Case Study:
After a very successful career as a professional cyclist, James was forced to retire after recovering from a major health scare. Even though his health was compromised, James’ passion for staying connected with the professional cycling community was still strong. So, he decided to establish BRU to leverage his professional cycling network as well as his firsthand knowledge of the deficiencies in existing bicycle technology. Along with his two long-time training partners, John and Marie, James established BRU. The team was formidable with James responsible for sales and marketing, John handled bicycle assembly and operations, and Marie managed accounting and procurement.
BRU sold types of bicycles sold at high-end [bicycle] shops across the United States: ProRyder and RecRyder. ProRyder bicycles were targeted towards professional or serious cycling enthusiasts. RecRyder bicycles were geared towards recreational or novice cyclists. As evident in BRU’s branding strategy, recognition of James’ name drove the brand’s equity and to some extent, the company’s equity as well.
When James and his partners formed BRU ten years ago, they decided to restrict sales to 5,000 bicycles per year to enhance brand appeal, ensure quality and control growth. They also established fixed selling prices for ProRyder at $5,000 and RecRyder at $900. The price structure has remained the same year after year. The team also agreed to spend $1M in marketing per year to build BRU and sustain the Ryder brand.
As it turned out, BRU became they successful in the first five years of operations generating $3.7M in operating income annually. As a result, the three owners diverted some funds earmarked for marketing to reward themselves with a $600,000 raise. Despite the reduction in the marketing budget, BRU continued to generate consistent operating income until last year when it declined to $.4M even though the company continued to sell 5,000 bicycles.
The Rude Awakening
Late on a Sunday night, James sent a text to his partners to convene a meeting early Monday morning. To convey a sense of urgency, the text simply stated, “URGENT: Operating income down!”
When John arrived, he noticed James and Marie sitting in John’s office. So, he walked over to them and shut the office door. John, with a hint of irritation in his voice blurted out, “What’s going on, James? The text you sent sounded ominous.”
Undeterred James replied, “When sales decrease $8.2 million, and operating income is perilously close to breakeven, then I would say that’s urgent!”
“John, here is a copy of the comparative operating income statement I sent to James last night. In every measure, our financial performance is down,” Marie chimed in.
John commented, “How is that possible? We are selling the exact same number of bicycles at the same prices. Are we missing some sales?”
Marie responded, “Unfortunately, I wish that were the case, but it’s not. We sold exactly 5,000 bicycles this year. The issue is that we sold significantly more RecRyders that generate less contribution margin than ProRyders. This year, 70% of our sales were RecRyders. In the past, it was about 30%. And don’t forget, hourly wages for ProRyder assemblers is much higher than those assembling RecRyders.”
“I suspected that we were assembling more RecRyders this year than normal, but I had no idea the shift was so dramatic.” Addressing James, John asked, “Did something change last year in the bicycle market that you missed?”
James, a little embarrassed by John’s insinuation that he might have missed something in the market admitted, “Yes, something did change in the market. Mario Prince, the five-time Tour de Europa champion introduced Champion bicycles.”
“Wow, really?” It appeared that John was not aware that there was a new competitor in the marketplace.
“James, what impact do you think Champion had on our ProRyder sales last year?” Marie, ever the accountant, asked.
“I really don’t know. Last week was the first time I saw a Champion bicycle in person. From what I can tell, it is not significantly different from our ProRyder, but I am not certain,” James indicated.
A little agitated John piped in, “If we don’t figure out why no one is buying our ProRyders before next season, we will be out of business in three years!”
“Marie do you have any other information that might help us understand what happened?” James queried.
She handed a packet to her partners. “I generated three additional schedules: an operating income reconciliation between 2017 and 2018, variable standard cost and contribution margin by bicycle, and a summary of manufacturing variances by bicycle type. Maybe these figures can help us.”
James and John took several minutes to examine the packet. Then John said, “Thanks Marie. I think we all need a little more time to analyze all this information and our predicament."
“I agree. I think we should go back to our teams and scrutinize the tables Marie has provided. The state of our business has to be our #1 priority!” James said emphatically.
“So, let’s convene a week from today with several courses of actions?” Marie suggested.
“Sure, let’s regroup and comeback with ideas to how we can turn BRU around.” John agreed.
James stared at both John and Marie. After a long pause he said, “Hey, we can do this! We need to dig deep and be more aggressive. Remember, we are and always will be the formidable threesome!”
With James’ last comment, all three smiled. Then, Marie and John gathered their papers, stood up and left John’s office.
Meanwhile, James’ sat back, opened an issue of Bicycle Weekly and started to read the lead article on Mario Prince.
Q1 - Provide three possible courses of action or recommendations for BRU.
1st method:
The Indirect Method
The less common direct method requires building a cash flow statement from the ground up, using data from potentially thousands of individual transactions, although it's often difficult to gather data in this manner. Conversely, the indirect method uses information from the company's income statement and balance sheet, making the cash flow statement preparation a simple exercise.
For the indirect method, start your reconciliation with your company's net income, or profit, for the desired time period. Unlike the cumulative nature of the income statement numbers, the balance sheet works like a snapshot, showing data at a certain point in time. For this reason, you'll need two balance sheets, such as two consecutive monthly versions, because it is the changes in the balance sheet accounts that represent the amounts that have been adjusted.
Making the Adjustments
You'll need to make three types of adjustments to reach the operating cash flow.
Add or Subtract Noncash Items
In accrual accounting, some items change profits, but don't have any effect on cash flow. Reconciling net income to operating cash flow involves adding or subtracting these noncash items. To get started, enter all of the noncash expenses shown on the income statement during the given reporting period into your cash flow adjustment calculation. Depreciation and amortization are the most common examples, and these income statement expenses reduce net income but have no effect on cash flow, so they must be added back.
Factor in Current Assets
Opposite of the noncash items, certain current assets affect your company's actual cash flow but don't affect your income statement profit. They include inventory, accounts receivable and prepaid expenses. When a current asset increases, it reduces your operating cash flow in relation to net income. For example, if you have an item in inventory, that means you've laid out cash for it. But because of accrual accounting rules, if you haven't sold it yet, you can't report its cost as an expense, and therefore, its cost hasn't yet reduced net income.
This represents an accounting timing difference and needs to be factored into your reconciliation. For each category of current assets except cash, take the account balance from the balance sheet at the beginning of your given period and the same figure from the balance sheet at the end period. Subtract the beginning figure from the ending figure to get the period change for that particular current asset. Do this for all categories of current assets, and record these differences in your reconciliation calculation.
Calculate Current Liabilities
Current liabilities on the balance sheet include accounts payable and accrued expenses such as wages and rent. These accrued expenses have been incurred and reported, but the company has not yet paid out any cash. Current liabilities have the opposite effect on cash flow as that of current assets. When a current liability increases, such as accruing another week of wages owed, cash flow goes up, relative to net income.
For example, as workers earn wages, they report what they earn as an income statement expense, which reduces net income. But until you actually issue paychecks, their wages won't yet reduce cash flow. Calculate the period change in each category of current liabilities the same way you did for current assets, and add these results to your reconciliation.
The Final Reconciliation
If your company has any gains or losses coming from non-operating activities, you'll need to also factor these into your reconciliation. Look for gain or loss items on the income statement. Examples include charges related to discontinued operations, and any profit over book value from sales of non-inventory items, such as old equipment or office furniture. Take the appropriate figures from the income statement and add them to your reconciliation.
Start your reconciliation with net income at the top. Add back the total value of noncash expenses to your operating cash flow. Next, subtract the period change for each category of current assets. Then, add the period change in each category of current liabilities. Some of these period changes might be negative. Finally, add back any expenses related to non-operating activities, and subtract any income from non-operating activities.
Removing a negative charge increases your operating cash flow; adding a negative charge decreases your operating cash flow. Do the math to get to your reconciled cash flow from operations. If you add the two other sections of the cash flow statement, net cash flow from investment activities and net cash flow from financing activities, you'll have produced a complete cash flow statement.
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2nd method:
Control the Variable cost
Inventory: inventory cost should be maintained within a level
just to ensure the production. Over inventory levels can lead to
higher overhead costs and unnecessarily occupy much space from the
factory. This will, in turn, add to the variable cost and lower the
inventory turn over. So there should be continuous practice to
manage the production with the available inventory.
Forecast the requirement and arrange the inventory accordingly So
that the company doesn't pull extra items to inventory.
The total variable cost is simply the quantity of output multiplied by the variable cost per unit of output.
A company can increase its profits by decreasing its total costs. Since fixed costs are more challenging to bring down (for example, reducing rent may entail the company moving to a cheaper location), most businesses seek to reduce their variable costs. Thus, decreasing costs usually means decreasing variable costs.
A company that seeks to increase its profit by decreasing variable costs may need to cut down on fluctuating costs for raw materials, direct labor, and advertising. However, the cost cut should not affect product or service quality as this would have an adverse effect on sales. By reducing its variable costs, a business increases its gross profit margin or contribution margin.
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3rd method:
Contribution Margin=Gross Profit/ sales= (Sales−VC) / sales.
The contribution margin allows management to determine how much revenue and profit can be earned from each unit of product sold.
So if the variable costs are reduced marginally, then the CM will increase.
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