Baldwin Bicycle Company Objectives of Session 1. Practice in applying a comprehensive financial analysis framework to a “new business” opportunity. 2. Blending strategic marketing analysis and financial analysis. 3. Blending corporate strategy with marketing strategy This case is an excellent one for contrasting the conventional framework (Relevant Cost Analysis) with the Superior (?) framework (SCM)

1973—15 million bikes sold “bicycle boom” (Baldwin 135,000) 1982—10 million bikes sold (Baldwin 99,000) Baldwin: 1982 “Structural Financial Model” Capacity used now 98,791 units Total Capacity (one shift) 131,721 units Cost Structure Per Unit Fixed Mfg. (14% sales) $1470 Selling Price $110 S&A (22% sales) $2354 Variable Cost $66 $3824 Contribution $44 “Fixed” “Variable”

“Du Pont” Model Profit/Sales x Sales/Assets x Assets/Equity = Profit/Equity “Margins” “Asset “Leverage” = Shareholder Intensity” Return 255/10,872 10,872/8,092 8,092/3,102 = 255/3102 (2+%) (1.3x) (2.6x) (8%) USA Average?

1. The Relevant Cost Analysis—6 Steps 2. The “SCM” Analysis a. Basic Economics—Two ways b. Balance Sheet Review—Why relevant? c. Market Segmentation d. Product Positioning 3. A Strategic Assessment of the Decision 4. What would you recommend?!?!

Analysis of the Hi-Valu Proposal 1. Incremental Contribution Per Unit Revenue $92.29 Less Variable Costs Material $39.80 Labor $19.60 Variable Overhead (40% of $24.50) $9.80 $69.20 $23.09 Total Incremental Contribution (25,000 units @ $23.09) = $580,000 2. One-time Design Costs $5,000; too small; ignore it! QUESTION: Can we ignore a share of “fixed” manufacturing and selling & administrative expenses? Conventional framework says “Yes, ignore it.”

3. Investment (no fixed assets; only working capital) OR, Per At Baldwin OR, Per Commentary Units Per Unit Total (000) Raw Material (2 months) ~4,200 $39.80 $170,000 $ 160 Accounts Payable Offset (1 month assumed) (~2,100) $39.80 ($85,000) $(120) Work in Process ~1,000 $54.50a $55,000 $ 55 Finished Goods ~500 $69.20 $40,000 $ 35 At Hi-Valu Warehouse (2 months) ~4,200 $69.20 $290,000 $ 280 Accounts Receivable (1 month) ~2,100 $92.29 $190,000 $ 185 $660,000 $ 595 a Cost of a unit “1/2 complete” (39.80 +1/2 [19.60 + 9.80] )

4. Carrying Costs 23.5% on Raw Material + WIP + Finished Goods 19.0% on Accounts Receivable (19.0% on $190,000) = 40,000 $150,000 $150,000 = $6 per unit a. What rate to use? Debt rate vs. weighted average cost of capital Finance Cost + Non-financial Cost (tax, insurance, obsolescence, ...) b. The charge = rate x ∆Investment

If Relevant—A Big If! Type A / Type B 5. Erosion (3,000 units) Contribution on a “regular” bike: Sales per unit [~$11M ÷ 99,000] = ~$110 Variable cost per unit = ~$66 Per Unit = ~$44 Incremental Erosion costs (3,000 units @ $44) = ~$130,000 If Relevant—A Big If! Type A / Type B

6. Pulling the “Relevant Cost Analysis” Together A. ROI = Profit/Investment = (580a - 130b)/660 = 450/660 = 67%!!! “Good” if P/I > K = hurdle rate OR B. Residual Income = 580a - 130b - 150c = ~300 “Good” if RI > 0 a. ∆Contribution Margin 25,000 x $23.+ = ~$580,000 b. “Erosion” ~ 3,000 x ~ $44 = ~ $130,000 c . The Finance Charge (per item 4 above = $150,000)

Profit Model PAT/Sales x Sales/Assets x Assets/SE = ROE “Margins” “Asset “Leverage” Intensity” CURRENT: 1982 255 x 10,872 x 8,092 = 8% 10,872 8,092 3,102 WITH CHALLENGER 4351 x 12,8722 x 8,8373 = 13% 12,872 8,752 3,282 1) ∆PC of $580 - ∆Carry Cost of $150 - ∆Erosion CM of $130 = ∆$300 x ~60% = ∆$180 2) +∆$2.3M ($92 x 25,000) - ∆.3M ($110 x 3,000) = ∆$2M 3) +∆745 Working Capital Assets

Conventional Pro • Incremental profit and incremental ROI excellent (even with erosion). • The existing business covers the fixed costs (i.e. we are showing profits in 1982). The “Incremental” business need only show positive marginal contribution. • We have excess capacity and volume isn’t growing. • Opens up a new (for Baldwin) and more stable distribution channel (Hi Value). • Opens up a new market segment for growth for Baldwin (The “Discount Retail” segment”). • Risk seems low (or does it?!).

Cons • Can we really look at a deal on an “incremental” basis when it covers 25% of volume and runs for at least 3 years??!! • On a full cost basis, not attractive—Lose $16 per unit [92-69-15-24]. • Lousy ROE ( 8% ) now; Even with the H/V deal, the ROE is still not good ( 13% ); Need to get higher margin on the remaining capacity. • Creates a major cash crunch; Highly leveraged now; No debt capacity left; How to finance the incremental investment? • Inventory at H/V may run up to average 4 months, not 2 months; Implications for ROI, cash flow, and financing? • Additional sales losses, if current dealer’s drop Baldwin line? • A very sweet deal for H/V; Can we negotiate a better deal? (probably yes; should we try?)

BALDWIN: 1982 Balance Sheet Cash $342 A/P (45 days) + Accruals $852 A/R (45 days) $1,359 Bank Borrowing $2,626 Inventory (123 days)* $2,756 LTD $1,512 Fixed Assets $3,635 SE $3,102 $8,092 $8,092 D/E Ratio = = 135% 2,678 + 1,512 3,102 *~ 30,000 bikes in inventory = 30% of 1982 sales  1983 mfg. plan?!

Is this H/V deal “good business”? The “Positioning” Issue Selling 2 “similar”(?) products at different prices through different channels to the same (?) customers Is this H/V deal “good business”? I. Normal Channel: Delivered cost $110 + $10 (transportation) plus retail markup @ 40% on selling price Selling Price = $200 II. H/V: Delivered cost $92 + $8 (transportation) plus retail markup @ 25% on selling price Selling Price = $133 Is the $67 difference in price ($133 vs. $200) reflective of a difference in “value” to the customer? Brand Image Dealer Image Free Assembly Service Point of Sale Merchandising

Baldwin: Background • Currently profitable, but only modestly so (ROE 8%) • Heavily leveraged • Their old strategic niche is eroding away, slowly but surely, from “above” and “below” • Sales volume decreasing during last 2 years • A “solution” presents itself in the H/V offer Is it a good “solution”?

Impact of the H/V Deal on the “Current” Business Strategy? MINOR+ ? MAJOR+ • How much flexibility does Baldwin have to experiment? • How much urgency is there to “do something”? Does the H/V deal make sense strategically?

•. What is Baldwin’s strategic niche currently • What is Baldwin’s strategic niche currently? Does it matter if they stray from that? • Can we be a significant supplier simultaneously in two price segments with a substantially “identical” product? • How to implement diverse strategies (low cost and differentiation) within the same firm? • Avoid “stuck-in-the-middle”

Is the H/V deal a good one? • Financially? • Strategically? • Ethically? Post Mortem The “Message”?

Any Decision Must Take An Integrated View Of Framework for Strategic Cost Analysis • Sorting out the relevant costs • “Contribution” or “full cost profit” as the “metric” • How to best treat fixed or common costs “Mission Positioning” Framework • Build • Hold • Harvest • Divest How to compete successfully to accomplish the chosen mission • Low cost • Differentiation ANALYZE • Suppliers • Customers • Substitutes • New entrants • Competitors Any Decision Must Take An Integrated View Of Strategic Competitive Financial Mission Strategy Analysis Analysis Analysis There are no “Free Lunches,” “Good Cheap Cigars,” or “Short-Run Business Decisions”