Case study: Sailmakers Ltd

John Jeffries recently left the army after more than 20 years in the service. He had decided that at 45 years of age it was time to start a second career. Throughout most of his life John had a passion for yachting and had competed successfully in many off-shore yacht races. He felt that because of his expertise and interest in yachting and the fact that over the years he had cultivated many friends and contacts in the yachting world, he would be wise to invest his money and energies in this area of business.

After many months of searching for a suitable business, last October John and his wife agreed to purchase all of the shares of Sailmakers Ltd for 250,000 as at the 31 December. The company was involved in the manufacture of sails on an individual 'made to measure' basis for boats ranging in size from one-man dinghies to ocean-going yachts. Most of the customers were private individuals, although about 10% of orders each year were placed by small boat-builders. Sailmakers also undertook some repair work to damaged sails. The company was established in 1960 by Arthur Davies and was managed by him until his sudden death in August. Over that period Mr. Davies had shown a strong interest in the technical side of the business and the company enjoyed a good reputation for the quality of the products. However, Mr. Davies had had little interest in financial matters and maintained only rudimentary management accounting records.

Demand for Sailmaker's work had been very buoyant over recent years, the output being restricted only by the shortage of space at the company's premises and by the lack of appropriately skilled labor. John Jeffries could see no reason for the level of demand to fall in the future, but he could see no immediate prospects for expanding the workforce or finding larger premises.
In the three year period preceding Mr. Davies' death the results of the business were as follows:

First year Year before last Last year
Sales 490 501 516
Materials consumed 263 277 276
Production expenses 177 175 185
Admin expenses 11 12 1
Sales and distribution expenses
26 8 29
477 492 502
Net profit before directors expenses and Corporation tax
13 9 14

Although John was not impressed by the return on the business in the past he felt sure that Sailmakers had tremendous potential. He was confident that under his direction profits could improve dramatically.

During the last couple of months of last year John obtained the agreement of Mr. Davies' family, who were running the business temporarily, to gain access to the premises and to the company's accounting records. The manufacturing process was divided for supervisory purposes into three departments:

1. The cutting shop, where the sailcloth was marked out and cut according to the required size.

2. The machine shop, where the sails were sewn by workers operating sewing machines.

3. The inspection department, where the sails were inspected for quality and, if satisfactory, packed in sacks for dispatch to the customer.

The range of sails was so vast as to mean that the proportion of time spent by each sail being worked on in each department varied greatly.
The whole business occupied a building of 610 square meters of floor area. The building was leased at a fixed annual rent of 22,000 for a further six years.

The space was divided as follows:

Cutting shop 180 sq m.
Machine shop 250 sq m
Inspection department 120 sq m
Offices 60 sq m

During the forthcoming year it was expected that each production worker would work for 1,800 hours, after allowing for holidays etc; the annual salaries had been agreed at 9,900 each for the three people in the cutting shop, 9,000 each for the five people in the machine shop and 10,800 for the one person who works in the inspection department.

The offices where the secretarial and the accounting functions took place employed two part-time workers at 5,000 per annum each.

John undertook some analysis of past costs and after making allowances for some minor changes which he intended to make and for inflation, expected that other costs for the forthcoming year would be:

Rent 22,000
Local authority rates (taxes) 5,000
Selling and administrative costs 30,000
Depreciation of cutting shop equipment 8,000
Depreciation of machining shop equipment 20,000
Depreciation of inspection department equipment 3,000
Packing material and dispatch costs 9,000
Heating and lighting 5,000
Electric power 8,000
Cleaning premises 5,000
Thread etc used by sewing machines (indirect materials) 1,000

Sailcloth costs the company a range of prices, dependent on quality, up to $15.00 per square meter; it is expected that about 30,000 square meters of it will be used in the forthcoming year.

A matter of particular concern to John was the way in which prices for jobs were determined. In the past it seemed that pricing was left to Mr. Davies who operated a rather intuitive approach to the question. John felt that this was unsatisfactory.

John finally took up his management of Sailmakers on the first working day after the new year holiday, pleased to be in the 'driving seat' of his newly acquired business. He was also very pleased that Mr. Davies' family had kept Sailmakers going so well since his death; the company was operating at full capacity and there were no signs that its reputation had died with the previous owner.

During John's first morning a letter arrived from FG Marine, a manufacturer of sailing dinghies, with whom Sailmakers had done business before. The letter invited Sailmakers to tender for a batch of 20 sails for a new model of dinghy which FG Marine had developed and intended to test in the market. From the specifications supplied by FG Marine and with the advice of his own staff, John was able to estimate that each sail would require about 5 sq m. of sailcloth, costing 8.00 per sq m., would take 2 hours to mark out and cut in the cutting shop, 3 hours to machine in the machine shop and 1 hour to inspect and to pack in the inspection department.

1. Establish the full cost of the order and state any assumptions that you have made in deriving this figure. Note you have both cost centers and service centers to consider and you should develop overhead allocations for each. Use direct labor hours to allocate the overhead in each cost center. Apportion the office expense on the basis of number of employees. Note some of the overhead items may be applicable to only one department.

2. Derive a tender price for the order and justify your reasoning.

3. Derive a minimum tender price that the business might use if it was particularly keen to get the order.

4. Assume that John paid $200,000 for the business and that he borrowed all of the money at 10% interest, that he needs in addition a 7% return on his investment after the interest and that his sales to date will generate $31,000 in contribution toward these two items. How will this information influence your pricing decision?