BASIC IDEAS INVOLVED

 CAPITAL IS NOT FREE.

 THE RELEVANT CHARGE IS THE COST OF CAPITAL PLUS

INCREMENTAL CARRYING COSTS (INSURANCE, HANDLING, TAXES,
ETC).

 COST OF CAPITAL IS SOME FORM OF WEIGHTED AVERAGE ACROSS

THE DEBT AND EQUITY CAPITAL SOURCES USED BY THE FIRM.

 ANY SPECIFIC NUMBER CHOSEN IS, AT BEST, A ROUGH

APPROXIMATION BECAUSE THE TRUE COST OF CAPITAL CANNOT BE
OBSERVED.

 IF INCREMENTAL DEBT COSTS 18%, BEFORE TAX, A FIRST-CUT

WEIGHTED AVERAGE COST OF CAPITAL (AFTER TAX) MIGHT BE 13%
ASSUMING 1/3 DEBT AND 2/3 EQUITY IN THE CAPITAL STRUCTURE.

 INCREMENTAL CARRYING COST SEEMS TO BE ABOUT 4% A YEAR

(BEFORE TAX) FOR INVENTORY AND 0% FOR RECEIVABLES,
REJECTING PART OF THE CASE NOTE AS BEING JUST AN
ALLOCATION OF COMMON COSTS.

 COMBINING CARRING COSTS AND COST OF CAPITAL, AN AFTER-TAX

CHARGE OF 15% FOR INVENTORY AND 13% FOR RECEIVABLES IS A
REASONABLE FIRST CUT.
EXTRA INVESTMENT REQUIRED TO SUPPORT INCREMENTAL SALES :

Raw Material (2 months' stock)

~ 4,000 bikes x ~ $ 40 = ~ $ 1,60,000

Work in process (1,000 units)

"Half finished" implies about $55 semi-finished cost
(100 % of material plus half f labour and variable overhead)
~1,000 bikes x ~ $ 55 = ~ $ 55,000

Finished units in the factory

~ 500 bikes x ~ $ 69 = ~ $ 35,000

Finished units in the Hi-Valu warehouse

Per case facts, about 2 months' supply, on average
~ 4,000 bikes x ~ $ 69 = ~ $ 2,80,000

Accounts Receivable (30 days sales)

~ 2,000 bikes x ~ $ 92 = ~ $ 1,85,000

Less : Trade Credit

Assuming 45 days credit from the materials suppliers
~ 3,000 bikes x ~ $ 40 = (~$1,20,000)

Net Extra Investment ~ $ 5,95,000

COMPUTATION OF INCREMENTAL PROFITABILITY :

1. Incremental Profit Contribution for 25,000 bikes = ~ $ 2,88,000

($ 92 -$ 69 ) x 25,000 x 0.5

2. Incremental capital charge = ~ $ 1,00,000

3. Incremental residual income = ~ $ 1,88,000

[ 1 - 2 ]

4. Contribution Loss on 3,000 bikes ? Erosion Loss : strategically relevant

or not ???
CAVEATS :

 The consigned inventory issue

(Does Baldwinhave to tolerate this sort of imposition on
normal business term by Hi-Valu?)

 The capacity issue

(Is it wise for Baldwin to tie up most of its excess capacity,
unused though it currently is, for several years at well below
normal prices?)

 The long-run/short-run cost issue

(Is it really appropriate to ignore fixed overhead in a project
that uses almost 20% of Baldwin's capacity over a three-year
period ?)

 The uncertainty of Hi-Valu's demand.

(What happens to the incremental analysis if Hi-Valu takes
fewer than 25,000 bikes or more than 25,000 ?)

 The incremental debt capacity issue.

(Can Baldwin borrow an incremental $ 4,00,000 ~ $ 9,00,000 to
finance the project ?)
LEARNINGS IN TERMS OF ;

1. Cost Behaviour analysis

2. Profit - Contribution analysis

3. Long-run versus short-run product and customer profitability

4. Inventory and receivables carrying cost

5. Working capital management

6. Project return on investment (ROA versus residual income)

7. Balancing quantitative and qualitative issues in a decision

THE DISTRIBUTION STEP IN THE VALUE CHAIN :

Particulars One of Hi-Valu

Baldwin's Current Stores
Dealers

Purchase Cost $ 110 $ 92

Freight Cost 10 Truckload shpg 8
Delivered Cost $ 120 $100
Necessary Margin as % of S.P. 40% 25%
(Independent retailer) (Discount
merchandiser)
Implied retail Price $ 200 $ 133
MARKET SEGMENTATION :

Retail Pricing Suppliers

(1982) Fuji
B ianci
Univega
"Premium" Bike Peugot
High Price/High Qlty Trek
$300 and
up, fast .
Sold through bike .
stores .

Schwinn
"Value" Bike
Huffy
$150 - Midprice/Mid Qlty
Murray
$ 250 Ross
Sold through hardware, Raleigh
toys, sporting goods stores, Columbia
department stores Baldwin
.
.
? .
Low Price, Mid Qlty
Private Labels
Hi-Valu, Sears, Penney's
?

"Cheap" Bike
Low Price / Low Qlty Generic Brands
$100 +/- Closeouts
Sold through discount chains Distress Stock
(Bargain Barns, Caldor, Korvette's,…) .
.
 RETURN ON EQUITY :

Margins X Asset Intensity X Leverage = Return

(P/S) (S/A) (A/E)
Baldwin, 1981 $255K/$10.8M $10.8M/$8.0M $8.0M/$3.0M $255K/$3.0M
2.35% 1.34 2.61 8.2%
Average of US
manufacturing 5% 1.5 2 15%
(early 1980s)
Baldwin with ~$400K/$12.8M $12.8M/$8.6M $8.6M/ $400K/$3.0M
the Hi-Valu $3.0M.77
deal in 1982, at 3% 1.49 12.89%
best

BASIC ECONOMIC STRUCTURE :

• Contribution margin per unit $44(40% of sales)
• Fixed cost base (annually) :
Manufacturing : ~$1.5M
$3.9M
Selling and administration ~$2.4M
• Break even point = 89K units ($3.9M/$44), is about two-thirds
of one shift capacity

• Profit before tax at 99K units would be about $440K (10,000 x

$44). This estimate is quite close to the $474K earned in 1981

• Profit before tax at one shift capacity of 133K units = 44,000 x

$44 = $1.9M. This is excellent return on equity

• Asset Investment :
Inventory = 120 days (obviously more an advocate of JIC
than JIT)
Accounts receivable = 45 days, which is typical
Property turnover = 10.8/3.6 = 3x, which is reasonable

• Fixed cost percentage of sales:

Manufacturing = 1.5/10.8 = ~14%
Selling and administrative = 2.4/10.8 = ~22%

• Gross margin = ~26% of sales (2.8/10.8), a very low figure for

a consumer durables manufacturer

• Selling and administrative cost = ~22% of sales, which seems

very high for a low-margin manufacturer

COST DRIVERS :
• Contribution margin would only be $23 (25% of sales) instead
of $44, and it would be likely to fall steadily because of
competition from the Taiwanese and the Koreans.

• The break-even point would be 170K units ($3,9M/$23) or

about 130% of one shift capacity. (Break even point greater
than capacity is one sure strategic danger signal).

• If there are good reasons to stay with a one shift operation

and if the firm wants to earn 15% of ROE, on a $3M equity
base, it must earn $450K after tax or $900K before tax. This
requires ~39K bicycles (at $23 contribution each).

• This leaves ~94K bicycles to pay for fixed overhead (133K –

39K). At $23 per bicycle this allows ~ $2.2M for overhead (94K
x $23).

• Thus, the firm will have to cut its fixed costs by more than
40%, in the short run (from $3.9M to $2.2M) just to earn an
average return on equity.

• As prices come under continuing pressure from foreign

manufacturers, unless Baldwin can cut variable cost, margins
will fall and overhead will have to be cut even more.
STRATEGIC COST ANALYSIS FOR BALDWIN

Alternative #1. DO NOT ACCEPT THE HI-VALU DEAL

ROE is inadequate (~ 8%).

Middle market is slowly shrinking.

Even if Baldwin rejects the Hi-Valu offer, someone else will do it,
thereby further eroding Baldwin’s current niche. So, even its
current ROE of 8% is vulnerable.

Alternative #2. CURRENT NICHE PLUS HI-VALUE DEAL

ROE is still average (~13%) at best.

Great threat tot he core business. If their dealers drop Baldwin

products, the projected ROE of 13% is seriously open to
question. Baldwin might be forced to go 100% to Hi-Valu’s
niches, where the basic economics are marginal, at best.

What if Baldwin’s current dealers ask for a deal similar to Hi-Valu’s?

Going private label is a strategic shift; what are the organisational

implications of diluting the strategic thrust ?

An ethical issue : Is the difference in price of $133 versus $200

reflective of a difference in value to the customer?

Alternative #3. GO 100% TO HI-VALU’S NICHE

Basic economics are marginal, unless able to cut fixed

costs by more than 40%, just in the short-run.

Baldwin’s ability to compete long run against foreign

competition as a low-cost producer is very doubtful.