Chap 012
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Chapter 12 - Fundamentals of Management Control Systems
12
Fundamentals of Management Control Systems
Solutions to Review Questions 12-1. Accounting assigns costs and revenues to “responsibility centers” that correspond to the decision authority of managers. This allows the firm to measure performance based on the results of decisions by the manager. An effective corporate cost allocation system separates the results of decisions by corporate managers from those of business unit managers. 12-2. Although there are well-developed standards for many accounting transactions, accounting decisions still depend on the judgment of managers. There are also many estimates (for example, the depreciable lives of fixed assets) that are subject to managerial discretion. Performance measures based on accounting estimates are affected by these judgments, just as are the reported accounting numbers. 12-3. Top managers are viewed as agents of the Board of Directors. The Board of Directors can be considered the agent of the shareholders. 12-4. The division president would be the principal relative to subordinate managers.
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Chapter 12 - Fundamentals of Management Control Systems
12-5. In many cases managers are content to take a stated salary and perform optimally. However, in other organizations managers appear to perform better when given profit targets and other incentive devices. 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, these comments would make sense in the right organization setting. 12-6. Separation of duties helps prevent financial fraud because it limits the opportunity to commit the fraud. When a separation of duties exists, two or more individuals must engage in collusion to commit fraud. While collusion can and does occur, it increases the risk that someone will “blow the whistle” on the fraud. The increased risk of revealing fraud makes it less likely that fraud will occur. Thus, one manager might have the decision authority to authorize purchases and another manager has the decision authority to issue the payment.
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Chapter 12 - Fundamentals of Management Control Systems
Solutions to Critical Analysis and Discussion Questions 12-7. Local managers often have better information about local conditions. This information is valuable to the central headquarters in the planning process. But, local managers know that they will be evaluated by this information. Therefore, they have an incentive to bias the information. 12-8. Sales people can often influence costs by offering expedited delivery or other “extras” that do not reduce the revenue used to determine commissions but can increase costs. 12-9. There is a strong incentive to “find” $100,000 in income. The manager might defer maintenance or training or might offer special discounts for sales made before the end of the year. If the manager’s business unit earns $1 less than $10 million, his or her compensation is substantially less than if he or she can find the dollar. 12-10. Frequently managers will wait until near the end of the budget period to make discretionary expenditures. Sometimes managers will use "excess" funds from one period to stock up on supplies and other items that would normally be a part of the next budget period’s costs. (Managers have incentives to spend the money requested to maintain the credibility of their requests.) These activities are sometimes considered detrimental to the organization because they result in a waste of resources and improper timing of expenditures. Nonetheless, in many situations the cost of controlling these potentially adverse activities exceeds the benefits. 12-11. The service costs are being allocated on the basis of use when, in fact, some of the costs were incurred to provide capacity. Dual rates might be established so that the capacity costs would be allocated on the basis of the capacity requested by each of the departments while the use costs would be allocated on the current basis. An interesting problem arises when the joint capacity might be less than the capacity that would be required by each department individually. This problem of the “economies of scale” results in a need to find a basis for allocating the cost savings arising from such economies. No entirely satisfactory and unique solution is readily determinable.
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Chapter 12 - Fundamentals of Management Control Systems
12-12. 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. 12-13. Answers will vary. There are many reasons for pay not to reflect performance. In some cases, the reasons are because of collusion or other unethical or illegal reasons. Some other reasons, which might be defensible for business reasons include a desire to keep certain managers or how the performance of the firm compared to that of competitors. It is important when discussing performance measurement that the performance of the manager(s) be separated from the performance of the company (or business unit). Often, the managers might be performing well (poorly) although the organization is performing poorly (well). It is not uncommon for companies to place their best managers in units that are struggling. The balancing act firms must always perform when compensation is tied contractually to performance is between adhering to the terms of the contract and being “fair” to the managers when unforeseen circumstances arise. The problem is, of course, that the unforeseen circumstances more often cause performance to be below expectation, rather than the other way around. 12-14. The Treadway Commission listed the pressures to achieve unrealistically high, short-term financial results and incentive systems that focus on short-term financial results as examples of factors that might produce financial fraud. Combined, the two factors produce an environment that is highly conducive to fraud. Recent examples include Enron, Worldcom, and Tyco. In each of these cases, strong incentives and lack of strong oversight allowed managers to engage in unethical and illegal behavior.
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Chapter 12 - Fundamentals of Management Control Systems
12-15. Two explanations for the existence of unrealistic profit objectives for division managers are that upper management might be uninformed about the division, and that they might be too zealous regarding the company’s profit potential. In decentralized and widely dispersed companies, top management is usually not involved with the details of local operations. Unwittingly, top management could expect more from a division than operating and market conditions allow. On the other hand, top management could choose to knowingly expect unrealistic results, thinking that attempts to achieve the results will produce better results than if expectations were lower. 12-16. Committing financial fraud in the current period might seem to outweigh future problems that the fraud might cause. The perpetrator of the fraud might be promoted before the negative consequences of the fraud are revealed. Alternatively, the perpetrator of fraud might believe he or she will be fired if the short-run targets are not met, so he or she has little to lose by committing fraud to meet the targets.
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Chapter 12 - Fundamentals of Management Control Systems
Solutions to Exercises 12-17. (15 min.) Evaluating Management Control Systems: Chama Car Detailing. a. Based on the company’s method for measuring performance, Deana has done well. The actual wage was $2.01 (= $15.13 – $13.12) below the target wage. Mike has not performed well. Actual profits are $108,000 (= $745,000 – $637,000) below target profits. b. The management control system at Chama is possibly flawed. The low actual wages might indicate that the quality of employees hired is below the level needed to achieve the target profits. For example, the employees hired might require more training than expected or are less efficient than expected. As a result, Deana benefits from the low wage, but Mike (and the company) do not. Some recommendations for change might include:
Allow Mike or the store managers to hire with a ceiling on the wage (decision authority).
Evaluate Deana on wages with a requirement that employees hired have a minimum level of skill (performance evaluation).
Compensate Deana in part on store profits (compensation).
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Chapter 12 - Fundamentals of Management Control Systems
12-18. (20 min.) Evaluating Management Control Systems – Ethical Considerations: Magnolia Manufacturing. a. Income with the new technique will be $6 million (= $5 million x 1.20) or 20% above target. Without the new technique, there will be no bonus. With the new technique, Kevin’s bonus will be 2% (= 20% ÷ 10) of salary, or $3,000 (= 2% x $150,000). Michelle’s bonus will be 2% or $4,000 (=2% x $200,000). b. Income with the new technique will be $8.4 million (= $7 million x 1.20) or 68% above target. Kevin’s bonus will be 5% (the maximum) of salary, or $7,500 (= 5% x $150,000). Without the new technique, Kevin’s bonus will be $6,000 (4% x $150,000). Therefore, Kevin’s bonus will be $1,500 higher (= $7,500 – $6,000) with the new technique. Michelle’s bonus with the new technique will also be 5% or $10,000 (= 5% x $200,000). Without the new technique, Michelle’s bonus will be $8,000 (4% x $200,000). Therefore, Michelle’s bonus will be $2,000 higher (= $10,000 – $8,000) with the new technique. c. Income with the new technique will be $4.8 million (= $4 million x 1.20) or below the target profit. Neither Kevin nor Michelle will be eligible for the bonus. d. Kevin should not consider his bonus when deciding whether to employ the technique. If he finds that the current management control system leads to incentives to take actions not in the interests of the company, he should identify these to the CFO or other executive responsible for the system. e. Kevin is responsible for manufacturing and has little direct control over sales. One recommendation would be to evaluate Kevin based on costs relative to a budget based on production. As a result, he would have an incentive to take actions that reduce costs regardless of the level of revenues. Michelle could be evaluated on profits where costs are based on budgets for the number of units sold. This insulates Michelle from cost overruns in production. Finally, the limit on the bonus to 5% of salary probably means that the bonus has relative low incentive power. This should be increased.
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Chapter 12 - Fundamentals of Management Control Systems
12-19. (15 min.) Management Control Systems and Incentives: DC. This problem represents part of the incentive plan of a U.S.-based international conglomerate. This part of the incentive system was designed to focus managers on maximizing short-term earnings. a. This plan creates the following incentives for division managers:
Short-term orientation.
Once a target for the year is met, there is no incentive to improve further.
Negotiate to keep targets as low as possible. Use relative performance evaluation (peer company performance) to help keep targets low, if peer companies are performing lower than top management expects division managers at DC to perform.
Focus on financial results, perhaps at the expense of product development, employee training and other investments that will pay off later.
Incentives to manipulate accounting numbers to meet targets.
b. Is this a good plan? Would you want to be a division manager?
It’s a good plan if the company wants a short-run, financial focus, which it does.
The plan does not encourage inter-division activity. Each “tub” (i.e., division) is on its own “bottom.”
Answers will vary as to whether this is a good place to work. Risk-averse people who would like a stable job would probably not like this incentive arrangement. Consequently, the company hires managers who are relatively risk-taking, which the company wants.
As a footnote, the company also makes outright grants of stock to division managers on a discretionary basis. This award rewards managers that top management considers to be high performers even if their division earnings do not beat the target. Managers who get these grants might be those who spent resources on projects such as employee training, research, preventive maintenance, advertising and similar items that are expensed on the income statement but create long-term intangible assets.
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Chapter 12 - Fundamentals of Management Control Systems
12-20. (15 min.) Management Control Systems and Incentives: Heavy. This problem represents the change in an incentive plan at a company that manufactures machinery and engines. In negotiating a wage contract with the employees’ union, the company offered and the union agreed to a profit-sharing arrangement for workers instead of a wage increase. This agreement provided two good results from management’s point of view. First, the employees took on some risk because part of their pay was a function of profits instead of a fixed amount regardless of the company’s profit performance. Second, the arrangement addressed bad press that the company received because it had paid the workers “so little” while making ‘big profits.” Although management talked about the motivational effect of profit sharing, it acknowledged the reality that an individual worker had so little effect on company profits that there was no real motivational effect of the profit-sharing plan. Naturally, the workers liked the arrangement in profitable years but did not like it in unprofitable years. The union supported the profit-sharing arrangement because the expected value of the wages received under the arrangement exceeded the expected wages with a straight pay increase. The union got some political mileage out of a claim that a share of the profits now went to the workers instead of the ‘bosses” (i.e., the shareholders, we presume). 12-21. (15 min.) Alternative Allocation Bases: Packages-2-Go. a. Number of calls basis. Air Express 240,000 x $10,000,000 = $6,000,000 240,000 + 160,000 Ground Service 160,000 x $10,000,000 = $4,000,000 240,000 + 160,000 Check: $10,000,000 = $6,000,000 + $4,000,000 b. Time on Network Air Express 200,000 x $10,000,000 = $2,000,000 200,000 + 800,000 Ground Service 800,000 x $5,000,000 = $8,000,000 200,000 + 800,000 Check: $10,000,000 = $2,000,000 + $8,000,000
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Chapter 12 - Fundamentals of Management Control Systems
c. The allocation method is important because it might be used to evaluate division performance. Therefore, it could affect decisions the division managers make. 12-22. (10 min.) Single versus Dual Rates: Packages-2-Go. Air Express Fixed Variable
200,000 x $5,200,000 = 200,000 + 800,000 240,000 x $4,800,000 = 240,000 + 160,000
Total
$1,040,000 2,880,000 $3,920,000
Ground Service Fixed Variable
800,000 x $5,200,000 = 200,000 + 800,000 160,000 x $4,800,000 = 240,000 + 160,000
Total
$4,160,000 1,920,000 $6,080,000
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Chapter 12 - Fundamentals of Management Control Systems
12-23. (20 min.) Single versus Dual Rates—Ethical Issues. a. Gigabytes of Storage Basis Corporate 75,000 x $6,000,000 = $3,600,000 75,000 + 50,000 Government 50,000 x $6,000,000 = $2,400,000 75,000 + 50,000 Check: $6,000,000 = $3,600,000 + $2,400,000 b. Number of Consultants Basis Corporate 150 x $6,000,000 = $4,109,589 150 + 69 Government 69 x $6,000,000 = $1,890,411 150 + 69 Check: $6,000,000 = $4,109,589 + $1,890,411 c. Because the government contracts are cost-plus, the allocation basis will affect the revenues directly. If the allocation basis is approved as “reasonable,” this is something the consulting company will consider in determining the basis. If the terms of the contract do not specify the allocation basis and the basis is “reasonable,” it is not unethical.
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Chapter 12 - Fundamentals of Management Control Systems
12-24. (25 min.) Single versus Dual Rates. Corporate Fixed Variable Total
150 x $4,000,000 = $2,739,726 150 + 69 75,000 x $2,000,000 = 1,200,000 75,000 + 50,000 $3,939,726
Government Fixed Variable Total
69 x $4,000,000 = $1,260,274 150 + 69 50,000 x $2,000,000 = 800,000 75,000 + 50,000 $2,060,274
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Chapter 12 - Fundamentals of Management Control Systems
12-25. (20 min.) Single versus Dual Rates: Ajax Manufacturing. a. Number of Purchase Orders Basis Defense 5,000 x $1,000,000 = 5,000 + 20,000
$200,000
Commercial 20,000 x $1,000,000 = 5,000 + 20,000
$800,000
Check: $1,000,000 = $200,000 + $800,000 b. Dollar Amount of Purchases Basis Defense $100 x $1,000,000 = $400,000 $100 + $150 Commercial $150 x $1,000,000 = $600,000 $100 + $150 Check: $1,000,000 = $400,000 + $600,000 c. Because the government contracts are cost-plus, the allocation basis will affect the revenues directly. If the allocation basis is approved as “reasonable,” this is something the company will consider in determining the basis. If the terms of the contract do not specify the allocation basis and the basis is “reasonable,” it is not unethical.
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Chapter 12 - Fundamentals of Management Control Systems
12-26. (20 min.) Tone at the Top – Ethics. This case refers to an incident reported by NBC’s Dateline. The news group committed fraud (not financial fraud) when it rigged the GM trucks to blow up. The executive in this case set a tone that the behavior was not the problem, but getting caught was. The news group believed that the GM trucks would explode upon collision, they just didn’t in the demonstration for the cameras. This is analogous to executives believing that their companies are performing well, but the financial statements just don’t show that the company is performing well. So the executives “dress up” (that is, commit fraud) to make the financial statements tell the story that the executives believe should be told. NBC News might have been touting itself for having exposed the danger of GM's controversial ''sidesaddle'' gas tanks in a riveting Dateline NBC segment. Instead the network singed its reputation, and the car company won in the court of public opinion the safety battle it had lost in the courthouse. The NBC Dateline report included about one minute of crash footage that showed how the gas tanks of certain old GM trucks could catch fire in a sideways collision. After hiring detectives to check out the Dateline story, GM found that the fire was rigged. In particular, NBC said the truck's gas tank had ruptured, yet an X ray showed it hadn't; NBC consultants set off explosive miniature rockets beneath the truck split seconds before the crash. Some veteran observers of the news media claimed that they were not surprised by the fraud. They commented that the news media is very competitive and overeager to publicize sensational events.
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Chapter 12 - Fundamentals of Management Control Systems
12-27. (20 min.) Incentives and Ethics. The situation in this question is based on an actual case. In the actual case, the fraudulent activities were discovered by people who worked in the accounting department who discovered the invoices and shipping documents tucked away in the desk drawer of the accountant who colluded to commit the fraud. The “friend” was among those charged with the fraud because she knew about it and was suspected to be involved. She was eventually cleared of wrongdoing, but not until after several years of defending herself against the charges. She lost her job, and she spent a lot of time defending herself. If she were faced with similar circumstances again, she says she would immediately inform the head of the accounting department and at least two other people in the organization who were higher than her boss. Her initial contact would not be to accuse the alleged perpetrators of committing fraud, but would inquire as to the propriety of their actions in view of the company’s accounting and sales policies. In this way, she would avoid accusing someone of misbehavior before she had proof that what they did was wrong. If her inquiries were ignored, she would begin looking for a new job. 12-28. (20 min.) Internal Controls. a. The internal control is separation of duties between producing the sandwich and the financial transaction of recording the sale and taking the money. This separation of duties is a key element of internal controls. By separating production (that is, sandwich making) from the financial transaction, the shop owner is reasonably assured that the sandwich maker is not giving away free sandwiches, or even charging the customer for a half sandwich when the customer got a full sandwich. Separation of duties prevents theft by reducing the opportunity for the sandwich maker to give away the sandwich or charge too low a price, improves the accuracy of information by increasing the probability that the sandwich sale will be correctly reported, and reduces human errors by having two people involved in the transaction instead of one. b. A better internal control is to separate ringing up the sale from taking the money. The current procedure allows the person ringing the sale and taking the money to record the sale for less than it should be, charge the customer for the correct amount, and pocket the difference. c. Yes, by colluding, or working together, the two employees could beat the control. For example, the employees could charge the customer for a $6 sandwich, not ring up the sale, and pocket the cash.
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Chapter 12 - Fundamentals of Management Control Systems
Solutions to Problems 12-29. Evaluating Management Control Systems: SPG Company. Answers will vary. It is important to discuss all three elements of control systems (delegation of decision authority, performance measurement, and compensation systems) to ensure that recommended changes result in an efficient control system. Decision Authority: Marilyn has an incentive to produce low cost (and possibly low quality) products. One change would be to let Jack decide quality levels (and adjust the cost budget appropriately). Performance Measures: Another way to better align Marilyn’s incentives with the firm’s is to include profits in her performance evaluation. Some will argue that because Jack has no control over manufacturing, he should not be evaluated on profits, because that includes costs. However, as discussed with corporate cost allocation, if the costs used in the profit calculation are budgeted and not actual, Jack’s performance (relative to the target) will not be affected by Marilyn’s actions. Compensation Systems: The bonus parameter of 100% is unusually high providing very strong incentives for both Marilyn and Jack to do things to improve performance that might not be beneficial for the firm. This should probably be lowered (and the salary adjusted upward).
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Chapter 12 - Fundamentals of Management Control Systems
12-30. (40 min.) Analyze Performance Report for Decentralized Organization: Hall O’ Fame Products. a. An evaluation of the performance of James Davenport for the nine months ending September Year 3 would appear favorable if only the divisional performance measure figure were considered. The actual performance measure 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 materials and labor) has increased significantly as a percentage of sales.
The maintenance and repair costs included 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, James Davenport 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.
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Chapter 12 - Fundamentals of Management Control Systems
12-30. (continued) b. A performance evaluation system should reflect the division manager’s (D.M.) responsibilities (i.e., those things that are specifically controllable by the D.M. and for which the D.M. 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, Hall O’ Fame’s divisional management is solely responsible for the production and distribution of corporate products. 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 subtracted 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. CMA adapted.
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Chapter 12 - Fundamentals of Management Control Systems
12-31. (40 min.) Divisional Performance Measurement—Behavioral Issues: Paulista Corporation. 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 overemphasis on single measurement criteria and might 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 budget that is adjusted to reflect some variables outside the managers control to determine sales, net income, net income as a function of sales, and return on investment. Specific performance measures for the criterion “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.
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12-31. (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 might 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 that might 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 managementlevel decisions as well as having positive feedback. CMA adapted
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Chapter 12 - Fundamentals of Management Control Systems
12-32. (40 min.) Cost Allocations—Comparison of Dual and Single Rates: Pacifc Hotels. a. Allocations based on time usage: (1)
Proportion of Allocated Cost Department Total Time Luxury.................................................................. .15a $540,000b Resort.................................................................. .10 360,000 Standard.............................................................. .40 1,440,00 Budget................................................................. .35 1,260,000 $3,600,000
a
750 (750 + 500 + 2,000 + 1,750) = 750 5,000 = .15; .10 = 500 5,000; .40 = 2,000 5,000; .35 = 1,750 5,000
b
.15 x ($2,100,000 + 1,500,000) = $540,000; $360,000 = .10 x $3,600,000; $1,440,000 = .40 x $3,600,000; $1,260,000 = .35 x $3,600,000
(2) Dual allocations (1)
(2)
(3)
(4) Allocated Proportion of Equipment Reservations Cost
(5) Total Allocated Cols. 2 + 4
$90,000d 135,000 375,000 900,000
$405,000 345,000 1,215,000 1,635,000 $3,600,000
Proportion Allocated of Time Time Cost Usage Luxury.................................................................. .15a $315,000b .06c Resort.................................................................. .10 210,000 .09 Standard.............................................................. .40 840,000 .25 Budget................................................................. .35 735,000 .60 a
from part (a)
b
$315,000 = $2,100,000 x .15; $210,00 = $2,100,000 x .10; $840,000 = $2,100,000 x .40; $735,000 = $2,100,000 x .35
c
.06 = 45.0 (45.0 + 67.5 + 187.5 + 450.0) = 45 750; .09 = 67.5 750; .25 = 187.5 750; .60 = 450 750
d
$90,000 = .06 x $1,500,000; $135,000 = .09 x $1,500,000; and so on.
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12-32. (continued) b. Dual rates should be used. If a single rate (time usage) is used, there might not be a causal relationship between time usage and equipment-related costs. For example, Standard hotels had the highest time usage (and thus, was allocated a large share of total costs using a single rate), but had relatively low reservations. Using dual rates, Standard Group would receive a more representative share of costs.
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Chapter 12 - Fundamentals of Management Control Systems
12-33. (30 min.) Cost Allocation for Travel Reimbursement. a. (1) Since the round-trip cost of the Chicago-Paris portion (2 x $3,650 = $7,300) is less than the cost of the business-class ticket, the employee could request as much as $7,300. (2) The minimum cost to the company would be $4,900, the restricted round-trip fare from Chicago to Paris assuming company policy allows business-class travel for international trips. b. One alternative is to reimburse the employee for an unrestricted round-trip fare from Chicago to Paris, $7,300 (= 2 x $3,650). Another reasonable alternative could be computed as follows: The round-trip business portion of the trip was 8,280 miles (= 4,140 + 4,140). Dividing by the total mileage of 15,140 miles equals .55 or 55% of the business-class ticket. This alternative would result in a reimbursement of $5,245 (i.e., .55 x $9,537). Depending on policy some amount between $4,900 and $7,300 would usually be suggested as a basis for reimbursement. This problem demonstrates the need for ex ante policy when there are arbitrary and potentially contentious allocations. 12-34. (30 min.) Incentives, Illegal Activities, and Ethics. This situation is based on the alleged fraud at the company, Leslie Fay. a. Invoice backdating records revenues in periods earlier than they should be recorded. The dressmaker would have reported revenues and cost of goods sold for Year 1 that should have been reported in Year 2. Profits are overstated just for that period. The profits that were “moved’ into Year 1 are no longer available to be reported in Year 2. Consequently, frauds sometimes grow because managers continue to backdate invoices to make up for profits moved into earlier periods. b. The bonus plan provided the executives with a lot of benefits if the company met its earnings goals. Also, the chief executive officer put a lot of pressure on his subordinates to achieve short-term results. (This is not unusual in companies.) Statements of shock and dismay, such as those made by the CEO, are usually not sincere (in our experience.) On the other hand, the CEO did not commit the fraud, himself. The tone in the organization and top management pressure are not sufficient excuses to commit fraud.
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12-34. (continued) c. Distant locations are more difficult to monitor than those close by. If he desired, the CEO could have made frequent visits to the nearby location to observe activities. If he opposed the fraudulent activities, he could have had a personal hand in preventing them if he were personally observing the operations. Here is a real example. An employee who is uncomfortable engaging in fraudulent activities bumps into a top executive on the way to the parking lot. She tells the chief executive about the fraudulent activities. The chief executive in that case was able to learn about and put a stop to the fraudulent activities because the financial operations were in the same location as he. The distance between the financial operations and the corporate headquarters substantially reduced the probability of such chance encounters at Fallo Me (i.e., Leslie Fay).
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Chapter 12 - Fundamentals of Management Control Systems
Solutions to Integrative Case 12-35. (60 min.) River Beverages Case. Note:
It is important to understand the regional structure of the organization (Exhibit 12.3) as well as the production plant structure for the company’s Noncarbonated Drinks plant in St. Louis (Exhibit 12.4). Instructors might want to present an overview of this case before assigning it to students.
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 Exhibit 12.3). 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 Exhibit 12.4). 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.
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12-35. (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 and costs), or as cost centers (responsible only for costs)? The plant managers have very little control (if any) over sales projections. As shown in Exhibit 12.4, the division and district sales managers report separately to the division manager, and do not discuss the sales budget with the plant managers. It is very difficult to make a case that plant managers should be responsible for sales. However, plant managers are responsible for controlling costs and are directly involved in establishing budgeted costs. Thus, it is reasonable to treat the plant as a cost center and hold plant managers responsible for costs. If management wants to continue treating the plant as a profit center, plant managers should be involved in the sales budgeting process. 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 budget process will vary. One example follows: 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.
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12-36. (60 min.) Pepsi and Old Bottles Here are some of the factors contributing to the fraud.
Pepsi had strong incentives to perform well.
The company was decentralized, which reduced oversight by top management.
Pepsi’s top management relied heavily on its trust of employees for assurance that employees did not commit fraud.
Internal audit acted more as consultants than as watchdogs.
The fraud was committed in a foreign country distant from corporate headquarters, which is harder to monitor than a division located close to headquarters.
The use of foreign language inhibited the ability of auditors to ask penetrating questions in their investigations.
We did not state in the case that one of the 12 employees against whom the SEC filed formal charges committed suicide.
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12-37. (60 min.) Business Environment, Performance Measures, and Compensation Ethics: Kidder, Peabody (GE) a. You should report the flaw to managers responsible for the system. b. Even though you know the system is flawed and your superiors do not change the system, you should not use the flaw to improve your performance. You should also report the flaw to someone in authority or on the board of directors and alert them to this problem. c. The percentage of salary that can be earned as bonus differs greatly from industry to industry. There are (at least) two reasons for this:
First, different industries require different amounts of specialized knowledge from managers making the knowledge more valuable. In order to provide incentives to these managers, the amount of contingent compensation (contingent on the results of their decisions) is higher.
Second, individuals know more about their talents (for example, their ability to be successful traders) than the firms that hire them. This is referred to as “adverse selection.” Making more of their compensation contingent on performance leads only those who believe they are better at this activity than the average person to apply for the job.
d. (1) Apparently the managers have some money in the budget that could be used for investment or other opportunities that had not been used and, as a result, could beused to offset the surprise. For example, rather than spending $10 million on an R&D project, which would be an expense, the $10 million could not be spent. (2) In addition to R&D, other uses could include training, maintenance, or advertising. (3) The decision about returning the money in the budget should depend on whether the expenditure would raise the value of the company more than spending it. It should be independent of the write-off required by the false trading profits.
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Solutions to Review Questions 12-1. Accounting assigns costs and revenues to “responsibility centers” that correspond to the decision authority of managers. This allows the firm to measure performance based on the results of decisions by the manager. An effective corporate cost allocation system separates the results of decisions by corporate managers from those of business unit managers. 12-2. Although there are well-developed standards for many accounting transactions, accounting decisions still depend on the judgment of managers. There are also many estimates (for example, the depreciable lives of fixed assets) that are subject to managerial discretion. Performance measures based on accounting estimates are affected by these judgments, just as are the reported accounting numbers. 12-3. Top managers are viewed as agents of the Board of Directors. The Board of Directors can be considered the agent of the shareholders. 12-4. The division president would be the principal relative to subordinate managers.
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12-5. In many cases managers are content to take a stated salary and perform optimally. However, in other organizations managers appear to perform better when given profit targets and other incentive devices. 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, these comments would make sense in the right organization setting. 12-6. Separation of duties helps prevent financial fraud because it limits the opportunity to commit the fraud. When a separation of duties exists, two or more individuals must engage in collusion to commit fraud. While collusion can and does occur, it increases the risk that someone will “blow the whistle” on the fraud. The increased risk of revealing fraud makes it less likely that fraud will occur. Thus, one manager might have the decision authority to authorize purchases and another manager has the decision authority to issue the payment.
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Solutions to Critical Analysis and Discussion Questions 12-7. Local managers often have better information about local conditions. This information is valuable to the central headquarters in the planning process. But, local managers know that they will be evaluated by this information. Therefore, they have an incentive to bias the information. 12-8. Sales people can often influence costs by offering expedited delivery or other “extras” that do not reduce the revenue used to determine commissions but can increase costs. 12-9. There is a strong incentive to “find” $100,000 in income. The manager might defer maintenance or training or might offer special discounts for sales made before the end of the year. If the manager’s business unit earns $1 less than $10 million, his or her compensation is substantially less than if he or she can find the dollar. 12-10. Frequently managers will wait until near the end of the budget period to make discretionary expenditures. Sometimes managers will use "excess" funds from one period to stock up on supplies and other items that would normally be a part of the next budget period’s costs. (Managers have incentives to spend the money requested to maintain the credibility of their requests.) These activities are sometimes considered detrimental to the organization because they result in a waste of resources and improper timing of expenditures. Nonetheless, in many situations the cost of controlling these potentially adverse activities exceeds the benefits. 12-11. The service costs are being allocated on the basis of use when, in fact, some of the costs were incurred to provide capacity. Dual rates might be established so that the capacity costs would be allocated on the basis of the capacity requested by each of the departments while the use costs would be allocated on the current basis. An interesting problem arises when the joint capacity might be less than the capacity that would be required by each department individually. This problem of the “economies of scale” results in a need to find a basis for allocating the cost savings arising from such economies. No entirely satisfactory and unique solution is readily determinable.
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12-12. 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. 12-13. Answers will vary. There are many reasons for pay not to reflect performance. In some cases, the reasons are because of collusion or other unethical or illegal reasons. Some other reasons, which might be defensible for business reasons include a desire to keep certain managers or how the performance of the firm compared to that of competitors. It is important when discussing performance measurement that the performance of the manager(s) be separated from the performance of the company (or business unit). Often, the managers might be performing well (poorly) although the organization is performing poorly (well). It is not uncommon for companies to place their best managers in units that are struggling. The balancing act firms must always perform when compensation is tied contractually to performance is between adhering to the terms of the contract and being “fair” to the managers when unforeseen circumstances arise. The problem is, of course, that the unforeseen circumstances more often cause performance to be below expectation, rather than the other way around. 12-14. The Treadway Commission listed the pressures to achieve unrealistically high, short-term financial results and incentive systems that focus on short-term financial results as examples of factors that might produce financial fraud. Combined, the two factors produce an environment that is highly conducive to fraud. Recent examples include Enron, Worldcom, and Tyco. In each of these cases, strong incentives and lack of strong oversight allowed managers to engage in unethical and illegal behavior.
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12-15. Two explanations for the existence of unrealistic profit objectives for division managers are that upper management might be uninformed about the division, and that they might be too zealous regarding the company’s profit potential. In decentralized and widely dispersed companies, top management is usually not involved with the details of local operations. Unwittingly, top management could expect more from a division than operating and market conditions allow. On the other hand, top management could choose to knowingly expect unrealistic results, thinking that attempts to achieve the results will produce better results than if expectations were lower. 12-16. Committing financial fraud in the current period might seem to outweigh future problems that the fraud might cause. The perpetrator of the fraud might be promoted before the negative consequences of the fraud are revealed. Alternatively, the perpetrator of fraud might believe he or she will be fired if the short-run targets are not met, so he or she has little to lose by committing fraud to meet the targets.
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Solutions to Exercises 12-17. (15 min.) Evaluating Management Control Systems: Chama Car Detailing. a. Based on the company’s method for measuring performance, Deana has done well. The actual wage was $2.01 (= $15.13 – $13.12) below the target wage. Mike has not performed well. Actual profits are $108,000 (= $745,000 – $637,000) below target profits. b. The management control system at Chama is possibly flawed. The low actual wages might indicate that the quality of employees hired is below the level needed to achieve the target profits. For example, the employees hired might require more training than expected or are less efficient than expected. As a result, Deana benefits from the low wage, but Mike (and the company) do not. Some recommendations for change might include:
Allow Mike or the store managers to hire with a ceiling on the wage (decision authority).
Evaluate Deana on wages with a requirement that employees hired have a minimum level of skill (performance evaluation).
Compensate Deana in part on store profits (compensation).
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12-18. (20 min.) Evaluating Management Control Systems – Ethical Considerations: Magnolia Manufacturing. a. Income with the new technique will be $6 million (= $5 million x 1.20) or 20% above target. Without the new technique, there will be no bonus. With the new technique, Kevin’s bonus will be 2% (= 20% ÷ 10) of salary, or $3,000 (= 2% x $150,000). Michelle’s bonus will be 2% or $4,000 (=2% x $200,000). b. Income with the new technique will be $8.4 million (= $7 million x 1.20) or 68% above target. Kevin’s bonus will be 5% (the maximum) of salary, or $7,500 (= 5% x $150,000). Without the new technique, Kevin’s bonus will be $6,000 (4% x $150,000). Therefore, Kevin’s bonus will be $1,500 higher (= $7,500 – $6,000) with the new technique. Michelle’s bonus with the new technique will also be 5% or $10,000 (= 5% x $200,000). Without the new technique, Michelle’s bonus will be $8,000 (4% x $200,000). Therefore, Michelle’s bonus will be $2,000 higher (= $10,000 – $8,000) with the new technique. c. Income with the new technique will be $4.8 million (= $4 million x 1.20) or below the target profit. Neither Kevin nor Michelle will be eligible for the bonus. d. Kevin should not consider his bonus when deciding whether to employ the technique. If he finds that the current management control system leads to incentives to take actions not in the interests of the company, he should identify these to the CFO or other executive responsible for the system. e. Kevin is responsible for manufacturing and has little direct control over sales. One recommendation would be to evaluate Kevin based on costs relative to a budget based on production. As a result, he would have an incentive to take actions that reduce costs regardless of the level of revenues. Michelle could be evaluated on profits where costs are based on budgets for the number of units sold. This insulates Michelle from cost overruns in production. Finally, the limit on the bonus to 5% of salary probably means that the bonus has relative low incentive power. This should be increased.
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12-19. (15 min.) Management Control Systems and Incentives: DC. This problem represents part of the incentive plan of a U.S.-based international conglomerate. This part of the incentive system was designed to focus managers on maximizing short-term earnings. a. This plan creates the following incentives for division managers:
Short-term orientation.
Once a target for the year is met, there is no incentive to improve further.
Negotiate to keep targets as low as possible. Use relative performance evaluation (peer company performance) to help keep targets low, if peer companies are performing lower than top management expects division managers at DC to perform.
Focus on financial results, perhaps at the expense of product development, employee training and other investments that will pay off later.
Incentives to manipulate accounting numbers to meet targets.
b. Is this a good plan? Would you want to be a division manager?
It’s a good plan if the company wants a short-run, financial focus, which it does.
The plan does not encourage inter-division activity. Each “tub” (i.e., division) is on its own “bottom.”
Answers will vary as to whether this is a good place to work. Risk-averse people who would like a stable job would probably not like this incentive arrangement. Consequently, the company hires managers who are relatively risk-taking, which the company wants.
As a footnote, the company also makes outright grants of stock to division managers on a discretionary basis. This award rewards managers that top management considers to be high performers even if their division earnings do not beat the target. Managers who get these grants might be those who spent resources on projects such as employee training, research, preventive maintenance, advertising and similar items that are expensed on the income statement but create long-term intangible assets.
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12-20. (15 min.) Management Control Systems and Incentives: Heavy. This problem represents the change in an incentive plan at a company that manufactures machinery and engines. In negotiating a wage contract with the employees’ union, the company offered and the union agreed to a profit-sharing arrangement for workers instead of a wage increase. This agreement provided two good results from management’s point of view. First, the employees took on some risk because part of their pay was a function of profits instead of a fixed amount regardless of the company’s profit performance. Second, the arrangement addressed bad press that the company received because it had paid the workers “so little” while making ‘big profits.” Although management talked about the motivational effect of profit sharing, it acknowledged the reality that an individual worker had so little effect on company profits that there was no real motivational effect of the profit-sharing plan. Naturally, the workers liked the arrangement in profitable years but did not like it in unprofitable years. The union supported the profit-sharing arrangement because the expected value of the wages received under the arrangement exceeded the expected wages with a straight pay increase. The union got some political mileage out of a claim that a share of the profits now went to the workers instead of the ‘bosses” (i.e., the shareholders, we presume). 12-21. (15 min.) Alternative Allocation Bases: Packages-2-Go. a. Number of calls basis. Air Express 240,000 x $10,000,000 = $6,000,000 240,000 + 160,000 Ground Service 160,000 x $10,000,000 = $4,000,000 240,000 + 160,000 Check: $10,000,000 = $6,000,000 + $4,000,000 b. Time on Network Air Express 200,000 x $10,000,000 = $2,000,000 200,000 + 800,000 Ground Service 800,000 x $5,000,000 = $8,000,000 200,000 + 800,000 Check: $10,000,000 = $2,000,000 + $8,000,000
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c. The allocation method is important because it might be used to evaluate division performance. Therefore, it could affect decisions the division managers make. 12-22. (10 min.) Single versus Dual Rates: Packages-2-Go. Air Express Fixed Variable
200,000 x $5,200,000 = 200,000 + 800,000 240,000 x $4,800,000 = 240,000 + 160,000
Total
$1,040,000 2,880,000 $3,920,000
Ground Service Fixed Variable
800,000 x $5,200,000 = 200,000 + 800,000 160,000 x $4,800,000 = 240,000 + 160,000
Total
$4,160,000 1,920,000 $6,080,000
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12-23. (20 min.) Single versus Dual Rates—Ethical Issues. a. Gigabytes of Storage Basis Corporate 75,000 x $6,000,000 = $3,600,000 75,000 + 50,000 Government 50,000 x $6,000,000 = $2,400,000 75,000 + 50,000 Check: $6,000,000 = $3,600,000 + $2,400,000 b. Number of Consultants Basis Corporate 150 x $6,000,000 = $4,109,589 150 + 69 Government 69 x $6,000,000 = $1,890,411 150 + 69 Check: $6,000,000 = $4,109,589 + $1,890,411 c. Because the government contracts are cost-plus, the allocation basis will affect the revenues directly. If the allocation basis is approved as “reasonable,” this is something the consulting company will consider in determining the basis. If the terms of the contract do not specify the allocation basis and the basis is “reasonable,” it is not unethical.
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12-24. (25 min.) Single versus Dual Rates. Corporate Fixed Variable Total
150 x $4,000,000 = $2,739,726 150 + 69 75,000 x $2,000,000 = 1,200,000 75,000 + 50,000 $3,939,726
Government Fixed Variable Total
69 x $4,000,000 = $1,260,274 150 + 69 50,000 x $2,000,000 = 800,000 75,000 + 50,000 $2,060,274
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12-25. (20 min.) Single versus Dual Rates: Ajax Manufacturing. a. Number of Purchase Orders Basis Defense 5,000 x $1,000,000 = 5,000 + 20,000
$200,000
Commercial 20,000 x $1,000,000 = 5,000 + 20,000
$800,000
Check: $1,000,000 = $200,000 + $800,000 b. Dollar Amount of Purchases Basis Defense $100 x $1,000,000 = $400,000 $100 + $150 Commercial $150 x $1,000,000 = $600,000 $100 + $150 Check: $1,000,000 = $400,000 + $600,000 c. Because the government contracts are cost-plus, the allocation basis will affect the revenues directly. If the allocation basis is approved as “reasonable,” this is something the company will consider in determining the basis. If the terms of the contract do not specify the allocation basis and the basis is “reasonable,” it is not unethical.
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12-26. (20 min.) Tone at the Top – Ethics. This case refers to an incident reported by NBC’s Dateline. The news group committed fraud (not financial fraud) when it rigged the GM trucks to blow up. The executive in this case set a tone that the behavior was not the problem, but getting caught was. The news group believed that the GM trucks would explode upon collision, they just didn’t in the demonstration for the cameras. This is analogous to executives believing that their companies are performing well, but the financial statements just don’t show that the company is performing well. So the executives “dress up” (that is, commit fraud) to make the financial statements tell the story that the executives believe should be told. NBC News might have been touting itself for having exposed the danger of GM's controversial ''sidesaddle'' gas tanks in a riveting Dateline NBC segment. Instead the network singed its reputation, and the car company won in the court of public opinion the safety battle it had lost in the courthouse. The NBC Dateline report included about one minute of crash footage that showed how the gas tanks of certain old GM trucks could catch fire in a sideways collision. After hiring detectives to check out the Dateline story, GM found that the fire was rigged. In particular, NBC said the truck's gas tank had ruptured, yet an X ray showed it hadn't; NBC consultants set off explosive miniature rockets beneath the truck split seconds before the crash. Some veteran observers of the news media claimed that they were not surprised by the fraud. They commented that the news media is very competitive and overeager to publicize sensational events.
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12-27. (20 min.) Incentives and Ethics. The situation in this question is based on an actual case. In the actual case, the fraudulent activities were discovered by people who worked in the accounting department who discovered the invoices and shipping documents tucked away in the desk drawer of the accountant who colluded to commit the fraud. The “friend” was among those charged with the fraud because she knew about it and was suspected to be involved. She was eventually cleared of wrongdoing, but not until after several years of defending herself against the charges. She lost her job, and she spent a lot of time defending herself. If she were faced with similar circumstances again, she says she would immediately inform the head of the accounting department and at least two other people in the organization who were higher than her boss. Her initial contact would not be to accuse the alleged perpetrators of committing fraud, but would inquire as to the propriety of their actions in view of the company’s accounting and sales policies. In this way, she would avoid accusing someone of misbehavior before she had proof that what they did was wrong. If her inquiries were ignored, she would begin looking for a new job. 12-28. (20 min.) Internal Controls. a. The internal control is separation of duties between producing the sandwich and the financial transaction of recording the sale and taking the money. This separation of duties is a key element of internal controls. By separating production (that is, sandwich making) from the financial transaction, the shop owner is reasonably assured that the sandwich maker is not giving away free sandwiches, or even charging the customer for a half sandwich when the customer got a full sandwich. Separation of duties prevents theft by reducing the opportunity for the sandwich maker to give away the sandwich or charge too low a price, improves the accuracy of information by increasing the probability that the sandwich sale will be correctly reported, and reduces human errors by having two people involved in the transaction instead of one. b. A better internal control is to separate ringing up the sale from taking the money. The current procedure allows the person ringing the sale and taking the money to record the sale for less than it should be, charge the customer for the correct amount, and pocket the difference. c. Yes, by colluding, or working together, the two employees could beat the control. For example, the employees could charge the customer for a $6 sandwich, not ring up the sale, and pocket the cash.
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Solutions to Problems 12-29. Evaluating Management Control Systems: SPG Company. Answers will vary. It is important to discuss all three elements of control systems (delegation of decision authority, performance measurement, and compensation systems) to ensure that recommended changes result in an efficient control system. Decision Authority: Marilyn has an incentive to produce low cost (and possibly low quality) products. One change would be to let Jack decide quality levels (and adjust the cost budget appropriately). Performance Measures: Another way to better align Marilyn’s incentives with the firm’s is to include profits in her performance evaluation. Some will argue that because Jack has no control over manufacturing, he should not be evaluated on profits, because that includes costs. However, as discussed with corporate cost allocation, if the costs used in the profit calculation are budgeted and not actual, Jack’s performance (relative to the target) will not be affected by Marilyn’s actions. Compensation Systems: The bonus parameter of 100% is unusually high providing very strong incentives for both Marilyn and Jack to do things to improve performance that might not be beneficial for the firm. This should probably be lowered (and the salary adjusted upward).
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12-30. (40 min.) Analyze Performance Report for Decentralized Organization: Hall O’ Fame Products. a. An evaluation of the performance of James Davenport for the nine months ending September Year 3 would appear favorable if only the divisional performance measure figure were considered. The actual performance measure 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 materials and labor) has increased significantly as a percentage of sales.
The maintenance and repair costs included 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, James Davenport 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.
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12-30. (continued) b. A performance evaluation system should reflect the division manager’s (D.M.) responsibilities (i.e., those things that are specifically controllable by the D.M. and for which the D.M. 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, Hall O’ Fame’s divisional management is solely responsible for the production and distribution of corporate products. 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 subtracted 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. CMA adapted.
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12-31. (40 min.) Divisional Performance Measurement—Behavioral Issues: Paulista Corporation. 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 overemphasis on single measurement criteria and might 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 budget that is adjusted to reflect some variables outside the managers control to determine sales, net income, net income as a function of sales, and return on investment. Specific performance measures for the criterion “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.
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12-31. (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 might 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 that might 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 managementlevel decisions as well as having positive feedback. CMA adapted
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12-32. (40 min.) Cost Allocations—Comparison of Dual and Single Rates: Pacifc Hotels. a. Allocations based on time usage: (1)
Proportion of Allocated Cost Department Total Time Luxury.................................................................. .15a $540,000b Resort.................................................................. .10 360,000 Standard.............................................................. .40 1,440,00 Budget................................................................. .35 1,260,000 $3,600,000
a
750 (750 + 500 + 2,000 + 1,750) = 750 5,000 = .15; .10 = 500 5,000; .40 = 2,000 5,000; .35 = 1,750 5,000
b
.15 x ($2,100,000 + 1,500,000) = $540,000; $360,000 = .10 x $3,600,000; $1,440,000 = .40 x $3,600,000; $1,260,000 = .35 x $3,600,000
(2) Dual allocations (1)
(2)
(3)
(4) Allocated Proportion of Equipment Reservations Cost
(5) Total Allocated Cols. 2 + 4
$90,000d 135,000 375,000 900,000
$405,000 345,000 1,215,000 1,635,000 $3,600,000
Proportion Allocated of Time Time Cost Usage Luxury.................................................................. .15a $315,000b .06c Resort.................................................................. .10 210,000 .09 Standard.............................................................. .40 840,000 .25 Budget................................................................. .35 735,000 .60 a
from part (a)
b
$315,000 = $2,100,000 x .15; $210,00 = $2,100,000 x .10; $840,000 = $2,100,000 x .40; $735,000 = $2,100,000 x .35
c
.06 = 45.0 (45.0 + 67.5 + 187.5 + 450.0) = 45 750; .09 = 67.5 750; .25 = 187.5 750; .60 = 450 750
d
$90,000 = .06 x $1,500,000; $135,000 = .09 x $1,500,000; and so on.
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Chapter 12 - Fundamentals of Management Control Systems
12-32. (continued) b. Dual rates should be used. If a single rate (time usage) is used, there might not be a causal relationship between time usage and equipment-related costs. For example, Standard hotels had the highest time usage (and thus, was allocated a large share of total costs using a single rate), but had relatively low reservations. Using dual rates, Standard Group would receive a more representative share of costs.
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Chapter 12 - Fundamentals of Management Control Systems
12-33. (30 min.) Cost Allocation for Travel Reimbursement. a. (1) Since the round-trip cost of the Chicago-Paris portion (2 x $3,650 = $7,300) is less than the cost of the business-class ticket, the employee could request as much as $7,300. (2) The minimum cost to the company would be $4,900, the restricted round-trip fare from Chicago to Paris assuming company policy allows business-class travel for international trips. b. One alternative is to reimburse the employee for an unrestricted round-trip fare from Chicago to Paris, $7,300 (= 2 x $3,650). Another reasonable alternative could be computed as follows: The round-trip business portion of the trip was 8,280 miles (= 4,140 + 4,140). Dividing by the total mileage of 15,140 miles equals .55 or 55% of the business-class ticket. This alternative would result in a reimbursement of $5,245 (i.e., .55 x $9,537). Depending on policy some amount between $4,900 and $7,300 would usually be suggested as a basis for reimbursement. This problem demonstrates the need for ex ante policy when there are arbitrary and potentially contentious allocations. 12-34. (30 min.) Incentives, Illegal Activities, and Ethics. This situation is based on the alleged fraud at the company, Leslie Fay. a. Invoice backdating records revenues in periods earlier than they should be recorded. The dressmaker would have reported revenues and cost of goods sold for Year 1 that should have been reported in Year 2. Profits are overstated just for that period. The profits that were “moved’ into Year 1 are no longer available to be reported in Year 2. Consequently, frauds sometimes grow because managers continue to backdate invoices to make up for profits moved into earlier periods. b. The bonus plan provided the executives with a lot of benefits if the company met its earnings goals. Also, the chief executive officer put a lot of pressure on his subordinates to achieve short-term results. (This is not unusual in companies.) Statements of shock and dismay, such as those made by the CEO, are usually not sincere (in our experience.) On the other hand, the CEO did not commit the fraud, himself. The tone in the organization and top management pressure are not sufficient excuses to commit fraud.
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Chapter 12 - Fundamentals of Management Control Systems
12-34. (continued) c. Distant locations are more difficult to monitor than those close by. If he desired, the CEO could have made frequent visits to the nearby location to observe activities. If he opposed the fraudulent activities, he could have had a personal hand in preventing them if he were personally observing the operations. Here is a real example. An employee who is uncomfortable engaging in fraudulent activities bumps into a top executive on the way to the parking lot. She tells the chief executive about the fraudulent activities. The chief executive in that case was able to learn about and put a stop to the fraudulent activities because the financial operations were in the same location as he. The distance between the financial operations and the corporate headquarters substantially reduced the probability of such chance encounters at Fallo Me (i.e., Leslie Fay).
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Chapter 12 - Fundamentals of Management Control Systems
Solutions to Integrative Case 12-35. (60 min.) River Beverages Case. Note:
It is important to understand the regional structure of the organization (Exhibit 12.3) as well as the production plant structure for the company’s Noncarbonated Drinks plant in St. Louis (Exhibit 12.4). Instructors might want to present an overview of this case before assigning it to students.
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 Exhibit 12.3). 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 Exhibit 12.4). 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.
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Chapter 12 - Fundamentals of Management Control Systems
12-35. (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 and costs), or as cost centers (responsible only for costs)? The plant managers have very little control (if any) over sales projections. As shown in Exhibit 12.4, the division and district sales managers report separately to the division manager, and do not discuss the sales budget with the plant managers. It is very difficult to make a case that plant managers should be responsible for sales. However, plant managers are responsible for controlling costs and are directly involved in establishing budgeted costs. Thus, it is reasonable to treat the plant as a cost center and hold plant managers responsible for costs. If management wants to continue treating the plant as a profit center, plant managers should be involved in the sales budgeting process. 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 budget process will vary. One example follows: 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.
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12-36. (60 min.) Pepsi and Old Bottles Here are some of the factors contributing to the fraud.
Pepsi had strong incentives to perform well.
The company was decentralized, which reduced oversight by top management.
Pepsi’s top management relied heavily on its trust of employees for assurance that employees did not commit fraud.
Internal audit acted more as consultants than as watchdogs.
The fraud was committed in a foreign country distant from corporate headquarters, which is harder to monitor than a division located close to headquarters.
The use of foreign language inhibited the ability of auditors to ask penetrating questions in their investigations.
We did not state in the case that one of the 12 employees against whom the SEC filed formal charges committed suicide.
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Chapter 12 - Fundamentals of Management Control Systems
12-37. (60 min.) Business Environment, Performance Measures, and Compensation Ethics: Kidder, Peabody (GE) a. You should report the flaw to managers responsible for the system. b. Even though you know the system is flawed and your superiors do not change the system, you should not use the flaw to improve your performance. You should also report the flaw to someone in authority or on the board of directors and alert them to this problem. c. The percentage of salary that can be earned as bonus differs greatly from industry to industry. There are (at least) two reasons for this:
First, different industries require different amounts of specialized knowledge from managers making the knowledge more valuable. In order to provide incentives to these managers, the amount of contingent compensation (contingent on the results of their decisions) is higher.
Second, individuals know more about their talents (for example, their ability to be successful traders) than the firms that hire them. This is referred to as “adverse selection.” Making more of their compensation contingent on performance leads only those who believe they are better at this activity than the average person to apply for the job.
d. (1) Apparently the managers have some money in the budget that could be used for investment or other opportunities that had not been used and, as a result, could beused to offset the surprise. For example, rather than spending $10 million on an R&D project, which would be an expense, the $10 million could not be spent. (2) In addition to R&D, other uses could include training, maintenance, or advertising. (3) The decision about returning the money in the budget should depend on whether the expenditure would raise the value of the company more than spending it. It should be independent of the write-off required by the false trading profits.
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