Clark Shuman, the part owner and manager of an automobile dealership, was nearing retireme...

Clark Shuman, the part owner and manager of an automobile dealership, was nearing retirement and wanted to begin relinquishing his personal control over the business’s operations. (See Exhibit 1 for current financial statements.) The reputation he had established in the community led him to believe that the recent growth in his business would continue. His longstanding policy of emphasizing new car sales as the principal business of the dealership had paid off, in Shuman's opinion. This, combined with close attention to customer relations so that a substantial amount of repeat business was available, had increased the company's sales to a new high level. Therefore, he wanted to make organizational changes to cope with the new situation, especially given his desire to withdraw from any day-to-day managerial responsibilities. Shuman's three "silent partners" agreed to this decision.

*These amounts include all costs that are attributable to the department and exclude allocated capacity related dealership costs.

†Allowances on trade represent the excess of amounts allowed on cars taken in trade over their appraised value.

Accordingly, Shuman divided up the business into three departments: new car sales, used car sales, and the service department (which was also responsible for selling parts and accessories). He then appointed three of his most trusted employees managers of the new departments: Jean Moyer, new car sales; Paul Fiedler, used car sales; and Nate Bianci, service department. All of these people had been with the dealership for several years.

  Each of the managers was told to run his department as if it were an independent business. In order to give the new managers an incentive, their remuneration was to be calculated as a straight percentage of their department 's gross profit.

  Soon after taking over as manager of new car sales, Jean Moyer had to settle upon the amount to offer a particular customer who wanted to trade his old car as a part of the purchase price of a new one with a list price of $ 12,800. Before closing the sale, Moyer had to decide the amount he would offer the customer for the trade-in value of the old car. He knew that if no trade-in were involved, he would deduct about 15% from the list price of this model new car to be competitive with several other dealers in the area. However, he also wanted to make sure that he did not lose out on the sale by offering too low a trade-in allowance.

  During his conversation with the customer, it had become apparent that the customer had an inflated view of the worth of his old car, a far from uncommon event. In this case, it probably meant that Moyer had to be prepared to make some sacrifices to close the sale. The new car had been in stock for some time, and the model was not selling very well, so he was rather anxious to make the sale if this could be done profitably.

  In order to establish the trade-in value of the car, the used car manager, Fiedler, accompanied Moyer and the customer out to the parking lot to examine the car. In the course of his appraisal. Fiedler estimated the car would require reconditioning work costing about $700. after which the car would retail for about $3,700. On a wholesale basis, he could either buy or sell such a car, after reconditioning, for about $3,200. The wholesale price of a car was subject to much greater fluctuation than the retail price, depending on color, trim, model, etc. Fortunately, the car being traded in was a very popular shade. The retail automobile dealer's handbook of used car prices, the "Blue Book," gave a cash buying price range of $2,750 to $2,930 for the trade-in model in good condition. This range represented the distribution of cash prices paid by automobile dealers for that model of car in the area in the past week. Fiedler estimated that he could get about $2,200 for the car ‘ as-is” (that is, without any work being done to it) at next week’s auction.

  The new car department manager had the right to buy any trade-in at any price he thought appropriate, but then it was his responsibility to dispose of the car. He had the alternative of either trying to persuade the used-car manager to take over the car and accepting the used-car manager's appraisal price, or he himself could sell the car through wholesale channels or at auction. Whatever course Moyer adopted, it was his primary responsibility to make a profit for the dealership on the new cars he sold, without affecting his performance through excessive allowances on trade-ins. This primary goal, Moyer said, had to be “balanced against the need to satisfy the customers and move the new cars out of inventory—and there was only a narrow line between allowing enough on a used car and allowing too much."

  After weighing all these factors, with particular emphasis on the personality of the customer, Moyer decided he would allow $4,270 for the used car, provided the customer agreed to pay the list price for the new car. After a certain amount of haggling, during which the customer came down from a higher figure and Moyer came up from a lower one, the $4,270 allowance was agreed upon. The necessary papers were signed, and the customer drove off.

  Moyer returned to the office and explained the situation to Joanne Brunner, who had recently joined the dealership as accountant. After listening with interest to Moyer's explanation of the sale, Brunner set about recording the sale in the accounting records of the business. As soon as she saw the new car had been purchased from the manufacturer for $8,890, she was uncertain as to the value she should place on the trade-in vehicle. Since the new car's list price was $12,800 and it had cost $8,890, Brunner reasoned the gross margin on the new car sale was $3,910. Yet Moyer had allowed $4,270 for the old car, which needed $700 repairs and could be sold retail for $3,700 or wholesale for $3,200. Did this mean that the new car sale involved a loss? Brunner was not at all sure she knew the answer to this question. Also, she was uncertain about the value she should place on the used car for inventory valuation purposes. Brunner decided that she would put down a valuation of $4,270 and then await instructions from her superiors.

  When Fiedler, manager of the used-car department, found out what Brunner had done, he went to the office and stated forcefully that he would not accept $4,270 as the valuation of the used car. His comment went as follows:

My used-car department has to get rid of that used car, unless Jean (Moyer) agrees to take it over himself. I would certainly never have allowed the customer $4,270 for that old tub. I would never have given any more than $2,500, which is the wholesale price less the cost of repairs. My department has to make a profit too, you know. My own income is dependent on the gross profit I show on the sale of used cars, and I will not stand for having my income hurt because Jean is too generous toward his customers.

  Brunner replied that she had not meant to cause trouble but had simply recorded the car at what seemed to be its cost of acquisition, because she had been taught that this was the best accounting practice. Whatever response Fiedler was about to make to this comment was cut off by the arrival of Clark Shuman, the general manager, and Nate Bianci, the service department manager. Shuman picked up the phone and called Jean Moyer, asking him to come over right away.

  "All right, Nate," said Shuman, "now that we are all here, would you tell them what you just told me?" Bianci, who was obviously very worried, said, "Thanks Clark; the trouble is with this trade-in. Jean and Paul were right in thinking that the repairs they thought necessary would cost about $700. Unfortunately, they failed to notice that the rear axle is cracked, which will have to be replaced before we can sell the car. This will probably use up parts and labor costing about $530.

  “Besides this," Bianci continued, “there is another thing which is bothering me a good deal more. Under the accounting system we’ve been using, I can’t charge as much on an internal job as I would for the same job performed for an outside customer. As you can see from my department statement [Exhibit 2], I lost almost eight thousand bucks on internal work last year. On a reconditioning job like this, which costs out at $1,230. I don’t even break even. If I did work costing $1,230 for an outside customer, I would be able to charge him about $1,620 to $1,700 for the work this car needs, and I have always aimed for about the middle of the Blue Book range. That would give my department a gross profit of $430, and my own income is based on that gross profit. Since it looks as if a high proportion of the work of my department is going to be the reconditioning of trade-ins for resale, I figure that I should be able to make the same charge for repairing a trade-in as I would get for an outside repair job."

  Fiedler and Moyer both started to talk at once at this point. Fiedler, the more forceful of the two, managed to edge out Moyer: "This axle business is unfortunate, all right; but it is very hard to spot a cracked axle. Nate is likely to be just1as lucky the other way next time. He has to take the rough with the smooth. It is up to him to get the cars ready for me to sell.”

  Moyer, after agreeing that the failure to spot the ax le was unfortunate, added: "This error is hardly my fault, however. Anyway, it is ridiculous that the service department should make a profit out of jobs it does for the rest of the dealership. The company can't make money when its left hand sells to its right."

  At this point, Clark Shuman was getting a little confused about the situation. He thought there was a little truth in everything that had been said, but he was not sure how much. It was evident to him that some action was called for, both to sort out the present problem and to prevent its recurrence. He instructed Brunner, the accountant, to "work out how much we are really going to make on this whole deal," and then retired to his office to consider how best to get his managers to make a profit for the company.

  A week after the events described above, Clark Shuman was still far from sure what action to take to motivate his managers to make a profit for the business. During the week, Bianci, the service manager, had reported to him that the repairs to the used car had cost $1,376, of which $640 represented the cost of those repairs which had been spotted at the time of purchase, and the remaining $736 was the cost of supplying and fitting a replacement for the cracked axle. To support his own case for a higher allowance on reconditioning jobs, Bianci had looked through the duplicate invoices over the last few months and had found examples of similar (but not identical) work to that which had been done on the trade-in car. The amounts of these invoices averaged $1,610, which the customers had paid without question, and the average of the costs assigned to these jobs was $1,192. (General overhead was not assigned to individual jobs. In addition, Bianci had obtained from Brunner, the accountant, the cost analysis shown in Exhibit 2. Bianci told Shuman that this was a fairly typical distribution of the service department expense.

 Assume each department (new, used, service) is treated as a profit center, as described in the case. Also assume in a-c it is known with certainty beforehand that the repairs will cost $1,376.

 

In your opinion, at what value should this trade-in (unrepaired) be transferred from the new car department to the used car department? Why?

  In your opinion, how much should the service department be able to charge the used-car department for the repairs on this trade-in car? Why?

  Given your responses to a and b, what will be each of the three departments’ contributions on this deal?