As the operations manager for Valley Kayaks as described in

As the operations manager for Valley Kayaks (as described in the previous question), you find yourself faced with an interesting situation. Marketing has informed you that they have lost a number of sales because of a lack of inventory. Kayaks, being seasonal in nature, have to be in stock at your dealers if they are to be sold (customers are not willing to wait). The director of marketing proposes that you increase inventories by 25 percent (a major investment to you). She has also given the information in the following table. How would you assess this proposal from marketing? Your top management requires that any change must achieve a ROA greater than 30%. Show your calculations and then determine if the projected change in ROA justify the inventory investment?

Category	Current Values	Proposed Impact of Inventory increase
Sales	$2,000,000	25% + (improvement)
Cost of goods sold	$1,500,000	0%
Variable expenses	$300,000	10% - reduction (why?)
Fixed expenses	$100,000	15% + (increase)
Inventory	$300,000	25% +
Accounts receivable	$ 100,000	0%
Other current assets	$500,000	0%
Fixed assets	$400,000	0%

Solution

Category

Current Values

Proposed Impact of Inventory increase

Estimated Values

Sales

$2,000,000

   25% + (improvement)

1.25*(2000,000)

= $2,500,000

Cost of goods sold

$1,500,000

   0%

$1,500,000

Variable expenses

$300,000

10% - reduction (why?)

(1-0.1)*(300,000)

= $270,000

Fixed expenses

$100,000

   15% + (increase)

(1.15*100,000)

= $115,000.00

Inventory

$300,000

   25% +

(1.25*300,000)

= $375,000.00

Accounts receivable

$100,000

   0%

$100,000

Other current assets

$500,000

   0%

$500,000

Fixed assets

$400,000

   0%

$400,000

Return on Asset = ROA = Net profit margin/Asset Turnover

Net Profit margin = Net Profit/Net Sales = (Gross Margin – Total Expenses)/Net Sales

Gross Margin = Nets sales – Cost of Goods sold = 2,500,000 – 1,500,000 = $1,000,000

Total Expenses = Fixed Asset + Variable Asset = 270,000 + 115,000 = $385,000

Net Profit margin = (1,000,000 – 385,000)/2,000,000 = 615,000/2,000,000

Net Profit margin = 0.25 = 25%

Asset Turnover = Net Sales/Total Assets

Total Asset = Current Asset + Fixed Asset

Current Asset = Inventory + Accounts Receivable + Other current Assets = 375,000+100,000+500,000 = $975,000

Total Asset = 975,000 + 400,000 = 1,375,000

Asset Turnover = 2,500,000/1,375,000 = 1.82

Return on Asset = ROA = Net profit margin/Asset Turnover

ROA = 0.25/1.82

ROA = 14%

Since the estimated ROA is less than 30%, the proposal of increase inventory is not effective.

Projected change in inventory is not acceptable since its ROA is less than 30%

Category	Current Values	Proposed Impact of Inventory increase	Estimated Values
Sales	$2,000,000	25% + (improvement)	1.25*(2000,000) = $2,500,000
Cost of goods sold	$1,500,000	0%	$1,500,000
Variable expenses	$300,000	10% - reduction (why?)	(1-0.1)*(300,000) = $270,000
Fixed expenses	$100,000	15% + (increase)	(1.15*100,000) = $115,000.00
Inventory	$300,000	25% +	(1.25*300,000) = $375,000.00
Accounts receivable	$100,000	0%	$100,000
Other current assets	$500,000	0%	$500,000
Fixed assets	$400,000	0%	$400,000