Cedar Electronics Limited

John Big, the president of Cedar Electronics Limited $($CEL$),$ is troubled that the recently acquired appliance Division has been incurring large losses, and John is seeking advice on the division.

CEL is a large, widely held Canadian corporation that has specialized in the design and manufacture of electronic devices. One particularly successful product developed was the RX$-100,$ an electronic processor, designed to replace mechanical switching devices. The RX$-100$ was an instant success in the appliance industry but, within a year, competing products were rapidly replacing the RX$-100.$ In $2018,$ CEL had acquired Domino Appliances Limited $($DAL$)$ to CEL a captive market and a base for developing new devices.

At the time DAL was acquired, John restructured CEL into three divisions$-$Electronics, Appliance $($formerly DAL$)$ and RD&I $($Research$,$ Development & Inspection$)$ each of which was designed to be an investment centre. Division managers were free to sell externally but were expected to supply, source, and service internally. About $12\%$ of the Electronics Division's sales were comprised of RX$-100$s transferred to the Appliance Division at full cost plus $10\%.$ The RD&I Division sold a production quality control service, on contract, to the other divisions at variable cost plus $10\%$ and also contracted externally. RD&I was given a budget appropriation, for researching new products, which was not included in the calculation of its ROI.

John Big's objective in decentralizing the corporate structure was to make each division operate and be evaluated as if it were an independent business. Corporate overhead was allocated to the divisions on the basis of a percentage of sales. The division managers were each allowed to make annual investments of not more than $5\%$ of their divisional net assets on their own authority. CEL's after$-$tax cost of capital was estimated to be $10\%.$ Division managers were expected to earn $10\%($before taxes$)$ on their investment base, calculated on the book value of their current assets plus the net book value of their fixed assets.

John has called in Rita Smart, a recently qualified Chartered Professional Accountant, for advice.

John: Thank you for coming. There are some developments in our organization which disturb me and