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Gale Force Surfing

During mid-September 2015, the top

managers of the Gale Force Corporation, a
leading manufacturer of windsurfing
equipment and surfboards, were gathered in
the president’s conference room reviewing
the results of the company’s operations
during the past fiscal year (which runs from
October 1 to September 30).

“Not a bad year, on the whole,”
remarked the president, 32-year-old Charles
(“Chuck”) Jamison. “Sales were up, profits
were up, and our return on equity was a
respectable 15 percent. In fact,” he
continued, “the only dark spot
I can find in our whole annual report is the
profit margin, which is only 2.25 percent.
Seems like we ought to be making more
than that, don’t you think, Tim?” He looked
across the table at the vice president for
finance, Timothy Baggit, age 28.

“I agree,” replied Tim, “and I’m glad
you brought it up, because I have a
suggestion on how to improve that
situation.” He leaned forward in his chair
as he realized he had captured the interest
of the others. “The problem is, we have too
many expenses on our income statement
that are eating up the profits. Now, I’ve
done some checking, and the expenses all
seem to be legitimate except for interest
expense. Look here, we paid over
$250,000 last year to the bank just to
finance our short-term borrowing. If we

could have kept that money instead, our
profit margin ratio would have been 4.01
percent, which is higher than any other
firm in the industry.”

“But, Tim, we have to borrow like
that,” responded Roy (“Pop”) Thomas, age
35, the vice president for production.
“After all, our sales are seasonal, with
almost all occurring between March and
September. Since we don’t have much
money coming in from October to
February, we have to borrow to keep the
production line going.”

“Right,” Tim replied, “and it’s the
production line that’s the problem. We
produce the same number of products
every month, no matter what we expect
sales to be. This causes inventory to build
up when sales are slow and to deplete
when sales pick up. That fluctuating
inventory causes all sorts of problems,
including the excessive amount of
borrowing we have to do to finance the
inventory accumulation.” (See Tables 1
through 5 for details of Gale Force’s
current operations based on equal monthly
production.)

FINAL CASE STUDY

Case 5

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consent of McGraw-Hill Education.

Table 1 Sales Forecast (in units)
First Quarter Second Quarter Third Quarter Fourth Quarter

October 2014……. 150 January …………………. 0 April …………………… 500 July ……………………. 1,000
November ……….. 75 February ……………….. 0 May…………………….. 1,000 August ………………… 500
December ………… 25 March …………………… 300 June…………………….. 1,000 September……………. 250

Table 2 Production Schedule and Inventory (equal monthly production)

Beginning
Inventory

Production
This

Month Sales
End

Inventory

Inventory
($2,000
per unit)

October 2014…………… 400 + 400 – 150 = 650 $1,300,000
November ………………. 650 400 75 975 1,950,000
December ……………….. 975 400 25 1,350 2,700,000
January …………………… 1,350 400 0 1,750 3,500,000
February …………………. 1,750 400 0 2,150 4,300,000
March …………………….. 2,150 400 300 2,250 4,500,000
April ………………………. 2,250 400 500 2,150 4,300,000
May ……………………….. 2,150 400 1,000 1,550 3,100,000
June ……………………….. 1,550 400 1,000 950 1,900,000
July………………………… 950 400 1,000 350 700,000
August ……………………. 350 400 500 250 500,000
September ………………. 250 400 250 400 800,000

Table 3 Sales Forecast, Cash Receipts and Payments, and Cash Budget

October
2014 November December January February March

Sales Forecast

Sales (units) ………………………….. 150 75 25 0 0 300
Sales (unit price: $3,000) ………… $ 450,000 $ 225,000 $ 75,000 0 0 $ 900,000

Cash Receipts Schedule

50% cash ………………………………. $ 225,000 $ 112,500 $ 37,500 $ 450,000
50% from prior month’s sales* … $ 375,000 $ 225,000 $ 112,500 $ 37,500 0 0
Total cash receipts ……………. $ 600,000 $ 337,500 $ 150,000 $ 37,500 0 $ 450,000

Cash Payments Schedule

Production in units …………………. 400 400 400 400 400 400
Production costs (each = $2,000) $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000
Overhead………………………………. $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000
Dividends and interest ……………. 0 0 0 0 0 0
Taxes …………………………………… $ 150,000 0 0 $ 150,000 0 0
Total cash payments ………….. $ 1,150,000 $ 1,000,000 $ 1,000,000 $ 1,150,000 $ 1,000,000 $ 1,000,000

Cash Budget; Required Minimum Balance is $125,000

Cash flow ……………………………… $ –550,000 –662,500 –850,000 –1,112,500 –1,000,000 –550,000
Beginning cash ……………………… 125,000 125,000 125,000 125,000 125,000 125,000
Cumulative cash balance …………. –425,000 –537,500 –725,000 –987,500 –875,000 –425,000
Monthly loan or (repayment) …… $ 550,000 $ 662,500 $ 850,000 $ 1,112,500 $ 1,000,000 $ 550,000

Cumulative loan …………………….. $ 550,000 $ 1,212,500 $ 2,062,500 $ 3,175,000 $ 4,175,000 $ 4,725,000
Ending cash balance……………….. $ 125,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000

*September sales assumed to be $750,000.

Gale Force Surfing

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consent of McGraw-Hill Education.

“Now, here’s my idea,” said Tim. “Instead of producing 400 items a month,
every month, we match the production schedule with the sales forecast. For
example, if we expect to sell 150 windsurfers in October, then we only make 150.
That way we avoid borrowing to make the 250 more that we don’t expect to sell,
anyway. Over the course of an entire year the savings in interest expense could
really add up.”

“Hold on, now,” Pop responded, feeling that his territory was being threatened.
“That kind of scheduling really fouls up things in the shop where it counts. It causes
a feast or famine environment—nothing to do for one month, then a deluge the
next. It’s terrible for the employees, not to mention the supervisors who are trying
to run an efficient operation. Your idea may make the income statements look good
for now, but the whole company will suffer in the long run.”

Chuck intervened. “OK, you guys, calm down. Tim may have a good idea or he
may not, but at least it’s worth looking into. I propose that you all work up two sets
of figures, one assuming level production and one matching production with sales.
We’ll look at them both and see if Tim’s idea really does produce better results. If it
does, we’ll check it further against other issues Pop is concerned about and then make
a decision on which alternative is better for the firm.”

Table 3 (continued)

April May June July August September

Sales Forecast

Sales (units) …………………………… 500 1,000 1,000 1,000 500 250
Sales (unit price: $3,000) …………. $1,500,000 $3,000,000 $3,000,000 $3,000,000 $1,500,000 $ 750,000

Cash Receipts Schedule

50% cash ………………………………. $ 750,000 $1,500,000 $1,500,000 $1,500,000 $ 750,000 $ 375,000
50% from prior month’s sales …… $ 450,000 $ 750,000 $1,500,000 $1,500,000 $1,500,000 $ 750,000
Total cash receipts …………….. $1,200,000 $2,250,000 $3,000,000 $3,000,000 $2,250,000 $ 1,125,000

Cash Payments Schedule

Production in units ………………….. 400 400 400 400 400 400
Production costs (each = $2,000) . $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000 $ 800,000
Overhead ………………………………. $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000
Dividends and interest …………….. 0 0 0 0 $1,000,000 0
Taxes ……………………………………. $ 150,000 0 0 $ 300,000 0 0
Total cash payments ………….. $1,150,000 $1,000,000 $1,000,000 $1,300,000 $2,000,000 $1,000,000

Cash Budget; Required Minimum Balance is $125,000

Cash flow ………………………………. 50,000 1,250,000 2,000,000 1,700,000 250,000 125,000
Beginning cash ………………………. 125,000 125,000 125,000 125,000 400,000 650,000
Cumulative cash balance …………. 175,000 1,375,000 2,125,000 1,825,000 650,000 775,000

Monthly loan or (repayment) ………. ($ 50,000) ($1,250,000) ($2,000,000) ($1,425,000) 0 0
Cumulative loan……………………… $4,675,000 $3,425,000 $1,425,000 0 0 0
Ending cash balance ……………….. $ 125,000 $ 125,000 $ 125,000 $ 400,000 $ 650,000 $ 775,000

Table 4
Cash

Accounts
Receivable* Inventory

Total
Current

Case 5

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consent of McGraw-Hill Education.

Total Current Assets
First Year

Assets

October …………. $125,000 + $225,000 + $1,300,000 = $1,650,000
November ……… 125,000 112,500 1,950,000 2,187,500
December………. 125,000 37,500 2,700,000 2,862,500
January …………. 125,000 0 3,500,000 3,625,000
February ……….. 125,000 0 4,300,000 4,425,000
March …………… 125,000 450,000 4,500,000 5,075,000
April …………….. 125,000 750,000 4,300,000 5,175,000
May………………. 125,000 1,500,000 3,100,000 4,725,000
June………………. 125,000 1,500,000 1,900,000 3,525,000
July ………………. 400,000 1,500,000 700,000 2,600,000
August ………….. 650,000 750,000 500,000 1,900,000
September ……… 775,000 375,000 800,000 1,950,000

* Equals 50 percent of monthly sales

Table 5 Cumulative loan balance and interest expense (1% per month)

October November December January February March

Cumulative loan balance ……………….. $ 550,000 $1,212,500 $2,062,500 $3,175,000 $4,175,000 $4,725,000
Interest expense at
(prime, 8.0%, + 4.0%) 12.00% ………. $ 5,500 $ 12,125 $ 20,625 $ 31,750 $ 41,750 $ 47,250

April May June July August September

Cumulative loan balance ……………….. $4,675,000 $3,425,000 $1,425,000 0 0 0
Interest expense at
(prime, 8.0%, + 4.0%) 12.00% ………. $ 46,750 $ 34,250 $ 14,250 0 0 0
Total interest expense for the year: $254,250

Required 1. Tables 1 through 5 contain the financial information describing the

effects of level production on inventory, cash flow, loan balances,
and interest expense. Reproduce these tables if Tim’s suggestion
were implemented; that is, change the Production This Month
column in Table 2 from 400 each month to 150, 75, 25, and so on, to
match Sales in the next column. Then recompute the remainder of
Table 2, and Tables 3, 4, and 5 based on the new production numbers.
Beginning inventory is still 400 units. Beginning cash is still
$125,000 and that remains the minimum required balance.

2. Given that Gale Force is charged 12 percent annual interest (1 percent a
month) on its cumulative loan balance each month (Table 5), how much
would Tim’s suggestion save in interest expense in a year?

3. Up until now, we have not considered any inefficiencies that have
been introduced as a result of going from level to seasonal
production. Assume that there is an added expense for each sales
dollar of .5 percent (.005). Based on this fact and the information
computed in question 2, is seasonal production justified?