Chapter 25

Chapter 25 - Reporting and Evaluation

CHapter 25

REPORTING AND EVALUATION

Changes from the Twelfth Edition

All changes to Chapter 25 were minor.

Approach

Students should get a general idea of the difference between economic and managerial performance measurement, the nature of control reports, the criteria for good reports, and a beginning of an understanding of how to read such reports. A full understanding of the meaning of control reports requires years of experience and it also requires a thorough knowledge of the specific environment to which the reports pertain, so students should not be disturbed if they do not understand all the nuances of the sample reports included in the chapter. Nevertheless, they should acquire some ability to distinguish between what is significant and what is not significant, as well as an ability to spot fairly obvious red flags, that is, items requiring further investigation.

Both of the last two sections can be somewhat controversial. Whereas some companies are significantly reducing (or even eliminating) formerly intensive variance analysis processes, most still hew to this approach. Also, the total amounts of many executives incentive awards have prompted considerable criticism from certain quarters in recent years.

Cases

Harwood Medical Instruments PLC allows students to consider how a change in a bonus plan affects two divisions with quite different operating characteristics.Armco Inc.: Midwestern Steel Division illustrates a performance measurement system with measures cascading from strategic priorities down to the lowest organization levels.

Formosa Plastics Group describes a company that has an elaborate planning and performance measurement system but that uses mostly subjective evaluations of performance and highly smoothed bonus payments.Problems

Problem 25-1: Greene Enterprises

Performance Report

(A)(B)(A - B)(C)(B - C)

Budget

Actual

DifferenceBudgetedat Actual Volume

Difference

Sales

$56,000$63,000$7,000$63,000$ 0

Cost of goods sold

39,200 37,800 1,400(b) 44,100 6,300

Gross margin

16,800 25,200 8,400 18,900 6,300

Direct operating expenses:

Variable

(a) 6,720 8,000 (1,280)(c) 7,560 (440)

Fixed

10,000 10,000 0 10,000 0

Contribution to indirect costs

$ 80$ 7,200$7,120$ 1,340$5,860

(a)Direct operating expenses

$16,720

Less: Fixed expense

10,000

Variable expense

$ 6,720

(b) Cost of sales $39,200/budgeted sales $56,000 = 70%

.70 x $63,000 = $44,100, the cost of goods sold budgeted for actual volume.

(c) Budgeted variable costs $6,720/budgeted sales $56,000 = 12%

.12 x $63,000 = $7,560, the direct operating expenses budgeted at actual volume.

Sales increased substantially and were $7,000 more than expected. The indirect costs were $440 more than expected, but the cost of sales was only 60% of sales, rather than the budgeted 70%. These two factors account for the $5,860 difference between actual contribution to indirect costs and that expected at the actual sales volume. (The fairness of such an appraisal depends upon whether the predicted behavior of costs was realistic and reasonable.)

Problem 25-2: Watson Company

a.Performance Report(Division A

Current YearLast Year

Net sales

$252,000$216,000

Cost of goods sold:

Variable costs

$72,000$72,000

Division fixed costs

29,000 101,000 29,000 101,000

Gross margin

151,000 115,000

Selling and administrative expenses:

Variable expense

22,000 19,000

Division fixed expenses

25,000 47,000 22,000 41,000

Contribution to allocated costs and expenses

$104,000$ 74,000

b. Division A performed better in the current year than in the last year when the ratios of contribution to allocated costs to sales are made. ($104,000/$252,000 = 41% and $74,000/$216,000 = 34%.) Division managers cannot control allocated costs, and their performance should not be judged on the basis of net income/sales because the net income figure includes allocated costs. By comparing division contributions to allocated costs, the amount which each Division Manager contributes toward the overall company profits can be clearly seen. Bonuses based on division contributions would be in the best interest of both the managers and the company.

Problem 25-3: Machine Shop

a. If the report is meant to be a control report, the only two items strictly within the direct control of the machine shop supervisor are probably materials handling costs and supplies. Depreciation of machine shop equipment is a departmental direct cost, but the supervisor may not have much control over the amount. The costs for buildings and grounds, and general plant are allocated costs and cannot be controlled by the supervisor. Maintenance is controllable to the extent of the number of hours of maintenance time, but the supervisor cannot control the standard rate applied to these hours. Training costs might be similar to maintenance costs in that the supervisor might be able to control the amount of training time, but not the cost attributed to training.

b.Performance ReportMachine Shop

BudgetActualActualover (under)

Direct costs

Materials handling

$ 8,000$ 8,150$150

Supplies

5,200 5,000(200)

Depreciation- equipment

6,000 6,000 0

19,200 19,150 (50)

Indirect costs

Training

4,500 5,300

Maintenance

5,000 5,800

Building and grounds

3,700 3,700

General plant expense

2,500 2,600

15,700 17,400

Total direct and indirect costs

$34,900$36,550

Problem 25-4: Hopedale Companya.Performance Report - Month of April

Actual

Budget (a)Variance Favorable or (Unfavorable)

Controllable costs:

Salaries

$12,300$12,000$(300)

Indirect labor

20,500 19,640 (b) (860)

Indirect materials

2,550 2,640 (c) 90

Other costs

9,510 9,650 (d) 140

$44,860$43,930$(930)

(a) Budgeted costs at actual volume of 33,000 direct machine-hours consist of both fixed costs and variable costs calculated for the actual volume.

Fixed costs:Salaries

$12,000

Indirect labor

17,000

Other costs

8,000

(These are the same at any volume, because they are given as a fixed amount per month.)

(b) Variable indirect labor = $.08 x 33,000=$2,640

Total indirect labor costs budgeted = $17,000 + $2,640=$19,640(c) Variable indirect materials = $.08 x 33,000=$2,640(d) Variable other costs = $.05 x 33,000=$1,650

Total indirect other costs budgeted = $8,000 + $1,650=$9,650

b. Total actual costs for March were $930 higher than budgeted, with salaries and indirect labor higher than budgeted. More labor was probably used than expected, due to the greater volume than formerly budgeted.

The increase of $300 in salaries cost probably caused the increase in indirect labor cost also, perhaps for such as increased janitorial costs or routine maintenance.

(The expected volume was 29,000 machine-hours and was later revised to 34,000 machine-hours.) Although the actual volume of activity at 33,000 machine-hours was less than the revised budgeted 34,000 machine-hours, the favorable variances still resulted because the original budget was apparently based on a total yearly volume which is proving to be low. There seems to be good cost control over indirect material cost, as less was spent than budgeted.

Cases

Case 25-1: Harwood Medical Instruments PLCNote: This case is new for the Thirteenth edition..Approach

The Harwood Medical Instruments case was written in response to requests from instructors who want more short cases. It is also useful in an exam setting where multiple cases are used to test different subject materials.The case describes a company whose manager is concerned that the operating profit measure included in the companys bonus plan was too narrowly focused. He implemented a new bonus plan that reduced the weighting of importance placed on operating profit and that included more measures, including on-time deliveries, sales returns, patent applications, scrap and rework costs, and customer satisfaction. Presumably these factors were considered as critical success factors.

Suggested Assignment Questions

1. What was the purpose of the change?

2. Calculate the bonus earned by each manager for each six-month period and for the year 2007.

3. Evaluate the new plan. Is there any evidence that it produced the desired effects? What changes to the new plan would you suggest, if any?

Case Analysis and Pedagogy

1. The change was made because managers believed that operating income was not a good summary measure of short-term financial performance.2. The calculation of the bonuses earned in each division is shown in the tables below.

(000)Surgical InstrumentsUltrasound Diagnostic

Equipment

12Total12Total

Base bonus46.244.034.240.6

Delivery adjustment2.02.02.0-

Sales returns adjustment(15.0)5.0(3.0)5.0

Patents-1.04.08.0

Scrap/rework(4.9)(1.0)(5.5)-

Customer Satisfaction(5.0)(5.0)(5.0)-

Total23.346.069.326.753.680.3

Sales returns:

Surgical InstrumentsUltrasound Diagnostic

Equipment

(000)1212

Std.: 1% sales returns420440285290

Actual450420291287

(30)20(6)3

Bonus(15)5(3)5

Scrap/rework:Surgical InstrumentsUltrasound Diagnostic

Equipment

(000)1212

Std.: 1% of operating profit46.244.034.240.6

Actual51.145.039.738.2

(4.9)(1.0)(5.5)2.4

Bonus(4.9)(1.0)(5.5)-

3. There is evidence that the plan is producing some of the desired effects. In both divisions, as managers have gotten accustomed to the new bonus plan (2nd half of 2007), sales returns have declined, patent applications have increased, scrap and rework costs have declined, and customer satisfaction has increased. On-time deliveries have increased in the surgical instruments division, but not in the ultrasound diagnostic equipment division. As a result, the bonuses to be paid increased significantly in the second half of the year.Is this improvement good? It is if the performance factors added to the plan are truly critical success factors. The small incremental bonuses paid would seem to be money well spent. The money should be quite meaningful to the managers and, hence, quite motivating, yet not very expensive for the company.

But the two divisions seem to so different. Someone should consider whether the same factors should apply to both divisions and in the same weightings of importance. Each of the individual factors should be subjected to critical scrutiny. For example, are patents important in a division that sells such mundane products as scissors and clamps? And for that matter, does including patents applications in a bonus plan just encourage patent applications that never get approved, or even if they do, that never provide any real economic benefit to the division and company. And several of the factors have very specific performance constraints. Should the payoff functions be linear, rather than based on perhaps arbitrary performance constraints, such as 95% deliveries on time or 90% average customer satisfaction?The case does not provide enough information to answer these questions, but students should be able to identify the issues.

Case 25-2: Armco Inc.: Midwestern Steel Division*Note: This case is unchanged from the Twelfth Edition.

Approach

The Armco case was designed to illustrate a performance measurement system with measures cascading from strategic priorities down to the lowest organization levels. The system is not tightly linked with incentive compensation, although that is being discussed. Still, the focus on measured results promises to change managerial behaviors significantly.

The case is particularly interesting because it describes a major change from an old measurement system which was primarily designed for standard financial reporting purposes and was not perceived, at least by top management, to be effective for management control purposes. The new performance measurement system eliminated most of the allocations of indirect costs and helped managers understand the critical success factors in their areas.

In this case, then, students can understand two performance measurement systems and the companys reasons for changing from one to the other. They can evaluate the new system and decide whether the division managers have made optimal choices in designing their new system, and they can make a judgment as to whether the system should be used to increase the proportion of total compensation linked to performance.

Most of the students will conclude the new system is a substantive change for the better. But then they will get a dose of reality as they see the problems Armco is having getting managers to adapt to the new system.

Suggested Assignment Questions

1. What was wrong with the Midwestern Steel Divisions old system? (As part of your analysis, study Exhibit 3 carefully and figure out what the columns tell you, individually and in total.)

2. If the old system was so bad, why did the operating managers seem to like it?3. Evaluate the new system and the way in which it was being implemented. What changes would you recommend, if any? Why?

4. What should Rob Cushman do about the two items described in the Remaining Issues section of the case?

Case Analysis and Pedagogy

4. What factors most determine the success or failure of the Midwestern Steel Division? In particular, how important is cost control?

Carbon wire rod is a commodity product, so cost control is critical for this line of business.

There is some product differentiation in grinding media. Customers can measure how long the steel balls last, and they value long-lasting balls. Armco believes it has a superior manufacturing technology that causes its balls to last longer. Further manufacturing technology innovations would provide additional profits to the division.

Cost control is also important for grinding media, as Armco is the high cost producer in this market. Plant throughput (productivity) is one key to cost control. Armco can sell all the product it makes. (The plant has been operating at capacity for three years straight.)

Among the cost control challenges in the plant are the fact that the plant has old equipment, generally poor preventative maintenance practices (40% of the 700 hourly workers in the plant were maintenance workers), and less than optimum worker productivity.

The people left in the plan are the most senior. They would not be hurt that much by a shutdown. They have pensions. Cost control is not that important to them. It would cost the company about $200 million to shut down the plant (environmental clean-up, pensions, etc.).

Students might ask why Armco does not put more people or more equipment in the melt shop so it wouldnt be a bottleneck. The answer is that they would have to add a furnace, making an investment of approximately $100 million. This would add capacity which is not needed in the industry.

5. How were managers controlling performance with the old system? What were the strengths and weaknesses of the old system?StrengthsWeaknesses

1. Managers express need for detail so they can track month-to-month trends.

2. Has value in identifying problem areas.

3. Measured performance was based on managers ability to control cost above. System gave managers information consistent with objective they were given.

1. Too much detail. Some numbers didnt change. Some very small.

2. System designed for inventory costing purposes. Have to allocate costs. For performance measurement purposes, not sure if the allocations mean anything.

3. Source of some of the data is unclear.

4. Reports were delivered 15 days after month-end. This is too late.

5. System too focused on cost reductions, to the exclusion of other critical success factors.

6. Managers performances judged on things over which they had no control. Many costs were caused by people who did not report to the managers (e.g., capital spending, salaries, maintenance). Easy to blame poor performance on uncontrollables.

7. System not encouraging managers to work together. Much local data. Contributes to suboptimization.

8. Not graphic.

9. Accounting accruals distort the costs. Exampleannual August maintenance shutdown accruals start in January.

It is important to walk students through Exhibit 3. Pick some representative columns and have students talk about what they mean or dont mean. Among the useful examples to discuss are nonmetallics, salaries, electricity, lubricants, and loco cranes. Students should see the types of costs that make up total cost above. Which are the big items? Which items are variable and which are fixed? (The important ones are fixed. Costs per net ton are driven by tons produced.) Point out the distorting effect of the August maintenance shutdown.

S-orders represent extraordinary maintenance. It is accrued for. It is fixed in the short-run (a month), but it can vary over the year.

6. Why did the operating managers seem to like the old system?

Familiarity

Reports were related to budget

Managers cant be held accountable because they always had an excuse for poor performance. (Nenni: The traditional way we ran our operating review meetings was that the managers would find some items that didnt make sense. Then they would discredit the report and the accountants. We never got to the items the managers can and should control.)

Gives managers a false sense that they can control costs. Gives a global picture. (The managers would have liked to have the information every week.) Gives managers a sense that they are responsible for a large number (e.g., melt shop manager responsible for $50 million per year)

After the students have had their crack at the analysis, if it hasnt come up, the instructor might usefully point their attention to Bob Nennis quote about the problem with non-value-added chores under the new system and the difference between value-added and non-value-added work. (Non-value-added work includes everything customers are not willing to pay for.) One prominent example of the non-value-added work associated with the old system (which is Bob Nennis focus) is the administrative burden required to keep it going. The old system took five accountants to operate. The new system required only three, even in start-up mode; most of the accountants time was spent designing new reports. To what extent does Bob Nenni consider accounting to be value-added work?

7. What were the key features of the new system and what improvements did it promise?

Hit the key design choices and discuss them; for example:

Strategic (not just financial) focus. 10 key measures.

Priorities must come from the general manager and his direct reports. Priorities must cascade from above so that everybody is working on the right things.

Everybody agrees with the top four priorities(safety, productivity, quality, and up-time.

Safety is the #1 priority because managers do not want people to get hurt. It is not #1 because it is the largest cost.

Elimination of cost above measure

New system does not do a trend analysis (e.g., performance vs. a year ago or vs. last rolling 12 months). What is key is whether manager did in January what he said he would do (vs. agreed-to benchmark).

Focuses attention on important categories and provides more detail on those

Focuses on controllables. For example, melt shop manager controls KWH/T, not electricity

dollars/T. Purchasing negotiates the price.

Focuses more on productivity than costs.

Standardardizes everything. Everything is not driven by tons.

Apparent reduction in the manufacturing managers financial responsibility. (The new system reported only what the employees reporting to each manager spent. Those are the dollars that can be controlled.)8. What are the weaknesses of the new system?

Its not a cost system. Company still needs a cost system. The company still does not have a handle on what costs are controllable, what are fixed and variable, etc. Should show consumption, not purchases. (There is still a problem with the source of the data.)

The performance standards are not benchmarked with the best in the industry. (Firms in the steel industry do not share much operating performance information.)

Seasonal factors are ignored.

Uncontrollables still not handled well. For example, what happens if the plant shuts down for a few hours? Should this be segregated from the managers performance reports?

The system is not complete. Three measures(maintenance, on-time delivery, and inspection(are not yet implemented.

Should the system focus on exception reporting, rather than provide all the detail?

9. The implementation process.

Division managers decided to discontinue the old system immediately? What are the advantages and disadvantages of that decision?

Managers would never adapt to new system if old system was still running. After the switch to the new system, they were frequently in Rob Cushmans office begging for their old reports. (Actually the old system is still being run, for inventory valuation and product costing purposes. But the operating managers have not been told that the old system is still running.)

The risk of the immediate switch-over is that uninformed decisions will be made: Managers dont have their old information, and they dont yet understand the new information. But the new system seemed to work. The periods after the switch-over to the new system were the best in the history of the plant.

Department managers had no input into the design of the new system? Was that wise?

Ideally it should be the operating managers, not the accountants, who identify what is critical to their areas. But the operating managers were consulted, and they said only, We want the old system. Only three managers in the division wanted the new system(the general manager, the director of finance, and the manager of cost accounting. The other 997 people in the plant were indifferent to overtly combative.

What can be done to get operating managers to take the lead? Training? Hiring? Should accountants have a role in measuring quality, on-time delivery, etc.?

Why did Bob Nenni devote so much energy to the performance measurement system instead of working on, for example, an activity-based costing system, which Armco does not yet have?

He thought the performance measurement system, with its link to strategic priorities, was much more important than an accurate costing system.

10. Remaining issues:

When should something be considered uncontrollable?Under the new system at Armco, the handling of uncontrollables is at the discretion of the individual superior. The lines between controllables and uncontrollables are tough to define. The company has a culture of making excuses.

Should larger bonuses be linked to the new system measures?

The answer to this question is complex. Among other things, it depends on the trust people have in the measures and the companys compensation strategy (e.g., compensation competitiveness, amount of risk they want managers to bear).

11. What has happened since the case was written?

Many things have happened since the case was written. There was significant management turnover. First, the manufacturing cost manager (Scott Molaro) resigned. He got frustrated by the operating managers resistance to change. Then there was significant turnover among the operating managers. The works manager (Charlie Bradshaw) was asked to retire. The maintenance manager (Ed Graves) was fired. The rolling/finishing manager (Paul Phillips) retired.

In April 1992, Armco Inc. acquired Cyclops Industries, Inc., another specialty steel manufacturer. The combined company needed capital, so they spun off the Midwestern Steel Division. It is now a privately held, freestanding business.

As of March 1993, the new performance measurement system was still operating. The three missing measures were still not implemented. Rob Cushman was not sure the on-time delivery measures would be worth the cost of developing them. Managers were not sure how best to develop the maintenance measures. And they had not gotten around to developing the inspection measures.

Case 25-3: Formosa Plastics Group*Approach

The Formosa Plastics Group (FPG) case describes the reporting and evaluation system used by the largest private corporation in Taiwan. The case describes the companys organization and responsibility centers, budgeting processes and, particularly, methods of evaluating the performances of profit center managers when profit is to a large extent uncontrollable. The system is somewhat unusual in that the planning and reporting processes are quite detailed and costly, yet performance evaluations are highly subjective, and bonuses do not vary much from period to period.

Suggested Assignment Questions

1. Identify the major elements of Formosa Plastics Groups control system.

2. Is the Polyolefin division a profit center?

3. Managers at Formosa Plastics Group use subjectivity to eliminate some of the effects of uncontrollable factors from performance evaluations. Evaluate this choice. Did they have any alternatives?4. Evaluate FPGs incentive compensation system. What are the advantages and disadvantages of smoothing incentive compensation?

Case Analysis and Possible Discussion Questions

1. Describe the Formosa Plastics Group (FPG).

FPG is a Taiwan-based conglomerate consisting of more than 10 different companies located in Taiwan, China, and the United States. It includes several chemical, plastics, electronic, and textile companies, as well as a modern hospital, a nursing school, a technical college, and a medical college.

More facts about the company can be pulled from the case. Here is some more recent information:

a. In 1994, FPG completed a $2.1 billion petrochemical and plastics-making plant in Point Comfort, Texas. This was the largest investment by a privately held corporation in Texass history.

b. Taiwanese law does not include a holding company-type organization. FPG actually has a complex ownership structure. The dominant shareholders are a family of two brothers, Y.C. Wang (chairman, 80 years old in 1997) and Y.T. Wang (president, about 73 years old). The two brothers own at least 20% of all companies in FPG.

c. The case does not make it obvious, but the actual running of FPG is in the hands of the Chairman, not the President. Staff in the Presidents Office take orders both from the Chairman and the President directly. The Chairman has a dictatorial management style. He was raised by a poor village family and had to quit school after the sixth grade. But he taught himself how to master a complex company. His young brother (the FPG President) is more of a human relations-oriented person. Most people in Taiwan believe the two brothers make an excellent management team.

d. As an indication of the centrality of FPG in the Taiwanese economy and of the significance of the Chairman, in particular, it is interesting to note that the Taiwanese stock index fell 5% in one day in early 1994 when a rumor circulated that Chairman Y.C. Wang had died.

2. What are the major types of financial responsibility centers in FPG?

a. Companies and Divisions: investment centers (ROI measure)

b. Plants and Product Groups: profit centers

c. Production Processes and Group of Machines: cost centers

d. Non-production-oriented units, such as sales, technology, management: revenue or discretionary expense centers

3. What are the major problems facing FPG management in the early 1990s?

Labor shortages and rising wages. At FPG, labor costs are significant, but less than 20% of total production cost. They are actually much smaller in some divisions (e.g., polyethylene). Labor costs in the United States are approximately 50% higher than in Taiwan. Taiwanese wages are higher than in other producing countries (e.g., Indonesia, Mexico), but Taiwan has higher productivity than most developing countries.Many FPG divisions compete on price, but they cannot raise prices because their products are commodities. At the same time, most raw material prices (e.g., petrochemicals) are volatile and not controllable. Thus, profits go up and down. The goal of many of the divisions is simply to produce at full capacity.

A growing problem which is not directly relevant to this case is the radicalization of the environmental movement in Taiwan.

At the Polyolefin division, specific problems include uncertainty in the raw material markets with respect both to prices and availability and uncertainty in the markets for its own products.

4. Describe and evaluate the major elements of FPGs control system.

a. Each company and division has a target ROI. ROI is defined as profit before taxes but after allocation of corporate expenses divided by divisional investment only.

b. FPG uses a target costing (with benchmarking from Japanese companies) approach to the budget planning. Standard costs are revised promptly when conditions so warrant. These changing target costs are used to motivate continuous improvement.

c. An extensive set of monthly performance reports (Exhibit 3).

d. Chairman and Presidents monthly detailed performance review meetings with 30 senior managers.

e. Bonus plans. These plans have some unique features:

i. FPG bonus pools are determined at the time of budgeting, not after actual profit has been measured.

ii. The bonus potentials vary by organization level and role. Workers below section chief level receive a performance bonus program about 20-26% of their base salaries. Management has a special performance-based bonus fund. Technical people such as R&D have incentive rewards for good ideas.

iii. Total FPG bonus amounts paid per year did not vary much over time due to the Reserve Bank system. By creating reserves for bonuses, the company is smoothing the employees bonus stream.

iv. Every employee automatically gets 3-5 months of base salary as a so-called bonus each year. This is cultural. It is traditional in Taiwanese for every employee (even government employees and university professors) to get a minimum of two months pay as a year-end bonus. (Many Japanese firms give their employees at least four months pay as a year-end bonus.) These payments are not performance-dependent.

f. The Presidents Office

The Presidents Office (or Red Guard) is composed of 15 teams (340 employees) of specialists whose role is to collect information and to help division management. The Presidents Office has three levels. The top level staff usually have experience serving as division managers. The second level staff usually have experience serving as plants or product group managers. The third level staff usually have experience serving as department heads or section chiefs. The Presidents Office staff and some line managers will rotate every few years.This Office is a very costly system feature, but it serves three purposes: (1) helping the Chairman and the President to control and evaluate line managers, (2) helping different divisions, plants, and product groups to continuously improve their performance, and (3) serving as the training ground for these staff persons for future higher line positions. Many Japanese companies also rotate people through different functions in their career, so that by the time a Japanese manager gets into a top level position, he knows almost all the companys functions/processes/products.

It is interesting to note that the Chairman and the President also have many relatives working in different parts of FPG. Through regular family gatherings, relatives also provide some inside information on particular divisions or departments.

5. Describe FPGs annual planning process. Is it more a top-down or bottom-up process?

a. Four-month planning process, begins in September and ends in December.

b. It starts with a bottom-up planning. Division level managers submitted their sales plan and production plan. Then the top management made suggested revisions. The revision process iterates two or three rounds.

c. Top management uses the targeting pricing/costing approach. Continuous improvement is stressed. Each division is expected to use improvement projects to reduce costs each year. Funds are available for these projects.

d. Top management is prone to reject the initial budget proposals, to ask for more profit. This procedure adds a top-down dimension to the process, and it creates some gaming behavior. The lower-level managers expect their initial plan to come back for revision, so they produce a conservative plan which leaves some room for improvements in future round(s).

6. Describe FPGs performance evaluation process.

a. Primarily subjective, but objective numbers form a basis for the subjective evaluations.

b. The budget is used as the basis for evaluation. The probability of achieving targets is around 80-90%. Performance targets are sometimes revised due to environmental changes.

c. Managers are evaluated by considering controllable factors, both financial and nonfinancial measures, such as quantity of product sold, production efficiency, production schedules, consumption of materials, cost control, inventory control, leadership, and product quality.

d. Changes in results due to activities that were approved by top management after the budget was approved (e.g., improvement projects) are adjusted for in the evaluations.

e. Those making evaluations and assigning bonuses also take into consideration the persons ability and potential for the future, years in the company, teamwork, cooperation, and the situation the person faced. It is very subjective. FPG employees must trust their evaluators.

7. Is the Polyolefin division a profit center?

Yes and no. Profit of the entity is measured, but the manager, Mr. Hsaio, is not held accountable for profit. FPG managers have concluded that he does not control significant elements in the profit calculation. In particular, ethylene accounts for 60-65% of the divisions total product cost; there is only one local ethylene supplier owned by the government; ethylene prices are set by the government; ethylene prices fluctuate significantly; and prices of the divisions output (polyethylene) do not fluctuate with the input (ethylene) prices.8. So what is Mr. Hsaio held accountable for?

He is responsible for all aspects of his divisions performance except material price variances. In most of FPGs chemical businesses, particularly those which sell in commodity markets, material price variances are factored out as being largely uncontrollable.

Managers of other FPGs divisions are held substantially accountable for profits. Where the managers have substantial control over profits, profits are used as a major component of the performance evaluation. In such cases, the evaluations will be more transparent even though they are still subjective.

9. Is FPGs choice to allow high subjectivity in performance evaluations a good one?

It seems to work at FPG. The managers are comfortable with the system, and the company has been quite successful for a long period of time.

10. Are any of FPG managers control choices affected by national or cultural factors? If so, which choices were affected and which factors affected them?

FPGs control system differs in several significant ways from most Western companies:

a. It is a large company which is substantially owned and dominated by one family. The large Presidents Office and the detailed monthly performance reviews are two of the methods the top managers use. While seemingly everyone in FPG was satisfied that the current management control systems were effective, some managers wondered whether the system would continue to serve the company well in the future. Most important, they were concerned about a shift in management style if the current top-level managers retired. And many managers expected that research and new product development would become more important to FPG in the future, and this change could force the company to have a longer-term focus because the typical research and development cycle in the chemical industry was 4 to 5 years.

b. The heavy use of subjectivity in performance evaluations is more common in Asian companies than in Western companies. Most American managers and employees, for example, prefer a more objective evaluation system. They are less comfortable with giving their superior that much evaluation discretion and power (the power distance concept discussed in Chapter 19). They worry that a high degree of subjectivity in evaluations will cause unfairness and bias.

c. FPGs system, with its detailed monthly performance reviews and no long-term incentive program, appears very short-term oriented. Myopia danger is minimized, however, because most of the employees spend their whole career with the company. Thus, they are not able to avoid the harmful effects of their short-term actions. Further, FPG likes to have its bonus payments be relatively constant over time. A total bonus figure is put in the budget and is not varied by the actual amount of profit earned. As one manager explained, If this year is no good and next year is no good, maybe we will consider a lower bonus in the third year. But it is difficult to distinguish good and bad performance in the short-run, and we like to make the situation more steady. This philosophy contrasts with the tendency in most Western companies to make bonus payments ever more variable with short-term performance.

d. The use of year-end employee bonuses is traditional in Taiwan (and other Asian countries). (Employees also receive month salary on each of two national holidays.) These bonuses are not motivational, however, because they are not performance-dependent. Thus, they are not part of the companys control system.11. What happens when the chairman and president retire?

This is a major concern for FPG employees. Here is a representative comment from one manager:

As long as chairman Wang stays, fundamentally there will be no change. He is the founder, and he knows everything very well. Our system is good, and our goals will be the same. I dont even know how many of us have contemplated change because Chinese people believe their leaders will be long-lived. But when our chairman changes, things will be different. One mans leadership can have a significant effect.

If Chairman Wang retires, who will be the new leader? Would we change our strategic direction away from commodity chemicals in favor of creation of higher value added products? If that happened, would the system have to change? I guess it depends on the needs of the company and the philosophy of the new managers. It is clear that the second generation of managers will be different. They have been educated in Western Europe and the United States and have been less influenced by the Japanese.

12. Does anything else threaten FPGs system?

Some managers were also concerned that FPGs success might be threatened, ironically, by the advancing Taiwanese standard of living. They noted that the cost of labor was increasing, and it was becoming harder to motivate employees. One manager said, The younger generation likes leisure, and the older generation is getting lazy. They have more money and more time to spend it.

*This teaching note was prepared by Professor Kenneth A. Merchant. Copyright 1998 Kenneth A. Merchant.

*This teaching note was prepared by Professor Kenneth A. Merchant. Assistance from Professors Thomas W. Lin and Dan Elnathan is gratefully acknowledged. Copyright 1998 Kenneth A. Merchant.

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