Business Project Management – Internal divisions

Please refer to the attached word document. Please prepare a report justifying all your calculations. Please share the calculations as well.

Rita returned to her office and, after a lot of thought, identified the following six crucial issues that required attention:

1. continue/discontinue production of RX-100s
2. keep/drop the Appliance Division
3. keep/drop the Appliance Division’s sales outlets
4. transfer pricing
5. the capital investment to increase RX-100 production capacity
6. the system of management planning, reporting, motivation/evaluation, and decision making.

REQUIRED:As Rita Smart, draft a report to John Big, incorporating the six issues identified above together with any other issues which you consider relevant.

John Big, the president of Cedar Electronics Limited (CEL), is troubled that the recently acquired Appliance Division has been incurring large losses, and John is seeking advice on the division.

CEL is a large, widely held Canadian corporation that has specialized in the design and manufacture of electronic devices.  One particularly successful product developed was the RX-100, an electronic processor, designed to replace mechanical switching devices.  The RX-100 was an instant success in the appliance industry but, within a year, competing products were rapidly replacing the RX-100.  In 2006, CEL had acquired Domino Appliances Limited (DAL) to give CEL a captive market and a base for developing new devices.

At the time DAL was acquired, John restructured CEL into three divisions – Electronics, Appliance (formerly DAL), and RD&I (Research, Development & Inspection) – each of which was designed to be an investment center.  Division managers were free to sell externally but were expected to supply, source, and service internally.  About 12% of the Electronics Division’s sales were comprised of RX-100s transferred to the Appliance Division at full cost plus 10%.  The RD&I Division sold a production quality control service, on contract, to the other divisions at variable cost plus 10%, and also contracted externally.  RD&I was given a budget appropriation, for researching new products, which was not included in the calculation of its ROI.

John Big’s objective in decentralizing the corporate structure was to make each division operate and be evaluated as if it were an independent business.  Corporate overhead was allocated to the divisions on the basis of a percentage of sales.  The division managers were each allowed to make annual investments of not more than 5% of their divisional net assets on their own authority.  CEL’s after-tax cost of capital was estimated to be 10%.  Division managers were expected to earn 10% (before taxes) on their investment base, calculated on the book value of their current assets plus the net book value of their fixed assets.

John has called in Rita Smart, an external management consultant, for advice:

John:  Thank you for coming.  There are some developments in our organization which disturb me and need attention.  While CEL’s 2008 results show a profit, the Appliance Division shows a loss (Exhibit 1).  Bill Jones, the Appliance Division manager, claims that the RX-100s are a major problem and that, if he could source these externally, his divisional operating results would be greatly improved.  As it is, our appliances are over-priced and we are unable to keep our sales outlet managers because they feel the performance target of achieving a 5% profit on sales in unreasonable (Exhibit 2).

Rita:  The concept behind the decentralized structure, which we helped you introduce in 2006, was that each division would operate as an investment center and so maximize the divisional and corporate profits.  Since one of your objectives in purchasing the Appliance Division was to acquire the twenty-odd appliance sales outlets, it was also decided that these outlets should be managed as profit centres.

John:  Two problems have arisen here.  First, the prime objective in acquiring the Appliance Division was to establish a protected market for the RX-100 and for any subsequently patented in-house developed devices.  Bill Jones, the Appliance Division manager, uses every excuse to source RX-100s externally (Exhibit 3).  Second, our total appliance sales are just not of sufficient volume to provide enough throughput to make the sales outlets economically viable.  We may have to close some or all of them.

Rita:  How would you then market the division’s product?

John:  That is the problem.  To add to this problem, Tom Smith, the manager of the Electronics Division, has decided to make a capital investment to increase RX-100 production capacity (Exhibit 4).  I may have not only to step in and block this investment, but also enforce the internal sourcing rule.

Rita:  Strictly speaking, you should not involve yourself in investment center decisions as long as the division’s ROI is on target.

John:  Well, I would like your advice on these matters.  Remember that my prime responsibility is the bottom line of the income statement!

Rita returned to her office and, after a lot of thought, identified the following six crucial issues that required attention:

1. continue/discontinue production of RX-100s
2. keep/drop the Appliance Division
3. keep/drop the Appliance Division’s sales outlets
4. transfer pricing
5. the capital investment to increase RX-100 production capacity
6. the system of management planning, reporting, motivation/evaluation, and decision making.

REQUIRED:

As Rita Smart, draft a report to John Big, incorporating the six issues identified above together with any other issues which you consider relevant.

Please see notes on the next page.

Notes:

• The operating results of RX-100 sales to the Appliance Division were included at Mr. Big’s request.
• Appliance Division sales and selling expenses relate directly to the sales outlets. Cost of sales represent the manufacturing department costs.  Administration and corporate overhead represent overall division charges.
• All inter-divisional sales from the Electronics Division to the Appliance Division were priced at full cost plus 10%. The transfer price of RX-100’s to the Appliance Division was $9.90 per unit.  Internal sales of the production quality control service from the RD & I Division were prices at variable cost plus 10%.
• The operating costs were all at standard cost with the annual aggregate variance expensed at year-end.
• The effective tax rate was abnormally low due to RD & I write-offs and loss carry-forwards. The incremental tax rate is 40%.

EXIBIT 3

CEDAR ELECTRONICS LIMITED

MEMO FRO APPLIANCE DIVISION GENERAL MANAGER TO PRESIDENT

FROM:            Bill Jones

TO:                  John Big

DATE:            January 4, 2009

SUBJECT:      Explanation of external sourcing of RX-100s

During 2008, approximately 23% of our annual RX-100 requirement was sourced externally.  The reasons for external sourcing were as follows:

1. Insufficient internal production capacity to fulfill all our needs.

1. Inability of the Electronics Division to service rush orders on time.

1. Avoidance of undue delays arising from quality control problems with internally sourced RX-100s.

It should also be pointed out that equivalent products can be sourced externally at considerably lower cost:

If I could source all my division’s requirement of RX-100s externally, we could eliminate most of our loss.

Bill Jones

EXHIBIT 4

CEDAR ELECTRONICS LIMITED

MEMO FROM ELECTRONICS DIVISION MANAGER TO PRESIDENT

FROM:            Tom Smith

TO:                  John Big

DATE:            January 8, 2009

SUBJECT:      Capital Investment

Currently, my department has an annual RX-100 production capacity of 5,500,000 units which represents only about 85% of the Appliance Division’s annual requirement of RX-100.  Because Bill Jones claims that we cannot service his orders on time, he has sourced RX-100s externally.  This resulted in my department having a 500,000 unit surplus of RX-100s which were sold on the external market at a price of $9.00.

In order to solve the problems of under capacity and late delivery, I have decided to purchase a new specially designed machine which will be able to produce 1,500,00 units of RX-100s, expanding our total capacity of 7,000,00 units.  Units produced by the new machine will not require the quality control services of the RD & I Division.  We will be able to fill all of the Appliance Division’s requirements on a timely basis and still sell 500,000 units to external customers each year.

The ROI resulting from this $15,000,000 investment will be 19.7% as calculated below:

*$15,000,000 / (1,500,000 units x 7 years) = $1.43

Additional profit = 1,500,000 ✕ $1.97 = $2,955,000

The new machine should last about 7 years, by which time the RX-100 will be obsolete.  (Note:  The machine will be subject to a special CCA rate of 50% on the straight-line basis.)

Tom Smith