ZUMWALD AG Suttipun Boontawee, Esther Walker

Zumwald AG

Produced and sold a range of medical diagnostic imaging systems, biomedical test equipment and instrumentation.

Headquartered in Cologne, Germany Total annual revenues were slightly more

than €3 billion.

Zumwald AG

Decentralized management The managers of each division allow

considerable autonomy. Performance was evaluated, and

management bonuses were assigned, based on each division’s achievement of budgeted targets for return on invested capital (ROIC) and sales growth.

Zumwald AG

Involved in the dispute mentioned from three of the company’s divisions: the Imaging Systems Division (ISD) the Heidelberg Division (Heidelberg) Electronic Components Division (ECD)

Zumwald AG

ISD sold complex ultrasound and magnetic resonance imaging systems. These systems were expensive, typically selling for €500,000-€1million.

Heidelberg sold high-solution monitors, graphics controllers and display subsystems. Approximately half of its sales were made to outside

customers. ISD was one of Heidelberg’s major inside customers.

ECD sold application-specific integrated circuits and subassemblies.

The Dispute

In 2001, ISD designed a new ultrasound imaging system, called the X73. The new system offered users advantages in processing speed and cost, and it took up less space.

Heidelberg engineers participated in the design of X73, but Heidelberg was compensated for the full cost of the time its employees spent on this project.

Comparing 3 sources

Suppliers Cost per X73 System (€)

Heidelberg Division 140,000

Borgardus NV 120,500

Display Technologies Plc

100,500

Zumwald AG

What sourcing decision for the X73 materials is in the best interest of: The Imaging Systems Division? The Heidelberg Division? The Electronic Components Division?

Zumwald AG

The issue in the case arises because the manager of Heidelberg complained about not getting the ISD order.

Zumwald AG

What should Mr. Fettinger, CEO of Zamwald do?

Mr. Fettinger should probably listen to the arguments in order to learn the managers’ thinking processes Are they all aware of the key facts in the

situation? Do they understand the concept of

marginal cost pricing and contribution margin?

Question 1

Zumwald is better off if Heidelberg supplies the displays to ISD.

The Heidelberg quote to ISD is better for Zumwald taken as a whole because it includes some contribution both for Heidelberg and for ECD, Zumwald’s internal electronic subassembly supplier.

The variable costs for Heidelberg are €50,000. The fixed costs are not relevant because: Heidelberg is not operating at full capacity. So there

is a contribution of €90,000 to Heidelberg in the €140,000 quote to ISD.

Question 1

In addition, there is a contribution of €12,600 for ECD built into this quote. This is ECD’s internal price of €21,600 minus the variable costs of €9,000.

The advantage to ISD of sourcing from Display Technologies rather than Heidelberg is €39,500. This is far smaller than the total contribution to Zumwald divisions of €102,600 that would be unavoidable if Heidelberg does not get this order. The difference is €63,100.

Question 1

Cash outflow if sourced from Display Technologies

€100,500

Cash outflow if sourced internally:

Heidelberg variable costs excluding the ECD-supplied materials

€28,400

ECD variable costs €9,000 €37,400

Difference €63,100

Question 2

Heidelberg engineers helped ISD develop the X73.

Heidelberg was reimbursed for the cost of those engineers, but it earned no profit for this work.

Does this assistance imply a partnership that would include future sourcing of parts?

The case has enough information to show that this X73 business promises to be highly profitable for ISD

Question 3

Revenue for one X73 system €340

€340,000

Non-display material costs €72,000

Variable conversion costs €26,300 €98,300

Contribution before display costs €241

€241,700

Fixed conversion costs €117

€117,700

Gross margin before display costs €124

€124,000

ISD contribution if sourced from Display Technologies €141

€141,200

ISD contribution if sourced at Heidelberg’s price of €140 €140,000 €101,700

Question 3

Clearly there is room to force ISD to pay Heidelberg more than the Display Technologies’ price. That extra cost could provide additional margin to Heidelberg and ECD. But, alternatively, any price greater than €37,400 provides a contribution to Heidelberg and/or ECD.

Why shouldn’t Heidelberg shave its price to get this internal business? And if Heidelberg shaves its price, then it might well

ask ECD to shave its price below its normal 20% mark-up. So in some sense, these transfer prices are just moving profits from one division to another.

Question 3

Heidelberg’s manager, Paul Bauer, claims that he has been pleading with his salespeople not to shave prices, that he needs full margin business in order to achieve his plan. Does Mr. Bauer just not want to acknowledge the

price competition in this segment of the market? Is he ignorant of the marginal cost and contribution

margin concepts? Should he be fired? Or is Mr. Bauer merely willing to lose this business in

order to emphasize the importance of his pricing policy to his salespeople?

Maybe because of market conditions and customer price sensitivities, Heidelberg is better off giving up some business to retain higher margins, even though they are operating in a below-capacity condition.

Question 3

Price Unit Total

Price policy (000) Volume

Contribution Contribution

Full price 140 70 90 6,300

Cut price 100 100 50 5,000

What should Fettinger DO?

If the managers are all making rational arguments, then strong arguments can be made here for having Mr. Fettinger do nothing.

Zumwald operates in a highly decentralized fashion. Why not let it continue to do so? Let the managers have their autonomy and freedom of

sourcing. If there is a deal to be made, let the managers work it out

themselves. If this deal were a more substantial part of Zumwald’s total

business, then a stronger argument could be made for intervention.

But this deal, by itself, is worth less than 5% of each division’s revenues.

Heidelberg can probably earn the business by cutting its price to Display Technologies, but maybe it is not in its best interest to do so, even though internal sourcing of this deal seems to be in Zumwald’s best interest.

Is Zumwald Management faulty? motivates managers to make decisions

that are not in the best interest of the corporation as a whole!

Answer to that!

In most situations where local knowledge and fast decision-making is important: a highly decentralized system has great advantages.

But with decentralization comes risks of sub-optimization.

This case provides one common example of suboptimization.

Such a policy could require internal transfers to be, for example, at best outside market price, or at full (or variable) cost plus a normal markup. But would such policies really lead to better organizational decision-making?

Answer Continued

A policy like Zumwald’s could require internal transfers to be

at best outside market price or at full (or variable) cost plus a normal

markup.

Conclusion

Zumwald’s is better off if the sourcing is done internally.