Session 2: Business Strategy and Management Accounting
The Bradford Bicycle Company (Adapted from Shank and Govindarajan, 1993)
In May 1993, Suzanne Lester, marketing vice-president of Bradford Bicycle Company (BBC), was mulling over the discussion she had had the previous day with Karl Knott, a buyer from Hi- Value Stores plc. Hi-Value operated a chain of discount department stores in the North of England. Hi-Values sales volume had grown to the extent that it was beginning to add house- brand (also called private-label) merchandise to the produce lines of several of its departments. Mr Knott, Hi-Values buyer for sporting goods, had approached Ms Lester about the possibility of BBC producing bicycles for Hi-Value. The bicycles would bear the name Challenger, which Hi-Value planned to use for all of its house-brand sporting goods. BBC had been making bicycles for almost 40 years. In 1993, the companys line included 10 models, ranging from a small beginners model with training wheels to a deluxe 21 speed adults model. Sales were currently at an annual rate of about 10 million. The companys 1992 financial statements appear as below:
1. Balance Sheet as at 31 December 1992
Plant and Equipment (net) Inventories
000 Liabilities and Owners Equity
3,635 Owners equity
2,756 Long-term loan
1,359 Short-term bank loans
342 Accrued Expenses Creditors
3,102 1,512 2,626
8,045* 2,827 2,354
2. Income statement For the Year ended 31 December 1992
Cost of sales
Selling and administrative expenses Income before taxes
*Cost of sales includes 1.5 million of fixed manufacturing overheads.
Most of BBC sales were through independently owner retailers (toy stores, hardware stores, sporting goods stores) and bicycle shops. BBC had never before distributed its products through department store chains of any type. Ms Lester felt that BBC bicycles had the image of being above average in quality and price, but not a top-of-the-line product. Hi-Values proposal to BBC had features that made it quite different from BBCs normal way of doing business. First, it was very important to Hi-Value to have ready access to a large inventory of bicycles, because Hi-Value had had difficulty in predicting bicycle sales, both by store and by month. Hi-Value wanted to carry these inventories in its regional warehouses, but did not want title on a bicycle to pass from BBC to Hi-Value until the bicycle was shipped from one of its regional warehouses to a specific Hi-Value store. At that point, Hi-Value would regard the bicycle as having been purchased from BBC, and would pay for it within 30 days. However, Hi- Value would agree to take title to any bicycle that had been in one of its warehouses for four months, again paying for it within 30 days. Mr Knott estimated that on average, a bike would remain in a Hi-Value regional warehouse for two months.
Second, Hi-Value wanted to sell its Challenger bicycles at lower prices than the name-brand bicycles it carried, and yet still earn approximately the same dollar gross margin on each bicycle sold- the rationale being that Challenger bike sales would take away from the sales of
the name-brand bikes. Thus, Hi-Value wanted to purchase bikes from BBC at lower prices than the wholesale prices of comparable bikes sold through BBC usual channels. Finally, Hi-Value wanted the Challenger bike to be somewhat different in appearance from BBCs other bikes. While the frame and mechanical components could be the same as used on current BBC models, the guards, seats, and handlebars would need to be somewhat different, and the tyres would have to have the name Challenger moulded into their sidewalls. Also, the bicycles would have to be packed in boxes printed with the Hi-Value and Challenger names. These requirements were expected by Ms Lester to increase BBCs purchasing, inventorying, and production costs over and above the added costs that would be incurred for a comparable increase in volume for BBCs regular products.
On the positive side, Ms Lester was acutely aware that the bicycle boom had flattened out, and this trend plus a poor economy had caused BBCs sales to fall during the past two years. As a result, BBC currently was operating its plant at about 75 percent of one-shift capacity. Thus, the added volume from Hi-Values purchases could possibly be very attractive. If agreement could be reached on prices, Hi-Value would sign a contract guaranteeing to BBC that Hi-Value would buy its house-brand bicycles only from BBC for a three-year period. The contract would then be automatically extended on a year-to year basis, unless one party gave the other at least three- months notice that it did not wish to extend the contract. Suzanne Lester realised she needed to do some preliminary financial analysis of this proposal before having any further discussion with Karl Knott. She had written on a pad the information she had gathered to use in her initial analysis; this information is shown below.
Notes taken by Suzanne Lester
1. Estimated first-year costs of producing Challenger bicycles (average unit costs, assuming a constant mix of models):
Overhead (@ 125% of labour)
39.80 19.60 24.50* 83.90
* Overhead rate of 125% based on 100,000 bicycles per year. About 40% of manufacturing overhead is variable.
2. Unit price and annual volume: Hi-Value estimates it will need 25,000 bikes a year and proposes to pay us (based on the assumed mix of models) an average of 92.29 per bike for the first year. Contract to contain an inflation escalation clause such that price will increase in proportion to inflation-caused increases in costs shown in item 1 above: thus, the 92.29 and 83.90 figures are, in effect, constant amounts. Knott intimated that there was very little, if any, negotiating leeway in the 92.29 proposed initial price.
3. Assumptions for Challenger-related added inventories. Working capital requirement for raw material, work-in-progress, finished goods, etc, would increase by 600,000. Working capital gives rise to extra funding and administrative costs. I estimate administration costs will be about 5% of working capital value.
4. Impact on our regular sales: Some customers compare shop for bikes, and many of them are likely to recognize a Challenger bike as a good value when compared with a similar bike (either ours or a competitors) at a higher price in a non-chain toy or bicycle store. In 1992, we sold 98,791 bikes. My best guess is that our sales over the next three years will be about 100,000 bikes a year if we forego the Hi-Value deal. If we expect it, I think well lose about 3000 units of our regular sales volume a year. These estimates do not include the possibility that a few of our current dealers might drop our line if they find out were making bikes for Hi-Value.
5. For an initial analysis I propose to ignore taxation implications.
Lesters accountant has prepared the information below using an incremental contribution (or relevant cost analysis) approach as a basis for her decision on the offer:
Overhead (40% x 24.50) Contribution per bike
39.80 19.60 9.80
Total contribution on 25,000 units
Raw material, work-in-progress, finished stock and receivables less credit
2. Working capital:
received: = 600,000
3. Administration costs: 600,000 x 5% = 30,000.
YOU ARE REQUIRED to advise Bradford Bicycle Company on whether the offer should be accepted. Your assessment should consider both the financial and strategic implications of the offer.
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