Continuing with Toys-4-Kids, introduced in the preceding problem, the company’s production manager has argued for years that it is inefficient 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 percent to 65 percent with level production. (Recall that production mangers typically want to restrict production 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 average quarterly sales for the year. To estimate quarterly inventory use the following two formulas:
Inventory eoq = Inventory boq = 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?