managerial accounting

Falco Scooters (B) Written by Professor Igor Vaysman In 2010, the managers of Falco Scooters (a division of the Falco Group) decided to reduce the selling price of its flagship, high-end model, the Super-300 to generate additional unit sales. Sales volumes exceeded expectations: in 2011, Falco sold 1,507 Super-300's at the $2,925 price; in December 2011, Falco estimated annual sales of this model of 1,500 units for 2012-2015. Also in 2010, a global competitor aggressively entered the low-end scooter market, offering scooters at prices dramatically lower than Falco Scooters' low-end model, the City-100. Unable to match the lower prices, in 2011 Falco discontinued the production and sale of the City-100. Consequently, Falco Scooters' single state-of-the-art assembly facility had significant unused capacity. Because it was not possible to reduce the facility's total capacity, the company's managers were considering various options for using the excess capacity. Designing and introducing new products was the most popular idea. Two options - a second high-end model and a new off-road vehicle - were carefully investigated but in the end rejected because of heavy up-front investments required; this was not considered feasible because of the company's current liquidity constraints. Early in 2012, procurement executives from TonMart, a giant global retailer, approached Falco with an interesting proposal. For many years, TonMart offered private-label household goods. In the last decade, TonMart introduced a line of sporting goods, bicycles, and off-road vehicles under its own Swift brand. For the last three years, TonMart offered a low-end moped, named Swift Sprinter (sourced from a supplier in Malaysia); the retailer now wanted to introduce a high-end model, to be named Swift Glider. TonMart wanted the Swift Glider to be similar to Falco's Super-300, but with somewhat lower-priced components to keep the cost down. TonMart was willing to commit to purchase 1,200 Gliders per year at the price of $2,000 for a one-year trial period. It was clear from the discussions that the price was not negotiable because of TonMart's significant buying power and its willingness to source the Glider from one of Falco's competitors. TonMart's proposal was attractive. The 1,200 Gliders per year would increase Falco Scooter's capacity utilization to approximately 90% of practical capacity.1 Falco managers felt that using lower-priced components would allow the company to earn a profit on Gliders. To investigate this, Falco paid a scooter design specialist $10,000 to create a design for the Glider that would satisfy TonMart's proposal. Based on this design, Falco prepared the following per-unit information, comparing Falco's Super-300 with the proposed Glider: Super-300 Selling price Direct Materials Machine Hours Direct Labor 20 Variable Overhead Allocation $6 Fixed Overhead Allocation $100 Variable SG&A $2,925 $1,230 4 DLHs @ per DLH per MH $25 $30 per DLH Proposed Swift Glider $2,000 $1,080 4 20 DLHs @ $6 per DLH $100 per MH $5 $30 per DLH NOTES: 1. Falco Group managers believe that variable overhead at each division is really driven by DLHs. 2. In 2011, Falco started using practical capacity (measured in MHs) to allocate Fixed Overhead. Because of the use of practical capacity, the FOH Rate will not change if Falco agrees to build Swift Gliders. 1 This 90% estimate does not incorporate the erosion potential described in point 6 on the next page. 1 Falco analysts also prepared the following summary of additional key impacts of the TonMart proposal: 1. Effect on inventories. We will need to increase our Materials Inventory by one month's requirements (i.e. materials needed to build 100 Gliders). Finished Goods inventory will also increase; there will be typically 50 Gliders in our warehouses awaiting shipment to TonMart. The effect on Work-in-Process inventory will be immaterial. 2. Effect on receivables. TonMart will pay one month after bikes are shipped (i.e. our Accounts Receivable will increase, because at any given time, TonMart will owe us for 100 Gliders already in their possession). 3. Effect on payables. We pay for all our materials, supplies, utilities, and other overhead items one month after we incur the expense. We pay our employees also one month after we incur the expense. The variable SG&A expenses, on the other hand, are paid the moment they are incurred. 4. The relevant tax rate for evaluating TonMart's proposal is 30%. The appropriate after-tax discount rate for evaluating this proposal is 13% (this is the relevant after-tax opportunity cost of capital). 5. Inventory-related out-of-pocket costs. We pay annual insurance premiums equal to 1% of our inventory value. Our inventory-handling labor cost is variable; the annual inventory-handling labor cost is approximately equal to 3% of inventory value. 6. Impact on sales of Super-300. We distribute our scooters through independent specialist shops and local scooter dealers. Our current customers value the services provided by locally-owned businesses and probably would not go to discount chains and TonMart stores to buy a scooter. Still, we expect that Swift Gliders will be viewed as providing a great price-quality-functionality trade-off by many potential customers, possibly eating into the high-end scooter market. Our best estimate is that the sales of 1,200 Gliders by TonMart will reduce our annual Super-300 sales by 100 units. (For various reasons, this erosion in market share will have immaterial impact on our assets or liabilities.) A potentially bigger issue is that some of our current dealers may be unhappy if they find out that TonMart's Swift Gliders are made by us. 7. Effect on Fixed SG&A. We do not expect the TonMart proposal to have any effect on our Fixed SG&A of $100,000 per year. Address the following questions. 1. For this question only, ignore additional key impacts items 1-6 above. Compute: (i) the relevant pretax cost of building a Swift Glider, and (ii) the pre-tax unit contribution margin on each Glider. 2. What is the impact of the TonMart proposal on Falco Scooters' balance sheet? How should we incorporate that into our analysis? For simplicity, you should assume that the effect on our balance sheet takes place at a single point in time, at the time we sign the contract with TonMart. 3. How should we treat the \"erosion\" issue in point 6 above? 4. Provide a complete analysis of the estimated value created (or destroyed) by the TonMart proposal. Should Falco agree to the proposal? 2