DDKM Casio INC-1

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DDKM CASIO INC.: THE RISK-REWARD
TRADE OFF FROM OPERATING
LEVERAGE
Educational material supplied by The Case Centre
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Dr.Deepika Dhingra
Associate Professor, IILM Institute of Higher Education
Kirtika Malhotra
Assistant Professor, IILM Institute of Higher Education
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117-0024-1
FIN-2-0032 | DDKM Casio Inc.: The Risk-Reward Trade Off from Operating Leverage
DDKM CASIO INC.: THE RISK-REWARD
TRADE OFF FROM OPERATING
LEVERAGE
Dr.Deepika Dhingra
Associate Professor, IILM Institute of Higher Education
Kirtika Malhotra
Assistant Professor, IILM Institute of Higher Education
The Confrontation
As a new hire at DDKM Casio’s (Pro audio and Audio Visual equipments manufacturer
in India), Smith was perplexed with the task of evaluating proposals for enhancing the
company’s production process. His production manager, Ariana suggested him to opt
for a new technology that could create designer keys for DDKM Casio’s. Keeping in
view the external and internal factors of the organization such as fierce competition,
use of outdated keys and shrinking profits Ariana came up with a proposal of using a
new technology which could lead to manufacturing of designer keys for DDKM Casio’s.
For quite some time the sales department proclaimed that revenues of DDKM were
depleting because of using outdated keys than its competitors. Meanwhile, Ariana’s
constant pestering for approving the proposal of using a better technology irritated
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DDKM Casio Inc.: The Risk-Reward Trade Off from Operating Leverage | FIN-2-0032
Smith. She further mentioned how using a better technology might increase the fixed cost
of operations but will help in decreasing the variable costs leading to an elevation in the
margin per Casio. With the predictable boost in sales volume, there should not be any
challenge in covering the elevated fixed expenses and still produce higher net operating
income. Ariana knew of a resource who could help DDKM disassemble their old production
line. The resource known to Ariana was also talented enough to support in replacing the
old machinery with the new technology providing DDKM with a good trade-off. Smith
argued that it is crucial for a sales department to deliver as promised and considering the
instability in the economy an increase in fixed cost might not prove to be a safe move. If the
demand doesn’t increase as forecasted the firm could be in financial distress and might
lose the faith of lenders.
Since smith was not convinced by Ariana’s argument, she barged out asserting her intent to
discuss the proposal with the senior management.
Preparing the Presentation

Smith wanted to be just to Ariana’s proposal as it could prove to be valuable for the
organization if the demand goes as expected and remove further hurdles in production. At
the same time, he wanted to be sure that D.D Blair and K.M Cole, the CEO and CFO of
DDKM, respectively, really understood the added risk the company would be taking by
applying this change. He didn’t think a simple discussion of differences in break-even
points would be sufficiently convincing, not with the sales chief, Jessica Hill, supporting
Ariana and expounding on how much more in sales volume the company could potentially
generate. Smith settled in to review yet again what he knew about the company and its
competitive environment, the sales projections from Jessica Hill, and the operating
information from Ariana.
Background
Established in March 2008, DDKM Casio Inc Ltd. is a part of the DDKM Corporation
worldwide group of companies and offers variety of Casio’s, Pro audio and Audio Visual
equipments to the Indian market. It began its operations in October 2008 with its headquarters
at Delhi.
DDKM’s values were ingrained in customer focused management and operations; delivering
excellence in its products and services; uninterrupted endeavors to boost its existing market;
enrichment of research and development on a long range standpoint; assurance to care for
end users by even better service after sales; quest of further globalization of DDKM’s
business; and nurturing expansion through diversification.
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The owners kept the company small, opening in only four locations. They opted to forego
sales through retail vendors and in contrast with many of its competitors, to eschew online
sales.
To purchase a DDKM Casio, a customer must travel to a DDKM store. The quality of the
Casio and the uniqueness of the store environment are such that many Casio enthusiasts
make the pilgrimage, some even from overseas. All sales persons are experts and are well
qualified to discuss with customers the features of the variety of Casio’s. One section of the
store displays all Casio’s in line allowing the customers to try out the floor models, and
employees are motivated to make use of the equipment as their workload demands. The
store ambience is positive and serves to bring in swarm of clients each year-mostly to shop
but some just to observe the mix of proficient and proletarian Casio players mastering their
skills.
Current and Projected Sales and Operating Costs

Exhibit I presents a note from Jessica Hill, reporting pricing structure, current sales of
Casio’s manufactured by DDKM, and anticipated sales if the technology suggested by

Ariana, the production manager were implemented. Exhibit II gives a supplementary memo
from Ariana, demarcating present operating cost figures and anticipated cost data allied
with the new production process. Price and variable cost information are weighted averages
based on the past sales mix of the three variants.
Assignment Questions
Acting in the role of Smith, answer each of the following questions as the talking points for
your presentation to senior management:
I. Validate the present and estimated (with the new technology) breakeven levels of
sales reported by Jessica Hill. Calculate the degree of operating leverage (DOL) at
the projected annual sales level of 4,000 units, using present and proposed technology.
(assuming the firm could, in fact, produce units with the existing technology).
II. Analyze the computed DOL figures and elaborate the significance of the elevated
DOL at the estimated sales level of the planned new technology.
III. Illustrate DDKM’s total cost and revenue curve using a graph. Also, identify the two
breakeven sales levels for current and planned technology.
IV. Calculate the volume of sales at which Net operating Income for DDKM is the same
under using both production techniques and also exhibit the sales level on the graph.
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DDKM Casio Inc.: The Risk-Reward Trade Off from Operating Leverage | FIN-2-0032
V. Assume that Jessica Hill’s sales projections come from a normal distribution and the
weighted average price of the mix of Casio’s sold by DDKM is INR2,400.
Superimpose onto the graph created for question 3 a probability distribution of sales
with an expected sales level, E(Q), of 4,000 units and a standard deviation of 800
units. (Be sure the left tail of the probability distribution extends beyond the breakeven
level of output for the current production method.) What is the expected net operating
income and the probability of an operating loss with the current technology? With
the projected technology? Identify the areas of operating loss with each technology
under the probability distribution.
VI. Discuss how you would use your graph to explain the risk-reward implications of the
greater operating leverage inherent in cost structure expected with the proposed new
production process.
Exhibit I: Memo from Jessica Hill, Chief Sales Officer

Hi, Smith
Please find below a summary on the annual production and sales volume: The annual production and
volume of sales has been moderate in the past few years at about 2,200 units based on an average price per
Casio at INR2,400 (Computed as a weighted average based on sales).
Although, it’s been a while since I attended a statistics class I have tried my best to assess probabilities of
various scenarios. At this time we figure that 4,000 units is a reasonable expected sales level, with a standard
deviation of about 800 units. 4,000 units can be seen as a bit too optimistic but with our heavy surfeit of
orders we are confident that we will achieve the expected forecast.
I would suggest you to consider Ariana’s proposal. I know I’m just the sales chief and not an analyst, but my
computations exhibit that with the new production technique and the associated cost data provided by
Ariana (and no change in either our pricing or relative mix of model sales) we should have annual net
operating income of INR29,18,000 on 4,000 units. By contrast, the present technology and ongoing sales of
2,200 units per year we should be able to generate NOI of only INR2,11,000. Difference is directly proportional
to the increase in production and sales.
Thanks,
Jessica Hill
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Exhibit II: Memo from Ariana, Production Manager
Mr.Smith
Appreciating your suggestion on the need for adoption of a new technology. As suggested, I am providing
you the cost information relevant to the present manufacturing process and projected cost information if the
firm decides to opt the new technology.
The present technology will result in a variable cost of INR1,440 per unit. In addition, the yearly fixed costs
will amount to INR19,01,000 including maintenance expenses. Application of the proposed technology
would reduce the variable cost per unit to INR720, fifty percent of the existing variable cost. Fixed cost will
however be INR38,02,000, two-hundred percent of the existing cost. Given the expected new cost framework
and zero variability in the pricing structure of our Casio’s ,the breakeven level of sales is projected to move
up from 1,980 units to 2,260 units with the adoption of the new production technique.
Current sales reported are 2,200 units, reasonably higher than the breakeven level of 1,980. And, definitely,
with nil increase in sales there won’t be any rationale to replace the current production process with the
proposed one, more advanced technology since the breakeven level of sales with the new technology 2,260
would exceed current sales. However, given the surfeit of orders and increasing demand for DDKM Casio’s,
as shown in Jessica Hill’s sales projection, there is enough explanation for adopting the proposed technology
and breaking the current holdup in production.

Appreciate for your critical work on this project. I recommend that we apply the new technology as that will
boost its financial stability.
All the best,

Ariana
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117-0024-1

GSMC 2017, IIM Raipur ET CASES

Preparing the Presentation

Current and Projected Sales and Operating Costs

Casio’s manufactured by DDKM, and anticipated sales if the technology suggested by

Exhibit I: Memo from Jessica Hill, Chief Sales Officer

Exhibit II: Memo from Ariana, Production Manager

and breaking the current holdup in production.

All the best,

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