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Question Q6. Read the following case carefully, analyse it and answer the questions given at the end of the case.
Case: Ruia Corporation
Ruia Corporation with its corporate headquarters at Mumbai, has several divisions all over Maharashtra, which meant that they are all within a radius of 100 kilometers. They have designated all of them as investment centers. Their performance is judged on the basis of return on investment.
The case concerns one of their divisions at Mumbai whose products are sold to the Indian Railways. The division had a hoary history from the days of the British who encouraged a long-standing relationship with the railways. Its general manager, Ramaswamy Ayyar had been retained much beyond his age of superannuation as he was a respected engineer handling the difficult labour situation in Mumbai rather well. The senior officers of the railways also had a very high regard for his technical knowledge. The Mumbai division was also showing an excellent annual rate of return of 20 percent, whereas the rest of the company was averaging around only 12 percent.
The Composition of the Mumbai Division
The composition of the investments in the Mumbai division is shown in Exhibit 1. They used return on investment to reward their managers.
Exhibit 1
Cash Management
The cash management of the company was unusual. All the cash for all the divisions was parked at the corporate headquarters, which, at their discretion, kept it in the form of securities that yielded some returns but which were far below the rates expected from investments. But they were liquid and could be cashed with one day’s notice. The interests on these securities were credited to the divisions.
If the divisions did not wish to be burdened with unwanted cash in the denominators of their calculation of returns, they paid them back to the corporate headquarters.
If, on the other hand, they expected to make some capital investments, they could keep the cash parked with the headquarters. Paying the dividend had one disadvantage; if they wanted the money back for any purpose they had to pay interest at the cut-off rate of 15 percent.
All external payments were made by corporate headquarters and all sales proceeds similarly poured into these parked accounts. Thus, cash management was, in large part, the job of corporate headquarters but with substantial assistance of the division.
Accounts Receivable
The company had credit standards. Theoretically, the division could alter it. But practically, they did not want to deviate from, what was considered, a balanced approach. The problems of creditworthiness did not exist since their clients were the railways. Chasing bills was occasionally necessary but stopping supplies due to non-payment was an unthinkable alternative.
Raw Materials
Raw materials of special steel and copper were purchased for all the divisions by the headquarters. The quantity and purchase was determined by an assessment of the likely price fluctuations. If the price was likely to risk steeply, they bought a large lot.
Purchased Parts
These rates were negotiated by the divisions. But the periodicity of purchases were converted to a routinised task based on the EOQ formula,
where A is the annual usage, S is the cost per order and I the carrying cost of the average inventory (half of order quantity), which had three components, interest (X), storage costs (Y) and obsolescence (Z). The total costs were X + Y + Z = I.
But there was some controversy on the choice of interest rates. If they chose the cut-off rate of the company (12 percent), it would result in the denominator becoming less than if they chose the normal rate of return of the division (20 percent). This would mean larger orders and possibly higher discounts. But it would also mean higher inventories and therefore reduction of the ROI, as the denominator in the formula would increase. The division was single-minded by pursual of the ROI and therefore chose to use their own rate of return, namely 20 percent which would give them a higher ROI. This was not in the best interests of the company.
Work-in-Process
Ramaswamy Ayyar personally supervised to ensure that there was no pile-up of work-in-process. However, part of the work-in-process was purchased parts, which were delivered according to the routine system of ordering described earlier.
Finished Stock
Since there was close liaison with railways, the finished goods in stock were totally controlled.
Plant and Machinery
The acquisition of plant and machinery followed a tortuous course. First there were the company brainstorming sessions. Then there were the strategic plans which originated from the division and were scrutinized and approved by the headquarters. There were annual budgets again proposed by the division and approved by the headquarters followed by individual project analysis. Fifty percent of the projects were generally cost reduction proposals which were supported by an NPV analysis. The balance fifty percent were usually safety, welfare and environmental projects, which were not amenable to an NPV analysis and these were cleared on the basis of the objectives of the project. In either case they were cleared by the headquarters. However, it was within Ramaswamy Ayyar’s powers to approve of projects of upto two lakh rupees, provided the total of such amounts did not exceed 25 percent of the annual budget.
As could be seen, the division had practically no fresh asset proposals. They were happy with what they had.
The products of the Mumbai division had an excellent potential for being expected and the returns were above the cut-off point of 12 percent for project clearances in the company. The company had plenty of cash available for investments, but the chairman did not wish to force any project on the divisions.
According to the chairman, “What else is the meaning of designating them as investment centers. If they make wrong investments they should bear the consequences. Sometimes we may clear a wrong project but the responsibility will still lie with them. It is their duty to pick the right project and get it cleared by the headquarters. If the project is wrongly rejected by headquarters, even then, they are responsible for not being able to convince us.”
Land and Buildings
Since the land and building were old, they had appreciated as much as all land had in Mumbai and it was ten times the cost considered in exhibit I. If the return on investment were calculated on these replacement costs, it would have been(76 all other assets other than land and building + 240 land and building, which became ten times of 24 per cent shown in Exhibit 1 against land and building = 316). This yields a return of 6.32 per cent. This is, the return on investment on replacement on replacement values was at the much reduced rate of 6.32 percent. But if the whole factory was relocated just outside Mumbai, by selling off this factory and buying land in the new location, it was estimated by a consultant that the return would be just above the company cut-off rate. It would also give the company a large cash surplus, which it could use in other ventures, all of which could give much higher than the present cut-off rate of the company. As discussed earlier, the chairman did not wish to make any move without the initiation by the division.
Questions :
(a) Do you think the company is using the concept of investment centers creatively for the benefit of the company and for increasing goal congruence between the divisions and the company?
(b) What are the suggestions you would make to improve the situation?
Answer SUDHIR,
HERE IS SOME USEFUL MATERIAL.
REGARDS
LEO LINGHAM
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(a) Do you think the company is using the concept of investment centers creatively for the benefit of the company and for increasing goal congruence between the divisions and the company?
ABSOLUTELY, NO.
-the concept of investment centers does not exist at all.
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-it sounds more like
*all responsibilities.
*no accountability
*no authority.
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-the managers of the centers, are more like supervisors
to get the job done.
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-the cash management with the HO.
-the accounts receivable is literally in the hands of HO.
-The centers have very little say in the raw material area.
-there is systems for parts purchase
-the finished good is in the hands of HO.
-The plant/ machinery purchase is in the HANDS OF HO.
-the chairman's talk shows the ''investment centers'' exist in name,
but in deed, it is all HO CONTROLLED.
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(b) What are the suggestions you would make to improve the situation?
OPTION 1
-make the operation totally centrally controlled.
-this will remove all ambiguities in the responsibilities/accountabilities/authorities.
-the center manager's job is one of supervisory role.
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OPTION 2
-make the centers total profit centers.
-establish the parameters for the results /outcome.[ say, target +/- 10%]
-establish the parameters for the cost .[ say, target +/-5 %]
-establish the parameters for the capital layout .[ say, target +/- 7 %]
-establish the parameters for the ''all expenses'' .[ say, target +/- 10%]
-establish the parameters for the accounts receivable .[ say, target +/- 5%]
-establish the parameters for the raw material inventory .[ say, target +/- 10%]
-establish the parameters for the finished good inventory .[ say, target +/- 6 %]
ESTABLISH A BONUS SCOPE FOR THE MANAGERS,
WHERE THEY CAN EARN MORE, IF THEY PERFORM BETTER.
THE MAXIMUM BONUS SCOPE COULD BE 20% OF THEIR
ANNUAL SALARY PACKAGE.
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