Blake Romney became Chief Executive Officer of Peters Inc. two years ago. At the
ID: 2478178 • Letter: B
Question
Blake Romney became Chief Executive Officer of Peters Inc. two years ago. At the time, the company was reporting lagging profits, and Blake was brought in to “stir things up.” The company has three divisions, electronics, fiber optics, and plumbing supplies. Blake has no interest in plumbing supplies, and one of the first things he did was to put pressure on his accountants to reallocate some of the company's fixed costs away from the other two divisions to the plumbing division. This had the effect of causing the plumbing division to report losses during the last two years; in the past it had always reported low, but acceptable, net income. Blake felt that this reallocation would shine a favorable light on him in front of the board of directors because it meant that the electronics and fiber optics divisions would look like they were improving. Given that these are “businesses of the future,” he believed that the stock market would react favorably to these increases, while not penalizing the poor results of the plumbing division. Without this shift in the allocation of fixed costs, the profits of the electronics and fiber optics divisions would not have improved. But now the board of directors has suggested that the plumbing division be closed because it is reporting losses. This would mean that nearly 500 employees, many of whom have worked for Peters their whole lives, would lose their jobs.
Instructions
(a)
If a division is reporting losses, does that necessarily mean that it should be closed?
(b)
Was the reallocation of fixed costs across divisions unethical?
(c)
What should Blake do?
Response:
It would make sense to close a business segment that is not profitable or is reporting losses but the reality is that this solution is not applicable in all cases. The first key factor to take into consideration when determining whether or not close a department is how much of the fixed cost is eliminated and how much is going to get allocated to the departments that are left. The other factor is how much of contribution margin is going to be lost when that department is shut down. Taking into consideration the situation of Peters Inc., it would not be a good idea to shut down the Plumbing Department. Although we were not given exact numbers, we were told that the other two departments, Fiber Optics and Electronics were reporting losses and plumbing was the only profitable department. It was only after the company’s new CEO wrongly misallocated the fixed costs, that Fiber Optics and Electronics showed profits. So it is safe to assume that if Plumbing is shut down, Fiber Optics and Electronics would get back all their fixed costs that were allocated to plumbing plus at the unavoidable fixed cost belonging to plumbing which would truly burden those departments and devastate the company. In general, some times it is better to operate a department that runs at a loss if its fixed costs are unavoidable and the department has a good contribution margin.
However the actions of the CEO are not necessarily unethical if properly justified. For example if the accountants were able to identify a fixed cost that was shared but should only apply to plumbing then it would be okay. On the other hand, if the CEO simply had the accountants manipulate numbers with out validation then his actions and those of the accountants are unethical, as it appears to be in this situation.
The best thing for Blake to do is to analyze the possibility of closing down the departments that were actually operating at a loss, which are electronics, and fiber optics. Regardless of his idea of the “business of the future”, he needs to come to terms with the reality that this is not the best option for his company. Being the CEO it is his responsibility to employees and investors to keep the company running and maximize profits. If that means shutting down one or both of the departments then it needs to be done. If he moves forward with shutting down plumbing instead, then it will surely become evident that the fixed cost was wrongfully allocated. It would also mean that the company would surely fail because it would only be left with out the only department that actually was creating profits. Instead of spending time moving fixed costs to other departments Blake should try and identify ways to reduce the costs and increase the performance in Electronics and Fiber Optics.
Answer the 3 questions and write reaction to the reponse( agree or disagree, why)
(a)
If a division is reporting losses, does that necessarily mean that it should be closed?
(b)
Was the reallocation of fixed costs across divisions unethical?
Explanation / Answer
Hey Dear Student !!
1) Yes, I agree with your framing further i would like to add the point that rather than directly closing the division of plumbing management should inquire the reasons of losses that whether the reasons are accruing due to stand alone fixed cost or due to allocated fixed cost if it is due to only allocated fixed cost then closing this division will increase the overall losses in spite of profitable results. Further closing this unit may also results into loss of goodwill of company because we will have to terminate 500 employees of the division in one shot. They may also go on strike. So board have to take decision wisely.
2) Partially Agree, It was unethical act from the CEO side because un necessary allocating excess Costs to a division to show losses in one division and profit in others is not a good act. It will results into decreasing shareholders wealth because chances of taking wrong decision by Board would be very high which may results into losses for company. Further we should allocate fixed costs as per justifiable basis so that true picture of all divisions could be analysed.
3) Partially Agree, Blake should analyse the complete picture of all devisions, he should find out proper basis of allocation of fixed costs after proper allocation he should present the true profit & Loss. Further before closing any division he should check their contribution margins then compare this with avoidable fixed cost if contribution exceeds avoidable fixed cost then it doesn't make any sense to close the division on the other side if Avoidable fixed cost is over and above contribution then we should close the division because it will results into loss continuing it.
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