1.

0 INTRODUCTION

Baldwin Bicycle Company (BBC) was established in the 1940s for manufacturing upper

mid-range bicycles. Mrs. Suzanne Leister is the Vice President (Marketing) of the company. Its

merchandise range includes 10 models, from beginners model with training wheels to deluxe

12-speed adults models. BBC distributes its bicycle through a number of independent

merchants and sporting goods stores but has not infiltrated the discount retail chain section. By

1983, BBC had reached sales revenues of about $10 million per year although production was

functioning at 98,791 units in 1982, 25% below its capacity of over 130,000 units per year.

Sales were primarily through independently owned toy stores and bicycle shops. Ms. Leister

felt the BBC has the image of being above average in quality and price, but not a top of the

line product. She was pondering over the conversation she had a day before with Karl Knott, a

buyer from Hi-Valu Stores, Inc.

The Hi-Valu Proposition

Hi-Valu is involved in a chain of rebate department stores in the Northwest. Hi-Valus

sales volume had developed to the level that it is beginning to add house-brand merchandise

to the product lines of some of its departments. Hi-Valu approached BBC to offer a

private-label arrangement whereby BBC would produce a Challenger brand of bicycle, which

Hi-Valu intends to use for all of its house-brand sporting goods. An apparent good fit, Hi-Valu

estimates a requirement for 25,000 units per year, a number which would bring BBCs

production up to full capacity even in this depressed bicycle market. Hi-Valus proposal to BBC

had features that made it rather different from BBCs usual way of doing business. Several of

Hi-Valus proposed terms, however, digress from standard practices:

It is paramount to Hi-Valu to have ready access to a large inventory of bicycles, due to

 unpredictable volume of sales. Hi-Valu wants to carry these inventories in its regional

warehouses, but does not want title on a bicycle to pass from BBC to Hi-Valu until the

bicycle was dispatched and withhold payment until delivery to a specific store.

A bicycle would be paid within 30 days once a bicycle was shipped to a specific store or

120 days had passed in the regional warehouse.

Although the proposed Challenger line represents significant increase costs to produce,

Hi-Valu demands customized designs for handlebars, seats, tires, and packaging and

BBC was not designed as Porters low-cost provider, Hi-Valu would pay $92.29 per unit

less than the wholesale price of an equivalent model in order to preserve its own

margins.

Ms. Leister was highly aware of the fact that the bicycle boom had crushed out and also

the bad economy has caused BBCs sales volume to plummet over the last two years. As a

result, BBC currently runs its plant at about 75 percent of one-shift capacity. So looking at the

positive side, the added volume from Hi-Valus acquisitions could possibly be very attractive. If

an agreement is reached on prices, Hi-Valu would sign an exclusive contract with BBC for three

years. The contract would be automatically renewed unless either of the party expresses his will

to discontinue giving at least six-month notice.

2.0 PROBLEM STATEMENT

The proposal of Hi-Valu came at a time when Baldwin Bicycle Company is operating at

reduced capacity. Baldwin needs to examine the viability and profitability of this venture.
3.0 OBJECTIVES

To come up with a short-run alternative choice of decisions.

To analyze the cost behavior and its impact.

To apply differential cost accounting in selecting a good choice.

4.0 DATA PERTINANT TO CASE STUDY

Ms. Leister took notes of the Data pertinent to Hi-Valu proposal, below are the data:

1. Estimated first year costs of producing challenger bicycles (average unit costs, assuming a

constant mix of models):

Materials $ 39.80 *

Labour 19.60

Overhead (125% of Labor) 24.50

Total $ 83.90

* Includes items specific to models for Hi-Valu, not used in our standard models.

Accountant estimate 40% of overhead is variable ($18) and that the 125% of the direct labor

rate is based on a volume of 10,000 per year.

1. One time added costs of preparing drawings, and/or arranging for fenders, seats,

handlebars, tires, and shipping boxed that differ from those used in standard models is

estimated at $5,000 (2-months @ 2,500).

2. Unit price and annual volume: Hi-Valu estimates it will need 25,000 bicycles per year

and will pay average of $92.29 per bicycle for the first year. The contract will be
 adjusted for inflation, thus, the $92, 29 and $83.90 figures are in effect. Hi-Valu appears

firm on price.

3. Asset related costs (annual variable costs, as percent of dollar value assets):

Pretax funds for receivables and inventories 11.5%

Record keeping costs - receivables and inventories 2.0%

Inventory insurance 0.6%

State property taxes 0.7%

Inventory handling, labor and equipment 6.0%

Pilferage, obsolescence, damage etc. 2.2%

4. Assumptions for challenger-related added inventories (average over the year):

Materials: two months supply

Work in process: 1,000 bikes, half completed (but all materials for them issued).

Finished goods: 500 bikes (awaiting next shipment to Hi-Valus warehouse).

5. Impact on regular sales: Some customers comparison shop for bikes and many of them

are likely to recognize a Challenger bike as a good value when compared with similar

bike at a higher price in a non-chain toy or bicycle store. In 1982 BBC sold 98,971 and

if they forgo Hi-Valu deal, estimate sales of 100,000 per year will be made.

6. Estimate loss will be about 3,000 units of BBC regular sales volume a year since the

retail distribution is quite strong in Hi-Valus market regions. These estimates do not
 include the possibility that a few of their current dealers might drop out if they find out

BBC is making bikes for Hi-Valu.

5.0 FINANCIAL ANALYSIS

5.1 Relevant Cost Analysis (Q1,2,3,4)

A relevant cost is a cost that only relates to a specific management decision, and which will

change in the future as a result of that decision. The relevant cost concept is extremely useful

for eliminating unnecessary information from a particular decision-making process. For the

Baldwin Bicycle Company (BBC) case study, we have used this relevant cost analysis for the

short-term decision making on whether to accept the Hi-Valus proposal to produce new type of

bicycle to be used for its house-brand sporting goods.

5.1.1 Expected Added Profit

In order to identify the expected added profit from the Challenger line, we need to identify the

contribution per unit. Contribution per unit is the residual profit left on the sale of one unit; after

all variable expenses have been subtracted from the related revenue. This calculation is useful

to identify the minimum possible price at which to sell a product. This is to ensure that the

company would not face any losses when selling the goods produced. The calculation of

contribution per unit is:

(Total revenues - Total variable costs) / Total units

Using the data given in case study, we have analyzed the expected added profit from the new

Challenger line as below.

 Hi-Valu's sales price per unit $92.29
variable
production
costs:
Materials 39.80
Labor 19.60
Overhead ($24.50*40%) 9.80 69.20
Contribution margin per unit 23.09
Annual
25,000
volume
Total Contribution/Added profit $577,250

Based on the above calculation, the total added profit is $577,250 with the estimation volume of

Challenger line given by Hi-Valu about 25,000 units. So, if Baldwin Bicycle accepts Hi-Valus

proposal, it will be profitable for the company.

5.1.2 Expected impact of cannibalization of existing sales

Before accepting the proposal given by Hi-Valu, Baldwin company must identify the impact on

existing sales in order to evaluate whether the new proposal will give any losses for the

company or not. We have calculated the Baldwins loss contribution margin by using the

relevant cost analysis, as below.

Baldwins sales price per unit,

Margin = 2827/10872 = 26%

Assume, sales price per unit = x,
Sales Revenue Cost of Sales = Gross Margin
x COS = 0.26x
x 0.26x = COS
0.74x = COS
0.74x = $ 83.9
x = $113.38
Baldwin's sales price per unit $113.38
variable production costs: 69.20
Contribution margin per unit $44.18
Lost annual volume 3,000

Lost contribution margin/Opportunity costs $132,540

*Full cost $83.90 (74%)

*Contribution margin ratio based on the income statement ($2827/$10872 = 26%)

Results: Q1 and Q2

Using Hi-Valus offer to purchase the Challenger bike unit at $92.29, we have calculated unit

contribution margin at $23.09, which contributed the added profit of $577,250 for 25,000 unit

of bikes estimated. This amount, however, would cover the estimated loss of 3,000 regular sales

units through current dealers. Even when taking into account of the estimated 3,000 unit loss,

Baldwin Bicycle Company would gain a net revenue increase of $444,710 ($577,250 -

$132,540 = 444,710). As a result from the relevant cost analysis, this proposed project, can be

said as profitable for the company.

5.1.3 One Time Added Cost

Results: Q3

One time added costs is referring to the $5,000 cost incurred for the preparations of drawings

and designs and securing sources for fenders, seats, handlebars, tires, and shipping boxes. This

will only be included in the first year of the contract and will not affect changes in revenue or

variable cost. Thus, we propose for Baldwin Bicycle Company to ignore this cost for practical

purposes as this will be solved with idle time.

 5.1.4 Additional Assets and Related Carrying Costs

There is a need to calculate the additional assets and related carrying cost that will affect the

decision-making process on whether to accept or reject the proposal by Hi-Value. These added

assets and costs will be accounted annually during the proposed 3 year contract by Hi-Valu.

ADDED ASSETS AND RELATED CARRYING COSTS

ITEM CALCULATION TOTAL

Materials (25,000/12x2) x ($39.80 x 23%) 38,142
1,000($39.80 + 50%($19.60+$9.80)) x
Work in Process 9,265
17%
Finished Goods 500 x 69.20 x 23% 7,958
55,365
Finished Goods at (25,000/12x2) x $69.20 x 13.5%
38,925
Hi-Valu
Hi-Valu Receivables (25,000/12) x 92.29 x 13.5% 25,957
Total Asset Holding Cost 120,247

Results: Q4

The added assets and related carrying costs can be derived as follows:

i. Materials :
[(25,000 (bikes per year)/ 12 (no.of months) x 2 months supply] x [$39.80 (materials unit
average cost) x 23% (annual variable cost)]

ii. Work in Process :

1,000 bikes [$39.80 (materials unit average cost) + 50% (bikes half-completed) ($19.60 direct
labour + $9.80) x 17% (all annual variable cost except inventory handling labor)]

iii. Finished Goods :

500 bikes awaiting next carload-lot shipment x 69.2 (Baldwin variable production cost) x 23%
(annual variable %)

iv. Finished Goods at Hi-Valu

[(25,000 (bikes per year)/ 12 (no.of months) x 2 months supply] x x 69.2 (Baldwin variable
production cost) x 13.5% (pretax cost + record keeping cost)]
v. Hi-Valu Receivable:
25,000 bikes per year (Hi-Value Proposal) / 12 (no.of months) x 2 months supply x 92.9
(Hi-Valu purchase price per bike) x 13.5% (pretax cost + record keeping cost)]

In conclusion, after taking into account the annual variable cost for added assets we can

conclude that the total assets holding cost is $120.247 which consists of materials (2 months

supply), work in process, finished goods in Baldwin production, finished goods in Hi-Valu

warehouse and Hi-Valus account receivable.

5.2 Full Cost Analysis

ANIS DEFINITION TOLONG MASUKKAN 1 PARAGRAPH

5.2.1 Impact on Profits, Return on Sales, Return on Assets and Return on Equity (Q5)

a) Overall impact on profit

Profit is calculated as:

Profit= Total Revenue - (Cost of Goods Sold + Operating Expenses+ Taxes)

i) Expected profit from challenger line:

Sales price per unit $92.29

Variable costs:

Materials $39.80
 Labor 19.60

$69.20

Overhead ($24.50*40%) 9.80

Contribution margin per unit 23.09

Annual Volume 25,000

Total contribution $577,250

ii) Expected impact of cannibalization of existing sales:

Sales price per unit $113.38

Variable cost $69.20

Contribution margin per unit $44.18

Lost annual volume $3,000

Total lost contribution from regular bikes $132,540

iii) Additional assets and related carrying costs

 Materials (25,000/12*2)x $39.80 x 23% $38,142

Work in progress 1,000 ($39.80+ (50%(19.60 + $9.80 )) x 17% $9,265

Finished goods 500 x $69.20 x 23% $7,958

$55,365

Finished goods at Hi Valu (25,000/12*2) x $69.20 x 13.5% $38,925

Hi Valu receivables (25,000/12) x $92.29 x 13.5% $25,957

Total asset holding costs $120, 247

(i) Added contribution from Hi Valu $577,250

(ii) Lost Contribution from regular bikes sales ($132, 540)

(iii) Added asset holding costs ($120,257)

Effect on profit (excluding tax effects) $324,463

Effect on profit (with tax effects net of 46%) $175,210.02

b) Overall impact on Return on sales (ROS)

 ROS is the firms operating margin. Company use ROS as to calculate the ability of

company generate profits from the revenue. It is also used to know how much profit

generated per dollar of sales. The formula as below:

Return on sales (ROS) = Net income (before interest and tax)

Sales

ROS alternative 1 (Accept) 629/13,305*100 = 4.73%

ROS alternative 2 (Decline) 453/11,338*100 = 4.00%
Impact on ROS (4.00 4.73)/ 4.00 *100 = Increase by 18.25%

Details of return on sales calculation as table below:

Alternative 1 Alternative 2 Change Change %

(Accept) (Decline) (Alternative 1 -
In 000 1983 Alternative 2)
Sales 10,872 13,305 11,338 1,967 17%
Cost of sales (8,045) (9,665) (8,143) (1,522) 19%
Gross margin 2,827 3,640 3,195 445 14%
Other expenses (2,354) (2,474) (2,354) (120) 5%
Income before taxes 473 1,166 841 325 39%
Income tax expenses (218) (537) (388) (149) 38%
Net income 255 629 453 176 39%
Return on sales 2.35% 4.73% 4.00% 0.73% 18.25%

c) Overall impact on return on assets (ROA)

ROA is used to know how the company doing by using assets to generate earning. ROA

will be the indicator to know how profitable a company is of its total assets. It is also
 often referred as return on investment (ROI). The formula as below:

Return on assets (ROA) = Net income

Total Assets

ROA alternative 1 (accept) 629/8,721*100 = 7.21%

ROA alternative 2 (decline) 453/8545*100 = 5.3%

Impact on ROA (5.30-7.21) / 5.30 * 100 = Increase by 36.03%

Details on ROA calculation as below:

In 000 1983 Alternative 1 Alternative 2 Change Change %

(Accept) (Decline) (Alternative 1-

Alternative 2)

Assets 8,092 8,721 8,545 176 2%

Net income 255 629 453 176 38.85%

Return on assets 3.15% 7.21% 5.30% 1.91% 36.03%

d) Overall impact on return on equity (ROE)

ROE also known as return on net worth (RONW) where it measures the companys

profitability by showing how much profit a company able to generates with the money

invest by shareholders. The amount of net income returned as the percentage of

shareholder equity. Formula as below:

Return on equity (ROE) = Net income

Shareholder Equity
 ROE alternative 1 (accept) 629/3731 * 100 = 16.86%

ROE alternative 2 (decline) 453/3,555 * 100 = 12.74%

Impact on ROE (12.74- 16.86) / 12.74 * 100 = Increase by

32.30%

Details on ROE calculation as below:

In 000 1983 Alternative 1 Alternative 2 Change Change %

(Accept) (Decline) (Alternative 1-

Alternative 2)

Equity 3102 3,731 3,555 176 5%

Net income 255 629 453 176 39%

Return on assets 8.22% 16.86% 12.74% 4.12% 32.30%

5.2.2 Strategic Risks and Rewards (Q6)

If Baldwin agrees with the proposal, it has to analyze both risk and rewards so that she can

make better decision. Both risk and rewards are simplified as table below:

Proposal Risk Rewards

Hi-Valu proposed additional It will result in higher Probability for expansion as

product specification production costs, purchasing they will also focus on

(fenders, seats and cost. additional market segment

handlebars) (discount retail segment).

Hi-Valu proposed lower As the specification is It may helps to eliminate

selling price innovated and the selling exposure to risk due to poor

price is lower, Baldwin may economy condition.

 lost its current customer.

Hi-Valu proposed i) It will result in higher Higher capacity utilization may

exclusively production of inventory cost as the result to higher potential profits

Challenger at Baldwin inventory will up to average 4

bicycle line months instead of 2 months.

ii) Distribution of bicycle

will be focusing more on

Challenger

Below are also the risk and rewards if she decides not to accept the proposal:

Risk Rewards

As they currently facing poor economy, reject Baldwin may wants to focus more on its

the offer may cause decrease in sales. current bicycle product and make necessary

changes to improve the quality and

marketability of its bicycle.

They are currently excess in the capacity but Baldwin already has its own dealers hence

the volume of sale is not increasing. rejecting the offer may preserved the

established relationship with them.

CASE SUMMARY
If Baldwin decided to accept the proposal, it will gain positive impact on profit, return on sales,

return on assets and return on equity. Based on the calculation, summary of overall impact are

as follows:

Key Amount & Ratios

Profit $175,210.02

Return on sales (ROS) Increase by 18.25%

Return on assets (ROA) Increase by 36.03%

Return on equity (ROE) Increase by 32.30%

6.0 Decision

Results Q7

Based on our observation on the Hi-Valu proposal, Ms. Leister should accept the proposal

in the short-term period. This is based on the lucrative profit of $444,710 from production of

25,000 bicycles generated annually taking into account of added profit of $577,250 subtracted

by marginal lost of $132,540. Since the incremental production is sufficient without the need to

incur additional fixed cost, the proposal would result significant earnings for Baldwin Bicycle

Company.

Furthermore, as the case study reflects the business environment in 1982, we are of the

view that as long as existing businesses covers the fixed cost and show positive marginal

contribution will be beneficial to Baldwin Bicycle Company. This will enable Baldwin to gain

access to the stable distribution channel i.e. high capital store chains. This will provide

opportunity for Baldwin to collaborate with other store chains. In addition, this will open up a

new market segment in the discount retail segment for Baldwin to leverage from.
 However, we should assess the importance as to other assumptions that might affect this

decision in the long-run. For instance, Hi-Valu volume demand would increase after the three

year contract, additional sales in case current dealers drop the Baldwin line of bicycles.

7.0 RECOMMENDATION

The company would need to secure the additional capital required for at least two months +

30 days worth of bicycles for of materials, labour, inventory, and freight. So, in this situation,

Baldwin Bicycle Company would need to prepare higher amount of capital. Since, Baldwin

Bicycle Company does not have sufficient cash to finance the initial outlay, we recommend

them to seek credit terms from its suppliers to share some of the initial risks and defray

some the initial risks and defray some of the initial costs until it begins to receive some

payments from Hi-Valu.

Accept Hi-Valus offer with renegotiation on terms. The terms imposed by Hi-Valu transfer

all the business and financial risk to Baldwin Bicycle Company. The fact that Hi-Valu seems to

be able to impose such terms or Baldwin hints that it has proposals with other bicycle

manufacturers lined up in case Baldwin rejects the proposal. Now that the bicycle market is at a

low point, it is likely that if Baldwin passes up the offer, other manufacturers would appreciate

the incremental revenues. So, in this case, we recommend Baldwin to increase its power at the

bargaining table, to seek out similar arrangements with other discount chains competing directly

with Hi-Valu. This would pressure Hi-Valu into relaxing its credit terms at the risk of losing the

exclusive challenger agreement.

Besides that, we recommend Baldwin Bicycle Cycle to seek alliance with other

discounted chains. Discount chains can provide Baldwin with lucrative incremental revenues if
it decides to pursue the lower-priced segments. Other discount chains may decide to enter into

similar agreements as a response to the Challenger programme. In-house private-label brands

are popular among discount retailers, and it is likely that other chains may desire to enter into a

similar arrangement with Baldwin. In this case, Baldwin would have increased bargaining

power with Hi-Valu or its competitors, putting the discount chains against one another in trying

to secure a private label agreement. This would put pressure on the discount chains to relax

their credit terms.

We advise Baldwin Bicycle Company to create a segmentation technique to identify

potential target segments. With this segmentation technique, Baldwin will select segments that

align with its strategic objectives. With this Baldwin can avoid pleasing all customers. With this

Baldwin can avoid pleasing all customers and the company can spread its market.

With all the abovementioned recommendations, Baldwin Bicycle Company can accept

Hi-Valus proposal on making Challenger bicycles with proper risk management and

profitability for the company.

8.0 CONCLUSION

Accepting the proposal of Hi-Valu will be good for the company, as it will provide

additional profits for the company as it will provide additional profits for the company in 3

years. This is a good opportunity for the company to finally enter the mainstream market or

department store or department store chains like Hi-Valu.

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