Chapter 5
Profit Ceflter.
201
Case 5-2
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 fiv e department managers (new and used car sales, service, body, and parts departments). Exhibit 1 descdbes each department. Mr. Liddy strongly believed in the concept of evaluating each department individually as a profit center. But he also recog· nized 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 fmnchised dealer and factory-authorized service center for Ford, Saab, and Volkswagen. Multipl e franchi ses were becoming more common in the 1980s. But the value of multiple franchises did not com e ,vithout costs. Each of the three manufacturers used a different computerized system for tracking inventory and placing new orders. They also required their dea lerships 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 brea kout of investment for each product lin e. North Country also operated a body shop, and in mid-1989 opened a "whil e-you-wa it" oil change service for any ma ke of vehicl e. 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 faciljty. It was owned as a corporation by George Liddy and Andrew Jones, who were both equa lly 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 departments commonly referred to as the "back end" of a dealers hip. The owners were determin ed to maintain a profitable back end as a hedge agai nst depressed sales and lower margins in vehicles sales. In an industry characterized by aggressive di sc01lnting fu eled by a combination of high inventories, a more educated consumer, and a prolifemtion of new entrants, alternative sources of cash fl ow were crucial. Industry analysts were estimating that fewer than 50 percent of the dealers in the US would make a profit on new car sa les in 1990. Overall net profit margins were expected to fall below 1 percent of sa les (The Wall Street J ournal, December 11, 1989).
This case was written by Mark C. Rooney (T'90), under the supervision of Professor Joseph Fisher. Copyrigh t ~ by The Amos Tuck School of Business Administration, Dartmouth College.
125
202
Part One TM Management on ro
e l l En vironment
EXHIBIT 1
North Country Auto, lnc.-
Th Departmental Structure e New Car Sales and Used Car Sales They shared six salespersons. In The new and used car departments each had a sal~hm:::;:~'ers were paid a flat salary, plus a fixed departments shared an office manager and clerks .. de rtment's gross profit (calculated as sales new or used vehicle sold, and a percentage of their e~a reed on annual unit volume and margin of vehicles sold). When the owners and the manage~mitel one.third of the manager's expected dollar weights were set to mak~ each portion appr~f dual in>::entive bonus structure allowed the compensation. The owners claimed that thiS type . . t 'ned "If the margins are low, the flexibility in targeting margins ~nd volum:; Georg~ L~~~{e ::~~ ;~id strictly a commission on gross manager can try to make It up In volume. The sa es . t a flat salary plus a partial commission on dealerships in the area were changing sales compensation 0 profits generated. d' L'dd new model orders and The new car sales manager was responsible for recommen Ing to I y lIin rices and trade-in g mix among the three product lines. He also had the authOrity to approve se f P h d ' t bl e on customer transactions. Typically, the new car manager was allowed to trans er tetra e.~~a f ~. However, if the car was obviously of below average quality, the used .car department was as . or Ir estimate of value. The used car manager was responsible for controlling the mix of used car Inventory 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 mo~t labor intensive operation. Service comprised 11 bays w ith hydraulic lifts, one of which was used for the 011 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. au~orized work on ea:h of the specific Iin~s. 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 ;educ'ng the cost of idle time by cross·training, but were averse to risks of turnover among highly skilled labor I Retraining costs could triple when one person quit. . The primary sources of service department revenue were warranty maintenance and re ' k . ' nonwarranty maintenance an d repalf work,used car recon d' . Itloning, and the oil change pair wor ' . . "b ac ' t . II Warranty wor k was relm b ursed by th e f t orles at t h elr prescrl ed labor rates which w Operation. . , e r e yplca y as much as 20 percent lower than the rates charged directly for nonwarranty work. Lowe . warranty work were a potential problem for the dealership if they dissuaded the servic r margins on . . . " e delivering prompt servICe to recen t b uyers. D unng times 0 f near capacity utilization th manager from be motivated to schedule higher margin nonwarranty jobs in the place of warranty ;""o~.manager would Parts The parts department consisted of a manager, three stock keepers, and two clerks. The parts a flat salary plus a bo~us on department gross profits (computed as total parts sold less cost o~anager was paid manager was responSible for tracking parts Inventory for the three hnes and minimizing both parts) . The parts and "obsolescence." The owners defined obsolescence as a part in stock that was not sold in carrying costs Mr. Liddy estimated that as many as 25 percent of the parts·on·hand fell into this category Dover a year. parts (inventory turnover) averaged 100 days for the industry. The manager had to be an ~xpays SUpply of policies, stock requirements, and secondary market of three distinct and unrelated lines of m:rtho n ~he netum rc andlse. It was
(COntinUed)
126
EXHIBIT 1
(c oncluded)
the parts manager's job to use factory retu ' . opportunities so as to minimize large writem creditS n mt effectively and identify outside -downs. local wholesalers would pay as much as 80 percent of dealer cost for old parts. Dema nd for parts was derived almost c broke down as follows: 50 percent throug~ml>h:tely from other departments. Dollar sales volu",e in parts and 10 percent over-the-counter retail S' .~lVIce, 3~ percent through the body shop, 10 percent wholesale, at ra tes as much as 20 percent less th' '":u ar to SErVICe work, parts needed in warranty work '#ere reimbursed an pnces 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 nat salary plus a bonus on dep~rtmental profitability. To keep the shop in business in the long run, North Country Auto needed to Invest an addItIonal S50,000 in new As it was, the body shop was shOWIng a los.s after allocatIon of fixed overhead. Gross margins as as 60 percent could be attained, but to closer to 40 percent. rework and hidden damage beyond estimates tended to drive the",
011 Change Operation The deale rship's oil change business operated under the nationally franchised "Qwik Change" logo, using one bay in the service department and one of the semiskillecllllechanics. Volullle averaged 68 changes per week. The operation was not evaluated as an independent profit center but as a IIlCdns of filling unused capacity in the service de partment. The oil change franchise paid for all eqUiPIIICI1t, reducing the dealership's out-ofpocket investment to S500. After direct labor, direct parts, and the franchise fee, the dealership m~de about S10 .00 o n 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 COUN I RV AUTO, INC. Balance Sheet October 31, (In thousands) Assets uabillties and Equity
. . . . . . . . . . . .. .... . . , $ 32 C as h • • • • • • • • • 228 Accounts receivable ....... . •. . . . .•. .. 253 Saab inventory . .. . . . ... . .• .. . ..... . 243 • • • • • • • • • • • VW Invento ry .. . . . .. .. •. . 773 • • • • • • • Ford inven tory ...... . . ..... . 231 • • • • • • • • • • Used cars .. . ... .. .. .... . 7S • • • • ••• • Saab parts ... . ...... . . .... . 7S • • • • \NIl parts ......... . .. . .. . • • • • • • 226 • • • • • • Ford parts. . . . . . . . . . . . . . . . . . . . 6 Body shop materials .. . . . . . . . . : : : : : : . 89 Other curre nt assets .... . . . . . .
Accounts payable . . .... . . . .. .... . .. . S 73 Notes payable-veh icles ... . .... . . • . .. 1,294 344 Long-tea ill debt . . . . . . . . . . . . . . . . . . . .
•
Total liabilities ...... .. . • ...... •. .. .•
1,711
ComJ1lOn stock . . ...... .. ..... ..... . S 400 lOS Retained eamings .•.... ..•......... .
. . . .. .. . . . . . . . . . . . . . . . •
Stockholders' equity
85
Property &; equ ipment Net" . . ···•··· · (S377 M gross) . .. . • • • Total .. ...... . . . ...... . .. . .
"North Country lenses both the land an d the building.
TotaI•
•
• • • •
127
Pan One The Management Cont
rol En viTOI1",e
l1t
Geor
the dealership, all the Before George Liddy bought I~ent managers were paid salaries t of one business. Depa ' discretion based on overall as par . d t the owners end bonuS determ lDe a .sa I of each manager. ear and a subj ective a ppraI t m did not provide proper d · Y George Liddy beIleved thIS sys e al' d profit centers an . ve d ' decentr Ize d ch . managers. He behe UI d I f control. He instructe ea of his compensation as supeno r mo e s. o body and parts) to run hislher ' (new, used 'seJ'V1ce, He knew that the success of the profitmental managers . . . . d ndent busmess. . -.as If It were an In epe ndent upon the support of hIS managers. TheYmuat ter cont rol system was de pe . Uocat ing costs to their departments and believe understand t he ratIOnale fOi a fitab ' lity The managers' ~. that they had reasonable control over pro 1 . m 1989 were calculated on the basis of departmental gross pro~ts. below ' e were not considered \0 th e bonus calculatIOn. They were only profit lm . . . . . . th e gross statement outlining their responsIbIlitIes, to exercIse ". diClouscontro} told, in a J~ over discretionary expenses." Implementing a more comprehensIve control sya. tem tied to actual departmental net profits would require that Liddy break down costs traditionally regarded as general ove rhead into separate activities ated 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 departm ent manager would eventually have responsibility for all cont rollable 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 cha ngeover would allow Liddy, who was new to the dealership, time to become more knowledgeable about the intricacies of North Country A~to's accounting records. He did not want to lose credibility because of percelved a rbItrary c~~t alloca tions. Exhibit 3 gives a breakdown of department profi tabli1ty on an almost" full-cost basis . G In addit ion to findin g a way to effectively track departmental performance, Meo~~dLldbdY' had thO deVlse a sensible system for transfer pricing. Though l r. 1 y e leve d t at each department at N he 'call could operate as an independent busi ort ountry theoretI .y lationship existed amo th n efiss, he acknowledged that a complex mteueng e pro t cent . h .. ..:..transactions. A recent new vehi ers ~ t e course of nOI'mal bUDJ.Uthat could a rise. cle purchase Illustrates the potential probleJ118 Alex Walker, manager of the $14,150. This purchase was fi new car sales department, sold a new car for trade· in allowance of $4 800 n~nced by a cash down payment of $2,000, a $11 ,420, which included'fact~:n ~ bank loan of $7,350. The dealer'S cost 1f8S The' · r of the used car sa es d manage y pn ce plus sales commission . . __.... ~I.a l t ra d e·m vehIcle. The trade-in had epartment, Amy Robbins, exam1Dtl'lgUIdebook, published rno thl a wholesale guidebook value of $3 500· 'J1le I A n y was t b ' ..:Aft va ue. ctual values varied d a est, a near estimate of liquidawtlOns. These va riances Could ~ y WIth the supply-demand balance atautoaUCMs. Robbins believed that ~a s much a s 25 pe rcent of the book value. ..... ea rn a good ma rgin, so she chosseetcould sell th e trade-in quickly at $5.000 8P" o carry 1t 10 mve ntory instead ' ' .
.
il .'
128
EXHIBIT 3
Financial Stat e m e n t
NORTH COUN October 31 TRY AUTO, INC. O (Dollar f1g~::'8~ (lh months) n t ousands)
Chapter S Profit Center.
205
Sales ... Gross p r~fit ' ... . . . .. . . ....... . . Number of ~~i~ '(ve ''" I' .. . . .... . . : : : . . . .... •. .. ' 'h D' Ices re . .... Irect selling (com . . ' pairS, Or parts) . . .. •.. . Indirect labor . ... mISSIon I'< delivery) ..... : .. . •.. . Department advert' : . . . . . . . . . . . . . . . . . . . .•• .. Policy work- parts ~'~;";i~ .. '." . . .. . . ... : : : : : : : : . Supplies I'< utilities . . . . . e (gIveaways I'< rework) . . . : DepreCIatIon • • . . . . . . . .. . . . . • • • • Re nt . . . . . . .... ............. ..... Profit befor~ ~~;";~o· n 'e . .. .... . . . . : : : : : : : : . .. . ' 'x' o ther expenses: penses .... . ..... . . . • . •.. . ...
• •
New
Used
Service
Body
Parts
$6,558 502 474 s 96 162 91 29 22
3
$
$1,557 189 390 $ 25 74 30 12 18
1
$ 672 421 9,795 nla $ 237 19
14
89 10
$
22 7
$
19 15 67 50
$231 145 406 nla S 64 2 12 28 5
13
S 21
S 1,417 361 40,139 nla S 156 3 1 12 2 9 S 178
Interest (on new inventory) . Other In terest . .... . . . . . . .. . .. . Owners' salary: : : : : : : . . . .. ... .... .. . . .•. . . : : Insu rance . . . . . ... .. .. .. ... . . Net operating : : : : : . ..... . . ... . . . ... . : : : :
'~r~fi;
•
• •
•
• •
•
•
• • •
• •
•
•
• • • • • • •
S 110 21 65 35 $ 35
1. New car sales and gross
. Notes to Financial Statement margms (OOOs) break down as: Sales Gross Profit
# Units
Ford Saa b
VW
Fina ncing fees' 2. Used car sales and margins break down as: Retai l Wholesa le Financing fees'
B,114 1,502 1,794 148 S6,558
Sales
S193 90 117 102 S502
Gross Profit
243 73 158 nla 474
# Units
$1,045 423 1
$212 (59) 36 $189
177 213 nfa 390
3. Notes payable for vehicles is a revolving line of credit secured by new car inventory. Payments to th b k an are due upon sale of each vehicle financed in inventory. This liability has been reduced over the 10 months 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 dea ler 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 m each department. (COIllUlued)
pas~
129
Part One Th. MatUJif.....nt Control Enviroll»Unt
EXHIBIT 3
(corwllUkd)
rt tent, adjusted for the value of the 8. Rent is allocated by square footage used by each d,epa Ii rpose 01 keeping investing and 9. Interest expense is treated as a common expense or t he pu separate. . .. rty damage for the dealership as a 10. Insurance consists of both umbrella hablhty and prope ed ., "t' not feasible to the multiple types 01 coverages included and the bundl pnclOg, I IS costs by department. . related closely to 11 . Approximately 75 percent of the fixed costs 10 the used car and approximately 25 percent to wholesale sales. 1 service orde 5 12. Total number of parts sold during the year = 40,139 parts; total number 0 I during the year = 9,795 orders. . ' rh d ex nses' 13. Using Exhibit 3, North Country determined the follOWIng allocatIons for ove ea pe . New: $835/vehicle = $396,000/474 vehIcles Used: S665/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: S114 = S371,000/9,795 orders· 3 orders (lock, brakes, tune-up)
·F'innncc (CC6 consiSl of Income thot the dealer cams on dcnlcr,soUiced nulO loans. It. also includes the dealer's commission on aerviee CODliacl..... extended wnrrnnllcs IIOld I.hrough the dealership.
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. In performing the routine maintenance check on the trade-in, the service department reported that the front wheels would need new brake pads and 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 (perfOfmed 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 perfofmed for a retail price of $255 ($80 in parts, $175 in labor). The repair and tune-up work was completed and capitalized at retail coat into used car inventory at $705. These mechanical repairs would not n~ i1y increase wholesale value if the car subsequently were sold at the auctiOllThe 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 hourI1 rate and about 1.4 times for parts. George Liddy was concerned that the retail transfer price of the repai" ill conjunctIOn Wlth h1s plan to eventually allocate full costs to each . (as .illustrated . i~ Exhibit 3) might encourage the used car sales to aVOId the POSslb1hty of losses in her department by wholesaling trade-in CIII that .couId be r~sold at a profit for the dealership. This might also hurt the .... ershlp by making Its deals less attractive for new car customers. KnoWlng how 1mportant it was to maintain credibility with each ofthe~ partments, LIddy called a meeting with the three department manaaert- lit deCIded to use the recently completed new car sale to illustrate the ~ till' transactIOn would have on departments' profits In h ' tati u. LiCId1 I 'd h ' . 15 presen on,"'" ~ ' out t e transaction and allocation of profits and costs After this tlon, Mr. L1ddy asked for the I"Lactions of h ' d rt . 1S epa mont managers.
130
Chapler 5 Profit CCflt('rs
207
Alex Walker was the first to ch ime in , "I understand that the a llowance a bove book value 0 n t h e t ra de-lJ1 cannot be accounted for as profit Howeve r . . h terea] ' h . , . Iss ue IS ow to set the price between me and Amy when we tra nsfer the trade-lJ1. I refu e to b · es ponsl e lor a ny Ioss t h at mIght a n. . the t rade-lJ1 'bl' . . ', eI se If ve b h Icl e IS rIquI'd ate d at a uction for a n amount less than the wholesale guide~alue. Her depa rtm ent sh?uld be accountable for its valuation errors." . y Robb1l1s vehemently disagreed. "My department should not have to s ubs ,d,ze the profits of the new car sales di vision." Liddy quickly jumped into this deteriorating argument, "Obviously, we need to carefully consider how to set the price between the new a nd used car departm ents and who should be responsible for unexpected losses." "Another item that concerns me," Robbins went on, "is usi ng full retail price for pa rts and labor used in the repai rs of trade-ins. Given underutilized capacIty 111 sel-vice, I do not understand why 1 am charged full price. It doesn't ma ke sense for the servi ce department to mark up on projects undertaken for new and used car depa rtments within our own dealership. I can 't see how we can make profits when one part of our company sell s to another." Robbins added, "When I am unsure of the actual retail value, I tend to whol esa le rather than take a risk of a negative margin at retai l. However, wh en 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 sa me probl em with dealer-in stall ed options. When I am charged full price for options, I have no incentive to try to sell these items." "Hold on ," sai d the se rvice department manager. "I make my profit by selling servi ce, an d these a re the prices I would cha rge 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 del'ived a lmost completely from service, and we are de pendent on parts for quick de livery for repai rs." 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 profi ts in your de pa rtm ents, you do not negatively affect oth er de partments." Liddy continued, "I a m a lso concerned about the impact of capitalizing trade-in re pairs rather t han expensing immediately. We all know that wholesa le 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 s hould. Ca r inventory ties up cash, and a key measure of departm ental s uccess 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
. g the data in the transaction, compute the 1 U sIn . . ction to the new, used, parts, and servIce transa . sales commission of $250 for the trade-lI1 on a
Vlce,
profitability of this one d A epartments. ssume a se II" price 0 f $5 , 000 . lI1g (Note: Use the following allocations [new, $835; ~sed, $665; parts~ $32; se~. $1141 for overhead expenses while computll1g the profitab,hty of th,S
131
208
Part One
The A"onagemenl Control Environmen.t
one transaction. These overhead allocations are also sho wn as Note 13 ill Exhibit 3.) 2. How should the transfer-pricing system operate for each department (mar. ket price, fuJI retail , full cost, variable cost)? 3. Ifit were found one week later' that the trade-in could be wholesaled for on] $3,000, which manager s hould take the loss? Y 4. North Countr'y incurred a year-to-date loss of about $59,000 before alloc . tion of fixed costs on the wholesaling of used cars (see Note 2 in Exhibit 3~ Whol esa ling of used cars is theoretically supposed to be a break-even opera: tIOn . Where do you think the problem lies? 5. Should profit centers be eva luated on gross profit or "full cost" profit? 6. What advice do you have for the owners?
132 