Gretchen and Michaela as managers of their inherited business have all the good reasons to increase the profitability of Hallstead Jewelers after the dismal financial performance which resulted in a loss, which is almost double the income in 2004. The company has in fact aimed and intended for wider store space and had therefore expected to increase sales revenues. It did increase revenues in 2006 as compared to 2004 by not less than 30% but the increase was not enough to cover the increase as a result of the increased fixed cost which came mainly from the depreciation of leased assets and higher rent expense of the bigger space. Forced therefore to increase sales revenues, various options were evaluated to determine the effects of breakeven point in dollars and in units. The option to decrease price in order to increase volume will make it good for the company, removing the commission appears justified for its lack of relation to increase in revenues and increasing advertising expenses appears justified it will increase revenues for the company.
The company has embarked to have a bigger store space which causes the company to have leased assets renovated in 2005. The company knows it well that it will have to increase revenues to recover the increase in fixed cost and the slight increase in variable cost as a result of higher-cost products that it buys from its suppliers. The case facts however do not mention the demand of its products as measured from an external point of view in comparison with its competitors and as what may sustain by the economy. Its plan to increase advertising is premised in increased revenues which must be consistent with increased demand for the company’s products.
Table of Contents/List of Exhibits
Cover page ………………………………………………………………………………….. 1
Questions and Answers ……………………………………………………………………….3
This paper will attempt to help Gretchen and Michaela, managers, and co-owners of Hallstead Jewelers in figuring out what happened between 2004 and 2006 and explore the ideas about possible changes in strategy that would return the company’s business to profitability and a brighter future. This would specifically determine whether price reduction, adding advertising, or other strategies are needed to fend new internet jewelry competitors by using available information from the Gretchen and Michaela.
2. Questions and Answers
2.1. How has the breakeven point in the number of sales tickets (number of customer orders written) and breakeven in sales dollars changed from 2003, to 2004, and to 2006? How has the margin of safety changed? What caused the changes?
Before answering any question for computation of break-even point in a number of sales tickers, breakeven in dollars, and margin of safety, there is a need to define first the requirements of classifying the cost into variable costs and fixed costs components and in the computation of break-even analysis. Since case facts provide accounting information under the traditional or absorption costing, there is a need to convert the costs into their variable and fixed cost components. The concept of variable cost and fixed cost assumes that some costs change with changes in production but some remain the same in relation to changes in the volume of production or sales. What changes with production or sale volume is called variable cost and what remains unchanged within the relevant range is called fixed cost. Aside from the need to classify costs into variable and fixed, other assumptions under breakeven analysis include the following: Selling prices do not change as sales volume changes; productive efficiency does not change; inventory levels remain constant, that is, production equals sales, and volume is the only relevant factor affecting costs. The relevant range from which all the other underlying assumptions and concepts depend must also be valid.
In converting the cost per case facts into a variable and fixed cost components, there is a strong basis to consider the cost of goods sold as part of the variable cost. The cost of goods sold normally covers the cost of production in manufacturing concern, which includes direct materials, direct labor, and factory overhead. Since the Hallstead Jewelers is a retailer of jewelry products, it must be bought as complete products that it sells to customers. There is a strong basis therefore that the cost of goods sold is to be considered as a variable cost since the more the company sells, the more it buys goods for sale. In other words, there is a strong direct relationship between the cost of goods sold with sales revenues. The next thing to do then is to look at the breakdown of operating expenses and classify which is a variable cost and fixed cost. Among the operating expenses, the Commissions could be considered as a variable cost since the concept of a commission is to pay the same to salespersons or sales agents who take extra effort in increasing sales for the company. It is different from salaries which should be fixed since whether the salaried-salespersons make sales revenues or not, they will still receive their salaries for the period. After taking the Commissions from the operating expenses, the rest such as Advertising, Administrative expenses, Rent, Depreciation, and Miscellaneous Expenses could be treated as fixed costs already. Although the Miscellaneous Expenses appear to have increased from 2003 to 2004 and from 2004 to 2006, the same could not be considered variable since the revenues from 2003 to 2004 actually decrease in contrast. It could still be considered then as a fixed cost.
After the conversions to fixed costs and variable costs and several calculations, the break-even point in a number of sales tickets and breakeven in sales in dollars are 4534 tickets, $7.28 million; 5000 tickets, $7.62 million; and 7505; $11.65 million for the ears 2003, 2004 and 2006 respectively. See Exhibit A. The break-even point in dollars increased from 2003 to 2004 and then increased again from 2004 to 2006. This means that the company needed more sales revenues to break even in 2004 compared to 2003 and in 2006 as compared to 2003 and 2004. More sales could be a function of more sales volume or higher sales price or both. What may have caused the increased from 2003 to 2004 and from 2004 to 2006 increases are very evident in the decrease in the contribution margin ratio from 2003 to 2004 and then from 2004 to 2006. A decrease in contribution margin ratio is caused by higher variable cost in relation to sales revenues in 2004 as compared to 2003 and in 2006 as compared to 2004. Variable costs represent costs that vary with total sales revenues.
It must be pointed out however that fixed cost in relation to sales revenues also increased from 2003 to 2004 and from 2004 to 2006 as shown below:
The increases in fixed cost to sales ratios are evidently higher than the increase in variable cost to sales ratios. It can therefore be inferred that increases in variable cost and fixed cost in relation to sales should generally increase the breakeven sales in dollars. As to whether break-even sales volume has increased, the same could be confirmed to have increased in reality under the two comparisons made. It must be noted also that the price per ticket actually decreased from 2003 to 2004 but was increased from 2004 to 2006. If the price was decreased from 2003 to 2004, the effect should still be consistent since decreasing the price should entail more volume assuming the same level of revenues is targeted. As to how the margin of safety has changed, it may be stated that the same is expected to have behaved similarly with sales revenues which decreased from 2003 to 2004 and increased from 2004 to 2006. A deeper analysis would indeed confirm that from 2003 to 2004, the margin of safety did decrease from $1.29 million to $0.48 million but from 2004 to 2006, the margin of safety instead decreased from $0.48 million to negative $0.94 million. In effect, the increase in revenues from 2004 to 2006 by about 32% did not make the company safer. Since 2006, the company was already operating at a loss; thus, break-even sales dollars and in the volume are expected to be higher. As to what may have caused the changes, the same may be attributed to increased ratios of variable costs and fixed in relation to sales revenues. An increase in variable cost may have been caused by higher prices of products bought by the company from suppliers in 2004 as against 2003 and 2006 as compared to 2004. The increases for two comparisons were both by an additional 1% which means that it could have been caused by inflation. As to the increase in fixed cost ratio in relation to sales, the same may be blamed for the increased deprecation and rent expense as a result of the renovation of the store for wider space in 2005. No wonder the increase in fixed cost in relation to sales from 2004 to 2006 is more than double the increase from 2003 to 2004.
2.2. One idea that the consultant had was to reduce prices to bring in more customers. If average prices were reduced ten percent (10%), and the number of sales tickets (unit sales) increased to 7,500, would the company’s income be increased? With prices reduced, what would be the new breakeven point in sales tickets and sales dollars? Using 2006 figures, the company’s income would not be increased. If 2006 figures are assumed to be used for 2007, the result of reducing price while increasing volume is to increase the amount of net loss as incurred in 2006 from $406,000 to $1,168,075. See Exhibit B. The new break-even point in sales tickets will increase from 7505 in 2006 to 9,780 in 2007 while break-even sales in dollars will increase from $11.65 million in 2006 to $13.67 million in 2007. See Exhibit B. It would mean therefore that decreasing the price by 10% just to increase volume is not a good option because of the increase in net loss and increase of breakpoint in ticket and dollars.
2.3. Another idea that Gretchen had was to eliminate sales commissions. Hallstead’s was the only jewelry store in the city that paid sales commissions, and although both Grandfather and Father had insisted that commissions were one of the reasons for their success, Gretchen had her doubts. How would the elimination of sales commissions affect the breakeven volume? Eliminating the sales commission would reduce the break-even sales in tickets from 7505 to 6,885 if the same total sales price and total sales volumes for 2006 are used for 2007. See Exhibit C. Sales commission is supposed to increase sales volume because of more marketing efforts but it appears that increasing the same from 2004 to 2006 has not justified the increase in total revenues, thus removing the said sales commission is justified as the net loss was reduced from $406,000 to $98,250. See Exhibit C. It must be however noted that all other figures are assumed to be the same or maintained.
2.4. Michaela felt that a bigger store could benefit from greater advertising and suggested that they increase advertising by $200,000. How would this affect the breakeven point? Would you recommend that the sisters try this? Increasing advertising expenses must only be considered if there is a corresponding benefit or advantage that may be availed in terms of increased revenues. As stated earlier, increased revenues may be a function of increased volume, increased price, or both. Since advertising is meant to reach more prospective customers by telling them the benefits of purchasing the company’s products as compared to competitors, then it can be asserted that there could be increased revenues. Having a bigger store does not automatically result in higher revenues of the customers’ knowledge is not increased by promotional activities or other modes of advertising. Yes, I recommend that sisters should try this based sine based on the analysis made as per Exhibit D, sales revenues could be assumed to increase by 10%. It could not be that advertising is increased without expecting an increase in revenues and this could be based on previous experience of the company. If prices for 2006 will be maintained in 2007, increasing the volume by at least 6% and assuming all other things in 2006 to be equal for 2007, then the net loss of $406,000 would be made in net income of $36,703.46. See Exhibit D.
2.5. How much would the average sales ticket have to increase to breakeven if the fixed cost remained the same in 2007 as it was in 2006? This question assumes other figures are given for 2007 but case facts do not provide as such. From the answers given in previous numbers above, 2007 figures were assumed to be based on 2006 figures thus in answering this question, there is no difference to deal with. It should not be surprising therefore to sense some similarities with those already solved. The average sales ticket to breakeven if the fixed cost remained the same in 2007 as it was in 2006 would be at 7505 units if all other 2006 figures are assumed also in 2007. See Exhibit E.
2.6. What do you recommend that the managers at Hallstead Jewelers do?
The managers should disregard lowering the price because the big amount of fixed cost will not increase profits and will require higher breakeven in sales in units and break-even sales in dollars. Removing the sales commission would seem to be a logical option as it would make the bottom line positive when figures for 2007 are assumed to be the basis for the figures in 2006. Although the break-even point would increase as a result of removing the commission, the contribution margin ratio would increase since the commission is a big part of the variable cost. Adding advertising could however improve the company’s profitability if it will increase sales volumes or total sales. The company must however study the demand for the company’s product if such a premise is supported based on past experience. As shown in the analysis, an additional 200,000 in advertising if would result in increased sales volume by 6% at the 2006 price, the company would have profitable results. If the commission would be removed and replaced with advertising, the resulting net income would be higher. The main problem therefore of the company is how to increase revenues but the same could not be done by decreasing the price by 10% in order to increase the volume the loss would become higher. This should have been caused by the big amount of fixed cost that the company would have to recover as a result of the renovation of the stores for bigger sales spaces in 2005. Its purpose must be attained by increasing sales for the company. The company must increase sales by all means to recover the big amount of fixed cost. Based on Exhibit F, the company has very low sales per square foot for 2006 because of the renovation for bigger space. It would be a greater failure if the extra sales space created will not be used by increasing sales.
This paper has explored the different possibilities which could best help the company in restoring profitability and it would seem that price reduction is not a good option if the purpose is to increase sale revenues by increasing sales volume. Removing the sales commission appears supported as it would increase in net income as it has not justified the increase in revenues. Additional advertising of $200, 000 appears justified if it will increase total sales volume and/or directly increase sales revenues for the company to recover the big increase in fixed cost due to the renovation of the store’s space in 2005. The renovation was intended to increase store space which presupposes increase sales volume and consequently sales price; thus the company appears to be headed in such direction. Thus, the need to increase revenues as recommended to managers earlier is a must.
Exhibit A- Comparative Breakeven Analysis for 2003, 2004 and 2006
Exhibit B. Comparative results of reduced price and non-reduced price
Exhibit C – Comparative Results of With Commission and No Commission
Exhibit D – Effect if Advertising is increased by $200,000
Exhibit E – The result of fixed cost in 2006 is maintained in 2007.
Exhibit F- Comparative data – 2003, 2004 and 2006
Bruns (2007) Case Study – Hallstead Jewelers, Case no. 9-107-060, Harvard Business School
Terrill and Patrick (2007) Cost Accounting for Management, Holt, Rhinehart and Winston
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