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 beginner's 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-Valu's 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 BBC's production up to full capacity even in this depressed bicycle market. Hi-Valu's proposal to BBC had features that made it rather different from BBC's usual way of doing business. Several of Hi-Valu's 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 Porter's 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 BBC's 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-Valu's 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.

Assets

Current Liabilities and Owners' Equity

Cash

342

Current Liabilities

3,478

Accounts receivable

1,359

Noncurrent liabilities

1,512

Inventories

2,756

Total liabilities

4,990

Plant and equipment (net)

3,635

Owners' equity

3,102

8,092

8,092

Income Statement

For the Year Ended December 31, 1988

Sales revenue

10,872

Cost of sales

(8,045)

Gross margin

2,827

Gross margin percentage

26%

Other expenses

(2,354)

Income tax rate

46%

Income before taxes

473

Income tax expense

(218)

Net income

255

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 *

Labour19.60

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 inventories11.5%

Record keeping costs - receivables and inventories2.0%

Inventory insurance 0.6%

State property taxes0.7%

Inventory handling, labor and equipment6.0%

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-Valu's 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-Valu's 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)

Arelevant costis acostthat only relates to a specific management decision, and which will change in the future as a result of that decision. Therelevant 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-Valu's 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 volume

25,000

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-Valu's 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 Baldwin's loss contribution margin by using the relevant cost analysis, as below.

Baldwin's 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-Valu's 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

Work in Process

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

(25,000/12x2) 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 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] xx 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-Valu's account receivable.

5.2 Full Cost Analysis

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

500x $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 firm's 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:

In '000

1983

Alternative 1

(Accept)

Alternative 2

(Decline)

Change

(Alternative 1 - Alternative 2)

Change %

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

(Accept)

Alternative 2

(Decline)

Change (Alternative 1- Alternative 2)

Change %

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 company's 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

(Accept)

Alternative 2

(Decline)

Change (Alternative 1- Alternative 2)

Change %

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%

I found this solution posted on Course Hero. I understand how to calculate return on assets and return on equity, but I need help figuring out how to get the $8,721 in alternate 1 and the $8,545 change in assets in alternate 2. For return on equity, I need help determining where the $3,731 for alternate 1 and $3,555 for alternate 2 came from. Lastly, I cannot determine the cost of sales number for alternative 1 (which should be $9,665).