answer key kinneyaise19im

399 This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be

resold, copied, or distributed without the prior consent of the publisher.

Chapter 19 Performance Measurement, Balanced Scorecards, and

Performance Rewards

Questions 1. A mission statement expresses the

organization’s purposes and identifies how the organization will meet its customers’ needs through its products or services. Alternatively, a vision statement expresses where the organization wants to be in the future. The former is more short run oriented than the latter and should change periodically as customer preferences change. A values statement helps provide information on the firm’s organizational culture. It indicates the areas of organizational importance so that employees can internalize these beliefs and values.

Organizational strategies and missions are devised to achieve the goals and objectives of a firm. Control systems, including systems of performance measurement, are created to implement the missions and strategies of firms.

2. Performance measurement is necessary to

gauge whether a firm is pursuing its goals and objectives successfully. Without performance measurement systems, managers, shareholders, and others would have no basis to assess the success of operations or whether operations were being conducted efficiently.

Performance measures should be both qualitative and quantitative. The measures chosen must be reasonable proxies for the organization's critical success factors, many of which are not easily captured by financial or other quantitative measures. For example, managers need to employ qualitative measures to capture performance in the dimensions of customer service, product and service quality, product innovation, advancement in job skills, and effectiveness in communications.

In the absence of benchmarks, the performance measurements will not be meaningful. The performance measurements can be interpreted only when they are compared to benchmark measurements such as industry performance or a firm’s historical performance measurements.

3. It is expected that people will act specifically in accordance with how they are measured. Thus, individuals must know of and understand the performance measures used, so that managers can make decisions in light of the effects of alternative choices on the performance measures. Managers who are allowed to participate in the development of the measures by which their performance is assessed are more likely to accept the performance measures as valid and fair and to understand how their actions influence the measures.

4. In selecting bases for performance

measurement, managers should consider: • whether the measures capture progress

toward organizational goals, • the input of those being evaluated, • whether proposed measures are

appropriate for the skills and authority of those being evaluated, and

• methods to provide appropriate feedback on performance.

The traditional performance evaluation measures for cost centers are standard cost variances. Traditional measures for revenue centers are deviations from budgeted revenues. Historically, these measures have been used because they are consistent with a financial evaluation of performance. The major difference between a profit and an investment center is that the investment center has control over costs, revenues, and the level of assets that is employed. Accordingly, investment centers need to be evaluated based on their profitability relative to the value of assets used. Profit centers have no responsibility for assets and can be evaluated based on profit alone.

No, because the measures must be consistent with the span of authority and responsibility of each manager. This requirement means that different responsibility centers must be evaluated using different measures. Further, the chosen measures must be consistent with the time horizon of decisions made by the manager.

400 Chapter 19

This edition is intended for use outside of the U.S. only, with content that may be different from the U.S. Edition. This may not be resold, copied, or distributed without the prior consent of the publisher.

5. Conceptually, net cash flow from operations measures the same thing as net income. Thus, cash flow may be a useful measure in a profit or an investment center. The only difference between net cash flow from operations and accounting income are accounting accruals. Because many accounting accruals are susceptible to manipulation by managers, net cash flow is less prone to manipulation than alternative accounting measures. However, it is not beyond manipulation because cash flow can be affected to some extent by adjusting the timing of cash receipts and cash disbursements. It is best if both an accounting income and a net cash flow measure are used to evaluate performance. Each measure provides a quality standard for the other measure.

Like accounting income, the most significant weakness of net cash flow from operations is that it is a short-term measure and, thus, provides no long-term incentives.

6. In defining "income," managers have several major concerns that need to be addressed: • Is the measure wholly controllable by the

person being evaluated? • Is the measure susceptible to manipulation

by the person being evaluated? • Does the measure balance long-term and

short-term incentives? • Is the measure sufficiently related to overall

organizational goals?

Manipulation is an important concern because performance measures should be designed to capture only real performance and not manipulation of the performance measure. If a performance measure can be manipulated by managers, then they can achieve a high level of performance by either performing very well or manipulating the measure. External measures are far superior to internal measures in this respect because they are not susceptible to internal manipulation.

7. Residual income (RI) is a type of derivative of return on investment (ROI). In many ways, the relationship between RI and ROI is parallel to the relationship between net present value (NPV) and internal rate of return (IRR). RI provides a dollar measure of divisional achievement whereas ROI provides a percentage measure of achievement. The principal strength of RI is that it creates fewer problems with suboptimization than ROI, particularly in an environment in which ROI varies substantially across company divisions.

Economic value added (EVA) is similar to RI. The major distinction is that EVA uses invested capital as the asset base and the company’s cost of capital as the target rate of return. Thus, EVA should more nearly correlate with effects on shareholder value than RI. A weakness of RI is that it is typically computed using book values of assets rather than market values and the target rate of return is not necessarily the cost of capital. EVA is conceptually similar to RI in its computations but utilizes a market measure of asset value and applies a target return rate that reflects the cost of capital. EVA computations also include the effects of income taxes, which are normally excluded in computing RI.

8. By linking managerial rewards to performance, the welfare of managers is linked to their success in achieving organizational goals and objectives. Because a firm’s goals and objectives are reflected in the performance measurements, these measures are, in a sense, reflections of managers’ contributions to the achievement of the organization’s goals and objectives. The linkage forces managers to be directly concerned with achieving those goals and objectives.

The performance measurement and reward strategy for each managerial level must be consistent with the level of responsibility and authority given to each level and the contribution required of each individual manager. Although the reward must be consistent with achievement of overall goals, it must also consider the individual contributions of the managers and how effective they were in their sphere of control. Also, managers at higher levels are required to be more long-term oriented and managers at lower levels are required to be more short-term oriented. The performance and reward system must recognize these differences.

9. The balanced scorecard (BSC) is a conceptual approach to measuring performance that weighs performance from four perspectives. Managers choosing to apply the BSC are demonstrating a belief that traditional financial performance measures alone are insufficient to assess how the firm is doing and what specific actions must be taken to improve performance. The four perspectives in the BSC are financial, customers, learning/innovation, and internal processes.

10. To remain competitive, there has been a shift

in American industry toward performance-

Chapter 19 401


based compensation for two reasons. First, workers are becoming more removed from the actual production activities because of automation, making it more difficult to base compensation on direct observation. Second, there is an effort to develop a tighter linkage between pay and reward to make workers more goal oriented and make them more aware of the contribution required of them for the organization to be successful.

11. The outcome is suboptimization. When

performance measures and rewards of the individual, the organization, and its segments are compatible, workers maximize achievement of the organization’s goals while pursuing achievement of individual goals. When performance measures and rewards of individuals are only loosely correlated with the organization’s and segment’s goals, achievement of the individual’s goals may not result in achievement of the organization’s goals.

12. There must be consistency between the time

perspective of the reward system and the performance measurement system. If the time perspective of a performance-based pay plan is long-term, then the organization must select performance measures that capture long-term performance. Otherwise, suboptimization will result because achievement of performance targets will not necessarily result in achievement of the desired performance for the desired time frame.

13. If the organizational mission of each subunit is

unique, the performance measures of each subunit should also be unique. For example, if one subunit has a build mission and another subunit has a harvest mission, the former’s performance measures should concentrate on market share and sales growth. The latter’s performance measures should concentrate on profit and cash flow performance.

Financial performance measures are more appropriate for short-term performance measurement. To measure long-term performance, the better measures are often nonfinancial. For example, profit generated is a good short-term performance measure, but a poor long-term measure. Growth in market share is often a better indicator of long-term performance.

The time horizon of the performance measures is linked to the subunit mission. For example, performance measures should be long term for growth missions and short term for harvest missions.

14. Feedback is critical to improving performance.

Negative or critical feedback provides information about what the manager needs to change. It provides a focus for improvement. Positive feedback confirms what the manager is doing well and encourages continuation of behavior. Feedback provides information to (1) improve the reward system and (2) take action to improve future performance.

15. When employees hold stock, they have

personal incentives to act in the best interest of the stockholders. By providing employees with stock, managers are creating a natural incentive-compatible alliance between a firm’s employees and its stockholders. As stockholders, workers are likely to develop a broad view of the organization, rather than viewing the organization relative to their narrow roles as employees.

If managers are also shareholders, there is a natural consistency between their actions as managers and their actions as shareholders. This situation is not necessarily true when managers hold no stock. Consequently, performance measures must be devised that cause managers to act in the best interest of shareholders. To be effective, the performance measures must be highly correlated with shareholders’ objective of wealth maximization.

16. Equity in the reward structure must be

maintained throughout the organization. Equity requires consideration of the relative pay of top managers versus lower-level managers and workers. Ultimately, an equitable pay structure must balance the entitlement of labor, management, and capital.

A consideration of equity also requires that the reward system be sensitive to local differences (including living costs and tax effects) in global organizations. Currently, it could easily be argued that U.S. firms have relatively inequitable reward systems. The inequity results from the large disparity between average worker pay and top executive pay. Equity is necessary in the long run to keep all stakeholders motivated.

402 Chapter 19


Exercises 17. Division 1: $ 750,000 ÷ $ 5,000,000 = 15% Division 2: $ 250,000 ÷ $ 1,000,000 = 25% Division 3: $2,000,000 ÷ $20,000,000 = 10% 18. a. Asset Turnover = Sales ÷ Average Assets 4 = $3,600,000 ÷ Average Assets Average Assets = $3,600,000 ÷ 4 Average Assets = $900,000 b. Profit Margin = Segment Margin ÷ Sales .08 = Segment Margin ÷ $3,600,000 Segment Margin = $288,000 c. ROI = 8% x 4 = 32% 19. a. ROI = Income ÷ Assets Invested = ($26,400,000 - $24,600,000) ÷ $7,200,000 = $1,800,000 ÷ $7,200,000 = 25% b. Profit margin = Income ÷ Sales = $1,800,000 ÷ $26,400,000 = 6.82% (rounded) c. Asset turnover = Sales ÷ Assets invested = $26,400,000 ÷ $7,200,000 = 3.67 (rounded) d. ROI = Asset turnover × Profit margin = 3.67 x 6.82% = 25.03% Note: parts (a) and (d) differ slightly due to rounding. 20. Revenue $60,000,000 Expenses (56,000,000) Income 4,000,000 Target return (.10 × $22,400,000) (2,240,000) Residual income $ 1,760,000 The residual income is positive; thus, the division met its target return.

Chapter 19 403


21. a. Division 1 Division 2 Sales $2,100,000 $1,200,000 Variable costs (1,435,000) (300,000) Fixed costs (25,000) (700,000) Income 640,000 200,000 Target return: $3,050,000 x .12 (366,000) $1,100,000 x .12 _________ (132,000) Residual income $ 274,000 $ 68,000

According to the residual income measure, Division 1 outperformed Division 2.

b. Division 1 Division 2 Sales $2,562,000 $1,464,000 Variable costs (1,750,700) (366,000) Fixed costs (25,000) (700,000) Income 786,300 398,000 Target return: $3,050,000 x .12 (366,000) $1,100,000 x .12 _________ (132,000) Residual income $ 420,300 $ 266,000

Based on the residual income, Division 1 will outperform Division 2 in the absolute amount of residual income generated. However, one should note that Division 2 actually had greater improvement than Division 1 in residual income from the base case in part a). Division 2’s residual income increased by $198,000 compared to Division 1’s increase of only $146,300. Similarly, the percentage increase in residual income for Division 2 was 291%, while the percentage increase in residual income in Division 1 was merely 53%.

c. Division 2 is has more operating leverage (relatively more fixed costs than

Division 1) and, therefore, benefits to a more significant extent from an increase in sales volume. If sales decreased rather than increased, Division 2’s residual income would have decreased at a faster rate than Division 1’s.

22. a. Income = Sales - Variable Costs - Fixed Costs = $39,000,000 - ($39,000,000 x 0.45) - $6,750,000 = $39,000,000 - $17,550,000 - $6,750,000

= $14,700,000

ROI = Income ÷ Assets invested = $14,700,000 ÷ $25,000,000 = 58.8% b. Income $14,700,000 Target return (0.14 x $25,000,000) (3,500,000) Residual income $11,200,000

404 Chapter 19


c. Profit margin = Income ÷ Sales = $14,700,000 ÷ $39,000,000 = 37.7% (rounded) d. Asset turnover = Sales ÷ Assets Invested = $39,000,000 ÷ $25,000,000 = 1.56 23. EVA = After-tax Income - (Cost of Capital x FMV of Capital) $3,270,000 = After-tax Income - (0.11 x $26,500,000) $3,270,000 = After-tax Income - $2,915,000 After-tax Income = $6,185,000 24. a. EVA = After-Tax Income - (Cost of Capital x FMV of Capital) = $13,260,000 - (0.13 x $8,900,000) = $13,260,000 - $1,157,000 = $12,103,000 b. Determining the amount of capital invested in a particular division is

difficult because divisions do not issue debt or stock as companies do. The challenge faced is to divide the firm’s total value among its operating divisions. One would start by determining the amount of capital invested in the entire company and then apportion this amount among the divisions. The established value would include both debt and equity. The level of debt investment can be estimated by the face amount of the debt if market values cannot be obtained. If the debt is publicly traded, the market value can be determined readily. The stock value can be found by multiplying the market value per share by the number of shares outstanding. This approach is appropriate for both common and preferred stock. Next, the firm’s total market value must be divided among the operating divisions. This step will involve some judgment. One approach is to allocate market value to the divisions based on relative book value of assets. A second approach is to establish the value of divisions by determining the value of independent companies operating in the same industries as the divisions. The market value of a division is set by multiplying the ratio of book value of the division to book value of the independent firm by the market value of the independent firm. A third approach would be to hire a consulting firm to establish appraised values for each division.

25. The new division will have a mission of “build.” When the new division is established, it will have only a potential customer base but no existing sales. Accordingly, the division’s major objective will be to obtain market share and establish a high rate of sales growth. This objective must be accomplished by adding value to existing services provided to clients.

Chapter 19 405


The same performance measures are not appropriate across a division’s entire life cycle. Performance measures established at the outset for this new division should emphasize growth. Later in the life cycle, performance measurements will be added or deleted to shift the focus to generation of cash flow and profits. Following are performance measurements that would be useful initially: • Percentage of existing clients that have video game installations. The

emphasis would be on measuring the annual growth in this number. • Sales growth. Sales targets should be established and compared to

actual levels of sales generated. • Percentage of clients who have received sales calls informing them of

the services available from the new division. As an early life-cycle performance measure, this measure captures the extent to which the new division has made contact with the existing client base.

• Number of face-to-face sales calls made to clients. This is similar to the prior measure but emphasizes personal contact.

• Sales and promotions budget. A key device to increasing market share will be the appropriate use of advertising and promotions. Budgets can be prepared for these expenditures, by category, and can then be compared against actual expenditures. This is a useful tool for understanding and executing a comprehensive and internally consistent marketing strategy.

26. Asset Turnover Profit Margin ROI RI a. N I I I b. D I ? ? c. I D ? ? d. I D I D* e. D** I ? ? f. N N N I g. I D I I h. I ? ? ? *As long as the target return < 100% of assets. **Assuming that the automation created an increase in the asset base. 27. No solution provided. Each student will have a different answer. 28. a. MCE = Value-added time ÷ Total time = 343 ÷ 2,450 = 14% b. Process productivity = Total units ÷ Value-added time = 391,020 ÷ 343 = 1,140 units per hour c. Process quality yield = Good units ÷ Total units = 360,000 ÷ 391,020

406 Chapter 19


= 92% (rounded) d. Throughput = Good units ÷ Total time = 360,000 ÷ 2,450 = 147 units per hour (rounded) e. Throughput = MCE x PP x PQY = .14 x 1,140 x .92 = 147 units per hour (rounded) 29. a. MCE = Value-added time ÷ Total time = 100,800 ÷ 288,000 = 35% b. Process productivity = Total units ÷ Value-added time = 3,360,000 ÷ 100,800 = 33.33 units per hour c. Process quality yield = Good units ÷ Total units = 2,923,200 ÷ 3,360,000 = 87% d. Throughput = Good units ÷ Total time = 2,923,200 ÷ 288,000 = 10.15 units per hour e. Management can increase throughput by decreasing non-value-added

activities, increasing total unit production and sales, decreasing the per-unit processing time, or increasing the process quality yield. These changes can be generated by adopting newer technology, reorganizing the plant, implementing activity-based management concepts, or investing in prevention costs of quality.

30. a. MCE = Value-added time ÷ Total time = 7,680 ÷ 12,000 = 64% b. Process productivity = Total units ÷ Value-added time = 26,112 ÷ 7,680 = 3.4 units per hour c. Process quality yield = Good units ÷ Total units = 24,800 ÷ 26,112 = 95% (rounded) d. Throughput = Good units ÷ Total time = 24,800 ÷ 12,000 = 2.1 units per hour (rounded)

Chapter 19 407


e. Throughput would be useful in a job shop because most jobs are typically taken with customer agreements as to quality of production/service and time of delivery. Calculation of throughput would provide useful information for future contracts. There would be an expectation of high process quality yield in a job shop because employees are more likely to be directly engaged in the production/service process and, thus, able to spot and correct defects as they occur. Eleanor Division might have low MCE because there is a significant amount of move distance between operations or idle time.

31. a. Annual pretax profits = Income increase – Depreciation Annual depreciation = $2,000,000 ÷ 5 = $400,000 Year 1: $ 200,000 - $400,000 = $ (200,000) Year 2: $ 300,000 - $400,000 = $ (100,000) Year 3: $ 380,000 - $400,000 = $ (20,000) Year 4: $1,600,000 - $400,000 = $1,200,000 Year 5: $1,600,000 - $400,000 = $1,200,000 b. Year 1: $ (200,000) x 0.02 = $ (4,000) Year 2: $ (100,000) x 0.02 = $ (2,000) Year 3: $ (20,000) x 0.02 = $ (400) Year 4: $1,200,000 x 0.02 = $24,000 Year 5: $1,200,000 x 0.02 = $24,000

c. Whether Mr. Wilke will want to invest depends largely on his personal time

horizon. Although investing in the project would reduce his compensation during the first three years, this reduction would be more than offset in the last two years. If Mr. Wilke’s time horizon is three years or less, he is unlikely to invest. If his time horizon is four years or more, he is likely to invest. Also, Mr. Wilke must deal with the possibility that he’d be dismissed from his position in one of the first three years due to poor performance if he invests in the project.

d. Yes. Upper management would likely view the project favorably. Using any

reasonable discount rate, the project has a positive NPV. 32. a. The high level of variable pay indicates compensation committees and

boards of directors believe that CFOs are in position to substantially influence operations and results. This is a very positive signal about the relative influence of the CFO in influencing financial and operational results.

b. There may be some risks to making CFO pay so dependent on operating

and financial results. Because the CFO is in a position of authority over the record keeping and reporting functions, CFOs may be tempted to manipulate reports such that reported results align with thresholds of

408 Chapter 19


higher payoffs. The variable pay creates an incentive to report results that provide higher levels of rewards.

Problems

33. a. Actual Flexible Master Amounts Budget Budget Sales $19,500,000 $19,500,000 $18,000,000 100% Var. costs (14,625,000) (13,650,000) (12,600,000) 70% CM 4,875,000 5,850,000 5,400,000 30% Fixed costs ( 3,615,000) (3,600,000) (3,600,000) Pre-tax income $ 1,260,000 $ 2,250,000 $ 1,800,000

Actual pretax income fell short of the expected amount by $540,000 ($1,800,000 - $1,260,000), despite the fact that the actual level of sales exceeded the expected level by $1,500,000. The higher sales revenue should have generated an additional $450,000 of income ($2,250,000 - $1,800,000) if costs and prices would have been maintained at the budgeted level. However, this effect was overwhelmed by either a lower per unit sales price or a higher per unit variable cost. Budgeted contribution margin was 30% of sales. The actual CM was only 25% of sales ($4,875,000 ÷ $19,500,000). Without knowing the number of units that were sold, the price and variable cost effects cannot be determined. By having the actual CM drop by 5%, pre-tax profits were lowered by $975,000 ($5,850,000 - $4,875,000). This is the principal cause of the drop in profits. A more minor effect was the increase in fixed costs, which exceeded the budgeted level by $15,000. These differences can be summarized as follows:

Effect of increase in sales $ 1,500,000 Effect of decrease in CM (2,025,000) Effect of increase in fixed costs (15,000) Net effect on pretax income $ (540,000) b. Complete income statements provide more information for isolating the

cause of differences between the budgeted and expected levels of income. By comparing only the actual and budgeted levels of pretax income, nothing is learned about the cause of the difference.

34. a. Analysis of the statement reveals a strong positive cash flow from

operations that has permitted acquisitions, dividend payouts and debt reductions for the three years.

Chapter 19 409


b. Revised Original 2007 Budget 2007 Budget Net CF from Operating Activities: Net income $ 45,100 $ 45,100 Add reconciling items 4,000 4,000 Total $ 49,100 $ 49,100 Net CF from Investing Activities: Sale (purchase) of PP&E (54,600) (4,600) Sale (purchase) of investments 18,400 (15,800) Other inflows (outflows) 2,400 2,400 Total $(33,800) $(18,000) Net CF from Financing Activities: Issuing notes for cash (7,000) (7,000) Paying dividends (8,000) (20,000) Total $(15,000) $(27,000) Net increase (decrease) in cash $ 300 $ 4,100 c. No, the net increase in cash will be only $300. The company would have to

settle for that or change plans. d. The above comparison can quickly give the president an overview of the

impact of the $50,000 LAN project. From the comparison, he can decide whether he is satisfied with the proposed changes in cash flows. By observing the cash flow effects of a particular project within the context of all of the other cash flows of the entity, the decision maker gains an appreciation of the significance of the project and of the entity's ability to implement the project.

35. a. Accrual accounting measures are subject to manipulation. Some of the

more common manipulations involve increasing or decreasing the level of discretionary expenses such as maintenance and advertising; increasing or decreasing production relative to sales; manipulating sales and purchases around a period's cutoff date; and manipulating estimates involving the life of assets, pension and retirement obligations, and costs of settling legal obligations.

b. The cash measure is just as subject to manipulation. For example, cash

can be manipulated by adjusting policies for credit sales, adjusting policies for retiring accounts payable, and advancing or delaying the payment of expenses around cutoff dates.

c. If any two measures are less than 100% correlated (in other words, the two

items measure different things), then a combination of the two measures will be less subject to manipulation than either is separately. Such is the case with cash flow and accrual income; some of the sources of manipulation can be identified, and a more complete picture of segment performance will be presented.

410 Chapter 19


d. Yes. In theory, the accrual income probably provides a better gauge of long-term profitability and is perhaps a better predictor of future cash flows. The annual cash flow measure provides more information on liquidity, cash management, and the policies for credit sales and purchases.

e. One possibility would be to utilize a more detailed budgeted income

statement, which would allow a line-by-line comparison with actual performance. This comparison would yield more information on both performance and manipulation.

36. a. Actual income: $28,250,000 - $25,885,000 = $2,365,000 Average assets: ($10,200,000 + $12,300,000) ÷ 2 = $11,250,000

Profit margin = $2,365,000 ÷ $28,250,000 = 8.37%*

Asset turnover = $28,250,000 ÷ $11,250,000 = 2.51*

ROI = 2.51 x 8.37% = 21%* *rounded

For 2006, the company’s stores slightly outperformed the industry (21% vs 18.9%). The better performance was attributable to a higher profit margin that dominated a slightly lower asset turnover.

b. Because the stores are already operating above industry norms on profit

margin, corporate management should concentrate on improving the asset turnover ratio. Asset turnover can be improved by either increasing sales or decreasing assets. However, overall, the stores are already exceeding the industry ROI so management must be careful not to decrease profit margin while they strive to increase sales or decrease assets.

c. The advantage of setting performance measures at the beginning of the

year is that management knows what the benchmark figures are as the year unfolds. The main disadvantage is that targets set at the beginning of the year do not control for industry level factors’ influence on results. Consequently, managers will be evaluated partly on factors that they cannot control.

37. a. Actual income: $24,000,000 - $22,560,000 = $1,440,000 Average assets: ($9,400,000 + $14,900,000) ÷ 2 = $12,150,000 Actual turnover = $24,000,000 ÷ $12,150,000 = 1.98 (rounded) Actual profit margin: $1,440,000 ÷ $24,000,000 = 6% Actual ROI = 1.98 x 6% = 11.88%

Chapter 19 411


The division exceeded its objective for asset turnover. However, the division failed to meet the target profit margin and ROI (1.8 × 8% = 14.4%) levels.

b. The division needs to improve its profit margin or the amount of profit

generated for each dollar of sales. Part of the poor performance may be due to the large increase in assets ($14,900,000 - $9,400,000 = $5,500,000) during the year. The return from the newly acquired assets is likely to be reaped in future periods rather than in the present period. Consequently, although most of the expense of operating the new assets is fully reflected in income, the revenues will be realized in future periods.

c. Income (from part a) $1,440,000 Target return ($12,150,000 x 0.12) (1,458,000) Residual income $ (18,000) 38. a. Sales (100,000 x $30) $3,000,000 CGS (5,200 x $9) + (94,800 x $10) ( 994,800) Gross margin 2,005,200 Expenses: Shipping (100,000 x $0.50) $ 50,000 Advertising ($5,000 x 12) 60,000 Salaries 700,000 Other costs 590,000 Repairs 10,000 (1,410,000) Net income before taxes $ 595,200 Projected income $ 595,200 Desired return on investment (0.13 x $4,500,000) (585,000) Residual income $ 10,200 b. Sales (105,000 x $30) $3,150,000 CGS (15,000 x $9) + (90,000 x $10) (1,035,000) Gross Margin 2,115,000 Expenses Shipping (105,000 x $.50) $ 52,500 Advertising ($5,000 x 11) 55,000 Salaries 694,500 Other costs 590,000 (1,392,000) Net income $ 723,000 $723,000 ÷ $4,500,000 = 16.07% return c. If Sanchez actually ships the delivery to the customer, it may anger the

customer and perhaps reduce future sales to that customer. Should Sanchez simply accrue the revenue and expense of shipping but not actually ship the goods, there is a possibility of misstating ending inventory and/or the cancellation of the sale before shipment. The failure to

412 Chapter 19


advertise, hire a personnel manager, and make needed repairs could adversely affect future operations. Finally, if Sanchez's supervisor determines that she has made such decisions for the sole purpose of obtaining her bonus, she may find herself without a job.

39. a. DuCharm Division

Contribution Margin For the Year Ended November 30, 2006

($000 Omitted)

Sales (1,484,000 units) $25,000 Less variable costs: Costs of goods sold $16,500 Selling expenses ($2,700 × 40%) 1,080 (17,580) Contribution margin $ 7,420

$7,420,000 ÷ 1,484,000 units = $5 per unit CM

b. 1. The pretax return on average investment in operating assets employed is 12%, calculated as follows:

ROI = Pretax operating income ÷ Average assets = $1,845,000 ÷ $15,375,000*

= 0.12 or (12%) *Average assets employed: ($15,750,000 + $15,000,000**) ÷ 2 = $15,375,000 **November 30, 2005 assets: $15,750,000 ÷ 1.05 = $15,000,000. 2. RI = Pretax operating income – (Minimum reqd. rate times avg. assets) = $1,845,000 - (0.11 x $15,375,000) = $1,845,000 - $1,691,250 = $153,750 c. The management of DuCharm Division would have been more likely to

accept the contemplated capital acquisition if residual income were used as the performance measure because the investment would have increased both the division's residual income and the management bonus. Using residual income, management would accept all investments with a return higher than 11 percent because these investments would all increase the dollar value of residual income. When using ROI as a performance measure, DuCharm's management is likely to reject any investment that would lower the overall ROI (12 percent for 2006), even though the return is higher than the required minimum, because this would lower bonus awards.

d. DuCharm Division must be able to control all items related to profits and

investment if it is to be evaluated fairly as an investment center using either ROI or residual income as performance measures. DuCharm must control all elements of the business except the cost of invested capital, which is controlled by Anderson Industries.

(CMA adapted)

Chapter 19 413


4 0. a. Powerboat ROI = ($18,000,000 - $16,200,000) ÷ $15,000,000 = 12% Sailboat ROI = ($48,000,000 - $42,000,000) ÷ $30,000,000 = 20% b. The Powerboats manager is the most likely to invest in a new project. Such

an investment would increase the overall ROI of the division. The Sailboats manager would not invest because the projected ROI on the new project is lower than the projected divisional ROI.

c. Such an outcome is inconsistent with overall corporate goals.

Companywide, the projected ROI is ($66,000,000 - $58,200,000) ÷ $45,000,000 = 17%. Thus, the company would probably want the Sailboats manager to make the investment and would prefer that the Powerboats manager reject the investment.

d. If the division managers were evaluated on the basis of residual income,

they would analyze how a new investment would affect the projected overall RI level in their divisions. The projected overall changes can be found as follows:

Powerboats Sailboats Projected ROI on new project 14 % 18 % Required target return 17 % 17 % Residual return (3)% 1 %

The project under evaluation by the Powerboats manager would cause his/her overall residual income to decline by an amount equal to 3% of the cost of the investment. On the other hand, the project under consideration by the Sailboats manager would generate an overall increase in RI by 1% of the cost of the new investment.

41. a. Projected EVA = $4,875,000 - (0.10 x $37,500,000) = $1,125,000 b. You would not invest in the project if it would result in a decline in your

overall projected EVA. Therefore, the maximum amount that you would invest would be the amount that would leave your projected EVA unchanged:

Pretax additional earnings $600,000 Taxes ($600,000 x 0.35) (210,000) After-tax change in earnings $390,000 Maximum investment x .10 = $390,000 Maximum investment = $390,000 ÷ .10 Maximum investment = $3,900,000

c. After-tax income = $4,875,000 + $390,000 = $5,265,000

Invested capital = $37,500,000 + $2,100,000 = $39,600,000 EVA = $5,265,000 - ($39,600,000 x .10) = $1,305,000

414 Chapter 19


42. To survive, firms need to manage effectively for both long-term survival and

short-term profitability, which are separate managerial concerns. Long-term survival is related to acquiring the necessary mix of inputs to remain competitive. Long-term management involves the hiring and training of talented employees, acquisition of capital improvements and technology, and the execution of strategies relative to products and markets. Short-term management is concerned with the effective and efficient management of resources (such as current assets) over the near term. Because long-term management has different objectives than short-term management, a different set of performance measures must be used to gauge success in each area. If no performance measures are geared to evaluation of long-term success, there is no incentive created for managers to be long-term oriented in their decision-making. By balancing performance measurement relative to time horizons, managers will be forced to consider both short-term and long-term consequences of decisions made.

43. a. MCE = Value-added time ÷ Total time = 15,680 ÷ 56,000 = 28% b. Process productivity = Total units ÷ Value-added time = 423,360 ÷ 15,680 = 27 units per hour c. Process quality yield = Good units ÷ Total units = 359,856 ÷ 423,360 = 85% d. Throughput = Good units ÷ Total time = 359,856 ÷ 56,000 = 6.4 units per hour (rounded) e. Yes, throughput should only consider units sold, not units produced.

Therefore, throughput would have been considerably lower because the process yield would have been lower.

Throughput = Good units ÷ Total time = 280,000 ÷ 56,000 = 5 units per hour f. Total time – Value-added time = Non-value-added time 56,000 – 15,680 = 40,320

40,320 x 0.80 = 32,256 new NVA time

32,256 + 15,680 = 47,936 total time Throughput = Good units x Total time

Chapter 19 415


= 359,856 x 47,936 = 7.5 units per hour (rounded) g. 423,360 x .90 = 381,024 good units Total new time (from part f) = 47,936 hours Throughput = Good units ÷ Total time = 381,024 ÷ 47,936 = 7.95 units per hour (rounded) h. Prieto could determine how the NVA time was being spent by preparing a

process map that would delineate all activities associated with the production of the product. One recommendation would be to implement an activity-based management system that would draw attention to the NVA activities and to the costs associated with those activities.

44. No solution provided. Each student will have a different answer. 45. No solution provided. Each student will have a different answer. 46. a. The evaluation measures are probably having a large effect on his

decision. By revealing the information about the obsolete inventory to the market, the stock price is likely to fall. Also, both the income statement and the balance sheet will suffer from the write-down. Both the income statement effect and the stock market effect will reduce the compensation paid to the company president, at least in the short run.

b. It is not an ethical treatment of either the existing shareholders or

potential shareholders. In the long run, both groups would be better off financially if the information about the obsolete inventory were revealed to the capital markets. Only in the short run are the existing shareholders better off from not revealing the information. However, one can easily anticipate the law suits that would be filed upon the market discovering the obsolete inventory after the new stock is issued. After the fallout, all parties would be worse off than they would have been with an honest and timely disclosure of the inventory information. Furthermore, the company would find it very difficult to make credible assertions about its financial position when it needed to return to the stock market in the future.

c. The decision to defer disclosure until after the issuance of the stock is

clearly an inappropriate course of action for the company. If the president persists in this view, the controller should go to the audit committee and reveal the problem to them. This committee could take action to disclose the information. Another alternative would be to take the information to the firm's public auditors, or as a last resort the controller could go to the SEC with the information.

47. No solution provided. Each student will have a different answer. 48. No solution provided. Each student will have a different answer.

416 Chapter 19


49. a. Quality (Internal Business Perspective) • defects per million • cost of quality (prevention, appraisal, internal and external failures) • supplier certification or certified items • reduction of supplier base • hours of employee quality training • hours of preventive maintenance • mean time between failure • certification of internal operations • unscheduled machine downtime • number of customer complaints, warranty claims, and recalls • unscheduled service call • percentage of lots rejected in error

b. Cost (Financial Perspective) • reduction in data transactions • materials shipped to point of use by supplier • dollars of product output per employee • throughput times from supplier to customer • budgeting expense trends • projects operating within budget

c. Production line flexibility (Internal Business Perspective) • reduction in cycle time • reduction in setup time • reduction in lot or batch size • increase in standard materials used per product • number of parts and levels in bills of material • degree of cross-training of production personnel

d. People productivity and development (Internal Business Perspective and Learning and Growth Perspective)

• sales per person • value added per person • employee turnover ratios • number of employees participating in improvement teams • competitive compensation packages • accident rates • absentee rates • training hours per employee • employee grievances • work days lost due to accidents • percentage of appraisals completed on time • percentage of positions filled from within the organization • percentage of employees with personal development plans

Chapter 19 417


• number of recognition events and awards

e. Inventory management (Internal Business Perspective)

• inventory turnover by product and group • inventory days on hand • inventory record accuracy • items above or below target limits • physical inventory variances • number of adjustments to inventory records

f. Lead time (Internal Business Perspective and Customer Perspective)

• delivery time to customers • setup reduction trends • in-house transit time • supplier delivery performance • throughput times • work in process investment • ratio of promised customer delivery lead time to cumulative production

lead time • administrative process times

g. Responsive after-sale service (Customer Perspective)

• number of hours of field service training • average response time to service calls • time to repair • availability of spare parts • warranty expense • overstocked field supplies

h. Customer satisfaction and retention (Customer Perspective)

• average customer response time • reduction in customer response time * number of complete items

delivered on time • time from customer's recognition of need to delivery • quoted lead time • customer order processing time • time from receipt of order to start of manufacturing • number of customer promises met • percentage of customer orders shipped on customer's request date • customer returns or complaints • backorder rate • degree of satisfaction with complaint resolution

418 Chapter 19


• number of customer partnerships established • number of certifications received from customers • enhanced customer value via added product features or reduced costs

i. Product and process design (Learning and Growth Perspective)

• time from idea to market • rate of new product introduction • percentage first firm to market • number of engineering changes after design • reduction in new product introduction lead time • new product sales revenue as a percent of total sale revenue • project completion cycle times • number of errors found during design review and evaluation

j. Manufacturing planning process (Internal Business Perspective)

• master schedule items achieved per week • final assembly schedule items achieved per week • material requirement plans achieved per week • manufacturing orders released on time • data accuracy of inventory, bills of materials, routings, and forecast • material and tooling availability • master production schedule on-time performance • number and types of changes made to MPS

k. Procurement process (Internal Business Perspective)

• average procurement cycle time • on-time performance of deliveries • reduction in purchasing lead time • purchase orders released on time • reduction of supplier lead times • purchase order errors • downtime because of shortages • excess inventory • percentage of parts from certified vendors

l. Manufacturing process (Internal Business Perspective)

• reduction of manufacturing lead time • percentage queue time in manufacturing lead time • percentage value-added time in manufacturing lead time • shop orders completed on time • manufacturing cycle times

Chapter 19 419


• unscheduled machine downtime • number of past due operations • yield and scrap rates • transactions per person

m. Management accomplishments (Financial Perspective)

• net income/number of employees • total sales/number of employees • net income/total direct labor payroll • net income/total factory payroll • total earned hours direct labor/total factory payroll

n. Marketing/Sales and customer service (Customer Perspective)

• total sales/number of employees • average lead time in backlog • lead time performance • premium freight outbound/total freight outbound • performance to sales plan • accuracy of forecast assumptions • number of incorrect order entries • credit request processing time

o. Delivery performance (Customer Perspective)

• timeliness and accuracy of supplier order placement and delivery • accuracy of shop floor schedule to customer requirements • ability to meet, but not exceed, MPS • correct quality and quantity delivery to customer per customer

requirements • analysis of lost sales due to delivery deficiencies

p. Financial accounting services (Internal Business Perspective)

• amount of nonvalue-added activity (scrap, rework, excess queue, and move time)

• total value of usable finished product produced per period per employee

• total cost and output value ratios • time-based overhead usage • performance to budget • percentage of late payments • time to respond to customer requests • number of billing errors

420 Chapter 19


• number of incorrect accounting entries • number of payroll errors

Measurement examples in this problem were taken from Ann Willis, “Aligning Performance Measurements with Organizational Strategies,” Hospital Materiel Management Quarterly (February 2001), pp. 54-63.

50. a. Based on the conversation between Terry Travers and Bob Christensen, it seems likely that their motivation would be stifled by the variance reporting system at Aurora Manufacturing Company. Their behavior may include any of the following:

• suboptimization, a condition in which individual managers disregard major company goals and focus their attention solely on their own division's activities, and

• frustration from untimely reports and formats that are not useful in their daily activities.

b. 1. The benefits that can be derived by both the company and its

employees from a properly implemented variance reporting system include the following:

• Variance analysis can provide standards and measures for incentive and performance evaluation programs.

• Variance reporting can emphasize teamwork and interdepartmental dependence.

• Timely reporting provides useful feedback, helps to identify problems, and aids in solving these problems. Responsibility can be assigned for the resolution of problems.

2. Aurora Manufacturing Company could improve its variance reporting

system so as to increase employee motivation, by implementing the following:

• Introduce a flexible budgeting system that relates actual expenditures to actual levels of production on a monthly basis. In addition, the budgeting process should be participative rather than imposed.

• Only those costs that are controllable by managers should be included in the variance analysis.

• Distribute reports on a timelier basis to allow quick resolution of problems.

• Reports should be stated in terms that are most understandable to the users (i.e., units of output, hours, etc.).

(CMA adapted) 51. a. EVA could discourage a high-growth strategy because this strategy almost

always requires that current profitability be reduced to achieve acceleration in sales. The reduction in profitability can be associated with increased costs of marketing and promotion and research and development.

b. Yes. The balanced scorecard could be used to provide incentives other

Chapter 19 421


than high current profitability. Specifically, some performance measures (and rewards) could be devised for the customer perspective:

• market share or growth in market share, • customer satisfaction, • sales growth, • customer complaint frequency, and • perceived product quality.

Still other measures could be devised for the innovation/learning perspective:

• number of new products developed, • research and development accomplishments, • number of new product ideas generated, and • increase in employee training.

The key to encouraging a division to grow, even if growth is to be achieved

at the expense of reducing current profits, is to link rewards of managers to the correct performance measures. By linking rewards to EVA, managers may be discouraged from investing in new assets that don’t provide an immediate return. Alternatively, by focusing measures on innovation and sales growth, incentives can be created for achieving a high growth rate.

52. No solution provided. Each student will have a different answer. 53. The most important point to be made in the arguments is that increases in pay

should be related to increases in performance. The minimum wage bestows larger pay without requiring a greater contribution of effort or talent. The likely consequence is a reduction in employment because the benefits of employing certain workers will no longer exceed the costs. It is unreasonable to believe that when higher costs are imposed on businesses with no compensating benefits, they will maintain the status quo in operations. Some firms will attempt to substitute automated systems for manual systems to reduce labor bills, and other firms will find it is now more desirable to employ higher skilled, more productive workers rather than lower skilled workers. In either case, some of the employees who were intended to be beneficiaries of the higher minimum wage will be unemployed. A more productive way to achieve higher income for workers at the bottom of the wage scale would be to find ways to improve their productivity and then reward them for it. For example, subsidized training could be given to minimum wage workers to allow them to improve their skills and abilities. Alternatively, simply creating an incentive structure that rewards employees for higher productivity encourages the workers to work harder, improve their abilities, and acquire higher-level skills. These incentives could be offered in the form of bonuses, profit sharing, or other types of variable pay. Two helpful Wall Street Journal articles related to this question were written by Gwendolyn Bounds: “Argument for Minimum-Wage Boost” (July 27, 2004), p. B3; “The Case Against a Higher Minimum-Wage” (August 3, 2004), p. B8.

422 Chapter 19


54. a. Year 1: $200,000 salary Year 2: $200,000 salary + $ 25,000 bonus = $225,000 Year 3: $200,000 salary + $150,000 bonus = $350,000 b. If the university goals go substantially beyond winning football games,

conference championships, and bowl games, the coach's contract certainly failed to promote goal congruence.

c. In designing contracts, wealth-maximizing managers will commonly attempt to maximize the performance measures that are the basis of the contract (subject to legal and ethical constraints). If the performance measures had been different in the coach's contract, it is reasonable to assume that his behavior would have been different.

d. Many different performance features could be considered. For example,

wage penalties could be included for any NCAA rules infraction or violation of school policy. In addition, performance measures could be added that would reward the coach for improvement in graduation rates and grade point averages of football players, and involvement of the football coaches and players in university and other civic activities. In any case, if the coach's compensation and job security are less directly tied to winning, violations of school policy and NCAA rules are much less likely to occur.

55. a. Asset turnover is defined as Sales ÷ Average Total Assets. If the

numerator is held constant and the denominator is reduced, the resulting quotient (asset turnover) must be, mathematically, larger. Dumping causes one of the assets (raw materials) to be smaller.

b. Top management would expect the plant manager to try to recover

something from the inventory he discarded, if it were indeed obsolete. It is highly unlikely that they intended that asset turnover be improved by discarding assets without benefit. It appears that the plant manager breached an implied understanding that his efforts be directed toward efficient operations. Other ethical considerations include unauthorized dumping on public lands and the possibility that the materials are toxic.

c. Jensen's options include the following:

• Remain silent. • Discuss the matter with the plant manager. • Hold a confidential meeting with someone high enough in the

organization to assess the problem and take any required action.

If Jensen remains silent, he can be considered an accomplice to the dumping and, thus, would be as unethical as the plant manager. If he tries to talk to the plant manager, Jensen may be able to convince the manager of the impropriety of the dumping. Of course, it is also possible that the manager would ignore Jensen's concerns and possibly fire Jensen. If Jensen talks to someone with the expertise and power to

Chapter 19 423


ascertain if there is a problem, Jensen may be convinced that the dumping is acceptable to both the company and (if legitimate) may even be considered good for the public in that it is clean landfill. If instead, the dumping is a problem, Jensen has done his ethical duty. (Jensen should, of course, attempt to talk to the plant manager first to determine all the facts and to avoid the implication of "going over” the boss's head.)

answer key kinneyaise19im

Documents