Chapter 22

Accounting: Text and Cases 12e Instructors Manual Anthony/Hawkins/Merchant

2007 McGraw-Hill/IrwinChapter 22

CHapter 22

CONTROL: THE MANAGEMENT CONTROL ENVIRONMENT

Changes from the Eleventh Edition

All changes were minor.

Approach

This chapter and the following one are a sharp change of pace from the preceding chapters because there are no numerical techniques or procedures to be learned. Instead, the chapters establish a framework and describe concepts that are essential to an understanding of the chapters that follow. It is probably desirable to point out this change of pace in assigning the chapter so that students will know what to expect.

Since the text expands on material that was introduced in Chapter 15, it may be desirable to ask students to reread Chapter 15 at this point. Points that were obscure when Chapter 15 was first assigned should now be clearer.

Although the topic has come up several times previously, it probably is desirable to emphasize again the fact that there are three types of management accounting information, each of which is appropriate to certain types of problems but not to others, and that mistakes are made when the wrong type of data is used. Illustration 22-3 is designed to make this point, particularly with reference to the differences between responsibility accounting and full cost accounting. It may be well to discuss this exhibit in detail. There is sometimes a tendency to play down the importance of full cost accounting because it is not useful in the control of responsibility centers, but this reflects an erroneous either-or attitude. It is not a case of choosing either one approach or the other, each approach is needed in a company, and each has its own uses.

Cases

Behavioral Implications of Airline Depreciation Accounting Policy Choices shows students that companies measurement choices vary widely and motivates a discussion as to whether these choices affect managers decisions, and if so how.

Shuman Automobiles Inc. introduces the concepts of responsibility centers and transfer prices in a setting that students can easily understand.

Zumwald AG is a transfer pricing case, with the emphasis on the behavioral effects of the transfer pricing alternatives.

Enager Industries, Inc., is a case on the introduction of an ROI measurement scheme for business divisions. It can be used to discuss almost any aspect of investment centers.

Piedmont University deals with several management control issues in a nonprofit organization, especially the use of profit centers.

Problems

Problem 22-1: Arbia Company

Relevant Costs

a. For financial statementsfull costs of Department 7:

$50,990, or $50.99 per unit for units sold or left in inventory.

b. Decisions to make or buy Part No. 105differential costs:

Purchase cost

$31.00per unit

Materials and labor cost if make

29.82per unit

Savings if make

$1.18(assuming no fixed costs are differential)

c. Assessing performance of manager of Department 7:

Costs for which the manager is responsible are the variable and fixed costs of Department 7, $36,700. Costs allocated to Department 7, $14,290, cannot be controlled by the manager. Nevertheless, they are often shown on responsibility center reports to indicate their magnitude.

Problem 22-2: Golub Company

a. The sales manager's complaint is justified. Product A has the largest net sales of the three products and under the allocation method used in the first year would, therefore, be charged the largest amount for advertising expense. However, the actual amount of advertising expense incurred on behalf of Product A, and hence the responsibility of the manager of Product A, is smaller than that incurred on behalf of Product B.

b. Product A should be charged $10,000 because that is the amount spent on behalf of Product A. It would be acceptable to charge Product A with an allocated portion of the institutional advertising, based on sales volume, but this amount should be separated from the $10,000 for which Product A is responsible.

Problem 22-3

The transfer price should probably be $240 per thousand boxes because the Hardware Division buying the boxes should not be expected to pay more than if it bought from an outside supplier at $239. This price from an outside supplier is likely because of the keen competition mentioned in the problem.

Problem 22-4: Urban Services, Inc.

a. The billing rate should be $104 per hour which is the same rate charged to outside clients since Portfolio Management is working at capacity. Any price less than this would reduce Portfolio Group profits, the criterion by which management evaluates performance.

b. If the Portfolio Management Group were not working at capacity, it would be to its advantage to hire its staff out to any internal group at a billing rate which could go as low as $57.00, its variable cost.

c. No, the Accounting Services Group ought to have the option of going outside to satisfy its consulting needs if it can do so at a rate lower than that demanded by the Legal Services Group. If the Legal Services Group does not have a bona fide outside business at $126.50, it will 1ikely return to the $115 rate. However, the option should remain with each manager to maintain an autonomous management environment.

Cases

Case 22-1: Behavioral Implications of Airline Depreciation Accounting Policy ChoicesNote: This case is unchanged from the Eleventh Edition.Purpose of Case

It seems obvious that firms choices of accounting policies will affect managers decision-making. But somehow when accounting choices are being considered, the financial reporting implications of the choices seem to dominate.

This case was written to force students to consider the decision-making implications of one seemingly important accounting policy choice decision. The example is of aircraft depreciation accounting for airlines. This example was chosen because property, plant and equipment (PP&E) comprises more than 50% of the total assets of an airline, and aircraft are a large proportion of the PP&E. Further, airlines depreciation policies vary significantly.Suggested Assignment Questions

This case was used successfully as part of a final exam. The exam questions, which are shown below (importance weightings in parentheses), can be adapted for use in a classroom setting.

(50%)1. Assume that at least some rewards for the management team (and, hence, also other employees) are based on performance measured in terms of accounting income and returns on net assets. Also assume that all of these airlines are growing; that is, they are adding to their fleet size.

What are the behavioral implications of each of the three depreciation-related accounting policy choices: (1) depreciation patterns (i.e., straight-line vs. accelerated); (2) estimated useful lives; and (3) residual values? Consider, at a minimum, the effects of each of these choices on decisions regarding:

a. Replacements of aircraft in service;

b. Pricing, assuming that prices are at least somewhat dependent on costs;

c. Evaluations of routes or lines of business;

d. Evaluations of managers, assuming that negotiated budgets provide the primary standards of performance.

(20%)2.Assume that in a particular U.S. airline company there is a conflict between the benefits of conservatism vs. liberalism in depreciation accounting. That is, for this company conservatism in depreciation accounting is greatly preferred for financial reporting purposes (for whatever reason) but for internal purposes the company would be better off if the policies were more liberal, or vice versa. Would you recommend to the managers of this company that they adopt a third set of books? That is, should they maintain one set of books for financial accounting purposes, another set for tax purposes, and a third set for the purposes of running the business?

(30%)3.If the managers of a particular airline do not want to maintain a third set of books, should they tend to be conservative or liberal in their aircraft depreciation accounting? Explain.

Case AnalysisOne question that can be usefully posed is: Why do airline companies choose different depreciation policies? These decisions seem to be driven primarily by financial reporting concerns. More liberal depreciation policies can be used to slow the recognition of expenses, perhaps to hide losses. More conservative policies can be used to create hidden reserves that facilitate managers management of earnings.

To a lesser extent, difference in aircraft depreciation policy choices might be driven by different economic realities. Some aircraft depreciate faster than others. These effects are generally smaller than most people assume, however. The major airlines fly the same types of planes, for the most part. And in any case, virtually every aircraft can fly almost indefinitely with proper maintenance.

Students should understand that the lives of aircraft can be greatly affected by management decisions. Aircraft lives are longer (a) if the airline cannot afford to, or chooses not to, replace the aircraft; (b) if there is an economic downturn that causes the aircraft to be used less intensively; and (c) if there are no new technological developments (e.g., fuel efficiency, noise, comfort). One issue that can be usefully explored in this class is: Which comes first, the accounting policy or the management decisions? Each can have a causal effect on the other.

Another useful question is to ask students which of the airlines mentioned in the case uses the most liberal accounting policy for its aircraft? Which uses the most conservative? Looking at the assumptions of aircraft lives will suggest to all that Lufthansa is the most conservative. American (AMR) is the most liberal.Question 1

What are the effects of this accounting policy choice on managerial decisions? More rapid depreciation causes higher expense on the income statement but reduces aircraft book values on the balance sheet more quickly. But, interestingly, the reality does not change at all! In the U.S., there are no tax effects and no cash flow effects, and the economic value of the company does not change. Academic studies have shown that the stock market is very good at seeing through fully disclosed differences such as these.

Some students get confused about this issue because they do not realize that in the books U.S. firms keep for tax purposes firms will depreciate their aircraft as quickly as possible, assuming that the company is profitable. The case tries to make this clear, in item #5 in the list of other facts. In some other countries the allowed disparities between the financial reporting and tax books of record are not as significant.

While there are no direct effects of this accounting policy choice on real firm value, value can be affected because managers decisions can be affected. Managers do make decisions based on accounting numbers. One of the clearest behavioral implications of depreciation accounting policies is in the replacement-of-aircraft decision. Managers in firms that depreciate aircraft slowly tend to be slow to replace their aircraft because they have to absorb the write-off of the remaining book value. This is a known empirical regularity. For example, Singapore Airlines and Lufthansa have quite young fleets (e.g., Lufthansa average age is 3.9 years), while companies such as AMR and Delta have fleets over twice as old. Similarly, more rapid depreciation will yield higher full costs in cost analyses and can affect pricing decisions and route/line of business analyses. Management evaluations, on the other hand, should not be affected because whatever depreciation policies are chosen are built into the budgets that are the primary performance standard.

In theory, management decision-making should be improved if the accounting records reflect the economic reality. We know, for example, that the early U.S. railroad companies did not depreciate their fixed assets. As a consequence, the railroads overstated their income and assets, and the railroad managers were misled by their own financial statements. Ultimately about 50% of the track put in place before 1900 was placed in receivership.

But what is the real economic depreciation of aircraft? The reality will vary somewhat with the type of plane and the aircrafts usage. In general, airframes depreciate based on the number of cyclestakeoffs and landingsto which they are subjected. The engines depreciate based on the number of hours of usage. In theory, maintenance could affect aircrafts real economic depreciation, but there is not much variation in airlines maintenance procedures. The procedures are largely determined by law.

Because used aircraft prices decline very slowly, the economic depreciation is likely to be much slower than any policy any airline currently uses. So all airlines aircraft depreciation policies are conservative, at least in relatively good economic times. Some are more conservative than others. What is the management decision-making implication of this conservatism?

Question 2

This question requires students to consider the benefits and costs of having, potentially, a third set of books. In theory, at least, keeping a set of books that better reflects the economic reality of the declining value of the aircraft assets should lead to better decision-making. Some companies have changed their depreciation policies exactly for this purpose, to better reflect the value declines in fixed assets and, hence, to better match costs and revenues. It is possible that a companys financial reporting strategy is not best served by a relatively accurate reflection of economic reality. Almost certainly a companys cash flow will be served by being conservative (rapid depreciation) in its tax records. So, in theory, at least, a company may be best served by maintaining three sets of book.

However, there is a cost of maintaining three sets of books. One cost is monetary. The charts of accounts and the processing systems must be established, and some transactions must be recorded three different ways. There is also a possible confusion cost, as not all employees will understand the differences in and the purposes for the three books of record.

Question 3

This question was posed to force students to reach a conclusion as to what one single accounting policy choice might be best. They might usefully make observations about each of four sometimes-conflicting concernsgood economic decision-making, financial reporting effects, potentials for asset write-offs (if assets are depreciated too slowly), and potentials for gameplaying.

Pedagogy

This case should only be used with students who have studied the mechanics of depreciation accounting. Generally, this is not a constraint because the depreciation topic seems to be included in every introductory financial accounting course.

Unless the instructor wishes to provide a tutorial on depreciation accounting or replacement cost depreciation, the discussion of this case can probably be completed in 50-60 minutes. One useful way to organize the discussion is to follow the order of the assignment questions.

Case 22-2: Shuman Automobiles Inc.

Note: This case is unchanged from the Eleventh Edition.

Approach

In this version of the old Bultman Automobiles case, I have added explicit questions to be certain the students understand the economics of the illustrative transaction, and how certain measurement approaches may cause similar future deals to be rejected. The discussion will generate a number of alternatives, which I force the students to analyze, not just identify. I sometimes find it fruitful in the midst of this discussion to reiterate the nature of the four different types of responsibility centers in terms of how inputs, outputs, and assets are measured with each approach. In the last few minutes of class, I suggest that the right measurement approach here is the one that is most congruent with Mr. Shuman's strategy for the dealership (see comments on question 4).

Comments on Questions

Question 1

The incremental profit on this transaction is as follows (alternate formats are possible):

Revenues:New car

$7,900 ($14,400 - $6,500)

Used car

7,100

15,000

Expenses:New car

12,240

Repairs

1,594

13,834

Incremental profit$1,166

I then point out that all any transfer price proposal does is allocate this $1,166 to the departments in a certain way. Although this should be obvious, in this introductory case some students do not realize it without it being made explicit.

Question 2

Various students will propose essentially every conceivable transfer price for the unrepaired trade-in. I ask for each proposal to be stated as a policy, since that is what will be needed to implement profit centers, and then to say what number would result from that policy in this particular instance. I avoid having students be evaluative of the proposals at this point; rather, I encourage the proliferation of ideas. I then do the same thing for the repair cost transfer price, although now the list usually amounts essentially to only four items: incremental cost, full cost, market price, and market price less a discount (justified by the used car department being service's biggest customer or by giving reconditioning work second priority).

With both lists on the board, I suggest that to save time in choosing from among all of the alternatives we first agree on some criteria or objectives that a good transfer pricing scheme should meet. A full list is given in the chapter's text under the heading multiple criteria. The three that I think absolutely must be brought out are (1) perceived as fair by the managers involved (this is almost always the first one mentioned when I teach this case in executive seminars), (2) leads to the managers' making decisions in the overall best interest of the dealership (i.e., goal congruence), and (3) does not distort departmental profitability (see the postscript at the end of this note for the rationale and illustrative numbers). In my experience, the first criterion alone tends to eliminate all options on the trade-in transfer price except auction, wholesale, and Blue Book: these are all market prices, and in a given instance auction and wholesale tend to be mutually exclusive. With respect to the repairs, the consensus usually is for market price less, perhaps, a volume discount; sometimes negotiating on a case-by-case basis is favored if the students perception is that this won't become too time-consuming for the two managers involved. I think that the issue of sourcing freedom for the used car manager should also be brought out, especially if the price is negotiated, the used car manager needs to have a legitimate option if the negotiation is to be meaningful.

So that the other issues can be discussed, at some point I cut off this discussion, explaining why I favor $5,000: it is Moyer's responsibility to dispose of the trade-in, and since we do not want in effect to put her in the used car business in competition with Fiedler, her only real option is the as-is market price; the $5,000 she could get by sending the car to the next auction. (Were this a cream-puff trade-in, she could probably wholesale it(i.e., sell it to another dealer.)

For the service department repairs, the price should be $2,152, an imputed market price. This is 135 percent of the $1,594 costs, the same markup as is illustrated several places in the case: $2,000/$1,480; $2,042 / $1,512; and $980,722/ $726,461-all equal 1.35. To the students arguing for an incremental-cost transfer price, I point out that Bianci could lower the usual markup if the service department has excess capacity and Fiedler is able to get a better price outside the dealership. I leave open the possibility of a discount, but say that we don't have time or information to reach a consensus on how large it should be.

With my favored transferred prices, the three departments will have contributions as shown in the table below. This makes it clear that if each manager is to run his or her department as an independent business (which is exactly what Shuman has told them, and reinforced by compensating them based on a percentage of department gross profit), Fiedler will not pay $5,000 for the used car. This means Moyer will sell it at auction, putting all dealership margin on the deal ($660) in the new car department. Whether this is good or bad depends on whether the service department is effectively at capacity without reconditioning work; I don't bring this up explicitly, but let the students discover it in answering question 3.

New CarsUsed CarsService

Revenues

$ 7,900new

5,000used$ 7,100used$ 2,152repairs

12,900 7,100 2,152

Expenses

12,240new 5,000used 1,594

______ 2,152repairs______

12,240 7,152 1,594

Increment profit

$ 660$ (52)$ 558

$1,166

Question 3

This question asks the student to assume the service department is at capacity (which seems to be the case with most car dealerships I've dealt with). The implication of this is that if the reconditioning work is performed, other work will be turned away; or, equivalently, if the reconditioning work is not performed, the service department will earn its $558 gross profit on outside work. In this case, if Fiedler rejects the trade-in, total dealership contribution will be $1,218 ($660 + $558), or $52 more than if Fiedler agreed (or were forced) to accept the trade-in. Thus, with the service department at capacity, the market-based transfer prices I argued for above will, with each manager trying to maximize his or her department's profit, also maximize dealership profit.

Question 4

Discussion of the previous two questions causes some students to realize that the best management control structure cannot be agreed upon without first deciding what role Mr. Shuman expects the service department to play in the overall strategy of the dealership. If Mr. Shuman views the service department essentially as an independent repair shop, then treating it as a profit center and charging cost plus 35 percent for internal work is appropriate. If he wants to keep the service department at capacity but give preference to customer work (as opposed to reconditioning), the department can be a profit center, but with a lower-than-market price for internal reconditioning work, so that such work is used to fill slack time. Finally, if he feels that car dealerships are differentiated from one another primarily by the accessibility and quality of work of their service departments, then he should downplay service profitability and tolerate occasional slack capacity so that a Shuman new or used car customer doesn't have to wait several days for repair work. This argues for an expense center approach, with an explicit effort made to measure service department customer satisfaction.

In my opinion, the first paragraph of the case makes it clear that it is this last strategy that Mr. Shuman has chosen. Thus, he should reconsider his proposal, which so greatly emphasizes the profitability of the service department. The case illustrates that the success of the dealership rests somewhat on the three managers' cooperating with one another and being willing to make quick decisions (the potential customer will only wait so long while a decision is made on a trade-in allowance) in the best interests of the overall dealership without being overly concerned about the impact of a decision on specific departments. (As an aside, I am told that one of the Big Three automobile manufacturers is having second thoughts about its past advice to dealers to set up service as a profit center, because the service departments are not concerned enough about being supportive of the sales departments.) My own preference, then, is to treat each sales department as a profit center and service as an expense center. I would pay each manager a salary, perhaps a bonus tied to one or more department-specific objectives, and definitely a percentage of dealership profits to encourage cooperation in the best interests of the dealership.

Postscript

One year an alert student pointed out that if 135 percent of reconditioning cost is used in Exhibit 1 for service department revenues and used car department costs (to reflect market prices for reconditioning work, rather than the former transfer prices), then service department gross profit becomes $340,331, and used car drops to $186,526. This completely alters the apparent relative profitability of the three departments, making service more profitable than new cars(but of course, this doesn't alter the need for careful interpretation of such interdependent figures. [The student had auto industry experience, and said Mr. Shuman was unusual if he really believed that new car sales (looked at in isolation) was more profitable than service work.] This also illustrates one reason for so many companies using market-based transfer prices: to avoid hidden subsidies that distort subunit profitability and, if not recognized, can lead to incorrect major resource allocation decisions.

Case 22-3: Zumwald AGNote: This case is unchanged from the Eleventh Edition.

Purpose of Case

This case describes a transfer pricing issue that is common in decentralized, divisionalized firms. The case raises issues about internal pricing and, more generally, the operation of a decentralized management structure.

Suggested Assignment Questions

1. What sourcing decision for the X73 materials is in the best interest of:

a. The Imaging Systems Division?

b. The Heidelberg Division?

c. The Electronic Components Division?

d. Zumwald AG?

2. What should Mr. Fettinger do?

Case Analysis

The suggested assignment points students in the right direction. Zumwalds ISD division is sourcing displays for its X73 system. The division solicited three quotes. The lowest quote, for 100,500 was from a British company, Display Technologies PLC. Another quote, for 120,500, came from a Dutch company, Bogardus NV. The high quote, for 140,000, came from Zumwalds Heidelberg Division.

Should ISD choose the Display Technologies quote? Possibly yes. But the Display Technologies quote causes some worries. One is about quality. Display Technologies is a new entrant to the market, and it has not yet had a chance to demonstrate the high quality that Bogardus, and presumably Heidelberg, has demonstrated. And the Display Technologies bid may be a low-ball bid to enter the market. For subsequent orders, they might have to raise the price significantly to maintain viability. This could cause ISD to incur some costs of switching suppliers at some time in the future. But the manager of ISD should be aware of these issues, and he decided to choose the Display Technologies quote.

The issue in the case arises because the manager of Heidelberg complained about not getting the ISD order. His arguments are the following:

1. Zumwald is better off if Heidelberg supplies the displays to ISD. Students should do the calculation to understand this conclusion.

The Heidelberg quote to ISD is better for Zumwald taken as a whole because it includes some contribution both for Heidelberg and for ECD, Zumwalds internal electronic subassembly supplier. The variable costs for Heidelberg are 50,000. The fixed costs are not relevant because Heidelberg is not operating at full capacity. So there is a contribution of 90,000 to Heidelberg in the 140,000 quote to ISD. Students might question the treatment of labor costs as fixed on the downside, but this is common in Germany.

In addition, there is a contribution of 12,600 for ECD built into this quote. This is ECDs internal price of 21,600 minus the variable costs of 9,000. (ECD is also operating below capacity.)

The advantage to ISD of sourcing from Display Technologies rather than Heidelberg is 39,500. This is far smaller than the total contribution to Zumwald divisions of 102,600 that would be foregone if Heidelberg does not get this order. The difference is 63,100. Financially, Zumwald is clearly better off if ISD sources the displays internally.

This calculation can be shown in different ways. Another method is to consider the net cash outflow to Zumwald of the sourcing alternatives. If the displays are bought from Display Technologies, the cash outflow for the displays is 100,500. If they are sourced internally, the total Zumwald cash outflow is:

Cash outflow if sourced from Display Technologies.100,500

Cash outflow if sourced internally:

Heidelberg variable costs excluding the ECD-supplied materials28,400

ECD variable costs9,00037,400Difference 63,1002. Heidelberg engineers helped ISD develop the X73. Heidelberg was reimbursed for the cost of those engineers, but it earned no profit for this work. Does this assistance imply a partnership that would include future sourcing of parts?

Students presenting this analysis showing the advantage to Zumwald of internal sourcing should be asked whether this means that Mr. Fettinger should order ISD to source the displays from Heidelberg. They will almost assuredly say yes. But then the issue is the price at which the transaction should be made.

The case has enough information to show that this X73 business promises to be highly profitable for ISD:

Revenue for one X73 system340,000

Non-display material costs72,000

Variable conversion costs26,30098,300Contribution before display costs241,700

Fixed conversion costs117,700Gross margin before display costs124,000ISD contribution if sourced from Display Technologies141,200

ISD contribution if sourced at Heidelbergs price of 140,000101,700

Clearly there is room to force ISD to pay Heidelberg more than the Display Technologies price. That extra cost could provide additional margin to Heidelberg and ECD. But, alternatively, any price greater than 37,400 provides a contribution to Heidelberg and/or ECD. Why shouldnt Heidelberg shave its price to get this internal business? And if Heidelberg shaves its price, then it might well ask ECD to shave its price below its normal 20% mark-up. So in some sense, these transfer prices are just moving profits from one division to another. What is fair to all parties?

Heidelbergs manager, Paul Bauer, claims that he has been pleading with his salespeople not to shave prices, that he needs full margin business in order to achieve his plan. Does Mr. Bauer just not want to acknowledge the price competition in this segment of the market? Is he ignorant of the marginal cost and contribution margin concepts? Should he be fired?

Or is Mr. Bauer merely willing to lose this business in order to emphasize the importance of his pricing policy to his salespeople? This latter possibility can be illustrated with the following hypothetical figures:

Price

Unit

Total

Price policy(000) VolumeContributionContributionFull price 140 70

90

6,300

Cut price 100 100

50 5,000

Maybe because of market conditions and customer price sensitivities, Heidelberg is better off giving up some business to retain higher margins, even though they are operating in a below-capacity condition.

So what should Mr. Fettinger do? Mr. Fettinger should probably listen to the arguments in order to learn the managers thinking processes? Are they all aware of the key facts in the situation? Does Mr. Bauer, in particular, understand the concept of marginal cost pricing and contribution margin?

If the managers are all making rational arguments, then strong arguments can be made here for having Mr. Fettinger do nothing. Zumwald operates in a highly decentralized fashion. Why not let it continue to do so? Let the managers have their autonomy and freedom of sourcing. If there is a deal to be made, let the managers work it out themselves. If Mr. Fettinger gets involved here, he will probably also have to get involved in many other similar disputes. If this deal were a more substantial part of Zumwalds total business, then a stronger argument could be made for intervention. But this deal, by itself, is worth less than 5% of each divisions revenues. Heidelberg can probably earn the business by cutting its price to Display Technologies, but maybe it is not in its best interest to do so, even though internal sourcing of this deal seems to be in Zumwalds best interest.

The final question that can be explored is the systemic question. Is the Zumwald responsibility center/performance measurement system faulty in that it motivates managers to make decisions that are not in the best interest of the corporation as a whole? There is no easy answer to this question. In most situations where local knowledge and fast decision-making is important, a highly decentralized system has great advantages. But with decentralization comes risks of suboptimization. This case provides one common example of suboptimization. Zumwald could establish a transfer pricing policy to try to induce better transfer pricing and, hence, sourcing decisions. Such a policy could require internal transfers to be, for example, at best outside market price, or at full (or variable) cost plus a normal markup. But would such policies really lead to better organizational decision-making?

Pedagogy

This case is relatively short and straightforward. Students do not need a lot of guidance to reach the conclusion that Zumwald is better off if the sourcing is done internally. Then, we suggest letting the students provide suggestions as to the best transfer price. The learning will come from the discussionof alternatives. Instructors should only intervene if students fail to recognize the advantages of decentralization.

Case 22-4: Enager Industries, Inc.*Note: This case is unchanged from the Eleventh Edition.

This case was written for use in a required one-semester course in management accounting, where usually only a single session is devoted to investment centers. Whereas most available cases on investment centers focus in detail on narrower issues, such as proper valuation of fixed asses for an investment center, this case is intended to raise both the rationale for having investment centers and some of the broader issues surrounding ROI and an investment center structure for a responsibility center.

Broad Case Issues

As different instructors will choose to emphasize different aspects of this case, I will simply describe sequentially the various issues the case raises.

1. Profit verse profitability. I raise the issue by asking, What is the overriding economic objective of a business? Typically the first answer is profit maximization. I then ask if that means a firm earning $100 million net income is twice as profitable as one earning $50 million? Students soon realize that the profit should be 1inked with the investment required to generate it, and we arrive at the conclusion that return on investment is a more meaningful measure of a firm's profitability.

2. Use of investment centers. Having established that ROI is a measure of interest to top corporate management, it is easy to see that responsibility for earning a reasonable return can be segmented and delegated, just as is profit responsibility delegated to profit center managers. However, if the measure is to be used in evaluating the investment center manager's performance, equitability requires that the manager be able to significantly influence both profit and investment. In many companies, this degree of responsibility is found only at the division level and above (where I am using division to connote an essentially self-contained business within the corporation).

At this point, I draw the very important distinction between using ROI to measure economic performance of a responsibility center and using it to measure the performance of the center's manager. (In my experience, this distinction is too frequently missing in industry.) There is really no need to treat a responsibility center as an investment center if the manager doesn't influence asset levels; this does not mean, of course, that the center's ROI can't be computed for analytical purposes (e.g., for consideration for discontinuing that responsibility center's activities)but this computation does not need to be performed frequently, or perhaps even regularly.

I also tell the students that the profit center/investment center distinction appears more in textbooks than in practice: most managers I have met call both types of responsibility center simply profit centers.

3. Definition of ROI. By now, the students are aware that ROI is (simplistically) defined as profits divided by investment. I now ask, What is investment? I am not trying at this point to get into valuation of specific assets, but rather the broader notion that to business people the word investment variously means total assets, assets less current liabilities or invested capital (equivalently, long-term liabilities plus owners' equity, or owners' equity.

I point out that none of these concepts is right or wrong(it depends on the perspective of the person considering ROI. A shareholder (and probably also securities analysts) would be most interested in return on equity. Corporate financial officers seem to focus on return on invested capital (the apparent notion being that current liabilities are both free and take care of themselves). Operating managers don't really care how the assets they manage were financed (nor can they usually tell, since all money is green); they (and their superiors) are concerned about how well the assets are utilized, leading to a return-on-assets (perhaps net of some or all current liabilities) perspective.

Exhibit 4 contains several ROI measures, to highlight the fact that the term ROI itself is extremely ambiguous. The calculation of return on invested capital has been adjusted for interest, whereas return on assets has not (because this is the way Enager is calculating ROA).

4. ROI growth and EPS growth not necessarily equivalent. I point out to students that it is possible to increase earnings per share while decreasing ROI. Indeed, Enager presents an example of this: from 1996 to 1997 EPS increased, but return on assets (ROA) went down.

One possible cause of this phenomenon is the fact that generally accepted accounting principles ignore the cost of equity capital in calculating net income. For example, a project returning (before interest) 6 percent on assets, which was financed with 8 percent debt, would diminish EPS But the same project financed by retention of internally generated funds would increase reported EPS, even if the project's ROA were less than the overall ROA would have been without the project (thus reducing overall ROA despite the increase in EPS). In Enager's case, this phenomenon occurred because (EBIT ($1,031) exceeded (interest ($382), thus increasing EPS; but (EBIT / (Assets= 9.1%, which was lower than the previous year's average of 9.5%.

5. Setting ROI targets. Although it is seemingly self-evident that different investment centers will have different risk profiles and ROI potentials, it is, nevertheless true that some companies use the same across-the board ROI target percentage for divisions in quite different businesses, as was done by Mr. Hubbard of Enager. I think this phenomenon occurs for a reason alluded to earlierconfusing what is a desirable economic return for the overall company with what is a reasonable return for the manager to achieve, given conditions in the industry, efficiency of the division's equipment, and so on. For purposes of managerial evaluation, a division's ROI target should be negotiated between the division manager and his or her superior, as part of the budgeting process.

6. Defining profit in ROI. Whatever degree of detail the instructor wishes to get into here, at a minimum students should realize that defining profit as net income calculated using the same generally accepted accounting principles as are used for reporting to shareholders is only one of many ways of defining profit for ROI computations. For example, income taxes can be omitted; depreciation can be based on replacement costs rather than historical costs; or a variable costing approach can be used instead of full costing. Also, a company can use the notion of controllable profit for calculating ROI.

In general, I think a definition involving controllable profit is best for calculating ROI for purposes of managerial evaluation, but that a net figure after including noncontrollable allocations is better for economic performance analyses. Again, in my experience, companies usually do not make this distinction and tend to use a GAAP net income figure in the ROI calculations. (See James S. Reece and William R. Cool, Measuring Investment Center Performance, Harvard Business Review, May-June 1978.)

7. Valuing investment in ROI. Whether one regards investment as total assets, invested capital, or owners equity, asset valuation affects the indicated amount of investment. Once again, in my experience, companies tend to value assets for ROI computation the same way they report asset amounts to shareholders. Students should realize that this alternative causes ROI to increase solely with the passage of time (as depreciation reduces the asset base) and may indicate improving performance when in fact the manager is running the business into the ground.

8. ROI versus residual income (EVA). While I feel this is too advanced for a one-session shot at ROI, some of my colleagues feel that residual income (now called economic value added by some consultants) should be introduced here. If so, an attempt should be made to convey the conceptual advantage of RI over ROIthat having to do with how a division manager would react to a project whose projected ROI is higher than the cost of capital but lower than the investment center's overall targeted ROI. This RI concept could also be raised earlier in the context of how to define profit, since RI essentially corresponds to the economist's view of what constitutes profit. Since it is the presence of GAAP-valued fixed assets in the formula that causes either ROI or RI to increase solely with the passage of time, I favor for managerial evaluation what I call partial RI, which is profit excluding interest less holding-cost rates applied to receivables and inventories.

9. New project proposals in an ROI system. This is the lead-off issue in Enager. If your students have been exposed to capital budgeting techniques, they quickly will point out that a discounting technique should be used to evaluate Ms. McNeil's new product proposal. Despite the normative truth of that statement, it is nevertheless quite conceivable that a manager might feel that a project that will improve EPS (and accounting ROI!) should be acceptable.

Another aspect of capital budgeting in an investment center setting (or companywide setting, for that matter) that often puzzles students is this: Why is the hurdle rate used in evaluating a new project higher than the division's ROI target? One reason is that a significant portion of a company's capital budget funds must be used for projects that will not (in any obvious way) increase profits(e.g., pollution control equipment. Thus, projects that will improve profits have to carry more than their fair share of profitability contribution in order to compensate the nondiscretionary (necessity) investments that tend to lower ROI. Other reasons include allowance for risk/uncertainty and the desire to improve ROI fairly rapidly.

10. Overall moral. ROI is conceptually simple, but complex to implement (if one recognizes the pitfalls, as Hubbard and Randall did not). Students should not be left with the feeling that ROI necessarily should be avoided, but rather that its implementation should be approached with great care.

Issues Specific to Enager

1. What is the incremental ROI on the proposed project? The case numbers are rigged so that the incremental EBIT percentage at any of the three prices is 13 percent ($130,000 / $1,000,000). A variation on this calculation is to say that, at least in an accounting sense, the average plant and equipment investment over the life of the project is only $250,000, giving an ROI of 17.3 percent ($130,000 / $750,000). We do not know the potential life of this project; its payback period is less than 4 years (we can't tell how much less: cash flow per year will be greater than the $130,000 income because the $170,000 fixed costs include depreciation).

I ask the students this question: Suppose Enager was committed to go ahead with this project(would you suggest a price per unit of $6, $7, or $8? Students cannot choose on the basis of incremental profit, which we have seen is the same ($300,000 contribution less $170,000 fixed costs = $130,000) at all three prices. Some will say $6 because it gives the largest market share (a point of view which may have validity, if one believes the Boston Consulting Group's experience curve hypothesis). Others will say $8, since that has the lowest break-even volume; however, in my opinion, one cannot choose based on break-even volume, since at each of the three prices the break-even volume is 56 2/3 percent of the estimated sales volume at that price, and profits are the same at the three estimated sales volumes.

Eventually, a student will realize that the current asset investment should not be assumed to be the same at all three prices (as I have let them implicitly assume to this point in the discussion): certainly a volume of 100,000 units ($600,000 revenues) will require more cash on hand, receivables, and inventories than would a volume of 60,000 units ($480,000). Therefore, the price chosen on short-term ROI analysis should be $8.

This discussion of variability of current assets with volume may also cause some students to notice that the projected level of current assets seems excessive. If volume = 100,000 units, average unit cost = $4.70; $50,000 cash is 39 days' expenses (really more, after considering depreciation); $150,000 receivables is 3 months' sales; and $300,000 inventories is 233 days worth. Based on the company's average ratios in Exhibit 3, the current asset picture at a price of $6 and volume of 100,000 units would be: (rounded)

$ 10,300

123,300

206,000

Total current assets

$339,600

Not only does projected ROI improve, but the three current asset utilization ratios used in this adjusted projection do not represent very laudatory current asset management. And again, the ROI (short-run, at least) would be still higher at the higher, price-lower volume combinations.

2. Explain Enager's 1997 versus 1996 results. This is best done, I feel using a duPont chart approach. (See, for example, Chapter 13 of the text.) Essentially all of the numbers for this analysis (on a return-on-assets basis) are included in Exhibit 3 of the case. This is a very useful approach, in my opinion, because it demonstrates how ROI is impacted by decisions made throughout the organization.

3. Enager's implementation of ROI. The preceding discussion in this commentary should make it rather clear that Enager's top management (i.e., Hubbard and Randall) fell into essentially every trap lurking behind the simplicity of the ROI fraction. In addition to the conceptual flaws, the top-down imposition of the new approach with little explanation or training for the managers was not a good way to introduce a major organizational change, and it's no wonder that there seems to be a lot more tension among our managers the last two years.

Personally, I feel Ms. Kraus has a good idea in the off-site retreat. However, it appears that Hubbard and Randall first should engage a consultant to discuss ROI and investment center implementation complexities with them and help them understand the causes of the current tension; perhaps this same person could then be engaged to play a major role in the retreat and subsequent training sessions.

Case 22-5: Piedmont University

Note: This case is unchanged from the Eleventh Edition.

Approach

The idea of profit centers in universities dates back many decades, probably to President A. Lawrence Lowell's dictum to the Harvard deans: Every tub on its own bottom. Although he did not use the term profit center (and for selling purposes this term may create resentment on the part of faculty and deans), he clearly meant that each school's revenues should be adequate to pay for its operating costs. This idea continues to influence the management control system at Harvard and is increasingly being considered by other universities.

The case provides an opportunity to discuss the principal problems that arise in implementing a profit center structure, and the situations described range from those for which a strong case can be made to those for which the results would be clearly dysfunctional. In discussing the several issues, two questions provide a central focus: (1) How would the recommended practice affect the motivation and attitude of the two parties: the party that receives the charge and the party that receives the revenue? (2) Are the benefits greater than the bookkeeping cost?

The case also permits a discussion of certain behavioral problems in management control: the danger that management runs in accepting an offer from a well-meaning, but perhaps not skilled, volunteer (and the difficulty of finding a graceful way of declining such help); the proper approach to gaining acceptance of ideas; the indication that a strong-minded president can turn an organization around, especially during a honeymoon period when the seriousness of the situation is recognized.

Question 1

General administrative costs. Charging these costs to individual schools would result in an operating statement that would report the extent to which the school's revenues were adequate to pay for its own costs plus a fair share of the central costs. The sum of the net incomes reported for each school would be the net income of the university. This charge might get the deans to recognize that the university necessarily incurs costs on their behalf, which must be met from some source. The practice might also cause the deans to question whether the central costs were too high, which would be one way of exercising control. Perhaps the central administration would be reluctant to tolerate such questions.

An alternative is to not charge these costs, or to charge only those that can be specifically identified with a given school (such as accounting, purchasing, personnel). This would reduce the technical and behavioral problems associated with the allocation of indirect costs.

Any basis of allocating indirect costs can be criticized because there is no scientific way of doing this, by definition. The criticism that the administration probably spends more than a proportional amount of time on the undergraduate school is probably justified, but there does not seem to be a feasible way of correcting this inequity.

If these costs are charged, the charge should probably be a budgeted amount, rather than the actual costs incurred. Allocating actual costs permits the central administration to pass costs that are greater than budgeted to the individual schools.

Gifts and endowment. The deans quite naturally would not favor giving the president authority to distribute $7 million as he chooses. Actually, the process would require that the schools put in their requests and the president allocate the funds in a way that causes the minimum amount of dissatisfaction. The president could not allocate the funds in a way that is perceived to be grossly unfair; he would lose the support of the deans if he did this. Moreover, the each tub on its own bottom idea can't work perfectly. The theological school, for example, does not cover its costs by some $3.1 million (Exhibit 1), whereas the business school has a surplus of $4.2 million, reflecting the attractiveness of its program to donors, the ability of its students to pay tuition, the need for financial aid, the opportunity to obtain research grants, and so on.

The business school surplus can lead to a discussion concerning the question of whether the president should have the authority to allocate such surpluses to other schools. Currently, this is a hot topic in many universities. Also, if it is decided that the library should not generate its own revenue, the central administration must make up the shortfall.

This topic provides an opportunity to discuss the question: should each part of an educational institution pay its own way? Carried to the extreme, less popular courses (Latin, Greek, advanced seminars) would be eliminated, even though they may make an important contribution to the university's total reason for being. Few would argue that each course should pay its own way, and by extension, the argument can be made that certain schools should be subsidized. On the other hand, if a given school does not obtain resources sufficient to cover its costs, questions can be raised occasionally (not every year) about the desirability of condoning it.

Athletics. Overall, this is one of the less sensible of the consultant's proposals. A case can be made for charging a fee for scarce resources (such as tennis courts, golf courses, or ski lifts) as a way of rationing these resources (but the case is not particularly strong). Presumably, however, the university wants to encourage intramural athletics, and charging a fee would not indicate such encouragement. The rationing argument is not applicable to intramural athletics. Also, there is an indication that intramural and individual athletics should be asked to subsidize intercollegiate athletics, which does not make much sense.

Maintenance. Permission for schools to use outside contractors is an important aspect of this proposal. The maintenance department's concern about the decline in maintenance quality has some merit, but it should be possible to exercise adequate quality control. The maintenance department should be given the authority to do this.

If schools can use outside contractors, the maintenance department must compete with them, which tends to motivate it to be efficient. It must control its costs and obtain enough work so that it breaks even, or there is an indication of poor management or that the department is too large. There should be a proviso that if the maintenance department is willing to do the work at not more than the outside price, it should be given the job. Furthermore, if the schools are not permitted to go outside, they are at the mercy of the maintenance department with respect to the priority of meeting their requests and the amounts spent. The pros and cons for maintenance are also applicable to other support departments: purchasing, accounting, and aspects of the personnel department (but not university personnel policy).

Computers. A few years ago, many colleges and universities did not charge students and faculty members for the use of computers (except possibly for faculty members working on cost-reimbursable contracts). The primary reason was that they wanted to encourage the use of computers. The tendency now seems to be in the other direction with respect to mainframe computers, on the grounds that the usefulness of computers is now generally recognized; the practice of charging for computer usage is by no means universal, however. (It is somewhat ironic that many universities keep careful controls over the use of postage and long-distance telephone cards, which involve much less cost than computers.)

Probably most computer work within a school, especially work done on personal computers, is done without charge. The issue here, however, is charging for work done on the engineering school computers by faculty and students at other schools. Assuming that usefulness is adequately recognized, the arguments here are essentially the same as those for maintenance.

A special circumstance about computers is that they have software that can supply detailed information about usage at low cost, so recordkeeping cost is not as important a factor as is the case with some of the other services discussed in the case.

I doubt that time will permit the class to get into the details of how a charge should be calculated. There is much discussion about this in the literature: a low charge for off-peak usage; a charge for setup time and assistance from computer personnel that is separate from the charge per minute of running time; a charge for plotters and other peripheral equipment; and so on. There may be advantages in detailed, possibly elaborate, charging systems; the question often is whether they are worth the cost.

Library. This is the extreme case of a situation in which charging for services rendered is likely to be counterproductive (but an outside consultant may not appreciate this). The university wants to encourage library usage, and charging a fee would tend to have the opposite effect. As the case states, the recordkeeping involved would be considerable, with thousands of transactions, each involving only a few pennies of cost. (As is the case with computers, library costs might be charged to cost-reimbursable contracts, but the charge can be arrived at by approximations derived from sample tests or other methods that are less expensive than keeping detailed records.)

Cross registration. On the one hand, it can be argued that if a course is offered, a few additional students do not cause any increase in costs. The argument against this is that a fair share of the cost of the course should be charged to each student, more specifically to the school from which the student comes. Opinions will differ as to the relative weight to be given to each side of the argument There is also the question of whether such a charge has a motivating influence on either the school from which the student comes or the school in which the class is located. If a charge is made, the method suggested in the case seems reasonable, with the possible exception that tuition may be considerably lower than the real cost of education, with the difference being made up from gifts and endowment earnings.

Question 2

Probably the difficulties with profit centers will come up in the discussion of question 1, and this question is intended merely as a means of catching gaps. In particular, the bad impression given by the term profit center should not be minimized; charging for services rendered is a more acceptable way of putting it. The taste of educating people when a new system is introduced should not be minimized. In particular, there tends to be friction and more arguments about how the charges are to be calculated than is warranted. Senior management should try to keep these arguments from becoming acrimonious. Otherwise, the deans and faculty will claim that the university is now being run for the benefit of accountants.

Question 3

One alternative to the profit center approach is, of course, to keep the present system. The pros and cons of this should come out in the discussion of question 1.

Students may propose other alternatives. It would be possible to charge certain expenses to the individual schools for information purposes, but not include them in the formal budgets nor make the corresponding credits to the departments that furnish the services. The idea would be to give the schools a better idea of the real cost of their operations without the work and possible friction that arises when these costs and revenue are included in the formal accounting system. This proposal, although similar to actual practice in some organizations (including the federal government), does not accomplish much, in my opinion. Without the motivation provided by inclusion of these costs in their budgets and the requirement that they live within these budgets, deans are unlikely to pay much attention to these memorandum records.

Question 4

The discussion of this question can get bogged down because of differences in the recommended treatment of the issues in question 1. It may be well to avoid it by asking for a resolution of each of these issues and then debating the question of whether this consensus(presumably the most desirable application of the profit-center idea(is better than the alternative.

As a strictly personal opinion (given here only as something to shoot at), I would definitely charge for maintenance work and similar support services (including the support functions of the central office). I would give the president authority to parcel out undesignated gifts and endowment earnings. I would probably charge for the use of the mainframe computers. I would probably not charge for tennis, golf, and skiing in order to ration scarce resources (on the grounds that a sign-up system is a better way of rationing). I would not charge for intramural athletics or for the library. I would charge for cross registration only if there was a substantial amount of it with the net transfers not washing out. Otherwise, the recordkeeping costs would exceed the benefits.

Also, I would not ask the deans to approve the proposal, or any part of it, as it comes from an outside consultant. I would say that the consultant's proposal was submitted solely to stimulate discussion. (The weaknesses of certain aspects of the proposal are so apparent that the whole idea may be rejected.) Having had the initial discussion, I would assign the job of developing a new proposal to someone in the administration (or possibly to a committee) so that the next version would be given to the deans as coming from within the institution and taking account of their concerns. If handled properly, I hope that the deans' reaction would be: we had an unrealistic proposal from a consultant which the president wisely rejected; we now have a practical one that is worth taking seriously.

For example, see L. Hall and J. Lambert, Cummins Engine Changes Its Depreciation, Management Accounting (July 1996), pp. 30-36.

*This teaching note was prepared by Professor James S. Reece. Copyright by James S. Reece.

123

_978891431.unknown

_978891476.unknown

_1211017949.unknown

_978891370.unknown