Going Postal: Analyzing Operating Income of the Wheels of Fortune
The Decision
It was a beautiful Saturday morning as Lance completed his ride in the hill country of central Texas. During his ride Lance thought, “What has caused the operating income of Wheels of Fortune to decline so drastically over the last year?” He was concerned that if the trend persisted, Wheels of Fortune, the bicycle assembly and wholesale company he started ten years ago, would cease to exist.
From the beginning, Wheels of Fortune was Lance’s brainchild. At forty, after surviving a significant health scare, Lance realized his professional cycling career was nearing an end. Yet, he wanted to stay connected to the cycling community he so dearly loved. He reasoned his years of professional cycling experience for the Postal team and firsthand knowledge of the deficiencies in existing bicycle technology uniquely qualified him to build a better bicycle.
During a ride after another grueling season, Lance mentioned his idea for Wheels of Fortune to his long-time training partners and best friends, Tyler and Sam. “Last week, after Sheryl told me she is expecting our first child and I decided to retire.”
Tyler a bit surprised asked, “I knew you were tiring of the professional circuit, but I didn’t think you were ready to retire. What’s next for you?”
Lance replied, “I’m going to start a bicycle company called Wheels of Fortune. The company will assemble bicycles to order from retailers. I know it is sudden, but I would like for you and Sam to be my partners. With your knowledge of bicycle assembly and technology, Sam’s accounting and procurement acumen, and my sales and marketing appeal, we would form an unbeatable team just like we did on the circuit.”
The Challenge
“Who called this meeting?” a slightly annoyed Tyler queried.
“I did,” Lance replied. “My apologies, I know how much we all hate meetings, but it could not be helped. Our operating income decreased drastically in the last year. At this rate, we won’t be in business much longer if we can’t figure out what happened. I asked Sam to generate a comparison of operating income for the past two years.”
Sam explained, “Our operating income decreased over $4 million in just one year even though we sold the same number of bicycles. Over the same period, our contribution margin per bicycle decreased by almost a $1,000. While the average variable cost per bicycle decreased significantly, it was not enough to offset the decrease in our average selling price per bicycle.”
Lance interrupted, “We have always sold professional bicycles for $5,500 and Novice for $1,000. How is it possible for our average sales price to decrease so drastically in one year without a price reduction?”
Sam replied, “That’s an excellent question and I thought the same. Our accounting records show that, while we continue to produce and sell at capacity of 4,500 bicycles, our sales mix shifted drastically. In prior years, 70 percent of total sales were generated from Professional bicycles. However, this year, 70 percent of sales are coming from Novice bicycles. The demand for Professional bicycles has decreased with a corresponding for Novice models.”
“We’ve been assembling the same top-of-the-line Professional bicycle for ten years. How is it possible that sales shifted so drastically?” Tyler asked.
Sam suggested somewhat sarcastically, “Perhaps, our Professional bicycles are no longer considered top-of-the-line.”
Lance sensing Tyler was a little put off chimed in, “So you are saying the shift in sales mix is the reason for our decreased operating income?”
“You are partially correct. The shift in sales mix impacted our average selling price. However, other factors contributed to the decrease in our operating income and need to be quantified. Specifically, we need to analyze our variable manufacturing and fixed selling and general administration costs,” Sam appraised.
“Okay. So, you are suggesting we have the data to analyze those costs?” Tyler asked hopefully.
“Yes; however, analyzing our variable manufacturing costs is much more complex than analyzing sales. We need to begin by comparing our expected or standard costs to assemble a bicycle with the actual cost to calculate manufacturing variances. Analyzing manufacturing variances will provide insight about spending and the efficiency of our assembly process,” Sam explained. “When we started the company, we used the following assumptions to generate standard costs and establish selling prices.”
“So, the direct labor and variable overhead costs are the expected conversion costs to assemble the bicycle kits (direct materials) into a bicycle?” Tyler asked.
Sam replied, “Correct. You will notice the direct labor to assemble Professional bicycles is more than double Novice bicycles. Because the frames and parts are so expensive on Professional bicycles, we decided to assign our most experienced assemblers to that department. In addition, as sales of our Novice bicycles increased, we were forced to transfer idle Professional assemblers to the Novice line to keep up with demand.”
Tyler added, “This is the first I’ve seen this. I am not certain how those changes impact our direct labor costs.”
“Calculating manufacturing variances can help us determine the dollar impact of those changes and others have on our variable manufacturing costs,” Sam affirmed, “I summarized the relevant direct material, direct labor, and variable manufacturing overhead costs in this table. The table shows the actual number of bicycle kits, direct labor hours, and variable overhead costs incurred to assemble 4,500 bicycles last year.”
After reviewing the information, Tyler replied, “It appears you have been keeping track of our actual costs for some time. How come we never calculated manufacturing variances before?”
Sam responded, “There was no need. For the first nine years of Wheels of Fortune, the company consistently generated $6 million in operating income. However, now we need to analyze everything including the $150,000 in raises we gave ourselves last year.”
A concerned Lance asked Sam, “Can you analyze our operating income, so we can make changes? If the trend continues, I might need to be forced to go back to the Postal team and I’m too old and out of shape for that.”
Sam enthusiastically replied, “Absolutely.”
Case Questions: Prepare your responses to the following the case questions as if you were Sam, the accountant for Wheels of Fortune.
1. Think about your initial observations of the potential causes of the decrease in operating income from 2016 to 2017.
2. Impact on operating income: Calculate the following to quantify the impact on decrease in operating incoming from 2016 to 2017 for Wheels of Fortune.
a. Standard variable cost and contribution margin per bicycle (percent & dollars): Utilizing the standard cost components and the selling price per bicycle, calculate the standard variable cost and contribution margin per bicycle at standard.
b. Sales mix impact: Analyze the impact of the shift in sales mix by determining the sales mix variance between 2016 and 2017.
c. Manufacturing variance impact for 2017 only: Calculate the following:
i. Total direct materials cost variance (price + usage/efficiency). DM price variance = variance between standard and actual * DM used and DM efficiency = excess used * standard cost
ii. Total direct labor (rate & efficiency). DL rate = variance in rate * actual DL hours and DL efficiency = DL std. rate * DL hours variance * # of bikes produced
iii. Total variable overhead variance = OH variance between std. & actual * # of bikes
d. Selling and general administration impact: Calculate and analyze the increase in selling and administration costs on Wheels of Fortune 2017 operating income.
e. Operating income reconciliation: Utilizing the operating income reconciliation from 2016 to 2017, check your calculations from items b-d above for accuracy before completing #2.
3. Recommendations: Based on your financial analysis, generate a professional memo to the partners with your short (less than a year) and long-term (up to five years) recommendations on how to improve the company’s operating income integrating information from the schedules you created. A reader with limited financial expertise (e.g. Lance) should be able to comprehend your analysis and associated recommendations.
Table TN-1: Comparative operating income statement
Table TN-2: Summary of standard costs
Table TN-3: Summary of 2017 actual costs
3
2017
Bicycle Kit:
Used1,400
Price per kit3,200$
Direct labor hours15,525
Direct labor rate per hour44$
Variable overhead per bicycle180$
2017
Bicycle Kit:
Used3,200
Price per kit690$
Direct labor hours20,790
Direct labor rate per hour38$
Variable overhead per bicycle65$
Wheels of Fortune
Summary of Actual Costs
Professional
Novice
Difference
Operating Income 20165,757,000$
Total Sales Mix Variance (from 2b)(3,204,000)
Manufacturing Variances:
Direct Materials Variance (from 2c)
Price(568,000)$
Efficiency(180,000)
Direct Labor Variance (from 2c)
Rate(228,420)
Efficiency(137,700)
Variable Overhead Variance (from 2c)
Spending(87,750)
Total Manufacturing Variances(1,201,870)$
Selling & General Administration (from 2d)(150,000)
Operating Income 20171,201,130$
Wheels of Fortune
Income Reconciliation
2016 to 2017
ProfessionalNovice
3,000$ 600$
10 6
40$ 30$
150$ 50$
Summary of Standard Costs
Wheels of Fortune
Summary of Standard Costs
Bicycle Kit per unit
Direct labor hours per bicycle
Variable overhead rate per bicycle
Direct labor rate per hour
