Case 15-1: AB Thorsten 1. Which proposal should Gillot support -- the Swedish or the Belgian proposal? Explain your answer. 2. Regardless of your answer to the previous question, if the plant were not built and the product were produced in Belgium and shipped to Sweden, what transfer price would be appropriate? (Note: You do not need a numeric transfer price, but rather you should describe how the transfer price would be determined.) 3.What changes in the management control systems would you recommend to Gillot?

708 Part I II Variations i n M anagement C ontrol Casn 1 i|-l AB Tkonsrrn "You will see from my report that the XL-4 project shows an excellent rate ofreturn on the Skr 700,000 investment and is also a logical extension ofour product developnent and growth stratery here in Sweden. My management and I strongly recommend this project." Anders Ekstrom, Managing Director AB Thorsten, Stockholm ( 100 p ercent-owned s ubsidiary o f R oget S .A.) "Any extra XL4 which Ekstrom might sell in Sweden can be produced in our existing plant in Gent for no additional investment. Ekstrom is not only very optimistic about the sales potential, he is also underestimating the manufacturing problems and costs he will face. I recommend that you inform Ekstrom that it is in Roget's best interest for him to import from Belgium any XL-4 he can sell in Sweden." Pierre Lambert, Vice President for Domestic and Export Sales a nd M anufacturing, I ndustrial P roducts G roup, Roget S .A. B russels Roget S.A. Roget S .A.1 w as o ne o f t he l argest i ndustrial companies in Belgium. The company was incorporated in 1928 by merging three smaller fiirns that all produced industrial chemicals for sale in B elgium. B y 1 981 R oget h ad e xpanded t o produce 208 basic and specialty chemical products in 21 factories, for sale throughout Europe. Until the mid-70s, Roger was organized with one large manufacturing division and one large sales division in Belgium. A department of the sales division was devoted to export sales. HowThis c asei s a dapted f rorn A B T horcten ( A), ( B), a nd ( C) c ases,w hich were p repared b y P rofessorsC . E . S ummer e nd G . S hillinglaw a nd are copyrighted by the Institute for Management Development, Lausanne, S witzerland. r"AB" a nd " S.A." a re a bbreviations u sed i n S weden a nd Belgium t hat a re s inilar States. t o " Corp." o r " Inc." i n t he U nited ever, in the late 70s, exports glew so fast, and domestic markets became so complex, that the company created three main product divisions (Food, I ndustrial, a nd T extile), e ach w ith i ts own manufacturing plants and sales organization. In addition, the company created foreign subsidiaries to take over the businesses in certain areas. For example, in Industrial Chemicals the company had two subsidiaries-one in the U nited K ingdom a nd o ne i n S weden (Thorsten), which served all of Scandinavia. At the same time, the Domestic Department of the Industrial Chemicals Division exported to the rest of Europe. The United Kingdom and Sweden accounted for 9 percent and 5 percent, respectively, of sales in that Division. Mr. Gillot (see Exhibit 1) was responsible for profits from all industrial chemicals; Mr. Lambert was responsible for profits from domestic operations (manufacturing and sales of industrial c hemicals) a nd e xport s ales t o c ountries where the company did not have subsidiaries or factories; and Mr. Ekstrom was responsible for profits in Scandinavia. The company utilized a rather liberal bonus system to reward executives at each level, based on the profits oftheir divisions. This, t ogether w ith a p olicy o f p romotion from w ithin, h elped s timulate m anagers i n Roget to a degree not enjoyed by some of its competitors. It also helped the company to retain key people in an industry where experience was of great importance. Many of the compauy's e xecutives h ad b een i n t he s tarch chemicals business all of their business lives. It was a complex business, and it took many years to learn it. Certain policies-rules of the game--governed relationships w ith t he s ubsidiary c ompanies. These policies were intended to maintain the efr- l M C @ S a C.E.S ummer nd G . S hillinglaw, anagement ontrol ystems, 2001, vlcGraw-Hill. p F f C Copied nderl icenceromA ccess opyright. udherr eproductionrohibited. u Chapter 14 Multinational 709 Organiaations Enusrr 1 Roget S.A* organizational chnrt Vice Pregident Research Vice President Engineering Vice R esident Finance Senior Vice President Industrial Chemicals Vice P resident Domestic and Export Operations Senior Vice hesident Textile Chemicals Managiug D irector Roget L td. ( U.K.) ciency of the whole Roget complex, while at the same time $ving subsidiary managers autonomy to rr.r-n treir own businesses. For exarnple, a t subsidiary manager could determine what existing Roget products to sell in the local market. Export sales would quote the same price as they quote a gents i n a ll c ountries. O f c ourse, a ll prices were subject to bargaining on both sides. Second,subsidiaries were encouraged to propose to division management in Brussels the development of new products.If these were judged feasible, n ew p roducts l r'ere m anufactured i n B elgium for supply to world markets. Third, the subsidiary managing director could build manufacturing plants if the investment in the local market were adequately justified. 7 LO Part III Variations in Management Contml AB Thorsten Initial AB T horsten w as p urchased b y R oget S .A. i n 1972. Since that time, Thorsten's board of directors had consisted of four persons: Mr. Michel Gillot, senior vice president in charge of Roget's industrial c hemicals d ivision; M r. I ngve N orgren, a S wedish b anker; M r. O ve S vensen, a Stockholm industrialist; and the managing director. Swedish law required any company incorporated in Sweden to have at least two out side directors, and the Roget management felt fortunate in finding two men as prominent as Norgren and Svensen to senre on the Thorsten board. During the frrst four years of Roget's ownership, Thorsten's sales fluctuated between Skr. 5 and 7 m illion, b ut h it a l ow i n 1 976.2T he B oard decided at that time that the company was in serious trouble, and that the only alternative to selling the company was to hire a totally difrerent management group to overhaul and streamline company operations. On the advice of the Swedish directors, Mr. Anders Ekstrom, a 38-year-old graduate of the Royal I nstitute o f T echnology, w as h ired a s managing director. He had 16 years of experience as a production engineer for a large paper machinery c ompany a nd a s d ivision m anager responsible for profits in a large paper company, Ekstrom j oined A B T horsten i n J anuary o f 1977. S ince t hat t ime, s ales h ad i ncreased t o Skr. 2 0 m illion a nd p rofits h ad r eached l evels t hat R oget's m anagement f ound h ighly satisfactory. Ekstrom s aid t hat a t t he t ime h e j oined Thorsten, he knew it was a risk: In S eptember o f 1 980, E kstrom h ad i nformed the T horsten b oard o f d irectors t hat h e p roposed to study the feasibility of constructing a factory in Sweden for the manufacture of XL-4, a starch-based adhesive chemical used in drying paper. He explained that he and his customer engineers had discovered a new way of helping paper mills adapt the dryer sections of their huge paper machines at very low cost so that they could use )il-4 instead of competitors' products. Large paper mills would realize dramatic savings in material handling and storage costs a nd a lso s horten d rying t ime s ubstantially. Shortened drying tirne increases the effective capacity of a paper machine. It was Ekstrom's j udgment t hat h is i nnovation w ould allow h im t o d evelop a m arket i n S weden a lmost as big as Roget's present worldwide market for XL-4. This product was currently being produced i n R oget's D omestic D epartment a t the rate of 600 tons per year, with none going to Sweden. Ekstrom stated: I l iked the c hallenge of building a c ompany. I f I d id a good j ob here I would have t he c onfidence o f N orgren and Svensen as well as of t he Roget m anagement i n Brussels. I f elt t hat s uscesding in t his s ituation w ould teach me t hings t hat would m ake m e m ore c ompetent a s a top e xecutive. So I c hose t hisjob even t hough I h ad a t the time ( and s till have) ofrers f rom other c ompanies. 2Most monetary amounts in t his c ase are s tated i n S wedish kronor (Skr). Proposal for Manufacture of lil-4 At t hat m eeting, M r. G illot a nd t he o ther d irectors seemede nthusiastic. D uring t he n ext s ix m onths, w e d id the a nalysis. M y m arketing d irector u sed m odern m arket research techniques to estimate the total potential in S weden a t 8 00 t ons o f)C-4 p er y ear, u sing t he c ustom engineered approach we wre proposing. We interviewed important customers and conducted triale in t,he mills of three big companies whidr proved that with the introduction of our machine designs, the large cost savings a nd c apacity e xpansion w ould i ndeed m aterialize. We determined that if we could gell the product for Skr. 1,860 p er t on, w e c ould c apture a t l east o ne'half o f t he market within a three-year period, or 400 tons a year. At the same time, I called the head of the corporate engineering division ia Belgium and asked for his help in designing a p lant t o p roduce 4 0O t ons o fXI-4 p er y ear and in estimating the cost of tbe investment. This ig a routine thing. The central stafT divisions are advisory and always comply with requests for help. He assigned a project manager and four other engineers to work on the design o f f actory a nd m achinery a nd t o e etimate t he cost. A t t he e ame t ime I a ssigned t hree n en f rom m y staff to work on the project. In three months this joint task g roup r eported t hat t he n ecessary p lant c ould b e built for about Skr 700,000. All of this we summarized in a p ro f orma c alculation l Exhibit 2 ]. T his c alculation, Chaptcr 14 E:qnrt 2 7tL MultinationalOrganizations KL4z lhe Swedish Proposat (in Skr.) 2 End. of Year 0 1 2 3 4 5 6 7 Plant 56 34 SoLes Voriable Contributionl Ton Worhing Pricel Costl (col.3-4) Ton Capi.tal Ton -?00,000 -56,000+ -2,000* 2,000 -7,000* 1,850 1 ,850 1,850 1 ,860 1 ,850 +150,00Or 65,000+ 1,850 + 1,ofi) 1,000 1,000 1,O00 1,000 1,000 1,000 1,000 850 850 850 850 850 E50 Number o fTons 200 800 400 400 400 400 400 rc 78 Total Contribution bol.5 * 0 Promotion C osts 130,000 200,000 i265,OO0 75,000 3,[0,000 50,000 3410,00O 60,(X)0 34O,0oO 50,o0o 60,000 340,000 340,000 50,000 Tuesl Net Cash Flows (1+2+7-8-9) ( 36,000) 20,000 76,000 76,000 7 5,W 145,000 145,0fi) -756,000 103,000 153,000 216,000 215,000 2l5,OOO 145,OO0 360,0Oo tTheee workiag cepitrl iDvestrnent amou.Dtaare Det of t! 6ealita. iTaxeo are calculated after depreciating Skr, 700,000 over a 5-year period oa straight-lioe baeis. tSales value, net ofappropriate taxes, asouming plant will b closed at end ofeeven yeare. together w ith a c omplete w ritten e xplanation, w as mailed to Mr. Gillot in early April 1981. I felt rather excited, as did most of my ataff. We all know that in0roduction ofnew products is one ofthe keys to our continued growtlr and profitability. The yield on this inveetment wae well above the mininum 8 percent egtabliehed as a guideline for n ew inveetment by t he Roget v ice p resident of finance, We algo knew that it was a good analysis, uoing modern tools of management. In the cover letter, I a sked that it be put on t he agenda f or t he n ext Thorsten b oard m eeting. The minutes of the next board meeting held in S tockholm o n A pril 2 8, 1 981, q uoted E kstrom's remarks as he explained the proposal to other directors: You will see from the summary table [Exhibit 2] that this project is profitable. Gentlenen, it seeme clear from theoe figures that we can justifr tbis investment in Sweden on the b asis of s ales t o t he Swedish m arket. T 'he group vice president for finance has laid down the policy that any new investment shoulal yield at least an 8 percent return. lbis particular proposal erceeds that aubstantially, using a v ery c onservative s even-year l ife. M y management aud I etrongly reco--end thia project. Ekstrom later recalled Gillot's reactions in his role as chairman of the Ttrorsten board: Gillot e aid that it s eened t o him t o be a c lear c aee. H e aeked positive guestions, nainly about the longer-term likelihood that we could sell mme than 400 tons a year, and about how we would frrance any further expansion. I explained that we in Sweden were vety firm in our judgment that we would reach 400 tons a year even before one year, but felt constrained to shoq, a consenrative estimate of a three-year transition period. We aleo ehowed him how we could finance any furttrer erpansion by borrowing in Sweden. That is, if Roget would furnish the initial c apital, a nd i f t he 4 00 t ons g oal w ere r eached quickly, any further expansion would easily be financed by local banks. ltre two Swedish directon confirned this. Ttre board voted unanimouely to constnrst the plant. I)isagreement about the lil,4 Proposal About a week later, Gillot telephoned Ekstrom: I have been through sone additional discussions with the production and marketing people here in the Domeetic Department. They thint the engineering design and plant cost is accurate, but that you are too optinistic on your sales forecaet. It looks like you will have tojustifr this m ore. Ekstrom said: I pushed him to eet up a meeting the following week. firis waa attended by nyseUand my marketing and production d irectore f rom S weden, a nd f our p eople f rom Belgium-Gillot, Lavanchy (director of rnanufacturing), Gachoud (director ofsales), and Lambert (vice president for d omestic a nd e xport), T hat w as o ne o f t he w orst 7 L2 Part III Variations in Managem.ent Control meetings of my life, It lasted all day. Gachoud said that they had sales experience from other countries and that in his j udgment t he m arket potential and our s hare w ere too o ptimistic. I t old him over nnd over how w e a r:rived a t this figure based on our c ustom engineered a pproach, but he just kept repeating th.e over-optimistic argument. Then Lavanchy s aid t hat t he production ofthis p roduct is complicated, and t hat he had difficulties p roducing i t in Belgium, even with trained workers who had long experience. I told him I only needed five trained production workerg a nd t hat h e c ould s end m e t wo m en f or t wo months i f he liked, t o t rain Swedes t o do t he j ob. I i mpressed on him that they could oversee manufacturing for ue in Sweden until we learn, if they ditl not have confidence in Swedish tecbnolory. He repeated that the difficulties in manufacturing were enormous. Lavanchy then said that since the whole world market for Roget was only 600 tons a year, it was inconceivable that Sweden alone could make 400 tons. Gillot ended the meeting without a decision, and s aid t hat h e h oped a ll concerned would do more investigation of thia subject. He indicated that he wotrld think about it hirnselfand let us know when another meeting would be held. Ekstrom returned to Stockhohn and reported the m eeting t o h is o wn s taff, a nd t o t he t wo Swedish members of his board: They, l ike I , were r eally disgusted. Here we w er, o perating w ith initiative ancl with excellent f inancial t echniques. R oget r nanagement had often m ade e peechesi n which they emphasized t he necessity f or d ecentralized profrt responsibility, and for authority and initiative on the p art o f f oreign s ubsidiaries. O ne of m y m en s aid t hat they seem t o t alk decentralization and act l ike t in g ods at the same t ime. M r. Norgren, t he Swedish b anker o n Ttrorsten's board, expressed s urprise. I c onsidered t his carefully. I t is s ound business f or AB T horsten, a nd X L-4 will h elp t o b uild o ne m ore g rowth c ompany i n t he Swedish e conomy. Somehow, t he m anagement i n B russels has failed to understand ttris. I dictated a letter to Mr. Gillot telling him that I didn't know why the project was rejected, t hat Roget has a r ight t o its o wn r easons, but that I was prepared t o r esigrr as a director. I t i s n ot that I a n angry, or t hat I have a r ight t o d ictate d ecisions for t he whole worldwide Roget organization. I t i s simply that if I spend my time studying policy decisions, which a re not appreciated by parent c ompany m anagement, then it is a waste of m y t ime t o c ontinue. Finally, E kstrom s tated: While I certainly wouldn't bring t Jrese m atters o ut i n a public meeting, I t hink t hose Belgian production a nd sales people s imply \\ ilant t o build t heir empir.e a nrl m ake the money in Belgi'm. firey dont care about Thorsten and Sweden. We have the ideae and initiative, and they take them and get the payoff. Further Study Mr. Gillot received Norgren's letter in late May 1981. He then contacted Messrs. Lavanchy, Gachoud, and Bols (V.P. finance, Roget) and told them that the Swedish XL4 project had become a matter of key importance for the whole Roget Group, because of its implications for company profrts, a nd f or t he m orale a nd a utonomy o f subsidiary m anagement. H e a sked t hem t o study the matter very carefully and report their recommendations in one month. Meanwhile, he wrote Ekstrom, "Various members of the Corporate H eadquarters a re s tudying t he p roposal very seriously. You will hear from me within about six weeks regarding my frnal decision." Lavench5/s Rsponse A month after he was asked to study the XL-4 project m ore c losely, L avanchy g ave G illot a memorandum explaining his reasons for opposing the proposal: At your request, I have reexamined thoroughly all of the cost f igures t hat b ear o n t he X L-4 p roposal. I f intl t hat mpnufacture o f t his p roduct i n S weden w ould b e h ighly uneconomical, f or t wo r easons: ( l) o verhead c osts w ould be higher, and (2) variable costs would be greater. As t o t he f irst, w e c an p roduce X L-4 i n G ent i n o ur existing p lant w ith l ess o verhead c oet. S uppose t hat Thorsten d oes s ell 4 00 t ons a y ear s o t hat o ur t otal worldwide g ales r ise t o 1 ,000 t ons. We c an p roduce t he whole 1,00O tons in Belgium with essentially the eame capital i nvestment w e h ave n ow. I f w e p roduce 1 ,000 tons, o ur f ixed c oets w ill d ecrease b y S kr. 1 20 a t on.3 that m eans S kr. 7 2,000 i n s avings o n p roduction f or d omestic a nd e xport t o c ountries o ther t han S weden ( 600 tons a year), and Skr. 120,000 for worldwide production including S weden ( 1,000 t ons). S econd w e c ould a lso save o n v ariable c osts. I f w e w ene t o p roduce t he e xtra total fixed cost in the Gent factory was the equivalent of Skr. 1 80,000 a year. D ivided b y600, t his e quals S Lr.300 a ton. I fit w ere s pread o ver 1 ,000 t one, t he a verage f ired c ost would b e S kr. 1 80. Chapter Enusrr 3 End of Year 0 1 2 3 4 o 6 7 Plont lC-4: 74 Multindtiorrol The Belgian Proposal 23456 Scles Worhing Pricel Copitol T on *64,0,00* -10,000* 2 ,000 -10,000* 1 ,850 1,850 1,950 1,950 1,850 +74,000 1 ,850 (in Skr.) Varidbl,e Contributianl T on Costl ( col.3-4 T ont 1,380 1,380 1,380 1,380 1,380 1,380 1,380 713 Orgd,nizatians 620 470 470 470 470 470 470 N umber o fTons 200 s00 400 400 400 400 400 78 Total Cont rib ut in n Pro mot ion C oste kol.5*6) 124,000 141,000 188,000 188,O00 1E8,000 188,000 188,000 130,000 75,000 50,0oo 50,000 50,mo 50,000 50,000 Tws 10 Net Cash Flowa (1+2+7-8-9) (3,000) 33,000 69,000 69,000 69,000 69,000 69,000 s4,000 -13,000 23,000 69,000 69,000 69,000 69,000 143,000 *Working cspital ainounts are Eet of tar credits. tVeriable cost per ton =SKr. 1 ,380 = Manufactruing 9 30 Shipping from Belgium tn Sweden= = Swedisbimport tlut5r = Total variablecost 60 _199 1,380 400 tons in Belgium, the total production of 1,000 tons a year would give us longer production runs, lower average setup costs, and larger raw Dlaterial purchaBes, tbus allowing maBs purchasing and m aterial handling a nd lower p urchase prices. M y accounting departnent h as studied this and c oncludes t hat our average v ariable costs will decrease from Skr. 960 e ton to Skr. 93O. This Skr, 2 0 p er t on d ifference m eatrs a s avings o f S hr. 12,000 i n B elgian domeetic production and a s aving o f Skr. 20,000 f or t otal worldwide production a esuming that S weden t akes 4 00 t one a y ear. T axes o n t hese added p rofits a re a bout t he s ame i n B elgium a nd Sweden-about 50 percent of taxable income. In conclusion, a n ew p lant s houltl n ot b e b uilt. E kstrom i s a bright young man, but he does not know the adhesives busineee. H e would be c aught up in c ostly p roduction migtakes from t he v ery beginning. I r ecommend t hat you inform the Thorsten management that it is ir the Company's interest that they muet buy ftom Belgium." Bolste Response The same week, Gillot received the following memorandum from Erik Bols, Roget's financial vice president: I am sending you berewith eetimatee of the working capital r equiremente i f R oget i ncreaees i ts p roduction o f XL-4 in our Belgian plant from 600 to 1,000 tons a year lExhibit 3 1. I nitially, w e w ill n eed S kr. 5 4,000, f or a dditional inventories and accounts receivable. By the end of the aecond year, this will have increased to Skr. 74,000. Ttre working eapital qmounts shown in thie erhibit are based on the applicable law which permits bugiaegses to deduct 60 percent of iacremental inventory costs from taxable income. I have also looked at Lavanch5/s calculations for the fixed and variable manufacturing costs, and am in full agreement with them. In conclueion, I see no r eaeon t o s pend S kr ? 00,000 t o b uild a f actory i n Sweden w hen w e h ave e xceee c apacity i n o ur B elgian plant which can produce the incremental tons at lower cost and with lower manufacturing risk. Gillot's Response In early July 1981, Gillot Bent a letter to Ekstrom indicating that the XL-4 proposal was turning out to be more of a problem than he had a nticipated. H e i ncluded c opies o f t he memos f rom L avanchy a nd B ols. H e s aid h e was not yet in a position to grve final approval. 7 r4 Part III Variations in Monagement Control He said he would let Ekstrom know his decision as soon as possible. 4. Ekstrom'e lhoughte Ekstrom expressed some impatience with the way things were going: I have other projects that need developing for Thoraten, and this hind of long-range planning takee much tise and energy. Also, just keepirrg on top of the normal operating problems ofthe business we already have takes up a lot of my time. Sometimes I feel like tellirrg them to go and sell XL-4 t hemselves. 5. 6. Queetione 1. Using the numbers from Exhibit 2, what is your estimate of the NPV (at 8 percent) for the Swedish proposal. Also, what is the 6-year IRR? 2. What is the NPV (at 8 percent) and IRR of the Belgian proposal in Exhibit 3? 3. What are the key arguments for and against the alternatives presented by the 7. 8. contending parbies from Belgium and Sweden? Is ever5rthing that is being expressed by Ekstrom and the Belgium management above board? What are the respective hidden agendas that can be anticipated for each party, and in what way do they coincide? In what way can they be expected to diverge? Ifyou were in Gillof,s shoes, would you support the Swedish or the Belgian proposal? Why? Ignoring your answer to question 5, if the plant were not built aud the products were shipped from Belgium to Sweden, what transfer price would be appropriate? lVhat are the competitive advantages of Roget S.A.? What is Roget's stratery in the industrial chemicals business? Are the management control systems designed to support this strategf What changes in the management control systems would you necommendto Gillot? 708 Part I II Variations i n M anagement C ontrol Casn 1 i|-l AB Tkonsrrn "You will see from my report that the XL-4 project shows an excellent rate ofreturn on the Skr 700,000 investment and is also a logical extension ofour product developnent and growth stratery here in Sweden. My management and I strongly recommend this project." Anders Ekstrom, Managing Director AB Thorsten, Stockholm ( 100 p ercent-owned s ubsidiary o f R oget S .A.) "Any extra XL4 which Ekstrom might sell in Sweden can be produced in our existing plant in Gent for no additional investment. Ekstrom is not only very optimistic about the sales potential, he is also underestimating the manufacturing problems and costs he will face. I recommend that you inform Ekstrom that it is in Roget's best interest for him to import from Belgium any XL-4 he can sell in Sweden." Pierre Lambert, Vice President for Domestic and Export Sales a nd M anufacturing, I ndustrial P roducts G roup, Roget S .A. B russels Roget S.A. Roget S .A.1 w as o ne o f t he l argest i ndustrial companies in Belgium. The company was incorporated in 1928 by merging three smaller fiirns that all produced industrial chemicals for sale in B elgium. B y 1 981 R oget h ad e xpanded t o produce 208 basic and specialty chemical products in 21 factories, for sale throughout Europe. Until the mid-70s, Roger was organized with one large manufacturing division and one large sales division in Belgium. A department of the sales division was devoted to export sales. HowThis c asei s a dapted f rorn A B T horcten ( A), ( B), a nd ( C) c ases,w hich were p repared b y P rofessorsC . E . S ummer e nd G . S hillinglaw a nd are copyrighted by the Institute for Management Development, Lausanne, S witzerland. r"AB" a nd " S.A." a re a bbreviations u sed i n S weden a nd Belgium t hat a re s inilar States. t o " Corp." o r " Inc." i n t he U nited ever, in the late 70s, exports glew so fast, and domestic markets became so complex, that the company created three main product divisions (Food, I ndustrial, a nd T extile), e ach w ith i ts own manufacturing plants and sales organization. In addition, the company created foreign subsidiaries to take over the businesses in certain areas. For example, in Industrial Chemicals the company had two subsidiaries-one in the U nited K ingdom a nd o ne i n S weden (Thorsten), which served all of Scandinavia. At the same time, the Domestic Department of the Industrial Chemicals Division exported to the rest of Europe. The United Kingdom and Sweden accounted for 9 percent and 5 percent, respectively, of sales in that Division. Mr. Gillot (see Exhibit 1) was responsible for profits from all industrial chemicals; Mr. Lambert was responsible for profits from domestic operations (manufacturing and sales of industrial c hemicals) a nd e xport s ales t o c ountries where the company did not have subsidiaries or factories; and Mr. Ekstrom was responsible for profits in Scandinavia. The company utilized a rather liberal bonus system to reward executives at each level, based on the profits oftheir divisions. This, t ogether w ith a p olicy o f p romotion from w ithin, h elped s timulate m anagers i n Roget to a degree not enjoyed by some of its competitors. It also helped the company to retain key people in an industry where experience was of great importance. Many of the compauy's e xecutives h ad b een i n t he s tarch chemicals business all of their business lives. It was a complex business, and it took many years to learn it. Certain policies-rules of the game--governed relationships w ith t he s ubsidiary c ompanies. These policies were intended to maintain the efr- l M C @ S a C.E.S ummer nd G . S hillinglaw, anagement ontrol ystems, 2001, vlcGraw-Hill. p F f C Copied nderl icenceromA ccess opyright. udherr eproductionrohibited. u Chapter 14 Multinational 709 Organiaations Enusrr 1 Roget S.A* organizational chnrt Vice Pregident Research Vice President Engineering Vice R esident Finance Senior Vice President Industrial Chemicals Vice P resident Domestic and Export Operations Senior Vice hesident Textile Chemicals Managiug D irector Roget L td. ( U.K.) ciency of the whole Roget complex, while at the same time $ving subsidiary managers autonomy to rr.r-n treir own businesses. For exarnple, a t subsidiary manager could determine what existing Roget products to sell in the local market. Export sales would quote the same price as they quote a gents i n a ll c ountries. O f c ourse, a ll prices were subject to bargaining on both sides. Second,subsidiaries were encouraged to propose to division management in Brussels the development of new products.If these were judged feasible, n ew p roducts l r'ere m anufactured i n B elgium for supply to world markets. Third, the subsidiary managing director could build manufacturing plants if the investment in the local market were adequately justified. 7 LO Part III Variations in Management Contml AB Thorsten Initial AB T horsten w as p urchased b y R oget S .A. i n 1972. Since that time, Thorsten's board of directors had consisted of four persons: Mr. Michel Gillot, senior vice president in charge of Roget's industrial c hemicals d ivision; M r. I ngve N orgren, a S wedish b anker; M r. O ve S vensen, a Stockholm industrialist; and the managing director. Swedish law required any company incorporated in Sweden to have at least two out side directors, and the Roget management felt fortunate in finding two men as prominent as Norgren and Svensen to senre on the Thorsten board. During the frrst four years of Roget's ownership, Thorsten's sales fluctuated between Skr. 5 and 7 m illion, b ut h it a l ow i n 1 976.2T he B oard decided at that time that the company was in serious trouble, and that the only alternative to selling the company was to hire a totally difrerent management group to overhaul and streamline company operations. On the advice of the Swedish directors, Mr. Anders Ekstrom, a 38-year-old graduate of the Royal I nstitute o f T echnology, w as h ired a s managing director. He had 16 years of experience as a production engineer for a large paper machinery c ompany a nd a s d ivision m anager responsible for profits in a large paper company, Ekstrom j oined A B T horsten i n J anuary o f 1977. S ince t hat t ime, s ales h ad i ncreased t o Skr. 2 0 m illion a nd p rofits h ad r eached l evels t hat R oget's m anagement f ound h ighly satisfactory. Ekstrom s aid t hat a t t he t ime h e j oined Thorsten, he knew it was a risk: In S eptember o f 1 980, E kstrom h ad i nformed the T horsten b oard o f d irectors t hat h e p roposed to study the feasibility of constructing a factory in Sweden for the manufacture of XL-4, a starch-based adhesive chemical used in drying paper. He explained that he and his customer engineers had discovered a new way of helping paper mills adapt the dryer sections of their huge paper machines at very low cost so that they could use )il-4 instead of competitors' products. Large paper mills would realize dramatic savings in material handling and storage costs a nd a lso s horten d rying t ime s ubstantially. Shortened drying tirne increases the effective capacity of a paper machine. It was Ekstrom's j udgment t hat h is i nnovation w ould allow h im t o d evelop a m arket i n S weden a lmost as big as Roget's present worldwide market for XL-4. This product was currently being produced i n R oget's D omestic D epartment a t the rate of 600 tons per year, with none going to Sweden. Ekstrom stated: I l iked the c hallenge of building a c ompany. I f I d id a good j ob here I would have t he c onfidence o f N orgren and Svensen as well as of t he Roget m anagement i n Brussels. I f elt t hat s uscesding in t his s ituation w ould teach me t hings t hat would m ake m e m ore c ompetent a s a top e xecutive. So I c hose t hisjob even t hough I h ad a t the time ( and s till have) ofrers f rom other c ompanies. 2Most monetary amounts in t his c ase are s tated i n S wedish kronor (Skr). Proposal for Manufacture of lil-4 At t hat m eeting, M r. G illot a nd t he o ther d irectors seemede nthusiastic. D uring t he n ext s ix m onths, w e d id the a nalysis. M y m arketing d irector u sed m odern m arket research techniques to estimate the total potential in S weden a t 8 00 t ons o f)C-4 p er y ear, u sing t he c ustom engineered approach we wre proposing. We interviewed important customers and conducted triale in t,he mills of three big companies whidr proved that with the introduction of our machine designs, the large cost savings a nd c apacity e xpansion w ould i ndeed m aterialize. We determined that if we could gell the product for Skr. 1,860 p er t on, w e c ould c apture a t l east o ne'half o f t he market within a three-year period, or 400 tons a year. At the same time, I called the head of the corporate engineering division ia Belgium and asked for his help in designing a p lant t o p roduce 4 0O t ons o fXI-4 p er y ear and in estimating the cost of tbe investment. This ig a routine thing. The central stafT divisions are advisory and always comply with requests for help. He assigned a project manager and four other engineers to work on the design o f f actory a nd m achinery a nd t o e etimate t he cost. A t t he e ame t ime I a ssigned t hree n en f rom m y staff to work on the project. In three months this joint task g roup r eported t hat t he n ecessary p lant c ould b e built for about Skr 700,000. All of this we summarized in a p ro f orma c alculation l Exhibit 2 ]. T his c alculation, Chaptcr 14 E:qnrt 2 7tL MultinationalOrganizations KL4z lhe Swedish Proposat (in Skr.) 2 End. of Year 0 1 2 3 4 5 6 7 Plant 56 34 SoLes Voriable Contributionl Ton Worhing Pricel Costl (col.3-4) Ton Capi.tal Ton -?00,000 -56,000+ -2,000* 2,000 -7,000* 1,850 1 ,850 1,850 1 ,860 1 ,850 +150,00Or 65,000+ 1,850 + 1,ofi) 1,000 1,000 1,O00 1,000 1,000 1,000 1,000 850 850 850 850 850 E50 Number o fTons 200 800 400 400 400 400 400 rc 78 Total Contribution bol.5 * 0 Promotion C osts 130,000 200,000 i265,OO0 75,000 3,[0,000 50,000 3410,00O 60,(X)0 34O,0oO 50,o0o 60,000 340,000 340,000 50,000 Tuesl Net Cash Flows (1+2+7-8-9) ( 36,000) 20,000 76,000 76,000 7 5,W 145,000 145,0fi) -756,000 103,000 153,000 216,000 215,000 2l5,OOO 145,OO0 360,0Oo tTheee workiag cepitrl iDvestrnent amou.Dtaare Det of t! 6ealita. iTaxeo are calculated after depreciating Skr, 700,000 over a 5-year period oa straight-lioe baeis. tSales value, net ofappropriate taxes, asouming plant will b closed at end ofeeven yeare. together w ith a c omplete w ritten e xplanation, w as mailed to Mr. Gillot in early April 1981. I felt rather excited, as did most of my ataff. We all know that in0roduction ofnew products is one ofthe keys to our continued growtlr and profitability. The yield on this inveetment wae well above the mininum 8 percent egtabliehed as a guideline for n ew inveetment by t he Roget v ice p resident of finance, We algo knew that it was a good analysis, uoing modern tools of management. In the cover letter, I a sked that it be put on t he agenda f or t he n ext Thorsten b oard m eeting. The minutes of the next board meeting held in S tockholm o n A pril 2 8, 1 981, q uoted E kstrom's remarks as he explained the proposal to other directors: You will see from the summary table [Exhibit 2] that this project is profitable. Gentlenen, it seeme clear from theoe figures that we can justifr tbis investment in Sweden on the b asis of s ales t o t he Swedish m arket. T 'he group vice president for finance has laid down the policy that any new investment shoulal yield at least an 8 percent return. lbis particular proposal erceeds that aubstantially, using a v ery c onservative s even-year l ife. M y management aud I etrongly reco--end thia project. Ekstrom later recalled Gillot's reactions in his role as chairman of the Ttrorsten board: Gillot e aid that it s eened t o him t o be a c lear c aee. H e aeked positive guestions, nainly about the longer-term likelihood that we could sell mme than 400 tons a year, and about how we would frrance any further expansion. I explained that we in Sweden were vety firm in our judgment that we would reach 400 tons a year even before one year, but felt constrained to shoq, a consenrative estimate of a three-year transition period. We aleo ehowed him how we could finance any furttrer erpansion by borrowing in Sweden. That is, if Roget would furnish the initial c apital, a nd i f t he 4 00 t ons g oal w ere r eached quickly, any further expansion would easily be financed by local banks. ltre two Swedish directon confirned this. Ttre board voted unanimouely to constnrst the plant. I)isagreement about the lil,4 Proposal About a week later, Gillot telephoned Ekstrom: I have been through sone additional discussions with the production and marketing people here in the Domeetic Department. They thint the engineering design and plant cost is accurate, but that you are too optinistic on your sales forecaet. It looks like you will have tojustifr this m ore. Ekstrom said: I pushed him to eet up a meeting the following week. firis waa attended by nyseUand my marketing and production d irectore f rom S weden, a nd f our p eople f rom Belgium-Gillot, Lavanchy (director of rnanufacturing), Gachoud (director ofsales), and Lambert (vice president for d omestic a nd e xport), T hat w as o ne o f t he w orst 7 L2 Part III Variations in Managem.ent Control meetings of my life, It lasted all day. Gachoud said that they had sales experience from other countries and that in his j udgment t he m arket potential and our s hare w ere too o ptimistic. I t old him over nnd over how w e a r:rived a t this figure based on our c ustom engineered a pproach, but he just kept repeating th.e over-optimistic argument. Then Lavanchy s aid t hat t he production ofthis p roduct is complicated, and t hat he had difficulties p roducing i t in Belgium, even with trained workers who had long experience. I told him I only needed five trained production workerg a nd t hat h e c ould s end m e t wo m en f or t wo months i f he liked, t o t rain Swedes t o do t he j ob. I i mpressed on him that they could oversee manufacturing for ue in Sweden until we learn, if they ditl not have confidence in Swedish tecbnolory. He repeated that the difficulties in manufacturing were enormous. Lavanchy then said that since the whole world market for Roget was only 600 tons a year, it was inconceivable that Sweden alone could make 400 tons. Gillot ended the meeting without a decision, and s aid t hat h e h oped a ll concerned would do more investigation of thia subject. He indicated that he wotrld think about it hirnselfand let us know when another meeting would be held. Ekstrom returned to Stockhohn and reported the m eeting t o h is o wn s taff, a nd t o t he t wo Swedish members of his board: They, l ike I , were r eally disgusted. Here we w er, o perating w ith initiative ancl with excellent f inancial t echniques. R oget r nanagement had often m ade e peechesi n which they emphasized t he necessity f or d ecentralized profrt responsibility, and for authority and initiative on the p art o f f oreign s ubsidiaries. O ne of m y m en s aid t hat they seem t o t alk decentralization and act l ike t in g ods at the same t ime. M r. Norgren, t he Swedish b anker o n Ttrorsten's board, expressed s urprise. I c onsidered t his carefully. I t is s ound business f or AB T horsten, a nd X L-4 will h elp t o b uild o ne m ore g rowth c ompany i n t he Swedish e conomy. Somehow, t he m anagement i n B russels has failed to understand ttris. I dictated a letter to Mr. Gillot telling him that I didn't know why the project was rejected, t hat Roget has a r ight t o its o wn r easons, but that I was prepared t o r esigrr as a director. I t i s n ot that I a n angry, or t hat I have a r ight t o d ictate d ecisions for t he whole worldwide Roget organization. I t i s simply that if I spend my time studying policy decisions, which a re not appreciated by parent c ompany m anagement, then it is a waste of m y t ime t o c ontinue. Finally, E kstrom s tated: While I certainly wouldn't bring t Jrese m atters o ut i n a public meeting, I t hink t hose Belgian production a nd sales people s imply \\ ilant t o build t heir empir.e a nrl m ake the money in Belgi'm. firey dont care about Thorsten and Sweden. We have the ideae and initiative, and they take them and get the payoff. Further Study Mr. Gillot received Norgren's letter in late May 1981. He then contacted Messrs. Lavanchy, Gachoud, and Bols (V.P. finance, Roget) and told them that the Swedish XL4 project had become a matter of key importance for the whole Roget Group, because of its implications for company profrts, a nd f or t he m orale a nd a utonomy o f subsidiary m anagement. H e a sked t hem t o study the matter very carefully and report their recommendations in one month. Meanwhile, he wrote Ekstrom, "Various members of the Corporate H eadquarters a re s tudying t he p roposal very seriously. You will hear from me within about six weeks regarding my frnal decision." Lavench5/s Rsponse A month after he was asked to study the XL-4 project m ore c losely, L avanchy g ave G illot a memorandum explaining his reasons for opposing the proposal: At your request, I have reexamined thoroughly all of the cost f igures t hat b ear o n t he X L-4 p roposal. I f intl t hat mpnufacture o f t his p roduct i n S weden w ould b e h ighly uneconomical, f or t wo r easons: ( l) o verhead c osts w ould be higher, and (2) variable costs would be greater. As t o t he f irst, w e c an p roduce X L-4 i n G ent i n o ur existing p lant w ith l ess o verhead c oet. S uppose t hat Thorsten d oes s ell 4 00 t ons a y ear s o t hat o ur t otal worldwide g ales r ise t o 1 ,000 t ons. We c an p roduce t he whole 1,00O tons in Belgium with essentially the eame capital i nvestment w e h ave n ow. I f w e p roduce 1 ,000 tons, o ur f ixed c oets w ill d ecrease b y S kr. 1 20 a t on.3 that m eans S kr. 7 2,000 i n s avings o n p roduction f or d omestic a nd e xport t o c ountries o ther t han S weden ( 600 tons a year), and Skr. 120,000 for worldwide production including S weden ( 1,000 t ons). S econd w e c ould a lso save o n v ariable c osts. I f w e w ene t o p roduce t he e xtra total fixed cost in the Gent factory was the equivalent of Skr. 1 80,000 a year. D ivided b y600, t his e quals S Lr.300 a ton. I fit w ere s pread o ver 1 ,000 t one, t he a verage f ired c ost would b e S kr. 1 80. Chapter Enusrr 3 End of Year 0 1 2 3 4 o 6 7 Plont lC-4: 74 Multindtiorrol The Belgian Proposal 23456 Scles Worhing Pricel Copitol T on *64,0,00* -10,000* 2 ,000 -10,000* 1 ,850 1,850 1,950 1,950 1,850 +74,000 1 ,850 (in Skr.) Varidbl,e Contributianl T on Costl ( col.3-4 T ont 1,380 1,380 1,380 1,380 1,380 1,380 1,380 713 Orgd,nizatians 620 470 470 470 470 470 470 N umber o fTons 200 s00 400 400 400 400 400 78 Total Cont rib ut in n Pro mot ion C oste kol.5*6) 124,000 141,000 188,000 188,O00 1E8,000 188,000 188,000 130,000 75,000 50,0oo 50,000 50,mo 50,000 50,000 Tws 10 Net Cash Flowa (1+2+7-8-9) (3,000) 33,000 69,000 69,000 69,000 69,000 69,000 s4,000 -13,000 23,000 69,000 69,000 69,000 69,000 143,000 *Working cspital ainounts are Eet of tar credits. tVeriable cost per ton =SKr. 1 ,380 = Manufactruing 9 30 Shipping from Belgium tn Sweden= = Swedisbimport tlut5r = Total variablecost 60 _199 1,380 400 tons in Belgium, the total production of 1,000 tons a year would give us longer production runs, lower average setup costs, and larger raw Dlaterial purchaBes, tbus allowing maBs purchasing and m aterial handling a nd lower p urchase prices. M y accounting departnent h as studied this and c oncludes t hat our average v ariable costs will decrease from Skr. 960 e ton to Skr. 93O. This Skr, 2 0 p er t on d ifference m eatrs a s avings o f S hr. 12,000 i n B elgian domeetic production and a s aving o f Skr. 20,000 f or t otal worldwide production a esuming that S weden t akes 4 00 t one a y ear. T axes o n t hese added p rofits a re a bout t he s ame i n B elgium a nd Sweden-about 50 percent of taxable income. In conclusion, a n ew p lant s houltl n ot b e b uilt. E kstrom i s a bright young man, but he does not know the adhesives busineee. H e would be c aught up in c ostly p roduction migtakes from t he v ery beginning. I r ecommend t hat you inform the Thorsten management that it is ir the Company's interest that they muet buy ftom Belgium." Bolste Response The same week, Gillot received the following memorandum from Erik Bols, Roget's financial vice president: I am sending you berewith eetimatee of the working capital r equiremente i f R oget i ncreaees i ts p roduction o f XL-4 in our Belgian plant from 600 to 1,000 tons a year lExhibit 3 1. I nitially, w e w ill n eed S kr. 5 4,000, f or a dditional inventories and accounts receivable. By the end of the aecond year, this will have increased to Skr. 74,000. Ttre working eapital qmounts shown in thie erhibit are based on the applicable law which permits bugiaegses to deduct 60 percent of iacremental inventory costs from taxable income. I have also looked at Lavanch5/s calculations for the fixed and variable manufacturing costs, and am in full agreement with them. In conclueion, I see no r eaeon t o s pend S kr ? 00,000 t o b uild a f actory i n Sweden w hen w e h ave e xceee c apacity i n o ur B elgian plant which can produce the incremental tons at lower cost and with lower manufacturing risk. Gillot's Response In early July 1981, Gillot Bent a letter to Ekstrom indicating that the XL-4 proposal was turning out to be more of a problem than he had a nticipated. H e i ncluded c opies o f t he memos f rom L avanchy a nd B ols. H e s aid h e was not yet in a position to grve final approval. 7 r4 Part III Variations in Monagement Control He said he would let Ekstrom know his decision as soon as possible. 4. Ekstrom'e lhoughte Ekstrom expressed some impatience with the way things were going: I have other projects that need developing for Thoraten, and this hind of long-range planning takee much tise and energy. Also, just keepirrg on top of the normal operating problems ofthe business we already have takes up a lot of my time. Sometimes I feel like tellirrg them to go and sell XL-4 t hemselves. 5. 6. Queetione 1. Using the numbers from Exhibit 2, what is your estimate of the NPV (at 8 percent) for the Swedish proposal. Also, what is the 6-year IRR? 2. What is the NPV (at 8 percent) and IRR of the Belgian proposal in Exhibit 3? 3. What are the key arguments for and against the alternatives presented by the 7. 8. contending parbies from Belgium and Sweden? Is ever5rthing that is being expressed by Ekstrom and the Belgium management above board? What are the respective hidden agendas that can be anticipated for each party, and in what way do they coincide? In what way can they be expected to diverge? Ifyou were in Gillof,s shoes, would you support the Swedish or the Belgian proposal? Why? Ignoring your answer to question 5, if the plant were not built aud the products were shipped from Belgium to Sweden, what transfer price would be appropriate? lVhat are the competitive advantages of Roget S.A.? What is Roget's stratery in the industrial chemicals business? Are the management control systems designed to support this strategf What changes in the management control systems would you necommendto Gillot