Reference no: EM132626082

Avalon Décor - Case Study

Karen Townsend and her friend Elizabeth Thompson were chemistry graduates who loved to experiment and developed two relatively low-cost home decorating aids. They fulfilled a dream five years ago when, with modest capital, but contracts with several regional building supply stores, they formed Avalon Decor. The products were good quality and Avalon finished in the black its very first year, although the joint owners were not entirely comfortable with the financial side of the business. During the past few years, both felt it necessary to complete evening courses to increase their business skills.

A Marketing Decision

• About 12 months ago, the joint owners concluded that Avalon's products were underappreciated and that sales could, and should be, substantially higher. They replaced an unproductive salesperson and, more importantly, made a key marketing decision. They decided to reduce Avalon's advertising in trade journals and use the money saved to attend more trade shows. They reasoned that trade shows are a relatively inexpensive way to display the company's products, and are an opportunity to meet major corporate buyers, face-to-face. That is precisely what happened. Avalon's exhibits were impressive, and important contacts were made with some industrial users, and even one national retailer. The joint owners are in the process of negotiating several large contracts for the coming year and product enquiries are markedly higher. Because of all this, Avalon's sales growth is expected to increase sharply in the next three years, and sales are estimated to more than double by the end of 2020. The owners predict sales of $1,933,000 in 2018, $2,609,000 in 2019, and $3,132,000 in 2020.

• On the one hand, the joint owners are extremely pleased with the forecast because it is evidence of what they have long believed: The company manufactures quality products at a reasonable price. The downside is that such large growth will undoubtedly require external financing and could cause managerial difficulties. While the joint owners will explore several financing alternatives, they recognise that the first step is to estimate the external funds needed for the period. After all, before they decide on a financing option, they want a reasonable projection of what needs to be raised. And it is even possible that most of the expected growth can be internally financed.

Forecasting Considerations

• To develop the forecast, the joint owners decided to meet with Harry Singh, Avalon's accountant, and Peter Jones, Avalon's general manager. All agree that the sales projections are quite reasonable in view of the activity resulting from the trade shows, and may even be a bit low. They also decide to concentrate on the 2018 forecast at the initial meeting. A few months ago, Jones began implementing several cost-cutting measures that are expected to generate a 32 percent gross margin each year of the forecast. Due to economies of scale, administrative expenses are expected to increase less than proportionately with sales, and the group estimates a 20 percent increase in 2018. The relevant tax rate is 30 percent. Singh pointed out that the financial forecast also needs to consider the tighter credit terms offered by many of Avalon's suppliers. Company records show that two years ago about 80 percent of Avalon's purchases were on terms of 2/10, net 30. That is, most suppliers offered a 2 percent discount to customers who paid within ten days but, in any event, full payment was expected by day thirty. Roughly 20 percent of the purchases were on terms of net 30. Avalon always took the discount when it was offered. Company records also show that during the past year only about half of Avalon's suppliers offered the above discount. Singh strongly believes that even fewer vendors will offer a discount in the future, and thinks that it is wise to assume and the joint owners concur, that only a third of all future purchases will be made on terms of 2/10, net 30. In addition, he recommends that Jones's gross margin estimate be reduced to 31 percent, in part because of fewer trade discounts. After some discussion, Jones agrees that Singh's points are well made and my estimate of gross margin is probably a bit high.

• The discussion then turns to working capital management. Inventory control has been a problem for Avalon at times. Elizabeth Thompson believes that inventory turnover (CGS / inventory) can be increased to 7.7, mainly by using suppliers with shorter delivery time. Karen Townsend, however, is sceptical. She thinks that it is unrealistic to think that Avalon's inventory management can be improved and believes that some type of estimate based on historical inventory patterns is appropriate. Despite her objections, however, the group decides to use Elizabeth's estimate.

• Avalon's historical experience with its accounts receivable will be of little help in future receivables. In the past, Avalon has offered terms of net 30; 1/10, net 30; and 2/10, net 30. Quite frankly, which one Avalon offered depended on the bargaining power and importance of the customer. And many of Avalon's new clients are quite large businesses, who have insisted on a longer payment period. For the purpose of this forecast, the team decide to assume that they will offer credit terms of net 30 and net 45. They estimate that 40 percent of all sales will be on terms of net 30, and that 80 percent of this group will pay on time, though taking the full 30 days. The 20 percent who pay late are expected to take an extra 10 days, or 40 days in all. Sixty percent of all sales are estimated on terms of net 45. The team believe that these customers will tend to be more reliable and stable and, thus, expect that 90 percent of these sales will be paid on time, that is, on day 45. The 10 percent who will be late are predicted to take an extra ten days. The team expect that virtually all sales will be collected and they estimate that bad debt expense will be insignificant and can be ignored. The group also thinks that cash should be 3 percent of sales, other current assets will be 0.6% of sales, and accruals are best estimated using past information.

• Avalon's predicted 2018 spending on plant, land, and equipment is estimated to be $175,000. These expenditures partly reflect the replacement of existing equipment, but mainly result from the new facilities necessary to accommodate the growth in sales.

Financial Issues

• Avalon will pay no dividends during 2018. The company has one loan outstanding, and the amount due is $20,000 each year. Assuming no additional borrowing, annual interest expense will decline since the loan's balance also declines, and the rate is fixed. Still, it is likely that some, if not most of any new funds, would be borrowed. For the time being, however, the forecasters decide to ignore the possibility of any new debt, except for the assumption that interest expense will remain constant over the forecasting period.

• Singh says he has enough information to develop an estimate for 2018 and then, as the meeting is about to break up, Karen Townsend raises an issue that she'd like to discuss at a future time. We frequently negotiate credit terms with customers, she notes. And we often give in to the customer, especially if we sense we risk losing a sale. I'm interested in knowing when, if ever, we should be firmer about our credit terms. We've never really looked carefully at this question, you know.

Question 1) Identify and explain which section of Avalon's Financial Policy and Procedures manual needs to be updated. What improvements to recommend?

Question 2) Identify and explain the standard accounting technique which would be used to forecast Avalon's inventory levels for the 2018 year. Show the calculation of this amount.

Question 3) identify all of the assumptions which Avalon is planning to use to calculate its 2018 forecast

Question 4) Identify and explain any gaps in the way Avalon is planning to develop its financial forecasts for 2018

Question 5) Once the 2018 forecast has been completed and documented, how should it be approved?