Accounting Project  Darren Chung-Ta Chang, Ryan Hsu, Andrea Kao, George Chao-Chih Ko  April 24, 2002

Case Study: Lille Tissages, S. A.

THE CASE 

The case being investigated involves a large French textile company, Lille Tissages, S.A., facing stiff competition and whose managers are forced to reconsider pricing plans for Item 345, one of their most successful products. 

THE SITUATION

As shown in Exhibit 1, Lille Tissages has lost significant market share on Item 345 in recent years.  At its prime, the firm commanded 35% of industry-wide production of the particular item.  However, the estimated percentage for the year prior to the date of the case study has faltered to about 20%.

To remedy the staggering market share lost, high profile officials of the company are analyzing a possible pricing strategy, proposed by the sales director, for Item 345 in an effort to regain ground.  The sales director proposed that if the firm were to reduce the price of Item 345 to FF15, they would be able to increase sales to 175,000 (or 25% of industry production) units.  If the firm were to keep the price at the current value of FF20, they would only be able to sell 75,000 units (and no less).

The focus of the study will discuss implications of price of Item 345 by addressing the following points:

• Should the firm change the price
• Will the Item 345 department likely to agree with a lowering of costs
• How will competition react
• Will the firm earn profit when Item 345 is at a lower price

METHODOLOGY

The study group has approached the problems from the standpoint of unit contribution margin and total contribution.  In order to use this approach, the team has to first identify the variable and fixed costs in producing Item 345 (see Exhibit 2).

The following are declared as variable cost: direct labor, material, material spoilage, and direct department expense.  All these items are charged on a per-item produced basis.  Indirect department expense is considered fixed because the cost is sunk regardless of the level of production.  General overhead and selling & administrative expenses are company fixed costs applied to the division.

Also note that the team disagrees with the method Lille Tissages, S.A. uses to apply General Overhead costs.  The team argues that the description given to General Overhead (administrative, occupancy, supervision, etc) suggests that it should be considered a fixed amount, which means it should decrease a the number of units produced increases.  To find this fixed amount, the team decided to use the average of the total General Overhead from volumes that were produced in previous years. 

SHOULD LILLE TISSAGES LOWER THE PRICE TO FF15?

The issue at hand is whether the firm would benefit as a whole in the proposed price drop.  Changing the unit sales price will alter the unit contribution margin (CM), which is the sale price minus variable cost.  Analysis shows (refer to Exhibit 3) that at a selling price of FF20, the CM is FF13.20 per meter.  If Lille Tissages is to follow through with the new pricing plan and drop the sales price to FF20, the unit CM will fall from FF13.20 to FF8.51.

With the contribution margin calculated, the total contribution can be evaluated for the two production levels.  At FF20, sales volume is predicted to be 75,000 units.  Therefore, the estimation of the total contribution would be FF990,000 (FF13.20×75,000).  The sales director is certain that the company could sell 25% of the 1997 industry total, or 175,000 units, if it adopted the FF15 price.  At these rates, the total contribution is calculated to be FF1,489,250 (FF8.51×175,000).

At first glance, per unit contribution margin calculations connote a feeling that the firm should not drop the price to FF15 since sales price of FF20 shows much higher contribution margin per unit.  However, total contribution calculations clearly indicate that selling a larger volume at a lower price will result in higher contributions towards fixed costs.  From contribution standpoint, Lille Tissages should drop the price to increase demand, and ultimately derive higher total contributions towards the company’s fixed costs.

WILL THE ITEM 345 DEPARTMENT LIKELY TO AGREE WITH THE LOWERING OF COSTS?

This question concerns the situation where the department producing Item 345 is to be considered a profit center.  By definition, a profit center is an organizational subunit whose manager is held accountable for profit.  From this viewpoint, the main issue at hand is under which pricing plan would Department 345 gain more profit, that is, higher revenue and lower expenses?

At selling price of FF20 and sales volume of 75,000 units, the total revenue is estimated to be FF1.5 million and total expense FF1.64 million (refer to Exhibition 3).  Total expense minus total sales gives negative profit of FF0.14 million. Similarly, for the selling price of FF15 and sales volume of 175,000 units, the total revenue is estimated to be FF2.63 million and total expense FF2.68 million.  These figures result in negative profit of FF0.05 million.

Based on the estimation of total expense and total sales, selling prices of FF15 and FF20 will both result in non-positive profits, or lost of earnings, but losing less at price FF15.  Since the goal of a profit center manager is to maximize profit in any situation, he would likely agree to sell Item 345 at the lower price of FF15.

IS THERE ANY POSSIBILITY THAT COMPETITION MIGHT RAISE THEIR PRICES IF LILLE TISSAGES MAINTAINS ITS PRICE OF FF20?  IF SO, HOW DO YOU TAKE THIS FACTOR INTO YOUR ANALYSIS?

If Lille Tissages maintains its price of FF20, their competition may raise their prices, as long as their contribution margin is higher than their margin at a lower price.  One impact of their increase in price these competitors must consider is the inevitable fact that they will begin to lose market share since the general public of the textile industry believe that Lille Tissages produce better product.  Given this situation, the competitors will have to perform a thorough market research similar to Lille Tissages to determine how much market share they would loose if they raise their price and what the optimum price would be to bring them the largest contribution margin per unit.

At the same time, when the competitors of Lille Tissages loses their market share, Lille Tissages would very likely be the beneficiary of this particular sector of the market.  As a result, Lille Tissages will likely to have a different sales volume, more specifically higher than 75,000 units (which they have originally anticipated at the price of FF20).  As one can see from Exhibit 3, when Lille Tissages can sell 125,000 units, or a market share as high 17.85% (125000/700000), at FF20, the company will be able to make a higher profit than selling 175,000 units at FF15 even though the lower price has a higher market share of 25%.   

AT FF15, WILL LILLE TISSAGES EARN A PROFIT ON ITEM 345?  HOW DO YOU DECIDE?

Since FF15 is high enough to cover factory costs at the 175,000 production level, profitability of Item 345 will depend on how much of the company’s Selling & Administrative Expenses is allocated to this department.  With the current allocation practice (65% of the factory cost), Lille Tissage will not see profit on Item 345.  The reason being that too much overall company selling and administrative expense allocated to this department.

Suppose that Lille Tissages changes its allocation practices.  The point at which the company sees neither profit nor loss is about 62% at FF15 (see Exhibit 4), i.e. if the percentage of Selling & Administrative expenses allocated to this department is lower than 62%, then Lille Tissage sees a profit on this item.  Otherwise, the company will see a lost on this investment. 

In addition, consider the situation from the perspective of the firm.  Since one does not know the overall fixed cost for the company, the sales revenue generated at the set price may already cover the overall fixed of the company and therefore the Item 345 is already making a profit.  Lastly, since it was stated that any action taken on Item 345 would not have any substantial impact on the sales of the other product lines, one does not need to consider the possibility of selling Item 345 at a loss and recover that loss by the increase in sales profits at the other product lines.

CONCLUSION

From our analysis above, Lille should lower the price to FF15 in order to benefit the company as a whole.  However, the product is very competitive.  The company has to prepare a strategy to make this item profitable.  We have prepared a long-term analysis for item 345.  Our analysis shows that Lille shall lower the price and try to force some competitors out of business.  As a result, Lille can gain more market share at a high contribution margin.  The following is our long-term analysis.

Assumptions:

• The industry total for item345 keeps growing at a rate of 10%.
• Inflation rate is 2%.
• Same costing system is used throughout the industry.
• Lille Tissages has unlimited capacity.
• Interest rate = 10%, (r = 0.1).
• Competitors’ main source of income is from item 345.
• Total department fixed cost is 487125.

Based on the above assumptions, we analyze the possible outlooks of item345 for three different pricing schemes.  The three schemes are: 1) FF20 for the next four years.  2) FF15 for the next four years.  3) FF14 for the first two years and FF22 for the last two years.  As shown in the following graph, scenario 3 can generate the most of operating income.  Operating income is calculated as total contribution margin minus total department fixed cost.  In addition, scenario 3 has the highest NPV among three scenarios.  Clearly, Lille Tissages should adapt scenario 3 as its long-term strategy for item 345.  Please refer to Exhibit 5 for detail calculations.

In Scenario 3, Lille Tissages lowers the price to FF14 for 1997 and 1998 to gain more market shares.  Since Lille’s competitors all have higher costs and some of them are in tight financial straits, its’ competitors will be driven out of business if they cannot follow the price reduction in the first two years.  As a result, Lille Tissages can absorb their market share and raise the price to FF22 at the end of 1998.  However, some of Lille’s competitor ought to survive, but they are small and have limited capacity.  As the supply reduces while demand increases, the price of item 345 will increase.  This is the reason why Lille Tissages can raise the price and gain more market share in 1999.  The Lille Tissages’ estimated market share is 35%, 40%, 45% and 45% for 1997, 1998, 1999 and 2000, respectively.

Exhibit 1 Item 345, Prices and Production, 1991-1996

Exhibit 2 Cost Categories in Producing Unit of Item 345

 
Exhibit 3 Calculation of Short-term Analysis

Exhibit 4 Desired Selling & Administrative Expense Allocation Calculation

Exhibition 5    Calculation of Long-term Analysis

Copyright @ Andrea Kao, Cornell University
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