This case study, if you have the AQA Business Studies for AS, is on page 130. The main topic this case study is based on is integrated finance, cash flow problems, profit margins, overdrafts and ways of increasing profit.
DeDeLicious Ltd produces luxury chocolates that are sold mainly through independent stores and delicatessens. The business was set up in 2003 and its head office is in the centre of Oxford. The company’s turnover this year is expected to be £400,000. It’s net profit margins have generally been around 20%, until recent increases in the cost of milk and pay increases for staff squeezed them to 12%. JoJo Salter, the managing director, is also concerned about the cash flow difficulties that the firm has experienced recently. It’s main customers have been slow to pay for the company’s products despite DeDeLicious reminding them that payment was due on several occasions. JoJo has talked to a bank that provides a factoring service, but dropped the idea when she realised that its charge would amount to 6% of revenues of the business. As she told her finance manager: ‘That will halve our profit margins!’ JoJo is having sleepless night about the financial situation because the company already has a big overdraft.
1) What is meant by the term overdraft?
An overdraft is a short-term borrowing from a bank; the business borrows only as much as it needs to cover its daily cash shortfall.
2) Excluding the possibility of factoring, calculate the company’s expected profits for the year.
400,000*0.12 = £48000
3) Explain one way in which the company might increase its profits.
DeDeLicious, to increase profits, can change the distribution channel they are using. At the moment, they are only going to independent stores and delicatessens. By expanding their channel to wholesalers will help make their products more available to consumers. However, this means DeDeLicious will be mass marketing therefore will have to increase competitiveness. As their prices are premium, they will have to rethink their marketing mix to help adapt their business and product to bigger and more competitive markets.
4) Analyse two ways in which DeDeLicious might improve its cash flow.
Already, taking an overdraft out is out of the question as they are already using a big overdraft and therefore will have a big interest rate on that overdraft. Therefore, it may be better if the business removes the overdraft. The first method is to use a loan, which will give the business an ‘injection’ of cash improving cash flow. The interest rate won’t be as high as they are on an overdraft and will be more of a long term solution to their cash flow problem. The second method involves using tighter credit control. Although this may the customers less happy, it is vital for DeDeLicious as they have numerous customers being very slow with their payments. However, this also may stop customers in future from buying for DeDeLicious: customers only came to them because of the casual credit they offered.
Overall, I think DeDeLicious should use a loan to improve their cash flow. Because tightening credit control may dissatisfy customers, the loan is the best option as it deals both with the cash flow problem and doesn’t have a negative effect on the customers. Although tightening credit control won’t cost the business a penny, it may put customers off in future which could result in another cash flow problem: something DeDeLicious do not want.
5) Should improving its cash flow be more important for DeDeLicious than improving its profit margin? Justify your answer.
Cash flow and profit margins are both extremely important within a business. The Cash flow for DeDeLicious has had problems which is why it’s a sensible option to improve it. However, the profit margin for DeDeLicious has dropped from 20% to 12% (40% drop) or even 6% (70% drop) if JoJo decides to debt factor to increase cash flow.
The cash flow firstly is resulting in the business having to pay for interest from an overdraft, which is quite high. If they don’t deal with the cash flow problem, the overdraft would get bigger and bigger (its already big) and therefore the interest would increase as well. The problem would get worse. However, their profit margin is on a worrying decrease due to cost of milk and pay increases for staff. If the profit margin keeps decreasing, the cash flow will get worse too. The profit margin has a knock on effect to the cash flow. With a profit margin of 12% meaning £48,000 expected profit for this year, the business should decide whether they think improving the profit margin provide the cash to get DeDeLicious out of the cash flow problem. If not, it may be best to forget about the profit margin and just think about the cash flow.
The profit margins have decreased because they have kept the prices of their chocolates the same while the costs to make them has gone up. They could either place the increased costs onto the final price, which may affect sales depending on how elastic their chocolate is. Mass marketing the product by choosing a different channel is well out of the question if they decide to do this as the higher premium price will make DeDeLicious not competitive at all.
Ultimately, I think DeDeLicious should concentrate more on cash flow than profit margin. To improve profit margin, it will take a longer term approach as you can’t just change costs and price in an instant. The short term problem is the cash flow, which the business should deal with straight away. There are many methods DeDeLicious can perform to improve cash flow: Loan, capital investment, personal finance, trade credit and debt factoring, they have the options. The low profit margin will mean the cash coming in from the business won’t be as high as expected. The main thing they need to know is that they are still making a profit, of 12%. If they get the cash flow into the positive, they can then put their efforts into improving the profit margin, which will secure the cash flow even more.