CONTROL: THE MANAGEMENT CONTROL ENVIRONMENT
CONTROL: THE MANAGEMENT CONTROL ENVIRONMENT
Changes from the Twelfth Edition Changes from the Twelfth Edition All changes were minor.
All changes were minor. Approach
Approach
This chapter and the following one provide a distin
This chapter and the following one provide a distinct change of pace from the preceding chapters becausect change of pace from the preceding chapters because they present few numbers. There are no numerical techniues or procedures to be learned. !nstead" the they present few numbers. There are no numerical techniues or procedures to be learned. !nstead" the chapters establish a framewor# and describe concepts that are essential to an understanding of the chapters establish a framewor# and describe concepts that are essential to an understanding of the chapters that follow. !t is probably desirable to alert students to this change so that they will #now what to chapters that follow. !t is probably desirable to alert students to this change so that they will #now what to e$pect.
e$pect.
%ince the te$t e$pands on material that was introduced in Chapter &'" it may be desirable to as# students %ince the te$t e$pands on material that was introduced in Chapter &'" it may be desirable to as# students to reread Chapter &'
to reread Chapter &' at this at this poinpoint. (oints that t. (oints that were obscurwere obscure e when Chaptwhen Chapter &' er &' was first assignewas first assigned d shoushouldld now be clearer.
now be clearer.
Although the topic has come up several times previously" it probably is desirable to emphasi)e again the Although the topic has come up several times previously" it probably is desirable to emphasi)e again the fact that there are three types of management accounting information" each of which is appropriate to fact that there are three types of management accounting information" each of which is appropriate to certai
certain types of n types of probproblems but not to lems but not to otheothers" and that rs" and that mistmista#es are made a#es are made when the wrong type of when the wrong type of data isdata is used. !llustration 22-* is designed to ma#e this point" particularly with reference to the differences used. !llustration 22-* is designed to ma#e this point" particularly with reference to the differences between responsibili
between responsibility accounting and full cost accounty accounting and full cost accounting. !t may be well to discuss this e$hibiting. !t may be well to discuss this e$hibit in detail.t in detail. There is sometimes a tendency to play down the importance of full cost accounting because it is not There is sometimes a tendency to play down the importance of full cost accounting because it is not useful in the control of responsibility centers" but this reflects an erroneous +either-or, attitude. !t is not a useful in the control of responsibility centers" but this reflects an erroneous +either-or, attitude. !t is not a case of choosing either one approach or the other" each
case of choosing either one approach or the other" each approach is needed in a company" and each approach is needed in a company" and each has itshas its own uses.
own uses. Cases Cases Behavioral
Behavioral Implications Implications of of Airline Airline Depreciation Depreciation Accounting Accounting Policy Policy ChoicesChoices shoshows ws ststudeudents nts thathatt companies measurement choices vary widely and motivates a discussion as to whether these choices companies measurement choices vary widely and motivates a discussion as to whether these choices affect managers decisions" and if so how.
affect managers decisions" and if so how. Shuman Automobiles Inc
Shuman Automobiles Inc . introduces the concepts of responsibility centers and transfer prices in a setting. introduces the concepts of responsibility centers and transfer prices in a setting that students can easily understand.
that students can easily understand. Zumwald AG
Zumwald AG is a transfer pricing case" with the emphasis on the behavioral effects of the transfer pricingis a transfer pricing case" with the emphasis on the behavioral effects of the transfer pricing alternatives.
alternatives. nager
nager Industries! Industries! IncInc." is a case on the introduction of an /! measurement scheme for business." is a case on the introduction of an /! measurement scheme for business divisions.
divisions. !t can be used to discus!t can be used to discuss almost any aspect of invs almost any aspect of investment centers.estment centers. Piedmont "niversity
Piedmont "niversity deals with several management control issues in a nonprofit organi)ation" especially deals with several management control issues in a nonprofit organi)ation" especially the use of profit centers.
Problems
Problem 22-1: Arbia Company elevant Costs
a. 0or financial statements1full costs of epartment 3:
4'5"665" or 4'5.66 per unit for units sold or left in inventory. b. ecisions to ma#e or buy (art 7o. &5'1differential costs:
(urchase cost...4*&.55 per unit Materials and labor cost if ma#e... 26.82 per unit %avings if ma#e...4&.&8 9assuming no fi$ed costs are differential c. Assessing performance of manager of epartment 3:
Costs for which the manager is responsible are the variable and fi$ed costs of epartment 3" 4*;"355. Costs allocated to epartment 3" 4&<"265" cannot be controlled by the manager. 7evertheless" they are often shown on responsibility center reports to indicate their magnitude.
Problem 22-2: Golub Company
a. The sales manager=s complaint is >ustified. (roduct A has the largest net sales of the three products and under the allocation method used in the first year would" therefore" be charged the largest amount for advertising e$pense. ?owever" the actual amount of advertising e$pense incurred on behalf of (roduct A" and hence the responsibility of the manager of (roduct A" is smaller than that incurred on behalf of (roduct @.
b. (roduct A should be charged 4&5"555 because that is the amount spent on behalf of (roduct A. !t would be acceptable to charge (roduct A with an allocated portion of the institutional advertising" based on sales volume" but this amount should be separated from the 4&5"555 for which (roduct A is
responsible. Problem 22-
The transfer price should probably be 42<5 per thousand bo$es because the ?ardware ivision +buying, the bo$es should not be e$pected to pay more than if it bought from an outside supplier at 42*6. This price from an outside supplier is li#ely because of the #een competition mentioned in the problem.
Problem 22-!: "rban #er$ices% &nc'
a. The billing rate should be 4&5< per hour which is the same rate charged to outside clients since (ortfolio Management is wor#ing at capacity. Any price less than this would reduce (ortfolio roup profits" the criterion by which management evaluates performance.
b. !f the (ortfolio Management roup were not wor#ing at capacity" it would be to its advantage to hire its staff out to any internal group at a billing rate which could go as low as 4'3.55" its variable cost.
%ervices roup does not have a bona fide outside business at 4&2;.'5" it will &i#ely return to the 4&&' rate. ?owever" the option should remain with each manager to maintain an autonomous management environment.
Cases
Case 22-1: Behavioral Implications of Airline Depreciation Accounting Policy Choices (ote:#his case is unchanged from the #welfth dition$
Purpose of Case
!t seems obvious that firms choices of accounting policies will affect managers decision-ma#ing. @ut somehow when accounting choices are being considered" the financial reporting implications of the choices seem to dominate.
This case was written to force students to consider the decision-ma#ing implications of one seemingly important accounting policy choice decision. The e$ample is of aircraft depreciation accounting for airlines. This e$ample was chosen because property" plant and euipment 9((E comprises more than '5D of the total assets of an airline" and aircraft are a large proportion of the ((E. 0urther" airlines depreciation policies vary significantly.
#uggested Assignment )uestions
This case was used successfully as part of a final e$am. The e$am uestions" which are shown below 9importance weightings in parentheses" can be adapted for use in a classroom setting.
9'5D &. Assume that at least some rewards for the management team 9and" hence" also other employees are based on performance measured in terms of accounting income and returns on net assets. Also assume that all of these airlines are growing that is" they are adding to their fleet si)e.
Fhat are the behavioral implications of each of the three depreciation-related accounting policy choices: 9& depreciation patterns 9i.e." straight-line vs. accelerated 92 estimated useful lives and 9* residual valuesG Consider" at a minimum" the effects of each of these choices on decisions regarding:
a. eplacements of aircraft in service
b. (ricing" assuming that prices are at least somewhat dependent on costs c. Evaluations of routes or lines of business
d. Evaluations of managers" assuming that negotiated budgets provide the primary standards of performance.
e.
925D 2. Assume that in a particular H.%. airline company there is a conflict between the benefits of conservatism vs. liberalism in depreciation accounting. That is" for this company conservatism in depreciation accounting is greatly preferred for financial reporting purposes 9for whatever reason but for internal purposes the company would be better off if the policies were more liberal" or vice versa. Fould you recommend to the managers of this company that they adopt a third set of boo#sG That is" should they maintain one set of boo#s for financial accounting purposes" another set for ta$ purposes" and a third set for the purposes of running the businessG
9*5D *. !f the managers of a particular airline do not want to maintain a third set of boo#s" should they tend to be conservative or liberal in their aircraft depreciation accountingG E$plain. Case Analysis
/ne uestion that can be usefully posed is: Fhy do airline companies choose different depreciation policiesG These decisions seem to be driven primarily by financial reporting concerns. More liberal depreciation policies can be used to slow the recognition of e$penses" perhaps to hide losses. More conservative policies can be used to create hidden reserves that facilitate managers management of earnings.
To a lesser e$tent" difference in aircraft depreciation policy choices might be driven by different economic realities. %ome aircraft depreciate faster than others. These effects are generally smaller than most people assume" however. The ma>or airlines fly the same types of planes" for the most part. And in any case" virtually every aircraft can fly almost indefinitely with proper maintenance.
%tudents should understand that the lives of aircraft can be greatly affected by management decisions. Aircraft lives are longer 9a if the airline cannot afford to" or chooses not to" replace the aircraft 9b if there is an economic downturn that causes the aircraft to be used less intensively and 9c if there are no new technological developments 9e.g." fuel efficiency" noise" comfort. /ne issue that can be usefully e$plored in this class is: Fhich comes first" the accounting policy or the management decisionsG Each can have a causal effect on the other.
Another useful uestion is to as# students which of the airlines mentioned in the case uses the most liberal accounting policy for its aircraftG Fhich uses the most conservativeG Boo#ing at the assumptions of aircraft lives will suggest to all that Bufthansa is the most conservative. American 9AM is the most liberal.
%uestion &
Fhat are the effects of this accounting policy choice on managerial decisionsG More rapid depreciation causes higher e$pense on the income statement but reduces aircraft boo# values on the balance sheet more uic#ly. @ut" interestingly" the reality does not change at allI !n the H.%." there are no ta$ effects and no cash flow effects" and the economic value of the company does not change. Academic studies have shown that the stoc# mar#et is very good at seeing through fully disclosed differences such as these.
%ome students get confused about this issue because they do not reali)e that in the boo#s H.%. firms #eep for ta$ purposes firms will depreciate their aircraft as uic#ly as possible" assuming that the company is profitable. The case tries to ma#e this clear" in item J' in the list of +other facts., !n some other countries
Fhile there are no direct effects of this accounting policy choice on real firm value" value can be affected because managers decisions can be affected. Managers do ma#e decisions based on accounting numbers. /ne of the clearest behavioral implications of depreciation accounting policies is in the replacement-of-aircraft decision. Managers in firms that depreciate replacement-of-aircraft slowly tend to be slow to replace their replacement-of-aircraft because they have to absorb the write-off of the remaining boo# value. This is a #nown empirical
regularity. 0or e$ample" %ingapore Airlines and Bufthansa have uite young fleets 9e.g." Bufthansa average age is *.6 years" while companies such as AM and elta have fleets over twice as old. %imilarly" more rapid depreciation will yield higher full costs in cost analyses and can affect pricing decisions and routeKline of business analyses. Management evaluations" on the other hand" should not be affected because whatever depreciation policies are chosen are built into the budgets that are the primary performance standard.
!n theory" management decision-ma#ing should be improved if the accounting records reflect the economic reality. Fe #now" for e$ample" that the early H.%. railroad companies did not depreciate their fi$ed assets. As a conseuence" the railroads overstated their income and assets" and the railroad managers were misled by their own financial statements. Hltimately about '5D of the trac# put in place before &655 was placed in receivership.
@ut what is the +real, economic depreciation of aircraftG The reality will vary somewhat with the type of plane and the aircrafts usage. !n general" airframes depreciate based on the number of cycles1ta#eoffs
and landings1to which they are sub>ected. The engines depreciate based on the number of hours of usage. !n theory" maintenance could affect aircrafts real economic depreciation" but there is not much variation in airlines maintenance procedures. The procedures are largely determined by law.
@ecause used aircraft prices decline very slowly" the economic depreciation is li#ely to be much slower than any policy any airline currently uses. %o all airlines aircraft depreciation policies are conservative" at least in relatively good economic times. %ome are more conservative than others. Fhat is the management decision-ma#ing implication of this conservatismG
%uestion '
This uestion reuires students to consider the benefits and costs of having" potentially" a third set of boo#s. !n theory" at least" #eeping a set of boo#s that better reflects the economic reality of the declining value of the aircraft assets should lead to better decision-ma#ing. %ome companies have changed their depreciation policies e$actly for this purpose" to better reflect the value declines in fi$ed assets and" hence" to better match costs and revenues.& !t is possible that a companys financial reporting strategy is
not best served by a relatively accurate reflection of economic reality. Almost certainly a companys cash flow will be served by being conservative 9rapid depreciation in its ta$ records. %o" in theory" at least" a company may be best served by maintaining three sets of boo#.
?owever" there is a cost of maintaining three sets of boo#s. /ne cost is monetary. The charts of accounts and the processing systems must be established" and some transactions must be recorded three different ways. There is also a possible confusion cost" as not all employees will understand the differences in and the purposes for the three boo#s of record.
1 0or e$ample" see B. ?all and L. Bambert" +Cummins Engine Changes !ts epreciation", (anagement Accounting
%uestion )
This uestion was posed to force students to reach a conclusion as to what one single accounting policy choice might be best. They might usefully ma#e observations about each of four sometimes-conflicting concerns1good economic decision-ma#ing" financial reporting effects" potentials for asset write-offs 9if assets are depreciated too slowly" and potentials for gameplaying.
Pedagogy
This case should only be used with students who have studied the mechanics of depreciation accounting. enerally" this is not a constraint because the depreciation topic seems to be included in every introductory financial accounting course.
Hnless the instructor wishes to provide a tutorial on depreciation accounting or replacement cost depreciation" the discussion of this case can probably be completed in '5-;5 minutes. /ne useful way to organi)e the discussion is to follow the order of the suggested assignment uestions.
Case 22-2: Shuman Automobiles Inc
(ote: #his case is unchanged from the #welfth dition . Please see the printed Instructor*s +esource Guide for the ,arvard #eaching -ote$
Case 22-!: "um#al$ A%
(ote:#his case is unchanged from the #welfth dition . Purpose of Case
This case describes a transfer pricing issue that is common in decentrali)ed" divisionali)ed firms. The case raises issues about internal pricing and" more generally" the operation of a decentrali)ed management structure.
#uggested Assignment )uestions
&. Fhat sourcing decision for the 3* materials is in the best interest of: a. The !maging %ystems ivisionG
b. The ?eidelberg ivisionG
c. The Electronic Components ivisionG d. Numwald AG
2. Fhat should Mr. 0ettinger doG Case Analysis
The suggested assignment points students in the right direction. Numwalds !% division is sourcing displays for its 3* system. The division solicited three uotes. The lowest uote" for O&55"'55 was from a @ritish company" isplay Technologies (BC. Another uote" for O&25"'55" came from a utch company" @ogardus 7P. The high uote" for O&<5"555" came from Numwalds ?eidelberg ivision.
%hould !% choose the isplay Technologies uoteG (ossibly yes. @ut the isplay Technologies uote causes some worries. /ne is about uality. isplay Technologies is a new entrant to the mar#et" and it has not yet had a chance to demonstrate the high uality that @ogardus" and presumably ?eidelberg" has demonstrated. And the isplay Technologies bid may be a low-ball bid to enter the mar#et. 0or subseuent orders" they might have to raise the price significantly to maintain viability. This could cause !% to incur some costs of switching suppliers at some time in the future. @ut the manager of !% should be aware of these issues" and he decided to choose the isplay Technologies uote.
The issue in the case arises because the manager of ?eidelberg complained about not getting the !% order. ?is arguments are the following:
&. Numwald is better off if ?eidelberg supplies the displays to !%. %tudents should do the calculation to understand this conclusion.
The ?eidelberg uote to !% is better for Numwald ta#en as a whole because it includes some contribution both for ?eidelberg and for EC" Numwalds internal electronic subassembly supplier. The variable costs for ?eidelberg are O'5"555. The fi$ed costs are not relevant because ?eidelberg is not operating at full capacity. %o there is a contribution of O65"555 to ?eidelberg in the O&<5"555 uote to !%. %tudents might uestion the treatment of labor costs as fi$ed on the downside" but this is common in ermany.
!n addition" there is a contribution of O&2";55 for EC built into this uote. This is ECs internal price of O2&";55 minus the variable costs of O6"555. 9EC is also operating below capacity.
The advantage to !% of sourcing from isplay Technologies rather than ?eidelberg is O*6"'55. This is far smaller than the total contribution to Numwald divisions of O&52";55 that would be foregone if ?eidelberg does not get this order. The difference is O;*"&55. 0inancially" Numwald is clearly better off if !% sources the displays internally.
This calculation can be shown in different ways. Another method is to consider the net cash outflow to Numwald of the sourcing alternatives. !f the displays are bought from isplay Technologies" the cash outflow for the displays is O&55"'55. !f they are sourced internally" the total Numwald cash outflow is:
Cash outflow if sourced from isplay Technologies...O&55"'55 Cash outflow if sourced internally:
?eidelberg variable costs e$cluding the EC-supplied materials...O28"<55
EC variable costs...O6"555 O*3"<55 ifference... O;*"&55
2. ?eidelberg engineers helped !% develop the 3*. ?eidelberg was reimbursed for the cost of those engineers" but it earned no profit for this wor#. oes this assistance imply a partnership that would include future sourcing of partsG
*.
%tudents presenting this analysis showing the advantage to Numwald of internal sourcing should be as#ed whether this means that Mr. 0ettinger should order !% to source the displays from ?eidelberg. They will almost assuredly say yes. @ut then the issue is the price at which the transaction should be made.
The case has enough information to show that this 3* business promises to be highly profitable for !%:
evenue for one 3* system...O*<5"555
7on-display material costs O32"555
Pariable conversion costs...O2;"*55.... ..O68"*55 Contribution before display costs...O2<&"355 0i$ed conversion costs...O&&3"355 ross margin before display costs...O&2<"555 !% contribution if sourced from isplay Technologies...O&<&"255 !% contribution if sourced at ?eidelbergs price of O&<5"555...O&5&"355
Clearly there is room to force !% to pay ?eidelberg more than the isplay Technologies price. That e$tra cost could provide additional margin to ?eidelberg and EC. @ut" alternatively" any price greater than O*3"<55 provides a contribution to ?eidelberg andKor EC. Fhy shouldnt ?eidelberg shave its price to get this internal businessG And if ?eidelberg shaves its price" then it might well as# EC to shave its price below its normal 25D mar#-up. %o in some sense" these transfer prices are >ust moving profits from one division to another. Fhat is fair to all partiesG
?eidelbergs manager" (aul @auer" claims that he has been pleading with his salespeople not to shave prices" that he needs full margin business in order to achieve his plan. oes Mr. @auer >ust not want to ac#nowledge the price competition in this segment of the mar#etG !s he ignorant of the marginal cost and contribution margin conceptsG %hould he be firedG
/r is Mr. @auer merely willing to lose this business in order to emphasi)e the importance of his pricing policy to his salespeopleG This latter possibility can be illustrated with the following hypothetical figures:
(rice Hnit Total
(rice policy 9555 Polume Contribution Contribution 0ull price &<5 35 65 ;"*55 Cut price &55 &55 '5 '"555
Maybe because of mar#et conditions and customer price sensitivities" ?eidelberg is better off giving up some business to retain higher margins" even though they are operating in a below-capacity condition.
%o what should Mr. 0ettinger doG Mr. 0ettinger should probably listen to the arguments in order to learn the managers thin#ing processesG Are they all aware of the #ey facts in the situationG oes Mr. @auer" in particular" understand the concept of marginal cost pricing and contribution marginG
!f the managers are all ma#ing rational arguments" then strong arguments can be made here for having Mr. 0ettinger do nothing. Numwald operates in a highly decentrali)ed fashion. Fhy not let it continue to do soG Bet the managers have their autonomy and freedom of sourcing. !f there is a deal to be made" let the managers wor# it out themselves. !f Mr. 0ettinger gets involved here" he will probably also have to get involved in many other similar disputes. !f this deal were a more substantial part of Numwalds total business" then a stronger argument could be made for intervention. @ut this deal" by itself" is worth less than 'D of each divisions revenues. ?eidelberg can probably earn the business by cutting its price to isplay Technologies" but maybe it is not in its best interest to do so" even though internal sourcing of this deal seems to be in Numwalds best interest.
The final uestion that can be e$plored is the systemic uestion. !s the Numwald responsibility centerKperformance measurement system faulty in that it motivates managers to ma#e decisions that are not in the best interest of the corporation as a wholeG There is no easy answer to this uestion. !n most situations where local #nowledge and fast decision-ma#ing is important" a highly decentrali)ed system has great advantages. @ut with decentrali)ation comes ris#s of suboptimi)ation. This case provides one common e$ample of suboptimi)ation. Numwald could establish a transfer pricing policy to try to induce better transfer pricing and" hence" sourcing decisions. %uch a policy could reuire internal transfers to be" for e$ample" at best outside mar#et price" or at full 9or variable cost plus a normal mar#up. @ut would such policies really lead to better organi)ational decision-ma#ingG
Pedagogy
This case is relatively short and straightforward. %tudents do not need a lot of guidance to reach the conclusion that Numwald is better off if the sourcing is done internally. Then" we suggest letting the students provide suggestions as to the best transfer price. The learning will come from the discussion of alternatives. !nstructors should only intervene if students fail to recogni)e the advantages of decentrali)ation.
Case 22-&: 'nager In$ustries( Inc)
(ote:#his case is unchanged from the #welfth dition .
This case was written for use in a reuired one-semester course in management accounting" where usually only a single session is devoted to investment centers. Fhereas most available cases on investment centers focus in detail on narrower issues" such as proper valuation of fi$ed asses for an investment center" this case is intended to raise both the rationale for having investment centers and some of the broader issues surrounding /! and an investment center structure for a responsibility center.
*road Case &ssues
As different instructors will choose to emphasi)e different aspects of this case" ! will simply describe seuentially the various issues the case raises.
&. Profit verse profitability. ! raise the issue by as#ing" +Fhat is the overriding economic ob>ective of a businessG, Typically the first answer is +profit ma$imi)ation., ! then as# if that means a firm earning 4&55 million net income is twice as profitable as one earning 4'5 millionG %tudents soon reali)e that the profit should be &in#ed with the investment reuired to generate it" and we arrive at the conclusion that return on investment is a more meaningful measure of a firm=s profitability.
2. "se of investment centers . ?aving established that /! is a measure of interest to top corporate management" it is easy to see that responsibility for earning a reasonable return can be segmented and delegated" >ust as is profit responsibility delegated to profit center managers. ?owever" if the measure is to be used in evaluating the investment center manager=s performance" euitability reuires that the manager be able to significantly influence both profit and investment. !n many companies" this degree of responsibility is found only at the +division, level and above 9where ! am using +division, to connote an essentially self-contained business within the corporation.
At this point" ! draw the very important distinction between using /! to measure economic performance of a responsibility center and using it to measure the performance of the center=s
manager. 9!n my e$perience" this distinction is too freuently missing in industry. There is really no need to treat a responsibility center as an investment center if the manager doesn=t influence asset levels this does not mean" of course" that the center=s /! can=t be computed for analytical purposes 9e.g." for consideration for discontinuing that responsibility center=s activities1but this computation does not need to be performed freuently" or perhaps even regularly.
! also tell the students that the profit centerKinvestment center distinction appears more in te$tboo#s than in practice: most managers ! have met call both types of responsibility center simply +profit centers. +
*. Definition of +.I . @y now" the students are aware that /! is 9simplistically defined as profits divided by investment. ! now as#" +Fhat is investmentG, ! am not trying at this point to get into valuation of specific assets" but rather the broader notion that to business people the word +investment, variously means total assets" assets less current liabilities or invested capital 9euivalently" long-term liabilities plus owners= euity" or owners= euity.
! point out that none of these concepts is right or wrong it depends on the perspective of the person considering /!. A shareholder 9and probably also securities analysts would be most interested in return on euity. Corporate financial officers seem to focus on return on invested capital 9the apparent notion being that current liabilities are both +free, and +ta#e care of themselves,. /perating
managers don=t really care how the assets they manage were financed 9nor can they usually tell" since +all money is green, they 9and their superiors are concerned about how well the assets are utili)ed" leading to a return-on-assets 9perhaps net of some or all current liabilities perspective.
E$hibit < contains several /! measures" to highlight the fact that the term /! itself is e$tremely ambiguous. The calculation of return on invested capital has been ad>usted for interest" whereas return on assets has not 9because this is the way Enager is calculating /A.
<. +.I growth and PS growth not necessarily e/uivalent . ! point out to students that it is possible to increase earnings per share while decreasing /!. !ndeed" Enager presents an e$ample of this: from &66; to &663 E(% increased" but return on assets 9/A went down.
/ne possible cause of this phenomenon is the fact that generally accepted accounting principles ignore the cost of euity capital in calculating net income. 0or e$ample" a pro>ect returning 9before interest ; percent on assets" which was financed with 8 percent debt" would diminish E(% @ut the same pro>ect financed by retention of internally generated funds would increase reported E(%" even if the pro>ect=s /A were less than the overall /A would have been without the pro>ect 9thus reducing overall /A despite the increase in E(%. !n Enager=s case" this phenomenon occurred because
∆E@!T 94&"5*& e$ceeded ∆interest 94*82" thus increasing E(% but ∆E@!T K∆AssetsR 6.&D" which was lower than the previous year=s average of 6.'D.
;. Setting +.I targets. Although it is seemingly self-evident that different investment centers will have different ris# profiles and /! potentials" it is" nevertheless true that some companies use the same +across-the board, /! target percentage for divisions in uite different businesses" as was done by Mr. ?ubbard of Enager. ! thin# this phenomenon occurs for a reason alluded to earlier1confusing what is a desirable economic return for the overall company with what is a reasonable return for the manager to achieve" given conditions in the industry" efficiency of the division=s euipment" and so on. 0or purposes of managerial evaluation" a division=s /! target should be negotiated between the division manager and his or her superior" as part of the budgeting process.
3. Defining 0profit1 in +.I . Fhatever degree of detail the instructor wishes to get into here" at a minimum students should reali)e that defining +profit, as +net income calculated using the same generally accepted accounting principles as are used for reporting to shareholders, is only one of many ways of defining profit for /! computations. 0or e$ample" income ta$es can be omitted depreciation can be based on replacement costs rather than historical costs or a variable costing approach can be used instead of full costing. Also" a company can use the notion of controllable profit for calculating /!.
!n general" ! thin# a definition involving controllable profit is best for calculating /! for purposes of managerial evaluation" but that a +net, figure after including noncontrollable allocations is better for economic performance analyses. Again" in my e$perience" companies usually do not ma#e this distinction and tend to use a AA( net income figure in the /! calculations. 9%ee Lames %. eece and Filliam . Cool" +Measuring !nvestment Center (erformance", ?arvard @usiness eview" May-Lune &638.
8. 2aluing 0investment1 in +.I . Fhether one regards +investment, as total assets" invested capital" or owners euity" asset valuation affects the indicated amount of investment. /nce again" in my e$perience" companies tend to value assets for /! computation the same way they report asset amounts to shareholders. %tudents should reali)e that this alternative causes /! to increase solely with the passage of time 9as depreciation reduces the asset base and may indicate improving performance when in fact the manager is +running the business into the ground.,
&5. +.I versus residual income 32A4$ Fhile ! feel this is too advanced for a one-session shot at /!" some of my colleagues feel that residual income 9now called economic value added by some consultants should be introduced here. !f so" an attempt should be made to convey the conceptual advantage of ! over /!1that having to do with how a division manager would react to a pro>ect whose pro>ected /! is higher than the cost of capital but lower than the investment center=s overall targeted /!. This ! concept could also be raised earlier in the conte$t of how to define +profit", since ! essentially corresponds to the economist=s view of what constitutes profit. %ince it is the presence of AA(-valued fi$ed assets in the formula that causes either /! or ! to increase solely
with the passage of time" ! favor for managerial evaluation what ! call +partial !", which is profit e$cluding interest less holding-cost rates applied to receivables and inventories.
&&. -ew pro5ect proposals in an +.I system . This is the +lead-off, issue in Enager. !f your students have been e$posed to capital budgeting techniues" they uic#ly will point out that a discounting techniue
should be used to evaluate Ms. Mc7eil=s new product proposal. espite the normative truth of that statement" it is nevertheless uite conceivable that a manager might feel that a pro>ect that will improve E(% 9and accounting /!I should be acceptable.
Another aspect of capital budgeting in an investment center setting 9or companywide setting" for that matter that often pu))les students is this: Fhy is the +hurdle rate, used in evaluating a new pro>ect higher than the division=s /! targetG /ne reason is that a significant portion of a company=s capital budget funds must be used for pro>ects that will not 9in any obvious way increase profits e.g." pollution control euipment. Thus" pro>ects that will improve profits have +to carry more than their
fair share of profitability contribution, in order to compensate the nondiscretionary 9necessity investments that tend to lower /!. /ther reasons include allowance for ris#Kuncertainty and the desire to improve /! fairly rapidly.
&2. .verall 0moral$1 /! is conceptually simple" but comple$ to implement 9if one recogni)es the pitfalls" as ?ubbard and andall did not. %tudents should not be left with the feeling that /! necessarily should be avoided" but rather that its implementation should be approached with +great care.
&ssues #pecific to Enager
&. 6hat is the incremental +.I on the proposed pro5ect G The case numbers are +rigged, so that the incremental E@!T percentage at any of the three prices is &* percent 94&*5"555 K 4&"555"555. A variation on this calculation is to say that" at least in an accounting sense" the average plant and euipment investment over the life of the pro>ect is only 42'5"555" giving an /! of &3.* percent 94&*5"555 K 43'5"555. Fe do not #now the potential life of this pro>ect its paybac# period is less than < years 9we can=t tell how much less: cash flow per year will be greater than the 4&*5"555 income because the 4&35"555 fi$ed costs include depreciation.
! as# the students this uestion: %uppose Enager was committed to go ahead with this pro>ect would you suggest a price per unit of 4;" 43" or 48G %tudents cannot choose on the basis of incremental profit" which we have seen is the same 94*55"555 contribution less 4&35"555 fi$ed costs R 4&*5"555
at all three prices. %ome will say 4; because it gives the largest mar#et share 9a point of view which may have validity" if one believes the @oston Consulting roup=s e$perience curve hypothesis. /thers will say 48" since that has the lowest brea#-even volume however" in my opinion" one cannot choose based on brea#-even volume" since at each of the three prices the brea#-even volume is '; 2K* percent of the estimated sales volume at that price" and profits are the same at the three estimated
sales volumes.
Eventually" a student will reali)e that the current asset investment should not be assumed to be the same at all three prices 9as ! have let them implicitly assume to this point in the discussion: certainly a volume of &55"555 units 94;55"555 revenues will reuire more cash on hand" receivables" and inventories than would a volume of ;5"555 units 94<85"555. Therefore" the price chosen on short-term /! analysis should be 48.
This discussion of variability of current assets with volume may also cause some students to notice that the pro>ected level of current assets seems e$cessive. !f volume R &55"555 units" average unit cost R 4<.35 4'5"555 cash is *6 days= e$penses 9really more" after considering depreciation 4&'5"555 receivables is * months= sales and 4*55"555 inventories is 2** days worth. @ased on the company=s average ratios in E$hibit *" the current asset picture at a price of 4; and volume of &55"555 units would be: 9rounded
cash days= 8 $ days *;' 4<35"555 Cash = ... 4 &5"*55 AK days= 3' $ days *;' 555 " ;55 4 ceivables e = ... &2*"*55 4<.35 $ days &;5 $ days *;' units 4&55"555 s !nventorie = ... 25;"555
Total current assets...4**6";55 &3.*D: 9vs. 22.8D 42*5"555 4**6";55 4&*5"555 /!. Avg. = + =
7ot only does pro>ected /! improve" but the three current asset utili)ation ratios used in this ad>usted pro>ection do not represent very laudatory current asset management. And again" the /! 9short-run" at least would be still higher at the higher" price-lower volume combinations.
*. 7plain nager8s &99: versus &99; results . This is best done" ! feel using a +du(ont chart, approach. 9%ee" for e$ample" Chapter &* of the te$t. Essentially all of the numbers for this analysis 9on a return-on-assets basis are included in E$hibit * of the case. This is a very useful approach" in my opinion" because it demonstrates how /! is impacted by decisions made throughout the organi)ation.
'. nager8s implementation of +.I . The preceding discussion in this commentary should ma#e it rather clear that Enager=s top management 9i.e." ?ubbard and andall fell into essentially every trap lur#ing behind the simplicity of the /! fraction. !n addition to the conceptual flaws" the top-down imposition of the new approach with little e$planation or training for the managers was not a good way to introduce a ma>or organi)ational change" and it=s no wonder that +there seems to be a lot more tension among our managers the last two years.,
(ersonally" ! feel Ms. Sraus has a good idea in the off-site retreat. ?owever" it appears that ?ubbard and andall first should engage a consultant to discuss /! and investment center implementation comple$ities with them and help them understand the causes of the current +tension, perhaps this same person could then be engaged to play a ma>or role in the retreat and subseuent training sessions.
Case 22-*: Pie$mont +niversity
(ote: #his case is unchanged from the #welfth dition . Approach
The idea of profit centers in universities dates bac# many decades" probably to (resident A. Bawrence Bowell=s dictum to the ?arvard deans: +Every tub on its own bottom., Although he did not use the term +profit center, 9and for selling purposes this term may create resentment on the part of faculty and deans" he clearly meant that each school=s revenues should be adeuate to pay for its operating costs. This idea continues to influence the management control system at ?arvard and is increasingly being considered by other universities.
The case provides an opportunity to discuss the principal problems that arise in implementing a profit center structure" and the situations described range from those for which a strong case can be made to those for which the results would be clearly dysfunctional. !n discussing the several issues" two uestions provide a central focus: 9& ?ow would the recommended practice affect the motivation and attitude of the two parties: the party that receives the charge and the party that receives the revenueG 92 Are the benefits greater than the boo##eeping costG
The case also permits a discussion of certain behavioral problems in management control: the danger that management runs in accepting an offer from a well-meaning" but perhaps not s#illed" volunteer 9and the difficulty of finding a graceful way of declining such help the proper approach to gaining acceptance of ideas the indication that a strong-minded president can +turn an organi)ation around", especially during a honeymoon period when the seriousness of the situation is recogni)ed.
%uestion &
General administrative costs . Charging these costs to individual schools would result in an operating statement that would report the e$tent to which the school=s revenues were adeuate to pay for its own costs plus a fair share of the central costs. The sum of the net incomes reported for each school would be the net income of the university. This charge might get the deans to recogni)e that the university necessarily incurs costs on their behalf" which must be met from some source. The practice might also cause the deans to uestion whether the central costs were too high" which would be one way of e$ercising control. (erhaps the central administration would be reluctant to tolerate such uestions.
An alternative is to not charge these costs" or to charge only those that can be specifically identified with a given school 9such as accounting" purchasing" personnel. This would reduce the technical and behavioral problems associated with the allocation of indirect costs.
Any basis of allocating indirect costs can be critici)ed because there is no +scientific, way of doing this" by definition. The criticism that the administration probably spends more than a proportional amount of time on the undergraduate school is probably >ustified" but there does not seem to be a feasible way of correcting this ineuity.
!f these costs are charged" the charge should probably be a budgeted amount" rather than the actual costs incurred. Allocating actual costs permits the central administration to pass costs that are greater than budgeted to the individual schools.
Gifts and endowment . The deans uite naturally would not favor giving the president authority to distribute 43 million as he chooses. Actually" the process would reuire that the schools put in their reuests and the president allocate the funds in a way that causes the minimum amount of dissatisfaction. The president could not allocate the funds in a way that is perceived to be grossly unfair he would lose the support of the deans if he did this. Moreover" the +each tub on its own bottom, idea can=t wor# perfectly. The theological school" for e$ample" does not cover its costs by some 4*.& million 9E$hibit &" whereas the business school has a surplus of 4<.2 million" reflecting the attractiveness of its program to donors" the ability of its students to pay tuition" the need for financial aid" the opportunity to obtain research grants" and so on.
The business school surplus can lead to a discussion concerning the uestion of whether the president should have the authority to allocate such surpluses to other schools. Currently" this is a hot topic in many universities. Also" if it is decided that the library should not generate its own revenue" the central administration must ma#e up the shortfall.
This topic provides an opportunity to discuss the uestion: should each part of an educational institution pay its own wayG Carried to the e$treme" less popular courses 9Batin" ree#" advanced seminars would be eliminated" even though they may ma#e an important contribution to the university=s total reason for being. 0ew would argue that each course should pay its own way" and by e$tension" the argument can be made that certain schools should be subsidi)ed. /n the other hand" if a given school does not obtain resources sufficient to cover its costs" uestions can be raised occasionally 9not every year about the desirability of condoning it.
Athletics. /verall" this is one of the less sensible of the consultant=s proposals. A case can be made for charging a fee for scarce resources 9such as tennis courts" golf courses" or s#i lifts as a way of rationing these resources 9but the case is not particularly strong. (resumably" however" the university wants to encourage intramural athletics" and charging a fee would not indicate such encouragement. The rationing argument is not applicable to intramural athletics. Also" there is an indication that intramural and individual athletics should be as#ed to subsidi)e intercollegiate athletics" which does not ma#e much sense.
(aintenance. (ermission for schools to use outside contractors is an important aspect of this proposal. The maintenance department=s concern about the decline in maintenance uality has some merit" but it should be possible to e$ercise adeuate uality control. The maintenance department should be given the authority to do this.
!f schools can use outside contractors" the maintenance department must compete with them" which tends to motivate it to be efficient. !t must control its costs and obtain enough wor# so that it brea#s even" or there is an indication of poor management or that the department is too large. There should be a proviso that if the maintenance department is willing to do the wor# at not more than the outside price" it should be given the >ob. 0urthermore" if the schools are not permitted to go outside" they are at the mercy of the maintenance department with respect to the priority of meeting their reuests and the amounts spent. The pros and cons for maintenance are also applicable to other support departments: purchasing" accounting"
and aspects of the personnel department 9but not university personnel policy.
Computers. A few years ago" many colleges and universities did not charge students and faculty members for the use of computers 9e$cept possibly for faculty members wor#ing on cost-reimbursable contracts. The primary reason was that they wanted to encourage the use of computers. The tendency now seems to be in the other direction with respect to mainframe computers" on the grounds that the usefulness of computers is now generally recogni)ed the practice of charging for computer usage is by no means universal" however. 9!t is somewhat ironic that many universities #eep careful controls over the use of postage and long-distance telephone cards" which involve much less cost than computers.
(robably most computer wor# within a school" especially wor# done on personal computers" is done without charge. The issue here" however" is charging for wor# done on the engineering school computers by faculty and students at other schools. Assuming that usefulness is adeuately recogni)ed" the
arguments here are essentially the same as those for maintenance.
A special circumstance about computers is that they have software that can supply detailed information about usage at low cost" so record#eeping cost is not as important a factor as is the case with some of the other services discussed in the case.
! doubt that time will permit the class to get into the details of how a charge should be calculated. There is much discussion about this in the literature: a low charge for off-pea# usage a charge for setup time and assistance from computer personnel that is separate from the charge per minute of running time a charge for plotters and other peripheral euipment and so on. There may be advantages in detailed" possibly elaborate" charging systems the uestion often is whether they are worth the cost.
<ibrary. This is the e$treme case of a situation in which charging for services rendered is li#ely to be counterproductive 9but an outside consultant may not appreciate this. The university wants to encourage library usage" and charging a fee would tend to have the opposite effect. As the case states" the record#eeping involved would be considerable" with thousands of transactions" each involving only a few pennies of cost. 9As is the case with computers" library costs might be charged to cost-reimbursable contracts" but the charge can be arrived at by appro$imations derived from sample tests or other methods that are less e$pensive than #eeping detailed records.
Cross registration. /n the one hand" it can be argued that if a course is offered" a few additional students do not cause any increase in costs. The argument against this is that a fair share of the cost of the course should be charged to each student" more specifically to the school from which the student comes. /pinions will differ as to the relative weight to be given to each side of the argument There is also the uestion of whether such a charge has a motivating influence on either the school from which the student comes or the school in which the class is located. !f a charge is made" the method suggested in the case seems reasonable" with the possible e$ception that tuition may be considerably lower than the real cost of education" with the difference being made up from gifts and endowment earnings.
%uestion '
(robably the difficulties with profit centers will come up in the discussion of uestion &" and this uestion is intended merely as a means of catching gaps. !n particular" the bad impression given by the term +profit center, should not be minimi)ed charging for services rendered is a more acceptable way of putting it. The taste of educating people when a new system is introduced should not be minimi)ed. !n particular" there tends to be friction and more arguments about how the charges are to be calculated than is warranted. %enior management should try to #eep these arguments from becoming acrimonious. /therwise" the deans and faculty will claim that the university is now being run for the benefit of accountants.
%uestion )
/ne alternative to the profit center approach is" of course" to #eep the present system. The pros and cons of this should come out in the discussion of uestion &.
%tudents may propose other alternatives. !t would be possible to charge certain e$penses to the individual schools for information purposes" but not include them in the formal budgets nor ma#e the corresponding credits to the departments that furnish the services. The idea would be to give the schools a better idea of the real cost of their operations without the wor# and possible friction that arises when these costs and revenue are included in the formal accounting system. This proposal" although similar to actual practice in some organi)ations 9including the federal government" does not accomplish much" in my opinion. Fithout the motivation provided by inclusion of these costs in their budgets and the reuirement that they live within these budgets" deans are unli#ely to pay much attention to these memorandum records.
%uestion =
The discussion of this uestion can get bogged down because of differences in the recommended treatment of the issues in uestion &. !t may be well to avoid it by as#ing for a resolution of each of these issues and then debating the uestion of whether this consensus presumably the most desirable application of the profit-center idea is better than the alternative.
As a strictly personal opinion 9given here only as something to shoot at" ! would definitely charge for maintenance wor# and similar support services 9including the support functions of the central office. ! would give the president authority to parcel out undesignated gifts and endowment earnings. ! would probably charge for the use of the mainframe computers. ! would probably not charge for tennis" golf" and
s#iing in order to ration scarce resources 9on the grounds that a sign-up system is a better way of rationing. ! would not charge for intramural athletics or for the library. ! would charge for cross registration only if there was a substantial amount of it with the net transfers not washing out. /therwise" the record#eeping costs would e$ceed the benefits.
Also" ! would not as# the deans to approve the proposal" or any part of it" as it comes from an outside consultant. ! would say that the consultant=s proposal was submitted solely to stimulate discussion. 9The wea#nesses of certain aspects of the proposal are so apparent that the whole idea may be re>ected. ?aving had the initial discussion" ! would assign the >ob of developing a new proposal to someone in the administration 9or possibly to a committee so that the ne$t version would be given to the deans as coming from within the institution and ta#ing account of their concerns. !f handled properly" ! hope that the deans= reaction would be: we had an unrealistic proposal from a consultant which the president wisely re>ected we now have a practical one that is worth ta#ing seriously.