AF 495 Case 1 October 20, 2011 Case Analysis: The Body Shop Since its inception in the 1970s, The Body Shop has experienced phenomenal growth. Specifically, revenue was growing at a rate of more than 20% per year. In the 1990s, the previously experienced revenue growth began to decline rapidly. There were numerous reasons for the steady decline in revenue growth. The two most important of these were a loss of brand image and severe competition from other skin and hair-care companies. The Body Shop expanded too quickly to maintain its previous level of profitability and traditionally recognized brand image.

Even after Roddick, the founder and chief executive officer stepped down in 1998 The Body Shop continued to have problems. While revenue began to grow, pretax profit was declining and a new strategy emerged. “The strategy consisted of three principal objectives: to enhance The Body Shop Brand through a focused product strategy and increased investment in stores; to achieve operational efficiencies in our supply chain by reducing product and inventory costs; and to reinforce our stakeholder culture” (Shank and Vaccaro 120). A forecast was produced to evaluate the success of this strategy.

How was the forecast derived? Why were the base case assumptions chosen? The forecast to evaluate the success of Gournay’s proposed strategy was derived by using the same percentage of sales growth from the 2001 period to extrapolate the next three years of data. By using a percentage of sales growth method I was able to focus on growing each account that is directly related to sales by the same percentage as sales increased. I did not, however, use this method for all of the accounts. Gournay’s strategy hinges upon achieving operational efficiency by reducing product and inventory costs.

The primary accounts affected by this strategy are Cost of Goods Sold and Operating Expenses. This forecasting method was chosen because it is equally important to account for past historical performance and the current prevailing situation the company faces. This method will give an accurate assessment of the standing of the company with its newly implemented strategy so that decision can be made as to how to proceed further. The base assumptions used to create this forecast are derived directly from the company itself with special attention paid to the strategy proposed by Patrick Gournay.

The percentage growth was taken from the last recorded year of earnings. This 13% yearly increase is deemed to be an appropriate estimate because the company has seen a decline in its revenue growth rate and it is unlikely due to current market conditions (increased competition) that it will achieve revenue growth rates in excess of 20% which was the case during the company’s prime. It is also important to figure in the impact that a successful implementation of Gournay’s strategy will have. If the plan in implement in 2002, it is expected that the result will not be immediate.

Best case scenario, the impact will begin to show in 2003 but the full impact may not be visible until 2004 or later. Based on the pro forma projections, how much additional financing will The Body Shop need during this period? The company will need approximately GBP 2,700,000 to assist in the new strategy. This will be used primarily to invest in stores and the established product line. Because the company is experiencing financial trouble in the form of decreases in profits, it will be difficult to convince investors to fund this endeavor with equity so The Body Shop will need to finance it with debt.

If the company can implement changes quickly enough to increase the dividend payment to shareholders so as to restore some of their confidence, it may be enough to fund some of the expense with equity but not all. The company has to focus on decreasing or eliminating costs in the COGS and operating expenses categories to reduce the amount of financing needed. Another strategy would be to deter costs as exceptional costs or long-term debt so the company can pay these debts later when the strategy has begun to pay off.

With these changes and improvements the working capital of the company should increase which will allow for further reductions and perhaps less interest expense because debts will be paid sooner. What are the three main assumptions/drivers in the forecast? What is the effect of varying these assumptions? Why are these assumptions so important? The most important assumption regarding the forecast is the effect of Gournay’s strategy on the Cost of Goods Sold account. In order to avoid incurring additional debt COGS needs to remain under 42% of sales through the 2004 period.

This is illustrated in the sensitivity analysis conducted regarding Debt, Excess Cash and COGS. COGS are expected to increase by 5%-5. 5% each year. The company has been in the skin and body care industry since its creation and it does not have any new product development or significant increase in inventory planned so while COGS will increase due to the nature of costs, it should not exceed this limit. The level of COGS that will maximize profit as evidenced by the analysis is 35% of sales for the period.

However, it is highly unlikely that this level will be achieved because efficiency would need to increase considerably and companies are rarely, if ever, able to operate at optimal levels. As long COGS as a percentage of sales stays below 44% the company will be able to avoid incurring additional debt related to the cost of goods. [pic] Another important assumption is that the strategy will have a positive effect on operating expenses. Operating expenses are a significant cost to the company right now at 50% of Sales.

Allowing operating costs to remain so high is seriously affecting the profit of the company because more profit is being used to pay for this expense. Although the strategy has the potential to reduce this expense if implemented correctly, it is very unlikely that the company will be able to see a decrease in operating expenses in just a three year period. The company will definitely see a decrease in the percentage increase of operating expenses but to see a significant decrease in operating expense itself the company will need to evaluate the strategy for a longer period.

If the company can find a way to reduce variable expense related to operating expense and in the process increase sales of its established goods, this impact may be more immediately seen. The sensitivity analysis produced below shows at which percentage levels the company can set operating expenses to and still avoid additional debt. The last important assumption is that the strategy will begin to pay off relatively quickly. For the company to be able to survive and prosper in a competitive market, it must be able to pay its own expenses.

The Body Shop needs to be able to repay its expenses and debts and still have money to give to its shareholders or reinvest in the company. An analysis of the COGS sales percentage in the 2003 period reveals that even if the percentage of COGS to sales increases to above the level determined for the base year the company can still avoid additional debt which shows that the company is capable of improving its financial means to repay expenses.

There are certain expenses that will be accrued in future periods due to debt financing and current operations which accounts for the declining profit in 2004 but if the strategy is successful the impact of it will begin to recoup expenses. What is the relevance of these findings to Roddick? What are the implications? What action should be taken? If The Body Shop monitors COGS and Operating Expenses closely so that they remain within a profitable range (because the net profit of the company is directly related to these accounts), Patrick Gournay’s strategy should have a significantly positive impact on the profitability of the company.

This strategy should therefore be implemented immediately. The company will be able to focus on lowering variable costs associated with operating expenses while controlling COGS in respect to its established product line because a company should be most efficient at something it has been doing for its entire lifetime. If The Body Shop can successfully monitor each of these crucial pieces, profits will increase across the income statement. The company should see an increase in profit both before and after tax which was not the case before Gournay took over.

It is also important to realize that the company will need to finance these implementations through debt and it should be prepared for this scenario. Debt will affect the debt to equity ratio which is an important indicator of the financial health of a company. A debt to equity ratio that is too high will indicate that the company has leveraged itself too much and may be in fear of bankruptcy. An ideal situation would be to convince shareholders to invest more equity into the company but this may be difficult to achieve because the company is already in trouble.