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)

KPI Break-even point (BE) Margin of safety (MOS) Net Profit (NP) Return on capital employed (ROCE)

ORIGINAL BUDGET $200,000 54.5% $108,000 18.0%

OD'S SUGGESTION $182,383 58.5% $113,000 20.5%

SD'S SUGGESTION $255,556 47.2% $102,800 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 Directors proposition, 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 breakeven 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 capital relative 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.

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) 2. Variable materials cost increases by 15% and other fixed costs decline by 20% (i.e. $10,000) (scenario 2) 3. Variable materials cost increases by 5% and other fixed costs decrease by 15% (i.e. $7,500) (scenario 3) 4. Variable materials cost increases by 5% and other fixed costs decline by 10% (i.e. $5,000) (scenario 4) The table 2 below answers these questions: TABLE 2: Sensitivity analysis for Operations Directors suggestion
OD'S SUGGESTION Sales Less Variable costs: Materials Labour $ 440,000 105,000 142,000 247,000 193,000 44% 40,000 40,000 80,000 113,000 550,000 OD'S SUGGESTION $182,383 58.5% 80,000 112,500 550,000 SCENARIO 1 $182,857 58.4% 105,500 142,000 SCENARIO 1 $ 440,000 SCENARIO 2 $ 440,000 SCENARIO 3 $ 440,000 SCENARIO 4 $ 440,000

Contribution Contribution Margin Ratio Less Fixed costs: 40,000 Selling and Admin 40,000 Other Net profit Capital employed Key performance indicators Break-even point (BE) Margin of safety (MOS)

115,000 105,000 105,000 142,000 142,000 142,000 247,500 257,000 247,000 247,000 192,500 183,000 193,000 193,000 44% 42% 44% 44% 40,000 40,000 80,000 103,000 550,000 SCENARIO 2 $192,350 56.3% 40,000 42,500 82,500 110,500 550,000 SCENARIO 3 $188,083 57.3% 40,000 45,000 85,000 108,000 550,000 SCENARIO 4 $193,782 56.0%

Net Profit (NP) Return on capital employed (ROCE)

$113,000 20.5%

$112,500 20.5%

$103,000 18.7%

$110,500 20.1%

$108,000 19.6%

The column labelled Scenario 2 shows that increasing variable material costs further by 10% 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 Sales Less Variable costs: Materials Labour $ 484,000 110,000 156,200 266,200 217,800 45% 40,000 75,000 115,000 102,800 620,000 115,000 118,700 620,000 110,500 142,000 SCENARIO 1 $ 486,200 SCENARIO 2 $ 462,000 SCENARIO 3 $ 484,000 SCENARIO 4 $ 484,000

Contribution Contribution Margin Ratio Less Fixed costs: 40,000 Selling and Admin 75,000 Other Net profit Capital employed

105,000 110,000 110,000 142,000 156,200 156,200 252,500 247,000 266,200 266,200 233,700 215,000 217,800 217,800 48% 47% 45% 45% 40,000 75,000 40,000 40,000 70,000 80,000 115,000 110,000 120,000 100,000 107,800 97,800 620,000 620,000 620,000

Key performance indicators Break-even point (BE) Margin of safety (MOS) Net Profit (NP) Return on capital employed (ROCE)

OD'S SUGGESTION $255,556 47.2% $102,800 16.6%

SCENARIO 1 $239,251 50.8% $118,700 19.1%

SCENARIO 2 $247,116 46.5% $100,000 16.1%

SCENARIO 3 $244,444 49.5% $107,800 17.4%

SCENARIO 4 $266,667 44.9% $97,800 15.8%

When comparing Scenarios 1, 2 with Scenarios 3 and 4 we see that Cam Ltds 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 sugg estion 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 associated with each alternative may help the management make a better decision. As one can see from the sensitivity analysis, ODs and 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.

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 cost structure) 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 Sales Less Variable costs: Materials Labour $ 440,000 100,000 142,000 242,000 198,000 45%

OD'S SUGGESTION $ 440,000 105,000 142,000 247,000 193,000 44% 40,000 40,000

SD'S SUGGESTION $ 484,000 110,000 156,200 266,200 217,800 45% 40,000 75,000

Contribution Contribution Margin Ratio Less Fixed costs: Selling and Admin 40,000 Other 50,000 Net profit Capital employed

90,000 108,000 600,000

80,000 113,000 550,000

115,000 102,800 620,000

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, on the 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)

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

ORIGINAL BUDGET Sales Less Variable costs: Materials Labour $ 440,000 100,000 142,000 242,000 198,000 45%

OD'S SUGGESTION $ 440,000 105,000 142,000 247,000 193,000 44% 40,000 40,000

SD'S SUGGESTION $ 484,000 110,000 156,200 266,200 217,800 45% 40,000 75,000

Contribution Contribution Margin Ratio Less Fixed costs: Selling and Admin 40,000 Other 50,000 Net profit Capital employed

90,000 108,000 600,000

80,000 113,000 550,000

115,000 102,800 620,000