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Volume 14
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Table of Contents
Case 1
The Aristocrat Furniture Company Case: Performance Measurement
and Business Valuation ............................................................................................................. 1
Case 2
Ciba Specialty Chemicals: Unlocking Significant Shareholder Value ........................................ 15
Case 3
Letsgo Travel Trailers: A Case for Incorporating the New Model of the Organization
into the Teaching of Budgeting ............................................................................................... 33
Case 4
Using EVA at OutSource, Inc. ......................................................................................................... 39
Case 5 (A)
RVF Systems Inc. .............................................................................................................................. 45
Case 5 (B)
RVF Systems Inc. .............................................................................................................................. 65
Case 6
Evaluating Product Line Performance: The Case of Wellesley Paint ......................................... 73
Addendum to Volume 12, Cases from Management Accounting Practice
Destin Rides Again ........................................................................................................................... 79
Case 1
Global is a fully integrated manufacturer and distributor of a broad line of dining room,
bedroom, and hotel furniture and related products. They have always coveted Aristocrats
name, products, and reputation because Global has been unable to develop or acquire suitable products, including sofas, love seats, couches, and chairs, to compete in the high-end
home furniture market.
Marsten is also concerned about Phoenix Furniture Corporation, for whom he has much
more respect. Headquartered in Arizona and about three times the size of Aristocrat, Phoenix
produces an excellent line of high-quality products primarily for the office furniture market.
Like Aristocrat, they have developed proprietary processes and brand names and have attempted to protect them. Marsten Richardson understands, however, that Phoenix wants to
expand its product line to include the chairs and couches that are the mainstay of Aristocrats
product line. Phoenix intends to diversify gradually into the home furniture market and expand geographically to the New England and mid-Atlantic states.
Like Aristocrat, Phoenix is a closely held business, a majority of which is owned by the
White family. Marsten first met the Phoenix CEO, Harry White, at a trade show more than 30
years ago, and they have kept in touch ever since. One philosophical difference that always
separated the two is organized labor. While Aristocrat has employed primarily union labor
for the last 30 years, Harry White strongly opposes unions and has never dealt with one even
though Phoenix has four locations. Harry has avoided union organizing by having a very
open policy on employee relations and strong employee benefits and a profit-sharing plan.
While organized labor has never held a dominant position in the furniture industry,
particularly in the South and West, employees of many firms in the North and East are represented by unions. Organized labors overall decline in the United States during the latter part
of the 20th century also occurred in the furniture manufacturing industry. The number of
employees represented by unions in that industry has declined from a high of 22% in 1968 to
about half of that at present. Global has both union and nonunion shops. And while the total
cost for an hour of labor does not vary substantially from Aristocrat to Global or Phoenix,
Marsten believes that both Aristocrat and Phoenix have enjoyed lower labor costs as a percentage of sales because of their more efficient production techniques.
Even with a successful history and a loyal customer base, Marsten viewed Aristocrats
substantial interest-bearing debt as a significant burden for the firm. In addition to the continuing litigation with Global over patent and design infringement, he has seen Aristocrats
profit margins gradually erode over the last 10 years as competitors have slowly developed
competing production technologies and improvements in product design.
Aristocrat is threatened even more with a changing market structure and merchandising
techniques. They have always sold through major distributors and a network of specialty
dealers who handled their high-quality product lines. New merchandising techniques, however, have cut into the market share of both of these distribution channels, rendering each a
declining force in sales. Mass merchandisers, home centers, direct mail distributors, and catalog wholesalers are all growing distribution channels that are becoming increasingly price
competitive.
Some of the major players in the market are particularly effective at advertising and
creating the image that they are the high-quality or low-price leaders when this is not always
the case. Aristocrat lacks both the market share and size and the distribution channels to
adequately present their messagehigh product quality, strong customer service and warranties, and competitive prices. Aristocrat also faces the continuing disadvantage of Globals
ability to obtain quantity discounts in their purchase of specialty items such as fabrics, hard2
ware components, and laminates. In addition, Globals status as a fully integrated manufacturer brings them cost savings in raw material commodities such as wood products.
Given this series of competitive threats facing Aristocrat, Marsten felt it was essential to
track Aristocrats progress in meeting the competition. To do so, he had always relied on a
combination of overall firm profitability and Aristocrats market share data in key markets.
Specifically, he followed Aristocrats annual market share in its three largest local markets
based on trade association data. More recently, Philip Dhurt, director of operations, had convinced Marsten to add a series of nonfinancial performance measures in the operations area to
his key set of indicators. Philip explained that these cycle time measures would reflect asset
efficiency, and that as asset efficiency improved, so would Aristocrats financial performance.
Besides the issue of competitive threats, Marsten has also recently been forced to recognize management succession concerns within Aristocrat. While his oldest of four children,
Dudley, is very bright, he has always lacked the ambition and discipline required to excel in
an executive position.
His second oldest, Penelope, possesses excellent technical skills and entrepreneurial spirit
but had personal and philosophical differences with her father. After six years in the family
business, she sold her 8% interest back to the company as treasury stock and left five years
ago to start her own company, which manufactures a line of specialty furniture products
aimed at the restaurant and tavern market. Her firm, known as Pene Company, though small,
is now turning a profit and has shown more than 20% sales growth for the last two years.
Marstens third child, Blakely, is both loyal and ambitious but has demonstrated poor
judgment in both personal and business matters. Two years ago he went through a particularly acrimonious divorce in which the value of his stock in the company was agreed to between the parties as a trade-off; i.e., Blakely got the shares in the family company and his
spouse received other assets of the marriage. Blakely and Dudley both carry the title and
salary of vice president at Aristocrat, but neither contributes significantly to the companys
success.
The fourth child, Bisby, has been mentally handicapped since birth, and his shares are
held in trust for him. The trustee is his sister, Penelope.
At 63, Marsten recognizes his need to develop and implement a succession plan for
Aristocrat as soon as possible. He was recently diagnosed with prostate cancer, but his doctor
assured him that, with proper care and attention, his life was not threatened. His lifestyle,
however, was expected to change, and the companys present lack of executive-level management was more apparent then ever before. In light of both the competitive and succession
concerns, Marsten recently decided to have a valuation of the business performed for strategic planning purposes. The valuation was to assess the fair market value of 100% of the voting and non-voting common stock of Aristocrat.
Marsten was curious about how an option that he was consideringto sell a tract of land
carried on the companys books at $500,000 but recently appraised at $4 millionmight affect
the valuation of Aristocrat. The land originally had been been acquired as a site for future
development, but its market value had grown so rapidly that this opportunity cost rendered
it uneconomical for its original purpose. The company is presently renting it to a retailer and
recording the rent as other income on the income statement; in 19H5 the rent was $120,000.
Through continuing improvements in design and manufacturing processing, the company
had developed adequate capacity in their existing facility for the foreseeable future.
Ownership of the company at the end of 19H5 (H is for historical and 19H5 is the most
recent historical year) was as follows:
3
Voting Stock
Shareholder
Marsten Richardson
Number
Non-Voting Stock
%
Number
Total Shares
100,000
100.00%
410,000
50.0
510,000
Dudley Richardson
0.00
0.00
80,000
9.56
80,000
Blakely Richardson
0.00
0.00
80,000
9.56
80,000
Bisby Richardson
0.00
0.00
80,000
9.56
80,000
0.00
0.00
170,000
20.73
170,000
100,000
100.00%
820,000
100.00%
920,000
0.00
80,000
80,000
100,000
900,000
1,000,000
* Marsten Richardsons older brother and only sibling who, along with Marsten, first acquired shares in their
fathers initial capitalization of the company.
Marstens wife, Emily, is a very capable associate who has worked with him in the business for many years without drawing a salary. She is in charge of sales and marketing and has
personal contacts with several key accounts that are critical to the company. Although Emily
is in good health, she is distraught over Marstens health problems and wants to start immediately to enjoy the fruits of their many years of hard labor.
The company was recently approached by Inverness Investments, a mutual fund with a
portfolio of blue chip companies. Inverness occasionally buys a controlling interest in highgrowth specialty companies. The management of Inverness have no investment experience
in the home furniture industry but were impressed with the information they could gather
about Aristocrat. They contacted Marsten three months ago through an intermediary to explore a sale of the company to their mutual fund.
Because of his concerns about succession, Marsten had resisted his initial reaction, which
was to decline Inverness expression of interest. Instead, he instructed his attorneys to prepare appropriate nondisclosure agreements and to proceed with an initial exchange of information.
As Marsten pondered his options, including a potential sale of the company, he was
continually tempted to maintain his ownership. He had always worked long hours and was
uncertain if he could be happy in retirement. Marsten and Emily already owned a vacation
home in the South where Emily now wanted to extend their annual vacation from one to six
months. Marsten knew he would grow bored. He was also intrigued by Penelopes success
with her new company. He suspected that if they could just learn to get along, she would be
an excellent CEO for Aristocrat.
Further, he continued to enjoy the challenges associated with important operational decisions facing the firm. In fact, he was giving considerable thought to two proposals brought to
him by Philip Dhurt, a trusted and long-time member of Aristocrats top management team.
Philip was known to have an excellent knowledge of the latest operating trends in the business, plus a knack for exploiting opportunities in imaginative ways.
4
Aristocrat
Annual sales
Fixed assets (net)
Inventory
Total assets
Net income
1,970.8
616.7
425.2
1,255.0
146.0
72.0
22.5
13.3
52.3
4.7
Order cycle
Production cycle
Delivery cycle
Total cycle
1.7 days
3.1 days
5.8 days
10.6 days
9.1 days
14.8 days
25.2 days
49.1 days
Philips study found, first, that Global uses a computerized order system that allows
their stores to communicate immediately with the factory concerning products in short supply. This system is represented by Globals much lower order cycle time than Aristocrats (1.7
days versus 9.1 days for Aristocrat). This short order cycle time in turn has contributed to
their program to reduce inventory.
Second, Global uses an innovative production technology in their factories that allows
them to minimize the time necessary to convert from production of one product to another.
This is reflected in Globals advantage of a much lower production cycle time (3.1 days versus
14.8 days for Aristocrat). Reducing production setup time in this way again contributes to
Globals inventory reduction program. It enables them to match production closely to demand, thereby avoiding the need to carry extensive inventory in their warehouse facilities.
Third, Globals automated technology links their factories to their warehouses and the
warehouses to the retail facilities that carry their products. The advantage conferred by this
technology is reflected in Globals shorter distribution cycle time (5.8 days versus 25.2 days
for Aristocrat), with the result that Global has less invested in inventory that is in transit
between factory and warehouse and warehouse and retail facilities.
Philip emphasized to Marsten that Globals technological superiority in production and
distribution was enabling Global to achieve a corresponding advantage in generating returns
from operational assets. To counter this advantage, Philips proposal called for introducing a
three-day special program that guaranteed delivery to the retailer or wholesaler within
three days of receipt of an order. Philip designed this program based on similar initiatives in
the office furniture business segment that he learned about in trade association conventions
and publications. His research indicated that for office furniture, the standard lead time had
fallen from 20 weeks in the late 1970s to 26 weeks in the mid-1990s. Standard lead time is the
sum of order placement time, manufacturing time, and delivery time. Some furniture manufacturers, however, offered premium service in as short a period as two days. For example,
5
Steelcases 48-hour special delivery program promises delivery of some 250 products in popular
colors and finishes to a specified location within two working days.
Philip believed that a corresponding three-day special program for Aristocrats sofas and
chairs would offer several important advantages. First, it would appeal to retailers who could
now tailor their inventory more effectively to the latest trends in customer demand while
simultaneously reducing the retailers total inventory and related carrying costs. Second, and
more important, the three-day special would form part of a flexible manufacturing strategy
for Aristocrat in which they would reduce their own overall standard lead time from 42 days
to 14 days. The 14-day overall average would include programs such as the three-day special
with very short standard lead times, as well as other products with longer lead times, but
none would exceed 24 days. Philip saw the great benefit to Aristocrat of the three-fold reduction from 42 to 14 days as being the corresponding increase that it would produce in Aristocrats
effective production capacity. He believed that even if not all of this increase in capacity would
become effective in the first few years, Aristocrats effective production capacity would conservatively be doubled. In turn, Aristocrats healthy profit margins would enable the firm to
double its net income, thereby earning enough to cover the cost of the investment in flexible
manufacturing technology within a relatively short time.
More specifically, Philip estimated an investment of $10 million would be required for
the flexible manufacturing equipment and related support. In turn, if doubling production
capacity produced a proportional increase in revenue, the result would be additional revenue
of $70 million. He believed that at Aristocrats current profit margin, the addition to the bottom line would mean that the investment would pay for itself within two or three years.
Philip had studied the innovations made in the office furniture segment of the industry
carefully. His conclusion was that the key to competing effectively in the future rested with
effective use of technology in production and distribution. Technology promised to enable
Aristocrat to do more with the resources it had, and in Philips mind, this was the key. He
emphasized to his staff that every dollar of Aristocrats assets must double its production in
sales to meet his targets over the next five years. In turn, these targets were externally generated benchmarks. They were based on where he saw the industry going over the next several
years.
To help focus production department personnel on the needed improvements in asset
efficiency, Philip had devised a series of nonfinancial performance measures. These measures
tracked Aristocrats progress in generating more sales from its assets. Specifically, Philip began by dividing standard lead time into three components: order time, manufacturing time,
and delivery time. Next, each of these major components was further divided into five to 10
major subcomponents. These nonfinancial performance measures were calculated daily and
posted prominently in the central operations area of the unit responsible for the measure.
Aristocrat employees took the measures very seriously and devoted considerable time and
attention to improving them because a growing portion of their pay and bonus was determined by an incentive compensation system tied to these performance measures.
After listening to Philips first proposal, Marsten was excited at how the projected boost
in profitability would help secure Aristocrats long-term industry position. At the same time,
experience had taught him that Philips enthusiasm for operational superiority could sometimes cloud his financial judgment.
In addition, Marsten had several questions to raise with Philip in their next meeting.
First, given what he estimated as a five-fold advantage in total cycle time enjoyed by Global,
why didnt Global have an even greater superiority relative to Aristocrat in generating sales
6
from their assets? Second, Marsten wondered about how well the efficiency focus of the new
production and distribution technology would coordinate with Aristocrats current market
niche at the top end of the furniture market. Likewise, would these changes be compatible
with Aristocrats unionized labor force, which was suspicious of change and not as technically sophisticated as that of other competitors such as Phoenix or Global? For example, Marsten
had seen demonstrations of automated production and distribution in one of Phoenixs production hubs, and he was struck by how small in number the labor force was and by how
individual production employees appeared very comfortable with a computerized production
and scheduling system. In contrast, Aristocrats production philosophy historically had been
built around a tradition of skilled woodworking with important reliance even today on hand
craftsmanship. Finally, would this investment in new technology make Aristocrat more attractive to a buyer if Marsten decided to sell the firm at some point after making the investment?
earnings per share would have been an average of 40% less, producing a proportional drop in
our stock price.
As the discussion moved into specific details, Marsten was further impressed at Blakelys
ability to provide a careful, objective reconstruction of what losing CD would have done to
the firm. For example, Blakely described how the age of CDs production facility actually
worked to Aristocrats advantage. Much of the plant and equipment was already fully depreciated, and the remainder was close to it, with the result that Aristocrat enjoyed a significant
cost advantage via the lower overhead that resulted. Marsten himself had recognized that CD
was still profitable, although at a diminished level, but he had apparently underestimated
how much CD contributed to the firms overall financial health.
When Marsten met again with Philip the next day to review Blakelys case for keeping
CD, the primary result was confusion, at least for Marsten. Philip rejected Blakelys entire
analysis, saying that it couldnt be more incorrect. In place of Blakelys careful spreadsheets
that Marsten could follow easily, Philip proposed what he called an EVA perspective. Based
on the EVA perspective, Philip concluded that operating CD was destroying value for Aristocrat, despite being profitable. The EVA concept was new to Marsten, and he felt himself beginning to agree with Blakelys suggestion that Philip might have some ulterior motive for trying
to persuade Marsten to part with what was obviously a very big part of Aristocrats success.
Philip attempted to explain that EVA stood for economic value added and that it measured
how much value a company created or destroyed in a given year. To do so, it charged the firm
a certain cost of capital for all employed capital. Either value was created by generating returns beyond the cost of capital, or value was destroyed if the firms returns failed to cover the
cost of capital. Marsten had difficulty appreciating what EVA added to the usual accounting
measure of a firms profit.
been office furniture, so the merged companies would have two distinct customer bases. Furthermore, their product lines and production processes were different enough that they did
not expect to be able to consolidate operations quickly. Like Aristocrat, Phoenix was struggling with the changing merchandising trends in the industry. Even with the acquisition of
Aristocrat, they would lack the buying power of Global, and short-term marketing or distribution synergies appeared to be limited. Also because Phoenix ran like Aristocrat, they had a
thin management structure and, at least in the short term, would have to rely on Marstens
and Emilys expertise and contacts.
Adjustment Issues
Marstens compensation. Marsten Richardsons compensation package exceeds market rate.
A human resources experts research indicated that the total cost of market-rate compensation paid to an arms-length CEO of a furniture manufacturer the size of Aristocrat over the
past five years would have provided the following savings, inclusive of payroll-related burdens: 19H1 and 19H2, $500,000; 19H3, $400,000; 19H4 and 19H5, $480,000.
Blakelys and Dudleys VP compensation. The compensation paid to these two related parties is more than market, given their level of competence. A likely buyer would have them
report to its executive staff with the expectation that either they would upgrade their performance or be replaced. These positions are necessary, and the market cost of the positions will
be similar to what these two insiders are paid.
Litigation expenses (nonrecurring). The company has been spending considerable amounts
over the past several years in efforts to stop what it considers to be patent infringements by
Global Furniture, Inc. Marsten has indicated a decision was made at the end of last year to
stop this litigation to avoid the ongoing costs. This situation may be revisited in the event
Aristocrat is not sold. Over the past five years these expenses have been as follows: 19H2,
$56,000; 19H4, $224,000; and 19H5, $610,000; in the other two years there were none.
Facilities. The building and land are leased on an arms-length basis at a market rate. The
current lease term has two years to go, and there are four five-year options. All options have
stipulated terms and conditions, which are reasonable in light of market conditions.
Land (nonoperating). The $4 million-valued nonoperating land has been rented out for the
following rents: 19H5, $120,000; 19H4 and 19H3, $110,000; 19H2, $95,000; and 19H1, $75,000.
The above rates, which total 19.6%, reflect the average market return, adjusted for size.
That is, in the long term, small, publicly traded stock has generated a return of 19.6% on
average. In addition, factors specific to the subject company that make it more risky must be
considered. If the subject company appears to have greater risk than the typical small, publicly traded company, the discount rate should be increased accordingly. Assume that an additional specific risk adjustment factor for Aristocrat is 7.0%.
10
Taxes
Assume that Aristocrats combined federal and state corporate tax rate is 40%.
Growth Factors
Marsten Richardson expects that Aristocrat, if it continues without being sold, can achieve
a 4% growth rate, roughly equal to inflation. Given the industrys excess capacity, this expectation is consistent with the industry forecasts for the near to intermediate term. It is reasonably consistent with Aristocrats performance over the past five years, during which it has
achieved a slightly higher growth rate. This growth rate may become harder to maintain
given the competitive challenges previously detailed and the fact that Marsten is getting tired
and has health concerns. Aristocrats lack of a management succession plan adds to doubts
about the companys growth potential.
Case Requirements
Performance Measurement and Business Decisions
1. Evaluate Philips proposal for Aristocrat to invest heavily in technology. In your analysis, you can assume that the operational improvements that Philip envisions are technically
feasible. That is, the proposed investments will be able to generate the improvements in the
operational measures that Philip emphasizes. However, is this necessarily sufficient to make
the investment worthwhile? Pay particular attention to what Aristocrat is likely to be able to
achieve from these operational improvements. Are they likely to be able to turn the improvements in nonfinancial performance measures into correspondingly positive financial results?
2. Evaluate Philips proposal to sell the Custom Cabinetry Division. What do you think
of Blakelys arguments that such a sale would have crippling effects not only on the firms
profitability but also on its prestige? What is the argument that Philip is apparently making,
based on an EVA perspective, to suggest that Blakelys conclusions are fundamentally flawed?
Business Valuation
3. Surveys in the middle and latter part of the 1990s have indicated that business valuation is considered among the most important and fastest growing areas of public accounting
practice. Increasingly, the profession recognizes the need for management and owners of
closely held companies to monitor shareholder value and manage the company to maximize
this value. This should be done whether the company is preparing for a sale or simply to
enhance value on an ongoing basis.
Before management can evaluate acquisition offers made by potential buyers, they must
first clearly understand the shareholders present position. That is, management must first
determine the companys fair market value on a stand-alone basis before it can properly evaluate
its investment value to one or more strategic buyers. This case presents computation of fair
market value as the beginning of this process.
The income approach to business valuation is based on the theory that the value of a
company can be determined by computing the present value of the future returns of that
business discounted at a rate of return that reflects the riskiness of the business. While this
theory is both simple and convincing, its application is far more complex. The appraiser must
first derive the rate of return, which begins with the estimate of a discount rate, usually for the
next periods net cash flow for equity. This rate can then be applied in a multiperiod discounting method. Alternatively, a single period capitalization method can be employed, which
11
involves converting a discount rate to a cap (capitalization) rate. The benefit or return stream
employed can be other than net cash flow. When a different return stream is used, as illustrated in this case, which uses net income to invested capital, the rate of return must be adjusted accordingly. The appraiser most often determines either the value of the equity of the
business or the value of the invested capital, which is commonly defined as the interestbearing debt and equity. In the merger and acquisition setting, buyers and sellers are usually
interested in determining the value of the entire enterprise because this is the investment
usually sold. This quantity is referred to as invested capital. Because invested capital includes both interest-bearing debt and equity, the corresponding return measure is the firms
weighted average cost of capital.
This portion of the case is intended to illustrate the valuation process.
Estimate the value of a 100% controlling interest in Aristocrat on a stand-alone basis, i.e.,
its fair market value without consideration of any possible synergies. Likewise, for this part of the
case, use only the original historical financial statement data, i.e., do not consider the outcome of the
proposals made by Philip Dhurt. Using the single period capitalization method and net income
to invested capital, first develop your estimate of the value of the invested capital of Aristocrat and then convert this estimate to a value for equity.
4. After having developed your answer to the previous question, answer the following
discussion questions:
General Management
5. Discuss how the management succession issues facing Aristocrat are likely to influence, first, Marstens response to the two specific proposals addressed in questions 1 and 2
above and, second, the value of Aristocrat, which is the focus of questions 3 and 4 above. How
should Marsten handle the succession issue?
6. Should Marstens decision with respect to the two proposals in questions 1 and 2
depend on his decisions with respect to whether to sell the company? If so, in what ways?
12
13
2.15
4.56
8.35
5.83
2.33
1.11
0.07
0.08
0.22
1.22
11.4%
4.6%
6.9%
15.4%
-4.0%
7,304
(1,891)
5,413
2,165
3,248
100.0%
63.0%
37.0%
22.0%
15.0%
0.4%
47,280
29,786
17,494
10,402
7,092
212
FINANCIAL RATIOSUNADJUSTED
taxes (EBT)
Income taxes
Net income
Sales
Cost of sales
Gross profit
Operating expenses
Operating income
Other income (expense)
Earnings before interest
and taxes (EBIT)
Interest expense
Earnings before
19H1
5,842
2,337
3,505
7,844
(2,002)
54,681
34,996
19,685
12,030
7,655
189
19H2
2.19
4.81
7.51
6.53
2.70
1.24
0.06
0.08
0.22
1.14
10.7%
4.3%
6.4%
14.3%
-3.7%
100.0%
64.0%
36.0%
22.0%
14.0%
0.3%
6,412
2,565
3,847
8,546
(2,134)
61,524
39,991
21,533
13,228
8,305
241
19H3
ACTUAL
Exhibit 1-1
2.03
5.78
7.56
4.87
2.80
1.34
0.06
0.08
0.23
1.10
10.4%
4.2%
6.3%
13.9%
-3.5%
100.0%
65.0%
35.0%
21.5%
13.5%
0.9%
2.38
4.28
5.87
3.76
2.94
1.27
0.07
0.09
0.26
1.33
7,780
3,112
4,668
9,766
(1,986)
67,983
44,189
23,794
14,276
9,518
248
19H4
11.4%
4.6%
6.9%
14.4%
-2.9%
100.0%
65.0%
35.0%
21.0%
14.0%
0.4%
2.26
4.80
6.34
3.62
3.20
1.38
0.06
0.09
0.27
1.31
11.10
9.40
7,759
3,103
4,655
9,631
(1,872)
72,035
48,263
23,772
14,407
9,365
266
19H5
10.8%
4.3%
6.5%
13.4%
-2.6%
100.0%
67.0%
33.0%
20.0%
13.0%
0.4%
14
30,560
15,100
42,610
(800)
Total equity
Treasury stock
11,100
4,800
Common stock
Retained earnings
27,510
Total liabilities
9,020
3,060
Accrued payables
Long-term debt
5,960
Accounts payable
2,900
42,610
Total assets
20,330
Other assets
(10,230)
Fixed assets
3,460
19,380
5,110
Inventory
5,660
Accounts receivable
5,150
End of
Year H1
ACTUAL
Exhibit 1-2
100.0%
35.4%
-1.9%
26.1%
11.3%
64.6%
43.4%
21.2%
7.2%
14.0%
100.0%
6.8%
47.7%
-24.0%
71.7%
45.5%
8.1%
12.0%
13.3%
12.1%
44,070
16,100
(800)
12,100
4,800
27,970
18,430
9,540
3,090
6,450
44,070
2,900
20,270
(11,960)
32,230
20,900
2,950
5,360
7,280
5,310
End of
Year H2
100.0%
36.5%
-1.8%
27.5%
10.9%
63.5%
41.8%
21.6%
7.0%
14.6%
100.0%
6.6%
46.0%
-27.1%
73.1%
47.4%
6.7%
12.2%
16.5%
12.0%
45,830
16,860
(800)
12,860
4,800
28,970
18,630
10,340
3,460
6,880
45,830
2,900
21,940
(13,710)
35,650
20,990
2,800
8,220
8,140
1,830
End of
Year H3
100.0%
36.8%
-1.7%
28.1%
10.5%
63.2%
40.7%
22.6%
7.5%
15.0%
100.0%
6.3%
47.9%
-29.9%
77.8%
45.8%
6.1%
17.9%
17.8%
4.0%
53,410
17,970
(800)
13,970
4,800
35,440
23,930
11,510
3,640
7,870
53,410
2,900
23,100
(14,690)
37,790
27,410
3,010
11,750
11,590
1,060
End of
Year H4
100.0%
33.6%
-1.5%
26.2%
9.0%
66.4%
44.8%
21.6%
6.8%
14.7%
100.0%
5.4%
43.3%
-27.5%
70.8%
51.3%
5.6%
22.0%
21.7%
2.0%
52,320
17,510
(800)
13,510
4,800
34,810
22,910
11,900
3,760
8,140
52,320
2,900
22,520
(15,120)
37,640
26,900
2,080
13,320
11,360
140
End of
Year H5
100.0%
33.5%
-1.5%
25.8%
9.2%
66.5%
43.8%
22.7%
7.2%
15.6%
100.0%
5.5%
43.0%
-28.9%
71.9%
51.4%
4.0%
25.5%
21.7%
0.3%
Case 2
The spin-off of Ciba Specialty Chemicals is already energizing the organization, encouraging entrepreneurial behavior and increasing our competitiveness. We believe that we are
creating optimal conditions for sustained success.
Dr. Rolf A. Meyer, Chairman
On March 6, 1996, Ciba-Geigy and Sandoz announced a surprise merger that created the worlds
second-largest life sciences conglomerate, Novartis. With SFr36 billion in sales and SFr100 billion
($83 billion) in market value, this was the worlds biggest merger. To many employees of Cibas
industrial sector, the announcement came as a shock. Ciba-Geigy had underperformed the Swiss
stock market for several years. But since the company was considered conservative, nobody expected a move as drastic as a merger with archrival Sandoz.
In the months after the merger, initial disbelief gradually gave way to cautious optimism. In
the largest corporate spin-off ever, Cibas industrial sector would become an independent company, with annual sales of SFr6.7 billion. The new company would focus on the specialty chemicals market, its core business; Novartis would be a pure life sciences company. For Ciba Specialty Chemicals people, the prospects of an independent company were a source of anxiety and
motivation.
In 1997, with Ciba SC completely on its own, chairman Dr. Rolf Meyer and CEO Dr. Hermann
Vodicka faced both opportunities and challenges. After the spin-off from Novartis, Ciba SC was
left with a strong product portfolio and an excellent market position but, historically, a mediocre
financial performance. Ciba SCs 7.5% operating profit margin fell way short of the 15% industry
benchmark, and only two of the five divisions earned their cost of capital. The SFr8 billion market
value of the new company (right after the spin-off) could be justified only by a major restructuring, cost cutting, and aggressive growth to regain market share lost through past inappropriate
strategies. Completely new structures had to be put in place, and the company needed to position
itself in the market. Still, on the up side, Ciba employees were energetic, proud, and motivated.
15
Ciba Specialty Chemicals is organized into five divisions. Two of them are turnaround businesses. Each division is a global market leader in its chosen field. However, although the divisions have superior products and very high market shares, their financial performance has been
weaker than that of their competitors. (See Exhibit 2-1 for details of the strategy and competitive
position of the divisions.)
The divisions were:
Additives. This was the most successful of Ciba's divisions, bringing in about 50% of the
contribution. The key challenge was to defend its margins and its strong market position.
Pigments. With the exception of 1996, this division also performed very well.
Performance Polymers. After a problem year in 1991, restructuring had improved the situation. The turnaround was almost achieved, and the division was now a strong performer
whose main challenge was to maintain growth and further improve performance.
Consumer Care and Textile Dyes. After difficult years in 199395, the turnaround of these
divisions was well underway.
Mr. Franz Gerny, head of Human Resources, saw these challenges for the people:
We want to keep the good aspects of old Ciba. However, in certain areas we must be tougher.
People who dont deliver and who dont get results do not belong in the new company.
16
In the past, we didnt walk the talk. We didnt react quick enough, when younger people
where looking for more challenge. Now we need to learn to fight hardernot to find excuses for not reaching an objective.
Financial
engineering
Disposals
and
acquisitions
Strategic and
operating
opportunities
Perception
gap
Optimal
restructured
value
Potential value
with internal
and external
improvements
Potential value
with internal
improvements
Company value
as is
Current
market value
Source: Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 2nd
ed., New York: John Wiley & Sons, Inc., 1996.
This was not enough, however, to sway the investors. Ciba still underperformed the market.
And shareholders still perceived the business portfolio as too broad and the company as unfocused. The market clearly preferred focused businesses, and Sandoz had been rewarded for its
decision to spin off Clariant, their specialty chemicals business, in 1995. Before the merger with
Sandoz, the estimated shareholder value benefits from breaking up the business portfolio and
managing the units as separate, focused businesses were estimated at several billion Swiss francs.
The decision to spin off the specialty chemicals business had already been made before the merger.
(See Exhibit 2-2 for stock market reactions to the merger.)
A company is creating shareholder value if its after-tax operating return is higher than its cost of capital. A number
of investment banks estimated Cibas WACC (weighted average cost of capital) to be approximately 7% (see Exhibit 2-1 for examples).
17
After the merger and subsequent spin-off, Ciba Specialty Chemicals was expected to create
additional shareholder value by streamlining operations and by gaining focus due to managing a
homogeneous business. Geographic expansion and new product development would bring the
newly focused business faster and more profitable growth. Now, after the divorce, Ciba was in
the unique position of being able to start with a clean slate, in effect, to create from scratch the
optimal structures and conditions for success.
Like old Ciba, the new organization had five divisions. The old organization had been functional, with partly centralized R&D and purchasing and shared manufacturing, but now the divisions were fully accountable for strategy, R&D, marketing, and the whole supply chain, including purchasing. Moving Ciba away from their old product management focus, the new structure
created fully integrated, segmented business units (see Figure 2-2 and Exhibit 2-3).
Pigments
Performance
Polymers
Consumer
Care
Textile
Dyes
16 Geographic Regions
Shared services
Research Board
Customer Value Board
(Key account management)
Manufacturing council
The business support functions also went through a major change, based on an efficient
shared services concept. The country organizations, with 72 country heads, were replaced by
16 regional presidents. Group services would be provided from 14 regional business support
centers. Costly duplications in finance, IT, HR, and administration were avoided. In IT, for example, 25 people now performed a broader array of tasks than 170 people had before. Common
accounting and the introduction of shared computer systems supported the structure.
The objective of the new organization was simple: a clear distribution of tasks, driven by
efficiency, while maintaining the local know-how. Dr. Jacobi commented:
18
We want to avoid unproductive discussions about who does what and who pays. The old
planning and reporting process was very complex. We spent lots of energy fighting internal
cost allocations. For example, one-third of our mainframe capacity was used for calculating
internal charges. On the other hand, there was also too much duplication in execution. Our
new structure is based on very standardized systems, clear interfaces, but, most importantly, on a clear definition of responsibilities and execution tasks.
We simplified the structure because we just could not afford the old structurethis type of
change was long overdue, and the reaction was very positive. But we had the right people,
and we were able to make the most of the situation.
now on, future business drivers would be excellent products plus all the things that contributed
to customer value (see Exhibit 2-4).
During its long history, the Ciba brand name had established a very strong position in the
market. As one customer remarked, I perceive Ciba to mean high quality and outstanding service. Another said, Ciba is a label, and we trust this label because we know what the Ciba
quality is worth. Thats very important. The strength of the bond Ciba had established with its
main customers showed that the Ciba brand had considerable brand value that would translate
into shareholder value. So the Ciba name was kept. But to differentiate Ciba from other companies and to express the strengths and values of the new company, a new visual identity was
conceiveda butterfly (see Exhibit 2-5).
Cibas positioning was very well received among customers, investors, and employees.
Brendan Cummins said:
For the first time, we have a name, a vision, and clear systems aligned to support the business strategy. The new mission is focused, punchy, and conveys a specific message. It will
be THE driving force of the culture of the new company.
It was a tremendous boost to morale when we found out that we could retain the name of
Ciba. Most employees felt that Ciba stood for something. This was especially the case in
China, where we had a strong brand name and more than 100 years of tradition. And the
butterfly met with unexpected positive response from the customers. Everyone is visually
impacted by the new symbol. For our employees, it is indicative of the new cultureit is
light and quick.
Financial Incentives
To link management with shareholder interest, Ciba came up with an innovative compensation package. The base salary was set at or below the average market level. In certain cases, this
resulted in a lower fixed salary for some managers. A short-term incentive plan for the top 700
people moved the total compensation to the upper 25 industry percentile if certain shareholderoriented targets such as sales growth and operating profits were met. The executive committee
and board members had to join a leveraged executive asset program (LEAP). They had to make a
commitment to invest one years salary in Ciba stock and hold on to it for at least five years. Stock
options provided upside leverage if the share price increased, but any downside risk was assumed by the individual. The share plan was offered on a voluntary basis, and with a smaller
amount, to an additional top 250 executives, of whom 99% subscribed to the plan. In addition, to
motivate the workforce, each of the 20,000 people working for the company received one free
virtual share.
20
The future drivers of value were expected to come from end-user applications developed
closely with customers. Technical customer services and consultative selling were going to be
critical to understanding the end users needs. The globalization of the customers was going to
require focused account teams, wide geographic reach, and a wide range of products. With product life cycles getting increasingly shorter, time to market was now critical. Ciba SC needed to
move from a tradition of sequential product innovation to a concurrent, but financially more
risky, product development process.
Consumer Care was reorganized into business segments with responsibility for product and
production-related strategies and assets, including R&D, production, marketing, supply chain
management, and four business areas responsible for sales. This reorganization provided new
focus and a new identity by breaking out of traditional markets and segments.
All we did was to open up space and provide a window of opportunity by moving the
necessary resources to the point where people are accountable. The energy was already
there, and we just had to release it.
The restructuring of the mature and very fragmented Textile Dyes business had already
started with the appointment of Dr. Jean-Luc Schwitzgubel as division head in 1995. The basic
problems were an obsolete, reactive business structure that wasnt driving the business forward,
too many products, underutilized capacities, and a lack of momentum due to market share losses.
Most management practice is based on cost control. It is true that we cannot be in business
if we dont have the right cost structure. However, we lost SFr300 million in sales between
199395, and there is no way we could reduce cost that fast. Instead, we need to focus on
growth and new business development. Everything is driven by revenue.
The old Ciba, with its pharma mentality, had always followed a premium pricing strategy.
But although Textile Dyes products and technical service were excellent, customers were no
longer willing to pay a premium. Costs were too high, and asset utilization was too low. A certain
technical arrogance had ensued from the companys being in a leading market position so long.
In addition to the necessary cost cutting, the new organization unleashed the sales people and
created a clear focus on selected core segments. Prices were reduced to reflect a competitive,
value-based pricing strategy, and a major product development program was initiated. As a result, 60 new products had been introduced in the last 12 months, while unattractive product lines
had been eliminated.
The Future
On June 10, 1997, Ciba SCs stock price reached SFr140. The share price reflected shareholders
expectations of significantly higher future profits (see Exhibit 2-6). To live up to these expectations, Ciba had to grapple with a number of challenges.
21
First, above-average growth would not be achieved with a traditional product management
approach. Ciba wanted to enter the market segments where research mattered, which meant
becoming much more focused on innovation. To be on the leading edge, one must either be faster
than competitors or develop more patents. According to CEO Dr. Hermann Vodicka, a key challenge was to manage the product portfolio effectively in a constantly changing environment.
Second, the industry was expected to undergo major changes. As a supplier to many companies that ultimately created and marketed branded consumer products, Ciba SCs business was
affected by consumer trends. Consumers expected increasingly higher quality at lower prices. At
the same time, the global retailers were becoming increasingly powerful. Cibas major clients, the
consumer goods producers, were putting increasing pressure on their suppliers to deliver value.
As an alternative to a protection approach (i.e., patents), Ciba could respond by co-branding.
Ciba already had limited branding experience with its Araldite products. Several other products,
such as the UV protection fabric finish, had very high potential for being branded. However,
retailers generally disliked too many labels, and Ciba had neither the experience nor the advertising budgets to support a major brand.
The third challenge was that the battle was likely to move into emerging markets, such as
Asia, that had an altogether different cost structure and philosophy. Ciba had already moved
some activities, such as formulation, to these markets.2 However, with the customer base becoming ever more global, both opportunities and risks were looming.
Ciba Specialty Chemicals intended to address these challenges within the shareholder value
framework. The balance sheet was strong, and the spirit was high. Meanwhile, the stock price
kept rising, and expectations in the capital markets kept going up.
22
Formulation is the step after the chemical synthesis where customer-specific products are created.
Akzo Nobel
Mitsubishi
Chemicals
Imperial
Chem.
RhnePoulenc
Dow
Bayer
BASF
Hoechst
Du Pont
Source: The Fortune Global 5 Hundred Ranked Within Industries, Fortune, August 4, 1997, p. F-16.
DSM
Morton
Hercules
Great Lakes
Dow
Corning
Eastman
Chemicals
W.R. Grace
Solutia
(Monsanto)
Rohm Haas
Dainippon
Bayer
Akzo Nobel
BASF
Ciba SC
ClariantHoechst
0.00
Chart includes specialty chemicals sales only. Clariant and Hoechst merged their operations
in 1997.
Source: Kerri A. Walsh and Andrew Wood, Specialties New Lineup, Chemical Week, April 30, 1997, pp. 3748.
23
24
merger
announced
1700
1500
Ciba bearer
Sandoz bearer
1300
Novartis bearer
Index
1100
900
700
4/97
1/97
10/96
7/96
4/96
1/96
10/95
7/95
4/95
1/95
500
Start of
premarketing
2100
Price range
announced
Shareholder
value
2000
1900
CSC+Novartis
Novartis
1800
Index
1700
1600
First day of
rights trading
1500
26.5.97
30.4.97
1.4.97
28.2.97
31.1.97
3.1.97
1400
25
Divisions:
strategy
marketing
production
R&D
purchasing
supply chain
management
communication
Regions:
sales
communication
representation
information
technology
finance
legal structures
safety
environment
Corporate:
global portfolio
strategy
acquisitions
treasury
communication
safety
environment
legal services
Old structure
New structure
divisions
divisions
geographic countries
geographic regions
corporate services
One company
One team
One chance
grown structure
clear focus on product management
slowness
26
Respect
the
environment
Embrace change as a
source of new
opportunities
Innovative,
entrepreneurial and
action-oriented
Deliver
value beyond chemistry
to
maximize valuation
Committed to
customers and
operational
excellence
Excel in competence
and performance
Our Direction:
We have a strong global operational basis with target-oriented initiatives in place and a high level
of customer orientation.
We have a worldwide network of excellent, motivated people and management whose compensation is linked to target achievement.
We will continuously measure progress against the best in class and improve our business.
While we are determined to reduce our asset base and cost structures, we will outgrow our markets with innovative products geared to create value for our customers.
All divisions have committed to outperform their competitors.
Source: Ciba company documents.
27
28
29
Exhibit 2-6.
A. Historical Financial
Total
1991
1,980
1,269
1,301
945
1,421
6,916
1992
2,066
1,297
1,303
1,046
1,423
7,135
1993
1994
1995
1996
First half,
1997
2,097
1,295
1,245
1,074
1,419
7,130
2,222
1,216
1,238
1,091
1,316
7,083
2,067
1,081
1,239
1,026
1,083
6,496
2,065
1,108
1,322
1,073
1,173
6,741
1,184
590
797
657
729
3,957
376
155
54
158
103
(358)
488
453
110
74
188
3
(265)
563
438
28
135
186
(36)
(252)
499
346
50
75
122
40
(132)
501
194
63
91
107
73
(51)
477
Total
Net oper. assets
Additives
Consumer Care
Perf. polymers
Pigments
Textile Dyes
Shared op. assets
Total op. assets
Non-operating assets
Total assets
2,274
1,377
1,265
1,189
1,918
805
8,828
1,244
10,072
2,141
1,286
1,215
1,182
1,736
772
8,332
1,283
9,615
2,072
1,197
1,147
1,227
1,570
874
8,087
1,284
9,371
ND
ND
ND
ND
ND
ND
ND
ND
ND
2,345
1,139
1,460
1,518
1,619
744
8,825
1,393
10,218
115
73
89
65
95
59
496
110
78
53
53
91
28
413
108
87
61
55
80
7
398
118
71
52
60
71
12
384
60
32
27
26
35
53
233
169
75
67
87
120
38
556
124
72
69
74
78
51
468
126
69
60
111
68
28
462
144
62
95
166
71
21
559
47
22
37
67
31
16
220
4,254
3,813
2,811
2,838
5,519
4,684
23,919
4,366
3,997
2,893
2,896
4,954
4,799
23,905
4,379
3,886
2,933
2,959
4,586
4,589
23,332
ND
ND
ND
ND
ND
ND
ND
ND
ND
ND
ND
ND
ND
ND
87
42
64
34
48
26
301
94
47
63
37
46
28
315
99
45
59
41
43
26
313
111
37
56
44
49
28
325
ND
ND
ND
ND
ND
ND
ND
Depreciation (amortization)
Additives
Consumer Care
Perf. polymers
Pigments
Textile Dyes
Non-divisional
Total
Capital expenditure
Additives
Consumer Care
Perf. polymers
Pigments
Textile Dyes
Non-divisional
Total
Personnel
Additives
Consumer Care
Perf. polymers
Pigments
Textile Dyes
Corporate
Total
R&D expenditure
Additives
Consumer Care
Perf. polymers
Pigments
Textile Dyes
Corporate
Total
ND = not disclosed
30
1994
2,333
214
103
2,441
959
Clariant
1995
2,145
211
106
2,406
923
1996
2,337
235
133
2,774
1,115
1994
7,083
563
352
9,615
5,041
Ciba SC
1995
6,496
499
305
9,371
4,886
1996
6,741
501
311
10,023
4,389
Personnel
8,678
8,410
8,554
23,905
23,332
ND
Sales growth
Gross profit %
Operating profit %
Sales/Assets
ROE
Mkt costs (% of sales)
Admin (% of sales)
R&D (% of sales)
Labor (% of sales)
Capex (% of sales)
Working capital (% of sales)
- inventory (days)
- accounts receivable (days)
- accounts payable (days)
-5.0%
37.9%
9.2%
0.96
10.7%
20.3%
5.7%
3.2%
24.9%
5.1%
42.5%
177
73
51
-8.1%
39.0%
9.8%
0.89
11.5%
20.1%
5.9%
3.2%
24.5%
4.2%
49.6%
188
74
45
9.0%
37.9%
10.1%
0.84
11.9%
19.2%
5.9%
2.7%
23.3%
4.2%
49.5%
164
86
45
-0.7%
37.1%
7.9%
0.74
7.0%
10.5%
14.2%
4.4%
27.3%
5.8%
35.9%
155
63
107
-8.3%
36.6%
7.7%
0.69
6.2%
10.8%
13.3%
4.8%
29.9%
6.8%
39.6%
180
63
114
3.8%
36.4%
7.4%
0.67
7.1%
10.9%
13.3%
4.8%
ND
8.0%
45.9%
177
73
140
26.50
231
346/396
33.25
279
367/586
4.87
70
NA
4.22
68
NA
4.38
61
NA
General benchmarks:
Gross margin
Operating profit (%, 1995)
Working capital (% of sales)
- inventory (days)
- accounts receivable (days)
- accounts payable (days)
Sales/Assets
ROE
Clariant-Hoechst merger:
Sales
EBITDA
EBIT
Capex
US Specialty European
Chemicals chemicals
13.4%
Clariant
(1996)
2,337
371
235
98
10.8%
Best
Croda
practice
chemicals Akzo Nobel
(UK)
(Holland) benchmark
40%
18%
39%
15%
8.7%
9.1%
18.0%
29.7%
66
99
48
53
46
54
1.09
1.16
1.20
33%
20%
Hoechst
(1996)
6,565
844
490
425
31
1996
1997
340
202
535
300
Estimated annual savings are SFr80 million in 1997 and SFr150 million annually thereafter. Clariants
cost-reduction target is SFr180 million annually within three years.
Capital Expenditure: Ciba SCs target capital expenditure is 6% of sales.
Investment Expenditure: In 19972000, Ciba SC intends to invest SFr600650 million in major
investments. The expected breakdown is:
Additives
Pigments
Performance Polymers
Textile Dyes and Consumer Care
50 %
25 %
15 %
10 %
Asia
Europe
USA
Switzerland
30 %
25 %
25 %
20 %
130
Ciba SC
120
110
32
29.5.97
30.4.97
1.4.97
28.2.97
100
Case 3
According to the National Opinion Research Center at the University of Chicago, 78% of
boomers (aged 3351) own their own home, 45% are satisfied with their financial situation, 67%
have not been hospitalized in the past five years, 73% are married, and 69% of their households
have two wage earners. By the year 2000, boomers are expected to have an estimated $1 trillion to
spend. By 2010, the United States will be home to 53 million people 55 and older, with eight states
expected to double their elderly population: Alaska, Arizona, California, Colorado, Georgia, Nevada, Utah, and Washington. Seniors respond to benefit-driven messages; to attract them, advertising has to communicate tangible benefits rather than features and amenities.
33
hurricane season, flooding, and even droughts have had negative effects on the sales and rentals of
travel trailers), Letsgos management believes these problems will be mitigated in the future by
global warming. All sales projections are done by Mark Newman in his role as Letsgos president.
To keep from losing sales, the company maintains finished goods inventory on hand at the
end of each month equal to 300 trailers plus 20% of the next months sales. The finished goods
inventory on December 31, 1997, was budgeted to be 1,000 trailers. Jim West, Letsgos vice president of marketing and sales, would rather see a minimum finished goods inventory of no less
than 1,500 trailers. Jim refuses to talk to Tom Sloan, Letsgos production manager. Tom is always
trying to get Jim to consider adopting flexible inventory levels, which Jim is certain would affect
his yearly bonus. The vice president of sales and marketing is eligible for a 20% bonus based on
sales. Unfortunately, Jim did not receive a bonus in 1997. Sales were up, but Mark refused to give
Jim the bonus, although it was earned, due to the high number of customer complaints. Jim was
really steamed when he heard no bonus. Didnt Mark know those complaints were for poor
quality? All of Jims efforts to grow sales and attract customers were, once again, destroyed by
Tom Sloan and his production failures.
Trailer Production
Sheet aluminum represents the companys single most expensive raw material. Each travel trailer
requires 30 square yards of sheet aluminum. The wholesale cost of sheet aluminum varies dramatically by time of year. The cost per square yard can vary from $13 in the spring, when new
construction tends to start, to $6 in December and January, when demand is lowest. In September
1997, the Department of Energy and the aluminum industry launched a collaboration to pursue
technologies to improve energy efficiency and production processes. This pact will increase global competitiveness and enhance the environmental performances of a key manufacturing sector
by applying advanced scientific know-how to day-to-day industry needs (Secretary of Energy
Hazel R. OLeary, September 1997). This collaboration will increase the aluminum industrys competitiveness and thus help businesses that rely on aluminum to reduce costs. Manufacturers requiring aluminum as a raw material potentially should be able to negotiate better purchase prices
from suppliers.
Aluminum promises to be the construction material of the future. The use of aluminum in
vehicles, including travel trailers, is increasing rapidly due to a heightened need for fuel-efficient,
environmentally friendly vehicles. Aluminum can provide a weight savings of up to 55% compared
to an equivalent steel structure, improving gas mileage significantly. The aluminum industry and
suppliers are dispersed across four-fifths of the country, yet they are largely concentrated in four
regions: the Pacific Northwest, industrial Midwest, northeastern seaboard, and mid-South. Although
this is a broad geographic presence, Letsgo Travel Trailers will be affected by distribution costs.
Vicky Draper, Letsgos vice president of purchasing and materials handling, is eager to implement just-in-time as a way of lowering Letsgos aluminum cost, to offset the expense of distributionLetsgo is located in Pennsylvania. Vickys projected 20% bonus, recently announced by
Mark and effective for year-end 1998, is based on her ability to lower total material cost. Initially
enthusiastic about her job and ability to earn a significant bonus, Vicky has become discouraged
and angry. She is unable to convince Letsgos current aluminum supplier to sign a prime vendor
contract, and her efforts to locate an alternative vendor willing to accept the conditions of a justin-time contract have similarly failed. She blames Tom Sloan. Letsgos current aluminum vendor
refuses to sign a just-in-time prime vendor contract due to Toms uneven production schedule
and his refusal to pay on time. Tom has been seen reading the help wanted ads, and Vicky overheard him talking to an employment agency.
34
In keeping with the policy set by Tom as Letsgos production manager, the amount of sheet
aluminum on hand at the end of each month must be equal to one-half of the following months
production needs for sheet aluminum. The raw materials inventory on December 31, 1997, was
budgeted to be 39,000 square yards. The company does not keep track of work-in-process inventories. Total budgeted merchandise purchases (of which the sheet aluminum is a significant part)
and budgeted expenses for wages, heat, light and power, equipment rental, equipment purchases,
depreciation, and selling and administrative for the first six months of 1998 are given below:
Merchandise purchases
Wages
Heat, light, & power
Equipment rental
Equipment purchases
Depreciation
Selling & admin.
Merchandise purchases
Wages
Heat, light, & power
Equipment rental
Equipment purchases
Depreciation
Selling & admin.
January
February
$870,000
624,000
130,000
390,000
300,000
250,000
400,000
$1,320,000
1,008,000
195,000
390,000
300,000
250,000
400,000
March
$1,110,000
1,104,000
220,000
390,000
300,000
250,000
400,000
April
May
June
$690,000
672,000
135,000
340,000
300,000
275,000
400,000
$420,000
432,000
110,000
340,000
300,000
275,000
400,000
$330,000
240,000
110,000
340,000
300,000
275,000
400,000
Merchandise purchases are paid in full during the month following purchase. Accounts
payable for merchandise purchases on December 31, 1997, which will be paid during January,
total $850,000.
Competition
All forms of vacation and leisure activities, including theme parks, beach or cabin rentals, health
spas, resorts, and cruise vacations compete with Letsgo Travel Trailers for the consumer dollar.
Other recreational purchases such as automobiles, snowmobiles, boats, and jet-skis are indirect
competitors.
Travel trailer manufacturers such as Rexhall Industries, Coachman Industries, Winnebago
Industries, Foremost Corporation of America, and Thor Sales Industries also offer a moderate-tolow-priced trailer. Manufacturers that offer more diverse product lines such as high-end trailers
with luxury accommodations could compete for the fairly affluent senior market.
Coachman Industries, a direct Letsgo competitor, has become a leader in the recreational vehicle, motor home, and travel trailer industry through a commitment to quality and value based on
excellence in engineering and attention to detail. Creative engineering, combined with high-accuracy analysis, reduced material costs at Coachman by more than 60% and labor costs by 78%.
Budget Preparation
To minimize company time lost on clerical work, Letsgos accounting department prepares and
distributes all budgets to the various departments every six months. Per Mark Newman, Freeing departmental managers from the budgeting process allows them to concentrate on more
pressing matters. In keeping with the recently announced bonus plan for the vice president of
35
purchasing and materials handling, Newman has instructed the accounting department to budget aluminum at $6 per square foot. The accounting manager recently received a 20% bonus for
having prepared the budgets on time with little or no help from the other functional areas.
Cash
Letsgos vice president of finance, Becky Newman, has requested a $800,000, 90-day loan from
the bank at a yet to be determined interest rate. Since Letsgo has experienced difficulty in paying
off its loans in the past, the loan officer at the bank has asked the company to prepare a cash
budget for the six months ending June 30, 1998, to support the requested loan amount. The cash
balance on January 1, 1998, is budgeted at $100,000 (the minimum cash balance required by Letsgos
board of directors).
Human Resources
To accomplish the companys corporate strategic goals, Letsgo Travel Trailers encourages upward communication among all its employees, from senior management to line employees. Decision making, although not an entirely democratic process, is based on a team approach. Newman,
as Letsgos president, encourages managers to think in terms of the marketplace and to look at
the business of travel trailers as a whole rather than as functional department successes and
decisions. In fact, Newman is so committed to the idea of cooperative management and teamwork that he has hired three separate human resource consultants in the past six months to lead
the companys managers through team-building exercises.
Required
1. Discuss the validity and reasonableness of Letsgos sales projections.
2. Prepare production, purchasing, and cash budgets for Letsgo for the first six months of
1998 using the following formats (hint: spreadsheet programs are wonderful!):
Production Budget
Budgeted sales
Add: desired ending inventory
Total needs
Less: beginning inventory
Trailer production
Jan
Feb
____
____
Six
Months
March
April
May
June
____
____
____
____
____
____
____
____
____
____
____
____
Purchases Budget
Jan
Trailer production
Sheet metal needs per trailer
Total production needs
Add: desired ending inventory
Total material needs
Less: beginning inventory
Total sheet metal purchases
Cost per square yard
Total cost
36
Feb
March
April
May
June
Six
Months
_____ _____
_____
_____
_____
_____
____
_____ _____
_____
_____
_____
_____
____
_____ _____
_____
_____
_____
_____
____
$____
$
$____ $____
$
$
$____
$
$____
$
$____
$
$____
$
Cash Budget
Jan
$____
Feb
$____
March
$____
April
$____
May
$____
June
$____
Six
Months
$____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
____
Discuss the advantages and disadvantages of the budgets you have prepared. Whom in the
company does the budget help and whom, potentially, does it hurt. Does the budget help or hurt
the sales department? What about production and finance? How are the various functional areas
affected and why?
3. Andy Baxter, newly hired by Letsgo from a competitor, suggests preparing the production budget assuming stable production. Prepare a second and third set of production, purchasing, and cash budgets with production held to a constant 3,000 trailers per month for the second
set of budgets and 3,500 trailers per month for the third set of budgets, using the following approach for the production budget (the purchasing and cash budget format remain as presented in
question 2):
Production (trailers)
Add: beginning inventory
Total available
Less: budgeted sales
Ending inventory
Jan
Feb
March
April
May
June
Six
Months
3,000
____
3,000
____
3,000
____
3,000
____
3,000
____
3,000
____
18,000
____
____
____
____
____
____
____
____
Discuss the advantages and disadvantages of the second and third sets of production, purchasing, and cash budgets you have prepared. Whom in the company do these budgets help and
whom, potentially, do they hurt? Do these budgets help or hurt the sales department? What
about production and finance? How are the various functional areas affected, and why?
4. What should Letsgo use to measure performance for each of the managers in the case?
What bonus system would you suggest that incorporates these measures and also encourages
the managers to work as a team?
37
1992
13,765
1993
14,880
1994
15,991
1995
17,809
1996
19,634
Projected sales
1998
28,000
1999
33,600
2000
40,320
2001
48,384
2002
58,060
1997
23,322
The detail sales for 1997 (actual) and 1998 (projected) by month are as follows:
January
February
March
April
May
June
July
August
September
October
November
December
Total number of trailers
1997
Actual
1998
Projected
1,983
3,218
3,981
3,240
1,755
901
763
611
1,622
1,678
1,439
2,131
23,322
2,500
4,000
5,000
3,000
2,000
1,000
1,000
1,000
2,000
2,000
2,000
2,500
28,000
Actual sales in dollars for the last two months of 1997 and budgeted sales for the first six
months of 1998 follow:
November 1997 (actual)
December 1997 (actual)
January 1998 (budgeted)
February 1998 (budgeted)
March 1998 (budgeted)
April 1998 (budgeted)
May 1998 (budgeted)
June 1998 (budgeted)
$1,439,000
2,131,000
2,500,000
4,000,000
5,000,000
3,000,000
2,200,000
1,100,000
Past experience shows that 25% of a months sales are collected in the month of sale, 10% in
the month following the sale, and 60% in the second month following the sale. The remainder is
uncollectible.
38
Case 4
Ive been hearing a lot lately about something called MVA, which stands for market value
added, and I was curious whether it is something we can use at OSI, Keith Martin said. Keith
is president and CEO of OutSource, Inc. His guest for lunch that day was a computer industry
analyst from a local brokerage firm. Keith had invited him to lunch so he could get more
information on MVA and its uses.
Yes, the analyst replied, Ive heard a great deal about EVA and MVA. EVA is a residual income approach in which a firms net operating profit after taxescalled NOPATis
compared to a minimum level of return a firm must earn on the total amount of capital placed
at its disposal. MVA represents the difference between the market and book value of a company over a period of time.
Have you seen the most recent issue of Fortune? he continued, handing Keith a copy.
It has an article1 in it updating Stern Stewarts list of the top 1,000 firms ranked by MVA. You
will also be interested in an earlier Fortune article2 on EVA, or economic value added. EVA is
closely related to MVA. However, dont be misled by the simplicity of the EVA calculations in
that article. The after-tax operating profitNOPAT, as you called itand the amount used for
capital dont come directly off the financial statements. You have to analyze the footnotes to
determine the adjustments that have to be made to come up with those amountsBennett
Stewart calls them equity equivalents, or EEs, in his book, The Quest for Value.3
Those articles sound like very interesting reading for me, especially at this point, Keith
said. Can you send me copies?
Sure, said the analyst. But tell me, what is it about MVA and EVA that piqued your
interest in trying them at OSI?
In tracking our industry, Keith replied, I see the stock prices of some of our key competitors, like Equifax, increasing. Yet when I compare OSIs recent growth in sales and earnings, our return on equity and earnings per share compare well to those firms, but our stock
price doesnt achieve nearly the same rate of increase, and I dont understand why.
The analyst replied, Some of those firms might be benefiting from using EVA already,
and the market value of their stock probably reflects the results of their efforts. It has been
shown that a higher level of correlation exists between EVA and a stocks market value than
has been found with the traditional accounting performance measures, like ROE or EPS.
But the MVA 1,000 ranking probably includes only large firms, Keith observed after
looking over the article the analyst gave him. Will EVA work in a small service firm like OSI?
1
2
3
Ronald B. Lieber, Who Are the Real Wealth Creators?, Fortune, December 9, 1996, pp. 107108, 110, 112, 114.
Shawn Tully, The Real Key to Creating Wealth, Fortune, September 20, 1993, pp. 3840, 4445, 48, 50.
The Quest for Value, G. Bennett Stewart III, New York: HarperCollins Publishers, Inc., 1991.
39
Most of the largest U.S. firms are in the Stern Stewart MVA ranking, the analyst said,
but Ive read about EVA being used at smaller firms. And some firms in the ranking are
service firms, such as AT&T, McDonalds, Marriott International, and Dun & Bradstreet. Im
not an expert on MVA or EVA, but I dont see any reason why it wouldnt work at OSI.
Id like to find out more about MVA and EVA and how we can use them at OSI. For
example, weve talked about a new incentive planwill EVA work in that area? And, if so,
will it help us in deciding how we should organize and manage our operations as we expand
and grow? Can you get me more information on these things?
An application EVA is touted for is its use in incentive plans, the analyst replied. A team
of students from Capital University has been assigned to me this fall to do an industry-related
project, and I was looking for something meaty for them to do. This looks like just the ticket. Ill
brief them on it and have them come over to get the necessary information and interview you.
Great! I look forward to meeting them, Keith said.
Company Information
OutSource, Inc. (OSI) is a computer service bureau that provides basic data processing and
general business support services to a number of business firms, including several large firms
in their immediate area. Its offices are in a large city in the mid-Atlantic region, and it serves
client firms in several Mid-Atlantic states. OSIs revenues have grown fairly rapidly in recent
years as businesses have downsized and outsourced many of their basic support services.
The CorpInfo Data Service (CIDS) classifies OSI as an information services firm (SIC
7374). This group is composed, in large part, of smaller, independent entrepreneurs that provide a variety of often-disparate services to both corporate and government clients. Market
analysts feel a continuously healthy economy translates into strong potential for higher earnings by members of this group. A factor sustaining an extended period of growth is the increased attention of firms to controlling costs and outsourcing their non-core functions,
such as personnel placement, payroll, human resources, insurance, and data processing.
This trend is expected to continue to the end of the decade, probably at an increasing rate.
Several firms in this industry have capitalized on their growth and geographic expansion to
win lucrative contracts with large clients that previously had been awarded on a market-bymarket basis.
Although OSI operates out of its own facilities, which include some computing equipment and furniture, the bulk of its computer processing power is obtained from excess
computer capacity in the local area, primarily rented time during third-shift operations at a
large local bank. To be successful in the long term, however, OSI management knows it
must expand its business considerably, and, to ensure full control over its operations, it
must set up its own large-scale computing facility in-house. These items are included in
OSIs long-range strategic plan.
As OSIs reputation for accurate, reliable, and quick response service has spread, the
firm has found new business coming its way in a variety of data processing and support
services. The issue has been deciding which services to take on or stay out of in light of the
current limitations on OSIs computing resources, to ensure it can continue to provide highquality service to its customers. Things definitely are looking up for OSI, and industry market
analysts have recently begun to look more favorably on its stock.
In 1993, OSIs board decided to pursue additional opportunities in payroll processing
and tax filing services. OSI purchased a medium-sized firm that had an established market
40
providing payroll calculation, processing, and reporting services for several Fortune 500
firms on the East Coast. Now OSI is in the midst of developing a new payroll processing
system, called PayNet, to replace the outmoded system originally created by the firm it
acquired.
Once PayNet is developed, it will give users an integrated payroll solution with a simpler, more familiar graphical user interface. From an administrative perspective, it will allow
OSI to reduce its manual data entry hiring, to speed data compilation and analysis, and to
simplify administrative tasks and the updating of customer files for adds, moves, and changes.
PayNet will serve as the backbone for OSIs service bureau payroll processing operations in
the future, but, at present, developmental and programming costs have proved higher than
expected and will delay the rollout of the final version of the new payroll engine. Beta testing
of the production version of PayNet was delayed from the second to the third quarter of 1996.
Inventories are stated principally at cost (last in, first out), which is not in excess of market. Replacement cost would be $2,796 more than the 1994 inventory balance and $3,613 more than the
1995 inventory balance.
B.
Deferred tax expense results from timing differences in recognizing revenue and expense for tax and
reporting purposes.
C.
On July 1, 1993, the company acquired CompuPay, a payroll processing and reporting service firm.
The acquisition was accounted for as a purchase, and the excess of cost over the fair value of net
assets acquired was $109,200, which is being amortized on a straight-line basis over 13 years. Onehalf year of goodwill amortization was recorded in 1993.
D.
Research and development costs related to software development are expensed as incurred. Software development costs are capitalized from the point in time when the technological feasibility of
a piece of software has been determined until it is ready to be put on line to process customer data.
The cost of purchased software, which is ready for service, is capitalized on acquisition. Software
development costs and purchased software costs are amortized using the straight-line method over
periods ranging from three to seven years. A history of the accounting treatment of software development costs and purchased software costs follows:
1993
1994
1995
Expensed
Capitalized
Amortized
$166,430
211,852
89,089
$467,371
$ 9,585
5,362
18,813
$33,760
0
$4,511
5,111
$9,622
Short-term debt:
$8,889
Rate: 8.0%
Long-term debt:
Current portion
Long-term portion
$18,411
$98,744
Rate: 10.0%
Rate: 10.0%
$117,155
=
=
=
=
=
5.0%
12.5%
1.20
8.0%
35.0%
Requirements
The management of OutSource, Inc. has asked you to prepare a report explaining EVA (economic value added) and MVA (market value added), how they are calculated, and how they
compare to traditional measures of a firms financial performance. OSIs management also
would like to know the advantages and disadvantages of using EVA to evaluate the firms
performance on an on-going basis, as well as in assessing the performance of individual managers throughout its organization. As part of your report, calculate EVA and MVA from
OutSource, Incs financial statements for 1995 using both the operating approach and the
financing approach as described in Bennett Stewarts book, The Quest for Value. Finally, OSIs
management would like to know if EVA can be used as part of an incentive system for its
employees and how it should proceed to implement such an incentive system at OutSource,
Inc. You are to prepare a 20-minute video presentation covering these points.
42
Less-Accumulated depreciation
Total non-current assets
Goodwill
1995
1994
$144,724
217,085
15,829
61,047
----------$438,685
$169,838
192,645
23,750
49,239
----------$435,472
$123,135
33,760
151,357
3,650
----------$311,902
85,018
----------$226,884
$109,600
14,947
141,892
8,844
----------$275,283
57,929
----------$217,354
88,200
----------$753,769
========
96,600
----------$749,426
========
$27,300
67,085
45,050
19,936
30,155
28,458
17,192
----------$235,176
$31,438
57,483
32,250
12,100
28,950
27,553
29,769
----------$219,543
98,744
117,155
6,784
4,850
100,000
100,000
219,884
32,056
61,125
----------$413,065
----------$753,769
========
219,884
32,056
55,938
----------$407,878
----------$749,426
========
43
1995
$2,604,530
1,466,350
---------------
Gross profit
Less: Operating expenses
Selling, general and administrative
Research and development
Other expense (income)
Write-off of goodwill and other intangibles
$1,138,180
$902,388
89,089
59,288
13,511
---------------
$73,904
$1,009
12,427
---------------
62,486
21,870
---------------
Earnings (Loss)
$40,616
=======
OutSource, Inc.
Statement of Cash Flows for
The Year Ended December 31
1995
$40,616
21,978
5,111
(24,440)
7,921
(11,808)
9,602
12,800
7,836
1,205
905
(12,577)
1,934
-----------
$61,083
($36,619)
8,400
-----------
($28,219)
($4,138)
(18,411)
(11,000)
(24,429)
-----------
($57,978)
($25,114)
$169,838
$144,724
=========
44
Case 5 (A)
The meeting agenda focuses on analyzing the last quarters results and preparing the 1988
budget. This is the fourth meeting dedicated to this topic.
In the executive committee room, the chief directors are poring over the thick printouts of
budget results and are desperately trying to explain the budget discrepancy that appeared in Mr.
Piazzolos global results.
Piazzolo (highly pragmatic): We really need to understand what happened, and act.
Zerbib: Its simple. Look at our production costs. We can tell thats where the problems are
because production costs rose 12% over the last quarter.
Bonnot: Were going to have to deal with that situation, but we cant forget our other objectives. Often we incur higher costs to meet our customers demands in terms of quality. I think the
budget constraints lead us to focus excessively on cost reduction and that we should maintain a
more balanced view of our problems.
Artaud: To manage my sales personnel, I need concrete data linked to my activity. Since the
current system doesnt fill my needs, I have built my own database to track the type of equipment
my department sells, who our prospects are, the discounts we grant, and so on. Its not always
accurate, but I have information on my desk every week that lets me make decisions quickly.
Breton: Its true we dont get a lot of information from these budget reports. We spend time
explaining budget discrepancies and sending information to the controllers department, and we
dont get anything in return. This system doesnt help me in everyday management.
Piazzolo: I understand that you need information you feel is field-based, but I would like
us to keep in mind our long-term objectives, even if our horizon is more and more limited. If we
want to succeed, we have to work toward the same goal.
Copyright 1998 by F. Giraud, V. Lerville-Anger, and R. Zrihen
45
The current management accounting system was developed by Mr. Zerbib, and hes very
proud of it. Every month, on the 11th day after the end of the previous month, he circulates a
detailed account statement, with a comparison to the budget and the corresponding discrepancies. This document is sent to committee members with the balance sheet. Mr. Zerbibs precision
and dependability were the basis for his previous promotions in an American company where he
worked before joining RVF.
Piazzolo: We need to look at these management tools seriously. The budget reporting is very
well done, but I dont think it covers all our needs. Well study the problem. Right now I suggest
that we spend the rest of this meeting on 1988 perspectives and strategies.
Overall Environment
The year 1988 should be characterized by growth in France and worldwide.
For EEC countries, the GDP should vary in volume by +4% compared with 1987. This
growth should be accompanied by inflation, at a tolerable level, of approximately 3.6%.
France should profit from this worldwide growth (GDP growth in volume is equal to
+4.5%). Inflation will be controlled (+3.1% over the year), but unemployment will remain
high (10% of the active population). Purchasing power linked to French household revenue
(+3.4% preceding year) and their consumption (+3.5%) should rise substantially.
Moreover, a survey carried out by the Crdit National among 970 companies shows
the year to be exceptional on the following six points:
46
Japan 18%
United States 37%
Mid-range
systems 19%
Mainframe 24%
Minisystems 18%
47
1987
Est.1988
88/87
Estimated average
annual growth
360.5
479.6
618.2
28.9%
31.0%
Very small
($26K/$50K)
10.9
11.9
14.3
20.2%
14.5%
Small
($50K/$320K)
13.9
16.6
18.7
12.7%
16.0%
Middle
($320K/$1,400K)
0.8
0.8
1.1
37.5%
17.3%
Mainframe
(>$1,400K)
0.4
0.4
0.5
25.0%
11.8%
386.5
509.3
652.8
28.2%
30.0%
Delivery total
Sector Segmentation
In reality, software can be viewed as a highly specialized business sector, while services other
than customer service are provided by a few distributors. The following breakdown consequently
appears more logical: scientific supercomputers, mainframes (the segment in which RVF is positioned), minicomputers (where DEC acquired a substantial market share with PDP), and microcomputers and workstations.
Last, there is another specialized sector, peripherals (hard disks, tape drives, printers, and
light tables). This sector is little known. Consequently, little information is available, although we
know that for some makers, peripherals offer an excellent way to reach major customers already
equipped with mainframes.
Sector Features
RVF Systems is present in the mainframe market as well as in the peripherals market (hard
disk drives). Contrary to popular belief, the success of this sectors major companies is not linked
to technological progress, which consequently does not offer a competitive edge. In reality, the
companies that have been successful in this sector relied on solid sales networks already set up for
older data processing technologies and for office machines. This is true for companies such as
IBM, Remington Rand, NCR, etc.
In regard to the technology factor, RVF and its products offer a technology equivalent to, if
not superior to, the technology of IBM, the eternal market leader. Nonetheless, despite the leaders efforts to streamline and regulate innovation, it would be highly imprudent to make a hypothesis regarding product stability, technology, markets, and/or prices. In 1985, RVF held 2.8%
of the worlds mainframe market. Worldwide market shares are shown in Exhibit 5(A)-4.
48
IBM
UNISYS
FUJITS
U
NEC
HITACHI
CONTROL DATA
BULL
AMDAHL
AUTRES
49%
8,20%
8,20%
4,80%
4%
5,10%
4,10%
2,60%
14%
OTHERS
14%
AMDAHL
3%
BULL
4%
CONTROL DATA
5%
IBM
49%
HITACHI
4%
NEC
5%
Japanese = 17 %
FUJITSU
8%
UNISYS
8%
IBMs market share is being nibbled away each year (in 1978 IBMs market share stood at
60%) by the Japanese (NEC, Hitachi, Fujitsu), as well as by new competitors such as RVF. A
shot at surviving in this sector entails growth. Indeed, RVFs margins in the 1980s were very
comfortable (profit before interest and taxes was greater than 20%; revenue and cash flow were
twice the industry average). The learning experience curve had a significant impact. In comparison with industrial sector companies, service companies lagged in equipment acquisition.
Acquiring a mainframe represents a key capital outlay, so in their relations with a potential
client, computer manufacturers frequently find themselves in the following situation: (1) either
they rent out the system to their client (on a four-year basis), in which case they recover the value
of the equipment sold in their own required working capital (the average price of a mainframe is
around $8 million), or (2) they offer their client the means to finance this acquisition.
In the 1960s and 70s, IBM established a dominant market position. With its market share
topping 70% of the world market, Big Blue had carved out a quasi monopoly, largely focused on
a global sales presence that was consistent and efficient (permanent identification and communication with decision makers). The impact of IBMs dominance was so great that one computer
systems director hesitated three times before deciding to purchase a central unit from a competitor, even though the competitors technology was more advanced. Thus, to justify a non-IBM
equipment decision, the competitors price has to be distinctly lower. For a computer systems
director, forgoing IBM means taking an individual risk.
Therefore, it is very difficult for RVF to solicit IBMs customers. An indirect path is via peripheral supplies (disk drives). Peripheral supplies provide the opportunity to prove ones technology and service quality, in the hopes of one day selling a mainframe. Given the context, manufacturers must hold on to their customers for a long time.
Until 1975, IBMs software policy was proprietary, making its software incompatible with all
other machines. A client who had an IBM system couldnt change central units and manufacturers
49
without also changing software. This policy led to an antitrust lawsuit against Big Blue instigated
by Control Data. The trial ended 12 years later with IBMs acquittal. Nonetheless, as early as 1975
nonproprietary software began to appear (Unix), and IBM was obliged to reveal its compatibility
protocol, which helped spawn compatible competitors.
When competing with IBM, a chance to sign a contract involves:
Offering equipment that is totally compatible with that of the market leaders, Big Blue;
Reassuring high-level decision makers technologically; these decision makers include computer system directors and managing directors, so a personal relationship is key and could
involve hosting a visit to the manufacturers plant or research unit;
Providing impeccable service quality, even for peripherals, especially in regard to customer
service and repairs;
Positioning oneself with a better technology, a much lower price, and a solution to the
aforementioned financing problem.
Questions
1. Clearly state the problems RVF is encountering in terms of the management accounting
system.
2. Build the main axes of the Tableau de Bord (see Exhibit 5(A)-6 for design process):
Translate this mission and strategy into quantified objectives (two or three objectives).
Define the action variables (or key success factors) corresponding to each objective (a
maximum of seven).
Identify the managers involved for each action variable (see blank document in Exhibit 5(A)-7).
3. Using this base, build a Tableau de Bord for the customer service department and then
build one for the managing director (use the blank documents in Exhibit 5(A)-8). Include:
Objectives;
Action plans corresponding to the previously identified action variables (specific actions to be carried out by the manager and actions delegated to his subordinates);
Indicators corresponding to the objectives and to the action plans.
Exhibit 5(A)-5
Schedule
1.
2.
3.
4.
5.
52
-5%
1987
Actual
1988
Forecast
22
$6,600
$145,200
70%
$4,620
$1,980
$43,560
10
$6,270
$62,700
55%
$3,449
$2,822
$28,215
CPU model 5
Quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
1987
Actual
2
$12,000
$24,000
90%
$10,800
$1,200
$2,400
1988
Forecast
14
$11,400
$159,600
80%
$9,120
$2,280
$31,920
Services
Quantity
Sales price per contract
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
1987
Actual
6
$1,200
$7,200
80%
$960
$240
$1,440
1988
Forecast
7
$1,240
$8,680
80%
$992
$248
$1,736
Maintenance
Quantity
Sales price per contract
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
1987
Actual
100
$800
$80,000
60%
$480
$320
$32,000
1988
Forecast
115
$800
$92,000
60%
$480
$320
$36,800
1987
Actual
24
1988
Forecast
24
$241,200
69%
$302,100
70%
$74,760
$92,055
Products
TOTAL HARDWARE
CPU quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
53
1988
Forecast
Revenue
% cost/sales price per unit
$87,200
62%
$100,680
62%
Total margin
$33,440
$38,536
1987
Actual
1988
Forecast
Revenue
%cost/salesprice per unit
$328,400
67%
$402,780
68%
Total margin
$108,200
$130,591
TOTAL SOFTWARE
GENERAL TOTAL
1988
Forecast
$169,200
72,000
80,000
7,200
328,400
$222,300
79,800
92,000
8,680
402,780
Cost :
- computers
- peripherals
- maintenance
- services
Cost of revenue
123,240
43,200
48,000
5,760
220,200
162,165
47,880
55,200
6,944
272,189
Gross margin
- computers
- peripherals
- maintenance
- services
Gross margin
45,960
28,800
32,000
1,440
108,200
60,135
31,920
36,800
1,736
130,591
42,204
8,888
51,092
48,275
9,679
57,954
$57,108
$72,637
Revenue
- computers
- peripherals
- maintenance
- services
Total revenue
Operating expenses
- Sales & marketing
- General & administration
Operating expenses
Operating income
54
1988
Forecast
50
80
25
10
165
60
85
25
10
180
Maintenance
Hardware technicians
Software technicians
Engineers & managers
Others
Total
300
25
24
15
364
350
30
28
15
423
6
2
3
11
10
6
4
20
Production
Workers
Technicians
Engineers & managers
Others
Total
220
45
14
20
299
250
50
17
25
342
40
15
55
40
17
57
GENERAL TOTAL
Workers
Technicians
Engineers & managers
Others
220
376
210
88
250
440
238
94
GENERAL TOTAL
894
1,022
55
1988
Forecast
$38,404
3,800
$42,204
$44,475
3,800
$48,275
Maintenance
Direct cost
Indirect cost (includ. spare parts)
Total cost
$33,549
14,451
$ 48,000
$40,612
14,588
$55,200
$1,407
4,353
$5,760
$ 2,907
4,037
$6,944
23,994
19,206
$43,200
28,578
19,302
$47,880
6,888
2,000
$8,888
7,679
2,000
$9,679
104,242
43,810
$148,052
124,251
43,727
$167,978
56
1988
Forecast
Revenue
Revenue increase
Hardware rev./total rev. in %
Maintenance rev./total rev. in %
Services rev./total rev. in %
73%
22%
2%
23%
75%
20%
2%
27%
40%
40%
20%
27%
40%
40%
20%
23%
21%
Operating income/revenue in %
17%
18%
367
6,568
5
7
6%
394
6,713
4
7
6%
$256
$132
$524
$162
$144
$166
$268
$130
$347
$170
$140
$164
RATIOS
57
58
Detailed Action
Variables
Managing
Director
Customer
Services
Sales/
Marketing
Finance
Human
Resources
Production
59
Exhibit 5(A)-8.
Customer Services
Tableau de Bord
a/ Result indicators1
Objectives
60
Indicators
Reference Value
General level action variables (see Exhibit 5(A)-6) for which C.S. relations have been identified. These variables should answer a
specific goal at C.S. level (strategy implementation). Due to this fact, deciding to design a Tableau de Bord may show inconsistencies between the overall strategy and local orientation.
Action Variables
Action Plan
Indicators
Reference Value
61
62
Indicators
Reference Value
Action Plans
Indicators
Reference Values
63
Related Departments
Customer Service
Sales
Human Resources
Production
64
Indicators
Reference Value
Case 5 (B)
On December 1, 1992, provisional results are reported to the general management. The report
shows negative operating results, and after financial costs have been deducted, it shows an even
greater loss. Management is quite concerned, and Mr. Piazzolo consequently has gathered his
team to try and get a better picture of the situation. The goal is to reach the breakeven point.
At the beginning of the meeting, the sales manager, Mr. Artaud, highlights the key evolutions of the past few years.
First, we were confronted with an all-out price war, which since 1988 has led to a free fall of
55% of the price per MIPS.1 We believe this trend will be accentuated in 1993 with a drop in prices
of 25%. The surge in minicomputers has been detrimental to mainframe sales. The peripheral
sector has also been hit, with prices slashed in half. How can we survive in such an environment?
How should we place ourselves strategically? Should we pursue our business manufacturing
computers?
Bonnot (production manager): I dont understand. Weve always made computers that have
the worlds best technology and have always met our clients needs. Are we going to cut off the
branch we are sitting on?
Zerbib (finance director): Come, come, the figures speak for themselves! Hardware margins
dont even cover the overhead costs, and that doesnt include clients who are more and more
reluctant to pay maintenance fees. How can we reach a balance? The situation is untenable, and
we should be asking some serious questions.
Piazzolo (managing director): Whats clear is that we cant refuse sales contracts on the grounds
that our margins are too low. Weve lost so many customers that our market share has slipped
more than 25%. The priorities are crystal clearwe need to boost volume and gain market share.
To do this, we need to track market trends and develop services.
Breton (customer service manager): We fully back your idea, which is a normal evolution for
our department. Given our successful zero default policy on all our computers, weve gained real
experience. If we get the necessary financial support, we have the means to develop the offerings.
Zerbib: The debate is more basic. I agree that given our goals, we need to take additional
measures. But were not talking about reallocating resources. Im not talking about developing
what already exists but taking on a new branch involving a completely different structure. This
new branch means another culture in both focus and structure. Its practically the antithesis of our
65
mainframe culture. For example, integrating mainframes requires project management and follow-up, employees who are focused on other applications and equipment. Our current values are
structured around our equipments technological superiority. Moreover, the current salary structure wont allow us to be competitive in terms of clients. Maybe we should think of setting up a
separate company to handle this specific branch.
Piazzolo: Take it easy, gentlemen. The strategy is clear: develop sales mainly via our services.
The Performance Scorecard (Tableau de Bord) needs to underline this new priority and account
for directing performance.
Zerbib: The strategy may be clear, but if we want the Tableau de Bord to be realistic, the
responsibilities must be well defined, which isnt the case now.
Piazzolo: Youre right. I thought I could put off the decision making, but I think its worth
clearing up the problem now. Setting up a separate entity doesnt seem like the right idea if we
want to pursue synergy with our current activities. On the other hand, weighing down client
relations compromises our mainframe branch, and we need all our skills focused there. So we
need to create a new division to develop services. This department will be managed as a separate
entity and should be self-sufficient financially. Its objective will be to reach critical mass very
quickly. In a year, revenue should be twofold.
Questions
1. Why must the Tableau de Bord be changed?
2. Analyze the December 1 meeting. What are the issues that will affect the future design of
the Tableau de Bord? Why is Mr. Piazzolos final intervention important?
66
1993/1992
-55%
-25%
1992
Actual
1993
Forecast
Quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
1
$1,822
$1,822
55%
$1,002
$820
$820
0
0%
-
CPU model 5
1992
Actual
1993
Forecast
29
$5,130
$148,770
80%
$4,104
$1,026
$29,754
24
$3,848
$92,340
78%
$3,001
$846
$20,315
1992
Actual
1993
Forecast
3
$6,200
$18,600
86%
$5,332
$868
$2,604
14
$4,650
$65,100
87%
$4,046
$605
$8,463
1992
Actual
1993
Forecast
150
$342
$51,300
78%
$267
$75
$11,286
170
$257
$43,605
80%
$205
$51
$8,721
Quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
CPU modeI 6
Quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
DASD (peripherals)
Quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
67
Services
Quantity
Sales price per contract
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
Maintenance
Quantity
Sales price per contract
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
TOTAL HARDWARE
CPU quantity
Sales price per unit
Revenue
% cost/sales price per unit
Unit cost
Margin per unit
Total margin
TOTAL SOFTWARE
Revenue
% cost/sales price per unit
Total margin
GENERAL TOTAL
Revenue
% cost/sales price per unit
Total margin
68
1992
Actual
1993
Forecast
50
$1,800
$90,000
90%
$1,620
$180
$9,000
100
$1,800
$180,000
86%
$1,548
$252
$25,200
1992
Actual
1993
Forecast
165
$560
$92,400
79%
$442
$118
$19,404
180
$540
$97,200
68%
$367
$173
$31,104
1992
Actual
1993
Forecast
33
38
$220,492
80%
$201,045
81%
$44,464
$37,499
1992
Actual
1993
Forecast
$182,400
84%
$277,200
80%
$28,404
$56,304
1992
Actual
1993
Forecast
$402,892
82%
$478,245
80%
$72,868
$93,803
1993
Forecast
Revenue:
- computers
- peripherals
- maintenance
- services
Total revenue
$169,192
51,300
92,400
90,000
$402,892
$157,440
43,605
97,200
180,000
$478,245
Cost:
- computers
- peripherals
- maintenance
- services
Cost of revenue
$136,014
40,014
72,996
81,000
$330,024
$128,662
34,884
66,096
154,800
$384,442
Gross margin:
- computers
- peripherals
- maintenance
- services
Gross margin
$33,178
11,286
19,404
9,000
$72,868
$28,778
8,721
31,104
25,200
$93,803
Operating expenses:
- Sales & marketing
- General & administration
Operating expenses
$59,724
13,257
$72,980
$65,618
13,500
$79,117
Operating income
-$
113
$14,686
69
1993
Forecast
61
90
25
10
186
65
95
28
9
197
Maintenance
Hardware technicians
Software technicians
Engineers and managers
Others
Total
400
40
30
15
485
220
50
45
15
330
130
80
15
225
320
320
25
665
Production
Workers
Technicians
Engineers & managers
Others
Total
100
55
20
50
225
95
50
20
10
175
44
22
66
42
22
64
100
625
328
134
95
640
595
101
1,187
1,431
70
1993
Forecast
$55,524
4,200
$59,724
$61,418
4,200
$65,618
Maintenance
Direct cost
Indirect cost (including spares parts)
Total cost
$56,659
16,337
$72,996
$41,533
24,563
$66,096
$42,557
38,443
$81,000
$139,656
15,144
$154,800
Production
Direct cost
Indirect cost
Total cost
$24,960
15,054
$40,014
$21,831
13,053
$34,884
$11,257
2,000
$13,257
$11,500
2,000
$13,500
$190,956
76,034
$266,990
$275,938
58,959
$334,897
GENERAL TOTAL
Direct cost
Indirect cost
Total cost
71
1993
Forecast
Revenue
Revenue increase
Hardware revenue/total revenue in %
Maintenance revenue/total revenue in %
Services revenue/total revenue in %
55%
22%
22%
19%
42%
17%
38%
20%
22%
21%
10%
18%
20%
32%
14%
22%
21%
0%
3%
339
6,605
5
7
6%
334
7,358
6
7
4%
321
151
360
201
178
225
333
200
233
211
199
234
Operating income/revenue in %
Revenue by head in 000 $
Revenue by A.E. in 000 $
Average CPU sold by 10 A.E.
Number of sales support by 10 A.E.
G & A headcount/total headcount
Expense by person (in 000 $)
- Sales & marketing
- Maintenance
- Services
-G&A
- Production
- Total
72
Case 6
Im not looking forward to breaking the news to Mrs. W. Shes going to take this pretty hard,
groaned Charlie Oliver, the controller of Wellesley Paint Company. He and Don Smith, state liaison for the firm, were returning from a meeting with representatives of the Virginia General Services Administration (GSA), the agency that administers bidding on state contracts. Charlie and
Don had expected to get the specifications to bid on the traffic paint contract, soon to be renewed.
Instead of picking up the bid sheets and renewing old friendships at the GSA, however, they were
stunned to learn that Wellesleys paint samples had performed poorly on the road test and the
firm was not eligible to bid on the contract.
Charlie and Don were on their way to report to the president of the company, Victoria
Wellesley. Mrs. W., as the employees fondly refer to her, is the 70-year-old widow of the companys
founder and has served as president of the company since his death in 1987. Mrs. W. is very
proud of the quality of the firms products and also of its close ties with the state of Virginia,
where her family have been prominent citizens since before the Civil War. The label on cans of
Wellesleys house paint features a picture of her ante bellum home.
Wellesleys two main product lines are traffic paint, used for painting yellow and white lines
on highways, and commercial paints, sold through local retail outlets. Because of the small size of
the firm, all employees handle multiple tasks. For example, Don Smiths official job title is state
liaison, and during contract negotiations he is the firms main contact with state officials. When
no negotiations are pending, however, he often drives a forklift in the warehouse or travels to
road test sites where he operates the striping equipment used to apply traffic paint to the highway.
Production Process
The paint production process is fairly simple. Raw materials are kept in the storage area that
occupies approximately half of the plant space. Large tanks that resemble silos are used to store
the latex that is the main ingredient in their paint. These tanks are located on the loading dock just
outside the plant so that when a shipment of latex arrives, it can be pumped directly from the tank
truck into these storage tanks. Latex is extremely sensitive to cold. It cannot be stored outside or
even shipped in the winter without heated trucks, which are prohibitively expensive for a small
firm such as Wellesley.
The company and situation described in this case are real. The names of the firm and all individuals have been changed to protect
their privacy.
73
Paint is mixed and packaged at six identical production stations. Each station has two 1,000gallon mixing vats so that while the first batch of paint is being pumped into drums, another
batch of paint can be mixed. An employee pours ingredients into a mixing vat according to a
predetermined formula. When the mixing is complete, a sample is tested by the technical director
for color, thickness, texture, and drying time. He issues directions for any additional ingredients
or approves the batch. Workers then pump the paint into 55-gallon drums from a hose attached to
the mixing vat. The amount of paint that can be produced is limited by the available equipment
and production space.
Traffic Paint
Currently, Wellesley has the traffic paint contracts for the states of Pennsylvania, North Carolina, Delaware, and Virginia. Of last years total production of 380,000 gallons, 90% was traffic
paint. Of this amount, 88,000 gallons were for the Virginia contract. Each state has unique specifications for color, thickness, texture, drying time, and other characteristics of the paint. For example, paint sold to Pennsylvania must withstand heavy use of salt on roads during the winter.
Paint for North Carolina highways must tolerate extended periods of intense heat during summer months.
The process of bidding on a traffic paint contract begins with a road test under the supervision of the National Association of Highway Paints (NAHP), an independent organization supported by state funds. NAHP designates a certain stretch of highway to serve as the road test site.
Any paint manufacturer may apply stripes of their paint at the test site. NAHP monitors the test
site and reports the results to the state highway department. State personnel review the reports
and invite the manufacturers of the best-performing paints to submit bids. The firm that submits
the lowest bid wins the contract.
Contracts, which normally cover a five-year period, specify only the price per gallon and
quality requirements such as drying time and road-life. The timing of deliveries is determined
later based on state work schedules and weather constraints. Demand is highly seasonal, as states
do most of their highway painting in June, July, and August. The total amount of paint a state will
order is not determined until spring, when the states know how much of their highway budget
remains after winter snow removal costs have been paid.
After the paint is produced, the state must test the paint before approving it for shipment. A
sample is sent to the state laboratory, which may take up to two months to perform the testing. In
the meantime, Wellesley must store all the manufactured paint in its warehouse. At times, the
warehouse has been filled to capacity, and drums of paint are stored in the aisles, production
areas, and any available inch of space.
Due to the high cost of shipping paint, most paint producers can be competitive on price
only in locations fairly close to their production facilities. Accordingly, Wellesley has enjoyed an
advantage in bidding on contracts in the eastern states close to Virginia. However, one of their
biggest competitors, Heron Paint Company of Houston, Texas, is building a new plant in North
Carolina. With lower costs due to their efficient new facility and their proximity, Heron will become a major competitive threat.
Commercial Paint
Wellesleys commercial paint line includes interior and exterior house paints in a wide range
of colors formulated to approximate authentic colonial colors. Because of the historical association, the line has been well received in Virginia. Most of these paints are sold through paint and
hardware stores as the stores second or third line of paint. The large national firms such as Benjamin Moore or Sherwin Williams provide extensive services to paint retailers such as computer74
ized color matching equipment. Partly because they lack the resources to provide such amenities
and partly because they have always considered the commercial paint a sideline, Wellesley has
never tried to market their commercial line aggressively.
Mrs. W. is worried about the future of the company. The firms strategic goal is to provide a
quality product at the lowest possible cost and in a timely fashion. After absorbing the shock of
losing the Virginia contract, Mrs. W. wondered whether the firm should consider increasing production of commercial paints to lessen the companys dependence on traffic paint contracts. Her
son, who manages the day-to-day operation of the firm, believes they can double their sales of
commercial paint if they undertake a promotional campaign estimated to cost $15,000. The average price of traffic paint sold last year was $9 per gallon. For commercial paint, the average price
was $11.
Cost Data
Charlie Oliver has assembled the following data to evaluate the financial performance of the
two lines of paint. The primary raw material used in paint production is latex. The list price for
latex is $13.50 per pound. If the firm uses more than 150,000 pounds annually they qualify for a
10% discount; 450 pounds of latex are needed to produce 1,000 gallons of traffic paint. Commercial paint requires 325 pounds of latex per 1,000 gallons of paint. In addition to the cost of the
latex, other variable costs are as shown below.
Raw materials cost per gallon of paint:
Camelcarb (limestone)
Silica
Pigment
Other ingredients
Direct labor cost per gallon
Freight cost per gallon
Traffic
0.38
0.37
0.12
0.06
0.46
0.78
Commercial
0.54
0.52
0.38
0.03
0.85
0.43
Last year, overhead costs attributable to the traffic paint totaled $85,000, including an estimated $25,000 of costs directly associated with the Virginia contract. Overhead costs attributable
to the commercial paint are $13,000. Other manufacturing overhead costs total $110,000. Charlie
estimates that $9,000 of this amount is inventory handling costs that will be avoided due to the
loss of the Virginia contract. Both the remaining manufacturing overhead and the general and
administrative costs of $140,000 are allocated equally to all gallons of paint produced.
Required
1. The firms strategic goal is to provide a high-quality product to customers at a reasonable
cost and in a timely fashion. What specific quality, cost, and time issues are relevant to traffic
paint? To commercial paint? What information does the firm need to assess the performance of
each product line on the three strategic dimensions of quality, cost, and time?
2. Calculate the contribution margin (selling price minus variable costs) and gross margin
(selling price minus all manufacturing costs) per gallon for each type of paint and total firm-wide
profit under each of the following scenarios:
Scenario A
Scenario B
Scenario C
Key Concern
Financial perspective
Customer perspective
Continuous improvement
To implement the Balanced Scorecard, a firm first sets goals for each dimension and then
defines performance measures to assess progress toward these goals. Suppose Charlie has asked
your help in designing a Balanced Scorecard for Wellesley Paint. What goals might be appropriate
for each of the four dimensions, in light of the firms strategic (quality, cost, time) objectives?
What performance measures would you suggest for each of the four dimensions?
4. Based on your answers to questions 1 through 3, what should the firm do?
76