1. Executive Summary
North Country Auto, Inc. was restructured by George Liddy so that each department will operate as an independent profit center. However, a recent new car purchase sparked friction and disagreements among division heads on setting of transfer prices and allocation of costs and profits. It was important that as one department aims to maximize profit, it does not negatively affect other departments. Issues that needed to be resolved include setting of transfer prices between departments, formalizing intercompany transactions, the divisional structure (use of profit or cost center), and the proper allocation of company profits among departments. After doing the analysis, it was decided that transfer price should be set at market price for New to Used Car department and Service to other departments, where as full cost plus mark-up to be used from Parts and Body Shop to other departments. Furthermore, it was determined that a better structure for the company would be for the New, Used, and Service departments to remain as profit centers, while the Parts and Body Shop department be changed to cost centers because the division managers did not have direct or influential control on the division's profit. The division managers' bonus scheme should also be revised so they can be measured in terms of variables which they have control over. For a profit center to be efficient and effective, it must be able to work autonomously without too much top level intervention.
2. Case Context
In 1988, George Liddy became part owner of North Country Auto, Inc. (NCAI) where all departments operated as part of one business. In 1989, he implemented a new control system to divisionalize each department into five separate profit centers. In evaluating bonuses of each division manager, gross profit was used to measure their performance. A recent new vehicle purchase highlighted some problems with the new structure, in terms of transfer price and allocation of costs. This sparked some controversy between departments and is an issue yet to be resolved.
3. Problem Definition
Should all departments be classified as profit centers?
What transfer pricing method should be used between each department to maintain overall company profitability?
What is the appropriate incentive scheme for the managers?
4. Framework for Analysis
1.Analyze each profit center. Use recent new car purchase to highlight problems, divisional managers' concerns, and exhibits provided. 2.Review transfer price between each division
3.Evaluate the bonus scheme of each responsibility centers
New Car Sales
The new car sales manager has control over the product mix and the authority to approve the selling price. With the current structure, he also had the authority to approve trade-in allowances on customer transactions.
Used Car Sales
The used car sales manager has control over product mix and the selling price of the used or trade-in cars.
The source of revenue for this department were warranty maintenance and repair work, non-warranty maintenance and repair work, used car reconditioning, and the oil change operation. There was no mark up for parts provided by this department to other departments. Warranty work is charged at a discount of as much as 20%, while non-warranty work provide higher margin. Its manpower is highly skilled to provide support for the dealership.
The demand for this department is almost completely from the other department of the company. Parts needed in warranty work were reimbursed at discount rates as much as 20% than price for non-warranty work.
The department could realize profits as high as 60% but due to rework and hidden damage beyond estimates decreases it to 40%. However this department is reporting a loss after allocation of fixed overhead due to an additional investment.