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Accounting Text and Cases 12 Ed. Chapter 23

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Robert Anthony, David Hawkins, Kenneth A. Merchant

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Accounting Text and Cases 12 Ed. Chapter 23

  1. 1. 1 CHAPTER 23 CONTROL: THE MANAGEMENT CONTROL PROCESS Changes from Eleventh Edition All changes to Chapter 23 were minor. Approach The management control cycle deserves emphasis. The hardest part to understand is strategic planning, because it tends to be less precise and systematic than budgeting. Yet, strategic planning is a key step in strategy implementation, since it involves the transformation of broad strategies into specific product plans. Most students find the material on behavioral aspects interesting and important. Some, however, regard any statements about human behavior as “manipulative,” and hence, unethical. They have the impression that managers spend their time exploiting workers and view behavioral principles as assisting in this exploitation. A counter to this impression, if it should arise, is that it is important that managers understand how people behave, not for the purpose of exploiting them but, rather so that they can reduce frustrations and provide an atmosphere that will permit employees to release their full potential. The example of computer costs is a way of showing that the purpose is not to exploit, but rather to motivate people to act in a way that helps the organization without, in any way, harming the individual. Cases Tru-Fit Parts, Inc. deals with problems caused by not giving enough thought to the behavioral implications of measurement systems. Industrial Electronics, Inc. raises a number of issues, including performance measurement, performance standards, functions linking performance with incentive awards, and the behavioral responses by managers and employees to incentives. It also makes a nice exam case when the examination time is limited. Las Ferreterías De México, S.A. de C.V. illustrates some of the problems managers commonly face when they use the return on investment (ROI) measure of performance. Boise Cascade Corporation asks students to understand the cost-based billing scheme of a data processing department of a large corporation and to consider whether prices should be set to encourage certain types of user behaviors (e.g., do their processing at night, make greater use of personal computers). Berkshire Industries PLC illustrates the advantages of and the problems faced in building a performance measurement and incentive system around an “economic profit” measure.
  2. 2. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 2 Problems Problem 23-1: Sandalwood Company a. Divisions $ (000s) Total N E W S Sales ..................................................................................................................................................................................$3,800 $1,520 $570 $1,140 $570 Less: Avoidable costs........................................................................................................................................................2,675 835 234 1,392 214 Divisional contribution......................................................................................................................................................1,125 685 336 (252) 356 Corporate headquarters cost ..............................................................................................................................................975 390 146 293 146 $ 150 $ 295 $190 $ (545) $210 Division Sales Revenue % of Sales (1) Allocated Costs (2) Total Costs (2) - (1) Avoidable Costs N $1,520 40% $390 $1,225 $ 835 E 570 15 146 380 234 W 1,140 30 293 1,685 1,392 S 570 15 146 360 214 $3,800 100% $975 $3,650 $2,675 Unless its profitability can be improved in some way, the Weston Division should be closed because it does not appear to be able to cover its own costs nor contribute to the total overall profitability. The Southboro Division does not cover its share of Corporate Headquarters cost, but it does cover its own costs and makes a contribution to overall profitability. b. Business may be seasonally influenced by geographic location. However, the long-run future outlook should be the guideline. In the long-run, all costs are considered variable and all divisions are expected to bear a fair burden of corporate administration costs. Even though the Southboro Division is making a contribution, some adjustments must be made in the long-run. One other consideration may be the influence of one division’s output on another’s profit. For example, some of Edgewood Division’s sales may be a direct result of some sales of the Southboro Division. Lastly, other variables include human factors and hardships endured by employees. All of these factors must be accounted for in the decision to close certain divisions. Problem 23-2: Tarrell Company a. The Tarrell Company sales compensation plan provides financial motivation to the sales force to make profitable sales. First, sales commissions are contingent upon the collection of accounts receivable. Thus, salespersons are discouraged from selling to high credit-risk customers simply to generate sales volume (a double-edged condition; see part b). The sales commission is based upon product profitability. This motivates members of the sales force to direct their efforts toward the most profitable products in the line. Third, salespersons are not penalized if price concessions are considered necessary and desirable to attract certain customers. Finally, the substantial year-end bonus provides a strong economic stimulus to sales persons to meet their annual sales quota. b. The Tarrell Company’s sales compensation plan has several major deficiencies. Most notably, the flat 15 percent bonus for meeting or exceeding the annual sales quota does not stimulate a salesperson to exceed the quota by more than a slight safety margin. Salespersons are further discouraged from making sales far in excess of the quota due to the method of setting sales quotas. By setting the annual quota at 50 percent of prior year’s sales, a salesperson increases his or her quota for the
  3. 3. ©2007 McGraw-Hill/Irwin Chapter 23 3 following year by making sales well in excess of the current year’s quota. If a salesperson has achieved his or her quota near the end of the year, he or she would be motivated to hold back sales until the following year. Second, the commission/collection policy could discourage the sales force from contacting prospective customers who would be classified as slow, but collectable. Third, the standard gross margin is not necessarily a good measure of product profitability. Product contribution margin would be a better measure of product profitability. The standard gross margin does not reflect cost-volume-profit relationships. Nor does it consider directly traceable marketing costs. Finally, the reward system is apparently limited to monetary rewards. The system does not provide for higher order rewards such as peer or superior recognition. Problem 23-3: Alexander Company a. Standards are often classified into three typesideal (tight), attainable (reasonable), or easy (loose). Standards that are too loose or too tight will generally have a negative impact on worker motivation. If standards are too loose, workers will tend to set their goals at this low rate, thus reducing productivity below what is obtainable. If the standard is too tight, workers will realize that it is impossible to attain the standard. They will become frustrated and will not attempt to meet the standard. An attainable or reasonable standard that can be achieved under normal working conditions is likely to contribute to the worker’s motivation to achieve the designated level of activity. The plant management can participate in the setting of standards, or top management can impose standards. Workers and plant management will tend to react negatively in the long-run to imposed standards because they will feel threatened. If they participate in setting the standard, they can identify with the standard procedure and the standard could become one of their personal goals. In the case of Alexander, it appears that the standard was imposed on the plant. In addition, management used an ideal standard to measure performance. Both of these actions appear to have had a negative impact on output over the first six months. b. Alexander made a poor decision to use dual standards. When the workers learn of the dual standard, the company’s entire measurement system will become suspect and credibility will be lost. Company morale could suffer because the workers would not know for sure how the company evaluates their performance. As a result, total disregard for the present and any future cost control system is likely to develop. Problem 23-4: Concord Publications a. (1) The academic and administrative units will experience important operational changes. They will now have the decision-making power to select the publications to be issued, the quality and character of publication, and the quantity of the publication. Concomitant with this increased decision power will be the responsibility for the financial consequences of their acts through the inclusion of publication costs in their budget and “charge-back” from CP for services used. Now academic and administrative units will be motivated by a desire to get the most value from their publications relative to the budgeted amount for publications. These units should experience higher morale as a result of these changes. (2) Concord Publications will lose the decision-making power over the choice of publications to be issued and the quality and quantity of the publications. CP essentially has become a production shop, rather than a complete publication service, and as a result, financial responsibility is diminished to only cost control. The management and professional staff of CP will likely have lower morale due to its change from a professional publication shop to a production shop, and they may be less motivated to produce fine publications because they no longer have a significant amount of influence on the publication decision.
  4. 4. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 4 (3) The operational change for the college will be the shift in publication responsibility from CP to the other units. The budget system will need to be revised to include responsibility for publication costs in the academic and administrative unit budgets. Also, a method to calculate and record the charge-backs must be developed. The academic and administrative units may be more careful in their selection of publications because they will be charged with the costs. CP may be less concerned about cost control because the costs are allocated, and there could be a reduction in the quality of publications. More conflicts between CP and the other units are likely to arise due to the lessened power of CP combined with the inevitable disputes over the proper charges. b. The president used a unilateral approach to introduce organizational change. This approach relies very heavily on the president’s hierarchical position in the college. The definition and solution to the problem were specified by the president and directed downward. In addition, the president’s memorandum tends to be impersonal, formal, and task-oriented. This approach assumes that people are highly rational and best motivated by authoritative directions. Cases Case 23-1: Tru-Fit Parts, Inc.* Note: This case is unchanged from the Eleventh Edition. Approach This case, based on my contacts with an actual NYSE company, enables students to gain insights in two areas of control system design. First, it illustrates (in the transfer pricing area) that some problems are not completely soluble, and that a system with only a few problems may be better than an evident alternative. Second, the case illustrates how a myopic view of control systems can create problems; in two instances the company considered a specific behavioral aspect of a measurement scheme but neglected to recognize the possibility of undesirable side effects of its approach. I have used this case also as a 90-minute exam, with this assignment Assume you are a consultant to Tru-Fit Parts, Inc. The information given in the case was collected by you during a visit to the company. You are to analyze that information and then link your analysis to specific recommendations. For exam purposes, assume you are presenting your analysis and recommendations to me, rather than to an officer of Tru-Fit; this means you can tell me things you would choose not to tell the company, but you are still in the role of a consultant. By my standards, the below-average students overreact to the transfer pricing problem and fail to see the plant manager bonus system adjustment’s role in AM-Manufacturing relations. Almost all students understand the reason that inventories are excessive for most of the year. In class, I let students deal with the three issues in whatever order they wish. Their discussion will tend to lead to the summary comments I’ve put at the end of this note. Comments on Questions Transfer price disputes. Case figures on sales indicate that AM Marketing’s purchases from the manufacturing divisions total $200 million annually, compared with $440 million sales of those divisions outside the company. The combination of this $200 million internal sales amount and the nature of Tru- Fit’s products causes students to realize that there must be thousands of parts for which transfer prices * This teaching note was prepared by professor James S. Reece. Copyright © by James S. Reece.
  5. 5. ©2007 McGraw-Hill/Irwin Chapter 23 5 must be established. The procedure for pricing parts with OEM equivalents was as objective and fair as feasible, in my view, and “caused virtually no disputes.” For parts with no Tru-Fit OEM equivalents, I feel that “a few disputes” which “usually were resolved by the two divisions involved” and which only “occasionally” were arbitrated is the best the company could hope for, given the lack of objective data for setting these prices. (This is not to say the company didn’t try to identify other suppliers’ prices for these parts; but those prices, being from manufacturer to distributor rather than at later channels in the distribution chain, were not that easy to learn since AM Marketing didn’t buy and distribute other manufacturers’ parts.) Thus, in my judgment, no change is called for here. (This was also Tru-Fit’s CFO’s feeling, but he welcomed an outsider’s ratifying it. As a result of our conversation, one segment of a management training program we developed for the company dealt with the notion that there is no such thing as a perfect, dispute-free transfer pricing system.) AM-Manufacturing relations. This causes students the most difficulty of the three stated problems. Many students will argue that changing company policy and letting AM Marketing buy on the outside will solve the problem. This proposal overlooks the fact that the present bonus scheme adjustment would not cause the manufacturing profit centers to be penalized if AM Marketing shifted some purchases to outside suppliers, just as they are not penalized now if they favor OEM customers over AM when the plants are operating at or near capacity. (The proposal also does not recognize how strongly and validly held such policies aimed at protecting company image can be.) It seems, then, that the plant manager bonus adjustment for sales volume variances associated with AM, while meeting its intended objective of equitability, is causing an undesirable side effect. Given that top management wants to increase the AM portion of total outside sales, this is a serious problem. (A sharp student will note the reason for wanting to increase AM sales: at present AM sales are $360 million, with a cost of goods soldi.e., purchases from the other divisions at OEM market pricesof $200 million, giving a gross margin for AM of 44 percent!) One proposal to deal with this problem is to make the plants expense centers. To me, this begs the issue, because someone in the manufacturing division will still have to decide how to allocate capacity at times when combined OEM and AM demands exceed that capacity. With the OEM marketing tradition in two of the three divisions, it is not evident that AM Marketing would get any more favored treatment if the division top management made these capacity allocation decisions. Another option is to do away with the bonus system adjustment, so that AM Marketing’s purchases affect the manufacturing divisions in the same way that OEM customers’ purchases do. This should at least make the divisions indifferent as between selling to AM or OEM, whereas now they are motivated to favor OEM. This is the approach I favor, except it doesn’t go far enough. Since AM sales are so profitable, top management probably wants AM Marketing to be a more favored customer. This could be achieved by a small across-the-board premium added to all transfer prices, or by having a multitiered bonus plan that enables plant managers to share a part of AM profits (i.e., base part of the bonus on plant profit and part on total company profit). I prefer the latter over an inflation of now-realistic transfer prices. Inventory levels. Top management was concerned that productivity-improving capital expenditures, whose savings might not materialize during the first few months, would not be aggressively proposed by the divisions unless the short-run negative impact such projects would have on ROI was somehow cushioned. That was the rationale behind freezing the investment base at the January 1 level. This is an example of the fixed-asset fixation in some managers’ minds when it comes to designing investment center measurement schemes; rather, investment center schemes have the most impact on controllable current assetsin this case, inventories. Quite obviously the near Christmas draw-down of inventories had little (if anything) to do with vacations, but rather was to reduce the denominator of the ROI fraction
  6. 6. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 6 at year-end so as to increase accounting ROI. In effect, the plants were profit centers, not investment centers; and controllable current assets will tend to increase relative to sales (i.e., collection period and inventory turnover will decline) with a profit center measurement approach, since increased current assets will provide some additional sales at the margin, and there is no charge levied on these assets. The company could achieve its intended motivational goal if it were to freeze just the fixed assets portion of the investment base, and base ROI calculations on the average of quarterly or monthly current asset measurements. A better approach, I feel, is to make it clear to managers that ROI targets will be adjusted downward if an otherwise attractive capital budgeting request is approved but it will have a short-run negative impact on ROI. Other issues. Generally, discussion of the three stated problems will raise some question about the appropriateness of Tru-Fit’s organization structure. In particular, consolidation of the three separate OEM sales groups is likely to be proposed, and perhaps even consolidation of all manufacturing activities under a single manager. In this regard, to me the two key facts in the case are: (1) “each division’s OEM marketers tended to work with different people in a given customer’s organization;” and (2) “two of the three divisions had been independent companies before being acquired by Tru-Fit.” Note that OEM sales personnel are not “sellers” in the usual sense of the word. They are more like adjuncts to the OEM companies’ own design departments; working with different people in the OEM companies thus means working with different engineering and design departments, not just different purchasing agents. Since there is no evidence in the case that there is any need for interplay between Tru-Fit manufacturing divisions, but there probably is a need for sales-production interplay within a division, I would leave the structure as it is and capitalize on the perceived autonomy of these three divisions. Also, some students usually are critical of the discretionary adjustment in the bonus scheme. (Such students also tend to prefer my grading them using an equation that weights their written work, with no discretion on their classroom contributions.) Certainly, this discretion can make it possible for a superior to “play favorites.” However, the company’s intent was to reduce the emphasis on short-term measured accounting results, and to take into account longer-term perspectives, community activities, development of subordinates, and the like. It might well be preferable to do this with a more formal MBO system; but absent such a system, I think that having the discretionary aspect of the bonus is better than having a 100- percent accounting formula-based bonus. Also, there may be criticism that the higher a person was in the hierarchy, the more standard bonus points he or she had. If one assumes that salary is related to the organizational hierarchy, the effect of this was to equalize potential bonus as a percentage of salary. When this is clearly understood by students, some of the criticism is eliminated, though it is still a valid issue whether the CEO of an organization should more-or-less automatically receive the largest bonus. Finally, with coverage in the business press the past few years about EPS-based bonus pools, there may well be discussion of tying the annual bonus pool size by formula to annual EPS Certainly, this would seem to lead to a short-run results emphasis. From top management’s perspective, it is difficult to justify to shareholders not having the bonus pool tied to each year’s results. Many companies are struggling with this issue today, with stock options often seen as providing a better short-run versus long-run balance. It is interesting to note that in many large Japanese companies, the accepted culture is that if earnings fall in a given year, everyone’s bonus is lowered (or even eliminated); and everyone takes a salary cut if it’s a really bad year. That’s certainly a short-run approach, yet other aspects of the Japanese business and economic culture reinforce an overall longer-term perspective. Summary Comments. In using this case as an exam, the student responses caused me to provide the following comments as overall feedback:
  7. 7. ©2007 McGraw-Hill/Irwin Chapter 23 7 1. Before you suggest a solution to a problem, be sure that you have thought about what is causing the problem. Many so-called business “problems” are really dilemmas, where one may be pleased with minor improvement because a true “solution” is not possible. (Some students propose residual income to deal with the excess inventories; but that doesn’t help if the investment base remains frozen as of January 1.) 2. If you are confident a change is needed, anticipate the difficulties in “selling” it, especially if your proposal is likely to be viewed as “radical” or “academic” (e.g., residual income, two-step or shadow- price transfer prices, etc.). 3. If management believes there is a problem, you must address that belief, even though you feel the problem is either minor or insoluble (e.g., the transfer pricing disputes); but addressing it does not mean proposing change for change’s sake. Case 23-2: Industrial Electronics, Inc.* Note: This case is changed from that appearing in the Eleventh Edition. The numbers have been modified to provide greater differentiation among the divisions. Purpose of Case This case, which is really a short vignette, was written primarily for exam purposes in situations where the examination time is short. But the case can also be used as the basis for a class discussion. The case raises a number of issues, including performance measurement, performance standards, functions linking performance with incentive awards, and the behavioral responses by managers and employees to incentives. Suggested Assignment Questions Here are the questions used in the exam setting (importance weightings assigned to each question are shown in parentheses): (20%) 1. Calculate the bonus award (as a percent of base salary) that would be given to the manager of each of the following five divisions under the proposed new bonus system. These divisions are representative of the range of divisions within IE. ($000) Division Budgeted Operating Profit Budgeted Operating Assets Actual Operating Profit Actual Operating Assets A $1,000 $8,000 $1,150 $7,000 B 1,000 8,000 4,500 7,000 C 50 1,000 300 800 D (700) 4,000 (300) 4,200 E 600 2,000 100 1,800 Professor Kenneth A. Merchant wrote this teaching note. Copyright © Kenneth A. Merchant.
  8. 8. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 8 (20%) 2. Evaluate (i.e., discuss the pros and cons of) the current bonus system. (30%) 3. Evaluate the proposed bonus system. (30%) 4. Propose a bonus system that you believe is optimal for IE. Why do you think your proposed system is optimal? Explain. Discussion The case starts by describing an ineffective incentive system. The old system was replaced by a new system that is quite different, but still not without problems. Question 1 Question one forces the students to apply the description of the new system to a hypothetical situation. The purpose is to help them understand a key detail in the new system. Most students have no problem solving question one. The bonus awards (as a percent of base salary) in Divisions A through E, respectively, are 63.5%, 150% (the formula says 231%, but the maximum is 150%), 63.7%, 68.8%, and 26.2%. Question 2 Question two asks for an evaluation of the current (old) bonus system. This system provided managers with bonuses based on a share of overall corporate profit after taxes in excess of 12% of book net worth. Advantages of the current system 1. It is a wealth sharing system. If the company does well, all managers do well, and vice versa. The company has to make larger payouts when it is best able to do so. 2. The system might encourage teamwork because everyone is rewarded on the same measure of group performance. 3. The performance targets are fixed and timeless. Thus there are no politics in the negotiation of performance targets. 4. The system is easily understandable. Disadvantages of the current system 1. Except for the highest level of managers, corporate performance is largely uncontrollable. Division managers’ bonus awards are little affected if their division has an outstanding or a poor year. 2. The timeless goal (12%) does not reflect the economic situation or changes in the situation. 3. Profit after tax is not a good reflection of value creation. 4. There is no charge for the use of assets that are financed by debt. The asset and the debt net to zero in the effect on book net worth. 5. The bonus cutoffs, both at the bottom (corporate performance below 12%) and the top (maximum bonus of 150% of salary), are potentially bad. a. The current situation, in which corporate performance is below the minimum performance level, has discouraged some of the managers. This discouragement could lead to demotivation and turnover.
  9. 9. ©2007 McGraw-Hill/Irwin Chapter 23 9 b. There are performance regions where there is no link between performance and bonus awards. This can adversely affect motivation. The cutoffs also provide motivations for gamesmanship (i.e., moving income and assets between performance periods). Question 3 Question three asks for an evaluation of the proposed new system. Advantages of the proposed new system 1. The measures are more controllable. Division managers will be held accountable for division results; group managers for group results; and corporate managers for corporate results. 2. The awards are based on an economic profit, or residual income, performance measure. Managers would be charged for tying up assets in their business. 3. The type of financing used to acquire the assets would not affect the measure. 4. The performance targets would be tailored to each business unit. Presumably they would be more realistic and more equitable and would engender greater commitment from each of the managers. Disadvantages of the proposed new system 1. The performance measures, which are accounting-based, are short-term oriented. This could be particularly costly in a high technology business where innovation is a critical success factor. Short-term accounting measures discourage research and development-related investments. 2. The measures are just uniform, summary results indicators. They are not at all linked with strategy, and they provide no operating guidance for managers as to how to accomplish the results. 3. Cash is arbitrarily assigned to the operating units. Why? 4. Charging for fixed assets based on net book values causes well known problems. Among other things, returns go up just with the passage of time and, hence, NBV-related measures motivate managers not to replace older, more depreciated assets. 5. There seems to be no adjustments made based on whether the company leases or owns fixed assets. 6. The costs of capital does not vary across operating units, and it seems not to change over time, such as with interest rate changes. 7. There is a scalability problem that may be perceived by some managers to be unfair. That is, the bonus earned on, say, each $100k of economic profit is different across divisions. 8. Budget targets are difficult to set equitably in uncertain environments such as IE operates in. 9. The system provides room for gamesmanship (e.g., window dressing, creation of budget slack). 10. Under the new system, bonuses will probably be paid even when an operating unit is not making target. Is this desirable, particularly when the targets are set to be highly achievable? 11. Organizational interdependency seems to be small, but to the extent that divisions have to cooperate, there is a chance here of suboptimization. The division-level performance measures reward solely division performance. 12. Is the new plan too complex? Will the affected managers understand it?
  10. 10. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 10 Question 4 Question four asks for student recommendations. In answering question four, students must try to address as many of the weaknesses of the new system as they can while retaining the advantages. They must also consider the costs of their suggestions, as well as the benefits. There is no perfect solution here. The purpose of the exercise is to expose students to some issues firms commonly face and to get them thinking about various alternatives, and their costs and benefits. Pedagogy This is a short case. However, because it contains descriptions of two incentive plans and raises so many issues, the discussion of it can easily consume an entire class period of 75 minutes or even more. Following the ordering of the student assignment questions provides a logical way to develop the material. However, completing the discussion of the old system (question two) might usefully be completed before starting the discussion of the new system (questions one and three). Case 23-3: Las Ferreterías De México, S.A. de C.V.* Note: This case is unchanged from the Eleventh Edition. Purpose of Case This case was written to illustrate some of the basic problems with the return on investment (ROI) measure of performance. The problems arise in both the numerator (profit) and denominator (investment) of the ROI measures. The case provides sufficient detail to allow students to discuss both how to measure the basic elements of profits and investments and the behavioral implications of the use of these measures. Students should also consider alternatives to the use of ROI measures. The case also allows for discussion of some other issues that managers face in the design and implementation of incentive systems. These include decisions about what employees to include in the plan, what target bonus to set for each type of employee included, whether to use a bonus pool feature, how to design the function linking performance measures and incentive awards, and how to set fair performance standards for all employees. Suggested Assignment Questions 1. Evaluate the proposed bonus plan that Mr. Gonzalez is considering. 2. How, if at all, would you modify the proposed plan? Case Analysis Background It is useful to start the discussion by clarifying some key facts. Ferreterías is a publicly held company. Its managers aspire to have the company be a Mexican equivalent of Home Depot or Lowe’s. * Professors Kenneth A. Merchant and Wim A. Van der Stede wrote this teaching note. Copyright © 2003 by Kenneth A. Merchant and Wim A. Van der Stede.
  11. 11. ©2007 McGraw-Hill/Irwin Chapter 23 11 Ferreterías is not a small business. It operates 82 stores, organized into nine geographical regions. With most student groups, it is probably useful to clarify the key recurring decisions in the business, and then to identify who in the organizational hierarchy makes these decisions. Table TN-1 presents such a list: Table TN-1 Key Recurring Decisions Key recurring decisions Person(s) responsible for making the decision Order right items in the right quantities S Staffing with right numbers of good people S Pricing S Granting credit S (with corporate check on large decisions) Selling S, R (large contractors only) Store location and design C Advertising S Control expenses S Key: S = store R = region C = corporate This table makes it obvious how important the store manager role is in the company. The store managers have considerable autonomy, so they play a key role in affecting the success of each store location. Old Incentive Plan Before this new proposal, performance-dependent incentives were not an important part of the Ferreterías management system. Bonuses were small (2-5%) of base salary, and they were based on the company’s overall profits, so they were not controllable to any significant extent by any except the company’s very top managers. Mr. Gonzalez also provided some subjective bonuses for exemplary performance. These weak incentives seem to have caused some employees to become lazy and to be not focused on the aspects of performance important to the company’s success. These problems are indicated in the quote that opens the case. New Incentive Plan A consulting firm designed the new incentive plan. A number of issues might be discussed. One is the decision to exclude all employees except the store, regional, and corporate managers. Clearly the lower- level employees create value for the company, but the consulting firm decided to exclude them with the reasoning that Ferreterías could not measure effectively the performances of these individuals. If prompted, some students will undoubtedly be able to suggest things that could have been done. For
  12. 12. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 12 example, sales people could have been rewarded for bringing profits from new sales or for increasing sales from existing customers. Yard workers could have been rewarded for receiving positive customer feedback. Another issue is the division of the bonus pool. Corporate managers are to be given, on average, 3% (15%5 people) of the bonus pool. Regional managers get 1.67% each. Store managers get 0.85% each. In comparison, the corporate bonus awards seem too high, particularly given that the top two managers, the CEO and COO, are excluded from this plan. A third issue is the function linking the measures with the bonus awards. There is a lower-level cutoff of 5%; no manager of a store earning an ROI of less than 5% earns any bonus. There is also an upper cutoff at 11%. In 2002, then, six store managers earned no bonuses, and 15 managers earned the maximum. Students should be asked to consider the behavioral implications of these cutoffs. The managers below the 5% cutoff and above the 11% cutoff will be motivated to incur all the worthwhile expenses they can in the current period and deferring all the revenues possible to the subsequent period because these shifts will have no effect on their bonus. Thus, a gameplaying environment is created. A fourth issue is controllability. The performance standards are the same for all the stores, but their performance prospects are almost assuredly not equal. Some stores have better locations, and some probably have more efficient layouts. Ideally, performance standards should vary by individual location. This could be done through a formal budget negotiation process or more mechanically, such as by adjusting the goals for differences in local construction activity. A related problem: are the six managers earning no bonuses really the worst managers? Maybe they are good managers who were transferred to poor performing stores and have not yet had a chance to turn around that performance? There is no provision for making allowances for this contingency. That may make it difficult for the company to induce good managers to move to poor-performing outlets. Ferreterías may want to distinguish the evaluation of the store location from the evaluation of the manager. Finally, the logic of basing bonuses on a proportion of corporate profits can be questioned. The bonus pool feature does limit the company’s exposure. This is a wealth-sharing feature of the plan. If the corporation does not do well, then payouts to employees are reduced. But corporate performance is essentially uncontrollable, even by managers at the store and regional levels, so this bonus pool feature just subjects these employees to uncontrollable risk. The yards do not seem to be greatly interdependent, so there is no need to have a “group reward” to motivate teamwork. The focus of the discussion, though, should be on the technical aspects of the ROI calculation and the behavioral impacts of making ROI the central measurement in a bonus plan. The text reading provides a summary of some of the advantages and disadvantages of using ROI as a criterion for evaluating and rewarding managerial performance. Instructors can remind students of this list if that is deemed desirable. The Calculation of Profit The accounting treatment of revenues seems unfair in part. Stores are not given credit for sales orders written by personnel at regional or corporate levels, yet the store has to provide the good for that sale. Thus the stores incur the stocking and handling costs. Customer service on these sales may also suffer because the stores are not dealing with their own customers. The stores are charged with all their local expenses, direct charges from regional and corporate headquarters, and allocations of all indirect costs. Some of even the local expenses may not be
  13. 13. ©2007 McGraw-Hill/Irwin Chapter 23 13 controllable by the store manager. The rental and depreciation amounts may result from decisions made by managers in the corporate office. The same arguments apply to the advertising material, catalogs, and other materials. Will managers have the opportunity to reject such material if they feel they can accomplish their objectives with less expensive advertising that doesn’t conform to corporate policy or corporate image? Will that be allowed? Some of the direct charges may have a behavioral impact. For example, will charges for credit checks discourage their use? The case does not provide much information about the allocations of indirect expenses, but these raise some questions. Do the allocation bases have any economic meaning? And why are the allocations of actual expenses, not standard. This allocation method makes the yards bear the cost of any corporate budget overruns. The Calculation of Investment The calculation of investment similarly raises a number of measurement issues. Including month-end cash balances as investment will encourage managers to get rid of their cash at the end of the month. End-of- period gameplaying like this is commonly referred to as window dressing. What purpose is served by holding managers accountable for cash balances and what behavioral effects are produced should be of concern. Likewise, including month-end inventory at cost creates an opportunity for mangers to manipulate their inventories in such a way that their investment is reduced. The effect of such reductions, however, will inevitably be on the level of service they can provide to customers. Ferreterías’ system does not enable the calculation of a cost of stock-outs. Month-end receivables also provide opportunities for discretionary action by yard managers in allowing credit, or by different managers adopting different policies and, hence, encouraging consumers and customers to deal with one yard as opposed to another simply because of their credit policies. Most students will quickly recognize the arguments against including investment in automobiles, trucks, equipment, furniture and fixtures at their depreciated (net book value) cost. To illustrate the point, instructors can draw a figure showing that ROI of any entity being evaluated in terms of the return on the net book value of assets will increase over time, just with the passing of time. Use of net book value can have some perverse behavioral effects. It can cause managers to delay replacing assets and to operate with older, less efficient or less attractive, equipment and facilities. In the event extra equipment is available, yard managers might have a tendency to dispose of the newer rather than the older equipment because of the effect it will have on the investment base. Using net book value also causes problems in comparing performance across yards because the yards’ assets are of different ages. A related issue—leases at Ferreterías are not capitalized. Implementation Issues While little information is given about the process by which the plan has been developed, students can infer that the managers who will be greatly affected by the plan seem to have had little or no input into the design. At the end of the case, Mr. Gonzalez is lamenting that he will have to be the one to announce the implementation of the plan. This lack of participation can be costly both because the expertise of the people at the operating levels was not tapped and because participation itself reduces resistance to implementation. Pedagogy This teaching note has been written in roughly the order in which we suggest discussing the issues. At the start of class, it is desirable to clarify both what is important for Ferreterías and who in the organization is responsible for the various key decisions.
  14. 14. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 14 Before evaluating the new plan, it is useful to clarify the key elements of the plan. We like to have the students describe the plan along many of the common plan dimensions, including the form of the awards (here cash), performance measures, degree of discretion allowed in making the awards, the shape of the results/reward function, the size and frequency of the awards, the degree of uniformity of awards throughout the organization, and the source of the funding (bonus pool). Then students can be asked to evaluate the new plan and to suggest possible improvements. Instructors should focus on the behavioral impacts of the plan and other plan alternatives. It is the induced behavior of the employees in the company that will produce value, or not. Case 23-4: Boise Cascade Corporation* Note: This case is unchanged from the Eleventh Edition. Approach This case was written to illustrate a cost accounting/billing system in the difficult accounting environment of corporate data processing.1 The case raises an interesting twist because managers at Boise Cascade were considering not using actual (or average) costs for charging out usage of personal computers (PCs). They were leaning toward undercharging for PC usage in hopes of creating a desired behavioral responsegreater PC usage. Suggested Assignment Questions Suggested assignment questions are contained in the case. If the instructor does not want to raise issues related to responsibility centers at this point, a topic discussed in Chapter 22, question 1 can be omitted. Case Analysis Question 1: Is Boise Cascade’s CDPS a profit center? This is not an easy question. On the surface, CDPS appears to be a profit center since it generates revenues and a profit. However, the best answer to question 1 is that CDPS is really a cost center, for a number of reasons: 1. Unlike most profit centers, CDPS’s goal was not to maximize profit. Its goal-was to report exactly 22% PROTC. This goal is essentially a break-even goal. It forces CDPS to earn an average rate of return on the assets it used so that the organization does not dilute corporate return on equity. CDPS managers were embarrassed when their organization earned a 40.6% PROTC in 1991. This performance meant they had “overcharged” Boise Cascade’s product organizations for the services they used. 2. CDPS does not generate any outside revenue. This is not a necessary condition for being a profit center, but it can be almost a sufficient condition. If CDPS had many outside customers, Boise Cascade would have little choice but to make CDPS a profit center. * This teaching note was prepared by Professor Kenneth A. Merchant. Copyright © 1998 by Kenneth A. Merchant. 1 Much has been written about this topic, and instructors can assign supplementary readings to delve into this area more deeply. One possibility is R.L. Nolan, “Controlling the Costs of Data Services,” Harvard Business Review (July-August 1977), pp. 114- 124. See also, D. Kilpatrick, “Why Not Farm Out Your Computing?” Fortune (September 23, 1991), pp. 103-112.
  15. 15. ©2007 McGraw-Hill/Irwin Chapter 23 15 3. Most important, CDPS managers do not make any trade-offs between revenues and costs. Their prices are not market based (although some market comparisons are made for control purposes); their prices are really just a way to pass on the costs. They are set to represent cost plus a margin to provide a return on the assets employed. Question 2: Evaluate the CDPS billing system. Do Dwight Kirscht’s criticisms have any merit? Before they can critique the billing system, students must understand the system. Walking through the system is a good way to start the class. Figure TN-I shows a schematic of the billing system. Figure TN-1 Schematic of CDPS billing system (similar to cost accounting system) CDPS managers picked the 15 most important cost drivers (billing categories). It is clearly not a complete list. For example, in addition to the list of 15, they could have chosen to charge for inches of paper used and hours of talk with a support person. Meters were set up to measure how much of each resource (billing category) was being consumed by a particular job. CDPS managers put prices on the consumption of each resource at various times a day, with the goal to generate exactly 22% PROTC. The alternative to this two-stage system is a one-stage system that would allocate costs directly from CDPS to users. This could be done based on a (necessary rough) estimate of percent usage or from line- items to jobs, perhaps on the basis of use of labor (e.g., programmer hours) or equipment (e.g., CPU, printer) hours.
  16. 16. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 16 Here are some questions that can be posed to force students to think more deeply about the system: 1. What if a user wants a tape mounted for an hour. (This is a billing category no longer in use.) There would be no charge for this service. The costs would be spread to all other users. 2. Where are the PC support costs? They are not separately identified. They are located in a number of cost line-items 3. What does Boise Cascade know about whether the costs are fixed or variable? There is nothing in the formal system that makes this distinction, but CDPS managers intuitively understand the distinction. They know that most of the hardware costs are fixed, and many of their charges reflect user opportunity costs more than CDPS costs. For example, the cost of running a job during peak daytime hours is no greater than that caused by running it at night except for the fact that the peak usage slows the entire system. In addition, they recognize that hardware must be acquired to serve peak needs. One more peak-time job could cause the acquisition of an entire new computer or printer, so prices are set to discourage peak-time usage. In order to critique the billing system, students should first consider the goals for the system. These are described in the case: 1. establish and account for the costs of providing the services; 2. provide an incentive for users to “thoughtfully manage” their use of the resources; 3. aid CDPS in managing computer capacity; 4. facilitate financial justification for capital and expense requests. Is this a good set of goals? Dwight Kirscht might make the following additions: 1. The charges should be reproducible. If you submit the same job at the same time of day, you should get the same charges. 2. The charges should be externally benchmarked. They should be competitive and apply pressure for CDPS management to manage well. Is the billing system meeting its goals? Clearly CDPS has maintained a system that accounts for costs, and this cost information seems to be used for managing CDPS. However, Dwight Kirscht claims that the internal computer algorithms, which were built in 1972, are obsolete. The case does not provide enough information to get into this issue, but some classes will have a student “expert” who will want to expand on this point. There is evidence in the case that the charges cause users to understand at least some of the costs of the resources they are using. This understanding affects their behavior (e.g., scaling back resource-intensive applications). But to the extent that some users do not understand some of their charges, Dwight Kirscht’s criticism is valid in this area. It is clear that the charges are not reproducible. This is another of Dwight Kirscht’s criticisms. The charges are based on units of production, not units of output. A job submitted at a busy time will be charged more, perhaps substantially more, than a job submitted at a slack time. And the charges are not formally externally benchmarked. CDPS had a sense that their charges were reasonable only because outside service bureaus had not submitted bids for some or all of the business.
  17. 17. ©2007 McGraw-Hill/Irwin Chapter 23 17 Dwight Kirscht suggests that CDPS should not charge for use of its services at all. Is this a good idea? A company might not want to charge for computer services if any of the following conditions exist? 1. The costs of computer services are immaterial, or the costs of billing is greater than the benefits. (But at Boise Cascade, CDPS’s annual expenses are $8.3 million, versus $75.3 million net income. This is clearly not immaterial.) 2. Computer services does not add directly to the value of the corporation’s products. It may just involve staff functions, such as payroll and bookkeeping. In such cases, it is not particularly important for users to see the cost details. They have no decision-making authority in these areas. (But CDPS provides many value-added services.) 3. Computer services costs do not make a difference to managers in the measurement/evaluation/ incentive system. If managers don’t pay attention to the cost information, there is no reason to show them that information. (But that is not the case at Boise Cascade.) 4. Managers do not understand computers and the costs they entail. (If this is the case, should these people be managers?) 5. The company wants to encourage EDP use, regardless of cost. (This may be the case with PCs at Boise Cascade. It is not the case with the centralized computer resources.) Question 3: Evaluate the new system for charging for the use of personal computers. Where were the PC support costs before the change? They were buried in other line-items and charged to other users. Which of the following PCs being used within Boise Cascade should be charged by CDPS?  PC used for inputting jobs to the mainframe?  A 10-year-old PC rim by an experienced user who requires no user support?  An Apple Macintosh computer (which is not well supported by CDPS)?  A home PC on which a manager sometimes works?  A laptop computer a manager sometimes uses in the office and sometimes at home? CDPS’s decision was finally to charge for support of all PCs (both IBM- and Apple compatible) in the Boise offices with non-dial access to CDPS computers. They excluded laptops, portables, and home computers that are exclusively used in dial access mode. If the cost of PC support was $122 per month, why did CDPS managers decide to charge just $100? It was a round number that was easy to explain and to sell. Further, with the growth in PCs, it would soon be accurate: $60,930610 PCs = $100/month.
  18. 18. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 18 Case 23-5: Berkshire Industries PLC* Note: This case is unchanged from the Eleventh Edition. Purpose of Case The Berkshire Industries PLC case was written to illustrate the use of “economic profit” in a performance measurement system. Consulting firms have developed various measures of economic profit; EVA™ , developed by Stern Stewart & Co. is probably the best known. All of these economic profit measures are modified versions of the concept that accountants have traditionally called “residual income.” In this case, students are asked to evaluate an economic profit measure that involves two common measurement adjustments, capitalization and amortization of advertising expenses and the elimination of goodwill amortization. The case also raises some related results control system issues. The system proposed in the case includes automatic ratcheting of performance targets, a results/reward function without thresholds and caps, and a “bonus bank” that smoothes out the bonus awards. Each of these system elements can be evaluated. Students must also consider some implementation issues. Suggested Assignment Questions 1. Were Berkshire’s motivations for a new incentive system reasonable? If so, what were their main options for a new system? Was an economic profit-focused system a reasonable choice? 2. Use the data pertaining to the Snack Food Division, as shown in Exhibit TN-1, to calculate: a. The economic profit for the division for 2000 and 2001 b. The economic profit target for the division for 2001 c. The division manager’s bonus payout (% of salary) for 2000 and 2001. (Assume that the slope of the payoff line for 2000 was arbitrarily set by Berkshire management to equal 1.0.) 3. Assume the base salary of the manager of the Snack Foods Division was ₤120,000 in both 2000 and 2001. How much cash would the manager receive from his bonus payouts in 2000 and 2001? 4. Evaluate the Berkshire Industries’ new incentive plan. What changes would you recommend, if any? 5. Should Mr. Embleton make special adjustments of the economic profit figures or the bonus payouts for personnel in the Spirits Division in 2000 and 2001? Why or why not? Instructors should use question 2 only if they want to get into the details of the economic profit calculation. Beware: While the concept is straightforward, students who are not comfortable with accounting have considerable difficulty with the calculations. * Professors Kenneth A. Merchant and Wim A. Van der Stede wrote this teaching note. Copyright © by Kenneth A. Merchant and Wim A. Van der Stede.
  19. 19. ©2007 McGraw-Hill/Irwin Chapter 23 19 Case Analysis The company’s motivation for a new incentive system arises from two concerns. First, the board was concerned that Berkshire managers’ interests were not aligned with those of shareowners. The board members were particularly concerned that EPS was not a good measure since growth in EPS did not translate into stock price appreciation. Second, the board wanted to introduce more objectivity into the performance evaluation and reward system. Some board members believed that too much subjectivity in the reward system results in a weak correlation between bonus awards and actual operating performance. Furthermore, the subjective part of the bonus system caused managers to spend more time negotiating their bonus rather than worrying about generating profit. In general, the benefits of an economic profit-type system include the following:  It introduces balance sheet accountability to managers, some of whom are accustomed to thinking only about income figures.  It aligns managers’ actions with shareowner values by encouraging managers to invest only in projects that generate a return greater than the cost of capital. An economic profit system is not the only alternative for holding managers accountable for capital usage. Other bottom-line, summary performance measures, such as ROI, RONA, ROE, ROC, can be used for that purpose. So can any of several combination-of-measures systems, such as those focused on “key performance indicators,” management-by-objectives (MBO) systems, and Balanced Scorecards. These latter systems can hold managers accountable for capital-related measures, such as asset turnover, inventory turnover, and days receivables. Economic profit measures are intuitively appealing because they are consistent with finance theory. They signal to managers that they should make all investments promising returns greater than the company’s cost of capital. However, there is evidence in the case, and also in some academic research studies, that economic profit measures are not highly correlated with stock price changes and, hence, shareholder value. The correlation between economic profit measures and shareholder returns is probably higher in good economic times, when most performance indicators—shareholder returns and economic profits, as well as accounting returns, profits and sales—are all generally trending upward. It is lower when the economic cycle is changing. The problem is that shareholder value is based on market estimates of the future, while economic profit, like accounting profit, is a backward-looking measure. Economic profit measures do not provide the measurement panacea that their label implies. The second and third assignment questions, which will be time consuming for the students, are clearly optional. They are designed to force students to get into the detail of the economic profit and bonus calculations. Without the numerical example, many students will gloss over the details of the calculations, assuming that they understand how the system works. But, there are a lot of complexities to comprehend. The completed table is shown in Exhibit TN-2. To do these calculations, students must prepare the advertising expenditure amortization schedule, as shown in Exhibit TN-3. The economic profit calculation is shown in Exhibit TN-4.
  20. 20. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 20 The answer to assignment question #3 is shown in Exhibit TN-5. The fourth question asks students for an evaluation of the new system. Each of the elements of the system can be evaluated separately. Each element has its advantages and disadvantages. Students should understand that there is no perfect system. Are economic profit measures congruent with changes in shareholder value? There is indication in the case that it is not. But it may not be any worse than the various accounting measures, and it is better than just accounting profit, which does not have an asset focus in it. The automatic ratcheting of performance targets has the advantage of taking politics and gamesmanship out of the target negotiation processes. But a ratcheting system does not use any knowledge about changing business conditions and prospects. The problem in the Spirits Division illustrates this problem. Is the 75% ratcheting parameter appropriately responsive to improving or declining performance? The elimination of payout thresholds and caps is generally a good idea. The lower and upper payout constraints create ranges where there is no link between performance and rewards. Thus they can undercut motivation and stimulate gamesmanship in those performance ranges. But companies that use such constraints argue that they should not have to pay bonuses for performance that is not above minimal levels. And they worry that extremely high payouts are likely to be more due to uncontrollable luck and/or poor bonus plan calibration than they are to extraordinarily good management performance. The bonus bank idea is good in that it smoothes out the bonus payouts. This can be helpful to managers faced with paying a largely fixed set of personal expenses (e.g., mortgage). The bonus bank also provides an employee retention benefit. If managers leave the company, they forfeit all the remaining balances in their bonus bank. But the bonus bank makes the payouts less responsive to changes in performance. This can be seen in Exhibit TN-5. Thus it can dilute the motivational messages that the incentive system is trying to provide to the managers. A general criticism that students can make of the system, too, is that it is relatively complex. Can managers understand all the elements of the system, which is quite different from what they were accustomed to? If they do not understand all the details, does it really matter? Is all the complexity necessary? The fifth question asks whether Mr. Embleton should make some kind of special allowance for the Spirits Division of Berkshire Industries in 2000 and 2001. This is a controllability issue. The poor economic conditions seem to be out of the control of the managers of the Spirits Division. If budgets were prepared for this division, the budgets could reflect the poor conditions. Use of a ratcheting system for setting performance targets does not take economic conditions into consideration. Should Mr. Embleton have empathy for the Spirits’ managers? One purpose of implementing the economic profit system was to reduce the amount of discretion in the assignment of bonuses. On the other hand, if the division will truly suffer significant employee turnover because of the loss of bonuses, perhaps some intervention is called for. Pedagogy The teaching of this case will depend significantly on how much the instructor wants to get into the calculation of economic profit and the bonus awards. If the instructor wishes to have the students develop
  21. 21. ©2007 McGraw-Hill/Irwin Chapter 23 21 all the numerical answers to the assignment questions as posed, a reasonable timing for a 75-minute class is as follows: The company and its need for change 10 minutes The economic profit and bonus calculations 30 Evaluate the system and possible alternatives 25 The issue in the Spirits Division 10 75 minutes Exhibit TN-1 Operating Data from Berkshire Industries’ Snack Foods Division (£000) 1996 1997 1998 1999 2000 2001 From the income statement: Net operating profit before the following items: 137,051 162,401 184,898 194,321 Consumer advertising expense (20,661) (23,730) (26,410) (31,007) (41,568) (39,191) Goodwill amortization 0 0 0 (15,000) (30,000) (30,000) Net operating profit before taxes 110,641 116,394 113,330 125,130 Income tax payments (41,293) (51,501) (54,131) (60,327) Net operating profit after taxes (NOPAT) 69,348 64,893 59,199 64,803 From the balance sheet: Net operating assets (book): 593,040 630,268 580,920 568,113 Accumulated amortization of goodwill 0 0 0 15,000 45,000 75,000 Economic profit ? ? Economic profit performance target 28,0001 ? Division manager’s bonus: Target bonus 50%1 50%1 Bonus payout (% salary) ? ? Note: 1) Cumulative advertising expense through the end of 1997 is £181,410. 2) Cumulative advertising amortized through the end of the 1997 is £167,507. 1 Established by management.
  22. 22. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 22 Exhibit TN-2: Berkshire Industries’ Snack Foods Division—Completed Table (£000) 1996 1997 1998 1999 2000 2001 Net operating profit before the following items: 137,051 162,401 184,898 194,321 Consumer advertising expense (20,661) (23,730) (26,410) (31,007) (41,568) (39,191) Goodwill amortization 0 0 0 (15,000) (30,000) (30,000) Net operating profit before taxes 110,641 116,394 113,330 125,130 Income tax payments (41,293) (51,501) (54,131) (60,327) Net operating profit after taxes (NOPAT) 69,348 64,893 59,199 64,803 Net operating assets (book): 593,040 630,268 580,920 568,113 Accumulated amortization of goodwill 0 0 0 15,000 45,000 75,000 Economic profit 32,256 29,309 Economic profit performance target 28,000 31,1922 Division manager’s bonus: Target bonus 50% 50% Bonus payout (% salary) 65.2%3 43.9%4 Exhibit TN-3: Consumer Advertising Amortization Schedule for Snack Foods Division (£000) 1998 1999 2000 2001 Consumer advertising expense 26,410 31,007 41,568 39,191 Amortization (3-year period): 1996 expend. 6,887 1997 expend. 7,910 7,910 1998 expend. 8,803 8,803 8,803 1999 expend. 10,336 10,336 10,336 2000 expend. 13,856 13,856 2001 expend. 13,064 Amortization of advertising expenditures under economic profit 23,600 27,049 32,995 37,256 Cumulative advertising expense since company was founded 207,820 238,827 280,395 319,586 Less cumulative advertising amortized through end of 1998 if economic profit had been used 191,107 218,156 251,151 288,407 Net capitalization of advertising for economic profit calculation of capital 16,713 20,671 29,244 31,179 2 28,000 + (32,256-28,000) * 0.75 3 0.50 + [(32,256 – 28,000)  28,000] * 1 = 0.652 (i.e., 65.2%) 4 0.50 + [(29,309 – 31,192)  31,192] * 1 = 0.439 (i.e., 43.9%)
  23. 23. ©2007 McGraw-Hill/Irwin Chapter 23 23 Exhibit TN-4 Economic Profit Calculation for Snack Foods Division (£000) 2000 2001 NOPAT: Net operating income before taxes 113,330 125,130 Add back: Consumer advertising expense 41,568 39,191 Subtract: Amortization of advertising expenditures under economic profit (32,995) (37,256) Add back: goodwill amortization 30,000 30,000 Adjusted net operating profit before taxes 151,903 157,065 Current year’s income tax payments (from Exhibit TN-1) (54,131) (60,327) Adjusted NOPAT 97,772 96,738 Capital: Net operating assets (book) 580,920 568,113 Add: Capitalized advertising expenditures 29,244 31,179 Add: Accumulated goodwill amortization 45,000 75,000 Adjusted Capital 655,164 674,292 Capital charge (10%) 65,516 67,429 Economic profit 32,256 29,309
  24. 24. Accounting: Text and Cases 12e – Instructor’s Manual Anthony/Hawkins/Merchant 24 Exhibit TN-5 Bonus Bank Balance Calculation for Manager of Snack Foods Division (£000) 2000 2001 Beginning balance in bonus bank 0 13,6805 “Excess bonus” earned 18,2406 (7,320)7 Balance in bonus bank 18,240 6,360 Excess bonus paid to manager 4,560 1,590 Target bonus 60,000 60,000 Bonus paid to manager 64,5608 61,590 5 18,240 – 4,560 6 15.2% x 120,000 7 -6.1% x 120,000 8 60,000 + 25% * 18,240

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