Total Equipment Hire Ltd (TEH) hires out plant and equipment to construction companies and small building firms. The company has a high level of debt. Company background TEH has three product lines:
Product line Examples Customer type and period of hire % of revenue
Heavy equipment Bulldozers, cranes, diggers, excavators and concrete pumping vehicles (includes trained operator) Large construction companies for periods of over a month 70%
Small tools and equipment Hand tools and small items of plant, such as generators and pumps Small building firms for periods of less than two weeks 20%
Scaffolding Scaffolding Existing customers who will also hire large or small equipment at the same time as scaffolding 10%
Each product line is run as a separate division, although all equipment is stored and maintained at one site, so many of the costs are incurred jointly. TEH's equipment is of good quality, reasonably new and well maintained. The company's support service is also good, with prompt and efficient delivery to the customer's site for all items. As a result, the business is perceived as being above average quality and hire charges therefore include a price premium over many rivals.
Total revenue was £240 million in the year ended 31 December 2008, but is estimated to fall to around £180 million in the year ending 31 December 2009. The reduction is reasonably evenly spread, in proportionate terms, across the three divisions and is due to both volume reductions and price discounts.
Impact of the recession
The building and construction industry has suffered in the recession. As a consequence, demand for equipment hire has reduced very significantly in 2009 compared to 2008. There has been a significant reduction in the number of days hiring, but also there is fierce competition in the industry resulting in downward pressure on hire charges.
The key industry benchmark is a utilisation rate of 90% (i.e. equipment is being hired out nine working days in every ten) but, up to the end of 2008, TEH operated with a utilisation rate of around 80%. This lower utilisation rate was due to TEH holding a wide variety of equipment to satisfy customers' occasional needs for infrequently used equipment. Customers were therefore attracted to TEH for all their equipment needs as a comprehensive service was provided. In 2009 TEH's utilisation rate has fallen to 70%, compared to an industry average of 78%.
TEH estimates that it will make a loss for the year ending 31 December 2009. Operating cash flows have been negative and the company is unable to borrow further. As a result, there is doubt over whether the company will be able to make the half yearly interest payment of £15 million that is due on 1 January 2010. A board meeting has recently taken place.
The board meeting
Helen Chen, the finance director, opened the meeting: "We need to generate cash quickly by selling some of our equipment. I know we will make a loss on sale, but I think we need to sell off about 20% of our equipment in order to generate cash of around £60 million. Where we have more than one item of the same type of equipment we could sell off one, so we maintain our product range. We also need
to cut costs. We spend far too much on customer service and delivering equipment promptly. We need to reduce our labour and transport costs, even if the service to customers deteriorates."
Paula Penny, a non-executive director, interrupted: "I agree that cash needs to be generated from selling equipment, but we should be more focused on closing down one division: either small tools or scaffolding. The performance of these divisions needs to be measured to decide which one to close."
Frank Fitt, the operations director, was furious with these suggestions: "If we sell off that amount of equipment we will destroy our whole strategy, as we will lose customers who want a complete product range from one hirer. During the recession, we know we will also only raise cash for about half what the equipment is worth."
The managing director, Jeff Jones, joined in: "I prefer not to sell equipment. Instead, I have entered into some tentative negotiations with a multinational shipping and transport company, International Transport and Trading plc (ITT). A central African country is having a major dam constructed and it has an urgent, but temporary, need for heavy plant and machinery. ITT has suggested a joint venture whereby, under a three year contract, we would make available up to 40% of our heavy plant and machinery.
"According to the proposed contract, this equipment needs to be available for immediate transport to Africa on request. ITT would transport the equipment to Africa and deal with the customers in return for 50% of the rental fee. ITT would collect the fees directly from the client and then pay TEH its share. It is estimated that the gross rental fees would be about 75% of the equivalent hires in the UK, but utilisation will be near 100% for requested items during their time in use on the project in Africa. ITT has offered, on signing the agreement, to make an upfront payment of £10 million to TEH in respect of our share of future hirings on the project, to help us with our short-term liquidity problem."
(a) Explain the potential impact on TEH's strategy and operations which could arise from Helen Chen's proposals for divestment of equipment and cost reduction.
(b) Discuss the issues to be considered in measuring the financial and non-financial performance of the small tools and scaffolding divisions in order to determine which division should be considered for closure, in accordance with Paula Penny's suggestion.
(c) Evaluate the benefits and problems of Jeff Jones' proposed joint venture arrangement with ITT. Identify any matters that need to be clarified between TEH and ITT before a decision on whether to proceed with it can be made.
(a) Explain the potential impact on TEH's strategy and operations which could arise from Helen Chen's proposals for divestment of equipment and cost reduction. (8 marks)
The potential impact of Helen Chen's proposals could be devastating. Selling off 20% of the equipment will reduce the capacity of TEH and this could damage the business of the company. Making a loss on sale means three things, the present equipment with TEH becomes less; in addition, TEH has to pay the full price for the equipment when the recession goes. Further, Total Equipment Hire Ltd is likely to miss business opportunities because of less equipment. Helen Chen's suggestions that where Total Equipment Hire Ltd has more than one equipment, one be sold is very simplistic. Usually, some equipment have a high demand and so have multiple pieces of equipment. Selling of equipment which the company has more than one piece will severely hamstrung the capacity of Total Equipment Hire Ltd.
The strategy of Total Equipment Hire Ltd has been to deliver high quality (relatively new and in good maintenance equipment) equipment with very good customer service. This is the strategy with which Total Equipment Hire Ltd differentiates its services (1). Chen's suggestion of reducing customer service and selling off equipment will lead to greater pressure on single equipment and lead to customer dissatisfaction. The result will be that ...
This response presents a brilliant discussion on Total Equipment Hire Ltd.
High-low methods, accounting analysis, CVP, and leverage
EXERCISE4-5. High-Low Method
Campus Copy & Printing wants to predict copy machine repair expense at different levels of copying activity (number of copies made). The following data have been gathered: (see attached)
Determine the fixed and variable components of repair expense using the high-low
method. Use copies made as the measure of activity.
EXERCISE 4-8. Account Analysis
Reef Office Supplies is interested in estimating
the cost involved in hiring new employees. The following information is available regarding
the costs of operating the Human Resource department at Reef Office Supplies
in May when there were 50 new hires.
Human Resource Department
Staff salaries $25,000
Manager salary 7,000
Office supplies 200
Depreciation of office equipment 300
Share of building cost (based
on square feet occupied by
Human Resources) 1,500
a. Use account analysis to determine fixed cost per month and variable cost per new
b. The company is planning to hire 60 employees in June. Estimate the total cost of
Human Resources for June..
c. What is the expected incremental cost associated with hiring 10 more employees
than were hired in May?
EXERCISE 4-12. CVP Analysis, Profit Equation
Clyde's Marina has estimated that fixed costs per month
are $240,000 and variable cost per dollar of sales is $0.60.
a. What is the break-even point per month in sales?
b. What level of sales is needed for a monthly profit of $60,000?
c. For the month of July, the marina anticipates sales of $1,200,000: What is the expected level of profit?
EXERCISE 4-17. Operating Leverage
(see attached for data)
a. Calculate profit as a percent of sales in the prior year.
b. Suppose sales in the current year increase by 20 percent. Calculate profit as a percent
of sales for the new level of sales and explain why the percent is greater than the
one calculated in Part a.
EXERCISE 4-18. Constraints
Dvorak Music produces two durable music stands:
Stand A Stand B
Selling price $80 $70
Less variable costs 20 40
Contribution margin $60 $30
Stand Arequires 5 labor hours and standB requires 2 labor hours. The company has
only 320 available labor hours per week. Further, the company can sell all it can produce
of either product.
a. Which stand(s) should the company produce?
b. What would be the incremental benefit of obtaining 10 additional labor hours?
PROBLEM 4-12. Multiproduct CVP
Fidelity Multimedia sells audio and video equipment
and car stereo products. After performing a study of fixed and variable costs in the
prior year, the company prepared a product-line profit statement as follows:
For the Year Ended December 31,2007
Audio Video Car Total
Sales $3,000,000 $1,800,000 $1,200,000 $6,000,000
Less variable costs:
Cost of merchandise 1,800,000 1,260,000 600,000 3,660,000
Salary part-time staff 120,000 80,000 30,000 230,000
Total variable costs 1,920,000 1,340,000 630,000 3,890,000
Contribution margin 1,080,000 460,000 570,000 2,110,000
Less direct fixed costs:
Salary, full-time staff 300,000 250,000 210,000 760,000
Less common fixed costs:
Other administrative costs 560,000
Total common fixed costs 690,000
a. Calculate the contribution margin ratios for the audio, video, and car product lines.
b. What would be the effect on profit of a $100,000 increase in sales of audio equipment
compared with a $100,000 increase in sales of video equipment, or a $100,000
increase in sales of car equipment? Based on this limited information, which product
line would you recommend expanding?
c. Calculate the break-even level of sales for the company as a whole.
d. Calculate sales needed to achieve a profit of $1,500,000 assuming the current mix.
e. Determine the sales of audio, video, and car products in the total sales amount calculated
for Part d.