Baldwin Bicycle Company Case Study, Groupe 2
For four decades, Baldwin Bicycle Company has been in the business of
manufacturing bicycles. Their diverse product range encompasses ten different
models, catering to a wide spectrum of customers, from novices to those seeking
top-tier 12-speed adult bikes. In 2019, the company achieved a remarkable sales
figure of 98,791 bicycles, primarily distributing them through independent specialty
retailers and bike shops.
In May of the following year, Suzanne Leister, who serves as the Vice President of
Marketing at Baldwin, was presented with an exciting opportunity to collaborate with
a prominent retail chain located in the Northwestern United States, known as Hi-Valu
Stores, Inc.
Following its expansion, Hi-Valu ventured into marketing its own line of products, and
they decided to launch 'Challenger' brand bicycles. Their approach to Ms. Leister
was motivated by the need for a yearly supply of 25,000 units, which were to be sold
at a price of $92.29 per unit—below the prevailing market rate for this bicycle
category. While this initially appeared to present an opportunity for Baldwin Bicycle
Company to fully utilize its production capacity, several clauses in the contract
proposed by Hi-Valu deviated from the customary and standard agreements
To begin with, Hi-Value's stipulations involve the need for ongoing bicycle access
within their warehouses, with payment deferred until either 30 days post-delivery to
the Hi-Value customer or, alternatively, after a 120-day stint in the regional
warehouse. Furthermore, it's crucial to emphasize that accepting this contract would
entail a reduction of 3,000 units in regular sales, whereas rejection would likely result
in an estimated 100,000 units in sales for the upcoming year.
To assess the feasibility of accepting this contract, a comprehensive analysis of
relevant costs and associated investments is imperative. Additionally, it is essential
to consider the prevailing bicycle market conditions and other qualitative factors that
are specific to Baldwin Bicycle Company.
Executive Summary :
Bicycle Company (BBC), a well-established mid-range bicycle manufacturer with a
40-year experience, has recently been presented with an interesting proposition by
Hi-Valu, a growing discount retail chain. To have BBC exclusively produce the
ChallengerTM brand of budget bicycles, which are priced lower than BBC's standard
product lines, Hi-Valu suggested a private-label deal. Although this arrangement
promises substantial additional sales of 25,000 units, it has unusual terms, such as
lower prices and longer payment terms. Given that the additional units may be
produced during plant downtime, a related cost analysis showed that there was
potential for sizable additional profits from the Challenger agreement. This possibility,
however, presents a strategic disparity with BBC's best-cost provider approach and
requires a sizable initial capital spend of $787,000, which is more than the available
resources of the corporation.
The recommendation is for BBC to take the Challenger contract into consideration
while actively renegotiating its terms with Hi-Valu. With this strategy, BBC is able to
look for favorable credit terms that better suit the company's financial capabilities and
strategic goals while working to possibly profit from the increased sales.
1.
What is the relevant cost per unit of manufacturing a Challenger
bike? (ignore one-time added costs)
According to Suzanne Leister’s preliminary financial analysis, the estimated first-year
costs of producing Challenger bicycles (average unit costs, assuming a constant mix
of models) is $81.20.
This price includes the costs of materials, direct labor (DL) and overhead (150% of
DL). Materials and DL are relevant costs as they are specific to this product. These
two costs will be different depending on whether Baldwin Bicycle Company accepts
the contract.
$38.903 $16.90
However, the accountant says only about 40% of total production overhead is
variable. This means that 60% of the manufacturing overheads is irrelevant, as they
contain fixed charges that are sunk costs.
40% of Overhead: $25.404 * 0,4 = $10.16
So the relevant cost per unit of manufacturing a Challenger bike is:
Materials
38.90
DL
16.90
Relevant Overhead
10.16
Relevant cost per unit
65.96
2. What is the amount of net extra capital investment required for the
Challenger deal? (assume 60-day credit from the material suppliers)
In the terms outlined in Karl Knott's initial proposal, it is evident that the introduction
of a new bicycle manufacturing line is anticipated. These terms specify that the
bicycles produced would be directly stored at Hi-Value once the manufacturing
process concluded. Furthermore, these conditions express a desire for a distinct
model, differing from Baldwin's customary offerings, while retaining the same frame
and mechanical components. In line with Suzanne Leister's strategy, the remaining
components are essentially spare parts considered as inventory to be procured.
Consequently, as there is no need for extra space or additional machinery, the
incremental net investment required for the Challenger contract amounts to $0.
3. What is the cost (on a per bicycle basis) of the net extra capital
investment required for the Challenger deal?
The additional cost of this contract per bicycle is represented by the variations in the
costs of the Challenger bicycle compared to the bicycles usually manufactured.
A Challenger bicycle costs $81.20 to produce, whereas a bicycle usually costs
$81.43 to produce, if we divide the total production costs by the number of bicycles
produced in 2019.
Then we add the $5,000 start-up costs to the Challenger. By dividing this number by
the number of Challengers planned for this year, we have a unit cost of $0.20.
Finally, we add the opportunity costs. For regular bicycles, we can only use the gross
margin, as no information is given on the allocation of selling and administrative
costs. This gives an opportunity cost of $2.12.
In order to have relevant elements of comparison, we will also use the gross margin,
multiplying it by 3000 because this is the number of units that will not be sold, then
dividing it by the total number of units expected to be sold, i.e. 25,000. This gives us
$3.43 in opportunity costs per Challenger sold.
If we add up the costs for the bicycles and then for the Challenge, and take the
difference between the costs, we see that the additional cost per bicycle is $1.28.
4. Should the Challenger deal be charged for the lost sales of bikes
through the regular distribution channel ("erosion" or "cannibalization" cost)?
If so, what is the relevant “erosion” cost?
Yes, the Challenger deal should be charged for the lost sales of bikes through the
regular distribution channel. This is known as cannibalization cost, which occurs
when a new product or venture reduces the sales of existing products. In this case, if
Hi-Valu's Challenger bikes attract customers who would have otherwise bought
Baldwin's regular bikes, it leads to a reduction in regular bike sales.
To calculate the relevant cannibalization cost, we need to estimate the number of
regular bikes that will be lost due to the Challenger deal. Leister estimates that they
might lose about 3,000 units of regular sales volume a year.
First, we calculate the price of the bikes sold by Baldwin under Baldwin brand:
They made 10,872 K$ in 2019 while selling 98,791 bikes. So, the price of a bike sold
by Baldwin is (10872/98791) = 110.05 $
Finally, we ca lculate the relevant “cannibalization” cost:
(Price of a Baldwin Bike - Price of a Hi-Valu Bike) * 3000= (110.05-92.29) * 3000 =
53 281.5$
5. What is the profitability of the Challenger deal? (Assume an income
tax rate of 50%)
To calculate the profitability of the Challenger deal, we need to consider the relevant
costs and revenues associated with it.
Cost of manufacturing a Challenger bike: Based on the information provided, the
cost of manufacturing a Challenger bike is $81.20 per unit.
Additional capital investment: As calculated before, the additional cost per capital
is 1.28$.
Erosion or Cannibalization Cost: As calculated before, it amounts to 53 281.55$,
so it is 2.13$ per bike.
Revenue from Challenger bike sales: Hi-Valu plans to buy 25,000 Challenger
bikes at an average price of $92.29 per bike.
Now, let's calculate the profitability:
Profit = (92.29 – 81.2 $ - 1.28$ - 2.13$) * (1- tax rate) = 7,68$ * 0,5 = 3,84$ per bike
after tax
The challenger deal would generate: 96 000 $ in profits per year.
3,84$ * 25000 = 96 000 $
The whole challenger deal would generate 288 000 $ in profits before applying
weighted average cost of capital.
If we apply the WACC, the deal would generate 209 916 $
96 000 * (1-15%) + 96 000 * (1-15%)^2 + 96 000 * (1 – 15%)^3 = 209 916 $
6. What are the major qualitative issues to consider before accepting or
rejecting the Challenger deal?
The major qualitative issues to consider before accepting or rejecting the Challenger
deal are:
- Brand Image: Producing a lower-priced house-brand product may affect how
consumers perceive their existing products.
- Supply Chain and Inventory Management: The need to maintain a large
inventory for Hi-Valu and potential challenges in managing different product lines and
specifications.
- Long-Term Relationship: The commitment to a three-year contract and the
potential risks or benefits of such a long-term relationship with Hi-Valu.
- Competitors reaction: How competitors might react to this deal and how it could
lead to a price war.
- Production challenges: The additional complexities in manufacturing, packaging,
and logistics for the Challenger bikes.
- Financial Risk: Becoming partially dependent on Hi-Valu since and their sales,
engaging 2 months material supply as well as production costs.
Question 7 : Financial Analysis
a. Relevant Cost Analysis
We used Relevant Cost Analysis to explore our options. We only considered costs
and revenues that directly relate to the situation at hand. See Appendix 4 for details.
Hi-Valu offers to buy our units for $92.29 each, giving us a profit of $23.09 per unit
($577,250.00 for 25,000 units). However, we expect to lose 3,000 units in regular
sales through our usual channels. While it's possible that this loss may occur even
without the deal, it's relevant because it's different from our base scenario. This
means we'd lose $115,155.16 in sales ($38.39 per bicycle for 3,000 units). Even
after considering this loss, we'd make a net revenue increase of $457,094.84. In
simple terms, this project is profitable when we look at relevant costs and revenues.
b. Capital Investment
If we accept Hi-Valu's offer, we'll need more working capital to fund the Challenger
program. According to Appendix 4, this additional cost for the Challenger program is
$31.51 per unit, totaling $787,631.94 for 25,000 units a year.
c. Payment Terms Evaluation
The terms Hi-Valu is suggesting could create cash flow problems for us. While our
monthly expenses would average $65,645.83, Hi-Valu might not pay for the first
month's bicycles ($192,270.08) until three months into the deal. With an 18%
discount rate, this means our yearly expenses would have a present value of
$371,293.16, but our cash inflows (at months 3, 6, 9, and 12) would only total
$304,412.96. This results in a negative net present value (NPV) of -$66,880.20. In
simpler terms, without considering the time value of money, this deal seems
profitable due to the weak bicycle market. However, with an 18% discount rate, we
need to renegotiate the terms. The current terms put too much risk on us, and that's
not acceptable.
d. Debt and Leverage
We currently have a high level of debt compared to our equity, with a debt-equity
ratio of 1.5 (the standard is 1.0). In contrast, Huffy Corporation's ratio is 0.62,
indicating they could handle more debt. Our inventory turnover is slow, with units
sitting in our warehouse for over four months, which is twice as long as Hi-Valu's
estimate. Huffy, on the other hand, has a much higher inventory turnover. Given our
high debt and average performance, it might be hard for us to secure debt funding
for the Challenger program.
e. Company Performance
We have a total asset turnover of 1.34, a return on assets of 3%, and a return on
equity of 8%, which is lower than the industry standard. In comparison, Huffy had
much higher returns in 2000. If we don't go ahead with the Challenger program, we
anticipate stagnant sales for the next three years.
Question 8 : Strategic Analysis
a. Market Segmentation
There is no defined market segmentation strategy in place at Baldwin Bicycle
Company (BBC). Their target client segments and their intended positioning within
those categories have not yet been determined. Rather, it appears that they are
attempting to reach out to a wide range of clients by providing a complete product
line in the mid-priced category. It can result in inefficiencies and could weaken their
marketing efforts if they are not focused on targeting particular client segments. BBC
should identify its target customers and then modify their product offerings and
marketing tactics to fit those markets.
b. Lack of Clear Competitive Advantages
Despite having a more than 40-year history of producing bicycles, BBC has not
adequately established any unique competitive advantages that set them apart from
other producers. Their return on equity is likewise below average, and their
production efficiency is comparatively low. They don't provide top-of-the-line goods,
but they do make bicycles of above-average quality. BBC has a variety of models,
from entry-level to luxurious 12-speed, but they don't have any distinctive
technologies or practices that would give them an advantage over their competitors.
Question 9: Would you accept the Challenger deal ?
Given the possibility of considerable earnings growth, Baldwin Bicycle Company may
find it financially advantageous to accept the challenger deal as is. The requirement
for a substantial upfront capital commitment of $787,000, which BBC presently lacks,
is only one of the difficulties it faces. Although BBC might ask suppliers for favorable
credit terms and perhaps equity funding from shareholders, the high debt-to-equity
ratio makes obtaining bank financing a risk. Accepting the sale would require a
substantial change in BBC's strategic focus because it would imply a movement
towards the cheap bicycle market, which may not be possible given BBC's present
skills and resources.
On the other hand, accepting Hi-Valu's offer while renegotiating the parameters gives
BBC the chance to profit financially while reducing some of the deal's dangers. The
study shows that Hi-Valu's terms, notably the extended payment schedule, shift
significant commercial and financial risks to BBC. BBC might be able to reduce some
of the risks and get better terms by renegotiating these arrangements. Additionally,
pursuing such agreements with other discount retailers might strengthen BBC's
negotiating position and put pressure on Hi-Valu to extend more lenient loan terms.
Therefore, I would accept the challenger deal and renegotiate the terms.