New Heritage Doll Company: Capital Budgeting In mid-September of 2010,
Emily Harris, vice president of New Heritage Doll Company's production
division, was weighing project proposals for the company's upcoming
capital budgeting meetings in October. Two proposals stood out based on
their potential to strengthen the division's innovative product lines
and drive future growth. However, due to constraints on financial and
managerial resources, Harris knew it was possible that the firm's
capital budgeting committee would decline to approve both projects. She
also knew that New Heritage's licensing and retail divisions would
promote compelling projects of their own. Consequently, Harris had to be
prepared to recommend one of her projects over the other. The Doll
Industry Revenues in the U.S. toy and game industry totaled S42 billion
in 2008 and were projected to increase by 4.6% per year to $52.5 billion
by 2013. The market was divided into two broad segments: video games
(48%) and traditional toys and games (52%). The second segment was
further divided into infant/preschool toys (14.5%), dolls (14.1%),
outdoor & sports toys (12.3%), and other toys & games (59.1%)
including arts and crafts, plush toys, action figures, vehicles, and
youth electronics. The U.S. market for toys and games was dominated by
large global enterprises that enjoyed economies of scale in design,
production, and distribution. Revenues were highly seasonal; the largest
selling season in the United States coincided with the winter holiday
period. Within the toy and game segment, U.S. retail sales of dolls
totaled $3.1 billion in 2008 and were projected to grow by 3% per year
to $3.6 billion by 2013. The doll category included large, soft, and
mini dolls, as well as doll clothing and other accessories. The
phenomenon of "age compression"— the tendency of younger children to
acquire dolls that had traditionally been designed for older
girls—reduced growth in the "baby-doll" sub-segment. Competition among
doll producers was vigorous, as a small number of large producers
targeted similar demographics and marketed their dolls through the same
media. Lasting franchise value for a branded line of dolls was rare; the
enormous success of Barbie® dolls was an obvious exception. More
recently and on a much smaller HBS Professor Timothy Luehrman and HBS
MBA Heide Abelli prepared this case solely as a basis for class
discussion and not as an endorsement, a source of primary data, or an
illustration of effective or ineffective management. This case, though
based on real events, is fictionalized, and any resemblance to actual
persons or entities is coincidental. There are occasional references to
actual companies in the narration. Copyright © 2010 Harvard Business
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of Harvard Business Publishing. Harvard Business Publishing is an
affiliate of Harvard Business School. scale, New Heritage also had
created a durable franchise for its line of heirloom dolls. But the
popularity of most doll lines waned after a few years. New Heritage
Dolls The New Heritage Doll Company was founded in 1985 by Ingrid
Beckwith, a retired psychologist specializing in child development and
the grandmother of two young girls. Dr. Beckwith believed the dolls
produced by the major toy companies did little to develop girls'
imagination or foster a positive self-image, so she created a line of
dolls with unique storylines and wholesome themes. Dr. Beckwith's dolls
struck a chord among mothers and grandmothers who also rejected the
dated, cliched images portrayed by the popular dolls of the day. By
2009, New Heritage had grown to 450 employees and generated
approximately $245 million of revenue[1] and $27 million of operating
profit from three divisions: production, retailing, and licensing. The
production division, discussed further below, designed and produced
dolls and doll accessories. The retailing division offered a unique
"intergenerational experience" for grandmothers, mothers, and daughters,
centered upon the character histories and storylines of the company's
dolls and delivered through an online website (42%), a mail-order paper
catalog (33%), and a network of retail stores (25%). In fiscal 2009, the
retailing division generated roughly $190 million of revenue and $4.8
million of operating profit. The licensing division was started in 1998,
and represented the company's newest and most profitable division. It
sought to extend the New Heritage brand and capitalize on high levels of
customer loyalty by selectively licensing the company's doll characters
and themes to a variety of media that reached the firm's target
demographic of toddler to pre-teen girls. In fiscal year 2009 the
licensing division generated $24.5 million of revenue and $14.5 million
in operating profit. New Heritage's Production Division Production was
New Heritage's largest division as measured by total assets, and easily
its most asset-intensive. Approximately 75% of the division's sales were
made to the company's retailing division, with the remaining 25%
comprising private label goods manufactured for other firms. Table 1
summarizes the division's various sources of revenue and operating
income. Table 1 New Heritage Private Label Total Production Division
Data: Dolls Accessories Dolls Accessories Revenue ($ millions) 80 14 26 5
$125 Operating Income ($ millions) 4.4 0.5 2.3 0.3 $7.5 New Heritage's
dolls and accessories were offered under distinct brands with different
price points, targeting girls between the ages of 3 and 12 years. The
company's baby dolls were generally priced from $15-$30, and were
offered to younger girls in earlier stages of development. These dolls
typically came with a "birth certificate" and a short personal history.
Dolls in the higher-end of this category incorporated technology that
produced a limited amount of speech and motion. For the $75-$150 price
range, New Heritage produced a line of heirloom-quality dolls and
accessories. These were designed to appeal to older girls and to convey a
sense of cultural and family tradition among grandmothers, mothers, and
daughters. The heirloom dolls had more elaborate accessories and
personal histories. Finally, the company offered a line of high-end
dolls based on fictional "celebrities," each associated with a
charitable cause and embracing more contemporary fashion trends. These
dolls targeted girls in the so-called "tween" age range of 8-12 years,
and also were priced from $75-$150. Like the heirloom dolls, celebrity
dolls also came with more elaborate stories and accessories. New
Heritage outsourced much of its production to a select number of
contract manufacturers in Asia. To ensure product quality and safety,
the company maintained a fulltime staff to oversee material sourcing,
production, and quality control on site at each of its manufacturing
partners. Manufacturing activities that required precise tolerances or
proprietary processes, along with all the creative elements (design and
product prototyping, for example), were handled in-house at the
company's headquarters facilities in Sacramento, California. Capital
Budgeting at New Heritage New Heritage's capital budgeting process
retained some of the informality that characterized the company's early
years as an innovative startup. As the company grew, deliberate steps
were taken to decentralize some of the project approval process and
increase spending authority at the division level. However, large and/or
strategic spending proposals were reviewed at the corporate level by a
capital budgeting committee consisting of the CEO, CFO, COO, the
controller, and the division presidents. The committee examined projects
for consistency with New Heritage's business strategy and sought to
balance the needs and priorities of each division against practical
financial and organizational constraints. The committee also sought to
understand project interdependencies and the potential for a given
investment to strengthen the whole company, not solely the division
proposing it. New Heritage's capital budget was set by the board of
directors in consultation with top officers, who in turn sought input
from each of the divisions. The capital and operating budgets were
linked; historically, the capital budget comprised approximately 15% of
the company's EBITDA. The committee had limited discretion to expand or
contract the budget, according to its view of the quality of the
investment opportunities, competitive dynamics, and general industry
conditions. Before being considered by the committee, projects were
described, analyzed, and summarized in self-contained proposal documents
prepared by each division. These contained business descriptions, at
least five years of operating and cash flow forecasts, spending
requirements bv asset category, personnel requirements, calculations of
standard investment metrics, and identification of key project risks and
milestones. Financial Analyses Financial analysis began with operating
forecasts developed with oversight from New Heritage operating managers.
Revenue projections were derived from forecasts of future prices and
volumes. Fixed and variable costs were estimated separately, by expense
category. Forecasts of working capital requirements were likewise vetted
by line managers, who paid particular attention to a project's
requirements for various types of inventory. Forecasts for fixed assets
and related depreciation charges were developed in cooperation with
analysts reporting to the controller. Operating projections for a given
project were used to develop cash flow forecasts that would underpin
calculations of net present value (NPV), internal rates of return (IRR),
payback period, and other investment metrics. Cash flow forecasts were
intended to capture the incremental effect of a proposed project on the
firm's cash flow for each year within the forecast period. That is, each
project's cash flow forecasts excluded non-cash items, such as
depreciation charges, and non- incremental items such as sunk costs
(i.e., costs that would be incurred regardless of whether a given
project was undertaken or not). The cash flow forecasts were computed on
an after-corporate-tax basis, but excluded all financing charges. Some
elements of the cash flow forecasts were prepared with assistance from
treasury analysts, but most of the necessary adjustments were well
understood by division staff. New Heritage assigned discount rates to
projects according to a subjective assessment of each project's risk.
High-, medium-, and low-risk categories for each division were
associated with a corresponding discount rate set by the capital
budgeting committee in consultation with the corporate treasurer.
Assessments of each project's risk were made at the division level, but
subject to review by the capital committee. Factors considered in the
assessment of a project's risk included, for example, whether it
required new consumer acceptance or new technology, high levels of fixed
costs and hence high breakeven production volumes, the sensitivity of
price or volume to macroeconomic recession, the anticipated degree of
price competition, and so forth. In 2010, "medium"-risk projects in the
production division received a discount rate of 8.4%. High- and low-risk
projects were assessed at 9.0% and 7.7%, respectively. Projects that
created value indefinitely, given continuing investment, were treated as
going concerns with a perpetual life. That is, NPV calculations
included a terminal value computed as the value of a perpetuity growing
at a constant rate. However, to preserve an element of conservatism, the
capital committee generally insisted on relatively low perpetual growth
rates - lower than New Heritage's historical growth and lower than
near-term growth forecasts for a given division. Investment
Opportunities in the Production Division Emily Harris was focused on two
of the production division's most attractive current proposals. The
first involved expanding the successful Match My Doll Clothing Line to
include matching all- season clothing for tween girls and their favorite
dolls. The second involved a new initiative, the Design Your Own Doll
line, which employed web-based doll-design software to let users
"customize" a doll's features to the customer's specifications. Match My
Doll Clothing Line Expansion The Match My Doll Clothing line originally
consisted of a few sets of matching doll and child clothing and
accessories for warm weather. It quickly became successful after the
daughters of a few celebrities were spotted and photographed wearing
items from the line, and girls' magazines included some of the line in
"what's hot to wear" sections. Given recent publicity, Marcy McAdams,
the brand manager responsible for the line, believed the timing was
perfect to expand. Specifically, McAdams proposed to create an "All
Seasons Collection" of apparel and gear covering all four seasons of the
year. She expected the new offerings to be at least as profitable as
the existing line, since its current popularity would make it possible
to maintain premium prices. She also hoped to take advantage of off-peak
discounts offered by some suppliers and contract manufacturers as they
tried to smooth their capacity utilization. In the same fashion, McAdams
argued the expansion would help reduce, or at least not exacerbate, the
seasonality in New Heritage's sales and earnings. To exploit the
current popularity of the original Match My Doll Clothing line,
especially given the fickle nature of children's fashion trends, McAdams
believed the opportunity had to be exploited without delay. Her
investment proposal contained relatively large outlays for R&D,
market research, and marketing to maximize the probability of quick
acceptance and longer-term success for the follow-on line. Upfront
investment expenditures are summarized in Table 2. Table 2 Match My Doll
Clothing Extension Outlays Initial Expenditures ($ thousands) 2010
Upfront R&D $ 625 Upfront Marketing 625 Investment in Working
Capital 800 Property, Plant & Equipment 1.470 Total $ 3,520 The
R&D and marketing expenditures would be deductible for tax purposes
at New Heritage's 40% corporate tax rate. The property, plant and
equipment was expected to have a useful life of 10 years; the associated
depreciation charges, shown in Exhibit 1, were based on the modified
accelerated cost recovery system ("MACRS") allowed by the IRS. Working
capital requirements, shown in Table 2 for 2010 and in Exhibit 1 for
subsequent years were based largely on recent historical experience with
the original Match My Doll Clothing line. Finally, given the proven
success of Match My Doll Clothing, Harris believed the project entailed
moderate risk—that is, about the same degree of risk as the production
division's existing business as a whole. Design Your Oiun Doll This
initiative targeted existing New Heritage customers, many of whom owned
several of the company's heirloom dolls. The company's research showed
that, when asked what features (e.g., appearance, ethnicity, "life
story," etc.) New Heritage should give to future dolls, loyal customers'
responses had a high correlation with their own personal data. That is,
girls wanted dolls like themselves. Further research suggested that
many loyal customers would purchase yet another doll if they could
customize the doll's features to create a "one-of-a-kind" addition to a
girl's or family's existing collection of dolls. It also promised to
increase the girl's pride in and identification with the doll, both
because of their shared features and because of the girl's participation
in creating the doll. This in turn further cemented customer loyalty.
The customization process would begin with a new section of New
Heritage's website, where proprietary design software enabled the
customer to select physical attributes of the doll such as hair color,
hair length & style, skin color, eye shape, eye color, and other
facial features. The software could combine selected features and
produce a photo-realistic image showing the finished doll with
user-selected accessories. The customer could zoom in or out on the
image and rotate it to see different aspects. The software made it easy
to try out different combinations of features and accessories before
making a purchase. Elizabeth Holtz, brand manager for heirloom dolls,
was very excited about the project. She observed, "A girl's relationship
with her favorite doll is often partly mommy and partly big sister.
Either way, having your doll look more like you is really powerful. And
there's excitement in the experience: exploring the website, naming the
doll-to-be, selecting her first outfit ...even the anticipation of
waiting for the new doll to arrive. I really think this is big." Holtz
also believed that the dolls could command a premium price. "Customers
will naturally expect to pay more [for a custom doll]," she said. Market
research with focus groups revealed significant enthusiasm for the
product concept and supported the notion of premium prices. However,
even a limited degree of customization increased manufacturing
complexity and expense. Further, because of the low production runs and
volume, fixed costs on a per unit basis were expected to be relatively
high. Consequently, the breakeven volume for the project was also
expected to be high. The web-based software tools and order entry system
required New Heritage to make significant modifications to its existing
technology infrastructure, expand its webhosting capacity, and modify
the terms of its third-party service agreements to ensure a higher level
of service quality. The majority of the R&D expenditures shown
below were related to software development, hardware upgrades, and web
design. The development time involved, including product testing, was
expected to be approximately 12 months. Initial outlays, some of which
occurred in 2010 and some in 2011, are summarized in Table 3. Table 3
Design Your Own Doll Outlays Initial Expenditures ($ thousands) 2010
2011 Upfront R&D $ 841 Upfront Marketing $ 360 Investment in Working
Capital $1,000 Propertv, Plant & Equipment S 4.610 Total $ 5,811 $
1,000 As with Match My Doll Clothing, the required R&D and marketing
costs would be tax deductible. Manufacturing equipment had to be
ordered by the end of 2010 to be ready for production at the beginning
of 2012. While New Heritage had the option to pay for custom equipment
in quarterly installments, the firm could get a substantial discount by
paying for the equipment up front, in 2010. Figures in Table 3 and
Exhibit 2 reflect the discounted cost of the equipment. To support the
forecasted level of sales, substantial investment in working capital
(primarily work in process inventory of partially manufactured dolls)
would be required beginning in 2011. And still more equipment would have
to be purchased and installed no later than 2014. In years 2015 and
following, investments in working capital and equipment would revert to
patterns familiar from the production division's traditional lines of
dolls. To complete development work, Holtz planned to use some of the
company's existing IT staff. The majority of the work would take place
during calendar 2011. The number of people and their fully loaded costs
are shown Table 4. These costs were not included by Holtz in the initial
outlays shown in Table 3 or in the forecasts presented in Exhibit 2.
The development personnel Holtz needed were considered "corporate"
resources and were almost certainly available to work on the project.
Table 4 Design Your Own Doll Development Personnel, ($ 000s) Application
Development Personnel Costs: Number Salary Total Web Application
Developers 1 $ 150 $ 150 Database Manager 1 160 160 Systems Integration
Specialist 1 $ 125 125 Total Cost $ 435 Finally, Holtz needed to give
Harris her assessment of the project's riskiness. On the one hand,
Design Your Own Doll had a relatively long payback period, introduced
some untested elements into the manufacturing process, and depended on
near-flawless operation of new customer-facing software and user
interfaces. If the project stumbled for some reason, New Heritage risked
damaging relationships with its best customers. On the other hand, the
project had a relatively modest fixed cost ratio, and it played to the
company's key strength—creating a unique experience for its consumers.
Harris's Decision Emily Harris still needed to complete her review and
financial analysis of the two proposals. McAdams and Holtz were in
frequent touch with Harris and both had offered to respond to any
questions she might have about the proposals: the business case, the
financial projections, the operating details, or anything else. Harris
expected that she would indeed have some follow-up questions as she
worked through her financial analyses. She also knew that her final
recommendation might disappoint some executives within the division, who
would scrutinize it closely. It had to be well-supported.
