HERIOT-WATT UNIVERSITY

ACCOUNTING – DECEMBER 2015

Section II

Case Studies

Case Study 1

Salzburg Products GmbH is a small family-owned company based in Innsbruck, Austria.

The business was started by Frau Landsberg in 1948 and then handed down to her sons
and daughters. It manufactures a single product – a unique brand of peach-flavoured
cheese, produced to a special recipe known only to the family itself.

The company is now operated by the grandchildren of the founder and they are having
some problems in dealing with the competitive and crowded European market for cheese
products.

The management, led by Georg Landsberg as CEO, are starting to prepare next year’s
budget and have assembled the following data:

Forecast annual sales 65,000 cases (of 24 cheeses)

Forecast selling price (per case) €80.00

Product cost (per case)

Direct materials €30.00
Direct labour €3.50
Variable manufacturing overhead €2.90

Fixed overheads (annual)

Manufacturing €1,400,000
Selling & Distribution €650,000
Administration €725,000

Their initial impression is that this set of forecast data will not produce an outcome
satisfactory either to them or to the family shareholders. Therefore, the management
team has convened to consider some alternative approaches that might improve the
outcome next year.

The following approaches are discussed at a management meeting:

1. Christiana Landsberg, the Chief Operations Officer, considers that the company
should look at repositioning its product by moving upmarket and selling at higher
prices. She considers that the market would accept a €5 increase in selling price
per case. However, marketing expenditure would have to increase by €100,000 to
convince the market of the ‘improvement’ in the product. Fixed manufacturing

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 overhead could be expected to fall by €60,000 per year as well. Christiana
concedes that this approach could also lead to a 12,000 decrease in cases sold.

2. Geneva Landsberg, the Commercial Director, suggests that the product price be
cut by 6%, leading to an estimated 12% increase in sales. She expects that the
increased volume will result in a saving of €3 per case in variable costs. She
estimates that the volume increase would also lead to a rise of €70,000 in annual
fixed manufacturing overhead together with an increase of €15,000 in
administration overheads.

3. Dagmar Landsberg, the Marketing Director, reveals that she has received a request
from a supermarket chain to supply 25,000 cases per year at a 40% discount on
normal selling price. Existing sales would not be affected, but she estimates that
fixed manufacturing overhead would have to increase by €145,000 to meet the
extra volume. Also, she believes that they should allow for another €60,000 in
administration overheads. Dagmar insists that this extra business can be added to
the current budget. Other members of the management team are concerned that
such a contract will damage the market’s view of the company’s brand.

Georg is confused about the impact of these different scenarios and seeks your help in
comparing the outcomes so that the company may decide upon the best way forward.

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Required:

1. Prepare the original budgeted Profit and Loss Account for next year and
identify the current break-even level of sales (in cases).
(8 marks)

Original budgeted Profit and Loss Account € €

Sales 65,000 cases at €80/case 5,200,000

Variable Costs 65,000 cases at €36.40/case 2,366,000

Contribution 2,834,000

Fixed Costs
Manufacturing 1,400,000
Selling & Distribution 650,000
Administration 725,000
2,775,000

Profit 59,000

Current Break-even Level

= Fixed Costs
Contribution Margin per unit

= 2775000
(80.00 - 36.40)

= 2775000
43.60

= 63647 cases

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2. Prepare the revised (and separate) budgeted Profit and Loss
Accounts for each of the different scenarios outlined by the different
members of the family – (1) to (3) above.
(17 marks)

Approach 1 Increase Prices

Revised Profit and Loss Account € €

Sales 53,000 cases at €85/case 4,505,000

Variable Costs 53,000 cases at €36.40/case 1,929,200

Contribution 2,575,800

Fixed Costs
Manufacturing 1,340,000
Selling & Distribution 750,000
Administration 725,000
2,815,000

Loss -239,200

Approach 2 Cut Prices and Increase Volumes

Revised Profit and Loss Account € €

Sales 72,800 cases at €75.20/case 5,474,560

Variable Costs 72800 cases at €33.40/case 2,431,520

Contribution 3,043,040
Fixed Costs
Manufacturing 1,470,000
Selling & Distribution 650,000
Administration 740,000
2,860,000

Profit 183,040

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 Approach 3 Supermarket Option

Revised Profit and Loss Account € €

Sales 65,000 cases at €80/case 5,200,000

25,000 cases at €48/case 1,200,000
6,400,000

Variable Costs 90,000 cases at €36.40/case 3,276,000

Contribution 3,124,000

Fixed Costs
Manufacturing 1,545,000
Selling & Distribution 650,000
Administration 785,000
2,980,000

Profit 144,000

3. Comment on your analysis of these three scenarios and advise the

management which of these options to pursue.
(5 marks)

The current budgeted profit of €59,000 is clearly unattractive. However,

Christiana’s proposal of a price increase and volume reduction moves the business
into a significant loss of €239,200 – and therefore it should be rejected.

Both Geneva’s and Dagmar’s plans lead to higher profits than budgeted.
Dagmar’s plan to accept the supermarket offer threatens the brand’s reputation
and produces a lower profit than Geneva’s. For these reasons, it should also be
declined. Nonetheless, we should note that the volume increase might produce
some other benefits in lowering variable costs.

The best proposal is Geneva’s – decreasing prices by 6% and increasing sales

volume by 12% – as it increases the expected profit to £183,040.

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Case Study 2

Vienna Kuchen GmbH is a long-established Austrian business, famous for its special
chocolate cakes. Over the past couple of years, the company has been experiencing some
manufacturing problems with its antiquated, rather quaint bakery equipment. In turn, this
has led to a stream of customer complaints about the drop in quality in their cakes.

The directors have been concerned about the loss of reputation of their products, which
has resulted in a fall in sales and profits during the year to 31 October 2015. This has
been the first year of disappointing financial results after a decade of consistent growth.

Reluctantly, the directors have had to consider the renewal of their entire manufacturing
equipment line. Quotations have been received from the two main suppliers of bakery
equipment:

1. Innsbruck Kuchhandlung KG €1,650,000

• payment terms – 80% on delivery, 10% in year 1 and 10% in year 2

• annual maintenance charge – €40,000 (in years 1 and 2), €60,000 (in years 3
and 4) and €80,000 in year 5
• agreed buyback – €120,000 (in year 6)

2. Linz Spezial Equipment GmbH €1,775,000

• payment terms – 60% on delivery, 30% in year 1 and 10% in year 2

• annual maintenance charge – €25,000 (in years 1–3) and €50,000 (in years 4
and 5)
• agreed buyback – €250,000 (in year 6)

Both quotations will enable the company to increase output levels to meet customer
demand for the foreseeable future.

The company accountant has met with the Sales and Marketing director and assembled
sales projections for the next five years, which assume that the company can retrieve its
market position and recommence its past growth trend. The sales projections are
assumed to be achievable, irrespective of which equipment supplier is selected.

On the basis of these sales projections, the company accountant has prepared forecast
income statements for each of the five years. He has forecast the continuation of current
cost levels. However, these income statements exclude the impact of the suppliers’
maintenance costs as these are uncertain until the equipment choice is made.

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Forecast income statements for the next five years:

Year 1 Year 2 Year 3 Year 4 Year 5

€’000 €’000 €’000 €’000 €’000
Sales 2,000 2,450 2,700 2,920 3,200
Cost of Sales 1,250 1,360 1,425 1,480 1,585
Gross Profit 750 1,090 1,275 1,440 1,615
Overheads 320 380 510 490 535
Profit before tax 430 710 765 950 1,080
Taxation 75 125 140 230 285
Profit after tax 355 585 625 720 805

The following information is also available:

1. Taxation will be paid to the government in the year after the profits have been
earned.
2. Other overheads include the following depreciation charges in respect of the
company’s other non-current assets (excluding the new bakery equipment):
€’000
Year 1 35
Year 2 35
Year 3 25
Year 4 25
Year 5 10
3. All sales are made on a credit basis. In view of the growth in sales, the accountant
has assumed that debtors at each financial year-end will increase in line with sales
– being the equivalent of 20% of annual sales. Debtors at the end of year 0 are
assumed to be €350,000.
4. All purchases/cost of sales and overheads are assumed to be paid on a cash basis.
5. The company’s cost of capital is 9% per annum with the following relevant
discount factors:
Year 1 0.917
Year 2 0.842
Year 3 0.772
Year 4 0.708
Year 5 0.650
Year 6 0.596
6. In assessing the two options, the directors have decided that it is appropriate that
they include the buyback options (year 6) in the evaluation as they can provide
significant financial incentives in the event of a future decision to upgrade the
equipment.

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Required:

Using the net present value approach, assess the financial merits of each
supplier’s equipment and comment on which supplier is preferable from a
quantitative perspective only.
Total 30 marks

Cash Flow from Profits – Common to both Options

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

€’000 €’000 €’000 €’000 €’000 €’000 €’000

Profit before Tax 430 710 765 950 1080

Add Back: Depreciation 35 35 25 25 10

Taxation -75 -125 -140 -230 -285

Increase in Debtors -50 -90 -50 -44 -56

(see Note 1)
Cash Flow from Profits 415 580 615 791 804 -285

Note 1 Sales 2000 2450 2700 2920 3200

Projected Debtors at 20% 400 490 540 584 640
Less Prior Year Debtors -350 -400 -490 -540 -584
Therefore, Increase in
Debtors 50 90 50 44 56

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Assessment – Innsbruck Kuchhandlung KG Quotation

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

€’000 €’000 €’000 €’000 €’000 €’000 €’000

Cash Flow from Profits 0.0 415.0 580.0 615.0 791.0 804.0 -285.0

Purchase Cost -1320.0 -165.0 -165.0

Annual Maintenance -40.0 -40.0 -60.0 -60.0 -80.0

Buyback Option 120.0

-1320.0 210.0 375.0 555.0 731.0 724.0 -165.0

Discount Factors at 9% 1.000 0.917 0.842 0.772 0.708 0.650 0.596

Annual Present Values -1320.0 192.6 315.8 428.5 517.5 470.6 -98.3

Net Present Value 506.6

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Assessment – Linz Spezial Equipment GmbH Quotation

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6

€’000 €’000 €’000 €’000 €’000 €’000 €’000

Cash Flow from Profits 0.0 415.0 580.0 615.0 791.0 804.0 -285.0

Purchase Cost -1065.0 -532.5 -177.5

Annual Maintenance -25.0 -25.0 -25.0 -50.0 -50.0

Buyback Option 250.0

-1065.0 -142.5 377.5 590.0 741.0 754.0 -35.0

Discount Factors at 9% 1.000 0.917 0.842 0.772 0.708 0.650 0.596

Annual Present Values -1065.0 -130.7 317.9 455.5 524.6 490.1 -20.9

Net Present Value 571.5

Conclusion: On quantitative grounds, recommend the Linz equipment.

© Heriot-Watt University, December 2015

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