Question: Compare the costs of production under a seasonal production plan (in which Toyworld, Inc. produces toys to order) with the costs of a level production plan......

24 Jan 2024,2:30 AM

 

Turn-in Assignment: Toyworld

 

Submit an excel file with your completed pro-forma in the Analysis tab, and the answers to questions 3 and 4 (you will see space for these answers at the bottom of the Analysis worksheet).

 

Goals:

1. Construct more challenging and more realistic pro-forma financials,
2. Understand how seasonality of a business can affect financing needs and business decisions.

 

Assignment:

 

In this case you will be comparing the costs of production under a seasonal production plan (in which Toyworld produces toys to order) with the costs of a level production plan (in which Toyworld produces toys at a steady rate throughout the year).  Level production lowers overtime and production costs but increases inventory, storage, handling, and obsolescence costs.  There may be other costs and benefits of level vs. seasonal production that will be revealed in your pro forma forecast.

 

1. Review the pro forma balance sheet and income statement given in the case for the seasonal production plan.  First, try to understand the underlying assumptions used to generate that pro forma (see footnotes).

 

2. Prepare new monthly pro forma income statements and balance sheets assuming the firm switches to level production.  You will use Mr. McClintock’s assumptions from the case text and information from the seasonal pro-forma to do this. 

 

Below are some hints to guide you along the way:

 

Helpful Hints: Income Statement

 

First, you will prepare the pro forma income statement under level production.

 

1. Sales is filled in for you.  Notice there is no change from the seasonal pro forma. Since we are only changing our production patterns (not our marketing, pricing, etc), this makes sense.
2. Cost of goods sold and operating expenses will be different from the seasonal estimates.  Use McClintock’s assumptions from the last paragraph in the case to generate new estimates for these items under level production.  COGS will be 65.1% of sales under level production, due to the saved overtime and additional direct labor savings.  Operating expenses will increase by a total of $115K, due to the increased storage and handling costs.  You should allocate these costs evenly across months: divide 115 by 12 and add this amount to the operating expense estimate from the seasonal proforma.
3. Interest expense, Notes Payable Bank.  Ignore this line for now and come back to it later.  This is the interest on Toyworld’s borrowing from their bank line of credit.  We don’t know what that is until we figure out how much Toyworld will have to borrow.
4. Interest expense, LTD.  This is the interest expense on your already-existing borrowing—probably this is interest on a mortgage.  Assume the interest charge on the already-existing long-term debt is $4,000 per month from January to June and $3,000 from July through December.  (This seems consistent with the seasonal pro forma in the case.)
5. Interest income.  Again, ignore for now and come back to it later.  This will be income earned from any excess cash that the business generates.  You will figure out this excess cash amount later when you fill in the balance sheet.
6. Income taxes.  Apply a 34% tax rate to the “Profit before tax” for that month.  This tax rate is the one used in the seasonal pro-forma: see footnote (d) in Exhibit 2.
7. Net income. Don’t forget to include the interest income and interest expense categories in your formula for net income, even though those categories are not filled in yet.  You want your formula for NI to take them into account when they are filled in later.

 

Helpful Hints, Balance Sheet:

 

1. Cash.  Set cash, for all months, at the minimum balance of $200K.  This is the minimum cash that Toyworld needs to have on hand to operate.  Toyworld can never go below this amount without endangering its operations, but in some months, Toyworld may go above it.  The excess cash, above $200K, will go in a different account we will call “Excess Funds”.  We will assume that Toyworld puts this excess in a bank account that earns interest (the minimum cash of $200K will not earn interest).
2. Accounts receivable.  Notice footnote (b) in the seasonal pro forma balance sheet (Exhibit 1).  This means that, at the end of any given month, Toyworld’s accounts receivable will be equal to its sales over the current and the prior month.  The same should be true under level production, so you can just copy the AR from the seasonal proforma.
3. Inventory.  Here, you need to make use of the idea that production (not inventory, as in the seasonal pro forma) will be level over the course of the year. Note that in the seasonal pro forma, the inventory ends where it starts, at 586.  You can assume the same will be true under level production.

The following identity will be helpful to calculate inventory from month to month:

Beginning Inventory

+ Production

= Inventory Available

- Cost of Goods Sold

= Ending Inventory

This table is also in your spreadsheet in rows 46-51. 

Assuming that inventory levels are the same in Dec 1993 and Dec 1994 means, in turn, that the total cost of the goods sold by Toyworld during 1994 is equal to the total cost of the goods it produces during 1994.  If you have calculated the COGS for each month above, then the total COGS for the year will be filled in for you, in cell O8. Take this figure, divide by 12, and use this as your monthly production for all 12 months to fill in the cells in row 48.

4. Net plant and equipment.  This will be the same as seasonal proforma—it is reasonable to assume that fixed assets would not need to change if the company moves to level production. 
5. Accounts payable (AP).  AP at the end of each month will be the amount owed to suppliers for the raw materials that Toyworld purchases on credit.  It evolves according to the following relationship:

Beginning AP

+ Purchases

= AP Avail

- Payments to Suppliers

= Ending AP

The switch to level production will also affect this item, since Toyworld’s production schedule will change. Footnote (e) from Exhibit 1 tells us that Toyworld will purchase $3M[1] in materials in 1994. Since production is level, divide this by 12 to get your purchases for each month.  The payments to suppliers during a month will be simply the beginning AP for that month, since Toyworld pays in 30 days.

6. Accrued taxes evolve according to the following relationship:

            Beginning Accrued Taxes

            + Current Taxes

            = Accrued Taxes Avail

            - Payments to Gov’t

= Ending Accrued Taxes

The Current Taxes figure is just the tax line from the income statement (row 16).  Use footnote (g) in Exhibit 1 for help with the amounts and timing of payments to the government.  Note that Toyworld makes a payment in March for its taxes due at the end of 1993, and it also makes payments in April, June, Sept. and Dec. based on its estimated taxable income for 1994. 

7. Current portion of LT debt, Long-term debt.  No change from seasonal.  Just as in the income statement, we are assuming that this mortgage debt remains as-is.
8. Shareholders’ equity.  To get Shareholders Equity for a given month, take last month’s SE and add the NI from the current month, to reflect the increase or decrease in retained earnings.
9. Total liabilities and equity.  For this item, sum up the liabilities and shareholders’ equity.  Notice that the answer you get will not equal the total assets: the balance sheet does not balance.  The “Funds Needed” and “Excess Funds” will be used to rectify this problem.
10. Funds needed: When total assets exceed total liabilities plus equity, take the difference and put it here.  This will represent the additional borrowing you will need from your bank line of credit to fund Toyworld for that month.  If total assets are less than total liabilities plus equity in any month, this category should be zero.  This was done for you in the Dec 93 balance sheet for illustration.
11. Excess funds: When the converse is true (total liabilities plus equity exceed total assets), this means the firm has extra cash on hand.  Take the difference between the two categories and place it here.  If total assets are greater than total liabilities plus equity in any month, this category should be zero.

 

Now, return back to the income statement.

Incorporate interest income and expense back into your pro forma income statement.  If at the end of any month Toy World has a cash balance in excess of the required minimum level of $200,000, assume it earns interest on the excess at a 4% annual rate during the following month.  (To convert an annual interest rate into a monthly interest rate, just divide the annual rate by 12).  Similarly, when Toy World is required to borrow funds at the end of any month (when Funds Needed is positive), assume it pays interest on the borrowed funds at a 9% annual rate during the following month.

 

You are done!  Now, we can consider the costs and benefits of moving to level production in a more thorough way.  Answer the following questions:

 

3. If Toyworld moves to level production, how large of a line of credit will they need to obtain from their bank to cover their financing needs for 1994?  Is it larger than what they would need under seasonal production?  Why is this?
4. Recommend to management whether Toy World should move to level production.  In your analysis, be sure to compare the profitability of Toy World under seasonal and level production.  Are there any benefits or risks that Toy World will encounter under a level production plan that are not already addressed by the pro forma?