Baldwin Bicycle Company Baldwin But Challenger Sales Taken From

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Baldwin Bicycle Company

Teaching Commentary

OVERVIEW

This short but very rich case is particularly useful for illustrating “strategic accounting” because the conclusions that

emerge from a “relevant cost” analysis diverge so widely from the conclusions suggested by a “strategic cost” analysis.

In order to contrast the two perspectives, we will first present the “relevant cost” analysis—an exercise in financial

analysis for a potential “extra chunk” of business. We then present the “strategic analysis” of the case.

This strategic analysis, based heavily on concepts articulated in marketing strategy and in competitive strategy

RELEVANT COST ANALYSIS OF THE HI-VALU OFFER

This perspective would typically consider cost behavior as a starting point. From case facts, it is not difficult to

deduce that the incremental cost of producing a Challenger bike is about $69 (material, direct labor, and about $9+ of

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A second element of the relevant cost analysis

would typically be the cost of carrying the incremental

Raw Material (2 months stock)

~ 4,000 bikes x ~ $40 = ~ $160,000

Work in process (1000 units)

Finished units in the HV warehouse

per case “facts,” about 2 months

supply, on average

~ 4,000 bikes  ~ $69 = ~ $280,000

(Less a trade credit offset)

Assume 45 days credit from

the materials suppliers

~ 3,000 bikes  ~ $40 = (~ $120,000)

• Cost of Capital is some form of weighted average

across the debt and equity capital sources used by

the firm.

be 13%, assuming 1/3 debt and 2/3 equity in the

capital structure {[1/3  (18%x.5)] + 2/3(15%)}.

• Incremental carrying cost seems to be about 4% a

Combining these two components of the

carrying cost calculation produces an annual cost

bike to about $5 per bike. This is well below the

$11.50 after tax marginal contribution [($92 – $69) 

.5], even at the high end of the investment and carry

cost range.

A third element of the relevant cost analysis

Whether or not an erosion charge is relevant is

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arguable. Assuming that 3,000 customers who

otherwise would have bought a Baldwin bicycle do in

fact buy a Challenger bicycle, the lost profit is certainly

real to Baldwin. On the other hand, it probably is

them. In this context, focusing on the “erosion” is not

only arrogant (our products are impervious to decline

unless we cannibalize them), but also short sighted (we

lose the opportunity to sell new products but sales of

the old products decline anyway). Thus, a strong

argument can be made to exclude the erosion charge.

Summarizing the components of the cost

analysis, we can calculate the incremental profitability

as follows:

This is a very attractive return!

This is clearly only a first approximation of the

incremental return because it ignores the time value of

money. A multiperiod, discounted cash flow approach

would be preferable. Also, it leaves open the time

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

Only the last one of these five potential

concerns requires additional analysis. The other four

are more qualitative than quantitative. The debt

capacity issue does require explicit attention.

The $2.6 million level of short-term debt is

very high for a year-end balance sheet for a company

like Baldwin. December 31 should be a point in the

year of nearly maximum liquidity for a manufacturer of

a seasonal, consumer durable product like bicycles.

moving” or even obsolete product. And, it is all

financed with short-term debt!

Even though the incremental residual income

from the project looks very attractive, it is problematic

whether the firm could justify borrowing yet another

$600,000 or so for the HV project. One imaginative

thought in this regard is reworking some of these bikes

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On balance, this analysis comes down to very

attractive incremental short-run profits, coupled with

some qualitative caveats that mitigate, somewhat, this

• long-run versus short-run product and customer

profitability

• inventory and receivables carrying cost

Also, it treats these themes in a context that

involves sufficient marketing complexity (the erosion

issue, and the private label volume enhancement idea

for makers of branded products) and sufficient

uncertainty (the short-term debt crunch and the

structure of the consigned inventory provision) that it

will support excellent discussion with senior

STRATEGIC ANALYSIS OF THE HV OFFER

We are not aware of many cases in which the

strategic cost analysis yields such totally different

case. This is not a criticism of these managers; rather,

it is a comment on the prevailing narrow conception of

cost analysis among American businesses.

totally silent on these issues is further evidence of what

contemporary managerial accounting authors see as

“relevant” concerns. Based on general knowledge of

retailers’ profit margins and some estimating of freight

costs, it is possible to construct the following strategic

Necessary (inde- (discount

margin as % pendent merchan-

of sales price retailer) 40% diser) 25%

Implied Retail Price $200 $133

Is this difference of $67 reflective of a

sale merchandising, service) or “per–ceived” value

(brand image, dealer image) do obviously differ

between the two products. But, do they differ by $67

worth on a $200 purchase? This is a real issue.

It is also possible to develop a simple market

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Exhibit A

Market Segmentation

Suppliers

Fuji

Bianci

Univega

Peugot

Trek

•

Reta il Pricin g

(1982)

$300 and

up fast

I. “P remium ” bike

High price/High quality

Sold through bike st ores

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Drawing again upon general knowledge of

trends in retailing over the past few decades, it is very

likely that a big share of Challenger sales will come

from people who otherwise would have shopped in a

has developed almost exactly as Porter’s competitive

strategy framework would predict (Porter, 1980). One

can compete successfully by being different and by

commanding a premium price for that differentiation —

such as BMW in automobiles. Or, one can compete by

forces analysis and if growth rates and investment rates

do not force a quick shake out of the weaker players (as

they have done in microcomputers, for example). But

the firms that lack a sustainable competitive edge will

eventually wither. Their future is behind them!

This analysis suggests that what Baldwin is

really doing by putting HV into business is not only

needs. Cost analysis can play a significant role in

evaluating this strategic opportunity. Examining the

overall profitability of Baldwin is one way to assess the

attractiveness of its current strategic niche. Looking at

the switch” or they have been forced into the current

situation by supposedly short-term loans that became

long-term, de facto, when inventory was not converted

into sales. This strategic assessment of risk and return

relationships makes it much harder to argue that

• Fixed cost base (annually):

Manufacturing ~$1.5M

$3.9M

Selling & Administration ~2.4M }

• Break-even point = 89K units ($3.9M/$44.), which

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• Fixed Cost % of Sales:

Manufacturing = 1.5/10.8 = ~14%

Selling & Administrative = 2.4/10.8 = ~22%

It is, in fact, true that bicycle sales in the

United States reached a peak of fifteen million units in

1973 and had declined to ten million units in 1982. It is

thus not surprising that Baldwin looks like a company

that sorely needs a lot more volume than it is getting.

they became so readily available in discount chains.

Chevrolet and Oldsmobile were totally different

automobiles in the 1950s. Many people believe that

supplying HV, but they do not have to cooperate with

HV’s strategy by offering the $200 Baldwin bike as the

“stalking horse” for the $133. Challenger bike. If they

normally stock two or three brands, to give their

customers a choice, they can add Huffy or Ross or

Murray or Schwinn and drop Baldwin from the set.

Exhibit B

Return on Equity

Margins (P/S) x Asset Intensity (S/A) x Leverage (A/E) = Return

deal in 1982, at best (3%) (1.49) (2.87)

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

operation and if the firm wants to earn 15% ROE

on a $3M equity base, it must earn $450K after tax

or $900K before tax. This requires ~39K bicycles

(at $23. contribution each).

Can Baldwin realistically expect to compete as

a supplier of low cost bikes once the attraction of its

mid-range brand image has eroded? What would be the

possible source of its cost advantage? Very few

American firms have learned to play this game well,

Plus

• Looks like great RI

• Utilizes excess capacity

• Opens new channel of distribution for Baldwin

that is a “growth market”

Minus

• Looks extremely profitable for HV. Can we

• Major cash flow crunch—can we borrow

$600K?

• At best, puts company ROE at “average” level

• Strategically very risky

What looks like a good opportunity from a

1. Go 100% to “Premium” segment.

2. Try to find new product opportunities in the value

niche (mountain bikes, etc.).

• Even if we reject the HV offer, someone else will

do it, thereby further eroding our current niche.

So, even our current ROE of 8% is vulnerable.

Alternative #2 Current Niche + HV Deal

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

• Great threat to the “core” business. If our dealers

drop our product, the projected ROE of 13% is

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

organizational implications of diluting our strategic

thrust?

• 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.

product development, market development, and

manufacturing retooling required to enter and succeed

in this new niche probably would take far more money

TEACHING STRATEGY

We use this case in an unusual way. We assign it for

day one of the required managerial accounting course.

We also distribute this teaching commentary in

advance.