Survey Masters HBS case study analysis

¶ … Masters

Linda's assumptions contributed to the conclusion that small projects are at least as profitable as large projects. When she first drew up the analysis, the dividing line between large projects and small ones was somewhat arbitrary. More importantly, she divided the overhead expenses along those same arbitrary lines. Salaries are not an intelligent way of dividing project types, or for dividing overhead. Linda should have adopted an activity-based costing approach, or at the very least divided project sizes on the basis of revenues or survey sizes and then worked backwards from there to determine the costs. Even with her second analysis, splitting the projects evenly into "large" and "small" creates an arbitrary divide. Because Natalie and Carlos are seeking strategic direction, they need to have clear, logical definitions for "large project" and "small project." These definitions need to be based on fundamental differences between the two types of project. If there are no fundamental differences, then perhaps the entire question of the company's direction needs to be re-phrased.

In order to remedy this situation, Linda would need to begin with a specific definition of the different types of projects. Barring that, any arbitrary distinctions between project types, if they are to have meaningful distinctions, the middle ground should be excluded. To understand the nature of small projects, only the smallest should be considered; likewise for large projects, only the largest should be included. Again, though, the assignment of overhead must be conducted on a basis that is congruent with actually overhead usage. Overhead is nearly 2/3 of the company's cost structures, so it cannot be assigned in such a haphazard fashion. Overhead assignment must take place on the basis of the activities to which it continues. If the company does not understand to contribution that different overhead elements makes to the revenues, it needs to acquire this information.

2. To determine the relationship between project size and profitability, there are a number of ways to break down the overhead by activity. This breakdown should be conducted on the basis of each activity, so that a more complete understanding of the relationship is known. Weighted averages can be used. Survey design has the following cost structure for overhead:

Large = (50/160)(640,000) = $200,000

and Small= (110/160)(640,000) = $440,000

For data collection and tabulation the same weighted average calculation would be as follows:

Large = (600/4200)(370,000) = $52,857

and Small = (3600/4200)(370,000) = $317,142

And for analysis and report preparation:

Large = (250/1300)(390,000) = $75,000

and Small = (1050/1300)(390,000) = $315,000

This gives total overhead for large projects as $200,000 + $52,857 + $75,000 = $327,857

And for small projects $440,000 + $317,142 + $315,000 = $1,072,142

This gives the following income statements:

Large

Small

Revenue

1,300,000

1,500,000

Salaries

400,000

400,000

Overhead

327857

1072142

Net Income

572,143

27,858

Net Margin

44.01%

1.86%

The large projects are clearly more profitable than the small projects, once the overhead is allocated accurately. Smaller projects simply have a much lower degree of profitability. If the trend in evidence here holds, it is reasonable to conclude that most of the profitability in the "small" project category comes from the largest of the small projects. There is likely to be a substantial number of small projects that are money-losers.

3. Survey Masters does not need to reject small projects outright. It is recommended that the company focus its efforts on large projects as these are the most profitable. However, this is not the full slate of reasonable recommendations. To this I would add that the company is simply not charging enough money for the small projects. The company should increase the rate it charges customers for smaller projects to bring the margins associated with those projects more in line with the margins for the large projects. The market may not respond favorably to the increased prices, and in any event the disparity in margins is so great that the gap may be all but impossible to close. Thus, even with higher rates charged for smaller projects, larger projects are going to be more profitable. Thus, Survey Masters should focus on large projects, as they have the highest profit margins.

Future projects to undertake with clients should therefore be oriented towards large projects. The company should restructure its operations and marketing efforts in line with this new emphasis on large projects, in order to attract more such projects in future. This will allow the company to build share in large projects, phasing out small projects gradually as prices are increased. 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 staff they need would result in a decreased operating margin. 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.