Should Polar sports make the change to level production and why?

In early January 2012, Richard Weir, president of Polar Sports, Inc., sat down with Thomas Johnson, vice president of operations, to discuss Johnson's proposal that Polar institute level monthly production for 2012. Since joining the company less than a year earlier, Johnson had become concerned about the many problems arising from its highly seasonal production scheduling, which reflected the seasonality of sales of skiwear and accessories. Weir understood the cost savings and improved production efficiency that could result from level production, but he was uncertain what the impact on other aspects of the business would be. Polar Sports, a fashion skiwear manufacturer based in Littleton, Colorado, carried production lines in high-quality ski jackets, snow pants, sweaters, thermal soft shells and underwear, and accessories such as gloves, mitts, socks, and knit caps. The company produced most of these products in a wide range of styles, sizes, and colors. Polar had a unique design of skiwear that employed special synthetic materials for better insulation and durability. The design and color of products changed annually. Dollar sales of a given product line could vary as much as 30% to 40% from year to year. The ski apparel design and manufacturing business was highly competitive. The industry comprised a few large players and a number of smaller firms. Besides several major competitors in the market such as North Face, Burton, Karbon, Spyder Active Sports, and Sport Obermeyer, highend designers like Prada and Giorgio Armani had recently entered the technical skiwear market. Occasionally, a company was able to gain share in that competitive market by developing and marketing new fabrics and using innovative patterns in a given year; typically, however, competitors were able to market similar products the following year. Unlike Polar, several large producers had shifted their major production to Asia and Latin America to save on labor costs, making their products more competitive in price. Fierce competition in both design and pricing resulted in short product lives and a relatively high rate of company failures. Company Background Polar Sports, Inc., was established in 1992 by Richard Weir, a retired professional snowboarder. His desire was to produce high-quality skiwear and accessories for people of all ages and abilities. Through Weir's expansive network of ski instructors and resorts, Polar was able to sell a few hundred units of high-quality products by the third year of operation. Polar experienced fast growth since the late 1990s, after sponsoring a number of snowboarding events and endorsing a few talented athletes who later competed in several international competitions. Polar became a popular brand among both professional and amateur skiers and snowboarders. The company's sales growth was affected only slightly by the 2008-2009 economic recession. In 2011, Weir hired Thomas Johnson, a production manager at a sports equipment factory, as vice president of operations. The skiwear production process, though not complex, was nevertheless labor intensive. It required designers to constantly come up with new styles to stay ahead of competing products. The designers worked closely with raw-materials suppliers in developing new fabrics. Focusing on both the technical and the fashion aspects of their products, Polar's designers helped create a high-tech temperature-control fabric for the base and middle layers, providing both breathability and waterproofing. The production technology required skilled labor, and the process was primarily manual, which ensured that stitching was accurate and jackets and pants were properly insulated. Company Financials The popularity of skiing and snowboarding had grown tremendously over the past two decades. According to a National Sporting Goods Association survey, at the end of 2010 more than 15 million Americans over seven years of age participated in skiing or snowboarding. The skiwear manufacturing industry experienced fast growth in the 2000s with the rising popularity of winter extreme sports such as snow kiting and heli-boarding. Polar achieved progressive market share through its unique design and expansive sales network. Its sales grew from \$4.65 million in 2001 to $16.36 million in 2011. With a number of promising new designs under production, sales were projected at $18.0 million for 2012. However, the ultimate success of the new designs depended greatly on how well the market would respond. In recent years, more-intense competition had made accurate predictions increasingly difficult. Polar's net income reached $897,000 in 2011 and was projected to be $1,147,000 in 2012 under seasonal production. Tables A and B show the latest financial statements. The cost of goods sold had averaged 66% of sales in the past and was expected to remain at approximately that level in 2012 under seasonal production. Operating expenses, projected to be 24% of sales, would be incurred evenly throughout each month of 2012 under either seasonal or level production. Polar was facing a corporate tax rate of 34%. Table A Consolidated Income Statement, 2009-2011 (in thousands of dollars) Table B Balance Sheet at December 31, 2011 (in thousands of dollars) As noted, sales of skiwear and accessories were highly seasonal, with more than 80% of annual dollar volume generated from September through January. Table C shows both actual monthly sales for 2011 and projected monthly sales for 2012. Polar pursued three sales channels: wholesale, catalog, and online direct sales. Polar's wholesale channel, which accounted for 70% of sales, included about 1,000 dealers, sporting goods stores, specialty ski stores, and department stores. During the SIA Snow Show in Colorado, the biggest annual exhibition for skiwear manufacturers held in late January, Polar presented its latest product designs, which would be released in the fall. It often received orders representing around 15\% of its annual sales right after the show; these were shipped in September. Customers usually took 60 days to pay for wholesale purchases, and the collection experience had been very satisfactory. Transactions with catalog and online direct sales were usually settled on the date of purchase. 913-513 | Polar Sports, Inc. Table C Monthly Sales (in thousands of dollars) Polar's practice was to fulfill customers' orders promptly. A small fraction of capacity at Polar's Littleton plant was required to meet orders from February through July each year. From August through January, the company greatly expanded its workforce. New employees were hired and trained, and existing employees were asked to work overtime. All equipment was used more than 15 hours per day, which called for frequent maintenance. Whenever possible, shipments were made on the same day an order was placed. Production was scheduled to match sales for each month. Under seasonal production, in 2012 Polar would maintain the same level of inventory that it held on December 31, 2011. The accounts payable balance at the end of month was assumed to be 50% of the cost of goods sold that month. This figure was related to material purchases that accounted for 50% of the cost of goods sold for 2012. Total material purchases, based on 30-day payment terms, were forecasted to be $5,940,000 in 2012. The 2011 year-end cash balance of $500,000 was regarded as the minimum necessary for the operation of the business. Polar had borrowed from its local bank through a line of credit. At the end of 2011, a loan of $826,000 was outstanding. The local bank was willing to increase the limit on the company's credit line up to $4 million in 2012; any advances in excess of that amount would be subject to further negotiation. According to the loan covenant, the outstanding balance on the line of credit was not to exceed two-thirds of accounts receivable and inventory combined. The average interest rate Polar paid on its line of credit was 6% in 2011. Any withdrawal in excess of $2 million would be subject to 11% interest. Polar had an outstanding long-term bond for $1 million on its balance sheet as of December 31, 2011. The long-term bond carried a coupon rate of 8% and was being amortized by payments of $50,000 in June and December of each year. Johnson believed the company would be able to hold capital expenditures equal to depreciation at $300,000, evenly distributed throughout the year. As a result, the company's net amount of plant, property, and equipment would be kept at the same level for 2012 under either seasonal or level production. Proposal to Adopt Level Production in 2012 Johnson was concerned with many problems arising from the method of seasonal production. Machinery that stood idle for half of each year was then subjected to intensive use, leading to excessive maintenance costs. Mass manufacturing of different styles and sizes resulted in frequent setup changes on the machinery. In addition, hiring and training new contract-based employees proved to be costly. Wage premiums due to overtime dramatically increased operating costs. Many of these problems could be resolved if the company adopted level production, Johnson believed. He mentioned to Weir that vendors and retailers had expressed strong interest in Polar's new designs, which would probably lead to a successful sales year in 2012. Those facts suggested that 2012 would be a great year to experiment with level production. Purchase terms would not be affected by the change in production scheduling. Johnson believed that level production would save the company $480,000 by eliminating overtime premiums and reducing maintenance costs. The company would realize another $600,000 through reduced hiring and training costs. For simplicity's sake, the cost of goods sold was assumed to be 60% and would not change monthly under level production. However, some of the savings would be offset by increased storage and handling costs of $300,000 in 2012. Weir understood that the risk of product obsolescence was substantial, and predicting which products would sell the best often proved to be difficult. The company could be burdened with excess merchandise for those styles and colors that retailers had not purchased with level production. Styles that drew a poor market response would be deeply discounted at the end of the selling season. Weir also speculated about the effect of level production on the company's financing needs in 2012. He anticipated that profits, inventories, accounts receivable and accounts payable would fluctuate as a result of a move to level production, but he could not be sure what the overall impact on funds inflows and outflows would be. It was crucial that he understand this to avoid possible violations of Polar's loan covenants. As Weir sat in his office and contemplated making the switch to level production, he considered the trade-off between the potential cost savings and the financial risks that the company might face, as well as the implications of the switch for short-term financing needs. For the exclusive use of I. arias, 2 For the exclusive use of I. arias, 2023