Baldwin Bicycle Company

Background:        

Baldwin Bicycle Company is a manufacturer and supplier of a range of adults and children’s bicycles for almost 40 years. Ms. Suzanne Leister, the company’s marketing vice president received a proposition from Karl Knott, a buyer from Hi-Valu Stores about the possibility of becoming a contract manufacturer for Hi-Valu’s house brand bicycles bearing the name, “Challenger”. Baldwin’s bicycles had experienced a decline in sales volume for 2 years consecutively and are currently operating at 75% of its capacity. Therefore, the proposal from Hi-Valu to buy their excess capacity presents an opportunity to optimize their production. To kick start the discussion, Hi-Valu outlined a few key requirements:

• Need ready access to a large inventory of bicycles due to unpredictable volume of sales
• Wanted to purchase Challenger from Baldwin at a lower price compared to wholesale price of comparable bikes sold in the usual channels
• Wanted Challenger bike to have a different appearance from Baldwin’s other bikes

1. What is the expected added profit from the Challenger line?

The added profit can be calculated by subtracting the additional Challenger bikes revenue from the total costs required to produce the additional bikes and income tax expense. Fixed costs are not relevant in this case as expenses such as rental will not change as a function of the activity of the business. Variable costs are considered here as it varies according to the units of bikes produced. Hi-Valu forecast 25,000 bikes a year and offered to pay an average price of $92.29 per bike for the first year. The variable costs identified to produce the bikes are materials ($39.80), direct labor ($19.60) and overhead ($9.80); based on assumption that 40.0% of total production overhead cost is variable. Income tax rate is calculated at 46.09% as per previous year. Assuming sales are around $10 million, the added profit is calculated at $174,918.42.

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Table 1: Added Profit from Challenger Bikes

1. What is the expected impact of cannibalization of existing sales?

Baldwin bike expects around 3,000 units of its own brand to be cannibalized per year if they were to go through with the Hi-Valu deal. If not studied carefully, market cannibalization can potentially have a negative effect on a Baldwin’s profit margin, even with the increasing contribution from Challenger bike sales. The average price of a Baldwin bike based on gross margin of 26.0% is calculated at $113.38. After subtracting the variable costs, the unit contribution per Baldwin bike is $44.18 (39.0% of revenue). This demonstrates that Baldwin bike is more profitable compared to Hi-Valu’s contribution of $23.09 per bike (25.0% of revenue).  However, the total volume expected from Hi-Valu bikes sales contributes more in terms of absolute profit after deducting the loss of market share of Baldwin bike. The expected lost contribution is shown in below:

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Table 2: Lost Contribution of Baldwin Bikes

1. What costs will be incurred on a one-time basis only?

Hi-Valu wanted slight modification on the appearance of the Challenger bike to differentiate it from the Baldwin bikes. The modifications include branding the tires, redesigning the fenders, seats and handlebars while the frame and the mechanical components remain the same. The Challenger bike also require separate packaging with Hi-Valu and Challenger brand printed on the box. The additional costs expected from these specifications are design cost, production of mold for the parts, sourcing of materials for the parts and sourcing of shipping boxes. This one-time added cost is estimated to be $5,000.00.

1. What are the additional assets and related carrying costs?

 The main additional asset-related costs identified are increases in the carrying cost of inventory and receivables. The carrying cost of inventory is the cost incurred by Baldwin bike over a certain period to hold and store its inventory, including insurance, taxes, labour costs, depreciation and replacement of items. These additional costs are considered separately for the different stages of inventory management (raw materials, work in progress and finished goods) and are shown in the table below:

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Table 3: Asset-related Costs as % of Dollar Value Assets

The Challenger related added inventories were provided and calculated:

Materials: 2 months’ supply

Work in progress (50% complete): 1,000 bikes

Finished goods in warehouse: 500 bikes

Materials

= Total annual volume x 2 months x cost of raw materials x % of asset related costs

= 25,000 x (2/12) x $39.80 x 23.0%

= $38,141.67

Work in progress

= Total half-completed bikes x [raw materials + (direct labour + variable overhead)/2] x % of asset related costs

= 1,000 x [$39.80 + ($19.60 +$ 9.80)/2)] x 17.0%

= $9,265.00

Finished goods in warehouse

= Total completed bikes x (raw materials + direct labour + variable overhead) x % of asset related costs

= 500 x $69.20 x 23.0%

= $7,958.00

Finished goods at Hi-Valu

= Total annual volume x 2 months x (raw materials + direct labour + variable overhead) x % of asset related costs

= 25,000 x (2/12) x $69.20 x 13.5%

= $38,925.00

Hi-Valu receivables

= Total annual volume x 1 month x price per bike x % of asset related costs

= 25,000 x (1/12) x $92.29 x 13.5%

= $25,956.56

Therefore, the summary of the asset and related costs for Hi-Valu bikes are:

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Table 4: Asset-related Costs for Hi-Valu Bikes

1. What is the overall impact on the company in terms of:

1. Profits

Assuming that sales were currently at an annual rate of $10 million, the total sales revenue expected from the Hi-Valu deal will bring total revenue to $12,307,250.00. However, this is at the expense of cannibalizing its own sale of bikes with an estimated loss of profit at $132,540.00. Baldwin bike will also need to take into consideration the asset-related costs that incurred from the production of Challenger bikes which amounts to $120,246.23. The net contribution from Hi-Valu is calculated as follow: