Professional Documents
Culture Documents
12
12-1
12-5.
In many cases managers are content to take a stated salary and perform optimally.
However, in other organizations managers appear to perform better when given profit
targets and other incentive devices. Lower-level managers are also closer to their
respective markets. With an incentive system these managers are more likely to take
actions to respond to changes in their respective markets. However, an executive manager
elects the performance evaluation and incentive system that is best for the specific
organization. Hence, these comments would make sense in the right organization setting.
12-6.
Separation of duties helps prevent financial fraud because it limits the opportunity to
commit the fraud. When a separation of duties exists, two or more individuals must
engage in collusion to commit fraud. While collusion can and does occur, it increases the
risk that someone will blow the whistle on the fraud. The increased risk of revealing fraud
makes it less likely that fraud will occur. Thus, one manager might have the decision
authority to authorize purchases and another manager has the decision authority to issue
the payment.
12-2
12-3
12-12.
Large divisions are, all other things being equal, more likely to rank in the upper half.
Hence, a large division manager would tend to receive a bonus with performance that is
just barely above the cost of capital whereas a smaller division might need to earn a return
far in excess of the cost of capital in order to earn a bonus. The approach used also does
not take into account differences in capital charges that might be appropriate for different
divisions.
12-13.
Answers will vary. There are many reasons for pay not to reflect performance. In some
cases, the reasons are because of collusion or other unethical or illegal reasons. Some
other reasons, which might be defensible for business reasons include a desire to keep
certain managers or how the performance of the firm compared to that of competitors.
It is important when discussing performance measurement that the performance of the
manager(s) be separated from the performance of the company (or business unit). Often,
the managers might be performing well (poorly) although the organization is performing
poorly (well). It is not uncommon for companies to place their best managers in units that
are struggling.
The balancing act firms must always perform when compensation is tied contractually to
performance is between adhering to the terms of the contract and being fair to the
managers when unforeseen circumstances arise. The problem is, of course, that the
unforeseen circumstances more often cause performance to be below expectation, rather
than the other way around.
12-14.
The Treadway Commission listed the pressures to achieve unrealistically high, short-term
financial results and incentive systems that focus on short-term financial results as
examples of factors that might produce financial fraud. Combined, the two factors produce
an environment that is highly conducive to fraud.
Recent examples include Enron, Worldcom, and Tyco. In each of these cases, strong
incentives and lack of strong oversight allowed managers to engage in unethical and
illegal behavior.
12-4
12-15.
Two explanations for the existence of unrealistic profit objectives for division managers are
that upper management might be uninformed about the division, and that they might be
too zealous regarding the companys profit potential. In decentralized and widely
dispersed companies, top management is usually not involved with the details of local
operations. Unwittingly, top management could expect more from a division than operating
and market conditions allow. On the other hand, top management could choose to
knowingly expect unrealistic results, thinking that attempts to achieve the results will
produce better results than if expectations were lower.
12-16.
Committing financial fraud in the current period might seem to outweigh future problems
that the fraud might cause. The perpetrator of the fraud might be promoted before the
negative consequences of the fraud are revealed. Alternatively, the perpetrator of fraud
might believe he or she will be fired if the short-run targets are not met, so he or she has
little to lose by committing fraud to meet the targets.
12-5
Solutions to Exercises
12-17. (15 min.)Evaluating Management Control Systems: Chama Car Detailing.
a. Based on the companys method for measuring performance, Deana has done well.
The actual wage was $2.01 (= $15.13 $13.12) below the target wage. Mike has not
performed well. Actual profits are $108,000 (= $745,000 $637,000) below target
profits.
b. The management control system at Chama is possibly flawed. The low actual wages
might indicate that the quality of employees hired is below the level needed to achieve
the target profits. For example, the employees hired might require more training than
expected or are less efficient than expected. As a result, Deana benefits from the low
wage, but Mike (and the company) do not.
Some recommendations for change might include:
Allow Mike or the store managers to hire with a ceiling on the wage (decision
authority).
12-6
12-7
Short-term orientation.
Once a target for the year is met, there is no incentive to improve further.
Its a good plan if the company wants a short-run, financial focus, which it does.
The plan does not encourage inter-division activity. Each tub (i.e., division) is on
its own bottom.
Answers will vary as to whether this is a good place to work. Risk-averse people
who would like a stable job would probably not like this incentive arrangement.
Consequently, the company hires managers who are relatively risk-taking, which
the company wants.
As a footnote, the company also makes outright grants of stock to division managers on a
discretionary basis. This award rewards managers that top management considers to be
high performers even if their division earnings do not beat the target. Managers who get
these grants might be those who spent resources on projects such as employee training,
research, preventive maintenance, advertising and similar items that are expensed on the
income statement but create long-term intangible assets.
12-8
12-9
200,000
x $5,200,000 =
200,000 + 800,000
240,000
x $4,800,000 =
240,000 + 160,000
Total
$1,040,000
2,880,000
$3,920,000
Ground Service
Fixed
Variable
800,000
x $5,200,000 =
200,000 + 800,000
160,000
x $4,800,000 =
240,000 + 160,000
Total
$4,160,000
1,920,000
$6,080,000
12-10
12-11
150
x $4,000,000 = $2,739,726
150 + 69
75,000
x $2,000,000 = 1,200,000
75,000 + 50,000
$3,939,726
Government
Fixed
Variable
Total
69
x $4,000,000 = $1,260,274
150 + 69
50,000
x $2,000,000 =
800,000
75,000 + 50,000
$2,060,274
12-12
$200,000
Commercial
20,000
x $1,000,000 =
5,000 + 20,000
$800,000
12-13
12-14
12-15
Solutions to Problems
12-29. Evaluating Management Control Systems: SPG Company.
Answers will vary. It is important to discuss all three elements of control systems
(delegation of decision authority, performance measurement, and compensation
systems) to ensure that recommended changes result in an efficient control system.
Decision Authority: Marilyn has an incentive to produce low cost (and possibly low
quality) products. One change would be to let Jack decide quality levels (and adjust
the cost budget appropriately).
Performance Measures: Another way to better align Marilyns incentives with the firms
is to include profits in her performance evaluation. Some will argue that because Jack
has no control over manufacturing, he should not be evaluated on profits, because that
includes costs. However, as discussed with corporate cost allocation, if the costs used
in the profit calculation are budgeted and not actual, Jacks performance (relative to
the target) will not be affected by Marilyns actions.
Compensation Systems: The bonus parameter of 100% is unusually high providing
very strong incentives for both Marilyn and Jack to do things to improve performance
that might not be beneficial for the firm. This should probably be lowered (and the
salary adjusted upward).
12-16
Variable cost of sales (direct materials and labor) has increased significantly as a
percentage of sales.
The maintenance and repair costs included in the budget and probably needed
have not been incurred.
Allocated corporate fixed costs are below budget. While these costs should have no
effect on the performance of this division, its inclusion in the report does affect the
residual income figure.
Budgeted additions to plant fixed assets have not been made. The decision to
postpone obtaining these fixed assets at the division level could have been made
for the purpose of reducing the investment base and the imputed interest charge, or
to reduce the investment base.
12-17
12-30. (continued)
b. A performance evaluation system should reflect the division managers (D.M.)
responsibilities (i.e., those things that are specifically controllable by the D.M. and
for which the D.M. is held accountable). A good division performance measurement
should present the performance of the manager unobscured by extraneous items
that are not subject to the D.M.s control. In this instance, Hall O Fames divisional
management is solely responsible for the production and distribution of corporate
products.
Specific features of the performance measurement reporting and evaluation system,
which should be revised, are as follows:
A flexible budget based upon production as well as sales should be used so that
divisions can better reflect the actual level of activity achieved.
Allocated corporate fixed costs obscure the divisions performance since such costs
are not subject to division management control. Ideally, corporate-level fixed costs
should not be allocated. However, if corporate management feels it necessary to
allocate corporate-level fixed costs, they should be relegated to a position as a final
subtracted item from divisional residual income.
The investment base used to compute residual income uses year-end values for
receivables and inventories as opposed to some average-value method. An
average value would more accurately reflect the activities in these accounts over
the time period being analyzed.
Plant assets are under the joint authority of the division and the corporation,
thereby limiting the control at the divisional level.
CMA adapted.
12-18
The use of multiple criteria for performance measures should be a more equitable
standard of evaluation. This performance measure tends to reduce overemphasis
on single measurement criteria and might also balance extremes in performance in
one area versus another.
Static budgets established six months before the start of the year would be
replaced by flexible budgets, which would be subject to change as needed.
b. Specific performance measures for the criterion doing better than last year could
include total sales, contribution margin, controllable costs, net income, net income as a
function of sales, return on investment, market share, and productivity. Measurement
of these items should be compared in absolute terms or by percentages to the prior
year.
Specific performance measures for the criterion planning realistically could include an
analysis of variance between actual and budget and the use of a budget that is
adjusted to reflect some variables outside the managers control to determine sales, net
income, net income as a function of sales, and return on investment.
Specific performance measures for the criterion managing current assets could
include accounts receivable turnover, inventory turnover, return on current assets, and
year-to-year comparisons of current assets in total and by account classification.
12-19
12-31. (continued)
c. The motivational and behavioral aspects of the achievement of objectives system
depend upon the level of acceptance of the system by top management and the
divisional managers.
Divisional managers could have a sense of participation in the role of goal setting
and budget development, which could encourage goal congruence.
Top management support along with timely and regular reviews of performance will
promote division managers feelings of self-worth.
Programs that might be instituted to promote morale and give incentives to divisional
managers in conjunction with the achievement of objectives system include the
following:
Intrinsic motivators can be provided by allowing the manager to assess his/her own
achievements and his/her own worth.
Increased morale can result from participation in budget setting and managementlevel decisions as well as having positive feedback.
CMA adapted
12-20
750 (750 + 500 + 2,000 + 1,750) = 750 5,000 = .15; .10 = 500 5,000;
.40 = 2,000 5,000;
.35 = 1,750 5,000
(2)
(3)
(4)
Allocated
Proportion of Equipment
Reservations
Cost
(5)
Total
Allocated
Cols. 2 + 4
$90,000d
135,000
375,000
900,000
$405,000
345,000
1,215,000
1,635,000
$3,600,000
Proportion Allocated
of Time Time Cost
Usage
Luxury..................................................................
.15a
$315,000b
.06c
Resort..................................................................
.10
210,000
.09
Standard..............................................................
.40
840,000
.25
Budget.................................................................
.35
735,000
.60
a
.06 = 45.0 (45.0 + 67.5 + 187.5 + 450.0) = 45 750; .09 = 67.5 750;
.25 = 187.5 750; .60 = 450 750
12-21
12-32. (continued)
b. Dual rates should be used. If a single rate (time usage) is used, there might not be a
causal relationship between time usage and equipment-related costs. For example,
Standard hotels had the highest time usage (and thus, was allocated a large share of
total costs using a single rate), but had relatively low reservations. Using dual rates,
Standard Group would receive a more representative share of costs.
12-22
12-23
12-34. (continued)
c. Distant locations are more difficult to monitor than those close by. If he desired, the
CEO could have made frequent visits to the nearby location to observe activities. If he
opposed the fraudulent activities, he could have had a personal hand in preventing
them if he were personally observing the operations. Here is a real example. An
employee who is uncomfortable engaging in fraudulent activities bumps into a top
executive on the way to the parking lot. She tells the chief executive about the
fraudulent activities. The chief executive in that case was able to learn about and put a
stop to the fraudulent activities because the financial operations were in the same
location as he. The distance between the financial operations and the corporate
headquarters substantially reduced the probability of such chance encounters at Fallo
Me (i.e., Leslie Fay).
12-24
Division managers submit a report to the vice president for the region that includes
forecasts for capital, sales, and income. This report is used for strategic planning
purposes.
The strategic research team develops sales forecasts for each division while
considering economic conditions and current market share for each region. The
strategic research team reports directly to the vice president of each region (see
Exhibit 12.3). This team is able to more accurately integrate division products and
assess demand for complementary products than the individual division managers.
Once the corporate forecast is completed (using the information from division
managers and the strategic research team), district sales managers estimate sales
for their district. The district sales managers report to the division sales managers
for each division (see Exhibit 12.4). However, the district sales managers return
their forecasts to the division managers rather than to the division sales manager.
The strategic research team and division controller review the forecasts prior to
sending the forecasts on to top management (probably to check for
reasonablenessthe strategic research team and controller likely know more about
the divisions market than top management).
After the sales budget is approved by top management, it is separated into a sales
budget for each plant. Since the sales budget is already established, plant managers
are responsible for establishing the budget for costs and profit given specific
predetermined sales projections. The plant budgets are established as follows:
Each department within the plant is required to develop cost standards and cost
reduction targets. (The department personnel will likely know more about these
costs than upper management. Thus, it is reasonable to have them be involved in
the process.)
A member of the strategy team and controller review the budget process with the
plant manager to make sure the budget is reasonable.
12-25
12-35. (continued)
The final budgets are fine tuned by the vice presidents and CEO and
submitted to the board of directors for approval in early June. (The vice presidents
and CEO must be able to justify the budgets to the board, and thus, review it and
make any necessary changes before submitting it.)
b. The question is should the plants be treated as profit centers (responsible for sales
and costs), or as cost centers (responsible only for costs)?
The plant managers have very little control (if any) over sales projections. As shown in
Exhibit 12.4, the division and district sales managers report separately to the division
manager, and do not discuss the sales budget with the plant managers. It is very
difficult to make a case that plant managers should be responsible for sales. However,
plant managers are responsible for controlling costs and are directly involved in
establishing budgeted costs. Thus, it is reasonable to treat the plant as a cost center
and hold plant managers responsible for costs. If management wants to continue
treating the plant as a profit center, plant managers should be involved in the sales
budgeting process.
c. The primary question is what behavior is top management trying to promote with the
budgeting process? In general, River Beverages management wants its employees to
maximize production efficiency (thus minimizing production costs), and maximize
profits.
Answers concerning the advantages and disadvantages of the budget process will
vary. One example follows:
Plant managers are held responsible for sales and costs even though they only have
control over costs. Sales departments can cut prices or offer promotional campaigns
that negatively affect a plant managers profit. In this example, it is not advantageous to
assign responsibility for sales to plant managers without control over pricing and
promotional decisions.
12-26
Pepsis top management relied heavily on its trust of employees for assurance that
employees did not commit fraud.
The fraud was committed in a foreign country distant from corporate headquarters,
which is harder to monitor than a division located close to headquarters.
The use of foreign language inhibited the ability of auditors to ask penetrating
questions in their investigations.
We did not state in the case that one of the 12 employees against whom the SEC filed
formal charges committed suicide.
12-27
Second, individuals know more about their talents (for example, their ability to be
successful traders) than the firms that hire them. This is referred to as adverse
selection. Making more of their compensation contingent on performance leads
only those who believe they are better at this activity than the average person to
apply for the job.
d. (1) Apparently the managers have some money in the budget that could be used for
investment or other opportunities that had not been used and, as a result, could
beused to offset the surprise. For example, rather than spending $10 million on an
R&D project, which would be an expense, the $10 million could not be spent.
(2) In addition to R&D, other uses could include training, maintenance, or advertising.
(3) The decision about returning the money in the budget should depend on whether
the expenditure would raise the value of the company more than spending it. It should
be independent of the write-off required by the false trading profits.
12-28