London Automotive Canada (LAC) is an international firm that is organized into three divisions.

Each is treated as a profit center. Divisional performance evaluation and managerial bonuses are based on achieving a 12% return on their investment (ROI) calculated as a pretax divisional income divided by the divisional investment. John Adam, President of LAC, is concerned about both divisional and overall corporate performance of 20X1. Following is a discussion between John Adam and Heather Ramsay the newly appointed Corporate Controller.

John Adam: (President) "We are now an international organization, and I am not sure what is going on in all the divisions. The performance of Technology Division is of concern to me". (Exhibit 1)

Heather Ramsay: (Corporate Controller) "But John, you had laid out some ground rules for the divisional managers about their performance. You said this morning that they are independent business units and should strive to maximize their divisional profits. Some of the financial policies we have at LAC do not give me the impression that they have autonomy to act as an independent Profit Centre".

John Adam:"Yes Heather, in the interest of LAC, I have instructed the divisional vice-presidents to buy and sell from each other as much as possible. The transfer price should be reasonable and not to exceed 1.25 times the full production costs. All I seem to hear from the vice presidents is the unfairness in terms of prices charged by one division to the other. Perhaps, you can look at their grievances so that we can mitigate friction and help achieve cooperation between divisions".

Organizational Structure

Technology Division (TD - Samantha Savage) of LAC manufactures two types of automotive components - Standard and Deluxe. These are sold to various automotive firms in Ontario and international customers. The production process involves product design, machining of parts, assembly, and quality assurance. TD has a strong reputation for its quality and offers guarantee of complete customer satisfaction. Demand for Standard products exist in the open market, but TD has been instructed to sell Standard to the Specialty Division (SD). Cost information of TD is given in Exhibit 1.

Samantha Savage of TD has been complaining that her divisional ROI is decreasing due to its sale to SD at a specified price. She Felt that the transfer price of Standard to SD should be increased to existing market price of $500. She even threatened to stop producing altogether the Standard if she cannot sell them in the open market where demand exists for 8,000 units. Alternatively, she can use the capacity to produce Deluxe and sell them all in open market at the going price of $600. The only restriction facing TD is that it has a total capacity of 200,000 machine hours per year to produce a combination of both Standard and Deluxe.

Specialty Division (SD - Paul Dubois) manufactures Braking system for heavy trucks and require the incorporation of Standard product from TD for their final product. The products at SD are valued for their durability and overall good performance. The operating result for SD is given in Exhibit 2.

John Adam is apparently pleased with the performance of SD as the sales and profits continue to increase.

Paul indicated that the sale of braking system is very price sensitive and an increase of standard from TD at $500 would increase his price from SD affecting his profitability. This would cause the domestic sales volume to fall to 3,500 units a year. Paul has been complaining about the decreasing level of service from TD causing delays in production and final delivery to the clients. Lack of cooperation from TD will be a definite loss of sales and profitability to SD.

International Division (ID - Erin O'Toole) of LAC is in Ireland with a corporate tax rate at 30%.

The mandate for ID is to modify and customize the Braking Systems imported from Canada and sell them in Europe. ID pays a 20% duty based on the transfer price from SD. Custom officials in Ireland carefully monitor the invoices of imported goods to ensure that the products are transferred at "fair values".

The Republic of Ireland considers any price between full production costs and 150% of full production costs to be within the definition of fair value. Information on ID performance is given in Exhibit 3.

ID is only three years old, but it has already gained a significant market share in Ireland and UK by following a penetration pricing strategy. All indications are that sales would continue to grow with possible expansion into other European countries. Erin indicated to John, based on her market research in Europe, that the proposed increase in price from SD would lead to an increase in modified Braking System by $300 per unit. This in turn would cause the sales volume drop to 1,700 units per year.

At the end of the meeting John Adam requested Heather to analyze the company's current situation, including the TD manager's two proposals, and recommend improvements.

Heather noted that she needed to address at least the following issues:

• Impact on ROI on both (Transfer price to $500 and the stopping the production of Standard)
• Some of the behavioral implications of these proposals for the divisions and LAC
• Setting up proper Transfer Pricing policies going forward.
• Organizational changes and strategic redirection with Adam that may promote goal congruence.
• Overall Performance evaluation, bonus system and sustainability (Exhibit 4 for partial financial statements from Heather Ramsay)

Required:

Take the role of Heather Ramsay and make a formal report to John Adam to address all the issues and others that you may feel relevant to the case.

Exhibit 1 Technology Division - 20X1

Standard Deluxe Total TD

Unit Price Volume Unit Price Volume Total

Volume (Units) 6,000 22,000 28,000

Revenue (Million) $400 $2,400 $600 $13,200 $15,600

Direct Costs:

Materials 150 900 135 2,970 3,870

Labour 70 420 90 1,980 2,400

Production Overheads:

- Variable 45 270 25 550 820

- Fixed 55 330 70 1,540 1,870

Variable S & Admin 10 60 35 770 830

Total Direct Costs $330 $1,980 $ 355 $ 7,810 $ 9.790

Fixed S & Admin 4,750

Total Costs $14.540

Pre-tax Divisional Income $ 1,060

Machine Hours used /Unit 4 24,000 8 176,000 200,000

Net Divisional Investment $12,000

Divisional ROI 8.83%

Exhibit 2 Specialty Division - 20X1

Per Unit Volume Total (1,000)

Sales: Domestic $3,300 4,000 $13,200

Sales: Transfer to ID: $3,625 2,000 7,250

Total Sales: 6,000 $20,450

Direct Materials (Note 1) $1,300 6,000 7,800

Direct Labour 1,200 6,000 7,200

Variable Production Overhead 100 6,000 600

Fixed Production Overhead 300 6,000 1,800

Selling & Administrative:

Variable 50 6,000 300

Fixed 350 6,000 2,100

Total Costs $3,300 $ 19,800

Pre-tax Divisional Income $ 650

Net Divisional Investment $ 5,000

Divisional ROI 13.0%

Note. 1 Includes Standard at $ 400/unit from the ED

Exhibit 3

International Division - 20X1

(Canadian Dollars)

Per Unit Total (1,000)

Volume 2,000

Revenue (10% mark-up, transferred-in cost from SD) $ 4,785 $9,570

Cost of Braking system (Note 1) 4,350 8,700

Gross Margin $ 435 $ 870

Selling & Admin Costs:

Variable 50 100

Fixed 85 170

$ 135 $ 270

Pre-tax Divisional Income $ 300 $ 600

Divisional Investment $ 3,000

Divisional ROI 20.0%

Note 1.As acquired from SD on braking system at 125% of full production costs (rounded to the nearest dollar) plus 20% import duty on goods imported into Ireland.

Exhibit 4

Divisional Assets Distribution($1,000) - As of 20X1

Total Long-term Debt Owner's' Equity

Technology Division 12,000 4,000 8,000

Specialty Division 5,000 2,500 2,500

International Division 3,000 1,200 1,800

Other Information:

• Cost of Financing 8% (pre-tax) 15%
• Tax Rate assumed (LAC) 30.0% -Cost of capital calculation purposes for all divisions.
• Risk Adjustment Factor1.25 (You may round up Cost of Capital to nearest whole number)