Reference no: EM13892255

Toys-4-Kids manufactures plastic toys. Sales and production are highly seasonal. The following list of figures is a quarterly pro forma forecast indicating external financing needs for 2012. Assumptions are in parentheses.

Toys-4-Kids 2012 Quarterly Pro Forma Forecast ($ thousands)
	Qtr 1	Qtr 2	Qtr 3	Qtr 4
Net sales	$ 300	$ 375	$3,200	$5,000
Cost of sales (70% of sales)	210	263	2,240	3,500
Gross profit	90	113	960	1,500
Operating expenses	560	560	560	560
Profit before tax	(470)	(448)	400	940
Income taxes	(188)	(179)	160	376
Profit after tax	($ 282)	($ 269)	$ 240	$ 564
Cash (minimum balance = $200,000)	$1,235	$ 927	$ 200	$ 200
Accounts receivable (75% of quarterly sales)	225	281	2,400	3,750
Inventory (12/31/11 balance = $500,000)	500	500	500	500
Current assets	1,960	1,990	3,120	4,450
Net plant & equipment	1,000	1,000	1,000	1,000
Total assets	$ 2,960	$2,708	$4,100	$5,450
Accounts payable (10% of quarterly sales)	30	38	320	500
Accrued taxes (payments quarterly in arrears)	(188)	(179)	160	376
Current liabilities	(158)	(142)	480	876
Long-term debt	400	400	400	400
Equity (12/31/11 balance = $3,000,000)	2,718	2,450	2,690	3,254
Total liabilities and equity	$2,960	$2,708	$3,570	$4,530
External financing required	$     0	$     0	$ 530	$ 920

Continuing with Toys-4-Kids introduced in the above information, the company's production manager has argued for years that it is inef- ficient to produce on a seasonal basis. She believes the company should switch to level production throughout the year, building up finished goods inventory in the first two quarters to meet the peak selling needs in the last two. She believes the company can reduce its cost of goods sold from 70 to 65 percent with level production.

(Recall that production managers typically want to restrict produc- tion to left shoes only so as to reduce costs.)

a. Prepare a revised pro forma forecast assuming level production. In your forecast, assume that quarterly accounts payable under level production equal 10 percent of the average quarterly sales for the year. To estimate quarterly inventory, use the following two formulas.

Inventoryeoq = Inventoryboq + Quarterly production - Quarterly cost of sales

Quarterly production = Annual cost of sales/4

where eoq and boq refer to end of quarter and beginning of quarter, respectively. Please ignore the effect of increased external financing required on interest expense.

b. What is the effect of the switch from seasonal to level production on annual profits?

c. What effect does the switch have on the company's quarterly ending inventory? On the company's quarterly need for external financing?

d. Do you think the company will be able to borrow the amount of money required by level production? What obsolescence risks does the company incur by building up inventory in anticipation of future sales? Might this be a concern to lenders?