Question

You are an executive in a large healthcare company with five lines of business. There are no economies of scope (this will be discussed in a future module). Those lines of business order services (accounting, information technology, and warehousing) from three "service divisions" of the company. You are given the following information for the revenues, direct costs (e.g., costs of production), and capital (e.g., value of the property, plant, and equipment) associated with these five lines of business, as well as the total variable costs from the three 'internal services' divisions. (You are ignoring fixed corporate overhead costs which will not change with a change in the size of the company.) All dollar amounts are in millions of dollars. Business # 1 2 3 4 5 Revenue (millions) $25 $30 $5 $15 $25 Total direct costs (millions) $18 $26 $4 $11 $21 Capital invested (millions) $20 $12 $16 $8 $14 For each business, calculate the return on capital, but ignore the indirect costs from the three service divisions. This is calculated as (revenue - total direct costs)/capital invested. You will enter this information, to three decimal places, in Moodle. A return of 12.46 percent would be reported as 0.125. As an executive in this company you are concerned with the following: (1) the businesses have little incentive to reduce their request for services from the three service divisions; (2) the service divisions are unable to tie their requested budgets to the value of their services; and (3) some of the businesses may have low returns on capital and should be sold off. To initially address these issues you are imposing an internal pricing system, where each of the three service divisions charges the businesses for the services provided. The expected percentage allocation of the variable costs from each to service division to each business are given in the matrix below. Notice that the sum of any allocations from a service division sum to 1.0. Service division 1 2 3 4 5 1             0.10             0.15             0.20             0.25             0.30 2             0.25             0.20             0.15             0.10             0.30 3             0.30             0.20             0.15             0.10             0.25 Service division Total variable costs (millions) 1 $5 2 $3 3 $2 Use this information to allocate the service divsions' variable costs to the five businesses. Recalculate the return on capital for each of the five businesses. You will enter this information, to three decimal places, in Moodle. Suppose that the market rate of return for similarly risky investments is 14 percent. If you took the approach of Goizueta at Coca-Cola, which businesses should be sold?

Answer 1

The problem has been solved here under

Business	1	2	3	4	5
Revenue (million) A	25	30	5	15	25
Total Direct Cost  (million) B	18	26	4	11	21
Profit(million) (A-B)=C	7	4	1	4	4
Capital Invested(million) D	20	12	16	8	14
Return on Capital (C/D)= E	0.35	0.333	0.063	0.5	0.286

Calculation of Variable Cost of Each Service Divisions

Service Division	1	2	3	4	5
1 (Total Variable cost * Percentage allocated)	(5*.010)=0.5	(5*.015)=.75	(5*.20)=1	(5*.25)=1.25	(5*.30)1.5
2 (Total Variable cost * Percentage allocated)	(3*.25)=.75	(3*.20)=.60	(3*.15)=.45	(3*.10)=.30	(3*.30)=.90
3 (Total Variable cost * Percentage allocated)	(2*.30)=.60	(2*.20)=.40	(2*.15)=.30	(2*.10)=.20	(2*.25)=.50
Total(1+2+3+)	$1.85	$1.75	$1.75	$1.75	$2.90

Calculation of Revised Return on capital

Business	1	2	3	4	5
Revenue (million) A	25	30	5	15	25
Total Direct Cost  (million) B	(18+1.85)=19.85	(26+1.75)=27.75	(4+1.75)=5.75	(11+1.75)=12.75	(21+2.90)=23.90
Profit(million) (A-B)=C	5.15	2.25	-0.75	2.25	1.10
Capital Invested(million) D	20	12	16	8	14
Return on Capital (C/D)= E	0.258	0.188	-0.047	0.281	0.079

Therefore Business 3 should be sold off as it is incurring losses and hence negative return of capital.