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Text & Cases

Robert Simons
Harvard Business School, Boslon

Contributors:
Antonio Ddvila
IESE, University of Navarra, Barcelona

Robgrt S. Kaplan
HarvarU Busine.ss School. Boston

Pearson Education International

Upper Saddle River, New Jersey 07458
 0: H P T R

Building a Proflt Plan

f)rofit plans are the principal tools that managers use to price their business and
I operating plans, make ffade-offs between different courses of action, set
performance and accountability goals, and evaluate the extent to which business
perfomrance is likely to meet the expectations of different constituents.
The terms profit plan and budget are often used interchangeably. A budget refers
to the resource plans of any organizational unit that either generates or consumes re-
sources. The ter:n profit plan is reserved for units that generate profits-stand-alone
business units that generate and are held accountable for both revenues and expenses.
Thus, managers might refer to the budget of the maintenance department (which gener-
ates expenses, but no revenues), or to the budget of the sales-order department (which
generates revenues without full accountability for expenses), or to the profit plan of a fi-
nancial services business (which has full accountability for sales, operating expenses,
and profit).
Regardless of terminology, the preparation of prof;t plans and budgets follows a
consistent pattern in most organizations. Several months before the beginning of each
fiscal year (the normal twelve-month operating cycle of the business), managers develop
their profit plans or budgets. The objectives of this planning Drocess are tfueefold:

. To lranslate the strategy of the business into a detailed plan to create value. Tltis
process requues managers to agree on assumptions, evaluate strategic a-lternatives, and
arrive at a consensus regarding a business strategy and its ability to satisfy the demands
of different constituencies.
. Tb evaluate whether sfficient resources are available to implement the intended strat-
eg),.Companies need resources to fnance their current operations (operating cash) and
to invest in new assets for future growth (investment cash).
' Tb create a foundation to link economic goals with leading indicators of strategy i1np1s-
mentation. To implement strategy successfully, flnancial goals must be linked with key
business input, process, and output measures.

To build a profit plan, managers need to answer three different questions relating
to the economics of their business.
First, managers must ask, does the organization's strategy create economic value?
Strategies may sound attractive when described by proponents in bright words and col-
orfrrl phrases, but strategies need to be translated into accounting numbers to evaluate
how they actually create value. Does it pay to invest in a new strategic opporhrnity?
How attractive are different strategic alternatives? Boston Retail has been successful
with its line of clothing for women college students. However, the fashion market
 BUILDING A PR.oFIr Puqn 79
CHAPTER
'

FIGURE 5-1 Three Wheels of Profit Planning

Cash Wheel

Profit Wheel (";?T:1"

so,rceiRobertSimons,..Templat6forProfitPlmiog',,Boston:HmrdBusinessSchoolCase9l199l:032.1998.

Theprofitplanprovidesinformatiolontheeconomicresourcesavailabletothe
companyandhelps**ug",.*aluatethetrade-offsfacingthem.Differentstrategiesre-
opening new
Retail, the inveitment plan for
quire different investm#ts For Boston to the product
the tu-" fturr neef! to add furniture
clothing stores in New York is not
line.Perhapsmanagerswo,rafiketoi"ve'tinallofthesealternatives'butresources
arelimitedarrdmanagersareforcedtolaketrade-offs.Itisnoteasytochoose:Some
expansion' whereas others may
pre-
mana ay favor geographical
fer to
 CHAPTER5 BUILDING A PROFIT PLAN 8I

FIGURE 5-2 The ProfitWheel

Cash Wheel

Profit Wheel

managers'beliefs about cause-and-effect relationships. For example, managers may de-

cide to increase the level of advertising if they believe that it will cause a significant in-
crease in the level of sales. Similarly, they may invest in training for their employees if
they believe that this expenditure will improve customer service or increase quality. Fi-
nally, the profit plan captures the commifinent of managers to an intended strategy. For
example, the merger between Chemical Banking Corporation and Chase Manhattan
Corporation reflected the belief of managers in these two businesses that the banking in-
dustry had untapped economies of scale that the new company could capture.
 CHAPTER 5 BUILDING A PROFIT PLAN 83

EXTIIBIT 5-1
Boston Retail
20X1 Operating Results with Key Assumptions for 20X2
2OX1 ACTUAL
(x ruouseNos
on oou-nns) KEY ASSI.A{PTIONS FOR 2OX2

Income Statement
$9,200 107o sales growth
Sales
Costs of goods sold 4.780 sarrrc Vo of sales as 20Xl
Gross margin 4,420
Wages and salaries 1,530 4Vo fitowth
Rent and facilities 840 57o growth
Advertising 585 smne Vo of sales as 20Xl
Administrative exPenses 435 sarrc Vo of sales as 20Xl
Interest 72 estimated at 65
DePreciation 57 add depreciation of new assets

Training 38 2.5Vo of wages and salaries

Other 54 4Vo growth
809
- Profit before taxes
- Income tax 283 35Vo ofprofit
Net profit $ s26

. KEYBALANCE SIIEET FIGURIS DECEMBER 3I,2OX1 KEY ASSUMPTIONS FOR 2OX2

Assets
Cash $ 208 Cash stay at same a/o level of cash expenses
will
Accounts receivable 255 Accorrnts rrceivable at same Volevel of sales
In','entory 985 Inventorl' at same % of cost of goods soid
Property, plant, and equipment 1,854 Property, plant, and equipment increases by new
investment
Other assets 325 Other assets :upby 5OVa
Total assets $3.627

Liabilities
Accounts payable $ 209 Accounts payable at same Vo of cost of goods sold
Bank loan 1,180 Pay back dcbt of $100,000
Stockholders' equity 2.238
Total liabilities and
stockholders' equity $3,627

generate proflts that are reinvested in to generate more sales. Over time, alrnost
assets
every decision in a company impacts fhe level of sales. However, managers consider
most carefully those decisions that have direct influence on sales during the current
planning period, such as:
 CHAPTER 5 BUILDING A PROFIT PLAN 85

Step 2: Forecast Operating Expenses

After the expected level of sales is determined, the next task for managers is to estimate
operating expenses. To make this estimate, different categones of operating expenses
must be anal,yzcd differentl-v.
The first category of operating expense is variable costs. As the name suggests,
variable costs vary proporttonolly with the level of sales or production outputs- Variable
costs are typicaliy estimated as a percentage of sales. To do so, managers must assume
that the cause-and-effect relationships between inputs and ouputs are constant over the
relevant range of sales. That is, an increase in sales volume is assumed to lead to a pro-
portional increase in the usage of inputs. Raw materials is an example of a variable cost
in a manufacturing firm. If sales .rolume of a particular product increases by IOVo, we
can expect the level ofraw material inputs to increase by 107o. Interest expense to cover
short-tirm loans in a bank is another example of a variable cost. The more short-term
loans that the bank makes to its customers, the more interest it earns (revenue), but also
the more interest it pays to borrow that money (variable costs)'
In forecasting variable costs, managers must detennine the actual percentage num-
ber that relates each category of variable costs to sales. For example, managers may de-
termine that material costs can be set ai 21Vo of sales, labor costs at l8%o, enetgy costs at
4% of sales, and so on. In most cases, a lower cost percentage is preferred (unless re-
ducing variable costs forces higher fixed costs). There are several ways in which vari-
able costs can be reduced as a percentage of sales:
. Taking advantage of economies of scale (e.g., installing one large machine in place of
three imaller, liss-efficient machines) and economies of scope (such as combining
distribution channels for different products to eliminate redundant or underutilized
resources)
. Improving operating efficiencies (for example, re-engineering or streamlining rvork
flows to do the same work with fewer resources)
. Bargaining with suppliers to negotiate Icwer pnces
. Redesigning products to lower their cost of production
. Increasing prices3

The second category of operating expenses is nonvariable costs. As the name im-
plies, norwariable costs do ruot vary directly with the level of sales. However, it wotrld be
i -irtut" to think that they do not vary at all (thus, we avoid calling them fixed costs).
These costs are typically large and have become a higher percentage ofthe operating ex-
penses of most companies in recent yeals. Nonvariable costs are of three types:
. Committed (or engineered) costs. Some expenses are determined by previous manage-
ment decisions and, therefore, are not subject to discretion during the current proflt
planning period. Depreciation is usually a committed cost because it depends on past
investmint decisionJ and company accounting policies. The salaries of managers, engi-
neers, and long-term employees are normally also committed costs, as is the cost of a
long-term lease.

3
This altemative reduces variable costs in percentage terms because sales revenue-the denominator-goes uP
 CHAPTERS BUILDINC A PROFIT PI..AN 87

profit is the flnancial measure of ihe economic value that is available for distribu-
tion to the residual claimants-equity holders-or for reinvestment in the business.
Proflt is the most important number in evaluating the financial performance of any
company.

Step 4: Price the Investment in Nerv Assets

When managers have agreed on expected sales, operating e)".penses, and profit numbers,
they have created the most important part of a proflt plan: the expected income state-
ment. However, the process of translating strategy into economic value does not end
there. To finish the profit plan, managers must look at the required level of investment in
new assets, including working capital such as inventory and accounts receivable-
As the recursive profit wheel shows, the predicted level of sales is itself deter-
rnined by the level of assets available to generate those sales. Therefore, managers must
decide the levels and types of investments that are required to supPort dbsired sales (and
strategies). At this point in the process, assumptions about the levels and types of assets
needed to support the prolit plan rnust be backed up by an asset investment plan. The
investment plan is another important tool to implement strategy.
There are two main types of assets for which managers must consider investment:
operating assets and long-term assets. (The cash wheel that we study in the next
section is used to determine the investment in operating assets needed by the com-
pany.) The proposed investment in long-term productive assets is called the capital
investrnent plan. A capital investment plan must reflect and support the intended
strategy because it often commits the company to a limited set of strategic alterna-
tives. For example, in the late 1970s, Intel Corporation decided to invest resources in
the design arrd production of microprocessors and to redrrce its focus on commodity
computer memori.es. Intel's capital investrnent plan included resoutces to develop mi-
croprocessors and to build manufacturing facilities. The plzrn refiected managernent's
new strategy and ensured that sufficierrt resources would be in place to make that strat-
egy a reality.
Exhibit 5 - 2 present s the 2OX2 asset investment plan for Boston Retail, assuming
no major changes in strategy. Anticipated growth in the business will require larger bal-
ances in accounts receivable ($26,000) and inventory ($98,000), although these require-
ments will be partially flnanced by an increase in accounts payable ($21,000). Some
store displays also must be replaced and updated. Two capital initiatives are also
planned: (1) a new computerized accounting system that will integrate purchasing, in-
ventory record keeping, and SKU (stock keeping unit) management, and (2) an expan-
sion of the warehouse to accornmodate the increase in,business.
Before we finish ourbrief introduction to the asset investment plan, we must men-
tion hovr companies assess whether any single capital investment proposal is financially
attractive. The most corlmon investment evaluation technique is net present value. Fi-
nance books discuss this technique in depth because it is a basic tool in the flnance tool-
box. Any investment proposal that is included in the capital investment plan should meet
these financial criteria or be included for compelling strategic reasons. We will have
more to say about this in Chapter 7, when we discuss in detail how to create a capital in-
vesfinent plan.
 CHAPTER.5 BUILDTNC A PROFIT PLAN 89

Sensitivity Analysis at Allied Signal

Lawrence Bossidy, cEo of Aliied Signal, has strong opinions about proflt planning:
"one of the first things that struck me when I came here was that it was more or
less accepted practice that you put a pian together and then rnissed it. we don't
need meaningless targets. We neec an operating plan that recognizes that underly-
ing assumptions are often wrong and that provides options when that happens.
"Good flnance people are ihe ones who can help give real meaning to operat-
ing plans. when you say you're going to get a 6vo improvement in productivitv,
they're the ones who are supposed to ask where, What are the projects? When are
they going to be done? How much mcney are they going to be providing? If we're
going to grow by 5Vo, they ask the tough questions: Where are we going to grow?
What products are going to grow by 5vo2 How are we going to get price increases?
Good financial involvement is critical in constructing a sound operating plan; it re-
ally drives at the particulars."

Source: Noel M. Tichy and Ram Charari, "The CEO as Coach: An Interview with Allied Signal's Lawrence A.
Bossidy," Ilarvard Business Review 73 (March-April 1995): 68-7S.

CASH WHEEL
Before a profit plan can be accepted as feasible, managers must forecast whether the
company will have enough cash to operate (cash wheel) and whether the return to in-
vestors is sufficiently attractive (ROE wheei). If either of these critical consfraints is not
met, then managers must go back to the drawing board and adjust the profit plan.
The cash wheel (Figure 5-3 on page 92) illustrates the operating cash flow cycle
of a business: Sales of products and services to customers generate accounts receivable,
which are eventually turned into cash; this cash is used to produce inventory, which
in turn can be used to generate more sales. However, depending on the nature of
the business, considerable time can elapse between the moment that the company
disburses cash to purchase inventory and pay operating expenses until it receives
cash from customers for goods and services received. During this period of time, the
company may have to borrow from lenders to cover its ongoing operating and capital
expenses.
Looking at the cash'wheel, we chn understand why a company may need more or
less operatirg cash, depending on its industry and its strategy. High levels of inventory
require more operating cash to finance the inventory. Similarly, if credit terms to cus-
tomers are 60 days instead of 30 days, the company needs to borrow more from the
bank to cover its cash outflows during the additional 30 days. Conversely, a company
can reduce its operating cash by delaying payments to its suppliers, usually by negotiat-
ing better credit terms.
 CHAPTER5 BUILDING A PROFIT PLAN 9I

2OX2 PROFIT PLAN 2OX2 PROFIT PLAN

(oerrursrtc ScENARIo (PEssMIsrIC SCENARIo
2OX2 PROFIT PLAN rsz cnowrn) No cnowru)

$10,120 $10,580 $9,200

5.258 5,497 4.780
4,862 5,083 4,420
t,s9l 1,591 r,591
882 882 882
644 673 585
478 500 435
65 65 65
r09 109 109
40 40 40
56 56 56
997 1,167 657
349 408 230
$___648_ $ 759 $ 427
DECEMBER 31,,20X2

$ 302 $ 361 $ 184

281 293 255

1,083 1,133 985

2,005 2,005 2,005

325 325 325

$ 3,996 $ 4.117 $3,7s4

$ 230 $ 240 $ 209

880 880 880
2.886 2,997 2.665

$ 3,996 $ 4.117 $3.7s4

 CHAPTER 5 BUILDING A PROFIT PLAN 93

must choose to either revise their profit plan

by reducing groyth or, alternatively' they
cash reserves'5
can consider issuing new equity to increaie their
The basic technique ror compotiog the cash whcel is quite simple' The most intu-
itive way to estimate cash requirements
each specific time period. To estimate
time, rnanagers project the cash that
tomers-and the cash that they will disburs
and for committed costs such as interest
following:
cash - Cash received Cash paid to suppliers
Operating
neededduringaperiod_fromcustomersancoperatingexpenses
our personal fir^ances to de-
This is the method that most of us employ when budgeting
termine whether we have sufficient cash
r rent and car payments'
course the name of this cash
You may remember from your fin
use the direct method to estimate
flow method: it is the direct method. comparries often
a week, or a month' For each pe-
cash requirements for short periods of time-a day,
riod, managers estimate thut will be collected (cash inflows) and cash that will be
"urh are larger than cash outflows, then the cash on
faid out (cish outflows). If cash inflows outflows exceed inflows-the
hand increases. If, however, the opposite tolds-cash
must make very detailed
company,s cash position gets *o.t". Sometimes, conrpanies
they may hit cr exceed their fixed
cash forecasts-even aaity-if managers project
that
borrowing limit.
down by the four
Exhibit 5-4 shows Boston Retail's cash plan for 2ox2 broken
(ruarters cf the year. The analysis indicates a small cash shortfall in quarter one'
which
must be covered bY bank borrowing'
To estimate cash needs over longer periods of time-to tie
in with the monthly'
generally use the indirect
quarterly, or yearly profit plan projections-companies
from your financial accounting class)' To
m"tr,oa (this method'should alsoLe-familiar
projected income as shown on the
use the indirect method, managers start with their
profit plan and fcllow four steps to estimate their cash needs'

Step l: Estimate Net Cash Flows from Operations

Asimpletechniquetoestimateoperatingcashflowistouseameasureknownas
and Amorti-
EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation'
cash-based-operating earnings that
zation.It is a rough calculation of nonaccrual-or

5
The sustainable growth rate of any business is defined as

Sustainable growth rate = ROE x (1 - Dividend payout ratio)

whcre the dividend Payout ratio is
Cash dividends Paid
Dividend payout ratio = --- N"t tr""."

a full discussion of the implications an! use of this

Inlerested readers can refer to any standard finance textbook for
formula.
 CHAPTER 5 BUILDING A PROFIT PLAN 95

ingc Boston Reta

flow n Exhibit 5-
to have aPPr
cash flow available to fund growth, repay debt'
pay
tribute any dividends to shareholders' If opening a

$200,000 in working capital, the business

will have
(after tax payments andinterest) to open three new stores, assurning it does not use its

cash for debt repayment, dividends, or other types of investment'

Assets
Step 3: Price the Acquisition and Divestiture of Long'1snn
of investment and cash' At
Different strategies and initiatives will require different levels
new com-
Boston Retaii, the investment plan for 20X2 (Exhibit 5-2)
suggests that the
puter system, warehouse exp^ansion, and store dispiays will require $260,000'
This

EXHIBIT 5-5
Boston Retail
Cash Plan for 20X2
(Prepared using EBITDA)
20x2

Cashatthebeginningoftheyear $ 208

C ash from OP e rati.ng Ac tiviti e s

taxes
Profit after 648
Tax payments 349
Interest pavments 65

Add: depreciation and other noncash exPenses 109

EBITDA I,I7I
-vVo
Chan g e s in rkin g C aP i t al
Decrease (increase) in accounts receivable
(26)
Decrease (increase) in inventory
(e8)
2L
lncrease (decrease) in accounts payable
Cash flow from operating activities 1,068

C as h from Inv e stme nt A c t iv it i e s

Investment in new assets (260)

Cash from Financ in g Activ itie s

Pay back debt

(300)
Additional borrowing required
Tax payments
(34e)
Interest payments _(0'
Total cash flows 94

Cash at the end of the Year $ 302

 CHAPTER 5 BUILDINC A PROFIT PLAN 97

equipment, however, manufacturers disburse most of their operating cash for the pro-
duction and distribution of skis at least five monlhs earlier. As a result, these businesses
need the most borrowing at the beginning of the season, when they have used up all
their cash to manufacture inventory but have not yet received any cash from customers.
Estimating the aggregate or average difference between cash inflows and cash outflows
over the entire year will not reveal the shortfall that occurs before che ski season begins.
Managers in these companies may pay a lot of attention to weekly cash requirements
during the few critical months before the start of the season.
The cash wheel higtrlights the fact that all businesses have a significant amount of
resources tied up in accounts receivable, inventory and other working capital accounts.
As a result, managers must work diligently to accelerate the flows around the cash
wheel, thereby freeing up cash for investment. finarrcing, or operations growth.
CFO Magazine conducted a survey of large public companies in 32 industries to
learn how effectively managers were able to turn working capital into cash. In their sam-
ple, the average company earned $4.2 billion in revenue and generated roughly 9 cents
of cash flow for every dollar of sales. On average these companies collected from cus-
tomers every 5C days, paid suppliers every 33 days, and turned inventory i 1 times per
year. For the largest companies in the sample, the authors of the survey noted a "rule of
30": they collect bills in 30 days, pay bills in 30 days, and turn invento4v in 30 days.
Although all companies can benefit from managing the cash wheel more effi-
ciently, the savings for large companies can be truly significant. For example, Owens
Corning recovered $175 million from managing its working capital more effectively;
General Motors set a goal lor 1997 to find $10 billion in working capital savings.6

ROE WHEEL
Businesses that earn tire rnost profit will be betier off: They will have srore resources to
invest in future opportunities; they will be able to pay higher dividends to investors;
their stock price will be higher; and their cost of debt will be lorryer. Thus, profit can be
considered both a constraint and a goal: A minirnum level of profit is necessary for sur-
vival (a constraint), but more is always better than less (a goal).
Both stock price and dividend payments depend on a business's ability to generate
profits from the invcstments that stockholders make in the business. In the most basic
sense, when a stockholder invests $100 in a firm, the managers of the lirm use the $100
Lo purchase assets, which are then deployed to earn profit for the benefit of the stock-
holder- The critical measure, therefore, is the amount of profit that managers are able to
generate from the $100 investment entrusted to them. If the business generates $20,
profit can be measured intwo ways. First, the business could report a $20 profit-an
absolute measure of success. Alternatively, managers could calculate the retur'n on
shareholders' investment by comparing the profit output ($20) wiih the investment input
($1001. In this case, the return on the stockholder investment of $100 would be ZOVo-a
ratio.

6
S. L. Mintz and C. Lazere, "I-nside the Corporate Cash Machine," CFO Magazine, trrire 1997, 54-62.
 CHAPTER 5 BUILDING A PROFIT PLAN 99

around
As with the profit wheel and the cash wheel, we can work systematically
(see
the ROE wheel to determine if the profit to
plan is adequate meet expectations
Figure 5-4).

Step Calculate Overall Return on Equity

l:
Return on equity (ROD is calculated as follows:
Net Income
ROE:
Shareholders' EquitY

FIGURE 5-4 The ROE Wheel

Cash Wheel ( lnventorv

Invest;ncnts
oPe;'ating
) profit wheel
t1xpenses / in Assets

ROE Wheei ('"ur*r,

 PLAN iOI
CHAPTER 5 B{'JILDINC A PROFIT

5-3 into the for-

pt"ry.l:* numbers from Exhibit
can
For Boston Retail' we P.l:g leverage'
ptni"oiliti asset turnover' and
mula to assess project"a
Assets
v Sales x
Net [ncome :

ROE: --Sul.r-- ^ Assets Shareholders' EquttY

3,996
648 v lo'120 x 2,886
10,120
l'4 : 0.225',F
: 0.064 X 2'5 x
X Asset X Financial Leverage
: Profitability Ratio
Ratio Turnover
Ratio

(* diference due to rounding)

on sales with as-

is projected to earn 6.47o netingome
we can see that the business of these three indicators
,"if" .lf ,.+- i,"lo*uinution
set turnover or z.S -J'i"r""r"r"
yields ROE of 225Vo'

step 2: Estimate Asset utilization are often

T":"nt
ision or profir center..T"g_":., capital em-
for return on
n as ROCE"u'f i"n stands
pattern as above:
CE follows the same

RocE: Ie:Hs1 x c"prffir,)"[

ROCE in different ways'.s

cisely what managers ofiant additional informatton
The detailed de ose a sYS-

about the effective utilizati 5d ecom-

of obtain

break
ation ratios shown and

rhem down into more

detai irXffit HrH'T""',i; *"
Some of the more
20
ROCE Tree are (using
 CHAPTER5 BUILDIi'iG A PROFIT PLAN IO3

and, ultimately, profit. Generally, a higher number is

preferred, indicating that managers
maximutn advantage. Once ROCE and detailed
have used the assets entrusted to them to
the use of the resources un-
asset-utilization ratios have been estimated, managels assess

der their stewardshiP.

Step 3: ComPare Proiected ROE

with tndustry Benchmarks and Investor Expectations
once overall expecied RoE is calculated, managers must compare it to some
bench-
mark or standard io see how it stacks up against competitors and investor expecta-
analysts, and others
tions. Managers are sensitive to the ROE expected by investors,
on investment lead
who monitor the financial performance of their firm. High returns
to high stcck prices and to the willingness of investors to commit additional
finan-
cial resources to support the growth of the firm. Low returns cause the
opposite

result. Therefore, -unug"r, typically know-through discussion with analysts and

company directors-th" p.oE ttrat is anticipated from the performance of their busi-
ness. The returns generated by other simiiar businesses provide an
easily calibrated
yardstick.
For Boston Retail, managers might compare their ROE with other
publicly traded
figures for
fashion retailers such as tne Limited, GAP, and Nike, whose comparative
1997 are as follows:

ASSET FINANCIAL
PROFIABILITY TURNOVER LEVERAGE

2.4Vo 2.1 2.1

The Limited l0.6Vo
8.ZVo 1.9 2.1
Gap 33.7Vo
Nike 25.2Vo 8.7Vc 1.7 l;7
22.5Vo 6.47c 2.5 1.4
Roston Retail

As with the cash wheel, if the expected ROE is not sufficiently high to meet ex-
pectations, it is back to the drawing board to find ways to increase profit or make
better

use ofexisting assets.

Key Financial Measures

Based on our analysis of the principal components of the profit, cash, and ROE wheels,
we can summarize the primary financial measures for any business:

' sales
o profit or net income
. cash flow
. invesEnent in new assets
. return on equity (or ROCE)
. Det income + sales : profitability
. sales -:- assets : asset turnover
 CHAPTER5 BIJILDING A PROFIT PLAN IO5

EXHIBIT 5-6
Boston Retail
Assumptions Underlying Alternative Strategies
ALTERNATTVE 1: GEOGRAPIIICAL EXPANSION INTO NEWYORK STATE

Description of Intended StrategY

Open threr stores in New York state at the beginning of the year

Additional Investment in New Assets

$120,000 in fixed assets per new store (flve years' straighlline
depreciation schedule)
Same investment in working capital as existing stores
$20,000 in advertising per new store

Operating Resubs
Sales per store expected to be the existing average
Cost stn:cture as in existing stores (7o of sales)

aLTERNATTVE 2: ADDING A NEW PRODUCT LINE

Description of Intend.ed StrategY

Introduce premium outdoor furniture proCuct line in Boston Retail's three biggest stores

Additional Inveslment in Nev' As sets

$25,000 per store (flve years' straighrline depreciation schedule)

Sarne investment in working capital as existing product l-ine
$10,000 in advertising Per store carrying futniture

Operating Results
Expected ilcrease in sales Per store with furniture of2Od)o
Expected gross margin as ciothing iine
Administrative costs uP bY l57o
Wages and salaries uPbY 70Vo
Additional cost structure as existing business (7o of sales)

However, economic criteria alone are not enough to fully assess each strategic al-
ternative. Recall our discussion in Chapter 2. hofit plans may look attiactive but actu-
ally deplete the core competencies of the firm, or be at odds with the culrent market po-
sition of the company. During the 1980s and early 1990s, for example, Apple Computer
showed impressive economic pelformance, but the company was using up its advantage
built over the previous years without creating new competitive advantage. The result
was continuous economic problems in the 1990s. For Boston Retail, we could ask our-
selves: Are both of these strategic alternatives consistent with Boston Retail's competen-
cies? (We cover pertbrmance measurement and control systems related to this question
in Chapter 10.)
 CHAPTER' BUII-DING A PROFIT PLAN 107

EXHIBIT 5-8
Boston Retail
Quarterly Cash Plan for 2AX2 for Alternative Strategies
(Prepared by estimating cash inflows and outflows)
STRAIEGIC AXTERNATTVE I
GEOGRAPHICAL EXPANSION FIRST SECOND TI{IRD FOTIRTH
INTO NEWYORK QUARTER QUARIER QUARTER QUARTER

Cash at the beginning of the quarter $ 208 $ 200 s 200 $ 200 $ 208
(cash balance at least 200)

Cash Inflows
Cash received from customers 1.91i 3,588 3,271 4,901 13,673
Borrowing required 758 15 (24) (203\ 546
Total cash inflows 2,669 3,603 3,249 4,698 14,219

Cash Outflows
Cash paid to suppliers i,136 1.930 t,844 2,649 7,559
Cash expenses 752 l,5M 1,236 1,880 5,372
Investrnent in new assets 620 620
Tax payments 94 94 94 94 3'76
Pay back debt 75 75 75 75 300
Total cash outflows 2,677 3,603 3.249 4.698 14.227
Total cash flows (8) (8)
Cash at the end of the quarter $ 200 $ 200 $ 200 $ 2oo $ 2oo

STR,AiTEGIC AXIERNATTVE 2
PRODUCT.LINE E)GANSION FIRST SECOND THIRD FOURTH
INTO FI'RNITURE QUARTER QUARTER QUARTER QUARTER TCTTAL

Cash at the beginning of the quarter $ 208 $ 200 $ 200 $ 200 $ 208
(cash balance at least 200)

Cash Inflows
Cash received from customers 1,591 2,894 2,640 3,9s4 tr,079
Borrowing required 388 (77) (93) (218) _---
Total cash inflows 1.979 2.8t7 2.547 3.736 tt.o79
Cash Outflows
Cash paid to suppliers 908 1,509 t,440 2,091 5,948
Cash expenses 565 t,129 928 I,4IL 4,033
Investrnent in new assets 33.I 335
Tax payments tu LM 104 tu 416
Pay back debt 75 75 75 75 300
Total cash outflows 1.987 2.817 2.547 3.681 _1Jp32
Total cash flows (8) 55 47
Cash at the end of the quarter $ 2oo $ 200 $ 200 $ 255 $ 2ss