Now, please note that closure is not the only option available (we ll discuss some other options later in this presentation).

Transcription

1 Alternative Choice Decisions Hello and welcome to today s presentation on Alternative Choice Decisions. Alternative Choice Decisions include decisions such as whether a company should add or drop a product line, make a product or buy it from external sources and whether a business unit should be closed or remain open. First, a little background - why couldn t we simply make a decision based on the company s financial statements? Well, if you recall, the financial statements are prepared according to GAAP. As a result, inappropriate decisions may be made if we relied only on the information provided in the financial statements. In addition, certain business activities require allocations, the interpretation of which could result in incorrect decision-making if not fully understood. For example, if a company owned a building that housed two divisions, it may allocate property taxes based on the square footage of a building. If the company closed one division, yet kept the entire building, the property taxes would still be payable. Any assumption that property taxes would be reduced by the closing of a division, would be incorrect. There are other costs that may also be allocated to different divisions. For example, costs such as mortgage interest and insurance on the building could also be treated in this way. So we can see it is important to be cautious about using information from financial statements that have been generated as the result of an allocation. OK, it s time to move on to our example. Today, we are going to talk about Amazing Disasters Inc. Amazing Disasters has two divisions - its Games Division, and its Software Division. The Games Division manufactures products which it then sells to distributors across Canada. The Games Division Income Statement is showing a loss of $375,000. Now, please note that closure is not the only option available (we ll discuss some other options later in this presentation).

2 But in order to determine whether or not the Games Division should be closed, we ll first need to take a closer look at the Income Statement. We ll start by creating a table that includes the original Income Statement as well as three new columns called Pre-closure, Post-closure, and Differential. The Differential column shows the differences in costs between the two alternatives (i.e. closing the Games Division and keeping it open). Next, we ll examine each line on the table to determine what the implications will be for Amazing Disasters if the Games Division is closed. You will need to refer to the assumptions and information about Amazing Disasters that are provided in your course notes. Pre- Closure Post- Closure Differential Sales 5,000,000 0 (5,000,000) Let s start with sales. If the Games Division closes its doors, it s pretty easy to see that there will be no more external sales. Therefore, the Post-closure column will show zero and the Differential column will show a negative 5 million Let s look next at the Cost of Sales (remember, this can also be called the Cost of Goods Sold). Included in the Cost of Sales, will be items such as material, labour and fixed manufacturing overhead. Do any of these trigger a red flag? Well, how about fixed manufacturing overhead? Why would that remain if the division closed? Well, lets look, for example, at amortization on the building. Amortization is a fixed cost that would remain even if the division closed, since the company would still own the building. In the course notes, we are told that overhead accounts for 5% of the Cost of Sales. So this means that 5% of the $4,200,000 will remain after closure of the division. $4,200,000, times 5% equals 210,000. So, in the Post-closure column, we need to add 210,000.

3 Cost of Sales 4,200, ,000 3,990,000 This leaves us with 3,990,000 in the differential column. We arrived at this number by taking the Pre-closure amount of 4,200,000, and deducting the Post-closure amount of 210,000. Marketing Manager 50,000 50,000 0 OK, let s see what happens to the Marketing Manager. The Marketing Manager s salary is allocated to two divisions. Since it isn t reasonable to assume that the Marketing Manager would take a huge cut in salary, we ll have to assume that the entire amount remains a cost of the organization if the Games Division closes. This will leave us with zero in the differential column, as we won t save anything on this item. Research and Development 375, ,000 So let s move down to the next line, Research and Development. If the Games Division is closed, the staff who are responsible for developing new games will no longer be required. So in the Post-closure column, we would place 0 and place 375,000 in the differential column. But before we move on, let s think about what other costs may be associated with laying off the Research and Development staff. What about severance pay? Although we won t deal with severance pay right at the moment, let s keep this item in mind for later on in our analysis. Sales Commissions 300, ,000 OK, the next line is Sales Commissions. Games Division Sales will be zero, and since the commissions relate to the sales, the commissions will also be reduced to zero. Therefore, we will put zero in the Post- closure column and 300,000 in the differential column to represent this saving.

4 In the course notes, it states that a portion of the administrative expenses are allocated between the two divisions based on sales dollars. Since these allocations would not be eliminated upon the closure of the Games Division, this would not result in a savings for the company. Administration 200, ,000 40,000 The notes also state, that one individual could be laid off, resulting in a savings of $40,000 a year. So we ll enter 160,000 in the Post-closure column (Calculated as 200,000 minus 40,000). We can now see that the result is 40,000 in the Differential column, representing the savings associated with laying off staff. Interest 250, ,000 0 Now let s think about how interest works in this case. In our notes, it states that interest costs are allocated to the divisions based on square feet occupied. Since the company would still own the building, there will be a mortgage in place, and therefore, the company will still have to pay interest to the bank. Interest 250, ,000 0 Since bank interest is still being paid, we will need to included 250,000 in the Post-closure column. This will leave us with zero in the Differential column. Rental revenue 309, ,000 You will notice that the line item Rental Revenue was not included in the original financial statement of the Games Division. Let s think about why we need to include it now. Well, the building was occupied by the Games Division and the Software Division.

5 If we close down the Games Division, that will leave us with the opportunity to rent out the portion of the building that was occupied by that division. If we assume that there are tenants available, then, in our analysis, we should include the rental opportunity that has presented itself upon the closure of the Games Division. So, let s add the $309,000 into our table under Rental Revenue. Okay, now that we have filled in all the line items, we can total up the columns. You can see that Pre-closure, we have a loss of 375,000. Post closure, we have a loss of 361,000. Now let s have a look at the Differential column - we can see here that if we close the Games Division there will be a net savings of $14,000. Sales 5,000,000 (5,000,000) Cost of Sales 4,200, ,000 3,990,000 Gross Margin 800,000 (210,000) (1,010,000) Marketing Manager 50,000 50,000 Research & Development 375, ,000 Sales Commissions 300, ,000 Administration 200, ,000 40,000 Interest costs 250, ,000 Earnings from Operations (375,000) (670,000) (295,000) Rental Revenue 309, ,000 Income before Taxes (375,000) (361,000) 14,000 What this means is that each year, we are actually $14,000 better off if we close the Games Division, than if we kept it open. This sounds pretty good doesn t it? Have we forgotten anything? Well what about the severance pay we mentioned earlier? In the notes it says the $200,000 will be needed to cover severance costs. So how does this piece of information fit into our decision-making? If the severance payments of 200,000 are divided by our yearly savings of 14,000, it shows us that would take about 14.3 years to recover the severance pay. Does this sound like a good option?

6 Well to me that sounds like rather a long time to recover the severance pay, and perhaps not the best plan for action. So perhaps we should re-examine the situation. Is there anything in the current operation that we could change? Could we increase our sales? Could we cut any of our costs? In summary, are there any other ways that we could reduce the loss? Perhaps if we were to be creative, we could find another way to resolve the situation. Before we finish, I want to note that in addition to running the numbers, closing a division always calls for a thorough examination of both quantifiable issues and non-quantifiable issues. Examples of non-quantifiable considerations include: Mandatory compliance; for example keeping a division open to ensure the company complies with regulatory bodies. Perception of stakeholders; for example, closure may have a negative impact on the options the company has to raise capital. Goodwill created in the local community and beyond by continuing operations. Even though today we have concentrated on the number crunching aspects of the problem, I hope you can see that in practice, these types of decisions are much more involved. I hope this presentation has helped you understand some of the complexities involved when considering closing a division. Goodbye and thank you very much for watching this presentation.