Texas Eastman Company Objectives To illustrate how financial profitability measures can be used by workers to manage day-to-day operating

decisions. Understand how to push down profitability information to empower employees. Know the design and information-processing prerequisites for daily profitability analysis. Appreciate the role of finance staff experts in preparing profitability analysis. Case Background The Texas Eastman case provides an excellent opportunity to discuss how financial measurements can support a company's Total Quality Management program. Occasionally, industrial engineering and operations management types denigrate financial measurements and encourage companies to cut all ties between their direct physical and operational measurements and their company's financial system. In effect, they are saying that quality improvement efforts can only be inhibited by financial measurements. The Texas Eastman case provides a vivid counter-example to such claims. First, the financial measurement system is devised by a chemical engineer department manager, not a finance or accounting person. Second, and more important, the financial system he develops plays a vital role in the success of the quality program. Discussion Q: What kind of financial reporting system is being used to provide feedback on operations? The Period Report is actually a well-designed system. Building from projections and commitments made in the budgeting process, as encapsulated in the Annual Operating Plan, the report is a sensible summary of period operations. It is flexed with respect to the volume and mix of actual output. The five variances help to identify the principal sources of variation of actual from budget, such as volume, mix, and external price changes. I particularly like how promised improvements from capital expenditures are linked into the standards. The thoughtful treatment of volume variances also deserves mention. In most companies, production managers receive favorable volume variances for producing in excess of budgeted amounts. Also, they are penalised with an unfavorable volume variance during a period when production falls short of budgeted amounts. This practice usually makes it impossible for an organisation to achieve just-in-time operations. Though told by JIT not to produce unless the next stage is ready for the product, department managers are penalised for following this discipline, and rewarded for overproducing even when the production could be of the wrong products or in excess amounts. At TEX, most volume variances are treated as noncontrollable at the departmental level. Favorable, controllable volume variances are earned only when demand exceeds rated capacity and the manager squeezes out extra yield and output to meet this demand. Conversely, a controllable unfavorable volume variance occurs only when production falls short of budgeted amounts and fails to satisfy existing demand. In summary, the TEX Departmental Period reporting system is a thoughtful, well-designed standard cost system, whose specifications are updated to reflect current operating conditions. Many companies have a lot worse. Q: How useful is the Departmental Period Reports in the information-rich environment of TEX, where 30,000 observations are being produced about the processes every 2-4 hours? The Period Report comes out much too late and at too aggregate an activity level to be useful for operators or department heads. What do the managers and operators say to the finance group when this report is issued? The typical response is "Too late, it's history; doesn't tell us about the future." What do the managers and operators say to the finance group when

this report is issued? The typical response is "Too late, it's history; doesn't tell us about the future." What do the operators and managers tell us now? The answer, "Still too late!" The point, of course, is that even were the information available at the end of day 28, it is still too late for effective action. Q: Would a daily version of the same report be helpful to managers and operators? This is a tough question. The format of the report with its emphasis on historical standards and variances would likely be difficult for an operator to understand and link back to operations that occurred yesterday. Operators can relate to quantities of inputs and outputs, not variances. Q: Is there any need for a financial report? The answer to this question is the main focus of the discussion. I have identified at least five key benefits from the Daily Income Statement. 1. 2. 3. The Q: What information did Briley need in order to produce the Daily Income Statement? 1. Most important is that the statement requires accurate measurements of the quantities of inputs consumed and outputs produced each day. Also it requires an accurate assessment of the quality of the outputs produced. Fortunately, these data were already being produced as part of the extensive investment in information technology made by TEX, so no additional measurements were required for this report. This is an important point. It would be unusual for it to be worthwhile to make new measurements just to produce a financial report. But with the tremendous expansion of information collected about production processes, financial reports can be much more timely and comprehensive by building on to the new information freely available in production and production control systems. 2. In contrast to the accurate measurement of quantities and quality, Briley could rely on ballpark estimates of the prices of outputs and inputs. This is most clear in the case of the 50% discount for off-spec material. How did Briley know whether it was 50% or 52% or 49%? For the purposes he wanted, getting the quality discount approximately correct was fine. Similarly the prices of the intermediate products and the inputs to the production process need only be roughly estimated. This is an important point for organisations thinking about applying the Briley Daily Statement to their departmental operations. Accurate prices for the intermediate products, such as stuffed printed circuit boards or etched wafers, need to be roughly estimated to value the output, but detailed studies need not be performed. Should Briley change the prices of the output products and input factors daily in response to changes in market prices? I believe the answer to this question is "No." Changing the prices daily would focus operators' attention on changing the mix of inputs consumed and outputs produced based on daily fluctuations. This is not the mission of the 3B Department. Production targets and mix are determined centrally. The goal of the operators is to learn how to produce the desired mix most efficiently while maintaining quality. Changing prices daily can only confuse the operators and distract them from their fundamental- task. Only if the company wanted operators to change the mix of inputs used, or outputs produced, in response to external price changes [as occurs in some paper companies using a combination of expensive input chemicals] would it be helpful for them to see daily price changes. Should there be major changes in relative prices, such as a dramatic increase in the price of energy or feedstock, or decrease in prices of outputs (ethylene and propylene) then these changes should be incorporated to signal the new economics of the cracking process. 3. It is also worth noting the treatment of capital cost. In order to make this concept real to the operators, the capital cost is treated as a mortgage payment to repay the company for use of the equipment. Most of the

operators would be familiar with the mortgage concept, from incurring loans for their house, farm, automobile or truck. The mortgage analogy is even better than depreciation since it can include a return on capital (the interest rate) in addition to the return of capital. The equivalent daily mortgage payment for equipment employed was calculated by the TEX finance staff for Briley, and the amount held constant each day. Operators were not to take action based on this figure, but needed to see it to understand that much of the apparent profits from daily operation were needed to repay the heavy capital investment in the plant. 4. The report also allowed for loan repayments for special projects that were implemented to increase yield or quality. This allowed operators to formulate new investment proposals and see the cost of the investment in these proposals. The instructor can also note Briley's "manipulation" of the facts to place a 50% premium on the use of cooling water. As with the discount for bad quality, Briley is internalising his estimate of the long run cost of using an input resource beyond that currently reflected in the standard cost of that resource. Q: Was the Daily Income Report accepted? How do we know? The operators welcomed the report each day; as evidence, note the incident in the case when Briley would return from a business trip, the operators asked him to calculate the daily income for the days he was away. How often does the finance staff get a call from operating departments asking where the monthly variance report is and when would it be delivered? Initially, the motivation for the Daily Income Report came from attempting to achieve the targeted period profit that would earn the operators a new kitchen. But even after the kitchen was earned, the operators continued to want to see the daily statement, without any explicit incentive now tied to achieving income goals. At this point, I shift the tone of the discussion away from the details of the report to a more conceptual plane by the following transition question: Q: We all seem to be accepting the usefulness of the daily income statement in the 3B plant. But I have been hearing a lot of criticism of American management being too short-term oriented, of paying too much attention to achieving quarterly income goals. Why are we happy with a daily income statement for 3B yet critical of a quarterly income statement for U.S. corporations? Should we give a daily income statement to the president of Eastman Chemicals or the CEO of Eastman Kodak? Students generally find it difficult to describe their intuitive feelings about why they like the 3B daily income statement yet believe that quarterly income statements are less representative of a company's operations. In the 3B Cracking Plant, all inputs are converted to outputs in almost a continual stream. Certainly, a day is a long enough period to match the output and revenues produced with all the inputs consumed in the 3B plant. In companies, however, especially for the types of decisions taken at the highest levels of the corporation, many inputs are not fully converted into outputs for several years. Thus expenditures on R&D, new technology, advertising, promotion and distribution, and employee training and skill enhancement yields benefits for many periods and years into the future. A quarterly income statement measures expenditures on these categories well but most of these expenditures have yet to be converted into outputs. The 3B income statement works because virtually all expenditures are converted into output each day. This point enables us to generalise from the 3B situation to other companies. For production processes that take one week or longer for inputs to be converted into outputs, a daily income statement would not be helpful. We would have too much trouble valuing the status of workin­-process inventory. This suggests that an income statement be created for a time period commensurate with the duration of the production process, at a time when we can get a full accounting for inputs consumed and outputs produced.

Q: What should Pat Kinsey, as chief accountant, do next? What role should the central finance staff play in disseminating the 3B innovation? standards for internal pricing. Ideally, the output prices established by 3B should be used as the input prices for departments that take 3B's The answer to this question leads to a discussion about the role for the finance group versus decentralised initiatives. Some argue that the finance group should just stay out of the way and let local initiatives flourish without encumbrance or formality. Others raise the conflict that will occur if department managers think they are doing well, but the periodic TEX financial reports show unfavorable trends. It would be confusing to have local income signals pointing in one direction, when the centralised, more official system points in the opposite direction. In general, we can conclude that the central finance staff can play a useful integration and support role in extending the 3B report: 1. Provide hardware and software support to reduce the burden on other department managers who wish to develop the new report. Briley prepared his department's report by hand for several months. Not everyone will be as committed as he in taking on all the extra work this involved. In fact, the TEX finance staff did work to find a user-friendly programming system, a download system from the main-frame computers, and a standard userinterface for department managers to use to prepare their customised statements. This process, however, took longer than expected and, to date, has slowed down the dissemination of daily income reporting. 2. Establish output. Otherwise, the finance staff will have to strip out inter-departmental profits and losses in attempting to get a global picture of the plant's operations. Attempting to have the output priced from one department be the value of inputs transferred to the next department will encourage a dialogue about the value of intangibles such as quality, ontime-delivery, and adherence to budgeted product-mix. 3. Monitor external prices to determine when prices should change in local departmental models. Also monitor inventory levels between departments (if any) to reconcile between profits reported locally and profits reported at the plant. 4. In an ideal world, the finance staff might be able to produce its 4 Week Report by aggregating and reconciling the daily income reports from each department. In this way, the financial results would be prepared from managerial reports. This would be in sharp contrast to the situation in companies today where financial reports are prepared first and then mailed to managers who then try to extract useful information from them.