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Case Study: Canadian Technology Services
Canadian Technology Services
BACKGROUND
Barbara Richards, CEO of Canadian Technology Services (CTS) was going through the financial statement for the year ended in 2015 and was troubled with low divisional profits and overall corporate earnings. Prior to her appointment as the CEO in 2010, she had been working closely with the Chairman of the Board, her father Mark Richards, for the past seven years, after earning a CPA.
Barbara was behind reorganizing CTS into three autonomous profit centers in 2012 - The Research Divisions (RD), Power Division (PD) and International Division (ID) - all having complete P & L responsibility. The financial policy also dictated a target ROI of 15% before taxes. Some of the products produced are transferred between and among these divisions. To promote cooperation among divisional managers, Barbara introduced a policy of internal sourcing as much as possible.
The latest released partial financial information for CTS for 2015 appears in Exhibit A.
RD is the research and development wing of CTS. Since 2010, it has been successful in commercializing a product CT-10 with wide application in the industry. RD has proto type facility but lacks full production facilities on its own. It depends on PD for any enhancement to basic CT-10 that has full production facility. RD sells CT-10 mostly to external markets. Occasionally, it makes modifications to CT-10, if required, and transfers to ID as well.
RD and PD have agreed to have this transfer at full cost plus 20% to recover the original investment in R and D. Lately CT-10 has been coming under stiff competition, as similar imitations are now available in the marketplace.
Tom Baker, the Divisional VP of ID had recently indicated to Barbara that ID would be bidding on a contract to supply 1,000 of an equipment to Italy that uses CT-10 as a sub component. This may offer a long-term business prospects in Europe. He complained that the price of $750 for CT-10 from RD to ID was too high and that he could not compete at this price. (Exhibit B).
Other quotations from two suppliers ranged between $550 from France and $600 from Germany for similar and substitute products having comparable specifications as CT-10. The German supplier suggested that their firm would consider offering a royalty of $100 per unit if RD can share their technology and blue prints with them. The German firm can replicate CT-10 to exact specifications.
OPERATIONS
A recent complaint from Mike Bose, the divisional VP of RD to Barbara earlier suggested that Tom Baker, divisional VP of ID would partner with the least-cost French supplier and not act in the best interest of the company. Barbara felt it was time that she arranged a meeting with the divisional managers to address the disappointing 2015 financial results and discuss divisional issues.
MEETING
Barb Richards (CEO): Good morning everybody! Mike, can you go first as you have some serious concerns with Tom. I am sure others will follow. I have also asked Shelly Sanchez, our new CFO to join us to understand some of these numbers and her independent thoughts.
Mike Bose (VP – RD): Thanks Barbara. I thought our policy was to internally source as much as possible. We have developed the CT-10 and have invested a lot in R & D. The price of $750 covers our cost plus royalty, modifications and a reasonable mark-up. Our success depends on continuous innovation and our core competencies are in new product development.
We are coming under severe competition and I am unable to meet the target of 15% ROI. We have an excellent reputation for our R&D capability and the quality products we bring to the market.
Peter Spence (VP - PD): Barb, you know that we have nearly reserved 30% of our capacity to produce CT-10 and transfer to RD. Currently, I am operating at 85% of capacity that includes other products not transferred internally. My ROI expectation is in jeopardy if Tom purchases a substitute products from France or Germany. The agreement between Mike and I is to produce CT-10 in my division and transfer to him at $500. I believe this is justified. (Exhibit D). Outsourcing is not the answer now. We need to think as to how best we can use my facilities and make a reasonable return for myself and for CTS.
Tom Baker: (VP – ID): My problem is that I need thiscontract to make the required ROI of 15%. We have an opportunity to build long lasting relationship with this client in Italy and unless we come up with a reasonable quote, we may miss this opportunity. My market intelligence and support from Shelly in pricing these 1,000 units, tells me that the competitive bid would be around $3.50 million against our price of $4.50 million. (See Exhibit C).
Shelly Sanchez: (CFO): ID may be saving through outsourcing. Yes, German supplier can replicate our design and offer a lower price by offering a royalty fee. But, I am also concerned about giving out our product specifications and trade secrets, especially when we are promoting CT-10 now.
We need to look at costing, pricing, capacity factors and other risks before I can make a meaningful recommendation. All our divisions are profit centers and the transfer pricing disputes among divisions should be resolved at that level but maintain goal congruence overall. We need to revisit our strategy and performance evaluation system. Divisions are free to make their operational decisions. However, our focus on the corporate ROI requirement should still be 15%.
Mike Bose (VP- PD): I agree with Shelly. But, I still maintain that we need to recover our investment and continue to develop new products. Perhaps, I should control my own destiny and need to come up with a proposal to expand my pilot manufacturing facilities into full production. I do not have enough financial information but I believe our cost of capital is around 15%.
LOOKING FORWARD
Barb Richards (CEO): Before we can do all that Mike, we need to refocus on our future.
Perhaps, it is time we re-strategized and developed a better planning and control system for CTS.
I am also worried about the sustainability of CTS in general. Let us also look other measures beyond ROI. I am beginning to doubt if our current organizational structure is conducive for our continued business. Our Board of Directors is looking for more transparency.
We are a medium sized enterprise, need to grow, maintain our presence in the market, build on our reputation and continue to be innovative and profitable. Shelly, please take the lead, work with the divisional managers and make your recommendations by next week. We certainly need to make some important decisions!
Required:
Take the role of a business advisor and help the team identify the main issues, conduct appropriate analysis, quantitative and qualitative considerations to arrive at recommendations for Ms. Richards.
Exhibit A Condensed partial financial information:
Canadian Technology Services
Year Ended 31 December 2015 ($ Millions)
RD PD ID Total
Total Net Revenues 10.00 20.00 8.00 38.00
Income (before taxes) 1.00 2.50 2.00 5.50
Selected Balance Sheet Information
Current Assets 2.00 5.00 3.00 10.00
Fixed Assets @ acquisition 15.00 25.00 10.00 50.00
Depreciation (Accumulated) 6.00 15.00 3.00 24.00
Long-term Debts (LTD) 10.00 10.00 5.00 25.00
Current Liabilities 1.00 2.00 2.00 5.00
LTD maturity 2018 2018 2018 N/A
For financial analysis, Return on Equity is assumed to be constant for all divisions @ 15%
LTD - Interest Rates - arranged by the corporate at 8%
Typical tax rate for CTS is 30%
Exhibit B
Unit Pricing
Quote from RD for supply of 1,000 units of CT-10 to Industrial Division (ID)
Transferred-in Cost from Electric Product Division (Exhibit D) $500
Recovery of R & D Investment (Royalty) * 100
Internal Modification Costs 25
Total Product Cost $625
Mark-up @ 20% 125
Transfer Price to ID $750
* It was agreed that the developmental cost of $6 million would be amortized over an expected production and sale of 100,000 units.
- RD has been successful in selling 90,000 of units so far in the open market and hopes to recover the balance in the next couple of year, as demand continues for CT-10.
Exhibit C:
Bid Price for the Italian Proposal
(1,000 units using CT-10 as a part component) – Proposed Costing
Direct Material $ 1,800,000 *
Direct Labour 1,500,000 *
Variable Overhead 260,000
Fixed Overhead 350,000
$ 3,910,000 *
Mark-up @ 15% (rounded) 590,000
Proposed Bid$ 4,500,000 or $4,500/unit
* Includes the transfer price of $750 for CT-10 as above in Exhibit B.
Exhibit D
Costing Structure of Power Division for CT-10 per Unit
Direct Material $ 150
Direct Labour 170
Manufacturing Variable Overhead 50
Fixed Overhead 40
$ 410
Mark-up @ 20% 82
$ 492
Shipping Costs to ID 8
Transfer Price to PD from RD $ 500
Other Notes:
1. Barbara had repeatedly stated in many of her executive meetings that she would prefer to consider expansion of the company. However, she is also aware that it is important to sustain CTS as a viable company before expanding.
- Mike Bose has always wanted to be truly autonomous. He needed to have this authority to invest in expansion.
- Tom Baker carries an EU passport in addition to his Canadian Passport. He always wanted to have his connection in Europe.
- Peter Spence aspires to become the next CEO. But he knows that he needs to have more exposure to international markets.
