Acting as an outside consultant, what would you recommend that Pepe do? Give the data in the case, perform a financial analysis to evaluate the alternatives that you have identified( Assume that the new inventory could be valued as six week;s worth of the yearly cost of sales. Use a 30 percent inventory carrying cost rate.) Calculate a pay-back period for each alternative.
In this case, Pepe Jeans has enjoyed considerable financial success with its current business model. However, on the other hand, individual retailers are compliant about the inflexible ordering system, indicated that if the ordering system is more flexible, the sales of Pepe Jeans could increase by 10%.
Current Sales = $ 200 000 000
Extra 10% of sales = 10% * $200 000 000 = $20 000 000
Profit before taxes (PBT) at the rate of 32%, which means the there will be an profit increase based on the extra 10% sales Extra increase on PBT = 32% * $20 000 000 = $ 6 400 000
First alternative: Decrease of lead time would lead to an increase on the cost of good sales by 30% Current yearly cost of good sales (COGS) is 40% of total sales COGS = 40% * $200 000 000 = $80 000 000
As the cost will goes up 30% by reduce the lead time, there would be extra COGS generated Extra COGS = 30% * $80 000 000 = $24 000 000
In return for this increase in the cost, Pepe Jeans make an increase in the PBT of $6 400 000. However, as the COGS(24 000 000) is too much than the extra PBT($6 400 000) Profit and Loss = -$17 600 000
The advantage of this alternative is Pepe Jeans can reduce the lead time to market, and no capital investment is required for this change, but the disadvantage is $17 600 000 dollars burden is created every year.
As no investment is been made to this alternative, so there is no pay-back period.
Second Alternative: Introducing finishing operation into U.K Initial fixed cost for equipment = $1 000 000
Fixed renovation fee = $300 000
Total fixed fee = $1 300 000
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