Knit and Eat
KnitAndEat (KAE) is a large chain of farms based in the southern United States. They raise sheep, primarily for wool, but also producing meat from the older ewes.
The chain has been expanding but has noticed a decline in profits in the past couple of years. The CEO has hired us to investigate the cause and provide a solution.
Identify the problem
The issue is why KAE’s profits have been declining. The candidate should start by structuring their approach. They should understand that profit is determined as a function of revenues and costs:
Now, the candidate should ask appropriate questions to understand the company, its products, revenues and costs.
The company has three products:
- Woollen yarn for knitting: this is sold directly to consumers
- Worsted yarn: used to produce fine garments. The same quantity is sold each year to a suit manufacturer on a contractual basis. The contract is due to expire at the end of this year
- Mutton: produced from the older ewes and sold to supermarkets
Both the mutton and wool markets are highly commodified.
The market as a whole is growing.
Takeaways:
Since the market is growing, the profitability issue could come from:
- a decrease in revenue due to losing market share to one or more competitors
- a decrease in prices
- an increase in costs
- some combination of these factors
Leading the analysis
The candidate should ask questions to understand both the revenue and cost structure of the company in order to proceed with the analysis.
Revenues
Takeaway
Sales of mutton and woollen yarn have increased, whereas worsted yarn sales have remained the same (as per contract). This means KAE has not been losing revenues to competitors.
In Y3 and Y4 the revenue on woollen yarn has not increased despite volume increasing. This indicates either an increase in costs or a decrease in prices.
Pricing
As suspected, the price for woollen yarn has been decreasing, which is one reason for the decrease in profits.
A decrease in demand is unlikely since we know the market is growing and sales are going up. Thus, the most likely scenario is a price war.
However, the candidate should not stop here and should continue on to investigate costs as well.
Costs
Again, the problem is woollen yarn, for which fixed costs have increased periodically.
The candidate should inquire which portion fixed costs have increased and why. Potential costs would be:
- Rents
- Salaries
- Utilities
A good candidate will note the correlation between the increase in costs for woollen yarn and the decrease in costs for worsted wool and inquire about it.
However, it also means that the process of making woollen yarn was left to individual craftsmen themselves, who now have to hand-comb the wool. The process is more painstaking to do manually and, therefore, craftsmen have repeatedly requested raises.
Takeaways
It is now clear that the reduction in profits comes from the combination of a decrease in prices and an increase in fixed costs in woollen yarn.
The following calculations for woollen yarn can be made to confirm:
Revenue
Y1: 30 x 2m= 60m
Y2: 30 x 3m= 90m
Y3: 25x 4m = 100m
Y4: 20x5m = 100m
Y5: 20x6m= 120m
Costs
Y1: 15 x 2m = 30m
Y2: 15 x 3m = 45m
Y3 20 x 4m = 80m
Y4 25x5m = 125m
Y5 25 x6 = 150m
Profits
Y1: 60-30 = 30m
Y2 = 90- 45 = 45m
Y3 = 100-80 = 20m
Y4 = 100-125= -25m
Y5 = 120 – 175 = -55m
Total profits = 5m
Delivering the recommendation
The candidate should advise the client as follows:
The decrease in profit is due to the increase in costs and decrease in price for woollen yarn.
The increase in costs comes from re-tasking combing machines to produce worsted fabric, which resulted in woollen yarn being produced manually and craftsmen repeatedly asking for raises due to the difficulty of the process.
The decrease in price comes from a price war created by the entry to the market of a new competitor.
Next steps could include:
- Investing in further equipment, which would reduce the need for manual labour and drive down costs from salaries
- Stopping production of woollen yarn altogether and focus existing resources on producing worsted yarn, since it yields the highest margins. Since a contract is due to be renegotiated, KAE can attempt to increase the quantity bought by suit manufacturers by offering a slightly lower price, which would be sustainable by creating economies of size.
