Fence Co. Case

Fence Company Ltd.

Robin L. M. Cheung Student #0024338

For Professor D. Armishaw A621 Managerial Accounting

McMaster University

Fence Company Ltd.

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Established in 19x5, Fence Company Ltd. is the brain-child of two brothers, Robert and Morris Wood. Catering to the residential housing market, FC is a low-cost provider of wooden fences. After a financially distressing year, FC requires an overhaul to its cost and pricing structure, its marketing, human resources, and its operations—indeed, it has yet to establish an overall strategy congruent with its competencies and resources. The current financial and strategic position of FC was evaluated using various formal systematic models, such as Nadler and Tushman’s (1997) Congruency model, Porter’s (1985) Five Forces, and company analysis (SWOT). These models point to a best-cost provider strategy supported with expanded marketing and seasonal work teams. Fence Company Ltd. must no longer compete solely on price but also on quality and brand, which can allow pricing at a premium. Fence Company must first reduce its fixed costs. The secretary awarehouse expenses should be eliminated and replaced with cellular telephone and delivcosts. Better controls are required for the tools and machinery to avoid additional expenses following years. Sales commissions should be changed to encourage more sales, but of smaller one-house projects rather than large groups. The volume discount to group sales should be eliminated, as it resulted in negative earnings. As a benchmark, FC should aim to return 8% on investment—a reasonable target given the current economic climate.

Fence Company Ltd.

BBBackground aacckkggrroouunndd Equally owned by two brothers, Robert and Morris Wodd, Fence Company Ltd. (FC) Was incorporated in March, 19x5. Catering to the residential fence market, it offers volume discounts for group purchases, guarantees to repair defective fences at no cost, and has a capacity of 36,000 metres per year.

Industry Analysis IInndduussttrryy AAnnaallyyssiiss The Canadian fencing industry, along with all residential construction industries, has been hit hard since the beginning of the 19x0 recession. In fact, Industry Canada cites this period as being the “most prolonged period of stagnation…since the Great Depression.” This stagnation has been mainly attributable to cyclical, demographic, and structural factors. Owing to excess capacity generated during the previous decade and the concurrent slow growth in the overall Canadian economy, Fence Company faces a particularly difficult challenge in the next few years.

See Appendix 1 for a comprehensive industry analysis.

The Problem TThhee PPrroobblleemm Fiscal year 19x5 was a difficult one for Fence Company. It is now late March, 19x6, and the Woods must make some modifications to their current business model in order to remain viable. The 50,000 metres projected for 19x6 is unreasonable, since this projected volume exceeds capacity by 39%.

Company Analysiss CCoommppaannyy AAnnaallyyssiis See Appendix 2 for complete Congruency and SWOT analyses. The use of formal models facilitates systematic development of feasible alternatives. In order to propose alternative courses of action that fit FC’s specific context, its current internal and external situation, its competitive environment, its strategic objectives, and its competencies and resources must be considered. General recommendations made at the generic level without regard for specific company context are therefore avoided since all recommendations take FC’s specific context into account.

Fence Company Ltd.

Practical As umptions PPrraaccttiiccaall AAsssssuummppttiioonnss

ssumed

A number of assumptions were integrated into this financial model: Variable Costs are Linear This model assumes that variable costs, such as materials and labour, are linear over the relevant range; that is, there are no volume discounts on material, and no additional costs to hiring supplementary teams. 100-metre Average Fence Length The model assumes an average house to require 100 metres of fence. Obviously, many houses will require more or less fencing; however, all orders were ato comprise 100 linear metres. Constant Selling Price The model assumes a non-negotiable pricing of $12 per metre for base scenario. This conservative assumption assumes that sales closes each sale at the minimum expected $12 per metre price point. Each sale is assumed to close for the same price. Similarly, in each proposed scenario, all orders are presumed to be closed for the same selling price per metre. Non-adjacent Multiple Orders In the case of one-, two-, and four-house multiple orders, the $120 machine transportation fee is assumed to apply to each order. Further, multiple orders are presumed to be non-adjacent for the purposes of calculating length of fencing. Adjacent orders would result in reduced machine transportation costs and reduced materials cost for the shared portions of the fences. Non-Unionized Labour Labour is presumed to be non-unionized. Although management is legally prohibited from interfering in the formation of unions, labour force is presumed to be non-unionized. This results in lower wage costs, easier lay-offs, and higher productivity. Minimum Salaries Fixed The required $12,000 salary for secretarial staff and $15,000 per owner are assumed to be fixed and constant. Although including the $15,000 per owner is controversial given the business is a limited partnership, this is presumed to be an absolutely necessary minimum required return for the purposes of analysis. Return on investment (ROI) is therefore assumed to be over and above the required salaries. Snow-Ploughing is Incremental The model assumes that the $500 per winter month truck rental expense and its associated revenues are incremental to FC’s core competency of fence construction. It is therefore excluded from the base scenario. 5% Premium for Just-in-Time Deliveries Because supplier premiums for JiT on-site delivery of required materials was not specified, a 5% premium was assumed for the purposes of developing a financial model.

Fence Company Ltd. All Teams Share One Truck The model assumes that one truck is used by all teams. Once the team and materials are delivered to the site, the truck can leave to service another team (during the multi-team summer months). Cellular Telephone Costs $100 per month In order to evaluate the feasibility of replacing the full-time secretary with cellular telephones for the two owners, the cellular telephone was assumed to cost $50 per person per month, or $100 per month.

Financial AAnalysis FFiinnaanncciiaall Annaallyyssiiss FC’s current proposed 19x6 budget is detailed in Appendix 3. According to their planned allotment of work teams (outlined in Appendix 3), assuming an average fence order-size of 100 metres, maximum capacity is estimated at 360 houses (orders) per year. Base Scenario Not Viable Given its current cost and pricing structure, FC is far from able to break even with its most conservative offer, the one-house, 100-metre order. This order gains FC an estimated contribution margin of $118 per house. In order to break even relying entirely on 100-metre orders, FC would have to build 78,814 metres of fencing, or over 788 house orders. With a maximum capacity of 36,000 metres (360 houses) per year, FC is not able to remain viable with its current 100-metre pricing structure. Its most generous offer, a four-house, 400-metre order offers increased sales commission and a volume discount. This pricing structure results in a negative contribution margin; every four-house, 400-metre order loses FC approximately $152. The Solution: Cut Costs Fence Company must align its cost and price structure more closely with its capabilities. Given its estimated production ceiling of 36,000 metres in 19x6,

Alternattives AAlltteerrnnaatiivveess Differentiate the Product The Woods have undertaken Porter’s low-cost provider strategy by default. The focus is on volume, attracting clients on the basis of price. Although the Woods brothers guarantee quality, they have not delivered it. This morphs the guarantee from an asset to a liability. FC must segment its market and position itself to target it most effectively. In a market with low barriers to entry, a price war inevitably results in only one winner—the customer. FC must not rely on low-cost cut-throat pricing to attract customers. It can focus either on a quality product, or specialty fences with features not offered by competitors. Without a formal research and development department, however, FC is limited to offering prefabricated fence products. As such, new entrants also have access to the same product base. A novel way of developing a new product without R&D would

Fence Company Ltd.

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be applying fencing to porches and verandas in fashionable ways. This would particularly appeal to the luxury homeowner who is less price-sensitive. Develop new Products FC could erect barriers to entry by specializing in a particular type of fence. Intellectual property laws would protect product innovations provided their technologies have not been presented to the public in a disclosing nature. The cost to protect a technology with a patent, however, would be estimated in the tens of thousands; however, with FC’s estimated 19x6 revenues of $436,000, establishing a research and development division and acquiring and prosecuting patents is far out of reach. The company’s core competencies lie in assembling fences fparts, not developing new ones. Realign Business as Best-Cost Provider Rather than try to serve all segments of a heterogeneous market and compete solely on the basis of price, Fence Company should identify its target segments and pursue a best-cost provider strategy, emphasizing delivering its previously-stated value proposition of quality

workmanship while striving to optimize cost structure to maintain competitiveness with new entrants. Cash out or Sell the Business The Woods brothers have made little capital investment and have nfirm commitments, such as collective agreements or long-term leases. Potential new entrants also recognize the relative ease of exiting the industry, increasing competitiveness. If FC wants to become competitive, it must make a new value proposition that results in increased benefits and presents potential new entrants with a barrier to exit.

Increase Advertising Little (1970) describes a sigmoidal mathematical relationship between advertising expenditure and short-run sales response. No advertising efforts were under way in 19x5 and none were planned for 19x6. FC’s sales would, therefore, increase exponentially with sufficient advertising expenditures. This level would be determined by Little’s ADBUDG (1970) function calibrated with inexpensive marketing research information. Increase Teams to meet Demand Although FC currently has a capacity of 36,000 metres, the Wood brothers estimated the market to be 50,000 metres. Because FC is not bound by a collective agreement barring hiring seasonal short-term workers, FC could easily hire seasonal or student workers as required. Cut Costs FC currently has a high proportion of fixed costs that cannot be justified by expected revenues. A full-time secretary at $12,000 per year can be replaced by a cellular telephone for each of the owners for $1,200 per year. Instead of stockpiling inventory in a warehouse, FC can negotiate Just-in-Time delivery agreements with its suppliers. At 5% additional cost, this still represents a net savings of $16,140 over base (assuming capacity production at 36,000 metres per year). Merge with Another Company Fence Company could elect to merge with another company. This could be either a contracting/construction company or a supplier (vertically integrating) or with a deck or

Fence Company Ltd. veranda specialist (horizontal). This strategy would allow FC to exploit economies of scale and additional resources; however, the brothers would lose a significant amount of control and identity.

Recom endations RReeccoommmmmeennddaattiioonnss Fence Company should establish a best-cost provider strategy and support it with adequate marketing and human resources. The Woods estimated the total 19x6 market size to be 50,000 metres (500 houses). Although their current team configuration cannot support this demand, FC could supplement its workforce during the summer months and access additional low-cost student work. Best-Cost Provider Strategy The best-cost provider strategy aims to provide the best possible product at the best possible price. While this seems to be a contradiction, it really represents a balance. The Woods should ensure appropriate product quality by ensuring better controls. This can be accomplished through establishment of more rigorous and formal standards. This would represent an additional fixed cost; however, once a standard has been developed, variable costs are required to implement it. Alternatively, the Woods could consider pursuing a niche strategy. They could cater to upscale luxury homeowners, who would be willing to pay a premium for attractive quality fences or to agricultural clients who would require large orders on the same site and regular maintenance contracts. Cut Costs Regardless of the strategy FC chooses, however, it must reduce its costs. The current cost structure requires production of 78,800 metres of fence to break-even. This not only exceeds current capacity, but it also exceeds estimated market demand. Wage rate is assumed to be minimum wage and therefore cannot be reduced legally. Materials costs are assumed to be at their minimum assuming that FC receives volume discounts already and stockpiles material in the warehouse. The warehouse expense, however, could be removed. This would reduce the need for a truck to transport materials. It is estimated that FC would then be required to pay a 5% premium for Just-in-Time delivery of materials and for ordering in smaller quantities. The secretary can be replaced by two cellular telephones—one for each owner. Although the secretary may be able to accommodate more callers, the current market size of 500 houses distributed evenly over the nine-month work term would translate into less than three calls per day. Assuming the owners are not actually involved in the unskilled labour, three calls per day can easily be handled by the two owners. This represents a net savings of $10,800 per year—a 90% reduction in the relevant costs. Because all tools from the previous years must be replaced, this expense is included in all estimates; however, the new tools must be controlled better. This could be accomplished by issuing each worker with a numbered set of tools which must be checked in at the end of a the following year’s expenses by a significant portion of the $3,000 (a portion would be required each year for amortization of the tool depreciation).

Fence Company Ltd. Supplement Workforce to Meet Demand During the peak summer seasons, FC can supplement its workforce by hiring student workers. Student workers have a lower legislated minimum wage and are less career-oriented than the regular workers. Not constrained by a collective agreement, FC is free to adjust its workforce to meet demand. Its current planned work team distribution accommodates 36,000 metres per year (assuming 20 work-days per month):

Month Work Teams Capacity (metrres) April 1 2,000 May 3 6,000

June 3 6,000 July 3 6,000

August 3 6,000 September 3 6,000

October 1 2,000 November 1 2,000

Total 36,000

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The brothers estimated the market size to be 50,000 metres. This can be accomplished by the addition of student workers as follows:

Month Work Teams Capacity (metrres) April 1 2,000 May 4 8,000

June 5 10,000 July 5 10,000

August 4 8,000 September 4 8,000

October 1 2,000 November 1 2,000

Total 50,000

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University and college students can begin work earlier than high school students; thus, the combined school students can accommodate more work teams during June and July. Increase Marketing Efforts In order to tap into this expanded market, or to expand the market greater than 50,000 metres per year, FC can increase marketing efforts. Little’s ADBUDG model (Little, 1970) outlines the exponential growth of sales due to increased advertising and promotion. Cluster analysis and factor analysis can be applied to previous customers (pre-existing data that are readily available within FC’s own files) to identify customer segments which can be effectively targeted with appropriate pricing and materials. Little’s quantitative model can also be used to determine the optimal promotional expenditures and produce a time-phased budget. Evaluate Snow Ploughing Plan As Incremental The brothers propose to rent the truck for a snow-ploughing operation during the off season (Winter). This does not align well with FC’s core competency

Fence Company Ltd. of erecting fences; however, because the business is essentially dormant during this period, the brothers can evaluate this option. This should be viewed as an incremental cost, however, and the costs of renting the truck during the winter were not included in calculations pertaining to the fence business; further, revenues resulting from ploughing snow are irrelevant to FC’s operations, since FC’s competencies do not include ploughing snow—perhaps the Woods’ do. Eliminate Volume Discounts and Reduce Commissions Since the volume discount increases variable costs so significantly that no profit is possible, it should be eliminated; further, the $13 price should be enforced and supported with a differentiated product of higher quality or singular construction. Vinyl fencing is a new alternative that provides better ruggedness at comparable cost to wood. The overall budget assumes that fences will be sold at $13 per metre, and assumes group sales are sold at $12 per metre. Even with this structure, however, group sales are unprofitable and should not be implemented. Commissions should be structured to encourage the more profitable single-house orders. For this reason, a constant 5% commission is suggested for single or group sales; however, calculations estimated the commission at 6%. This supports a high performing salesperson by increasing commissions based on volume of single-house sales while not encouraging group sales.

Fence Company Ltd. References Nadler DA and Tushman ML. 1997. A congruence model for organization problem solving. In

Managing Strategic Innovation and Change: A collection of readings. Oxford University Press. New York.

Fence Company Ltd.

AAAp eendix 1: Industry Analysis pppppennddiixx 11:: IInndduussttrryy AAnnaallyyssiiss Porter’s Five Forces

RIVALRY AMONG

COMPETING SELLERS • Low margins—cut-throat

competition in low-cost provider segments

• Many are members of Canadian Fence Industry Association (CFIA)—have more credibility

• Re• Ni

beco

• MeAsatt

BUYERS

• Significant power • Residential contractors • Residential homeowners • Reduced discretionary

income due to recession

SUP LIERS • Reliable supplies crucial

to on-time delivery wheusing Just-in-Time delivery

• Short-term profitability crucial to maintaining supplier relationships and credit

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SUBSTITUTES

• Vinyl fencing—comparable cost, greater reliability

• Increased trust among neighbours may reduce demand for fences

POTENTIAL NEW ENTRANTS

latively easy to enter market che and best-cost provider strategies yieldtter returns than Fence Company’s low-st provider strategy mbership in Canadian Fence Industry sociation relatively simple and increases ractiveness to clients.

Fence Company Ltd.

AAAppppppeeennndddiiixxx 222::: CCCooonnngggrrruuueeennncccyyy aaannnddd SSSWWWOOOTTT AAAnnnaaalllyyyssseeesss Nadler and Tushman (1997) developed a congruency model that facilitates systematic generation of feasible alternatives given an organization’s environment, history, and core competencies given its selected strategy. This model has been used to develop alternative courses of action for FC based on its specific situation. Without taking strategy, competencies, and organizational structure and background into account, recommendations are not defensible.

Fence Company Ltd.

CCCompetenciiies • Mediocre fence-

building capability • Small capacity • Low reliability

oommppeetteenncc eess

- Establish better internal co- Consider alternatives to Po- Increase customer base (m

- Customer-centric - Low barriers to entry - Low product diversity

- Achieve return on investm- Target ROI of 8 per cent - Short-term profitability im- Long-Term growth

EEEnviiironment///RRResources///HHHiiistory - Limited financial resources - Young (1-year-old) company - Low product reliability

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Organizational Culture • Family-owned • Informal, loose

controls Informal perform

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• ance management

TTTaskkks • Devise and implement

internal controls • Optimize cost

structures • Reconsider overall

strategic position

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FFFormalll OOOrganiiizatiiion Ar angements

• Informal organization

structure • Project-based teams • Flexible work teams • Not constrained by

collective agreements

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SSStrategy ntrols rter’s low-cost provider strategy ost customers are one-time clients)

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Fence Company Ltd.

STRENGTHS WEAKNESSES

Flexible staffing Can lay off as required Low wage rates

Rent equipment as required Non-unionized workforce Student summer breaks closely match peak times Operating Leverage relatively low

Lack of adequate quality controls Guarantee work without actual quality Lack of formal business judgment Discount structure hurts margins rather than

improves Commission structure hurts margins

OPPORTUNITIES THRREATS Housing starts indicate growing market Large low-cost student summer workforce Gain credibility by becoming member of Canadian

Fence Industry Association (CFIA)

Low barriers to entry Low barriers to exit Recessions—economic factors

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Financial Analysis

Fence Company Ltd.

Base ScenarioHouses 1 2 4 Teams Capacity (houses)

Metres 100 200 400 April 1 20Selling Price $12 $12 $12 May 3 60

Revenues $1,200 $2,400 $4,800 June 3 60Less Vol Disc $0 $0 July 3 60

Commission 5% 6% August 3 60Less Commission $60 $144 $384 September 3 60

Net Revenues $1,140 $2,256 $3,936 October 1 20November 1 20

Variable Costs 1 2 4 Total 360Wood 660.00$ 1,320.00$ 2,640.00$ Nails 110.00$ 220.00$ 440.00$

Transportation 120.00$ 240.00$ 480.00$ Labour 132.00$ 264.00$ 528.00$

Total VC 1,022.00$ 2,044.00$ 4,088.00$ 1 2 4

CM $118.00 $212.00 B/E (houses) 788.1356 877.3584906UCM $118.00 $106.00CM% 9.83% 8.83%

Fixed Costs 1 2 4Secretary 12,000.00$ 12,000.00$ 12,000.00$

Management 30,000.00$ 30,000.00$ 30,000.00$ Warehouse 30,000.00$ 30,000.00$ 30,000.00$

Tools 3,000.00$ 3,000.00$ 3,000.00$ Truck

April 500.00$ 500.00$ 500.00$ May-Sept 2,500.00$ 2,500.00$ 2,500.00$

Oct/Nov 1,000.00$ 1,000.00$ 1,000.00$ Machine 4,800.00$ 4,800.00$ 4,800.00$

Gas/Maintenance 8,000.00$ 8,000.00$ 8,000.00$ Telephone 1,200.00$ 1,200.00$ 1,200.00$

Total FC 93,000.00$ 93,000.00$ 93,000.00$

-$4808%

-$152.00 -2447.37 -$38.00-3.17%

Fence Company Ltd.

Scenario 1: ProposedHouses 1 2 4 Teams Capacity (houses)


Revenues $1,300 $2,600 $4,800 June 3 60Less Vol Disc $0 $0 $0 July 3 60

Commission 5% 6% 5% August 3 60Less Commission $65 $156 $240 September 3 60


Variable Costs 1 2 4 Total 360Wood 693.00$ 1,386.00$ 2,772.00$ <-- 5% JiT Delivery PremiumNails 115.50$ 231.00$ 462.00$ <-- 5% JiT Delivery Premium


Total VC 1,060.50$ 2,121.00$ 4,242.00$ 1 2 4

CM $174.50 $323.00 $318.00 B/E (houses) 299.1404 323.2198142 656.60UCM $174.50 $161.50 $79.50CM% 13.42% 12.42% 6.63%

Fixed Costs 1 2 4Secretary -$ -$ -$

Management 30,000.00$ 30,000.00$ 30,000.00$ <-- Assume management requirement of $30k is fixedWarehouse -$ -$ -$

Tools 3,000.00$ 3,000.00$ 3,000.00$ Truck

April 500.00$ 500.00$ 500.00$ May-Sept 2,500.00$ 2,500.00$ 2,500.00$

Oct/Nov 1,000.00$ 1,000.00$ 1,000.00$ Machine 4,800.00$ 4,800.00$ 4,800.00$

Gas/Maintenance 8,000.00$ 8,000.00$ 8,000.00$ Telephone 2,400.00$ 2,400.00$ 2,400.00$ <-- $100/month for cellular phones to replace secretary

Total FC 52,200.00$ 52,200.00$ 52,200.00$

Scenario 2: Proposed Additional TeamsHouses 1 2 4 Teams Capacity (houses)


Revenues $1,300 $2,600 $4,800 June 5 100Less Vol Disc $0 $0 $0 July 5 100

Commission 5% 6% 5% August 4 80Less Commission $65 $156 $240 September 4 80


Variable Costs 1 2 4 Total 500Wood 693.00$ 1,386.00$ 2,772.00$ <-- 5% JiT Delivery PremiumNails 115.50$ 231.00$ 462.00$ <-- 5% JiT Delivery Premium


Total VC 1,060.50$ 2,121.00$ 4,242.00$ 1 2 4

CM $174.50 $323.00 $318.00 B/E (houses) 299.1404011 323.2198142 656.60UCM $174.50 $161.50 $79.50CM% 13.42% 12.42% 6.63%

Fixed Costs 1 2 4Secretary -$ -$ -$

Management 30,000.00$ 30,000.00$ 30,000.00$ <-- Assume management requirement of $30k is fixedWarehouse -$ -$ -$

Tools 3,000.00$ 3,000.00$ 3,000.00$ Truck

April 500.00$ 500.00$ 500.00$ May-Sept 2,500.00$ 2,500.00$ 2,500.00$

Oct/Nov 1,000.00$ 1,000.00$ 1,000.00$ Machine 4,800.00$ 4,800.00$ 4,800.00$

Gas/Maintenance 8,000.00$ 8,000.00$ 8,000.00$ Telephone 2,400.00$ 2,400.00$ 2,400.00$ <-- $100/month for cellular phones to replace secretary

Total FC 52,200.00$ 52,200.00$ 52,200.00$

Fence Company Ltd.