For-U Jeans Customization Lab: Financial Essay And Risk Analysis.

Financial Report

Question:

Discuss about the Financial Analysis Report for For-U Jeans.

For-U Jeans is looking to target the increasing base of young customers who seek adventurous, fun clothes that they can identify with. The product department and the marketing department have come up with an idea to include customize the jeans that are sold, in order to make the jeans more personal and unique for their customers. It is hoped that once customers like the idea of customizing jeans, they would develop some brand loyalty and the idea of customization would hopefully lead them to purchase more jeans.

This report is a financial report on the case. A Financial Report helps understand the total investment required during the life of a project, the total direct and direct costs associated with it and the total income that may be accrued over the life of the project. A financial case report gives an insight into the possibility of profits or losses that may be expected from a project so that managers can make better decisions. The Financial case project also contains the various alternatives available to managers to helps them make the right decisions. This report provides a brief analysis of the total costs associated with the project over the life of the project. The report also lists the various sources of revenue over the life of the project and the expected revenues from each of these sources. ( Public Sector Accounting Standards Board, 2001)

Additionally, the report also provides an analysis of the financial possibilities on some key parameters like payback period, Net Present value, Internal Rate of Return and more. ( Public Sector Accounting Standards Board, 2001) Hopefully, managers will be able to use this report as a guide to making financial decisions regarding investment in the project. The Customization Lab has very high investment costs and it is important to understand the future cash flows (and discounted cash flows)  are worth the heavy investment made in the present year.

The purpose of this appraisal is to evaluate whether the Customization Lab would be a good investment and add value to the line of products that For- U Jeans has on offer. The Customization Lab is being proposed as completely a digital venture. Customers will be able to select from various options online to personalize their jeans. Some of these customizations include a range of finishing touches such as scrape wash, blast wash, faded, rugged wash and scuffed. Once customers choose their favorite pair of jeans from the products on offer by For-U, they will able to customize it by selecting from a range of customizations.  The Lab will exclusively focus on online sales at the moment. There will be no plans to introduce the custom labs in brick and mortar shops or other retail avenues. The value of this lab may include monetary and non-monetary benefits. Customization of Jeans will be a unique way to connect with new customers and offer variety to existing customers. It is expected that the new service on offer will help build some customer loyalty towards the brand by helping to portray the brand as fun, relatable brand. Additionally, it is hoped that sales of jeans offered by For-U Jeans currently will pick up due to the new services

For-U Jeans Customization Lab

To complement this new line, the product department has also thought of introducing a new cost-effective line of jeans for consumers. It is hoped that the as customers visit the customization Lab, they will have an additional option of purchasing Freesom Jeans. The total cost of introducing this new line is $100,000. This will be a limited edition line called “Freedom” with only 2000 jeans for sale, each pair of jeans to be sold at $75.  It is hoped that the jeans would be sold out within the first six months of the date of sale. The new line, even if the custom lab is not approved could still be an independent option to add to the existing line of products. The brand will not spend on advertisement or promotion of this new line, given that it is a cost effective and limited edition collection available only online. It is being introduced simply to attract new customers and provide some variety in price to the existing customers.

• The expected demand has been projected based on market survey. This survey was done considering specifically targeting the demographic of 16- 32 years old male and female residents all over Australia. The survey showed that there is indeed a market for customized jeans. While making demand projections, consumer taste and preferences have been assumed to be constant.
• The charges for shipping the product to the consumer have been excluded as shipping charges will be counted at actual.
• Inflation analysis has not been included as the size of the project is currently not large enough and inflation is not expected to be a big factor. Inflations has been captured as the costs are increasing, in spite of the increasing number of customers.
• The costs of Jeans include the total costs including the costs of purchasing raw materials, costs of transport and warehousing, producing and packaging jeans etc. There are no additional costs to procurement of jeans.
• All costs have been converted into Australia Dollar and no currency exchange is required.
• This analysis gives a seven year return analysis for the project. The internal norms of the Company require, that for any venture to get approved , it must show returns greater than 14% per annum. This is the discount rate for the investment of the project.
• It is assumed that the customized lab will be able to meet the increased demand over the period of seven years.
• Diminishing returns are not taken into consideration while making this analysis.
• Depreciation is assumed to be straight line depreciation.

A simple “risk analysis” exercise helps understand the basic risks that could possibly be related to the project and management. The method used here is the Preliminary Risk Analysis. Given below are the some of the key parameter on which the risks have been analysed. (Vesper, 2014)

• Risk Elements: These are the possible people or activities that could pose a threat to the project
• Consequence: Consequence refers to the chain of events that could occur , sh
• Likelihood: Likelihood refers to the chances of the occurrence of any risk event or risk element. In this analysis, likelihood can take the following values: Low,(1) medium (2), high (3)
• Severity of consequence: This refers to the potential for a negative impact. Severity can take four values: Insignificant (1), Low (2), Medium (3) High (4)
• Risk Score: This is the scale of risk. Risk Score = Likelihood X Severity.
• Risk Score can take values between 1 and 12, 1 symbolizing lower risks while 12 symbolizes high risks.

(Vesper, 2014)

These are risks related to the supply chain i.e the procurement of the goods from the market.

Demand Risk: (Martino, Fera, RafaeleIannone, & Miranda, 2017)

Risk Element

These typically relate to estimating demand wrongly and not preparing the supply chain accordingly

Consequence:  Underestimation of demand will lead to placing fewer orders. In, this may lead to inability to fulfill demand. In turn, that may lead to customers loss of potential revenues directly.

Potential Causes: Lack of correct market information or analysis, Poor Decision making

Likelihood: 2

Severity: 3

Risk Score: 6

Supply risks

(Martino, Fera, RafaeleIannone, & Miranda, 2017)

These risks depend on the supply structure and are mostly related to sourcing and outsourcing issues.

Risk Elements

Elements that could threaten the supply of products either from the raw material market to For- U jeans. The lack of regular supply could be due to a variety of factors such as unreliable suppliers, problems in transportation etc.

Consequences

Disturbances in supply can

1. Raise the cost of goods
2. Delay delivery to the customer which in turn would disrupt the fulfillment in demand. This in turn could affect revenues in monetary terms and brand value in non monetary terms.

Likelihood: 2

Severity:2

Risk score:4

Process Risk

 (Martino, Fera, RafaeleIannone, & Miranda, 2017)

These risks relate to the internal operation of the Company. The company should be able to handle the addition of a new department , new processes etc. There are several procedures that must be adjusted to the new addition to the Company’s assets. For example, there would be issues relating to warehousing, transfer pricing and more.

New Line of Jeans - Freedom

Risk Elements

1. Lack of communication between managers.
2. Time Lag to adjustment of all Company processes to the new addition

Consequences

1. Lack of communication could disturb the operations of the Company and affect efficiency in the given year.
2. General Inefficiency

Likelihood: 3

Severity: 3

Risk Scale: 9

Control Risks

(Martino, Fera, RafaeleIannone, & Miranda, 2017)

These risks relate to the moving parts of the network  i.e the other network actors. This could lead to non-standardization of product as well as processes.

Risk Elements

1. Supplier risks would imply the provision of non-standard product.
2. Operations risk would imply ht enon standardization of processes such as non-standard invoicing, non-standard merchandising and packaging etc.

Risk Consequences

1. This could increase the chance of consumer complaints, product returns etc.
2. Operations Risk: This could lead to operational inefficiency

Likelihood: 3

Severity: 3

Risk Scale: 9

Financial Risks

(Martino, Fera, RafaeleIannone, & Miranda, 2017)

These risks relate to the financial aspect of project management

Risk Elements:

1. Excess Costs: The actual costs could be greater than the projected costs
2. Lower Revenues: The actual revenues could be lower than the projected revenues.

Consequences

1. Profit Margins could be hurt, leading to potential losses.
2. Total Cash inflows could be lower, leading to potential losses

Likelihood: 2

Severity: 3

Risk Scale: 6

Marketing Risks

(Martino, Fera, RafaeleIannone, & Miranda, 2017)

These risks relate to the marketing and advertising of products.

Risk Elements

1. Lack of clarity in marketing
2. Increase in budget of marketing costs

Consequences

1. The consumer may not receive the message of the brand clearly and it would directly affect revenues.
2. The cost benefit balance would be overthrown. There may also, temporary liquidity issues in the marketing expenditure overshoots the budget.

Likelihood: 2

Severity:2

Risk Scale: 4

Exogenous Risks

Exogenous Risks are those risks that are a result of elements that are not within the network actors of the project. The likelihood and severity of these risks cannot be determined. Hence, they are not included in this analysis.

Environmental: These risks relate to the environmental factors such as natural disasters etc.

Risk Element: Disasters such as hurricanes, earthquakes can disturb business as usual

Consequence: Natural disasters can affect the supply chain, damage inventory, reduce demand temporarily

Market Risks

These are the risks related to the nature of the markets and are not a result of the actions of the firm or any of the network actors of the firm.

Risk Element:

Changing tastes and preferences may lead to declining demand of the products. The young group is especially prone to giving up on a fashion trend after a period of time.

Consequences:

If demand lowers, it could directly affect revenues. The investment could result in losses.

Changes in consumer habits are a significant risk category over the period of seven years.

Risk Element

 Consumer spending may decline. Australia has one of the highest levels of household debts in the world, due to the availability of easy credit. The lack of availability of easy credit or the changes in spending habits of consumers may reduce demand for the product

(Martino, Fera, RafaeleIannone, & Miranda, 2017)

Consequence

Changes in spending habits may overthrow all projections and lead to an overall decline in revenues.

The lab will require an initial investment of $1,550,000 to establish the lab with a straight line basis depreciation for 10 years. As mentioned before, the cost of adding the “Freedom” line is $100,000. It is important to note here that the line will be introduced whether or not the Customization Lab is approved. It is expected that all the units of the “Freedom” jeans will be sold out during the first six months of introduction, at the price of AUD75.

Revenue and Cash Flows

As service charges, every customer will be charged $40.00 as subscription for every year maximum up to three jeans.

It is expected that, in the opening years, 36,000 customers from Australia will use the service. Based on some market research, the usage of services by customers is expected to increase by 10% per annum over the life of the lab. The firm does not expect to increase the price of the service over the seven years. It expects that there will be no change in the yearly subscription costs and subscription fee will remain at $40.00 per customer over the life of the lab. The custom lab is expected to increase the total sales of For-U Jeans by $600,000 in its first year of operation. The total amount of growth in sales is expected to increase at the rate of 12% p.er annum over the seven years. The total final costs of these jeans are 60% of the total revenue. No other costs are applicable:
The fixed and variable costs for the lab are as follows:

• Personnel costs = AUD 800,000 Per Annum
• Cost of materials = AUD 200,000 Per Annum
• Other costs – AUD 25000 per annum
• Marketing and Advertising Expenditure = AUD 46000 per annum.

These costs will increase by 6% per annum over the life of the project.

Using the information above the cash flows can be calculated as follows:

• Depreciation has been included in costs and divided uniformly over the period of seven years

Costs of Goods Sold

‘Costs of Goods Sold’ is essential the total costs of manufacturing the product, from the factory to the outlet. (Seigel & Shim, 2000). Costs of goods sold are all the Total Costs that are expected to be accrued over the period of the analysis.  Here, the total costs for the project are added. The initial investment has been taken in to account by way of depreciation.

Table 1 Total Cost of Goods Sold  for the Project Per Year (in AUD)

Year	Total Costs of Customization per year  (in AUD)	Total Costs of Jeans Per Year (in AUD)	Depreciation Per year (in AUD)	Total Costs of Goods Sold  Per Year (in AUD)
1	1071000	403200	221428.571428571	1695628.57142857
2	1135260	451584	221428.571428571	1808272.57142857
3	1203375.6	505774.08	221428.571428571	1930578.25142857
4	1275578.14	566466.972	221428.571428571	2063473.68342857
5	1352112.82	634443.006	221428.571428571	2207984.39742857
6	1433239.59	710576.166	221428.571428571	2365244.32742857
7	1433239.59	795845.304	221428.571428571	2450513.46542857

Profits and Profits After Tax

Profits are takes as Revenues-Costs. However, given the effects of taxation, profits may not be a good measure to understand the value of investment. Hence, profits after tax are analysed. Profits after tax reflect the profits that would be accrued after the taxes would be paid.

Table 2 Total Profits and Profit After Tax Per Year

Year	Total Revenues per year  (in AUD)	Total Costs per year  (in AUD)	Total Profits per year  (in AUD)	Profit After Tax per year  (in AUD)
1	2112000	1695628.57142857	416371.42857143	291460.000000001
2	2336640	1808272.57142857	528367.42857143	369857.200000001
3	2585356.8	1930578.25142857	654778.54857143	458344.984000001
4	2860751.62	2063473.68342857	797277.93657143	558094.555600001
5	3165709.01	2207984.39742857	957724.61257143	670407.228800001
6	3503428.01	2365244.32742857	1138183.68257143	796728.577800001
7	3877456.84	2450513.46542857	1426943.37457143	998860.362200001

Annual Rate of Return (ARR)

Accounting Rate of Return is a simple measure that depicts the rate of return without discounting for the discount rate i.e without taking into consideration the time value of the investment.

Accounting Rate of Return  (ARR) was calculated as Average Return over 7 years / Average Investment over 7 years (Seigel & Shim, 2000) The Average Return was takes as the total Revenues over the period of seven years divided by 7. The Average Investment was taken as the total costs (Total Initial Investment + Total Costs Over Seven Years)  and divided by 7.

Risk Analysis

ARR = 0.25%

Net Present Value

Net Present Value gives an idea about the. Present Value of an Investment for a series of cash flows that will be accrued in the future. (Frederick, 1999) It takes into consideration the value of investment discounted at the desired Discount Rate (here taken as 14%). Discount Rate is that Rate of Return that is the assigned value for forgoing present consumption in favour of future returns. Here, the assigned value was taken at 14%

Internal Rate of Return

‘Internal Rate of Return’ is that Rate of Return, where the Net Present Value is reduced to Zero. It provides an idea about the idea of the attractiveness of a project. The Internal Rate of Return was calculated from a series of trial and error to observe at which percentage does the value of NPV come the nearest to zero.

In order to calculate the Net Present Value,  I used MSEcel and the NPV function. The cash flows were taken from the total Profits After Tax  (Seigel & Shim, 2000)  in the corresponding year in MSExcel. 

Table 3 Net Present Value and Internal Rate of Return When Customization services are priced at $40

Parameter	Value
Net Present Value	$103,333.33
XIRR	10

Sensitivity Analysis is used to measure the changes that would occur to the financial returns when some variables in the analysis are changed. For example, the addition of the new line of jeans, the Freedom Jeans will serve as an additional source of income for the Customization Lab.

Similarly, changing the Annual subscription charged for Customization Services may change the Revenues. Hence, Sensitivity Analysis is performed in order to understand how given changes in some variables would change the financial outlook of the project.

Here we have taken two analyses:

1. Analysis for Freedom Jeans as a complimentary Good to the customization: The availability of cost effective jeans may attract customers. If Freedom Jeans are sold as a product as Customization Services are sold as as add –on, it may spur the customers to try the services. However, the costs of the new line of products must be weighed against its benefits. Hence, the analysis given below is performed.
2. Changing the prices of Customization Services: Customization Services are priced at AUD 40 , keeping in line the general trend in the market for such services. However, it is possible that customers may not find it attractive to pay an upfront charge of subscription of $40 . Additionally, if the price of customization Services is slightly lower than the general , prevalent price in the market, the firm may have a cost advantage.  Hence, the financial analysis of the customization services is analysed at AUD35 per year. On the other hand, it is possible that For- U is under pricing the product and raising the prices may increase the revenue. Hence, an analysis is also conducted with the price of customization services at AUD 50 as subscription charges

The results for both these analyses are given below.

Analysis for Freedom Jeans as a complimentary Good to the customization

• In this case, there is an additional costs of AUD 100,000. The additional expenditure of AUD 100,000 is depreciated over the period of 7 years.
• The revenues of AUD 75 X 2000 were added to the total revenues of the first year. The Revenue projections for the rest of the period of the remain unchanged.
• Same Taxes are applicable. All calculation methods are same as previously used.

Table 4 The Revenues, Costs and Profit After Tax for the Addition of Line

Total Revenues	Total Costs of Goods Sold	Total Profits	Total Profits After Tax
2262000	1709914.28571429	552085.71428571	386459.999999997
2336640	1822558.28571429	514081.71428571	359857.199999997
2585356.8	1944863.96571429	640492.83428571	448344.983999997
2860751.62	2077759.39771429	782992.22228571	548094.555599997
3165709.01	2222270.11171429	943438.89828571	660407.228799997
3503428.01	2379530.04171429	1123897.96828571	786728.577799997
3877456.84	2550793.55971429	1326663.28028571	928664.296199997

Table 5 Net Present Value , Internal Rate of Return, Accounting Rate of Return with the Addition of Freedom Line

Parameter	Values
Net Present Value	0 AUD
Internal Rate of Return	14
ARR	0.113485171616551

The Net Present Value of the Investment is zero. It is possibly because the Rate of 14% per annum is the Internal Return Rate. Hence, 14% per annum was taken as Internal Return Rate.

Customization Services are Priced Differently

Table 5: Total Revenues When Customization Services are prices at $35 per Year

Year	Number of Customers	Revenues From Sales in  Jeans	Revenues From Customization	Total Revenues
1	36000	672,000	1260000	1932000
2	39600	752640	1386000	2138640
3	43560	842956.8	1524600	2367556.8
4	47916	944111.6	1677060	2621171.62
5	52,707.60	1057405	1844766	2902171.01
6	57,978.36	1184294	2029242.6	3213536.21
7	63776.2	1326409	2232167	3558575.84

Table 6 Total Profits and Profits After Tax for Customization Services at the Rate of $35 Per Year

Total Revenues	Total Costs of Goods Sold	Total Profits	Total Profits After Tax
1932000	1695628.57142857	236371.42857143	165460.000000001
2138640	1808272.57142857	330367.42857143	231257.200000001
2367556.8	1930578.25142857	436978.54857143	305884.984000001
2621171.62	2063473.68342857	557697.93657143	390388.555600001
2902171.01	2207984.39742857	694186.61257143	485930.628800001
3213536.21	2365244.32742857	848291.88257143	593804.317800001
3558575.84	2536506.87542857	1022068.96457143	715448.275200001

Table 7 Net Present Value , Internal Rate of Return, Accounting Rate of Return When Customization services are priced at $35

Parameter	Value
Net Present Value	$103,333.33
XIRR	12
ARR	1.25124441575158

 Table 8 Total Revenues when Customization Services are priced at $50 per year

Year	Number of Customers	Revenues From Sales in  Jeans	Revenues From Customization	Total Revenues
1	36000	672,000	1800000	2472000
2	39600	752640	1980000	2732640
3	43560	842956.8	2178000	3020956.8
4	47916	944111.6	2395800	3339911.62
5	52,707.60	1057405	2635380	3692785.01
6	57,978.36	1184294	2898918	4083211.61
7	63776.2	1326409	3188810	4515218.84

Table 9 Total Profits and Profits After Tax When Customization Services are Priced at $50

Total Revenues	Total Costs	Total Profits After Tax	Total Profits After Tax
2472000	1695628.57142857	776371.42857143	543460.000000001
2732640	1808272.57142857	924367.42857143	647057.200000001
3020956.8	1930578.25142857	1090378.54857143	763264.984000001
3339911.62	2063473.68342857	1276437.93657143	893506.555600001
3692785.01	2207984.39742857	1484800.61257143	1039360.4288
4083211.61	2365244.32742857	1717967.28257143	1202577.0978
4515218.84	2536506.87542857	1978711.96457143	1385098.3752

 Table 10 Net Present Value ,  Internal Rate of Return, Accounting Rate of Return When Customization Services are priced at AUD50

Parameter	Value
Net Present Value	$92,339.89
XIRR	10
ARR	19.6341143681367

The term business sustainability is very important in this context. Any sustainable business should be built on three pillars or “Triple Bottom Line”. This was a term introduced by John Elkington in 1994. (Hindle, 2009)  and encompassed three aspects of Financial , Environmental and Social. Financial sustainability has been discussed above. However, modern firms have an added responsibility as member of the society and do not only seek  financial gain but also seek to add net value to the society.

The two other important considerations are mentioned below:

• Environmental: This aspect includes creating an environmentally sustainable value chain. The environmental aspect of the project may relate to reducing the carbon footprint of all processes in the value chain, making efforts to source environmentally sustainable products etc.

• Energy Reduction: For-U Jeans may have to start analysing the amount of energy input that is used in producing per unit of jeans and try to reduce it. The jeans are being customized. This implies that each pair of Jeans will be treated individually or would be treated with a small batch of other jeans This could possibly lead to an increase in energy use and the Company must try to keep it’s energy footprint to the minimum. (Bonini & Gorner, 2011)
• Ecologically Sensitive Materials: The Company could also consider ecologically sensitive materials, organic materials, eco friendly paints etc. The Company could market these as a level of customization to the product i.e these could be included as customised options by the Company. Including ecologically sensitive materials may not necessarily affect the bottom line. Additionally, such an option could help market the product to the socially and environmentally conscious consumers by offering them a different modification of the same

• Social: The social aspect relates to the impact that the Company has on the society. Social sustainability starts with creating a better environment for the employees and can be extended to having a positive impact on the different members of the society that come in touch with the business. (Bonini & Gorner, 2011)

• The firm can consider ethical sourcing by ensuring materials are purchased only from supplier that are certified by Fair Labour Certification.
• Alternatively, For- U could consider ethical sourcing by ensuring materials are purchased only from firms that do not employ any form of child labour

The decision analysis for this project is being done based on the Profits After Tax, Net Present Value, Internal Rate of Return as well as the accounting Rate of Return

Scenario 1: Customization Services without the addition of “Freedom” Line

 The Net Present Value is lower that the Present Value. The Investment may make profits but it does not fulfill the criteria of 14% Required Rate of Return. The Accounting Rate of Return is 7%. This is not very high. Hence, although the project may make profits, it would not be a great investment , speaking in strictly monetary terms.

Scenario 2: Customization Services with the addition of “Freedom” Line

The Freedom line adds value in the form of profits. Additionally, the NPV was 0, thereby confirming that the Internal Rate of Return is 14%.  This meets the company stated criteria of 14% . Hence, this would be a good investment.

Scenario 3: Customization Services Prices at AUD 35

The profits are lower, even if NPV is same. This is not a good investment, even if the price of services may be attractive to the consumer. The accounting Rate of Return is very poor.

Scenario 4: Customization Services Prices at AUD 50

Profits are higher and Internal Rate of Return is lower. Hence, from a point of view of analysis, this is a good investment. The price point of AUD 50 may not be attractive to customers and may lead to change in projections even if the accounting rate of return is low.

Recommended Decision

From an investment point of view, returns will be maximized if the revenues from the Freedom Line are added to the profits of Scenario 4 i.e when the customization services are prices at AUD 50

• The firm can look to improve its costs by seeking to reduce its costs, in the operational and advertising department.
• The firm can seek to expand its consumer base by increasing advertising and marketing efforts.
• The firm can raise the costs of customization to $50 per year.

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