At Toy World Inc., President Jack McClintock is considering the adoption of a level monthly production plan for the coming year. The manufacturer of children’s plastic toys currently employs a production plan that follows the seasonality of sales. In considering whether to implement a level monthly production schedule, we compared the benefits and costs of both methods in relation to the financial and operational needs of the business. This allowed for an in-depth analysis of the savings allowed by a level monthly production schedule, and the impact of such a system on timing, cash flow and risk. As a toy manufacturer, Mr. McClintock’s company would face unique risks under the ...view middle of the document...
Level monthly production would also allow Mr. McClintock to benefit from greater flexibility in filling emergency production orders during off-peak times, as production would be maintained regardless of sales. Another advantage of the proposed production system is the positive impact on employees; training needs would be reduced, as workers would not need to relearn their operations as sales increase, and employee burnout would be mitigated during peak season. Net income in 1994 would also be higher under level monthly production than seasonal ($589,000 and $351,000, respectively), if change in interest expense is ignored. Finally, the proposed plan would improve the liquidity of the company, as demonstrated by a higher current ratio (see Appendix 3).
Costs of Level Monthly Productions
The primary cost of a level monthly production plan is a constrained cash flow. Cash would need to be committed towards increased storage and handling costs amounting to $115,000 annually, which would be incurred during the months when production would exceed sales. Seasonal production does not have this expense as production occurs in response to customer orders. Therefore, the $490,000 labour cost savings would be offset by this expense. Cash flow is further restricted due to accounts payables being maintained levelly through the year. Under level monthly production, raw materials would need to be purchased regularly every month regardless of customer demand. This would result in additional funding requirements beginning in March, and the short-term loan amount would rise until the company receives payment from sales in August; the loan would begin to be paid off in November.
A constricted cash flow is a further cost to Toy World Inc. because it would result in less interest income being earned by the company. Under level monthly production, cash would be kept at the minimum level of $200,000 every month except for January and February, which is lower than the balance under a seasonal schedule. Since Toy World Inc. is earning a 4% annualized rate of return on monthly cash balances, a reduction in interest income would be experienced by the company, thus further cutting into the savings allowed by level monthly production.
Level monthly production would also require a greater external financing need than seasonal production; from June to November, a funding requirement of over $2 million is necessary, with the maximum reaching almost $4 million in September (see Appendix 1). This is problematic because Toy World Inc.’s primary bank, City Trust Company, has stated a willingness to only extend their existing line of credit to $2 million. Therefore, the current credit limit is not sufficient to cover the financial need of a level monthly production plan. If Mr. McClintock were to meet the financing requirements of this plan through an additional loan, he would need to consider the increased interest expense that would result. Financing up to $4 million with...