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4) ICC has annual revenues of $2 billion primarily from selling and leasing large
networked workstation systems to businesses and universities. The manufacturing
division produces the hardware that is sold or leased by the marketing division.
After the expiration of the lease, leased equipment is returned to ICC, where it is
either disassembled for parts by the field service organization or sold by the
international division. Internal studies have shown that equipment leased for 4
years is worth 36 2/3 percent of it original manufacturing cost as parts or sold
overseas. About half of ICC’s systems are leased and half are sold, but the fraction
being leased by ICC is falling proportion of total sales.
The leasing department is evaluated on profits. Its annual profits are based on the
present value of the lease payments from new leases signed during the year, less the
unit manufacturing cost of the equipment. Direct selling, shipping, and installation
costs. The present value of the service agreement costs.
Each leased piece of equipment will be serviced over its life by the ICC’s field service
organization. The leasing division arranges a service contract for each piece of
leased equipment from the field service organization. The field service organization
commits to servicing the leased equipment at a fixed annual cost, determined at the
time the lease is signed. The leasing department then builds the service cost into the
annual lease payment.
The leasing department negotiates the lease terms individually for each customer.
In general, the leasing division sets the annual lease terms to recover all three cost
components plus a 25% mark up. The 25 percent markup for setting the annual
lease payment seemed to work well in the past and provided the firm with a
reasonable return on its investment when the ICC had dominance in the workstation
market niche. However, in recent years new entrants have forced the ICC leasing
department to reduce its markup to as low as 10 percent to sign leases. A this small
margin, senior management is considering getting out of the lease business and just
selling the systems.
The following lease to Gene Science is being priced by the leasing department. A
four-year lease of a small network of three workstations is being negotiated. The
unit manufacturing cost of the network is $30,000. The service costs, which are
payable to the field service department at the beginning of each year, are $2,000,
3000, 4000, and $5000. Selling, shipping, and installation costs are $7000. The
leasing department has 8 percent cost of capital. To simplify the analysis ignore all
tax considerations.
a) Using a 25 percent markup on costs and an 8 percent discount rate, calculate
the fixed annual lease payment for the four-year lease to Gene Science.
b) Comment on some likely reasons why a 25 percent markup on leased
equipment is proving more difficult to sustain. Should ICC abandon the lease
market? What are some alternative courses of action?
13) Beckett is a large car dealership that sells several automobile manufacturers
new cars (Toyota, ford, lexus, and Subaru). Beckett also consists of pre-owned cars
department and a large service department. Beckett is organized into 3 profit
centers: New cars, pre-owned cars, and service. Each profit center has a manager
who is paid a fixed salary plus a bonus based on the net income generated in his or
her profit center.
When customers buy new cars, they first negotiate a price with a new car
salesperson. Once they have agreed on a price for the new car, if the customer has a
used car to trade in, the pre-owned cars department manager gives the customer a
price for the trade in. IF the customer agrees with the trade in price offered by preowned cars, the customer pays the difference between the price of the new and
traded in prices.
Suppose a customer buys a new car for $47,000 that has a dealer cost of $46,200.
The same customer receives and accepts $11,000 for the trade in of her used car and
pays the balance of $36,000 in cash. In this case, new cars shows a profit of $800. If
the customer does not accept the trade in value, she does not purchase the new car
from Beckett.
Once the deal is struck, the trade in is then either sold by pre-owned cars to another
customer at retail or is taken where it is sold at wholesale. Continuing the above
example, suppose the customer accepts $11,000 as the trade in for her used car. The
pre-owned car department can sell it on its used car lot for $15,000 at retail or sell it
at auction for $12000. If the trade in is sold for $15000, pre-owned cars would have
profit of $4000. If it is sold at auction, pre-owned cars reports a profit of $1000.
a) Descibe some of the synergies that exist within Beckett. In other words, why
does Beckett consist of 3 departments ( New Cars, Pre-owned cars, and
Service) as opposed to just selling new cars, or just selling used cars, or just
providing service?
b) What potential conflicts of interest exist between the New Cars and Preowned cars department managers? For example describe how in pursuing
their own self interest, the manager of New cars or pre-owned cars will
behave in a way that harms the other manager?
c) Suggest two alternative mechanisms to reduce the conflicts of interest you
described in part b.
21) Easton has recently acquired a wholly owned cable company (TT Cabling). With
the acquisition, Easton has two profit centers; Irvine and TT Cabling. Currently TT
sells most of is cables to a different set of customers than those who have their
board built by Easton. After the acquisition, Easton has a single sales force that sells
board assembly, box build, and cables.
Easton assembles the electronic controller for a particular health imaging system for
Scopics Imaging (SI). Easton manufactures the circuit boards, buys a sheet metal box
designed specifically to house the boards, buys the cables to connect the boards
within the box and other cables to connect the box to other components, tests the
box, and delivers the competed unit to SI to plug the box into its imaging system.
The following table summarizes Irvine’s cost for one complete SI box
Fixed costs
Variable cost
Total costs
Metal box
$347
$347
Circuit boards
Cable harnesses
Box build and test
Total
$1460
998
2458
9375
1275
720
11,717
10,835
1275
1718
14,175
Although Irvine purchases the cables for the SI program from an outside cable
company. Easton senior managers are analyzing whether to have TT Cabling supply
these cables. The managers of TT Cabling have submitted a bid to Irvine of $1700
for the four cables in the SI assembly. The Irvine managers oppose buying the cables
from TT because the TT bid of $1700 is significantly higher than the outside cable
supplier ($1275). The bid of $1700 submitted by TT for the four SI cables consists of
variable costs of $1000, fixed manufacturing costs of $300, and profits of $400. The
quality of the TT cables is the same for both the TT cables and the outside suppliers
of cables.
When bidding on the new proposals that involve complete box builds, Easton
management wonders whether they should continue to solicit price quotes from
outside cable suppliers only, solicit bids from both outside cable suppliers and TT,
or only get price quotes from TT Cabling.
Write a memo to the senior managers of Easton Electronics proposing a policy that
describes how Easton should decide whether to purchase cables externally or
internally. The memo should describe the decision making process, the relevant
considerations, and the underlying objectives of such a policy. Use the SI cables as
an example of how your Easton cable sourcing policy should be applied.
Running head: PROBLEMS
1
Problems
David Schwarz
California Southern University
MGT 86512
Dr. Mark Pugatch
December 27, 2015
Running head: PROBLEMS
2
20 a) L + L/1.08 +L/1.08^2 +L/1.08^3 = 1.25 [ $39,000 + $3,000/1.08 + $4,000/10.8^2 +
$5,000/1.08^3]
3.577L = $61,470
L = $17,185
Therefore, to be able to recover 125 percent of its costs, the annual lease payment is
$17,185.
b) Increased competition has put more pressure on the leasing department’s profit
margins and markups. Just because the markups are decreasing, some of them as low as
10 percent, does not necessarily mean that the ICC should stop leasing the equipment. A
problem that is causing the leasing department to lose business is that they are trying to
recover 125 percent of their costs, not including the salvage value of the leased
equipment when it comes off of the lease. Therefore, while the leasing division is
showing a 25 percent profit, the firm as a whole is making more money on the lease and
the additional profits are showing as profits in the field service organization and the
international division who gets the returned equipment for free. The leasing department is
in a sense of subsidizing the other two units. If the leasing department sold the returned
equipment to the field service organization or the international division, they could set a
much lower lease price.
L + L/1.08 +L/1.08^2 +L/1.08^3 = 1.25 [ $39,000 + $3,000/1.08 + $4,000/10.8^2 +
$5,000/1.08^3] – $30,000 x 36.667%/ 1.08^4
3.577L = $61,470 – $11,000 x 0.7350
L = $14,925
3.577 x $14,925 = M%[[ $39,000 + $3,000/1.08 + $4,000/10.8^2 + $5,000/1.08^3]
M = $53,387 / $49,176
M = 1.086
The calculations show that the leasing division can lower its markup to about eight
percent if they do not receive the salvage value of the returned equipment. The firm is
still making 25 percent markup including the value of the returned equipment. ICC
should not stop the lease market. Rather, they should change the way decision rights are
petitioned and the give the rights regarding the returned leased equipment to the leasing
department to make the decision as to how the equipment is best used. Lastly, the
performance evaluation of the leasing department should be changed to give this
department the revenues from the used equipment.
13 a) By offering new and used cars as well as service to go with, Beckett is offering the
customer a lot of convenience. This type of offer provides the customers one-stop
shopping that lowers their transaction cost. When buying a new car, customers usually
have a used car that they no longer want. Though they could still sell that car themselves
through local ads, in doing this would serve as an inconvenience. There is a tax
advantage to trading in the old car. Sales tax is paid on the difference between the new
and old car prices. If the used car is sold privately, the buyer pays more sales tax on the
new vehicle.
Running head: PROBLEMS
3
b) The system that is currently being used gives the decision rights to negociate the price
of the trade-in to the pre-owned car manager. While this manager has the knowledge of
the trade-in is worth, the manager does not have the incentive to take into account the
possible lost profit on the new car if the customer rejects the trade-in price. It is in this
case that the pre-owned car manager should be willing to take a lower profit on the tradein. However, the manager is not paid for any part of the new car profits. Further, if the
new car purchase brings in a big enough profit, the manager should be willing to take a
loss on the trade-in. This can only occur if the new car salesman can persuade the preowned car manager to take the deal. An alternative to that would be if the new car
salesman goes to their manager and to the owner of Beckett to convince the pre-owned
car manager to take the deal. Like anything else this would take some time and the
possibility of the buyer walking away would increase as time progresses.
c) A solution is to the base part of the pre-owned car manager’s bonus on the new car
department’s profits. Assuming the pre-owned car manager’s bonus was based on 70
percent of the profits in pre-owned cars and 30 percent of the new car profits. It would be
then that the pre-owned car manager has some incentive to take a lower profit on the
trade-in f it meant making the new car sale. Becket could install a transfer price where
new car profits are calculated as the difference between the selling price of the new car
and its cost, in addition to the difference between the Kelly blue book wholesale value of
the trade-in and the trade-in allowance given to the customer buying the new car and
trading in the old one. It is in this way that new cars get awarded for both the sale of the
new car and the estimated profit on the trade-in. The pre-owned car profit is the
difference between the price they receive when it sells the trade and the blue book price.
21) In terms of biding on cables, Easton faces three alternatives; to solicit price quotes
from outside cable suppliers only, solicit bids from both outside suppliers and TT, or only
get bids from TT Cabling. Soliciting bids from outside suppliers is inferior to the second
alternative. TT could possibly be able to supply the cables for a cheaper price that outside
suppliers. Similarly, the third alternative is predominately a version of the second because
outsiders provide cheaper cables than TT. Further, getting outside bids in addition to
TT’s bids allows Easton to benchmark TT’s production effectiveness. As a result it would
behoove Easton to get bids from both while preparing build proposals.
While the cost of cables is traditionally a small part of the total cost of the complex box
builds, if the costs of the cables is too high, it is at the margin that the high cable costs
could cause Irvine to lose the bid. Ceteris Paribus, who has the lower Irvine bid would
likely win. The price TT charges for cables is the transfer price for the cables. The double
marginalization issue in transfer pricing states that the internal selling division should not
make a profit on the intermediate goods transferred because this causes the selling
division to set too high of a final price to the consumer and to sell too few units. By
following this rule, TT’s bid for the cables should only be its marginal cost. In the case of
the SI cables, TT’s variable is $1000. Since all costs are variable in the long term, TT’s
cost is its fixed and variable cost, or $1300 on the SI cables. The advantage to following
TT to bid the full cost of $1300 is that Easton management avoids having to watch which
of TT’s costs are fixed rather than variable. If variable cost transfer pricing is used as the
policy, then TT has incentives to reclassify fixed cost as variable.
Running head: PROBLEMS
4
TT is being treated as a profit center. As a profit center, TT has no incentive to bid and
build cables at a variable cost. TT has more incentive to bid cables on a full cost basis.
TT is treated as a profit center because it was recently acquired. TT could be treated as a
cost center in the same way board assembly, box build, and testing are evaluated and
rewarded. Converting TT to a cost center eliminates the double marginalization issue and
as a result removes the incentive for TT to change a price to Irvine that recovers its costs
and report profit. Making TT a cost center allows it to focus on producing high quality
cables on time at a minimal cost. However, the marketing of TT cables to outsiders
would have to be handles through Easton’s current sales and marketing department. TT is
currently marketing its cables to other companies and if TT retains this sales function,
then TT should be retained as a profit center.
…
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