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Analysis of Case 26-5

Bryan Jerrett Louise Krogh Sherrie Reynolds Nov. 9, 2005

Synopsis of case Definition of Problem Possible Alternative Solutions Evaluation of Quantitative Factors Evaluation of Qualitative Factors Recommendations

Baldwin Bicycle Company (BBC) has been making above average bicycles for almost 40 years Hi-Valu Stores Inc. (HVS) has approached BBC to produce a house-brand of bicycles for them Hi-Valu wants the Challenger to look different and cost less than Baldwin's regular line Preliminary financial analysis of the proposal is needed

The Hi-Valu offer represents a chance for BBC to increase production capacity but at a greater cost per unit than its current product.

Because the quantity and buying price put forth by Hi-Valu are non-negotiable, and assuming that laying off the excess capacity is not a possibility, the number of alternatives are limited:
Reject Accept

the proposal/maintain status-quo the proposal

In conducting preliminary financial analysis, Suzanne Leister must consider quantitative elements in order to determine which alternative would be most financially beneficial to BBC These include:
Differential revenues Differential costs
Cost of sales, one-time costs, asset-related costs, tax expenses

Differential profit

Base case balance sheet:


Assets Cash Accounts receivable Inventories Plant and equipment (net) $333333 ,3 .3 $3 ,3333 ,333 . 3 $3 ,3333 ,333 . 3 $3 ,3333 ,333 . 3 $3 ,333 ,333 . 33 Liabilities and Owners' Equity Current Liabilities $3 ,3333 ,333 .3 Noncurrent liabilities $3 ,3333 ,333 .3 Total liabilities $3 ,3333 ,333 .3 Owners' equity $3 ,3333 ,333 .3 $3 ,333 ,333 .33

Assets Cash Accounts receivable Inventories Plant and equipment (net)

Alternative balance sheet:


$333333 ,3 .3 $3 ,3333 ,333 . 3 $3 ,3333 ,333 . 3 $3 ,3333 ,333 . 3 $3 ,333 ,333 . 33

Liabilities and Owners' Equity Current Liabilities $3 ,3333 ,333 .3 Noncurrent liabilities $3 ,3333 ,333 .3 Total liabilities $3 ,3333 ,333 .3 Owners' equity $3 ,3333 ,333 .3 $3 ,333 ,333 .33

Base Case: Sales revenues

Alternative (Year 3 ): Sales revenues Baldwin name Challenger name Total sales revenue Cost of sales Baldwin name Challenger name Total cost of sales Gross margin Other Expenses Other differential costs One-time added Asset-related costs Income before taxes Income tax expense Net income

$33 ,3333 ,333 .3 Cost of sales

$33 ,3333 ,333 .3 $3333333 , ,3 .3 $33 ,3333 ,333 .3 $3333333 , ,3 .3 $3333333 , ,3 .3 $3333333 , ,3 .3 $3333333 , ,3 .3 $3333333 , ,3 .3 $33333 , .3 $33 .33 ,333 $333333 ,3 . 3 $333333 ,3 . 3 $333 .33 ,333

Gross margin Other expenses Other differential costs One-time added Asset-related costs Income before taxes Income tax expense Net income

$3333333 , , 3 .3 $3333333 , , 3 .3 $3333333 , , 3 .3 $333 . $333 . $333333 ,3 . 3 $333333 ,3 . 3 $333 .33 ,333

Differential revenues: those revenues that are different under one set of conditions than they would be under another Conduct a comparison of the projected revenues for the base case scenario (reject proposal) and the alternative scenario (accept proposal)

Reject Proposal Projected sales:


100,000 bikes

Accept Proposal Projected sales:


97,000 Baldwin 25,000 Challenger

Unit price:
$110.05

Sales revenue:
$11,005,051

Unit price:
$110.05 $92.29

Sales revenue:
$12,982,150

Differential costs: those costs that are different under one set of conditions than they would be under another

Conduct a comparison of the projected costs for the base case scenario (reject proposal) and the alternative scenario (accept proposal)

Reject Proposal Unit cost:


$81.43

Accept Proposal Unit cost:


$81.43 Baldwin $83.90 Challenger

Cost of sales:
$8,143,454

Income tax expense:


$233,945

Cost of sales:
$9,996,651

Asset-related costs:
$95,379

Income tax

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 onetime basis only? 4. What are the additional assets and related carrying costs?

Revenue Total Costs = Profit Reject Proposal: $273,652 Accept Proposal: $286,333 Difference: $12,681 By accepting the proposal, BBC stands to make $12,681 more than by maintaining the status-quo

Three year contract between BBC and HVS


One-time costs of $5000 are incurred by BBC in year one

Profit from yrs. 2 and 3 increases, from yr. 1, by $2,696 resulting in a total differential profit of $15,377
Expenses Income Before Taxes Tax Expense Income

Cannibalization: to deprive of vital elements or resources, such as personnel, equipment, or funding, for use elsewhere The impact of cannibalization is the 3000 less Baldwin bikes expected to be sold, plus the uncertainty of the success of the Challenger line of bikes

The one time costs that are incurred are the $5000 associated with the preparations of drawings and designs and procuring sources for fenders, seats, handlebars, tires, and shipping boxes

The additional assets are the increases in inventories and receivables associated with the addition of the production of the Challenger line The increase in inventory is $269,633 and the increase in receivables is $247,138 The added carrying costs are 23% of added inventories and 13.5% of added receivables which amount to $62,015 for inventories and $33,364 for receivables

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?

Profit Return on sales Return on assets Return on equity Profit Return on sales Return on assets Return on equity

33 33 $33333 ,3 33 % . 3 33 % . 3 33 % . 3

Base case Year 3 $33333 ,3 33 % . 3 33 % . 3 33 % . 3

Alternative year 3 $33333 ,3 33 % . 3 33 % . 3 33 % . 3

Base case Years 3 3 Alternative Years 3 3 & & $33333 ,3 $333333 ,3 . 3 33 % . 3 33 % . 3 33 % . 3 33 % . 3 33 % . 3 33 % . 3

A decision cannot be based solely on numerical analysis While numbers may appear favourable, it is imperative to consider the unmeasurable factors

While calculations are useful in narrowing down alternatives that should be considered, qualitative analysis assists in making the final judgement For each alternative there are associated risks and rewards

What are the strategic risks and rewards?

Risks BBC may face continually declining sales due to a poor economy BBC will continue to produce at only 75% production capacity

Rewards Maintain loyalty from current distributors Maintain 40-year reputation for above average quality and price

Current dealers may drop Baldwin line Current dealers may request a similar product (Challenger) Loss of street cred Putting faith in a new product

BBC may find itself with an abundance of Challengerspecific inventory Extra costs may result in having to use cheaper materials

With Challenger line, BBC will be producing at a higher capacity Greater penetration of the market through new market segments

If Baldwin name is not on the Challenger bike, BBC's reputation may not be damaged Strong Challenger sales may balance weak Baldwin sales

What should the company do and why?

Because there is a lack of research conducted regarding the new Challenger line, uncertainties exist as to how it will fare in the market However, because of the poor state of the economy accepting the proposal from HVS is a good idea for BBC

Raise production capacity from approx. 75% to approx. 97% Increase in Challenger sales could offset decreasing Baldwin sales

The condition of the economy is unlikely to improve in the short term, therefore taking a risk on a three year contract that projects favourable sales promises a better situation than they are currently facing Based on the information given, Baldwin Bicycle Company should accept Hi-Valu's proposal

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