Infantino Saab is a car dealership that has been in business for 40 years at the same 20...

Infantino Saab is a car dealership that has been in business for 40 years at the same 20-acre location selling and servicing new and “pre-owned” (used) Saabs. Two years ago Infantino Saab replaced its aging showroom and service center with a new, state-of-the-art facility. When Ms. Infantino’s father started the dealership, the business was on the outskirts of town. Now with city sprawl, the dealership is located on a busy commercial street surrounded by other dealerships, restaurants, and shopping centers.

The market for new cars is very competitive because many buyers shop on the Internet before visiting new car dealers. Once customers decide to purchase a new car from a dealer, they usually trade in their used car to avoid the hassle of selling the car themselves, and hence these new car buyers are willing to accept lower prices from car dealers for their trade-ins. Also, pre-owned cars have higher margins because there is less competition for used cars, as each used car differs in terms of mileage, condition, and options. Suppose a new car is sold for $45,000 ($500 over dealer cost) and the buyer receives a trade-in allowance on his old car of $8,000 and pays the difference in cash. That used car is then sold for $10,800. The dealer makes $500 on the new car and $2,800 on the used car. Infantino also offers parts and service for the new and pre-owned cars it sells.

Infantino Saab is organized into three departments: New Cars, Pre-owned Cars, and Service. All three share the same building and lot where the new and used cars are displayed. Ms. Infantino compensates her three department heads based on residual income. After careful analysis by her financial manager, they determine that all three departments should be charged for the capital invested in their departments at 16 percent.

The new building cost $12 million and the land cost $900,000. The following table summarizes the land and building utilization by each department, each department’s net income, and other net assets invested in each department:

For example, the new car department occupies 50 percent of the land and 30 percent of the building. It had net income of $600,000 and other net assets of $2,500,000. Other net assets consist of all inventories and receivables (net of external financing) invested in the department. For example, the new car department has a substantial inventory of new cars. But this new car inventory is mostly financed by short-term bank loans. The new car department pays interest on these loans, which is deducted (and hence included) in the new car department’s net income of $600,000. Each department’s income consists of all revenues and expenses directly traceable to that department, including interest on any debt used to finance the department’s inventory. Income taxes are not included in each department’s net income reported in the table. Infantino Saab uses the trade-in allowance of used cars taken in trade as the transfer price of used cars in calculating the net incomes of the new and pre-owned car departments.

Required:

a. Calculate the residual income of each of the three divisions of Infantino Saab.

b. Discuss the relative profitability of the three departments. Which is making the most money and which is making the least amount of money?

c. Discuss whether the residual incomes of the three departments capture the true profitability of each department. What problems do you see in the way Ms. Infantino is evaluating the performance of the three department managers and of Infantino Saab as a whole?