HBSP Product Number TCG 019 THE CRIMSON PRESS CURRICULUM CENTER THE CRIMSON GROUP, INC. Mercanca, S.A. If a department can't cover all of its costs, which include its fair share of overhead, we should get rid of it. It's that simple! The speaker was Ricardo Delgado, controller of Mercanca, S.A., a large distributor of appliances in Santa Tecla, a small industrial town just outside San Salvador, the capital of El Salvador. He was discussing the poor financial performance of the company's video department at a monthly meeting of the company's department managers. BACKGROUND Mercanca imported large appliances and distributed them to retailers throughout Central America. It carried three broad lines of merchandise: audio equipment (such as stereo tuners, CD players, and M3 players), video equipment (including televisions and DVD players), and portable communication devices (such as cell phones and PDAs). Each line accounted for about one-third of the company's total sales revenue. Financial statements for the most recent year are contained in Exhibit 1. Recently, Sr. Delgado had begun to prepare product line (or "department," as each product line was called) income statements. The video department's income statement for the first quarter of the current year is contained in Exhibit 2. Of the three departments, only the video department lost money during the quarter. The other two had profit margins of about 5 percent. REACTIONS Ernesto Gallardo, the video department's manager was not happy with Sr. Delgado's conclusions: This so called income statement may show a loss, but it misses a lot of important factors. First, it's just for three months, and a slow three months at that, coming just after the holidays. Second, the video department helps out the other departments a lot. Buyers come here to buy TVs for their stores, and they wander into the audio department or the communication department, and they sometimes buy something there too. How do you measure that on our department's income statement. Juana Fuentes, the company's managing director, had another set of concerns: Let's forget the loss-leader argument, Ernesto. Video sales are helped by audio and communications sales too. Also, since we don't have any other data to go on, let's assume the first quarter is representative of the year, even though it may not be. I'm still not convinced that we'd be better off as a company by getting rid of the video department. I think your job, Ernesto, as manager of the department, is to look closely at the operating expenses on Ricardo's income statement and to analyze them. Assume that this quarter is representative of the year, and forget any sales in other departments. Try to get back to me by the end of this week with your assessment of whether we'd really be better off by getting rid of your department. Assignment 1. Assume that each department's sales in the first quarter of the current year were one-third of the company's total sales. Also assume that that each of the other two departments had gross profit margin percentages of 25 percent. What was Mercancia's income or loss before taxes for the quarter? 2. Analyze what the company's income or loss before taxes would have been without the video department? Be specific in explaining the differences, addressing each of the notes to Exhibit 2. 3. Is Mercanca, S.A. a financially viable company? What additional information would you like to have to assist you in your assessment? MERCANCA, S.A. Exhibit 1. Financial Statements for Last Year MERCANCA, S.A. Exhibit 2. Video Department Income Statement First Quarter of Current Year [Converted from Colones into U.S. Dollars and rounded to nearest thousand] Notes: (1) This amount is one-third of the total warehouse personnel payroll. Warehouse personnel were not assigned to any particular department, and they worked for all three departments on most days. The video department's product lines were not as extensive as those of other departments, but the items were much more cumbersome to carry. As a result, the personnel spent about one-third of their time handling the video department's products. (2) This amount was assigned to each department on the basis of its share of total net sales revenues. The company had 2 delivery trucks and each truck required a driver and an assistant. When a delivery truck went out, it usually contained merchandise from all three departments. (3) Sales personnel were paid on a straight commission basis. The rate was 2.4 percent of sales. (4) This line included the salaries of the department manager and his office staff, all of whom worked exclusively for the video department. Each of the other departments had a similar arrangement. (5) The company's rent and utilities were allocated to each department on the basis of its share of total square footage. The company had a 5-year non-cancelable lease for its facilities. Each department occupied about one-third of the total area. (6) Insurance was based on the company's inventory. It varied slightly depending on how fragile the items were, but generally was about 1.5 percent of the COGS amount. (7) These were the costs of the company's central administration, such as the salary of the managing director, the salaries of her office staff, the company's accounting and legal departments, consulting fees, and other administrative items in the central office. Each department was allocated a share of these costs based on its percentage of sales dollars. HBSP Product Number TCG 019 THE CRIMSON PRESS CURRICULUM CENTER THE CRIMSON GROUP, INC. Mercanca, S.A. If a department can't cover all of its costs, which include its fair share of overhead, we should get rid of it. It's that simple! The speaker was Ricardo Delgado, controller of Mercanca, S.A., a large distributor of appliances in Santa Tecla, a small industrial town just outside San Salvador, the capital of El Salvador. He was discussing the poor financial performance of the company's video department at a monthly meeting of the company's department managers. BACKGROUND Mercanca imported large appliances and distributed them to retailers throughout Central America. It carried three broad lines of merchandise: audio equipment (such as stereo tuners, CD players, and M3 players), video equipment (including televisions and DVD players), and portable communication devices (such as cell phones and PDAs). Each line accounted for about one-third of the company's total sales revenue. Financial statements for the most recent year are contained in Exhibit 1. Recently, Sr. Delgado had begun to prepare product line (or "department," as each product line was called) income statements. The video department's income statement for the first quarter of the current year is contained in Exhibit 2. Of the three departments, only the video department lost money during the quarter. The other two had profit margins of about 5 percent. REACTIONS Ernesto Gallardo, the video department's manager was not happy with Sr. Delgado's conclusions: This so called income statement may show a loss, but it misses a lot of important factors. First, it's just for three months, and a slow three months at that, coming just after the holidays. Second, the video department helps out the other departments a lot. Buyers come here to buy TVs for their stores, and they wander into the audio department or the communication department, and they sometimes buy something there too. How do you measure that on our department's income statement. Juana Fuentes, the company's managing director, had another set of concerns: Let's forget the loss-leader argument, Ernesto. Video sales are helped by audio and communications sales too. Also, since we don't have any other data to go on, let's assume the first quarter is representative of the year, even though it may not be. I'm still not convinced that we'd be better off as a company by getting rid of the video department. I think your job, Ernesto, as manager of the department, is to look closely at the operating expenses on Ricardo's income statement and to analyze them. Assume that this quarter is representative of the year, and forget any sales in other departments. Try to get back to me by the end of this week with your assessment of whether we'd really be better off by getting rid of your department. Assignment 1. Assume that each department's sales in the first quarter of the current year were one-third of the company's total sales. Also assume that that each of the other two departments had gross profit margin percentages of 25 percent. What was Mercancia's income or loss before taxes for the quarter? 2. Analyze what the company's income or loss before taxes would have been without the video department? Be specific in explaining the differences, addressing each of the notes to Exhibit 2. 3. Is Mercanca, S.A. a financially viable company? What additional information would you like to have to assist you in your assessment? MERCANCA, S.A. Exhibit 1. Financial Statements for Last Year MERCANCA, S.A. Exhibit 2. Video Department Income Statement First Quarter of Current Year [Converted from Colones into U.S. Dollars and rounded to nearest thousand] Notes: (1) This amount is one-third of the total warehouse personnel payroll. Warehouse personnel were not assigned to any particular department, and they worked for all three departments on most days. The video department's product lines were not as extensive as those of other departments, but the items were much more cumbersome to carry. As a result, the personnel spent about one-third of their time handling the video department's products. (2) This amount was assigned to each department on the basis of its share of total net sales revenues. The company had 2 delivery trucks and each truck required a driver and an assistant. When a delivery truck went out, it usually contained merchandise from all three departments. (3) Sales personnel were paid on a straight commission basis. The rate was 2.4 percent of sales. (4) This line included the salaries of the department manager and his office staff, all of whom worked exclusively for the video department. Each of the other departments had a similar arrangement. (5) The company's rent and utilities were allocated to each department on the basis of its share of total square footage. The company had a 5-year non-cancelable lease for its facilities. Each department occupied about one-third of the total area. (6) Insurance was based on the company's inventory. It varied slightly depending on how fragile the items were, but generally was about 1.5 percent of the COGS amount. (7) These were the costs of the company's central administration, such as the salary of the managing director, the salaries of her office staff, the company's accounting and legal departments, consulting fees, and other administrative items in the central office. Each department was allocated a share of these costs based on its percentage of sales dollars