Risk Management

Chapter 6
Solution

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Multinational car manufacturer
Dysfunctional behaviour is a potential problem because transfer prices are, effectively,
imposed from outside the group. A subsidiary company will not necessarily be able to
recover all of its costs and generate a realistic profit when selling to a fellow group
member. For example, a component manufacturer in a low-cost environment may be
able to charge intra-group transfers at a higher price than the prevailing arm's­ length
market price. That will leave the component manufacturer with an artificially high profit,
whereas the buyer may be aggrieved that the purchase from a fellow group member
costs as much as, or even more than, buying the same component on the open market
from a third party.

Managers will have very little control over their reported performance if these transfer
prices are used. For example, a local increase in the cost of labour could coincide with
a worldwide reduction in the cost of the product (e.g. electronic components) and so
the subsidiary responsible for manufacturing a component could be forced to reduce
transfer prices at the very time that its cost base is increasing.

These arrangements could lead to dysfunctional behaviour with subsidiary company

boards attempting to reduce prices in a sub-optimal manner in order to report higher
profits. For example, a subsidiary with high input prices may attempt to reduce local
costs in order to boost added-value. That could result in short cuts being taken over
health and safety or maintenance in order to inflate profit and such savings may prove
to be uneconomic in the long run.

Management time could be wasted because of constant internal arguments about

transfer pricing. Staff time could be spent tracking and monitoring market prices in
order to ensure that any favourable changes are implemented immediately.

Managers may be demotivated if profit-related bonuses or staff evaluations are based

on these externally imposed transfer prices.

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Subsidiaries could even attempt to disrupt internal transfers of generic parts in order
to justify buying from third parties from whom a discount can be negotiated.

The risk of dysfunctional behaviour could be avoided if M invests in an appropriate

management accounting system. The subsidiaries could report on the basis of value
added for internal management accounting purposes. The fact that alternative figures
are used for external reporting to national tax authorities need have little or nothing to
do with the basis upon which management teams are evaluated. Indeed, M will have
to produce such information anyway in order to ensure that the company is making
the correct decision with respect to make or buy.

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D cars

(a) Balanced scorecard

Financial

Revenue growth would be a useful means of encouraging the divisional managers to

enable the business to grow through generating sales. That could be measured on a
short-term basis, e.g. by measuring month-by-month sales in comparison with
previous years, or longer term, e.g. by aiming for annual growth.

Return on equity would be a useful longer term measure to counter the potential for
dysfunctional behaviour if sales or some other short term measure is introduced.
Aiming for an increase in annual RE will give divisional managers a long-term goal for
financial performance.

Customer

Repeat sales, perhaps measured in terms of sales made to customers who purchased
a car from D during the previous three years, would give the divisions a long-term goal
of developing a good working relationship with existing customers. Ideally, customers
will buy a car from D and be encouraged to return after, say, two or three years to
trade it in and buy another.

Conversion of car sales into service sales should be measured. D should aim to
generate as much revenue as possible from car buyers I by selling additional products
such as regular servicing and

maintenance. Apart from the contribution from that activity, the company will also be
keeping contact with customers and may be able to target promotion more effectively,
e.g. by having a member of sales staff telephone a customer whose mileage is high
to point out the benefits of switching to a newer model.

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Learning and growth

The development of innovative marketing and promotional techniques is vital because

D's products are essentially identical to those of the other vehicle dealerships that it is
competing against. Cost effective marketing strategies must be developed in order to
maintain footfall through dealerships. Those strategies should not focus on price
because there is little to be gained from entering a price war with competitors.

New products may be difficult to develop in this market, but that does not make
innovation impossible. For example, the dealerships could I offer to collect customers'
cars for servicing during the working day and return them after the work has been
completed. Such developments would possibly generate revenue in themselves and
would also give the opportunity to correspond with customers to remind them of D's
interest in their business.

Internal business processes

The number of complaints or requests for rectification of faults on new cars should be
minimised (or eliminated). The dealership is responsible for preparing new cars for
delivery, which would include valeting and cleaning the vehicle and checking for any
manufacturing defects that were not noticed by the maker. All of this work should be
done to such a high order that customers are not disappointed because of an
avoidable complaint.

Sales effort should be linked to inventory availability to avoid old inventory and also to
ensure that customers are committed to a purchase before a competitor has the
opportunity to take their business. If supplies of popular models are running low then
sales staff should be encouraged to press the possibility of an alternative from the
dealership's product range or to offer a new car in place of a second hand car or vice
versa.

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(b) (i) Dysfunctional behaviour

The biggest problem is that of transfer price. If a customer offers a car of a different
make as a trade-in then the dealership will be aware that it will be passed on to another
dealership or division.

The dealership may feel that there is no real incentive to negotiate the lowest
acceptable price or the trade in with the customer if that cost will be recovered from
elsewhere within D.

Vehicles are to be serviced before their sale and that will be a cost to the dealership
that undertakes the work. Dealerships may underspend on servicing because of the
possibility that the car will be transferred to another dealership or division. That could
harm the company's reputation when the cars are subsequently sold with defects that
should have been corrected. Problems with cars may take some time to appear and
so it may be possible to overlook defects that will not be obvious until after the vehicle
has been resold.

(ii) Solutions

All transfers should be valued at their market value, using the "going rate" for a model
of that age and mileage. Such rates are relatively easy to determine for used cars and
so there should be little cause for dispute.

All trade-ins should be serviced by the dealership that receives the cars for sale, which
may not be the dealership that accepts the car as a trade-in if the car is not of the
same make as the dealership's franchise. The dealership that receives the car for sale
should pay full market value, but should be able to recover repair costs against that
as an incentive to check the car carefully before accepting it.

If a car is subsequently transferred to another division in order to balance inventories

then the receiving division should be able to recover any rectification costs from the
other division, again to avoid dealerships having an incentive to leave faults
uncorrected.