Question: Hardhat Ltd.’s budget committee, which has
Hardhat Ltd.’s budget committee, which has members drawn from all the major functions in the business, is meeting to consider the projected income statement for 2020/2021, which is composed of the ten months’ actuals to the end of January 2020 and estimates for the last two months of the financial year:
Hardhat Ltd: Projected income statement 2018/2019:
After some discussion of information principally supplied by the finance director, John Perks, the committee agreesthe following changes for the 2021/2022 budget: 30% increase in number of units sold 20% increase in unit cost of materials 5% increase in direct labour cost per unit 10% increase in variable indirect cost per unit 5% increase in indirect fixed costs 8% increase in selling expenses, arising solely from increased volume 6% increase in administrative expenses, reflecting anticipated higher salary and other costs rather than any effects of the expected increased sales volume.
The increase in sales volume is meant to be a significant step towards an ambitious target market share which was included in the latest review of Hardhat’s strategic plan at the insistence of the marketing manager, Keith Boskin. Despite the change in volume, inventory quantities are expected to change little next year because of planned efficiency gains in the supply and handling of materials and despatch of finished goods. The composition of the production cost of a unit of finished product in 2020/2021 for materials, direct labour and production overhead was in the ratio of 3:2:1 respectively. In 2020/2021 £40,000 of the production overhead was fixed. No changes in production methods or credit policies are anticipated for 2021/2022. The managing director, Steve Hartley, has set a target profit before tax for 2021/2022 of £2,000,000, and the budget committee are now debating what this might imply for the unit selling price, on the basis of the information they have assembled so far.
The consensus appears to be that the profit target is very tough, but that presumably this is what Steve and the chairman, Lord Haretop, believe the city expects. Keith Boskin is worried that the imposition of the short-term target profit will jeopardize the staged attainment of his long-run market share. ‘I’m concerned that, in order to meet the profit (target imposed by Steve Hartley) we’ll have to drastically put up our price. If that happens we might hit the profit, but it’ll ruin my plans for damaging the prospects of Farfetched Co., who have been trying to take market share from us for some time now via heavy marketing expenditure – I think they’re getting desperate because our cost structure and product quality are better than theirs! If we can just keep squeezing them for another year or two, we might force them out of the market, or get them to agree to a takeover on reasonable terms.
Then we’d effectively have the market to ourselves.’ Dick Whittington, Keith’s deputy, asked ‘rather than putting up the price, could we work out how many units we’d have to sell at the old price to meet the profit target? Then we could check to see whether it would be within the plant’s capacity.’ Mark Catchall, the production manager, intervened at this point, saying ‘we can make up to 150,000 units a year with the present plant, but could we sustain that capacity output for long? I doubt it. We might have to invest in extra capacity, which is a whole new ball game. Besides, I don’t really believe we can sell an extra 30,000 units next year, never mind 50,000 units, especially at an enhanced price. I suspect we will only manage to sell an extra 20,000 units at best, and perhaps only 10,000: what would that do for our profits, John?’ John replied that he didn’t know but would investigate the various suggestions and come back to the next meeting in a week’s time with some figures. As he walked back to his office, John privately mused that perhaps the MD and chairman wanted to boost short-term profits to make it easier to raise the finance to take over Farfetched Co., in which case it wouldn’t hurt to give some thought as to the best source of finance for such a deal.
Required:
Write a report to the board of Hardhat Ltd setting out the financial effects of the various proposals and make recommendations as to what price Hardhat should charge next year and in the longer run. Your report and presentation should cover:
(a) the sales price needed to earn the target profit, using the information compiled by the budget committee;
(b) the number of units that would have to be sold at the old price to meet the target profit, and whether this seems feasible;
(c) what the profit would be if the sales price calculated in (a) were adopted, but sales volume only rose by 10%, or at best 20%;
(d) any other factors you think should be taken into account when making decisions about the price to be charged next year, such as any change in risk involved in the cost–volume–profit structure you propose; the link between short- and long-run prices; and the interactions between acquisitions policy, financing decisions and pricing decisions.
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