North Country Auto, Inc.

George G. Liddy, part owner of North Country Auto, Inc., was feeling pretty good about the new control systems recently put in place for his five department managers (new and used car sales, service, body, and parts departments). Exhibit 1 describes each department. Mr. Liddy strongly believed in the concept of evaluating each department individually as a profit center. But he also recognized the challenge of getting his managers to "buy in" to the system by working together for the good of the dealership.

Background

North Country Auto, Inc., was a franchised dealer and factory-authorized service center for Ford, Saab, and Volkswagen. Multiple franchises were becoming more common in the 1980s. But the value of multiple franchises did not come without costs. Each of the three manufacturers used a different computerized system for tracking inventory and placing new orders. They also required their dealerships to maintain an adequate service facility with a crew of trained technicians that, in turn, necessitated carrying an inventory of parts to be used in repairs. Exhibit 2 gives balance sheet data with a breakout of investment for each product line. North Country also operated a body shop, and in mid-1989 opened a "while-you-wait" oil change service for any make of vehicle.

The dealership was situated in an upstate New York town with a population of about 20,000. It served two nearby towns of about 4,000 people as well as rural areas covering a 20-mile radius. North Country began operations in 1968, and in 1983 moved one mile down the road to its current 6-acre lot, 25,000 square-foot facility. It was owned as a corporation by George Liddy and Andrew Jones, who were both equally active in day-to-day operations. Mr. Liddy purchased an interest in the dealership from a previous partner in 1988. Mr. Jones had been part owner since the start of the business. Whereas Mr. Liddy focused his energies on new and used car sales, Mr. Jones concentrated on managing the parts, service, and body shop departmentscommonly referred to as the "back end" of a dealership.

The owners were determined to maintain a profitable back end as a hedge against depressed sales and lower margins in vehicles sales. In an industry characterized by aggressive discounting fueled by a combination of high inventories, a more educated consumer, and a proliferation of new entrants, alternative sources of cash flow were crucial. Industry analysts were estimating that fewer than 50 percent of the dealers in the US would make a profit on new car sales in 1990. Overall net profit margins were expected to fall below 1 percent of sales (The Wall Street Journal, December 11, 1989).

EXHIBIT 1 North Country Auto, Inc.The Departmental Structure

New Car Sales and Used Car Sales

The new and used car departments each had a sales manager. They shared six salespersons. In addition, these departments shared an office manager and clerks. The managers were paid a flat salary, plus a fixed sum per new or used vehicle sold, and a percentage of their department's gross profit (calculated as sales minus cost of vehicles sold). When the owners and the managers agreed on annual unit volume and margin goals, the dollar weights were set to make each portion approximately one-third of the manager's expected total compensation. The owners claimed that this type of dual incentive bonus structure allowed the managers flexibility in targeting margins and volume. George Liddy maintained, "If the margins are low, the sales manager can try to make it up in volume." The sales force was paid strictly a commission on gross profit. Many dealerships in the area were changing sales compensation to a flat salary plus a partial commission on gross profits generated.

The new car sales manager was responsible for recommending to Liddy new model orders and inventory mix among the three product lines. He also had the authority to approve selling prices and trade-in allowances on customer transactions. Typically, the new car manager was allowed to transfer the trade-in at blue book. However, if the car was obviously of below average quality, the used car department was asked for their estimate of value. The used car manager was responsible for controlling the mix of used car inventory through buying and selling used vehicles at wholesale auto auctions.

Service

The service department occupied over half of the building's usable square footage and was the most labor intensive operation. Service comprised 11 bays with hydraulic lifts, one of which was used for the oil change operation. The department employed a manager, 10 technicians, 3 semiskilled mechanics, 2 counter clerks, and 3 office clerks. The manager was paid a flat salary plus a bonus on the department's gross profit on labor hours billed (computed as labor dollars billed minus total wages of billable technicians and mechanics). Service revenue consisted of labor only. No markup for parts was realized by service department. The bonus portion was planned to be approximately 50 percent of his salary. The technicians, mechanics, and clerks were all paid a flat salary, regardless of actual hours billed. The technicians required specialty training to perform factory-authorized work on each of the specific lines. Sending a technician to school cost about $4,000 over a two-year period. The owners estimated that a new hire could cost as much as $10,000 in nonbillable overruns on warranty jobs, where reimbursement was limited to standard allowable labor hours. Of the 10 techs, 4 were certified for Ford, 3 for Saab, and 3 for Volkswagen. George Liddy and Andrew Jones contemplated reducing the cost of idle time by cross-training, but were averse to risks of turnover among highly skilled labor. Retraining costs could triple when one person quit.

The primary sources of service department revenue were warranty maintenance and repair work, nonwarranty maintenance and repair work, used car reconditioning, and the oil change operation. Warranty work was reimbursed by the factories at their prescribed labor rates, which were typically as much as 20 percent lower than the rates charged directly for nonwarranty work. Lower margins on warranty work were a potential problem for the dealership if they dissuaded the service manager from delivering prompt service to recent buyers. During times of near capacity utilization, the manager would be motivated to schedule higher margin nonwarranty jobs in the place of warranty work.

Parts

The parts department consisted of a manager, three stock keepers, and two clerks. The parts manager was paid a flat salary plus a bonus on department gross profits (computed as total parts sold less cost of parts). The parts manager was responsible for tracking parts inventory for the three lines and minimizing both carrying costs and "obsolescence." The owners defined obsolescence as a part in stock that was not sold in over a year. Mr. Liddy estimated that as many as 25 percent of the parts-on-hand fell into this category. Days supply of parts (inventory turnover) averaged 100 days for the industry. The manager had to be an expert on the return policies, stock requirements, and secondary market of three distinct and unrelated lines of merchandise. It was the parts manager's job to use factory return credits most effectively and identify outside wholesale opportunities so as to minimize large write-downs. Local wholesalers would pay as much as 80 percent of dealer cost for old parts.

Demand for parts was derived almost completely from other departments. Dollar sales volume in parts broke down as follows: 50 percent through service, 30 percent through the body shop, 10 percent wholesale, and 10 percent over-the-counter retail. Similar to service work, parts needed in warranty work were reimbursed at rates as much as 20 percent less than prices charged for nonwarranty work.

Body Shop

The body shop consisted of a manager, three technicians, and a clerk. The manager, like the others, was paid a flat salary plus a bonus on departmental profitability. To keep the shop in business in the long run, North Country Auto needed to invest an additional $50,000 in new spray-painting equipment. As it was, the body shop was showing a loss after allocation of fixed overhead. Gross margins as high as 60 percent could be attained, but rework and hidden damage beyond estimates tended to drive them down to closer to 40 percent.

Oil Change Operation

The dealership's oil change business operated under the nationally franchised "Qwik Change" logo, using one bay in the service department and one of the semiskilled mechanics. Volume averaged 68 changes per week. The operation was not evaluated as an independent profit center but as a means of filling unused capacity in the service department. The oil change franchise paid for all equipment, reducing the dealership's out-of-pocket investment to $500. After direct labor, direct parts, and the franchise fee, the dealership made about $10.00 on each oil change priced at $21.95. The owners were willing to devote an extra bay to this operation if volume warranted.

EXHIBIT 2 Balance Sheet

NORTH COUNTRY AUTO, INC. Balance Sheet October 31, 1989 (In thousands)

Assets

Liabilities and Equity

Cash. . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 32

Accounts payable . . . . . . . . . . . . . . . .

$ 73

Accounts receivable. . . . . . . . . . . . . . . . .

228

Notes payablevehicles. . . . . . . . . . .

1,294

Saab inventory . . . . . . . . . . . . . . . . . . . .

253

Long-term debt . . . . . . . . . . . . . . . . . .

344

VW inventory . . . . . . . . . . . . . . . . . . . . .

243

Ford inventory . . . . . . . . . . . . . . . . . . . .

773

Total liabilities. . . . . . . . . . . . . . . . . . .

1,711

Used cars . . . . . . . . . . . . . . . . . . . . . . . .

231

Saab parts. . . . . . . . . . . . . . . . . . . . . . . .

75

VW parts. . . . . . . . . . . . . . . . . . . . . . . . .

75

Ford parts. . . . . . . . . . . . . . . . . . . . . . . .

226

Body shop materials . . . . . . . . . . . . . . .

6

Stockholders' equity

Other current assets . . . . . . . . . . . . . . . .

89

Common stock. . . . . . . . . . . . . . . . . . .

$ 400

Retained earnings. . . . . . . . . . . . . . . . .

205

Property & equipmentNet* . . . . . . . .

85

($377M gross)

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$2,316

Total. . . . . . . . . . . . . . . . . . . . . . . . . . .

$2,316

*North Country leases both the land and the building.

George Liddy's Challenge

Before George Liddy bought into the dealership, all the departments operated as part of one business. Department managers were paid salaries and a yearend bonus determined at the owners' discretion based on overall results for the year and a subjective appraisal of each manager.

George Liddy believed this system did not provide proper motivation for the managers. He believed in decentralized profit centers and performance-based compensation as superior models of control. He instructed each of his departmental managers (new, used, service, body, and parts) to run his/her department as if it were an independent business. He knew that the success of the profit center control system was dependent upon the support of his managers. They must understand the rationale for allocating costs to their departments and believe that they had reasonable control over profitability. The managers' bonuses in 1989 were calculated on the basis of departmental gross profits. Expenses below the gross profit line were not considered in the bonus calculation. They were only told, in a statement outlining their responsibilities, to exercise "judicious control over discretionary expenses." Implementing a more comprehensive control system tied to actual departmental net profits would require that Liddy break down costs traditionally regarded as general overhead into separate activities associated with specific departments. His strategy with the managers involved a gradual phasing in over the next few years of an "almost" full-cost allocation system, where each department manager would eventually have responsibility for all controllable costs incurred in the department. Fixed expenses, such as interest expense, would be allocated by Liddy for his own decisions, but would not be used in the managers' bonus

calculations.

The gradual changeover would allow Liddy, who was new to the dealership, time to become more knowledgeable about the intricacies of North Country Auto's accounting records. He did not want to lose credibility because of perceived arbitrary cost allocations. Exhibit 3 gives a breakdown of department profitability on an "almost" full-cost basis.

In addition to finding a way to effectively track departmental performance, George Liddy had to devise a sensible system for transfer pricing. Though Mr. Liddy believed that each department at North Country theoretically could operate as an independent business, he acknowledged that a complex interrelationship existed among the profit centers in the course of normal business transactions. A recent new vehicle purchase illustrates the potential problems that could arise.

Alex Walker, manager of the new car sales department, sold a new car for $14,150. This purchase was financed by a cash down payment of $2,000, a trade-in allowance of $4,800, and a bank loan of $7,350. The dealer's cost was $11,420, which included factory price plus sales commission.

The manager of the used car sales department, Amy Robbins, examined the trade-in vehicle. The trade-in had a wholesale guidebook value of $3,500. The guidebook, published monthly, was, at best, a near estimate of liquidation value. Actual values varied daily with the supply-demand balance at auto auctions. These variances could be as much as 25 percent of the book value.

Ms. Robbins believed that she could sell the trade-in quickly at $5,000 and earn a good margin, so she chose to carry it in inventory instead of wholesaling it for a value estimated to be $3,500. Mr. Walker, in turn, used the $3,500 value in calculating his actual profit on the new car sale.

EXHIBIT 3 Financial Statement

NORTH COUNTRY AUTO, INC.

October 31, 1989 (10 months) (Dollar figures in thousands)

New

Used

Service

Body

Parts

Sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$6,558

$1,557

$ 672

$231

$ 1,417

Gross profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

502

189

421

145

361

Number of units (vehicles, repairs, or parts) . . . . . . . . . .

474

390

9,795

406

40,139

Direct selling (commission & delivery) . . . . . . . . . . . . . .

$ 96

$ 25

n/a

n/a

n/a

Indirect labor . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

162

74

$ 237

$ 64

$ 156

Department advertising . . . . . . . . . . . . . . . . . . . . . . . . . .

91

30

19

2

3

Policy workparts & service (giveaways & rework) . . .

29

12

14

12

1

Supplies & utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

22

18

19

28

12

Depreciation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3

1

15

5

2

Rent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

89

22

67

13

9

Profit before common expenses . . . . . . . . . . . . . . . . . . . .

$ 10

$ 7

$ 50

$ 21

$ 178

Other expenses:

Interest (on new inventory). . . . . . . . . . . . . . . . . . . . .

$ 110

Other interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

21

Owners' salary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..

65

Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

35

Net operating profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 35

Notes to Financial Statement

1. New car sales and gross margins (000s) break down as:

Sales

Gross Profit

# Units

Ford

$3,114

$193

243

Saab

1,502

90

73

VW

1,794

117

158

Financing fees*

148

102

n/a

$6,558

$502

474

2. Used car sales and margins break down as:

Sales

Gross Profit

# Units

Retail

$1,045

$212

177

Wholesale

423

(59)

213

Financing fees*

89

36

n/a

$1,557

$189

390

3. Notes payable for vehicles is a revolving line of credit secured by new car inventory. Payments to the bank are due upon sale of each vehicle financed in inventory. This liability has been reduced over the past 10months by approximately $1.5 million.

4. Indirect labor consists of department managers, clerks, bookkeepers, and work involving tasks directly related to the activities in a specific department. It does not include sales commissions or billable employees in the back end.

5. Departmental advertising is assigned to departments based on actual ads placed.

6. Policy work consists of dealer concessions made to customers arising from disputes over dealer-installed options on new vehicles, warranty coverage, or cost of repairs. These costs are allocated to the departments in which they occur.

7. Depreciation is allocated by historical cost of leasehold improvements or equipment in each department.

8. Rent is allocated by square footage used by each department, adjusted for the value of the space.

9. Interest expense is treated as a common expense for the purpose of keeping investing and financing costs separate.

10. Insurance consists of both umbrella liability and property damage for the dealership as a whole. Because of the multiple types of coverages included and the bundled pricing, it is not feasible to break out coverage costs by department.

11. Approximately 75 percent of the fixed costs in the used car department related closely to retail vehicle sales and approximately 25 percent to wholesale sales.

12. Total number of parts sold during the year 40,139 parts; total number of service orders undertaken during the year 9,795 orders.

13. Using Exhibit 3, North Country determined the following allocations for overhead expenses:

New: $835/vehicle $396,000/474 vehicles

Used: $665/vehicle $157,000 * 0.75/177 vehicles

Parts: $32 $183,000/40,139 parts 4.55/part * 7 parts

(2 brake kits, 1 lock assembly, 4 tune-up parts)

Service: $114 $371,000/9,795 orders * 3 orders

(lock, brakes, tune-up)

*Finance fees consist of income that the dealer earns on dealer-sourced auto loans. It also includes the dealer's commission on service contracts and extended warranties sold through the dealership.

In performing the routine maintenance check on the trade-in, the service department reported that the front wheels would need new brake pads and rotors and that the rear door lock assembly was jammed. The retail estimates for repair would be $300 for the brakes ($125 in parts, $175 in labor) and $75 to fix the lock assembly ($30 in parts, $45 in labor). Cleaning and touch-up (performed by service department as a part of the service order for lock and brake) would cost $75. The service department also recommended that a full tune-up be performed for a retail price of $255 ($80 in parts, $175 in labor).

The repair and tune-up work was completed and capitalized at retail cost into used car inventory at $705. These mechanical repairs would not necessarily increase wholesale value

if the car subsequently were sold at the auction. The transfer price for internal work recently had changed from cost to full retail equivalent. The retail markup for labor was 3.5 times the direct hourly rate and about 1.4 times for parts.

George Liddy was concerned that the retail transfer price of the repairs in conjunction with his plan to eventually allocate full costs to each department (as illustrated in Exhibit 3) might encourage the used car sales manager to avoid the possibility of losses in her department by wholesaling trade-in cars that could be resold at a profit for the dealership. This might also hurt the dealership by making its deals less attractive for new car customers.

Knowing how important it was to maintain credibility with each of the departments, Liddy called a meeting with the three department managers. He decided to use the recently completed new car sale to illustrate the effect that transaction would have on departments' profits. In his presentation, Mr. Liddy laid out the transaction and allocation of profits and costs. After this presentation, Mr. Liddy asked for the reactions of his department managers.

Alex Walker was the first to chime in, "I understand that the allowance above book value on the trade-in cannot be accounted for as profit. However, the real issue is how to set the price between me and Amy when we transfer the trade-in. I refuse to be responsible for any loss that might arise if the trade-in vehicle is liquidated at auction for an amount less than the wholesale guidebook value. Her department should be accountable for its valuation errors."

Amy Robbins vehemently disagreed. "My department should not have to subsidize the profits of the new car sales division."

Liddy quickly jumped into this deteriorating argument, "Obviously, we need to carefully consider how to set the price between the new and used car departments and who should be responsible for unexpected losses."

"Another item that concerns me," Robbins went on, "is using full retail price for parts and labor used in the repairs of trade-ins. Given underutilized capacity in service, I do not understand why I am charged full price. It doesn't make sense for the service department to mark up on projects undertaken for new and used car departments within our own dealership. I can't see how we can make profits when one part of our company sells to another."

Robbins added, "When I am unsure of the actual retail value, I tend to wholesale rather than take a risk of a negative margin at retail. However, when I do this, we may be losing as an organization as a whole."

"I agree with Amy on this," stated Walker, "and I have the same problem with dealer-installed options. When I am charged full price for options, I have no incentive to try to sell these items."

"Hold on," said the service department manager. "I make my profit by selling service, and these are the prices I would charge for outside work. To sell service for a lower price inside defeats the purpose of this profit center idea. But I do have a problem with getting full price for parts. The demand for parts is derived almost completely from service, and we are dependent on parts for quick delivery for repairs."

Liddy jumped back in. "Obviously, we are dependent on each other for quality and prompt service. We need to make sure that, as each of you maximizes profits in your departments, you do not negatively affect other departments."

Liddy continued, "I am also concerned about the impact of capitalizing trade-in repairs rather than expensing immediately. We all know that wholesale values drop with each publication of the new guidebook. I am afraid that, when a car is slow to sell, we might be reluctant to sell the car at a loss, even though we should. Car inventory ties up cash, and a key measure of departmental success is our inventory turnover [average industry inventory turnover was 75 days for new cars and 45 days for used cars]. In conclusion, while I think the profit center concept makes good sense for this business, I am concerned about the frictions that are taking place between the departments."

Questions

1. Using the data in the transaction, compute the profitability of this one transaction to the new, used, parts, and service departments. Assume a sales commission of $250 for the trade-in on a selling price of $5,000. (Note: Use the following allocations [new, $835; used, $665; parts, $32; service, $114] for overhead expenses while computing the profitability of this one transaction. These overhead allocations are also shown as Note 13 in Exhibit 3.)

2. How should the transfer-pricing system operate for each department (market price, full retail, full cost, variable cost)?

3. If it were found one week later that the trade-in could be wholesaled for only $3,000, which manager should take the loss?

4. North Country incurred a year-to-date loss of about $59,000 before allocation of fixed costs on the wholesaling of used cars (see Note 2 in Exhibit 3). Wholesaling of used cars is theoretically supposed to be a break-even operation. Where do you think the problem lies?

5. Should profit centers be evaluated on gross profit or "full cost" profit?

6. What advice do you have for the owners?