Old Rusty
W. Banks
Rusty Karr the owner and general manager of Waterloo Auto Ltd. was feeling his age and wanted to consider semi-retirement. He wanted to retain only a very senior management role and not to be involved in the day-to-day operations of the dealership. The profits of the dealership were fundamentally important to Rusty’s future lifestyle.
As the founding owner of the dealership in 1968, he had seen the dealership grow to the current sales level of approximately 600 new cars and 600 used cars annually. His service facility has also expanded to 18 service bays. In Rusty’s opinion his long standing policy of emphasizing new car sales as the principle business of the dealership had lead to the growth. He also attributed this to developing the customers and playing close attention to the customer’s needs. Most customers both new and used had returned to the dealership several times to make additional purchases. The latest income statement is shown in the exhibit along with an analysis of the service department expenses.
To accomplish semi-retirement Rusty needed to make organizational changes. Talking with his daughter, a recent Laurier MBA graduate, he felt that the profit centre approach would best fit his requirements. Thus the dealership was divided into three profit centres. The new cars sales department was to be run by Sue Me, the used car sales department by Le Mon and the service department by Otto Baun. All of these people had been key players at the dealership for the past ten years.
Each manager was told to run their department as if it was an independent business. Under the profit centre approach each manager would receive their compensation based on a percentage of gross profits (revenue – cost of goods sold) for their centre. Feeling good about his organizational change Rusty went to play golf and started planning on a four week holiday to Tuscany.
The Transaction:
During Rusty’s golf game, Sue was embracing the challenge and opportunity in her new role as manager of the new car sales profit centre. She was negotiating the sale of a new car. The customer had a trade-in. The list price of the new car was $30,400 which was already discounted by the dealership to $ 29,900 as part of an advertizing blitz. If there was no trade-in, to be competitive with other dealerships in Waterloo, Sue would have offered a discount on the list price of 8.3% on this model. The new car cost the dealership $27,000.
In order to establish a value for the used car, Sue offered the customer a coffee and said she wanted to get an opinion from the used car manager. The customer enjoyed the tepid coffee and a few out-of-date magazines while Sue and Le examined the trade-in. Le felt that the car would need some minor reconditioning work costing about $800 after which the car would retail for about $14,000 or wholesale for about $12,000. Le felt the car could be sold for about $10,000 as is at the car auction next week. The Canadian Black Book provided the cash buying price range of $10,600 to $11,100.
During the conversation with the customer it became apparent, as with most customers, that they had an inflated view of the value of the trade-in. The customer felt the trade-in should be valued at $15,000. Sue wanted to close this deal and knew some hard negotiating would be necessary. The new car had been in stock for some time and the model generally was not selling well. There was some room to bargain and still make a profit but care was needed.
Sue had the right under the profit centre approach to buy any trade-in she wanted at any price she deemed reasonable, but then she was also responsible to dispose of the used car. After further negotiation the customer and Sue made a deal. The trade-in value would be $15,000 and the new car would be sold at the list price of $30,400. The new car was delivered to the customer three days later at which time the customer presented Sue with a certified cheque for $15,400 and surrendered the used vehicle.
The Aftermath:
After the customer drove away in the shiny new car, Sue went to see Bob Pennywise the bookkeeper to outline the transaction. Bob was new to dealership accounting and wanted to learn the ropes. He listened carefully to Sue. Sue calculated the profit to be $2,600 (list of $30,400 less dealer cost of $27,000 less reconditioning cost of $800). Bob was hesitant to process the transaction since the trade-in allowance was $15,000 for a car that was estimated to be worth between $10,000 and $14,000. In the end Bob accepted Sue’s accounting and processed the transaction.
When the used car manager Le Mon found out that Sue and Bob had processed the transaction with the trade-in valued at $15,000 he was outraged. With his compensation now based on departmental profit, he could not see anyway of making a profit on the sale of the used car. Simply, the old car was not worth $15,000. He refused to accept the car in his department.
Another Issue – cracked transmission casing:
The reconditioning was started almost immediately. While checking the underside of the car the technician noted leaking fluid coming from the transmission casing. The casing had a crack and would need repairs. He immediately reported the issue to Otto the manager of the service department. The repair would probably use up parts and labour costing $1,200.
At this point Rusty arrived back at the dealership after a great golf game and heard the argument. The three managers and the bookkeeper were having a heated discussion about the transaction and trying to determine how to divide the revenue and cost among the three departments. He invited the group into his office.
Otto immediately began with his issues. Since his income was now based on profits, why should he not charge the other departments the same rate for the services of his department that he charges other customers. For the reconditioning and transmission repair jobs he could normally charge $2,700 and make a tidy profit. Since this is for the dealership he can only charge $2,000 which provides no profit. He has no incentive to do internal work.
Next Le, who was red in the face, forced his issue on the table. Why should I be responsible for the transmission casing? Sue made the decision to offer $15,000 on the trade-in. She consulted with him on the price but she simply went ahead. She should bear the cost.
Sue responded that this is ridiculous. The cracked transmission casing is unfortunate but she does not have the expertise that Otto has to spot the problem. It was not her fault. Also she should not be forced to pay Otto the market rate for service work. If this was the case then she should be allowed to shop for the best deal at other repair places.
With all of the debating, Rusty could see his plans of a Tuscan vacation going out the window. Rusty felt that all of his managers had reasonable arguments but he did not want to act as the referee. He wanted to be semi-retired and go to Tuscany.
QUESTIONS:
1) Suppose the new car deal is consummated with the used car being retailed for $14,000 and the reconditioning and transmission repairs completed at a cost to the dealership of $2,000. Assume that all sales personnel are on salary (no commissions) and that general overhead costs are fixed. What is the dealership incremental gross profit on the total transaction (new and used cars sold)? 2) Assume that each department (new, used, service) is treated as a profit centre as described in the case. What are the departmental gross profits for each department? 3) Is there a strategy that would increase total dealership profit? 4) Is there a better approach than the three profit centre approach?