02 May ANADIAN MOTORS INTERNATIONAL
ANADIAN MOTORS INTERNATIONAL
Canadian Motors International (CMI) is an international organization that is organized into three divisions. Each is treated as a profit center. Divisional performance evaluation and managerial bonuses are based on achieving a 12% return on investment (ROI) calculated as a pretax divisional income divided by the divisional investment. CMI organizational structure is shown in Exhibit 1.
Paul Singer, President of CMI, is very concerned about both divisional and overall corporate performance of 2017. The following is a summary of discussion among senior management team of CMI.
Paul Singer: (President) “We are now an international organization and I am not sure what is going on in all the divisions. The performance of Engineering Division is of concern to me”. (Exhibit 2)
Erin Hunter: (Corporate Controller) “But Paul, you had laid out some ground rules for the divisional managers to work within. I heard you say this morning that they are all supposed to act as independent business units and maximize divisional profits. Some of the financial policies do not give me the impression that they have autonomy to act as an independent profit centre”.
Paul Singer: “In the interest of CMI, I have instructed the divisional vice-presidents to buy and sell from each other as much as possible and that the price of transfer would be 1.25 times the full production costs. Every time I turn around, all I seem to hear are the complaints from the vice presidents that there is no fairness in terms of prices charged by one division to the other”. I also keep hearing about the new approach – Economic Value Add (EVA) – to sustainability. Perhaps, we should start to incorporate this measurement as well at CMI.
Background
Engineering Division (ED – Kevin Brenner) of CMI manufactures standard carburetor engines and Fuel Injected engines. The manufacturing process involves product design, machining of parts, assembly and quality assurance.ED has developed a strong reputation in the industry for its product quality and offers guarantee of complete customer satisfaction. Lately though, the CMI corporate has expressed concerns about their inability to meet the target of 12% ROI. The corporate tax rate in Canada for CMI is 40%. Although autonomous, and the demand for these carburetors exist in the open market, the carburetors produced in ED are sold to the Snowmobile Division (SD) of CMI.
The manufacturing information for the engines is also given in Exhibit 2. The manager of ED, Kevin Brenner, has been complaining that his division’s ROI is decreasing due to its sale to SD at a specified price. He has argued with Paul Singer that the price his engine should be increased to $500, which is the market price for such an engine. Kevin Brenner has threatened to stop producing altogether the carburetor engines as he can use the capacity to produce the Fuel Injected engines and sell them in open market at the going price of $600 per engine. The only restriction facing ED is that it has a total capacity of 200,000 machine hours per year to produce a combination of the two engines it produces.
Snowmobile Division (Brian Thompson – SD) manufactures snowmobiles valued for their durability and overall good performance. The profitability information for SD is given in Exhibit 3. Presently, SD buys its entire carburetor engine from ED for the production of snowmobiles. Paul Singer is pleased with the performance of SD as the sales and profit s continue to increase. Paul knew from Brian Thompson, the impact of raising the price of carburetor to $500.Brian indicated that the sale of snowmobile is very price sensitive this proposal would necessitate an increase in price of snowmobiles to $3,400. This would cause the domestic sales volume to fall to 3,500 units a year.
In addition, Brian has also been complaining about the decreasing level of service from ED to SD causing delays in production as well as final delivery to the clients. If improvements and cooperation were not to come there will be a definite loss of sales.
International Division (Erika Johanson – ID) of CMI is located in Sweden with a corporate tax rate at 30%. Erika Johanson stationed at Stockholm is the vice-president of this division. The mandate for ID is to customize and sell the snowmobile imported from Canada in Europe. ID pays a 20% duty based on the transfer price from SD. Custom officials in Sweden carefully monitor the invoices of imported manufactured goods to ensure that the products are transferred at “fair values”. The government of Sweden considers any price between full production costs and 150% of full production costs to be within the definition of fair value. Information on ID performance is given in Exhibit 4.
ID is only two years old but it has already gained a significant market share in Sweden by following a penetration pricing strategy. All indications are that sales would continue to grow with possible expansion into other European countries. Erika indicated to Paul Singer that the proposed increase from SD would lead to an increase in snowmobile price by $300 per unit. This in turn would cause the sales volume drop to 1,700 units per year.
At the end of the meeting Paul Singer requested Erin Hunter to analyze the company’s current situation, including the ED manager’s two proposals, and recommend improvements.
Erin noted that she needed to address at least the following issues:• Impact of each proposal (price increase to $500 and the stopping the production of Carburetor) on return on investment (ROI)• Some of the behavioural implications of these proposals for the divisions and CMI• Setting up proper Transfer Pricing policies going forward.• Organizational changes with Paul that may promote goal congruence.• Overall Performance evaluation, including EVA and bonus system
Required:
Take the role of Erin Hunter and prepare a formal report to Paul Singer to address all of the issues and any others that you feel are relevant to the case.
Exhibit 1
Canadian Motors InternationalCMIC
Carburetors & Fuel SnowmobilesInjected Engines In Canada in Canada in Sweden & EuropeExhibit 2Engine Division
Carburetor Fuel Injected Total ED
Unit Price Volume Unit Price Volume TotalVolume (Units) 6,000 22,000 28,000
Revenue (Million) $400 $2,400 $600 $13,200 $15,600Direct Costs:Materials 150 900 135 2,970 3,870Labour 70 420 90 1,980 2,400Production Overheads:– Variable 45 270 25 550 820– Fixed 55 330 72 1,584 1,914Variable S & Admin 10 60 37 814 874
Total Direct Costs $330 $1,980 $ 359 $7,898 $ 9.878Fixed S & Admin 4,733Total Costs $14,611Pre-tax Divisional Income $ 989
Machine Hours 4 24,000 8 176,000 200,000
Divisional Investment $11,696Divisional ROI 8.5%Exhibit 3Snowmobile Division
Per Unit Volume Total (1,000)
Sales: Domestic $3,300 4,000 $13,200Sales: Transfer to ID: $3,610 2,000 7,220Total Sales: 6,000 $20,420Direct Materials (Note 1) $1,300 6,000 7,800Direct Labour 1,200 6,000 7,200Variable Production Overhead 100 6,000 600Fixed Production Overhead 288 6,000 1,728Selling & Administrative:Variable 52 6,000 312Fixed 361 6,000 2,166Total Costs $3,301 $ 19,806Pre-tax Divisional Income $ 614
Divisional Investment 4,083Divisional ROI 15.0%
Note. 1 Includes engine at $ 400/unit from the ED
Exhibit 4International Division(Canadian Dollars)
Per Unit Total (1,000)Volume 2,000
Revenue $ 4,700 $9,400Cost of Snowmobile (Note 1) 4,332 8,664Gross Margin $ 368 $ 736
Selling & Admin Costs:Variable 47 94Fixed 86 172$ 133 $ 266Pre-tax Divisional Income $ 235 $ 470
Divisional Investment $ 2,379
Divisional ROI 19.5%
Note 1. As acquired from snowmobile at 125% of full production costs (rounded to the nearest dollar) plus 20% import duty on goods imported into Sweden.
Further assumption:Cost of capital adjusted for risks = 12%
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