Problems With Assumptions Given: Selling, General, and Administrative Expenses

The document outlines several assumptions in the given case that may be overly optimistic: 1) The projected 1% decrease in SGA/sales expenses assumes tighter cost controls, but does not account for costs previously absorbed by the previous owner. 2) The projected increase to a 40% gross margin is higher than historical levels and could attract new competitors, decreasing prices and margins. 3) The assumed 2% real growth rate in prices is optimistic given the case describes the industry growth as flat or declining, and mature firms typically see growth rates around inflation. 4) Continual real price increases cannot continue indefinitely and increased sales would require higher capital expenditures not reflected in the forecasts.

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Problems With Assumptions Given: Selling, General, and Administrative Expenses

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ARVIND

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Problems with Assumptions Given

1) Selling, general, and administrative expenses: The forecast given

in the case assumes that SGA/sales is 14% which is 1% decrease from
historical 15% under Stout’s ownership. There can be for and against
argument for it as he presence of an owner-manager will produce tighter
cost controls. Others may argue that some of Canaveras’s costs may have
been carried by Stout.

2) Gross Margin: The total gross margin of the firm is projected to rise to
about 40%, which is higher than the 28% margin that the firm stated for the
year 1990.The owner can point out that as the industry margin has been
improving from 1990%, this could be a realistic assumption. But as
competitors would see an industry providing 40% margin, more number of
firms will try enter this segment. Resulting in decrease of margin as you
cannot charge higher unit price for the same product. Hence the
assumption of 40% gross margin compared to 28% in 1990, seems quite
optimistic assumption.

3) Real Growth Rate of Price: As stated in the case, real growth rate is
assumed to be 2% till company exist, which is again a quite optimistic
assumption, because it is mentioned in the case itself that the growth of the
industry is flat even if it’s not declining. And as firms matures the growth
rate of firm merely reduces to 0.5%+- the nominal growth rate. That is the
growth rate at which the firms earn enough that they can be a growing
concern.

4) Sales growth and operating constraints: The main driver of firm’s

extraordinary growth rate has been the real price increase of the firm. But
the price increase cannot continue indefinitely as new players would enter
into market and they would pull down the prices to the fair value. Another
way to achieve this growth rate is increase in the volume of sales which
could be achieved by increasing the capex on yearly basis. But the
forecasted income statement and the balance sheet hasn’t been adjusted
on that line.