Step 7: Contribution Margins Web viewACCT11059: Accounting, Learning & Online...

ACCT11059: Accounting, Learning & Online Communication Assignment 2 Steps 7 - 10

Step 7: Contribution Margins

Product Surcare Concentrated Non-Bio Laundry Liquid

Wash 630ml

http://www.surcare.co.uk/

Surcare Sensitive Fabric Conditioner

Concentrate 1L


Oven Pride Complete Oven Cleaner 500ml

http://www.ovenpride.com/

Retail Price £2.78 £1.50 £4.00

McBride plc Selling Price

£2.08 £1.12 £3.00

Variable Cost £0.21 £0.21 £0.33

Contribution Margin (£)

£1.87 £0.91 £2.67

Contribution Margin (%)

90% 81% 89%

When completing research of my three chosen products produced by McBride plc I realised that because McBride is a manufacturer as opposed to a retailer I was going to have to search the retailer’s websites to gain an idea of the retail price for these products. I then decided that in order to have a reasonable estimate for the contribution margin for these products I would have to reduce the retail price in to take into consideration the mark-up the retailers would have placed on these products. My research showed that in most cases the mark-up for products is 50% of the retail price however this varies and can be greater or lesser. I have decided a reasonable mark-up for these products would be 25% as there is very little the retailer needs to do, generally the product is just taking up space on the shelf, it is not as though they had to actively try and sell the product as you would say a washing machine, it is also not as though their overhead costs of holding the item would increase as would say with milk where you have to keep it refrigerated.

The next step was determining the variable costs, to do this I undertook a bit more research so that I could determine a reasonable estimate of the price per product for what I determine the variable costs to be for these products.

Some background for my estimated variable cost:£0.04 material for 1 bottle £0.20 oven cleaner £0.04 printing on bottles

£0.04 material for 1 box £0.01 casual wages £0.12 liquid laundry wash/fabric softener

1S0291459 Natasha Hodgson

http://www.ovenpride.com/




I also came across this interesting read while researching the variable costs, it talks about how the cost of manufacturing laundry detergent is very low as one of the major ingredients used is actually just water, it also included other factors which were not 100% relevant to my research but non the less an interesting read.

https://www.quora.com/What-is-the-cost-of-manufacturing-laundry-detergent

While the contribution margins for these three products look extremely promising (which they are), I believe that for McBride plc their fixed costs will be quite high, meaning that the majority of this contribution margin will be put towards covering fixed costs and only a small percentage of this will actually go towards returning a profit.

What kind of things would be included in McBride’s fixed costs?Administration costs Maintenance costs Full-time manufacturing staff wages

Electricity / Water / Phones Rent on Buildings Rates on Buildings and Land

Why have I classified these as fixed costs and why do I feel that the dollar value associated with these items are high? I might start with the issue of wages, I have included wages in both variable and fixed costs, but why? For variable I have only considered casual wages, whereas for fixed I have considered full-time manufacturing staff, also included in administration and maintenance costs are staff wages. I learnt from my production and operations management unit last term that regardless of the size of the run (i.e. producing just 1 item or producing 100,000 items) the set-up time and costs involved will remain the same. By taking this into consideration I have therefore classified that there should be wages that are fixed which associate to the set-up of the run, and any additional staff which are consequently needed for a large run (during the manufacturing process and after which are needed in the packaging and warehousing department) I would consider as casual wages and allocate to variable costs. Administration wages and maintenance wages I decided were not dependant on the size of the run so therefore should be fixed. Then also included in fixed costs were the general overheads associated with running the manufacturing plants, warehouses and offices, these include rent on buildings not owned, rates on buildings and land and general electricity, water and phones etc.

So considering the large amount of fixed costs associated with manufacturing these products I would consider that even if a product had a positive contribution margin as opposed to a negative contribution margin that this should not automatically determine that this product should be included in the product mix for the company. A small but positive contribution margin will likely cause the company to be non-profitable because it can’t reasonably cover the fixed costs for the company. I am sure McBride has done the math and has worked out what average contribution margin % is needed in order to be profitable.

What jumps out at me about the difference between the contribution margins of the three products chosen? I thought it was quite interesting to note that the fabric softener comes in a 1L bottle and retails for only £1.50 (McBride selling price of £1.12) yet the laundry liquid is only in a 630ml bottle but retails at £2.78 (McBride selling price of £2.08). What this is telling me is that the market demand is higher for laundry liquid than it is for fabric softener, which from my own experience would be correct as I don’t even use fabric softener. Yet I considered the variable costs for producing these two products would be much the same as there would be in my opinion more ingredients in laundry liquid as opposed to fabric softener, also I considered that it would cost much the same to make the bottles even though one is larger (just because something is smaller it does not necessarily mean it is cheaper to produce, I often ponder this when buying children’s shoes, are they so


https://www.quora.com/What-is-the-cost-of-manufacturing-laundry-detergent


expensive because it actually costs a lot to produce them, or is it because the market demand of them is high because children grow so damn fast?). Because I have determined the variable costs to be the same for these two products it therefore makes sense that the one with the higher selling price has the higher contribution margin. I think this contribution margin is purposely higher because they know they could push the selling price of this product up because of the market demand for it.

Resource and Market ConstraintsBecause all three products chosen include plastic bottles I have decided to discuss the production of plastic bottles as one of McBride’s possible resource constraints. As the oven cleaner is the only product which comes in a cardboard box I thought this would also be a good resource constraint to discuss.

Product Surcare Concentrated Non-Bio Laundry

Liquid Wash 630ml


Concentrate 1L


Bottle size 630ml 1L 500ml

Units per 1L bottle size

1.59 1 2

Contribution margin (£) per 1L bottle size

£2.97 £0.91 £5.34

If I were to hypothetically consider that these were the only three products which McBride produced and there was a shortage on the materials needed to make the plastic bottles worldwide and McBride was only allocated enough material to produce 1,000,000 1 litre bottles I could use the information in the above table to make a decision about McBride’s best product mix to achieve the greatest profit (this too is hypothetically considering you could make smaller sizes e.g. two 500ml bottles would require the same amount of material as one 1L bottle).

From the information in the above table you could argue that McBride should cease producing laundry liquid and fabric conditioner and focus solely on producing and selling oven cleaner as this produces the highest contribution margin. However I am also considering there is a shortage on cardboard and I only have enough cardboard to make 1,000,000 boxes. The oven cleaner is only in a 500ml bottle though so 1,000,000 bottles of oven cleaner would only use up half of the plastic material allocated meaning we can look at McBride’s other two products.

This one should seem simple too, however I am going to add another factor. Because laundry liquid and fabric softener are related products I am going to include a condition that for every three bottles of laundry liquid produced one bottle of fabric softener must also be produced. Therefore in order to work out the remaining allocation of plastic material to complete our product mix we need to work out how much plastic material goes into three bottles of laundry liquid and 1 bottle of fabric softener.

(1 x fabric softener bottle size) + (3 x laundry liquid bottle size) = (1 x 1) + (3 x 0.63) = 2.89 L

By using this number we can then divide the remaining plastic material by this number to give us how many bottles of fabric softener we will have.

500,000 / 2.89 = 173,010 bottles of fabric softener



We then multiply our bottles of fabric softener by 3 to give us how many bottles of laundry liquid we will have.

173,010 x 3 = 519,030 bottles of laundry liquid

Consequently because of these factors McBride’s product mix will look like this:

Product Surcare Concentrated Non-Bio Laundry

Liquid Wash 630ml


Concentrate 1L


Number of Units 519,030 173,010 1,000,000

Contribution Margin per Unit (£)

£1.87 £0.91 £2.67

Contribution Margin for Total Units (£)

£970,586.10 £157,439.10 £2,670,000



Step 8: Ratio Analysis & Economic Profit

Profitability Ratios2016 2015 2014 2013

Profitability RatiosNet Profit Margin Net profit after tax/ sales 2.5% -0.1% -2.6% 0.7%Return on Assets Net profit after tax/ total assets 4.1% -0.2% -4.4% 1.2%

The profitability ratios come as no surprise, it was quite evident from looking at McBride’s annual reports that they had been struggling for some time to be profitable, even though 2013 is a positive it is minimal and McBride was still struggling. In 2015 the board of directors decided that McBride’s profitability was something that needed to be greatly considered and the driving factors behind these poor results had to be addressed. This deeper looking provided McBride with their new strategy of ‘Repair, Prepare, Grow’ with 2016 being the first year of this new strategy being implemented and immediate results being seen I think it is fair to say that McBride plc is on their way back up to a well-run highly efficient manufacturing company.

Efficiency Ratios2016 2015 2014 2013

Efficiency (or Asset Management) RatiosDays of Inventory Inventory/ av.daily cost of goods sold 63.2 52.9 49.1 60.7Total Asset Turnover Ratio Sales/ total assets 1.63 1.78 1.73 1.71

I will first make note on the Asset Turnover, while you would expect that as the profitability of a company would increase so too would their asset turnover this isn’t necessarily the case, as you can see for McBride plc. However I can explain that for McBride the reduction in their Asset Turnover isn’t bad it is in fact part of their ‘Repair, Prepare, Grow’ strategy. As part of prepare which was implemented in 2016 McBride actually reduced their product range that they offered their customers. McBride was previously sacrificing profitability in order to provide flexibility for their customers by offering a large range of products in a large range of sizes. By simplifying their range McBride was able to reduce costs incurred for producing the products. How did this work, well it goes back partially to the set-up time and costs which I mentioned in step 7 that regardless of the size of the run (i.e. producing just 1 item or producing 100,000 items) the set-up time and costs involved will remain the same. So for McBride their set-up costs were huge because of the many different runs involved in providing such an array of products and sizes. Because McBride has reduced their range their sales have also reduced (which was to be expected) which is why the Asset Turnover has decreased, however this isn’t a negative impact in the case of McBride as despite this profits are increasing.

Remember: Sales do not directly relate to profit!

Days of Inventory; one of my peers Danielle Bradley made comment to me that it was interesting that although McBride’s profitability had increased their days of inventory had actually gotten worse. I agree this is an interesting point so I set about trying to understand why. Days of inventory is also something I learnt about last term in production and operations management, inventory is necessary for the daily running of a business however learning to balance the amount of inventory is essential. It is important to not run out of inventory as you consequently lose sales if the inventory is not in place, and risk losing customers to competitors. However on the other hand too much inventory will lose the business money too as inventory is essentially money which is tidied up in



goods, on top of that there is also the cost involved in storing the excess inventory. So why has McBride’s days of inventory increased, as their profitability has increased? My thoughts on this is that because McBride is reducing costs associated with production they may have increased the size of their production runs, this would make sense as it reduces the costs of set-up for the runs and McBride could probably reduce the costs of materials if they are buying in larger volumes. This would explain the increase in inventory, so I wonder if this is the case.

Remember: Days of Inventory do not directly relate to profit!

Liquidity Ratios2016 2015 2014 2013

Liquidity Ratios Current Ratio Current assets/ current liabilities 1.09 1.03 1.07 0.94

In 2013 McBride had current liabilities greater than current assets, this meant that in the case of all current creditors requiring payment at the same time McBride could not cover the costs. This is a direct result of McBride having no cash / cash equivalent in 2013. Thankfully their current ratio has improved in the years after.

Remember: Cash is King!

Financial Structure Ratios2016 2015 2014 2013

Financial Structure RatiosDebt/ Equity Ratio Debt/ equity 505.9% 589.4% 526.4% 317.8%Equity Ratio Equity/ total assets 16.5% 14.5% 16.0% 23.9%

The Debt/Equity Ratio was one that I initially looked at and was puzzled as 2013 had the smallest Debt/Equity Ratio. I would have thought that the percentage for 2013 would have been higher than what it was considering their current assets didn’t cover their current debts. Then I remembered the reason behind their current ratio being below 1 was because McBride did not have cash in 2013 cash comes under assets, hence their assets were a lot lower than other years whereas debt was only slightly larger. Also the financial structure ratios take into consideration total debt and assets not just current, when looking at the non-current debt for 2013 that was actually much lower for 2013 than in the years following. Finally I looked at equity, equity was a lot higher in 2013 than in the years following, this information helped to explain why the percentage was a lot lower in 2013. I wanted to understand why in the years following 2013 McBride’s equity had reduced, I discovered that the main contributing factor for this was the accumulated losses which McBride was carrying, this amount dramatically increased in 2014 when McBride made a huge loss. Therefore this loss was also carried forward to 2015 and 2016 meaning the equity remained quite a lot lower than the equity in 2013.



I can now appreciate why Cheryl Haupt’s company Funtastic has a negative equity, as they have been running at a huge loss for years, and with these losses being carried forward and accumulating each year it was just a matter of time until their equity became a negative. It is also interesting to note that Funtastic’s shares are no longer listed, to me this just confirms the financial difficulty the company is facing and are probably putting procedures in place to cease business.

Similarly this information helps to explain the Equity Ratio, for McBride the Equity Ratio is higher in 2013 because of the higher equity (not necessarily a change in assets). The same can be seen with Cheryl’s company Funtastic, as the years progress and their equity becomes worse because of the accumulated losses each year you can see that the Equity Ratio also dramatically decreases. Things do not look good for Funtastic.

Here is a quick look at Funtastic and how the negative equity has effected the ratios.



Market Ratios2016 2015 2014 2013

Market Ratios Pence Pence Pence PenceEarnings per Share (EPS) 9.3 (0.4) (10.5) 3.0 (in pence)Dividends per Share (DPS) 3.6 3.6 5.0 5.0 (in pence)Price Earnings Ratio 16.72 (265.49) (9.16) 36.81

Market Ratios, this one I decided I needed to do a little extra playing around with, because the EPS and DPS totals are in pence I decided it made sense to multiply my total by 100 so they could be shown in pence on my spreadsheet. This was logically the correct decision for me as in the case of 2015 having such a low figure if this were shown in pounds it would be (0.004) a little ridiculous and quite a lot harder to try and derive meaning from a figure such as this. The market price per share was also in pence so it made the calculations for the Price Earnings Ratio easier to calculate too. I was quite happy to find that when I compared the figures I had calculated for EPS and DPS to the figures shown in the annual report that they matched. It is interesting to note that the EPS doesn’t relate to the DPS, the DPS is decided by the board of directors in their dividend policy. As you can see in 2013 and 2014 McBride paid out 5 pence per share however in 2015 & 2016 it was only 3.6 pence per share, this is because of a change in their dividend policy in order to keep more cash in the company to be used to increase their profitability and financial position. For shareholders this may have been disappointing, however in the long run this should increase the value for shareholders.

Price Earnings Ratio, for me this was a little more difficult to derive meaning from. I guess for me on first look I thought it showed how many years it would take of receiving dividends before you have recovered your cost of buying the shares in the first place, a kind of payback period I guess. But on closer inspection this is not the case, this would have been market price per share / dividends per share, we are instead looking at market price per share / earnings per share. So a little more research was needed for me to determine what McBride’s Price Earnings Ratio was telling me.

I found great understanding by reading about Price Earnings Ratio on Investopedia http://www.investopedia.com/terms/p/price-earningsratio.asp

Tips to remember about Price Earnings Ratio from Investopedia:

Generally a high P/E ratio means that investors are anticipating higher growth in the future. The average market P/E ratio is 20-25 times earnings. The P/E ratio can use estimated earnings to get the forward looking P/E ratio. Companies that are losing money do not have a P/E ratio.

The first thing to note about McBride is that for 2014 & 2015 the Price Earnings Ratio is not applicable as the company is making a loss in those years (I thought this would be the case as the I couldn’t derive any meaning from those numbers and even if I negated them and turned them into positive numbers the figures were still illogical). Next is that in 2013 for every £1 earned the stocks were valued at £36.81 (or I guess I could change that to every 1 pence earned stocks were valued at 36.81 pence, either way they are the same). In 2016 for every £1 earned the stocks were valued at £16.72. So what does this tell me? Does that mean that in 2013 because the Price Earnings Ratio was high that investors were anticipating higher growth in the future or does it tell me that the stocks were overvalued?


http://www.investopedia.com/terms/p/price-earningsratio.asp


I found this share price chart on McBride’s website quite interesting, the share price is on the rise, does this show a gained investor confidence in the company due to their increased profitability? It looks to me that their new ‘Repair, Prepare, Grow’ strategy is well and truly working.

Ratios Based on Reformulated Financial Statements2016 2015 2014 2013

Ratios Based on Reformulated Financial StatementsReturn on Equity (ROE) 24.75% -3.65% -42.27% 2.44%Return on Net Operating Assets (RNOA) 20.75% -9.76% -17.61% 5.25%Net Borrowing Cost (NBC) 17.44% -13.68% -0.17% 8.98%Profit Margin (PM) 4.65% -2.04% -3.92% 1.29%Asset Turnover (ATO) 4.46 4.78 4.49 4.07Economic profit (in millions) £16.4 -£29.1 -£45.7 -£8.9 (in millions)

Return on Equity shows how well the company is making use of the equity investors’ interest in the company. The figures are consistent with the facts already identified about McBride that in the years 2013 through to 2015 the company was not performing well, with a huge loss reported in 2014 as reflected in the ROE.

The story is much the same for Return on Net Operating Assets (OI/NOA), this ratio shows how well the company is making use of their assets, looking at 2016 you can see that the RNOA is 20% this



means that for every £1 of NOA the company was able to return an OI of £0.20, this isn’t bad if you consider that most of the assets for the company would have an effective life of longer than 5 years.

Net Borrowing Costs, the figures for this in 2014 and 2015 look a little funny, this is because in those years McBride have NFI rather than NFE, which was attributed to gain on cash flow hedges and net investment hedges. It makes sense that they would have a gain on these items in those years because in 2014 and 2015 McBride made a significant loss on currency translation differences from their operations in other companies. These hedges are a mitigation of financial risk for issues such as these. Therefore that NBC for these years are rather meaningless. I guess it is interesting to note again that in 2016 the NBC has increased even though the profitability of the company has increased. I looked into why this was and this was due to losses on the cash flow hedges and net investment hedges. I guess this is because hedges work both ways as a mitigation of risk, when money has been lost there is a gain on hedges to balance it out, when money has been gained there is a loss on hedges to balance it out. I guess if you were confident you were not going to make a loss on currency etc. then you wouldn’t bother with the hedges however it is a form of insurance against this happening (and insurance companies need to make money too).

Economic Profit = (RNOA – cost of capital) x NOA, RNOA is driven by both PM and ATO. By looking at the figures in the spreadsheet it is glaringly obvious that for McBride the driving factor for the turning point in their Economic Profit is PM. Over the four years ATO has barely changed, this is because NOA has generally stayed quite stable and sales have consistently been high, which has led to very little change year on year for ATO. PM however has varied because of the significant change in OI, therefore you could say the driving force behind McBride’s Economic Profit is PM which stems from increased OI which stems from decreased expenses, which all stems back to McBride’s ‘Repair, Prepare, Grow’ strategy. I think the proof this strategy is working is clearly shown in the figures.

One thing I can note is that if I were looking to invest in McBride in 2014 the decision would have been an easy “No, stay clear”. However looking at it now in 2016, with the knowledge into how they improved their profitability, and having seen their strategy for the future, the decision may very well be different.



Step 9: Capital Investment Decision

When deciding on a capital investment decision for McBride I decided to take inspiration from their annual report and calculate the NPV, IRR and payback period for capital investments they have already started to implement or they have plans to implement. There was however still a fair amount of estimation involved as none of this included dollar figures. The cost of capital used for both is 10%.

Investment Opportunity – PET Bottle MachinesThis investment decision was inspired from a case study provided in McBride’s 2016 annual report as detailed below:

The case study refers to only one of McBride’s sites, therefore the investment decision I have decided to look into is upgrading McBride’s other major PET WUL manufacturing sites with the new machines. The original cost is the estimated price of these new machines for the sites. The estimated cash flows are an estimate of what the benefit of 15% more capacity could look like in terms of increased cash flows. For years one and two I have estimated the cash flows as being significantly lower because of the time taken to implement the new machines at all sites and get them up and running, particularly manufacturing downtime in year one while the upgrades are occurring.

PET Bottle MachinesOriginal Cost (2017) £’000 2,000Estimated Future Cash Flows £’000Year 1 - 2018 500Year 2 - 2019 2,500Year 3 - 2020 5,000



Year 4 - 2021 5,000Year 5 - 2022 5,000Year 6 - 2023 5,000Year 7 - 2024 5,000

Investment Opportunity – New Warehousing FacilitiesThis investment decision also grew from something I read in the 2016 annual report about new warehousing facilities for McBride plc in the future plans. Again this required a great deal of estimation on the original cost of this investment and the possible future cash flows that this would bring. From a little more digging through the annual report I was able to discover that McBride is currently paying rent of £4.4million, I thought it was quite likely that this rent was for such warehousing building etc. so I have decided that this amount would be the maximum yearly future cash flow for this investment.

New Warehousing FacilitiesOriginal Cost (2017) £’000 16,000Estimated Future Cash Flows £’000Year 1 - 2018 1,000Year 2 - 2019 4,000Year 3 - 2020 4,400Year 4 - 2021 4,400Year 5 - 2022 4,400Year 6 - 2023 4,400Year 7 - 2024 4,400



Recommendation and LimitationsBy comparing the two decisions, and presuming that only one can be chosen, my recommendation to the board of directors of McBride plc would be to invest their capital in PET bottle machines. The reason behind this is because the risk involved in this investment is extremely minimal. The payback period is 1.6 years, after this point there is no longer a risk of losing money. Not only that, but the NPV and IRR are huge, with £16million for NPV and 102.89% for IRR.

Limitations however include the fact that the future estimated cash flow has a higher chance of being incorrect for the PET bottle machines than for the new warehousing facilities. The new warehousing facilities are using a figure that will be saved by not having to pay rent, whereas the PET bottle machine is purely an estimate of how the 15% increased capacity and greater efficiency of the new machines would impact on the future cash flows (so quite a bit of variability there).

Further limitations of the NPV and IRR for both investment decisions include variability in figures if say the NPV and IRR are worked out over a different time frame. I have included a comparison in the table below demonstrating the difference in these figures if the NPV and IRR are worked out over only five years rather than the seven for these investments.

PET Bottle Machines New Warehousing FacilitiesNPV £’000 (7 years) 16,185.07 1,999.56NPV £’000 (5 years) 10,796.91 -2,742.03IRR (7 years) 102.89% 13.24%IRR (5 years) 98.86% 3.90%

If we were to consider that McBride had enough capital to invest in both decisions this variance in calculation between 5 years and 7 years may influence their decision about investing capital in the new warehousing facilities as the NPV is negative and IRR is less than the cost of capital. These figures do not reflect the likely future gain that the warehouse facilities may bring, considering they could have an effective lifetime value of 20 years plus. Personally I think the New Warehousing Facility is a good investment, however from looking just at these figures of NPV and IRR the decision would likely sway towards it being an unprofitable and high risk investment.


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