Costing a Shoe Selling Business - Case Study Example

Costing a shoe selling business The proposed business will be located within the greater London area, and average rents may range between 1000-1500 pounds. The store will stock a variety of footwear for adults, including boots in the price range of 100-150 pounds, sandals and slippers in the price range of 25 to 65 pounds, trainers in the price range of 60 to 100 pounds. Estimated costs for inventory of about 70 pairs of shoes are 5000 pounds. Other costs are as below: Based upon the above estimates, the following is a rough break down of costs on a monthly basis: Fixed costs : These are the costs that do not change irrespective of the number of shoes that are sold.(www.teneric.co.uk) Lease of premises 1000 pounds License fees 50 pounds Wages and salaries 1600 pounds Insurance 100 pounds Total fixed costs 2750 pounds Variable Costs: These are the costs that can be changed as sale conditions change on a day to day basis. Utilities 150 pounds Transport costs 100 pounds Commissions,overheads 200 pounds Inventory 5000 pounds comprising: 10 sets of boots - 1200 pounds 25 sets of trainers - 2000 pounds 35 sets of sandals and slippers - 1800 Total variable costs 5450 pounds Unit cost statement for shoes: Assuming that the total number of shoes stocked and sold in one month is 70 pairs of shoes, only variable costs will be taken into account (www.osbornebooks.co.uk at pp 4) Utilities (150/70) 2.14 pounds Transport (100/70) 1.42 pounds Commissions and overheads (200/70) 2.85 pounds Inventory (5000/70) 71.43 pounds Therefore, total marginal cost per unit 77.84 pounds Annual Marginal costing statement for the financial year: Assuming that an average of 70 sales are sold per month for 8500 pounds, the yearly sales figure works out to 102,000 pounds. Sales amount for a unit shoe works out to 8500 / 70 = 121.42 pounds. Fixed costs for the year = 2750 pounds X 12 = 33,000 pounds Variable costs for the year = 5450 pounds X 12 = 65,400 pounds Per Unit For Year Sales 121.42 pounds 102,000 pd Less variable costs 77.84 pds 65,400 pd Contribution 43.58 pds 36,600 pd Less Fixed costs 33,000 pd Profit 3,600 pounds Break Even Analysis: The break even analysis is performed on the basis of assessment of costs based upon the number of units that are expected to be sold.(www.connection.cwru.edu). Similarly, the total sales revenues are also computed on the basis of anticipated units that are expected to be sold each month. The variable costs per unit is 77.84 pounds and the number of units expected to be sold is roughly assessed as in the range of 50 to 70 pairs of shoes a month. The average unit sale price for each show is taken as $121.42. The Break even analysis table is shown below: BREAK EVEN ANALYSIS TIME PERIOD TOTAL FIXED COSTS TOTAL VARIABLE COSTS TOTAL SALES REVENUES 2 months $5,500 $8,096 $6,313.84 4 months $5,500 $6,227 $9,713.60 6 months $5,500 $6,616 $10,320.70 8 months $5,500 $9,341 $14,570.71 10 months $5,500 $8,562 $13,356.20 12 months $5,500 $10,586.24 $16,513.12 18 months $5,500 $9,496.48 $14,793.18 24 months $5,500 $10,117.90 $15,784.60 30 months $5,500 $10,584.88 $16,513.12 36 months $5,500 $11,052 $17,241.64 Hence, from the table, it may be noted that the break even point is reached after ten months from the time the business begins operating. This is the time when the profits in the amount of $13,356.20 exceed the sum of the fixed and variable costs ($5500 +$8562 = $14,062). Hence this is the point where the business has first begun to show profits in that the revenue from sales is greater than the total expenses on fixed and variable costs. At this point, 110 units of shoes have been sold in a two month period, which brings it to an average of 55 pairs of shoes sold per month. Margin of Safety: The margin of safety is used to calculate how much the level of sales can fall before there will be a loss to the business. It is calculated by the formula: Margin of safety = Expected Sales level - Break even sales level. The break even sales level that has been established by the above table is 55 pairs of shoes per month. Therefore, if the expected sales per month is 70 pairs of shoes, the sales figures can fall even up to 55 pairs of shoes and the business will break even. However if the volume of shoes sold should fall below 55 pairs, then it is likely that the business will experience a loss. Uncertainty analysis: Since the shoe business is just being started, advertising may play a crucial role in adding to sales. However, the business is being started in one of the prime localities in London, which in itself is likely to pull in the shoppers. If the new business is to embark upon advertising, its initial capital expenditure will be even heavier, therefore the business may need to evaluate how much of benefit is likely to be obtained from such a move. Therefore a decision tree will evaluate two alternatives: (a) start advertising campaign (b) restrict advertising to boards outside the store. In the case of both alternatives, the attempt that will be made is to assess the potential market reaction and what the result is likely to be on the basis of three probable outcomes (a) good (b) moderate and (c) poor. (Decision tree - source: www.mindtools.com) Good High cost blitz poor Advertising Campaign good Low cost ads moderate poor In store advertising' good poor In terms of the decision nodes, for the first option using advertising , i.e, the high blitz advertising campaign, the probability of good, moderate and poor outcomes are estimated at 0.4, 0.4 and 0.2 respectively, while for the low cost ads, it is estimated as 0.3, 0.4 and 0.3. Similarly, for the limited or in store advertising option, the probability of a good or poor response is taken as 0.6 and 0.4. Based upon these values, the tree values may be computed as follows: (a) high blitz option: (0.4 probability good outcome) X 10,000 pounds (value) = 4000 pounds (ii) (0.4 probability moderate outcome) X 5000 pounds (value) = 2000 pounds (iii) (0.2 probability poor outcome) X 2000 pounds = 400 pounds. Total value of this option = 6400 pounds (b) Low cost advertising option: (0.3 probability good outcome) X 5,000 pounds = 1500 pounds (ii) (0.4 probability moderate outcome) X 5000 pounds(value) -= 2000 pounds. (iii) (0.3 probability poor outcome) X 2000 pounds (value) = 600 pounds. Total value of this option 4100 pounds (c) In store advertising or limited advertising option: (0.6 probability good outcome) X 2000 pounds (value) = 1200 pounds (0.4 probability poor outcome) X 1000 pounds (value) = 400 pounds. Total value of this option is 1600 pounds. This is the expected value that can accrue from each of the options. However, the costs that will be incurred for each option must also be considered. For the high blitz advertising option, the amount spent may be as high as 10,000 pounds, therefore effective gains may be negative and there may be about 3600 more spent, as opposed to the expected gains that might accrue. For the moderate advertising option, the expected expenses may be about 5000 pounds, therefore the effective gain will be a negative value of 900 pounds. For the low cost option, the expenses may be very low, to the tune of about 500 pounds, therefore the effective value of the investment may be about 1100 pounds. Therefore, from the above decision tree analysis, in which probability of gain is pitted against potential expenses that might be incurred, it appears likely that the net figures do not justify entering into a high advertising campaign at this time. Since the store is located in a highly populated and up-market area of London, it is possible that limited in store and local area advertising may be adequate to pull in sales, at least initially when the store is started. The best customers for the store are likely to be those who visit this highly populated area of London. Recommendations: This business is proposed to cater to the affluent section of the shopping public, while also stocking some selections in the median price ranges. The price ranges of shoes proposed are those that are applicable for designer or brand varieties. The initial costs of setting up the business are likely to be high, since rents and cost of inventory will be high at first. However, with time, it is likely that discounts can be supplied from suppliers, which may increase the profit margins. The store needs to sell at least 55 pairs of shoes in a month and this appears to be a reasonable estimate, since the shop is located in a highly populated area of London. In regard to advertising, the decision tree appears to indicate that it may represent an investment that may not generate the desired gains as compared to the expense that will be involved. Moreover, since the store expenses are high on inventories, etc, it may not need the advertising since the area is one of high traffic and likely to generate sales with some strategic local advertising. The store may be able to reach break even point within about 10 months, after which it may be able to consider expanding business by targeted advertising, such as developing a website and offering shoes for online sales to customers located in other areas. At this stage it may also need to factor in delivery charges, etc. References: "Break Even Analysis" [online] Retrieved August 9, 2007 from: http://connection.cwru.edu/mbac424/breakeven/BreakEven.html Decision tree analysis: [online] Retrieved August 9, 2007 from: http://www.mindtools.com/dectree.html "Marginal costing" [online] Retrieved August 9, 2007 from: http://www.osbornebooks.co.uk/pdf/active_accounting_22.pdf What costs are fixed' [online] retrieved August 9, 2007 from: http://www.teneric.co.uk/nl110204.html Read More