1

Barbie Company

(Break-Even Analysis and

Leverage)

After he received his M.A. in chemistry, specializing in plastics, Mickey Mahon joined the plastics division of a major chemical firm. His wife, Leslie, had managed the toy department of Shield’s, a large department store in Chicago, before their marriage in 1960. As a hobby, Mrs. Mahon designed and Mr. Mahon produced certain toy

items that they gave to their friends on Christmas, birthdays, and other occasions. These toys were very well received, and a number of the Mahons’ friends asked to buy additional ones that they, in turn, could use as gifts. Mrs. Mahon’s successor in Shield’s toy department also urged them to produce additional quantities to be marketed through the store.

In the summer of 1966, the Mahons decided to devote their full time to the commercial production of toys, and on January 1, 1967, the Barbie Company commenced operations. The initial plans were well laid. Sales during the first year totaled $1 million, and by 1977 they had grown to $10.5 million. The annual sales for the firm’s first

11 years, together with certain other operating statistics, are presented in Table 1.

 Total toy industry sales are quite stable, but because of fads and fashions, individual firms experience considerably more instability than does the industry as a whole. The Barbie Company, for example, “missed the market” in 1972 and 1975, when its new designs were not especially well received, and sales dropped significantly during both those years.

Sales instability presents a financial planning problem in the toy industry, and this problem is heightened by the seasonal nature of the business. About 80 percent of all sales are made during the months of September and October, when stores are stocking up for the Christmas season, but collections are not generally made until January and February, when stores have received their Christmas receipts and are able to meet their obligations to the toy manufacturers. Toy manufacturers have a choice of production techniques. They can either produce heavily during the April-to-September period in anticipation of the Christmas sales, or they can follow a practice of level production during the year, storing output produced during the off-season period. The advantages of uniform production are that fixed-asset requirements are reduced and better personnel can be obtained because of the full-time employment Seasonal production; on the other hand, reduces the danger of obsolescence due to style changes, decreases the storage problem, and reduces the need for financing to carry off-season inventories. The Barbie Company has been following a seasonal production pattern, pattern, producing

about 70 percent of its output during the April-through-September period and 30 percent during the remainder of the year. 

Although the company has been continuously profitable, costs have been getting out of hand in recent years. The main plant was built in 1970, and additional capacity has been provided for in various rented buildings in the west Chicago area. The lack of centrally located production facilities and the need to train new labor during the peak production period are considered to be the primary reasons for the disproportionate increase in cost and the declining profit margin on sales. Leslie Mahon is convinced that the firm should buy some land adjacent to the present plant, construct an automated and integrated production complex, and produce at a more uniform rate throughout the year. She also proposes to build a plant large enough to meet projected sales demand for some years into the future. Mickey Mahon, on the other hand, is worried about increasing fixed costs in a firm characterized by sales fluctuations. He believes that it would be sounder practice to slow down the firm’s rate of

expansion and consolidate its present position Mickey believes that his wife’s approach, which would enable the firm to maintain its rapid growth and perhaps even make the family quite wealthy, would also jeopardize the continued existence of the firm. It is estimated that variable costs will amount to approximately 85 percent of sales during 1978 if the present production setup is continued. Fixed costs for 1978 under the existing setup will be about $1.2 million, and $485,000 of this will be depreciation. If Leslie Mahon’s expansion proposal–which calls for expenditures of approximately $3 million for plant, equipment, and increased working capital, all to be financed by a 10-year loan from an insurance company–is carried out, variable costs will fall to approximately 75

percent of sales. At the same time fixed costs will rise to $2,200,000 per year. Depreciation in this case will be an estimated $1,400,000 per year.

Economics of expansion dictate that the Mahons must take the step all at once if they are going to take it at all, since expansion in stages is too costly. If the expansion is not undertaken, Leslie Mahon believes that a larger profit margin can be restored by concentrating on cost control.

Since 1971, sales have been increasing at about a 29 percent rate compounded annually. The Mahons do not expect sales to continue to grow at this rate, but they do anticipate that a 20 percent annual sales increase can be attained over the next several years if the $3 million expansion is undertaken. Without this expansion the Mahons agree that sales growth after 1977 will only be about 15 percent. 

Table 1

Barbie Company

OPERATING DATA.1967-1977 (IN THOUSANDS)

1967 1968 1969 1970 1971 1972 1973 1974 1975 . 1976 1977

Sales 1,000 1,250 1500 1950 2350 2,000 3,600 4,800 $4,200 7,500 10,500

Leas variable costs: _

Cost of sales 770 962 1,155 1,502 1,810 1,540 2.772 3,696 3,233 5,775 8,084

Selling sad

Administrative

Expenses

50 63 75 98 118 100 180 240 210 375 525

Total variable costs 820 1,025 1,230 1,600 1,928 1,640 2,952 3,936 3,443 6,150 8,609

.

Contribution to

overhead and profits

180 225 270 350 422 360 648 864 757 1,350 1,891

Less fixed operating

costs:

Rent 55 96 148 241 437.

Depreciation 59 80 81 116 131 152 179 216 301 388 443

Taxes, property 8 13 10 _19 16 18 32 61 90 116 I80

Total fixed Operating costs 67 93 91 135 147 170 266 373 539 745 1,060

Earnings before

interest and taxes

113 132 179 215 275 190 382 491 218 605 831

Less Interest 5 5 13 11 16 16 24 21 22 31 40

Earnings Before Taxes* 108 127 166 204 259 174 358 470 196 574 791

Less income taxes** 38 48 67 84 111 70 158 212 80 262 366

Profit After Taxes 70 79 99 120 148 104 200 258 116 312 425

Leas dividends 40 40 40 40 40 40 40 40 40 40 40

Addition to retained

Earnings

30 39 59 80 108 64 160 218 76 272 385

Net profits after taxes as a percentage of sales 7.0% 6.3% 6.6% 6.2% 6.3% 5.2% 5.5% 5.4% 2.8% 4.2% 4.0% * 5 % of sales.

 = 

Required

1, Calculate the break-even point in dollars for 1978, assuming that present production methods are continued.

Also calculate estimated 1978 sales and express the break-even point as a percentage

of 1978 sales. Under the expansion program the estimated 1978 sales are $12.6 million,

and Barbie breaks even at a sales level of $8.8 million, or 70 percent of estimated sales.

2. Assuming that the expansion program is undertaken, what is the estimated EBIT

(earnings before interest and taxes) for 1978? (Note: If the expansion program is not instituted,

 estimated 1978 earnings before interest and taxes would be $611,250).

.At what level of sales would profits be equal under the two production methods? (Hint: Use the equation BE=Sales-(FC +VC+PROFIT )

where profit = zero. On one side of the equal sign substitute the formula for non-expansion; the other side of the equal sign substitute the same equation bu

he formula for “with expansion”. So you will have BE without expansion = BE with expansion. Next, you can eliminate Sales since sales will be the same

mount. You can then express VC as a percent of sales and solve for sales).

3. Assuming that the expansion program is instituted, what would happen to before-tax earnings if 1978 sales

level by about the same rate that sales fell in 1975? If the expansion program was not instituted, EBIT would be

$170,250 if sales fell by this same percentage.

4. Assuming that depreciation is the only noncash charge, what is the cash break-even sales level for the

non-expansion alternative? The cash break-even sales level for expansion is $3.2 million.