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Case Study: Toy World

Shunde Tu 000196745

Student Name: Shunde Tu


Student ID: 000196745
Course: MGT 121( Financial Management II)

Case Study on Toy World

I.

Situation Audit
a) Plastic Toys Manufacturing Industry Overview
i.
Highly seasonal, with a majority of sale volume generated between Aug. and Nov.
ii.
Competitive landscape
1. Highly competitive, populated by a large number of companies
2. Fierce design and price competition, with short product lives and a relatively
high rate of company failures
3. Low entry barrier resulted from low capital and technology requirements.
4. Influx of imported toys intensified competitive pressure on smaller firms.
b) Company Overview
The company studied in the case is Toy World, a manufacturer of plastic toys for children.
More than 80% of the sale was generated between Aug to Nov. Toy World Inc.s practice was
to produce in response to customer orders. Therefore, the production was highly seasonal,
and not more than 25%-30% of manufacturing capacity was used for the first seven months.
c)

II.

III.

Product Overview
i.
Produce a wide range of designs, colors and sizes for most of its product categories.
ii.
Dollar sales of a particular product had sometimes varied by 30%-35% from one
year to the next.
Problem Statement
The companys production had been scheduled to accommodate the seasonality of sales.
The production manager proposed to adopt level production to reduce labor costs. The
feasibility and benefit of adopting level production would be studied in detail.

Problem Breakdown and Analysis


a) Pros and Cons of Seasonality Production, as compared with Level production
i.
Advantages of Seasonality Production
1. Lower Inventory. Less storage and handling cost
2. Be able to respond to market changes. Since the sales of a particular product
varies greatly year from year, its difficult to forecast the sales precisely, under
level production
ii.
Disadvantages of Seasonality Production

Case Study: Toy World

1.
2.
3.

Shunde Tu 000196745

Overtime premiums reduced profits


Seasonal expansion and contraction of work force resulted in recruiting
difficulties and high costs associated with training and quality control
Machinery was subjected to heavy use and frequent setup changes during peak
production time.

b) A comparison of two methods of production from the financial perspective


I constructed a comprehensive model for the two scenarios (namely, seasonal production and
level production) based on the assumptions given in the case. I attach the complete model at
the end of the case study for your reference.
i.

From the net profit perspective, assuming borrowing rate remained the same, the
pro forma net profit for year 1994 under level production was $523,000, compared
with $354,000 under the seasonal production, representing a 48% increase!!

ii.

However, further analysis shows that, under level production, there would be
serious problem with cash position, as the company accumulate huge inventory in
the first 7 months that were not sold. Therefore, the company needs to borrow
short-term loans from the bank to finance its operations. Below are two charts
comparing the cash balance, bank notes outstanding and inventory level, under two
production scenarios, on pro forma basis, assuming a minimum cash level of 200K.

4,000

4,000

3,500

3,500

3,000

3,000
Amount (in '000 USD)

Amount (in '000 USD)

Key B/S Items - Seasonal Production

2,500
2,000
1,500

Key B/S Items - Level Production

2,500
2,000

Cash
Inventory
Notes payable, bank

Cash
Inventory
Notes payable, bank

1,500

1,000

1,000

500

500

Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Nov Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Time

Time

As we can see, under seasonal production, the maximum bank credit required is $1.79 MM,
while under level production, the maximum bank credit required is $3.70 MM. This is a
serious flaw, because the bank was probably only willing to extend a credit line of up to $2.0
MM in 1994 and any advancer in excess of $2.0 MM would be subjected to further
negotiations. If the company wasnt able to finance that gap, it would not be able to adopt
level production.
iii.

Lets first assume that upon negotiation, the bank would agree to increase credit
limit but would charge the company a higher interest rate for the credit in excess of
$2.0MM to compensate for the risk. I conducted a sensitivity analysis to see how
increased financing cost would influence net profit. Result is presented on next

Case Study: Toy World

Shunde Tu 000196745

page, which shows that the profit would still be relatively high even under very
high interest charges for additional credit under level production.
Sensitivity Analysis - Net Profit under level production

Net Profit (in '000 USD)

600

500
Profit under level
production
Profit under seasonal
production
400

300
5%

10%

15%

20%

25%

Interest Rate on Borrowings in excess of 2 MM

iv.

IV.

While financial analysis shows that level production outweigh seasonal production
from the net profit perspective, we need to be extremely aware of the fact that the
model was based on the assumption that companys sales would beat forecast and
the company will be able to finance its working capital shortfall. If either of these
two assumptions didnt work out, level production would lead to bankruptcy.

Solutions and Recommendations


a) Financing
As discussed above, the company would need to finance as much as $3.7 MM workingcapital loans if it adopted level production, while the bank might only be willing to lend
$2.0MM. Possible solutions are:
i.
Raise more equity (common or preferred stocks)
ii.
Issue more bonds/ convertible bonds
iii.
Renegotiate with the bank
iv.
Finance its accounts receivables by giving up a small percentage of them. (This
will only partially mitigate the problem)
v.
Persuade its customers (mostly stores) to purchase earlier, by providing some
incentives. In this way, inventory level will drop and thus reducing financing needs.
b) Forecasting ability
As discussed above, level production would require a precise forecast of sales for year 1994.
The company might compare its forecast and actual sales volume through 1991-1993 to see
whether the company had good forecast ability. If the company always missed forecast by a
large number, it must be extremely cautious in adopting level production.
c) A hybrid of seasonal and level production
There might be a point between seasonal and level production while the company would be
able to balance the pros and cons of both production methods and achieve a better return
within acceptable risk level. However, further calculation is needed.