Clayton Bicycle Company

ACCT 501 Final Case Spring 2010

THIS CASE IS TO BE COMPLETED IN A PROFESSIONAL MANNER. THE FOLLOWING GUIDELINES WILL APPLY:

1. All materials should be typed (or electronic file suitable for email).

2. Clarity of expression and logical support for answers will be an important consideration in evaluating the papers.

3. Computations should be shown in a neat and orderly fashion. Separate schedules may be used to summarize computations, but they must be clearly referenced to the text in such a way as to improve readability and understanding.

4. STUDENTS ARE TO COMPLETE THIS ASSIGNMENT INDEPENDENTLY!

There should not be communication among other members of the class, or anyone else. Contact the instructor for clarification of the assignment or any related questions.

5. The completed case will be due NO LATER than 6:00 p.m. on May 5, 2010. Either hardcopy or email submissions will be accepted.

We will meet on May 5, 2010 to discuss the case. CLIFF TOP BICYCLE COMPANY

In May 1983, Suzanne Leister, marketing vice president of Cliff Top Bicycle Company, was mulling over the discussion she had the previous day with Foxy Slyman, a buyer from Wall Smart Stores, Inc. Wall Smart operated a chain of discount stores in various areas of the United States. Wall Smart’s sales volume had grown to the extent that it was beginning to add “house-brand” (also called “private-label”) merchandise to the product lines of several of its departments. Mr. Slyman, Wall Smart’s buyer for sporting goods, had approached Ms. Leister about the possibility of Cliff Top producing bicycles for Wall Smart. The bicycles would bear the name “Super Bullet,” which Wall Smart planned to use for all of its house-brand cycles.

Cliff Top had been making bicycles for almost 40 years. In 1983, the company’s line included 10 models, ranging from a small beginner’s model with training wheels to a deluxe 12-speed adult’s model. Sales were currently at an annual rate of about $10 million. The company’s 1982 financial statements appear in Exhibit 1. Most of Cliff Top’s sales were through independently owned retailers (toy stores, hardware stores, sporting goods stores) and bicycle shops. Cliff Top had never before distributed its products through discount store chains of any type. Ms. Leister felt that Cliff Top bicycles had the image of being above average in quality and price, but not a “top-of-the-line” product.

Wall Smart’s proposal to Cliff Top had features that made it quite different from Cliff Top’s normal way of doing business. First, it was very important to Wall Smart to have ready access to a large inventory of bicycles, because Wall Smart had great difficulty in predicting bicycle sales, both by store and by month. Wall Smart wanted to carry these inventories in its regional warehouses, but did not want title on a bicycle to pass from Cliff Top to Wall Smart until the bicycle was shipped from one of its regional warehouses to a specific Wall Smart store. At that point, Wall Smart would regard the bicycle as having been purchased from Cliff Top, and would pay for it within 30 days. However, Wall Smart would agree to take title to any bicycle that had been in one of its warehouses for three months, again paying for it within 30 days. Mr. Slyman estimated that on average, a finished bike would remain in a Wall Smart warehouse for 2 months.

Second, Wall Smart wanted to sell its Super Bullet 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 Super Bullet bike sales would take away from the sales of the name-brand bikes carried by Wall Smart. Thus, Wall Smart wanted to purchase bikes from Cliff Top at lower prices than the wholesale prices of comparable bikes sold through Cliff Top’s usual channels.

Finally, Wall Smart wanted the Super Bullet bike to be somewhat different in appearance from Cliff Top’s other bikes. While the frame and mechanical components could be the same as used on current Cliff Top models, the fenders, seats, and handlebars would have to have the name Super Bullet molded into their sidewalls. Also, the bicycles would have to be packed in boxes printed with Wall Smart and Super Bullet names. These requirements were expected by Ms. Leister to increase Cliff Top’s purchasing, inventorying, and production costs over and above the added costs that would be incurred for a comparable increase in volume for Cliff Top’s regular products. 4

On the positive side, Ms. Leister was acutely aware that the bicycle boom had flattened out, and this plus a poor economy had caused Cliff Top’s sales volume to fall the past two years.* As a result, Cliff Top currently was operating its plant at about 75 percent of one-shift capacity. Thus, the added volume from Wall Smart’s purchases could possibly be very attractive. If agreement could be reached on prices, Wall Smart would sign a contract guaranteeing to Cliff Top that Wall Smart would buy its house-brand bicycles only from Cliff Top 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 Leister realized she needed to do some preliminary financial analysis of this proposal before having any further discussions with Foxy Slyman. She had written on a pad the information she had gathered to use in her initial analysis; this information is shown in Exhibit 2.

*Note: The American bicycle industry had become very volatile in recent years. From 1967 through 1970 sales averaged about 7 million units a year. By 1973 the total was up to a record 15 million units. By 1975 volume was back down to 7.5 million units. By 1982 volume was back up to 10 million units, still well below the peak years. 5

EXHIBIT 1

Financial Statements (thousands of dollars)

Cliff Top COMPANY

Balance Sheet

As of December 31, 1982

Cash 342 Accounts payable 512

Accounts receivable 1,359 Accrued expenses 340

Inventories 2,756 Short-term bank loans 2,626

Plant & Equipment (net) 3,635 Long-term note payable 1,512

Total liabilities 4,990

Owners’ equity 3,102

8,092 8,092

Cliff Top COMPANY

Income Statement

For the Year Ended, December 31, 1982

Sales revenues 10,872

Cost of goods sold 8,043

Gross margin 2,829 6

Selling & admin exp.* 2,354

Income before taxes 475

Income tax expense 190

Net income 285

NOTE: *Total fixed selling & administrative expenses were $2 million. All variable selling and administrative costs are related to shipping. No significant change in these behavior patterns is anticipated for future years. 7

EXHIBIT 2

1. Estimated first-year costs of producing Super Bullet bicycles (average unit costs, assuming a constant mix of models)

Materials 39.80 *

Labor (assume variable) 19.60

Manufacturing overhead 20.00 **

NOTES: * Does not include preparing materials specific to models for Wall Smart, our production manager estimates this additional cost would be $4.25 per unit.

** The accountant (such a sweet lady) provided this manufacturing overhead rate, which was the same one used last year (based on a “normal volume” of 100,000 units). Her estimate is that 60 percent of total manufacturing overhead cost is fixed. She believes that manufacturing overhead cost behavior patterns will remain the same as in 1982 (per unit variable manufacturing overhead and total fixed manufacturing overhead will not change).

2. Unit price and annual volume: Wall Smart estimates it will need 24,000 bikes a year and proposes to pay us (based on the assumed mix of models) an average of $92.00 per bike for the first year. The contract would 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 $92.00 and the cost figures are in effect, “constant dollar” amounts. Slyman intimated that there was very little, if any, negotiating leeway in the proposed price. Ms. Leister is aware that Wall Smart normally takes a very aggressive position on terms with its suppliers. 8

3. After-tax asset-related costs: The firm estimates that incremental out-of-pocket interest costs related to increased investment in receivables or inventories will be 10% (based on the average asset values) 9

EXHIBIT 2 (Continued)

4. Assumptions for added inventories and receivables related to Super Bullet (average over the year):

Finished goods: 1,500 bikes (awaiting next shipment to Wall Smart warehouses) plus the amount in Wall Smart warehouses

Cliff Top will pay for shipping items to Wall Smart’s warehouses, and the variable shipping costs behavior pattern is assumed to be the same as 1982.

5. Impact on our regular sales (analysis from Leister):

Some customers comparison shop for bikes, and many of them are likely to recognize a Super Bullet bike as a good value when compared with a similar bike (either ours or a competitor’s) at a higher price in a non-chain toy or bicycle store. In 1982, 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 Wall Smart deal. If we accept it, I think we’ll lose about 8,000 units of our regular sales volume a year, since our retail distribution is quite strong in Wall Smart’s market regions. This estimate does not include the possibility that a few of our current dealers might drop our line completely if they find out we’re making bikes for Wall Smart. 10

REQUIRED: Answer the following questions (showing all computations in an orderly fashion and presenting conclusions in a logical and effective manner):

Due to recent changes, the income tax rate should be 30% for the next three years.

1. In the first year of the contract, what would be the TOTAL INCREMENTAL impact on net income of adding the Super Bullet line? Be sure to consider ALL relevant items for which you have information! This requirement does not mean specifically 1983 – do not try to “fine-tune” this answer to a certain number of months in 1983! Simply calculate the impact for the first full twelve months of the deal! For this initial requirement, you should stay within the assumptions given in the case.

YOU SHOULD NOT PRESENT A TOTAL INCOME STATEMENT (combining the Super Bullet line with our current lines)!! ONLY PRESENT THE INCREMENTAL IMPACT OF THE SUPER BULLET!!!!!!

Hint: You may find it easier to initially compute some of the items regarding the Super Bullet on a per-unit basis and then move to totals where that approach is simpler.

2. Are there aspects of Wall Smart’s offer which cause you particular concern? List and explain (be as specific as possible). What additional information would you like to have before making this decision?

3. What are the strategic RISKS and REWARDS of adding the Super Bullet line? Be as specific as possible!

4. Should Cliff Top Company accept the Super Bullet business assuming Wall Smart is unwilling to 11

make changes in their conditions? Why? Be specific - I want a YES or NO answer with a

CAREFUL EXPLANATION OF YOUR REASONING!

5. Independent of your answer to Question 4, what other strategic issues face Cliff Top

Bicycle Company? What alternatives might they consider to the Wall

Smart proposal?

If you anticipate significant changes in Cliff Top’s operations, how might some of the strategic management and accounting techniques discussed during the latter part of the class be useful?