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Case 16: Too Hot To Handle!
Case 16: Too Hot To Handle! When Patsy opened her full service salon and day spa three yearsago, she knew that she would have to make some difficult choicesregarding the hiring and firing of qualified professionals such ascosmetologists, estheticians, nail technicians and massage therapists.However, she was confident that her salon management training at ChicUniversity coupled with her industry experience as a stylist would serveher well. And serve her well they certainly did! Within three years ofstarting her own business, and after a few setbacks, she had managed toassemble a team of 10 salon professionals who were all extremelymotivated, people-oriented, and driven individuals who worked hard atretaining their clients and drumming up retail sales. Of course, Patsy hadput in place an incentive plan, which the stylists found to be challenging,yet lucrative. Patsy’s salon revenues had grown significantly each yearto their current annual level of $500,000. On average, the salon servicedabout 40 customers per day with an average ticket of $50. However, over the past year or so a number of new salons andnail spas had opened up in the city. Competition had become much moresevere and customers were being swayed by numerous discount coupons.Patsy was well aware that her current sales growth rate of 10% would notcontinue for very long. At the suggestion of some of her regular clients, she decided toexplore the possibility of expanding her service offerings to includetanning booths. She figured that such an addition would complement hercurrent salon business by offering customers the opportunity to come infor about 15-30 minutes and have a worthwhile tanning experience orbetter still to enjoy a relaxing tan instead of waiting out in the lounge. As Patsy began exploring the various costs and investmentsrequired, she realized that she had very little knowledge about the tanningbusiness. What appealed to her the most was that the revenues from thetanning business would be all hers to keep unlike the other salon serviceswhere she paid the salon professional a commission of up to 50% of therevenue generated from the services rendered. What was most confusingto Patsy was whether she should go in for the tanning dome unit or therelatively cheaper tanning bed. “Call up that toll free number that’s listed on the Sun-QuestCatalog”, said her ever-resourceful husband, Alan, who worked as a salesrepresentative for a chemical company. “It always works for me,” headded. After many hours of agonizing over the issue, Patsy finally gavein and made the call. The salesman, Mike, who answered the call was extremelyhelpful, courteous, and convincing. “Tanning is a great complement to aSalon and Spa,” he said. “We have shipped many units to salons all overthe country, and they seem to be doing pretty well.” “Let’s say I do start the tanning service at my salon, Mike,should I go in for the less expensive tanning bed or the more expensivetanning dome?” asked Patsy, eager to sort out her dilemma. “Well,”responded Mike, “Each unit has its own pros and cons. The bed costsconsiderably less than the dome, but it takes longer for an equivalent tanper session. The dome on the other hand, costs more, but it does the jobfaster, provides for a complete body and facial tan, and lasts longer.”“Do you have a comparison chart showing the approximate costs,features, and revenue potential of each option, Mike?” asked Patsy.“Absolutely,” said Mike. “I would be happy to email you a copy rightnow, if you like.” “That would be great!” said Patsy, “It would certainlyhelp me make an informed decision. As you can see, Mike, I really wantto figure out which of these two units is Too Hot To Handle!”Exhibit 1Some Relevant InformationSalon Hours:Sunday, Monday Closed Tuesday-Thursday 9 AM – 7 PM Friday 9 AM – 5 PM Saturday 9 AM - 2 PMAdvertising Costs $300 per month (Yellow Pages Ad.) $200 per month (other advertisements)Patsy’s After-tax cost of funds: 11% per yearDepreciation method: Straight line over 5 yearsTax rate: 30%Exhibit 2Mike’s EmailFrom: Mike Reynolds <[email protected]: Thursday, February, 10 200X 11:45 AMTo: e: Tanning equipment comparison chartDear Patsy,As per our conversation, I am attaching a comparison table showing therelative costs and features of the dome and bed units. Please call our tollfreenumber if you need any more information. We look forward todoing business with you. Dome Unit Tanning BedCost (including shipping) $7800 $2800Set up cost $500 $200Electricity cost per session $0.50 $0.30Number of sessions/hour 4 3Number of bulbs needed 48 28Cost per bulb $22 $22Bulb life 1300 hours 1300 hoursUnit life 8 years 5 yearsSuggested price/visit $3 $3Space requirement 9 ft X 5ft X 5ft 10 ft X 10 ft roomOther incomeTanning Lotion 1 bottle/10 sessionsProfit per sale $5Questions:1. Develop operating cash flow forecasts for the relevant lives ofeach type of tanning equipment using 100% (Best case), 80%(Most Likely Case), and 50% (Worst Case) occupancy estimatesfor each tanning option. Assume straight line depreciation and atax rate of 30%.2. Calculate and comment upon the accounting, cash, and financialbreak-even sales for the dome unit and the tanning bed unitrespectively.3. Calculate the net present value, payback period, and thetraditional IRR for each tanning option under the variousscenarios. What do the decision rules indicate?4. Can Patsy evaluate this business project by assuming just a onetimepurchase? Why or why not? What other evaluationmethods should Patsy use?5. If you decide to use the replacement chain method, how do thecalculation and decision change?6. What are some externalities, side effects, and other relevantissues that could affect the decision?7. Based upon your analysis, which of the two units is “Too Hot to Handle”? Why?
