Celtex is a large, quite successful, decentralized specialty chemical producer

Celtex is a large, quite successful, decentralized specialty chemical producer organized into five independent investment centers. Each of the five investment centers is free to buy products either inside or outside the firm and is judged based on residual income. Most of each division's sales are to external customers. Celtex has the general reputation of being one of the top two or three companies in each of its markets.

Leopoldo Garcia, president of Synchem, Celtex's synthetic chemicals division, and Walid Murad, president of the consumer products division, are embroiled in a dispute. It all began two years ago when Wally asked Leo to modify a synthetic chemical for a new household cleaner. In return, Synchem would be reimbursed for out of pocket costs. After Synchem spent considerable time perfecting the chemical, Wally solicited competitive bids from Leo as well as several outside firms; he then awarded the contract to one of the outside firms, which was the low bidder. This annoyed Leo, who expected his bid to receive special consideration because he developed the new chemical at cost, yet the outside vendor took advantage of his division's R&D.

The current conflict has to do with Synchem's producing chemical Q47, a standard product, for consumer products. Because of an economic slowdown, all synthetic chemical producers have excess capacity. Synchem was asked to bid on supplying Q47 for consumer products. Consumer products is moving into a new, experimental product line and Q47 is one of the key ingredients. Although the magnitude of the order is small relative to Synchem's total business, the price of Q47 is quite important in determining the profitability of the experimental line. Leo bid $3.20 per gallon. Meas Chemicals, an outside firm, bid $3. This time, Wally is annoyed because he knows that Leo's bid contains a substantial amount of fixed overhead and profit. Synchem buys the base raw material, Q4, from the organic chemicals division of Celtex for $1 per gallon. Organic chemical's out-of-pocket costs (i.e., variable costs) are 80 percent of the selling price. Synchem then further processes Q4 into Q47 and incurs additional variable costs of $1.75 per gallon. Allocated fixed overhead adds another $.30 per gallon.

Leo argues that he has $3.05 of cost in each gallon of Q47. If he turned around and sold the product for anything less than $3.20, he would be undermining his recent attempts to get his salespeople to stop cutting their bids and start quoting full-cost prices. Leo has been trying to enhance the quality of the business he is getting, and he fears that if he is forced to make Q47 for consumer products, all of his effort the last few months would be for naught. He argues, "I already gave away the store once to consumer products and I won't do it again." He questions, "How can senior managers expect me to return a positive residual income if I am forced to put in bids that don't recover full cost?"

Wally, in a chance meeting at the airport with Diana Philapados, senior vice president of Celtex, described the situation, and asked Philapados to intervene. Wally believed Leo was trying to get even after their earlier clash. Wally argued that the success of his new product venture depended on being able to secure a stable, high-quality source of supply of Q47 at low cost.

Diana has hired you as a consultant and has asked you to do the following:
1. Prepare a statement outlining the cash flows to Celtex of the two alternative sources of supply for Q47.
2. Offer advice regarding how Diana should handle the issues raised by Wally.

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