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CHAPTER 25
REPORTING AND EVALUATION
Changes from the Twelfth Edition
All changes to Chapter 25 were minor.
Approach
Students should get a general idea of the difference between economic and managerial performance
measurement, the nature of control reports, the criteria for good reports, and a beginning of an
understanding of how to read such reports. A full understanding of the meaning of control reports requires
years of experience and it also requires a thorough knowledge of the specific environment to which the
reports pertain, so students should not be disturbed if they do not understand all the nuances of the sample
reports included in the chapter. Nevertheless, they should acquire some ability to distinguish between
what is significant and what is not significant, as well as an ability to spot fairly obvious red flags, that
is, items requiring further investigation.
Both of the last two sections can be somewhat controversial. Whereas some companies are significantly
reducing (or even eliminating) formerly intensive variance analysis processes, most still hew to this
approach. Also, the total amounts of many executives incentive awards have prompted considerable
criticism from certain quarters in recent years.
Cases
Harwood Medical Instruments PLC allows students to consider how a change in a bonus plan affects two
divisions with quite different operating characteristics.
Armco Inc.: Midwestern Steel Division illustrates a performance measurement system with measures
cascading from strategic priorities down to the lowest organization levels.
Formosa Plastics Group describes a company that has an elaborate planning and performance
measurement system but that uses mostly subjective evaluations of performance and highly smoothed
bonus payments.
25-1
Problems
Problem 25-1: Greene Enterprises
Performance Report
(A - B)
(C)
(B - C)
Budgeted
at Actual
Budget
Actual
Difference
Volume
Difference
Sales..................................................................................................................................................................................................
$56,000
$63,000
$7,000
$63,000
$
0
Cost of goods sold.............................................................................................................................................................................
39,200
37,800
1,400
(b) 44,100
6,300
Gross margin.....................................................................................................................................................................................
16,800
25,200
8,400
18,900
6,300
Direct operating expenses:
Variable.............................................................................................................................................................................................
(a) 6,720
8,000
(1,280)
(c) 7,560
(440)
Fixed.................................................................................................................................................................................................
10,000
10,000
0
10,000
0
Contribution to indirect costs............................................................................................................................................................
$
80
$ 7,200
$7,120
$ 1,340
$5,860
(a) Direct operating expenses........................................................................................................................................................
$16,720
Less: Fixed expense.................................................................................................................................................................
10,000
Variable expense......................................................................................................................................................................
$ 6,720
(A)
(B)
Performance Report
Division A
Current Year
Last Year
Net sales.................................................................................................................................................................................
$252,000
$216,000
Cost of goods sold:
Variable costs.....................................................................................................................................................................
$72,000
$72,000
Division fixed costs...........................................................................................................................................................
29,000
101,000
29,000
101,000
Gross margin..........................................................................................................................................................................
151,000
115,000
Selling and administrative expenses:
Variable expense................................................................................................................................................................
22,000
19,000
Division fixed expenses.....................................................................................................................................................
25,000
47,000
22,000
41,000
Contribution to allocated costs and expenses.........................................................................................................................
$104,000
$ 74,000
25-2
b. Division A performed better in the current year than in the last year when the ratios of contribution to
allocated costs to sales are made. ($104,000/$252,000 = 41% and $74,000/$216,000 = 34%.) Division
managers cannot control allocated costs, and their performance should not be judged on the basis of
net income/sales because the net income figure includes allocated costs. By comparing division
contributions to allocated costs, the amount which each Division Manager contributes toward the
overall company profits can be clearly seen. Bonuses based on division contributions would be in the
best interest of both the managers and the company.
Problem 25-3: Machine Shop
a. If the report is meant to be a control report, the only two items strictly within the direct control of the
machine shop supervisor are probably materials handling costs and supplies. Depreciation of machine
shop equipment is a departmental direct cost, but the supervisor may not have much control over the
amount. The costs for buildings and grounds, and general plant are allocated costs and cannot be
controlled by the supervisor. Maintenance is controllable to the extent of the number of hours of
maintenance time, but the supervisor cannot control the standard rate applied to these hours. Training
costs might be similar to maintenance costs in that the supervisor might be able to control the amount
of training time, but not the cost attributed to training.
b.
Performance Report
Machine Shop
Budget
Actual
Actual
over (under)
Direct costs
Materials handling.................................................................................................................................................
$ 8,000
$ 8,150
$150
Supplies.................................................................................................................................................................
5,200
5,000
(200)
Depreciation- equipment........................................................................................................................................
6,000
6,000
0
19,200
19,150
(50)
Indirect costs
Training.................................................................................................................................................................
4,500
5,300
Maintenance..........................................................................................................................................................
5,000
5,800
Building and grounds.............................................................................................................................................
3,700
3,700
General plant expense............................................................................................................................................
2,500
2,600
15,700
17,400
Total direct and indirect costs....................................................................................................................................
$34,900
$36,550
Problem 25-4: Hopedale Company
25-3
a.
Actual
Budget (a)
Controllable costs:
Salaries..............................................................................................................................................................................
$12,300
$12,000
$(300)
Indirect labor.....................................................................................................................................................................
20,500
19,640 (b)
(860)
Indirect materials...............................................................................................................................................................
2,550
2,640 (c)
90
Other costs.........................................................................................................................................................................
9,510
9,650 (d)
140
$44,860
$43,930
$(930)
(a) Budgeted costs at actual volume of 33,000 direct machine-hours consist of both fixed costs
and variable costs calculated for the actual volume.
Fixed costs:
Salaries..........................................................................................................................................................
$12,000
Indirect labor.................................................................................................................................................
17,000
Other costs.....................................................................................................................................................
8,000
(These are the same at any volume, because they are given as a fixed amount per month.)
(b) Variable indirect labor = $.08 x 33,000=$2,640
Total indirect labor costs budgeted = $17,000 + $2,640=$19,640
(c) Variable indirect materials = $.08 x 33,000=$2,640
(d) Variable other costs = $.05 x 33,000=$1,650
Total indirect other costs budgeted = $8,000 + $1,650=$9,650
b. Total actual costs for March were $930 higher than budgeted, with salaries and indirect
labor higher than budgeted. More labor was probably used than expected, due to the
greater volume than formerly budgeted.
The increase of $300 in salaries cost probably caused the increase in indirect labor cost
also, perhaps for such as increased janitorial costs or routine maintenance.
(The expected volume was 29,000 machine-hours and was later revised to 34,000
machine-hours.) Although the actual volume of activity at 33,000 machine-hours was less
than the revised budgeted 34,000 machine-hours, the favorable variances still resulted
because the original budget was apparently based on a total yearly volume which is
proving to be low. There seems to be good cost control over indirect material cost, as less
was spent than budgeted.
Cases
Case 25-1: Harwood Medical Instruments PLC
Note: This case is new for the Thirteenth edition..
25-4
Approach
The Harwood Medical Instruments case was written in response to requests from instructors who want
more short cases. It is also useful in an exam setting where multiple cases are used to test different subject
materials.
The case describes a company whose manager is concerned that the operating profit measure included in
the companys bonus plan was too narrowly focused. He implemented a new bonus plan that reduced the
weighting of importance placed on operating profit and that included more measures, including on-time
deliveries, sales returns, patent applications, scrap and rework costs, and customer satisfaction.
Presumably these factors were considered as critical success factors.
Suggested Assignment Questions
1. What was the purpose of the change?
2. Calculate the bonus earned by each manager for each six-month period and for the year 2007.
3. Evaluate the new plan. Is there any evidence that it produced the desired effects? What changes to the
new plan would you suggest, if any?
Case Analysis and Pedagogy
1. The change was made because managers believed that operating income was not a good summary
measure of short-term financial performance.
2. The calculation of the bonuses earned in each division is shown in the tables below.
(000)
Surgical Instruments
1
Base bonus
Total
Ultrasound Diagnostic
Equipment
1
2
Total
46.2
44.0
34.2
40.6
2.0
2.0
2.0
(15.0)
5.0
(3.0)
5.0
1.0
4.0
8.0
Scrap/rework
(4.9)
(1.0)
(5.5)
Customer Satisfaction
(5.0)
(5.0)
(5.0)
Total
23.3
46.0
26.7
53.6
Delivery adjustment
Sales
adjustment
returns
Patents
25-5
69.3
80.3
Sales returns:
Surgical Instruments
(000)
Ultrasound Diagnostic
Equipment
1
2
420
440
285
290
Actual
450
420
291
287
(30)
20
(6)
Bonus
(15)
(3)
Scrap/rework:
Surgical Instruments
(000)
Std.: 1%
profit
1
of
operating
Ultrasound Diagnostic
Equipment
1
2
46.2
44.0
34.2
40.6
Actual
51.1
45.0
39.7
38.2
(4.9)
(1.0)
(5.5)
2.4
Bonus
(4.9)
(1.0)
(5.5)
3. There is evidence that the plan is producing some of the desired effects. In both divisions, as
managers have gotten accustomed to the new bonus plan (2 nd half of 2007), sales returns have
declined, patent applications have increased, scrap and rework costs have declined, and customer
satisfaction has increased. On-time deliveries have increased in the surgical instruments division, but
not in the ultrasound diagnostic equipment division. As a result, the bonuses to be paid increased
significantly in the second half of the year.
Is this improvement good? It is if the performance factors added to the plan are truly critical success
factors. The small incremental bonuses paid would seem to be money well spent. The money should
be quite meaningful to the managers and, hence, quite motivating, yet not very expensive for the
company.
But the two divisions seem to so different. Someone should consider whether the same factors should
apply to both divisions and in the same weightings of importance.
25-6
Each of the individual factors should be subjected to critical scrutiny. For example, are patents
important in a division that sells such mundane products as scissors and clamps? And for that matter,
does including patents applications in a bonus plan just encourage patent applications that never get
approved, or even if they do, that never provide any real economic benefit to the division and
company. And several of the factors have very specific performance constraints. Should the payoff
functions be linear, rather than based on perhaps arbitrary performance constraints, such as 95%
deliveries on time or 90% average customer satisfaction?
The case does not provide enough information to answer these questions, but students should be able
to identify the issues.
This teaching note was prepared by Professor Kenneth A. Merchant. Copyright 1998 Kenneth A. Merchant.
25-7
3.
4. Evaluate the new system and the way in which it was being implemented. What changes would you
recommend, if any? Why?
5. What should Rob Cushman do about the two items described in the Remaining Issues section of the
case?
Case Analysis and Pedagogy
4. What factors most determine the success or failure of the Midwestern Steel Division? In particular,
how important is cost control?
Carbon wire rod is a commodity product, so cost control is critical for this line of business.
There is some product differentiation in grinding media. Customers can measure how long the steel
balls last, and they value long-lasting balls. Armco believes it has a superior manufacturing
technology that causes its balls to last longer. Further manufacturing technology innovations would
provide additional profits to the division.
Cost control is also important for grinding media, as Armco is the high cost producer in this market.
Plant throughput (productivity) is one key to cost control. Armco can sell all the product it makes.
(The plant has been operating at capacity for three years straight.)
Among the cost control challenges in the plant are the fact that the plant has old equipment, generally
poor preventative maintenance practices (40% of the 700 hourly workers in the plant were
maintenance workers), and less than optimum worker productivity.
The people left in the plan are the most senior. They would not be hurt that much by a shutdown.
They have pensions. Cost control is not that important to them. It would cost the company about $200
million to shut down the plant (environmental clean-up, pensions, etc.).
Students might ask why Armco does not put more people or more equipment in the melt shop so it
wouldnt be a bottleneck. The answer is that they would have to add a furnace, making an investment
of approximately $100 million. This would add capacity which is not needed in the industry.
5. How were managers controlling performance with the old system? What were the strengths and
weaknesses of the old system?
25-8
6.
Strengths
1. Managers express need for detail so they can track
month-to-month trends.
2. Has value in identifying problem areas.
3. Measured performance was based on managers
ability to control cost above. System gave
managers information consistent with objective
they were given.
Weaknesses
1. Too much detail. Some numbers didnt change.
Some very small.
2. System designed for inventory costing purposes.
Have to allocate costs. For performance
measurement purposes, not sure if the allocations
mean anything.
3. Source of some of the data is unclear.
4. Reports were delivered 15 days after month-end.
This is too late.
5. System too focused on cost reductions, to the
exclusion of other critical success factors.
6. Managers performances judged on things over
which they had no control. Many costs were
caused by people who did not report to the
managers (e.g., capital spending, salaries,
maintenance). Easy to blame poor performance
on uncontrollables.
7. System not encouraging managers to work
together. Much local data. Contributes to
suboptimization.
8. Not graphic.
9. Accounting accruals distort the costs. Example
annual August maintenance shutdown accruals
start in January.
It is important to walk students through Exhibit 3. Pick some representative columns and have
students talk about what they mean or dont mean. Among the useful examples to discuss are
nonmetallics, salaries, electricity, lubricants, and loco cranes. Students should see the types of costs
that make up total cost above. Which are the big items? Which items are variable and which are
fixed? (The important ones are fixed. Costs per net ton are driven by tons produced.) Point out the
distorting effect of the August maintenance shutdown.
S-orders represent extraordinary maintenance. It is accrued for. It is fixed in the short-run (a month),
but it can vary over the year.
7. Why did the operating managers seem to like the old system?
Familiarity
Managers cant be held accountable because they always had an excuse for poor performance.
(Nenni: The traditional way we ran our operating review meetings was that the managers would
find some items that didnt make sense. Then they would discredit the report and the accountants.
We never got to the items the managers can and should control.)
Gives managers a false sense that they can control costs. Gives a global picture. (The managers
would have liked to have the information every week.)
25-9
Gives managers a sense that they are responsible for a large number (e.g., melt shop manager
responsible for $50 million per year)
After the students have had their crack at the analysis, if it hasnt come up, the instructor might
usefully point their attention to Bob Nennis quote about the problem with non-value-added chores
under the new system and the difference between value-added and non-value-added work. (Nonvalue-added work includes everything customers are not willing to pay for.) One prominent example
of the non-value-added work associated with the old system (which is Bob Nennis focus) is the
administrative burden required to keep it going. The old system took five accountants to operate. The
new system required only three, even in start-up mode; most of the accountants time was spent
designing new reports. To what extent does Bob Nenni consider accounting to be value-added
work?
8. What were the key features of the new system and what improvements did it promise?
Hit the key design choices and discuss them; for example:
Priorities must come from the general manager and his direct reports. Priorities must cascade
from above so that everybody is working on the right things.
Safety is the #1 priority because managers do not want people to get hurt. It is not #1 because
it is the largest cost.
New system does not do a trend analysis (e.g., performance vs. a year ago or vs. last rolling 12
months). What is key is whether manager did in January what he said he would do (vs. agreed-to
benchmark).
Focuses on controllables. For example, melt shop manager controls KWH/T, not electricity
Apparent reduction in the manufacturing managers financial responsibility. (The new system
reported only what the employees reporting to each manager spent. Those are the dollars that can
be controlled.)
Its not a cost system. Company still needs a cost system. The company still does not have a
handle on what costs are controllable, what are fixed and variable, etc.
25-10
Should show consumption, not purchases. (There is still a problem with the source of the data.)
The performance standards are not benchmarked with the best in the industry. (Firms in the steel
industry do not share much operating performance information.)
Uncontrollables still not handled well. For example, what happens if the plant shuts down for a
few hours? Should this be segregated from the managers performance reports?
Should the system focus on exception reporting, rather than provide all the detail?
Division managers decided to discontinue the old system immediately? What are the advantages
and disadvantages of that decision?
Managers would never adapt to new system if old system was still running. After the switch to
the new system, they were frequently in Rob Cushmans office begging for their old reports.
(Actually the old system is still being run, for inventory valuation and product costing purposes.
But the operating managers have not been told that the old system is still running.)
The risk of the immediate switch-over is that uninformed decisions will be made: Managers dont
have their old information, and they dont yet understand the new information. But the new
system seemed to work. The periods after the switch-over to the new system were the best in the
history of the plant.
Department managers had no input into the design of the new system? Was that wise?
Ideally it should be the operating managers, not the accountants, who identify what is critical to
their areas. But the operating managers were consulted, and they said only, We want the old
system. Only three managers in the division wanted the new system the general manager, the
director of finance, and the manager of cost accounting. The other 997 people in the plant were
indifferent to overtly combative.
What can be done to get operating managers to take the lead? Training? Hiring? Should
accountants have a role in measuring quality, on-time delivery, etc.?
Why did Bob Nenni devote so much energy to the performance measurement system instead of
working on, for example, an activity-based costing system, which Armco does not yet have?
He thought the performance measurement system, with its link to strategic priorities, was much
more important than an accurate costing system.
25-11
Under the new system at Armco, the handling of uncontrollables is at the discretion of the
individual superior. The lines between controllables and uncontrollables are tough to define. The
company has a culture of making excuses.
This teaching note was prepared by Professor Kenneth A. Merchant. Assistance from Professors Thomas W. Lin and Dan
Elnathan is gratefully acknowledged. Copyright 1998 Kenneth A. Merchant.
25-12
4.
5. Evaluate FPGs incentive compensation system. What are the advantages and disadvantages of
smoothing incentive compensation?
Case Analysis and Possible Discussion Questions
1. Describe the Formosa Plastics Group (FPG).
FPG is a Taiwan-based conglomerate consisting of more than 10 different companies located in
Taiwan, China, and the United States. It includes several chemical, plastics, electronic, and textile
companies, as well as a modern hospital, a nursing school, a technical college, and a medical college.
More facts about the company can be pulled from the case. Here is some more recent information:
a. In 1994, FPG completed a $2.1 billion petrochemical and plastics-making plant in Point Comfort,
Texas. This was the largest investment by a privately held corporation in Texass history.
b. Taiwanese law does not include a holding company-type organization. FPG actually has a
complex ownership structure. The dominant shareholders are a family of two brothers, Y.C. Wang
(chairman, 80 years old in 1997) and Y.T. Wang (president, about 73 years old). The two brothers
own at least 20% of all companies in FPG.
c. The case does not make it obvious, but the actual running of FPG is in the hands of the Chairman,
not the President. Staff in the Presidents Office take orders both from the Chairman and the
President directly. The Chairman has a dictatorial management style. He was raised by a poor
village family and had to quit school after the sixth grade. But he taught himself how to master a
complex company. His young brother (the FPG President) is more of a human relations-oriented
person. Most people in Taiwan believe the two brothers make an excellent management team.
d. As an indication of the centrality of FPG in the Taiwanese economy and of the significance of the
Chairman, in particular, it is interesting to note that the Taiwanese stock index fell 5% in one day
in early 1994 when a rumor circulated that Chairman Y.C. Wang had died.
2. What are the major types of financial responsibility centers in FPG?
a. Companies and Divisions: investment centers (ROI measure)
b. Plants and Product Groups: profit centers
c. Production Processes and Group of Machines: cost centers
d. Non-production-oriented units, such as sales, technology, management: revenue or discretionary
expense centers
3. What are the major problems facing FPG management in the early 1990s?
Labor shortages and rising wages. At FPG, labor costs are significant, but less than 20% of total
production cost. They are actually much smaller in some divisions (e.g., polyethylene). Labor costs in
the United States are approximately 50% higher than in Taiwan. Taiwanese wages are higher than in
other producing countries (e.g., Indonesia, Mexico), but Taiwan has higher productivity than most
developing countries.
25-13
Many FPG divisions compete on price, but they cannot raise prices because their products are
commodities. At the same time, most raw material prices (e.g., petrochemicals) are volatile and not
controllable. Thus, profits go up and down. The goal of many of the divisions is simply to produce at
full capacity.
A growing problem which is not directly relevant to this case is the radicalization of the
environmental movement in Taiwan.
At the Polyolefin division, specific problems include uncertainty in the raw material markets with
respect both to prices and availability and uncertainty in the markets for its own products.
4. Describe and evaluate the major elements of FPGs control system.
a. Each company and division has a target ROI. ROI is defined as profit before taxes but after
allocation of corporate expenses divided by divisional investment only.
b. FPG uses a target costing (with benchmarking from Japanese companies) approach to the budget
planning. Standard costs are revised promptly when conditions so warrant. These changing target
costs are used to motivate continuous improvement.
c. An extensive set of monthly performance reports (Exhibit 3).
d. Chairman and Presidents monthly detailed performance review meetings with 30 senior
managers.
e. Bonus plans. These plans have some unique features:
i.
FPG bonus pools are determined at the time of budgeting, not after actual profit has been
measured.
ii. The bonus potentials vary by organization level and role. Workers below section chief level
receive a performance bonus program about 20-26% of their base salaries. Management has a
special performance-based bonus fund. Technical people such as R&D have incentive
rewards for good ideas.
iii. Total FPG bonus amounts paid per year did not vary much over time due to the Reserve
Bank system. By creating reserves for bonuses, the company is smoothing the employees
bonus stream.
iv. Every employee automatically gets 3-5 months of base salary as a so-called bonus each year.
This is cultural. It is traditional in Taiwanese for every employee (even government
employees and university professors) to get a minimum of two months pay as a year-end
bonus. (Many Japanese firms give their employees at least four months pay as a year-end
bonus.) These payments are not performance-dependent.
f.
25-14
This Office is a very costly system feature, but it serves three purposes: (1) helping the Chairman
and the President to control and evaluate line managers, (2) helping different divisions, plants,
and product groups to continuously improve their performance, and (3) serving as the training
ground for these staff persons for future higher line positions. Many Japanese companies also
rotate people through different functions in their career, so that by the time a Japanese manager
gets into a top level position, he knows almost all the companys functions/processes/products.
It is interesting to note that the Chairman and the President also have many relatives working in
different parts of FPG. Through regular family gatherings, relatives also provide some inside
information on particular divisions or departments.
5. Describe FPGs annual planning process. Is it more a top-down or bottom-up process?
a. Four-month planning process, begins in September and ends in December.
b. It starts with a bottom-up planning. Division level managers submitted their sales plan and
production plan. Then the top management made suggested revisions. The revision process
iterates two or three rounds.
c. Top management uses the targeting pricing/costing approach. Continuous improvement is
stressed. Each division is expected to use improvement projects to reduce costs each year. Funds
are available for these projects.
d. Top management is prone to reject the initial budget proposals, to ask for more profit. This
procedure adds a top-down dimension to the process, and it creates some gaming behavior. The
lower-level managers expect their initial plan to come back for revision, so they produce a
conservative plan which leaves some room for improvements in future round(s).
6. Describe FPGs performance evaluation process.
a. Primarily subjective, but objective numbers form a basis for the subjective evaluations.
b. The budget is used as the basis for evaluation. The probability of achieving targets is around 8090%. Performance targets are sometimes revised due to environmental changes.
c. Managers are evaluated by considering controllable factors, both financial and nonfinancial
measures, such as quantity of product sold, production efficiency, production schedules,
consumption of materials, cost control, inventory control, leadership, and product quality.
d. Changes in results due to activities that were approved by top management after the budget was
approved (e.g., improvement projects) are adjusted for in the evaluations.
e. Those making evaluations and assigning bonuses also take into consideration the persons ability
and potential for the future, years in the company, teamwork, cooperation, and the situation the
person faced. It is very subjective. FPG employees must trust their evaluators.
7. Is the Polyolefin division a profit center?
Yes and no. Profit of the entity is measured, but the manager, Mr. Hsaio, is not held accountable for
profit. FPG managers have concluded that he does not control significant elements in the profit
calculation. In particular, ethylene accounts for 60-65% of the divisions total product cost; there is
only one local ethylene supplier owned by the government; ethylene prices are set by the government;
ethylene prices fluctuate significantly; and prices of the divisions output (polyethylene) do not
fluctuate with the input (ethylene) prices.
25-15
25-16
e.
11. What happens when the chairman and president retire?
This is a major concern for FPG employees. Here is a representative comment from one manager:
As long as chairman Wang stays, fundamentally there will be no change. He is the founder, and
he knows everything very well. Our system is good, and our goals will be the same. I dont even
know how many of us have contemplated change because Chinese people believe their leaders
will be long-lived. But when our chairman changes, things will be different. One mans
leadership can have a significant effect.
If Chairman Wang retires, who will be the new leader? Would we change our strategic
direction away from commodity chemicals in favor of creation of higher value added
products? If that happened, would the system have to change? I guess it depends on the
needs of the company and the philosophy of the new managers. It is clear that the second
generation of managers will be different. They have been educated in Western Europe and
the United States and have been less influenced by the Japanese.
12. Does anything else threaten FPGs system?
Some managers were also concerned that FPGs success might be threatened, ironically, by the
advancing Taiwanese standard of living. They noted that the cost of labor was increasing, and it was
becoming harder to motivate employees. One manager said, The younger generation likes leisure,
and the older generation is getting lazy. They have more money and more time to spend it.
25-17