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Anthony/Hawkins/Merchant
balance sheet items, but the dealership general managers incentives do not seem to consider them. So is
the general manager an investment center manager?
Regarding performance measurement: The departments are profit centers, but not all costs are allocated
to them. They are more like gross profit centers. The salespeople are held accountable for gross profit
on the deals they initiate, so each salesperson is also a little profit center. The service advisors are paid on
commission, so each advisor is a revenue center. The service technicians, though, are paid for work
accomplished.
It is useful to discuss why some seemingly uncontrollable indirect costs are allocated to departments (see
Exhibit 3). These allocations are mandated by Toyota, so that they can compare dealership departments on
a common basis that treats each department more or less as a standalone business. Allocating the costs
also gives the department managers information as to what services are being provided for them, and it
gives them some power to complain if the size of the allocations becomes too high.
This issue can lead into a discussion of the differences between authority and responsibility
(accountability). Generally, managers are held accountable for results in areas where they have authority.
But here, the general sales managers bonuses are based on performance measured in terms of profit after
overhead allocations (line 59 in Exhibit 3). This is an example of a situation where this manager is held
accountable for areas over which he has less than full authority. Conversely, the service managers
bonuses are based on the departments gross profit performance, which is before allocations.
It is apparent in the case that some of the measures can be gamed. Puente Hills Toyota managers worry
about the gaming in the service area, and they seem to have adequate controls over these behaviors. The
Customer Satisfaction Index (CSI) measure is also gamed. But here the managers seem to encourage the
gaming because it makes the dealership look better to Toyota. Does the dealership need an un-gamed CSI
measure for its own management purposes? How will they get accurate information about problems if and
when they exist?
Transfer pricing of service jobs done for internal customers (particularly the used car department) is
done at market prices. The alternative would be to give the internal customer a discount, or perhaps even
to transfer at cost. What would happen under that alternative? It would shift profits from Service to Used
Cars. It would also provide little incentive for Service to do internal work. Puente Hills Toyota transfers at
market prices because they want to measure each department as a stand-alone business and they want to
have the Used Car Department get as much priority in the Service area as any other customer.
The measurement focus in this business is on profit measures. Do profit measures provide a good
indication of value creation in the car retailing business? The answer here is probably yes. This is
primarily a short-term business. Dealerships are not making many investments that involve large lags
between time of investment and payoff (e.g., R&D), and they are not creating many intangible assets. The
one exception is customer goodwill, so it is not surprising that Toyota mandates that considerable effort
also be devoted to the measurement of CSI.
Some useful class discussion can focus on the structure of the incentive plans. Depending on the focus of
the class and the class time available, the instructor can have the students complete an incentive plan
matrix. On a whiteboard, list any or all of the key incentive plan elements. With adequate time, I use the
following:
1. Who is included in the plan?
2. Form of payment
3. Frequency of payment
2007 McGraw-Hill/Irwin
4.
5.
6.
7.
8.
9.
Chapter 28
In an array of columns, list the roles for which the instructor wants to clarify the incentive system. These
might include the general manager, general sales manager, service manager, salespeople, service advisors,
service technicians.
Among other things, this analysis will show that:
The assignment question asks students for an evaluation of the system, which requires them to identify
good and bad points about it. In addition to the points raised above, they might mention the following:
(-) There are no deferred compensation elements that might provide retention and tax benefits.
(-) This is an incentive system that would require the company to pay sizable bonuses even if the
company is losing money.
(-) There is no bonus for teamwork. How much teamwork is necessary? The case mentions one area
that could be improvedservice referrals to sales.
(?) Is the company paying too much? Answering this question would require knowledge of industry
benchmarking. Some of these data are provided in the case Appendices. Puente Hills Toyotas
practices seem in line with other dealerships.
(?) The bonuses are all formula-based. Would it be useful to allow some subjectivity in case
unforeseen events unfold?
Generally, however, this measurement and incentive system probably must be considered as effective.
Much of this system is dictated by Toyota, and this is an industry and company that has refined its
systems over the years. And within the Toyota family, Puente Hills Toyota is a top performer.
Anthony/Hawkins/Merchant
Is construction of the new factory in the U.K. in the best interest of Axeon N.V.?
2.
Ignoring your answer to question 1, if the plant were not built and AR-42 was shipped
from the Netherlands to the U.K., what transfer price would be appropriate?
3.
Case Analysis
A. Product Sourcing Alternatives
Despite the existence of many relevant data in the case, the answer to the first assignment ques tion is not
an easy one. There are two alternatives for producing AR-42: U.K. and Netherlands.
The best place to start is with the discounted cash flow analysis, a summary of which is presented in
Exhibit 2 of the case. Case Exhibits 3 to 5 provide back-up detail. The analysis is straightforward, and it
presents no computational difficulties. The new-factory project shows a positive net present value using
an 8% rate, which seems to be the marginal borrowing rate for Hollandsworth in the U.K. And the project
shows a 15% IRR, which is above Axeons 12% hurdle rate. So, based on these analyses, the project
looks worthwhile.
Was there anything wrong with this initial analysis? The analysis looks sophisticated, and most students
will instantly empathize with Mr. Wallingford. However, criticisms can be made of his analysis:
1.
The end-of-project recovery value of equipment and working capital is a surrogate for
the cash flows after the end of seven years. It is likely that this is biased downward. Why would
all sales and profits stop after that date? Is there no learning that has come from this project?
Does the project have no option value?
2007 McGraw-Hill/Irwin
Chapter 28
2.
Wallingford might well have presented some sensitivity analyses, reflecting more
pessimistic forecasts. These might have headed off some of the criticism that came later from
Axeons director of sales.
3.
So we see in the case that the Dutch managers argue that producing the AR-42 in the Netherlands is an
even better alternative than that proposed by Mr. Wallingford. Some of their arguments question some of
the numbers in the Hollandsworth analysis. The Axeon director of sales (Mr. De Rijcke) questioned the
sales forecasts. But who understands the U.K. market better, the local general manager or the functional
specialist in a foreign country?
The Axeon director of manufacturing (Mr. Oosterling) questioned both the U.K. facilitys ability to handle
the manufacturing and the cost assumptions. Students should think about his statements regarding costs.
The fixed costs are already sunk, so they are not relevant to the analysis. The analysis of the variable costs
(as shown in Exhibit 6 of the case) is misleading. As shown in Exhibit-TN 1, an average variable cost of
1860 on the full 1000 tons of production implies an incremental variable cost of 1800 on the additional
400 tons for U.K. sales. This incremental variable cost is the relevant cost when comparing the two
investment proposals. So Mr. Oosterling has overstated his case.
Next, the instructor can turn to the discounted cash flow comparisons. Exhibit-TN 2 shows an analysis of
the Netherlands proposal. The revised analysis still favors the Netherlands proposal, mainly due to the
much greater initial investments for the U.K. proposal.
U.K. Proposal
Net Present Value @ 8%
Internal Rate of Return
916,000
20%
Netherlands Proposal
1,288,790
26%
In addition, taking into account the higher risks involved in the U.K. startup relative to the Netherlands
expansion, the U.K. hurdle rate should be higher, which makes the Netherlands alternative even more
attractive.
On the other hand, sensitivity analyses would show that the U.K. managers could face significant sales
shortfalls and manufacturing problems and still have a project with a positive net present value. In terms
of that criterion, or even the Axeon 12% hurdle rate criterion, perhaps the impact of the startup
complications are not as significant as the Axeon functional managers believe them to be.
Further, the irrelevance of the fixed costs in the Netherlands proposal makes sense only if the Netherlands
has, and will always have, excess capacity for producing AR-42. In other words, the assumption of zero
opportunity cost of the fixed plant is valid only if the Netherlands capacity is greatly overbuilt. If this is
Anthony/Hawkins/Merchant
the case, it suggests problems with Netherlands capacity planning in the past. The longer the time
horizon, the better the U.K. proposal looks.
Other issues such as nationalism and perceived autonomy are also important. Axeon N.V. is increasingly
embracing a philosophy of decentralization. Therefore, even if the U.K. proposal is not optimal, forcing
manufacturing of AR-42 in the Netherlands will undercut the perceived decentralization in the company.
Another consideration is the nationalistic sentiments of the English. This is suggested by the requirement
of a majority of local directors for the Hollandsworth board and the threatened resignation of Mr. Nobel.
An increase in duties on AR-42 is likely if the U.K. viewed Axeon as exploiting the U.K. market from the
Netherlands.
Finally, Mr. Wallingford is known to be enthusiastic and innovative. If he feels that he has less autonomy
than before and all the benefits go to the Netherlands, his enthusiasm and innovative spirit are bound to
suffer. He might be less committed to developing the AR-42 market in the U.K. And, based on his
outstanding performance at Axeon, opportunities for Mr. Wallingford to leave Axeon for a competitor are
probably abundant. Can Axeon afford to lose him?
B. Why did Mr. van Leuven behave as he did?
It is easy to be critical of Mr. van Leuven in this case. He caused much of the problem because he did not
manage the process very well. He should learn that in some situations he should refrain from comment
when he is exposed to early-stage proposals at board meetings. His early encouragement in this situation,
which he subsequently reversed, caused much of the disappointment from the Hollandsworth personnel.
Mr. van Leuven was also representing Axeon at the Hollandsworth board meeting. Ideally, he should have
proposed the alternative of sourcing from the Netherlands early in the decision-making process. Much of
Mr. van Leuvens behavior in the case was designed to find a way out of a problem that he probably knew
he had caused.
C. The Transfer Pricing Issue
If the AR-42 for the U.K. is sourced from the U.K., then the analysis is complete. However, if AR-42 is
supplied from the Netherlands to the U.K., then a transfer price must be established. There are a number
of transfer pricing possibilities:
1.
Market price. This would award most of the profit to the producer, in this case, the
Netherlands.
2.
Cost, or cost plus a mark-up. Cost can be defined anywhere from incremental
variable cost to full cost, and the mark-up can be variable (a fixed amount per unit) or a lump sum
(to compensate the Netherlands for costs of the increased working capital and the use of its
capacity).
3.
A two-book system. This would involve crediting the Netherlands at market price but
charging the U.K. only the variable cost. This would make both divisions happy, presumably, but
it would lead to a double counting of profits and require a corporate elimination.
In many decentralized companies, managers would allow the division managers to negotiate a fair
transfer price. But in this case, because of the friction already generated between personnel in the U.K.
and the Netherlands, negotiation may not be possible. So here Mr. van Leuven probably has to choose a
transfer pricing method and a means of implementing his decision.
2007 McGraw-Hill/Irwin
Chapter 28
The total contribution per ton of AR-42 is as follows (using figures from year two and following):
Selling price
Variable costs
Shipping
Duty
3,700
(1,800)
(100)
(100)
2)
Decentralization Strategy
Low cost
Key function
Production
Marketing
Responsibility Centers:
Production
Investment center
Anthony/Hawkins/Merchant
Marketing
Revenue center
Profit/Investment center
To some extent, Axeons control system is a compromise between full decentralization, which would use
highly autonomous local investment centers, and full centralization, which would have the local
organizations be only marketing outposts, revenue centers.
We also see in the case that the current reward system includes a bonus based entirely on the local
division results. This seems to reinforce the decentralization strategy. Alternatively, even under a decentralization strategy, a bonus might be based partly on company-wide profits to promote cooperation
between divisional managers. A reward system can reinforce a chosen strategy as well as compensate for
the weaknesses of the chosen strategy.
So Axeon seems to be gradually embracing decentralization. Both the line and the staff organizations
have significant power (decision rights). The friction we see in the case is typical of a matrix organization
where country managers like Wallingford are often at odds with functional specialists at headquarters. Mr.
van Leuven has to play an integrator role. He should smooth over the rough spots that will inevitably
arise.
E.
There is no correct solution here; there are only pros and cons. The options are to source in the U.K.,
source in the Netherlands, or delay. Delay means possibly source in the U.K. after the viability of the
market has been demonstrated. Asking students to vote as to their preference will reveal significant
differences in opinion. This vote, if one is taken, should come very late in the class.
While it appears that the economics of this decision favor the Netherlands, our own take is that the
decision in this case should probably favor the U.K. If a decentralized organizational structure is appropriate for Axeon, as it appears to be, then decentralization must be allowed to work. Motivate the local
managers to take initiative, and reward them for taking that initiative. The Hollandsworth proposal
exceeds the established hurdles, so allow Hollandsworth managers to proceed with their plan. If students
recommend the seemingly superior economic choice of sourcing the production, then they should just be
made to understand the negative motivational effects that choice will have on the motivation of the U.K.
managers, and possibly even their successors.
Longer-term, Axeon might try to implement a more sophisticated analytical procedure so that the right
alternatives are properly addressed in proposals such as that analyzed here.
What happened?
In the real world situation, the Hollandsworth project was rejected. The transfer price was set at 3700, so
the full cost to Hollandsworth (including shipping and duty) was 3900. Initially Hollandsworth
managers tried to sell AR-42 at a price of 4500 per ton, but the volume sold was miniscule. Eight months
later they lowered the price to 4200. The annualized rate of sales went to 150 tons, and Hol landsworth
managers thought that the potential was there for annual sales of 200 tons at that price. Four months later
they lowered the price to 3700. The annualized rate of sales went to 270 tons. With this result, the
Hollandsworth managers thought that they had clearly demonstrated the potential for annual sales of 400
tons at that price.
Axeon began an increased push to sell AR-42 in other parts of the world. Quickly they filled the capacity
of the plant in the Netherlands. Hollandsworth eventually got permission to build a plant in the U.K.
2007 McGraw-Hill/Irwin
Chapter 28
Mr. Wallingford did not leave the Hollandsworth immediately. Instead, he focused on other issues and
continued to be a highly successful manager. Some years later, Mr. van Leuven was promoted. Mr.
Wallingford was offered Mr. van Leuvens job, but he turned it down because he wanted his children to be
educated in the U.K. Soon after having made that decision, he was offered a position of managing director
of a larger U.K. company, and he accepted that offer.
Student Takeaways
Students can learn a lot from this case. They can practice their technical skills, such as those required to
do net present value analyses, and they can apply their transfer pricing theories to a real world-like
situation. But perhaps most importantly, by seeing that what appears to be a good investment is not made
and understanding why not, students can see that the process of management is more intriguing and more
complicated than it usually appears in textbooks.
Pedagogy
Many students see this case as difficult. Some amount of floundering with the numbers is useful, but if the
floundering continues, instructors should be prepared to step in and help clarify the analysis. That
understanding is essential before moving on to the more qualitative aspects of the case. Suggested timing
in a 75-minute class is as follows:
40 min.
15 min.
15 min.
The fit between the existing control system and the companys strategic priorities
5 min.
What happened/summary
75 minutes
Exhibit TN-1
Relevant Cost Analysis
Calculation of incremental variable cost per ton of manufacturing
AR-42 in the Netherlands for shipment to the U.K.:
Projected average variable cost in the Netherlands at 1000 tons
Projected total variable cost in the Netherlands at 1000 tons
1,860
1,860,000
1,900
1,140,000
720,000
Anthony/Hawkins/Merchant
(720,000 / 400)
1,800
1,800
100
100
2,000
800,000
Exhibit TN-2
Working capital
-120
Sales price
per ton
Incremental cost per ton
-20
-20
4,000
3,700
3,700
3,700
3,700
3,700
3,700
2,000
2,000
2,000
2,000
2,000
2,000
2,000
2,000
1,700
1,700
1,700
1,700
1,700
1,700
160
(4)
(5)
Sales
(in tons)
200
300
400
400
400
400
400
(6)
Total contribution
(4) x (5)
400
510
680
680
680
680
680
(7)
Promotion costs
260
150
100
100
100
100
100
(8)
Tax
40% of
(6) (7)
56
144
232
232
232
232
232
64
196
348
348
348
348
508
(9)
-120
1,288,790
1 years
10
2007 McGraw-Hill/Irwin
Chapter 28
26%
Exhibit TN-3
Flexibility;
Market sensitivity
Economies of scale;
Production efficiency
Axeon
11