Mma Ramotswe's Bakery: Weighing a Second Oven
Mma Ramotswe runs a small bakery in Mogoditshane selling bread and fat cakes. Monthly sales are P48,000. Ingredients and packaging cost P19,200; rent is P6,000; wages are P9,000; electricity and water are P3,800; transport is P2,200. She is considering a second oven costing P60,000, financed by a five-year bank loan at 12% simple interest per year. She estimates the new oven would raise monthly sales by P14,000, with ingredient and packaging costs rising to 40% of the extra sales, and electricity rising by P1,200 per month. She would also need one part-time assistant at P2,500 per month. She has P8,000 in savings and is unsure whether to use it as a deposit or keep it as a buffer.
1. Calculate the bakery's current monthly profit and profit margin. Then decide whether the second oven is financially worthwhile in its first year, showing your figures.
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Current position
- Total costs = 19,200 + 6,000 + 9,000 + 3,800 + 2,200 = P40,200
- Monthly profit = 48,000 − 40,200 = P7,800
- Profit margin = 7,800 ÷ 48,000 × 100 = 16.25%
Effect of the oven (per month)
- Extra contribution = 14,000 − (40% × 14,000) = 14,000 − 5,600 = P8,400
- Extra fixed costs = 1,200 (electricity) + 2,500 (assistant) = P3,700
- Extra profit before loan interest = 8,400 − 3,700 = P4,700
- Loan interest = 60,000 × 12% = P7,200 per year = P600 per month
- Net extra profit = 4,700 − 600 = P4,100 per month, or P49,200 per year
Judgement: the oven adds roughly P49,200 a year against a P60,000 outlay, so it pays for itself in about 15 months. That is attractive, but the margin of safety matters: if the extra sales forecast is only half right (P7,000), extra contribution falls to P4,200, which is barely above the P4,300 of extra fixed and interest costs. The decision is worthwhile only if she is confident demand exists; she should test demand for a month before committing.
2. Advise Mma Ramotswe on whether to use her P8,000 savings as a deposit or keep it as a buffer, referring to the risks facing a small bakery.
Read the worked answer
Using the savings as a deposit reduces the loan to P52,000, cutting interest from P7,200 to P6,240 a year - a saving of only P960, or P80 a month. That is a small gain.
Against this, the bakery faces real risks: flour and cooking oil prices can rise, electricity tariffs can change, the oven may break down, and demand falls in months when customers have less cash. With monthly fixed costs of P40,200, even one weak month could leave her short. An P8,000 buffer covers roughly a week of total costs plus an emergency repair.
Judgement: the interest saving is too small to justify losing all liquidity. A better compromise is to keep the P8,000 as a buffer and, once the oven has traded profitably for three or four months, use accumulated profits to make a partial early repayment. She should also confirm the loan terms allow overpayment without penalty, and negotiate a fixed interest rate so her repayments do not rise if bank rates increase.