CH-18-20 Organizational Design, Responsibility Accounting, and Evaluation of Divisional Performance – Cost Management: Strategies for Business Decisions : Chapter Notes

This Document Contains Chapters 18 to 20 Chapter 18 Organizational Design, Responsibility Accounting, and Evaluation of Divisional Performance Chapter Outline A. Cost Management Challenges — Chapter 18 offers five cost management challenges. 1. As companies grow, what is the best way to manage them? What are some benefits and costs of decentralization? 2. How can a responsibility accounting system foster goal or behavioral congruence for an organization? 3. What are the major types of responsibility accounting centers? 4. What is the key feature of activity-based responsibility accounting? 5. How is investment center performance typically measured? B. Learning Objectives — This chapter has eight learning objectives. 1. Chapter 18 explains the role of responsibility accounting in fostering goal or behavioral congruence. 2. The chapter lists several benefits and costs of decentralization. 3. It describes the distinguishing characteristics of responsibility centers and the various types: a cost center, a discretionary cost center, a revenue center, a profit center, and an investment center. 4. Chapter 18 shows how to prepare a performance report for various responsibility centers. 5. The chapter demonstrates how to compute an investment center’s return on investment (ROI), residual income (RI), and economic value added (EVA). 6. It explains how a manager can improve ROI by increasing either the sales margin or capital turnover. 7. The chapter describes the pros and cons of using ROI and RI as divisional performance measures. 8. Chapter 18 explains various approaches for measuring a division’s income and invested capital. C. Most large organizations are divided into smaller units, each of which is assigned particular responsibilities. The people placed in charge of these units should be motivated to strive toward the goals that the organization wants to achieve. Goal congruence results when managers of subunits throughout an organization have incentives to perform in the common interest. Ideally, members of an organization have such a strong team spirit that goal congruence is a natural outcome of that spirit. In most cases, however, employees must be motivated to behave as if their personal goals were congruent with organizational goals through a set of performance evaluation and incentive systems. This results in behavioral congruence. Responsibility accounting, which is comprised of the tools and concepts used to measure performance of people and departments, is used to foster behavioral congruence. The fundamental purpose of a responsibility accounting system is to reap the benefits of decentralization, while minimizing the costs of decentralization. 1. Decentralization of large organizations became necessary as organizations became too large and complex to be under the authority of just a few people. A centralized organization has a small group of decision makers at the top. Subordinates carry out the decisions as they are handed down, but the subordinates do not participate in any decision making. A decentralized organization, on the other hand, allows people at lower levels of management make key decisions in the subunits that they are responsible for. Top management makes the major, strategic decisions. Decentralization has some benefits but also has some costs. 2. Large organizations benefit from decentralization the most if there is a system in place to ensure that lower-level managers will do a good job without day-to-day oversight of their activities. Six benefits of decentralization are as follows: (1) decentralization allows managers with particular skills to manage those parts of the organization where those skills are needed. This eliminates the need for top managers to be skilled in all areas of operation. (2) Giving managers autonomy and responsibility prepares them for higherlevel management positions. (3) Managers with decision-making authority usually exhibit greater motivation than those who merely follow directions of others. (4) Delegating decisions to lower-level managers frees up time of higher-level managers to make strategic decisions instead of being bogged down in daily decision making. (5) Empowering employees to make decisions makes use of their knowledge and expertise of day-to-day operations. (6) Delegating decision-making authority to lower levels allows an organization to respond on a timely basis to opportunities and problems that arise. 3. In addition to the benefits of decentralization, there are also some costs. They are as follows: (1) Managers may have a narrow focus on their own unit’s performance instead of the overall goals of the organization. (2) If managers have a narrow focus on their subunit, they may ignore the consequences of their actions on other subunits. (3) Decentralized organizations run the risk of having duplication of tasks or services. For instance, a decentralized organization that authorizes departments to purchase their own office equipment may find that two departments, right next to each other, purchase copiers, when the two departments probably could have shared one. D. Responsibility accounting is a systematic way to ensure that workers in an organization will work toward achieving the organization’s goals. The basis of a responsibility accounting system is the designation of each subunit as a particular type of responsibility center. A responsibility center is a subunit in an organization whose manager is held accountable for specified financial and nonfinancial results of the subunit's activities. There are five types of responsibility centers. 1. A cost center is a subunit whose manager is responsible for the cost of an activity for which a well-defined relationship exists between inputs and outputs. In manufacturing, production departments are usually designated as cost centers. 2. A discretionary cost center is a subunit whose manager is held accountable for costs where the input-output relationship is not well defined. Support departments in organizations are discretionary cost centers. 3. A revenue center is a subunit whose manager is held accountable for the revenue attributed to the subunit. The manager of Ladies Dresswear in a department store is a revenue center manager. 4. A profit center is a responsibility center where the manager is responsible for profits. Since profits are obtained by subtracting costs from revenues, the manager of a profit center is accountable for both costs and revenues. 5. An investment center has a manager who is accountable for the subunit’s profit as well as invested capital used to generate its profits. A division of a large corporation is typically designed as an investment center. Managers of investment centers usually have the authority to make some capital investment decisions. Some organizations use the terms profit center and investment center interchangeably. E. Performance reports are prepared by the manager of each responsibility center. A performance report shows budgeted and actual amounts of key financial results appropriate for the type of responsibility center involved. The performance report for a cost center of a manufacturing facility would contain budgeted and actual activity and then would report cost variances, as described in Chapters 16 and 17. A manager of a revenue center would complete a performance report showing budget and actual information and would include variances like those presented in Chapter 17 (sales variances). This performance report might also summarize customer profitability. A performance report is completed and submitted to the next higher-level manager. The lowerlevel manager’s subunit is a part of the higher-level manager’s larger subunit. 1. Responsibility accounting, budgeting, and variance analysis are closely related. The flexible budget provides the benchmark against which actual revenues, expenses, and profits are compared. 2. Contemporary cost management systems extend the basic measures of financial performance of cost, revenue, and profit by incorporating activity-based analysis of costs, revenues, and profits. Activity-based responsibility accounting directs management attention to costs and revenues and also places emphasis on activities. F. The purpose of having a responsibility accounting system is to elicit certain types of behavior. Unless the system is developed and used properly, an organization runs the risk of eliciting inappropriate behavior. 1. The proper focus of a responsibility accounting system is information. One danger in having a responsibility accounting system where managers must explain unfavorable outcomes is that there may be some sense that unfavorable outcomes should be blamed on managers. If this is how managers feel about the responsibility accounting system, they may take steps to manipulate data or undermine it in other ways. 2. A performance report is even more informative if the costs and revenues are split between those that are controllable by the reporting manager and those that are not controllable. Segregating costs or revenues is not an easy task, but, to the extent it can be done, it aids higher-level managers to more accurately evaluate the performance of lower-level managers. 3. The best result of a responsibility accounting system is one that motivates the desired behavior of managers. For instance, the sales manager, whose main focus is on making sales, may be motivated to accept rush orders without regard to the additional production costs that might result. A responsibility accounting system that charges the sales manager for the production costs of an expedited order might result in the manager being more careful about making promises of fast delivery to customers. G. Although managers of cost, revenue, and profit centers are evaluated based on controlling costs or achieving revenue or profit goals, the highest-level responsibility center, an investment center, is probably given the closest scrutiny by top management. In addition to the fact that these managers’ performance reports include the results of lower-level units, they are held accountable for the effective use of investment resources. There are three common measures of performance for managers of investment centers. They are return on investment, residual income, and economic value added. 1. Return on investment (ROI) is the most commonly used measure of investment center performance. It is calculated as: ROI = Income/Invested capital ROI makes different investment centers in an organization comparable to each other. Absolute dollar amounts of profit can be misleading. Suppose two investment centers generated $10 million and $20 million in profits. Just looking at the profits, it appears that the second subunit’s performance was better than the first. But suppose it took investments of $100 million and $400 million to generate those profits. The ROI for the first investment center is 10%, while the ROI for the second investment center is only 5%. a. The ROI can be expressed in a different way. An alternative calculation is: ROI = (Income/Sales Revenue) * (Sales Revenue/Invested capital) By canceling out the sales revenue terms, ROI can be more readily calculated. However, it is useful to determine ROI using the longer expression because it highlights the fact that the return on investment is actually earned for two reasons. The longer expression is sometimes referred to as the DuPont model. i. Income/sales revenue is called sales margin. This part of ROI shows how much of the profit was generated as a percentage of sales revenue. Clearly, the higher this percentage is, the higher the return on investment will be. ii. Sales revenue/invested capital is called capital turnover. This expression shows how much revenue is generated for every dollar of capital investment. A higher number for this expression implies that invested capital is being used effectively. 2. Improving a division’s ROI can be accomplished by increasing sales margin or by increasing capital turnover. It is useful to look at the DuPont model expression of ROI to see what needs to be done to improve profitability. Suppose sales revenues are increased but income and invested capital are held constant. ROI will be exactly the same as before. Thus, increasing sales without increasing profits will not increase overall profitability. a. Increasing income is the most obvious way to increase ROI, but it is not an easy way. Income can be increased by either increasing revenues (higher sales) or by decreasing costs. Income can also be increased by raising prices but selling less product. In this case, total revenue is held constant but income is higher. b. The other way to increase ROI is to raise capital turnover. It should be noted that, turnover could be increased by raising sales revenue or lowering invested capital. However, if revenue is raised without raising income as well, or lowering invested capital as well, there will be no effect on ROI. Decreasing invested capital is a challenging goal. Large chunks of invested capital are committed, long-term, fixed assets. These cannot be easily eliminated. c. Although ROI is widely used as a performance measure, it has one important drawback. Since managers are evaluated based on their division’s ROI, there may be some disincentives for managers to make capital investments that are good for the organization as a whole but not good as it relates to divisional ROI. For instance, if a manager’s division has an ROI of 15%, and a capital investment has a ROI of 11%, the new ROI for the division would become something less than 15%. Thus, even if an ROI of 11% is acceptable for the organization as a whole, because it exceeds organizational cost of capital, the manager might be tempted to reject it because of the effect it would have on his or her division’s ROI. d. There is an ethical component to the situation just described. Recall that the responsibility accounting system is supposed to motivate behavioral congruence for the good of the organization. In the situation just described, the manager would be tempted to reject a viable investment option because of the effect on his or her own interests. This is especially true if bonuses, promotions, or even one’s job could be at risk if divisional ROI declines. This highlights the dangers of using just one performance measure. Residual income or economic value added are other performance measures that may be used to supplement ROI. 3. An alternative performance measure for investment centers is residual income (RI). ROI is computed without regard to the cost of capital. Residual income looks at the profitability of a prospective capital investment based on how much income remains after accounting for the organization’s cost of capital. If residual income with the proposed investment is higher than residual income is without the investment, then the proposed capital project should be accepted. Residual income is calculated as: RI = Investment center’s profit – (investment center’s invested capital * Imputed interest rate) The imputed interest rate is the firm’s cost of acquiring investment capital. a. Residual income is a dollar amount, not a percentage like ROI. This is, in fact, one of the drawbacks of using it. Since RI gives an absolute dollar amount, it cannot be used to evaluate different investment centers with differing investment decisions to make. A very large division with RI of $40,000 for a project should not be evaluated the same as a very small division with RI of $20,000 (the first project is probably not twice as beneficial as the second is). b. RI and ROI should both be used for different purposes or in conjunction with each other. 4. Economic value added (EVA) is the third measure used to evaluate performance of investment centers. EVA is: Investment center’s after-tax operating income – [(Investment center’s total assets – Investment center’s current liabilities) * Weighted-average cost of capital)]. EVA is similar to residual income, except for two things. First, an investment center’s current liabilities are subtracted from total assets. Second, weighted average cost of capital is used instead of an imputed interest rate. The weighted average cost of capital WACC) takes into account the two sources of long-term capital — debt and equity. WACC is calculated as: [(After-tax cost of debt capital) * (Market value of debt) + (Cost of equity capital) * (Market value of equity)] divided by (Market value of debt + market value of equity) a. The EVA is expressed as a dollar amount. The advantage of calculating EVA is that it evaluates overall performance of the division like ROI does, but it tells top management fairly readily when a division is in trouble. If the EVA is negative, it means the division is a financial drain on the company’s resources. It sounds an alarm that management can respond to immediately. H. ROI, RI, and EVA all use profit and invested capital in their formulas. This raises the question of how to measure divisional profit and invested capital. There are various ways to do this. 1. There are several ways to measure an investment center’s capital. Here are some considerations. a. Asset balances (or invested capital) may be averages of beginning and ending balances. ROI, RI, and EVA are measures of performance over a period of time, while asset balances are measured at one point in time. Average asset balance is used because it, at least, gives a simple measure of the asset base over the time period being evaluated. b. How much of the asset base should be included for a division? Some companies use total assets. Other companies use total productive assets, excluding nonproductive assets. A third view is that total assets less current liabilities should be used, based on the logic that current liabilities must be paid with current assets, so current assets should be reduced by this much. A fourth consideration is whether gross or net book values should be used. Using gross book value when a considerable portion of the asset base has been depreciated might distort results. This last consideration deserves more discussion. i. Net book value has two advantages over gross book value. First, it is consistent with balance sheet information prepared for financial reports and allows for a more meaningful comparison of ROI measures across different companies. Second, net book value is more consistent with net income used in calculating ROI. The income figure deducts the current period’s depreciation expense. iii. Proponents of the use of gross book value argue that depreciation methods are arbitrary, and so they should not be included in performance measures. Perhaps a more compelling argument is that the net book value artificially inflates the ROI, RI, and EVA over time. This being the case, managers might be motivated to hang on to old equipment too long, and they might be reluctant to acquire new, more efficient assets. c. The asset base for a division might also include allocated assets. For instance, divisions may have accounts receivable allocated when customers purchase product from several divisions. 2. Choosing the method for measuring investment center income is another concern for managers. One factor to consider is how controllable is the income attributed to a division. A division’s net income figure may be derived from including several allocated expenses, like allocated income taxes, facility-level expenses allocated from corporate headquarters, interest expenses allocated from corporate headquarters, expenses traceable to the division but controlled by others, and general and facility-level expenses controllable by the division manager. An argument could be put forth that no allocated expenses beyond the control of the division manager should be factored into that manager’s performance measures. 3. One point to keep in mind when considering what information to use for estimating assets and income is that ROI, RI, and EVA are used to evaluate managers’ and divisions’ performance. In evaluating the manager’s performance, one should consider only costs and revenues that the manager can control. Evaluation of a division is done for a different purpose. The main purpose of evaluating a division is to see if it is viable in terms of profitability. Traceability of costs is more important than controllability. 4. Even though costs like allocated income taxes, and other costs allocated from corporate headquarters are not controllable by division managers, they are routinely included in performance reports to remind division managers that there are other costs that must be covered by the profits of various divisions in order for the organization as a whole to be profitable. 5. During periods of inflation or for global companies operating in high-inflation countries, it could be justifiably argued that historical-cost asset valuation should be supplemented with replacement-cost asset values. I. ROI, RI, and EVA are all short-term performance measures that evaluate performance one year at a time. An investment center is comprised of the product of strategic decisions intended to benefit the organization over long periods of time. A correct evaluation of multiperiod strategic decisions is to look at a longer window of time. 1. A more appropriate evaluation of a long-term investment is to perform a post-audit of an investment decision. The problem with this approach, however, is that strategic decisions are made on an ongoing basis and are usually part of a bundle of investments that are used together. 2. Another way to evaluate long-term investment is to use a balanced scorecard approach. The balanced scorecard is presented in Chapter 21. J. Large, decentralized nonprofit organizations need to evaluate performance of divisions and managers just as much as for-profit organizations do. It is especially challenging to do this because the profit motive is not there to elicit efficient, productive activity. Often, managers of non-profit and government organizations are working there for reasons that are not purely financial. They may be less receptive to formal control procedures than their business counterparts. The goals of non-profit organizations may be less clear-cut than for-profit organizations. Some goals may contradict. For instance, an organization may have the goal of providing medical care to a rural, impoverished community. It may have another goal to stay within its budget. Clearly these goals conflict if the budget is fixed. K. Top management must be conscious of the need to modify its performance evaluation system in accordance with the changes in its organization. Some warning signals that may indicate a need to modify or add performance measures include: (1) a change in organizational strategy; (2) an absence of non-financial performance measures; (3) no measures associated with a critical process or success factor; (4) adoption of new technology or organization structure; (5) market share drop; (6) financial crisis; (7) reports that are ignored by managers; (8) managers motivated to do non-value-added tasks; (9) performance measures monitor only costs; (10) measures are all short-term in nature; (11) product has moved into a new phase of its life cycle; (12) measures do not tell how one can do better; (13) functional groups do not work well together; (14) measures are extremely precise; (15) measures are only internally focused; (16) managers and employees cannot articulate critical success factors for an organization. Problem 1 – Chapter 18 Learning objectives: 4, 5, 6 Responsibility centers, performance reports, ROI, RI, and EVA Completion time: 45 minutes ABC Companies has three divisions, X, Y, Z. Some financial information with regards to these divisions follows: Item X Y Z Sales 187,000 248,500 367,500 Cost of sales- as a percentage of sales 42% 46% 52% Sales commission 5% 4% 3% Marketing expense 8,400 12,200 15,800 Administration expense 9,800 13,900 16,900 Home office cost allocation 8,000 8,000 8,000 Income tax rate: 20% Assets 500,000 600,000 800,000 Current liabilities 50,000 120,000 180,000 Long-term liabilities 150,000 180,000 120,000 Required rate of return 12% Average cost of capital 9% Required: 1) divisional income and company income 2) divisional return on investment 3) divisional residual income 4) divisional EVA 5) divisional return on equity Solution: Item X Y Z Total Sales 187000 248500 367500 803000 Cost of sales 78540 114310 191100 383950 Gross margin 108460 134190 176400 419050 Sales commission 9350 9940 11025 30315 Marketing costs 8400 12200 15800 36400 Administration exp. 9800 13900 16900 40600 Home office 8000 8000 8000 24000 Income before tax 72910 90150 124675 287735 Income tax 14582 18030 24935 57547 Net income 58328 72120 99740 230188 Assets 500000 600000 800000 1900000 Current liabilities 50000 120000 180000 350000 Long-term liabilities 150000 180000 120000 450000 Equity 300000 300000 500000 1100000 2) ROI 14.6% 15.0% 15.6% 15.1% 3) RI 12910 18150 28675 59735 4) EVA 17828 28920 43940 90688 5) ROE 19.4% 24.0% 19.9% 20.9% Problem 2 LO 4 Performance reports Estimated time: 15 minutes Omid Printers has three divisions. Each division has a production department, a sales department, and a quality control department. Each department has three sections. For example, the production department has printing, cutting, and collating sections. Explain how the performance report for this company should be designed and prepared. The company CEO will get a summary report which will give the total cost of each division plus the detail of costs which are the direct responsibility of the CEO. Each division manager will get a report inclusive of a total of costs for the departments under the manager’s control plus the details of costs under the manager’s control. In turn, each department will get the summary of charges of sections under the department manager’s control plus any other costs incurred directly by the department. Each section will get a report with the detail of the costs incurred. The costs should tie together and add up for the company as whole. Preferably, there should be a budget and actual column for the month as well as on a year-to-date basis. The report format should correspond to the company’s organizational structure and how responsibilities are divided. The above chart depicts the detail of departments and sections for Division B only as a guide on how the detail of the performance report is to be prepared and presented. Problem 3 LO: 5 and 6 Return on investment Estimated time: 25 minutes Saba Signs Company has provided the following data: Item End of the year Amount Proposed addition Sales $2,400,000 600,000 Investment $4,800,000 !,800,000 Profit $384,000 $108,000 Required: a) determine ROI before the additional investment b) determine ROI for the additional investment c) determine ROI after the additional investment d) will the manager accept the additional investment using ROI why or why not? e) If Saba wants to increase ROI to 10% but cannot change the current profit level and sales amount, what options does he have? Show your computations. f) If Saba wants to increase ROI to 10% but cannot change sales or investment, how much the profit should change to? g) If Saba wants to increase ROI to 10% given the same level of investment and profit, how much should sales increase to assuming that the margin on incremental sales amounts to 20%. Solution: Item Before Additional Total Profit 384,000.00 108,000.00 492,000.00 Sales 2,400,000.00 600,000.00 3,000,000.00 Investment 4,800,000.00 1,800,000.00 6,600,000.00 Margin 0.16 0.18 0.16 Turnover 0.50 0.33 0.45 a, b, c, ROI 0.08 0.06 0.07 d) Manager will reject the additional investment: it lowers the current ROI. e) Reduce investment 3,840,000.00 1,080,000.00 4,920,000.00 ROI 0.10 0.10 0.10 f) increase profit 480,000.00 180,000.00 660,000.00 ROI 0.10 0.10 0.10 G) Increase sales 2,880,000.00 960,000.00 3,840,000.00 Problem 4 LO: 6 Residual income Estimated time: 25 minutes Saba Signs Company has provided the following data: Item End of the year Amount Proposed addition Sales $2,400,000 600,000 Investment $4,800,000 !,800,000 Profit $384,000 $108,000 Current liabilities $400,000 200,000 Cost of capital 5% 5% Tax rate 20% 20% The company requires a residual income of 6%. Required: a) Determine residual income before and after the additional investment. b) Will the company accept the proposed additional investment if the measure used is residual income? c) Determine the company’s Economic Value Added (EVA). Solution: Item Amount Addition Total Profit 384,000.00 108,000.00 492,000.00 Investment 4,800,000.00 1,800,000.00 6,600,000.00 Required rate of return 0.06 0.06 0.06 Cost of capital 0.05 0.05 0.05 Tax rate 0.20 0.20 0.20 Liabilities 400,000.00 200,000.00 600,000.00 Residual income 96,000.00 - 96,000.00 b) the company will accept the additional investment. Income after tax 307,200.00 86,400.00 393,600.00 c) EVA 87,200.00 6,400.00 93,600.00 Sample Quiz Use this data to respond to questions 1 through 4. Omid Publishing Company has three divisions: A, B, and C. The revenues of these divisions are $29,000, 48,000, and 63,000 respectively. Variable costs of these divisions amount to 57%, 59%, and 64% of the given revenues. The divisions’ short-term controllable fixed costs are $4,200, 5,200, and 6,200 respectively. The divisions’ long-term controllable fixed costs amount to $3,800, 4,900, and 5,700 in the order given. The company’s uncontrollable costs amount to $7,150, and income tax is at 20% of operating income. (Note: for computation of cost of capital, consider the given interest rates to be net of tax effects). 1. Short-term controllable margin for division A amounts to a. $4,470 b. $8,270 c. $12,470 d. $16,270 e. None of the above. Answer: b Learning Objective: 4 2. Long-term controllable margin for division B amounts to a. $9,580 b. $14,480 c. $19,680 d. $23,580 e. None of the above. Answer: a Learning Objective: 4 3. Division C’s contribution margin amounts to a. $10,780 b. $16,480 c. $22,680 d. $28,480 e. None of the above. Answer: c Learning Objective: 4 4. Company’s net income amounts to a. $14,144 b. $17,680 c. $24,830 d. $39,230 e. None of the above. Answer: a Learning Objective: 4 The remaining data is used in conjunction with questions 5 through 15. Company’s assets amount to $200,000; 20% of which is for division A and the balance split equally between divisions B and C. However, $8,000 of division B assets are unused fixed assets that are temporarily stored until they can be disposed of. One-half of company assets are in debt — 20% of debt is in current liabilities. Current value of equities is 40% higher than its related cost. Current value of debt is the same as cost for A and B divisions and $3,500 less than cost for C due to sudden drop in interest rates. Interest for borrowed funds for A and B is at 8% and for C, it is at 12%. Company’s required rate of return is at 9%. Required return on equity is at 14%. 5. Division A’s margin (rounded) amounts to a. 15% b. 17% c. 18% d. 20% e. None of the above. Answer: a Learning Objective: 5 6. Division C’s margin (rounded) amounts to a. 15% b. 17% c. 18% d. 20% e. None of the above. Answer: b Learning Objective: 5 7. Operating assets turnover for division A (rounded) amounts to a. 67% b. 70% c. 73% d. 79% e. None of the above. Answer: c Learning Objective: 5 8. Operating assets turnover for the company amounts to a. 67% b. 70% c. 73% d. 79% e. None of the above. Answer: c Learning Objective: 5 9. Return on investment for division B, using operating assets amounts to a. 8.8% b. 11.1% c. 13.3% d. 13.5% e. None of the above. Answer: c Learning Objective: 5 10. Return on investment for division C amounts to a. 8.8% b. 11.1% c. 13.3% d. 13.5% e. None of the above. Answer: d Learning Objective: 5 11. Residual income for division B, using operating assets amounts to a. $400 b. $870 c. $3,100 d. $3,580 e. None of the above. Answer: c Learning Objective: 5 12. Residual income for the company, using operating assets amounts to a. $400 b. $870 c. $3,100 d. $3,580 e. None of the above. Answer: e Learning Objective: 5 13. Division A’s long-term debt plus equity at cost amount to a. $32,000 b. $44,000 c. $72,000 d. $88,000 e. None of the above. Answer: a Learning Objective: 5 14. Weighted average cost of capital for division B amounts to a. 11.82% b. 12.60% c. 13.82% d. 14.82% e. None of the above. Answer: a Learning Objective: 5 15. Weighted average cost of capital for division C amounts to a. 11.82% b. 12.60% c. 13.82% d. 14.82% e. None of the above. Answer: c Learning Objective: 5 For questions 16 and 17 also assume that the common costs are divisible to $1,150 chargeable to division A and the balance split equally between divisions B and C. 16. EVA for division A amounts to a. -$2,545 b. -$5,138 c. -$5,454 d. -$13,135 e. None of the above. Answer: a Learning Objective: 5 17. EVA for the company amounts to a. -$2,545 b. -$5,138 c. -$5,454 d. -$13,135 e. None of the above. Answer: d Learning Objective: 5 18. A division’s investment in conjunction with ROI may be a. operating assets. b. operating and non-operating assets. c. assets minus current liabilities. d. replacement value of assets. e. All of the above. Answer: e Learning Objective: 8 19. To improve margin in conjunction with ROI computations, a. sales may be increased. b. income may be increased. c. assets may be increased. d. assets may be decreased. e. a and d Answer: b Learning Objective: 6 20. An advantage of ROI is that a. it encourages managers to accept projects which provide returns in excess of the company’s required rate of return. b. it encourages managers to attempt to increase asset turnover. c. it encourages managers to attempt to increase the margin. d. All of the above. e. b and c Answer: e Learning Objective: 7 21. An advantage of EVA over RI is that a. it excludes current liabilities from total investment b. it uses imputed interest rate c. it uses income before interest and taxes d. all of the above e. a and c Answer: a LO: 7 22. Cost of long-term debt is computed by dividing a. before tax interest divided by book value of debt b. after tax interest divided by book value of debt c. before tax interest divided by market value of debt d. after tax interest divided by market value of debt e. none of the above Answer: d LO: 7 23. Cost of equity capital is computed by dividing a. income before tax divided by cost of equity b. income after tax divided by cost of equity c. income after tax divided by market value of equity d. income after tax divided by market value of equity e. none of the above. Answer: c LO: 7 Chapter 19 Transfer Pricing Chapter Outline A. Cost Management Challenges — Chapter 19 provides four cost management challenges. 1. What is the primary purpose of establishing a transfer price policy? 2. What are four methods for setting transfer prices? 3. What is the significance of excess capacity in the transferring division, and what impact does that have on the transfer price? 4. Why might income-tax laws affect the transfer-pricing policies of multinational companies? B. Learning Objectives — This chapter has five learning objectives. 1. Chapter 19 explains the purpose and role of transfer pricing. 2. The chapter explains how to use a general economic rule to set an optimal transfer price. 3. It explains how to base a transfer price on market prices, costs, or negotiations. 4. It discusses the implications of transfer pricing in a multinational company. 5. It discusses the effects of transfer pricing on segment reporting. C. The chapter discusses the effects of transfer pricing on segment reporting. A transfer price represents the amount charged when one division sells goods or services to another division within an organization. Transfer pricing is a challenge for cost managers because it represents an economic event that must be recorded in the accounting system. Deciding what the transfer price should be is the challenge. Transfer of goods and services within an organization do not impact the organization’s profits as a whole organization. However, the buying and selling divisions’ profits are affected by transfer prices charged. A high transfer price increases profits for the selling division and increases costs for the buying division. If divisions are evaluated using ROI, residual income, or economic value added, then the transfer price can affect the performance of each division. This fact may motivate managers to pursue strategies for transfer pricing that are not congruent with organizational goals. 1. In a highly decentralized organization, managers are given the autonomy to decide whether to accept or reject orders and whether to buy from inside the organization or from outside. The goal in setting transfer prices is not to motivate managers to buy internally. It is to motivate managers to make decisions that support the overall goals of the organization. Thus, the transfer price chosen should allow each division manager to maximize his or her own profits, while also maximizing the company’s profit. 2. There is a general transfer-pricing rule that ensures goal congruence. It is: Transfer price = Additional outlay cost per unit incurred because goods are transferred + Opportunity cost per unit to the organization because of the transfer. a. This general rule separates the transfer price into two pieces. The first piece is just the additional costs incurred to manufacture the product (or provide the service), plus any applicable costs that are directly related to the transaction to transfer goods internally. b. The second piece of the transfer price, the opportunity, represents the amount of contribution margin given up to make the sale internally. In other words, if a sale could be made to an outside buyer, the difference between the outside buyer’s price and the additional outlay costs per unit equals the opportunity cost. The opportunity cost of selling internally depends on whether the selling division has excess capacity or not. 3. Assume the selling division has no excess capacity. This means that all production capacity is currently being used to sell product at the market price. The transfer price is the outlay cost plus foregone contribution margin. This is just the existing market price. That is the case, because for every unit sold internally, one less unit can be sold to external customers. a. Given the case that the selling division has no excess capacity, how can the general transfer-pricing rule be used to promote goal or behavioral congruence? One should next look at the buying division’s situation. Suppose the transfer price for a part is $40. Suppose the buying division can obtain the same item from another supplier for $35. The buying division should buy from the other supplier. Why? Because the selling division can sell the product to external customers instead of selling internally. The buying division can buy externally at $5 less than it could if the item was purchased internally. This will increase profits for the company as a whole. b. Suppose the selling division has no excess capacity, its transfer price is $40, and other suppliers’ charge $45. In this case, it is better for the buying division to buy internally. The selling division should be indifferent since the transfer price is the same amount that would have been charged to external buyers. 4. Now, consider the case where the selling division has excess capacity. In this case, the general rule for a transfer price would assume that opportunity costs are zero. All demand for external sales can be met, and excess capacity can be used to satisfy internal demand. Now, suppose again that the price charged to external customers is $40. Suppose further that this $40 price included contribution margin of $14. The opportunity cost of $14 becomes $0 when there is excess capacity. In this case, the transfer price is $26. a. Suppose, as described earlier, that the buying division could buy an item for $35 from another supplier. In the case where the selling division could sell the item for $40, it would be better not to transfer the item internally. In the case of excess capacity where the transfer price is now $26, it makes sense for the selling division to accept the internal order, and it makes sense for the buying division to buy internally. In this case, it is unlikely that the buying division could find the item externally for less than the transfer price. 5. Theoretically, the general rule for transfer pricing should work well and should promote goal or behavioral congruence. In reality, there are some challenges associated with setting the transfer price, outlined below. a. The external market may not be perfectly competitive, so the opportunity cost is not always easy to determine. In a perfect competitive market, the market price does not depend on the quantity sold by any one producer. Under imperfect competition, a single producer can effect the market price by varying the amount of product available in the market. This makes the opportunity cost variable because it depends on decisions about the amount available to external buyers. b. Another complication arises when there is no outside market for the item to be sold internally. In the most extreme of these cases, the company may even combine the buying and selling divisions, so the transfers occur without a need to set transfer prices. c. A third complication arises when the goods being transferred are unique or when special equipment must be acquired to produce the items being transferred. These special situations could be viewed as opportunity costs since the producing division could have used those resources for more profitable activities. d. A fourth complication arises when the selling manager has excess capacity and has no opportunity cost. It is to the advantage of the organization for the selling division to manufacture and sell the product to the buying division using excess capacity. Yet, the selling manager is evaluated based on the profitability of his or her division. If items are produced and sold (transferred) without any contribution margin, the selling manager’s profitability will not increase as a result. e. Because of the complexities encountered in real transfer pricing situations, the general rule for transfer pricing is sometimes modified, as described below. 6. In the simplest case, the transfer price equals the external market price. This occurs when the market is perfectly competitive and the selling division has no excess capacity. 7. There may be occasions where an industry experiences a period of significant excess capacity and extremely low prices. Under such extreme conditions, transfer price cannot equal market price. In this unusual case, the transfer price should be based on the longrun external market price instead of the current, artificially low market price. 8. Many companies use negotiated transfer prices. Division managers may start at the external market price and seek reductions based on savings that may occur because the internal transfer may involve less cost than external sales. For instance, sales commissions are not necessary, and transportation and shipping costs may be less if the two divisions share facilities. Negotiated transfer prices may also be used when there is no external market. a. Negotiated transfer prices have two drawbacks. Negotiations can cause divisiveness and competition between division managers. This can undermine cooperation and cohesiveness. b. A second drawback is that negotiating skill can erroneously become an evaluating mechanism for managers. If, for instance, the selling division manager is very effective at negotiating the transfer price, the selling division may look better simply because of the selling manager’s negotiating ability. 9. An alternative to a market-based or negotiated transfer price is a cost-based transfer price. 10. In general, when making a transfer pricing decision, the transfer price should be based on standard costs instead of actual costs. If actual costs were used, the costs of any inefficiencies would be passed on to the buying division. 11. Cost-based transfer pricing can be improved by adopting activity-based costing. This would improve the accuracy of costs used to determine transfer price. 12. When the producing division is not provided with financial motivation for selling product internally, motivational problems can arise. There are several remedies to this problem. a. A supplying division whose transfers are almost all internal could be organized as a cost center. Then the manager is not responsible for generating profit, and the manager’s performance is not based on profit measures. b. A supplying division who sells externally could be structured so that external sales activity is treated as profit center activity, and internal sales activity could be treated as part of cost center activity. 13. A tempting solution to disputes between managers regarding transfer price disagreements is to have upper management intervene. Once a company establishes a transfer pricing policy and gives managers autonomy to accept or reject orders or transfer prices, it is best not to intervene directly. 14. In the case where the transfer price could cause the buying and selling managers to reject internal transfers when they should not, a dual transfer pricing system could be set up. Using this approach, the buying division is charged with only the cost of the transferred product, while the selling division is given credit for some profit. D. The transfer pricing issue becomes much more complex and controversial in a global environment. This is true because of tax laws, royalties, and other laws related to definition of cost and transfer of profits outside of a country. Since tax rates vary among countries, companies are motivated to set transfer prices that will increase revenues in low-tax countries and increase costs in high-tax countries. 1. International tax authorities look closely at transfer prices when examining tax returns of companies engaged in related-party transactions that cross national boundaries. Companies often are required to provide support for the transfer prices they use. 2. In addition to the tax effects on transfer pricing decisions, import duties may influence the transfer prices chosen by companies. Import duties, or tariffs, are fees charged to importers that are based on the value of the goods being imported. If there are import tariffs, a company will be motivated to set the transfer price low in order to minimize the amount of import tariffs assessed. E. The Financial Accounting Standards Board (FASB) requires companies engaged in different lines of business to report certain information about segments. This includes segmented reporting of revenue, profit or loss, assets, depreciation and amortization, capital expenditures, and certain specialized items. International organizations must also report segmented information by geographic region. The FASB promotes the use of market-based transfer prices for financial (external) reporting purposes. The determination of market price is not always feasible, as has been discussed earlier in this chapter. Companies usually are forced to estimate market price of items for which a market price is not readily available. F. Although most of the discussion in Chapter 19 revolves around the transfer pricing issue for a manufacturing firm, it is also used in service sector firms and in non-profit organizations. Problem 1 – Chapter 19 Learning objective 4 Transfer pricing in a multinational environment Time required: 60 minutes Ryan Company that has two divisions M & N. Product X is manufactured in US and sold domestically and to division N in France as well. A total of 900 units of X is produced and sold at $410 a unit in the U.S. Division N requires 300 units of X. Company has a total capacity of 1200 units. The company estimates the cost to be $190 in variable costs per unit with a total fixed costs of $72,000. Selling and administration expense in the U.S. comes to $90,000 inclusive of sales commission at 5% of domestic sales. Shipping cost to N (payable by N) amounts to $3,600. Division N packages the item and puts a label on it at a cost of $32 a unit and sells it for $560 a unit. It incurs a promotional and administrative cost amounting to $15,000. Income tax rate in the U.S. is 30% and it is 50% in France. Required: 1) Determine divisional and company profit if transfer cost is set at market price. 2) Determine profit if transfer price is set at total cost. 3) Determine profit if transfer price is set at variable cost. 4) Would it be to the company’s advantage to buy from an outsider rather than produce N’s requirement if an outsider can sell the item to N for $220 a unit? Show your computations. 5) At what transfer price, total profit will be maximized and what is the problem with this approach? Solution: 1) Qty. Division M Division N Total Sales 900 369000 369000 Transfer 123000 168000 168000 Total S 1200 492000 168000 537000 V. CGS 900 171000 171000 V. CGS T 300 57000 57000 Transfer 123000 Shipping 3600 3600 Extra work 9600 9600 Fixed costs 72000 72000 G & A 90000 15000 105000 O. I. 102000 16800 118800 Taxes: 30%, 50% 30600 8400 39000 Net income 71400 8400 79800 2) Qty. Division M Division N Total Sales 900 369000 369000 Transfer 75000 168000 168000 Total S 1200 444000 168000 537000 V. CGS 900 171000 171000 V. CGS T 300 57000 57000 Transfer 75000 Shipping 3600 3600 Extra work 9600 9600 Fixed costs 72000 72000 G & A 90000 15000 105000 O. I. 54000 64800 118800 Taxes: 30%, 50% 16200 32400 48600 Net income 37800 32400 70200 3) Qty. Division M Division N Total Sales 900 369000 369000 Transfer 57000 168000 168000 Total S 1200 426000 168000 537000 V. CGS 900 171000 171000 V. CGS T 300 57000 57000 Transfer 57000 Shipping 3600 3600 Extra work 9600 9600 Fixed costs 72000 72000 G & A 90000 15000 105000 O. I. 36000 82800 118800 Taxes: 30%, 50% 10800 41400 52200 Net income 25200 41400 66600 4) total cost = 190 + 60 = 250 Due to fixed costs, it is better to transfer internally than buy at $220. 5) Qty. Division M Division N Total Sales 900 369000 369000 Transfer 139800 168000 168000 Total S 1200 508800 168000 537000 V. CGS 900 171000 171000 V. CGS T 300 57000 57000 Transfer 139800 Shipping 3600 3600 Extra work 9600 9600 Fixed costs 72000 72000 G & A 90000 15000 105000 O. I. 118800 0 118800 Taxes: 30%, 50% 35640 0 35640 Net income 83160 0 83160 Solution (5) portrays the optimal solution in terms of income maximization. However, most countries have established transfer pricing policies to avoid the possibilities of tax shifting. If the company cannot justify why Division N has been charged a price which is more than the going market price, the company must be able to substantiate and justify its transfer price. Otherwise, it may be subject to not only adjusting the price but also potential penalties for an unsubstantiated transfer price. Problem 2 LO: 2 Setting an optimal transfer price Estimated time: 15 minutes Jennifer Company has two divisions, A and B. Product X which is sold in the market place at $25 a unit can also be transferred to unit B and processed further before it is sold for $39 a unit. The capacity for making X is 15,000 units. B requires 6,000 units of this total. The variable cost associated with producing X is $17 and the total cost amounts to $23. The additional variable costs incurred on X in department B amounts to $7 a unit with an additional total fixed costs of $24,000. Required: a) What is the optimal transfer price when there is excess capacity? b) What is the optimal transfer price when the excess capacity is only 2,000? c) What is the optimal transfer price when there is no excess capacity – from A’s, B’s, and Company perspectives? Solution: a) With excess capacity the minimal optimal transfer price is the incremental cost which is often the same as variable cost ($17). The acceptable range should be between $17 and $25 less savings realized such as packaging, labeling, and shipping. b) 17 + ((4,000 * (25 – 17))/6,000) = 22.33 c) From A’s perspective the TF should be $25 because that is what the market will pay. From B’s perspective the TF should be $25 less savings realized on shipping, labeling, and packaging. However, if B stays idle due to lack of materials, the company will incur additional loss of (39 – 25 – 7) = $7 per unit. Therefore, it is to the company’s overall advantage to ascertain that the transfer of the 6,000 units to B takes place at any price to avoid the possibility of losing it to outsiders. Problem 3 LO: 3 Cost based transfer prices Estimated time: 30 minutes Ryan Enterprises sells product N to outsiders. It is considering selling its excess capacity goods to Division B at cost. Current production is at 5,000 unit level. Production capacity is at 6,000 units. Cost figures follow: Item Standard costs Actual costs Unit level costs $66,000 $72.000 Batch-level costs $24,000 $23,200 Product-level costs $32,000 $33,450 Facility-level costs $120,000 $118,200 Customer-level costs $54,000 $55,800 Determine transfer price per unit using unit level, batch-level, product-level, facility-level, and customerlevel costs separately and together at both standard and actual costs and at current level and capacity level output. All costs will vary with production level except for facility-level costs. Item Standard Std.Capacity Actual Unit level costs 66,000.00 72,000.00 Batch level costs 24,000.00 23,200.00 Product-level costs 32,000.00 33,450.00 Facility-level costs 120,000.00 120,000.00 118,200.00 Customer-level costs 54,000.00 54,000.00 Total costs 296,000.00 300,850.00 Output Unit cost: 5,000.00 6,000.00 5,000.00 Unit-level costs 13.20 13.20 14.40 Batch level costs 4.80 4.80 4.64 Product-level costs 6.40 6.40 6.69 Facility-level costs 24.00 20.00 23.64 Customer-level costs 10.80 10.80 10.80 Cost per nit 59.20 55.20 60.17 Note: if cost is to be used instead of the market price, it is better to use standard cost rather than actual costs. Because the latter is subject to fluctuations with no input or influence on the part of the buyer whereas, better planning and accountability is possible through the use of a predetermined standard cost. Furthermore, use of standard costs based on capacity utilization is often preferred due to the consistency that it provides. Problem 4 LO: 3 Dual transfer pricing Estimated time: 20 minutes Shahnaz Designs has two divisions Omid and Saba. Saba buys product M from Omid. Even though it appears that Omid has some excess capacity most of the times, it insists that the transfer price should be at market price of $32 less $4 due to less packaging and transportation and the amount of sales commission saved on the 3,000 units that it usually buys from Omid. Saba insists that a fair price would be somewhere between Omid’s variable cost of $16 (and not the full cost of $24) and current market price Omid has a capacity of 10,000 units. Saba does some further processing at a cost of $30,000 (60% of which is variable) and sells the items for $49 a unit. Shahnaz agrees that the two divisions compute their transfers at a price that they are comfortable with. Prepare the related income statement using market price, variable cost, and then dual pricing approach in your analysis. Item Omid Saba Total a) the market price approach Sales in units 10,000.00 3,000.00 10,000.00 Sales in dollars 308,000.00 147,000.00 371,000.00 Marketing costs 28,000.00 - 28,000.00 Transfer price - 84,000.00 - Variable costs 160,000.00 18,000.00 178,000.00 Fixed costs 80,000.00 12,000.00 92,000.00 Profit 40,000.00 b) the variable cost approach 33,000.00 73,000.00 Sales in units 10,000.00 3,000.00 10,000.00 Sales in dollars 272,000.00 147,000.00 371,000.00 Marketing costs 28,000.00 - 28,000.00 Transfer price - 48,000.00 - Variable costs 160,000.00 18,000.00 178,000.00 Fixed costs 80,000.00 12,000.00 92,000.00 Profit 4,000.00 c) Dual pricing approach: 69,000.00 73,000.00 Sales in units 10,000.00 3,000.00 10,000.00 Sales in dollars 308,000.00 147,000.00 371,000.00 Marketing costs 28,000.00 - 28,000.00 Transfer price - 48,000.00 - Variable costs 160,000.00 18,000.00 178,000.00 Fixed costs 80,000.00 12,000.00 92,000.00 Profit 40,000.00 69,000.00 73,000.00 As seen from the above examples, the consolidated income remains the same regardless of the transfer price used. Sample Quiz 1. If there is excess capacity, the transfer price is often a. market price. b. opportunity cost plus incremental cost. c. variable cost or variable cost plus profit. d. full cost plus profit. e. a or b Answer: c Learning Objective: 2 2. A dual transfer pricing system is set up where a. the two sides cannot agree on a price and the difference in price between the two sides is absorbed by the home office. b. a ready market price is not available and the two sides must come up with an agreeable price. c. the buyer buys at variable cost and the seller only sells at full cost. d. the two sides agree to use a cost basis for transfer pricing. e. None of the above. Answer: a Learning Objective: 3 3. If variable cost is used in transfer pricing, it is preferable to use a. standard variable cost because the buyer does not wish to be stuck with inefficiencies of the selling division. b. standard variable cost because the seller does not wish to pass along the variations in cost. c. actual variable cost because the buyer is well-advised to deal with the real rather than anticipated costs. d. actual variable costs because the seller is well-advised to deal with the real rather than anticipated costs. e. None of the above. Answer: a Learning Objective: 3 4. The objective(s) of transfer pricing is / are a. to motivate managers. b. to provide an incentive for managers to make decisions consistent with the firm’s goals. c. to provide a basis for fairly rewarding the managers. d. All of the above. e. b and c Answer: d Learning Objective: 1 5. The basic methods used in transfer pricing are a. variable or full costs. b. dual prices. c. market price or negotiated price. d. All of the above. e. b and c Answer: d Learning Objective: 3 6. To minimize taxes, some multinational companies set high transfer prices a. when goods are shipped from low tax countries to other low tax countries. b. when goods are shipped from low tax countries to high tax countries. c. when goods are shipped from high tax countries to low tax countries. d. a or b e. a or c Answer: b Learning Objective: 4 7. Market pricing approach in transfer pricing a. helps to preserve unit autonomy. b. provides incentive for the selling unit to be competitive with outside suppliers. c. has arm’s-length standard desired by taxing authorities. d. may be the most practical approach when there is significant conflict. e. All except d. Answer: e Learning Objective: 3 8. Variable costing method of transfer pricing is a. easy to implement. b. intuitive and easily understood. c. more logical when there is excess capacity. d. All of the above. e. a and b Answer: d Learning Objective: 3 Use this data to respond to questions 9 through 15. US-UK Multinational transfers 500 units of TV’s from US to UK. The TV’s cost $280 a unit (60% of which is variable cost). The market price for these TV’s is at $390 each. The US division’s incremental tax rate is at 30%, whereas the UK taxes are at 55%. The UK subsidiary incurs a cost of $24 per set and sells the units for $430 a unit. 9. US division’s profit after tax using market transfer prices amounts to a. $36,000 b. $38,500 c. $42,100 d. $44,800 e. None of the above. Answer: b Learning Objective: 4 10. UK division’s profit after tax using total cost for transfer pricing amounts to a. $20,350 b. $24,350 c. $26,350 d. $28,350 e. None of the above. Answer: d Learning Objective: 4 11. US division’s profit after tax using variable costs for transfer pricing amounts to a. $39,200 b. $-39,200 c. $53,550 d. $-53,550 e. None of the above. Answer: b Learning Objective: 4 12. UK division’s profit after tax using variable costs plus a mark-up of 30% for transfer pricing amounts to a. $42,210 b. -$42,210 c. $21,560 d. $-21,560 e. None of the above. Answer: a Learning Objective: 4 13. US division’s profit after tax using full costs plus a mark up of 20% amounts to a. $15,750 b. $19,600 c. $29,600 d. $35,350 e. None of the above. Answer: b Learning Objective: 4 14. Tax for the company with the use of market price in transfer pricing amounts to a. $20,900 b. $27,650 c. $34,650 d. $42,350 e. $48,650 Answer: a Learning Objective: 4 15. Tax for the company with the use of full cost as transfer price amounts to a. $20,900 b. $27,650 c. $34,650 d. $42,350 e. $48,650 Answer: c Learning Objective: 4 Use this data to respond to questions 16 through 18. N&R Company transfers a product from division N to division R. Variable cost of this product is anticipated to be $40 a unit and total fixed costs amount to $8,000. A total of 100 units are anticipated to be produced. Actual cost, however, amounts to $50 for variable costs. Fixed costs were same as budget. However, actual output was twice as many. 16. Budgeted cost per unit amounts to a. $90 b. $92 c. $115 d. $120 e. None of the above. Answer: d Learning Objective: 5 17. The transfer price based on budgeted variable costs plus 130% markup amounts to a. $90 b. $92 c. $115 d. $120 e. None of the above. Answer: b Learning Objective: 5 18. The transfer price based on actual full cost plus 30% markup amounts to a. $117 b. $140 c. $150 d. $156 e. None of the above. Answer: a Learning Objective: 5 19. The forecasted market price was $150 a unit. The actual price was $140. It was anticipated that marketing and packaging costs which general customers require and internal transfer does not require amounts to $12. The actual non-required costs per unit amounts to $11. The negotiated transfer price based on budgeted market price should be a. $126 b. $129 c. $135 d. $138 e. None of the above. Answer: d Learning Objective: 5 20. Transfer pricing is used in a. centralized companies. b. only international companies. c. only domestic firms. d. only companies that need to minimize foreign taxation. e. none of the above. Answer: e Learning Objective: 5 21. Company X has two divisions Y and Z. Y can produce and sell 2,000 units of M. It can currently sell 1800 units to the outside market. Cost per unit is $29 with a total fixed cost of $18,000. The product sells for $33 per unit. Y needs 200 units a period. What should be the minimum selling price for the 200 units? a. $19 b. $26 c. $31 d. $33 e. none of the above Answer: a LO: 5 22. Company X has two divisions Y and Z. Y can produce and sell 2,000 units of M. It can currently sell 1800 units to the outside market. Cost per unit is $29 with a total fixed cost of $18,000. The product sells for $33 per unit. Y needs 400 units a period. What should be the minimum selling price for the 200 units? a. $19 b. $26 c. $31 d. $33 e. none of the above Answer: b LO: 5 Transfer price = 19 + [(33 – 19) * 200]/400 = 26 Where 19 is the item’s variable cost [29 – (18,000 / 1,800)] The second part of the equation is the opportunity cost of losing the market on 200 units that the division could have sold to outsiders versus the 400 that is gained by selling to division Z. 23. Company X has two divisions Y and Z. Y can produce and sell 2,000 units of M. It can currently sell 1800 units to the outside market. Cost per unit is $29 with a total fixed cost of $18,000. The product sells for $33 per unit. Y needs 400 units a period. Division Y suggests a price of 27 and division Z insists on paying not more than $25 per unit – this is the price currently being charged by an outsider. The company president agrees to both demands using the dual pricing logic. Based on this a. division Y’s income increases by $400. b. division Z’s income is not affected. c. company’s income is not affected d. all of the above e. none of the above. Answer: d LO: 3 Y is better off by a dollar a unit. Z is not affected. Company as a whole is not affected either. Chapter 20 Strategy, Balanced Scorecard, and Incentive Systems Chapter Outline A. Cost Management Challenges — There are three questions addressed in this chapter. 1. How do cost managers use their understanding of current operations to predict future outcomes? 2. How does the use of the balanced scorecard show each employee how his or her performance affects the company’s success? 3. How does the balanced scorecard differ from the measures of organizational cost and performance, which have been used for as long as organized companies have existed? In addition, the chapter explains the prevalent incentive systems and their pitfalls. B. Learning Objectives — This chapter has four learning objectives. 1. Recognize and recommend lead indicators in the areas of organizational learning and growth, business production process efficiency, and customer value. Explain the importance of lead indicators in building a balanced scorecard for communication, motivation, and evaluation. Explain the benefits and costs of a balanced scorecard Explain how organizations implement a balanced scorecard of performance measures. Understand the key principles of performance-based incentive systems Evaluate the advantages and disadvantages of alternative features of incentive systems. Discuss ethical issues of incentive systems. Understand three theories of motivation and incentives (Appendix). C. Eight broad management decisions were introduced in Chapter 1. They are: (1) An organization’s long-term strategy must be chosen: (2) The scale of the organization and the scope of operations must be determined: (3) The use of resources must be planned and organized in a way that maximizes the efficiency of operations; (4) Plans and organizational change must be implemented; (5) Results must be measured and reported; (6) Individuals and sub-units in the organization must be motivated and then evaluated; (7) Plans and results must be communicated to appropriate individuals and sub-units; and (8) Decision making and improvement initiatives must be evaluated. The first four of these decisions were presented and discussed in Chapter 1. Chapter 20 presents and discusses the remaining four management decisions in the context of lead and lag indicators, target costing, and the balanced scorecard. D. Lead indicators are performance measures of early value-chain activities. Lead indicators predict outcomes of value-chain operations that occur in the future. Lead indicators of current successes can be used as predictors of future successes. Lead indicators are used to identify future financial and nonfinancial outcomes to guide management decision making. 4. There are three major types of lead indicators, which are discussed in more detail below. They are measures of (1) organizational learning and growth; (2) business and process efficiency; and (3) customer satisfaction and loyalty. 5. Lag indicators measure final outcomes of management plans. Though lag indicators are useful for evaluation of financial results (e.g., profitability), lead indicators are the measures needed to ascertain that profit outcomes occur as expected. 6. Lead and lag indicators are related to each other. Lead indicators that are performance measures at one stage of an organization’s value chain may be lag indicators in another stage of the value chain. For instance, a lead indicator may be customer satisfaction for an existing product. If management decides that customer satisfaction is lower than desired, then this may become a lag indicator for improving the production process. This change will, in turn, result in a lead indicator measuring customer satisfaction again. E. Balanced scorecard is a strategy formulation and communication device as well as a causal model of lead and lag indicators of performance. It incorporates financial and non-financial measures such as customer, production, and employee issues that lead to a firm’s financial success. This model emphasizes that issues such as on-time delivery, percentage of goods returned, number of defects, waste, employee training, etc. are important factors which can lead to a company’s overall success. F. One of three key types of lead indicators is measurement of organizational learning and growth. Organizations grow through the learning and growth of employees. When employees learn, there should be increased customer satisfaction, ability to meet future needs, and new sales may result. A good atmosphere for employees also leads to higher satisfaction and lower turnover. Employee learning can be obtained and monitored in four ways. 1. Training and education. Training can be developed in-house or can be brought to an organization. Employees may also be reimbursed for training and education obtained from external sources. 2. Reward employee innovation. New products and services are often the result of employee innovation. Progressive managers encourage employees to share knowledge and ideas via team decision making. 3. Reward and measure opportunities for improvements. Employee suggestions should be encouraged. 4. Measure the amount of time needed to develop new products and services. Timely innovations give organizations a competitive edge. G. The second of the three important types of lead indicators is measurement of process efficiency. Process efficiency is the ability to transform inputs into outputs at lowest cost. There are two types of processes to consider. 1. Production processes result in the production of products or services. Business processes support production processes. These support activities are essential to the smooth running and operation of any organization. Measures of the efficiency of both production and business processes are lead indicators of financial performance. Supplier relations are becoming increasingly important as companies outsource more business and production activities. Many firms develop supplier rating systems to indicate which suppliers are certified for delivery of products without inspection. Trusted suppliers help the firm in terms of quality, efficiency, and cost control. 2. One measure of efficiency is measurement of quality. These indicators assess whether customers’ expectations have been met. a. Customers can be internal or external. Internal customers are employees or subunits that have received partially completed products or services from other employees or subunits. External customers are the final customers, who buy the goods and services. If internal customers receive poor quality, then external customers also will receive poor quality. b. Measures of quality must begin at the beginning of a process, where internal customers (employees) can identify and correct problems. c. Measures of quality based on external customers include customer inquiries about orders (related to on-time delivery), customer complaints, cancellations, and returns. 3. A second measure of efficiency is measure of productivity. a. The simplest measure of productivity is total factor productivity. It is calculated as Total Revenue/Total Cost. Factor productivity can be benchmarked against competitors. The higher the total factor productivity is, the more efficient an operation is. b. Other measures of productivity include sales revenue per employee; trends over time; and cost savings from new processes. 4. A third measure of efficiency is cycle time. Cycle time is the total processing time/number of good units produced. This represents the time from a unit of product being ordered to the time the unit is shipped to the customer. Ideally, the shorter the cycle time the better. 5. A fourth measure of efficiency is called throughput efficiency. The throughput time ratio is value-added time/total processing time. The lower the ratio is, the more inefficient the process is. This ratio gives managers information about non-value-added activities, which should be eliminated or minimized. H. The third of the three types of lead indicators is measurement of customer satisfaction and loyalty; i.e., customer value. Measuring customer satisfaction is a lead indicator of future sales. Customer satisfaction measures whether a product or service meets customer needs. Satisfaction is related to characteristics of the product itself — performance of the product, style, adaptability, durability, reliability, safety, and technical specifications. Customer satisfaction is also related to the quality of customer service (before and after the sale). Finally, customer satisfaction is based on customers’ willingness to pay the price based on product quality and competitors’ product offerings. Measuring customer loyalty refers to the likelihood that there will be repeat sales. This metric is a lag indicator since it measures how customers have behaved in the past. However, it is also a lead indicator because it gives managers information about retention of customers for new product offerings. Organizations operating in the competitive market internationally must consider the diversity of social and cultural norms when evaluating customer satisfaction. I. Customer value should also be measured in terms of customer retention and loyalty, sales growth, market share, and customer risk. 1. Customer retention or loyalty measures indicate how well a company is doing in keeping its customers. It often costs five times as much to obtain a new customer. So it is wise to try to retain the current customers. 2. To increase profits, companies must not focus on cost reduction alone. They need to focus equally on sales growth. 3. It is also important to see if the company maintains and increases its market share as compared to its competitors. This will assure the company’s focus in understanding the market and its competitive position. 4. Most companies take a risk with their customers to facilitate and increase sales through credit. However, this should be a measured risk. While some bad debts may occur but excessive bad debts indicates failure of the company’s credit system. J. Ultimately, the company’s success or failure is measured in financial terms: profit margin, revenue growth, customer profitability, and overall return on investment. These topics were individually discussed in the earlier chapters. Plans and results must be communicated to the appropriate individuals and sub-units. 1. Lead indicators must be reported to employees so they can see the link between their job and customer value and profit. 2. The balanced scorecard is one way to communicate the impact of employee effort to employees. a. A balanced scorecard reports both quantitative and qualitative measures of performance. b. A balance scorecard is based on a causal model that shows the relation among lead and lag indicators of organizational performance. c. A balanced scorecard should link: (1) learning and growth; (2) business and production process efficiencies; (3) customer value; and (4) financial performance. If an organization is able to link the first three, then financial performance (i.e., profit) will follow. d. The causal model upon which the balanced scorecard is based is formally stated as: Y = b(X), where  is the Greek symbol meaning “delta,” or change in; X represents a change in an upstream element, and Y represents a change in a downstream element, or an outcome. K. Incentive compensation plans have been in existence, at least as early as 1918, at General Motors Corporation. Today, virtually all large companies and some non-profit organizations have incentive compensation plans. Everyone knows that employees must be paid for the work that they do. Incentive compensation plans go beyond this basic idea, because they pay employees for performance. With incentive compensation plans, at least some portion of a manager’s income is not guaranteed but is dependent on a measure of organizational performance. There are two key elements of incentive compensation plans. They are (1) the measure of performance and (2) the method of compensation. 1. An article from 1975, entitled “On the Folly of Rewarding A While Hoping for B,” explained the problems with incentive plans that did not motivate employees to do the things the plan was supposed to motivate them to do. A danger to avoid in designing an incentive plan is to motivate undesirable behavior among employees. 2. The starting point in designing an incentive plan is to decide on what the desired behavior of employees is. The organization must have a clear vision of what goals it wants to achieve before developing an incentive structure that will motivate employees to achieve them. There are two theories of human behavior that address key motivational aspects of incentive compensation plans. They are expectancy theory and agency theory. One must also be conscious of the differences between extrinsic and intrinsic rewards in designing an incentive system. L. Expectancy theory says that people will act in ways that they expect will provide them with the rewards they desire and will prevent the penalties that they wish to avoid. Thus, incentive plans must accomplish two things. Incentive plans must provide rewards that are desirable and assure that penalties can be avoided. Incentive plans must provide a high probability that behaving as the organization desires will lead to the rewards. M. Extrinsic rewards come from outside the individual. These include money, gifts, and promotions. Intrinsic rewards come from within the individual. They include personal satisfaction of doing a job, a sense of well-being about an outcome, or a feeling that some activity has been helpful to others. Incentive structures need to incorporate opportunities for both extrinsic and intrinsic rewards into their incentive system. N. An absolute performance evaluation system compares individual performance to a set of standards or expectations. Relative performance evaluation is based on comparing an individual’s performance to that of others. 1. Performance evaluation formula describes rewards earned for specific achievements, such as, achieving a target cost or revenue. 2. Subjective performance evaluation is based on non-quantified criteria. O. The balanced scorecard, introduced earlier in the chapter, is a causal model of lead and lag indicators of performance. It provides a useful way to think about alternative methods people use when designing the performance evaluation part of incentive compensation plans. If the concept of a balanced scorecard is used properly, it should show every person in an organization how his or her job contributes to the ultimate goal of the organization. This view requires a fundamental change in the management styles currently in use at most companies. There are four basic balanced scorecard perspectives. They are (1) the learning and growth perspective, (2) the internal business perspective, (3) the customer perspective, and (4) the financial perspective. These concepts are reintroduced in this chapter in terms of financial and non-financial performance measures. The learning and growth perspective focuses on the capabilities of people. Managers are responsible for developing employee capabilities, and they would be evaluated based on their success at accomplishing this goal. Three key measures of their success would be employee satisfaction, employee retention, and employee productivity. a. Employee satisfaction has a direct impact on employee morale, which in turn affects productivity, quality, customer satisfaction, and responsiveness to situations. Employee satisfaction can be measured by sending surveys, interviewing employees, or observing employees at work. b. Employee retention is an indicator of employee satisfaction. Retention is important because employees develop organization-specific intellectual capital and, therefore, are a valuable asset to the organization. It is also expensive to hire and train new employees. A common measure of employee retention is employee turnover, which is the percentage of people who leave each year. c. Employee productivity recognizes the importance of output per employee. Fairly simple measures of output can be developed. d. A good incentive system rewards managers who promote high employee satisfaction, low employee turnover, and high employee productivity. The second perspective of a balanced scorecard is the internal business and production process perspective. There is a cause-and-effect relationship between the learning and growth perspective and the internal business and production process perspective. Internal business has to do with the internal workings of a company. It relates to how smoothly things run. Employees who understand their company can suggest ways to improve the internal workings of the company. a. Supplier relations are an important component of the internal business perspective. The rise of outsourcing has made the need for reliable suppliers even more critical. Companies have begun to certify suppliers, based on whether product can be received without inspection. Managers should be given incentives to get suppliers certified, working with them to reduce costs and increase quality. b. Incentives for improving processes are also necessary. Improving processes may result in the shortening of throughput time. Recall, throughput time is the total time from when the order is received by the company until the customer receives the product. The customer perspective focuses on how the organization should look to its customers if it is to succeed. The proper development of an incentive system from the customer’s perspective is based on a good understanding of the characteristics of the customers the company serves. Fast food restaurants serve the needs of people in a hurry or people who will not sit quietly and wait for their food (like small children). Fancy, expensive restaurants serve the needs of more sophisticated patrons, who want to enjoy the entire experience of eating out. a. Customers care about three things in general — product price, product functionality, and product quality. The incentive system must reward employees for meeting the needs of its customers. b. There are four measures of performance from the customer perspective. i. Customer satisfaction measures indicate whether the company is meeting customers’ expectations. Many businesses dealing with consumers use customer satisfaction forms. Other businesses may survey their customers over the telephone or use other, less formal methods. ii. Customer retention or loyalty measures indicate how well a company is doing in keeping its customers. A rule of thumb in business is that it costs five times as much to get a new customer as it costs to keep an existing customer. Managers should be motivated through the incentive structure to keep existing customers happy and loyal. iii. Market share is another measure of how a company is doing from the perspective of customers. Market share measures a company’s proportion of the total business in a particular market. If managers are rewarded for bringing in new customers, market share will grow. iv. Customer profitability is a fourth consideration. Keeping customers happy and loyal is fine, as long as they are enhancing profits of the company. The financial perspective of the balanced scorecard uses financial performance measures such as net income or return on investment. Financial measures provide measures that allow comparability across different organizations. Financial measures in the balanced scorecard are lag indicators. They do not inform managers as to how to improve performance. More broadly, financial measures include revenues, costs, cash flow, operating income (before or after extraordinary income and taxes), return on investment, residual income, economic value added, and stock price. All these items except stock price are based on the company’s financial records. 1. Implementing the balanced scorecard requires a commitment on the part of management to collect the data necessary to complete the performance measures in the evaluation system. The benefits of each piece of the balanced scorecard must more than compensate for the cost. The challenge in the case of the balanced scorecard is that it is hard to quantify the financial benefits of many parts of a balanced scorecard. Typically, implementing the balanced scorecard takes months or even years. It is an iterative, ever-changing process because targets change, organizations change, and strategies change. Some of the changes result from lead indicator information provided by the balanced scorecard. P. Economic value added is an investment center’s after-tax operating income minus the investment center’s total assets, net of current liabilities times the investment center’s weighted-average cost of capital. More simply, EVA is essentially the amount of earnings generated above the cost of capital required to generate those earnings. EVA can also be computed for an entire company. 1. As discussed earlier, EVA is essentially the same concept as residual income (RI). RI has been used as a performance measure since the 1920’s when it was adopted by General Motors. EVA was adapted from RI by consultants and now is used by companies in various forms. Starting with the financial results reported in external financial reports, companies make modifications to these numbers ranging from adjustments to goodwill amortization to treatment of R&D expenditures. 2. The major benefit of using EVA is its focus on the cost of capital multiplied by net assets. Using EVA in incentive plans gives managers incentives to eliminate assets that earn less than the cost of capital and to invest in those that earn more than the cost of capital. 3. Even though the balanced scorecard has highly non-financial content and EVA has highly financial content, these two performance evaluation measures can both be successfully used, if developed and implemented properly. Q. A critical aspect of a workable incentive compensation system is choosing the correct incentive to motivate the desired behavior. There are several choices an organization can make, and there is no single, universally correct incentive structure. Some different motivational issues are outlined below. Should managers be rewarded for current performance or future performance? If the rewards are based on current performance, the compensation is usually given in the form of cash or stock that can be cashed immediately or soon after the award. If the reward is based on future performance, the compensation may be deferred. For instance, a manager may be promised stock options if earnings increase by 10% over the next three years. Two advantages of rewarding future performance are that managers will establish long-term profit goals instead of only short-term goals, and they will have incentives to stay with the company. A disadvantage of deferred compensation is that if it is too far in the future, managers might not be motivated to try to achieve it. Most companies use combinations of current and deferred rewards for top managers but use current rewards for lower managers and their subordinates. Should rewards be based on division performance or company-wide performance? There are mixed views of the best approach, and the answer is company-specific. There are advantages and disadvantages of each approach. If incentives are provided to improve division performance, the manager’s focus may be too narrow. If rewards are based on company-wide performance, the division manager may not see the link between activities in his or her own division. A compromise is to use both performance measures as part of the incentive structure. Should rewards be based on a fixed formula or be flexible? Companies sometimes promise a set percentage or number of shares or stock options based on achieving a performance goal. Others prefer a case-by-case reward system. Although the case-by-case approach allows managers to factor in events like acquisition of new, expensive production equipment or a major program for employee training reduced division profits, it also allows some subjectivity that may be biased to come into play. Should performance evaluation be based on accounting results or stock performance? a. Tying performance to stock performance should align managers’ incentives with those of shareholders. Although this should give the manager proper motivation, it may be difficult for the manager to see the link between divisional performance and stock performance. Also, the stock’s value may fluctuate for reasons that are out of the control of managers. b. Stock options are a stock performance-based reward. Managers cannot diversify away their investment risk as others can, because they only are entitled to options in their own firm. c. EVA is an accounting-based performance measure. Its main benefit is that it is directly related to division activities. Should managers be evaluated based on absolute performance measures or relative performance measures? Relative performance evaluation occurs when companies compare a division manager’s performance to other division managers in the same industry. Although viewed favorably as a method to evaluate performance, the disadvantage of such a measure is that it does nothing to motivate managers to move out of low performing industries into industries that perform well. Absolute performance measures are those where the manager is evaluated based on his or her own division’s performance in comparison to pre-established goals, prior year’s performance, or the company’s performance as a whole. The disadvantage of doing this is that the benchmark may be unfair for managers of divisions where the outcome is normally lower than the company’s average because of the nature of the division. For instance, a division with a new, very highly demanded product may earn a return of 30%, while the division with a mature product may earn a return of only 8%. The 8% return may actually be a high return, based on the maturity and demand for the mature product, and the 30% may be low considering the high level of demand for the new product. Should the award given be cash, stock, or other prizes? The benefits of giving cash awards to employees are obvious. Receiving a cash bonus at year-end gives managers immediate feedback regarding their performance. Stock awards are not as liquid, but they align the interests of managers with those of the stockholders. In many companies, there is an unwritten rule that managers not sell stock until they leave the company or retire. Stock options, which give people the right to purchase a certain number of shares of stock at a specified price gives managers an incentive to increase the value of stock. Stock options will have no value if the market price of the stock declines below the price offered in the options. Some companies give prizes instead of cash or stock. Employees may appreciate prizes more and might remember the work they accomplished to receive it. Cash awards may be spent quickly and soon be forgotten. R. Large non-profit organizations need to have incentive systems to motivate employees just as much as for-profit organizations do. Managers must be motivated to perform well based on nonfinancial dimensions since there are no profit goals to achieve. Financial performance is likely to be related to accountability in the handling of funds. If a non-profit organization is organized as a bureaucracy, then managers may be evaluated based on adherence to the rules of the bureaucracy (as in the military). In charitable organizations, the rewards received by employees may be intrinsic. Helping others less fortunate than oneself may be the reward gained instead of receiving a cash bonus. Some non-profit organizations are adopting evaluation methods and incentive structures that mirror their for-profit counterparts. The balanced scorecard has been successfully implemented in universities. The US Postal Service, which is in direct competition with for-profit organizations like Federal Express and UPS, have a goal to break even and to manage itself in ways that are similar to a for-profit business. S. Compensations can take the form of current rewards or deferred rewards. Current rewards can better be linked to current performance. Deferred compensation induces the good manager to stay with the company longer. Many companies use a combination of both kinds of rewards. Rewards in addition to salaries can take the form of cash bonuses, stock awards (that can not be immediately sold), stock appreciation rights (SARs), and stock options. With stock option, the manager is given the right to purchase the stock at a certain price during a certain time period. Stock options provide a great incentive for managers for boosting the stock price. Recent evidences of manipulation of stock prices by executives in huge corporations have led the financial and business community as well as the government to start thinking in terms of what can be done to alleviate such problems. Cost savings has also been used as a means for providing incentives to management. This is particularly effective for non-profit organizations such as hospitals. Incentive systems, therefore, can include a mix of absolute or relative performance measures, formulae-based or subjective performance measures, financial or non-financial performance, narrow or broad responsibility measures, current or deferred rewards, and salary or bonus awards. T. Agency theory relates to the behavior of principals, who assign (delegate) responsibility to agents. Employers are principals, and employees are agents. There are many principal-agent relations in a business. For instance, the board of directors plays the principal role to top managers, who are agents. Top management plays the role of a principal to division managers, who are the agents. 2. Agency theory differs from expectancy theory in that it focuses on the relations between principals and agents, while expectancy theory focuses on what motivates the individuals (i.e., agents), without considering who the principal is. 3. Expectancy theory considers what motivates people. Agency theory’s primary concern is the “agency cost,” which includes the costs incurred by principals to control agents’ actions, as well as the costs to principals if agents pursue their own interests. 4. Agency theory suggests that employees will not automatically behave in ways that their employers desire. Employees may prefer to work at a leisurely pace. Employees may be tempted to steal, if assets are easily accessible. 5. According to agency theory, the objective of a good incentive compensation system is to minimize agency costs. Problem 1 – Chapter 20 Learning objectives 3, 4, 5 Balanced scorecard Time needed: 30 minutes Alan Enterprises spent $28,600 in employee training in 2002. from a total of 160 employees, eight employees resigned during the year and were replaced with new ones. Employees succeeded in introducing five innovative ideas for which management gave them recognition and prizes amounting to $7,500. Defective products amounted to 192 units from a total of 2,400 units produced. Productive time amounted to 22,500 from a total of 25,000 recorded as processing time. The company’s sales amounted to $630,000 from a market which is around 9 times this size. 3 out of 50 major customers have gone bankrupt leaving an uncollectible bad debts of around $19,700. Variable cost of production amounted to 56% of sales. Sales commission is at 6%. Fixed costs amount to $129,500 and general and administration costs amount to $87,450. This is in addition to the employee related costs stated above. The company has a total asset of $243,000. The company expects to increase the employee related costs by 25% in 2003 but hope that defects will be reduced by 30%, production efficiency will increase by 7%, sales will increase by 18% - although market will not change in total, and variable costs will decrease by 8%, fixed costs will increase by 3%. G & A will increase by 4%. Bad debts will be the same amount. Total assets will remain at the same level. Required: Prepare a balanced scorecard for 2002 and its forecast for 2003. Solution: Balanced Scorecard for Alan Enterprises Income statement: Sales $ 630,000 18% $ 743,400 Variable costs $ 352,800 -8% $ 383,000 Sales commission $ 37,800 $ 44,604 Fixed costs $ 129,500 $ 133,385 G & A $ 87,450 $ 90,948 Bad debts $ 19,700 $ 19,700 Employee training $ 28,600 25% $ 35,750 Innovations $ 7,500 25% $ 9,375 Item Yr 2002 % change Yr 2003 1) Organizational growth and learning Employee training 28600 25% 35750 Innovations 7500 25% 9375 2) Business and production processes efficiency: Defective products 0.08 -30% 0.056 Prod. Efficiency 0.9 7% 96.30% 3) Customer value: Customer risk 3 failed 3 failur es Market share 11.11% 13.11% 4) Financial: Sales Growth $ 630,000 18% $ 743,400 Profitability -5.3% 3.6% Return on assets -13.72% 10.96% Profit $ (33,350) $ 26,638 Assets $ 243,000 $ 243,000 Problem 2 Learning objective 6 Alternative incentive plans Time needed: 30 minutes Enton Company compensates its junior employees based on 10% of actual income distributed equally among the 1000 employees payable within 30 days after the end of the year plus 5% of stock appreciation for the year, 20% of planned income plus 10% of stock-appreciation for the 100 mid-level employees payable within seven months of the current year based on stock values on June 30th of the current year, and pays its 10 top-level executives, 30% of the revised income for the current year and 30% of stock appreciation as of the end of September during October of each year. Planned sales for 2003 amounted to 1.3 billion dollars. Planned costs included fixed costs of .35 billion dollars and variable costs amounting to 40% of sales. Taxes amount to 24% of income. Revised sales on 9/30th for the year is expected to be 1.1 billion dollars with a 10% increase in variable costs and a 5% reduction in fixed costs. Actual sales, however, amounted to .8 billion dollars with both fixed and variable costs being 12% higher than the anticipated level. Stock prices were at $22 at the beginning of the year, $26 as of June 30th, and $27 as of September 30th. At the end of the year, in spite of multi-million-dollar audits, several frauds and manipulation of records were discovered and the stock price plunged to $1.25. There were a total of 67 million shares outstanding during the year. Required: Determine planned and actual income and compute compensation per employee for each group. Then, provide a criticism of the company’s compensation plan. Solution: The student and the professor are asked to provide comments and analysis based on their own understanding of the above scenario and analysis. Problem 3 LO: 2 Selecting balanced scorecard measures Expected time: 15 minutes Saba suggests to Omid that if he wants to see drastic improvement in his business operations and profitability, he needs to invest in learning and growth. Explain what is involved in learning and growth and how it can impact sales and profitability. Solution: The four aspects of a balanced scorecard are: Financial performance, Customer performance, Business and production process performance, and Organizational learning and performance. Organizational learning and performance which typically includes items such as employee training and education, employee satisfaction, employee turnover rates, employee innovativeness and opportunities for improvement eventually impact the business and production process performance through higher productivity, less defect rates, less waste and scrap, less accidents, and higher quality product, this in turn leads to higher customer satisfaction, less returns and allowances, more on-time delivery, more responsiveness to customer questions, etc. This in turn will lead to better financial performance through higher sales, less costs, and higher profits. Problem 4 LO: 4 Implementation of a balanced scorecard Estimated time: 20 minutes Iraj Enterprise was dissatisfied about the company’s performance – sagging in sales and profit. Accordingly, management launched a $90,000 investment in employee training and education. The related costs in 2007 amounted to only $15,000. Management has asked you to prepare a report assessing improvements if any with regard to sales, costs, and profits as a result of this investment. Sales for 2007 before this investment amounted to $500,000 with costs amounting to $480,000 – 60% of which is variable. Variable costs include $96,000 in wastes, scrap, return, employee loss time, and accident related costs. In 2008, sales amounted to $600,000 with costs amounting to $560,000 with 50% of costs being variable. The variable costs associated with wastes, scraps, returns, employee loss time, and accident related costs amounted to $36,000 for 2008. Prepare an analysis of improvement, if any, and explain the potentials for the future. Item 2,007 % sales 2008 % sales % impr. Sales 500,000 100% 600,000 100% 20.0% Waste, etc. 96,000 19% 36,000 6% 63% Other variable costs 192,000 38% 234,000 39% Training 15,000 3% 90,000 15% -500% Other fixed costs 177,000 35% 180,000 30% Totals 20,000 4% 60,000 10% 200% Note that variable costs and fixed costs as a percentage of sales have slightly increased. However, investment in employee training has reduced waste, etc. by 63% from its current levels in spite of the increase in sales. The investment in training has more than paid off through lower costs, increased sales, and higher profits. Sample Quiz 1. Lead indicators are measures of final outcomes of management plans and their execution. are measures of early value-chain operations that signal future outcomes of later operations. help decision makers predict later problems and prevent costly mistakes. b and c None of the above. Answer: b Learning Objective: 1 2. Major type(s) of lag indicators are/is a. organizational learning and growth. b. business and manufacturing process efficiency. c. customer satisfaction and loyalty. d. All of the above. e. financial statements and inventory values. Answer: e Learning Objective: 1 3. Measures of efficiency include a. high quality. b. high productivity. c. long cycle time. d. All of the above. e. a and b Answer: e Learning Objective: 1 4. Throughput efficiency is the a. time spent adding customer value to products and services. b. total cycle time. c. ratio of work content to lead time. d. All of the above. e. a and b Answer: c Learning Objective: 1 5. Total factor productivity is the a. value of goods and services divided by total cost of providing them. b. total cost of goods and services divided by their sales value. c. total cost of goods divided by total cost of services of providing them. d. total sales value of goods and services divided by total number of units produced. e. None of the above. Answer: a Learning Objective: 1 6. Average cycle time equals a. value-added time divided by good units produced. b. value-added time divided by total processing time. c. total processing time divided by good units produced. d. total processing time divided by total units produced. e. None of the above. Answer: c Learning Objective: 1 7. The Balanced Scorecard is a a. causal model of lead indicators of performance. b. causal model of lag indicators of performance. c. causal model of lead and lag indicators of performance. d. cause-and-effect relationship model of financial indicators of performance. e. None of the above. Answer: c Learning Objective: 2 8. Consider these facts for Company A: * rework time 1,760 hours * waiting time 2,880 hours * product assembly 24,400 hours * units produced 1,200 units Average cycle time amounts to a. 20.33 hours. b. 21.60 hours. c. 22.73 hours. d. 24.20 hours. e. None of the above. Answer: d Learning Objective: 2 9. Consider these facts for Company A: rework time 1,760 hours * waiting time 2,880 hours * product assembly 24,400 hours * units produced 1,200 units Throughput efficiency rate is at a. 84% b. 86% c. 89% d. 93% e. none of the above Answer: a Learning objective: 2 10. Company B’s total defects amounted to 420 units from a total output of 2,100 in 2002. In 2003, the company had the same number of units of defects from a production of 3,360. Percent improvement in performance from 2002 amounts to a. 0 % b. 7.5% c. 12.5% d. 37.5% e. none of the above Answer: d Learning objective: 4 11. The learning and growth dimension of the balanced scorecard may include a. employee training and education b. employee satisfaction c. employee turnover d. innovations e. all of the above Answer: e Learning objective: 4 12. The learning and growth dimension of the balanced scorecard may include a. innovations b. opportunities for improvement c. supplier relations d. all of the above e. a and b Answer: a and b Learning objective: 4 13. Business and production processes efficiency may include a. new service development b. employee productivity and error rates c. service costs d. all of the above e. a and b Answer: d Learning objective: 4 14. Dimensions of company performance may include a. learning and growth. b. business and production process efficiency. c. customer value and financial performance. d. All of the above. e. b and c Answer: e Learning Objective: 4 15. Proactive use of balanced scorecard can lead to a. creation of customer value at lower cost. b. loyal customers who continue to buy the firm’s products. c. increased profitability. d. All of the above. e. b and c Answer: d Learning Objective: 4 16. An upstream element in a financial planning model may be change in retention of existing customers. change in gross margin ratio. change in the number of bank accounts. All of the above. a. and b Answer: a Learning Objective: 4 17. Advanced Company estimates that spending $22,100 in employee training, and hiring a customer service representative at the cost of $27,800 a year will result in reducing variable production costs by four percent and increasing sales by eleven percent. Production and sales amount to 4,000 units; selling price is $190 per unit; and total product cost is $150 — 70% of which is variable cost. The net advantage/disadvantage of this endeavor amounts to $3,452 disadvantage. $5,300 disadvantage. $6,148 advantage. $9,600 advantage. None of the above. Answer: c Learning Objective: 3 18. Advanced Company estimates that spending $22,100 in employee training will result in reducing production costs by four percent, and hiring a customer service representative at the cost of $27,800 a year will increase sales by eleven percent. Production and sales amount to 4,000 units, selling price is $190 per unit, and total product cost is $150 — 70% of which is variable cost. The net advantage of the acceptable project amounts to a. $13,348 b. $11,248 c. $6,148. d. $9,600. e. None of the above. Answer: a Learning Objective: 3 19. Advanced Company estimates that spending $22,100 in employee training, and hiring a customer service representative at the cost of $27,800 a year will result in reducing variable production costs by four percent and increase sales by eleven percent. Other costs will increase by $11,448. Production and sales amount to 4,000 units, selling price is $190 per unit, and total product cost is $150 — 70% of which is variable cost. The net disadvantage of the unacceptable project amounts to a. $3,452. b. $5,300. c. $6,148. d. $9,600. e. None of the above. Answer: b Learning Objective: 3 20. Computer spreadsheets are particularly useful in financial modeling through a. modeling relationships among financial measures of performance. b. modeling relationships among non-financial measures of performance. c. using the spreadsheet program merely as a calculator. d. All of the above. e. a and b. Answer: e Learning Objective: 1 21. Expectancy theory is based on the principle that a. people will act in ways that they expect will provide them with the rewards that they desire and prevent the penalties that they wish to avoid. b. people should act in accordance with the wishes of their employers based on their assigned responsibilities. c. people will act in accordance with what their loved ones wants them to do. d. people should act in accordance with their moral and religious beliefs. e. None of the above. Answer: a Learning Objective: 8 22. The balanced scorecard normally includes a report that consists of a. the factors of customer satisfaction, customer retention, and growth in market share. b. he factors of employee retention and employee training. c. the factors of promoting higher quality and higher productivity rates. d. the factors of financial, customer, learning and growth, and internal business perspectives. e. None of the above. Answer: d Learning Objective: 2 23. The financial perspective of the balanced scorecard includes a. the factors of customer satisfaction, customer retention, and growth in market share. b. the factors of employee retention and employee training. c. the factors of promoting higher quality and higher productivity rates. d. the factors of financial, customer, learning and growth, and internal business perspectives. e. None of the above. Answer: e Learning Objective: 2 24. The financial perspective of the balanced scorecard could include a. efficient and effective use of assets. b. improvement in company liquidity. c. increases in profitability and market value of its shares. d.All of the above. e. b and c Answer: d Learning Objective: 2 25. A measure of performance in learning and growth could be a. employee turnover rate. b. employee hours spent in training. c. estimating the value of employee suggestions. d. All of the above. e. a and b Answer: e Learning Objective: 2 26. A measure of performance on customer perspective could be a. percent of customers retained each year. b. percent of companies in the region who do business with the firm. c. the amount of return on assets. d. All of the above. e. a and b Answer: e Learning Objective: 2 27. An internal business and production process measure of performance could be a. return on equity. b. growth in market value of shares. c. reducing the inventory levels. d.All of the above. e. a and b Answer: c Learning Objective: 2 28. C+ Company had an income before tax of $95,000. Total assets amount to $550,000. From this amount, 35% is in equities and $180,000 is in long-term debt. The company has a cost of capital requirement of 12%. Tax rate is at 20% of income. EVA for this firm amounts to a. $10,000 b. $18,300 c. $28,000 d. $31,300 e. None of the above. Answer: d Learning Objective: 5 29. C+ Company had an income before tax of $95,000. Total assets amount to $550,000. From this amount, 30% is in equities and $180,000 is in long-term debt. The company has a cost of capital requirement of 12%. Tax rate is at 20%. Return on investment amounts to a. 13.8% b. 17.3% c. 19.0% d. 20.8% e. None of the above. Answer: b Learning Objective: 5 Use this data to respond to questions 30 and 32. A+ Consulting rewards its managers’ based on performance. A measure of performance is profitability. Another measure may be growth in stock value. Profit has decreased by 50 % from prior year amount of $80,000, and stock value has increased by 20% from its prior year level of $200,000. 30. If manager’s compensation is based on 25% of profits, his compensation for the prior year amounts to a. $60,000 b. $50,000 c. $30,000 d. $20,000 e. None of the above. Answer: d Learning Objective: 5 31. If manager’s compensation is based on 25% of the value of stocks, his compensation for the current year amounts to a. $60,000 b. $50,000 c. $30,000 d. $20,000 e. None of the above. Answer: a Learning Objective: 5 32. If manager’s compensation is based on 25% of future stock growth and the stock value doubles from its current levels, his compensation will amount to a. $20,000 b. $40,000 c. $60,000 d. $80,000 e. None of the above. Answer: c Learning Objective: 5 33. B+ Company bases its managers’ rewards on overall performance. The two managers receive 40% of the overall profit, which is divided equally between them. Division 1 had a profit of $90,000 and division 2 had a profit of $210,000. Division 1 manager’s profit sharing amounts to a. $36,000 b. $84,000 c. $60,000 d. $120,000 e. None of the above. Answer: c Learning Objective: 5 34. C+ Company bases its managers’ rewards on divisional performance. Each manager receives 40% of the division’s profit less $10,000 for reserves, which is subtracted from profit before distribution of the balance to the manager. Division 1 had a profit of $90,000, and division 2 had a profit of $210,000. Division 1 manager’s profit sharing amounts to a. $32,000 b. $36,000 c. $80,000 d. $84,000 e. None of the above. Answer: a Learning Objective: 5 35. E+ Company board of directors is consideration to compensate its CEO based on 30% of either excess sales growth or excess stock price growth if the growth is in excess of 8%. Sales amounted to $200,000 with a growth rate of 23%. Common stock price grew from a total of $400,000 by 18%. If excess sales growth method was chosen as a basis for CEO’s compensation, the amount would be a. $9,000 b. $10,000 c. $11,000 d. $12,000 e. None of the above. Answer: a Learning Objective: 5 Use this data to respond to questions 36 through 40. G+ is a division of GHI Company. This data pertains to G+ division. Sales amounted to $800,000. Cost of sales is 60% of sales. Other direct expenses of the division amount to 15% of sales. Allocated expenses are $90,000. Interest amounts to 10% of long-term debt. Taxes are 30% of income. Total assets are $500,000 with 10% representing short-term and 40% representing long-term debt. 36. The division’s cost of sales amount to a. $320,000 b. $380,000 c. $420,000 d. $480,000 e. None of the above. Answer: d Learning Objective: 5 37. The division’s direct expenses amount to a. $120,000 b. $150,000 c. $180,000 d. $200,000 e. None of the above. Answer: a Learning Objective: 5 38. The division’s taxes amounts to a. $20,000 b. $22,000 c. $25,000 d. $27,000 e. None of the above. Answer: d Learning Objective: 5 39. Division’s net income amounts to a. $63,000 b. $70,000 c. $83,000 d. $90,000 e. None of the above. Answer: a Learning Objective: 5 40. Division’s EVA, assuming an average cost of capital of 10%, amounts to a. $18,000 b. $21,000 c. $24,000 d. $27,000 e. None of the above. Answer: a Learning Objective: 5 Instructor Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533