Three products of Nestle

The products listed below are priced in the Nigerian local currency Naira.

Milo 500g                                            $700

Variable Cost                                      $300

Contribution Margin                           $400

 

Maggi Seasoning (100 cubes)             $220

Variable Cost                                      $140

Contribution Margin                           $80

 

Nescafe Gold Blend 100g                  $1075

Variable Cost                                      $800

Contribution Margin                           $275

 

For this step the assumption that the sales price and the variable cost remains the same and there are no economies of scale gained in larger production units or sales discounts for larger purchases. In practice both of these would normally exist.

The contribution margin could change depending on the volume of purchases as larger retailers may get better prices for bulk purchasing. This would lower the sales prices thus changing the contribution margin. Therefor different customers would have different contribution margin for the same product. In turn the larger production of a particular product could lower the variable cost and also change the contribution margin.  

The contribution margins will not be the same for all products. There are several reasons for this. Firstly if all the contribution margins were the same the company would not be competitive in the marketplace. If all the above three products had the same contribution margin as the Milo tin of $400 this would affect the selling price. The Maggi seasoning cubes would now be sold at a price of $540, more than double the original price. The customer may not want to pay this price and the company will see reduced sales and therefore less profit. The sales price can also be determined by the marketplace and increased competition or a monopoly can alter the contribution margin of a product.

Also there are different processes involved for different products. Each product contains different ingredients which come at different costs. These differences will impact on the variable costs of each product and thus alter the contribution margin. For example some raw materials may need to be imported and some can be produced locally resulting in different costs. 

The marketing department can also have an impact on the contribution margin. How a company markets itself in contrast to other competitors will alter the contribution margin. Although in a different category to Nestle this can be seen in the technology landscape. Apple markets itself as a premium product and through its very successful marketing team enjoys higher margins than much of the sector. A company marketing itself as a cheaper alternative may enjoy more sales but lower contribution margins.

A firm may produce a range of products with different contribution margins for varying reasons. The products may be complimentary products. For example if Apple had only stayed with the Mac computer it would not have reached the popularity it enjoys today. The interconnectivity of its products is an important part of its success in the highly competitive technology sector.

 

Profitability is also a reason to produce multiple products. By only producing the product with the highest contribution margin you are limiting sales. There is only so much of one product customers can buy. To increase profitability and stay relevant other products need to be offered. Although they may have a lower contribution margin they may still generate profits above the cost of capital and increase overall profits.

 

A potential constraint on Nestle would be changing consumer attitudes. This may involve consumer tastes, attitudes towards health and attitudes towards labour or resource practices. Changing attitudes towards healthier products would impact on the amount of Milo it may produce or awareness of labour practices could impact on the popularity of products such as Milo or Nescafe.

Resource quality and cost may act as a constraint. Improved labour practices may increase the cost of raw materials and thus impact the amount of production.

The political environment can change and act as a constraint on productions. For example a new government could demand more production locally and less imports. It may introduce a quota system or simply increase taxes on imports. The economic environment can impact on the types of food people will buy. A luxury item such as Nescafe Gold may become unpopular in down times and less expensive brands may become more popular. This may be especially important in Nigeria as the country’s economy is plagued by corruption, high unemployment and linked to the prices of oil which in recent times as fallen.

Restating the financial statements: comments and concerns

I didn’t have too many difficulties in restating my firm’s financial statements. Although now I have written that statement I bet I have got it all wrong.

I was lucky as my firm didn’t have too many items in its statements. My firm also separated operating activities and financing activities in the statement of comprehensive income. So all I had to do was rearrange the statement into the format shown in chapter 4 and to calculate the tax benefit for both the operating and financial activities. The one issue I had for the statement of comprehensive income was other comprehensive income. My firm only had other comprehensive income for two years and I wasn’t sure where to add the tax effect for these items. I left them in the other comprehensive income section separate to the operating and financial sections so it didn’t pollute those figures. In chapter 4 I did see property fair value movements included. I didn’t see anything like that in my firm. They did have an impairment loss on property, plant and equipment but that was for a discontinued product line and as such it should remain in operating activities.

The one thing I enjoyed about the restating and how it was done is that it actually makes you read through the notes to better understand items. This was very helpful when restating the balance sheet. The item cash and cash equivalents were broken into cash and bank balances and call deposits. I didn’t know what a call deposit was and upon further research I found it was an interest earning account where money could be pulled from at any stage if needed. This is similar to a savings account I have. I decided that similar to myself the purpose of this account is to earn interest and as such I classified it as a financing activity.

I also considered classifying the bank overdraft as financing as it is essentially a short term loan from the bank. A loan from a bank would normally be considered financing however as it results from the day to day operations I included it as operating. I was then rereading chapter 4 and realised the answer was already there and I didn’t need to think about it so much.

My firm also provides loans and advances to company employees. Although these are loans which must be paid back with interest I kept these in the operating section as they are not used for financing activities. I consider these a cost of doing business and a tool used to keep employees much the same as fringe benefits and as such they are related to operating activities.

The other concern I had was the item trade and other payables. Within this item was included an import finance loan. I didn’t know what an import finance loan was so I had to research this term. After consideration I believe it is a financing activity even though it is used as a facility to ease the burden of imports which are an essential operating activity. Unlike a bank overdraft it is not linked to any other accounts and the cash is not used for day to day operations.  

Chapter 4 ideas, reflections and reactions

Before I read this chapter I must say I was keen to explore. I wondered if there would be some hidden secret to unlocking the information provided in financial statements. I have never really analysed financial statements before so this was all going to be new to me.

The analogy of the fish markets made sense. Capital markets are predictions on future cash flows based on publicly available information. Predictions take into consideration past performance, competitors, legal landscape, future needs and much more. Not all of this can be known so the future predictions may be right or they may be completely wrong. The point is with the fish market or any other physical item for that matter you can see it, touch it, even smell it if you want to however this cannot be done in the capital market. In the capital market you can only base decisions for resource allocations on predictions. As such there needs to be some sort of framework to make these predictions.

We are also at the mercy of management and their chosen accounting methods of choice and disclosure practices. I guess this is similar to the McDonalds burger ads you see on TV. They look so fresh and full yet when you receive your order the burger is not the same. What I mean by this is the financial statements can be manipulated to a certain extent to promote a positive performance just like the burgers on the ads are manipulated to show them in their best light. However what you get may not necessarily be what is promoted just like financial statements to an extent.

Looking at the free cash flow examples shows how you can be easily misled if you focus only on the cash flows with no thought of the surrounding numbers or information. In fact the same can be said for net present value (NPV) and internal rate of return (IRR) ratios. In fact the same can apply for any ratio as there is no single measure which gives you all the information you need. For example if you had two competing projects and could only choose one, logic would say choose the project with the higher NPV however all this does not show the money that needs to be invested. This is exactly what is shown in the example in this chapter. One project may have a higher NPV but it may require a lot more to be invested to earn that profit. If more money is tied up in an investment this also increases the risk of the project, something which NPV does not consider.

Reading through the economic profit section and more specifically the cost of capital really makes you think of your own life. It is definitely true that capital can only be used or invested on one thing at a particular time. Capital can be money or even time. I think of all the opportunities forgone by making the decisions I have so far in my life time. It’s funny how you don’t really consider the cost of capital in our own private lives. Especially in regards to future finances.  Oh my I wish I could go back and change some of them. I am sure many people are like that and such is the value of hindsight. Lucky we have ratios and other frameworks to assist in our finance investments. Unfortunately they are not foolproof.

The difference between the economic profit ratio and other ratios is that it takes the cost of capital into account. It essentially reduces the operating income down to an amount over and above the cost of capital the company employs. The cost of capital may be an arbitrary figure or it may be based on a weighted average and take into account such things as the debt structure of the company and the risk free rate of return or the return on government bonds.

I have never broken a financial statement down into operating and financing activities. I think it is a good thing. It allows more clarity and you can see each activity more clearly. It is important to see both the debt structure of a firm and how its operations are performing. Separating both also gives you a better measure of management performance. I was lucky as my firm already separated most of its operating and financing activities in the income statement so it was really only the balance sheet which required much attention to detail. For me restating the financial statements also allowed me to understand the underlying data more clearly as I was forced to read the attached notes when deciding whether an item was operating or financing.  

When I first saw the statement of changes in equity section I was bracing myself for the pain. I haven’t had much to do with this report and whilst it is relatively small it raises questions for me. However proceeding through the section I realised my hesitance was unfounded. In fact this looks the easiest section to restate. I wish I had time to restate other company’s financial statements to get the hang of it and develop a deeper understanding.

I used the tip and printed out my firms financial statements for the assignment to place either an O or an F next to them. It was quite helpful as it allowed me to browse through the notes to the financial statements on my computer and record the F or the O on the printout. I was able to go back and forth between the two without any confusion. At first I thought a bank overdraft would be considered a financing activity because it is essentially a short term loan provided by the bank to the company. I only vaguely knew what a bank overdraft was so I researched the term through google and after reflection I agreed that it would be an operating liability as the purpose of this item if for day to day operations. It is also linked to other operating accounts so it doesn’t really meet the requirements to classify it as a financing loan.

The ratios were familiar to me not only from previous courses but also previous work experience in an industrial supplies company. The profit margin was used mostly to ensure we had enough margins in our sales compared to other industry competitors or other customers. Where the margins were a bit light or small we investigated opportunities to increase whether through higher sales price or lower buying price. This sometimes involved renegotiating buying contracts to get better discounts which in turn required us to buy more stock in some instances. Thus we had to explore the costs and capabilities of having more stock in our warehouse and also the opportunity cost of the increased purchases.