This business report will outline which expansion option is most efficient and profitable and whether either should be undertaken. The report has been paired with an excel workbook containing all relevant calculations required to determine the business decision. The included calculations in the excel workbook are breakeven analyses for both renting and purchasing, a profit analysis for the first three years of business for both options and respective payback periods. These calculations will be referenced throughout the report as supporting evidence to recommended decisions.
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Thorough research was conducted to find fair and realistic estimates for the required cost estimates. These estimates were required to determine the breakeven points and annual profits found in the excel workbook as they contribute to the overall sum of fixed costs. The interest rate of 3.39% was derived from Bank Australia (2019). Tas Water (2019), state that the fixed water charge for a 25mm connection is $535. Both electricity and rent charges were allocated via amounts listed by Numbero (Cost of Electricity usage, 2019 & Cost of Rent 2019). Electricity was inclusive of water charges so after multiplying the monthly rate of $235.19 by 12, $535 was deducted to account for the water charge previously allocated. The amount for rent was $1,285.50 per month so this amount has been multiplied by 12 to account for a year.
Profitability can be increased by changing the sales price or the mix of existing sales or both. Which alternative would be better for the business depends upon several factors. The first change is the business environment in which the company is currently operating in. If there are several competitors already providing the same kind of goods and services, then price should be the same as the competitors have. In such perfect market condition, a small change in price may drastically change the sales volume because sales volume is highly elastic to price. Here in this case, restaurant service is common to most and therefore, due to a large number of competitors, price couldn’t be increased unless there is some speciality in products or services. Secondly, the sales can be changed. However, again it requires some specific tasks needed to be carried out by the business. Promotional and marketing activities will need to be increased to meet the targeted sales mix. Consumers’ tastes and market demand would also need to be considered. Good customer service and promptness may yield better results for the desired sales mix. Thus, in this case, sales mix can be changed only to increase the profit.
Further, John and Denise are producing three kinds of burgers – small, regular and large. The contribution margin, as per the excel workbook, shows a large burger is highest at $2.50 per unit, while regular and small burgers only contribute $2.00 and $0.70 in profit respectively. Thus, the company should focus on increasing the sales volume of large burger.
From the Breakeven Analysis found on sheet one of the excel workbook, we can see that John and Denise are required to produce less units in order to break even under the purchasing option as opposed to the renting option. This is due to the fact that fixed costs are higher for the renting option as the amount of rent to be paid of $15,426 is larger than the extra interest that would be required to be paid on a $450,000 loan of $15,255.
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Since, John and Denise wish to open another restaurant by either purchasing an existing building or by renting, it again must consider two things – the initial outlay and the contribution margin. The payback period for the “Rent” option is only 2 years while it is 10 years for the “Purchase” option. The calculations in the excel workbook on the payback period sheet show that per annum cash flow is $62,500, the sum of targeted profit and depreciation. The cumulative cash flow for purchasing includes the amount for the property of $450,000, the conversion costs at $100,000 as well as the fixtures and fittings and new kitchen equipment at $25,000 and $100,000 respectively. The sum of these amounts gives a total cumulative cash flow of $675,000, being repaid at $62,500 a year, after 10 years there will still be $50,000 left to be paid. The cumulative cash flow for renting only consists of the fixtures and fittings as well as the kitchen equipment as I have assumed a restaurant ready property will have been chosen, thus avoiding the conversion costs. This means the cumulative cash flow is only $125,000 and can be paid off in 2 years at $62,500 per year. Therefore, John and Denise should proceed with the “Rent” option. Under the “Rent” option, the contributions per unit for small, regular and large burgers are $0.45, $1.63 and $2.05 respectively as seen by the breakeven analysis in the excel workbook. The contribution per unit for large burgers is highest and therefore, John and Denise should focus on selling of large burgers.
Overall, it is concluded that mixing of existing sales would be the most appropriate option to increase the profit. Currently, John and Denise are producing three kinds of burgers – small, regular and large. The contribution margin of large burger is highest in both the existing restaurant and the proposed opening of another restaurant. Therefore, they should focus more on selling of large burgers. Regarding whether or not they should purchase a building for a new restaurant or rent an existing building, arguments can be made for either option. As seen in the annual profit tables in the excel workbook, option 1 (purchasing) is more profitable in all three years implying that it is the logical choice. However, it cannot be ignored that in all three years the business was still making a loss, with purchasing’s loss being slightly less than renting’s. If John and Denise are more concerned about paying back the cumulative cash flow, then it would be more ideal to go with the renting option as it has a payback period of two years as opposed to the 10+ years that purchasing would take. I would suggest that John and Denise go with the purchasing option as it is more profitable than renting and it also provides them with the option to sell the property if they ever feel the need or want to. My final recommendation would to avoid expanding in the first place. John and Denise would be suffering losses for several years so there is little point in expanding. It would take over 10 years as outlined in the payback period work sheet before John and Denise would begin to make a profit and 10 years of losses could have detrimental effects on their existing business.
- Cost of Interest (2019). Information retrieved from: https://www.bankaust.com.au/globalassets/product/schedules/loan/loans-rate-schedule.pdf
- Cost of Water usage (2019). Information retrieved from: https://www.taswater.com.au/Your-Account/Water-and-Sewerage-Charges
- Cost of Electricity usage (2019). Information retrieved from: https://www.numbeo.com/cost-of-living/in/Hobart
- Cost of Rent (2019). Information retrieved from: https://www.numbeo.com/cost-of-living/in/Hobart
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