Baldwin Bicycle Company In May, Suzanne Leister, marketing vice president of Baldwin Bicycle Company, was mulling over the discussion she had had the previous day with Karl Knott, a buyer from Hi-Valu Stores, Inc. Hi-Valu operated a chain of discount department stores in the Northwest. Hi-Valu's sales vol- ume had grown to the extent that it was beginning to add "house-brand" (also called "private- label") merchandise to the product lines of several of its departments. Mr. Knott, Hi-Valu's buyer for sporting goods, had approached Ms. Leister about the possibility of Baldwin's producing bicy- cles for Hi-Valu. The bicycles would bear the name "Challenger," which Hi-Valu planned to use for all of its house-brand sporting goods. Baldwin had been making bicycles for almost 40 years. The company's current line included 10 models, ranging from a small beginner's bike with training wheels to a deluxe 21-speed adult's model. Sales were currently at an annual rate of about $10 million. (The company's financial state- ments for last year appear in Exhibit 1.) Most of Baldwin's sales were through independently owned toy stores and bicycle shops. Baldwin had never before distributed its products through de- partment store chains of any type. Ms. Leister felt that Baldwin bicycles had the image of being above average in quality and price, but not a "top of the line" product. Hi-Valu's proposal to Baldwin had features that made it quite different from Baldwin's normal way of doing business. First, it was very important to Hi-Valu to have ready access to a large in- ventory of bicycles, because Hi-Valu had had great difficulty in predicting bicycle sales, both by store and by month. Hi-Valu wanted to carry these inventories in its regional warehouses, but did not want title on a bicycle to pass from Baldwin to Hi-Valu until the bicycle was shipped from one of its regional warehouses to a specific Hi-Valu store. At that point, Hi-Valu would regard the bicy- cle as having been purchased from Baldwin, and would pay for it within 30 days. However, Hi-Valu would agree to take title to any bicycle that had been in one of its warehouses for four months, again paying for it within 30 days. Mr. Knott estimated that on average a bike would remain in a Hi-Valu regional warehouse for two months. Second, Hi-Valu wanted to sell its Challenger bicycles at lower prices than the name-brand bi- cycles it carried, and yet still earn about the same dollar gross margin on each bicycle sold-the ra- tionale being that Challenger bike sales would take away from the sales of the name-brand bikes. Thus, Hi-Valu wanted to purchase bikes from Baldwin at lower prices than the wholesale prices of comparable bikes sold through Baldwin's usual channels. Finally, Hi-Valu wanted the Challenger bike to be somewhat different in appearance from Bald- win's other bikes. While the frame and mechanical components could be the same as used on cur- rent Baldwin models, the fenders, seats, and handlebars would need to he somewhat different, and the tires would have to have the name "Challenger" molded into their sidewalls. Also, the bicycles would have to be packed in boxes printed with the Hi-Valu and Challenger names. Ms. Leister thought that possibly these requirements would increase Baldwin's purchasing, inventorying, and production costs over and above the added costs that would be incurred for a comparable increase in volume for Baldwin's regular products. On the positive side, Ms. Leister was acutely aware that the "bicycle boom" had flattened out, and this plus a poor economy had caused Baldwin's sales volume to fall the past two years. As a result, Baldwin currently was operating its plant at about 75 percent of one-shift capacity. Thus, the added volume from Hi-Valu's purchases could possibly be very attractive. If agreement could be reached on prices, Hi-Valu would sign a contract guaranteeing to Baldwin that Hi-Valu would buy its house-brand bicycles only from Baldwin for a three-year period. The contract would then be automatically extended on year-to-year basis, unless one party gave the other at least six-months' notice that it did not wish to extend the contract. Ms. Leister realized she needed to do some preliminary financial analysis of this proposal be- fore having any further discussions with Mr. Knott. She had written on a pad the information she had gathered to use in her initial analysis; this information is summarized in Exhibit 2. Assignment 1. What is the expected added profit from the Challenger line? 2. What is the expected impact of cannibalization of existing sales? 3. What costs will be incurred on a one-time basis only? 4. What are the additional assets and related carrying costs? 5. What is the overall impact on the company in terms of (a) profits, (b) return on sales, (c) return on assets, and (d) return on equity? 6. What are the strategic risks and rewards? 7. What should Ms. Leister do? Why? Assets Cash BALDWIN BICYCLE COMPANY Exhibit 1. Financial Statements (thousands of dollars) Balance Sheet (as of December 31) Accounts receivable Inventories Plant and equipment (net) Liabilities and Owners' Equity $342 Current liabilities $3,478 1,359 Non-current liabilities 1512 2,756 Total liabilities 4,990 3.635 Owners' equity 3.102 $8,092 $8,092 INCOME STATEMENT For the Year Ended December 31 Sales revenues $10,872 Cost of sales 8.045 Gross margin 2,827 Other expenses 2.354 Income before taxes 473 Income tax expense 218 Net income $255 Exhibit 2. Data Pertinent to Hi-Valu Proposal Notes Taken by Suzanne Leister 1. Estimated first-year costs of producing Challenger bicycles (average unit costs, assuming a constant mix of models): Materials Direct labor Overhead (@125% of direct labor) $39.80* 19.60 24.50 # $83.90 Includes items specific to models for Hi-Valu, not used in our standard models. Accountant says about 40 percent of total production overhead cost is variable; 125% of DLS rate is based on volume of 100,000 bicycles per year. 2. One-time added costs of preparing drawings and/or arranging sources for fenders, seats, han- dlebars, tires, and shipping boxes that differ from those used in our standard models; approxi- mately $5,000. 3. Unit price and annual volume: Hi-Valu estimates it will need 25,000 bikes a year and proposes to pay us (based on the assumed mix of models) an average of $92.29 per bike for the first year. Contract to contain an inflation escalation clause such that price will increase in propor- tion to inflation-caused increases in costs shown in item 1, above; thus, the $92,29 and $83.90 figures are, in effect, "constant-dollar" amounts. Knott intimated that there was very little, if any, negotiating leeway in the $92.29 proposed initial price. 4. Asset-related costs (annual variable costs, as percent of dollar value assets): Pretax cost of funds (to finance receivables and inventories) Record keeping costs (for receivables and inventories) Inventory insurance State property tax on inventory Inventory-handling labor and equipment Pilferage, obsolescence, damage, etc. 11.5 2.0 0.6 0.7 6.0 2.2 5. 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 carload-lot shipment to a Hi-Valu warehouse). 6. Impact on our regular sales: Some customers comparison shop for bikes, and many of then are likely to recognize a Challenger bike as a good value when compared with a similar bike (either ours or a competitor's) at a higher price in a non-chain toy or bicycle store. Last year, we sold 98,791 bikes. My best guess is that our sales over the next three years will be about 100,000 bikes a year if we forgo the Hi-Valu deal. If we accept it, I think we'll lose about 3,000 units of our regular sales volume a year, since our retail distribution is quite strong in Hi-Valu's market regions. These estimates do not include the possibility that a few of our current dealers might drop our line if they find out we're making bikes for Hi-Valu.