Paul Knotts, president of Photo Swift, a website that allows sharing of photos, wants to expand his business to make other uses of the pictures that are posted on the host website. He calls together his marketing and development head, Rachelle Wright, and his management accounting specialist, Susan McCoy, to talk about potential new products and their impact on the company.

Paul: Good morning, all! Thought we’d start off the week by brainstorming to come up with some new products for our product line. The sharing of photos is going so well, there has to be some other things we can offer to boost revenues and profits.

Rachelle: My team’s been thinking about different options, Paul. We could offer photo albums with nice covers that could be given as gifts. We could add to that personalized calendars, which we’d print and ship from headquarters.

Susan: Wait a minute! We don’t have the software or the hardware for doing these things. I thought we were concerned about costs this year. I think we could find some cost-cutting projects that would help raise profits without investing in new products and equipment.

Paul: I don’t know if just cutting costs is enough. We can run very lean given our business model, but if we don’t keep coming up with new products, we’re going to eventually hit the wall.

Susan: Then I’d rather see us put some money into advertising. New products are risky, and the forecasts Rachelle’s group put together make me a bit nervous. They show growth with no changes in our structure. Now they want to add bells and whistles to the site that will require outlays with no guarantee of inflows downstream. I’m nervous about the whole concept.

Rachelle: I don’t know what you’re talking about, Susan! My group does market research before we put forward any projections. Remember, our bonus is tied to hitting sales targets, not like yours, which is tied solely to profits. Without new products, we will have trouble making those sales targets in coming years. To be fair to my team, we need to start adding products to our line to give them something to sell!

Paul: It seems like the two of you have very different pictures of the future of this firm. I have trouble believing it’s all because of the result of different incentive structures; you both bonus on company profits, just not in the same degree! I want a company that is growing. So, Rachelle, how do you see the new product lines shaping up?

Rachelle: Well, we’ve run some projections. We believe that an optimistic forecast would be sales of $2.5 million in photo albums and $2 million in calendars. Together, they would also increase our regular sales from their current $18 million to $20 million as people come back for additional photos.

Susan: That’s very optimistic, Rachelle, and you know it. We ran the financial projections and found that it was more likely that we’d sell $1.5 million in photo albums and $1 million in calendars. And, the bump in regular sales would only be $500,000. We saw this as the likely scenario, with a 60% probability of occurring. When we add the $2.4 million in software and hardware that we’ll need to offer these products, and the 50% variable costs that come with all of our products, it’s hardly worth the risk!

Rachelle: We think our scenario is the likely one, with a 60% probability of occurring. I thought your group did some studies that dropped our variable cost down to 40%. Your scenario is very pessimistic. I’d say it isn’t impossible, but that it has only a 20% chance of occurring. There is also a 20% chance that the actual outcome will be in the middle of our two plans. That would see $2 million in photo albums and $1.5 million in calendars, and $1.5 million in new sales. I agree it will take us $2.4 million to get the business up and running, but it leaves us open to other new products that use the same technology downstream. And, the equipment will be useful for three years, so that’s really only an additional $800,000 per year in fixed costs. There’s always a new twist we can put on photographs. I see T- shirts and hats, and all sorts of things downstream! We’ve got a great little business here!

Paul: I hate to see us so far apart, but I like the idea, Rachelle. Tell you what, Susan, why don’t you and your group run the scenarios the way that Rachelle sees them. Change the probabilities if you’d like, so we get two perspectives. And, I’d like to see the plan include the option of getting variable costs down. Since our fixed costs are significant, every penny we get into contribution margin [revenues minus variable costs] increases our profitability. I want those cost savings and the new products!

Susan: I’ll do it, Paul, but my instincts tell me that Marketing’s projections are once again too rosy. Remember last year when we had to run sales to finally hit our sales goals? We can’t count on sales, which are lower profit, to make sure they hit their target sales goals. If we add these two products, I hope you make midstream adjustments to the marketing goals for the year. The rest of us will be facing a bigger risk if the company ’s profit goals, and, hence, profit sharing, are negatively impacted by these plans!

Paul: Concerns noted, Susan. Why don’t you run the scenarios? And since our fixed costs are currently sitting at $7.5 million per year, why don’t you add in a bit of breakeven analysis on the most likely scenario so I can get a feeling for the riskiness of the project? See you both next week when we’ll continue the discussion. Rachelle, keep working your group for new ideas and refinements of your projections, while Susan and her group start developing options for us, costed out, of course! Paul tended to be optimistic, but he needed to get his two key managers on the same page. Maybe running the numbers would help. And he’d definitely have to make adjustments to Marketing’s incentive plan to make sure they did not just come up with ideas to boost sales but that do not raise profits. Sales were okay, but profits were king.

REQUIRED:

a. Generate the profitability of the three scenarios using the current variable cost ratio of 50%.

b. Calculate the expected value of the plans given Rachelle’s probabilities. Now redo the expected value with the optimistic plan being 20% likely, the midrange plan 50% likely, and the pessimistic option 30% likely.

c. Calculate the breakeven point for the company before and after adding the new business.

d. Calculate the payback using Rachelle’s middle scenario (album sales $2 million).

e. Redo these four steps using the 40% variable cost ratio that is targeted for the year.

f. What recommendation would you make to Paul? Why?

g. How do you feel about the company dynamics? Is there some way to use incentives to bring the objectives of these two top managers into closer alignment?