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

Chapter 18 Organizational Design, Responsibility Accounting, and Evaluation of Divisional Performance ANSWERS TO REVIEW QUESTIONS 18.1 Goal congruence results when the managers of subunits throughout an organization strive to achieve objectives that are consistent with the goals set by top management. In order for the organization to be successful, the managers and employees throughout the organization must be striving toward consistent goals. 18.2 Some responsibility centers are responsible only for costs. The assembly unit of a manufacturing plant would be a good example. On the other hand, some responsibility centers, such as sales offices, are responsible for revenues. Other responsibility centers such as corporate divisions are responsible for both revenues and costs. Finally, some responsibility centers are responsible for revenues, costs, and investment in company assets. The chief executive officer is the prime example of this. The designation of responsibility centers depends on the specific organizational structure and management system in the organization. 18.3 There exists a number of accounting alternatives that can be chosen by management. Moreover, financing decisions (e.g., lease vs. buy) may also be selected by management. The alternative chosen can have an impact on the reported accounting numbers and the reported investment base. If management compensation is dependent upon the income measure (and, possibly, in conjunction with the investment base), management may have a pecuniary incentive to choose a specific alternative even though such a choice may not be in the optimal long-run interest of the company. By choosing both the measurement system and the operating decisions, there may be a conflict of interest for the agent-manager. 18.4 In many cases managers are content to take a stated salary and perform optimally. However, in other organizations managers perform better when given profit targets and other incentives. Lower level managers are also closer to their respective markets. With an incentive system these managers are more likely to take actions to respond to changes in their respective markets. However, an executive manager elects the performance evaluation and incentive system that is best for the specific organization. Hence, the executive’s comments would make sense in the right organization setting. 18.5 The five types of responsibility centers are described as follows: • Cost center: A responsibility center, the manager of which is accountable for the subunit's costs. (An example is a production department in a manufacturing firm.) • Discretionary cost center: A responsibility center, the manager of which is held responsible for the subunit’s costs, and in which there is not a well specified relationship between inputs and outputs. • Revenue center: A responsibility center, the manager of which is accountable for the subunit's revenue. (An example is a sales district in a wholesaling firm.) • Profit center: A responsibility center, the manager of which is accountable for the subunit's profit. (An example is a particular restaurant in a fast-food chain.) • Investment center: A responsibility center, the manager of which is accountable for the subunit's profit and the capital invested to generate that profit. (An example is a commuter airline division of an airline company.) 18.6 ROI measures scale the division accounting profit by the investment required. Managers would have incentives to maximize accounting measures of profit without regard to the investment required if only profits are evaluated. (Use of economic profits would not have this problem, of course.) 18.7 This problem arises more frequently than one would hope. Since costs are accumulated in responsibility centers usually according to where the cost is incurred, it is quite likely that the production department will be charged with a cost that originated by the action of some other (e.g., sales) department. In accepting the rush order, the sales department would either have raised the selling price to compensate for the special delivery or undertaken the rush order to avoid losing a sale. The extra costs incurred in other departments as a direct result of the sales department's action should be chargeable back to the sales department. 18.8 If the return on a specific project is greater than the company’s cost of capital, but this return is lower than the division’s average ROI, a division manager would have an incentive to avoid that project even though it would benefit the company as a whole. 18.9 Example of the calculation of residual income: Suppose an investment center's profit is $100,000, invested capital is $800,000, and the imputed interest rate is 12 percent: Residual income = $100,000  ($800,000) (12%) = $4,000 The imputed interest rate is used in calculating residual income, but it is not used in computing ROI. The imputed interest rate reflects the firm's minimum required rate of return on invested capital. 18.10 The use of gross book value instead of net book value to measure a division's invested capital eliminates the problem of an artificially increasing ROI or residual income across time. Also, the usual methods of computing depreciation, such as straight-line or declining-balance methods, are arbitrary. As a result, some managers prefer not to allow these depreciation charges to affect ROI or residual-income calculations. 18.11 The economic value added (EVA®) is defined as follows: EVA® is a registered trademark of Stern Stewart. Economic value added differs from residual income in its subtraction of the investment center’s current liabilities and its specific use of the weighted-average cost of capital. 18.12 An alternative to using ROI, residual income, or EVA to evaluate a division is to look at its income and invested capital separately. Actual divisional profit for a period of time is compared to a flexible budget, and variances are used to analyze performance. The division's major investments are evaluated through a post-audit of the investment decisions. This approach avoids the necessity of combining profit and invested capital in a single measure, such as ROI or residual income. ANSWERS TO CRITICAL ANALYSIS 18.13 It would be appropriate to change a particular plant from a profit center to an investment center if the manager of the plant is given the authority to make significant investment decisions affecting the plant’s resources. 18.14 Rarely does a single individual completely control a result in an organization. Most results are caused by the joint efforts of several people and the joint impact of several events. Nevertheless, there is usually a person who is in the best position to explain a result or who is in the best position to influence the result. In this sense, performance reports based on controllability really are based on a manager's ability to influence results. 18.15 Large divisions are, all other things being equal, more likely to rank in the upper half. Hence, a large division manager would tend to receive a bonus with performance that is just barely above the cost of capital whereas a smaller division might need to earn a return far in excess of the cost of capital in order to earn a bonus. The approach used also does not take into account differences in capital charges that might be appropriate for different divisions. 18.16 It is important to make a distinction between an investment center and its manager, because in evaluating the manager's performance, only revenues and costs that the manager can control or significantly influence should be included in the profit measure. The objective of the manager's performance measure is to provide an incentive for that manager to adhere to goal-congruent behavior. In evaluating the investment center as a viable economic investment, all revenues and costs that are traceable to the investment center should be considered. Controllability is not an issue in this case. 18.17 A division's ROI can be improved by improving the sales margin, by improving the capital turnover, or by some combination of the two. The manager of the automobile division of an insurance company could improve the sales margin by increasing the profit margin on each insurance policy sold. As a result, every sales dollar would generate more income. The capital turnover could be improved by increasing sales of insurance policies while keeping invested capital fixed, or by decreasing the invested assets required to generate the same sales revenue. 18.18 If the division can rent and the rent does not have to be capitalized for inclusion in the investment base, the residual income will increase so long as the income from the asset exceeds the lease payment. 18.19 The chief disadvantage of ROI is that for an investment that earns a rate of return greater than the company's cost of raising capital, the manager in charge of deciding about that investment may have an incentive to reject it if the investment would result in reducing the manager's ROI. The residual-income measure eliminates this disadvantage by including in the residual-income calculation the imputed interest rate, which reflects the firm's cost of capital. Any project that earns a return greater than the imputed interest rate will show a positive residual income. 18.20 (1) Total assets: Includes all divisional assets. This measure of invested capital is appropriate if the division manager has considerable authority in making decisions about all of the division's assets, including nonproductive assets. (2) Total productive assets: Excludes assets that are not in service, such as construction in progress. This measure is appropriate when a division manager is directed by top management to keep nonproductive assets, such as vacant land or construction in progress. (3) Total assets less current liabilities: All divisional assets minus current liabilities. This measure is appropriate when the division manager is allowed to secure short-term bank loans and other short-term credit. This approach encourages investment-center managers to minimize resources tied up in assets and maximize the use of short-term credit to finance operations. 18.21 Using ROI as the sole performance measurement index will tend to discourage new investment and innovation. Managers will tend to focus on short-run performance. Quality tends to be sacrificed for quantity. Bleak Prospects could improve its situation by adopting a performance system that includes nonfinancial measures of performance such as requiring that a certain level of sales come from new products and that defective goods and rework rates be below a certain level. 18.22 The rise in ROI or residual income across time results from the fact that periodic depreciation charges reduce the book value of the asset, which is generally used in determining the investment base to use in the ROI or residual-income calculation. This phenomenon can have a serious effect on the incentives of investment-center managers. Investment centers with old assets will show higher ROIs than investment centers with relatively new assets. This result can discourage investment-center managers from investing in new equipment. If this behavioral tendency persists for a long time, a division's assets can become obsolete, making the division noncompetitive. SOLUTIONS TO EXERCISES 18.23 (10 min) Designating responsibility centers The type of responsibility center most appropriate for each of the following organizational subunits is indicated below. • Movie theater: Cost center or profit center. • Radio station: Profit center. • Claims department: Cost center. • Ticket sales division of an airline: Revenue center. • Bottling plant: Cost center. • Orange juice factory: Profit center. • College of engineering at a university: Profit center. (By designating the college of engineering as a profit center, this subunit is encouraged to generate research grants and manage its operations most effectively. The term "profit center" is used in a slightly different way here. No subunit in a university really makes a profit. However, treating the college of engineering like a profit center means that this subunit's management will have considerable authority in managing the subunit's revenues and expenses.) • European division of a multinational manufacturing company: Investment center. • Outpatient clinic in a profit-oriented hospital: Profit center. • Mayor's office of a city: Cost center. 18.24 (45 min) Return on investment ROI is an often-used indicator for how well a business uses its invested capital to earn a profit. It can be improved by increasing sales margins, and/or decreasing invested capital or increasing capital turnover. For example, The Wall Street Journal reported that 7-Eleven planned a large increase in capital investment to fund its technology systems in order to improve supply chain management and offer new services to customers. This action will (on its own) decrease ROI. A key question is whether this negative effect on ROI will outweigh the improved sales margins expected from the improved supply chain management, and the improved sales revenue expected from the added customer services. 18.25 (50 min) Performance report for hotel PERFORMANCE REPORTS FOR AUGUST: SELECTED SUBUNITS OF OVERLOOK INN (IN THOUSANDS) Flexible Budget* Actual Results* Variance† Food and Beverage Department Banquets & Catering $ 649 $ 657 $ 8 F Restaurants 1,801 1,795 6 U Kitchen (1,065) (1,069) 4 U Total profit $ 1,385 $ 1,383 $2 U Kitchen Kitchen staff wages $ (85) $ (86) $1 U Food (690) (690) — Paper products (125) (122) 3 F Unit-level (var.) overhead (75) (78) 3 U Facility-level (fix.) overhead… (90) (93) 3 U Total expense $(1,065) $(1,069) $4 U *Numbers without parentheses denote profit; numbers with parentheses denote expenses. †F denotes favorable variance; U denotes unfavorable variance. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 18.26 (10 min) Responsibility accounting; equipment breakdown The appropriate responsibility-accounting treatment for each of the scenarios is the following: a. Since the cost of idle time incurred in Department B was due to the breakdown of improperly maintained machinery in Department A, the costs of the idle time should be charged to Department A. b. If the machinery had been properly maintained, it would be more appropriate not to charge the cost due to idle time in Department B back to Department A. This cost should be considered a normal cost of operating in a sequential production environment. The managers of Department B should anticipate such normal machine breakdowns and plan their production scheduling to accommodate them. 18.27 (25 min) ROI versus residual income Argentina’s peso is denoted below by p. Annual income = 140,000 p – (360,000 p ÷ 5) = 68,000 p 0 Year 0 Investment: Beginning of Year 0 Investment: End of Year* 0 Base: Average Investment** 0 (a) ROI 68,000 p Base 0 (b) Residual Income 68,000 p – (25% x Base) 1 360,000 p 288,000 p 324,000 p 21.0% (13,000) p 2 288,000 p 216,000 p 252,000 p 27.0% 5,000 p 3 216,000 p 144,000 p 180,000 p 37.8% 23,000 p 4 144,000 p 72,000 p 108,000 p 63.0% 41,000 p 5 72,000 p 0 p 36,000 p 188.9% 59,000 p *Beginning of year balance less annual depreciation of 72,000 p (360,000 p ÷ 5) **Average of beginning-of-year and end-of-year investment balances. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 18.28 (10 min) Impact of new project on performance measures a. ROI before: b. ROI after: *$46,500 = $84,000 – ($225,000 / 6) 18.29 (10 min) Impact of leasing on performance measures a. With the lease, the incremental income is the operating cash flow minus the lease payment or $10,000 = $84,000 – $74,000. The new ROI is: b. RI = $390,000 – .2($1,300,000) = $130,000 c. $130,000 +$84,000 – ($225,000 / 6) - .2($225,000) = $131,500 OR $390,000 + $84,000 – ($225,000 / 6) - .2($1,300,000 + $225,000) = $131,500 d. $130,000 + $84,000 – $74,000 = $140,000 OR ($390,000 + $84,000 – $74,000) – .2($1,300,000) = $140,000 18.30 (10 min) Compare alternative measures of division performance a. Using return on investment measures (* denotes greater ROI): *East: ($35,000 / $100,000) = 35% West: ($195,000 / $750,000) = 26% Using residual income measures (* denotes greater residual income): East: $35,000 – (21% x $100,000) = $14,000 *West: $195,000 – (21% x $750,000) = $37,500 b. Yes. *East: $35,000 – (26% x $100,000) = $9,000 West: $195,000 – (26% x $750,000) = 0 *Indicates division with “better” performance. 18.31 (45 min) Internet search of annual reports; ROI and residual income a. Students’ calculation of return on investment and residual income will depend on the company selected and the year when the internet search is conducted. Students will need to decide how to determine the income and the invested assets to use in both calculations. The discussion in the text will serve as a guide in this regard. b. Some companies’ annual reports include a calculation and discussion of ROI in the “management report and analysis” section or the “financial highlights” section. Students’ calculation of ROI may differ from management’s due to differing assumptions about the determination of income and invested capital. 18.32 (45 min) Historical cost, net book value vs. gross book value a. and b. Comparing results using net book value and gross book value: a. Net Book Value b. Gross Book Value Year 1: ($1,000,000 – $400,000) ($1,000,000 – $400,000) ($4,000,000 – $400,000) $4,000,000 = $600,000/$3,600,000 = 16.7% = $600,000/$4,000,000 = 15% Year 2: ($1,000,000 – $400,000) ($1,000,000 – $400,000) [$4,000,000 – (2 x $400,000)] $4,000,000 = $600,000/$3,200,000 = 18.8% = $600,000/$4,000,000 = 15% Year 3: ($1,000,000 – $400,000) ($1,000,000 – $400,000) [$4,000,000 – (3 x $400,000)] $4,000,000 = $600,000/$2,800,000 = 21.4% = $600,000/$4,000,000 = 15% Year 4: ($1,000,000 – $400,000) ($1,000,000 – $400,000) [$4,000,000 – (4 x $400,000)] $4,000,000 = $600,000/$2,400,000 = 25% = $600,000/$4,000,000 = 15% EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 18.32 (continued) c. Using beginning-of-year asset values: (1) Net Book Value (2) Gross Book Value Year 1: ($1,000,000 – $400,000) ($1,000,000 – $400,000) $4,000,000 $4,000,000 = $600,000/$4,000,000 = 15% = $600,000/$4,000,000 = 15% Year 2: ($1,000,000 – $400,000) ($1,000,000 – $400,000) ($4,000,000 – $400,000) $4,000,000 = $600,000/$3,600,000 = 16.7% = $600,000/$4,000,000 = 15% Year 3: ($1,000,000 – $400,000) ($1,000,000 – $400,000) [$4,000,000 – (2 x $400,000)] $4,000,000 = $600,000/$3,200,000 = 18.8% = $600,000/$4,000,000 = 15% Year 4: ($1,000,000 – $400,000) ($1,000,000 – $400,000) [$4,000,000 – (3 x $400,000)] $4,000,000 = $600,000/$2,800,000 = 21.4% = $600,000/$4,000,000 = 15% (3) Naturally, there is no change under the gross book value method. With the net method, both alternatives (using end-of-year asset values versus beginning-of-year values) show the same trend of rising ROIs as the assets depreciate. This is to be expected. The end-of-year value is the next year’s beginning-of-year value. 18.33 (20 min) Weighted-average cost of capital The weighted-average cost of capital (WACC) is defined as follows: The interest rate on Chelsea Construction Associates’ $60 million of debt is 10 percent, and the company’s tax rate is 40 percent. Therefore, the after-tax cost of debt is 6 percent [10%  (140%)]. The cost of Chelsea’s equity capital is 14 percent. Moreover, the market value of the company’s equity is $90 million. The following calculation shows that Chelsea’s WACC is 10.8 percent. 18.34 (20 min) Economic value added (EVA) The economic value added (EVA) is defined as follows: For Chelsea Construction Associates, we have the following calculations of each division’s EVA. Division After-Tax Operating Income (in millions) Total Assets (in millions) Current Liabilities (in millions) WACC Economic Value Added (in millions) Real Estate $20(1.40)  $100  $6  .108 = $1.848 Construction $18(1.40)  $ 60  $4  .108 = $4.752 SOLUTIONS TO PROBLEMS 18.35 (35 min) Designating responsibility centers for a hotel Memorandum Date: Today To: H. I. Peak, General Manager of Estes Park Hotel and Resort From: I.M. Student Subject: Responsibility Centers Estes Park Hotel and Resort is a profit center as specified by the corporation's top management. The hotel's general manager does not have the authority to make significant investment decisions, so an investment-center designation would be inappropriate for the hotel. The Grounds and Maintenance Department and the Housekeeping and Custodial Department should be cost centers, since these departments do not generate revenue. The Food and Beverage Department should be a profit center, since the department's manager can influence both the costs incurred in the department and the revenue generated. The Food and Beverage Director can determine the menu, set meal prices, and make entertainment decisions, all of which significantly influence the department's revenue. The Hospitality Department also should be a profit center. The Director of Hospitality has significant influence in setting room rates and making decorating decisions, which affect the department's revenue. The Director also makes hiring and salary decisions for the department's staff, which significantly affect departmental expenses. The Hospitality Department's three subunits (Front Desk, Bell Staff, and Guest Services) should be cost centers, since they do not generate revenue. The managers of these subunits can significantly influence the costs incurred in their units through hiring and salary recommendations, staff scheduling, and use of materials and equipment. 18.36 (45 min) Designing a responsibility accounting system Memorandum Date: Today To: Sandra Jefferson, President of Albuquerque Medical Equipment Company From: I. M. Student Subject: Responsibility-Accounting System Albuquerque Medical Equipment Company's critical success factors are as follows: 1. Cost-efficient production: The firm must meet the market price, which implies producing in a cost-efficient manner. 2. High product quality: Stated by the company president as necessary for success. 3. On-time delivery: Also noted by the company president as critical to the firm's success. Note that the product price is not a critical success factor, since it is largely beyond the company's control. The price is determined by the market. A responsibility-accounting system in which the plants are profit centers is consistent with achieving high performance on the firm's critical success factors. The plant managers are in the best position to influence production cost control, product quality, and on-time delivery. The sales districts should be revenue centers, in which the sales district managers are accountable for meeting sales projections. Suppose the plants are cost centers and the sales districts are revenue centers. When a rush order comes in, the plant manager's incentive is to reject it because rush orders tend to increase production costs (due to increased setups, interrupted production, etc.). The sales district manager's incentive is to push rush orders, because accepting a rush order results in a satisfied customer and increased future business. Thus, there is a built-in conflict between the plant managers and the sales district managers. 18.36 (continued) If the plants are profit centers, then each plant manager is encouraged to consider both the costs and the benefits of a rush order. The cost is increased production cost, and the benefit is a satisfied customer. Since the plant manager is rewarded for achieving a profit, he or she has an incentive to weigh the cost-benefit trade-off inherent to the rush-order problem. In conclusion, I recommend that the plants be designated as profit centers and the sales districts be designated as revenue centers. 18.37 (40 min) Analyze performance report for decentralized organization a. An evaluation of the performance of Patrick Anderson for the nine months ending September, Year 3 would appear favorable if only the divisional residual income figure were considered. The actual residual income is well above the nine month budgeted figure. However, closer examination of the report reveals that overall performance cannot be considered satisfactory for the following reasons: • Variable cost of sales (direct material and labor) have increased significantly as a percentage of sales, i.e., 45.2% ($995/$2,200) versus 38% ($798/$2,100). • The maintenance and repair costs implied in the budget and probably needed have not been incurred. • Allocated corporate fixed costs are below budget. While these costs should have no effect on the performance of this division, its inclusion in the report does affect the residual income figure. Corporate policy dictates that division managers minimize their investment in inventories and maintain control over plant fixed assets. In this respect, Anderson has not performed as well as expected for reasons described as follows: • Inventories have increased significantly relative to sales volume and to divisional investment. • Budgeted additions to plant fixed assets have not been made. The decision to postpone obtaining these fixed assets at the division level could have been made for the purpose of reducing the investment base and the imputed interest charge, or to reduce the investment base. b. A performance evaluation system should reflect the division manager’s responsibilities (i.e., those things that are specifically controllable by the division manager and for which the division manager is held accountable). A good division performance measurement should present the performance of the manager unobscured by extraneous items that are not subject to the D.M.’s control. In this instance, American Traditions’ divisional management is solely responsible for the production and distribution of corporate products. 18.37 (continued) Specific features of the performance measurement reporting and evaluation system which should be revised are as follows: • A flexible budget based upon production as well as sales should be used so that divisions can better reflect the actual level of activity achieved. • Fixed divisional costs should be so identified and subtracted from a divisional contribution margin. • Allocated corporate fixed costs obscure the division’s performance since such costs are not subject to division management control. Ideally, corporate level fixed costs should not be allocated. However, if corporate management feels it necessary to allocate corporate level fixed costs, they should be relegated to a position as a final subtract item from divisional residual income. • The investment base used to compute residual income uses year-end values for receivables and inventories as opposed to some average-value method. An average value would more accurately reflect the activities in these accounts over the time period being analyzed. • Plant assets are under the joint authority of the division and the corporation, thereby limiting the control at the divisional level. 18.38 (60 min) Preparation of performance reports for a hospital a. Performance Report for August: Selected Subunits of Bay State General Hospital Flexible Budget Actual Results Variance* Year Year Year to to to August Date August Date August Date Bay State General Hospital $582,700 $4,661,600 $581,150 $4,658,300 $1,550 F $3,300 F General Medicine Division $210,000 $1,680,000 $204,000 $1,670,900 $6,000 F $9,100 F Surgical Division 140,000 1,120,000 141,000 1,115,800 1,000 U 4,200 F Medical Support Division 182,700 1,461,600 182,650 1,465,600 50 F 4,000 U Administrative Division 50,000 400,000 53,500 406,000 3,500 U 6,000 U Total cost $582,700 $4,661,600 $581,150 $4,658,300 $1,550 F $3,300 F Medical Support Division Nursing Department $70,000 $560,000 $75,000 580,000 $5,000 U $20,000 U Radiology and Labor-atory Department 18,000 144,000 18,100 144,000 100 U -- Nutrition Department 71,700 573,600 71,950 578,600 250 U 5,000 U Housekeeping Department 10,000 80,000 11,600 86,000 1,600 U 6,000 U Maintenance Department 13,000 104,000 6,000 77,000 7,000 F 27,000 F Total cost $182,700 $1,461,600 $182,650 $1,465,600 $ 50 F $4,000 U Nutrition Department Regiestered Dieticians’ Section $ 7,500 $60,000 $7,500 $ 60,000 -- -- Food Service Section 33,200 265,600 35,050 272,600 $1,850 U $7,000 U Kitchen 31,000 248,000 29,400 246,000 1,600 F 2,000 F Total cost $71,700 $573,600 $71,950 $ 578,600 $ 250 U $5,000 U Food Service Section Patient Food Service $17,000 $136,000 $18,500 $ 137,000 $1,500 U $1,000 U Cafeteria 16,200 129,600 16,550 135,600 350 U 6,000 U Total cost $33,200 $265,600 $35,050 $ 272,600 $1,850 U $7,000 U Cafeteria Food servers’ wages $8,000 $64,000 $9,000 $ 72,000 $1,000 U $8,000 U Paper products 4,500 36,000 4,400 36,200 100 F 200 U Utilities 1,000 8,000 1,050 8,100 50 U 100 U Maintenance 400 3,200 100 1,100 300 F 2,100 F Custodial 1,050 8,750 1,050 8,550 -- 200 F Supplies 1,250 9,650 950 9,650 300 F -- Total cost $16,200 $129,600 $16,550 $135,600 $350 U $6,000 U *F denotes favorable variance; U denotes unfavorable variance. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE b. Arrows are included on the performance report to show the cost relationships. 18.38 (continued) c. A variety of responses are reasonable for this question. Since the data given in the problem do not include the individual variances over several months, it is not possible to condition the investigation on trends. The largest variances in the performance report are the most likely to warrant an investigation. The following variances for August would likely catch the attention of the hospital administrator: General Medicine Division $6,000 F Administrative Division 3,500 U Nursing Department 5,000 U Maintenance Department 7,000 F Food servers' wages 1,000 U The $1,000 variance for food servers' wages is smaller than some of the variances not listed above. However, it is a relatively large variance for only one cost item in the subunit. In contrast, the $1,600 variance for the kitchen is for an entire subunit of the hospital. 18.39 (55 min) ROI and residual income a. The missing amounts are indicated in the following table, and explanatory notes follow. Dayton Division Cincinnati Division Sales revenue $10,000,000 $2,000,000e Income $ 2,000,000 $ 400,000 Average investment $ 2,500,000 $2,000,000f Sales margin 20%a 20% Capital turnover 4b 1 ROI 80%c 20%g Residual income $ 1,800,000d $ 240,000h Explanatory notes for requirement (a): c ROI = sales margin  capital turnover = 20%  4 = 80% d Residual income = income – (imputed interest rate)(invested capital) = $2,000,000 – (8%)($2,500,000) = $1,800,000 e Sales margin = 20% = Therefore, sales revenue = $2,000,000 18.39 (continued) fCapital turnover = 1 = Therefore, invested capital = $2,000,000 gROI = sales margin  capital turnover ROI = 20%  1 = 20% hResidual income = income – (imputed interest rate)(invested capital) = $400,000 – (8%)($2,000,000) = $240,000 b. Answers will vary widely. Three ways to increase the Dayton Division’s ROI are: (1) Increase income, while keeping invested capital the same. Suppose income increases to $2,250,000. The new ROI is: (2) Decrease invested capital, while keeping income the same. Suppose invested capital decreases to $2,400,000. The new ROI is: (3) Increase income and decrease invested capital. Suppose income increases to $2,100,000 and invested capital decreases to $2,400,000. The new ROI is: c. ROI = sales margin x capital turnover = 25% x 1 = 25% 18.40 (30 min) Equipment replacement and performance measures a. $750,000 [($800,000 + $1,000,000) + ($800,000 + $1,000,000 – $300,000 – $250,000)]/2* = 49.2% *Average investment equals average of beginning and ending asset balances for year. b. $750,000 – $700,000* [($800,000 + $1,000,000) + ($800,000 + $1,000,000 – $300,000 – $250,000)]/2** = 3.28% *Loss on old equipment equal to its $1 million cost less $300,000 depreciation. **Average investment equals average of beginning and ending asset balances for year. c. $1,005,000* [($550,000 + $1,300,000) + ($550,000 + $1,300,000 – $400,000** – $250,000)]/2*** = 65.9% *Net income: Revenues $3,520,000 (up 10%) Expenses: Variable 440,000 (up 10%) Fixed 1,425,000 (down 5%) Depreciation: Equipment 400,000 *** Other 250,000 Net income………….. $1,005,000 **$400,000 = ($1,300,000 - $100,000) / 3 years *Average investment equals average of beginning and ending asset balances for year. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 18.40 (continued) d. Ideally, all managers in an organization should try to make decisions that are optimal for the whole company. However, it is difficult to fault a division manager who optimizes for his or her division, particularly when the incentive system is designed to encourage the division manager to maximize divisional performance measures such as ROI, residual income or EVA. 18.41 (20 min) Evaluation of trade-offs in return measurement a. The machine is going to result in a positive net benefit so you would want to acquire it as early in the year as possible so you could obtain a full year’s benefits. b. For the manager, the relevant cost is the lost bonus this year if the machine is purchased this year versus the effect on the manager’s bonus that would arise from the increased depreciation charge. If the manager waits until next year, then the return on investment for this year would be the 49.2% as indicated in requirement (a) of the preceding problem. For the coming year, the ROI would be calculated as shown below. (This calculation assumes that the new equipment is bought at the beginning of the year.) $940,000 – $700,000 = $240,000 = 18.0% $800,000 – (2 x $250,000) + $1,495,000 – $465,000 $1,330,000 Where: $1,495,000 = $1,300,000 x 1.15 $465,000 = $1,495,000 – $100,000 3 years $700,000 = loss on disposal of the old equipment $940,000 = $1,005,000 + $400,000 – $465,000 For the company, the relevant costs would be the 15% price increase versus any savings the company might realize on its capital costs if it waits until next year. However, it is difficult to see how the division or company would be better off by waiting a few weeks and incurring an added 15% cost. 18.42 (40 min) Increasing ROI or residual income over time Year Income Before Depreciation Annual Depreciation Income Net of Depreciation Average Net Book Value* ROI Based on Net Book Value† Average Gross Book Value ROI Based on Gross Book Value 1 $150,000 $200,000 $(50,000) $400,000 — $500,000 — 2 150,000 120,000 30,000 240,000 12.5% 500,000 6.0% 3 150,000 72,000 78,000 144,000 54.2% 500,000 15.6% 4 150,000 54,000 96,000 81,000 118.5% 500,000 19.2% 5 150,000 54,000 96,000 27,000 355.6% 500,000 19.2% *Average net book value is the average of the beginning and ending balances for the year in net book value. In Year 1, for example, the average net book value is: †ROI rounded to the nearest tenth of 1 percent. a. This table differs from Exhibit 18-6 in that ROI rises even more steeply across time than it does in Exhibit 18-6. With straight-line depreciation, ROI rises from 11.1 percent in Year 1 to 100 percent in Year 5. Under the accelerated depreciation schedule used here, we have a loss in Year 1 and then ROI rises from 12.5 percent in Year 2 to 355.6 percent in Year 5. b. One potential implication of such a ROI pattern is a disincentive for new investment. If a proposed capital project shows a loss or very low ROI in its early years, a manager may worry about the effect on his or her performance evaluation in the early years of the project. In an extreme case, a manager may worry that he or she will no longer have the job when the project begins to show a higher return in its later years. EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE 18.42 (continued) c. Increasing residual income over time: Based on Net Book Value Based on Gross Book Value Year Income Before Depreciation Annual Depreciation Income Net of Depreciation Average Net Book Value* Imputed Interest Charge† Residual Income Average Gross Book Value Imputed Interest Charge† Residual Income 1 $150,000 $100,000 $50,000 $450,000 $45,000 $ 5,000 $500,000 $50,000 0 2 150,000 100,000 50,000 350,000 35,000 15,000 500,000 50,000 0 3 150,000 100,000 50,000 250,000 25,000 25,000 500,000 50,000 0 4 150,000 100,000 50,000 150,000 15,000 35,000 500,000 50,000 0 5 150,000 100,000 50,000 50,000 5,000 45,000 500,000 50,000 0 *Average net book value is the average of the beginning and ending balances for the year in net book value. †Imputed interest charge is 10 percent of the average book value, either net or gross. Notice in the table that residual income, computed on the basis of net book value, increases over the life of the asset. This effect is similar to the one demonstrated for ROI. It is not very meaningful to compute residual income on the basis of gross book value. Notice that this asset shows a zero residual income for all five years when the calculation is based on gross book value. 18.43 (30 min) Decision to capitalize or expense and performance measurement a. Calculation of ROI: ROI: Base Year ROI: Current Year Successful efforts $900,000 ($1,720,000 – $900,000) (used in base year) $6,900,000 ($8,100,000 – $900,000) = 13.0% = 11.4% Full-cost (used by $1,720,000 new management) $8,100,000 = 21.2% b. Calculation of bonus: 10% x $820,000 = $82,000 c. The board should reject the request for a bonus. The purpose of the bonus is to provide an incentive to management to improve actual performance. However, management has just manipulated the figures by which performance is measured. If the accounting method had not been changed, both income and ROI would have shown decreases in the present year. 18.44 (40 min) Divisional performance measurement; behavioral issues a. The proposed Achievement of Objectives System (AOS) would be an improvement over the current measure of divisional performance for the following reasons: • There appears to be greater participation in the establishment of objectives by divisional managers. • The use of multiple criteria for performance measures should be a more equitable standard of evaluation. This performance measure tends to reduce over-emphasis on single measurement criteria and may also balance extremes in performance in one area versus another. • Realistic planning encourages accurate budget estimations and promotes intermediate and long-range objectives, which enhances goal congruence. • Static budgets established six months before the start of the year would be replaced by flexible budgets which would be subject to change as needed. • The emphasis on performance is based upon factors controllable by and upon efforts actually directed by divisional managers. b. Specific performance measures for the criterion “doing better than last year” could include total sales, contribution margin, controllable costs, net income, net income as a function of sales, return on investment, market share, and productivity. Measurement of these items should be compared in absolute terms or by percentages to the prior year. Specific performance measures for the criterion “planning realistically” could include an analysis of variance between actual and budget and the use of a flexible budget to determine sales, net income, net income as a function of sales, and return on investment. Specific performance measures for the criteria “managing current assets” could include accounts receivable turnover, inventory turnover, return on current assets, and year-to-year comparisons of current assets in total and by account classification. 18.44 (continued) c. The motivational and behavioral aspects of the achievement-of-objectives-system depend upon the level of acceptance of the system by top management and the divisional managers. • Divisional managers could have a sense of participation in the role of goal setting and budget development which could encourage goal congruence. • Multiple criteria enhance a sense of equity or fairness, and remove pressures to pursue measured goals, the achievement of which may conflict with corporate long-run objectives (i.e., promotes goal congruence). • Divisional managers should have an increased sense of responsibility and control over activities within their divisions once they are not held responsible for uncontrollable factors. • Top management support along with timely and regular reviews of performance will promote division managers’ feelings of self-worth. Programs which may be instituted to promote morale and give incentives to divisional managers in conjunction with the achievement-of-objectives system include the following. • Intrinsic motivators can be provided by allowing the manager to assess his/her own achievements and his/her own worth. • Extrinsic motivators can be developed through a manager’s competition against him/herself or with other divisions with recognition given to the successful participants in the form of awards or monetary incentives. • Increased morale can result from participation in budget setting and management level decisions as well as having positive feedback. 18.45 (40 min) ROI and management behavior a. Most of the specific actions that division managers can take which would result in increasing division ROI and decreasing corporate ROI relate to investment proposals. The division managers have the responsibility to recommend investment opportunities for their divisions. The facts in the problem would suggest that they have been recommending only investments which are a “sure thing” to increase division ROI and screening out investments which would lower division ROI even though improving corporate ROI. In addition, the postponement of capital investments makes the divisional asset base smaller for the calculation of division ROI. Further, the managers are not likely to recommend projects which would improve division ROI in the long-run but would depress it in the short-run (start-up periods). b. MMTC’s corporate goals and goals for its divisions are not congruent. Improving the division ROI does not automatically lead to improved corporate ROI. Certain actions could be taken by a division which would improve its ROI, such as rejecting an investment below its ROI but above the corporation ROI, but would not necessarily improve corporate ROI. The emphasis on division ROI as the most important appraisal factor for salary changes does not provide the proper motivation because divisional executives are motivated to maximize division ROI without regard to the corporate ROI. Additionally, division managers are indifferent as to the amount and timing of cash flows because cash is not part of the division’s investment base. However, the corporation is not indifferent to cash flow because it has to invest the cash. c. The changes should be two-fold in character. The emphasis on a single measure for performance evaluation should be eliminated. Additional factors important to division and corporate goals should be included. One approach would be to establish a target ROI which would include allowances for start-up costs of long-term projects. The company could consider the residual profits concept of divisional performance measurement. The divisions would be charged “interest” cost of assets employed and performance would be measured on the basis of the division profits above the “interest” charges. Factors other than ROI also should be included in the policy. The long-run success of the company requires attention to such items as: • new products and/or new markets. • new manufacturing technology. • improvement in sales volume and/or market share. • cost efficiency. 18.46 (45 min) Weighted-average cost of capital and EVA a. The weighted-average cost of capital (WACC) is defined as follows: The interest rate on LSB’s $80 million of debt is 9 percent, and the company’s tax rate is 40 percent. Therefore, the after-tax cost of debt is 5.4 percent [9%  (140%)]. The cost of LSB’s equity capital is 14 percent. Moreover, the market value of the company’s equity is $120 million. The following calculation shows that LSB’s WACC is 10.56 percent. b. The economic value added (EVA) is defined as follows: For Louisiana Shrimp Boats, Inc., we have the following calculations of EVA for each of the company’s divisions. Division After-Tax Operating Income (in millions) Total Assets (in millions) Current Liabilities (in millions) WACC Economic Value Added (in millions) Properties $28.9(1.40)  $145  $3  .1056 = $2.3448 Food Service $14.9(1.40)  $ 64  $6  .1056 = $2.8152 EXCEL SOLUTIONS ARE FOUND IN EXCEL SOLUTIONS FILE SOLUTIONS TO CASES 18.47 (30 min) Evaluate performance evaluation system; behavioral issues a. An answer that assumed that managers should only be held responsible for what they control would make the following arguments: The financial reporting and performance evaluation program of Drawem Company is inappropriate as a measure of the responsibilities of the Bildem Division. Bildem is being evaluated as a profit or investment center when it has no control over pricing, production and investment decisions. In actuality, Bildem Division is a cost center and the performance report should only consider costs under the control of Bildem management. Additionally, the corporate general service costs should not be included on the performance report because these costs are not under the control of the division management. Moreover, the allocation basis is artificial in that corporate management determines Bildem Division sales volume. Bildem’s managers currently share some of the organization-wide risk because they are held responsible for things they do not control. Presumably, they must be compensated for sharing this risk if they are risk-averse. On the other hand, they may attain nonpecuniary rewards from being an “investment center” instead of a cost center. Despite the fact that Bildem’s managers are held responsible for things outside of their control, it is not clear that Bildem’s managers or the company would be better off by making Bildem a cost center, although it is a cost center, de facto. b. Following the notion that managers should be held responsible only for what they control, the answer to requirement b would be: The following revisions should be made to Drawem Company’s financial reporting and performance evaluation system. • Evaluate Bildem Division as a cost center and include in the analysis only those costs under the control of division management. • Introduce a budget system possibly including a flexible budget format which would be used with costs classified as fixed and variable. • The allocated corporate general services costs should not be included in the report. However, if management wants to include the corporate services, it should be identified separately and treated as the final addition to division costs. • Corporate computer costs should be included on the report. The amount charged should be based upon actual usage and a predetermined standard rate. • Provided a flexible budget is used for the actual level of production activity, a variance analysis can be included in the evaluation. The variances should be identified as price or efficiency related. 18.47 (continued) • The report could be expected to analyze noneconomic aspects of production other than costs. Performance measures to consider might include manpower levels, inventory levels, order backlogs, training programs, and new products or developments. 18.48 (60 min) Budgeting and responsibility accounting a. Sales projections are made at three levels: • Division managers submit a report to the vice president for the region that includes forecasts for capital, sales, and income. This report is used for strategic planning purposes. • The strategic research team develops sales forecasts for each division while considering economic conditions and current market share for each region. The strategic research team reports directly to the vice president of each region. (See the illustration in the text.) This team is able to more accurately integrate division products and assess demand for complementary products than the individual division managers. • Once the corporate forecast is completed (using the information from division managers and the strategic research team), district sales managers estimate sales for their district. The district sales managers report to the division sales managers for each division. (See the illustration in the text.) However, the district sales managers return their forecasts to the division managers rather than to the division sales manager. The strategic research team and division controller review the forecasts prior to sending the forecasts on to top management (probably to check for reasonableness—the strategic research team and controller likely know more about the division’s market than top management). After the sales budget is approved by top management, it is separated into a sales budget for each plant. Since the sales budget is already established, plant managers are responsible for establishing the budget for costs and profit given specific predetermined sales projections. The plant budgets are established as follows: • Each department within the plant is required to develop cost standards and cost reduction targets. (The department personnel will likely know more about these costs than upper management. Thus, it is reasonable to have them be involved in the process.) • A member of the strategy team and controller review the budget process with the plant manager to make sure the budget is reasonable. • Final budgets are submitted by April 1. 18.48 (continued) The final budgets are fine tuned by the vice presidents and CEO and submitted to the board of directors for approval in early June. (The vice presidents and CEO must be able to justify the budgets to the board, and thus, review it and make any necessary changes before submitting it.) b. The question is: “Should the plants be treated as profit centers (responsible for sales revenue and costs), or as cost centers (responsible only for costs)?” An evaluation of River Beverages’ critical success factors helps to frame the issues. A critical success factor is something that is (1) under the control of the organization, at least partially, and (2) is critical in order for the organization to succeed. River Beverages’ critical success factors are product quality, timeliness of delivery, and cost efficiency. The following table shows the impact of the sales management and the plant management on each of these factors: Critical Success Factor Impact of Sales Mgmt. Impact of Plant Mgmt. ______________________________________________________________________ Quality Little or no impact Great impact Delivery timeliness Great impact Great impact Cost efficiency Little (except “rush orders”) Great impact ______________________________________________________________________ Given the impact of the plant management on all of River Beverages’ critical success factors, the plants should be profit centers. Then the plant managers can make the critical trade-offs regarding accepting or rejecting rush orders, insuring on-time delivery, and controlling production costs. However, the plant managers should be given more of a role in the budgeting process. The sales managers should be given incentives to get orders in on a timely basis. An alternative arrangement is to make both the sales districts and the plants profit centers and use transfer prices as products are shipped. (Chapter 19 covers transfer pricing.) 18.48 (continued) c. The primary question is “what behavior is top management trying to promote with the budgeting process?” In general, River Beverages’ management wants its employees to maximize production efficiency (thus minimizing production costs), and maximize profits. Answers concerning the advantages and disadvantages of the budgeting process will vary. One example is the following: Plant managers are held responsible for sales and costs even though they only have control over costs. Sales departments can cut prices or offer promotional campaigns that negatively affect a plant manager’s profit. In this example, it is not advantageous to assign responsibility for sales to plant managers without control over pricing and promotional decisions. Solution 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