 102,800 118,700 100,000 107,800 97,800

Capital employed 620,000 620,000 620,000 620,000 620,000


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Key performance

indicatorsOD'S SUGGESTION SCENARIO 1 SCENARIO 2 SCENARIO 3 SCENARIO 4

Break-even point (BE) $255,556 $239,251 $247,116 $244,444 $266,667

Margin of safety (MOS) 47.2% 50.8% 46.5% 49.5% 44.9%

Net Profit (NP) $102,800 $118,700 $100,000 $107,800 $97,800Return on capital

employed (ROCE)16.6% 19.1% 16.1% 17.4% 15.8%

When comparing Scenarios 1, 2 with Scenarios 3 and 4 we see that Cam Ltd s profit is

more sensitive to changes in sales than changes to fixed costs, although changes in

either will significantly affect profit and other performance indicators.

3. Conclusion

The question is which alternative of plans management should select. Considering the

cost structures underlying the two alternatives, if companys sales are expected to

increase in future, management might prefer Sales Directors suggestion, where the

higher operating leverage will result in higher profitability. Conversely, if management

expect sales to decrease in future, Operations Directors plan sounds more reasonable

to choose, as its lower operating leverage will result in higher profit. To illustrate,

assume that sales have decreased to $400,000. The SDs suggestion will generate a

contribution of $133,800 and $18,800 profit, whereas ODs suggestion will have a

contribution of $153,000 and $ 73,000 profit. If the declining sales scenario is carried

further, say to the break-even point, ODs plan, with higher margin of safety, ensures

that the company is in a less risky position: Sales can decline $257,617 (58.5%) before

losses will begin, as compared to $228,444 (47.2%) for SDs plan. Having the lowest

break-even point is another bonus for ODs plan, because this allows the company to

begin generating operating profit more quickly. Information regarding risks associatedwith each alternative may help the management make a better decision. As one can

see from the sensitivity analysis, ODsand SDs plans make the profit more sensitive to

variance in variable materials cost and sales, respectively. Hence, in the former case,

My suggestion is to stick with the alternative that will result in higher expected profit

after taking possibility and magnitude of potential loss on sales into consideration. In

another terms, management should select the Operations Directors plan.


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As you can see, there is no simple answer as to which type of cost structure is better. As discussed in the

previous section, operating leverage is neither good nor bad. Every company is different, so several factors must be

considered: whether sales are expected to increase or decrease from the current level, how stable sales volumes are,

and how willing management is to take risks. Certainly, low fixed costs and high variable costs (Company As coststructure) provide a much more conservative cost structure than low variable costs and high fixed costs (Company

Bs cost structure). Thus, if management is reluctant to take risks, it will want its costs to be variable rather than

fixed whenever possible. In our example, Company A has a higher MOS and will experience much narrower swings

in profit than will Company B. Company B has a lower MOS and will be more profitable in good times, but will

have higher losses in bad times.

ORIGINAL BUDGET OD'S SUGGESTION SD'S SUGGESTION

$ $ $

Sales 440,000 440,000 484,000


Materials 100,000 105,000 110,000

Labour 142,000 142,000 156,200

242,000 247,000 266,200

Contribution 198,000 193,000 217,800

Contribution Margin Ratio 45% 44% 45%

Less Fixed costs:

Selling and Admin 40,000 40,000 40,000

Other 50,000 40,000 75,000

90,000 80,000 115,000

Net profit 108,000 113,000 102,800

Capital employed 600,000 550,000 620,000


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III. Appendix A:

If the proposed policy of Operations Director is achieved, Cam Ltd. can reduce their

average inventories level by $50,000 and make a further saving of $10,000 on

stockholding costs. However, the cost of variable materials will increase by 5%. We

have:

Adjusted budgeted total variable cost = $247,000 ($242,000 + 5%* $100,000)

Adjusted budgeted total fixed cost = $80,000 ($90,000 - $10,000)

Adjusted budgeted capital employed = $550,000 ($600,000 - $50,000)

The implementation of Sales Directors suggestion, onthe other hand, will result in 10%

improvement in sales volume and $20,000 increase in average account receivables

over the next year. Although there will be no change in the ratios of variable costs to

sales revenue, an extra $25,000 marketing costs will be incurred. So:

Adjusted expected sales revenue = $484,000 ($440,000 + 10%* $440,000)

Adjusted budgeted total variable cost = $266,200 ($484,000

*($242,000/$440,000)

Adjusted total fixed cost = $115,000 ($90,000 + $25,000)

Adjusted capital employed = $620,000 ($600,000 + $20,000)


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Modified budgeted income statements for the alternative suggestions can be found in

the Appendix A.

ORIGINAL BUDGET OD'S SUGGESTION SD'S SUGGESTION

$ $ $

Sales 440,000 440,000 484,000


Materials 100,000 105,000 110,000

Labour 142,000 142,000 156,200

242,000 247,000 266,200

Contribution 198,000 193,000 217,800

Contribution Margin Ratio 45% 44% 45%Less Fixed costs:

Selling and Admin 40,000 40,000 40,000

Other 50,000 40,000 75,000

90,000 80,000 115,000

Net profit 108,000 113,000 102,800

Capital employed 600,000 550,000 620,000

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