Going Postal: Analyzing Operating Income of the Wheels of Fortune

The Decision

It was a beautiful Saturday morning as Lance completed his ride in the hill country of central Texas. During his ride Lance thought, What has caused the financial performance of Wheels of fortune to decline so drastically over the last year? He was concerned that if the trend persisted, Wheels of Fortune, the bicycle company he started ten years ago, would cease to exist.

From the beginning, Wheels of Fortune was Lances brainchild. At forty, after surviving a significant health scare, Lance realized his professional cycling career was nearing an end. Yet, he wanted to stay connected to the cycling community he so dearly loved. He reasoned his years of professional cycling experience for the Postal team and firsthand knowledge of the deficiencies in existing bicycle technology uniquely qualified him to build a better bicycle.

During a ride after another grueling season, Lance mentioned his idea for Wheels of fortune to his long-time training partners and best friends, Tyler and Sam. Ive decided to retire. Last week, Sheryl told me she is expecting our first child and Ive decided it is time to call it a career.

Tyler a bit surprised asked, I knew you were tiring of the professional circuit, but I didnt think you were ready to retire. Whats next for you?

Lance replied, Ive decided to start a bicycle company called Wheels of Fortune. I know it is sudden, but I would like for you and Sam to be my partners. With your knowledge of bicycle assembly and technology, Sams accounting and procurement acumen, and my sales and marketing appeal, we would form an unbeatable team just as we did on the circuit.

The Challenge

Who called this meeting? a slightly annoyed Tyler queried.

I did, Lance replied. My apologies, I know how much we all hate meetings, but it could not be helped. Our operating income decreased drastically last year. At this rate, we wont be in business much longer if we cant figure out what happened. I asked Sam to generate a comparison of operating income for the past two years.

Sam explained, Our operating income decreased over $4 million in just one year even though we sold the same number of bicycles. Over the same period, our contribution margin per bicycle decreased by almost a $1,000. The average variable cost per bicycle decreased significantly, but it was not enough to offset the decrease in our average selling price per bicycle.

Lance interrupted, We have always sold professional bicycles for $5,500 and Novice for $1,000. How is it possible for our average sales price to decrease so drastically in one year without a price change?

Sam replied, Thats an excellent question and I thought the same. Our accounting records show that, while we continue to produce and sell 4,500 bicycles, our sales mix has drastically changed. In prior years, 70 percent of total sales were generated from selling Professional bicycles. However, this year, 70 percent of sales are coming from selling Novice bicycles. The demand for our Professional bicycles has decreased but has increased for our Novice models.

Weve been assembling the same top-of-the-line Professional bicycle for ten years. How is it possible that our sales shifted so drastically? Tyler asked.

Sam suggested, Perhaps, our Professional bicycles are no longer considered top-of-the-line.

Lance sensing Tyler was a little put off chimed in, So you are saying the shift in sales mix is the primary driver to our decreased operating income?

You are partially correct. The change in sales mix impacted our average selling price. However, other factors caused our operating income to decrease and need to be analyzed. Specifically, we need to analyze our variable manufacturing and fixed selling and general administration costs, Sam appraised.

Okay. So you are suggesting we have the data to analyze those costs and expenses? Tyler asked hopefully.

Yes; however, analyzing our variable manufacturing costs is much more complex than analyzing sales. We need to begin by comparing our expected costs (standards) to assemble a bicycle with the actual costs to assemble a bicycle to calculate manufacturing variances. Examining these variances will provide insight about spending and the efficiency of our manufacturing process, Sam explained. When we started the company, we used the following assumptions to generate standard costs and establish selling prices.

So, the direct labor and variable overhead costs are the expected conversion costs to assemble the bicycle kits (direct materials)into a bicycle? Tyler asked.

Sam replied, Correct. You will notice the direct labor to assemble Professional bicycles is more than double Novice bicycles. Because the frames and parts are so expensive on Professional bicycles, we decided to assign our most experienced assemblers to that department. In addition, as sales of our Novice bicycles increased, we transferred assemblers from the Professional line to the Novice line.

Tyler added, This is the first Ive seen this I am not certain how those changes impact our direct labor costs.

Calculating manufacturing variances can help us determine the dollar impact of those changes and others on our variable manufacturing costs, Sam affirmed, I summarized the relevant raw material, direct labor, and variable manufacturing overhead costs in this table.

After reviewing the information, Tyler replied, It appears you have been keeping track of this data for some time. How come we never calculated manufacturing variances before?

Sam responded, There was no need. For the first nine years in business, we consistently generated $6 million in operating income annually. However, now we need to analyze everything, including the $150,000 raise we gave ourselves last year.

A concerned Lance asked Sam, Can you use this data to analyze our operating income, so I dont have to go back to our Postal team? I am too old and out of shape for that.

Sam enthusiastically replied, Absolutely.

Case Questions:

1. Initial observation of the potential causes of the drop in operating income.
2. Impact on operating income: Perform an analysis to identify the root causes of the differences in operating incoming from 2016 to 2017 for Wheels of Fortune.
   1. Standard variable cost and contribution margin per bicycle (percent & dollars):Utilizing the standard cost components and the selling price per bicycle, calculate the standard variable cost and contribution margin per bicycle at standard.
   2. Sales mix impact:Analyze the impact of the shift in sales mix by determiningthesales mix variance. Discuss the results and the effect the shift had on operating income.
   3. Manufacturing variance impact:Calculate direct materials (price & usage), direct labor (rate & efficiency), and variable overhead variance.
   4. Selling and general administration impact: Prepare an analysis of the impact the increase in selling and administration costs has on Wheels of Fortune operating income.
   5. Operating income reconciliation:Prepare a schedule reconciling operating income from 2016 to 2017 integrating your calculations from items b-d abov
   6. Contribution Margin Income Statementat Standard Cost:For decision-making purposes, prepare a contribution margin income statementusing standard costs information and any manufacturing variances calculated in items b d.
   7. Margin of safety and breakeven: Assuming the company can assemble bicycles at standard variable cost, calculate breakeven (sales dollars & units) and margin safety (percent & per unit) for 2016 and 2017.
3. Recommendations:Based on your analysis, generate short and long-term recommendations to improve the companys operating income. Your analysis should integrate information from the schedules you created. A reader with limited financial expertise (e.g. Lance) should be able to comprehend your analysis and associated recommendations.

Wheels of Fortune Operating Income Statement Bicycles Sold 4,500 4.500 Per Bicycle 2016 Per Bicycle $ 18,675,000 $4,150.00 $ 2017 10,575,000 $2,350,00 Sales Dollars Direct Material Costs Direct Labor Costs Variable Overhead Total Variable Costs Contribution Margin Contribution Margin Percent Selling & General Administration 10,260,000 $2,280,00 $ 1,503,000 334.00 540,000 120,00 12,303,000 $ 2,734,00 $ 6,372,000 $1,416.00 $ 34.12% 6,688,000 $1.486.22 1,473,120 327.36 447,750 99.50 8,608,870 $ 1.913.08 $ $436.92 1,966,130 18.59% s 615,000 136.67 S 765,000 170.00 Operating Income S 5,757.000 $1,279.33 $ 1,201,130 $266.92 Wheels of Fortune Standard Costs Summary of Standard Costs Professional Novice Bicycle Kit per unit S 3,000 S 600 Direct labor hours per bicycle 10 6 Direct labor rate per hour $ 40S 30 Variable overhead rate per bicycle $ 150 S 50 Wheels of Fortune Summary of Actual Costs Professional 2016 Bicycle kit Usage 3,150 Price $ 3,000 $ Direct labor hours 31,500 Direct labor rate per hour s 40 S Variable overhead per bicycle S 150 S Nowice 2016 Bicycle Kit: Usage 1,350 Price $ 600 S Direct labor hours 8,100 Direct labor rate per hour S 30S Variable overhead per bicycle S 50 S 2017 1,400 3,200 15,525 44 180 2017 3.200 690 20,790 38 65 Wheels of Fortune Operating Income Statement Bicycles Sold 4,500 4.500 Per Bicycle 2016 Per Bicycle $ 18,675,000 $4,150.00 $ 2017 10,575,000 $2,350,00 Sales Dollars Direct Material Costs Direct Labor Costs Variable Overhead Total Variable Costs Contribution Margin Contribution Margin Percent Selling & General Administration 10,260,000 $2,280,00 $ 1,503,000 334.00 540,000 120,00 12,303,000 $ 2,734,00 $ 6,372,000 $1,416.00 $ 34.12% 6,688,000 $1.486.22 1,473,120 327.36 447,750 99.50 8,608,870 $ 1.913.08 $ $436.92 1,966,130 18.59% s 615,000 136.67 S 765,000 170.00 Operating Income S 5,757.000 $1,279.33 $ 1,201,130 $266.92 Wheels of Fortune Standard Costs Summary of Standard Costs Professional Novice Bicycle Kit per unit S 3,000 S 600 Direct labor hours per bicycle 10 6 Direct labor rate per hour $ 40S 30 Variable overhead rate per bicycle $ 150 S 50 Wheels of Fortune Summary of Actual Costs Professional 2016 Bicycle kit Usage 3,150 Price $ 3,000 $ Direct labor hours 31,500 Direct labor rate per hour s 40 S Variable overhead per bicycle S 150 S Nowice 2016 Bicycle Kit: Usage 1,350 Price $ 600 S Direct labor hours 8,100 Direct labor rate per hour S 30S Variable overhead per bicycle S 50 S 2017 1,400 3,200 15,525 44 180 2017 3.200 690 20,790 38 65