Toy World, Inc. is a company that has been manufacturing toys for children since 1973. Since 1976, the company has enjoyed profitable operations. At the end of 1993, revenue and profit came close to $8 million and $270 thousand respectively. With Jack McClintock as president and Dan Hoffman as production manager, the two have tried to find a strategy to adjust operations to the volatility of the toy market. Sales in the toy market are seasonal, reaching peaks in the months of August through December, while remaining relatively flat during the remaining months of the year. This seasonality has affected the company’s production schedule. During the off season, inventory is low, skilled workers are underutilized, and machinery is left idle. When the busy season finally arrives, Toy World is forced to hire more workers, pay additional overtime wages, and operate at full capacity.
Dan Hoffman sees inefficiencies in this schedule and proposes a level production plan that would eliminate overtime wages and fully utilize skilled workers. Under his plan, toys would be manufactured evenly every month, allowing inventory levels to build in the months leading up to the holidays. In addition to using cash, the company must also take on additional loans to compensate for the high inventory levels. In an industry that has relatively low capital requirements, Hoffman’s strategy may increase overall profitability, but it jeopardizes the company’s liquidity.
1. What factors could Mr. McClintock consider in deciding whether or not to adopt the level production plan?
The main factors Mr. McClintock should consider when deciding whether or not to adopt the level production plan comes down to the trade off between liquidity and profitability. Given the highly seasonal nature of the industry, producing goods ahead of time has strong risks associated with it. If management’s projections are incorrect, the company could incur significant inventory write-downs or write offs.
Additionally, the company will incur extra costs of storing the inventory that will accumulate in the first half of the year. Further, Mr. McClintock should analyze the differences in amount and timing of the company’s external funding needs under the level production plan, and whether or not the financing needs can be met by the current credit line of $2 million. To assess the impact of these factors, we prepared pro forma financial statements under level production.
2. What savings would be involved?
The savings involved in leveling production include reductions in overtime premiums as well as a decrease in additional labor costs. Expenses involved in this production overhaul include increased shipping and handling expenses and an increase in interest expenses. Both of these expenses are a result of having increased inventory levels. Total savings less total expenses from the new production strategy results in positive net savings of $148,000.
See Exhibit E.
3. Prepare the pro forma financial statements and estimate the external funding needs required.
In preparing monthly statements under the level production plan, several adjustments were made to management’s original projections (Exhibit A). Given the annual savings in overtime premiums as well as direct labor, cost of goods sold under level production would be reduced from a constant 70 percent of sales to 65.1 percent of sales. However, this is slightly offset by the annual increase in storage and handling costs, which is accounted for in operating expenses. To determine the interest income, we multiplied the average monthly cash balance by the 4 percent annualized return provided by management. Income taxes remained at 34 percent, arriving at a total net income of $661 for 1994.
The most significant adjustments made to the balance sheet were under inventory, accrued taxes, and notes payable. As is depicted in Exhibit B, we prepared schedules for both accrued taxes as well as inventory. Management provided a specific tax payment schedule, which was subtracted from each month’s income taxes to arrive at ending accrued taxes. As for inventory, beginning inventory plus finished goods completed less cost of goods sold determined each month’s ending inventory. Under level production, the finished goods completed should be constant month over month. We determined this number by dividing the annual cost of goods sold by 12. Finally, notes payable was our plug figure. As this line item represents the company’s existing credit line, it can be further analyzed to assess the company’s amount of added funds required and the timing of the needs under level production.
External Funding Needs
Toy World Inc. will require large external funding in order to support inventory levels leading up to the holiday season. Toy World currently has a $2 million line of credit with the bank. In order to support the level production plan, we estimate that Toy World will need a line of credit of close to $4 million in the month of September.
4. Compare the liabilities patterns feasible under the alternative production plans. What implications do their differences have for the risk assumed by the various parties?
Under the alternative production plans, the timing and amount of funding that Toy World will need to keep up with inventory projections significantly differs. For example, in June, due to the lags of the 60-day collection periods, strong funding will be needed to keep up with the level production. If management moves forward with the current seasonal production plan, they would not take on the further liabilities and maintain lower cash balances in the busy months of September to December. The most significant tradeoffs of the two scenarios are between liquidity, profitability and leverage. If the toys ended up not being as popular as they forecasted, then the various parties would take on the risk of the rising inventories.
Toy world would then have to decide whether or not to hang onto the excess inventory in anticipation of increased demand, or rid themselves of inventory to increase working capital. Either way, this risk, if came to fruition, would be a lose-lose situation for if they hold onto it and demand doesn’t bounce back, then they lost some working capital, but if demand does bounce back, and they have gotten rid of the inventory, they will find themselves unable to keep up with demand. Also, the industry has relatively no barriers to entry so taking on more debt in this volatile industry to increase inventories would be risky as products have short lives and a relatively high rate of company failures.
Given the inherent risks associated with producing toys significantly ahead of time, we decided to conduct a sensitivity analysis around this factor (Exhibit D). Specifically, we assessed the impact of writing off 10 percent of the prior month’s inventory balance. This change would be reflected as a direct reduction in inventory, as well as a corresponding increase in cost of goods sold, resulting in a 382 percent decrease in net income from seasonal production. While 10 percent of total inventory write downs is an extreme downside situation, the key take away is the importance of how accurate management’s projections are. In a level production plan, management will have to begin producing for peak sales periods early on in the year, greatly increasing the risk of inaccurate projections. Therefore, one of the most critical considerations in adopting level production is the confidence in management’s ability to accurately forecast industry trends.
Despite past profitability and success, our analysis shows that Toy World, Inc. could benefit greatly from an operational restructuring. Adjusting their business model to implement a level production plan in 1994 as opposed to past seasonal production will result in a positive impact on the company’s profitability. However, in order to implement these changes, Toy World, Inc. will need an extension on their line of credit. Further, our sensitivity analysis shows the importance of having strong confidence in management’s projection ability. If the company believes that their projections will be accurate enough to avoid significant inventory write offs, and can obtain approval for an extension in the line of credit, transitioning to a level production plan will greatly improve profitability and operational efficiency.