Objective:
The main objective of Abrams Company is to resolve two conflicts in the business due to differing functions performed by the three profit centers. The first one is to create harmony between the three manufacturing divisions and the Aftermarket. The second objective is to eliminate excessive inventory of the four divisions.
Main Issues
1. How should the transfer price be set between the OEM parts plants and the AM division for the unique parts?
2. (a) How fair is it to treat the AM Division as a profit center? (b) Since the Aftermarket (AM) division has no control over cost, should it be treated as a revenue center?
3. Delivery and part availability pressure led to excessive inventory. How should this inventory problem be solved?
4. Discuss the pros and cons of the ROI measure at Abrams?
Discussion of Issue 1
In case of Abrams Company where its respective divisions sell parts to original equipment manufacturers (OEMs) and Aftermarket (AM), different transfer price methods have to be utilized to manage the buying and selling of goods to two different markets. This is important in order to distinguish the dollar amounts to be used for two different transactions. For instance, in the exchange of good in Aftermarket (AM), it is highly recommended the use of Negotiated transfer price; this kind of transfer price is negotiated between divisions that are usually with mediation by central management since AM is part or a subunit of Abrams Company. Of course, the use of market price as the transfer price is always applicable when transacting with external markets such as the original equipment manufacturers (OEM).
However, in selling unique parts, the profit center or division may impose the use of cost-plus transfer price because the manufacturing cost of the product is too expensive or sometimes the division finds it hard to predetermine the value of the item. This type of transfer price is appropriate for both OEM and AM because the item probably is highly competitive in the market for its distinctiveness and quality. The price that will set off in the market whether through OEM or AM might be a little higher compared to ordinary parts; the credit therefore is due to the uniqueness of the item.
Cost-plus pricing is adopted when a profit center lacks information to set price where estimation of the average variable cost is the basis in setting the price. In this estimation the company has already marked up other costs including the profit margin for the division. On the other hand, negotiated transfer is highly appropriate when there are different market prices and that the company wants to take control the bargaining process that goes on between divisions to avoid possible conflicts. Likewise, market price is always the actual price agreed on between the buyer and the seller developed using a proxy measure.
Discussion of Issue 2
Aftermarket division (AM) can be considered a profit center because it follows the criteria of a business unit that involves cost and revenue. Aftermarket in the description buys unsold parts from Ignition Parts Division, Transmission Parts Division and Engine Parts Division of Abrams Company, which it later sells to wholesalers. Though it does not manufacture on its own but just like other profit centers it measures its efficiency through its ROI or return of investment. Similarly, like any other business units, aftermarket can be considered a complex entity because it constitutes a business system of its own, it responds to changing market demands, and follows certain marketing strategies in order to earn profit.
Likewise, given the description of the aftermarket, this division in Abrams Company is also appropriate to say a revenue center because revenue centers are devoted in earning or raising revenue that incur some costs in one way or another although it does not take costs into account. The difficulty for this scenario is that management cannot easily determine if the subunit is making a profit. However, in case of Abrams Company, profit is highly feasible because the management determines the transfer price from internal to external market.
Discussion of Issue 3:
In the report, “both the AM division and the three product divisions carried excessive inventories most of the year,” which proved to be a big burden on the company. Excessive inventory has to be eliminated because it affects greatly the return of investment or ROI of the company as over-supply of the product may have an effect on transfer price. Due to this problem, the company is exposed to unexpected costs such as storage costs, insurance, or physical deterioration. A delay in ROI is another consequence of excessive inventory, which may disturb the cash flow. The usual reason for the occurrence of the problem is inefficient forecasting of demands and/or lack of operational planning.
To manage or minimize the problem of excessive inventory, the company must be willing to keep the lean supply chain by streamlining the supply with demands. To effectively eliminate excessive inventory, a well-organized supply chain through an improved inventory management system. This involves forecasting within the limit of the business plan relying on records of past sales. In case of unsold items, it would be helpful also to sell these products to AM at lower transfer price to reduce the stocks.
Discussion of Issue 4: Pros and Cons of ROI measure at Abrams
The Abrams Company computed its target ROI through “actual profit divided by actual beginning-of-the-year net assets, which includes allocated overhead expenses and taxes. Its advantage is that, this formula provides a clearer view of how much the cost is spent for doing business and how much the plant contributes to the expenses. Thus, expected profit is visible and realistic.
Its disadvantage is that, estimation of ROI may sometimes difficult as calculation may delay due to differing beginning-of-the-year assets. Likewise, profits may be earned after a longer period of time.
Recommendation
Despite decentralization of authority and responsibilities, it is important that Abrams Company creates a policy that would guide and put limitations on the functions of the profit centers without losing its edge as an independent body. The only purpose of the policy is to check and maintain accountability with the other profit centers being parts of a bigger organization. This policy must also cover the use of a similar inventory model by the four divisions.
Second, the company must improve its control system over each profit center to eliminate conflicts in decision-making. It must create clear perspective how business flows to present AM as equally important as OEM. It must also have involvement in serious matters especially in money matters.
Opinion
The company has a loose management because it concentrates on the profit/revenue than on the whole operation of the business. There would come a time that when the conflict between AM and other profit centers become even worse, there would be some divisions that will split from the organization and will operate on its own. Each profit center must discern the control and authority of the CEO to maintain collaborative activities within the company.
