Cybernetics Canada Limited BACKGROUND Cybernetics Canada Limited (CCL), headquartered in Toronto, has been in business since 2010 producing and supplying electronic components in North America and Europe. Its products are well received due to their simplicity, quality and ease of application. Adam Samson, the CEO for CCL was concerned about the financial performance of the fiscal year ending in 2022. The partial CCL financial information for 2022 appears in Exhibit A. CCL is organized into three divisions - Research Divisions (RD), Electronics Division (ED) and International Division (ID) - all having complete P & L responsibility. As a financial policy, Adam had set a target, for performance evaluation purposes, a Return on Net Asset (RONA) metric of 15% based on Net Income on an after-tax basis. To promote cooperation among divisional managers, he had instituted a policy of internal sourcing as much as possible. RD has been successful in designing and marketing a generic electronic product (Zeta) with wide demand in the Artificial Intelligence (AI) application industry. The other two divisions - ED and ID require Zeta for their installation in their products depending on modifications as requested by customers. RD has prototype facility but lacks full production and modification capabilities. So, it relies on ED for any required modifications. Basic Zeta can also be sold directly in the open market. ED makes and sells its own products to external markets and has no significant transfer to other divisions. However, it does make custom modifications to Zeta received from RD and transfers back to RD as needed. ID was established in 2016 in Ireland to sell its products to take advantage of various tax incentives and to expand into Europe. ID makes and sells its own products in Europe that includes modified Zeta. RD has agreed to the transfer of the modified Zeta to ID as needed to promote goal congruence. Lately though, Zeta has been coming under stiff competition, as similar technological imitations are now available in the global markets. EXPANSION IN EUROPE AND DIVISIONAL CONFLICT Tom Pascal, the Divisional VP of ID had recently indicated to Adam that ID would be bidding on a lucrative contract to supply 400 of its devices to Italy that uses modified Zeta. Winning this contract is highly desirable as this may lead to continued long-term business prospects in Europe. He complained that the transfer price of $800 from RD is too onerous for him to compete and RD is not acting in the best interest of CCL. (Exhibit B) Market research revealed that quotations from two other suppliers of comparable Zeta products ranged between $550 (France) and $575 (Germany). The German supplier would even consider offering a discount of $75 per unit if RD can share their technology andblueprints with them. The German firm can replicate the modified Zeta to exact specifications. Samantha Davis, the divisional VP of RD complained to Adam that Tom Pascal - divisional VP of ID - would likely buy the least-cost French supplier instead of the internal transfer and not act in the best interest of CCL. Adam arranged a meeting with the divisional managers to address 2022 results and to discuss transfer pricing issues and focus on divisional cooperation and their performance. MEETING Adam Samson (CEO): Good morning, everybody! Tom, you seem to have some serious concerns with Samantha about the transfer price from her division. I have also asked Harriet Spoon, our new CFO, to join us and offer her independent thoughts. Samantha Davis (VP - RD): Adam, I thought our policy was to internally source as much as possible. We have developed Zeta and have invested a lot in R & D expenditure. The price of $800 covers our cost-plus royalty, average cost of modifications from ED, and our standard mark-up. Our success depends on continuous innovation and core competencies in new product development. We are under severe competition, and I am unable to meet the target of 15% RONA. We have an excellent reputation for our R&D capabilities and the quality of products we bring to the market. Saleem Ahmad (VP - ED): Adam, you know that we have reserved 15% of my divisional capacity to modify Zeta, price it and transfer to RD as needed. I am operating at nearly 85% of my nominal capacity that includes other products not transferred internally. My RONA expectation is in jeopardy if Tom (ID) purchases substitute products from France or Germany. The price of generic Zeta is set at $500 (Exhibit D). Tom Pascal: (VP - ID): I need this contract to make the required RONA of 15%. We have an opportunity to build long term relationship with this client in Italy and explore further expansion into Europe. Our market intelligence tells me that the competitive bid for 400 units be around $ 0.50M against our price of $0.70M (Exhibit C). Our bid definitely needs to be lower than the market bidding. We must get this contract as it would benefit all of us. Harriet Spoon: (New CFO): If I may step in, I am sure that German supplier can replicate our design and offer a lower price. We are planning to grow, and I am concerned about giving our trade secrets to a third party now. I need to revisit our costing, pricing, capacity, and other risks factors before I can make a meaningful recommendation. All our divisions are profit centers and the transfer pricing disputes among divisions should be resolved at divisional level but maintain goal congruence overall. We need to revisit our strategy, compensation, and performance evaluation system. Divisions are free to make their own operating decisions. Our focus on the corporate RONA should remain at 15%.Samantha Davis (VP- RD): I agree with Harriet. I still maintain that we need to recover our investment and continue to develop new products. Perhaps, I should control my own destiny and expand my pilot manufacturing facilities into full production. I do not have enough financial information to make a business case. Perhaps Harriet can determine our cost of capital and conduct a proper analysis for expansion. LOOKING FORWARD Adam Samson (CEO): Before we do all that Samantha, we need to refocus and work as a team. It is time that we revisited our strategy, refocused on our value proposition, and developed a better planning and control system for CCL. I am also worried about the sustainability of CCL in general. Let us look at other measures beyond RONA. I am beginning to doubt if our current organizational structure is conducive for our business. We want to be profitable, sustainable and grow CCL methodically. We need to maintain our presence in the market, build on our reputation and continue to be innovative and expand into Europe. Naomi, please take the lead and work with the divisional managers to arrive at key conclusions and recommendations. We certainly need to make some important decisions! Required: Take the role of a business advisor, identify the key issues, conduct appropriate analysis, and address quantitative and qualitative factors for your recommendations to Mr. SamsonExhibit A Condensed partial financial information: Cybernetics Canada Limited Year Ended 31 December 2022 (5 Million - Canadian) RD ED ID Total Total Revenues 10.00 25.00 15.00 50.00 Operating Income (before taxes) 1.50 3.50 1.80 6.80 Selected Balance Sheet Information Current Assets 3.00 4.00 5.00 12.00 Fixed Assets @ acquisition 15.00 25.00 10.00 50.00 Depreciation (Accumulated) 8.00 14.00 2.00 24.00 Long-term Debts (LTD) 4.00 6.00 5.00 15.00 Current Liabilities 2.00 3.00 3.00 8.00 LTD maturity 2025 2025 2025 Additional Information Assume that shareholders need an average return of 15% on equity. LTD - Interest Rates - arranged by the corporate at 6% . . Tax rate for CCL: Domestic 35%; Ireland 30%. Risk Adjustment factor for cost of capital is assumed at 1.4 for all divisions. You may round of the cost of capital to the nearest whole number. Exhibit B Quote from RD to ID: Unit Transfer Pricing Supply of 400 units of modified Zeta to ID Generic Zeta (Exhibit D) $500 Modification premium from ED to RD 95 Recovery of R & D Investment (Royalty) - see notes below 100 Total Product Cost $ 695 Mark-up @ 15% (rounded) 105 Transfer Price to ID $800 . The investment in the R & D facility totaled $3,000,000. This amount was amortized over a production of 30,000 units. Thus, Royalty/unit is set at $100/unit. RD has been successful in selling Zeta. It has already sold 25,000 units in the open market. It hopes to recover the royalty balance in the next couple of years, as demand continues to exist in the open market for the unmodified Zeta. ACC-930: Second Case submission Spring 2023Exhibit C: Bid Price for the Italian Proposal (400 units using modified Zeta as a part of ID Product) Total Unit (400 units) Direct Material S 200,000 * 500* Direct Labour 160,000 * 400* Variable Overhead 100,000 250 Fixed Overhead 125.000 312.5 585,000 * 1,462.5 Mark-up @ 20% 115.000 287.5 Proposed Bid 700.000 or $ 1,750 /Unit * Includes the transfer price of $800 for the modified Zeta (Exhibit B). Exhibit D Unit Cost Structure of Zeta (Generic prototype) Direct Material $ 150 Direct Labour 200 Manufacturing Variable Overhead 25 Fixed Overhead 42 Total Product Cost $ 417 Mark-up @ 20% (rounded) 83 Unit Cost - Zeta (base) $ 500 Note: The above cost does not include royalty charged to regular customers @ $100/unit Other Notes: 1. Adam Samson had repeatedly stated at various meetings that his focus is on growth. 2. Harriet feels that CCL should use additional metrics for financial performance purposes and needs to be profitable and sustainable before thinking of growth