Introduction
The client, Isaac, is planning to start a new venture that will import German chocolate into Canada and sell it. The firm AlpenChoc, which specialises in handmade artisanal chocolates, is prepared to sell him seven-year exclusive distribution rights in the country.
As such, he can leverage this advantage to establish a presence in the nation, find a customer base, and begin making a profit. Since Isaac has retired recently, he has the time and motivation to developing and expanding the business, both of which are critical to success. However, there is a concern regarding the potential of failure and the loss of the investment. The purpose of this report is to evaluate the project’s prospects, determine how likely it is to succeed and grow and provide a series of recommendations for the various aspects of the business.
Assumption and Estimate Summary
The first assumption that is required is that of the conversion rate between Canadian dollars and Euros. Understanding it is critical to any business that operates internationally and especially valuable to importers such as the proposed venture. This report will use the average value for the last year as reported by the Bank of Canada (2020a), where one euro is equivalent to approximately 1.48 Canadian dollars. The rate is subject to substantial and unpredictable fluctuation, which is why using a single data point is dangerous. The average is still likely to be generally inaccurate, but it can approximate the future to an adequate degree, assuming both economies remain stable. The business will plan based on this assumption, as it would be imprudent to rely on the strong growth of either currency in the foreseeable future.
The inflation rate is another critical assumption, mainly because the report will be using discounted cash flow analysis. Money depreciates over time, reducing the business’s profitability if its prices remain the same. Once again, it is possible to refer to the Bank of Canada (2020b), which shows an inflation rate of approximately 2.2% over the last year (using the median metric). The same considerations about stability apply as in the previous case, but inflation is easier to control because it is mostly limited to Canada’s internal economy. Moreover, according to Di Bartolomeo and Saltari (2017), most countries target an inflation rate between two and four per cent, and Canada fits into this interval. As such, with a stable economic situation, the nation’s growth is likely to continue at the same rate as before, making the 2.2% estimate mostly safe.
It is also necessary to make some assumptions about the miscellaneous costs of running the business. Some aspects of the company, such as refrigeration, will require the usage of electricity. However, the amount is likely negligible when compared with the overall size of the business. As it is challenging to estimate it accurately given the lack of information, it will be omitted from the report. The assets will be subject to depreciation (Weygandt, Kimmel and Kieso 2019), but due to their overall low cost and a lack of information, this factor will be omitted, as well.
The cost of maintaining the website is easier to determine, as Pricing & supported domain endings (2020) sets the annual price for a.ca website at $120, or CAD 161.06 as of the time of writing (Bank of Canada 2020c). As long as the business uses a reliable domain, there should be little need for maintenance. Also, the company will spend $1000 per month on advertising via various channels as a baseline estimate.
Discounted cash flow is appropriate in this case because, according to Hitchner (2017), it is best applied when short-term and long-term growth is likely to be different, and the company has not stabilised yet. While much of the analysis will focus on the short term, where inflation is unlikely to be highly influential, a more extended perspective is also warranted. However, it is still essential to factor in every possible element when making a potentially risky decision.
Barringer (2016) notes that a comprehensive evaluation of dangers is critical for ensuring that the project is reliable enough to merit an investment. Every start-up is associated with the threat of early failure and loss of money before they can begin operating successfully. By improving people’s understanding of the potential issues, the business can outline the impact of potential crises and the amount of starting capital required to address them.
The payment method used by the business warrants additional consideration due to the complexities that it brings. The transaction company will hold customers’ money until the month ends and transfer it in bulk two weeks after that. As a result, every month, all of the company’s sales during it will be filed as accounts receivable. Prendergast (2020) recommends that they are included in the sales for the period in the profit and loss statement.
The sensitivity analysis projections will use the same approach and treat customer payments as instant cash infusions. However, the paper will use the direct method for the cash flows statement, which means that accounts receivable will only be filed once the payment to the company is complete (Klammer 2017). The balance sheet has a dedicated section for accounts receivable, so the consideration does not apply there. The shipping time from Lindau to Toronto is also irrelevant because the company will buy the product in advance to compensate.
Break-Even Analysis
To conduct the break-even analysis, one has first to determine the fixed costs of operating the venture. Lee, Lee and Lee (2016) describe the general purpose of the break-even analysis as determining when the business’s revenues equal its costs. Some of the latter, known as variable costs, depends on the number of goods sold, while others remain constant, or fixed, irrespective of the firm’s activity. In this case, the prices of purchasing chocolate from AlpenChoc, shipping it to Toronto and delivering it to buyers will constitute variable costs.
Employee salaries, rent, and other miscellaneous expenses such as advertising and domain maintenance will constitute the fixed costs. As a side note, this analysis will not factor in the contract with Jade, which will generate profits due to its 33.82 CAD variable cost per box and its CAD 45 price. This contract is not permanent, and in the long term, it would be prudent to assume that the business will have to survive and make profits without it.
The company’s employees will receive CAD 3,000 per month, and the rent will be CAD 3,500. The business will also spend CAD 1,000 every month on advertising and CAD 10 on domain maintenance. Overall, the fixed costs come up to approximately CAD 8,510 per month. The variable costs include the CAD 106.56 purchase price per kilogram of chocolate and the CAD 20.72 price of delivering it to Toronto. There is also the CAD 6.00 shipping cost for delivering orders to customers and the handling fee of CAD 1.92, bringing the total variable cost to CAD 135.20.
As such, the contribution margin for each kilogram of chocolate sold should be approximately CAD 24.80. To compensate for the fixed expenses, the business will have to sell 343.15 kilograms of chocolate every month. The market study suggests that it can hit this figure and break even within the first year, further exceeding it by a factor of approximately two later on.
In the projections below, the business will not necessarily break even when it hits this mark. The reason is that it stocks supplies for a month ahead and will buy a higher amount of chocolate than it sells every month. As a result, while it technically makes a profit selling of the stock that was delivered last month, it spends more than its total revenue buying a higher amount of supplies. Once sales are high enough to offset the effect or stabilise at a set level, the company will begin making a profit. The former will typically only happen toward the end of the first year, while the latter always occurs at the beginning of Year 2 in the projection. As such, the business will lose money consistently throughout the first year on paper, even though its value will increase substantially.
Profit and Loss Statement
Table 1: Profit and Loss Statement for the Company.
Balance Sheet
The balance sheet below represents the company’s projected state at the end of the first year of operations.
Table 2: Balance Sheet for the Company.
Monthly Cash Flow
Table 3: Monthly Cash Flow for the First Year.
Annual Cash Flow
Table 4: Annual Cash Flow for Years 2 through 7.
Starting Capital Analysis
The business will stock supplies for a month ahead, necessitating an initial purchase and delivery of 75 kilograms of the chocolate for a total cost of approximately CAD 9,546. This figure is based on the market study, and he can stock more for situations where demand is higher than expected. To store them, Isaac will need to purchase the refrigerator and pay the deposit for the room, which amount to a total of CAD 26,000. The wrapping machine will cost CAD 2,200, and the website will incur an additional expense of CAD 8,500. Additionally, Isaac has spent CAD 5,000 on the market study, but this money does not factor in the final figure of CAD 46,246. All of these costs will have to be paid to conduct the essential setup before the company can begin operating.
As can be seen in the cash flow statement, the report assumes the starting balance of the business to be CAD 250,000. With this figure, it does not go into negative numbers before it can begin making money, and there is also a substantial safety margin in case of unexpected events. It is best to have it to avoid early bankruptcy before the company can break even (Vinturella 2017). If Isaac wishes, he can lower that figure and either rely on a lack of financial difficulties or invest additional money to rescue the business later. However, this report will assert a starting amount of approximately CAD 300,000 in addition to the licensing fee that the company will pay to AlpenChoc. That amount will be discussed below in more detail, with specific recommendations attached.
Sensitivity Analysis
Several factors can affect the company’s operations, potentially improving it or making it worse. According to Viguri and López (2019), it is prudent to conduct a sensitivity analysis to determine how changes in these parameters can affect the business’s performance. Exchange rates and inflation have been mentioned as potential issues above, but they are unlikely to fluctuate significantly. As such, there is little to no practical reason to analyse them as potential risk factors.
However, customer demand is a significant variable because of the price elasticity of chocolate (Buch-Andersen et al. 2019). AlpenChoc chocolates are likely in the premium category, which can substantially reduce demand, according to Wise and Feld (2017). On the other hand, the chocolate’s popularity may also exceed the projections of the market study. As such, two analysis cases of demand 25% below and above expectations will be featured in the following analysis.
Table 5: Financial Projection in the Case of 25% Lower Sales.
Projection for Low Demand
As can be seen from this projection, while the business’s performance will be substantially worse than in the case of the demand matching expectations, it will remain profitable from the second year onward. The reason is that the sales are still higher than would be necessary for the business to break even. With that said, it will take the company considerably longer to break even than in the case of average demand, which reduces its attractiveness and feasibility. Saxton, Saxton and Cloran (2019) recommend offering discounts and looking for wholesale channels to improve sales. The business will operate and make a profit, but it is a worse investment in this case.
Table 6: Financial Projection in the Case of 25% Higher Sales.
Projection for High Demand
In the case of substantially higher demand, the business breaks even earlier than in either of the other projections. Regardless, as a result of having to pay the income tax, its performance in the first year does not change substantially. The difference appears in the second year onward, with the net income being more than twice that of the previous case. Tech (2018) recommends that start-ups in such a situation look for further investment and expansion opportunities. In doing so, the company can secure additional sales and make higher profits, benefiting Isaac.
AlpenChoc Upfront Fee
If Isaac decides to start the venture, he will be paying AlpenChoc for a seven-year exclusivity contract. As can be seen in the cash flows statements (Tables 3 and 4), at the end of the seventh year the company is expected to have increased its cash on hand to approximately CAD 615,000 from a beginning CAD 250,000 after adjustment for inflation. The other assets, which should remain static and slowly depreciate throughout the 2nd to 7th years due to a lack of plans for further growth, should amount to another CAD 200,000.
The liabilities should be negligible due to a lack of debt and the presence of sufficient cash to make all of the company’s payments on time. According to Dieterle (2017), the business’s net worth amounts to the difference between its total assets and liabilities, and so, it should be approximately CAD 800,000 at the end of the period. With Isaac’s original investment of CAD 300,000, he can pay a maximum of CAD 500,000 for the exclusivity fee to maintain the status quo after seven years.
However, Isaac’s goal is to make money from the venture rather than put his money into circulation without benefiting from it. It would be preferable for him not to have to pay the full sum upfront, especially since it would drain his current finances entirely only for them to possibly recover years later. At the same time, there is no incentive for AlpenChoc to accept the exclusivity agreement without sufficiently high compensation.
The German company is presumably not selling in Canada at the moment, and the contract does not help it in any way other than enhancing its sales somewhat. The same effect could be achieved by letting Isaac begin selling their chocolate without the agreement. However, if it proves popular, other Canadian chocolate sellers are likely to contact AlpenChoc and start buying their products, creating competition. Overall, AlpenChoc is in a position of power, which enables it to request a high amount of money.
With that said, Isaac should probably rely on the goodwill of his friends in AlpenChoc as well as their interest in expanding the business. They will presumably still make money by selling their products to Isaac at a 40% discount. Moreover, should they try to breach the contract and enter the market themselves, their €120 price would translate into CAD 177.56 without the shipping costs, and the company would struggle to compete with Isaac’s business.
Fumagalli, Motta and Calcagno (2018) note that exclusivity contracts only succeed if it is unprofitable for the supplier to enter the market through another means and also suggest a fee for breaching the agreement as a method of guaranteeing compliance. Overall, a CAD 100,000 fee appears to be appropriate to make the offer enticing for AlpenChoc without compromising Isaac’s profits.
Conclusions
Overall, the business appears to have substantial potential for success, increasing its value substantially over the seven years of exclusivity. It will remain profitable even if the market study is incorrect by a significant margin, though its profits can decline substantially.
A starting investment of CAD 300,000 will be required to cover the projected initial losses and contingencies, which is well within Isaac’s means, and he will not have to take on any loans and the corresponding liabilities. As such, it is most likely worth the investment, though the venture’s focus on a single product from a specific company is a cause for concern. While CAD 100,000 should be enough to secure an exclusivity agreement with AlpenChoc, a lack of goodwill from the company or unpredictable events that interfere with supply can be devastating for Isaac’s business.
Recommendations
Isaac should start the company with a CAD 250,000 initial budget and whatever other investments are required to open it, as described above. Additionally, he should offer AlpenChoc CAD 100,000 for the exclusivity agreement and be prepared to go up to CAD 150,000-200,000 if the other company’s owners are dissatisfied with the initial sum. All of this money should come from Isaac’s finances rather than any loans because he has enough money to accommodate this move. The original plan to hire two part-time students and an assistant for the contract with Jade should be carried out, though Isaac should consider the services of an accountant. Overall, the venture appears to be trustworthy, eventually recouping its costs even in a scenario of a substantial lack of demand. As such, it can be implemented with only slight changes and will be likely to succeed.
However, in the long term, the company’s profits will stagnate and begin slowly declining due to inflation unless Isaac decides to start raising prices to compensate. The reason is that the product’s appeal is niche, and the demand is likely to hit its upper limit at the end of the first year of operations. While this event will happen after Isaac has made his money back and generated a substantial profit, it is a waste of resources. It would be more logical for the owner to continue developing the company, selling it when it becomes too difficult to manage with the current structure or when he is satisfied with the price offered. There are several strategies that he can use to do so, which will be discussed below.
The first approach is to expand internationally and tap another market that may manifest a high demand for premium chocolate. Canada shares a border with the United States, whose large population and wealth make it an excellent candidate. Moreover, AlpenChoc likely does not sell its products there, as it did not do so in Canada despite similar logistics. Longenecker et al. (2017) note that such an expansion would be expensive and challenging and suggest turning to government resources that help small businesses become global. An additional investigation into the available opportunities may be warranted before the final determination. The pros and cons of the approach in the case that Isaac can secure the necessary assistance are detailed below.
The primary benefit is the size and financial ability of the United States customers. With the difference in population between the two nations, Isaac’s business stands to increase its sales tenfold or more in the best-case scenario. While delivery from Canada to the United States may be expensive, the problem can be circumvented through shipping from Lindau into another warehouse located within the United States.
Some additional employees and equipment will be necessary for the operation to work, but the benefits outweigh the costs by a substantial margin. Moreover, when the management of the business becomes too difficult, Isaac can sell it and make a considerable return on his initial investment that will enable him to live comfortably or pursue further ventures. Overall, if the move succeeds, the benefits that the business can extract are massive and warrant consideration.
However, the likelihood of this success is subject to numerous complicating factors, such as competition. Isaac’s business is unlikely to secure an exclusivity agreement from AlpenChoc because it is likely to recognise the market’s potential and demand a massive sum that the company cannot afford. Without such a deal, if the company enters the U.S. market and achieves an initial degree of success, others will notice the opportunity and seek to import AlpenChoc products, as well.
Some may be doing so already, occupying the market share that Isaac’s company aims to take. Overall, even if a market for the chocolate exists in the United States, the business is unlikely to be able to capitalise on it in its entirety. This uncertainty makes expansion a substantially less attractive option, especially considering the lack of other readily available neighbouring nations.
An alternate expansion option is to try and increase the variety of products offered by the company by looking for other foreign chocolate companies and securing exclusivity agreements with them, as well. Some customers may be interested in firms other than AlpenChoc and choose to buy the new offerings where previously they would not purchase anything from the company. Denault (2018) highlights market development that targets unmet needs as an effective strategy for businesses that aim to grow. This approach should be easier to implement than international expansion once Isaac finds and contacts potential partners because there is less of a need to consider other nations’ business law. However, there is likely also a lower growth ceiling for the company because its customer base is still limited to a small section of Canada’s population.
The lack of competition is a significant advantage for this approach when compared to international expansion. It should not be overly expensive to secure exclusivity contracts with the suppliers, becoming the sole provider of specific varieties of chocolate in Canada.
In doing so, the company will be able to establish a strong brand among its target audience ahead of any possible competition. Moreover, the company will have additional distinguishing factors that it can use after its seven-year contract with AlpenChoc ends, assuming the company will not prolong it. It can also attempt an expansion into artisan sweets other than chocolate, though this idea is associated with several considerations such as storage and the need for market research. Similar to the first strategy, new equipment and employees will be necessary to conduct the growing operations, but the benefits will likely outweigh the costs substantially.
However, while other companies may struggle to compete with Isaac’s business if he takes such an approach, the different chocolates sold by the company will likely take sales away from each other. Given an increased choice, some customers may change their preferences from one of the brands offered to another without increasing the business’s overall revenue substantially. Without extensive market research, it is impossible to know how many artisan chocolate consumers are interested in exploring more options but dislike AlpenChoc, thus constituting the potential customer base for the business.
If the number of customers for a new brand turns out to be too low to bring in a significant profit, the company will lose money on the exclusivity deal. As such, the approach can be risky, though the danger can be alleviated by importing test runs of the different sweets and collecting feedback before committing to a contract.
This report recommends going with the second option to minimise the complications caused by the company’s expansion. The risks can be alleviated through careful planning and testing while the company gathers the resources to expand its range of offerings. Moreover, the additions should not require a significant commitment comparable to that necessitated by the U.S. expansion. However, Isaac should only begin considering this option once the company hits a stable volume of sales, and its performance and success can be measured objectively. In the case of the initial venture’s underperformance, expansion should not be a consideration. However, if the business overperforms, future initiatives will become more promising and be enabled earlier. Moreover, the situation may change over the first two years, and additional sources of income, such as partnerships with other businesses on a large scale, become available.
Critical Reflection
I believe that the analysis is mostly adequate, though there are some considerations that I would have liked to include in a more realistic scenario. Assets and liabilities are a particular concern because of the breadth of their definition. Wolk, Dodd and Rozycki (2017) highlight several legal definitions of each concept that emphasise different aspects and incorporate a variety of different items, such as depreciation.
I have tried to include some likely assets and liabilities while mentioning others in passing. However, in general, I have relied on vague guesses to evaluate the scope of some of the items on the balance sheet. In a real analysis, I would have had more information and been able to assess aspects such as the depreciation of equipment and property more accurately. In this case, the lack of accurate information is likely negligible, but in other situations, these factors may have had a massive impact.
The sensitivity analysis is another aspect in which the availability of information has limited me. As Moscato and de Vries (2019) note, several variables are typically included in sensitivity analyses to determine which one is more influential on the business’s performance. In particular, I would have liked to understand the importance of price to the success of the company. However, the analysis provided only gave data for the CAD 160 price point, making any extrapolation of changes in demand based on the price a risky endeavour.
This fact also makes it challenging to consider the possibility of future price adjustments to accommodate for inflation because customers may respond negatively to a perceived price increase. Overall, the provided information limited the usefulness of the sensitivity analysis significantly, though it was still sufficient to assure the business’s profitability.
All of these factors have combined to create some uncertainty and make me go over the calculations and correct mistakes I have made. As I proceeded to make the different statements and projections, I had to revisit and double-check the results I had obtained previously because of the mismatch in the numbers. According to Hatten (2020), this tendency to expose mistakes and lead to their correction is one of the strong points of the double-entry accounting system used by most businesses. However, I would have still recommended Isaac to use accounting software to ensure that human error is minimised. The task is challenging due to the number of different variables involved, and some omissions are almost inevitable. A computer would be able to take care of small details smoothly while letting the owner manage the broader perspective.
Throughout the analysis, I have gained a better understanding of how new companies operate early on and how financial statements reflect its current state. As Kapal (2018) notes, many start-ups fail early on, and the profit and loss statement supports this claim by showing substantial losses until the fourth quarter of the first year. The cash flows statement is particularly noteworthy because it highlights how, despite its net worth remaining static, the business’s cash reserves decline by almost CAD 200,000.
Cornwall, Vang and Hartman (2016) describe this situation as one of the typical problems in accounting, as the income statement alone would have suggested a much lower starting cash figure and may have led to the need for Isaac to find some money on short notice, whether from personal finances or through a loan. Each of the three financial statements presented in the paper is critical to the understanding of some aspect of the company’s functioning.
Overall, through the completion of this assignment, I have been able to gain an insight into how accounting is applied in real-world scenarios and the complexities associated with such a task. It can be challenging to keep track of resources for even a small business owner due to the number of different variables and considerations involved. Moreover, extensive research is required before planning can begin, with numerous factors to consider and evaluate.
I have also gained an appreciation for the system that is currently being used for accounting, having had an opportunity to see situations where each of the three statements offers a unique benefit. I have also gained a realistic image of a business’s functioning and the various factors that can affect its operations. I have reinforced my understanding of the basics and identified some factors that a manager has to understand and incorporate when participating in accounting or reviewing it.
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