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January 21, 2016

CASE: CONTRACT MANUFACTURING

Bicycle shop

Baldwin Bicycle Company


In May 2008,JayZ, marketing vice president of Baldwin
Bicycle Company, was mulling over the discussion she had
had the previous day with Pharrel W, a buyer from Hi Valu
Store, Inc. Hi-Valu operated a chain of discount
department stores. Hi-Valus sales volume had grown to
the extent that it was beginning to add housebrand (also called private-label) merchandise to the
product lines of several of its departments. Hi-Valus
buyer for sporting goods, had approached Baldwin about
the possibility of Baldwins producing bicycles for HiValu. The bicycles would bear the name Challenger,
which Hi-Valu planned to use for all of its house-brand
sporting goods.

The bicycle boom had flattened out,


As a result,
Baldwin currently was operated its plant at about 75
percent of one-shift capacity.
If agreement could be
reached on prices, Hi-Valu would sign a contract
guaranteeing to Baldwin that Hi-Valu would buy its housebrand bicycles only from Baldwin for a three-year period,
not any period shorter.

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
extended the contract.Hi-Valu estimates it will need
25,000 bikes a year and proposes to pay (based on assumed
mix of models) an average of $92.29 per bike for the first
year.
There were some additional conditions imposed by Hi
Value. It was very important to Hi-Valu to have ready
access to a large inventory of bicycles, because Hi-Valu
had had great difficulty in predicting bicycle sales, both
by store and by month.
Hi-Valu wanted to carry these
inventories in its regional warehouses, but did not want
buy them from Baldwin until the bicycle was shipped from
one of its regional warehouses to a specific Hi-Valu
store. At that point, Hi-Valu would regard the bicycle as
having been purchased from Baldwin, and would pay for it
within 30 days. For Baldwin, these conditions implied
that it would have to invest in finished goods inventory
and receivables. Event without these conditions, Hi Value
would have to invest in inventory as below:
a. Materials: two months supplies
b. Finished goods: 500 bikes (awaiting next carload lot
shipment to a Hi-Valu warehouse)

How do
decide on
the offer
strategicllay?

Baldwin had not been doing well financially. Besides


using only 75% of its 100,000 bikes per year capacity,
the company, the company operated on low profit margins.
It had also borrowed heavily. Recent Income Statement and
Balance sheet of the company are provided in Exhibits 2
and 3.
You are a consultant to the company. Advice on the
following:
1. What is the average price at which Baldwin had been
selling bicycles before the Hi Valu order? With that
data, would you still recommend that the Hi Value
order be accepted? Why?
2. If Baldwin accepts the order from Hi Valu, what is
the additional investment it would have to make to
finance additional inventory and accounts receivable?
If this investment is financed by a bank loan, what
would be the annual interest @ 12%/year? Additionally,
what can be the difficulties in getting a bank loan?
3. How can the acceptance of the Hi Valu order affect
Baldwins regular business? Can you identify the
reason why Baldwin should accept the order and why it
should not accept the order?
4. What is your recommendation to the top management?
Highlight the pros and cons of your recommendation.

Exhibit 1: Estimated first-year costs of producing


(average unit costs assuming a constant mix of model):

Challenger

bicycles

Materials .................$ 39.80*


Labor..................

19.60

Production Overhead (@ 125% of labor)24.50**


*Includes items specific


standard models.


to

$ 83.90
models

for

Hi-Valu,

not

used

in

Baldwins

**Accountant says about 40 percent of total production overhead cost is


variable; 125 percent of Direct Labor $ rate is based on volume of 100,000
bicycle per year.

Exhibit 2 Income Statement (Amount in $ 000)


For the Year Ended December 31, 2007






Sale revenues.
$ 10,872
Cost of Goods Sold..
8,045
Gross margin.
2,827
Selling and Administrative expenses 2,354
Income before taxes.
473
Income tax expense.
218
Net income..
255
Exhibit 3 Balance Sheet (Amount in $ 000)
As of December 31, 2007

Assets

Liabilities and Owners Equity

Cash.....
$ 342
Accounts receivable. 1,359
Inventories
2,756
Plant and equipment (net) 3,635



$ 8,092

Accounts payable
$ 512
Accrued expenses
340
Short-term bank loans. 2,626
Long-term Note payable. 1,512
Total liabilities.
4,990
Owners equity...
3,102

$ 8,092