3.
Hyundai Heavy Industries Co. is one of Korea’s largest industrial producers.
According to an article in BusinessWeek Online, the company is not only the
world’s largest shipbuilder but also manufactures other industrial goods
ranging from construction equipment and marine engines to building power
plants and oil refineries worldwide. Despite being a major industrial force in
Korea, several of the company’s divisions are unprofitable, or “bleeding red
ink” in the words of the article. Indeed, last year the power plant and oil
refineries building division recorded a $105 million loss, or 19 percent of its
sales. Hyundai Heavy Industries recently hired a new CEO who is charged
with the mission of bringing the unprofitable divisions back to profitability.
According to BusinessWeek, Hyundai’s profit-driven CEO has provided
division heads with the following ultimatum: “…hive off money-
losing businesses and deliver profits within a year—or else resign.”
Suppose you are the head of the marine engine division and that it has been
unprofitable for 7 of the last 10 years. While you build and sell in the
competitive marine engines industry, your primary customer is Hyundai’s
profitable ship-building division. This tight relationship is due, in large part, to
the technical specifications of building ships around engines. Suppose that in
our end-of-year report to the CEO you must disclose that while your division
reduced costs by 10 percent, it still remains unprofitable. Make an argument
to the CEO explaining why your division should not be shut down.
Given the tightly woven marine engine and shipbuilding divisions, economies
of scope and cost complementarities are likely to exist. Eliminating the
unprofitable marine engine division may actually raise the shipbuilding
division’s costs and cause that division to become unprofitable.
What conditions must hold for your argument to withstand the CEO’s
criticism?
For this argument to withstand criticism, you must show the CEO that the
quadratic multi-product cost function exhibits cost complementarities and
economies of scope, which occurs when a < 0 and f - aQ1Q2 >
0, respectively, and compare profitability under the different scenarios.
Explanation
Given the tightly woven marine engine and shipbuilding divisions, economies of scope
and cost complementarities are likely to exist. Eliminating the unprofitable marine
engine division may actually raise the shipbuilding division’s costs and cause that
division to become unprofitable. For this argument to withstand criticism, you must
show the CEO that the quadratic multi-product cost function exhibits cost
complementarities and economies of scope, which occurs when a < 0 and f - aQ1Q2 >
0, respectively, and compare profitability under the different scenarios.
