# Denver Furniture Corporation’s Financial Accounting Essay (Critical Writing)

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Updated: Nov 19th, 2020

## Introduction

The introduction of a new brand of product is a decision that should be analyzed comprehensively. Such products may be well received in the market, or the sales may fail to pick up. Also, the introduction of new products may affect the sales of existing products. Therefore, it is important to carry out a multifaceted feasibility study before the launch of such products.

The study can examine various areas such as the financial impact of the new product, as well as the target market, distribution channel, and effect of the new product on the sales of existing products.

In this scenario, Denver Furniture Corporation, a company well known for manufacturing high-quality products, intends to introduce a new brand that has a lower margin that than the existing brands. However, some in the company’s management is concerned about the idea that the new brand will affect the sales of the existing products. Another part of the management thinks that the new product will boost overall company sales. Thus, the decline in sales of existing products will be offset by the sales of the new product. Also, the company has excess capacity. Therefore, there will be no financial requirement to expand the current level of production.

## Objectives of the Paper

The paper seeks to carry out ratio analysis to ascertain the effect of the new brand. The three ratios that will be estimated return on assets, profit margin, and asset turnover. Thereafter, a comparison will be made between the value of ratios before and after the introduction of the new product. Also, a recommendation will be made on other options that the company can explore.

## Calculation of Ratios

The table presented below shows the calculation of ratios.

 (In thousands) Current Results Proposed Results without Cannibalization Proposed Results with Cannibalization Ratios Return on assets (profit for the year / total assets) 12,000 000 / 100,000 000 = 0.12 13,000 000 / 100,000 000 = 0.13 12,000 000 / 100,000 000 = 0.12 Profit margin (net income / sales revenue) 12,000 000 / 45,000 000 = 0.2667 13,000 000 / 60,000 000 = 0.2167 12,000 000 / 50,000 000 = 0.24 Asset turnover (total assets / sales) 45,000 000 / 100,000 000 = 0.45 60,000 000 / 100,000 000 =0.60 50,000 000 / 100,000 000 = 0.50

## Discussion of Results

A review of the table above shows that the current sales level is \$45 million. The forecasted sales level without cannibalization increases to \$60 million after the introduction of the new product. However, the effect of cannibalization reduces the forecasted sales level to \$50 million. The management estimated that \$10 million worth of sales for the new product will be from customers who would have bought the expensive products, explaining why the sales level dropped by \$10 million.

The current level of net income is \$12 million. The value is expected to increase to \$13 million without cannibalization. However, cannibalization will reduce the net margin to the original level of \$12 million. The total assets will remain constant because there are no adjustments that will be made to the production plant. A review of the sales revenue and the value of net income may indicate that there is a change in the profit level as measured by net income. It also shows that the sales revenue may increase by only \$5 million. The values give a narrow view regarding the effect of the new product. This creates the need for ratio analysis.

The three ratios computed above provide information on the profitability and efficiency of the company. First, the return on assets measures efficiency in the use of assets to generate income, showing the profit per unit of assets and measuring profitability and efficiency in the use of assets. Higher values of the ratio are preferred because they indicate better performance (Drury, 2013). The current value of return on assets is 12%. Without cannibalization, the value is expected to increase to 13%.

This shows that the introduction of the new product will improve the profitability and efficiency level if there is no cannibalization of existing sales. The estimated value of return on assets with cannibalization is 12%. This is similar to the existing state before the new product is introduced. Since cannibalization of existing sales is a reality that exists, it can be noted that the introduction of the new product does not affect the return on assets.

The second ratio is the net profit margin. It shows the amount of profit that is generated per unit of sales and measures the profitability of an entity. A higher value of the ratio is preferred. The profit margin before the introduction of the new product is 26.67%. After the launch of the new product, the value of the margin drops to 21.67% without the effect of cannibalization. Thus, the new product lowers the profit generated per unit of sales.

This can be attributed to the fact that the net income is not growing at the same rate as sales. The net income grows by 8.3%, while sales revenue increases by 33.3%. Also, the new line of furniture has a low margin. This explains the decline in the ratio. The net margin that is generated with cannibalization is 24%. The value is lower than the current level of net margin and slightly higher than that of the new product without cannibalization. Thus, it is clear that the new product will not help to improve the profit margin irrespective of cannibalization.

The third ratio is asset turnover. This is an efficiency ratio that measures the sales units that are generated from a unit of assets. A higher ratio is preferred because it shows that the company is using its assets efficiently to generate sales (Wahlen, Baginski, & Bradshaw, 2014). The asset turnover ratio before the launch of the new product is 0.45 times, which is quite a low value. After the introduction of the new brand, the ratio is expected to increase to 0.6 times without the effect of cannibalization (Horner, 2013). This shows an improvement from the current state and indicates increased efficiency in the use of assets.

Furthermore, the value of the asset turnover ratio with the effect of cannibalization is 0.50 times. This is a slight improvement from the current state of the company and a decline when compared with the results without the effect of cannibalization. Thus, the introduction of the new product increases the company’s efficiency in the use of its assets. This can be attributed to the use of excess capacity.

## Implications of the Results

The results above show that the new product will lead to increased sales revenue. The net income will also increase by \$1 million if the effect of cannibalization is ignored. Ratio analysis shows that return on asset increases by one point if the effect of cannibalization is ignored. However, there is no change in return on assets if the effect of cannibalization of current sales is taken into account. Therefore, the new product will not improve the current position of return on assets. Second, the new product line will not improve the profit margin. The margin after the introduction of the new product with and without the effect of cannibalization of current sales is lower than the state before the new product.

Finally, the new brand will increase efficiency in the use of assets as indicated by the asset turnover ratio. This can be attributed to the use of the company’s excess capacity. The analysis above shows that the new product will not improve the financial position of the company but will only keep the idle capacity busy, thus increasing the company’s efficiency in the use of assets. Therefore, with or without cannibalization of existing sales, the company will not be better off.

The company will only increase the sales of the low-margin product at the expense of the existing products. The company should not implement the proposal for introducing a new line of furniture because it does not improve the financial position of the company. However, if the management intends to pursue the proposal, then it will be profitable to eliminate the effect of cannibalization.

## Recommendation of Other Options and Conclusion

Apart from introducing the new line of furniture, there are several other options the company can consider. The first option is that the Denver Furniture Corporation can rent the unused capacity (Clarke, 2012). If the company cannot eliminate the effect of cannibalization, then it can rent out the excess capacity. The revenue collected will be added directly to the company’s income. This option affects increasing both the profit margin and return on assets. However, it will not affect the asset turnover ratio because there will be no change in sales. This option is suitable because it will ensure that the idle capacity is put to use without incurring additional costs.

The second option that the company can explore is to increase the sales level of the available line of products. This can be achieved through two approaches. In the first approach, the company could carry out extensive marketing. This can be achieved by increasing the amount that is spent on advertising and marketing. The second approach would involve reducing the price of existing products. Based on the calculations above, the current profit margin is 26.7%.

The company can reduce this margin to accommodate the two approaches. A reduction in price or increase in marketing expenses has the effect of increasing sales volume and reducing the idle capacity. Before implementing these two options, the management needs to ensure that the increase in sales revenue is higher than the anticipated decline in profit as a result of reduced prices and increased advertising costs. This will ensure that the profit margin will increase.

As pointed out in the discussion above, the “without cannibalization” scenario results in an increase in sales by \$15 million and profit by \$1 million. If the company wants to introduce this new brand, then efforts must be made to reduce the effect of cannibalization. This can be achieved by proper branding in such a way that the existing products are clearly distinguished from the current products. This can be done by carrying out aggressive marketing to achieve market segmentation. This will help to differentiate the two lines of products. However, the company should ensure that the gains from product differentiation are not eliminated by the marketing costs.

## References

Clarke, E. A. (2012). Accounting: An introduction to principles + practice (7th ed.). South Melbourne, Victoria: Cengage Learning Australia.

Drury, C. M. (2013). Management and cost accounting. New York, NY: Springer Publishers.

Horner, D. (2013). Accounting for non-accountants (9th ed.). New Delhi, India: Kogan Page Ltd.

Wahlen, J. M., Baginski, S. P., & Bradshaw, M. (2014). Financial reporting, financial statement analysis, and valuation: A strategic perspective. Boston, MA: South-Western Cengage Learning.

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