Case #2: Sales are increasing but my profits are dropping. Why?

Part of a ten-part series, this case study question about coconut water will leave you thirsty for more and ready to ace your consulting case interview
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Case study examples

Case interviews allow you to demonstrate how you think - your ability to understand a problem, break it down into its requisite parts, analyse them and communicate a solution. In this series, we give you ten case studies to give you an idea of how to approach the case and how to walk through it with your interviewer.

You may want to consider the case question first and think about how you might structure a response before looking at the ‘answer’. Of course, bear in mind there are many ways to answer a case, so this is just one example!

For the purposes of these examples, we will only look at market sizing and business cases.

Case #2: Sales are increasing but my profits are dropping. Why?

Question

A major producer of coconut water is in the business of processing and packaging coconut water for retail outlets. The packager has traditionally packaged the coconut water in 500mL containers. However, a few years ago, in response to the market, the producer purchased a machine that is able to package the coconut water in 1L containers as well.  

Over the next couple of years, sales for the product have continued to grow on average about 15 per cent per year. However, even though sales have continued to increase, profits have steadily declined. This is very confusing for the owner who cannot understand why. What’s happening?

Solution

We know that because sales have been increasing, it is likely the issue is with costs. So, while we may gather some information on revenue, we will focus on costs, to begin with. Furthermore, as the producer has changed the packaging, it is possible that there are additional costs incurred that have not been accounted for, which is causing the profits to decline.

Let’s take a look at what a possible dialogue with an interviewer could look like.

You: I am going to look at both the revenue and costs of packaging the coconut water. It is possible that given sales have increased but profits have declined, there is a problem on the cost side. However, I’ll start briefly with revenue before we move to costs.

Interviewer: That sounds like a good plan.

You: How much did the producer charge for the 500mL containers?

Interviewer: $2 per container

You: And how much for the 1L containers?

Interviewer: The producer thought that since this was twice the size, he would provide an incentive to buy, by selling them at $3.50 per litre.

You: How was the cost of the new equipment accounted for in the price?

Interviewer: The producer ended up raising prices across the board by $0.50 on all packages, both 500mL and 1L, selling them at $2.50 and $4.00 respectively.

You: What about the cost of packaging? Does it cost the same to package the coconut water in the 500mL as it does in the 1L?

Interviewer: Not quite. The new machinery requires more experienced labour as it is a little more complicated than the older machine. Plus, we now use plastic instead of paper. We thought that because the demand was higher for the 1L packaging, we would recoup our costs through increased volume.

You: Ok, I see. What about overhead costs?

Interviewer: All costs for the factory are added together and divided by the number of units produced.

You: Hmm, this sounds like it could be an issue of cost allocation. The price of the 1L containers should be higher due to higher costs. I would be interested in understanding how this is affecting the bottom line – what has been the trend in sales? For example, what percentage of 1L vs. 500mL containers is being sold?

Interviewer: The more our customers notice the 1L containers, the more they like them. As the overall volume is increasing, these 1L containers have comprised of 60 per cent of the sales. The producer has been very pleased about this

You: It seems however that the additional costs associated with the 1L containers were averaged out across all units, including the 500mL containers.

This has resulted in a misallocation of costs and inappropriate pricing. This means that the new 1L containers have been priced too low, and as a result, the more litres the coconut water producer sold, the more profit the company lost out on.

I suggest that the producer conduct a thorough analysis of activity-based costing to determine the overhead costs and direct costs associated with each item in the product line. They should then use this data to price accordingly.

Up next

Starting to make sense? Next, check out Case study: # 3 ‘The government is changing regulations, what should we do?’.