Best and Worst Case Scenarios
In this assignment you will develop best and worst case scenarios for next
round.
You need to balance two risks -- the risk of missed sales because of stock outs
(lost profits), and the risk of building too much inventory. In your worst case,
competition is fierce and you end up carrying lots of inventory and potentially
going bankrupt. In your best case, you sell everything but one unit on each
product and have lots of Cash. In the worst case, you have lots of
Inventory and little or no Cash.
If you add the Balance Sheet's Cash and Inventory together, you get a sense for
your reserves. A small reserve exposes you to both risks. But a big reserve
earns you nothing, not even bank interest. Therefore, you want to keep the
reserve as small as possible. With a perfect forecast, your reserve could be
tiny. The better your forecasting, the smaller the reserve you require.
Capsim prepares a set of pro forma accounting statements automatically. These
can be used to develop a best/worst case set of scenarios.
A. Make all the decisions you would normally for a round.
B. Go back to the Marketing Decisions page. For each product put in a forecast for the most units you think you could possibly sell. This is NOT the forecast you will use for the round (which you put in A) but a number larger than that.
C. On the Production Decision page, produce enough so that your starting inventory plus the production will equal your best-case forecast. Nothing extra. In your best-case you will use all your inventory and have nothing left.
D. Write down the Best Case:
i. forecast numbers for each product from (B)
ii. inventory dollar amount (should pretty much be 0) – get from the pro-forma balance sheet
iii. total dollar sales – get from the pro-forma income statement
iv.
cash balance – get from the pro-forma balance sheet
A. Now go to the Marketing Decisions page. For each product put in a forecast for the lowest number of units you think you could possibly sell. This is NOT the forecast you will use for the round but a number smaller than that.
B. Do not change the production! This is to test what happens if you build for the best-case but the worst-case happens.
C. Look at your cash balance – find on the Finance Decisions page. If your Cash is negative or zero, use Current or Long-Term Debt to bring Cash to a small positive number. This is important. Here is where you protect yourself against bankruptcy. If things go to hell in a hand basket, you must have enough cash to stay in business.
D. Write down the Worst-Case:
i. forecast numbers for each product
ii. inventory dollar amount (probably high) – get from the pro-forma balance sheet
iii. total dollar sales – get from the pro-forma income statement
iv.
cash balance – get from the pro-forma balance sheet
3. What is the spread between your best and worst-case Sales? A “spread”
is just the difference (subtraction) between two things. For example, in
your worst case, total sales might be $120M. In the best, $150M. The spread is
$150M - $120M = $30M.
The spread is the amount of inventory that would be left in the worse-case.
In other words, if you build enough product for the best case and the worst case
happens, you will be left with the difference in inventory.
That worst-case inventory can then be thought of in terms of how many months of
sales it would take to sell it all off or the percent extra you produced.
Calculate it both ways.
A. What is the spread between your best and worst-case Sales numbers?
spread = (best-case sales) – (worst-case sales)
B. What percent extra did you produce?
percent extra = spread / (worst-case sales)
B. What is the spread in number of months?
number
of months of inventory = (percent extra) * 12
4. The number of months of inventory you calculated in (3) may be very large. For example, if you get 6 months, that’s a lot of inventory to build that might not be needed. It costs money. How many months of inventory do you plan to make for your next round? You can calculate both ways.
A. If you say you will make 10% extra above your forecast (this is what most of you have been doing in the simulation), then
Number of months of inventory = .10 * 12
B. You can determine you will make N months extra inventory (just in case you forecasted low) and then in your simulation you will
percent extra = N / 12
5. If you have too much inventory, you may go bankrupt. But if you don’t produce enough, you lose out on profits. NOTE: your fixed costs were already covered by the sales you did make, even in the worst case. Therefore, additional sales would only incur the cost of goods. Marketing, R&D, and depreciation expense have already been paid for by the units you did sell. Even the Interest payments have been made. The missed costs are a big profit loss.
A. Calculate the cost of missed profits for one of your products. Pick a product.
B. Look at your product’s sales forecast in units for the next round. Suppose it is N.
Suppose you could have sold 5% more. How many units is that?
lost
sales = .05 * N
C. How much profit did you lose?
lost
profit = (lost sales) * (contribution margin %)
lost
profit = (lost sales) * (product price – material costs – labor costs)
The lost profit is the opportunity cost for that product of missing 5% in sales.
Deliverables
Your answers to questions above.