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					                       Cedar Electronics Limited
John Big, the president of Cedar Electronics Limited (CEL), is troubled that the recently acquired appliance
Division has been incurring large losses, and John is seeking advice on the division.

CEL is a large, widely held Canadian corporation that has specialized in the design and manufacture of
electronic devices. One particularly successful product developed was the RX-100, an electronic processor,
designed to replace mechanical switching devices. The RX-100 was an instant success in the appliance
industry but, within a year, competing products were rapidly replacing the RX-100. In 2002, CEL had
acquired Domino Appliances Limited (DAL) to give CEL a captive market and a base for developing new
devices.

At the time DAL was acquired, John restructured CEL into three divisions—Electronics, Appliance
(formerly DAL) and RD&I (Research, Development & Inspection)—each of which was designed to be an
investment centre. Division managers were free to sell externally but were expected to supply, source, and
service internally. About 12% of the Electronics Division's sales were comprised of RX-100s transferred to
the Appliance Division at full cost plus 10%. The RD&I Division sold a production quality control service,
on contract, to the other divisions at variable cost plus 10% and also contracted externally. RD&I was given
a budget appropriation, for researching new products, which was not included in the calculation of its ROI.

John Big's objective in decentralizing the corporate structure was to make each division operate and be
evaluated as if it were an independent business. Corporate overhead was allocated to the divisions on the
basis of a percentage of sales. The division managers were each allowed to make annual investments of not
more than 5% of their divisional net assets on their own authority. CEL's after-tax cost of capital was
estimated to be 10%. Division managers were expected to earn 10% (before taxes) on their investment
base, calculated on the book value of their current assets plus the net book value of their fixed assets.

John has called in Rita Smart, a recently qualified Chartered Accountant, for advice.

John:   Thank you for coming. There are some developments in our organization which disturb me and
        need attention. While CEL's 2004 results show a profit, the Appliance Division shows a loss
        (Exhibit 1). Bill Jones, the Appliance Division manager, claims that the RX-100s are a major
        problem and that, if he could source these externally, his divisional operating results would be
        greatly improved. As it is, our appliances are over-priced and we are unable to keep our sales outlet
        managers because they feel the performance target of achieving a 5% profit on sales is unreasonable
        (Exhibit 2).

Rita:   This concept behind the decentralized structure, which we helped you introduce in 2002, was that
        each division would operate as an investment centre and so maximize the divisional and corporate
        profits. Since one of your objectives in purchasing the appliance division was to acquire the
        twenty-odd appliance sales outlets, it was also decided that these outlets should be managed as
        profit centres.

John:   Two problems have arisen here. First, the prime objective in acquiring the Appliance Division was
        to establish a protected market for the RX-100 and for any subsequently patented in-house
        developed devices. Bill Jones, the Appliance Division manager, uses every excuse to source RX-
        100s externally (Exhibit 3). Second, our total appliance sales are not just of sufficient volume to
        provide enough throughput to make the sales outlets economically viable. We may have to close
        some or all of them.

Rita:   How would you then market the division's product?

John:   That is the problem. To add to his problem, Tom Smith, the manager of the Electronics Division,
        has decided to make a capital investment to increase RX-100 production capacity (Exhibit 4). I
        may have not only to step in and block this investment, but also enforce an internal sourcing rule.

Rita:   Strictly speaking, you should not involve yourself in investment centre decisions as long as the
        division's ROI is on target.

John:   Well, I would like your advice on these matters. Remember that my prime responsibility is the
        bottom line of the income statement!

REQUIRED:

 (1)    Identify and analyze all the business decisions relating to:
                  i) product RX-100, and
                 ii) the Appliance Division

 (2)    Evaluate the management control system and make appropriate recommendations.
                                                                            Exhibit 1
                                                                  CEDAR ELECTRONICS LIMITED
                                                               Summarized 2004 Operating Statements
                                                                             $'000s

                                                                              Internal RX-100                                               CEL Total
                                                                                 included in        Electronics   Appliance     RD&I        Including
                                                                            Electronics Division1    Division     Division2    Division   Internal Sales

 Sales:
  External...........................................................                       N/A        363,000      320,900      26,578         710,478
  Internal3...........................................................                    49,500        49,500            -      25,422          74,922
 Total Sales .........................................................                    49,500       412,500      320,900      52,000         785,400

 Cost of sales:
  Direct material ................................................                        15,000       143,477      180,600       6,860         330,937
  Direct labour ...................................................                       12,500        87,068       69,370      27,110         183,548
  Variable overhead...........................................                             5,000        16,360        9,230       1,101          26,691
  Variable RD&I ...............................................                            2,200        13,982       11,440           -          25,422
  Fixed factory overhead ...................................                               3,000        18,753       15,063       3,350          37,166
 Total Costs of sales............................................                         37,700       279,640      285,703      38,421         603,764
 Operating Profit .................................................                       11,800       132,860       35,197      13,579         181,636
 Administration ...................................................                          825         7,501        4,760       4,500          16,761

 Selling:
  Variable ..........................................................                       2,000       20,753       12,836         150          33,739
  Fixed ...............................................................                     2,000       15,002         7,506         60          22,568
 Corporate charges ..............................................                           2,475       20,625       16,045       2,600          39,270
                                                                                            7,300       63,881       41,147       7,310         112,338
 Divisional profit.................................................                         4,500       68,979       (5,950)      6,269          69,298

 Manufacturing variances4..................................                                                                                       7,074
 RD&I allocation ................................................                                                                                 5,000
 Income tax5 ........................................................                                                                            18,020
 Net income.........................................................                                                                             39,204
 Net assets ...........................................................                                350,000      110,000      55,000         530,000
 ROI ....................................................................                               19.7%             -      11.4%            7.4%



Notes:

1.    The operating results of RX-100 sales to the appliance Division were included at Mr. Big's request.
2.    Appliance Division sales and selling expenses relate directly to the sales outlets. Cost of sales represent the
      manufacturing department costs. Administration and corporate overhead represent overall division charges.
3.    All inter-divisional sales from the Electronics Division to the Appliance Division were priced at full cost plus 10%.
       The transfer price of RX-100s to the Appliance Division was $9.90 per unit. Internal sales of the production
      quality control service from the RD&I Division were priced at variable cost plus 10%.
4.    The operating costs were all at standard cost with the annual aggregate variance expensed at year-end.
5.    The effective tax rate was abnormally low due to RD&I write-offs and loss carry-forwards. The incremental tax
      rate is 40%.
                                                           Exhibit 2
                                                CEDAR ELECTRONICS LIMITED
                                               Appliance Division Sales Outlets
                                         Summarized 2004 Aggregate Operating Statement
                                                            $'000s

        Sales ....................................................................................................................   320,900
        Cost of Sales1 ......................................................................................................        314,273
                                                                                                                                       6,627
        Outlet operating costs:
         Variable ...........................................................................................................         12,836
         Fixed ................................................................................................................        7,606
        Outlet profit (loss) before managers' bonuses....................................................                            (13,715)
        Managers' bonuses ..............................................................................................                    -
        Outlet profit (loss) ..............................................................................................          (13,715)


Note:

1. The Appliance Division's sales outlets sell only products transferred from the Appliance Division's
   manufacturing department. Transfers are made at full manufacturing cost plus 10%.
                                                      Exhibit 3
                                            CEDAR ELECTRONICS LIMITED
                                     Memo From Appliance Division General Manager
                                                    To President



FROM:                 Bill Jones

TO:                   John Big

DATE:                 January 4, 2005

SUBJECT:              Explanation of external sourcing of RX-100s


During 2004, approximately 23% of our annual RX-100 requirement was sourced externally. The reasons
for external sourcing were as follows:

      (1) Insufficient internal production capacity to fulfil all our needs.

      (2) Inability of the Electronics Division to service rush orders on time.

      (3) Avoidance of undue delays arising from quality control problems with internally sourced RX-100s.

It should also be pointed out that equivalent products can be sourced externally at considerably lower cost:

                                                                                                Source
                                                                         Electronics Division       Externally on the Market
 Cost per unit:
   • RX-100 ..........................................................          $9.90
   • Equivalent product ........................................                                             $9.00

If I could source all my division's requirements of RX-100s externally, we could eliminate most of our loss.



Bill Jones
                                                          Exhibit 4
                                                CEDAR ELECTRONICS LIMITED
                                            Memo From Electronics Division Manager
                                                       To President



FROM:                Tom Smith

TO:                  John Big

DATE:                January 4, 2005

SUBJECT:             Capital Investment


Currently, my department has an annual RX-100 production capacity of 5,500,000 units which represents
only about 85% of the Appliance Division's annual requirements of RX-100. Because Bill Jones claims that
we cannot service this orders on time, he has sourced RX-100s externally. This resulted in my department
having a 500,000 unit surplus of RX-100s which were sold on the external market at a price of $9.00.

In order to solve the problems of undercapacity and late delivery, I have decided to purchase a new specially
designed machine which will be able to produce 1,500,000 units of RX-100s, expanding our total capacity
to 7,000,000 units. Units produced by the new machine will not require the quality control services of the
RD&I Division. We will be able to fill all of the Appliance Division's requirements on a timely basis and
still sell 500,000 units to external customers each year.

The ROI resulting from this $15,000,000 investment will be 19.7% as calculated below:

      Unit transfer price .........................................................................................              $9.90
      Unit production cost:                Direct material ..................................................            $3.00
                                           Direct labour .....................................................            2.50
                                           Direct overhead.................................................               1.00
                                           Fixed factory overhead* ...................................                    1.43    7.93
      Profit per unit ................................................................................................           $1.97

      * $15,000,000  (1,500,000 units  7 years) = $1.43
      Additional profit = 1,500,000  $1.97 = $2,955,000
                      $2,955,000
      ROI =                                    = 19.7%
                     $15,000,000

The new machine should last about 7 years, by which time the RX-100 will be obsolete. (Note: The
machine will be subject to a special capital cost allowance treatment, whereby one-half may be written off
in the first year of operation and the other half in the second year.)

				
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