Lille Tissage S.A.
One of the largest companies in the French textile industry is Lille Tissages, S.A. It is located in Lille, France. It produces different textiles and produces item 345 using equipment that cannot be used for any other item. In 2002, the company decided to raise prices to finance future expansion. LT is a profitable and financially healthy company and management believes that it could make the necessary changes in terms of price to affect its long-term goals.
LT enjoyed a 35% market share from 1998 to 2001. In 2002, its market share dropped to 30% and in 2003 it dropped to 20%. LT has priced itself competitively with the market from 1998 to 2001 but has increased price per meter to FF 20 in 2002 and sustained it in 2003 thereby resulting in the market share drop.
However, the reaction of the market to this strategy has alarmed LT’s management. In 2004, relevant company officials were on the brink of deciding the direction to take with respect to product 345.
Management believed that the industry would produce 700,000 meters in 2004. LT could take advantage of this by mirroring industry price to FF 15/meter that would bring their market share to 25% (or 175,000 meters). If prices were not reduced, management believes it will only get 11% of the market.
Figure 1 Lille Tissages Market Share and Selling Price for Item 345 (from case data)
Questions
1. Should Lille Tissages, S.A. lower the price to FF15.00/m? (Assume no intermediate prices are being considered)
The CVP analysis requires the identification of variable and fixed costs. These items are listed below.
Variable Costs:
Direct labor
Materials
Material spoilage
Direct department expenses
Fixed Costs
Indirect department expenses
Selling and administrative expenses
General overhead
After identifying and summing up the costs, we determine the Contribution Margin (CM) at varying levels of production. Contribution margin is the difference between selling price and variable costs. The calculated CM and the value to LT for all levels of production at selling prices of FF 20 and 15 per meter are shown below.
For 2004, management believes that it can sell either 125,000 meters of item 345 at FF 15/meter or about 75,000 meters at FF 20/meter. The calculations above show that at 75,000 meters and at FF 20/unit, the contribution value of item 345 is FF 990,000 while the alternative scenario at a selling price of FF 15/meter provides a contribution value of 1,063,750 from a total sale of 125,000 meters. That is a difference of FF 73,750 if LT is to sell item 345 at FF15/meter.
The obvious conclusion is for LT to lower its prices to FF 15/meter. This is to have the following effect:
Positive contribution of FF 73,750
Increase in market share from 20% (2003) to 25% (2004)
Sustained level of competitiveness. LT pricing their item 345 at industry prices would convey a sense of competitiveness for LT and given their product superiority, might translate to a recovery of market share.
2. If the department that produces Item 345 was a profit center and if you were the manager of that department, would it be to your financial advantage to lower the price?
If I had the responsibility of making decisions that affect revenues and costs of the department that produces item 345, I would not agree with the lowering of prices for the product. This is supported by the calculations shown below.
A profit center would always seek to find the largest profit by controlling costs or increasing gross revenues. Since we cannot control the costs here, our only choice is to pick an option between selling prices of FF 20/meter or FF 15/meter. Based on the calculations above, the item is only feasible to produce if it sells at FF 20/meter. At FF 15/meter, the item creates revenue losses (the selling price cannot recoup both variable and fixed cost components). At the expected volume of 75,000 meters, selling at FF 20/meter gives a net income of FF 15,000 while selling at FF 15/meter gives a net loss of FF 360,000. Any profit center manager will not agree to reduce prices of this item!
3. Is there any possibility that competition might raise their prices if Lille Tissages, S.A. maintains its price of FF20.00/m? If so, how do you take this fact into your analysis?
If LT retains its price of FF 20/meter, it is conceivable that competitors would raise prices under the following scenarios:
The loss in market share of competitors (and the gain of market share for LT) is offset by the net income generated from competitors selling price increase to FF 20/meter. If this happens, it is likely that LT will regain its market share, possibly move up to 35% (1998 levels) and the industry and LT will have one price for item 345.
Quality of item 345 from competitors become at par with LT such that an increase in price will not result in them loosing market share.
Cost of production increases such that a selling price of FF 15/meter creates non-feasibility for the production of item 345.
In all cases, competitors must examine their costs structures to determine their variable and fixed costs and most importantly, the contribution margins of producing item 345 at different output levels.
4. At FF15.00, will Lille Tissages, S.A. earn a profit on item 345? How do you decide?
LT will only make a profit on item 345 if it sells the product at a higher level than the total cost of the product. This is where an understanding of CM comes into light.
If we consider the total revenue minus total cost approach, selling item 345 at FF 15/meter is a losing proposition (as shown above). No profit center manager will agree to lower the price of the product from FF 20/meter to FF 15/meter.
However, if we look at the contribution margin, we know that selling item 345 at FF 15/meter will cover the variable cost components of the product. It cannot cover all fixed expenses, most of which are higher than the total direct costs of producing item 345.
For example, selling and administrative expenses are almost at the same level as the direct component costs. For item 345 to be sold at FF 15/meter profitably, the allocated selling and administrative costs must be studied and properly assigned. If this is the “true” selling and administrative cost of item 345, then there is no resolution but to sell the item at FF 20/meter. But if the selling and administrative costs can be re-allocated (i.e. through activity based costing), then item 345 may be produced by Lille Tissages profitably.
Figure 2 Direct Variable Cost and Selling and Administrative Cost Comparison
References
Accounting Principles II: Cost-Volume-Profit Analysis. Retrieved from http://www.cliffsnotes.com/study_guide/Cost-Volume-Profit-Analysis.topicArticleId-21248,articleId-21229.html Retrieved on June 12, 2012
Accounting Coach: Activity Based Costing. Retrieved from http://www.accountingcoach.com/online-accounting-course/35Xpg01.html Retrieved on June 12, 2012
European Commission: Textiles and Clothing Industry. Retrieved from http://ec.europa.eu/enterprise/sectors/textiles/index_en.htm Retrieved on June 12, 2012
Investopedia: Profit Centers. Retrieved from http://www.investopedia.com/terms/p/profitcentre.asp#axzz1xmm6Qkmh Retrieved on June 12, 2012
