Case Study: Monica’s Handbags
Monica, after completing an internship with a national apparel company, decided that she wanted to exercise her creative design talents and her strong entrepreneurial spirit by starting her own fashion business. She conducted fundamental market research and determined that there is an unfulfilled market need for the moderate fashion handbags that she had designed at the $100 retail price point. She also learned that the independent women’s apparel stores she was targeting require a 50% retail margin, which they often refer to as a “100% markup, or “keystoning ” to cover their own display and selling costs. Monica approached a number of independent local stores that liked her handbag design prototypes and her retail price point and would consider carrying her line, but she was told consistently that they purchased such moderately-priced fashion products through a particular apparel distributor. She, in turn, met with the well-established distributor and showed her designs and discussed his operations. The regional distributor was interested in representing her line to his independent retailers, but indicated that he required a “20% wholesale margin,” that is, 20% of Monica’s price to the retailers. Monica realized that to be successful in her new business she would have to manage her costs and contribution margins carefully and negotiate the distribution channels and retailer relationships wisely.
Monica’s Contribution Margins
Monica learned during her retail management course in college and her internship with a national retailer that she would have to generate sufficient contribution margins on her products to recover her fixed sales, general, and administrative costs of doing business. She determined that the contribution margin on each unit of product sold can be established by setting a reasonable wholesale price and subtracting all variable, or direct, costs to provide each unit. Monica realized that the retail handbag market had pre-determined price points to the end consumer, e.g., $100. Her wholesale price would be the retail price net of both the retailer and distributor margins, which motivated the partners to distribute her product through their channel. The wholesale price had to be sufficient to cover the product’s variable costs, including direct manufacturing and shipping costs, and thus produce a positive contribution to overhead.
Wholesale Price Determination
So, Monica sat with her tablet at her drafting board and did the necessary financial analysis.
She assumed that her retail price point of $100 to the end consumer was realistic, given the confirmations she received from several independent retailers and the regional distributor. Monica also assumed that the independent retailers would require a 50% margin, and thus would markup her wholesale price by 100%. So, what wholesale price could she set for the independent retailers? She calculated the retail unit price, the retailers’ unit margin, the distributor’s unit margin, and an acceptable wholesale unit price. She drew out the transaction prices and costs in a line diagram on her drafting board.
Variable or Direct Unit Costs
Monica had negotiated for the production of her designer handbags with a contract manufacturer, based in Vietnam, that she had come to know through her internship. She had also arranged LTL (less than truckload) shipment of each season’s new handbags directly from the factory to the distributor who, in turn, ensured that retailers’ shelves were stocked with Monica’s designs. At the volumes she projected each season, the manufacturing costs averaged $10 per unit. Her shipping costs, at current volumes, averaged $5 per handbag. She extended her line diagram to show these two direct costs. Monica could now determine her contribution margin per handbag.
Fixed Sales, General, and Administrative Costs
Monica had hired one salaried marketing person to assist her with all sales and promotions activities, including maintaining the website, entering order transactions, and running reports on an enterprise system. She had also retained an advertising agency, an attorney, an accountant, and a bank to facilitate all of her other general and administrative matters as needed. She rented a small office space near her residence for her design work, system operations, and business meetings. Monica estimated the total of these fixed overhead expenses at $25,000 per month. She felt that these were all necessary business expenses and that she could grow her volume with this support base in place.
Breakeven Volume and Market Share
Monica next determined the minimum volume of handbags that she would have to sell in order to cover her overhead expenses, which her seasoned accountant referred to as her “nut.” She divided her monthly overhead expense by the contribution margin per handbag, which she had calculated earlier, to determine her breakeven volume in units. She next extended this breakeven volume by her wholesale price to determine her breakeven sales volume, measured in dollars.
However, Monica also wanted some confirmation about the reasonableness of her breakeven volume expectations, and therefore sought to estimate what share of the market she would have to achieve in order to break even. Her earlier research found that the total U. S. retail market for moderately priced (~$100 at retail) fashion handbags was $120,000,000 per year. Based on her findings, she calculated the total number of such bags sold at retail in the U. S. in an average month. Monica then divided her monthly breakeven volume by one-twelfth of the total annual U. S. retail market, to determine her minimum market share to break even.
Profit Impact
Monica, however, would not be satisfied by achieving only a financial breakeven for her enterprise. She had not taken a salary from the business so far and had invested her own capital to get the business started. She reasoned that her time was worth money and the alternative of returning to her previous employer would involve a stable healthy income and considerably less risk. Monica wanted her business to generate a sustainable profit, so that she could reinvest in growing her enterprise and take a steady salary. She set an initial goal of earning a profit of $50,000 per month and sought to determine what volume she would need to sell in order to reach that bottom line target. If selling the breakeven number of units per month covered the $25,000 monthly overhead expense, how many handbags would Monica have to sell to generate a $50,000 monthly profit impact, beyond breakeven?
Trade Discounts and Terms of Sales
Monica had negotiated with the distributor for a 2% discount for payment at end of month, with net amount due in 90 days. The distributor generally did not take the offered discount, but rather paid at the end of each quarter, as was typical in the seasonal apparel trade.
Profit Margin
Monica was soon able to achieve her goal of an average profit impact of $50,000 per month on wholesale sales of $1,440,000 per year. What is the average profit margin, expressed as a percentage, of her expanded business?
A Grand New Opportunity
Monica next set a new goal to grow into a $2 million company in annual wholesale revenues. Soon, her sales assistant approached her at her drafting board with some good news! A buyer for Grand*Mart, one of the nation’s largest discount retail chains, who had seen Monica’s handbag designs on the website, e-mailed an invitation to propose a contract. The Grand*Mart buyer, however, was specific about several conditions for Monica’s proposal. Monica was excited about this prospective new customer, which in addition to her independent retailer business would help achieve her new total sales goal.
Sales and Profit Impact of the New Deal
Grand*Mart would accept 2,000 handbags per month of seasonal designs similar to Monica’s most popular handbags and stock them in 20 stores in a test region, handling all of the transportation from the overseas factory and all of the distribution to their stores in the U. S. Grand*Mart indicated that they would pay within 90 days, as the handbags sold through their stores, and they would increase the order each quarter based on the success of the trial. They proposed that a wholesale price of $20 per handbag would be acceptable to them under the terms and conditions, as described. Grand*Mart extended an invitation to Monica to call on their Mobile, Alabama headquarters during the next week and to present her “best and final offer” proposal to their buyers.
Monica realized that this one deal virtually would achieve her higher goal of becoming a $2 million business! However, she was concerned that Grand*Mart’s suggested wholesale price was low relative to the wholesale price she received in the independent retailer channel. Monica calculated that the proposed price would cover her present direct manufacturing cost and eliminate her direct shipping costs. However, she estimated that she would have to double her existing $25,000 per month overhead expenses to meet the required level of customer service that Grand*Mart specified for store advertising, customer support, and returns handling. She drew out Grand*Mart’s suggested transaction in a line diagram in order to determine the unit contribution margin and the profit impact that the deal, as proposed, would bring to pay the incremental overhead and drop to her bottom line each month.
A Time for Serious Reflection
Monica looked at this new line diagram and realized she had some key decisions to make. Should she propose the Grand*Mart deal, as they suggested, including the wholesale price? Should she take a pass on the Grand*Mart deal, and stay exclusively with the independent retailers’ channel in which she had success? Should she go to Mobile and renegotiate the deal, offering a “best and final” price that could be acceptable to both parties? And, importantly, what other financial and non-financial considerations should she contemplate before getting on a plane for Alabama?
Monica’s Further Research on Grand*Mart
Monica promptly went to three local Grand*Mart stores, thoroughly inspected the handbag sections, and recorded the prices of similar merchandise on the shelves. She also sent e-mail inquiries to several of her industry colleagues who knew the discount chain and the discount fashion trade well. From her field research, she garnered that Grand*Mart probably would price her handbags at $45 each, and that they would require at least a 33% contribution margin on their retail price. With this intelligence, Monica is able to estimate the maximum wholesale price, after incurred costs, that Grand*Mart might be willing to pay for each handbag. What is it? How does this additional information influence Monica’s decision about her “best and final price” offer? What would be the incremental profit impact of her new proposed deal with Grand*Mart?
Questions to answer for this assignment:
At what wholesale price will Monica sell her handbags to the distributor?
How many handbags must Monica sell per month in order to break even, if her overhead expense is $25,000 per month?
What share of the moderately priced (~$100 at retail) designer handbag market, estimated at $120,000,000 per year, must Monica achieve in order to break even?
How many handbags must Monica sell per month in order to achieve a bottom-line profit impact of $50,000 per month?
What is Monica’s profit margin (expressed as a percentage), if she generates $600,000 in profits per year on $1,440,000 in revenues per year?
What is Monica’s unit contribution margin (in dollars per handbag) on this specific deal, using Grand*Mart’s suggested wholesale price of $20, after incremental direct expenses?
What are Monica’s other financial and non-financial considerations for the suggested Grand*Mart deal? Should she take it?