Kwaysar Limited sells television satellite dishes Doth to retail outlets and directly to the public. The balance sheet is as follows

Kwaysar Limited sells television satellite dishes Doth to retail outlets and directly to the public. The balance sheet is as follows:

In the second half of the financial year ended May 31, 2010, the business generated a net income of $62,400 and sales of $525,000. It is believed that this level of performance will be repeated in the forthcoming six-month period, provided the business does not implement any changes to its marketing strategy. The business is determined to increase its market share, however, and is considering the adoption of a new marketing strategy that has been developed by the marketing department. The main elements of the new strategy are as follows:

1. The selling price of each satellite dish will be reduced to $90. At present each dish is sold for $120.

2. There will be an increase in the amount of advertising costs incurred by the business. Advertising costs will increase from $6,500 per month to $12,000 per month.

3. Retail outlets will be allowed to pay for satellite dishes three months after delivery. At present, customers are allowed one month's credit. Those retail outlets that continue to pay within one month will, for future sales, be given a 2% discount.

The marketing department believes that, due to the new strategy, sales in each of the first three months to retail outlets will rise to 1,000 units and sales to the public will rise to 300 units. Thereafter, sales each month will be 1,200 units and 400 units respectively.

Assuming the strategy is adopted, the following forecast information is available:

1. The purchase of satellite dishes will be made at the beginning of each month and will be sufficient to meet that month's sales. Each satellite dish costs $50. Suppliers are paid one month after the month of purchase.

2. Depreciation will be charged on buildings at 2% per year on cost and for furniture and fixtures at 15% per year on cost.

3. Motor vehicles costing $80,000 will be acquired and paid for immediately. These are required to implement the new strategy and will be depreciated at 30% per year on cost.

4. Wages will be $18,000 per month and will be paid in the month in which they are incurred.

5. Advertising costs will be paid for in the month incurred.

6. Other overhead costs (excluding costs mentioned above) will be $14,000 per month and will continue to be paid for one month after the month in which they are incurred.

7. The loan of $48,000 will be repaid in July 2010.

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8. Sales direct to the public will continue to be paid for in cash. No credit will be allowed.

9. It is estimated that 50% of retail sales will continue to be on one month's credit and 50% will be on three months' credit. Ignore taxation.

Required:

Assuming that the new marketing strategy is adopted:

(a) Prepare a pro forma income statement for the six-month period ended November 30, 2010. (A monthly breakdown of profit is not required.)

(b) Prepare a projected cash budget for the six-month period ended November 30, 2010. (A monthly breakdown of cash flows is not required.)

SOLUTION

Kwaysar Limited

(a) The pro forma income statement for the six months ended November 30, 2010 is as follows:

Kwaysar Limited Pro Forma Income Statement For the six months ended November 30, 2010 (in $ thousands)
Sales revenue
Retailers [($90 × 3,000) + ($90 × 3,600)]	594.0
Public [($90 × 900) + ($90 × 1,200)]	189.0	783.0
Opening inventory	44.0
Less Cost of goods sold
Purchases [($50 × 6,600) + ($50 × 2,100)]	435.0
Goods available for sale	479.0
Less Closing inventory	44.0	435.0
Gross profit		348.0
Less Overhead costs
Wages	108.0
Advertising expenses	72.0
Discount allowed [(1/2 × $594) × 2%]	5.9
Depreciation
Buildings	2.7
Furniture and fixtures	6.0
Vehicles	12.0
Other overhead costs	84.0	290.6
Net income		57.4
(b)	The projected cash budget for the six months ended November 30, 2010 is as follows:

Cash receipts	$000	$000
Sales
Retailers – 1 month		290.1
– 3 months		135.0
Public		189.0
		614.1
Cash payments
Accounts payable	387.0
Advertising costs	72.0
Vehicles	80.0
Loan repaid	48.0
Wages	108.0
Other overhead costs	84.0	779.0
Cash deficit		(164.9)	(164.9)
Opening balance		120.0	120.0
Closing balance		(44.9)	(44.9)
(c)	We can see from the pro forma income statement for the six-month period an 8 percent decline in net income as compared to the previous six-month period. The net income per $1 of sales generated declined from 11.9 percent ($62,400/$525,000 × 100) in the previous period to 7.3 percent ($57.4/$783.0 × 100) in the forecast period.

Implementing the new marketing strategy will mean that there will be additional expenditures on such items as vehicles and marketing costs, and collections from customers will be slower. These factors will combine to produce a cash deficit for the six-month period which will have to be financed in some way.

The decline in profitability and liquidity in return for an increase in market share indicates that the new strategy has little to commend it—at least in the short term. However, it is possible that over the longer term a large market share will allow the business to increase profits and improve its cash flows to compensate for the short-term problems.