Question
Standard level Paper 2(21)
Trestle Z PLC (TZ)
Trestle Z PLC (TZ), a specialist coffee roaster, operates in the secondary sector. Its instant coffees are sold worldwide in a very competitive market. Consumers in this market have strong brand loyalty.
Although demand for instant coffee has not grown in many richer countries, it is growing in emerging markets and Eastern Europe. TZ has no control over the price of its raw material (coffee beans), as prices are determined by world markets.
The directors of TZ want to increase the company’s gross profit margin and net profit margin and grow the business. Table 5 gives selected financial information for the company for 2019 and 2020.
TZ’s directors are considering two options.
Option 1: Take over a specialist coffee business
TZ is considering taking over Green Glass (GG) for $600 million. GG owns 1000 cafés in the USA that sell speciality products at high prices. It also has an e-commerce subscription service that sells its coffee beans to consumers. In 2020, GG’s net profits were $120 million. GG has a well-organized distribution channel and strong brand awareness in the USA. TZ would operate the cafés using the GG branding.
Option 2: Launch its own chain of cafés
These cafés would compete against established chains of cafés serving the mass market. Initially, the launch would be in three EU countries but would then, if successful, be launched across the world. TZ would produce a range of freshly ground coffees for sale in the cafés.
a. Define the term secondary sector.
b. Explain two factors that might prevent $T Z$ from increasing its gross profit margin.
c. Explain, using the Ansoff Matrix, TZ’s proposed takeover of GG.
d. Recommend whether TZ’s directors should choose Option 1 or Option 2.
▶️Answer/Explanation
Ans:
a. This sector includes both construction and manufacturing. It uses resources from the primary sector to manufacture finished goods or process raw materials to be used for other secondary sector business. The secondary sector supports both the primary and tertiary sector.
Award [1] for some understanding.
Award [2] for a clear definition.
Providing examples of secondary sector business alone is insufficient to receive marks. However, exemplification can strengthen a definition and be a basis for a second mark (if the definition was not fully complete).
b. $T Z$ will find it very difficult to reduce its cost of sales as raw material prices are dependent on the world price of coffee beans and $T Z$ has no control over these prices (it is a price taker).
$T Z$ will find it very difficult to raise prices as $T Z$ operates in a “very competitive market”.
To increase its gross profit margin $T Z$ would need to either
- raise its price OR
- reduce its costs of sales.
Mark as [2+2].
Award [1] for stating a reason why $T Z$ might not be able to increase its gross profit margin and an additional [1] for its explanation with reference to TZ. Award a maximum of [2].
c. Candidates can be awarded up to 2 marks for demonstrating a knowledge of the Ansoff Matrix and a further 2 marks for applying it the stimulus.
Candidates do NOT need to draw the Ansoff Matrix, but marks can be awarded if they do and place the takeover of GG in an appropriate sector. However, such an answer without any commentary is restricted to a maximum of 2 marks.
There is no single correct answer.
Candidates can be rewarded application marks if they suggest the takeover is either:
- product development as coffee retailers look at their existing market and seek to gain their customers’ loyalty with new and more exciting products, or
- market development as they take their existing product, coffee, and aim to extend to new niche markets (of their own creation) by educating their consumers to seek a new experience or
- market penetration – It is a good example of a product extension strategy, adding value to a product for the consumer.
- diversification – From a certain perspective, TZ’s proposed takeover of GG is a form of diversification, related diversification (though candidates are not required to use the word related).
Award [1] if the answer demonstrates a weak grasp of the Ansoff Matrix.
Award [2] if the answer demonstrates a sound grasp of the Ansoff Matrix.
Award [3] if the answer demonstrates a sound grasp of the Ansoff Matrix and the candidate explains why it might be considered to be either PD, MD or MP using the stimulus.
Award [4] if the answer demonstrates a sound grasp of the Ansoff Matrix and the candidate explains why it might be considered to be more than just one classification i.e. either PD or MD or PD or MP, MD or MP using the stimulus.
d Refer to Paper 2 markbands for 2016 forward, available under the “Your tests” tab > supplemental materials.
Option 1 Advantages
- Speed – once the deal is struck TZ will have expanded quickly.
- Proven profitability GG made a profit of $120m in 2021 – is therefore less risky than Option 2.
- This business has a well organised distribution channel and strong brand awareness in the USA and therefore is already well established.
Option 1 Disadvantages
- TZ only has $400m in cash and the takeover price is $600m and therefore TZ will need external finance the purchase.
- TZ will have to raise external finance, which means that its debt (and interest expense) will increase or some dilution of ownership will occur.
- This option is only based in US – will the concept transfer to other countries and how much cost will be incurred to establish its brand overseas?
Option 2 Advantages
- This can be seen as diversification, reducing risks as the market of jars of coffee has stagnated in many richer countries.
- It already has experience of purchasing coffee beans on a large scale and can use the same suppliers for its new chain of cafes.
- It has great potential as demand is growing in eastern Europe. Demand is also growing in emerging markets so the prospects for sales may be good.
Option 2 Disadvantages
- TZ has no experience of running cafes selling coffee.
- It will have to go head on with established brands (students are likely to name them e.g. Starbucks, Dunkin Donuts etc.) and may find it hard to compete with the brand loyalties already established.
- Will not have the economies of scale that existing chains have.
- Will take much longer – is only trialling this in 3 countries in EU.
- If successful in these countries will it work worldwide? – cannot be certain as consumers in these countries may have different tastes or attitudes to rest of the world.
In order to reach the top bands of the markscheme candidates must have a balanced view, made a judgement AND also used the data in Table 3 effectively.
Accept any other relevant evaluation.
The table below should be followed (along with the paper 2 markbands).
These mark awards in the table below should be viewed as maximums. That is, just because a candidate has one argument for option 1 and one argument against does not mean that they will automatically get a 4. One strong argument for one side and merely a weak or nominal argument for the other side might result in a 3.
Marks should be allocated according to the paper 2 markbands for May 2016 forward.
Question
Standard level Paper 2 (21)
KapTan
KapTan (KT ), which manufactures rechargeable batteries for cordless consumer products like vacuum cleaners, began five years ago as a business with a product orientation. It sells business to business (B2B). Multinational companies dominate the rechargeable battery industry, and KT suffered from cash-flow problems in its first year of trading. Its profits are small and, in the last two years, have fallen.
KT has now developed an innovative battery that is small and lightweight. This battery is an emergency power source allowing electric cars to reach a charging station. However, the battery can only be used ten times before it runs out. KT has insufficient finance to create a battery that can be recharged an unlimited number of times.
Through market research, KT has discovered that:
- no other emergency batteries for electric cars exist
- owners of electric cars fear running out of power
- KT ’s new battery could be obsolete in five years.
KT has the capacity to produce 90 000 of these new batteries each year. The average cost is $200 per unit. KT has insufficient funds to invest in additional capacity.
KT is considering two options:
Option 1: Market and sell directly to existing car owners through business to consumer (B2C) at a retail price of $400. KT will need to borrow significant capital to finance this option.
Option 2: Accept an offer of a five-year strategic alliance with a manufacturer of electric cars. KT would provide its product exclusively at $250 per unit. Sales are guaranteed.
Table 2: KT’s forecasted and guaranteed worldwide unit sales (in 000s) for the two options
a. Define the term product orientation. [2]
b. With reference to Option 1, for $K T$, explain the relationship between the product life cycle, investment, profit and cash flow. $[4]$
c. With reference to $K T$, explain two problems that a new business may face. [4]
d. Recommend whether $K T$ should choose Option 1 or Option 2. $[10]$
▶️Answer/Explanation
Ans:
a. A company following a production orientation chooses to ignore their customers’ needs and to focus only on efficiently building a quality product. They do not undertake market research identifying customer reactions to their proposed product before commencing production. This type of company believes that if they can make the best product their customers will come.
Candidates are not expected to word their responses exactly as above.
If the candidate says something to the effect of “The company focuses on the product,” award [1]. A second mark can be awarded if the candidate then offers a contradistinction such as “ignores the market,” “does not do market research,” “does not appeal to the market,” etc.
Award [1] for identification of one characteristic of a product-orientated business.
Award [2] for a full, clear description.
b. Initial research and development costs plus the costs involved in launching a product usually means a product will be a loss maker in its early years. Cash flows may be negative. As sales grow and the product moves into the growth phase, profits are likely to be positive but the company will require additional working capital Not until the product reaches the maturity phases of the life cycle are cash flows and profits likely to be positive. In the decline phase, cash flows and profits are likely to remain positive. The cash flows especially should be solid with the contraction of necessary working capital. For KT, the investment in R&D for the new battery will have had a negative effect on cash flow and profits. Once the product is launched, Option 1 forecasts see quite large sales and therefore large cash inflows. However, we do not know about the marketing costs, which will increase cash outflows. Sometime in year 2, further investment would be needed if sales targets in years 3 and 4 are to be fulfilled as projected sales exceed capacity. This investment would increase fixed costs and reduce profits.
If a candidate shows some understanding the relationship between the product life cycle, investment, profit and cash flow, but with no application to the stimulus, award [1].
If the candidate shows clear understanding of the relationship between the product life cycle, investment, profit and cash flow, but with no application to the stimulus, award [2].
If the candidate shows some understanding of the relationship between the product life cycle, investment, profit and cash flow and has some application to the stimulus, award [2].
If the candidate shows clear understanding of the relationship between the product life cycle, investment, profit and cash flow and has some application to the stimulus, award [3].
If the candidate shows clear understanding of the relationship between the product life cycle, investment, profit and cash flow and has detailed application to the stimulus, award [4].
If a candidate writes or draws some sort of table (such as exist in several of the textbooks IB students use) listing the stages of the product life cycle and showing the relationship between stages of the life cycle and their relationship to investment, cash flow and profit, accept and award [2] marks if well executed with no application to the stimulus and award [1] if poorly executed with no application to the stimulus.
If the candidate applies to the stimulus, either by making inserts into the table or with commentary before or after it, award an additional [1 to 2] according to the depth and quality of the application.
c. Problems any new business may face include:
- Competition – KT faces stiff competition in the market for batteries for consumer products from multinationals.
- Cash flow problems – KT suffered from cash flow problems in its first year of trading.
- Human resources issues, particularly finding the right staff.
- Insufficient marketing.
- Market research – KT is product orientated and therefore will not have undertaken market research before developing is products.
- Poor planning.
- Insufficient start-up capital.
Accept any other relevant problems that a new business may face.
Mark as 2 + 2.
For [2], candidates must identify a problem, explain it, and apply it to the stimulus.
N.B. If the candidate addresses an issue at the end of the time period specified in the stimulus and notes a problem that KT may face then, do not accept (as the business will no longer be new).
Refer to Paper 2 markbands for 2016 forward, available under the “Your tests” tab > supplemental materials.
Option 1: Selling car batteries directly to car owners. They currently sell B2B rather than B2C.
Advantages:
- Higher initial revenues per unit – KT will receive $400 per unit by selling directly to consumers, compared to only $250 per unit if sold to a car manufacturer.
- Sales are higher in option 1 for the first 2 years and at 410 000 over 5 years are 95 000 higher.
- Total revenues are higher at $164 000 000 compared with $78 750 000.
Disadvantages:
- KT has no experience of selling directly to consumers as it is currently a B2B business. It will need to decide HOW it will allow customers to order its products – via its website or by phone – both solutions will require additional spending.
- KT will need to undertake a marketing campaign to raise awareness of its new products. As a B2B business, KT has no experience of engaging consumers. Funds will need to be found to finance a marketing campaign to raise awareness of its product and to persuade consumers to buy the product.
- The data in Table 1 is only a forecast and therefore may exaggerate its potential. KT may sell much less than forecast which affects its profitability.
- Further investment would be needed to meet demand as full capacity is exceeded in years 3 and 4. The cost of this investment is unknown. KT has insufficient funds to invest in new capacity.
Option 2: Form a five-year strategic alliance with a manufacturer of electric cars.
Advantages:
- Sales are guaranteed as the partner in the strategic alliance has agreed to buy a set number for 5 years. This alliance provides the business with certainty.
- KT avoids capacity issues as maximum annual sales are 85 000 units (batteries), which is below KT’s capacity of 90 000 units.
- No additional marketing costs.
Disadvantages:
- Sales are lower than option 1 for years 1,2,3,4 and 5.
- Unit revenues are lower at $250 rather than $400 per unit.
- Total sales and sales revenue are lower at 315 000 units with a total revenue of $78 750 000.
Balance in the context of this question means having at least one advantage and one disadvantage for each option (and, thus, addressing both options).
Accept any other relevant evaluation.
These mark awards in the table below should be viewed as maximums.
Marks should be allocated according to the paper 2 markbands for May 2016 forward.