Guillermo Navallez (Navallez) has several important decisions to make regarding the future of Guillermo Furniture Store (GFS). Computations of return on investment, residual income, economic value-added data, and break-even analysis provide insight for decision-making and development of optimal performance measures. Choosing the most lucrative course of action requires analyzing cost relationships and behaviors, developing a management control system that helps set production standards and goals, and ties managerial efforts to organizational goals.
Measures of Profitability
GFS measures the performance of the organization by linking balance sheets from previous periods in 2008 and matching its sales, cost of goods sold, and other expenses in its income statement for June 2008 (see Table 1). The table includes return on investment (ROI) ratio, residual income, and economic value-added (EVA) amounts that measure investment-center performance.
Return on investment (ROI) is a measure of financial performance defined as income divided by the investment made to earn that income (University of Phoenix, 2010, Week Six Supplement). The calculated rate of ROI uses percentages as a means of simplifying comparisons between different sizes of investments within the organization, and between different companies within the industry. The negative residual income indicates that the cash income invested in the economic resources does not create value. The company’s rate of ROI is acceptable to production managers at 4.46%, at the same time other managers and the rest of the company are experiencing economic loss of EVA dollars. With cost of capital the same for both mid-grade and high-end production; adjustments to close the gap between after-tax operating income and tax expenses may increase residual income. Navallez focuses on reversing loss of economic profit (EVA) deciding to link EVA performance targets to management bonuses as part of the organizational control system. In this way, the use of EVA as a performance measurement will promote goal congruence and lead to better management decisions over simply using ROI values (Horngren, et al., 2008).
Cost Relationships and Behaviors
With an economic loss of $57,425, negative economic value of $91,308, and rate of return on investment of 4.46%, Navallez needs to analyze costs in the company to determine which area of the business needs improvement to increase the company’s productivity and profitability. GFS does not have a high-tech approach like other companies in the industry and is a negative influence on sales in both the high-end and mid-grade product lines. Investing in new technology may be one solution for the company. Although costs to implement new technology are high the company can double its profit because the company can focus on making more furniture at a faster rate. The company’s cost driver needing the most focus is technology because demand for mid-grade furniture is high and this will increase sales revenue. Technology would also reduce the amount of labor and would allow GFS to compete with other companies in the industry. Investing in new technology carries risk as it increases fixed costs (Horngren, et al., 2008). However, these types of risks are healthy for a company that is trying to increase its customer base and the lack of technology is preventing this from happening. Variable costs will increase as a result of training, set up of new technology, and depending on where management places implementation costs of the new technology, fixed costs may have a slight change or remain the same. There currently is no technology in place so Navallez should focus on other production costs like the stain resistant coating and flame retardant processing. By promoting the coating process of products to other furniture companies GFS can increase revenue from joint product ventures and contracts to coat other manufacturers’ products. Navallez needs more information before making the decision to add new technology and looks to results of the break-even analysis of product lines.
The break-even point is the level of sales at which revenue equals expenses and net income is zero (Horngren et al., 2008, p. 54). This means that if the break-even units and dollars are above production figures the company will record a loss. If it is below recorded production units and dollars the company will show profit. According to the break-even analysis in Table 2, the total units to break-even, 854 units, are lower than the June 2008 sales figures of 1,589 units. The break-even dollars, $286,225, are also lower than recorded from June 2008. This shows that the company is trending over the break-even point for June 2008 and will recognize a profit.
The break-even analysis also shows that the high-end product has a higher contribution rate at 38% than the mid-grade product at 26% with a total composite contribution rate of 29%. Even though units sold are approximately three-quarters less than mid-grade the higher sales price is the main factor to the larger contribution rate. If production and sales increase, variable costs would also increase and the break-even point would change to match the costs and sales. The type of flame retardant in the coating process is expensive and increases variable costs considerably. Excluding the flame retardant from the manufacturing process would decrease the break-even point and increase profits. The plant capacity for flame retardant is 1,152 units, which is over the break-even point of 854 units but lower than actual sales of 1,589 units. The amount of flame retardant at plant capacity is not enough to cover total plant production capacity.
Guillermo Furniture Store
Cost-Volume-Profit (CVP) Analysis
30 June 2008
Mid-Grade High-End Total
Selling Price $300 $477 $335
Variable Cost 223 295 237
Contribution Margin $77 $182 $98
Contribution Margin Rati 35.60% 38.14%3 39.14%
Fixed Cost $83,393
Break-even units 854
Break-even dollars $286,225
Note: Excludes returns and income tax expense.
Organizational Control System
Navallez’s sole ownership of GFS is straining under competitive pressures; the company considers reorganization strategies and identifies capabilities including its strengths and weaknesses. The analysis indicates the company may benefit by separating costs by area, looking for opportunities to increase productivity and profitability, and conducting an industry comparison. The analysis also uncovers incongruence between Navallez and his managers and between the managers and employees: a lack ethical goals balancing management efforts is increasing the size of variance between budget/actual costs and production runs. The first step is for Navallez to communicate clearly to his managers the goals and expectations, allowing them to take part in the organizational planning process. Changes must come from the top-down to ensure a uniform deployment. This step is crucial to close the gap between production line variances. Managers ignoring the budget to produce higher volumes of products have more to consider than higher bonus objectives.
Establishing realistic organizational goals provide the foundation for implementing a management control system. Significant to the process of changing employee and management behavior is capturing relevant data; however, not all data is meaningful, so determining which data to collect and review is critical (Moreno, n.d.). Accurate measurements of relevant data both financial and non-financial are inputs to the business scorecard and other reporting tools (see Figure 1). GFS leadership decides to limit initial monitoring and metrics to provide benchmarking, and a two-month acceptance and training period. A combination of activities analysis and staff recommendations will provide future monitoring points. The following measurements are priority-starting points:
-Production bonus structure will shift away from units production to metrics-based objectives focusing on reducing the variance of budgeted-to-observed for all production lines.
-Sales bonus structure will shift from types of sales favoring high-end products to sales in alignment with short-range production planning.
Encouragement of long-term contracts will form a partial basis for long-range production planning and reduce current production and sales variances. Changing the bonus structure will be immediate along with securing employee buy-in of a phased-in approach to future planning changes.
Business scorecard summary of variance data indicates future planning should include metric areas such as:
2.Strategic positioning relative to competitors.
3.Advance training to prevent downtime during technology shifts.
4.Canvassing customer needs and expansion into new market areas.
5.Customer database development.
External pressures from foreign competition, large retailers, and shrinking profit margins press Navallez into action. Evaluating cost relationships and measures of profitability such as ROI, residual income, and EVA show negative economic performance. Break-even analysis reveals that the flame retardant process does not add significant value to plant profitability but the company could retool its plant capacity to make mid-grade or high-end units that would increase profit margins. To regain its competitive edge and profitability Navallez gathers his management team, secures their buy-in, and begins strategic planning and ethical realignment of production initiatives starting with the immediate restructuring of management bonuses. After establishing goals and objectives, a business scorecard encourages communication and feedback between all levels of the organization. The scorecard measures financial and non-financial goals along with process improvements throughout the organization, supports employee development, and ties managerial efforts to a rewards system that promotes productivity and profitability.
Horngren, C. T., Sundem, G. L., Stratton, W. O., Burgstahler, D., & Schatzberg, J. (2008). Introduction to management accounting (14th ed.). Retrieved from the University of Phoenix eBook Collection database.
Moreno, G. (n.d.). How to create a relational database with Java. Retrieved from http://people.emich.edu/gmoreno/Culminating/HowToCreate.html.
University of Phoenix. (2010). Week Six Supplement: Ratio calculations. Retrieved September 30, 2010, from University of Phoenix, ACC/561 – Accounting course website.