m10/3/busmt/hp2/eng/tz0/xx+...– 12 – m10/3/busmt/hp2/eng/tz0/xx/m+ (iii) using the boston...

M10/3/BUSMT/HP2/ENG/TZ0/XX+

2210-5012

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2. The Berkeley

The Berkeley is a movie theatre owned by Ed Andrews. It shows old movies and recent independently financed films. The movies appeal to niche1 audiences, which would not be shown at the multi-screen cinema complex called The Max located five kilometres away.

As a sole trader, Ed’s financial position is deteriorating. Only 40 % of films shown at The Berkeley return a small profit. The manager of The Max phoned Ed two months ago and offered to takeover The Berkeley. Ed politely refused.

Cinema attendance has declined and Ed is aware that technology is changing people’s viewing habits. Recent releases of old movies on DVD and the lower price of home cinema systems to show these movies have led evening attendances to fall dramatically. Ed has calculated the cross-elasticity of demand for movie tickets, in relation to the price of these DVDs. He found that movie attendance at The Berkeley and DVD releases were very close substitutes.

Ed has just been offered a chance to be the first cinema in the region to show the second film “Film X”, of a young filmmaker called Judd Peterson. Judd’s previous movie had been a huge success. The potential demand for his “Film X” is so high that it would be shown twice at this premiere but Ed must guarantee a target profit of US$10 000. Ed anticipates selling all tickets at both showings.

Ed has prepared some figures for his break-even analysis if he shows “Film X”:• capacity of The Berkeley = 1200 per showing• price of movie ticket = US$12• fixed costs = US$12 000 (this includes target profit of US$10 000) to be split equally over the

2 showings• variable costs per ticket sold = US$6.

Ed has a dilemma: if “Film X” is successful, The Berkeley will receive a substantial revenue boost as well as free publicity. This could also help Ed bring more diverse films to The Berkeley, especially little known international films, which would fulfil a long-held ambition of his. However, if he shows “Film X”, Ed risks changing the perception of customers that The Berkeley provides films for a niche market to a perception that it provides films for a mass-market2. He is concerned that customers would expect similar movies in the future.

1 niche: a much more focused segment of the market with a smaller potential customer base classified perhaps by income levels, age or other demographic factors2 mass-market: an attempt by a company to produce goods and services which try to satisfy the needs of as many consumers in a market as possible

(This question continues on the following page)

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Turn over

(Question 2 continued)

(a) (i) Identify two characteristics of a sole trader. [2 marks]

(ii) Define the term cross-elasticity of demand. [2 marks]

(b) (i) Prepare a fully labelled break-even chart for The Berkeley for one showing of “Film X” at the premiere. [6 marks]

(ii) Calculate the total profit of The Berkeley if it shows “Film X” twice and comment on your results. [3 marks]

(iii) Using The Boston Consulting Group (BCG) matrix, explain two reasons for the manager of The Max’s decision to offer to takeover The Berkeley. [6 marks]

(c) Analyse the relative importance of driving and restraining forces on The Berkeley if Ed decides to show “Film X”. [6 marks]

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2. (a) (i) Identify two characteristics of a sole trader. [2 marks]

These include but are not limited to:

unlimited liability – a firm’s finances are not separate from the owner’s

owned by one person but may have a number of employees

limited capital for expansion

any other relevant characteristic.

Award [1 mark] for each appropriate, correct characteristic identified, up to

a maximum of [2 marks].

(ii) Define the term cross-elasticity of demand. [2 marks]

Cross-elasticity of demand measures the responsiveness of demand for one

product, when the price of another product changes. The term is used to

help define substitutional and complementary relationships between

products.

Candidates are not expected to word their definition exactly as above.

As the formula is given award [0 marks] if the candidate merely writes the

expression down.

Award [1 mark] for a basic definition that conveys partial knowledge and

understanding.

Award [2 marks] for a full, clear definition that conveys knowledge and

understanding similar to the answer above.

For only a relevant: example or application to the stimulus award

[1 mark].


(b) (i) Prepare a fully labelled break-even chart for The Berkeley for one

showing of “Film X” at the premiere. [6 marks]

Calculations:

Fixed costs (includes target profit) = US$6000 12 000

2

Contribution = 12 6 = 6

Break-even point = 6000

6= 1000 for one showing

Variable costs: US$6 per unit: ticket sold

Total costs = US$6000 + US$6 per ticket sold

Margin of safety = 1200 1000 200 per showing

14

12

10

8

6

4

2

0 1 2 3 4 5 6 7 8 9 10 11 12

Loss

Total revenue

Profit

Total costs

Fixed costs +

target profit

Cinema tickets

sold (00s)

Break-even output seats sold

Costs

Revenue

(US$000s)

Break-even chart for The Berkeley for one

showing of “Film X”

Margin of safety

Break-even

point


Award marks as follows:

[1 mark] for appropriately labelled axes.

[1 mark] for an accurately drawn and labelled total revenue curve.

[1 mark] for an accurately drawn and labelled total costs curve. Own Figure

Rule (OFR) applies.

[1 mark] for an accurately drawn fixed costs and target profit curve.

[1 mark] for the identification of the break-even level of output (whatever the

value) and [1 mark] for showing the correct value of the break-even level of

output.

[6 marks] in total.

The margin of safety is not expected to be identified (despite the diagram).

If the break-even chart is accurately drawn but not neatly, using a ruler or

straight-edge, or out of proportion, award a maximum of [3 marks].

If the candidate produces a table rather than a chart, award [0 marks].

(ii) Calculate the total profit of The Berkeley if it shows “Film X” twice and

comment on your results. [3 marks]

Total profit for The Berkeley if both showings sell out

TR = 2400 12 = 28 800

TC = FC + VC

= 12 000 + (6 2400)

= 12 000 + 14 400

= 26 400

Total profit = 28 800 – 26 400 = US$2400

[1 mark] only for correct answer.

The break-even point is 1000 tickets sold for one showing with a margin of

safety of 200 tickets. After satisfying the target profit of US$10 000, Ed will

be left with a cash boost of US$2400.

Award [1 mark] if comments only refer to the fact that Ed will be making a

profit compared to the current loss making situation.

Award [2 marks] for a further development of the magnitude of the profit.

Also, possibly but not necessarily comments on the break-even point or on

any other information in the stimulus material.


(iii) Using The Boston Consulting Group (BCG) matrix, explain two reasons

for the manager of The Max’s decision to offer to takeover

The Berkeley. [6 marks]

The BCG matrix need not be written in full although a number of

candidates will do so. The key is to be able to apply elements of the matrix

to The Berkeley as being part of The Max’s portfolio. There is no correct

classification here. Marks will be awarded for appropriate explanations

relevant to the stimulus.

Possible applications:

If The Max sees itself as a cash cow with limited potential for growth

given the technological/social external environment then The Berkeley could

be perceived as:

A problem child (question mark) with The Max seeing the potential to

develop it further as it complements the mass market audience of

The Max.

As a dog blocking out potential competition – defensive reasons for

acquisition.

One could argue that the manager of The Max may regard The Berkeley

as a potential star that can be moved into the cash cow position with a

new marketing plan and appropriate financial investment. This can be

seen as a defensive move of the proposed acquisition.

Alternatively, The Max might see itself as a cash cow with limited

potential growth, looking at a takeover as an extension strategy.

There is no exact information in the stimulus material in order to identify

the exact position of The Berkeley’s product therefore accept any reasonable

explanation in context.

Accept any other relevant explanation.

Mark as 3+3.

Award [1 mark] for a brief and general answer (possibly just a list) with no

development/explanation.

Award [2 marks] for an adequate explanation of the reasons for the manager

of The Max’s decision to offer to takeover The Berkeley, though the

response may be lacking in clarity or detail. For [2 marks] there should be

some use of the BCG matrix.

Award [3 marks] for a clear and detailed explanation of the reasons for the

manager of The Max’s decision to offer to takeover The Berkeley.

Reference is made to the stimulus material and accurate use is made of the

BCG matrix.


(c) Analyse the relative importance of driving and restraining forces on

The Berkeley if Ed decides to show “Film X”. [6 marks]

A full force field analysis is not required but some candidates may wish to

highlight the key forces in a diagram. This would constitute part of the analysis as

long as the relative importance of each constituent part is analysed afterwards as a

separate section. If the candidate only provides a Lewin type analysis but no

examination, then the candidate should not proceed to [3 to 4 marks].

Key driving forces:

Ed’s determination to achieve his ambition for his niche audience

the ability to spread his passion for “world cinema” or “festival” movies

a fear of consenting to the takeover bid by The Max as Ed, the sole trader,

is facing difficulties

the fragile state of the finances of The Berkeley with the majority of films

shown not breaking even

use of technology at home affecting the nature of demand for The Berkeley’s

films

Judd’s previous success and anticipated demand for the premiere of “Film X”.

Key restraining forces:

fear of irrevocably changing the perception of The Berkeley away from

Ed’s ambition

fear of imitation or me-too aspect with respect to The Max, which might

damage The Berkeley as they do not have the economies of scale or financial

muscle to compete with The Max

fear of alienating existing customers.

The key driver would seem to be finance and the change in home viewing habits

situation. Most of the restraining forces will be weakened if The Berkeley is

threatened with closure due to external factors. We do not know the extent of the

financial position but clearly with only 40 % of films returning a small profit,

Ed must show “Film X” and generate a revenue boost to stave off extinction

before he can think about satisfying his loyal customers and fulfilling his

ambition.

Accept any other relevant analysis.

For one relevant issue that is one sided, award up to [3 marks].

If the response is a one-sided relevant approach with no analysis, award a

maximum of [4 marks]. If only the driving forces or the restraining forces are

analysed, award a maximum of [4 marks].

Marks should be allocated according to the markbands on page 3.

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SECTION A

Answer one question from this section.

1. Dan Electro

Dan Bowen is a sole trader who sells digital cameras directly to consumers. He owns an online business and all sales are processed electronically under the business name Dan Electro. The office, storage place and call centre are located together in an expensive and desirable city centre location.

Dan started the business three years ago by borrowing a considerable amount of money from a bank. He used his residential property as collateral* for the loan.

The cameras are bought and shipped from a reputable and reliable overseas supplier who charges a high price for good quality cameras and prompt transportation. Dan has to pay in advance for the cameras. Dan Electro’s customers are very loyal and see their purchase as good value for money. Repeat purchases comprise a large percentage of Dan Electro’s sales. Some customers have even indicated that they would pay a higher price for the cameras because of their quality and the good service he provides.

Dan is now worried about the forecasted rise in interest rates, inflation and an increase in online competition. Dan Electro may face some cash flow difficulties in the coming years. He is considering various strategies in order to prevent such possible cash flow difficulties.

Financial information for 2010 (all figures in US$)Fixed costs per yearRent 20 000Marketing 4000Administration 5000Interest payments 1000

Variable costs per cameraCamera 135Transportation 45Direct labour 20

Price per camera 250

Dan is expected to sell 700 cameras in 2010.

* collateral: the borrower’s property is offered to the lender as security if the loan is not paid back

(This question continues on the following page)

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Turn over

(Question 1 continued)

(a) (i) Define the term variable costs. [2 marks]

(ii) Identify two advantages for Dan of operating as a sole trader. [2 marks]

(b) (i) Construct a fully labelled break-even chart for Dan Electro for 2010. Calculate and indicate the break-even point, the margin of safety and the projected profit at 700 cameras (show all your working). [7 marks]

(ii) Calculate the number of cameras Dan Electro must sell in order to double the projected profit (show all your working). [2 marks]

(iii) Calculate the price per camera that needs to be charged (at expected sales of 700 cameras) in order to double the projected profit (show all your working). [2 marks]

(iv) Explain two possible limitations of the break-even model as a decision tool for Dan Electro. [4 marks]

(c) Examine two possible strategies for Dan Electro to prevent cash flow difficulties. [6 marks]

– 5 – N10/3/BUSMT/HP2/ENG/TZ0/XX/M

SECTION A

1. (a) (i) Define the term variable costs. [2 marks]

Variable costs are costs that vary in “direct proportion” to change in output/level of production.

Candidates are not expected to word their definition exactly as above. Award [1 mark] for a basic definition that conveys partial knowledge and understanding. Award [2 marks] for a full, clear definition that conveys knowledge and understanding similar to the answer above. For only a relevant: example or application to the stimulus award [1 mark].

(ii) Identify two advantages for Dan of operating as a sole trader. [2 marks]

Possible advantages could include: Dan as a sole trader has complete creative and management freedom Dan can be more customer focused due to constant interaction and

communication with the customers Dan does not have to share the profit with anyone else accept any other relevant advantage. Award [1 mark] for each relevant and appropriate advantage identified up to a maximum of [2 marks].


(b) (i) Construct a fully labelled break-even chart for Dan Electro for 2010. Calculate and indicate the break-even point, the margin of safety and the projected profit at 700 cameras (show all your working). [7 marks]

The break-even point is:

Fixed cost US$30 000

600 camerasContribution US$250 US$200

The margin of safety is: 700 600 100 units The projected profit at 700 units is: Margin of safety contribution per unit 100 units US$50 US$5000 Or:

Total revenue – total cost US$175 000 US$30 000 200 700 US$5000

180

160

140

120

100

80

60

40

20

0 100 200 300 400 500 600 700

Margin of safety

Cameras

Break-even point

Cost/revenue (US$000s)

Fixed costs

Total revenue Total costs

Profit


Do not double penalize candidates. Award marks as follows: [1 mark] for appropriately labelled axes. [1 mark] for an accurately drawn and labelled total revenue curve. [1 mark] for an accurately drawn and labelled total costs curve. [1 mark] for identification of the break-even point and [1 mark] for showing calculation at the correct value of 600. [1 mark] for identification of the margin of safety. [1 mark] for correct calculation of the projected profit. If the candidate produces a table rather than a chart, award [0 marks].

(ii) Calculate the number of cameras Dan Electro must sell in order to

double the projected profit (show all your working). [2 marks]

The doubled level of profit is:

Target: US$5000 2 US$10 000 Fixed cost target profit US$30 000 US$10 000

800 camerasContribution US$50

Do not double penalize for a mistake carried forward. Award [1 mark] for the correct workings and [1 mark] for the correct calculation/figure.


(iii) Calculate the price per camera that needs to be charged (at expected sales of 700 cameras) in order to double the projected profit (show all your working). [2 marks]

target profit + total costs US$10 000 (US$30 000 US$140 000)

Priceoutput 700

= US$257.14 (2 d.p.) Do not double penalize for a mistake carried forward. Award [1 mark] for the correct workings and [1 mark] for the correct calculation/figure.

(iv) Explain two possible limitations of the break-even model as a decision

tool for Dan Electro. [4 marks]

The possible limitations/drawbacks of the break-even model are: The model assumes that all cameras are sold. Dan Electro might not be able to sell all of its cameras and, therefore, the total revenue curve might not be as high/accurate as the model assumes: The model is also used under the assumption of unchanging conditions.

Inflation and interest rates might indeed increase (forecasted) which could affect the demand for the camera.

Also, the effectiveness of the model depends on the accuracy of the data. Dan might not have computed all the costs/revenue accurately.

The model assumes a linear relationship, which is quite unlikely in real life. Dan might decide to reduce the price of the cameras to stimulate sales.

Given the above, the use of the model can become less effective as a decision tool for Dan. Accept any other relevant explanation. Mark as 2+2. Award [1 mark] for identifying each relevant and correct limitation of the break-even model and [1 mark] for each explanation of the limitation with application to the stimulus material. Award a maximum of [2 marks] overall if there is no application to the stimulus material.


(c) Examine two possible strategies for Dan Electro to prevent cash flow difficulties. [6 marks]

Some of the possible strategies that are available for Dan Electro in order to overcome the forecasted cash flow difficulties are: Increase inflow of money: Dan can look for a partner. Forming a partnership can inject cash quickly with the added benefits of knowledge and expertise. The responsibilities of running the business can also be shared. However, Dan will lose the benefits of being a sole trader – benefits such as complete freedom in decision-making and the retaining of all profit. Dan could increase the price of the cameras. Dan has very loyal and, therefore, price inelastic customers. Some customers indicated that they would be willing to pay a higher price. This enables him to increase the price and at the same time to increase Dan Electro’s total revenue. However, given the increase of online competition and the current customers’ perception of the camera being good value for money, this option is somewhat risky. Dan Electro might end up with fewer customers and less total revenue. Dan Electro’s marketing expenses are relatively small. Dan might want to consider a marketing drive to promote the product so as to increase sales and then sell more than 700 cameras – which is rather a small amount. However, care has to be taken that the extra marketing expenditure does not outweigh the extra revenue. Perhaps it is a risk worth taking given the increased competition. Taking another loan from the bank might inject immediate cash, but may not be seen as a wise move as Dan is still paying back US$1000 in interest on the previous loan and the interest rate is predicted to rise. Decrease outflow of money: The main problem that can be seen from the data is the transportation cost per camera, which is a significant 22.5 % of the variable costs. Dan could negotiate a reduction in such costs with the current supplier. Perhaps a bulk buying deal can be agreed upon. However, Dan will have to take the risk of being left with unsold stock, which is risky given the fast changing technology in this market. Rent is currently extremely expensive. The costs for an “expensive and desirable” location are unnecessary given the fact that Dan operates an online business. A move to a cheaper and non-central location could provide a good solution. The service quality should not be harmed by this change. Also, Dan should ask for some credit facilities with the current supplier rather than continue with the current agreement of paying in advance. This will alleviate the cash flow difficulties. However, the supplier may not agree and may decide to supply to other retailers given the increase in online competition. Another possibility is to look for a cheaper local supplier. However, the quality of the cameras may be compromised and Dan Electro may lose its competitive advantage.


Accept any other relevant examination. To achieve the top markband candidates must give a balanced examination of two possible strategies. For one relevant issue that is one-sided, award up to [3 marks]. If the response is a one-sided relevant approach with no balanced examination, award a maximum of [4 marks].

Marks should be allocated according to the markbands on page 3.

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6. Paolo’s Pasta

PaoloCabrini runsa smallpasta-makingbusiness, calledPaolo’s Pasta. He has borrowed funds to purchaseaproperty, leasedmachinesandemployed two staff. Hismaincompetitor is calledFasta Pasta but there are also a number of general food shops selling fresh pasta as a small part of theirproductrange.Paolosellshispastaforapremiumpriceof$7perkilogram.Fullcapacityis12 000 kilograms of pasta per year. He incurred the following expenses in 2007.

Leasecosts $200perweek Mortgagepayment $500permonth Paolo’ssalary $300perweek Rawmaterials $1.25perkilogram(kg)ofpastaproduced Wages $1.60perkilogram(kg)ofpastaproduced Electricity/gas/water $0.15perkilogram(kg)ofpastaproduced

Paolo’s Pasta is currently producing an output of 10 000 kilogram per year. A large hotel chain has approached Paolo and offered to purchase �000 kilograms per year of pasta at a price of $4.50perkilogram.Paoloisconsideringtheofferandbelievesthatitmaybeworthwhileasheisconcerned about sales falling in the future.

(a) With reference to Paolo’s Pasta, distinguish between fixed costs and variablecosts. [3 marks]

(b) Construct a break-even graph showing the break-even level of output, themarginofsafetyandtheamountofprofitatcurrentoutputlevel.(Show any relevant workings) [5 marks]

(c) Paolo is considering changing the price of his pasta. Describe two possible pricingstrategiesandadvisePaoloonthemostappropriatetoadopt. [6 marks]

(d) EvaluatewhetherPaoloshouldaccepttheofferfromthehotelchain. [6 marks]

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6. (a) With reference to Paolo’s Pasta, distinguish between fixed costs andvariable costs. [3 marks]

Fixed costs are incurred by a business irrespective of output. They occur evenif nothing is produced and remain the same as the production rises or falls. Thefixed costs incurred by Paolo’s Pasta are leasing, mortgage payments andPaolo’s salary. Variable costs are dependent on the amount produced.The higher the output levels, the higher the variable costs. If nothing isproduced no variable costs will be incurred. The variable costs incurred byPaolo’s Pasta are raw materials, wages and electricity/water/gas.

[3 marks] An appropriate definition of both fixed costs and variable costs, a cleardistinction between the two and relevant examples from Paolo’s Pasta.

[2 marks] An appropriate definition of both fixed costs and variable costs. There may beno examples provided, or one or more examples are incorrect.

[1 marks] An appropriate definition of fixed costs and/or or variable costs (but perhapsnot both). There may be no examples provided or they may be incorrector inappropriate.


TR

Margin of safety

Profit at current capacity

(b) Construct a break-even graph showing the break-even level of output,

the margin of safety and the amount of profit at current output level. (Show any relevant workings) [5 marks]

Contribution Variable costs $1.25 + $1.60 + $0.15 = $3.00 per kg of pasta Selling price $7 per kg of pasta Contribution $7 – $3 = $4 per kg of pasta Break-even level of output Fixed costs ($500 x 52) + ($500 x 12 = $6000) = $32 000 Contribution $4 per kg of pasta Break-even quality $32 000 / 4 = 8000 kg of pasta per year Margin of safety Current output level – break-even level 10 000 kg – 8000 kg = 2000 kg Profit at current capacity Margin of safety × contribution: 2000 kg × $4 = $8000

72 64 56 48 40 32 24 16 8 0

0 1 2 3 4 5 6 7 8 9 10 11 12

TC

Rev/ Costs ($) (1000)

Kg of pasta/year (1000)

FC


[5 marks] The diagram is correct, properly labeled, drawn to a reasonable scale, and allthe points quantities are correctly identified. Relevant workings are shown. [3 to 4 marks] The diagram is essentially correct but there may be a small number ofminor errors. Relevant workings are shown. Or The diagram is correct, properly labeled, drawn to a reasonable scale, and allthe points quantities are correctly identified. Relevant working is not shown. [1 to 2 marks] There is a diagram, and recognition of costs and revenues, a break-even pointis attempted but might be wrongly identified. N.B. There is no need for the exact figures for break-even margin of safety andprofit to be given, so long as these are shown accurately on a suitably scaledgraph and clearly identified.


(c) Paolo is considering changing the price of his pasta. Describe two

possible pricing strategies and advise Paolo on the most appropriate to adopt.

[6 marks]

Cost-based pricing involves the addition of a profit element to the costsof production. This form of pricing guarantees a profit since the fixed and thevariable costs are all covered, and the price is always set above the costs toallow for a net margin. Its drawback is that it ignores the impact ofcompetition and consumers. If competitors are selling at lower prices then thefirm might see its sales decreasing rapidly. Competition-based pricing is where the price charged by competitors, not thecost of producing the good, is the main factor influencing pricing decisions.The pricing policy is most often used in markets with a lot of producers.Generally businesses are reluctant to lower prices for fear of setting a“price war” and they are reluctant to raise prices of fear of lower sales revenueas consumers switch to the relatively cheaper competitors. Consumer-orientated pricing is where the business analyses the marketconditions when setting the price. It considers the demand for the product andthe price elasticity of demand of the product along with market potential. Accept other relevant description and evaluation of any other pricing strategy. Paolo’s does not currently take into account its competitor’s prices. Paolopositioned his product as high quality high price. His prices are currentlyrelatively high (premium pricing / customer- value pricing) and his businessseems to do well with this approach. However, the market is becoming morecompetitive and Paolo is worried about future fall in sales. This might bebecause competitors are getting more efficient, selling good quality at lowerprices or other variables might be interfering (if income is dropping thenpeople might be swapping to inferior products). The customers’ perception ofhis products might be changing. He, therefore, needs to undertake marketresearch to fully understand the nature of his target market. He needs to knowwhat type of price and income elasticity his product has, the customers’perceptions and his product positioning, he needs to be aware of the sphere ofinfluence of his competitors and only then act accordingly. Customer orientated pricing or Competition based pricing might be appropriatestrategies. However, Paolo might have to sacrify some of his profit if pricesare lowered. A reduction in price might also chance the image of the product.Paolo might want to stick to his premium pricing to differentiate himself fromthe competitors. This strategy will be appropriate if the quality of his productsis indeed superior. He does have 2000 kg a year of spare capacity and this hasto be investigated. He might be losing market at $7 and a reduction could puthim closer to the competitors and increase the output.


[5 to 6 marks] Two appropriate pricing policies are identified, described in sufficient detailwith a balanced evaluation and appropriate application to the case.For [6 marks] a reasoned judgment is made as the most appropriate pricingpolicy in the circumstances. [3 to 4 marks] Two appropriate pricing policies are identified and described with someconsideration of their relevance. A maximum of [3 marks] should be awardedfor a detailed discussion of one pricing policy. At the lower end of the rangethe answer may lack detail and balance. [1 to 2 marks]

A limited and essentially descriptive answer.


(d) Evaluate whether Paolo should accept the offer from the hotel chain. [6 marks]

Currently Paolo’s Pasta has 2000 kg a year of spare capacity. It makes10 000 kg a year which are sold at the same price of $7 per kg, leaving anannual profit of $8000. He could therefore add a considerable amount to hisprofit if he were to be able to sell the 2000 kg, which he can make but not sell.If he could sell them at $7 per kg he would make an extra profit of $6000a year. Yet the hotel chain is offering to purchase 4000 kg per year. Therefore Paolowould need to produce annually 8000 kg sold at $7 to break-even, and he is leftwith 4000 kg to sell to the hotel chain at $4.50. Contribution from each one ofthese kilograms is $1.50. This will give him a profit of $6000 per year. Clearly if he sells to the hotel, his profit drops by $2000. On these groundsPaolo might decide not to accept the offer. If a competitor offers the samepremium quality product at the lower prices, the image of Paolo Pasta may beeroded and sales will fall. If he is to build extra capacity, extra capital has tobe raised and invested. It might be very risky given the prediction of increasedcompetition. Extra work might increase staff stress level and some motivationissues can emerge. On the other hand, sales are dropping. Paolo knows that the pasta market ishighly competitive since entry is relatively easy. There are no great barrierssince the capital needed is not a large amount. So accepting the offer might beconvenient in terms of securing a steady income throughout. He might be ableto decrease costs in the future, supply pasta to other hotel chains and end upgrowing into a larger manufacturer.

Yet Paolo might not like this dependent relationship at all and he might want tokeep his independence. He might be able to adjust his pricing policy,maybe discriminate better, and increase his output to get the same ormore profit. Accept any other relevant argument for or against the offer. Based on thefinancial and non financial data, in the short run the offer is not attractive.Perhaps the offer will pay off in the longer term when adjustment to theproduction facilities has been made as well as the changes in the marketoccurred. Accept any substantiated recommendation.


[5 to 6 marks] Both advantages and disadvantages of accepting the offer are evaluated in abalanced manner. A variety of issues- both financial and non financial areconsidered, including calculation of future profits and the drop in sales. [3 to 4 marks] Both advantages and disadvantages of accepting the offer are analysed but theanswer may lack balance. Some financial and non financial issues areconsidered, but calculation of future profits and the drop in sales are notpresented or are not entirely accurate

[1 to 2 marks]

A limited and essentially descriptive answer that may simply identify or listadvantages and/or disadvantages.

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5. Arica Sportswear plc

Arica Sportswear plc produces sports kits. The kits, which include shirts, shorts and socks, are sold by established sports shops across the European Union. The kits are sold to retailers for a premium price of $120. In their marketing, Arica Sportswear plc justify the relatively high price by emphasizing the quality of the materials used and the fact that each kit is customized with the team’s logo and sponsors’ names. The Arica brand is highly regarded by their target market of 12 to 24 year olds who are extremely loyal to the brand. The company’s products are used by many international teams, and endorsed by a number of sports and entertainment celebrities who have their names displayed on their Arica kit.

Recently the manufacture of the kits was relocated to a factory in a developing country. Each kit now costs Arica Sportswear plc $43 with an additional printing cost of $12 per kit. This cost is $10 lower per kit than when Arica Sportswear plc produced in their home country.

Sales representatives receive a commission of $3 per kit sold to retailers. Some have begun to complainthatthiscommissiondoesnotreflectthesaleseffortrequiredinanincreasinglycompetitivemarket segment. The transport costs for each kit is $2.Thefixedcostsofproductionare$720000per month. The factory capacity is 16 000 kits per month, and since last month, when a special marketing campaign took place, the factory is working at full capacity. The marketing manager has proposed to the board of directors that the price of the kits to retailers should be increased by 15 % toreflecttheirpopularityandtoaddresstheproblemsposedbytheirlimitedproductioncapacity.

(a) With reference to Arica Sportswear plc

(i) distinguishbetweenfixedandvariablecosts.

(ii) calculate the contribution earned per kit after relocation. (Show your working)

[2 marks]

[2 marks]

(b) construct a break-even chart and identify

(i) the monthly output of kits required by Arica Sportswear plc to break-even.

(ii) the margin of safety if the factory is producing at full capacity.

(iii) the monthly level of profit assuming 16 000 kits are manufacturedand sold. [8 marks]

(c) Evaluate the marketing manager’s proposal to increase the price of Arica sports kits to retailers by 15 %. [8 marks]

– 16 – N06/3/BUSMT/HP2/ENG/TZ0/XX/M+

5. (a) With reference to Arica Sportswear plc (i) distinguish between fixed and variable costs.

[2 marks]

Fixed costs: costs that do not change when the level of output changes e.g. rent, rates, interest. They only remain constant in the short-run.

Variable costs: costs that change in direct proportion to the output of a firm

e.g. raw materials, sales commission. [2 marks] The distinction between fixed and variable costs is clear and accurately explained. Examples are used from the case. [1 mark] There is some understanding of the distinction between fixed and variable costs, but there may be some lack of clarity.

(ii) calculate the contribution earned per kit after relocation. (Show your working)

[2 marks]

Variable costs = transport costs $ 2 manufacturing cost $43 printing $12 commission $ 3 $60 Contribution to fixed costs = price – variable cost $120 – $60 = $60 Award [1 mark] for the correct answer and [1 mark] for working up to a maximum of [2 marks].


(b) Construct a break-even chart and identify (i) the monthly output of kits required by Arica Sportswear plc to

break-even.

$000s

Output FC VC TC TR +/– 0 720 0 720 0 (720) 4 000 720 240 960 480 (480) 8 000 720 480 1200 960 (240) 12 000 720 720 1440 1440 0 Break-even point 16 000 720 960 1680 1920 240 Factory capacity

Sales/Rev ($000) 1440 0 12 16 Break-even = 12 000 kits (ii) the margin of safety if the factory is producing at full capacity.

Margin of safety = actual production less break-even output = 16 000 less 12 000 = 4 000 units

1920240

1680

⎧⎪⎨⎪⎩

Area of loss (TC > TR)

730

Output (000s)

Fixed costs

Area of profit (TR > TC)

Total Costs

Total Revenue

Margin of safety = 4000 units


(iii) the monthly level of profit assuming 16 000 kits are manufactured and sold.

[8 marks]

Profit = TR – TC At 16 000 units TR – TC $192 000 – $168 000 = $240 000 or [4 000 units $60 000 contribution = $240 000]

[6 to 8 marks] The break-even chart is accurately presented with the break-even output, margin of safety and level of profit correctly identified. If the margin of safety or level of profit are correctly calculated but not shown on the chart, a maximum of [7 marks] can be awarded. The lower end of the band is awarded where there are some minor omissions in presentation or calculation. [3 to 5 marks] There is a valid attempt at presenting a break-even chart, but there are some inaccuracies and/or omissions in presentation or calculations, which may mean that one or more of the answers are incorrect. When a candidate has just calculated the values correctly but there is no break-even chart a maximum [3 marks] should be awarded. [1 to 2 marks] The break-even chart and/or calculations are highly inaccurate or missing. The principles are understood only in a very general sense.

(c) Evaluate the marketing manager’s proposal to increase the price of

Arica sports kits to retailers by 15 %.

[8 marks]

The present pricing strategy employed by Arica Sportswear plc is a premium pricing strategy. It could be argued that the firm is price skimming as its “offer” is temporarily unique. The relatively high price of $120 is justified by the quality of the product and by the customization that takes place. It is clear that the brand is presently fashionable and adds value, justifying the higher price and that creaming the market will allow revenue maximization in the short run. Indeed, the present pricing strategy seems appropriate given the significant monthly profit level and the relatively high margin of safety. Clearly the product is very popular and the new factory is producing at full capacity. This will prove to be a problem as there is no flexibility if demand increases further, possibly leading to disappointed customers. A price increase should decrease demand in theory dependent on the products’ price elasticity. The 12 to 24 year old target market may be fashionable, but disposable incomes are often limited and the impact of a 15 % increase in price may be significant.


The marketing manager is suggesting that the market will accept such an increase and indeed this may enhance the status of the product. It would be advisable for the board of directors to commission some market research first to test these assumptions and ensure that a price increase will not damage the brand and lead to a decline in popularity; fashion is after all a fickle phenomenon. It is also important that customers do not notice a corresponding decline in quality from the new factory, which may undermine its premium position in the market place.

The price increase and cost decrease should allow Arica Sportswear plc to pay a higher rate of commission to its sales representatives. An alternative would be for the price to be reduced to reflect the lower manufacturing costs of Arica Sportswear plc. This cost plus approach could be justified if the revenues increase overall. However, the problem of overcapacity would have to be dealt with first, possibly through outsourcing or by opening new productive capacity. In a fashion market, price is often part of an image, but competition is likely to become fiercer if firms like Arica Sportswear plc appear to be achieving large profit margins. There is also the issue of market saturation, which may force Arica Sportswear plc to employ a more competitive pricing strategy in the medium to long term. The board of directors are likely to approve such an increase subject to reassurance that this will not damage the brand and lower the market share significantly. Research should be carried out before a discussion is made. [6 to 8 marks] The evaluation of the proposed pricing strategy reflects a good understanding of Arica Sportswear plc’s present market position and its operational difficulties. The discussion is balanced and makes relevant reference to Arica Sportswear plc. Business terminology and concepts are used appropriately. A judgement is made for [8 marks]. [3 to 5 marks] There is some understanding of pricing theory and the appropriateness of the proposed strategy though the discussion may not always be balanced. There is some attempt to use relevant marketing theory and/or terminology, but this may be limited. [1 to 2 marks] A limited and essentially descriptive answer.

m10/3/busmt/hp2/eng/tz0/xx+...– 12 – m10/3/busmt/hp2/eng/tz0/xx/m+ (iii) using the boston...

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