If the point comes where the company is faced with resource constraints and therefore needs to choose between mutually exclusive projects, it should focus on the larger of these projects because of the direct correlation between project size and profitability.
4. In preparing the projection of income, some assumptions should be made. The first is with respect to the number of projects undertaken. The company should assume some growth, based on historic organic growth in large projects and it should also assume that its new focus will result in some growth. A no-growth scenario (i.e. worst case) should also be examined to provide some sensitivity analysis to the discussion.
The second major assumption that should be utilized is that the company will be able to reduce overhead and staffing costs. Under the scenario provided, salaries were to remain unchanged, but a more realistic scenario is that salaries would be reduced in line with the revenue. The unrealistic scenario of $800,000 salaries with no growth will be included, but so will a more realistic no-growth scenario that features a corresponding reduction in salaries as redundant staff are laid off. Why refuse business if you are not going to take advantage of the cost benefits of doing so?
Income Projection Statement
Base Case
Reduced Salaries
Increased Revenue*
Total Net Sales
1,300,000
1,300,000
1,950,000
Salaries
800,000
400,000
600,000
Gross Profit
500,000
900,000
1,350,000
Gross Margin
38.46%
69.23%
69.23%
Overhead
327,857
327,857
491,785
Operating Profit
172,143
572,143
858,215
Operating Margin
13.24%
44.01%
44.01%
As this projection shows, when salaries are not reduced, the company's operating margin (net margin in Linda's projections, which do not account for income tax) is 13.24%. In 2006, the firm's operating margin was 600,000 / 2,800,000 = 21.4%. Thus, the firm would be less profitable.
This illustrates the silliness of proposing that the salaries would not be reduced under a scenario where the company would reject over half of its previous clients. When you cut your business in half, you must reduce your costs accordingly. If Natalie and Carlos have no intention of reducing salaries, they should not turn away the small customers. The resulting inefficiency associated with having twice...
The only way for Survey Masters to improve its operating margin if it rejects small projects would be to reduce its salary structure. The degree to which this should be done will reflect the company's optimism with respect to generating new business from its strategy of focusing strictly on large surveys. In two years, the company went from zero to 20 large surveys, an average of 10 per year. Thus, the increased revenue scenario is based conservatively on doing that again, bringing the business to 30 large surveys per year. To accommodate this growth, some of the redundant staff will be retained, such that the reduction is only one of 25% of salaries, rather than 50%. Unless the number of large surveys is expected to double, Survey Masters should not retain its full staff.
The other way to maintain full staffing levels is to still accept some small projects, but only from those customers that are willing to pay more for them. If prices for smaller projects are increased by 30%, and demand declines 70%, the income projection would be as follows:
Increase price on small projects; lower demand
Total Net Sales - Large
1,300,000
Total Net Sales - Small
585,000
Salaries
800,000
Gross Profit
1,085,000
Gross Margin
83.46%
Overhead - Large
327,857
Overhead - Small
321,643
Operating Profit
435,500
Operating Margin
23.10%
As this income projection indicates, such as strategy would result in significantly higher gross margin than any other strategy. However, the inefficiencies associated with maintaining any small projects would eat up a large portion of the added revenue. Operating margins are therefore lower than for the other scenario. A 30% price increase on smaller projects therefore may not be enough. While it represents an improvement over the basic no-growth, full salary retention scenario, it is not as profitable as the more realistic scenarios presented.
The degree to which small projects can be maintained will, however, be determined largely by the slope of the demand curve for such projects (price elasticity of demand) and this is unknown at present. Therefore, the best recommendation that can be made consists of the following:
1) Focus strictly on large projects
2) Increase price on small projects by 50% or more
3) Assume that the firm will not attract any small projects with these price increases, and make staffing…
