Brenda: Seth, I am trying to help you here. But there is no way that I can pay you $230 per unit. I have competitive bids from other vendors for about $170, and that difference means $1,200,000 in my bottom line. Because you helped me design the part, I am willing to split the difference and offer $200. This will help you ramp up your utilization and spread your fixed costs over a larger base. After all, we play for the same team, but there is a limit to the hit I can take.
Seth: I can do without help like that! I have been screaming at my sales guys to get full cost plus 15%, which is what I quoted you. I drew this line in the sand six months ago, and slowly but steadily it is paying off. I will be undercutting my own instructions if I give you the part for what you are asking. At $200, I barely break even and only if I eat the $240,000 I spent in designing the part and making mock-ups. Already, morale is low because we did not make bonus last year. Pricing at cost is a sure way for not making it this year as well.
Seth and Brenda are division managers for a large manufacturing firm that makes many different kinds of appliances. The firm operates on a decentralized basis, and division managers have considerable autonomy in pricing and sourcing. They also are held accountable for meeting divisional goals, usually set at stretch levels. Bonus compensation heavily weights divisional performance, although a portion (e.g., stock options) depends on corporate performance.
The highlighted dispute centers on an innovative part that Seth’s components division had designed in collaboration with Brenda’s refrigerator division. While there was no payment for the design, the intent was that Seth’s outfit would be the front-runner in the bidding. However, Seth’s bid of $230 per unit (for 20,000 parts annually) was substantially above other bids. The conversation excerpted above summarizes the heated exchange between the two managers.
Brenda is annoyed because she thinks she is doing Seth a favor and that he is looking a gift horse in the mouth. She knows that his division is operating at about 70% of capacity only and that his sales force is scrambling to find orders. This component would substantially increase Seth’s utilization. Brenda also has a desire to keep the relationship alive because Seth’s engineers have proved adept at solving thorny technical issues and his quality is decidedly better than that provided by his competitors.
Seth is upset too. He knows that Brenda would have paid for the design anywhere else. Moreover, he thinks that she saves a bundle with higher component quality. He points out that 15% is the average long-run rate of return for his segment of the industry.
For his coup d’etat, he whips out an accounting statement that shows the component’s variable manufacturing cost at $125 and allocated manufacturing overhead at $75 per part. He even ignored selling expenses (usually 10% of selling price) when arriving at the bid! He is planning to appeal to their joint boss to force Brenda to buy the part at $230.
Required:
a. Relative to buying for an outside supplier at $170 per unit calculates the change in the profit reported by Seth’s division and the firm as a whole if Brenda buys the component from Seth for $170 per unit. Repeat at prices of $200 and $230 per unit. Ignore any savings in Brenda’s plant due to higher quality.
b. What advice would you provide the corporate VP, who has Brenda and Seth as her direct reports? When formulating your recommendation, please be sure to consider Seth and Brenda’s motivations for their respective stance.
SOLUTION
Let us calculate profits at the two divisions, relative to the benchmark:
| $170 per unit | $200 per unit | $230 per unit |
|---|
| Seth’s division | ($170 - $125) × 20,000 = $900,000 | ($200 - $125) × 20,000 = $1,500,000 | ($230 - $125) × 20,000 = $2,100,000 |
| Brenda’s division | ($170 - $170) × 20,000 = 0 | ($170 - $200) × 20,000 = ($600,000) | ($170 - $230) × 20,000 = ($1,200,000) |
| Firm as a whole | $900,000 | $900,000 | $900,000 |
For Seth’s division, notice that we focus only on the contribution margin. This view assumes that the division has enough extra capacity, which makes the opportunity cost of its capacity is zero.
For Brenda’s division, the change in profit is directly proportional to the price differential paid.
The firm’s overall profit is unchanged at $900,000. If indeed, there is no other use for the capacity in Seth’s division, the firm benefits to the tune of $900,000 by forcing an internal transfer.
The VP confronts a difficult problem.
One solution is to force a transfer. This solution has the benefit of increasing the firm’s overall short-term profit by $900,000. This approach puts the excess capacity in Seth’s division to good use. The price on the transfer is likely to be a sticking point as the price effectively apportions the surplus between the two divisions. Brenda will push for a price close to $170 as that is her opportunity cost. Seth would push for a price close to $230, citing the development cost and the higher quality. No matter the final price, this solution is unlikely to be acceptable to at least one of the two division mangers.
An alternate solution is to do nothing. This solution seems odd at first blush because it leaves nearly a million dollars “on the table.” However, this might be the preferred solution. To understand why, notice that the opportunity costs for Seth and Brenda are key for the negotiations.
From Brenda’s perspective, her lowest estimate is $170 per unit. However, she is likely to go higher because she recognizes the higher quality from Seth. She also surely recognizes the value from nurturing a long-term relationship with a “reliable and high quality vendor.” Nevertheless, she has incentives to claim a low opportunity cost purely as a negotiating tactic. After all, every dollar she shaves off the price adds $20,000 to her bottom line.
From Seth’s perspective, the opportunity cost of the excess capacity is the key determinant of the validity of his stance. (The $240,000 in design is a sunk cost and should not affect his decision.) If the opportunity cost is truly zero (i.e., there is no other use for this capacity), then the computations in part (a) apply. However, only Seth is the person best equipped to estimate this opportunity cost. He has to consider the effect of a low price to Brenda on his other sales. Plus, he has been flogging a high quality –high price strategy and that appears to be paying off as he has received orders over the last six months. It is possible (and we do not have the necessary information to evaluate this outcome) that the market for Seth’s capacity is on an upturn and that more orders are over the horizon. This feature would raise the opportunity cost of Seth’s capacity. And, Seth is privy to this information.
From the VP’s perspective, forcing a transfer generates an immediate gain of $900,000 but is predicated on the assumption that the VP knows more than Seth about alternate opportunities for Seth’s capacity! It thereby undermines the entire philosophy of decentralization. Further, if Seth is truly wrong, he will come to his senses and re-negotiate. The $230 claim might be a negotiating bluff, just like Brenda’s claim of $170.
We believe that it is worthwhile for the VP to let the division managers figure this one out themselves. Negotiating such difficult issues is how managers distinguish themselves, and neither Brenda nor Seth is likely to leave a million dollars on the table. One or the other will yield (appealing to the VP might be a way to line up forces on Brenda’s side!) and the resolution will likely reflect the true opportunity cost for either party, as perceived by the division mangers.