114 Part One The Management Control Envirr;Tww'll

Case 3-3

General Motors Corporation

In an article in the NACA Bulletin, January 1, 19:27, Albert Bradley described the pricing policy of General Motors Corporation. At that time, Mr. Bradley was general assistant treasurer; subsequently, he became vice president, executive vice president, and chairman of the board, Thr following description consists; principally of excerpts from Mr. Bradley's article.

General Policy

Return on investment is the basis of the General Motors policy in regard to the pricing of product, The fundamental consideration is the average return over n protracted period of time, not the specific rate of return over any particular year or short period of time. The lang-term rate ofreturn on investment represents the official viewpoint as to the highest average tale of return that. can be expccted consistent with a healthy growth of the business, and may be referred to as the economic return attainable. Tho adjudged necessary rate of return' on capi tal will va ry ns hctwor-nscpnrn L(~ i i IlI!H ofind ustry as u I'e~lll t ofd i nr(~ren(:(~s in tifi!ri:'('co-n~)I'dc ~"j!.l:I:d,ions; and wiith in I'm:!a industry LlH~!I'I(' wi II hel;llIHill'l.:llIt djnl'r'(~neus 111 return on capil,nI, 1'(~~H1I.t.ing' primnrii!y frolll l.hn rnluf.ivuly g'i'Vitl,('I'

ulJh:i,oncy or em'laiin producers, .

TI.e fundamental' pulley in rcgurd to Jlricillg pruduct and expansion of' tho business also necessitates an orncial viewpoint as Lo til",! normal average ruto of plant operation. This relationship between assumed normal average rate of operation and practical annual capacity is known as standard volume,

The fundamental price policy is completely expressed in the conception of' standard volume and economic return attainable. For example, if it is the B.C· cepted policy that standard volume represents tW percent of' practical annual capacity, and that an average of 20 percent per annum must bo earned on the operating capital, ·it becomes possible to d.etermine the standard price of a product-that. is; thnt, price which wit.h plunts operating at 80 percent. of capacity will produce an annual return of 20 percent. of the investment.

Standard 'Volume

Costs ofproduction and dietribution per unit of product, vary with fluctuution in vO]Ullie. because of the fixed or nonvariable nature of some of the expense items, Productive materials and productive labor may be considered coststhat are 100 percent variable, since within reasonable limits the aggregate varies directly with volume, ani! OW COH~, 1)('1' unit r;r product, thcrefer«, rorunins

U Ii i Iurm, \,

Among the items (;:lil};~ified as man ufucl.urj ng' expensu or burden there GX~ isL v n ry i ng d~g:I'('!(!!i 01' I1l1du:I Li 011 wi 1.11 vol U IIW, ow i. ng to Lh ld I' g'n)H ter or ios.'w," dc:gn~<; ~),f' variability. Among the uhsulutely Excel ii'~cnlS are such expenses as

This case VVil5 prepared by R. N, Anthony, Harvard Busine5s School. Copyright © by the President and Fellows of Harvard College. Harvard Business School case 160-005.

·.

Behavior in Organizations 115

deprecsation and. taxes, which ma.~~~kreferred to as 100 percent fixed since within the limits of plant capacity the aggregate will not change, but the amount per unit of product will vary in inverse ratio to the input,

Another group of items may be classified as 100 percent variable. such as inspection and materia! handling; the amount per unit of product is unaffected by volume. Between: the classes of 100 percent fixed and tOO percent variable is a large group of expense items that are partially variable, such as light; heat, power, and salaries.

In General Motors Corporatiomstandard burden rates are developed! for each burden center, so that there will be included in costs a reasonable average allowance for manufacturing expense, In order to establish this rate, it is first necessary to obtain an expression ofthe estimated normal average rate of plant operation.

Rate of plant operation is . affected by such factors as general business conditlons.extent of seasonal fluctuationin sales likely within years of large. volume, policy with respect tu seasonal accumulation of finished and/or sernifinished product for the purpose of leveling the production curve, neeessity or desirability of maintaining excess 'plant capacity for emergency use, anr] many others. Each of these factors should be 'carefully considered by a manufacturer in the determination of size of a new plant to be constructed, and before making additions to existing plants, in order that there may be a

. logical-relationship between assumed normal average rate of plant operation and practical annual capacity, The percentage accepted by General Motors Corporation as its policy in regard to the relationship between assumed. normal rate of plant operation and practical annual capacity is referred to as stan-

dard volume. . .

'rho d~~grcll ofvnl"inhilil.y of man ufuetu I'lng expense havjng' beon dctcrmlncd, Lhe estnbllshed total expense at tho standard volume rute of operations CD.n be . estimated. A ~tand(trd burden. rate iff then developed, which represents the proper absorption of burden in costs at standard volume. In periods of low volume, the unabsorbed manufacturing expense is charged directly against profits as unabsorbed burden, while, in periods of high volume, the overabsorbed manufacturing expense is credited to profits, as overabsorbed burden,

Return on Investment ".

Factory costs and commercial expenses for the most part represent outlays by the manufacturer during the accounting period. An exception is depreciation of capital asseta, which have a e;l'eatet length of life than the accounting period. To allow for this element of cost, there is included! an. allowance for depreciation in tbe burden rates used in 'compiling costs. Before an enterprise calli. be CO~1- sidered successful and worthy of continuation or expansion, however, still another element of cost must be reckoned with. This is the cost of capital, including an allowance for profit.

Thus. the calculation of standard prices of products necessitates the establishment of standards of capital requirement. as wen as expense factors, representative of the normal average operating condition. 'rhe standard for capital employed in fixed assets is expressed as a percentage of factory cost, and the standards for working capital nrc expressed m part as a percentage of salol', and. in part as a percentage of factory cast.

116 Part One The Management Control Environment -

EXHIBIT i Allowance for Fi.."I~ed Investment

v, .. -

. ".~~;'.

Investment in plant and other fixed assets Practica.l annual capacity

Standard volume, perc.entaf practical annual capacity .Standerd volume equivalent (50,000 * 80%)

Factory cost per unit at standard volume

Annual factory cost of production at standard volume .~40,OOO * $1,000)

Standard factor for fixed investment (ratio of investment to annual factory cost of production; $15,000,000 + $40,000,000)

$15,000,000' 50,000 llhits 80% 40,000 units 1,000

$40,000,000

·0.375

The calculation of the standard allowance for fixed investment is illustrated by the example in Exhibit 1.

The amount tied up in working capital items should be directly proportional to the volume of'business. For example, raw mater-ials on hard should be in direct prnportion to the manufacturinu rcquircrnenta-e-so many days' supply or this material, so many days' supply of' that material, and so ou-v-depending on the condition and location of sources or supply, transportation conditions, etc. Work-in-process should be in direct proportion to the requirements of finished pruduction, aince it is dependent on the ICIlJ::-th of't.ime required for the muterial to pass from the raw to the finished stute, and the amount of labor arid other charges to be absorbed in the process. Finished product should be in direct proportion to sales rcquirc.ments. Account!"; receivable should he in direct proportion to sales, being dependent on terms of payment and efficiency of collections,

The Standard Price

These elements are combined to construct the standard price as shown in Exhibit 2. Note thr t the economic return attainable (20 percent in the illustration) and· the standard volume (80 percent as shown in Exhibit 1) are long-run figures and are rarely changed: 1 the oth er elements of the price are based on CUI'" rent estimates.

Difterences among Products

Responsibility for investment must be considered in calculating the standard price of each product as well as in calculating the overall price for all products, since products with identical accounting COBts mny he responsible for investments that vary greatly. In Exhibit 2, a uniform standard selling price 01$1,250 was determined. Let us now suppose that this organization makes and sells two products, A and B, with equal manufacturing C08t~ of $1,000 per unit and equal working capital requirements, and that 20,000 units of each product are produced. However, an analysis of fixed investment indicates that $10 million is applicable to product A, while only $5 million of fixed investment is applicable

I A Brookinqs Institution survey recorted that the principal pricing goal of Ceneral Motor5 Corporation in tihe 19505 was 20 percent 0'[ investment after taxes, See Robert F, l.anziiloti, "Pridng Objectives l,1 Large Companies," American Economic Review, December 195B.

Chapter 3 Behavior in Organizations 117

EXHIBIT 2. Illustration of Method, of Dete!rminntion O~~~dard. Price

, .;':;\ /l,Sales 20itimes

.r.e(:et\r,aOle,;,-~~~: ,,;":v,'SaLes', e , ••• 10 times

..... ~.;,~n"·CI.,., : '"S)acioryc,ost: 6tlmes

.' "'.:':~.'" .. Factory cost' 12 times

",:;;-.!.·:;:~W~;::~~:: ,:,: ;. " ,;

, ,;'201%~,{,~ (:":" . i

',I.· ":.";. " '-.

ratio ;r" : .::' '

'''''''''''''''.''''''', the He:ces's~i"rY' ,

~""';'~,""lfl"~r"'''''''';:':'' is arrived af ' ..

{oreom'mercial! '

""Y'If,.",h,tl> :"'i"~"-:!'!".';"" . ',: ~ .'.

_,, .. m,~I~ ... :n" .. ' _" factor/ho~t' ' ,

.. .: "fl"·

. ;i:,: ,~~'::;A'f"~r' " " '

Selling,prke, ~s a, ratio to factory cost ,:

. :. ~. '.. ...~ . .

- ~ \ .'

Ratio to Sales, . Ratio to Factory Cost

An;nu" Basis ' Annuall 'Basis

. ;O.050;·'.~"'~ ',:" . ~ .. 'r,""

- O'.l~~_: ;o~~~ .•.• '.:_ ~~ ."_

q.16% O.08M ,0.259 0,:375 '0.625',

.. "

.. .,' ~

.. \

",'. '.

0.030

0.125

0.070 . 0.100

Q b

1 + b = l_~ 0.125 = 1 250

1 - a t - 0.100 " .

'", ~ •• _j

If standard cost= .$1 ~OOO Then standard prke = $1 !,OOO .. 1.250 .=. $1,,250

----',,-----

to product 13. Each product must earn 20 percent on its investrnentin order Lo satisfy the standardcondition. Exhibit 3 illustrates the determination of the standard price for product A and product It

From this anaiysls of investment, it becomes apparent that product A, which has the heavier fixed investment, should sell for $1,278, while product B should sel] for only $1,222, in order to produce a return of 20 percent on the investment, Were both products sold for the composite average standard price or $1,250, then product A would not be bearing its share of the investment burden, while product B would be correspondingly overpriced.

Differences in working capital requirements, as between different products may also 'be important due to differences in manufacturing methods, sales terms, merchandising policies, etc. The inventory turnover rate of one line of products sold by a division of General Motors Corporation may be 6 times. a year, while -invsntory applicable to another line of products is turned over 30 times a year. In the second case, th.e inventory investment required per dollar cost of sales is only one fifth of that required in the case of the product with the slower turnover. Just as there ate differences in capital requirements as be" tween ([ITcrcm .. dAS140S of product, so may th~ standard requirements for the same class of product require modification from time to time due to permanent changes in manufacturing processes, in location of sources of supply, more efficient scheduling and handling of rr.aterials, etc.

The importance of this improvement to the buyer oJ General Motors products may be appreciated Irom the following example" The total inventory investment for the 12 months end.ed September 30, 1926, would ' have averaged $182,490,000 if the turnover taw of 19-2.3 (the best performance prior to ~925)

" _"':-"

, ~.,;;. /"',~

EXHIBIT 3 Variances in Standa!l.-,d Price, Due to Var ianees rril::tutc of Capital Tur-nover

Product A.

Product B

Tot al . Product (A p ~us B)

Ratio to Ratio to Ratio to .Ratio to R,atib to Ratio to

Sales Fa,ctory Cost Sales: factory Cost Sales Fact?')" Cost

Annual Basis Annual Basis Annual Basis Alilnua~ Basis .AmilUal Basis AllnLm'Basis

Sclllng price, as OJ :r:~ljo to fa .. ctory "" 1 + b 1..0 -I- O.15ID

(G'S~ 1- a io·=··o:ioo =1.278

Us'larndard cost

equats

Then standard price equals

Gross working capital Fixed inves,tment Total investment Economic return attainable 20%

\'\Iith the investment .ratio muluplied by 'tnis·, the necessary ne:t profit margin is an'ived at

.5!tajldard allowance ~or cornmerclal ~penses, .7%

Crass ma.rg~in over fact!oryc:ost

0_150 0.250 0.150 0.250 0.150
0.5010 0.250
--,,",- ._-- ~-
0.150 0..750 0,150 0,,500 0_1,S0 0.250 0.375

~.

O~625

0,030

0.15.0

0,030 0.100 '01;030 0.125
0.070 0.070 0.070
0:1010 0,150 0.100 0,100 0.100 o.rzs
a h 0 b a b
~ 1.0+0.1100 .

• - "........... ...•. :0: 1; .222

1.0 - 0.100

$1,000

$1,1000

$1 i00'O

$1,278

$1,22.2

$1,250

had not been bettered, or an. execs::; of *74,:367,000 over the actual average in .. vestment.In other words, Gencrnl Moltu's would have been compelled to charge $14,87:3,000 more II)!' iL.\'l product. during thi,r; 12-Inllnlh period than was actually charged if prices had been established to yield, say, 20 percent on. the operating capital required.

Conclusion

The :UH1!'yHi:~ as Ln the dcgn~c 0'1" v.<1l'h,hility til' Il.Hulll'i.lcturing and commercial expenses with increases Of decreases in volume of output, and the establishment or "standards" rOl' the yariowi investment items, makes it possible not only lo dcvelup "Standard Pl'il;!.~l"\," bu!. also to fill"ecu:-lt, withmuch gl:eatcr uecuracy than otherwise would-be possible, the capitul requnements, profits, and .re~ turn on capital at the different rates of operation, which may result from seasonal conditions or from changes in the general business situation. Moreover, whenever it is necessary eo calculate in advance the finul effect on net profits of'proposed increases or decreases in price, with their resulting changes in volume of output, consideration of the rea] economics of the situation is fa- < cilitated by the availability ofreliable basic data.

Chapter 3 Behavior in Organizations 119

It should be emphasized that the ba,~~·.·pri'cing policy stated in terms of the economic return attainable is a policy, rihdit does not absolutely dictate the specific price. At times, the actual price may be above, and at other times below, the standard price. The standard price calculation not only affords a means of in. terpreting actual or proposed prices in relation to the established policy, but at the same time affords CL practical demonstration as to whether the policy itself is sound. If the prevailing price of product is found to be at variance with the standard price other than to the extent due to temporary causes.It follows that prices should be adjusted; or else, in the event of conditions being such that prices cannot be brought in to line with the standard price, the conclusion is necessarily drawn that the terms of the expressed policy must be modified."

'Questions

1. An article in The Wall Street Journal, December 10, 1957, gave estimates of cost figures in "an imaginary, car-making division in the Ford-Chevrolet-Plymouth field." Most of the data given as part of this question are derived from that article. Using these data, compute the standard price. Working capital ratios are not given; assume that they are the same as those in Exhibit 2.

Investment in plant and. other fixed assets Required return on investment

Practical annual capacity

Standard volume-ass ume

Factory cost per unit:

Outside purchases of parts Parts manufactured inside Assembly labor

Burden

Total

$ 600,000,000 30% before income taxes 1,250,000 80%

s 500* $ 600* 75 125 $1,300

"Each of these items incl udes $50 of labor costs.

"Commercial cost," corresponding to the 7 percent in Exhibit 2, is added as a dollar amount, and includes the following:

Inbound and outbound freight Tooling and engineering

Sales and advertising Administrative and miscellaneous Warranty (repairs within guarantee)

Total

$ 85 50 50 50

15 $ 250

Therefore, the 7 percent commercial allowance in Exhibit 2 should be eliminated, and in its place $250 should be added to the price as computed from, !;he formula.

'Tills pareqraph is taken from <1[1 article by Donaldson Brown, then vice president, finance, General Motors Corporation, in Management and Admi(li~twtion, March 1924.

2. What would happen to profits and return on investment before taxes year in. which 1.7nll1111P ,~ve..s o'nl:,1 60 l'1·~.~'I~(H·1t r:f eapacity? ~?'l11aL "~YG·::.Id 11Ei~ in. a. year in which volume was 1 00 percent (If capacity? Assume that no: riable costs included in the si.sso unit costabove are $350 minion (i.e., , ·1·11),I"'c .. st .. ;1 ..•• ·1.1, U:>1 r:.U{) -- "'·l'F)~' ~'" <1'1' ')('1"(11 Jr" "' .. 1]1 "'I"t:II':II"""~ "U"'·'~11.",th!d

.. .Ii J.,;' U,.;II·~ 1.,,-,.1-pi ,r,J . ~j),.J, tl .11 l~_.' __ • "' .... ,. ..... , ,-, • oZ •• ''''--::_~ ~~:.",!, ~1:.~",._ ........... .._' .....

were sold at the standard price established in question 1, since the stanr price is not changed to reflect annual changes in vnlume,

3.In the 1975 model vear, General Motors g'nve cash I·p.hf.l!t~-~ IJ:r~.~ high as ~ per CfU' off the list price. In. 1'972 and HJ7;3 prices had been restricted by p control legislation. which required that selling prices could be increased! if costs had increased. Selling price» thereafter were not con trolled , altho there was always the possibility thut price controls could be reimposed 1971), dum and fOJ' automobiles wns ;:;harply lower than in 1974, portly cause of a general recession and partly beca use of' concerns about high g; Li"i;"; jHiw;.,. DOl'e; th« (ash 1,'etl<.iLt! ind icah.' that bem~ral Mot.on:: adopted n I pricing policy in 1 H7!l, (It' lis it CHHsi~tt'n t with the pulicy doscribed in the c!

4 .. Was this policy good cell' General Motors? Wa.s it good for America?