Page 7 - OCS Workbook - Day 2 Suggested Solutions (May 2018)

SUGGESTED SOLUTIONS

Unfortunately the consultants have not provided any probabilities so we don’t know how likely it
is that demand will fall that low. To fully assess risk we need both impact and probability. It might
be worth suggesting asking the consultants if they have any probabilities to work with.
Break-even and margin of safety

The break-even revenue shows how much revenue is required to make neither a profit nor loss.
In this case it is L$300,000 in each year. This allows you to discuss how certain you feel that sales
will exceed this. The expected revenue of L$350,000 in year 1 can therefore drop by 14% before a
loss is made. (Note: This is what is meant by the ‘margin of safety’).

The initial impression is that this does not seem to give much room for error, so it may be worth
reviewing where the estimates have come from and whether or not it is worth spending extra
money on market research to get greater assurances on this figure, especially as Mansako has not
sold clothing before or used this particular designer.
Standard deviation

The standard deviation is a statistical measure that gives an idea of the average spread of possible
outcomes around the expected volume.

Thus, if you could see all possible revenue figures in year 2, then on average they are 38% away
from the expected figure of L$400,000.
Initial impression is that this represents a significant risk but further work would be necessary to
assess whether it is acceptable or not when compared with the potential return.
Sensitivity analysis
Sensitivity analysis is best viewed as a more general form of break-even analysis.

In this case we are told that the selling price could fall by 10% in year one before a loss results.
In the same way that we discussed margin of safety above, the Board would need to assess how
certain they are of the projected selling prices and, in particular, whether they could be 10%
lower.
We would hope that the Mansako brand would transfer well to clothing and help ensure that the
budgeted prices would be achievable. However, there is a risk that the designs are considered too
‘alternative’ for our customers.

3. Preliminary recommendations
The predicted revenue and profit figures are fairly immaterial in terms of the bigger picture –
expected revenue in 2018 would increase over forecasts by just over 0.15% (350/232,124) and
boost gross profit by nearly 0.12% (175/141,828).
However, I am concerned that the risks are worryingly high:

1. This is a new venture and it may be that our estimates on sales revenue are over optimistic,
particularly as we have not sold clothing or used external designers before.

2. Stig’s designs may be too extreme to appeal to customers looking for affordable luxury.
Given this, it may best to view the new range as a pilot to gauge market reaction before extending
the range further. Even given this, the risks do seem excessive.

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