Chester & Wayne Fourth Quarter Budget Analysis

Rising Costs and Margin Pressure

After preparing the cash budget, including sales and expenses, for the fourth quarter of the year, it is important to review the information carefully. There are a number of trends and instances which warrant discussion, especially regarding the rising costs of goods and the decreasing margins. Thus, it is important to address such events with Mr. Chester and Mr. Wayne.

First, it is clear that the costs of goods are increasing, which is driving down the margin. In September, the costs of goods sold were $551,250. However, this number jumped to $638,120 in December. While this increase was partly due to an increase in sales overall, it also leaves the company vulnerable to rising costs of business. In this volatile economy, suppliers have begun raising prices. Yet, at the same time, it would be a mistake for Chester & Wayne to increase prices to compensate for the lost margins because many of their competitors are keeping prices much lower.

In fact, major food retailers like Walmart have a dominating force in the market that allows them to negotiate and force supplier prices down, where Chester & Wayne cannot. This creates a situation where Walmart can maintain much lower prices without significantly impacting margins. Yet Chester & Wayne are at the mercy of suppliers, but increasing unit prices would leave them at a disadvantage compared to competitors like Walmart. To compensate, there are other measures that can be taken.

The company could raise its desired monthly cash balance to a higher amount, closer to $150,000, in order to have greater flexibility when prices of supplies rise. This would mean lowering monthly investments into marketable securities as needed when profits are high, which may have a long-term impact. However, it keeps the current margins at a more desirable amount during price increases with suppliers.

Additionally, the executives were concerned about frequently occurring stock-outs, where there was not enough inventory to fill rising demands. Due to this, they wanted to see what would happen if inventory levels were raised to 30% or 40% instead of the 25% of sales at which they were currently set. It is true that sales have been increasing with each passing month, therefore demanding higher inventory amounts. Stock-outs can be extremely costly, since they deny a company the ability to meet increasing demands for products. This would ultimately help increase inventory, but it would also eat into the net cash available at the end of each month.

Inventory Management and Stock-Out Risk

Holding unused inventory can consume net cash that the company could use for other purchases or reinvestment into marketable securities. With rising costs associated with doing business outside of inventory costs, this may not be a smart idea. Not only would such a move eat into the cash, but it also creates other disadvantages. If sales took a turn and began to decrease, this would leave the company with excess inventory sitting around on hand that ate up valuable cash.

For example, with sales in November being collected at $805,424, a 40% inventory level increase would raise the inventory to $322,169. That is nearly double what the company paid for the new inventory to be stocked for December sales. This would dramatically reduce the ability to reinvest into market securities and would force the company to even sell some of its securities to meet the $120,000 cash target at the end of the month.

It would be better to increase inventory in lesser degrees, perhaps to 28%. This would increase the inventory available each month but without doubling the costs. Looking at November again, inventory costs would be at $225,518, much lower than if the company were to raise the inventory investment rate to 40%. This would help increase inventory levels. Another review in the next quarter should evaluate how the small increase performed in regards to stopping stock-outs. If they continued, another small increase of 2% can be added to inventory levels. The main idea is that inventory should be increased gradually so as not to waste much-needed net cash.

Finally, Mr. Wayne wants to discontinue the cash discount for prompt payment, while Mr. Chester wants to increase the discount to 3%. The discount is in place to get customers to pay more promptly, so that the company can acquire cash from accounts receivable at a faster rate. The discount is in place because it helps get cash into the company's hands, which takes a strain off operations. Essentially, the longer it takes for payment, the greater the risk that something happens and the company does not get paid. The earlier payment is received, the lower the risk.

When customers take a long time to make payments it can clog up budgets and force companies into situations where they may have to borrow short-term loans, even though they have major accounts receivable. When payments are paid early, it takes a lot of stress off the company. Moreover, research claims that early payment discounts lower borrowing costs and can even substitute for loans. The more money a company gets in hand, the less it has to borrow. This is particularly important in times when it is hard to borrow money or when interest rates are high.

Early Payment Discount Strategy

Yes, getting rid of the 2% discount will put more cash in the company's hands in the short term, but it simply is not worth the possibility of having to wait much longer periods to get paid. The discount is set at the right percentage in order to encourage customers to pay early without eating too far into sales profits. Thus, raising the discount may not be a benefit either. The early discounted sales are at an impressive 40% of the incoming sales revenues. Most of the customers who will pay early already are, and a small 1% increase is most likely not going to move the bulk of the others to pay early. Thus, the discounted rate should stay at 2%.

The following tables present the detailed cash budget for Chester & Wayne for the fourth quarter, showing sources and uses of cash, as well as the sales collection schedule by payment terms.

Cash Budget Summary (September–December)

Sales Collection Schedule by Payment Terms

Purchase and Expenses Summary