Electronic Games International: Capital Budgeting$1$

In mid$-$September of $2021,$ Yao Anzhu$2,$ vice president of Electronic Games International$$s production division, was weighing project proposals for the company$$s upcoming capital budgeting meetings in October. Two proposals stood out based on their potential to strengthen the division$$s innovative product lines and drive future growth. However, due to constraints on financial and managerial resources, Yao knew it was possible that the firm$$s capital budgeting committee would decline to approve both projects. He also knew that Electronic Games$$ licensing and retail divisions would promote compelling projects of their own. Consequently, Yao had to be prepared to recommend one of his projects over the other.

The Toy and Game Industry

Revenues in the U$.$S$.$ toy and game industry totaled $$42$ billion in $2019$ and were projected to increase by $4\mathrm{.}6\%$ per year to $$52\mathrm{.}5$ billion by $2024.$ The market was divided into two broad segments: video games $(48\%)$ and traditional toys and games $(52\%).$ The second segment was further divided into infant$/$preschool toys $(14\mathrm{.}5\%),$ dolls $(14\mathrm{.}1\%),$ outdoor & sports toys $(12\mathrm{.}3\%),$ and other toys & games $(59\mathrm{.}1\%)$ including arts and crafts, plush toys, action figures, vehicles, and youth electronics. The U$.$S$.$ market for toys and games was dominated by large global enterprises that enjoyed economies of scale in design, production, and distribution. Revenues were highly seasonal; the largest selling season in the United States coincided with the winter holiday period.

Electronic Games International

The Electronic Games International was founded in $1996$ by Jack Smythe. By $2020,$ Electronic Games had grown to $450$ employees and generated approximately $$245$ million of revenue$3$ and

$$27$ million of operating profit from three divisions: production, retailing, and licensing. The production division $($discussed further below$)$ designed and produced video games and accessories. The retailing division delivered through an online website $(42\%),$ a mail$-$order paper catalog $(33\%),$ and a network of retail stores $(25\%).$ In fiscal $2020,$ the retailing division generated roughly $$190$ million of revenue and $$4\mathrm{.}8$ million of operating profit. The licensing division was started in $2009$ and represented the company$$s newest and most profitable division. It sought to extend the Electronic Games brand and capitalize on high levels of customer loyalty by selectively licensing the company$$s game characters and themes to a variety of media that

$12022$ by Andrew Carrothers, PhD CFA PEng

$2$ Yao was originally from Xinxiang, Henan Province, PRC$.$ Per Chinese custom, the family name $($or surname$)$ is inherited from one's parents and shared with other members of the individual's immediate family. It always comes before the given name and is usually a single syllable$/$Chinese character.

$3$ The division revenue figures include approximately $$95$ million of internal sales within divisions which are eliminated when considering consolidated revenue for the company.

reached the firm$$s target demographic. In fiscal year $2020$ the licensing division generated $$24\mathrm{.}5$ million of revenue and $$14\mathrm{.}5$ million in operating profit.

Electronic Games$$ Production Division

Production was Electronic Games$$ largest division as measured by total assets, and easily its most asset intensive. Approximately $75\%$ of the division$$s sales were made to the company$$s retailing division, with the remaining $25\%$ comprising private label goods manufactured for other firms. Table $1$ summarizes the division$$s various sources of revenue and operating income.

Table $1$

Electronic Games Private Label Total

Production Division Data: Video games Accessories Video games Accessories

Revenue $($$ millions$)8014265$ $$125$

Operating Income $($$millions$)4\mathrm{.}40\mathrm{.}52\mathrm{.}30\mathrm{.}3$ $$7\mathrm{.}5$

Electronic Games outsourced much of its production to a select number of contract manufacturers in Asia. To ensure product quality and safety, the company maintained a fulltime staff to oversee material sourcing, production, and quality control on site at each of its manufacturing partners. Manufacturing activities that required precise tolerances or proprietary processes, along with all the creative elements $($design and product prototyping, for example$),$ were handled in$-$house at the company$$s headquarters facilities in Charlottetown, Prince Edward Island, Canada.

Capital Budgeting at Electronic Games

Electronic Games$$ capital budgeting process retained some of the informality that characterized the company$$s early years as an innovative start$-$up$.$ As the company grew, deliberate steps were taken to decentralize some of the project approval process and increase spending authority at the division level. However, large and$/$or strategic spending proposals were reviewed at the corporate level by a capital budgeting committee consisting of the CEO, CFO, COO, the controller, and the division presidents. The committee examined projects for consistency wit