PCI Construction Inc. June_2000_Solution Exam CMA

Solution to June 2000 Entrance Examination – Part 2

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Solution toJune 2000 Entrance Examination

Part 2Question 1 (240 minutes)The following sample solution presents one approach to the case. Candidates should note thatother valid approaches and conclusions are possible.

Date: June 21, 2000To: Vincent Goodrich, Acting President and CEOFrom: Dorothy Pedneault, ControllerRe: Strategic Direction of PCI Contruction Inc.

Attached is the requested report containing my analysis and recommendations regarding PCI’sstrategic direction.

Dorothy Pedneault

A Report to the Management of PCI Construction Inc.

TABLE OF CONTENTS

EXECUTIVE SUMMARY

INTRODUCTION

STRATEGIC DIRECTIONExternal Environment

STRATEGIC MISSIONOPPORTUNITIES AND THREATS- Contractor Industry- Retail Hardware IndustryCOMPETITIVE POSITION- Contractor Industry- Retail Hardware Industry

Financial AnalysisCASH FLOW- Liquidity- Inventory


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- Accounts Receivable- Long-term Versus Short-term Financing- Lease ProposalPROFITABILITYBUDGETINGCAPITAL STUCTURE

Internal EnvironmentMANAGEMENTHUMAN RESOURCES- Store Managers- Sales Representatives- Store Staff- Seasonal StaffINFORMATION SYSTEMSINTERNAL CONTROL

GENERATION AND CONSEQUENCES OF ALTERNATIVESBuild a PlantMerger with Kontact Co.Strategic Alliance With Marson’s MaterialsInvite an American Company to Buyout PCI

RECOMMENDATIONS

IMPLEMENTATION PLANStrategic MissionProduct LinesInventory ManagementPricingCustomer ServiceMarketingFinancial Management1999-2000 BudgetInformation SystemManagement

APPENDICESAppendix 1 – Market and Sales AnalysisAppendix 2 – PCI Construction Inc. Financial AnalysisAppendix 3 – PCI Construction Inc. 1999-2000 Quarterly Budget


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EXECUTIVE SUMMARYPCI Construction Inc. has performed well until recently by relying on its foundational value ofproviding quality service to contractors and homeowners at a reasonable price. Under themanagement of Oliver and Phil Parsons, PCI was a proactive firm that attempted to exceed itscustomers’ needs. At that time, PCI had enjoyed a relatively stable industry and regionalmonopolies, which ensured steady profits. In the past few years, however, PCI has had to adaptto uncontrollable events and adverse economic conditions. Competition has been increasing inthe retail hardware market and destabilizing in the construction industry.

All of these changes have gradually transformed PCI to a reactive firm. As such, PCI is nolonger anticipating its customer’s needs and has increasingly found itself lagging behind itscompetition with regards to innovations, such as assembled trusses. The result is an increase inthe bank overdraft and long-term debt to the point where solvency is an issue. PCI needs to takeaction to ensure the short-term survival of the business as well as its long-term growth.

PCI’s management should re-focus its mission on proactively anticipating its customers’ needsand meeting these needs on a timely basis. To accomplish this and promote growth, it isrecommended that a strategic alliance be established with Marson’s Materials, a firm which isadept at anticipating customer needs. Changes will also be required in PCI working capitalmanagement, marketing, information systems, and other aspects of its operations.

In the retail hardware market, attempts at competing with the large chains for the home repaircustomer should be abandoned. The focus should be placed on servicing the home improvemententhusiast, who is less price sensitive.

Working capital will need to be closely monitored to ensure adequate cash flow to manage PCI’sgrowth. The strategic alliance with Marson’s Materials will eliminate the need for a largeinvestment in a truss assembly plant. Leasing forklifts rather than purchasing them, together withimproving inventory management and other operational improvements will help increase cashflow. Contracting an experienced professional to assume the duties of Controller for the nextyear will also be essential to help control PCI’s finances and assist in the alliance negotiations.

Updating the information system and establishing a web page on the Internet will greatlyenhance PCI’s ability to attract and service customers, and to efficiently manage operations. Itwill be necessary, however, to finance this project by issuing new shares. Some of these sharesshould be offered to the Marson brothers, which will strengthen the relationship between PCIand Marson’s Materials and increase the probability of a successful strategic alliance.

It is anticipated that implementation of the recommended changes will lead to an exciting andprosperous future for PCI.


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INTRODUCTION

In fiscal 1998/99, PCI Construction Inc. (PCI) has experienced a significant decrease in sales. Ithas also experienced its first negative income before taxes, dropping from a profit of $809,000 toa loss of $1,023,000. Changing market conditions in the contractor business and an impendingemergence of another major competitor in the retail hardware business will put further pressureon PCI’s future profitability.

This, together with current cash flow problems, calls for a re-evaluation of PCI’s strategicposition, management philosophy and business processes.

This report presents an analysis of PCI’s current situation, and provides recommendations and animplementation plan to address the strategic and operational issues facing PCI. Adopting therecommended plan should result in a greatly improved financial position and should convincethe bank manager that the appointment of a management consultant is not necessary.

STRATEGIC DIRECTION

In light of the changing market conditions, PCI is currently considering a number of alternatives,including the possible merger or strategic alliance with existing competitors. To help assess thesealternatives and determine an appropriate strategic direction, a situation analysis of the externalenvironment, PCI’s financial position, and PCI’s internal environment are required.

External Environment

STRATEGIC MISSION

PCI currently does not have a formal strategic mission. The company has evolved from a smallfamily-owned store with an original mission to supply local farmers with tools and hardwareproducts, to a three-location operation that focuses more on the growing urban constructionmarket.

The current objectives of PCI include the following:

1. To provide excellent service at competitive prices to contractors to ensure loyalty.

2. To offer hardware products that satisfy the needs of farmers.

3. To sell high quality lumber products that are consistent with the needs of middle-classhomeowners.

4. To provide knowledgeable staff and custom plans to assist homeowners in completinghome improvement projects.

OPPORTUNITIES AND THREATS

Contractor Industry:

As seen in Appendix 1, the total market size of the contractor industry in the Cedarville area hasincreased during the 1994 to 1998 period (i.e., a 13.7% increase from $131 million to


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$149 million). However, a 2.7% decrease in the market size in 1999 shows signs that the marketmay be stabilizing. Therefore, PCI’s survival and growth in this industry will depend onmaintaining or increasing market share.

The low barriers to entry of contractors in the construction industry has created increasedcompetition between contractors which has resulted in greater emphasis on completingconstruction projects more quickly and economically. This in turn has placed more pressure onsuppliers such as PCI to be innovative in providing high quality products that save thecontractors’ time and money. The greater competition among contractors has also resulted inmore bankruptcies, which is increasing the risk of their defaulting on their accounts payable totheir suppliers.

Competition in the contractor market has been quite stable, but it is predicted that it will notremain so. The contractors are increasingly demanding assembled products and the associatedincrease in product quality, which will likely increase the need for suppliers such as PCI to bemore capital intensive and place greater emphasis on new product development. This growingdemand for assembled products presents PCI with an opportunity to increase its profits, as theseproducts have a higher revenue and gross margin potential than raw lumber as a result of thevalue-added service.

Industry consolidation through mergers, acquisitions and other alliances could threaten theregional monopolies that PCI and its competitors enjoy in the contractor segment. PCI could turnthis threat into an opportunity to gain market share in contractor segments that are currentlybeing serviced by competitors.

Retail Hardware Industry:

The size of the retail hardware market is more than 35 times greater than the size of thecontractor market, but has been less stable. For example, the retail hardware market size droppedby 36% from 1994-95 to 1995-96. During the next two years, market size made a partialrebound, growing by 29%, but there are signs that the market size decreased again in 1998-99. Itappears that this fluctuation in market size pertains mainly to the large category of customers thatare only occasionally involved in basic home maintenance. The stability in PCI’s sales in theretail hardware market is evidence that the smaller market pertaining to home improvementhobbyists has remained fairly stable.

The retail hardware market had recently undergone a rationalization in the Cedarville area,leaving it with two large chains that mainly service the large basic home maintenance market(i.e., 75 % of the total market) and a large number of small to mid-sized hardware stores thatmainly service the small home improvement hobbyist market (i.e., 25% of the total market). Thecurrent balance is threatened by the possibility of a third large retail chain, from the UnitedStates, entering the province’s market. Severe price competition will likely result, reducing PCI’schances for success in the basic home maintenance market. However, an opportunity will stillexist for PCI to expand its share of the total market by providing superior service to the marketniche comprised of home improvement hobbyists who are not particularly price conscious.Consolidation of PCI with some of these smaller stores may increase its chances of success inthis industry.


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COMPETITIVE POSITION

Contractor Industry:

PCI holds the third largest share of this market, which features only five major players. The keysuccess factors for the contractor market include the following: innovative products, high qualityproducts, product availability, quick delivery times and, to as lesser extent, reasonable prices.PCI has always ranked well in product quality, product availability, delivery, and competitivepricing, and but it has lagged behind competitors in adapting to product innovation.

Another key success factor is keeping good relations with contractors, since familiarity ofsuppliers with their customer’s needs and tendencies make ordering and communication easier.PCI has been successful over the years in establishing a good relationship with contractors,resulting in their being strongly loyal to PCI.

PCI’s market share has increased by more than 1.5% during the 1994 to 1998 period to a high of20.86%. However, by 1999, even its strong customer loyalty could not prevent an erosion ofmarket share (drop of 2.5%) caused by PCI’s lack of product innovation. With the market sizestabilizing, PCI’s market share will continue to decrease unless it addresses the productinnovation issue.

Retail Hardware Industry:

The key success factors for the retail hardware industry differ for the two main types ofcustomers. For the basic home maintenance market, price is the main key success factor. For thehome improvement hobbyist market, customer service and availability of special hardwareproducts are the main key success factors. Because of PCI’s limited purchasing power, it cannotprofitably compete with the two larger chains based on pricing. Therefore, PCI has had to focuson providing superior quality service to compete in the home improvement hobbyist market. Thisfocus, together with PCI’s stores being well located on main streets, has resulted in a solid baseof loyal customers.

PCI’s total market share fluctuated during the period of 1994 to 1998, but its total sales did notreflect the same fluctuations, which suggests that the market size changes were mainly related tothe basic home maintenance market. However, in 1998-99, PCI’s sales dropped to a five-yearlow of $12.5 million from a high of $14.8 million in 1997-98. Since there were no significantchanges in the competitive structure in the retail hardware industry during the past year, it isassumed that the decrease in sales resulted more from a decrease in the size of the market thanfrom a decrease in market share. This would indicate that PCI should continue to focus onproviding superior quality service in an effort to increase market share.

Although the retail hardware market is far larger than the contractor market, there is muchgreater competition and PCI’s market share is less than one-third of one percent. Although themajority of PCI’s sales are to home improvement hobbyists, this market is only 25% of the totalretail hardware market and PCI’s sales represent only around 1% of this market. Clearly, PCI is avery minor player in this market and must find additional competitive advantages if it wishes toimprove its profile in this market.


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Financial Analysis

With the changing nature of the external environment and the bank’s concern over PCI’s abilityto service its current level of indebtedness, it is important to carefully analyze PCI’s financialinformation. Various aspects are reviewed below, supported by the quantitative analysis shownin Appendix 2.

CASH FLOW

PCI’s sales are seasonal, which makes cash flow management quite challenging. During the firsthalf of the year, inventory levels are stocked up in preparation for the busy summer sales months.This results in large cash outflows in the early part of the year while cash inflows typically occurin the second half of the year.

Liquidity:

Ratio analysis shows that PCI’s liquidity has remained fairly stable and reflects the norm for theindustry (e.g., PCI’s current ratio of 1.35 in 1998-99 is comparable with 1.36 ratio of Marson’sMaterials which is considered to be financially healthy). However, in the event of an economicdownturn, PCI will not be able to cover its current liabilities, as indicated by the quick ratiobeing less than 1. This is especially true during the off-peak selling season, when it would bedifficult to liquidate its inventory.

Most of PCI’s working capital is tied up in inventory and accounts receivable; therefore,management of these assets is critical. Up until last year, PCI had succeeded in managing bothinventory and accounts receivable fairly well, as seen by the receivables turnover and inventoryturnover ratios being comparable with the benchmark ratios of two of its competitors.

With the decrease in sales experienced last year, the inventory levels could easily have gone outof control, but it appears that PCI had made an attempt at adjusting inventory levels to matchsales. Nevertheless, some improvement in this area is still required, particularly with theinventory of lumber products, to try to bring the inventory turnover ratio at least back to the levelof 4 time per year, and to decrease the bank overdraft levels.

Inventory:

The policy of keeping the inventory of hardware products to a minimum has been effective.However, the practice of purchasing large quantities of lumber and related products, whileproviding some savings from quantity discounts and providing protection from pricefluctuations, is tying up working capital. Other costs associated with this policy relate to storage,interest, inventory control, spoilage and theft. The costs versus benefits should be carefullyanalyzed to determine whether this purchasing policy should be revised. This analysis shouldtake into account the key success factor of product availability and quick delivery to contractors.PCI should be careful to avoid cutting back inventory to such an extent that customers and salesare lost.

Accounts Receivable:

The trend of contractors declaring bankruptcy and reopening under different names could have aserious impact on cash flows. To date, PCI’s contractors have always paid their accounts each


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month, but the increase in the receivables turnover ratio last year indicates that they are startingto take longer to pay. There is even a danger that Citrus Housing, which owes PCI $340,000,may default if it loses a lawsuit that it is facing. PCI must maintain its credit check practices andshould consider providing some incentives to contractors to pay their accounts earlier (e.g.,payment discount terms of 2/10, net 30; impose interest charges on late payments).

Long-term versus Short-term Financing:

Over the past two years, PCI’s net capital assets have increased substantially, but the long-termdebt has not increased by the same amount. At the same time, the bank overdraft has alsoincreased substantially. This indicates that PCI may inappropriately be using short-term debt tofinance long-term capital assets. This situation should be rectified. One way would be to convertsome of the bank overdraft to long-term debt.

Lease Proposal:

The proposal to lease forklifts would also help the cash flow situation. Rather than purchasingforklifts and bearing the expense of financing the purchase and maintaining the forklifts, PCIcould lease the forklifts as required. According to a financing consultant, the net present value ofthe leasing plan would be $55,500 over a 7-year span. By leasing the forklifts, PCI would havethe flexibility of increasing or decreasing the number of forklifts it leases according to its needs.

By selling all the forklifts it currently owns and leasing its forklift requirements according to theproposed plan (i.e., 9 under a long-term contract, 9 on a monthly basis for the peak months and 9on an hourly basis when required), the proceeds from the sale could be used to decrease the bankoverdraft by about 5% and decrease capital assets, which would help the balance of short-termversus long-term financing. However, it is doubtful that this change alone would eliminate thebank’s concerns. It should be noted that the 9 forklifts under long-term leases would have to becarried on the books as capital assets because there is a bargain purchase option and the term ofthe lease is greater than 75% of the estimated economic life of the forklifts. However, the other18 forklifts would be expensed as the related costs are incurred.

PROFITABILITY

Up until the 1997-98 year, PCI’s total sales had continually increased. However, there was a14.8% decrease in sales in the 1998-99 year, and a further 4.8% drop is expected for next year.With a stable gross margin percentage (i.e., between 23% and 24%) and very small profitmargins (i.e., less than 2% in the past 5 years), the bottom line has depended on increasing totalsales and strictly controlling expenses.

As can be seen from Appendices 1 and 2, PCI has managed to control its operating and sellingexpenses, but the increase in the administration and interest expenses together with the decreasein sales has resulted in a substantial loss in 1998-99. Unless a new strategic plan is set with theobjective of increasing sales, some cuts will have to be made in expenses to avoid incurringfuture losses.

The most significant expense is labour, which has remained relatively stable in relation to sales,except last year when sales decreased in greater proportion than labour. Reducing labour costs


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could have a great impact on the bottom line. However, care must be taken to keep service levelshigh, otherwise, there would be an adverse effect on sales.

It has been suggested that retail store employees be asked to accept a temporary 10% pay cut andthat lost salaries be partially reimbursed when sales targets are achieved. The sales targets wouldbe set to reflect achievable levels. It appears that this suggestion would decrease expenses in1999-2000 by $342,700, which is almost enough to offset the budgeted loss for the year. It alsohas the potential to motivate employees to increase cash flows and profitability. As well, thebank overdraft would be decreased and the balance of financing would be improved. However,care would have to be taken to gain the co-operation of the employees or the plan could backfire.Without their agreement, employees could decide to unionize or they could reduce service levels,resulting in greater losses.

Top management could present a good example by also participating in pay cuts of at least 10%and employees could be offered stock options in lieu of the pay cut. This would demonstrate tothe employees that they are considered as partners in the business, which is consistent with thephilosophies of both Phil and George in the past. Another refinement to this suggestion is to basesalary reimbursements and/or stock option awards on store profit targets rather than on salestargets. This would provide an incentive for cost control in addition to increased sales.

BUDGETING

The budget for 1999-2000 that was presented to the bank indicated that PCI is expecting a loss of$349,000 before taxes. The labour costs reflected in this budget were based of a regressionequation whereby labour hours varied direction with sales. While this regression equation has areasonable r2 value, its t-value of 1.92 is low (i.e., less than 2), which indicates that changes insales alone do not result in significant changes in labour hours. A better regression equation touse is the third model proposed by the statistician who analyzed various possible variables forpredicting labour hours. This third regression model takes into account the seasonality of sales,has a higher r2 value (.755) and the t-values for each variable are greater than 2 indicating thatthe variables are significant in terms of affecting the level of labour hours.

Appendix 3 contains a revised 1999-2000 quarterly budget using the statistician’s third model tocalculate labour costs. It shows that labour costs will be $46,000 higher than originally budgeted,resulting in a loss before taxes of $395,000. The cash flow problem will be even worse thanoriginally predicted in 1999-2000 and, even if the store staff accept a 10% pay cut, there will stillbe a loss before taxes of $48,000. More will have to be done to either increase sales or decreaseexpenses to eliminate the expected loss.

CAPITAL STRUCTURE:

PCI’s debt-to-equity ratio of 3.2 in 1996-97 is much greater than those of Kontact Co. andMarson’s Materials (i.e., 1.17 and 1.22), and is a major concern of the bank manager. Onepossibility to help improve our ratio is to pay management bonuses in the form of shares insteadof cash. Managers have expressed a preference for this and this would also help the cash flowsituation.

The situation with my father, Réjean Pedneault, wanting to sell his shares back to PCI wouldhave an adverse effect on both the debt-to-equity ratio and cash flows. There is a possibility that


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Peter Martin may want to buy the shares and take over the position of President and CEO. If thishappens, there is speculation that Peter may wish to fire you (Vincent) and George, and hire hisown children for key positions. In the past, Peter’s children have indicated that they are notinterested in the business, so it is unlikely that they would accept their father’s offer. It may bebest for PCI overall if you and some of the other shareholders could purchase at least enough ofRéjean’s shares to avoid Peter Martin from gaining controlling interest. Otherwise, an attemptshould be made to dissuade Réjean from selling his shares. Implementing a new strategic plancould go a long way towards convincing him to keep at least some of his shares.

In any case, the debt-to-equity ratio will remain a serious problem that needs to be addressed.

Internal Environment

MANAGEMENT

One of PCI’s past strengths was the family orientation of the business and the requirement of topmanagement to own shares in the company. This has ensured their strong commitment to thesuccess of PCI. The requirement that younger family members first work in junior positionsensured that they received a good appreciation of the operations.

Unfortunately, this focus on the family may cause Peter Martin to attempt to take control of thecompany by acquiring the majority shareholding. Steps must be taken to avoid a power struggle,which will likely cause much internal strife at a time when the company requires topmanagement focus and cooperation if it hopes to survive and grow. Peter has been a friend ofGeorge for a long time and may not really want to cause problems. He is entitled to feel someresentment at not being appointed as Acting President, but such feelings can be mitigated bytreating him as a valued member of the management team and including him in the decisionprocess regarding PCI’s future strategic direction. We will need his full cooperation andexpertise if we are going to improve cash flow through reduced inventories.

Another problem arising from advancing family members more quickly than unrelatedemployees is that experienced senior employees may become demotivated as a result of feelingthat there is no chance for advancement. Consequently, the performance of these employeescould decrease, or they may decide to work for one of PCI’s competitors.

It may be time to place less emphasis on family orientation and base promotions on merit. It mayalso be necessary to hire experienced professionals to help direct and manage the company,particularly if George and Réjean do not return. It will be important to have a strong financialcontroller during these difficult financial times, a position that I am not currently qualified toassume. Also, if George does not return as President, we will need someone to take over themarketing function, unless you feel that an experienced professional with strong leadership skillsshould be hired to assume the CEO position allowing you to refocus your attention on marketing.

HUMAN RESOURCES

It is clear that customer service is PCI’s core competency and main competitive advantage.However, some problems in this area have become evident.


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Store Managers

Conflicts occasionally occur between store managers or between store managers, salesrepresentatives and/or head office staff. Typically, these problems have been solved by eitherbringing in the CEO to mediate a compromise or by simply reassigning the sales representativeto another PCI outlet. This approach fails to identify the real source of the problem, whichtherefore continues unresolved.

For example, a recent conflict occurred where the Newtown store’s manager argued that heshould be authorized to sell materials to a new large customer who was acquired by a salesrepresentative associated with the Kellerton store. The sales representative of course wished toservice the customer through the Kellerton store.

Another example is the Westbrook store’s manager directing his sales representatives to recruitcontractors from areas that would be traditionally served by the Newtown store, causing theNewtown store’s manager to consider competing for these customers by reducing his prices.

The root cause of these conflicts is the fact that the store managers’ performance evaluation andbonus awards are based on exceeding individual store profit targets. This type of performanceevaluation system appropriately focuses store managers to maximize store revenues whilecontrolling costs, but it does not promote cooperation or communication between stores topromote overall company profits.

The performance evaluation system should place more emphasis on corporate goals, suchmaximizing overall company profits, not just the profits of the manager’s store. This shouldeliminate the dysfunctional behaviour exhibited by the Newtown store manager and encouragestore managers to help each other to provide the best service possible to all PCI customers.Awarding company shares instead of cash would contribute to an overall company focus.

Sales Representatives

The sales representatives are currently in an unusual position at PCI. They play a major role inbeing PCI’s main link with contractors, yet they are not required to report to anyone on theboard, and they do not seem to be provided with any guidance regarding PCI’s mission andfuture long-term plans. The sales representatives might become more effective if they wererequired to report to someone at head office, such as Robert Grondin or Peter Martin, who wouldmanage their performance and behaviour as well as provide them with guidance with respect tothe board’s priorities in terms of customer development and other strategic issues relating to thebusiness relationships with contractors.

Store Staff

Full-time staff are currently well qualified and paid well. They feel like part of the PCI familyand are motivated to provide superior service to customers. They may be persuaded to accept thepay cut proposal if they are compensated some other way, such as being given shares instead ofcash, or being offered a profit sharing plan. What must be avoided is their becoming dissatisfiedto the point that they either quit or decide to unionize. Either of these eventualities could becomemore expensive for PCI than continuing to pay these employees at their current wage rates.


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Seasonal Staff

Seasonal staff are currently not motivated to learn more about the construction industry from themore experienced employees or on their own. They lack a sense of belonging to the PCI family.This situation will not improve if their wage rates are cut by 10% unless they are provided withsome other incentive. Some suggestions to help promote a team spirit and motivate theseemployees to provide high customer service include recognition awards (e.g., free movie ticketsfor the part-time employee of the month) and holding a company picnic. PCI could also organizepaid on-the-job training for these employees using the experienced full-time staff as instructors.This would not only improve the seasonal staff’s knowledge about the construction industry, butwould also have a positive impact on the self-image of the full-time staff.

INFORMATION SYSTEM

The current information system, which is based on batch processing, may have been efficient inthe past, but it could be updated to enhance PCI’s inventory system, particularly orderprocessing. To help manage inventory better, PCI should move to a real-time system with accessto the Internet. There would be many advantages to such a system, such as the following:

1. It would allow each store to make on-line inquiries regarding inventory levels and sales.When one store receives an order for materials, the store manager would be able to checkfor available stock of the materials at his own store as well as at the other PCI stores. Thiswould allow PCI to decrease its order sizes and thereby decrease its investment ininventory. This could improve PCI’s working capital position dramatically.

2. It would allow PCI to sent orders to suppliers electronically, reducing the amount of timerequired between making an order and receiving the goods. This capability would beparticularly useful for ordering lumber related materials, as minimizing delivery time is acrucial requirement of the contractors. This would also result in improved cash flow.

3. It would allow PCI to find and order special products for the home improvementhobbyists, thereby improving service and product availability to these customers.

4. It would allow PCI to enter the e-commerce business, i.e., selling hardware products overthe Internet.

5. It would allow the stores to monitor the inventory levels more closely and to detectdiscrepancies in the inventory levels sooner.

6. It would allow the sales representatives to check the current inventory from a laptopcomputer while visiting contractors. This would improve the service to contractors byallowing them to make substitutions on the spot if one item is not in stock but anotherequivalent substitute is available.

7. It would allow PCI to use the Internet as a promotional tool. A website could beestablished which would introduce PCI’s products and services to prospective customersin its target markets, and keep current customers informed about new products.

Implementing such a system, however, may be expensive, as the current system cannot be easilyadapted and an online system will require more controls than the current system. It may be time


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to investigate the availability of systems used by other retailers. Before committing to a newsystem, a careful cost-benefit analysis should be conducted.

There is a question of whether there will be a need for a full-time information systems manager.Denis Marois has expressed an interest in such a position. Given his attachment to PCI’s currentsystem, which Denis developed, he may not be very objective if given the task of investigatingsystems to replace the current system. On the other hand, he already has an in-depth knowledgeof PCI’s operations and may be able to assess available systems more efficiently andeconomically than hiring an outside consultant to conduct the investigation and implementation.

INTERNAL CONTROL

PCI has been experiencing significant discrepancies between the results of periodic inventorycounts and recorded inventory levels. It is unclear whether these discrepancies are primarily dueto theft by customers, staff or sophisticated thieves, or to errors in recording changes ininventory. Steps should be taken to minimize the physical loss of inventory and the accuracy ofthe current recording of inventory changes should be investigated. Once the cause of anyrecording errors is identified, solutions should be found and implemented. The weaknesses in thecurrent system should also be taken into consideration when investigating new informationsystems.

The lumberyards are already fairly well protected by high fences and guard dogs. It would likelynot be cost effective to install more sophisticated security, such as electrically charging thefences, as knowledgeable thieves always seem to find a way to circumvent the security systems.

However, cost effective measures can be taken to reduce the risk of pilferage by staff andshoplifters. For example, inexpensive security cameras could be installed, some of which couldbe made highly visible and others which would not be so obvious. The knowledge that illegalactions may be recorded on camera has a deterring effect on would-be shoplifters.

GENERATION AND CONSEQUENCES OF ALTERNATIVES

Form the previous analysis of PCI’s current situation, it can be concluded that PCI’s immediatesurvival and future growth are being threatened. Four alternative actions are identified asfollows:

1. Build a plant to assemble products for the contractor market.

2. Merger with Kontact Co.

3. Form a strategic alliance with Marson’s Materials.

4. Invite an American company to buyout PCI.

Build a PlantThis option would directly address PCI’s weakness of lagging behind competitors in productinnovation and would be consistent with the trend of the industry becoming more capitalintensive. By building a plant to produce pre-assembled products for the contractor market, such


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as trusses, PCI will be able to retain its current loyal customers and to attract new contractorclients. This option, however, does not address the upcoming threats regarding the retail market.

While such actions as improving the inventory turnover, leasing forklifts and imposing atemporary pay cut on employees would improve the current cash shortage, they may not besufficient to convince the bank to provide financing to build a truss plant. PCI could attempt touse the success of Marson’s Materials as an example of the profitability of such a project toconvince the bank or other financing sources to advance the necessary funds to PCI to build theplant. However, this may be a difficult and expensive task given PCI’s recent weaknesses inmanaging its finances.

New equity capital may be necessary to help finance this project and to relieve the current cashshortage situation. However, one of the majority shareholders is interested in selling his shares,not buying new shares. If the other shareholders do not have the resources to purchase both theseand new shares, new external shareholders would have to be found. Care would have to be takento avoid losing control of the company to new partners.

Merger with Kontact Co.This option attempts to address the threats in the retail hardware industry more than in thecontractor industry. In the face of large retail chains dominating the market, one often-successfulstrategy for survival for smaller players is to merge with other small companies that were formercompetitors. This would be the situation between PCI and Kontact Co.

Kontact has a wider reach in the Cedarville area, with 11 outlets, but the average sales generatedper outlet of $6.8 million is significantly less than the $13 million sales average of PCI’s outlets.Kontact has focused more on the retail hardware side of the business than PCI, and has tried todeal with the big retail chains head on. While its financial position is stronger than PCI’s, itscompetitive strategy has resulted in profit margins that are lower than both PCI and Marson’sMaterials, which has negatively affected its financial situation.

Kontact would gain economies of scale from the merger and the effective elimination of acompetitor. One advantage for PCI’s shareholders would be increased family wealth and accessto the stock market. Réjean would probably favour this option as he may be more successful inselling the shares of the new Kontact Co. than his shares in PCI if there is no merger. Althoughthere had been bad blood between the PCI and Kontact families in the past, this may no longerbe a serious obstacle. Phil, who would certainly be opposed, is no longer involved and holds noshares, and George, the current majority shareholder, may be in favour as he had instigated themerger talks two years ago. However, Peter, Robert and Vincent may resist this option becausethey would lose control over future operations as Ted Dawson would be the CEO.

In the long run, with the entry of a third large retail chain in the market, it is likely that Kontactwill remain a relatively small player in the retail hardware market and will experience acontinued loss of market share unless it examines and changes its strategic direction away fromcompeting directly with the chain stores.


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Strategic Alliance with Marson’s MaterialsA strategic alliance with Marson’s Materials would stipulate that PCI could use the availablecapacity at Marson’s truss plant to service its customers and Marson’s would be allowed tocompete in PCI’s traditional territories.

This option allows PCI to address its product innovation weakness without having to make alarge capital investment. This in turn would allow PCI’s management to concentrate on its corecompetencies of customer service in both the contractor and retail hardware markets. Marson’swould gain by expanding the territory that it services and operating the plant at near capacity.

Both Marson’s Materials and PCI are similar in that they are family owned and operated. Byforming an alliance, each company remains independent and controls its own operations.Currently, Marson’s holds the largest share of the contractor market in the Cedarville area,servicing mainly the regions north of Cedarville. It is in a good financial position with good cashreserves. It is proactive in developing innovative products which is an advantage that PCI may beable to share as a result of an alliance.

One danger presented by this option is that Marson’s may at some future time attempt to takeover PCI’s territories, effectively putting PCI out of business, or it may actually take over PCI.

On the other hand, PCI could use Marson’s truss plant to bolster its competitive advantage in thecontractor business and help eliminate its cash flow problems by increasing its sales revenuesand gross margin percentage. With an improved financial position, PCI may be able to build itsown plant in the future and compete successfully against Marson’s. In the meantime, the twocompanies would be able to learn from each other, and might ultimately investigate thepossibility of merging.

Invite an American Company to Buyout PCIThis option would likely maximize shareholder wealth, and could open interesting opportunitiesand experiences for PCI’s executive and management as a result of having a foreign parent. Itcould also lead to opening foreign markets to PCI. There is speculation that aggressive Americanfirms would be willing to purchase a small Canadian company to gain a foothold in theprovince’s contractor market. PCI’s past success in this market could make it attractive to such afirm, but it would have to be willing to inject sufficient cash into PCI to bring it back to financialstability and satisfy the bank. PCI could try to make contact with an interested company throughinvestment bankers.

This option may not be desirable because a foreign parent company would not be familiar withthe provincial market and may have many different practices that would clash with PCI’s culture.Also, control over operations could be lost and the PCI “family” of employees could ultimatelybe disbanded.

RECOMMENDATIONS

PCI needs to decide whether it wishes to continue to compete in both the contractor and retailhardware market. Although there are signs that the contractor market size is stabilizing, PCI


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currently holds a large share of this market and it has a good chance of increasing its share if itbecomes proactive in new product development for the contractors.

The retail hardware market is vast and highly competitive. PCI has already made inroads towardsservicing the home renovation hobbyist niche that is not particularly well served by the largeretail chains. Although PCI’s share of this market is very small, there are opportunities toincrease sales and profit margins, thereby improving cash flows and the bottom line. Anyattempts at competing with the large chain stores based on low prices should be abandoned. Thetarget market of home renovation hobbyist are not particularly price sensitive, and this nicheshould not be used to subsidize the larger price-conscious home-repair market.

It is recommended that PCI continue to compete in both markets and to focus on its corecompetencies of excellent customer service and building strong customer relationships. Of thefour alternatives analyzed above, forming a strategic alliance with Marson’s Materials isrecommended. PCI will be able to improve its service to the contractor market without the needfor a capital investment. This will lead to increased sales and market share, which is vital toenable PCI to improve its financial position and pursue future growth through expansion.

IMPLEMENTATION PLAN

Strategic MissionThe first step in implementing the recommendations is to establish a clear mission that can becommunicated to all employees and customers of PCI. The following is a recommended missionstatement:

“To be the primary supplier of lumber-related products to contractors, andhardware products to home improvement enthusiasts and farmers, in theCedarville area. This will be done by providing superior service, expert adviceand high quality, innovative products to our customers.”

Product LinesTo support the mission of supplying high quality innovative products, PCI should always besearching for new products that would fit its customer’s needs. Development of innovativeproducts that would help contractors save time should be one of top management’s priorities. Forthe retail hardware business, customer needs may be different for each store, as they are now, sodifferent products should be featured at the different stores. The possibility of using the trussplant to assemble products for the home improvement hobbyist could be investigated.

The key in both industries would be to anticipate the customers’ needs and find (or invent) aproduct or service that would fill these needs.

Inventory ManagementPCI’s current practice of purchasing large quantities of products at a given point in time shouldbe discontinued in favour of ordering smaller quantities more frequently. The installation of anon-line information system that allows electronic ordering would result in reduced safety stock


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levels and lead times for orders, which would ultimately result in better cash flow managementand increased customer service.

An on-line information system would also allow PCI to increase the efficiency of inventorydistribution among the three outlets by providing timely access of information regarding thequantities and locations of inventory stocked at its three outlets or on order. Sales representativesand store staff would be able to more easily co-ordinate the flow of inventory to customers,resulting in improved customer service, increased sales, and savings in inventory carrying costs.

PricingPCI should discontinue its practice of matching the prices of large chain stores for basichardware products. PCI’s target market would be willing to pay a higher price for basic productsin return for specialty product availability, superior service and expert advice. Customers whoshop based on price alone would be better served by the large retail chains. By maintainingprofitable markups and eliminating loss leaders, the increased gross margins should make up forany losses in sales from price-focussed customers.

Pricing in the contractor industry has been largely dictated by the market. PCI’s stated pricingstrategy for building materials sold to contractors (i.e., cost plus gross margin percentage of notmore than 30%) is similar to the strategy used by its competitors. Since cost is determined by thesame spot market conditions that apply to everyone, it is difficult to successfully compete basedon pricing alone. The key to success in this market is to offer high quality service, including fastdelivery times and time-saving products, at competitive prices. PCI’s pricing formula has provedto be sufficiently competitive in the past, so there is no compelling reason to change this strategyin relation to raw lumber products. Pricing of products that are built in Marson’s plant, such astrusses, will have to be negotiated as part of the alliance agreement and will likely be based ongross margin percentages that are at least 30%.

Customer ServicePCI’s main strength in the contractor business has been the strong business relationships thathave been developed between PCI’s sales representatives and the contractors. To support theserelationships, sales representatives should be required to report to Peter Martin, who would keepthem informed about new product developments and other strategic issues that would help themin their dealings with the contractors. Peter could also collect and assimilate informationgathered by the sales representatives regarding the contractor’s various situations, which couldbe used to anticipate their needs. Top management could then determine how to fill these needson a timely basis.

Success in the retail hardware business will depend on PCI’s ability to deliver expert advice,high quality products and excellent service to the home improvement enthusiast as well asfarmers in the Kellerton region. PCI must continue to recruit full-time employees that have theexpertise to manage a variety of home improvement projects and to train the seasonal employeesso that they would be able to provide at least a basic level of advice. To avoid the risk of losingits skilled employees, PCI should continue paying them at the current rates.

Employees should be encouraged to not only guide customers through the project planning andmaterials acquisition process, but to also follow up on the project by keeping in touch with the


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customer. This type of caring service will develop strong customer loyalty, which will ultimatelylead to increased sales and market share.

MarketingMarketing to date has focussed on flyers and advertisements in local newspapers for hardwareproducts and price lists for construction products for contractors. These methods have been usedto focus on price, which is not one of PCI’s competitive advantages. The marketing effort shouldfocus on product and service quality. PCI should not try to present itself as a low cost provider.

Until PCI is able to afford more sophisticated methods of marketing, PCI should continue to useflyers and newspaper advertisements, but they should highlight new or specialized products andthe high quality of service offered by the store staff. Setting up a website that could be accessedby customers or assembling an electronic mailing list of customers could be an effective meansof communicating recent events, such as the introduction of new products, to PCI’s targetmarket.

The sales representatives should focus their discussions with contractors on the quality andavailability of products, with special attention on new products. An information system thatenables the sales representatives to access the inventory records from a laptop computer wouldbe an effective marketing tool.

New contractor business should be actively pursued by sales representatives in regions typicallyserviced by Kontact Co. and Renovations Unlimited to make up for any lost sales to Marson’sMaterials in the Newtown and Kellerton regions. Sales representatives should be encouraged tocontact contractors and begin developing a rapport with them even before new constructionprojects begin

Financial ManagementBefore PCI can implement a long-term strategic plan, it must deal with its short-term cash flowproblem. The following actions are recommended for immediate implementation:

1. Reduce the investment in inventory by 15% by decreasing order quantities and increasingorder frequency.

2. Eliminate loss leader pricing in retail stores.

3. Offer early payment discounts to contractors.

4. Sell the existing fleet of forklifts and lease required forklifts according to the proposedplan (see page 8).

5. Pay management bonuses in the form of company shares instead of cash.

6. Rather than implementing a temporary pay cut plan which could have a seriousdemotivational impact on valued employees, advance a new share offering to staff. Apayroll deduction plan could be implemented to assist employees in paying for the shares.This will improve cash flow and the debt-to-equity ratio by increasing equity and using


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the proceeds to reduce the amount of overdraft. It will also give the employees a greatercommitment to the success of the company.

7. Convert some of the short-term bank overdraft to long-term debt.

8. Determine where savings can be made in administrative expenses. Investigate thepossibility of sharing administrative resources with Marson’s Materials as part of thealliance agreement, resulting in savings for both companies.

The net effect of the above actions should be an increase in PCI’ cash position of $1.7 to$2 million.

1999-2000 BudgetThe actions to improve PCI’s cash position, unfortunately, will not have a significant impact onthe income statement. According to Appendix 3, a loss of $395,000 is budgeted for 1999-2000.Using the budgeted operating profit of 11.3% of sales, PCI requires a $3.5 million increase insales to breakeven. Without changing the budgeted retail sales, PCI would be required toincrease its contractor market share to the 20%-21% levels that it held in 1996-97 and 1997-98.This would certainly be achievable if PCI begins to offer products such as trusses to its clientsand pursues contractor business in other regions.

Therefore, PCI should initiate negotiations with Marson’s Materials as soon as possible. Positiveprogress in this respect could be offered as justification to the bank for an upward revision inbudgeted contractor sales to around $29 million.

Information SystemIt is time to replace Denis Marois program with one that is suited for electronic data interchangeand real-time processing. Such a system will greatly increase PCI’s ability to enhance its serviceto customers and to manage inventory more effectively. PCI should investigate whetherMarson’s Materials already has such a system in place. If so, PCI should include in itsnegotiations with Marson’s a request to share this technology. If not, PCI should try to convinceMarson’s to jointly hire an IT expert to find and install an appropriate system that would meetboth their needs. PCI could finance this project through a new share offering to currentshareholders and to the Marson brothers. This would improve the debt-equity ratio andstrengthen the ties between the two companies.

ManagementThe successful negotiation of a strategic alliance with Marson’s Materials will require the skillsof experienced management professionals. My father, Réjean, will likely not recover from hisillness soon enough to help with the negotiations. Therefore, PCI should hire an experiencedcontroller on a one-year contract basis. If at the end of one year it is apparent that my father willnot be able to resume his duties as Controller, a more permanent replacement will have to behired.

The marketing role will also be crucial in the upcoming year. Until George returns, PCI shouldoutsource the marketing function to marketing specialists. This will leave you (Vincent) withtime to concentrate on the negotiations with Marson’s.


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The co-operation of store managers will be an important factor in improving customer serviceand inventory management. The performance evaluation system should be based on theattainment of corporate goals, and performance measures should include non-financial factors,such as delivery times, in addition to controlling costs and increasing sales.


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Appendix 1Market and Sales Analysis

MARKET SIZE:

1998-99 1997-98 1996-97 1995-96 1994-95

Contractors:

Total sales (in ‘000s) $145,054 $149,132 $133,154 $134,155 $131,192

Growth (2.7)% 12.0% (0.7)% 2.3% NA

Retail Hardware:

Total sales (in ‘000s) NA $5,474,444 $4,740,714 $4,255,313 $6,662,500

Growth NA 15.5% 11.4% (36.1)% NA

PCI’S SALES ANALYSIS:

1999-2000Budget 1998-99 1997-98 1996-97 1995-96 1994-95

Sales to Contractors:

Total sales (in ‘000s) $25,320 $26,580 $31,109 $26,764 $25,637 $25,202

Sales growth (4.7)% (14.6)% 16.2% 4.4% 1.7% NA

Market share NA 18.33% 20.86% 20.1% 19.11% 19.21%

Change in market share NA (12.1)% 3.8% 5.2% (0.5)% NA

Retail Hardware Sales:

Total sales (in ‘000s) $11,930 $12,538 $14,781 $13,274 $13,617 $13,325

Sales growth (4.8)% (15.2)% 11.4% (2.5)% 2.2% NA

Market share NA NA 0.27% 0.28% 0.32% 0.20%

Change in market share NA NA (3.6)% (12.5)% 60.0% NA


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Appendix 2PCI Construction Inc.

Financial Analysis

PERCENTAGE OF TOTAL SALES:

1999-2000Budget 1998-99 1997-98 1996-97 1995-96 1994-95

Sales 100% 100% 100% 100% 100% 100%

Gross margin 23.7% 23.1% 23.4% 23.8% 23.2% 23.1%

Operating expenses 12.4% NA NA 12.8% 13.0% 13.0%

Labour 9.2% 11.0% 9.5% 9.5% 9.4% 9.3%

Operating profit 11.3% NA NA 11.0% 10.2% 10.0%

Selling expenses 1.7% NA NA 1.5% 1.6% 1.6%

Administrative expenses 6.3% 5.8% 4.2% 4.8% 4.8% 4.8%

Interest 2.6% 2.1% 1.5% 1.7% 1.6% 1.6%

Amortization 6.3% NA NA 1.7% 1.5% 1.3%

Income (loss) before tax (0.9)% (2.6)% 1.8% 0.7% 0.7% 0.8%

Sales Growth (4.8)% (14.8)% 14.6% 2.0% 1.9% NA

RATIO ANALYSIS:

1999-2000Budget 1998-99 1997-98 1996-97 1995-96 1994-95

Current ratio NA 1.35 1.46 1.28 1.24 1.24

Quick ratio NA 0.47 0.52 0.46 0.45 0.44

Receivables turnover (days) NA 46 38 38 38 NA

Inventory turnover (times/yr.) NA 3.4 4.1 4.0 4.0 NA

Asset turnover NA NA NA 2.1 2.2 2.2

Profit margin (0.7)% (1.96)% 1.32% 0.99% 0.55% 0.59%

Return on equity NA NA NA 8.6% 5.2% 5.7%

Return on assets NA NA NA 2.1% 1.2% NA

Debt-to-equity NA NA NA 3.2 3.3 3.4

Times interest earned (0.6) (0.3) 2.1 1.8 1.5 1.5


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Appendix 3PCI Construction Inc.

1999-2000 Quarterly Budget(in thousands)

Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total Sales: Retail $1,563 $2,003 $ 4,940 $3,424 $11,930

Contractors 3,655 6,674 8,721 6,270 25,320 5,218 8,677 13,661 9,694 37,250

Cost of goods sold 3,982 6,629 10,430 7,397 28,438Gross margin 1,236 2,048 3,231 2 297 8,812Gross margin % 23.69% 23.60% 23.65% 23.69% 23.66%Operating expenses:

Labour (note 1) 592 882 1,031 968 3,473Delivery 122 142 167 146 577Advertising 24 26 26 26 102Occupancy cost 139 138 110 113 500

877 1,188 1,334 1,253 4,652Operating profit 359 860 1,897 1,044 4,160Selling expenses 90 166 225 159 640Administrative expenses 551 591 604 592 2,338Interest 236 228 261 230 955Amortization 152 156 157 157 622

1,029 1,141 1,247 1,138 4,555Income (loss) before tax $ (670) $ (281) $ 650 $ (94) $ (395)

Note 1:

Labour was calculated using the third regression model as follows:

Number of direct labour hrs = 10,232 + .0056(sales) – 18,000(adjustment factor)

Quarter Labour Hours Labour Expense(@$15/hr.)

1 10,232 + (.0056) ($5,218,000) – 18,000(0) = 39,453 hrs. $ 591,795

2 10,232 + (.0056) ($8,677,000) – 18,000(0) = 58,823 hrs. 882,345

3 10,232 + (.0056) ($13,661,000) – 18,000(1) = 68,734 hrs. 1,031,010

4 10,232 + (.0056) ($9,694,000) – 18,000(0) = 64,518 hrs. 967,770

Total labour cost $3,472,920

Documents

PCI Construction Inc. June_2000_Solution Exam CMA