Question

Payton Furniture Corp. is nationally recognized for making high-quality products. Management is concerned that the company is not fully exploiting its brand power. Payton’s production managers are also concerned because their plants are not operating at near full capacity. Management is currently considering a proposal to offer a new line of affordable furniture. Those in favor of the proposal (including the vice president of production) believe that, by offering these new products, the company could attract a clientele that it is not currently servicing. It could also operate its plants at full capacity, thus taking better advantage of its assets. The vice president of marketing, however, believes that the lower-priced (and lower-margin) product would have a negative impact on the sales of existing products. The vice president believes that $10,000,000 of the sales of the new product will be from customers that would have purchased the more expensive product but switched to the lower-margin product because it was available. (This is often referred to as cannibalization of existing sales.) Top management feels, however, that even with cannibalization, the company’s sales will increase and the company will be better off.

The following data are available: (In Thousands)

Current Results - Sales Revenue: $45,000, Net Income: $12,000, Average Total Assets: $100,000.

Proposed Results without Cannibalization - Sales Revenue: $60,000, Net Income: $13,000, Average Total Assets: $100,000

Proposed Results with Cannibalization - Sales Revenue: $50,000, Net Income: $12,000, Average Total Assets: $100,000

Instructions: Compute Payton’s return on assets, profit margin, and asset turnover, both with and without the new product line. Discuss the implications that your findings in part (A) have on Payton’s decision. Are there any other options that Payton should consider? What impact would each of these have on the above ratios?

Answer 1

Hi

Solution: Cannibalization Particulars Sales Net income Profit Margin (Net income /Sales) Current Without With (In thousands) $45,000 60,000 $ 50,000 $12,000 $ 13,000 $12,000 26.67% 21.67% 24.00% Average Invested Assets Asset Turnover = (Sales / Average Invested Assets) 1,00,0001,00,000 1,00,000 0.50 0.45 0.60 Return on Investment (ROI) (Net income/ Average invested Assets) | 12.00%) 13.00%) 12.00% Observation: a) In case cannibalization will take place, only sale and asset turnover will increase. Net income will remain same b) Only in case of without cannibalization, net income will increase by 1% than current performance Recommendation: Company should focus on creating the new customers for its existing products by introducing new marketing techniques. That will better help in utilizing the idle capacity of plants. Because, in case company will start a new proposed line, the sale of existing products will decrese. Which will make negative impact on existing product sale. Further it may decrease the profitability of the company in future. When new customers will be created, then demand and sales of existing product will increase, which will technically increase the profit margin, turnover and return on assets.