Pack-It-Up Delivery

After graduating with an accounting degree from Major Metropolitan University and five years in public accounting, you decided to explore other professional options. You recently accepted an offer from your former classmate to join his accounting firm and are excited about your future prospects with the firm.

Gloria Walstrom has been a long-time client of the consulting firm. Her work experience has been largely confined to the transportation business, in which she has broad administrative and marketing experience, but not much accounting experience. Recent events have motivated Gloria to consider starting a new package-delivery-service venture, the proposed name of which is ‘Pack-It-Up’. She is acutely aware of the fact that with electronic commerce, such as Amazon and eBay, there is an increase in business demands for package delivery. She wonders, therefore, whether the timing might be right for a smaller, focused competitor along the lines of the business envisioned by Pack-It-Up. Such a venture would initially focus on intra-city deliveries in a major metropolitan center.

Because of her lack of financial experience and her long-time professional association with your classmate, Gloria recently contacted your firm with a request that the firm help her perform some financial planning. You will work with Gloria to create a profit-planning model (otherwise referred to as cost-volume-profit, or CVP, analysis) that responds to numerous questions regarding the profitability and financial risk associated with Pack-It-Up.

You will need to consider the single-product case, with two decision options related to choice of cost structure. Under cost structure alternative 1, Pack-It-Up would essentially contract with delivery personnel who would be paid on a commission basis. Delivery personnel in this situation would use their own vehicles (bicycles, motor bikes, etc.). This would result in a reduced capital investment on the part of Pack-It-Up with lower fixed costs. Under cost structure alternative 2, Pack-It-Up would provide its own fleet of delivery trucks (with associated depreciation, insurance charges, scheduled/fixed maintenance costs, etc.) and would pay its delivery personnel a fixed salary per year. Thus, it would incur relatively higher fixed costs.

Fixed costs under both decision alternatives would also include some administrative salaries and office-related expenses as well as advertising/promotion costs determined on a yearly contract basis. Accounting and tax- consulting costs are fixed on an annual basis under both alternatives.

To facilitate the profit-planning process, Gloria has obtained from trusted colleagues in a related business estimated costs associated with each of the two alternative cost structures (see table below). These estimated data are to be used as the basis of the consulting report you prepare for Gloria in response to the questions, she has raised in conjunction with the proposed business venture.

Decision inputs (data)

Data:
	Cost structure alternative 1	Cost structure alternative 2
Delivery price per package delivered	$90	$90
Variable cost per package delivered	$69	$38
Fixed costs (per year)	$686,900	$2,185,000

1. Profit planning: Gloria indicates that she is not contemplating the Pack-It-Up business venture with the objective of ‘just breaking even’. You are asked to demonstrate to Gloria the number of deliveries, that would have to be made under cost structure alternative 1 and alternative 2 to generate a pre-tax profit of $25,000 per year.
2. Provide a check on your answer in #1 by constructing for your client a Pro-forma CVP income statement for alternative 1 and alternative 2.
3. Thus far you’ve focused on demonstrating for your client how profit for her proposed new business changes in response to changes in volume. But, you know that profit is only one facet of the risk-return trade-off model. You want to make sure that in the report you are preparing for your client you adequately address the issue of risk, beyond the elementary analyses presented above. Calculate the degree of operating leverage for alternative 1 and alternative 2 using the sales targets identified in #1