Kathleen Grogan received her PhD in pharmacology ten years ago from Boston University. While there, she became interested in the business side of drug distribution and hence stayed on for an extra 18 month to earn an MBA. After graduation, she went to work for Capo Corporation a major drug manufacturer, where she managed the development of a new nonprescription antiallergy drug. Although the drug passed all US Food and Drug Administration (FDA) trials and was certified for general use, Capo simultaneously developed a similar drug that was cheaper to produce and equally effective in treating most, but not all, allergy symptoms. Thus, Capo decided not to proceed with production of the drug that Kathleen helped develop. However, Capo was willing to license production and distribution rights to another company. Kathleen thought that this might be a golden opportunity, so she quit her job with Capo to found her own company, Sooner Pharmaceuticals. The sole purpose of Sooner Pharmaceuticals is to obtain the license for, produce, and distribute the new drug, which Kathleen dubbed “SneezeRelief”
Kathleen is currently working on the business plan for Sooner Pharmaceuticals that she will present at a venture capital conference in New York. The main purpose of the conference is to match entrepreneurs with venture capitalists who are interested in providing capital to fledgling firms. She has spent a lot of time thinking about how Sooner Pharmaceuticals receivables should be managed. She is concerned about this issue because she knows of several small drug manufacturers that have gotten into serious financial difficulty because of poor receivables management.
Initially, Sooner Pharmaceuticals would sell directly and exclusively to four retail customers in the northeast (exhibit 27.1 provides the sales mix). If demand proved solid, the company would expand into other areas and wholesale channels. Sales are expected to be highly seasonal: Allergy drug sales are slow during the winter months, but they pick up dramatically in the spring when plant pollen levels reach a peak. Business falls off again in the summer, but it picks up in the fall when the ragweed season begins. Kathleen’s sales forecasts for the first six months of operations are given in exhibit 27.2. Assuming Sooner Pharmaceuticals receives financing and begins operations, the sales forecasts for the first six months of the second year are provided in exhibit 27.3.
Kathleen does not plan to give discounts for early payment; discounts are not widely used in the industry. On the basis of preliminary discussions with retail outlets (Sooner Pharmaceuticals customers), she forecasts the payment schedule shown in exhibit 27.4. She does not foresee any problems with bad-debt losses. First, the retailers with whom she plans to do business have been in operation for a long time. Second, she plans to carefully screen all customers. She believes these two factors will eliminate bad-debt losses. On average, she believes that 20 percent of receivables will contribute to profits, so 80 percent of receivables represent cash costs. Furthermore, the First National Bank of Oklahoma has indicated that its receivables financing would cost 8 percent annually.
In spite of her optimism regarding bad-debt losses, Kathleen is concerned about Sooner Pharmaceuticals potential level of receivables, and she wants to put in place a monitoring system that will allow her to quickly spot any adverse trends that develop. The total sales forecast for the first full year of operations is 800,000 packages. Each package, which will contain 12 tablets, will be priced at $5. Kathleen has hired you as an outside consultant to advise her about receivables management. So far, you have developed a model that produces accounts receivable balances, average collection period (ACP), aging schedules, uncollected balances schedules, and quarterly carrying costs for the end of March and the end of June. The uncollected balances schedule permits managers to remove the effects of seasonal and or cyclical sales variation and to construct an accurate measure of receivables payment patterns. Thus, it provides financial managers with better aggregate information than do such crude measures as the ACP or aging schedule. Kathleen anticipates that the venture capitalists at the conference will ask some questions concerning the interpretation of the receivables data, the sensitivity of the results to the basic assumptions, and the strategies to reduce carrying cost of receivables.