North country auto case Performance measurement lecture 4

North Country Auto (NCA), Inc., was a franchised dealer and factory-authorized service center for Ford,
Saab, and Volkswagen.

The value of multiple franchises did not come without costs. Each of the three manufacturers used a
different computerized system for tracking inventory and placing new orders + technicians required.

Second business of “while you wait” oil change

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

Industry analysts were estimating that fewer than 50 percent of the dealers in the US would make a
profit on new car sales in 2008. Overall net profit margins were expected to fall below 1% of sales

Liddy’s Challenge Before George Liddy bought into the dealership, all the departments operated as part
of one business. Department managers were paid salaries and a year-end bonus determined at the
owners' discretion based on the overall company’s results for the year and a subjective appraisal of each
manager. George Liddy believed this system did not provide proper motivation for the managers. He
believed in decentralized profit centers and performance-based compensation as superior models of
control. He instructed each of his departmental managers (new, used, service, body, and parts) to run
his/her department as if it were an independent business. He knew that the success of the profit center
control system was dependent upon the support of his managers.

Conflict of interest problem

Alex Walker, manager of the new car sales department, sold a new car for $14,150. This purchase was
financed by a cash down payment of $2,000, a trade-in allowance of $4,800, and a bank loan of $7,350.
The dealer's cost was $11,420, which included factory price plus sales commission. The trade-in had a
wholesale guidebook value of $3,500. The guidebook, published monthly, was, at best, a near estimate
of liquidation value. Actual values 2 The gross profit for the New cars and Used cars departments was
calculated as sales minus cost of vehicles sold (including a sales commission when applicable). The gross
profit for the Services department was computed as labor dollars billed minus wages of billable
technicians and mechanics. The gross profit for the Parts department was calculated as price of parts
sold less cost of parts. Cash………………………………. $ 32 Account receivable……………….. 228 Saab
inventory……………………. 253 VW inventory…………………….. 243 Ford inventory……………………. 773 Used
cars…………………………. 231 Saab parts………………………… 75 VW parts…………………………. 75 Ford
parts…………………………. 226 Body shop material………………. 6 Other current assets……………….. 89
Property& equipment-Net*……….. 85 ($377M gross) Total………………………………. $2,316 NORTH COUNTRY
AUTO, INC. Balance Sheet October 31, 2007 (In thousands) Accounts payable…………………. $ 73 Notes
payable-vehicles...…………. 1,294 Long-term debt….………………… 344 Total Liabilities…………………… 1,711
Stakeholders’ equity Common stock……….………… $ 400 Retained earnings………………… 205
Total……………………………… $ 2,316 4 NORTH COUNTRY AUTO, INC. October 31, 2007 (10 months) (Dollar
figures in thousands) varied daily with the supply-demand balance at auto auctions. These variances
could be as much as 25 percent of the book value. The manager of the used car sales department, Ms.
Amy Robbins, believed that she could sell the trade-in quickly at $5,000 and earn a good margin, so she
chose to carry it in inventory instead of immediately wholesaling 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 rotors 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 (performed 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 performed for a retail price of $255 ($80 in parts, $175 in labor).
The repair and tune-up work was completed and capitalized at retail cost into used car inventory at
$705. These mechanical repairs would not increase wholesale value if the cars subsequently were sold
at the auction. The transfer price for internal work recently had changed from cost to full retail
equivalent. The multiplier for defining retail prices for labor was 3.5 times the direct hourly rate and
about 1.4 times for parts. George Liddy was concerned that the retail transfer price of the repairs in
conjunction with his plan to allocate full costs to each department (as illustrated in Exhibit 3) might
encourage the used car sales manager to avoid the possibility of losses in her department by
wholesaling trade-in cars that could be retailed at a profit for the dealership

2. North Country incurred a year-to-date loss of about $59,000 before allocation of fixed costs on the
wholesaling of used cars (see Note 2 in Exhibit 3). Wholesaling of used cars is supposed to be a
breakeven operation in theory. What is then happening in practice?

Charged full retail price from service operations

Class lecture
Before company on a single business unit

AfterDecentralized and bonus based on each specific profit centres

Very low profitability margins and capital intensive business

Risk of Inventory

*With the new structure they are creating the tension of human behaviour

New cars rev 12,850 = 14,150- (4800-3500)  4800-3500 is the difference between the valuation and
the real value of the used car traded in  so the car valuation is a tool to make discounts and the
overvaluing of trade ins is like a discount to boost sales

But for used car we use the guide book value because it is more objective

Used car cost 4,455 = 3500 (book value) + 250 sales commissions + 235 parts at retail price + 470 service
at retail price

COGS for Parts = Rev / Markup  235 / 1.4 = 168

COGS for Services = Rev / Markup  470 / 3.5 = 134

The problems are

Interdependencyminimize interdependency and maximize proactivity

Dysfunctional behaviours (Low quality cars to used cars department + beared cost at retailinflated
prices)Used cars temptation to go for wholesale to reduce risks

2. North Country incurred a year-to-date loss of about $59,000 before allocation of fixed costs on the
wholesaling of used cars (see Note 2 in Exhibit 3). Wholesaling of used cars is supposed to be a
breakeven operation in theory. What is then happening in practice?

-No repairs needed so not in the discussion

-The only cost is 3500 and thanks to guided book prices it should sell at 3500 immediately

-But Repairs get capitalized so when you repair the car and you are not able to sell the car you have to
go for wholesale and sell at loss, or just with the passing of time the value in inventory would decrease.

3) Advice for the owners:

Performance measure:

1. First the amount of inventory is crucial for profitability, so we can measure the new car manager
performance by charging inventory financial costs: net op profit- financial charges  also for
other department
2. Use ROI because there is impact on BS, since low assets (less inventory) means more return
3. More objectives in the compensation pack (vector of objectives)  combine net operating profit
and the measure of inventory turnover

Structure of accountability

Combine New and Used since used is fully dependent on inputs from new Profit center

Combine Parts and Services as a profit center

Alternatively new car independent profit center

Used cars+Parts+Services as another profit center

Back end can be transformed in a cost centre in case there is few business outside the company for
parts and services + need to control the quality
A cost centre would be less focused on quality and if they have a bunisess outside tranfer pricing you
have a disincentive to pursue that business

TAKEAWAYS

MINIMIZE INTERDEPENDENCIES WRONG SEGMENTATION LEADS TO DISFUNCTIONAL BEHAVIOURS

IMPORTANCE OF INCLUSION AND EXCLUDION OF THINGS TO CALCULATE PROFIT AND RESULTS

COST CENTRE VS PROFIT CENTRE Depends on the objective fe. Of the back end