Solution manual cost accounting 12e by horngren ch 23

To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com CHAPTER 23 PERFORMANCE MEASUREMENT, COMPENSATION, AND MULTINATIONAL CONSIDERATIONS 23-1 Examples of financial and nonfinancial measures of performance are: Financial: ROI, residual income, economic value added, and return on sales Nonfinancial: Customer perspective: Market share, customer satisfaction Internal-business-processes perspective: Manufacturing lead time, yield, on-time performance, number of new product launches, and number of new patents filed Learning-and-growth perspective: employee satisfaction, informationsystem availability 23-2 The six steps in designing an accounting-based performance measure are: Choose performance measures that align with top management’s financial goals Choose the time horizon of each performance measure in Step Choose a definition of the components in each performance measure in Step Choose a measurement alternative for each performance measure in Step Choose a target level of performance Choose the timing of feedback 23-3 The DuPont method highlights that ROI is increased by any action that increases return on sales or investment turnover ROI increases with: increases in revenues, decreases in costs, or decreases in investments, while holding the other two factors constant 23-4 Yes Residual income (RI) is not identical to return on investment (ROI) ROI is a percentage with investment as the denominator of the computation RI is an absolute monetary amount which includes an imputed interest charge based on investment 23-5 Economic value added (EVA) is a specific type of residual income measure that is calculated as follows: Economic value After-tax Weighted-average Total assets minus added (EVA) = operating income – cost of capital current liabilities 23-6 Definitions of investment used in practice when computing ROI are: Total assets available Total assets employed Total assets employed minus current liabilities Stockholders’ equity 23-1 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-7 Current cost is the cost of purchasing an asset today identical to the one currently held if an identical asset can currently be purchased; it is the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased Historical-costbased measures of ROI compute the asset base as the original purchase cost of an asset minus any accumulated depreciation Some commentators argue that current cost is oriented to current prices, while historical cost is past-oriented 23-8 Special problems arise when evaluating the performance of divisions in multinational companies because a The economic, legal, political, social, and cultural environments differ significantly across countries b Governments in some countries may impose controls and limit selling prices of products c Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure may differ significantly across countries d Divisions operating in different countries keep score of their performance in different currencies 23-9 In some cases, the subunit’s performance may not be a good indicator of a manager’s performance For example, companies often put the most skillful division manager in charge of the weakest division in an attempt to improve the performance of the weak division Such an effort may yield results in years, not months The division may continue to perform poorly with respect to other divisions of the company But it would be a mistake to conclude from the poor performance of the division that the manager is performing poorly A second example of the distinction between the performance of the manager and the performance of the subunit is the use of historical cost-based ROIs to evaluate the manager even though historical cost-based ROIs may be unsatisfactory for evaluating the economic returns earned by the organization subunit Historical cost-based ROI can be used to evaluate a manager by comparing actual results to budgeted historical cost-based ROIs 23-10 Moral hazard describes situations in which an employee prefers to exert less effort (or to report distorted information) compared with the effort (or accurate information) desired by the owner because the employee’s effort (or validity of the reported information) cannot be accurately monitored and enforced 23-11 No, rewarding managers on the basis of their performance measures only, such as ROI, subjects them to uncontrollable risk because managers’ performance measures are also affected by random factors over which they have no control A manager may put in a great deal of effort but her performance measure may not reflect this effort if it is negatively affected by various random factors Thus, when managers are compensated on the basis of performance measures, they will need to be compensated for taking on extra risk Therefore, when performance-based incentives are used, they are generally more costly to the owner The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager 23-2 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-12 Benchmarking or relative performance evaluation is the process of evaluating a manager’s performance against the performance of other similar operations The ideal benchmark is another operation that is affected by the same noncontrollable factors that affect the manager’s performance Benchmarking cancels the effects of the common noncontrollable factors and provides better information about the manager's performance 23-13 When employees have to perform multiple tasks as part of their jobs, incentive problems can arise when one task is easy to monitor and measure while the other task is more difficult to evaluate Employers want employees to intelligently allocate time and effort among various tasks If, however, employees are rewarded on the basis of the task that is more easily measured, they will tend to focus their efforts on that task and ignore the others 23-14 Disclosures required by the Securities and Exchange Commission are: a A summary compensation table showing the salary, bonus, stock options, other stock awards, and other compensation earned by the five top officers in the previous three years b The principles underlying the executive compensation plans, and the performance criteria, such as profitability, sales growth, and market share used in determining compensation c How well a company’s stock performed relative to the stocks of other companies in the same industry 23-15 The four levers of control in an organization are diagnostic control systems, boundary systems, belief systems and interactive control systems Diagnostic control systems are the set of critical performance variables that help managers track progress toward the strategic goal These measures are periodically monitored and action is usually only taken if a measure is outside its acceptable limits Boundary systems describe standards of behavior and codes of conduct expected of all employees, particularly by defining actions that are off-limits Boundary systems prevent employees from performing harmful actions Belief systems articulate the mission, purpose and core values of a company They describe the accepted norms and patterns of behavior expected of all managers and other employees with respect to each other, shareholders, customers and communities Interactive control systems are formal information systems that managers use to focus an organization's attention and learning on key strategic issues They form the basis of ongoing discussion and debate about strategic uncertainties that the business faces and help position the organization for the opportunities and threats of tomorrow 23-3 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-16 (30 min.) ROI, comparisons of three companies The separate components highlight several features of return on investment not revealed by a single calculation: a The importance of investment turnover as a key to income is stressed b The importance of revenues is explicitly recognized c The important components are expressed as ratios or percentages instead of dollar figures This form of expression often enhances comparability of different divisions, businesses, and time periods d The breakdown stresses the possibility of trading off investment turnover for income as a percentage of revenues so as to increase the average ROI at a given level of output (Filled-in blanks are in bold face.) Revenue Income Investment Income as a % of revenue Investment turnover Return on investment Companies in Same Industry A B C $1,000,000 $ 500,000 $10,000,000 $ 100,000 $ 50,000 $ 50,000 $ 500,000 $ 5,000,000 $5,000,000 0.5% 10% 10% 2.0 2.0 0.1 1% 20% 1% Income and investment alone shed little light on comparative performances because of disparities in size between Company A and the other two companies Thus, it is impossible to say whether B's low return on investment in comparison with A’s is attributable to its larger investment or to its lower income Furthermore, the fact that Companies B and C have identical income and investment may suggest that the same conditions underlie the low ROI, but this conclusion is erroneous B has higher margins but a lower investment turnover C has very small margins (1/20th of B) but turns over investment 20 times faster I.M.A Report No 35 (page 35) states: ―Introducing revenues to measure level of operations helps to disclose specific areas for more intensive investigation Company B does as well as Company A in terms of income margin, for both companies earn 10% on revenues But Company B has a much lower turnover of investment than does Company A Whereas a dollar of investment in Company A supports two dollars in revenues each period, a dollar investment in Company B supports only ten cents in revenues each period This suggests that the analyst should look carefully at Company B’s investment Is the company keeping an inventory larger than necessary for its revenue level? Are receivables being collected promptly? Or did Company A acquire its fixed assets at a price level that was much lower than that at which Company B purchased its plant?‖ ―On the other hand, C’s investment turnover is as high as A’s, but C’s income as a percentage of revenue is much lower Why? Are its operations inefficient, are its material costs too high, or does its location entail high transportation costs?‖ ―Analysis of ROI raises questions such as the foregoing When answers are obtained, basic reasons for differences between rates of return may be discovered For example, in Company B’s case, it is apparent that the emphasis will have to be on increasing turnover by reducing investment or increasing revenues Clearly, B cannot appreciably increase its ROI simply by increasing its income as a percent of revenue In contrast, Company C’s management should concentrate on increasing the percent of income on revenue.‖ 23-4 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-17 (30 min.) Analysis of return on invested assets, comparison of two divisions, DuPont method Operating Income Software Division 2006 2007 2008 Services Division 2006 2007 2008 Infotech Systems, Inc 2006 2007 2008 $340 420 580 $1,500 $1,170 $310 22%= $330 25% = $293 $650 $420 + $330 = $750 $580 + $293 = $873 Operating Revenues Operating Income Operating Revenues $960 $420 42% = $1,000 $5,273 = $1,055 $340 $1,180 1,500 $1,170 = $2,340 $640 900 1,170 $310 $293 $1,180 = 26.3% 22% $2,340 = 12.5% $5,160 $4,200 + $1,500 = $5,700 $5,273 + $2,340 = $7,613 $1,600 $1,000 + $900 = $1,900 $1,055 + $1,170 = $2,225 $650 $750 $873 $5,160 = 12.6% $5,700 = 13.2% $7,613 = 11.5% $420 $580 $3,980 10% = $4,200 11% = $5,273 Total Assets $3,980 = 8.5% 10% 11% Based on revenues, the software division is about twice as big as the services division The services division earns higher margins (operating income as a percent of operating revenues); the software division turns over its assets at more than twice the rate of the services division (operating revenues as a multiple of total assets) The net result is that the ROI of the two divisions was similar (in the 30–50% range) But whereas the ROI of the software division has been increasing from 2006 to 2008, the ROI of the services division has been falling Overall, this has resulted in Infotech Systems showing stable profitability over the past three years 23-5 Operating Revenues Total Assets $3,980 $960 = 4.1 $4,200 $1,000 = 4.2 $1,180 $1,500 $640 = 1.8 $900 = 1.7 $5,160 $1,600 = 3.2 $5,700 $1,900 = $7,613 $2,225 = 3.4 Operating Income Total Assets $340 $580 $310 $330 $650 $750 $873 $960 = 35.4% 42% $1,055 = 55% $640 = 48.4% $900 = 36.7% 25% $1,600 = 40.6% $1,900 = 39.5% $2,225 = 39.2% To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-18 (10–15 min.) ROI and RI Operating income = (Contribution margin per unit 150,000 units) – Fixed costs = ($360 – $250) 150,000 – $15,000,000 = $1,500,000 ROI = Operating income = $1,500, 000 Operating income = = 6.25% $24, 000, 000 Investment ROI Investment [No of pairs sold (Selling price – Var cost per unit)] – Fixed costs = ROI Investment Let $X = minimum selling price per unit to achieve a 25% ROI 150,000 ($X – $250) – $15,000,000 = 25% ($24,000,000) $150,000X = $6,000,000 + $15,000,000 + $37,500,000 = $58,500,000 X = $390 Let $X = minimum selling price per unit to achieve a 20% rate of return 150,000 ($X – $250) – $15,000,000 = 20% ($24,000,000) $150,000X = $4,800,000 + $15,000,000 + $37,500,000 = $57,300,000 X = $382 23-6 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-19 (30 min.) Pricing, ROI, performance evaluation ROI = 20% = Operating income Investment Operating income $80,000,000 $16,000,000 Operating income = Target revenues: Fixed costs Variable costs, 100,000 × $1,600 Desired operating income Revenues $ 24,000,000 160,000,000 16,000,000 $200,000,000 The selling price per unit to achieve ROI of 20% is $200,000,000 ÷ 100,000 units = $2,000 ROI at Various Sales Volumes over Years Volume (units) 100,000 150,000 50,000 Revenues, $2,000 per unit $200* $300* $100* Variable costs, $1,600 per unit 160 240 80 Fixed costs 24 24 24 Total costs 184 264 104 Operating income $ 16 $ 36 $(4) Return on investment $16; $36; $(4) 80 20% 45% – 5% *All revenues, costs, and operating income are in millions of dollars A summary analysis of these three cases follows: Volume 100,000 150,000 50,000 Operating Income Revenues 8% ($16 $200) 12% ($36 $300) –4% ($(4) $100) × × × × Revenues Total Assets 2.50 ($200 $80) 3.75 ($300 $80) 1.25 ($100 $80) Return on Investment 20% 45% –5% Lauren Snyder may feel that the measure is unfair since the ROI is very sensitive to volume and selling price If she has no control on the selling price, and therefore on the demand for Hardy motorcycles, she may feel that she is being measured on a factor that is not controllable by her It is also unclear how much she can control costs in the short run It would be better to measure her division's performance on ROI relative to competitors, if possible Also, one year may be too short a time span in the use of an operating income measure for gauging performance or for paying bonuses For instance, motorcycle sales may be heavily influenced by general economic conditions that are uncontrollable by the division managers whose bonuses are significantly affected thereby Further, some short-run savings in manufacturing costs, which may temporarily boost ROI and bonuses, may have long-run damaging effects Examples include repairs, maintenance, quality control, and exerting severe pressures on employees for productivity 23-7 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-20 (25 min.) Financial and nonfinancial performance measures, goal congruence Operating income is a good summary measure of short-term financial performance By itself, however, it does not indicate whether operating income in the short run was earned by taking actions that would lead to long-run competitive advantage For example, Summit’s divisions might be able to increase short-run operating income by producing more product while ignoring quality or rework Harrington, however, would like to see division managers increase operating income without sacrificing quality The new performance measures take a balanced scorecard approach by evaluating and rewarding managers on the basis of direct measures (such as rework costs, on-time delivery performance, and sales returns) This motivates managers to take actions that Harrington believes will increase operating income now and in the future The nonoperating income measures serve as surrogate measures of future profitability The semiannual installments and total bonus for the Charter Division are calculated as follows: Charter Division Bonus Calculation For Year Ended December 31, 2006 January 1, 2006 to June 30, 2006 Profitability (0.02 $462,000) Rework (0.02 $462,000) – $11,500 On-time delivery No bonus—under 96% Sales returns [(0.015 $4,200,000) – $84,000] 50% Semiannual installment Semiannual bonus awarded July 1, 2006 to December 31, 2006 Profitability (0.02 $440,000) Rework (0.02 $440,000) – $11,000 On-time delivery 96% to 98% Sales returns [(0.015 $4,400,000) – $70,000] 50% Semiannual installment Semiannual bonus awarded Total bonus awarded for the year 23-8 $ $ 9,240 (2,260) (10,500) $ (3,520) $ 8,800 (2,200) 2,000 (2,000) $ 6,600 $ 6,600 $ 6,600 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com The semiannual installments and total bonus for the Mesa Division are calculated as follows: Mesa Division Bonus Calculation For Year Ended December 31, 2006 January 1, 2006 to June 30, 2006 Profitability (0.02 $342,000) Rework (0.02 $342,000) – $6,000 On-time delivery Over 98% Sales returns [(0.015 $2,850,000) – $44,750] 50% Semiannual bonus installment Semiannual bonus awarded July 1, 2006 to December 31, 2006 (0.02 $406,000) (0.02 $406,000) – $8,000 No bonus—under 96% [(0.015 $2,900,000) – $42,500] which is greater than zero, yielding a bonus Semiannual bonus installment Semiannual bonus awarded Total bonus awarded for the year Profitability Rework On-time delivery Sales returns $ 6,840 5,000 (1,000) $10,840 $10,840 $ 8,120 0 3,000 $11,120 $11,120 $21,960 The manager of the Charter Division is likely to be frustrated by the new plan, as the division bonus has fallen by more than $20,000 compared to the bonus of the previous year However, the new performance measures have begun to have the desired effect––both on-time deliveries and sales returns improved in the second half of the year, while rework costs were relatively even If the division continues to improve at the same rate, the Charter bonus could approximate or exceed what it was under the old plan The manager of the Mesa Division should be as satisfied with the new plan as with the old plan, as the bonus is almost equivalent On-time deliveries declined considerably in the second half of the year and rework costs increased However, sales returns decreased slightly Unless the manager institutes better controls, the bonus situation may not be as favorable in the future This could motivate the manager to improve in the future but currently, at least, the manager has been able to maintain his bonus with showing improvement in only one area targeted by Harrington Ben Harrington’s revised bonus plan for the Charter Division fostered the following improvements in the second half of the year despite an increase in sales: An increase of 1.9% in on-time deliveries A $500 reduction in rework costs A $14,000 reduction in sales returns 23-9 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com However, operating income as a percent of sales has decreased (11% to 10%) The Mesa Division’s bonus has remained at the status quo as a result of the following effects: An increase of 2.0 % in operating income as a percent of sales (12% to 14%) A decrease of 3.6% in on-time deliveries A $2,000 increase in rework costs A $2,250 decrease in sales returns This would suggest that revisions to the bonus plan are needed Possible changes include: increasing the weights put on on-time deliveries, rework costs, and sales returns in the performance measures while decreasing the weight put on operating income; a reward structure for rework costs that are below 2% of operating income that would encourage managers to drive costs lower; reviewing the whole year in total The bonus plan should carry forward the negative amounts for one six-month period into the next six-month period incorporating the entire year when calculating a bonus; and developing benchmarks, and then giving rewards for improvements over prior periods and encouraging continuous improvement 23-10 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Superior performance measures change significantly with the manager's performance and not very much with changes in factors that are beyond the manager’s control If Marks has no authority for making capital investment decisions, then ROI is not a good measure of Marks’s performance––it varies with the actions taken by others rather than the actions taken by Marks AMCO may wish to evaluate Marks on the basis of operating income rather than ROI ROI, however, may be a good measure to evaluate Dexter's economic viability Senior management at AMCO could use ROI to evaluate if the Dexter Division’s income provides a reasonable return on investment, regardless of who has authority for making capital investment decisions That is, ROI may be an inappropriate measure of Marks’s performance but a reasonable measure of the economic viability of the Dexter Division If, for whatever reasons— bad capital investments, weak economic conditions, etc.—the Division shows poor economic performance as computed by ROI, AMCO management may decide to shut down the division even though they may simultaneously conclude that Marks performed well There are two main concerns with Marks’s plans First, creating very strong sales incentives imposes excessive risk on the sales force because a salesperson’s performance is affected not only by his or her own effort, but also by random factors (such as a recession in the industry) that are beyond the salesperson's control If salespersons are risk averse, the firm will have to compensate them for bearing this extra uncontrollable risk Second, compensating salespersons only on the basis of sales creates strong incentives to sell, but may result in lower levels of customer service and sales support (this was the story at Sears auto repair shops where a change in the contractual terms of mechanics to ―produce‖ more repairs caused unobservable quality to be negatively affected) Where employees perform multiple tasks, it may be important to ―blunt‖ incentives on those aspects of the job that can be measured well (for example, sales) to try and achieve a better balance of the two tasks (for example, sales and customer service and support) In addition, the division should try to better monitor customer service and customer satisfaction through surveys, or through quantifying the amount of repeat business 23-17 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-27 (30 min.) Relevant costs, performance evaluation, goal congruence This problem illustrates the dysfunctional behavior that could be motivated by arbitrary allocations of corporate overhead to profit-conscious divisional managers Without the $800,000 in sales from the low-margin product line in the Andorian Division, the second quarter operating statements (in thousands) will be: Net sales Cost of sales Divisional overhead Divisional contribution Corporate overhead Operating income Andorian $1,200 450 150 600 288 $ 312 Orion $1,200 540 125 535 288 $ 247 Tribble $1,600 640 160 800 384 $ 416 Total $4,000 1,630 435 1,935 960 $ 975 The company is worse off as a result of dropping the low profitability line of products because it has lost $100,000 in contribution margin from the dropped product line with no reduction in corporate overhead Total operating income decreases from $1,075,000 in the first quarter to $975,000 in the second quarter The Andorian Division manager’s performance evaluation measure (divisional operating income) is higher ($312,000 in the second quarter versus $300,000 in the first quarter) as a result of dropping the low-profitability product line The Andorian Division manager is able to show a $12,000 higher operating income because the $100,000 in lost contribution margin from the dropped product line is more than offset by the $112,000 reduction in corporate overhead that is charged to the Andorian Division Andorian Division sales are now only 30% of corporate sales rather than the previous 41.7% of sales (so 30% of total corporate overhead costs of $960,000 equal to $288,000 are allocated to the Andorian Division in the second quarter, whereas 41.7% of $960,000 equal to $400,000 were allocated to the Andorian Division in the first quarter) The easiest solution is not to allocate fixed corporate overhead to divisions Then the problem of dysfunctional behavior will not arise But central management may want the division managers to ―see‖ the cost of corporate operations so that they will understand that the corporation as a whole is not profitable unless the combined divisions’ contribution margins exceed corporate overhead In this case, an allocation basis should be chosen that cannot be manipulated or is under the control of division managers It must also have the property that the action taken by one division does not affect the corporate overhead allocations that get made to the other divisions (as occurred in the second quarter for the company) In general, a lump sum allocation based on, say, budgeted net income, or budgeted assets, rather than an allocation that varies proportionately with an actual measure of activity (such as sales or actual net income), will minimize dysfunctional behavior The allocation should be such that managers treat it as a fixed, unavoidable charge, rather than a charge that will vary with the decisions they make Of course, a potential disadvantage of this proposal is that managers may try to underbudget the amounts that serve as the cost allocation bases, so that their divisions get less of the corporate overhead charges 23-18 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-28 (40–50 min.) ROI performance measures based on historical cost and current cost ROI using historical cost measures: Calistoga Alpine Springs Rocky Mountains $130, 000 $340, 000 $220, 000 $1,150, 000 $380, 000 $1, 620, 000 = 38.24% = 19.13% = 23.46% The Calistoga Division appears to be considerably more efficient than the Alpine Springs and Rocky Mountain Divisions The gross book values (i.e., the original costs of the plants) under historical cost are calculated as the useful life of each plant (12 years) the annual depreciation: Calistoga 12 $70,000 = $ 840,000 Alpine Springs 12 $100,000 = $1,200,000 Rocky Mountains 12 $120,000 = $1,440,000 Step 1: Restate long-term assets from gross book value at historical cost to gross book value at current cost as of the end of 2007 Construction cost index in 2007 Gross book value of long-term assets at historical cost Construction cost index in year of construction Calistoga Alpine Springs Rocky Mountain $ 840,000 $1,200,000 $1,440,000 (170 ÷ 100) (170 ÷ 136) (170 ÷ 160) = = = $1,428,000 $1,500,000 $1,530,000 Step 2: Derive net book value of long-term assets at current cost as of the end of 2007 (Estimated useful life of each plant is 12 years.) Estimated remaining useful life Gross book value of long-term assets at current cost at the end of 2007 Estimated total useful life Calistoga Alpine Springs Rocky Mountains $1,428,000 $1,500,000 $1,530,000 (2 ÷ 12) = (9 ÷ 12) = (11 ÷ 12) = $ 238,000 $1,125,000 $1,402,500 Step 3: Compute current cost of total assets at the end of 2007 (Assume current assets of each plant are expressed in 2007 dollars.) Current assets at the end + Net book value of long-term assets at current cost at the end of 2007 (Step 2) of 2007 (given) Calistoga Alpine Springs Rocky Mountains $200,000 + $238,000 = $ 438,000 $250,000 + $1,125,000 = $1,375,000 $300,000 + $1,402,500 = $1,702,500 23-19 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Step 4: Compute current-cost depreciation expense in 2007 dollars Gross book value of long-term assets at current cost at the end of 2007 (from Step 1) ÷ 12 Calistoga $1,428,000 ÷ 12 = $119,000 Alpine Springs $1,500,000 ÷ 12 = $125,000 Rocky Mountains $1,530,000 ÷ 12 = $127,500 Step 5: Compute 2007 operating income using 2007 current-cost depreciation expense Historical-cost,operating income – Current-cost Historical-cost depreciation expense in depreciation expense 2007 dollars (Step 4) Calistoga Alpine Springs Rocky Mountains $130,000 – ($119,000 – $70,000) $220,000 – ($125,000 – $100,000) $380,000 – ($127,500 – $120,000) = $ 81,000 = $195,000 = $372,500 Step 6: Compute ROI using current-cost estimates for long-term assets and depreciation expense Operating income for 2007 using current cost depreciation expense in 2007 dollars (Step 5) Current cost of total assets at the end of 2007 (Step 3) Calistoga Alpine Springs Rocky Mountains Calistoga Alpine Springs Rocky Mountains $ 81,000 ÷ $ 438,000 $195,000 ÷ $1,375,000 $372,500 ÷ $1,702,500 ROI: Historical Cost 38.24% 19.13 23.46 = 18.49% = 14.18% = 21.88% ROI: Current Cost 18.49% 14.18 21.88 Use of current cost results in the Rocky Mountains Division appearing to be the most efficient The Calistoga ROI is reduced substantially when the ten-year-old plant is restated for the 70% increase in construction costs over the 1997 to 2007 period Use of current costs increases the comparability of ROI measures across divisions’ operating plants built at different construction cost price levels Use of current cost also will increase the willingness of managers, evaluated on the basis of ROI, to move between divisions with assets purchased many years ago and divisions with assets purchased in recent years 23-20 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-29 (40–50 min.) Evaluating managers, ROI, DuPont method, value-chain analysis of cost structure Revenues Total Assets Operating Income Revenues ROI = Operating Income = Total Assets 2005 2006 1.11 ($600 $540) 0.94 ($480 $510) 0.26 ($157.5 $600) 0.13 ($ 60.5 $480) 0.29 ($157.5 $540) 0.12 ($ 60.5 $510) On Point 2005 2006 1.25 ($300 $240) 1.46 ($525 $360) 0.10 ($29.7 $300) 0.19 ($99.3 $525) 0.12 ($29.7 $240) 0.28 ($99.3 $360) NetPro NetPro’s ROI has declined sizably from 2005 to 2006 largely because of a decline in operating income to revenues (return on sales or ROS) On Point’s ROI has more than doubled from 2005 to 2006, in large part due to an increase in operating income to revenues (return on sales or ROS) The DuPont analysis tells us that NetPro’s ROI decline arises from a serious degradation in its ROS, and not from any significant problem in assets turns, i.e., its management should probably examine and try to fix its eroding margins This insight would not be available from a direct calculation of ROI Business Function Research and development a Production Marketing & Distribution Customer Service Total costs* a NetPro 2005 16% 30 39 15 100% For example, $71.2 $442.5; $40.2 $419.5; $35.9 *May sum to more than 100% due to rounding On Point 2006 10% 35 46 10 100% $270.3; $76.1 23-21 $425.7 2005 13% 40 36 11 100% 2006 18% 30 36 16 100% To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Business functions with increases/decreases in the percentage of total costs from 2005 to 2006 are: Increases Decreases NetPro Production Marketing & Distribution On Point Research and development Customer service Research and development Customer service Production NetPro has decreased expenditures in two key business functions that are critical in the computer industry–– research and development and customer service These costs are (using the chapter’s terminology) discretionary and they can be reduced in the short run without any short-run effect on customers, but such action is likely to create serious problems in the long run On Point, on the other hand, increased its percentage of total costs in these two areas Based on the information provided, Provan is the better candidate for president of Peach Computer Both NetPro and On Point are in the same industry Provan has been CEO of On Point at a time when it has considerably outperformed NetPro: a The ROI of On Point has increased from 2005 to 2006, while that of NetPro has decreased b The computer magazine has given the highest ranking to On Point’s main product, while NetPro’s received a lower ranking c On Point has received high marks for new products (the lifeblood of a computer company), while NetPro's new-product introductions have been described as ―mediocre.‖ It is likely that On Point’s better rating for its current product is based on customer service and its better rating for its new product is based on research and development spending 23-22 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-30 (25 min.) ROI, RI, ROS, management incentives If Mason Industries uses ROI to measure the Jump-Start Division’s (JSD’s) performance, Grieco may be reluctant to invest in the new plant because, as shown below, ROI for the plant of 19.2% is lower than JSD’s current ROI of 24% Operating income for new plant New investment Return on investment for new plant $480,000 $2,500,000 19.2% Investing in the new plant would lower JSD’s ROI and as a result, limit Grieco’s bonus The residual income computation for the new plant is as follows: Residual income = Income – (Required rate of return Investment Operating income Required return (Investment, $2,500,000 Residual income Investment) $2,500,000 $ 480,000 15%) 375,000 $ 105,000 Investing in the new plant would add $105,000 to JSD’s residual income Consequently, if Mason Industries could be persuaded to use residual income to measure performance, Grieco would be more willing to invest in the new plant Return on Sales (ROS) = Operating income Sales 480 ,000 = 20% 2,400 ,000 If Mason Industries uses ROS to determine Grieco’s bonus, Grieco will be more willing to invest in the new plant because ROS for the new plant of 20% exceeds the current ROS of 19% The advantages of using ROS are (a) that it is simpler to calculate and (b) that it avoids the negative short-run effects of ROI measures that may induce Grieco to not make the investment in the new plant Grieco may favor ROS because she believes that eventually increases in ROS will increase ROI and RI The main disadvantage of using ROS is that it ignores the amount of investment needed to earn a return For example, ROS may be high but not high enough to justify the level of investment needed to earn the required return on an investment 23-23 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-31 (20–30 min.) Division manager’s compensation, risk sharing, incentives (continuation of 23-30) Consider each of the three proposals that the management of Mason Industries is considering: a Compensate Grieco on the basis of a fixed salary without any bonus Paying Grieco a flat salary will not subject Grieco to any risk, but will provide no incentives for Grieco to undertake extra physical and mental effort b Compensate Grieco on the basis of division residual income (RI) The benefit of this arrangement is that Grieco would be motivated to put in extra effort to increase RI because Grieco's rewards would increase with increases in RI But compensating Grieco largely on the basis of RI subjects Grieco to excessive risk, because the division’s RI depends not only on Grieco's effort but also on random factors over which Grieco has no control Grieco may put in a great deal of effort, but the division’s RI may be low because of adverse factors (high interest rates, recession) that the manager cannot control For example, general market conditions will influence Grieco’s revenues and costs To compensate Grieco for taking on uncontrollable risk, Mason Industries must pay her additional amounts within the structure of the RI-based arrangement Thus, only using performance-based incentives costs Mason more money, on average, than paying a flat salary The key question is whether the benefits of motivating additional effort justify the higher costs of performance-based rewards c Compensate Grieco using other companies that also manufacture go-carts and recreational vehicles as a benchmark The benefit of benchmarking or relative performance evaluation is to cancel out the effects of common noncontrollable factors that affect a performance measure Taking out the effects of these factors provides better information about management performance However, benchmarking and relative performance evaluation are effective only when similar noncontrollable factors affect each of the companies in the benchmark group If this is the case, as it appears to be here, benchmarking is a good idea If however, the companies in the benchmark group are not exactly comparable because, for example, they have other areas of business that cannot be separated from their go-cart and recreational vehicle business, or they operate under different market conditions, benchmarking may not be a good idea If the noncontrollable factors are not the same, then comparing the RI of Grieco’s division to the RI of the other companies will not provide useful relative performance evaluation information Mason should use a compensation arrangement that includes both a salary component and a bonus component based on residual income The motivation for having some salary and some performance-based bonus in Grieco’s compensation is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager If similar noncontrollable factors affect the performance of the benchmark companies that also manufacture and sell gocarts and recreational vehicles, a bonus based on the JSD’s residual income relative to the residual income earned by the benchmark companies would be preferred 23-24 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-32 (30–40 min.) ROI, RI, DuPont method, investment decisions, balanced scorecard 2006 Newspapers Television Revenue Total Assets 0.939 ($9,660 $10,290) 2.133 ($13,440 $6,300) ROI = Operating Income Operating Income = Revenues Total Assets 0.239 ($2,310 $9,660) 0.224 ($2,310 $10,290) 0.025 ($ 336 $13,440) 0.053 ($ 336 $ 6,300) The Newspapers Division has a relatively high ROI because of its high income margin relative to Television The Television Division has a low ROI despite a high investment turnover because of its very low income margin Although the proposed investment is small, relative to the total assets invested, it earns less than the 2006 return on investment (0.224) (All dollar numbers in millions): 2006 ROI (before proposal) = $2,310 $10,290 = 0.224 Investment proposal ROI = $60 $400 = 0.150 2006 ROI (with proposal) = $2,370 $2,310 + $60 = = $10,290 + $400 $10,690 0.222 Given the existing bonus plan, any proposal that reduces the ROI is unattractive 3a Residual income for 2006 (before proposal, in millions): Operating Income Newspapers Television 3b Imputed Interest Charge $2,310 – 336 – Division Residual Income $1,235 (0.12 $10,290)= 756 (0.12 $6,300) = $1,075 (420) Residual income for proposal (in millions): Operating Income $60 Imputed Interest Charge – $48(0.12 $400) Residual Income = $12 Investing in the fast-speed printing press will increase the Newspapers Division’s residual income As a result, if Kearney is evaluated using a residual income measure, Kearney would be much more willing to adopt the printing press proposal 23-25 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com As discussed in requirement 3b, Bronson could consider using RI The use of RI motivates managers to accept any project that makes a positive contribution to net income after the cost of the invested capital is taken into account Making such investments will have a positive effect on Media Group’s customers Bronson may also want to consider nonfinancial measures such as newspaper subscription levels, television audience size, repeat purchase patterns, and market share These measures will require managers to invest in areas that have favorable long-run effects on Media Group’s customers 23-33 (20–30 min.) Division manager’s compensation, levers of control a Consider each of the three proposals that Rupert Bronson is considering: Compensate managers on the basis of division RI The benefit of this arrangement is that managers would be motivated to put in extra effort to increase RI because managers’ rewards would increase with increases in RI But compensating managers largely on the basis of RI subjects the managers to excessive risk, because each division’s RI depends not only on the manager’s effort but also on random factors over which the manager has no control A manager may put in a great deal of effort, but the division’s RI may be low because of adverse factors (high interest, recession) that the manager cannot control To compensate managers for taking on uncontrollable risk, Bronson must pay them additional amounts within the structure of the RI-based arrangement Thus, using mainly performance-based incentives will cost Bronson more money, on average, than paying a flat salary The key question is whether the benefits of motivating additional effort justify the higher costs of performance-based rewards The motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager Finally, rewarding a manager only on the basis of division RI will induce managers to maximize the division’s RI even if taking such actions are not in the best interests of the company as a whole b Compensate managers on the basis of companywide RI Rewarding managers on the basis of companywide RI will motivate managers to take actions that are in the best interests of the company rather than actions that maximize a division’s RI A negative feature of this arrangement is that each division manager’s compensation will now depend not only on the performance of that division manager but also on the performance of the other division managers For example, the compensation of Ken Kearney, the manager of the Newspapers Division, will depend on how well the manager of Television performs, even though Kearney himself may have little influence over the performance of these divisions Therefore, compensating managers on the basis of companywide RI will impose extra risk on each division manager, and will raise the cost of compensating them, on average c Compensate managers using the other division’s RI as a benchmark The benefit of benchmarking or relative performance evaluation is to cancel out the effects of common noncontrollable factors that affect a performance measure Taking out the effects of these factors provides better information about a manager’s performance What is critical, however, for benchmarking and relative performance evaluation to be effective is that similar noncontrollable factors affect each division It is not clear that the same noncontrollable 23-26 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com factors that affect the performance of the Newspapers Division (cost of newsprint paper, for example) also affect the performance of the Television division If the noncontrollable factors are not the same, then comparing the RI of one division to the RI of the other division will not provide useful information for relative performance evaluation A second factor for Bronson to consider is the impact that benchmarking and relative performance evaluation will have on the incentives for the division managers of the Newspapers and Television Divisions to cooperate with one another Benchmarking one division against another means that a division manager will look good by improving his or her own performance, or by making the performance of the other division manager look bad Using measures like RI and ROI—diagnostic levers of control—can cause managers to cut corners and take other actions that boost short-run performance but harm the company in the long run Bronson can guard against such problems by introducing and upholding strong boundary and belief systems of control within the company Strict codes of conduct should govern what employees cannot Bronson should also foster a culture where employees have a deep belief in the value of the company’s journalistic mission Another potential problem of an excessive focus on diagnostic measures is a myopic disregard for emerging threats and opportunities Interactive control systems, based on debate and discussion and regular review of strategic uncertainties and the competitive landscape can help overcome this problem Bronson should not only ask for regular reports on ROI, RI, etc., he should meet regularly with division managers, discuss 5- and 10-year strategic plans, and obtain their field-based inputs Such regular dialogues will help surface emerging threats and opportunities, and the action plans that need to be taken in response 23-27 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-34 (25 min.) Ethics, manager’s performance evaluation (A Spero, adapted) 1a Variable manufacturing cost per unit = $2 Fixed manufacturing cost per unit = $9,000,000 500,000 = $18 Total manufacturing cost per unit = $2 + $18 = $20 Revenues, $20 500,000 Variable manufacturing costs, $2 500,000 Fixed manufacturing costs, $18 500,000 Fixed marketing costs Total costs Operating loss Ending inventory: $0 1b $10,000,000 1,000,000 9,000,000 400,000 10,400,000 $ (400,000) Variable manufacturing cost per unit = $2 Fixed manufacturing cost per unit = $9,000,000 600,000 = $15 Total manufacturing cost per unit = $2 + $15 = $17 Revenues, $20 500,000 Variable manufacturing costs, $2 500,000 Fixed manufacturing costs, $15 500,000 Fixed marketing costs Total costs Operating income Ending inventory = $17 per unit 100,000 units = $1,700,000 $10,000,000 1,000,000 7,500,000 400,000 8,900,000 $ 1,100,000 It would not be ethical for Jones to produce more units just to show better operating results Professional managers are expected to take better operating actions that are in the best interests of their shareholders Jones’s action would benefit him at the cost of shareholders Jones’s actions would be equivalent to ―cooking the books,‖ even though he may achieve this by producing more inventory than was needed, rather than through fictitious accounting Some students might argue that Jones's behavior is not unethical––he simply took advantage of the faulty contract the board of directors had given him when he was hired Asking distributors to take more products than they need is also equivalent to ―cooking the books.‖ In effect, distributors are being coerced into taking more product This is a particular problem if distributors will take less product in the following year or alternatively return the excess inventory next year Some students might argue that Jones’s behavior is not unethical—it is up to the distributors to decide whether to take more inventory or not So long as Jones is not forcing the product on the distributors, it is not unethical for Jones to push sales this year even if the excess product will sit in the distributors’ inventory 23-28 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-35 (15 min.) Ethics, levers of control If Amy Kimbell ―turns a blind eye‖ toward what she has just observed at the UFP log yard, she will be violating the competence, integrity, and objectivity standards for management accountants Competence Perform professional duties in accordance with technical standards Integrity Communicate unfavorable as well as favorable information and professional judgments or opinions Refrain from engaging in or supporting any activity that would discredit the profession Objectivity Communicate information fairly and objectively Disclose fully all relevant information that could reasonably be expected to influence an intended user’s understanding of the reports, comments, and recommendations Kimbell should: a Try to follow established UFP policies to try to bring the issue to the attention of UFP management through regular channels; then, if necessary, b Discuss the problem with the immediate superior who is not involved in the understatement of quality and costs c Clarify relevant ethical issues with an objective advisor, preferably a professional person outside UFP d If all the above channels fail to lead to a correction in the organization, she may have to resign and become a ―whistle-blower‖ to bring UFP to justice UFP is clearly emphasizing profit, driving managers to find ways to keep profits strong and increasing This is a diagnostic measure, and over-emphasis on diagnostic measures can cause employees to whatever is necessary—including unethical actions—to keep the measures in the acceptable range, not attract negative senior management attention and possibly improve compensation and job reviews To avoid problems like this in the future, UFP needs to establish some strong boundary systems and codes of conduct There should be a clear message from upper management that unethical behavior will not be tolerated Training, role-plays, and case studies can be used to raise awareness about these issues, and strong sanctions should be put in place if the rules are violated An effective boundary system is needed to keep managers ―on the right path.‖ UFP also needs to articulate a belief system of core values The goal is to inspire managers and employees to their best, exercise greater responsibility, take pride in their work, and things the right way 23-29 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23-36 (30 min.) ROI, RI, division manager’s compensation, balanced scorecard ROS = ROI = 2a Operating Income Sales Operating Income Total Assets = = 1,800 ,000 = 15,000 ,000 1,800 ,000 = 10,000 ,000 18% X Operating income = 10,000 ,000 Total Assets Hence, operating income = 20% 10,000,000 = $2,000,000 Operating income = Revenue Costs Therefore, Costs = $15,000,000 $2,000,000 = $13,000,000 Currently, Costs = Revenues Operating income = $15,000,000 $1,800,000 = $13,200,000 ROI = 20% = Costs need to be reduced by $200,000 ($13,200,000 2b 12% $13,000,000) Operating income $1,800,000 = Total assets X Hence X = $1,800,000 20% = $9,000,000 PD would need to decrease total assets in 2007 by $1,000,000 ($10,000,000 ROI = 20% = = = = $9,000,000) RI Income (Required rate of return Investment) $1,800,000 (0.15 $10,000,000) $300,000 PD wants RI to increase by 50% $300,000 = $150,000 That is, PD wants RI in 2007 to be $300,000 + $150,000 = $450,000 If PD cuts costs by $45,000 its operating income will increase to $1,800,000 + $45,000 = $1,845,000 RI2007 = $450,000 = $1,845,000 (0.15 Assets) $1,395,000 = 0.15 Assets Assets = $1,395,000 0.15 = $9,300,000 PD would need to decrease total assets by $700,000 ($10,000,000 $9,300,000) Barrington could focus more on revenues and ROS Then, it will focus less on cutting costs and reducing assets and put more emphasis on customers, actual revenues, and how they translate into operating income Barrington may also want to consider nonfinancial measures such as customer satisfaction and market share, quality, yield, and on-time performance as well as monitor employee satisfaction and the development of employee skills Maintaining high performance along these measures will have a favorable long-run effect on PD’s customers 23-30 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Video Case The video case can be discussed using only the case writeup in the chapter Alternatively, instructors can have students view the videotape of the company that is the subject of the case The videotape can be obtained by contacting your Prentice Hall representative The case questions challenge students to apply the concepts learned in the chapter to a specific business situation McDONALD’S CORPORATION: Performance Measurement and Compensation While it may seem that McDonald’s aims for consistency and uniformity across all stores (restaurants), the operations differ from location to location and from region to region A store in one location may have few competitors, resulting in high sales figures and above-average profits In this case, the store manager may neglect items such as cleanliness or employee satisfaction If a store is given incentives to offer speedy service, quality may suffer For example, employees may not be friendly and mistakes at the drive-through window (orders filled incorrectly due to haste) can occur McDonald’s has chosen to provide a standard scorecard to its company-owned stores, but it weights the components of the scorecard differently to help focus the attention of store managers on the areas they need to work on the most, given differences in location, customers, and competitors According to the text, ROI is the most popular approach for incorporating the investment base into a performance measure It blends revenues, costs, and investment into a single percentage measuring profitability ROI can be increased by increasing revenues or decreasing costs Store managers have direct control over costs and are actually evaluated along a number of dimensions in this area (food cost and labor cost are the two largest) Managers also have sales revenue targets to achieve For the company-owned stores, managers may not have direct control over investment, however For example, the company’s investment in physical facilities and equipment rests outside the scope of the manager So using ROI means that managers are rewarded on the basis of investments made that they not influence or control On the other hand, management could evaluate store managers against ROI targets that factor in the investments already made and therefore are viable measures of performance for the restaurant managers Because managers not have direct control over investments, the dysfunctional incentives of managers not investing in projects that have a return less than the current ROI but greater than the cost of capital, not arise With 1,800 company-owned stores, it would be relatively easy to benchmark against stores within the company Stores with similar locations, demographic trends, and economic conditions could be compared The benefit of such a comparison is that any differences would be attributed to differences in the managers’ performances since the common uncontrollable factors would be factored out There is a downside cost, however This approach may reduce the incentive for store managers to help one another For example, a shortage of a critical food item or paper product at one store might be met by another, but if sharing adversely affects the store that provides the needed goods, the manager may be reluctant to so Goal incongruence may result since the managers would not be working together for the overall good of the company 23-31 ...To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 23- 7 Current cost is the cost of purchasing an asset today identical to the one currently... can currently be purchased; it is the cost of purchasing an asset that provides services like the one currently held if an identical asset cannot be purchased Historical-costbased measures of... original purchase cost of an asset minus any accumulated depreciation Some commentators argue that current cost is oriented to current prices, while historical cost is past-oriented 23- 8 Special