Discussed the bigger cash flow issue for the company
At present there does not seem to be any sort of a process to assess how credit worthy our customers are, either when granting new customers credit for the first time, or allowing existing customers higher level of credit. Furthermore there does not seem to be any sort of formal process for chasing up late payers. The result is that hardly a month goes by without there being some sort of issue relating to slow (or no) payment from a customer. The finance department blame the sales department for selling to un-creditworthy customers; whilst the sales department blame the finance department for not providing proper support to them.  You have met with Frances on her final day before she left for a two week holiday and she agreed that something needs to be done to resolve these ongoing problems once and for all. She suggested that you draft a proposal for a simple credit control mechanism that covers both new and existing customers which involves the co- operation of both the sales department and the finance department.  The standard credit terms offered to Hallam Ltd customers are 30 days from date of invoice. Frances has said that she will also send you a copy of the Statement of Financial Position (SOFP) as at 31st December 2013 from last year’s Financial Accounts to compare to the SOFP as at 31st December 2014.  During the discussion Frances also discussed the bigger cashflow issue for the company (of which slow paying customers is just one part) and complained that as a Board we have never grasped the importance of understanding the ‘working capital cycle’. She also started to mention the dangers of ‘over-trading’ but the conversation was cut short as Frances received an urgent phone call. Her parting shot was that all the relevant figures were in the accounts and that all we needed to do as a Board was to understand their relevance.  You have decided that as well as looking at credit control you also need to widen your Board Report to include an overview of the company’s cash position and what it needs to do to resolve the current constant shortage of cash (but in layman’s terms so that it can be appreciated by all Board members). 2. Requirements for Board Report d) [8%] Prepare a briefing note for the other (non-financial) Board Directors giving an overview of cashflow and how it differs from profitability in general terms (i.e. without relating it to Hallam Ltd at this stage). The briefing note should include explanations of liquidity, the operating cycle and over-trading. e) [6%] Present a full analysis and commentary for Y.E. 31/12/13 and Y.E. 31/12/14 of Hallam Ltd.’s liquidity and working capital management (including all appropriate ratio analysis). f) [8%] Present recommendations for action points to improve the company’s liquidity and working capital management (including proposals for a new credit control process) 3. YOUR RESEARCH ON :- HIGH PRODUCTION COSTS  The biggest selling individual product is consistently the ‘standard double wardrobe’ (or SDW as it is known) and this can be used as a typical representative product for most analysis purposes. In other words any results found for an ‘SDW’ unit will be fairly typical of other products, or indeed of all products. Standard Double Wardrobe (SDW)  You have discussed this issue with both Oliver and Frances and both agree that it would be sensible to use the June 2015 sales of the SDW as a sample product to investigate the current accuracy or otherwise of the standard costing system and to see how far adrift from out budgeted profit we were in June for this product. The answer to this can then be used to determine what future action is required to look at the other products. Frances has asked her Management Accountant (Tony) to forward you the relevant figures relating to the SDW in her absence.  Tony has confirmed that the current standard cost used by Hallam Ltd for a single Standard Double Wardrobe was last updated on 1st March 2015 and includes the following figures.  Direct Materials – 80 Kg of oak @ £0.60 per Kg  Direct Labour – 4 hours @ £8 per hour  Variable Production Overheads – £10 per unit Which gives the SDW a standard selling price of £300 based on Hallam’s standard 70% gross profit target.  Tony confirms that the Company’s June profit budget included a profit contribution from the sale of 120 SDWs of £25,200. In the event, the 112 SDWs were sold in June for a total sales value of £31,920.  Tony has analysed the production costs for the most recent batch of fifty SDWs manufactured (in May 2015) using the raw-material requisition figures and direct- labour time sheets supplied by the relevant production supervisor. These figures may be taken as typical of all SDWs sold in June and show that the actual figures for the most recent batch of fifty SDW units were :-  Direct Materials 4,050 Kg of Oak costing £2,835  Direct Labour 198 hours costing £2,100  Variable Overheads £515 The above figures for a batch of 50 will need to be ‘scaled’ up!  Oliver and the production supervisor have studied these ‘actual’ figures for the recent batch of 50 SDWs and confirm that there was not excessive material wastage involved in producing this batch and that the oak from the usual sole supplier (who has just imposed a price increase). The amount of labour hours was also considered reasonable though the factory is having to use more overtime (at ‘time and a half’ rate) than it would like. The variable overheads were considered fairly typical. 3. Requirements for Board Report g) [2%] In largely tabular form (including all relevant workings) show how much one standard Double Wardrobe (SDW) should cost and hence how much profit contribution (£ and %) a single SDW should make according to the company’s budget. b) [4%] By comparing the standard budget results anticipated for this product (see above), to the actual results for SDWs in June 2015, produce a table showing the revenues, various elements of cost and profit contribution for the month for :- The original budget for the month The flexed budget for the month The actual results for the month c) [6%] Using the results of the above (and additional calculations if necessary) clearly identify (by name) and state the value of each of the following variances and sub-variances in turn :- Sales Profit Volume Variance Sales Price Variance Direct Labour Rate Variance Direct Labour Efficiency Variance Direct Materials Price Variance Direct Materials Quantity Variance Variable Overhead Variance d) [2%] Produce a profit reconciliation statement which reconciles the original budget for this product for the month of June, to the flexed budget for the month, to the actual results for the month e) [6%] Then (largely in words) explain how each variance actually arose using the supplied figures to reconcile back to each of the previously calculated variances (i to vii above) (e.g. using a completely different example “The average actual selling price of the widget was £10 as opposed to the standard selling price of £11.50 i.e. each widget was sold for £1.50 less. There were 220 widgets sold in the month and so the lost profit as a result of this reduced selling price (i.e. the ‘Sales Price Variance’) was : 220 x £1.50 = £330 Adverse†f) [2%] Based on the recent actual costs how much GP(£) & GP(%) would we make if we sold an SDW at the current standard selling price of £300? What would be an accurate up to date standard cost for an SDW and based on a target 70% GP what should a revised standard selling price now be ? g) [2%] Any other operational or commercial recommendations ? 4. YOUR RESEARCH ON :- NEW PRODUCTION TECHNIQUES Email To Sales & Marketing Director From Oliver Copley [Operations Director] Date 17th July 2015 New Manufacturing Techniques I am really glad you asked me about new manufacturing techniques. As you probably gathered from last week’s somewhat ‘lively’ Board meeting this is an area I feel strongly about. I have actually been quietly been researching this for a number of months ever since I visited a manufacturing trade show in Birmingham and saw a live demonstration of the latest available Automatic Timber Processing (ATP) systems. These are essentially a fully programmable automated production line which can produce entire furniture components (drawers, doors, wardrobe shells etc) without any manual intervention. They are fascinating to see in action and I was planning to work up a capital investment appraisal proposal myself and to arrange a demonstration for the whole Board. I am very happy for you to now include this in the report Mike has asked you to compile. In summary each ATP production line needs to be ‘fed’ with standard sizes of oak sheets and lathes at the start of the production line, and it then automatically draws these onto the production line to be further trimmed, bevelled or routed as required. The ATP line then uses robot technology to assemble the component parts including all required gluing and fixing. The finished component is then taken off the end of the ATP line and moved to an assembly area where the final processes such as fitting doors to wardrobe shells, and loading drawers into a chest carcass are completed manually. All of our product designs would have to be programmed into the system but once this is done it would only be a case of adding in new designs when required. We will still need manual labour to ‘load’ and unload’ the two ends of the ATP line, plus for the final manual tasks and of course we will need machine supervisors to ensure that machine misfeeds etc are quickly cleared. Therefore overall I don’t think we will have to make any of our fulltime staff redundant, but we should be able to reduce our overtime bill and with this investment and the same level of workforce we can significantly lessen our costs and significantly increase our current maximum capacity which as you well know is at present limiting our sales growth. Perhaps best of all is that by using ATP systems we would no longer have to build in batches of 50 which then have to be stored in the Distribution Centre until sold. The current level of stock movements (production to storage , and storage to despatch) is not only costly in terms of space, it also requires highly paid forklift truck drivers. An ATP system runs off a standard range of timber ‘components’ (sheets, lathes, planks etc) of varying sizes which we can specify directly from our wood mill supplier. Once loaded the ATP line can then be programmed to produce a series of completely different products, just as efficiently as running the same one. So in theory at least we would no longer have to ‘build for stock , instead we can ‘build for sales’ on a day by day basis where we literally feed the days sales orders into the ATP line and those exact items are produced and can be transferred directly to the despatch department ! Finally not only does the ATP system dramatically reduce the labour costs per item made, it also reduces material wastage … not only by eliminating human mistakes but also because the ATP software optimises the production batch to minimise wastage of the precious solid oak ! A timber offcut from the side of a wardrobe will be held by the internal workings of the machine and used 20 minutes later as a shelf in a bookcase. I told you it was impressive ! I have already received quotes for supply and installation of the machinery and this represents an initial cost of £550,000 ! However Frances and I have already spent some time looking at the anticipated cash savings in both materials and production and handling labour and materials and we are confident that we could make cash savings of £120,000 per annum. The suppliers believe that the ATP line should have at least a 10 year life. They estimate that the machinery would still have a scrap value of £50,000 after these 10 years. On a separate note Frances seemed very excited about the idea of not having to hold stock of finished furniture because we are apparently having to pay 10% interest on a bank overdraft to maintain a warehouse full of furniture. You will have to look at the most recent management accounts to see what our current value of finished stock is, but I am sure that we could literally halve our requirement to hold finished stock if we had the flexibility to be able to largely produce to order. Frances said to keep this issue completely separate to the capital investment appraisal for the machinery itself, and to just regard it as an ‘added bonus’ I hope the above information helps and I look forward to seeing your end report. Regards Oliver To Sales & Marketing Director From Frances Wood [Finance Director] Date 17th July 2015 New Manufacturing Techniques Just before I leave for holiday as promised I will summarise the financial information you require to help you compile the report Mike has requested. Oliver and I have already spent some time looking at his proposal to largely automate our production process. As Oliver has no doubt already told you the required investment totals £550,000 which is clearly money we don’t have at present. We are fluctuating between a modest positive bank balance and a significant overdraft each month depending on how quickly your customers pay up ! There are of course two main routes we could pursue to increase the long-term investment in the company, namely debt or equity. I would suggest that you should summarise the pros & cons of both of these in your report. In fact Mike has always been reluctant to borrow heavily as he hates the idea of paying bank interest ! The truth is however that we are currently paying £20,000 of overdraft interest each year (at the exorbitant rate of 10% !) which we might be able to avoid if, as Oliver believes, we can drastically cut down on our massive stock holding of finished goods. We actually currently have very little debt finance (ignoring the bank overdraft which is short term) and most commentators would regard gearing (debt/total capital) under 20% as being relatively safe, so this is maybe something you would like to explore. The Bank Manager has frequently indicated that they are willing to make long term (secured!) loans to us of up to a maximum 80% of the value of the freehold premises which is more than the £550,000 we require. Having secured the loan on the freehold premises the bank are then willing to lend at a 5% variable interest over a 10 year term. As you know interest rates have remained at an all-time low since the 2008 financial crash, but must surely start rising at some point ! Then again, we could alternatively investigate issuing more share capital ! Having financed the project the key benefit to us is that the potential savings on production costs should be significant, with savings on both direct labour costs and on direct material costs (by reduced wastage). This would be invaluable and would give us options to either keep selling at our current prices whilst significantly improving our gross profit % margin , or allow us to become far more price competitive and allow us to aggressively reduce our selling prices to grow our sales. I would advise you NOT to analyse these effects numerically at this stage but to just mention them as possible benefits with maybe the odd £ figure here and there. I understand that Mike has asked you to work up some figures relating to this possible capital investment and he has asked me to provide some base figures for you. These are as follows :-  In cash terms having made an initial capital outlay of £550,000 we should then get an incremental cash benefit of £120,000 per year for 10 years, and the machinery should then have a scrap value of £50,000.  From a profit perspective (having depreciated the capital costs) we would expect to make an average of an additional £70,000 profit per annum. My advice would be to use these figures to evaluate the investment in four different ways :- i. Payback ii. Accounting Rate of Return (ARR) iii. Net Present Value (NPV) iv. Internal Rate of Return (IRR) [Use NPV @ 5% and NPV @ 20%] and don’t forget to briefly summarise the pros and cons of each of these methods. We’re not all accountants you know ! You may assume a 5% cost of capital. Keep any other potential benefits completely separate, but don’t forget to mention them (maybe even with a quick idea of the financial benefit if you can do a quick ‘back of envelope’ guesstimate !). I’m sorry I won’t be round for the next two weeks to help you with this but Mike tells me that you’re pretty good with figures ! Kind Regards Frances 4. Requirements for Board Report Using the above figures evaluate the proposed capital investment using the following four appraisal methods clearly explaining what each one shows, and the pros & cons of each method. a) [2%] Payback b) [2%] Accounting Rate of Return (ARR) * c) [4%] Net Present Value (NPV @ 5%) d) [4%] Internal Rate of Return (use NPV @ 5% and NPV @ 20%) e) [4%] Based on the results of the above provide firm recommendations (with reasons) on whether to invest or not. f) [6%] Include a brief discussion of the alternative ways of sourcing the required £550,000 of funding. Your report should include an explanation of what gearing is, how it is calculated, and the pros and cons of having low or high gearing (only very basic numerical calculations are required). * Use the SHU “Financial Fluency†version of the ARR formula and definition of ‘gearing’ 5. YOUR RESEARCH ON :- DIRECT SELLING  During your time as National Sales Manager with your previous company you were involved in their attempts to start selling online. You strongly believe that this is something Hallam Ltd should also be pursuing as a way of driving both sales and margin.  You have asked Anthony (Hallam’s most experienced sales representative) to carry out some preliminary market research on the potential market for direct selling. All of your forecasting assumptions will be based on the Standard Double Wardrobe (SDW) as a representative ‘average’ piece of furniture, and will assume a standard cost of £90 (ignore the current standard costing price review for the purposes of this forecasting exercise).  You envisage setting up an online sales channel which operates under the new and completely different brand name “Oakland’s Furniture” selling exactly the same existing products but direct to the end consumer rather than via retailers.  You envisage delivery being made by the company’s existing fleet of own trucks in conjunction with their existing deliveries to retailers. A ‘cost-neutral’ delivery fee will be charged (typically £20 per standard delivery of 1-3 items) and this is expected to cover any additional driver and diesel costs. As such all delivery revenue and delivery costs may be totally ignored.  A new B2C website with full e-commerce functionality will need to be developed and maintained and it is anticipated that employing a suitable web designer to do this will cost £45,000 per annum on a permanent ongoing basis. There will be no other software or hardware costs.  It is envisaged that you will require an office-based sales team to process the online sales orders and to answer any email/telephone sales queries. Based on your previous experience you believe that one fulltime sales handler will cost £25,000 per annum to employ and will be able to handle in the region of £200,000 to £300,000 worth of sales (exc. VAT) each per annum.  There is sufficient existing office space and spare office furniture and computers to cover the requirements of any new staff for at least the next five years, and so these costs and any other general overheads may be ignored.  Mike Thomas has requested a (spread sheet) five year incremental profit budget covering sales revenue, gross profit and direct variable costs (and ignoring any capital investment required) with a brief explanatory commentary and/or notes as required.  A key objective for you is obviously to highlight all the benefits of this proposal to Hallam Ltd (but also to mention any drawbacks to ensure balance). To Sales & Marketing Director From Anthony [Experienced Sales Representative] Date 18th July 2015 re. ‘Oakland’s Furniture’ Direct Selling Proposal As requested for the last few months I have been looking at the direct selling proposal from a ‘sales perspective’ to try and ascertain how many individual pieces of furniture we might sell in the first year ; what level of sales revenue this might result in ; and how this might then grow year on year. Sales Volume One of our competitor’s websites actually has a ‘real-time’ counter showing how items of furniture they have sold and so by monitoring this I have managed to establish that they are currently selling about 200 items per month !! Mind you they have been selling online for 5 years now , but I can see no reason why in 5 years’ time we cannot be at this same level. My educated guess for our first year sales would be 20% of this sales volume (i.e. 40 items of furniture per month) but then growing to 40% in year 2 , 60% in year 3 , 80% in year 4 and then 100% (i.e. 200 items per month) in year 5. Sales Revenue It is very hard to establish exactly what pieces of furniture we might sell online but I can see no reason why the online sales mix between different products should be significantly different to our existing sales mix achieved via our retail distributors. We know that our current standard selling price of an SDW (‘Standard Double Wardrobe’) to a retailer is ~£300 (exc. VAT) and that this represents a good average for all of our products. The problem is then trying to establish what sort of price for an SDW we might achieve when selling direct to the end consumer. I have discretely established that our most of our existing retailers utilise a mark-up of x2.4 on our (exc. VAT) standard selling price to calculate their (inc. VAT) retail price. This equates to a mark-up of 100% plus the VAT. So they will sell an SDW purchased from us for £300 ….. at £600+VAT = £720 i.e. x2.4 ) Looking at our competitor websites they seems to be selling direct to the public for online retail prices which are typically ~15% lower than the corresponding in-store retail price. So we might expect to be able to sell our ‘average’ SDW product online to the end consumer at ~£600 (inc. VAT). Best Wishes, Anthony. 5. Requirements for Board Report a) [8%] Produce a 5 year incremental sales and profit forecast for the proposed new sales operation, clearly stating and explaining any assumptions made. b) [8%] Provide a balanced commentary of the relative strengths and weaknesses of the proposal. State and justify your recommendation of whether or not to proceed with the proposal.
