Making Management Decisions
You are asked, individually, to provide an answer to the following decision problems. The work must be your own original work; all sources including internet sites must be fully and properly referenced. Where appropriate, the maximum word count is given alongside the question. You must avoid any breach of the University’s assessment regulations. Please provide a complete list of any references used, in Harvard format.
Velo City: ‘More haste, less speed’
Velo City was set up four years ago by two sisters, Jenny and Jess Wilson. The company produces high quality hand-built bicycles for both adults and children, which they have sold largely through specialist retailers in the UK. Velo City has a small factory just off the Holloway Road in Islington and employs about 20 people. Jenny Wilson is responsible for production decisions, while Jess looks after marketing; two years ago they recruited a former University friend of theirs, John Moto, to look after financial matters and he is now a partner in the business.
The company performed well financially until the second half of 2018, when UK economic growth slowed post-Referendum and consumer spending on more expensive bicycles began to decline. The situation worsened during the course of 2019 and John now believes that Velo City is making a small loss at current production levels. Both Jenny and Jess feel that some important decisions need to be made.
The factory has a capacity of 100 bicycles per week; until mid-2018, about 75% of this production capacity was being used, but this has since been running at 64% (or 64 units per week) including the whole of 2019. Assume an equal production split between adult’s and children’s bicycles and that all bicycles are sold. At a recent meeting of the management ‘team’ (in the local coffee bar), John suggested that Velo City should consider reducing its capacity more closely in line with lower demand for the company’s products. He believed that with reduced capacity, profitability might be improved because of the elimination of some fixed costs. Fixed costs are currently estimated to be running at about £45,000 per month. However, Jenny is more reluctant to cut production capacity, especially as there has been some evidence of a slow, upward trend in demand over the last three months. She has asked the other two whether it might be possible to cut costs without reducing production capacity.
Meanwhile, Jess has become increasingly concerned that Velo City might be losing its competitive advantage, which has thus far been based on the high quality of its hand-built bicycles. She has discovered that very similar bicycles of almost the same quality are now being imported from China and sold by the major retail chains at prices about 30% cheaper than Velo City’s own products.
Model Adult’s Bicycle Children’s Bicycle
Material Costs/Unit £80 £40
Labour Costs/Unit £60 £30
Distribution Costs/Unit £20 £10
Price/Unit £310 £200
Jess has begun to wonder whether the company can fight off this competitive threat or whether it is time to rethink its entire business strategy. One option that John would like the others to consider is whether the company should expand into European markets. However, this option has so far not seemed particularly attractive to Jess, who feels that the company has little knowledge of European markets and that Velo City has insufficient resources to expand without increasing borrowing.
In order to decide on the company’s strategy over the next six years, John commissioned some background research a few months ago from a consultancy company for £35,000. On the basis of this he has attempted to define and quantify the possible outcomes from the following three (mutually-exclusive) options:
1. Focus on UK market; increased promotion, cutting costs
This is Jess’s preferred option. Under this scenario, promotional expenditure (largely based around the expansion of the company’s internet presence) would require a £300,000 up-front initial investment. She has estimated (based largely on past experience, one would have to say) that this is expected to result in additional annual cash flows over the six-year period as follow:
Year 1 £60,000
Year 2 -£30,000
Year 3 £150,000
Year 4 £125,000
Year 5 £125,000
Year 6 £100,000
2. Expansion into Europe
This option is favoured by John, but appears more risky, because the market is untested and due to the exchange rate risk and uncertainty resulting from Brexit uncertainty. It involves expansion into European markets through boosting exports. This would require investing £240,000 related to servicing the European market and is expected to generate an additional cash inflow £65,000 per year for six years. (Assume that this has no impact on production and sales in the domestic market, which will remain at current levels; in other words, production and sales remain equivalent to 64% of workshop capacity).
3. Developing a new model of folding bicycle
This is Jenny’s preferred option. This would require an investment of £204,000 to modify the factory and add dedicated machinery (usable only for this model of folding bicycle), which will have six-year life, at which point the machinery will have zero salvage value. Production (and sales) are expected to run at 12 bicycles per week; Materials Costs and Labour Costs will each be £100 per unit. Distribution Costs are estimated to be £20 per unit. Jenny thinks that the folding bicycle should initially be priced at £280.
Use a Multi-Criteria Analysis (MCA) to evaluate the three options, based on the following criteria: Cost, Riskiness and Growth Potential. Based on information provided in the Case Study/Scenario, you should decide on (i) the weightings you would give to each of the three criteria, (ii) the rating you would give each option, using a scale that runs from 1 (worst) to 4 (best). Use the results of the MCA to advise the management of Velo City on the preferred option, outlining any limitations of the MCA technique.
a) Briefly discuss the impact of risk and uncertainty on business decision making. Relate this to Velo City and the views expressed by the three managers (Jenny, Jess and John). (Maximum 100 words).
b) Jess Wilson has asked you to model the effect of increased competition from new Chinese suppliers on Velo City’s monthly sales revenues (which she has identified as either being either, Low, Medium or High). Using her own rough estimates, she has produced the following pay-off matrix for you to analyse:
Competition from China (Sales Revenues £000s)
Options Low Medium High
Focus on UK 120 85 70
Expand into Europe 85 72 115
New Folding Bicycle 100 100 100
What strategy would you advise, based on the following criteria?
(i) Maximax (2 marks)
(ii) Maximin (2 marks)
(iii) Minimax Regret (4 marks)
c) Assume now that Jess has been able to use published market research data to derive the probability of the three ‘states of nature’ (Competition from China) occurring: Low (30%), Medium (30%) and High (40%). Calculate the Expected Monetary Value (EMV) of the three options (based on the data in the payoff matrix) and the risk neutral decision for Velo City.
d) What is the value of perfect information (regarding the likelihood of Competition from China) to Velo City? How should Velo City interpret this information?
Assume that the annual fixed cost of £540,000 (£45,000*12) is allocated between the two product lines as follows: £324,000 for adult bicycles and £216,000 for children’s bicycles. What is the estimated net annual profit/loss in 2019 for each product line and for the whole company at current production levels?
a) What was the break-even point in units for each product line (adult’s and children’s bicycles) in 2019?
b) Calculate the number of children’s bicycles that would have to be sold in order to achieve a target profit of £60,000. (4 marks)
c) What was the margin of safety as a percentage for adult bicycle sales in 2019 and how should this figure be interpreted?
For the three options for improving the company’s position (continued focus on the UK market, Expansion into Europe and New Folding bicycle) over the next six years:
a) Calculate the payback period for each option and suggest which option (if any) is worthwhile if it is the company’s policy not to take any option with a payback period longer than 4 years. Explain to the management team both the shortcomings of the payback method and its strengths.
b) Calculate the Net Present Value (NPV) for each option. Which option (if any) would you recommend Velo City should choose giving your reasons. Use a cost of capital of 10% for the option of Expansion into Europe (as it is riskier) and 9% for the other two options.
c) Explain, in principle, the approach you would use to calculate the Internal Rate of Return (IRR) of a project/option. Illustrate this by calculating the IRR of the option of Focusing on the UK market.
The management of Velo City would like to separately model the first-year profit from the new folding bicycle (Option 3), using scenario and simulation analysis. Assume a notional fixed cost for the first year of £34,000 (£204,000/6) and a selling price of £280/unit.
Assume the variable cost for the bicycle (Materials, Labour and Distribution) can vary between £180 and £260, with a most likely value of £220 per unit. The bicycle will sell for £280. First-year demand for the bicycle is expected to range from 520 to 728 units, with 624 units the most likely demand.
a) Set up the profit ‘model’. Provide base-case, worst-case and best-case scenarios for first year profit. (4 marks)
b) Jenny has estimated the likelihood of different levels of variable cost and first-year demand. Set up random number intervals (from 0.0 to 0.1) to match these probability distributions. (6 marks)
Variable Costs/Unit Probability First-Year Demand Probability
£180 0.35 520 0.30
£220 0.40 624 0.50
£260 0.25 728 0.20
c) Using the following random numbers, simulate the average first year profit from the folding bicycle over these five ‘trials’. (6 marks)
Trial 1 Trial 2 Trial 3 Trial 4 Trial 5
Variable Cost 0.333 0.125 0.790 0.552 0.099
1st Year Demand 0.239 0.932 0.785 0.001 0.988
Based on the preceding analysis, summarise your recommendations for Velo City (This should be in the form of a 200 word briefing note addressed to the company’s management).
Assessment criteria from Module Handbook
(i) Grasp of decision making concepts and techniques
(ii) Ability to apply this knowledge and the skills acquired to a pre-seen scenario