The Information Technology (IT) Department of M/s NEO FORGINGS Limited operates as a separate profit center and it provides IT consultancy services of different categories / varieties to their clients i.e. both internal as well as external clients. As the said division operates as a separate profit center within the organization, they bill all their clients in respect of the services provided by them and while doing so, a fair and reasonable degree of margin is invariably loaded in their bills (that are raised on both internal and external clients) to arrive at the total bill amount. As at the end of the financial year the performance of the IT Department is evaluated based on their performance during the year wherein the overall (and job-wise) profit earned by that department is invariably treated as an important yardstick along with the quality and promptness of the services offered by the said department. Such performance evaluation mechanism is characterized by a strong one-to-one correspondence with the incentives / bonus / salary hikes offered to the permanent employees working in that department and the same is also regarded as a key consideration while deciding on the promotion criterion for those permanent employees as well.

The IT Department is quite well reputed in the market essentially because of the professional and high quality consultancy services offered by them and hence, the said department is often approached by a number of external clients (pertaining to different corporate houses) requesting for such services. Usually, the said department offers four (4) different varieties / categories of IT consultancy services to their external clients that are referred to as Type A, Type B, Type C and Type D services respectively. While rendering these four types of services to the external customers, the said department adopts a somewhat unique business model. They employ a small group of contract employees who are professionally qualified and extremely well trained to handle the field level jobs. These contract employees are actually recruited (by the IT Department) based on the total time estimation that various orders / jobs actually demand and these contract employees are remunerated strictly on per hour basis. As some specific skill set and high quality professional capabilities and training are expected from such contract employees for undertaking the field level jobs at various client locations, the availability of such contract employees is limited in the market where the IT Department actually operates. As per the estimates developed by the senior management team of the IT Department, the total hour availability (from the entire group of such contract employees) during a financial year works out to 20,000 hours approximately. Some relevant information / details that pertain to the different categories of services offered to the external clients (by the IT Department) are summarized as under. The tabulated information distinctly reveals that the existing market demand of their services (that may be offered to the external clients) far exceeds their capacity measured in terms of the contract employees hours availability during a financial year.

TYPE "A" SERVICES

Revenue per order=Rs 1,500

Total Variable Cost incurred per order=Rs 1,300

Total hour involvement of the contract employees per order=3 Hours

It may be noted that the maximum number of orders that pertains to the Type A services that the IT department may secure from their external clients amounts to 2800 orders per financial year.

TYPE "B" SERVICES

Revenue per order=Rs 1,460

Total Variable Cost incurred per order=Rs 1,000

Total hour involvement of the contract employees per order=4 Hours

It may be noted that the maximum number of orders that pertains to the Type B services that the IT department may secure from their external clients amounts to 2500 orders per financial year.

TYPE "C" SERVICES

Revenue per order=Rs 1,400

Total Variable Cost incurred per order=Rs900

Total hour involvement of the contract employees per order=2 Hours

It may be noted that the maximum number of orders that pertains to the Type C services that the IT department may secure from their external clients amounts to 2300 orders per financial year.

TYPE "D" SERVICES

Revenue per order=Rs 1,300

Total Variable Cost incurred per order=Rs850

Total hour involvement of the contract employees per order=3 Hours

The maximum number of orders that pertains to the Type D services that the IT department may secure from their external clients amounts to 1600 orders per financial year.

A few days ago the Head of the IT Department had been approached by the Head of one of the Manufacturing Division of NEO FORGINGS Limited, wherein that departmental head had said that their division is also looking for some help and support from the IT Department. Actually, they are also in need of the "Type D" consultancy services during the year and such requirement is quite substantial as well. After having a detail discussion (on the matter) the two departmental heads came to the conclusion that during the current financial year the manufacturing division (as referred above) would actually provide as many as 2500 orders of "Type D" variety to the IT Department. The Head of the IT Department quoted a rate of Rs 1300 per order for such "Type D" services requested by that division (the same rate that is normally charged by the IT Department to their external clients). The departmental head of the manufacturing division opined that the quoted charges appear to be on a higher side and requested the IT Department to re-consider their quotation. The Head of the IT Department clarified that their department is expected to operate as a separate profit center and hence, they would be answerable to the top management of the company if they compromise on the profit parameters. He also mentioned that since they provide such services to external clients at the rate of Rs 1300 per order, the question of offering similar services (internally) at a reduced rate simply does not arise especially because the IT Department is not encountering any dearth of business (whatsoever) during the year under review.

After having the above discussion with the Head IT Department, the departmental head of the manufacturing department invited quotation from another third party who also provides similar (i.e. "Type D") IT services to various clients. That third party quoted a rate of Rs 1225 per order for a total of 2500 orders during the year.

On obtaining such a quotation from the third party IT consultant, the departmental head of the manufacturing division re-contacted the IT Head of his own company and commented,

QUOTE

The third party quotation that I have obtained is much lower than yours. Although I agree that this party is not as well reputed in the market as your department, they have actually agreed to provide similar quality services at a much lower cost. However, it goes without saying that, any-day I would personally prefer to obtain such services internally rather than getting it outsourced because, (naturally), I would have lot of faith and confidence on our internal expertise especially because your services are very well reputed in the market place. Please try to understand that we are working for the same company and unless you agree to offer a better rate to your internal clients, we won't be in a position to optimize on our total cost exposure. You'll surely appreciate that a reduction in the total cost would result into higher profits for our company as a whole. Hence, you must offer your services quoting a maximum rate of Rs 1200 per order. In fact, if you ask me, ideally you should offer us a rate which is marginally lower than Rs 1200 per order.

UNQUOTE

The Head IT Department responded by saying - "Nothing doing. I cannot cut down on the rate at all. I am answerable to the top management in respect of our divisional profitability and at the end of the day our performances would get evaluated based on the profit earned by our division. If I consider your request favourably, that would mean that I'll have to compromise on our departmental profitability parameters which might even adversely affect our bonus / incentives / salary hikes and even our future promotion ambitions".

On obtaining such a blunt refusal from the Head IT Department, the departmental head of the manufacturing division got extremely agitated and he wrote a "stinker" addressed to the CEO of the company challenging the stand taken by the Head IT Department. In that letter, he narrated the entire episode and finally supported his point of view with a very strong message given in the last paragraph of that letter which he guessed that the company CEO would simply fail to ignore. That last paragraph (of his letter) is reproduced below,

QUOTE

In all company meetings and presentations chaired by you, you keep on highlighting the importance of being "cost competitive" and hammer on the idea that, the success of our company depends on cost management issues. All of us working in the company had heard you saying numerous times that - "remember one thing, one paisa reduction in cost results in one paisa addition to profits and one paisa addition to cash flows". Can you please clarify now, how do we achieve the same if the general attitude of the other departments is just the opposite. If our own departments refuse to offer us competitive rates, how can we dream to become "cost competitive" in the market? If our own departments focus only on safeguarding their own turf and keeps on trying in all cylinders to protect their own profit motives, how would that ever benefit our company? I shall be really grateful if you personally talk to the Head IT Department and explain the situation. I tried - but I had failed. I guess that, you would be in a far better position to convince him so as to ensure that he sees better sense in our arguments.

UNQUOTE

On receipt of the above letter, the CEO called the senior management accountant of his company to his office and explained the entire situation to him. Thereafter, he enquired,

"Is it at all possible for the IT Department to quote a rate of less than Rs 1225 per order in the instant case? Kindly look at the matter and let me know. Now, if it is possible, I strongly believe that our IT Department should cater to all 2500 "Type D" orders of our manufacturing division this year at such reduced rates. What do you say?"

The management accountant studied the available data / information for half an hour or so, scribbled for some time in his note pad and BINGO !! He said,

But, sir, it is definitely possible. Our IT Department can actually cater to all 2500 orders of "Type D" variety as required by the manufacturing division at a rate which is in fact lower than Rs 1225 per order. If they take my advice, they would manage to satisfy the specific requirements of the manufacturing division and yet protect their own profit motives. In fact, it would definitely culminate into a win-win situation for both parties, namely, the IT Department and the manufacturing division. I'll talk to the Head IT Department shortly and get the matter clarified. Don't worry !!

a)Provide all necessary computations in a structured manner that might aid the management accountant to convince the Head IT Department that it would actually be possible for his department to quote a rate lower than Rs 1225 per order in respect of the 2500 "Type D" orders business proposed by the manufacturing division.