AC Corp Case

AC Corp. is a manufacturer of snow blowers for the North American market. It sells the AC Corp. brand through independent agents and produces units with the brand names of various retailers. Although largely an assembler of purchased parts at this time, AC Corp. does produce its own engines. It also sells engines to other manufacturers of snow blowers. Consequently, it has two operating divisions, engine manufacturing and snow blower assembly.

Once AC Corp. produced nearly all of its own components. However, over the last 20 years, it has gradually switched from making components to buying them. Now it makes only a single component, the engine. The switching to purchased parts was done gradually. AC Corp. wanted to make only those parts for which it had distinct competitive and strategic advantages.

The AC Corp. engines and snow blowers are durable, efficient, and competitively priced. These product characteristics have been crucial for success, and they require efficient labour, competitively priced and high-quality parts, mistake-free assembly, minimal inventories, and on-time deliveries. Also, to remain successful the engine division has an active research and product development team that is responsible for improving the products and manufacturing processes.

Once a year, the board of directors reviews divisional performance and assesses the company's future opportunities and threats. This is an informal occasion, but the directors, especially those with significant shareholdings, are very serious about understanding the operations and obtaining improved results. At this year's meeting, the directors were again unhappy with the performance of the assembly division. That division's general manager explained the poor performance as a consequence of the transfer price. The directors asked for a justification of the transfer price method and for recommendations for financial and non-financial criteria or information to assess the performance of both divisions. You, as the president to whom the general managers report, have taken upon yourself to resolve the board's concerns.

You first recognize that profitability of AC Corp. and its divisions has been positive and over the last few years largely comparable to the attached financial statements for the recent year (see exhibit 1). Each division reports as a profit centre, and the engine division is clearly superior. Perhaps because of this unevenness of profitability, there is a dispute between the general managers of the two divisions. The engine general manager wants a market-based transfer price. The assembly general manager wants it to be actual cost of goods sold plus 50 percent.

In reviewing the transfer price, you note that it is set at the average market price for long-

term contracts to other assemblers of snow blowers. For the latest year, AC Corp. sold 110,000 engines to outside customers, while the assembly division purchased 90,000 engines. The assembly division sold 50,000 AC Corp. snow blowers and 40,000 under other brand names. The bonus set by the directors last year was equal to 30 percent of a general manager's salary if their division's ROI exceeds 18 percent. The ROI is operating income divided by divisional investment. For example, it was 35% for the engine division ($10,500 / $30,000).

EXHIBIT 1

AC Corp. Snow Blowers AC Corp. Snow Blowers

Engine Division Assembly Division

Operating Statement: Operating Statement:

For the Year Ending November 30, 2020 For the Year Ending November 30, 2020

(in thousands of dollars) (in thousands of dollars)

REVENUE REVENUE

Outside sales $27,500 AC Corp. brand $30,000

Assembly division 22,500 50,000 Other brands 22,000 52,000

VARIABLE EXPENSES : COST OF GOODS SOLD 31,000

Manufacturing 21,000 GROSS MARGIN 21,000

Administration 3,000

Selling 3,000 27,000

FIXED EXPENSES : ADMINISTRATIVE EXPENSES 7,000

Manufacturing 7,000 SELLING EXPENSES 10,000

Selling, administration 3,000

Research and development 2,500 12,500 OPERATING INCOME $ 4,000

OPERATING INCOME $10,500

Division Balance Sheet: Division Balance Sheet:

Working capital $ 4,000 Working capital $6,000

Net fixed assets $26,000 Net fixed assets $36,000

Investment $30,000 Investment $42,000

Required:

As the president, prepare report to the board of directors that addresses and resolves their concerns. Base your recommendations on a mix of quantitative and qualitative analyses.