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Fun Games Company was founded by Avery Rinehart to produce a novelty item marketed under the name Puzzler. Each Puzzler cost the company $14 to produce. In addition to these production costs that varied in direct proportion to volume (so-called variable costs), the company also incurred $4,000 monthly ¡°being in business costs (so-called fixed costs) irrespective of the month's volume. The company sold its product for $22 each.
As of December 31, Rinehart had been producing Puzzler for three months using rented facilities. The balance sheet on that date was as follows:
As of December 31
Cash $ 58,500
Accounts receivable 27,500
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Common Stock $100,000
Retained earnings 0
Rinehart was very pleased to be operating at a profit in such a short time. December sales had been 750 units, up from 500 in November, enough to report a profit for the month and to eliminate the deficit accumulated in October and November. Sales were expected to be 1,000 units in January, and Rinehart¡¯s projections showed sales increases of 500 units per month after that. Thus, by May, monthly sales were expected to be 3,000 units. By September, that figure would be 5,000 units.
Rinehart was very conscious of developing good sales channel relationships in order to increase sales, so Puzzler deliveries were always prompt. This required production schedules 30 days in advance of predicted sales. For example, Fun Games had produced 1,000 Puzzlers in December for January sales, and would produce 1,500 in January for February¡¯s demand. The company billed its customers with stated terms of 30 days net, but did not strictly enforce this credit terms with the result that customers seemed to be taking an additional month to pay. All of the company's costs were paid in cash in the month in which they were incurred.
Rinehart's predictions came true. By March, sales had reached 2,000 Puzzlers, and 2,500 units were produced in March for April sale. Total profit for the year by March 31 had reached $24,000. In order to get a respite from the increasingly hectic activities of running the business, in mid-April Rinehart went on a family vacation.
Within the week, the company's bookkeeper called. Fun Games bank balance was almost zero, so necessary materials could not be purchased. Unless Rinehart returned immediately to raise more cash, the entire operation would have to shut down within a few days.
1. Prepare monthly income statements, balance sheets, and cash budgets based on sales increases of 500 units per month and 30-day advance production for January through September. When will the company need extra funds? How much will be needed? When can a short-term loan to cover the need be repaid?
In April through July, the company needs extra funds, respectively $1,000, $9,000, $5,000 and $1,000. These short-term bank loans can be repaid till October.
2. How is it possible that a company starts with $100,000 in capital and has profitable sales for a period of six months and still ends up with a zero bank balance? Why did Fun Games need money in April? How could this need have been avoided?
Because the company schedules the production 30 days in advance of predicted sales, and allow the customers take 2 months to pay. The inventory and the sales are increasing faster than the collecting of the accounts receivable.
In April: Inventory $42,000 Retained Earnings: $40,000
Accounts Receivable 99,000 Capital: 100,000
Fun ¡®n¡¯ Games, therefore, needed $1,000 in April (141,000-140,000).
This problem could have been avoided if the company strictly controlled the collection of the accounts receivable. For example, if they enforced the customers to pay the bill as the credit terms of 30 days net, the financial data would be as follow:
The total of the capital and retained earnings will always be greater than the total of accounts receivable and inventory, and the needs for extra funds can be avoided.
3. What would be the effect of this situation on the company's ability to operate? To answer this Question, consider what activities would be affected, what individuals would be touched and how would they be affected?
This situation will have a negative effect on the company's ability to operate. The production and the deliveries may be delayed because of the lack of the capital. And thus it will destroys the relationship with the customers in some degree and decrease the sales. The short of the money also may delay or reduce the salary and depress the workers motivation.