answers march2012 t4

7/31/2019 Answers March2012 t4

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The Chartered Institute of Management Accountants 2012 Page No: 1

Note:

This report is far more comprehensive than would be expected from a candidate in exam conditions.It is more detailed for teaching purposes.

T4- Part B Case StudyJot toy case March 2012

REPORTTo: Jon Grun, Managing Director, Jot

From: Management Accountant

Date: 28 February 2012

Review of issues facing JotContents

1.0 Introduction2.0 Terms of reference3.0 Prioritisation of the issues facing Jot4.0 Discussion of the issues facing Jot5.0 Ethical issues and recommendations on ethical issues6.0 Recommendations7.0 Conclusions

Appendices

Appendix 1 SWOT analysis Appendix 2 PEST analysis Appendix 3 Selection of new outsourced manufacturer for products YY and ZZ Appendix 4 VP own brand proposal Appendix 5 Inventory valuation Appendix 6 Calculations for outsourced manufacturers P and Q for licensed action figures Appendix 7 Email on the key criteria for the selection of outsourced manufacturers

1.0 Introduction

Jot is a small unlisted company which designs and outsources the manufacture of a range of childrenstoys. It has grown rapidly since it was established in 1998.

It is currently experiencing manufacturing problems due to an earthquake affecting 2 of its outsourcedmanufacturers and also quality problems with another outsourced manufacturer. The quality of thecompanys products, upon which its reputation is based, must not be compromised.

The Jot brand name is known for quality toys but it is important that its products appeal to cost-conscious retailers and price sensitive customers. Jot can use the cost-leadership strategy, usingPorters generic strategy framework, to select the minimum cost in its choice of manufacturers for products YY and ZZ.

2.0 Terms of reference

I am the Management Accountant appointed to write a report to Jon Grun, Managing Director of Jot, atoy company, which prioritises, analyses and evaluates the issues facing Jot and makes appropriaterecommendations.


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I have also been asked to write an email to the management team to set out the key criteria for theselection of new outsourced manufacturers in general, together with my recommendation on whichmanufacturer(s) should be appointed for products YY and ZZ. This is included in Appendix 7 to thisreport.

3.0 Prioritisation of the issues facing Jot

3.1 Top priority Manufacturing problems

The top priority is the loss of 2 outsourced manufacturers following the recent earthquake. They areunable to manufacture any products for Jot for the remainder of 2012. Therefore new outsourcedmanufacturers need to be identified and appointed urgently in order to manufacture products YY and ZZ,which total 150,000 units in 2012. This volume of products represents over 17% of Jots planned salesof 868,500 units in 2012.

3.2 Second priority Quality problem

The second priority is considered to be the quality problem with outsourced manufacturer Q for thelicensed action figure products. The current quality is not acceptable and the order of 80,000 need to bestarted again. However, it needs to be considered whether the order is retained by outsourcedmanufacturer Q at a higher price than the current contract or whether Jot should appoint outsourcedmanufacturer P.

3.3 Third priority VP proposal

This is considered to be the third priority as this is a large contract for this key customer. Additionally,there is a risk that Jot could lose VP as a customer, if Jot were to decline the own brand proposal. Jothas never produced branded products for any retailer before, only its own Jot brand, so this is a newventure for the company, but this could see high growth in sales volumes.

3.4 Fourth priority Inventory

The revised inventory valuation is considered to be the fourth priority issue. A realistic valuation for these slow-moving products needs to be established to ensure that the accounts for the year ended 31December 2011 are accurate and reflect realistic valuations. However, the proposed valuationssuggested by Boris Hepp, Sales Director, would result in a significant write-down.

A SWOT analysis summarising the strengths, weaknesses, opportunities and threats facing Jot is shownin Appendix 1.

A PEST analysis is shown in Appendix 2.

4.0 Discussion of the issues facing Jot

4.1 Overview

Jot is growing fast and is experiencing problems with some of its outsourced manufacturers. It needs tourgently address the problems caused by the loss of 2 outsourced manufacturers caused by theearthquake and the quality problems on the licensed products. It must maintain the quality of itsproducts to retain and enhance its reputation. Late delivery of products, or poor quality, could result inreputational damage to the Jot brand and have long-term consequences.

Jot has seven main customers which account for almost 70% of Jots sales and are therefore keyplaye rs with high power, in respect of Mendelows stakeholder analysis. One of these seven main

customers is VP, a major toy retailer in the USA. VP has approached Jot with a proposal to produce toysfor it under an own brand label. This could be a huge oppor tunity for Jot but also has a range of risks.


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4.2 Manufacturing problems

With the volume of products growing, Jot has only 20 outsourced manufacturers. Following the recentearthquake, the factories of 2 of these outsourced manufacturers have been destroyed and cannot bere-built in time in order to meet the required production of products YY and ZZ for 2012. The totalvolume of units of products YY and ZZ is 150,000 units for 2012.

Of the three manufacturers being considered only B has the capacity to supply all of products YY andZZ. Jot would appear to have three options:

Place the order for all of products YY and ZZ with one manufacturer but only Manufacturer B hasthis capacity.

Place the order for product YY with one manufacturer and ZZ with another but Manufacturer Cwould only have the capacity to produce all of product ZZ.

Place orders for products YY and ZZ with more than one of the three manufacturers or even spreadthe orders over all three of the shortlisted manufacturers.

There is an urgent need to locate and appoint one or more outsourced manufacturers to make productsYY and ZZ. Only one of Jots existing outsourced manufacturers, Manufacturer A, has some availablecapacity, but not enough capacity for both products. Therefore, Jot will need to select and appoint a newmanufacturer for some, or all, of the 150,000 units as Manufacturer A has only spare capacity for 120,000 units.

The sales forecasts are for 120,000 for YY and 30,000 units of ZZ. It is not proposed to appoint just onemanufacturer as this would be too risky. There is also the need to maximise profit by selecting themanufacturers that can produce these two products for the lowest cost. Both manufacturers B and Chave tendered a price that includes a set-up cost which is chargeable to Jot.

The selection of manufacturer(s) will depend on a number of criteria including in particular the deliveredcost of products to Jots warehouses, the quality of the products, and the reliability of the del iveries interms of timeliness. Flexibility may also be an important issue i.e. how responsive are these three

manufacturers to changes in planned order quantities. Additionally, the manufacturers approach to CSRshould also be an issue for Jot to consider.

Jot needs to do everything possible to reduce its cost base in order to improve its low profit margins.Jots operating profit margin was only 5.6% in 201 1, compared with, for example, the Lego Group whichhad an operating profit margin in 2010 which was significantly higher at 31.9%.

Appendix 3 shows the comparison of the three proposed manufacturers. This shows the totalcontribution for each product less the total set-up charges, resulting in the profit for each product for each manufacturer, taking into account the capacity constraint of 100,000 units for Manufacturer C.Each of the three shortlisted manufacturers has limited available capacity and it is necessary to consider the total profit that can be generated for each product by each of the outsourced manufacturers in order to maximise Jots profit. A summary table is as follows:

ManufacturerA

ManufacturerB

ManufacturerC

Product YY:Profit 000 72.0 156.0 181.0

Number of units 120,000 120,000 100,000

Profit per unit 0.60 1.30 1.81

Product ZZ:Profit 000 120.0 114.0 114.9

Number of units 30,000 30,000 30,000

Profit per unit 4.00 3.80 3.83


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As can be seen from the above table Manufacturer C has the highest profit per unit for Product YY at 1.81, and the highest overall profit for product YY at 181,000. Therefore in order to maximise profit,Manufacturer C should be selected to make product YY up to its capacity of 100,000 units. Therefore itwould be necessary to select either Manufacturer A or B to make the balance of 20,000 units of productYY.

All 3 manufacturers will generate very similar levels of total profit for product ZZ, with a range between 120 K and 114 K. If Manufacturer C is selected for product YY, then it will not have sufficient capacityfor manufacturing any of the ZZ products. Therefore, Manufacturer A or Manufacturer B should beselected for product ZZ.

Manufacturer A

This company already manufactures products for Jot, so it is a known outsourced manufacturer. It hasavailable capacity for only 120,000 units so it cannot produce both products but it could produce all of YY only or some of YY and all of ZZ.

Manufacturer A has the possible problem is that it is located in the same area near to the earthquake, sothis could result in other problems with communication links, roads and even further earthquakes.

The profit per product YY at only 0.60 per unit is far lower than competitors and therefore Manufacturer A should not really be considered to be the main manufacturer of product YY. However, it will generatethe highest profit for ZZ and therefore is very suitable for product ZZ.

Manufacturer A is known to Jot and is therefore lower risk and it has acceptable quality but has someproblems with CSR issues. Jot needs to work with manufacturer A to try to improve and resolve the CSRissues.

Manufacturer B

Firstly this company is located in Asia but not in China. Therefore, this is a new location for Jot to havean outsourced manufacturer and this will require new logistical links to be established. Shipping costs at

0.60 per unit are 50% higher than shipments from China.

Manufacturer B has a large amount of available capacity at 180,000 so it could produce one or both of these products for Jot.

Manufacturer B has a large set-up charge to establish production but it has a lower unit cost. Therefore,the greater the volume of production the lower the outsourced manufacturing cost will be for Jot. Theoverall profit for product YY (based on the full 120,000 units) is 156 K, which is 1.30 per unit. This isover double the amount of profit per unit compared to Manufacturer A but requires the full volume of 120,000 units to achieve this level of profit.

It should be noted that Manufacturer C (see below) achieves the highest profit for product YY, but has acapacity constraint of only 100,000 units. Therefore, Manufacturer A or B should be selected to producethe balance of 20,000 units.

However, for just 20,000 units of product YY, Manufacturer B would generate a loss, due to the highlevel of set-up costs, as shown below:

Contribution per unit (per Appendix 3) 1.80

Volume 20,000 units

Total contribution 36,000 Less set-up costs 60,000 Loss (24,000 )

Therefore, for the balance of 20,000 units of product YY, Manufacturer B would result in a loss andshould not be appointed. Therefore Manufacturer A should be selected for the balance of 20,000 units of product YY.


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Manufacturer C

Manufacturer C is based in Eastern Europe, which is near to the European sales markets. This wouldresult in Jot near -shoring some of its outsourced manufacturing. Near-shoring is defined as the transfer of business processes to a company in a nearby country.

Shipping costs are low at only 0.02 per unit. It would be useful for Jot to appoint a more localmanufacturer so that the outsourced manufacturer can be more responsive to late increases in salesvolumes and could result in Jot carrying lower inventory levels.

Manufacturer C has limited capacity at 100,000 and therefore could only produce part of the order for product YY or all of product ZZ.

Manufacturer C also has a set-up charge for the production of each product, although its set-up chargesare lower than Manufacturer B. Manufacturer C could generate the highest total profit for product YY at

181,000 but it could only manufacture 100,000 units of the required 120,000 units for product YY. Thedifference between the profit that could be made for product YY by appointing Manufacturer B, rather than Manufacturer C, is 25,000 (as Manufacturer B generates a total profit of 156,000 but this is for the total of 120,000 units).

Perhaps the balance of 20,000 units of product YY could be produced by Manufacturer A (asManufacturer B would be too expensive if the set up charge was incurred for only 20,000 units as shownabove).

Manufacturer C is only a little more expensive that Manufacturer A for product ZZ but as Manufacturer Cis the cheapest for product YY and it has limited capacity, it is proposed that it should not be consideredfor product ZZ.

Manufacturer C has acceptable CSR credentials and produces good quality products.

Overall

It seems realistic that Jot should appoint two or even all three of these outsourced manufacturers toensure that enough products are manufactured to meet sales forecasts and spread the risk of losingproduction capacity if there were to be any further problems.

The costs and profits for all three outsourced manufacturers for product ZZ are very similar. However, asManufacturer C will result in a far higher profit for product YY than the other two shortlisted outsourcedmanufacturers, it should definitely be selected to manufacturer product YY up to its maximum capacity.

4.3 - Quality problem

Jot appears to have a problem here with the outsourced manufacturing of 80,000 units of the licensedproducts, with very little time to sort the problem out. Jot requires 80,000 units to be delivered to Europeby the end of May, which is just over 2 months away, and therefore Jot must act quickly.

Michael Werner, Operations Director, conducted aggressive negotiations with Manufacturer Q (Q) onprice, and the contract price was agreed at 6.00 per unit. However, this has resulted in Q reducing thequality of its products to an unacceptable level. Following further discussions, Q now stated that if Jotagrees to the higher price of 7.00, then it will meet the required quality standards. However, should Jotwork with a manufacturer which is producing low quality products due to cost constraints. Can Q betrusted?

Jot has already incurred significant costs. Jot has already received 10,000 units for which it owes Q 60,000, and in addition is also liable to pay a further 60,000 for 10,000 units manufactured by Q butnot yet shipped. Jot is also liable to pay the licens e fee of 0.70 for each unit manufactured, resulting ina further cost of 14,000. Therefore the cost of these poor quality products manufactured to date by Q

will cost 134,000 in total plus any shipping costs. This is a significant amount and this should influenceJots decision as to whether it should work with Q and increase the price to 7.00 per unit or move theoutsourced manufacturing for the 80,000 products to another manufacturer.


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Jot could try and avoid paying the above 120,000 on the grounds that Q agreed to supply the productsin the first place and that the quality is not what was agreed. However, it would appear that Jot couldalso shoulder some responsibility here. In the first place, Jots contract did not specify the quality of theplastic. This could be viewed as an error on Jot s part. Also it would appear that Jot has been careless innot sampling some of the initial production run of 10,000 units before they were delivered. AlthoughMichael Werner had signed off the master moulds, the final products made should also have beeninspected by Jots quality control team .

However Q has manufactured products for Jot before and therefore presumably is aware of Jots typicalproduct quality requirements for its toys. It is fairly clear what has happened. In this very competitive toymarket, where price competitiveness is one of the major keys to success (and buyers, in this case Jot,have high power in the market place, using Porters 5 -forces analysis framework), Q was forced toagree to a price that was too low at 6.00 a unit , to enable Q to produce the licensed products at anacceptable quality. This is evidenced by Qs initial quote of 7.00 a unit, and Ps recent quote of 7.10per unit. However, at the end of the day Q did sign up to this contract but has produced poor qualityproducts. There is plenty of room for Jot to negotiate with Q as no payments have been made to date.

Calculations comparing the costs for manufacturers Q and P are shown in Appendix 6.

It would appear that Jot has two alternative options:

1. Agree to pay Q 7.00 per unit to produce 80,000 items, replacing the 20,00 0 units alreadymanufactured.

2. Place the order for 80,000 units with manufacturer P (P). Jot could probably get P to agree to a priceof 7.00, instead of 7.10, but the concern is whether P could actually make the new moulds for theproducts and then manufacture and deliver 80,000 products by the end of May 2012.

If Jot chooses to stay with Q, then Jot would be in a better negotiating stance to enable it to reduce theamount due for the 20,000 units of poor quality products that Q it has already produced. A 120,000write- off would have a big impact on Jots 2012 operating profits, currently forecast at 694,000.

If Jot decides to move the production of the 80,000 products to P for this work, then the importantquestion is whether the moulds and production can be achieved in the tight deadlines. If the productsare not available to Jots customers when the film is released than it may miss the sales and then thiscould result in Jot holding a large inventory of these items.

It may be possible for Jot to try to negotiate with Q and perhaps offer to pay Q for some of the faultyproduction and in exchange, Jot could try to obtain the master moulds for the characters from Q, whichhave been made by Q (and are owned by Q). If Jot were able to obtain these moulds, then it would savetime not having to make new moulds and this would allow Jot to appoint P, and to give the mouldsdirectly to P for it to use for the manufacturing of these products.

There is a need for closer quality control and inspection of production at the early stages to eliminate themanufacture of poor quality toys. Jots contract with its manufacturers should specify all aspectsincluding the quality of the plastics.

Furthermore, all outsourced manufacturing contracts must specify delivery dates and perhaps penaltiesfor late delivery, as it is crucial that delivery of all 80,000 units are made by end May 2012 in order tomeet customers orders for the film release in July 2012.

4.4 VP proposal

One of Jots seven main customers, VP, has approached Jot with an opportunity to supply productsusing an own brand range of products. This is a great opportunity for Jot and would increase thevolume of sales significantly, from the current level of 145,000 units to a forecast level of over 1,100,000units by 2017. The proposal is for a 5 year period only.

VP is one of Jots seven main customers and therefore holds significant power over Jot (Porters 5forces).


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Appendix 4 shows the full workings for the proposal for the 5 year period being proposed for ownbrand products.

A summary of the alternatives is as follows:

VP proposal forown brand

Carry on sellingJot products to VP

Growth in sales volumes each year 50% 12%

Sales volumes: 2013 units 217,500 162,400

2017 units 1,101,095 255,540

NPV 000 3,585 3,138

Difference in NPV 000 +447

The NPV based on the discounted margin of carrying on selling Jot branded products to VP, based ongrowth of 12%, is 3,138 K over the five year period. Sales volumes to VP by year 5 would be 255,540units.

If the VP own brand proposal were to be agreed, the NPV of the discounted margin would be 3,585 K, which is 447 K higher. Sales volumes of VP own brand products by year 5 is forecasted to be1,101,095 units.

The proposal will be analysed using the Johnson, Scholes and Whittingtons mo del of suitability,acceptability and feasibility.

Suitability The proposal is suitable and many toy retailers have own brand products designed and manufacturedby toy companies. These include the Early Learning Centre (ELC) toy retailer which has retail outletsthroughout Europe, as well as the global brand of ToysRUs which has own brand electronic productsmade for it by V-Tech.

It is unlikely that Jot could further penetrate the USA market without working closely with VP and thisproposal will allow Jot to work with a large toy retailer and could be an important step for Jot to gaingreater recognition and to boost the volumes of products sold.

Acceptability Appendix 4 shows that the proposal is financially acceptable as it generates a positive NPV of 3, 585 K,

which is 447 K higher tha n carrying on selling Jots own products to VP.

The proposal states that VP would place firm orders in March of each year, therefore the uncertainty of volumes to be manufactured is eliminated and VP would bear the risk of unsold inventory.

Whilst the NPV is higher than carrying on selling Jots own products to VP, Jot would need to ensurethat the volumes of VP own brand products grew at 50% each year as forecasted. This is a very highlevel of annual growth and by year 5 sales would be 1,101,095 units, which is over 4 times the volume of sales for VP using only 12% growth. This could generate high sales revenues for Jot and a goodreputation as the supplier of own brand toys to such a large retailer .

The NPVs are based on the assumption that the larger volumes of products would allow Jot to negotiatea manufacturing price reduction of 5% from its manufacturers. Perhaps at this higher level of production,

higher volume discounts could be obtained fr om Jots outsourced manufacturers, which could generatehigher margins for Jot.


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Feasibility The proposal is feasible as Jot has the experience and skills to produce a range of products using itsoutsourced manufacturers. Jot also has the skills to design and produce one exclusive product for VPeach year. Jot would need to ensure that the cost of design and prototypes did not exceed the fixedcharge of 0.25 million each year.

The proposal is that Jot would design an exclusive product for VP each year, but this could detract fromnew products developed by Jot for its other customers. How will VP choose the new product? Would itwork with one of Jots designers? Jot would not wish to allow VP to have its best new productexclusively for VP.

In respect o f the price reduction agreed with VP for own brand products, perhaps Jot should negotiatea price reduction which is based on a sliding scale depending on the volumes of own brand productsordered rather than a flat 20%. It is suggested that Jot tries to negotiate the selling price reduction from20% down to between 15% and 18% or to vary the price discount depending on volumes.

Additionally, perhaps a minimum volume of units for 2013 and 2014 should be written into the contractwith VP. The proposal only generates a positive NPV from year 3, so it is the first 2 years and thevolume increases of 50% which are crucial here. Perhaps the contract could have minimum volumes for the first 2 years, to protect Jot.

In terms of feasibility Jot would appear to be able to finance this growth in sales from operating profits.However, care would have to be taken with cash flow management caused by the build up of inventoriesfor VP before the high quarter 4 sales period. Jot also needs to consider the cash flow implications for the design and pre-production cost for designing an exclusive product for VP each year. Would this haveto be initially funded by Jot, or could an up-front payment from VP be negotiated?

The case material states that VP wishes to increase its range of own brand products and therefore if Jotwere to decline the VP own brand proposal, th en Jot runs the risk of losing VP as a customer entirely.It is possible that VP could select a different toy company to produce own brand products for it , if Jotdeclined this proposal.

VP is Jots main customer in the USA with over 90% of its sales and the loss of this single customer would be significant, as sales to VP in 2011 were over 2.0 million (20.3% of Jots total sales) .

A disadvantage of the own brand proposal is that Jot would have to manage a more complexmanufacturing process with two brands (the J ot brand and the VP brand) and different packaging for each branded product.

A potential disadvantage for Jot of VPs proposal would be a much lower brand awareness of Jotsname with consumers in the USA, since these consumers will only know the products as being VPbranded products.

Furthermore, this proposal w ould make Jots pl ans to expand further into the USA market difficult andcould result in the loss of sales to other USA customers. VP currently generates 90% of sales to theUSA and if it were to retail identical products using the VP own brand label, then it may make it difficultfor other retailers to compete. Therefore, potentially Jot could lose sales from other small USAcustomers worth 222 K (VP = 2.0 million / 90% x 10%). At Jots average gross margin of 32.3% (planfor 2012) this potential loss of sales could result in a fall in gross margin of around 72 K each year.

Overall, this is a good proposal which could see Jots sales revenue from this customer rise from 2.0million now to almost 12. 4 million in 5 years time (1,105,095 x 11.20 per product) based on volumerises of 50% per year for these own brand products. This is a significant proposal which demonstratesthat this key customer has confidence in Jots products in the competitive USA market.

4.5 - Inventory

This issue has both a business and an ethical aspect. From a business point of view Jot would appear to

be facing a potential further inventory write- down of 47,120 , as shown in Appendix 5. This would be asignificant figure compared with the 351,000 profit before tax shown in the unaudited accounts for theyear ended 31 December 2011.


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The external auditor is insisting that this adjustment must be made, and unless Jot can come up with agood argument as to why it should not, then this adjustment will have to be made. Jot cannot risk havinga qualified audit report. A qualified audit report is issued when the external auditors encounter asituation which does not comply with generally accepted accounting principles. It is particularly importantfor Jot to get a clean audit report, as Jot is so reliant on bank finance for support. It is likely that thecompanys bankers would automatically request a copy of Jots annual accounts each year.

However, the question that needs to be asked is why Boris Hepp, Sales Director, has not offered theseproducts to Jots existing customers at reduced prices, which has been done in previous years.Inventory valuations must be realistic and should reflect the lower of the cost or net realisable value, i.e.at what price Jot could sell these products to any of its customers.

Instead of arguing as to whether Boris Hepps valuations are correct or too high or too low, it issuggested that the sales department speaks to Jots customers urgently (perhaps just the seven maincustomers) and establish:

Whether any of the seven main customers is interesting in buying any (or all) of the remaininginventory for these 3 products.

What price they are willing to pay for these products.

If any of the customers is interested in buying these products, then a formal letter of intent to buy shouldbe obtained as proof of intention (or a purchase order from Jots customers) and this price can be usedfor inventory valuation purposes.

It is unlikely that the 1,200 units of product FF are really worthless as it is probable that they could besold at a substantially reduced price. Only if none of Jots customers is interested in product FF, shouldit then be written down to zero.

Jot should use what management information it possesses in respect of which customers havepreviously purchased products BB, CC and FF and to ask these customers if they are interested inpurchasing Jots remaining inventory.

It is suggested that Boris Hepp and his sales department are given a deadline of 1 week to contactcustomers to see if any customers are interested in procuring these products and at what price. After the1 week deadline, then Tani Grun, Finance and IT Director, should meet with Boris Hepp to jointly agreeon realistic values for each of these 3 products and to establish how many can be sold and at whatprice.

In future, inventory valuations should occur on a regular basis and Boris Hepp should not be advisingrevised valuation figures directly to auditors before he has discussed and agreed the valuations withTani Grun.

It is recommended that Boris Hepp be reminded of the importance of accuracy in respect of the databeing used for Jots financial statements. The level of profitability is a key indicator for businessvaluation purposes and for securing loan finance. An incorrect inventory valuation could have far

reaching effects.The ethical aspects of Tani Grun telling Boris Hepp to tell the auditors that his previous valuations wereincorrect will be discussed in the Ethics section of this report below.

5.0 Ethical issues and recommendations on ethical issues

5.1 Range of ethical issues facing Jot

There are a range of ethical issues facing Jot including the following:

1. Inventory pressure being put on Boris Hepp, Sales Director 2. Incorrect marketing material3. Pressure that was put on outsourced manufacturer Q to reduce its original tender price


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5.2 Inventory - pressure being put on Boris Hepp, Sales Director

5.2.1 Why this is an ethical issue

Boris Hepp, Sales Director, should establish a realistic valuation for these 3 products based uponfeedback from customers after establishing whether they would buy any of these older products. TaniGrun should not be allowed to unduly influence his valuation.

She should not i nstruct him to revise the valuations to a higher level and tell the auditors that hisprevious valuations were incorrect . This is unprofessional and unethical behaviour for a FinanceDirector.

5.2.2 Recommendations for this ethical issue

It is recommended that Boris Hepp speaks to Jot s seven main customers to see whether any areinterested in buying any of these products and at what price they would buy them. The inventory shouldbe valued at the lower of the current written-down price or the possible selling price, if this is even lower.

If the sales of these three products cannot be secured, then the product valuation should be written-off.

Tani Grun should be disciplined for trying to put pressure on a fellow director concerning the valuation of the inventory. She should attend a training course on the responsibilities of a company director.

5.3 Incorrect marketing material


The marketing material and packaging is knowingly making claims for the product to possess functionsthat the product does not have. This is a poor indication of the values of Sonja Rosik, MarketingDirector, that she remains unconcerned and is trying to allow the product to be sold, even though she isaware of the exaggerated claims for the product. This demonstrates a lack of integrity and this coulddamage Jots reputation.

It is unfair for Jon Grun, Managing Director, to ask Sonja Rosik to resign. However, she should bedisciplined and perhaps given a written warning.


It is recommended that the product packaging and marketing material should be amended andreprinted.

It is recommended that sales orders are not despatched to customers until the packaging and themarketing material is amended to ensure that only the true functions of the product are included.

It is recommended that Sonja Rosik is disciplined and sent on a training course to ensure that she fullyunderstands the responsibilities of being a director and the importance of truthful and accurate productdata.

Jot should also formalise its CSR charter and ensure that all employees are aware of the importance of truthful marketing material.

5.4 Pressure that was put on outsourced manufacturer Q to reduce its original tender price


Whilst this could be considered to be normal business practice to negotiate on price, excessive pressurethat has been put on outsourced manufacturers is not ethical or a sustainable practice.


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Michael Werner has pressurised outsourced manufacturer Q into reducing its tender price for the 80,000units of the licensed action figures, down from 7.00 to 6.00. The reduced price has now resulted inpoor quality of production. A different outsourced manufacturer, P, has now tendered a price of 7. 10.This indicates that Qs price of 7.00 was realistic. Jot should not exert undue pressure to reduce tender prices.


It is recommended that Jot negotiates with all of its outsourced manufacturers on price but that it shouldnot put significant pressure on them to reduce prices as this could have a detrimental effect on the finalquality of the manufactured products.

It is recommended that tenders should be sent to at least three outsourced manufacturers for eachproduct and that fair negotiations take place.

6.0 Recommendations

6.1 Manufacturing problems

6.1.1 Recommendation

It is recommended that Manufacturer C, in Eastern Europe, is appointed to manufacture 100,000 units of product YY as this maximises the profit for Jot.

It is also recommended that the balance of 20,000 units of product YY should be produced byManufacturer A, as Manufacturer C only has available capacity for 100,000 units.

It is recommended that Manufacturer B, based in a different Asian country, should be appointed tomanufacture all 30,000 units of product ZZ.

6.1.2 Justification

This combination of products and manufacturers will generate a total margin for these products of 307 ,000, which is just lower than the profit maximisation option.

This compares to a margin of only 270,000 if Manufacturer B w ere to be appointed for both products,which is a reduction of 37 ,000 compared to the recommended mix which will generate 3 07,000.Neither Manufacturer A or C has the capacity to produce both products.

Manufacturer C is the cheapest for product YY and therefore should be selected for this high volumeproduct up to the level of its capacity constraint of 100,000 units. Using Manufacturer C also has theadvantage of dealing with an outsourced manufacturer with very good quality, short transportation(based in Europe) and an acceptable CSR status.

The selection of Manufacturer A for the balance of 20,000 units is due to the lack of set up costs, whichmake Manufacturer B too expensive for only 20,000 units of product YY.

Whilst the cheapest manufacturer of product ZZ is Manufacturer A, with a total profit of 120,000, it isrecommended that Manufacturer B is appointed. This will result in a slightly lower total profit for thisproduct of 114,000, which is only 6,000 lower. However the justification for this recommendation toappoint Manufacturer B, rather than Manufacturer A, is:

Jot should widen its choice of outsourced manufacturers as it has growing volumes of sales.

Manufacturer B is located away from the earthquake area in China, should there be any further natural disasters.

It will give Jot an opportunity to work with a manufacturer in a different Asian country.

The difference in the profit between Manufacturer A and B is only 6,000 .


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The choice of using all three of the shortlisted manufacturers, A, B and C, will generate a profit of 307,000 which is only 6,000 lower than the profit maximisation option shown in Appendix 3.

6.1.3 Actions to be taken

1. It is recommended that before the order for product ZZ is placed with Manufacturer B that meetingsshould be held with the company to discuss Jots concerns over its CSR status. The rationale is thatJot would not wish to damage its reputation by dealing with an outsourced manufacturer with knownCSR problems without making some clear attempt at resolving the situation. It is suggested that Jotfollow The Lego Groups approach of requiring all its outsourced manufacturers to sign up to a Codeof Conduct covering issues such as child labour and health and safety.

2. Jot should work closely to resolve CSR issues with Manufacturer A.

3. Jot should monitor product quality closely with these two new outsourced manufacturers, B and C.

4. Jot should establish shipping and transportation links with its outsourced global logistics companyfor the transportation of goods from the new Asian country and the Eastern European country toJots warehouses.

6.2 Quality problem


It is recommended that the contract with outsourced manufacturer Q is terminated.

It is recommended that outsourced manufacturer P is appointed to produce the 80,000 units of thelicensed products.

6.2.2 Justification

Q has produced poor quality products at the current contracted price of 6.00 per unit. If Jot were toagree to increase the price paid to 7.00 per unit , there is no guarantee that it will deliver the requiredquality of product. Q appears not to be a reliable and trusted manufacturer and Jot should not continueto work with a company which does not deliver the right quality product at the price specified in theagreed contract.

Q allowed the contract price negotiations to happen and it signed a contract at the price of 6.00 per unitand it should have forewarned Jot of the ways in which it would cut costs and the impact this could haveon quality.

It is recommended that Jot negotiates what should be paid to Q for the 20,000 units it has alreadymanufactured to date, which are of poor quality. It is unfair for Jot to pay the full contracted cost of

120K (20,000 x 6.00). Perhaps Jot can negotiate to pay part of this in exchange for obtaining themaster moulds from Q.

The justification for recommending that outsourced manufacturer P is appointed is that quality is animportant aspect of Jots products, despite the slightl y higher cost per unit of 7.10. Perhaps this couldbe negotiated down slightly to 7.00 to match Qs revised price.

If the master moulds cannot be obtained from Q quickly, then P will have to make them and these willneed to be approved to ensure that they are accurate and meet the licensing terms for each character.


1. Negotiations with Q following the termination of the contract to agree whether Q will give the master moulds to Jot, or not, in lieu of Jot agreeing to make part payment for the 120 ,000 that is due.


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2. Alternatively, if Q will not give the master moulds to Jot, then a reduced payment by Jot should benegotiated for the poor quality products. A cost of 25% of the value due to Q is suggested i.e.

30,000 with the ability to negotiate up to 50% of the value. Q would not wish to take the case tocourt as Q is at fault in the quality of the production. Therefore, negotiations on what level of payment should be made, should take place urgently.

3. A contract with P should be prepared urgently, and the contract should include quality issues andspecify the quality of the plastics to be used, as well as an agreed and realistic delivery schedule.

4. It is important that all 80,000 units of these products are available to Jot by the end of May 2012, toallow time to deliver the products to its customers to coincide with the release of the childre ns filmand therefore the contract should specify delivery dates and include a penalty for late delivery.

6.3 - VP proposal


It is recommended that the VP own brand proposal be accepted.

It is recommended that Jot tries to negotiate the selling price reduction from 20% down to between 15%and 18% or to vary the price discount depending on volumes ordered by VP each year.

It is further recommended that the forecast growth of 50% be written into the contract, or the minimumnumber of products to be bought by VP for years 1 and 2 are written into the contract, in order to protectJot from lower levels of orders from VP.

6.3.2 Justification

By accepting the VP own brand proposal , this will allow Jot to generate high growth in sales volumesand could allow significant revenue growth in the competitive USA market.

If Jot were to decline the VP proposal, then it could lose its major US customer and 2.0 million salesrevenue, as VP could choose a competitor to m ake its own brand products. The risk of losing VP is toogreat to decline this proposal.

The rationale is also that the VP own brand proposal has a higher NPV than that from carrying onselling Jot products, with the difference in NPVs over 5 years at 447 K.

The rationale for the recommendation concerning the pricing structure proposed by VP is because Jotwill make significantly lower profits in both 2013 and 2014 than it would have done without the ownbrand proposal. Jot needs to protect itself from ove rly ambitious sales projections, especially in the firsttwo years.


1. Jot should enter into negotiations with VP regarding the accuracy of the ambitious sales growthtargets, with a view to having a sliding scale of price reductions up to 20% only if the 50% annualgrowth targets are achieved.

2. Jot should negotiate with VP concerning a minimum volume of products to be ordered in years 1and 2.

3. Jot should negotiate with VP regarding the timing of the payment for the annual 0.25 million for designing an exclusive product for VP.

4. Before Jot makes its final decision on the own brand proposal it should discusses this major

strategic initiative with its bankers. The rationale for this is to get the bank on -board in the event of a further overdraft facility being required to fund the possible extra working capital requirementscaused by the projected high sales growth.


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6.4 Inventory


It is recommended that Boris Hepp should speak to Jot s current customers , especially Jots seven maincustomers, to see whether they would be interested in purchasing some or all of these products atreduced prices.

It is recommended that a deadline for this contact with Jots customers to be made is one week fromtoday.

After this one week of contact with customers, it is recommended that Tani Grun should meet with BorisHepp to establish what volume and at what price any of the inventory for products BB, CC and FF couldbe sold. They should discuss and agree on a realistic valuation for any remaining unsold inventory for each of these 3 product lines or write off the entire value of any remaining inventory if it cannot be sold.

The revised valuation, after establishing what volume of these three products can be sold, and at whatprice, should be adjusted in the accounts for last financial year.

6.4.2 Justification

The justification is that Boris Hepp should make efforts to sell the remaining items of inventory for thesethree products rather than just write-down the value of inventory.

After customers have been contacted to try to sell some (or all) of the inventory for these products, thenthe remaining inventory should be written-down, or potentially written-off entirely. The inventory valueshould be a realistic value of what these products can be sold for. If they cannot be sold, then theyshould be written-off so that the Statement of Financial Position is not overstated.


1. Boris Hepp to contact Jots customers to try to sell the remaining inventory of these three products.

2. Any unsold inventory should be written down or written off, depending on whether it is realistic thatthese products could be sold in the future.

3. Tani Grun should liaise with the external auditors to advise on the what actions are being taken tosell these old product lines.

4. Tani Grun to finalise the inventory write-down or write-off, after customers have been contacted, andthen adjust last years accounts for the revised inventory valuation.

7.0 Conclusions

Jot s management team has been very successful since Jot was established in 1998 and the businesshas grown considerably. It has continued to be innovative and create new toys and has expanded itsgeographical markets substantially.

There is every reason to consider that Jot will continue to be successful and profitable but it needs tourgently address the problems with, and shortage of , its outsourced manufacturers. Jots managementteam needs to ensure that it works closely with its outsourced manufacturers so that a good businessunderstanding is established and that the outsourced manufacturers can produce the right qualityproducts at the right time, for Jot to supply to its customers.

This will allow Jots management team to concentrate on the business of designing and selling a rangeof innovative toys.


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Appendix 1SWOT analysis

Strengths

Successful and fast growing company.

Good product designs.Profitable company.High growth in sales revenue (almost 18%last year).Expanding geographical markets.Experienced and committed managementteam.Good safety record on its products.

Weaknesses

Dependent on just seven customers for 68% of sales revenue. Dependent on product designers and keyemployees. Reliant on only 20 outsourcedmanufacturers. Highly dependent on customers changingpreferences. Seasonal business with peak sales inquarter 4. Dependent on Jots senior managementteam and a loss of any member wouldhave serious consequences. Jot has not yet published a CSRstatement. Poor control over inventory and slowmoving products which could result in aninventory write-down.

Opportunities

VP proposal for own brand productsresulting in a large growth in salesvolumes.

To appoint one or more new outsourcedmanufacturers to produce products YYand ZZ.To appoint new outsourced manufacturersoutside of China as Manufacturers B andC are located in another Asian country andin Eastern Europe respectively.

Appoint a new outsourced manufacturer,P, to manufacture the licensed products.Improved control over outsourcedmanufacturers.To sell slow moving products rather thanwrite-down the inventory.

Threats

Loss of two of Jots outsourcedmanufacturers factories due to theearthquake.

Poor quality of production by outsourcedmanufacturer Q.Inaccurate marketing literature andpackaging for one product.Possible large write-down of Jotsinventory.Losing key employees.Need to comply with EU safetyregulations.Competitors actions and pricecompetition.

Note:The above SWOT analysis is detailed for teaching purposes. However, in exam conditions aSWOT containing fewer bullet points, which cover the main issues from the case and theunseen material, is expected.


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Appendix 2PEST analysis

Political/Legal

Changes in product safety.

Quality problems with Q concerning licensed products poorly madeBreach of Jots IPRs and loss of sales from copied products.

Economic

Recession resulting in lower disposable income resulting in lower levels of sales.Increased wage rates in China resulting in higher outsourced manufacturers prices.Current economic conditions re sulting in restricted finance being available from Jots bankers. Price competition.

Ability to sell slow moving products and whether Jots inventory needs to be written downfurther.

Social

Changing consumer tastes which could result in lower or higher sales for new products.Changing consumer tastes which could result in an inventory write down.

Technological

Cost of new technology.Faults on electronic components.


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Appendix 3 (page 1)

Selection of new outsourced manufacturer for products YY and ZZ

ManufacturerA

ManufacturerB

ManufacturerC

Product YY:

Revenue / unit 9.00 9.00 9.00

Less: Manufacturing cost / unit 8.00 6.60 7.05Less: Shipping cost / unit 0.40 0.60 0.02

Contribution / unit 0.60 1.80 1.93

Volumes units 120,000 120,000 100,000

Total contribution 72,000 216,000 193,000

Less: set-up cost 0 60,000 12,000

Profit 72,000 156,000 181,000

Profit ismaximised

Product ZZ:Revenue / unit 12.00 12.00 12.00

Less: Manufacturing cost / unit 7.60 6.60 7.75Less: Shipping cost / unit 0.40 0.60 0.02

Contribution / unit 4.00 4.80 4.23

Volumes units 30,000 30,000 30,000

Total contribution 120,000 144,000 126,900

Less: set-up cost 0 30,000 12,000

Profit 120,000 114,000 114,900

Profit ismaximised

Maximisation of profit is achieved as follows: Units Profit

Manufacturer C to produce 100,000 units of product YY 100,000 181,000

Manufacturer A to produce balance of 20,000 units of product YY 20,000 12,000Plus:Manufacturer A to produce all 30,000 units of product ZZ 30,000 120,000

Total profit for both products YY and ZZ 313,000

Note: An alternative approach which excluded sales revenue and calculated the cost minimisation approachwould be acceptable. This is shown on the next page in Appendix 3 (page 2).


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Appendix 3 (page 2)

Selection of new outsourced manufacturer for products YY and ZZ(Alternative format of cost minimisation)

A B C

YYVolume 120,000 120,000 100,000

Manuf. 8.00 6.60 7.05Ship. 0.40 8.40 0.60 7.20 0.02 7.07M+S cost 1,008,000.00 864,000.00 707,000.00Set up 0.00 60,000.00 12,000.00

Total cost 1,008,000.00 924,000.00 719,000.00

ZZVolume 30,000 30,000 30,000

Manuf. 7.60 6.60 7.75Ship. 0.40 8.00 0.60 7.20 0.02 7.77M+S cost 240,000.00 216,000.00 233,100.00Set up 0.00 30,000.00 12,000.00

Total cost 240,000.00 246,000.00 245,100.00

Costs minimised:YY Manufacturer C produces 100,000 at a cost of 719,000 YY Manufacturer A produces 20,000 at a cost of 168,000 ZZ Manufacturer A produces 30,000 at a cost of 240,000

Total cost 1,127,000


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Appendix 4

VP own brand propos al

Proposal time frame2013

Year 1

2014

Year 2

2015

Year 3

2016

Year 4

2017

Year 5Forecast with out own brand

Forecast sales volumes at 12 % growth Units 162,400 181,888 203,715 228,161 255,540

Current average sales price to VP 14.00Less:Current outsourced manufacturing cost 9.50Shipping costs 0.40Margin 4.10 665,840 745,741 835,232 935,460 1,047,714

Cost of capital 10% 0.909 0.826 0.751 0.683 0.621

Present value of margin 605,249 615,982 627,259 638,919 650,630

Cumulative present value 605,249 1,221,231 1,848,490 2,487,409 3,138,039

NPV 3,138,039Forecast of VP "own brand" products :

Forecast sales volumes at 50% growth Units 217,500 326,250 489,375 734,063 1,101,095

Forecast sales price less 20% 11.20Less:Forecast manufacturing cost with 5% reduction 9.025Shipping costs 0.40Margin 1.775 386,063 579,094 868,641 1,302,962 1,954,444

Cost of capital 10% 0.909 0.826 0.751 0.683 0.621

Present value of margin 350,931 478,332 652,349 889,923 1,213,710

Cumulative present value 350,931 829,263 1,481,612 2,371,535 3,585,245

NPV 3,585,245

Difference in NPV 447,206

Difference in margin each year - discounted (254,318) (137,650) 25,090 251,004 563,080

Note:The cost of designing one exclusive product each year is excluded as it will cover the costs incurred andis therefore not relevant.

Payback period : (based on discounted cash flows) is 4.21 years .


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Appendix 5

Inventory Valuation

Current Current Revised Revised DifferenceVolumes Valuation Valuation valuation valuation

Units / unit / unit

Product BB 4,900 6.30 30,870 2.50 12,250 (18,620)Product CC 2,680 12.50 33,500 5.00 13,400 (20,100)Product FF 1,200 7.00 8,400 0.00 0 (8,400)

Total 72,770 25,650 (47,120)


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Appendix 6

Calculations for outsourced manufacturers P and Q for licensed action figures

Manufacturer Q Manufacturer P Difference80,000 7.00 560,000 80,000 7.10 568,000 20,000 6.00 120,000 20,000 6.00 120,000

100,000 0.70 70,000 100,000 0.70 70000

Total Q = 750,000 758,000 Diff = 8,000 or Q = 560,000 P= 568,000 Diff = 8,000 or Q = 680,000 P= 688,000 Diff = 8,000


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Appendix 7

Part (b) Email on the key criteria for the selection of outsourced manufacturers

To: Jots Management Team

From: Tani Grun, Finance and IT Director

Date: 28 February 2012

Subject: Key criteria for the selection of outsourced manufacturers

Dear colleagues

1. Key criteria should include quality of the product, as poor quality could adversely affect Jotsreputation for producing top quality toys.

2. Ability of outsourced manufacturer to produce the required volumes of products at the right time tomeet Jots sales orders.

3. Location of the outsourced manufacturer. Currently all of Jots outsourced manufacturers are inChina. Whilst this is a low-cost location, it does not allow fast transportation of products to its keysales markets in Europe and USA.

4. Off-shore manufacturing does not allow outsourced manufacturers to be responsive to changes insales volume.

5. To consider outsourced manufacturers based in Eastern Europe as this would result in reducedshipping costs and possibly reduced inventory write-downs, as this could help Jot to have improvedcontrol over some of its production.

6. Outsourced manufacturers need to be responsive to the need for speed of products to the market,especially for new products, where sales volumes are not known with any certainty, as well as theneed to be responsive to meet any late sales orders.

7. To reduce the average manufacturing cost per unit in order for Jot to try to increase its grossmargins as Jots average cost per product in 2011 was 9.51 (6,719,000 cost of sales divided by706,300 products) and the shipping cost was 0.40 per unit.

8. In this price sensitive market for childrens toys, Jot could gain man y advantages by near-shoringand manufacturing some of its products in Eastern Europe, for example by appointing Manufacturer C.

9. Jot should appoint several new outsourced manufacturers as its volume of sales is increasing eachyear and it needs to expand its outsourced manufacturing capacity; the earthquake in China hasmade this situation more urgent.

10. It is recommended that:

Manufacturer A is appointed to manufacture 20,000 units of product YY.Manufacturer C, in Eastern Europe, is appointed to manufacture 100,000 units of product YY.Manufacturer B, in a different Asian country, is appointed to manufacture 30,000 units of product ZZ.

Best regards

Tani GrunNote:The above 10 sentences are slightly more detailed for teaching purposes and in exam conditions brief sentences are expected.

End of answer

answers march2012 t4

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