Cases From Management Accounting Practices

CASES FROM MANAGEMENT ACCOUNTING PRACTICES
Table of Contents
Case 1: Bal Seal Engineering

Robin Cooper
Case 2: Bill’s Custom Planters

William Stammerjohan
Deborah Seifert
Case 3: Dublin Shirt Company

Peter Clarke in assoc. with
in assoc. with Paul Juras
Wayne Bremser
Case 4: ECN.W
William Lawler
Case 5: Endesa
Gary M. Cunningham
Scott Ericksen
Francisco J. Lopez Lubian
Antonio Pareja
Case 6: Kincaid Manufacturing

Jon Yarusso
Ram Ramanan
Case 7: Osram.NA
John Shank
Lawrence Carr
William Lawler
Case 8: Pleasant Run Children’s Home

Brooke E. Smith
Mark A. McFatridge
Susan B. Hughes
Case 9: University Bottom Line
Enrico Uliana
Editor’s Remarks
I am pleased to present the nine teaching cases presented at the 2002 Conference of the
Management Accounting Section of the American Accounting Association. These cases
provide a wide range of topics and contexts for use in upper level undergraduate and
MBA classes. Here is a list of the cases, authors and topics discussed.
Bal Seal Engineering, by Robin Cooper, discusses alternative cost management

approaches: traditional, ABC, and TOC.
Bill’s Custom Planters, by William Stammerjohan and Deborah Seifert, discusses

production and cash flow projections, developing pro forma statements and sensitivity
analysis.
Dublin Shirt Company, by Peter Clarke in association with Paul Juras and Wayne
Bremser, discusses customer profitability analysis.
ECN.W, by William Lawler, discusses ABC in a service organization.
Endesa, by Gary M. Cunningham, Scott Ericksen, Francisco J. Lopez Lubian and

Antonio Pareja, discusses strategy and control issues in a changing organization.
Kincaid Manufacturing, by Jon Yarusso and Ram Ramanan, discusses supply chain
management.
Osram.NA, by John Shank, Lawrence Carr, and William Lawler, discusses economic
value to customer and related life cycle costing issues.
Pleasant Run Children’s Home, by Brooke E. Smith, Mark A. McFatridge, and Susan B.
Hughes, discusses dealing with the financial condition of a not-for-profit organization.
University Bottom Line, by Enrico Uliana, discusses management control issues in a

university.
I thank these authors and all of the other authors who submitted cases to
the conference. I also thank members of the editorial board for their help
in reviewing cases: Tom Albright, Wayne Bremser, Paul Juras, Ken
Merchant, Gary Sundem and, especially, Larry Carr and Jim Mackey. I
am grateful to the other conference organizers, Steve Hansen, K.
Sivaramakrishnan and Naomi Soderstrom for their advice and help. I am
grateful for the help of Leslie Estelle at the IMA for her work in putting
these cases into Management Accounting Quarterly. And on behalf of the
members of the Management Accounting Section of the AAA, I thank the
IMA for its support.
Bal Seal Engineering Company, Inc.
Peter Balsells and his late wife Joan founded Bal Seal Engineering Company, Inc in
1958. From humble beginnings, the firm grew steadily primarily based upon a strategy of
selling the most innovative products in the industry. In particular, Bal Seal’s products
were characterized both by the high value they provided and the technical manufacturing
challenges they overcame. The initial invention that formed the basis for the firm’s
success was a canted-coil spring in a polytetrafluoroethylene (PTFE) jacket (Figure 1).
The advantage of the canted-steel coil spring, over a conventional one, was its ability to
produce near uniform force over its operating range. In contrast, a conventional spring
provided a linearly increasing force as deflection increased (Figure 2). This property of a
canted coil spring was critical in ensuring both an effective seal and an extended
operating life.
The firm considered itself an industry leader and standard setter in providing customers
worldwide with innovative solutions to their industrial sealing problems. The firm, over
its 40-year life, had created in excess of 60 active patents and numerous other innovations
that had helped shape the seal and spring industry. This innovative history had provided
the firm with, what top management considered a sustainable competitive advantage. The
firm’s profit margins were historically higher than industry average reflecting both its
advantageous patent position and high level of engineering skills.
In 2000, sales were just under $25 million. The company’s customers were primarily in
the medical equipment, analytic equipment, industrial OEM, and semiconductor
industries. The company sold directly from the factory with the assistance of independent
manufacturer’s representatives who covered the territories of Canada and the United
States. Internationally, the company had a sales office in Western Europe and had
contracted with several distributors who provided coverage of the Japanese and
Australian markets.
Product Development
The firm had developed its own approach to product development that consisted of three
steps; design, fast prototyping, and production. In the design phase, the firm’s engineers
concentrated on understanding the customer’s requirements. The firm’s products were
used in a wide variety of applications and most were custom designed. Many of these
applications presented state-of-the-art challenges in sealing technology. Without careful
attention to the underlying requirements, the firm could easily fail to design an effective
seal. Fast prototyping consisted of rapidly creating a working example of the new
product. Fast prototyping had two advantages. First, the customer could, early in its own
product development process, test the new seal to ensure that it would be effective in the
specific application for which it was designed. Second, the fast prototype enabled the
manufacturing engineers to designate specific quality control steps and to establish
guidelines for cost-efficient production. The final step, production consisted of ensuring
that very high quality products were produced on a timely basis. The firm’s commitment
to quality was necessarily extreme because its products were relatively inexpensive
compared to the customers’ end products in which they were used. However, since seal
malfunction could lead to disastrous failure of the customer’s product, long-term
consistent performance of the firm’s products was essential. Consequently, Bal Seal’s
manufacturing process was geared to produce products that had exceptionally long mean-
times between failures.
Production Process
A spring-energized seal consisted of a plastic U-cup ring and a canted-coil spring. The
purpose of the plastic ring was to ensure that metal to metal contact did not occur
between a piston and its housing. In addition, the seal was often designed to provide the
piston with both support and guidance. The seal could either be mounted on the piston
(Figure 3) or on the housing (Figure 4). The springs and plastic rings were manufactured
independently and then assembled to create the seal. While springs were sold separately,
plastic rings were only sold as part of a completed seal.
Products were produced to order, only a small number of items were retained in finished
goods inventory. For small orders, only one production run was required. However, for
larger orders it was necessary to break production into multiple production runs so that
other orders were not excessively delayed. The production process consisted of three
major stages; spring production, ring production, and final production and assembly
(Figure 5).
Ring production required 5 major steps. The first step consisted of taking powdered
PTFE and mixing it. Subsequently the mixture was placed in an oven where it was
pressed under high pressure to form the desired shape. The shaped pipe was then
removed from the mold and cooked in a sintering oven to harden it. After sintering, the
sintered pipe was ground to the desired size and specifications. The completed seal blank
was then placed in the buffer inventory that was maintained before the computer
numerically controlled (CNC) machines. Blanks are machined to customer specifications
to create rings soon after receipt of the customer order.
Spring production was proprietary and only senior executives and the specially trained
workers were allowed to enter the area of the factory where springs were produced. Bal
Seal senior management was convinced that the firm had created a sustainable
competitive advantage from the proprietary technology associated with spring
production. Consequently, intense security was applied to this production area to ensure
that competitors could not learn anything from visiting Bal Seal or hiring its normally
trained employees.
Computer numerically controlled (CNC) equipment was used to create the seal. The part
was then inspected to ensure that it was up to specifications. Assembly consisted of three
major steps. In the first step, the spring and seal were assembled to create the completed
product. In the second step, the part was inspected to ensure that it met specifications. In
the final step, the completed seal was tested to ensure that it provided the near uniform
resistance that was characteristic of canted coil spring technology. The completed part
was then released to shipping and sufficiently early to insure on-time delivery. Only a
few standard parts were maintained in finished goods inventory to ensure that unexpected
demand for such items was met in a timely fashion. Total finished goods inventory
accounted for only two days of average production of stocked items.
Theory of Constraints
The theory of constraints emerged in the mid-eighties as a way to better manage

constrained resources and hence increase firm profits. Bal Seal had adopted the theory of
constraints as both its production philosophy and its product costing methodology in
1997. In the theory of constraints, a single machine, or class of machines, is identified as
the bottleneck. The bottleneck machine or machine class is the one that limits the overall
level of production of a product, product family, or product line. To maintain maximum
output, the bottleneck machine, or as it is more formally known the capacity constrained
resource, is kept busy at all times. Any other machine or production operation could be
idle as long as it does not lead to the bottleneck machine being starved.
The theory of constraints has its own language. The throughput of a system is the revenue
generated in the period of analysis.
Throughput = Revenue
The throughput contribution is the revenue generated by an order minus the totally
variable costs associated with it.
Throughput Contribution = Throughput – Totally Variable Costs
The operating expenses are all of the costs that are not totally variable with production
volume. Profit is given by subtracting operating expenses from total throughput
contribution:
Profit = Total Throughput Contribution – Operating Expenses
Ensuring that the maximum throughput contribution is generated maximizes the profit
generated. That objective is achieved by manufacturing products that have the highest
throughput contribution per constrained minute for which bottleneck capacity is
available. The throughput contribution margin per constrained minute is the throughput
margin generated by the order divided by the time it takes on the bottleneck machine
measured in minutes.
Throughput Contribution/ Constrained Minute = © 2001 by Robin Cooper 3
Throughput Contribution / Time on Bottleneck Machine
The objective of the theory of constraints is to maintain as high an average throughput

margin per constrained minute as possible, while keeping the bottleneck machine fully
loaded. If this objective is achieved, according to the theory of constraints, profits will be
maximized.
Five simple rules govern the approach:
1. Identify the constraint.

2. Decide how to exploit the constraint.
3. Subordinate everything else to the above decision.
4. Elevate the constraint.
5. If the constraint has been broken, go back to step 1
Under these five rules, the majority of continuous improvement efforts are focused upon
increasing the output of the bottleneck resource; only reduced attention is paid to making
the non-constraint activities more efficient.
At the heart of theory of constraints is the drum-buffer-rope scheduling system. In this

approach to scheduling, a protective buffer is maintained in front of the machine that
creates the constraint. This capacity constrained resource (CCR) buffer is designed to be
sufficiently large that it ensures that the bottleneck is never starved. Theoretically, the
size of the buffer is determined as a trade-off between security versus lead-time. In
practice, as was the case at Bal Seal, it is often determined from experience.
At Bal Seal, the conversion to the theory of constraints went extremely smoothly and
within three months the firm’s manufacturing performance had improved dramatically
with overall production levels higher and production costs lower. As the firm smoothed
out its production process, the firm’s cash flow became more predictable. Senior
management was very pleased with the ease of the transition to theory of constraints and
identified it as one of the major strengths of the approach. For example, they compared
their experience favorably to the length of time other firms had taken to shift to lean
production. In their opinion, the shift to lean production, typically took longer because it
required balancing most, if not all, of the firm’s production processes, not just the
bottleneck ones. In addition, they felt that the cultural changes under the theory of
constraints approach were much less demanding than those required by the adoption of
lean production. The non-bottleneck resources could be managed much the same as they
always had been thus reducing the amount of learning that had to be achieved to bring the
new production approach on line.
The theory of constraints was also adopted, at Bal Seal, as the basis for product costing.
Under the theory of constraint approach, with the exception of the costs that are totally
variable with the number of units produced, all other costs (operating expenses) are
assumed to be fixed in the short term. In most settings, the only significant totally
variable cost is material, other totally variable costs such as the electricity required to run
the machines are typically ignored as they are small compared to material costs and
instead, they are treated as part of operating expenses. At Bal Seal only material, freight,
and sales commissions were treated as totally variable costs and hence subtracted from
revenues to give the throughput contribution for the period. In the firm’s traditional cost
system, the freight and sales commission costs were treated as indirect costs and assigned
to products using direct labor dollars.
Activity-Based Costing
Activity-based costing emerged in the mid 1980s as a way to report more accurate
product costs than was possible by traditional cost systems. Activity-based cost systems
differed from their traditional counterparts in two ways. First, the cost pools represented
activities performed and not types of production processes. Second, the way costs were
assigned to products was more sophisticated. In traditional systems only unit-level cost
drivers were utilized. Unit level drivers were those drivers whose driver quantities
doubled when the number of units produced of a product doubled. Examples of
frequently used unit-level cost drivers in traditional systems include direct labor hours
and dollars, machine hours, and material dollars. In contrast, in activity-based cost system
two other types of cost drivers were utilized. The first type was batch-level drivers and
the second type was product-level drivers. Batch-level drivers were used to assign the
costs of activities that were performed every time a batch was produced. Examples of this
type of activity include machine setup, material movement, and production scheduling.
Examples of batch-level drivers include setup hours, number of setups, and number of
batches or production runs. Product-level drivers were used to assign the cost of activities
that were performed to sustain the ability to manufacture particular products. Examples
of product-level activities include parts administration, process engineering, and bill-of-
material maintenance. Examples of product-level cost drivers include number of parts,
number of part numbers, and number of engineering change notices.
Proponents of activity-based costing argue that it provides a more accurate picture of the
cost of the resources consumed by different products than traditional cost systems. In
particular, activity-based cost systems are sensitive to batch size and overall production
volume and thus report higher costs for the same product if it is made in small batches or
overall low volume than if it is manufactured in large batches or high overall volume. In
contrast, traditional systems reported the same product costs irrespective of the batch size
or overall production volume of a product. Thus, activity-based cost systems were
sensitive to scale economies while their traditional counterparts were not.
Product Costing at Bal Seal

In 2000, Bal Seal did not utilize either traditional or activity-based costing to determine
product costs; instead it relied solely upon its theory of constraints system to support its
pricing and order acceptance decisions. Prior to the adoption of the theory of constraints,
the firm had developed a traditional costing system. This system consisted of the direct
assignment of material, labor, and setup costs and the indirect assignment of all other
costs. The indirect costs were assigned to the products using a single cost pool using
direct labor dollars as the cost driver. In 1999, the overhead burden rate that would have
been used in the traditional costing system was 500%. Bal Seal’s traditional costing
system was slightly unusual in that it isolated the costs of setups from normal run costs.
Setup costs were assigned to the batch as a lump sum and then divided by the number of
units in the batch to develop a unitized setup cost. The sum of the run cost and the
unitized setup cost was the total unit cost of the product. The advantage of this approach
was that it reported different costs for the same product depending upon batch size with
reported unit costs dropping as batch size increased. Thus, Bal Seals’ old traditional
costing model, because of the way it incorporated setup costs, was somewhat sensitive to
batch size. However, since it ignored the implications of non-setup related batch-level
costs and all of the product-sustaining costs, it was at best a partial activity-based cost
system.
In 1999, a specialist in activity-based costing visited Bal Seal. He was interested in the
relationship between theory of constraints and activity-based costing and wanted to study
an active theory of constraints implementation. Many theory of constraints advocates
believed that activity-based costing was a misleading costing approach that led to poor
decisions. At the heart of this perspective was the inability of the activity-based costing
approach to identify bottlenecks and thus ensure that they were kept fully loaded. Since
any failure to keep the bottleneck fully and efficiently loaded resulted in lower profits,
the position adopted by advocates of the theory of constraints was that activity-based
costing led to inferior performance. In contrast, most activity-based costing advocates
had a different opinion; they believed that theory of constraints was the appropriate
solution for short-term decisions in which the firm’s infrastructure (their term for
operating expenses) could not be modified. However, they believed that over the long
run, the firm’s infrastructure could be modified in ways that led to overall superior
performance. Thus, they perceived the optimum solution to be to use theory of
constraints for short-term decisions and activity-based costing for long-term decisions.
To help understand the relationship between the two approaches, the specialist identified
five orders that the firm had recently received for different members of its Mark IV
family of Balance Seal products (Exhibit 1). The primary difference between the orders
was the number of units ordered. He chose these five orders because he felt that, despite
being from the same family of products, they covered the entire spectrum of orders
received by the firm. In particular, they captured small, medium, and large volume
orders. Furthermore, the selling prices of the Mark IV product family were relatively easy
to estimate despite being dependent upon the size of the order and the industry in which
seals were to be utilized. Mark IV seals were primarily used in medical equipment
industry and the historical bidding information was sufficiently detailed to enable quite
accurate estimates of probable selling prices to be developed. Such detailed information
was not available for many of the firm’s other product families.
The specialist asked Bal Seal management to determine the profitability of the five orders
using the theory of constraints. To provide a basis for comparison, he designed a simple
activity-based cost system for Bal Seal. This system identified two additional indirect
cost pools to the one that was used in the firm’s old traditional cost system. The first
additional cost pool was a batch-level one. It captured the costs of ensuring that a
production order was processed. The second additional cost pool captured the cost of the
product-level activities. In particular, it identified the parts administration costs
associated with each member of the Mark IV family. Removing the batch-level and
product-level costs from the direct labor cost pool reduced the direct labor dollar burden
rate to 115%. This burden rate also excluded the freight and sales commission costs
which the expert felt should be treated as costs of the order in addition to the setup and
order processing costs.
Management’s Reaction
Bal Seal top management was not convinced that even experimenting with activity-based
costing was a good idea. They justified this perspective based upon several deeply held
views. First, the success of theory of constraints, at Bal Seal, was such that they were
unwilling to risk disrupting it with even an experiment. Second, they believed that the
theory of constraints approach was philosophically superior and that activity-based
costing would simply cause people to focus excessive attention on non-bottleneck
resources. Attention that they felt was better directed to increasing the throughput of the
capacity constrained resource. Third, they believed that it would be confusing to have
two sets of reported product costs “floating” around the firm – one based on theory of
constraints and the other based on activity-based costing. In particular, they felt that this
confusion would be particularly serious if one of the two approaches recommended
selling a product that the other indicated was unprofitable.
Bal Seal Assignments
It will help considerably to work in Excel or another spread sheet program, as many of
the calculations are identical except for the price list. The following graphs will also be
beneficial in helping you gain insights into the capabilities of the various costing
approaches; traditional profit margin versus ABC profit margin, unit contribution or
profit versus volume, and ABC unit profit versus TOC unit contribution per minute.
Price Lists – Pair 1
1. Determine the cost and profitability of the five selected orders using the firm’s
traditional cost system, TOC system, and the activity-based cost system proposed
by the visiting specialist.
2. Bal Seal has only a small amount of bottleneck resource available. It receives an
order for 1,000 P5 Mark IVs and 35 orders for 10 units each of 35 different
products that have the same overall production characteristics as the P1 Mark IV
Balance Seal. The high volume order or all of the small volume orders will
consume the remaining bottleneck resources. Which of the orders would the three
costing approaches suggest accepting?
3. Which orders would you recommend be accepted?
Repeat the above calculations assuming that the selling prices are:
Product Identification Order Volume Selling

Price
P1 10 $100.00
P2 50 $20.00
P3 200 $4.75
P4 500 $3.00
P5 1,000 $2.50
Would your recommendations about which orders to accept change?
4. Analyze the pricing strategies that are being used in this industry based upon the
two sets of prices. Hint, it will help if you look at the rankings of profit in each
pricing scenario.
Price Lists—Pair 2
5. Repeat the calculations assuming that the selling prices are:
Product Identification Order Volume

Selling Price
P1 10 $69.50
P2 50 $16.50
P3 200 $9.50
P4 500 $8.50
P5 1,000 $8.25
6. Repeat the calculations assuming that the selling prices are:
Product Identification Order Volume

Selling Price
P1 10 $47.50
P2 50 $22.40
P3 200 $19.25
P4 500 $18.00
P5 1,000 $17.75
7. What is the best way to integrate TOC and ABC?
8. If your recommendations include computing both TOC and ABC costs, how
would you explain your solution to Bal Seal management given their concerns
about the potential resulting confusion?
9. Analyze the pricing strategies that are being used in this industry based upon the
last two sets of prices. Hint, it will help if you compare the unit ABC profits and
TOC contributions generated in each price scenario.
Exhibit 1
Information on the Mark IV Family of Balanced Seals
Order Information
Product Order Unit Number Estimated Annual

Identification Volume Selling Of Production Production
Number Price Runs for Order Volume
P1 10 $50.00 1 10
P2 50 $9.00 1 75
P3 200 $5.00 2 500
P4 500 $4.00 3 2000
P5 1,000 $3.75 5 5000
Cost Information
Material Costs $0.40

Labor Costs $0.33
Order Processing Costs $75.00
Set-Up Cost/Run $45.00
Parts Administration/Product $500.00
Freight 5% of selling price
Sales Commission 10% of selling price
Processing Time Information for CNC Machines
Run time per unit 1.5 minutes

Setup Time per run 30 minutes
Figure 1:
Bal Seal Engineering Company Inc.
Canted-Coil Spring Seal
Figure 2:
Canted-Coil Spring Performance
Normal Working
Deflection
Force
Conventional;
Spring
Canted-Coil
Spring
5% Deflection 35%
Figure 3:
Piston Mounted Seal
Piston
Figure 4:
Housing Mounted Seal
Piston
Figure 5:
Production Process
Final Shipping
Proprietary
Inspection
Spring Production Ring Production Material Production

Figure 6:
Production Timeline
Shipping
Buffer
Post-Constraint
Processing
Constraint
Process
Constraint
Buffer
Pre-Constraint
Processing
Bill’s Custom Planters1
William Stammerjohan, Washington State University
Deborah Seifert, Washington State University
Bill’s Custom Planters (BCP) manufactures a line of decorative wooden planter

boxes that are sold to both retail and wholesale customers. Dr. Bill started building
custom planter boxes in his garage as a hobby/business about ten years ago. His custom
planter boxes were so popular that he quit his “day job” seven years ago and began to
manufacture planter boxes full-time. Dr. Bill rarely builds a planter box himself anymore
because he is now the full time manager, production supervisor, sales force, and
bookkeeper. The word “custom” no longer truly describes the planter boxes because BCP
now offers only one model that is available in four, very similar, variations.
Several factors have contributed to increased popularity, increased demand, and

increased production volume for the planters over the last few years. A feature article in a
regional home improvement magazine, “Northwest Home and Garden” got the ball
rolling for the planters a couple of years after Dr. Bill went into business full-time. A
monthly display ad in the same magazine appears to have contributed to increases in both
retail sales and wholesale customer demand. Dr. Bill significantly increased production
capacity almost four years ago when he moved BCP into a new rented building and
bought all new equipment.
Like many small businesses, BCP’s growth has not been without setbacks. The
sale of planters is seasonal by nature and shortly after the move into the new building,
BCP was suddenly faced with new price competition from a much larger supplier of
garden supply products. The “custom” planters that BCP was building at that time were
priced a lot higher than the current more generic model. The market seemed to become
“price sensitive” overnight and the sales volume dropped precipitously. It took Dr. Bill
several months to realize that he had to simplify his product line and become competitive
if BCP was going to survive.
It seems that BCP has now weathered this storm, but there are some lingering
scars from this period. Dr. Bill’s credit rating is now far from perfect. This is the result of
several very late interest and principal payments on the equipment loan, and an inability
to make timely interest payments on a former credit line balance. After his former bank
canceled his credit line, several other local banks refused to extend credit to either Dr.
Bill or BCP. Dr. Bill feels fortunate that his current bank, No Heart Trust Co. (NHTC),
agreed to extend a small line of credit during BCP’s darkest days and has grudgingly
agreed to some small increases in the credit limit over the last two years.
The NHTC credit line currently has a $60,000 credit limit. NHTC requires BCP to
maintain a minimum cash (checking account) balance of $6,000, or 15% of the
1
We would like to thank Tom Albright for his insightful discussion comments at the
2002 AAA-MAS Conference.
outstanding credit line balance, whichever is greater. NHTC requires a minimum
payment of the accrued credit line interest on the last day of each month (12% annual
rate). The now current equipment loan requires a minimum principal payment of $2,000
plus accrued interest on the last day of the month (8% annual rate).
The key factors describing BCP’s current operations include the fact that all retail
sales are mail order and the wholesale customers are either home improvement or garden
supply stores. Retail customers pay for their purchases by credit card and all wholesale
sales are on account. The retail price is $70.00 plus $8.00 shipping and handling.
Wholesale customers receive a $20 per planter discount off the retail price and all
wholesale shipments are sent freight collect. On an annual basis, about 30% of the
planters are sold retail and 70% are sold wholesale.
NHTC deducts a 3% service charge on credit card sales and credits BCP=s
account almost instantaneously. Wholesale customers are billed on the last day of each
month and are given terms of 2%-10th/net 30. Forty percent of all credit sales are
collected during the discount period, 20% within the net 30 period, 25% one month late,
and 13% two months late. Roughly 2% of credit sales are never collected.
BCP has the capacity to produce 800 planters per month using one shift. BCP has
eight employees that each work 160 hours per month performing direct labor. Wood is
purchased from a local supplier on an “as-needed” basis. The local supplier has a very
good record for both quality and on-time delivery, but will only deliver on a COD basis.
The COD arrangement is another remnant of the period when Dr. Bill was not able pay
BCP’s bills on a timely basis. While Dr. Bill has re-established credit with the hardware
supplier, BCP must buy hardware in lots of 1,500 sets to receive competitive pricing.
Hardware delivery takes about one month from the time an order is placed. The hardware
supplier pays the shipping cost, but requires full payment within ten days of receipt of the
hardware. Selling and Administrative expenses are $2,500 per month plus $3.40 per
planter sold. All cash overhead costs, rent, shipping and handling costs, and selling and
administrative expenses are paid in the month incurred.
Dr. Bill’s current estimation of the cost per planter is as follows:
Bill’s Custom Planters

Schedule of Planter Cost
For 2003
Direct Materials:
Wood $10.00
Hardware (1 set per planter) 5.00
Direct Labor: (1.6 hours @ $11.00 per hour) 17.60
Variable Overhead ($2.00 per direct labor hour) 3.20
Fixed Overhead (based on 800 planters per month) 5.25
Cost Per Planter $41.05
The shipping and handling cost per planter sold retail is $6.00. The $4,200 per
month in fixed overhead is comprised of: building rent, $1,000; equipment depreciation
(12 year/straight-line), $2,000; and casualty and liability insurance, $1,200.
BCP’s expected financial condition is reflected in the 12/31/02 Pro Forma

Balance Sheet. Although Dr. Bill has returned BCP to profitability, and although all the
interest and other liabilities are now current, the equity balance is mostly the result of
money that Dr. Bill contributed to the corporation when he “cashed out,” his former day
job retirement account. Dr. Bill does not draw a regular salary, but was able to take a
modest dividend in September 2002…

Pro Forma Balance Sheet
As of 12/31/02
Cash $ 6,000
Accounts Receivable $ 43,750
Less: Allowance 2,250 41,500
Finished Goods Inventory (500 planters) 20,000
Hardware Inventory (1,200 sets) 6,000
Equipment $288,000
Less: Accumulated Depreciation 92,000 196,000
Total Assets $ 269,500
Accounts Payable (hardware) $ 7,500

Credit Line 30,000
Equipment Loan 190,000
Equity 42,000
Total Liabilities and Equity $ 269,500
The current accounts receivable balance results from credit sales over the last
three months of 2002 and from a few chronically past due accounts. Credit sales for
October, November, and December were $25,000, $20,000, and $30,000 respectively. As
usual, business has been up and down during the winter months. Dr. Bill generally tries to
increase the finished goods inventory over the late fall and early winter to be prepared for
the big sales months that follow. The expected sales for January through May 2002 are
900, 1,200, 1,400, 1,200, and 1,000 planters, respectively. Sales are expected to return to
a normal level of 800 planters per month by June. Dr. Bill expects 90% of the January
and February sales and 80% of the March sales to be to wholesale customers preparing
for their own spring sales. Dr Bill likes to start each month with enough finished goods to
supply at least 2 of that month’s sales requirements.
Dr. Bill is proud of the fact that he has returned his business to profitability, but is
perplexed by the fact that the business is not more profitable. He is also troubled by
business decisions he must make in the near future. Dr. Bill has approached your business
school in late December 2002 and asked for help and guidance. You have been assigned
the task of fulfilling his request. Your first task is to complete a production plan for the
first quarter of 2003. Given his credit history, Dr. Bill is particularly concerned with cash
needs. He is also concerned with staffing decisions during the upcoming busy season.
This assignment requires that you analyze information and make recommendations. Be
sure that you use all the information given, all the accounting and business knowledge
you possess, and your imagination when necessary.
You will find this to be a holistic process, i.e., you must consider the staffing
decisions and cash needs before making your final recommendation on a production
schedule. You may find it necessary to try several combinations of staffing and
production before you arrive at what you believe to be the “best solution.” Your task is to
write a memo to Dr. Bill that addresses each of the following questions. Your memo must
be supported by the schedules and pro forma financial statements listed after the
questions.
1. Address the general question of scheduling production. Explain why, or why not,
you recommend scheduling the excess production evenly each month? What is
the expected finished goods inventory at the end of each month if BCP follows
your production schedule? Do you believe that these inventories are adequate
and/or necessary? Why or why not?
2. Briefly discuss your recommended scheduling of hardware orders. What kind of

safety stock are you recommending? Why?
3. There are two options of providing the extra direct labor. BCP can ask the
existing employees to work overtime, or hire temporary employees during the
busy season. Existing employees would have to be paid time and a half to work
overtime, but can be expected to maintain their normal level of efficiency when
working up to about 200 hours per month each. Temporary employees can be
hired for $8.00 per hour, but their lack of experience and training is expected to
mean much less production per hour. It is expected that these employees will take
about 2.5 hours to build each planter. Be sure to include a discussion of both the
quantitative issues, cost per planter, and the qualitative issues driving this
recommendation. You can choose to fulfill the excess labor needs with any
combination of existing employees and/or temporary employees that you feel will
best serve the needs of BCP.
4. Does it appear that the $60,000 limit on the credit line is going to be adequate? If
not, what steps must BCP take and when will they need to be taken?
5. Although the expected wholesale sales for early 2003 look strong at this point in
time, the wholesale market remains very price conscious. Over the long run, Dr.
Bill believes BCP could double normal wholesale sales from 560 planters per
month to 1,120 planters per month under the following conditions: the wholesale
discount on all planters sold to wholesalers would need to be increased to $24 per
planter; the extra 560 units could be produced by a night shift with fully
productive employees that would be capable of producing a planter in 1.6 hours;
and the night shift could be staffed by paying these employees an additional $1.00
per hour.
Would you recommend increasing the discount? Why or why not? Be sure to
discuss the quantitative issues, expected profit, and the qualitative issues behind
this recommendation. You can assume that BCP would be able to sell the same
number of retail planters per month under either wholesale option.
The required schedules and pro forma financial statements are as follows:
1. Prepare a schedule that shows the beginning inventory, required

production, expected sales, and ending inventory for each month, January
through March 2003. Also show the quarterly totals. The following is a
suggested format:
Three-Month Rolling Production Schedule
For January through March, 2003
January February March Quarter

Beginning Inventory. 500 500
Required Production
Expected Sales
Ending Inventory
2. Prepare a schedule that indicates the order dates for hardware, the
expected arrival dates, the payment dates, the expected inventory prior to
arrival, the order quantity, and the expected inventory following arrival of
each order.

Hardware Order, Arrival, and Payment Schedule
For January through March, 2003
Expected Order Expected

Order Date Arrival Date Payment Date Inventory Quantity Inventory
3. Prepare a cash budget with columns for each month, January through
March 2003, and a fourth column for the quarterly totals. Include separate
lines for: expected cash collections from retail sales, expected cash
collections during the discount period, expected cash collections during
the net 30 period, and expected cash collections during each of the two
late periods. Include separate lines for each type of cash payment, e.g.,
wood, hardware, rent, interest, etc. Include separate lines for the beginning
cash balance, the ending cash balance, and the ending credit-line balance.
4. Prepare a pro forma schedule of the cost of goods manufactured, pro

forma income statement and pro forma balance sheet for the quarter
ending March 31, 2003. Assume that between January 1 and March 31,
2003, two wholesale accounts with combined balances of $1,450 are
identified as uncollectable. BCP capitalizes finished goods inventory at the
actual cost of production and uses the FIFO cost flow assumption.
5. Prepare a schedule or pro forma income statement that estimates the

differences in expected profit between the current wholesale discount and
the proposed wholesale discount.
THE DUBLIN SHIRT COMPANY *
by
Peter Clarke (University College Dublin), Paul Juras and Paul Dierks (Wake Forest
University).
* This case has been heavily adapted by Peter Clarke, with permission, from an
earlier case “Blue Ridge Manufacturing” prepared by Paul Juras and Paul Dierks
of Wake Forest University. The original version appeared in Management
Accounting, December 1993, pp. 57 – 59.
Address for correspondence: Peter Clarke, Department of Accountancy,

University College Dublin, Belfield Campus, Dublin 4, Ireland
E mail address: Peter.Clarke@ucd.ie
Keywords: Activity based costing and customer profitability analysis; target

costing; strategic issues and considerations.
This case has benefited from the helpful comments of James Mackey and Ella Mae
Matsumura and other participants at the Management Accounting Section
Research and Case Conference of the American Accounting Association, Austin
2002.
“For accounting professors who like hard sums and soft issues”
May 2002
THE DUBLIN SHIRT COMPANY
INTRODUCTION
The Irish clothing industry has changed beyond recognition over the past decade. High
cost structures have forced many indigenous and multinational clothing companies to
close down their operations and those that survived have had to find ways of gaining a
competitive advantage. Some have achieved this through switching to niche markets,
while others have begun to outsource garment production to cheaper overseas locations.
Such alternatives have been vital in ensuring the survival of the Irish clothing industry.
Ireland was, traditionally, an outsource location itself, especially for US multinationals
looking for a European manufacturing base with access to the European Economic
Community (now, the European Union). While a small number of multinational
companies remain in Ireland, many have closed and moved on as cost structures made
them uncompetitive. Morocco, Asian and Eastern European countries are becoming key
outsource locations. Employment in the clothing industry in Ireland currently stands at
about 8,000, which compares with an all-time high for the sector of approximately 15,000
ten years ago.
The Dublin Shirt Company was established in Ireland about a decade ago by its American
parent. It is a wholly owed subsidiary. At that time the Republic of Ireland had an
abundant supply of cheap, well-educated and English-speaking labour. In addition, it had
the lowest corporate tax rate in the European Union and a regulatory regime that was
unambiguously pro-business. The political system was stable and the population had
strong links to the US – the primary source of foreign direct investment (FDI) in Ireland.
The company manufactures polo-type sports shirts for the growing worldwide sports shirt
market. (The company presented former US president, Bill Clinton, with one of its shirts,
on his recent visit to Ireland, which included a game of golf in Ballybunion). They are
called sports shirts because their most popular use is for various sporting activities
including major sporting events such as the British Open, Ryder Cup, Super Bowl,
Wimbledon, etc. In addition to being sold to spectators at each event, they are also used
to promote the specific event itself.
The company is located in a small provincial town on the outskirts of Dublin. It is a

medium sized firm (by Irish standards) with annual sales of just under €16 million and an
investment base (i.e. net assets) of some €3 million. For the most recent fiscal year
(2001), the company budgeted for and generated a small loss. A small profit was
budgeted for and reported for the previous year. The CEO of the US parent has already
issued warnings about the continued operation of the company in Ireland due to its
precarious financial position. Obtaining a significant amount of interest-free, short-term
loans from its parent company recently averted a cash flow crisis. If nothing else,
everyone knew that making losses in a low tax regime was bad tax management for the
Group! (The average return on sales is about 4 percent for similar companies in Ireland).
The Company has a modern knitting plant and is currently operating at 70 percent
capacity. There are approximately 100 employees, and most of these are female machine
operatives who are paid on an hourly basis. The weekly payroll calculations consume a
great deal of resources since they are done manually. Because of the high investment in
capital equipment in previous years, together with the loss reported for the current year,
no provision for taxation need be made.
MANUFACTURING
The Dublin Shirt Company knits (i.e. manufactures) all its shirts. The basic product
produced by the company is a white sports shirt (in different sizes). Shirts are made in
three men’s sizes: medium, large and extra large (XL). The company does not
manufacture small sized shirts as it considers this size to be suitable only for children and
it believes this market segment to be rather small. The normal production cycle for an
order of white shirts is five days.
Depending on the client requirements, the shirt may be customized to order.

Customization involves three processes although each process is not, necessarily,
required for each shirt. The three processes are, in sequence, dyeing, stamping or,
alternatively printing, and embroidery.
Nearly two-thirds of the shirts are dyed in various colours. This increases the production
cost and extends the production cycle of an order by about three days. In addition, a
characteristic feature of the “sports shirt” is the promotional text and/or logo that is added
to each shirt. The promotional text and/or logo can be either printed on or machine
embroidered. In the majority of cases, the text is usually printed and this is referred to as
the printing process. The technical term used is that of “stamping” whereby the
appropriate text/logo is added to each sports shirt using a special printing machine.
Recently, the firm has had some difficulty with the “staying power” of the material
printed on these shirts. Customers have complained that the ink eventually cracks and
peels off. A small but increasing number of shirts (about 15%) have the text or logo of
the sports event embroidered rather than “stamped”. This embroidery work adds
enormously to the appeal of the product. The company tries to product each order well in
advance of dispatch so that there will always be a certain amount of finished goods in
stock at the end of each fiscal period.
CUSTOMERS
The Company’s sales are all on credit and are predominantly made to England and the
United States – countries that are outside the Euro zone. (To avoid foreign exchange
fluctuations, the company invoices all its sales in Euro). Typically, customers take about
60 days to pay their account. Currently, the company has 986 active customers. These
customers differ primarily in the volume and type of their purchase order, so management
classifies each customer in one of three groups - priority (8), team (154) and shop (824).
Priority customers are typically the large; international sports events that generate a great
deal of TV coverage. Typical examples are the British Open, Wimbledon, Super Bowl
etc. Shop customers are single shop operations (such as pro shops at golf courses), and
team customers are typically associated with specific teams or clubs. It is company
policy to conduct a full credit check on new customers to avoid the potential of bad debts.
As a result, the amount of bad debts incurred has been insignificant in recent times. The
low amount of bad debts is also partly due to the speed by which invoices are issued to
customers, together with a regular and frequent follow-up of all unpaid invoices. Table 1
gives product and customer classification statistics for 2001.
The Company has a different marketing approach to customers in each of its three
categories. A small group of in-house sales-people sells directly to buyers in the priority
customer category. Independent salespersons, paid on a commission only basis, call on
the licensing agent of customers classified in the team category. Advertisements placed
in regional magazines and newspapers target customers primarily in the "shop" customer
segment, who telephone or post in their orders. Not surprisingly, a significant cost for all
categories is the provision of sample shirts to potential clients.
INFORMATION & PERFORMANCE
In an attempt to start some sort of strategic planning exercise within the Irish plant, senior
managers recently identified its main competitive strengths and weaknesses.
Management believes that the critical strength of the company is in the quality of the
product, and that the weakness in recent years has been in customer service, particularly
in meeting scheduled deliveries. A mission statement for the company was recently
circulated for discussion by the Irish Board and read “to provide a reasonable return to
shareholders by providing high quality products to customers, delivered on time and at
the lowest cost”. However, due to more pressing matters no discussion took place. Thus,
little progress has been made in modifying the management accounting and information
system to monitor progress in relation to these critical success factors. Production costs
are accumulated as outlined below in Exhibit 1.
Exhibit 1: Production and cost accumulation process

Production process Cost information
Basic manufacture of white shirt Direct material (per unit)
Direct labour (per unit)
Manufacturing overhead (per unit)
Customisation of shirt
(a) Dyeing (about 63% of shirts) = Direct costs (outsourcing)
(b) Stamping/printing (about 85% of = Conversion cost (per unit)
shirts)
(c) Embroidery (about 15% of shirts) = Conversion cost (per unit)
Costs are accumulated separately for the basic manufacturing process i.e. the
manufacture of white shirts, and also for the customization process. The former process
accumulates costs as direct materials, direct labour or manufacturing overhead. In this
process, production overheads are absorbed on the basis of direct labour cost and this
approach has been in use for a number of years. Costs associated with customizing shirts
are accumulated separately under the heading of direct costs (for dyeing) and conversion
costs for stamping/printing or, alternatively for embroidery. Table 2 shows the firm’s
unit costs and sales price for various items for the most recent period.
The typical monthly management-reporting package consists of a summarized profit and

loss account and summarized balance sheet (Table 3), together with a detailed schedule
of aged accounts receivable. The profit and loss account in Table 3 shows the reported
loss for the recent fiscal year.
In order to restore profitability to the company, management would first like to ascertain
the profitability of the customers in its three customer categories – priority, team and
shop. At the moment, management has no basis for assessing customer profitability.
Yet, it is intuitive that some customers generate high profits while others do not generate
enough revenues to cover the expenses to support them. The basic problem here is that
different customers demand different levels of support. Management is aware that the
use of ABC information would enable a type of customer profitability analysis to be
applied. They have recently obtained data on how the selling and distribution, and
administrative expenses could be incorporated into a customer profitability analysis by
identifying cost pools and cost drivers for various customer related activities (Tables
4a/4b).
RECENT DEVELOPMENTS
Two recent developments that may have an impact on the company should be noted.
First, in the present climate, the Dublin Shirt Company can only afford to reduce its
prices if it can cut costs. The Sales Director suggests that the company can lower its
quality inspection costs by reducing inspections, which will improve on-time delivery
rates. This proposal is to be discussed at the next Board meeting.
Second, last week, the Sales Director proposed that the company should enter the
American market for women’s sports shirts, where comparable shirts sell for the
equivalent of €9.75. This is considered to be an excellent selling price, given the small
size of the shirt involved. Overall production costs would be similar to medium-sized
shirts and normal selling, distribution and administration costs would amount to €3 per
unit. Each shirt would require dyeing and also normal embroidery. A marketing
consultant has obtained information about specific features required for the lady wearer.
Working in conjunction with the firm’s cost accountant, he has presented information on
these features and approximate cost as follows:
Feature required by Cost (per unit) to add Importance ranking
the lady wearer (5 = most important)
Hanger (on inside of collar) €0.02 2
Hanger (on outside of shoulder) €0.04 3
Patch (breast) pocket €0.10 3
Embroidery on single sleeve €0.25 5
Double stitching (on V-neck etc.) €0.08 4
It is anticipated that the Dublin Shirt Company will sell these products through an agent,
with whom they have never dealt but who would like to place an order for 100,000 shirts
this year. The company recognises that this (new) market will require additional selling
costs in the US, equivalent to €1 per shirt. The Dublin Shirt Company requires a
contribution of €2 per unit but the goods are to be invoiced in US dollars unlike current
sales that are invoiced in Euro.
REQUIREMENTS
The management of Dublin Shirt Company has hired your consultancy firm to advise
them on the current situation and potential future developments. You are to prepare a
presentation for the company’s board of directors to include the following:
(1) A calculation of break-even point (in units) for the year ended 2001. For the purposes
of simplifying this calculation, you should assume that ONLY direct material and direct
labour costs are considered variable with respect to changes in volume. Clearly identify
your assumption regarding the sales mix in your calculation and specify why this
assumption is important in the context of CVP analysis.
5 marks
(2) A brief overview of what strategy you think the Dublin Shirt Company should adopt.
What do you consider to be the critical success factors in achieving this strategy?
10 marks
(3) A determination of the profitability of each of the three customer groups.
20 marks
(4) An identification and discussion of the strategic issues that may arise from the results
of your customer profitability analysis.
10 marks
(5) A description of the potential behavioural implications on the sales and administration
personnel arising from the implementation of ABC information.
15 marks
(6) A listing and brief justification of other potential cost pools and cost drivers that could
be used for selling and administration costs, in addition to the cost pools and cost drivers
listed in Table 4b.
5 marks
(7) Explain how a Balanced Scorecard might help a firm like the Dublin Shirt Company.
Give examples of performance measures that might be included under each of the
following five perspectives, namely: (i) financial, (ii) customer, (iii) internal business
process, (iv) learning and growth, and (v) community.
15 marks
(8) The Sales Director suggests that the company can reduce its inspection costs. Do you
agree with this proposal?
10 marks
(9) The Dublin Shirt Company is considering entering the women’s sports shirt market in
the US. What is the target manufacturing cost for these shirts? Indicate what features, if
any, should be added to the shirts already produced, in keeping with your target cost
calculations. Identify the strategic and international business factors that the management
of the Dublin Shirt Company should consider in making this decision.
10 marks
TOTAL: 100 MARKS

TABLE 1: PRODUCT & CUSTOMER STATISTICS FOR 2001
Sales in units by customer category

Shirt size: Priority Team Shop Total
X large 272,500 166,000 105,500 544,000
Large 366,000 186,000 103,000 655,000
Medium 360,000 190,000 960,000 1,510,000
Total units sold 998,500 542,000 1,168,500 2,709,000
Sales revenue (€) €6,029,700 €3,284,300 €6,566,900 €15,880,900
No. of units dyed 750,000 400,000 550,000 1,700,000
No. of units stamped 698,500 472,000 1,138,500 2,309,000
No. of units embroidered 300,000 70,000 30,000 400,000
No. of orders received 2,330 11,450 57,909 71,689
No. of shipments made 1,470 9,230 49,286 59,986
TABLE 2: COST AND REVENUE DATA FOR 2001
Basic Quantity Average Direct Direct Manuf’g

manufacture sales price material labour overhead
€6.60 €0.60 €0.40 €0.24

X large 544,000
€6.20 €0.55 €0.35 €0.21
Large 655,000
€5.45 €0.39 €0.30 €0.18
Medium 1,510,000
2,709,000
Customising Quantity Direct Conversion Total

cost (unit) cost (unit) cost
Dyeing 1,700,000 €1.40 N/A €2,380,000
Stamping 2,309,000 N/A €0.40 € 923,600
Embroidery 400,000 N/A €1.30 € 520,000
€3,823,600
TABLE 3: PROFIT AND LOSS ACCOUNT THE YEAR END 2001
units €
Sales: X large 544,000 3,590,400
Large 655,000 4,061,000
Medium 1,510,000 8,229,500
2,709,000 15,880,900
Less: Cost of goods manufactured €

Basic manufacturing costs 2,715,310
Customising 3,823,600 6,538,910
Gross profit 9,341,990
Less: Non-manufacturing overheads
Selling and distribution expenses 5,761,600
Administration expenses 3,584,450 9,346,050
Net loss for year (4,060)
Retained profit brought forward 1,537,810
Retained profit at end of year 1,533,750
BALANCE SHEET AT YEAR END 2001
Fixed assets
Buildings (net) 2,450,000
Plant and equipment (net) 1,740,000 4,190,000
Current Assets
Stock (inventory) 550,000
Debtors (accounts receivable) 2,600,000
3,150,000
Less: Current Liabilities
Trade and other creditors (4,406,250)
Net current assets (1,256,250)
Total assets less current liabilities 2,933,750
Financed by:
Ordinary share capital 1,400,000

Retained profits 1,533,750
Shareholders’ funds 2,933,750
TABLE 4A: THE ASSIGNMENT OF SELLING, DISTRIBUTION AND
ADMINISTRATION COSTS TO CUSTOMER RELATED ACTIVITIES
Percentage distribution to:

Selling & distribution Administration
Customer related activities
Accounts maintenance Nil 70%
Sales commission 5% Nil
Shipping activities i.e. deliveries 50% 10%
Sales visits 15% Nil
Tracking misplaced/lost items 20% 20%
Marketing/promotion 10% Nil
100% 100%
TABLE 4B: CUSTOMER RELATED ACTIVITIES AND ASSUMED

COST DRIVERS
Customer related activity Assumed cost driver
Accounts maintenance Number of orders received

Sales commission Direct allocation to team customers only
Shipping activities (i.e. deliveries) Number of shipments (deliveries) made
Sales visits Direct allocation to priority customers only
Tracking misplaced/lost items Number of units sold
Marketing/promotion Management estimate 1
1
Decided as: 20% to “team” customers and 80% to “shop” customers
ECN.W
Dave Roger, an experienced consultant from the e-commerce space, started

Electronic Commerce Network (ECN.W) 18 months ago. In studying this emerging
business model, he found the one area that caused the most problems for web merchants
was transaction processing. Although few people understood this, each seemingly simple
web sale involved some 12 underlying transactions (see Figure 1). Before the sale could
be transacted both credit worthiness and product availability had to be ascertained. If
both were answered in the affirmative, the transaction would then be made. This, then,
entailed a further logistics transaction and an accompanying tracking transaction. In
addition, the customer buying profile on the web merchant's data-base had to be updated.
These all had to be done seamlessly and on a real-time basis. Web customers had come
to assume instantaneous service.
The prevailing business model was that each web merchant would build (or buy)
an integrated software platform for transaction processing. Companies such as
Cybersource provided the credit confirmation software systems; Yantra the fulfillment
and inventory management systems; and Oracle the database management systems.
Interfaces had to be built to allow these systems to "talk" to one another. Since each of
these software systems was being upgraded on a regular basis, the maintenance of these
interfaces was a nightmare. To make matters worse for the web merchants, experienced
IT personnel in this area were scarce. And when one did gain the prerequisite
experience, head-hunters for large companies were quick to hire these IT people away.
As a result, web merchants found that they spent more time then they cared to on
transaction processing issues.
Dave Roger crafted a business model based upon a hosted network concept. The
ECN.W customer value proposition was as follows:
Web-merchants should spend the majority of their time on their primary

mission, value-creation through innovative marketing and sales offerings
to customers and clients2. You should avoid spending both scarce
managerial talent and investor capital on any activity that could best be
performed by third-party partners such as ECN.W. Do investors see the
value in you building transaction-processing systems with their
investment dollars that are sub-optimal in scale and soon obsolete? In you
hiring and training high-cost personnel to run these inefficient systems?
In you spending much of your creative energy trying to manage these
inefficient systems? The answer is clearly “NO.”
Join our network and get all these services seamlessly provided with
state-of-the-art applications run by highly trained IT professionals (see
Exhibit 2). We will convert a difficult-to-manage fixed infrastructure
cost into a totally scaleable variable one since you pay only on a per-
transaction basis. With us as your partner, you can spend your creative
energies where your investors expect.
Dave Roger had no problem obtaining initial funding. Within eighteen months he
had 10 merchants and their fulfillment partners loaded onto his network. His problem was
obtaining the next round of financing. Since the collapse of the Internet market, finding
funds was much more difficult. Unlike many of these failed companies, ECN.W had
satisfied customers and the growth potential was strong. Nonetheless. his investors were
now seeking more details than he could provide. Specifically, they wanted clarity of his
financial model. Exactly what did it cost him to "run" his business and how would he
create the return necessary to satisfy them? They suggested that he provide them with
"more detail and less vision" using an activity analysis.
Since Dave was not sure exactly what was necessary, Denise Pizzi was hired to
facilitate this analysis. She had come highly recommended. She quickly pulled together
a cross-functional team of ECN.W personnel to develop the required activity analysis.
Within a month, the group established that there were three high-level processes
that best defined ECN.W. -- Customer Capture, Customer Loading and Transaction
Processing. They had studied the first two in detail and arrived at the following:
1. Customer Capture involved all the activities that culminated in a signed
contract. These activities were identified as:
Customer Identification -- involved here were sub-activities trade-
show attendance, trade show preparation and advertising.
Through tracing of travel itineraries and such, it was established that in
2
Clients all also called fulfillers. An apt analogy is the role Wal-Mart, a brick and mortar
rather than web merchant, plays for its suppliers (or fulfillers in the e-commerce world)
such as a Procter & Gamble.
the past 12 months, ECN.W had spent approximately $875,000 on
these activities.3 This resulted in 1,200 customer leads.
Customer Qualification -- basic research to identify that high-potential
sub-set of the customer leads with enough size and credit worthiness to
pursue. ECN.W had out-sourced this activity to a credit agency,
paying approximately $175 per credit report.
Customer Sale -- telephone calls and site visits to pursue and,
hopefully, close the sale to those high-potentials. Of the 1,200 leads,
ECN.W had pursued 80, and successfully closed on 10 of the 80.4 The
other 70 had exited this activity prior to a signed contract either by
their own choice or ECN.W's. Appendix A has additional data for
this activity.
2. Customer Loading entailed all the activities necessary to enter the web
merchant and its fulfillers onto the ECN.W network. Over the past 12 months
the equivalent of 7 customers went through this whole process. The relevant
activities were identified as:
Business Operations Review -- outsourced to a number of
subcontractors who documented the operational flow of the
web merchant. ECN.W had spent about $3,600 each on the 7
reports.
System Design -- the writing by ECN.W technical staff of all
the software interfaces and configuration of hardware linkages
for transaction processing. It cost ECN.W about $5,000 each
on the seven systems.
Implementation & Certification -- installation and testing to
ensure system is working as designed. Although there was
minimal variation in the effort for the first two activities, this
one varied greatly depending upon a number of factors (see
Appendix B).
APPENDIX A
Customer Sale analysis detail
3
Initially, these activities were analyzed separately but since they were not mutually
exclusive (i.e., advertising resulted in trade show booth visits and trade show exposure
made advertising more effective, they were then aggregated.
4
Since all of the activity did not fall neatly into the twelve-month analysis window, these
numbers are expressed in full-time equivalents. Although some of the sales activity had
begun prior to the start of the past 12 months and some would continue on into the
following months, it was estimated that ECN.W pursued the equivalent of 80 and closed
10 in this time period.
The approximate $520,000 total cost for this activity pool came from across the
company. When a high potential customer expressed continued interest in that initial
phone call, site visits were organized. This meant flying out sales people as well as
technicians to demonstrate how the system worked. Top management of the larger
accounts also expected to meet with ECN.W top management just to ensure themselves
of the professional caliber of the company to which they were going to entrust a crucial
part of their business. The group found that there was much variability in this activity --
there was no "typical" account. Generally, they fell into two groups -- those that
understood the customer value proposition and the inherent costs of transaction
processing and those where the customer value proposition had to be demonstrated. For
the former, the process was as follows:
A visit to the potential customer site by a sales person and a
technician. This trip took approximately three days -- one for travel, one to
reach agreement between client and ECN.W on how transaction processing
was currently being done by the client, and one to demonstrate the advantages
of the hosted network approach.
A follow-on visit by the sales person to "close" the deal which
took on average two days -- one for travel and one for negotiation.
Sometime in between these two trips, Dave Roger would call
the customer to talk "CEO to CEO" after a thorough briefing on the customer
by the sales person. This took about a half-day of effort from both the sales
person and Dave Roger.
For the latter group, the sales process was more complicated due to the skepticism of the
customer. Unfortunately, 7 of the original 10 fell into this group.
An initial visit to the potential customer by the sales person just
to introduce ECN.W and explain in detail the customer value proposition.
This took on average two days -- one for travel and one for the customer
meeting and product demonstration.
A follow-on site-visit by the sales person and a technician.
This trip took approximately five days -- one for travel, three to educate the
client on how transaction processing was currently being done internally and
its costs, and one to demonstrate the advantages of the hosted network
approach.
A follow-on visit by the sales person to "close" the deal which
took on average two days -- one for travel and one for negotiation.
A site-visit by Dave Roger to demonstrate ECN.W's
commitment to customer satisfaction which took on average two days -- one
for travel and one for discussion
APPENDIX B
Implementation & Certification analysis detail
Like the other activities, costs for this activity pool came from across the
company and like the Customer Sale activity, there was high variability in this activity.
Customers fell into two broad groups: those that had a competent IT staff, were prepared
for and responsive to ECN.W's implementation team, and had only one fulfiller; and
those that were neither competent nor responsive and had many fulfillers -- four, on
average. For the former group, the installation and test procedure required a team of two
technicians, one at the customer site and the other at the fulfiller, for a total of only two
days -- one for travel and one for implementation. Most of the work was performed by
client and fulfiller IT personnel. Certification was done at ECN.W and required only one
additional day for minor debugging. For the latter group, however, the process was much
more difficult. Typically, it required a team of three technicians and two trips to the
customer site -- an initial three-day visit by two technicians and a second two-day trip by
a single technician for major revisions due to unforeseeable problems. Likewise, dealing
with multiple fulfillers that were less than prepared meant more and longer site visits for
the third technician, usually three days in duration -- one for travel and two for on-site
work. Certifying the system also took twice as long at ECN.W.
Assignment:
From the General Ledger (see Exhibit 3), travel expense reports and other varied sources
the group gathered the following data:
Number of sales people at ECN.W -- 2
Number of marketing people at ECN.W -- 2
Number of technicians at ECN.W -- 9
Training & Development expense detail - $25,000 for sales
and rest for technicians
Payroll benefits -- averaged 20% of salaries for all functions
Average round-trip airfare and related transportation costs per
person, $2,000
Typically a three-day trip meant three nights in a hotel; two
days, two nights; and so on at an average cost of $500 per night per person.
A) Prepare an activity cost estimate for Customer Sale and Implementation &
Certification.
B) Prepare a cost estimate for Customer Capture and Customer Loading processes in
total. Assume a 250-day work-year for all salaries.
Be prepared to discuss your logic regarding:

1. The proper definition of the object you are trying to cost,
2. Whether the cost pools for the activities you are costing are predominately fixed or
variable and how this effects your answer,
3. Assume that the group found that the costs associated with the 70 high potential
customers that withdrew from the sales process before signed contract totalled
$232,000. How would you treat this cost?
Exhibit 1
E-Commerce Transaction Detail
Transactions
#1
#2 credit company Credit check R
#3 e
#4 fulfiller In stock check a
#5 l
#6 fulfiller Ship if #1 & #2 “Yes”
Web -
Customer #7 Track
common carrier
Merchant #8 T
#9
credit company Charge customer i
#10
Update customer profile m
#11
e
#12 Transaction summary to
customer
Exhibit 2
ECN.W Value System
Visa,AmExp
MasterCard
Customer Web- Fulfiller

Merchant ECN.W
FedEx, UPS
Transaction flow
Physical flow
Exhibit 3
General Ledger Account Balances
(Last 12 Months)
Sales Salaries $ 250,000
Marketing Salaries $ 200,000
Technical Salaries $ 900,000
Administrative Salaries $ 200,000
CEO Salary $ 750,000
Payroll Benefits $ 460,000
Training & Development $ 182,500
Travel Expenses $ 340,000
Meals and Lodging $ 387,000
Consultants $ 287,000
Advertising $ 350,000
Other Marketing Expenses $ 180,000
ENDESA: MEASURING AND CONTROLING VALUE CREATED IN ENDESA
By
Gary M. Cunningham, Ph.D., CPA*
SCOTT ERIKSEN, PH.D., CPA, CMA,

CFM*
Francisco J. López Lubián, Ph.D.*
Antonio Pareja**
* Instituto de Empresa, Madrid, Spain

** ENDESA SA, Madrid, Spain
MEASURING AND CONTROLING VALUE CREATED IN ENDESA:
A CASE STUDY
In early March 2000, ENDESA’s corporate management presented its future vision
for the company to financial analysts. ENDESA’s commitment was to construct a
diversified portfolio of business units in the energy, telecommunications, and new
technologies sectors drawing on an existing customer base of more than 27 million and
exploiting geographic and operating synergies of the group.
“The ENDESA Group is no longer a simple electricity company. Our objective is to be a

global energy operator, centered on the needs of our customers and the development of
our abilities and intangibles, our international presence, and at the same time
strengthening our presence in related businesses like new technologies and
telecommunications.
At the end of 2000, ENDESA was the leading company in the Spanish electric
sector with market shares of 47% of the wholesale generation market and 43% of the
electricity distribution market. The distribution market is spread over a wide geographic
area in Spain with market shares of 45% in Catalonia; 31.6% in Andalucía and
Extremadura; 71% in Aragón; 5.2% in Cantabria, Asturias, and Galicia; and 10.9% in the
Canary and Balearic Islands. In addition, ENDESA has substantial operations in such
diverse areas as telecommunications, natural gas distribution, co-generated and
renewable electric energy, and the treatment and distribution of water and wastewater,
and new technologies services for business and individuals (See Figure I). Its current
geographic scope covers 12 countries in Europe, Latin America, and North Africa
following a major globalization strategy. ENDESA currently has over 20 million
customers divided roughly equally between Spain and international locations.
ENDESA’s web site in English can be viewed at www.endesa.es/english/ which provides
more details about all these activities.
BRIEF HISTORY OF ENDESA, S.A.
The enterprise that is now ENDESA was founded in 1944 as a basic state-owned
electric utility in Spain. It grew substantially starting in 1972 when it merged with a
hydroelectric generating company in Galicia in northwestern Spain, acquired mining
facilities all over Spain, and constructed large coal-fired electric generating plants in
remote areas of central, southern, and northwestern Spain. ENDESA Group was created
in 1983 when the enterprise acquired majority interests in several regional electric
distribution companies and established its position as a nation-wide electric utility
company. In 1991, ENDESA continued acquiring majority and minority interests in
regional electric generating and distribution companies in Spain.
In 1992, ENDESA Group began to expand internationally by acquiring
companies involved in the generation, transportation, and distribution of electric energy.
It became the one of largest Spanish companies in foreign investment, with business units
in France and Portugal in Europe, Morocco in North Africa, and Chile, Peru, Argentina,
Brazil, and Central America in Latin America.
At the same time as the international expansion, ENDESA began its
diversification strategy by acquiring hydroelectric generating plants, a major coal
production and marketing company in North America, and by creating ELCOGAS, the
largest installation in the world that uses coal gasification to produce electric energy. It
thus moved into renewable energy and new technologies. In addition, it acquired water
treatment and distribution utilities and wastewater treatment facilities in major Spanish
cities and in Latin America.
In the late 1990s, ENDESA acquired a major telecommunications firm in Spain.
In 2000, ENDESA became the largest shareholder and manager of a joint venture with an
Italian telecommunications company and another Spanish energy company to operate the
second largest fixed-line telephone company in Spain, the second largest mobile
telephone company in Spain, substantial other telecommunications in both Spain and in
Latin America. Also in the late 1990s, ENDESA acquired natural gas distribution
utilities in Spain and Portugal making it one of the largest in the natural gas market as
well.
NEW CHALLENGES, NEW SOLUTIONS

Changes in the Spanish electricity market began in 1998 with substantial changes
in laws designed to liberalize the system, introduce price competition, and improve the
quality of service. These changes made Spain the most liberal electric utility market in
Europe and among the most liberal in the world. A major feature of this liberalization
was giving customers that use more than 15GWH of electricity per year the right to select
the electricity provider. ENDESA was the first Spanish company to serve such
customers and now serves over 40% of this market.
Changes occurred in the financial environment as well. In 1988, an initial public
offering of shares occurred when the Spanish state disposed of 24.4% of the capital of
ENDESA, starting the process of privatization. In 1998, the privatization process of
ENDESA, S.A. was completed with the fourth public offering of the shares of the
company. ENDESA’s shares are now listed on the New York Stock Exchange as well as
on other exchanges in Europe.
With all of these changes, there has been a major change in management
orientation towards creating value. The vision of the company was redefined as that of a
global operator in the energy business and related services, with vertical integration to
cover the risks, horizontal integration to capture the synergies, a high level of
technological innovation, and effective adaptation to the new conditions and demands of
the markets. The value creation strategy of ENDESA is to continuously evaluate its
portfolio of business units, dispose of those that do not create sufficient value, and
expand into new businesses where value-creation potential is high. As a result, in 2001,
ENDESA consolidated all of its electricity assets in the northwest of Spain into VIESGO
and announced plans to sell VIESGO. ENDESA’s new business activities include such
things as providing high-value services to existing customers in addition to basic
electricity. For example, ENDESA provides such energy-related services as heating, air
conditioning, steam, and security to major customers who have selected ENDESA as
their electricity supplier in the liberalized Spanish market. ENDESA also sells consulting
services for expertise it has acquired in basic business systems like communications
information system technology. In 2001, ENDESA announced a joint venture with
Accenture, a major management consulting company, to offer systems consulting
services in Latin America. In addition, ENDESA seeks to leverage its intangibles
through such things as selling mobile telephone services to existing electric customers
and offering home security and maintenance services to existing residential electric
customers.
ENDESA is also changing its financial management strategy to include such
things as optimizing leverage and replacing relatively high-cost Latin American debt with
lower-cost European and North American debt. Techniques described in parts A and B
of this case are used as management tools to measure and control this value creation.
ORGANIZATION STRUCTURE
In 1999, the general meeting of the shareholders of ENDESA and its participating
electric enterprises in Spain approved a merger in which ENDESA absorbed the minority
shareholders of the participating companies. After privatization and merger, the
ENDESA Group structured itself into subsidiaries along business lines, each of which
focuses on creation of economic value according to the type of business. The major
subsidiaries and their value creation activities are shown in Figure 2. Additional smaller
subsidiaries include ENDESA’s power trading activities, mostly through its ten percent
ownership of the Amsterdam Power Exchange; and its innovative new on-line business
and personal buying services. The structure, which also the legal framework, is used for
financial management and financial control as described in parts A and B of the case.
Each subsidiary is further divided into business units. The legal structure of the business
units varies considerably, though, and does not necessarily follow the lines of business.
Measurements of economic value and related parameters are explicitly carried
down to the business unit level. In the view of ENDESA management, it is essential that
the business units consider themselves as value creation centers, rather than as cost or
revenue centers. The financial management and management control approaches
described in Parts A and B are designed specifically to communicate to business units
that they are indeed value creation centers.
ENDESA’s annual report for the year 2000, along with other information about
ENDESA can be obtained from the web site: www.endesa.es/english/ . To access the
financial reports, click on stockholders and then on annual report. Financial statements
are found in the section with legal documents.
MANAGEMENT EVALUATION
By April 2000, ENDESA Group had three years’ experience in applying its new
strategies and implementing new management tools. It had dedicated a considerable
quantity of economic resources and time of its managers. In reflection, there was a
general agreement about the advantages that this effort had accomplished. There was
also consciousness of the long road that still remained to be traveled. Some comments of
managers are:
“The most difficult part of this process has been to be sure this management model is
accepted and understood relatively well by the operating levels. After three years, all
persons know what are the rules of the game and what their individual objectives are in
line with them.”
“In the Group, 1,200 managers have variable compensation based on achieving their
objectives. On average, this variable part can be 25% of annual compensation.”
“The only ways to fight against initial rejection have been to establish clear
communication from the beginning, and to count on the support of upper management.”
“On another hand, a great communication effort has been achieved with the financial
markets through regular presentations of our results and future plans. We are convinced
that the market values this information and transparency very positively.”
“Among the areas we have pending is development of a complete and flexible

information system with a standard data base that facilitates decision making by different
managers.
PART A
MEASURING ENDESA’S COMMITMENT TO VALUE
In 1997, ENDESA’s corporate office of planning and control was charged with
implementing the value-creation project that would ultimately involve a change in culture
that would affect the entire organization. The need was apparent from the outset to
develop a measurement of value created. In the opinion of a high executive in charge of
this task:
¨In a group like ours, with a presence in different businesses and in different markets, it is
essential to be able to measure the contribution of each unit to creation of value and
using this measurement to be able to set management objectives directed toward
maximizing it. We would get a value measurement that has a high correlation with
market value added and on the other hand that is easy enough to be applied and
understood in all the organization.”
The measurement that was selected, economic value created (EVC), is a form of
residual income, that in the opinion of the Group management presented the following
advantages compared to the traditional measurements like return on investment (ROI)
and return on equity (ROE):
• It is an economic rather than an accounting measurement because it is based on
free operating cash flow which includes the depreciation tax shield effect, but
which is not reduced by the depreciation expense as is traditional operating profit.
• It allows the same measure of value created to be used by all business units
operating in distinct markets.
• It integrates aspects of both operating and financial management, but allows them
to be differentiated through decomposition into return on invested capital (ROIC)
and the weighted average cost of capital (WACC).
• The decomposition also integrates short-, medium-, and long-term management

objectives.
Also, compared to other value-creation measurements, EVC is very simple to apply and
easily understandable by all the members of the organization, although they do not have
financial knowledge.
FORMULATING THE MEASUREMENT
As a point of departure, ENDESA began with the definition of Economic Value
Added (EVA) (c) of Stern Stewart & Co.:
EVA = NOPAT- (WACC * IC)
in which:
NOPAT is the net operating profit after taxes,
WACC is weighted average cost of capital, and
IC is invested capital
After several meetings with members of the consulting firm, the company concluded it
could best develop the measurement it needed in-house. Contributing to this decision
was the degree of complexity that the adjustments required by the EVA (c) measurement
and the requirement that ENDESA´s model must be simple. The persons responsible for
developing the measurement in ENDESA believed that the measurement should not be
based on accounting profit because, in addition to the possibility of manipulating the
results, the company is very capital intensive and has a high depreciation charge that
reduces accounting profit. Therefore, a measurement based on cash flow was developed.
In the words of a high executive in the Management Information and Control Systems
department:
“We cannot establish a formulation that makes the computation of value creation
difficult. Incorporating a large number of accounting adjustments makes the model less
close to operating reality and therefore to the understanding that our managers have of
it. I do not want the persons responsible for the generating plants in Peru or Colombia
to begin calling me saying that they do not understand the calculation we have made and
that it gives nothing to them. The first objective should be simplicity of computation.
ENDESA decided on an annual value-creation measurement that is the difference

between cash flow obtained and that needed to keep the resources profitable, i.e.:
EVC = FOCF – (IC * WACC)
in which
EVC = Economic Value Created
FOCF = Free Operating Cash Flow
IC = Invested Capital, and
WACC = Weighted Average Cost of Capital
The computation of these parameters is presented in Figures 3, 4, and 5. Note that the
computation of FOCF does not include dividends or interest paid by ENDESA.
ENDESA believes that the effect of payments to suppliers of equity and debt capital on
EVC is captured in the factors used to compute WACC so that it is not appropriate to
deduct dividends and interest in the computation of FOCF. EVC is computed at
corporate, subsidiary, and business unit levels, clearly reinforcing the idea that business
units are value creation centers. At the corporate level, EVC is computed both before and
after minority interests, which are primarily in the Latin American business units.
The WACC at the business unit level must be further adjusted to add two
additional risk premiums. The first premium reflects the additional risk associated with
different industry sectors in which a business unit operates. Even though investments in
sectors other than electric utilities offer benefits of synergy and diversification, the
difference in the maturities of the markets and degree of competition present different
degrees of risk among the industry sectors that should be recognized. The second
premium represents risks associated with the different countries in which the company
operates or is considering investments due to differences in interest rates from local
borrowing, currency exchange rates, inflation, political factors, and other specific local
factors. In particular, investments in Latin American countries face systematic risks that
cannot be diversified away and for which the WACC must be adjusted. The company has
developed a multi-factorial model, which uses additional macroeconomic variables for
the sector and country in which a unit operates. The focus is on the risk the business unit
contributes to the group as a whole. A different set of risk premiums is used for equity
capital and for debt capital.
INVESTMENT AND DISINVESTMENT ANALYSIS
As part of its new financial management strategy, ENDESA has created a matrix
of its investment and disinvestment strategy for business units as shown based on
potential EVC and strategic fit as shown below:
STRATEGIC FIT
LOW HIGH
LOW POTENTIAL EVC Sell Sell
HIGH POTENTIAL EVC Hold Expand
Units with a high strategic fit are those in the core public utility sector; low strategic fit
represents those in the related areas where ENDESA has expanded. Business units with
low potential EVC, including those in the core electricity sector, such as VIESGO
mentioned in the introduction, will be sold to other investors with the expectation that the
unit will be more valuable to another owner. Units outside the core area with high
potential EVC will be held. The proceeds from the sale of business units will be used to
expand father in the public utility sector by acquiring units with high potential EVC.
ENDESA’s current strategy is to expand further into Europe, including Eastern Europe,
and in the Americas, including the US. Thus, ENDESA’s strategy is one of acquiring
business units, using its expertise to develop as much value in the unit as possible, and
then to hold or sell the unit depending on its EVC potential.
In evaluating investment opportunities, ENDESA estimates future cash flows
using procedures described above to determine FOCF. The minimum IRR is based on
the WACC which includes risk premiums for the specific industry sector and geographic
area, as described above. The minimum internal rate of return (IRR) is the WACC plus
an additional 4.5% return, which is considered to be the minimum acceptable return to
the shareholders.
Discussion Questions for Part A

1. Refer to ENDESA’s current business strategy. In what primary economic activity
is ENDESA engaged? (HINT: the primary economic activity is not the
generation and sale of electricity or related activities). Why is it necessary to
understand the strategy and primary economic activity in order to manage
ENDESA’s financial activities?
2. Why does EVC as computed by ENDESA reflect an economic rather than an
accounting perspective? What are the advantages and disadvantages of using a
cash flow perspective vs. an accounting perspective for financial management
tools?
3. From a financial management perspective, the depreciation charge is sometimes

viewed as a source of cash and as maintaining capital. Evaluate these claimed
purposes in general, and specifically with respect to ENDESA. Evaluate
ENDESA’s comment that cash flow is a superior to accounting measures of profit
because it does include the depreciation tax shield effect but not the depreciation
expense.
4. Why is the computation of IC different at the business unit level from the
corporate and subsidiary level?
5. Evaluate ENDESA’s policy of assigning risk premiums to industry segments and

to specific countries or geographic areas. What types of risks exist for industry
segments and for countries or geographic regions? Which macroeconomic factors
should ENDESA include in its model to determine the two types of risk
premiums? Evaluate ENDESA’s comment that the focus is on the risk that the
factor contributes to the overall risk of ENDESA group, referring to portfolio
theory in your evaluation. Evaluate ENDESA’s approach of assigning different
risk premiums to equity capital and debt capital.
6. Evaluate ENDESA’s policy of measuring EVC both before and after minority
interests. Why would such a distinction be important for ENDESA’s financial
management?
7. Evaluate ENDESA’s position that the effect of interest and dividend payments to
debt and equity suppliers on EVC is captured in the factors used to determine
WACC so that it is inappropriate to deduct these items in determining FOCF.
8. Evaluate ENDESA’s over-all financial management approach. What are the

strengths and weaknesses of this approach?
PART B
IMPLEMENTING VALUE-ORIENTED MANAGEMENT TOOLS.

Review the measurement of EVC and its parameters presented in Part A.
The EVC computation and its component parts are used as control devices at the
corporate, subsidiary, and business unit levels. Budgets are prepared for all of the
parameters of the EVC computation and variances are determined and analyzed for these
parameters. A template used to measure EVC and its variances at the corporate level is
presented in Figure 6. An example of a more detailed variance analysis of WACC is
presented in Figure 7.
At the corporate and subsidiary level, even though EVC is viewed as superior to
ROI alone, EVC can also be related to a measurement of ROI that ENDESA calls return
on invested capital (ROIC) where
ROIC = FOCF / IC
so that
EVC = (ROIC – WACC) * IC
In this form, the measurement permits control of different types of management in which
ROIC reflects commercial management and industrial productivity and WACC reflects
financial and fiscal management. This form of the EVC measurement also integrates
short-, medium- and long-term management objectives with ROIC and EVC reflecting
short-term; WACC the medium term; and FOCF the long term.
EVC is also decomposed in a value tree with variances as shown in Figure 8. In
this value tree, the individual component parts that make up the EVC measurement can
be identified down to the business unit level. This tree allows each component part to be
controlled at an appropriate level. The tree also communicates clearly to business units
that they are value centers and not mere cost or revenue centers.
VALUE DRIVERS
Once the EVC measurement was developed, ENDESA viewed its next challenge
was to be identifying the key factors that contribute to value creation and eventually
develop them into management tools such as the balanced scorecard. In the words on a
major executive:
... it is important to implant value-oriented management as deeply as possible into the
organization. The measurement of EVC, though, is not applicable to everyone in the
organization. Instead, there should be a series of operating-oriented indicators that
affect value, leaving EVC for those persons who have responsibility to account for the
results. All managers should know how their decisions affect value creation. If they are
to be rewarded based on value creation, then they should know clearly which items
create value and which do not.
After prolonged discussion and debate, ENDESA identified five value drivers for
which operating objectives can be developed that will eventually lead to a balanced
scorecard as follows:
Profitability is essentially the same value driver that companies have traditionally
used as the primary control device. In ENDESA it remains as a primary, but not the
only value driver. EVC and the value tree analysis described above relate to this
driver.
Strategy relates to ENDESA’s current strategy of managing the combination of EVC

and strategic fit of each business unit as described in Part A. The strategic fit
describes the degree to which a business unit fits with the core electric business. Units
with low EVC and low strategic fit are sold to provide funds for expansion. Units
with low EVC and high strategic fit will also be sold. ENDESA proposes to develop
as much value as it can in these units because of its management expertise and then
sell them to other electric companies for whom the unit will create future value.
ENDESA’s strategy is clearly one of holding and developing units with high or
potentially high EVC.
Intangibles management relates to exploiting ENDESA’s intangible assets as well as

leveraging their systems expertise. Two major examples are selling additional
services to established customer bases such as mobile telephones to electricity
customers and selling consulting services for the expertise it has acquired in
telecommunications, information and control systems, and other management
activities.
Optimizing WACC to achieve greater EVC involves such activities as optimizing

financial leverage and exchanging high-interest-rate Latin American debt with lower-
rate European and US debt. The substitution of European and US debt for Latin
American debt could substantially reduce the country risk premium.
Expansion involves investments in core businesses, mostly electricity related, in other

European countries and in the U.S. to achieve greater EVC through improved
management.
ENDESA has identified some 20 operating objectives related to these value

drivers that are being incorporated into a balanced scorecard. The balanced scorecard is
being implemented in 2001 at the corporate level and will be implemented at the
subsidiary and business unit level in the near future.
Discussion Questions for Part B
1. Refer to ENDESA’s current business strategy. In what primary economic activity
is ENDESA engaged? (HINT: the primary economic activity is not the
generation and sale of electricity or related activities). Why is it necessary to
understand the strategy and primary economic activity in order to evaluate
ENDESA’s management control systems?
2. The computation of EVA (c) which is developed and promoted by Stern Stewart
and Co. is based on net income as reported under US GAAP, from which
adjustments are made. Evaluate the suitability of this measurement for ENDESA
and similar companies outside the US that do not use US GAAP.
3. Evaluate ENDESA’s arguments that accounting-based measures of profit are not

suitable for measuring value created for purposes of management control.
4. Specific guidelines exist under US GAAP for the public reporting of cash flow.
Evaluate ENDESA’s cash flow computation with respect to the requirements of
US GAAP. Evaluate ENDESA’s position that it is inappropriate to deduct
interest and dividends in computing FOCF as would be required by US GAAP. A
significant departure from US GAAP is the inclusion of a portion of the equity in
earnings of subsidiaries that is not paid in cash dividends. Why do you think
ENDESA has included this item in its FOCF?
5. Why is depreciation computed and reported on the income statement under US

GAAP and under the accounting policies of most Anglo-Saxon countries?
Evaluate ENDESA’s decision to select a measurement of value created that
specifically excludes a depreciation charge.
6. Evaluate ENDESA’s policy of computing variances for all component parts of

EVC, including WACC and IC. How would you interpret the quantity and mix
variance for IC?
7. How does the decomposition of EVC into ROIC and WACC allow ENDESA to
separate operating and commercial management from financial and fiscal
management and to integrate short-, medium- and long-term objectives. Evaluate
this process from a management control perspective.
8. Traditional management control approaches have focused almost exclusively on

profitability as a control device. Yet, ENDESA has five value drivers that it
attempts to control. Evaluate ENDESA’s focus on additional value drivers.
9 Based on the information in the introduction and in Parts A and B of the case,
develop balanced scorecards that you would recommend for ENDESA at the
corporate, subsidiary, and business unit levels.
10. Evaluate from a management control perspective ENDESA’s policy of
variable compensation in which up to 25% of a manager’s compensation can depend on
meeting objectives
Figure 1
ENDESA’s Lines of Business
ENDESA Group
Energy and Related Telecommunications New Technologies
Businesses
Electricity: Fixed lines Commercial buying and
Generation Mobile telephones selling systems
Distribution Internet access Personal buying and selling
Trading Telecommunications via systems
Cogeneration cable Business internet consulting
Renewable energies Digital land television services
Gas Telecommunications Power line voice and data
Water and waste treatment engineering communication
For more details about each line of business, see ENDESA’s English-language web site
at http://www.endesa.es/english/.
Figure 2
Lines of Business and Organization Structure of ENDESA
ENDESA GENERACIÓN manages the generating and mining assets of ENDESA in

Spain. It aims to compete with better quantity, quality, and prices in the electricity
generation market. A major part of the value creation comes from the easy access to raw
materials; from proximity to gas pipelines, private customers, and interconnections with
other systems; and from the ability to expand the capacities.
ENDESA DISTRIBUCIÓN is a subsidiary holding company for the various companies

located all over Spain that transport and distribute electricity to customers who cannot yet
choose their electricity provider and for whom rates are set by regulatory authorities. The
business units are the original companies created or purchased by ENDESA which
continue to distribute electricity under their original names. Value comes from the ability
to adapt to variations in the market, long traditions, and commercial names recognized in
the market.
ENDESA ENERGÍA was founded as a subsidiary corporation in 1998 to cater to the

liberalized Spanish electricity market. It provides electricity to customers that can select
their energy provider because of the quantity of annual consumption with long-term
contracts in a competitive environment. This subsidiary also provides high-value-added
services to these customers by supplying and managing all energy-related activities such
as cooling, refrigeration, and air conditioning; heating and steam generation; and security.
In addition, this subsidiary sells technical and consulting services to other electric utilities
in all parts of the world, for example in planning and constructing new electric generating
plants and distribution networks. Business units are the individual customers and
projects. Value comes from catering to the needs of customers, and providing additional
high-value services with minimal additional capital investment.
ENDESA DIVERSIFICACIÓN is a subsidiary that invests in related businesses, such

as natural gas distribution, water and wastewater treatment and distribution,
telecommunications, renewable energy, and cogeneration, that have growth expectations.
Value comes through synergies, strategic alliances, and ENDESA’s serving as the
managing industrial partner bringing its business background and human capital.
ENDESA INTERNACIONAL is a subsidiary that manages ENDESA’s diverse

operations in markets outside of Spain: elsewhere in Europe, North Africa, and Latin
America. Value comes from diversification into other markets, applying ENDESA’s
management and technical expertise in areas of its core competencies, and growth
potential. In the very near future, ENDESA Europe will be created to manage European
operations.
ENDESA SERVICES was formed in 1999 as a subsidiary to handle the internal needs of
ENDESA in telecommunications, information and control systems, and supplies. It also
provides comprehensive consulting services in these areas to outside customers. Value
comes from ENDESA’s ability to sell services in areas in which it has acquired
considerable expertise with minimal additional capital investment and thus leverage a
part of the investment required to obtain the expertise.
Figure 3
Computation of Free Operating Cash Flow in ENDESA
Business Units:
Earnings before interest, taxes and depreciation allowance (EBITDA)

- Normal recurring capital expenditures
- Income taxes on operating income
+/- Changes in working capital
= Operating cash flow
+ Dividends received, or equity in earnings of controlled affiliates

= Free operating cash flow
EBITDA can be further divided as:
Operating revenues
- Variable costs
= Contribution margin
- Fixed operations and maintenance costs
= EBITDA
Subsidiaries and Corporate Level:
Free operating cash flow from the business units is aggregated for the subsidiaries and
corporate level with appropriate eliminations for inter-company transactions.
Figure 4
Computation of Invested Capital in ENDESA
Corporate and subsidiary IC:
Long-term debt
+ Provision for pensions and similar items
+ Shareholders’ equity
+ Minority interest
= Invested capital
Business unit IC:
Fixed Assets
+ Working capital
= Invested capital
Figure 5
Computation of Weighted Average Cost of Capital in ENDESA
Corporate WACC:
WACC = Ke (E/D+E) + Kd*(D/D+E)
In which Ke is the cost of equity capital and is determined by the formula:

Ke = Rf + {b}*(Rm – Rf)
and in which
Rf is the risk free rate of return based on the return of a ten-year Spanish treasury
obligation,
Rm is the market rate of return so that (Rm – Rf) is the risk premium of the market
above the risk free rate of return. This premium is currently set at four points.
{b} is beta, the factor representing the extent to which ENDESA’s stock varies with
respect to the market and is based on data published by financial analysts.
Currently the beta is 0.7.
Kd is the after-tax cost of debt determined by the formula: Kd=(IB+M)*(1-Tx)
in which:
IB is the appropriate inter-bank interest rate.
M is a margin that reflects ENDESA’s financial rating, and
Tx is the average effective tax rate, which is currently set at 28%
Business Unit WACC:

WACC = Ke (E/D+E) + Kd*(D/D+E)
In which
Ke is the cost of equity capital and is determined by the formula:
Ke = Rf + {b}*(Rm – Rf) + PMi + PMc, and
Kd is the after-tax cost of debt determined by the formula:

Kd=(IB + PMi + PMc + M) * (1 - Tx)
in which
PMi is the risk premium for the industry sector, and
PMc is the risk premium for the country, and
Tx is the effective tax rate for the country.

At the corporate level and in most business units the IB is the European interbank interest
rate (EURIBOR). Business units in some other locations, notably in the Americas, use
the London interbank interest rate (LIBOR).
Figure 6
Variance Analysis of EVC in ENDESA
EVC = FOCF - ( WACC x IC )

Actual for month = - ( x )
Budget for month = - ( x )
Variances
Monetary impact (Euros) = + +
Variances related to cash flow

Contribution Margin
Recurring capital expenditures
Working capital
Dividends received and equity in earnings
Variances related to WACC

Cost of equity funds
Cost of debt funds
Leverage
Variances related to IC
Quantity of Items
Mix of items
Figure 7
WACC Comparison with Budget in ENDESA
WACC = Cost of x ( 1 - Leverage ) + Cost of x Leverage

Equity Funds Borrowed Funds
Actual Actual % Actual %
Budget % Budget % Budget %
Variance Variance % Variance %
Base Rate + Country/ Euribor Libor

Business Risk Actual % %
Actual % Actual % Budget % %
Budget % Budget % Variance % %
Variance % Variance %
Chile %
10 Year Treasury Bond
Brazil %
Actual %
Colombia %
Budget %
Argentina %
Difference %
Peru %
Figure 8
Value Tree for EVC in ENDESA
Free Operating Cash Flow Actual May Budget variance

Actual May Contribution margin
Budget variance Recurring capital expenditures
Working capital changes
Taxes
EVC Resources employed
Actual May Actual May Total FOCF
Budget Variance Budget variance
Quantity variance
Mix variance
Capital charge Cost of Equity (%)
Actual May Actual May
Budget variance Budget variance
Impact Impact
WACC (%) Coste of Debt(%)

Actual May Actual May
Budget variance Budget variance
Actual Budget Variance Impact Impact
EVC
Leverage (%)
EVC(%) Actual May
ROIC Budget variance
WACC Impact
Gibson & Associates, Inc University of Notre Dame
KINCAID MANUFACTURING:
A CASE STUDY OF SUPPLY CHAIN COST MANAGEMENT
“What have I gotten myself into?” muttered Mike Peters to his longtime friend Joe
DiBiase. Mike had recently joined Kincaid as Corporate VP of Operations and was
reviewing the firm’s purchase price variance (PPV) reports for the past year. “It looks
like we have multiple suppliers for each commodity area and our PPV for the year was
over budget by almost $10 million.”
“It has been like this since I arrived five years ago, ” Joe responded. “The purchasing
departments are overwhelmed by supplier orders. They just can’t keep up with all of
engineering and manufacturing’s requests. It’s a simple equation of too few people
trying to do too much work. They’re constantly running around putting out fires. They
just need more time to do their jobs.”
Mike stared blankly at the stack of papers on his desk. Procurement fell under his control
and the CEO had singled out the PPV problem at his first Director’s Meeting as his
primary responsibility when he was introduced to the Board. The board responded by
directing Mike to create a cost savings program that not just eliminated the unfavorable
PPV but actually resulted in a favorable PPV of $2 million. Mike knew Joe was right
about his people putting out fires. He’d only been there a few days but it was obvious
that the purchasing department was in the business of crisis management. He would need
to make some major changes to reverse the PPV trend.
Purchasing Price Variance
Purchasing Price Variance (PPV) is an accounting measure many companies use to
analyze a purchasing department’s effectiveness. The variance is calculated by
comparing the standard cost (contract or budgeted price) of a product to the actual cost of
a product. Often the PPV is calculated on a yearly basis. A standard cost for a part is set
at the start of the year. Each purchase of that part is compared to the standard cost.
Variances may be the result of expedited orders, pricing reconciliation procedures,
unusually large or small order quantities, indexed pricing, or one time purchases. The
sum of the variances for all these purchases creates the yearly PPV.
PPV = (Actual Cost – Standard Cost) * Volume
Actual Actual Standard Variance

Activity Volume Cost Cost (Over/Under)
Purchase 1 1,000 $15.10 $15.00 $100
Purchase 2 2,000 $14.80 $15.00 ($400)
Purchase 3 1,500 $15.05 $15.00 $75
Yearly Variance 4,500 ($225)
In this example, the purchasing department would have a favorable PPV of $225 for the items purchased.
In measuring PPV, a negative number often indicates a favorable variance while a positive number
indicates an unfavorable variance.
Kincaid’s PPV breakdown is shown in the Appendix.
This case was prepared by Jon Yarusso, of Gibson & Associates Inc., and Ram Ramanan, of the University
of Notre Dame, as the basis for class discussion.
Copyright Ó 1999 by Gibson & Associates, Inc. All rights reserved.

Kincaid Manufacturing
Kincaid Manufacturing is a Fortune 500 firm with annual revenues of approximately $3
billion. Kincaid produces its own line of electronic office equipment including fax
machines, mailing machines, small to mid-size copiers, small to mid-size printers, and
other office related electronic equipment.
Jeffrey Kincaid founded Kincaid Manufacturing in 1912 as a manufacturer of paper and
office supplies. With Xerox’s introduction of the plain paper copier in 1959, Kincaid
slowly changed its manufacturing focus to electronic reproduction equipment. By the mid
1970’s, Kincaid had become a price and technology leader in certain niches of the office
products industry and remained so until the late 1980’s.
During the early 1990’s Kincaid recognized a shortcoming in its ability to match
competitor’s product improvements. Kincaid responded by restructuring its internal
departments to increase engineering and manufacturing support without increasing
overall costs. The restructuring did improve Kincaid’s product development but not as
much as initially hoped and costs actually increased throughout the company. Industry
advancements continued to narrow Kincaid’s technological edge and competitors were
aligning themselves to compete with Kincaid’s prices. The result has been a decrease of
Kincaid’s profit margin for the past four years and shareholders have begun to show their
displeasure. While Kincaid still enjoys an excellent reputation, increased sales, and the
role of market leader, its competition has substantially closed the gap in Kincaid’s niche
markets.
Kincaid's Market Share (Various Niche Markets)
80%
60%
40% Kincaid
Others
20%
0%
1985 1990 1995 1998
Procurement Strategies
Mike realized he would have to make a fundamental change in the purchasing
department’s operations and strategy. He knew about industry trends such as JIT II,
Strategic Alliances, eCommerce\eProcurement, and joint ventures and had seen the
effects of their implementation at other firms. He doubted, however, that they could be
successful here without the help of an outside consulting firm. His staff was too
inexperienced and time-crunched to take on any new initiative without some outside
guidance. Mike realized that he would require multiple resources and extensive training
for his staff. Mike began analyzing different consulting firms and the strategies each
could implement. He focused his search around four procurement strategies:
-2-
· Strategic Alliances –Most purchasing contracts are for one year and include price,
payment terms, and delivery information. These contracts are basic buyer-seller
relationships. Strategic alliances go beyond these standard purchasing contracts to
provide additional benefits for both companies. Strategic alliances are often multiple
year contracts, involve sharing of internal proprietary information and joint cost
reduction activities. Strategic alliances are often formed through two mechanisms.
The first is a natural progression and the second is a focused sourcing effort. Natural
progression occurs throughout time as one supplier slowly integrates itself into the
customer’s operations. Neither party makes any formal attempt to create the
relationship. The focused sourcing effort, on the other hand, is just the opposite. It is
an attempt by the customer to create value for both parties through a formal selection
process. Focused sourcing efforts require extensive time and resource commitments
from both sides.
· JIT2 – Just in Time (JIT) is an inventory control system in which supplies are
delivered in smaller quantities directly to the production floor to reduce the costs of
receiving and storing inventory. JIT II continues where JIT leaves off by involving a
supplier in all facets of a company. In JIT II, supplier personnel are brought in to act
as a component of the customer. The supplier representative schedule orders,
provides engineering support, and engages in product development. As evident, JIT
II requires an extremely strong relationship with a high deal of trust. It often follows
the formation and/or implementation of a strategic alliance. JIT II is a relatively new
concept pioneered by BOSE Corporation and implemented with great success at other
manufacturing giants such as GE.
· Joint Ventures – Joint ventures involve the partnering of two independent firms for a
single initiative. Often these joint ventures are structured around the co-development
of a new product. Joint ventures allow companies to share engineering resources and
dilute costs and therefore risk between two companies. Joint ventures, from a
purchasing standpoint, often limit the ability to strategically purchase a product.
Competitors may be able to provide more services at lower cost but the joint venture
locks the partners into a purchasing relationship. Results in joint ventures are
uncertain and take multiple years to achieve. Therefore, engineering often drives the
joint venture and purchasing is relegated to order fulfillment.
· eCommerce – In the past few years eCommerce has dominated the thoughts and
strategies of most of the Fortune 500. It is viewed as a business revolution, creating
new marketplaces for companies to conduct business. Even though very few
profitable business models were emerging in this new business realm, if a company
did not participate in a marketplace, auction, or exchange, it was viewed as archaic
and behind the times. In a knee-jerk reaction to this stigma, eCommerce been applied
to nearly every business action that involves a computer. It has been diluted with
more hype and hyperbole than any business change in the last 100 years. The truth of
eCommerce is that it is merely a new tool to conduct business. It enhances a
companies ability to communicate, exchange information, and conduct transactions at
increased speeds and, in theory, at lower costs. eCommerce, therefore, must be
understood in the context of the enterprise that conducts it, the services it performs,
-3-
and the environment in which it happens. In purchasing, the term eCommerce has
traditionally centered on electronic ordering and transactions initiated by the customer
at the seller’s website. A correlation would be the ability to purchase books from
Amazon.com. Recently, the trend has shifted to the ability of major manufacturers to
put their purchasing needs on-line and allow suppliers to bid on those needs and the
creation of public and private exchanges which bring supplier and buyer into on-line
communities. As eCommerce expands in purchasing, it is not out of the realm of
possibilities to merge whole supply chains together, sharing MRP forecasts and actual
orders real-time.
Mike knew the first step in his decision process would be an overall assessment of
Kincaid and its purchasing department. Mike chose a mid-size boutique (specialized)
consulting firm, Gibson & Associates to conduct the initial assessment.
High Level Analysis
Gibson & Associates conducted a high level analysis on Kincaid’s purchasing
department. Gibson focused on five main research activities in order to gain insight into
Kincaid’s purchasing operations. These activities included:
· Site Visits - Plant & Facility Tours
· Cross Functional Interviews
· Contract Analysis & Industry Benchmarking
· Supplier and Customer Interviews
· Data Collection and Commodity Analysis
The research allowed Gibson to assess how Kincaid was operating compared to best
practices within the office machines industry. The results of the research were as
follows:
Site Visits & Interviews
Kincaid has three manufacturing centers, in White Plains, NY; Houston, TX; and
London, England with White Plains also being the corporate headquarters. Each
manufacturing center has a primary focus for operations. Houston manufactures and
designs printers, London manufactures and designs copiers, and White Plains
manufactures and designs all other products.
Manufacturing operations at each site are under the supervision of a Regional Director of
Manufacturing. Manufacturing consists of assembly work with no additional fabrication
work. Kincaid, therefore, purchases all of the parts required for their business machines.
With the restructuring of the business units, responsibility for inventory management was
placed in the hands of manufacturing. The directive to the Regional Directors of
Manufacturing, with regard to inventory, was to keep regional parts inventory levels
below $15 million at all times. Management’s hope was that the manufacturing centers
would operate on a Just-In-Time system. The result, however, became one of spot buys
and little long term inventory planning. The spot buys required overnight shipments and
additional manufacturing costs. Suppliers split these costs with Kincaid but the net result
was often a purchase price of 5-10% higher than standard. While parts inventory levels
-4-
stayed below the $15 million levels, the lack of planning contributed greatly to the
unfavorable $13 million purchase price variance.
Engineering and design operations at each site are under the supervision of a Regional
Director of Engineering. Engineering and design consists of developing new products,
improving current products, and inspecting returned products for design flaws or
manufacturing defects. Engineering often uses new customized parts for each new
product in development. These new prototype parts are designed by Kincaid and
manufactured by one of the current suppliers. To keep prototype costs at a minimum,
corporate policy directed that each new part be sent out to bid to at least two suppliers.
The result was for each manufacturing site to keep at least two suppliers for each
commodity area.
The manufacturing and design efforts at each site are autonomous from other sites but fall
under the control of the Corporate VP of Operations. Each manufacturing center is
measured and rated on its performance in meeting new product development goals,
product support goals, and manufacturing output goals.
Purchasing was hardest hit by the restructuring in the early 1990’s. The department had
been reduced to 2-4 Regional Commodity Managers and 2 Junior Commodity Managers
per manufacturing site. Purchasing fell under the control of the Regional VP of
Operations.
-5-
Since the Regional VPs were not rated on purchasing measurements such as PPV, the
Commodity Managers were relegated to order fulfillment responsibilities and were rated
on operational measurements such as line down time. The reduction in responsibilities
has led to an abnormally high turnover rate in the purchasing department. The average
years of purchasing experience went from 15 years in 1988 to 7 years in 1998. Likewise,
the amount of training each commodity manager receives annually has decreased from 80
hours in 1988 to 25 hours in 1997.
Purchasing had little power to go look for outside suppliers. Any new suppliers had to be
approved by engineering and manufacturing. Consequently, the supply base has not
changed in about 15 years. Manufacturing and engineering have become extremely
comfortable working with the same companies and are typically against change. Many
are local companies that could respond quickly to Kincaid’s demands. Kincaid felt this
responsiveness was important to achieve the delivery cycles it required to keep inventory
levels down. As Jeff Montgomery, Director of Houston Manufacturing, put it:
-6-
“Our suppliers understand the little nuances of what we do. It would take a lot of time
and effort to develop similar relationships with other suppliers. Most supplier contracts
are one year rolling contracts and are only reviewed in times of dispute or poor
performance, but due to the strong relationships with our suppliers only a handful of
contracts are reviewed each year.”
Kincaid Competitor 1
Organizational Chart
Company
President
Divisional President Divisional President

Printers Copiers
VP of VP of VP of VP of VP of VP of
Manufacturing Purchasing Engineering Manufacturing Purchasing Engineering
Director of Director of Director of Director of Director of Director of

Manufacturing Procurement Engineering Manufacturing Procurement Engineering
Kincaid Competitor 2
Organizational Chart
Company
President
VP of VP of VP of
Manufacturing Purchasing Engineering
Director of Director of Director of Director of Director of Director of

Manufacturing Manufacturing Procurement Procurement Engineering Engineering
Copiers Facsimile Copiers Facsimile Copiers Facsimile
Contract Analysis & Industry Benchmarking

Most of the contracts were evergreen contracts (one year agreements that automatically
renewed if neither company attempted to renegotiate) that were basic blanket order
purchase agreements. The contract contained standard terms such as delivery times,
payment terms, price, and a yearly quantity. The yearly quantity, however, was not a
guarantee. Kincaid would provide six months of rolling forecasts to the suppliers and
Kincaid would be responsible for paying for two months of inventory. Most suppliers
provided customized parts that would take a new supplier 4-6 months to qualify so
suppliers were comfortable with the contract. The forecasts provided to suppliers,
however, were deliberately understated to keep surpluses from occurring. This helped
manufacturing meet its inventory ceiling. Shortages were overcome with spot buys.
-7-
Industry benchmarking showed that Kincaid’s actual prices for its high-spend parts were
5-10% more than could be negotiated in an open market. Kincaid argues that it spends
less on its procurement organizational budget, nullifying the increased prices. The
average procurement department for a firm Kincaid’s size has approximately 20 mid
level managers, 3 administrative staff, and 2-3 upper level executives. Kincaid has 9 mid
level managers and 6 lower level managers. Since there was no upper management,
purchasing was forced to report indirectly to the Vice President of Operations.
Supplier & Customer Interviews
In general, suppliers were happy with the relationship forged with Kincaid. For many
suppliers, Kincaid represented 25-50% of their business and the suppliers were very
attentive to the needs of Kincaid. Some suppliers, however, were upset at the
inconsistent order sizes. The instability made it impossible to accurately project
manufacturing schedules. Most of the suppliers, in good faith, only passed on a portion
of the added cost of spot buys. The reality was that these “good faith” agreements were
being taken advantage of by Kincaid and, unless ordering became more routine, a profit
multiplier would be added to the cost of the spot buys to account for the business lost
during line set up. Some suppliers also commented that they supplied similar product to
more than one manufacturing site but dealt with the sites independently.
Customers were satisfied with Kincaid’s product. Kincaid provided a great leasing
program, had a very knowledgeable sales force, and its products seldom broke down.
The one recurring complaint was that when a product did break down it took up to two
weeks to receive service parts. A few customers also hinted that Kincaid’s price
advantage had almost evaporated and unless Kincaid matched competitor’s innovations,
Kincaid may lose their business.
Commodity Analysis
Gibson investigated the purchase history of the items Kincaid used in its production.
GIbson divided the items into standard purchasing commodities that Gibson had dealt
with in the past. The term commodity is not used as a traded commodity but rather an
area of like purchases. The following represents the commodity breakdown Gibson
provided, a description of the commodity, and the results Gibson & Associates typically
achieved in each. The appendix contains summary spend information for Kincaid.
· Belting – Belting connects motors with the functional operations of a product. Belts
often feed paper through a printer, fax machine, etc. Belting is created from standard
materials and cut or molded into specific dimensions. Belting requires minimal
engineering support and can be purchased from multiple suppliers. Major belting
suppliers for Kincaid include Gates Rubber Company and Advanced Belt
Technology.
· Castings – Castings provide a mold for metal and plastic products. Many
manufacturing companies purchase the castings for their injection molding and large
machine parts in order to transfer these parts to different suppliers. Castings are
customized for each mold requirement and require engineering design and support.
Most of Kincaid’s casting suppliers own the drawings. Major castings suppliers for
Kincaid include Stroh Die Castings and Paber Aluminum.
-8-
· Circuit Boards – Circuit boards are composed of electronic circuits (capacitors,
resistors, programmable chips, etc) linked together on a thin plastic board. Circuit
boards are very complex and highly proprietary, with each circuit board being custom
designed for a particular machine. Circuit boards control the functionality of
electronic equipment and require engineering prototypes and extensive testing
procedures. It often takes months to qualify a new circuit board or a new supplier.
Major circuit board suppliers for Kincaid included Solectron, Celestica, and Plexus.
· Electrical Devices – Electrical devices are often standard industry models with slight
modifications. Electrical devices include transformers, solenoids, and transistors.
These products require engineering support during design but not much during
modification. Major electrical device suppliers for Kincaid include Lucas Controls
and Newark Electronics.
· Injection Molding (Plastics) – Injection Molding is often the external plastic shell of
electronic products. These parts are custom built but do not require engineering
support if castings (above) are provided. As the cost of manufacturing plastic
components continues to drop, injection molded parts are replacing sheet metal parts.
Kincaid intends to switch 70% of its sheet metal parts to injection molded parts
within the next two years. This will require a major engineering commitment on
Kincaid’s part to design and test the new injection molded parts. Major injection
molding suppliers for Kincaid include Donnelly Custom Molding and GE Plastics.
· Machined Parts – Machined parts are items created from metal working processes
such as grinding, polishing, forging, stamping, etc. Machined parts range from
simple screws to intricate metal plates. The amount of engineering varies greatly by
function of machining and castings (above) provided. Machined parts can be very
heavy and, therefore, very costly to ship. Markets, therefore, are very regional and
normally there is only a few competing suppliers (3-5) within a region. Machined
parts suppliers for Kincaid include Barton Products Corp and Sussex Machine Corp.
· Motors - Motors in this case refers to small electric motors. Motors are often
standard industry models with slight modifications. Like the electrical devices
commodity, these products require engineering support during design but not much
during modification. Major motors suppliers for Kincaid include Pittman Motors and
Philips Motors.
· Packaging – Packaging includes all components of packaging including boxes,
bubble wrap, wooden pallets, and tape. While some boxes are custom built for
particular products, most of Kincaid’s packaging product is industry standard.
Because of the low cost of packaging products, the cost to ship is often more than the
actual cost of the product. Packaging, therefore, is a very regional market. Packaging
suppliers for Kincaid include Apex and Smurfit Stone Container Corporation.
· Power Supplies – Power supplies are often standard industry models. Power supplies
are the adapter between an electrical source (an outlet in most cases) and the motor.
Major power supply suppliers for Kincaid include Lucent Technologies and Xentec.
· Rubber Components – Rubber components include many of the stoppers and
connectors within the product. Most rubber components are industry standard but
some customization does occur. Rubber Components require minimal engineering
-9-
support. Major rubber component suppliers for Kincaid include Minor Rubber
Company and Rogers Corp.
· Sheet Metal – Sheet metal parts are created by folding pieces of sheet metal into
support frames or exterior covering. Most sheet metal parts are custom built but do
not require engineering support. Sheet metal parts are often large, heavy, and costly
to ship. While this promotes local suppliers, the industry has numerous large
suppliers who can support multiple manufacturing locations. Major sheet metal
suppliers for Kincaid include Northeastern Precision Products and Barlow Metals.
· User Interface (Displays) – User interfaces are the message centers for electronic
products. User interfaces range from simple LCD panels in calculators to complex
printer interfaces. User interfaces require engineering design and support and new
products and suppliers must be tested and qualified. This process is less intensive
than the procedures for circuit boards but often lasts a month. Major user interface
suppliers include PCI and Cherry Electronics.
· Wire & Cable Harnesses – Wire and cable harnesses often connect circuit boards
(above) with other parts within the product. These products often consist of two
connectors and a piece of cable. The components of a harness are industry standard
and customized to meet product requirements. The entire part requires very basic
engineering support during the design phase but little ongoing support. Wire & cable
suppliers for Kincaid include AMP and Harbor Electronics.
Typical Commodity Savings*

Near Standard Material Low Engineering Highly Engineered
Commodities And Components Custom Components Custom Components
Custom Electronic:
Asphalt
Machined Parts Castings · Circuit Boards
Bulk Chemicals Belting Sheet Metal · User Interfaces
Coal and Coke Rubber Components Standard Electronics: · Cable Harnesses
Fiberglass Packaging · Motors Custom Plastics
· Power Supplies · Injection Molding
Paper
· Thermo-Forming
Resins
3% to 5% 5% To 10% 10% to 15% 10% to 20%
*Typical commodity savings is based on actual results achieved during strategic sourcing projects conducted by Gibson & Associates.
Categories are generalized but depending on specific client requirements may overlap columns. Specific detail are kept confidential
due to client demands.
- 10 -
Appendix 1: PPV Analysis
PPV Analysis*
Global Commodity 1998 Actual 1998 Expected Purchase Price Percentage
Areas Spend Spend Variance Variance
Circuit Boards $79,600,000 $73,310,000 $6,290,000 8.58%
Sheet Metal $21,860,000 $22,560,000 ($700,000) -3.10%
Machined Parts $33,920,000 $32,570,000 $1,350,000 4.14%
Electrical Devices $5,100,000 $4,910,000 $190,000 3.87%
Packaging $9,260,000 $9,970,000 ($710,000) -7.12%
Belting $8,300,000 $7,980,000 $320,000 4.01%
Displays (User Interfaces) $19,940,000 $19,090,000 $850,000 4.45%
Castings $9,600,000 $9,230,000 $370,000 4.01%
Plastics/Injection Molding $22,500,000 $22,590,000 ($90,000) -0.40%
Motors $17,540,000 $17,420,000 $120,000 0.69%
Rubber Components $5,120,000 $5,200,000 ($80,000) -1.54%
Power Supplies $6,780,000 $6,440,000 $340,000 5.28%
Wire & Cable Harnesses $24,680,000 $23,240,000 $1,440,000 6.20%
Total Target $264,200,000 $254,510,000 $9,690,000 3.81%
*Unlike many companies, Kincaid sets standards each year at the average price of the year before. In other
words, if Kincaid purchased a part at the beginning of the year for $10 and, due to inflation, the price rose to
$11 at the end of the year, the standard cost is set at $10.50. The result is a slightly inflated PPV each year
by the average inflation rate of 3.2%.
Appendix 2: Purchased Items Totals

Consolidated Purchases Analysis
Global Commodity UK White Plains Houston Total
Areas 98 Spend 99 Projected 98 Spend 99 Projected 98 Spend 99 Projected 98 Spend 99 Projected
Circuit Boards $22,480,000 $23,851,280 $44,360,000 $47,154,680 $12,760,000 $13,027,960 $79,600,000 $84,033,920
Sheet Metal $10,060,000 $8,396,000 $5,560,000 $5,059,600 $6,240,000 $6,371,040 $21,860,000 $19,826,640
Machined Parts $11,780,000 $11,820,000 $15,740,000 $16,731,620 $6,400,000 $6,534,400 $33,920,000 $35,086,020
Electrical Devices $1,780,000 $1,888,580 $2,200,000 $2,338,600 $1,120,000 $1,143,520 $5,100,000 $5,370,700
Packaging $3,400,000 $3,819,600 $3,740,000 $4,507,120 $2,120,000 $2,470,820 $9,260,000 $10,797,540
Belting $2,380,000 $2,525,180 $3,960,000 $4,209,480 $1,960,000 $2,001,160 $8,300,000 $8,735,820
Displays (User Interfaces) $6,240,000 $6,620,640 $7,960,000 $8,461,480 $5,740,000 $5,860,540 $19,940,000 $20,942,660
Castings $3,340,000 $3,543,740 $4,240,000 $4,507,120 $2,020,000 $2,062,420 $9,600,000 $10,113,280
Plastics/Injection Molding $5,240,000 $6,900,000 $12,100,000 $14,260,000 $5,160,000 $5,676,760 $22,500,000 $26,836,760
Motors $5,960,000 $6,323,560 $6,900,000 $7,334,700 $4,680,000 $4,778,280 $17,540,000 $18,436,540
Rubber Components $1,960,000 $2,079,560 $2,360,000 $2,614,980 $800,000 $918,900 $5,120,000 $5,613,440
Power Supplies $2,200,000 $2,334,200 $2,640,000 $2,806,320 $1,940,000 $1,980,740 $6,780,000 $7,121,260
Wire & Cable Harnesses $8,480,000 $8,997,280 $10,240,000 $10,885,120 $5,960,000 $6,085,160 $24,680,000 $25,967,560
Total Target $85,300,000 $89,099,620 $122,000,000 $130,870,820 $56,900,000 $58,911,700 $264,200,000 $278,882,140
Actual and historical spends by category enables companies to prioritize their efforts. A 10% savings in a $5 million category is offset by a 1% savings in a $60 million category. A common theme
in purchasing is to follow the trail of dollars. In a lack of other analytical tools, sorting spends by total dollars often will give purchasing managers a starting point for prioritizing their efforts.
Additionally, looking at trend information from year to year and spends across locations give indications as to the leverage opportunity of a commodity. In a decentralized organization such as
Kincaid, high spends in multiple locations for highly engineered products indicates large savings opportunities.
- 11 -
Appendix 3: Total Parts & Suppliers
Consolidated Part & Supplier Analysis
Global Commodity UK White Plains Houston Total
Areas Suppliers Parts Suppliers Parts Suppliers Parts Suppliers* Parts
Circuit Boards 4 56 7 98 2 28 12 182
Sheet Metal 12 534 9 212 11 298 29 1,044
Machined Parts 12 2,156 15 3,456 9 1,123 36 6,735
Electrical Devices 7 101 18 141 5 76 30 318
Packaging 2 329 4 298 3 178 9 805
Belting 11 398 4 430 5 287 20 1,115
Displays (User Interfaces) 2 51 4 74 2 35 8 160
Castings 9 213 6 324 6 198 21 735
Plastics/Injection Molding 8 277 5 578 7 288 18 1,143
Motors 1 28 3 34 1 27 5 89
Rubber Components 17 478 8 523 7 235 31 1,236
Power Supplies 3 37 4 42 2 29 9 108
Wire & Cable Harnesses 6 198 11 211 5 119 19 528
Total Target 94 4,856 98 6,421 65 2,921 247 14,198
* Some suppliers are in more than one location.
Analyzing the number of parts and suppliers in a commodity gives another indication of leverage opportunity as well as the difficulty to transition a
product from one supplier to another. For example, a category like Machine Parts might have great potential for leverage due to the large number
of suppliers but the number and complexity of the parts may make for a lengthy transition.
Appendix 4: Paredo (80/20) Analysis
80/20 Analysis
Global Commodity Total Annual Purchases 80/20 Analysis
Areas Parts Suppliers Spend Parts Parts % Suppliers Suppliers % Spend Spend %
Circuit Boards 182 12 $ 79,600,000 41 22.53% 6 50.00% $ 63,660,000 79.97%
Sheet Metal 1,044 29 $ 21,860,000 398 38.12% 9 31.03% $ 18,020,000 82.43%
Machined Parts 6,735 36 $ 33,920,000 2,789 41.41% 8 22.22% $ 27,460,000 80.96%
Electrical Devices 318 30 $ 5,100,000 61 19.18% 23 76.67% $ 4,080,000 80.00%
Packaging 805 9 $ 9,260,000 148 18.39% 2 22.22% $ 7,420,000 80.13%
Belting 1,115 20 $ 8,300,000 225 20.18% 5 25.00% $ 6,920,000 83.37%
Displays (User Interfaces) 160 8 $ 19,940,000 33 20.63% 6 75.00% $ 16,180,000 81.14%
Castings 735 21 $ 9,600,000 151 20.54% 13 61.90% $ 7,520,000 78.33%
Plastics/Injection Molding 1,143 18 $ 22,500,000 229 20.03% 15 83.33% $ 18,480,000 82.13%
Motors 89 5 $ 17,540,000 26 29.21% 2 40.00% $ 14,460,000 82.44%
Rubber Components 1,236 31 $ 5,120,000 241 19.50% 17 54.84% $ 4,060,000 79.30%
Power Supplies 108 9 $ 6,780,000 25 23.15% 4 44.44% $ 5,200,000 76.70%
Wire & Cable Harnesses 528 19 $ 24,680,000 99 18.75% 11 57.89% $ 19,520,000 79.09%
Total Target 14,198 247 $ 264,200,000 4,466 31.46% 121 48.99% $ 212,980,000 80.61%
Note: A rule of thumb in manufacturing is that 80% of a firm's annual procurement spend comes from approximately 20% of the
parts. This quick analysis often provides insight into how a firm is handling its high volume/high cost items and, therefore, the
success of its purchasing department. Categories where 80% if the spend is with greater than 20% of the suppliers oftens
indicates an opportunity to better leverage the spends of a company.
- 12 -
Mike asked the consultants from Gibson to prepare a response focusing on the following
problems. Use the information from the case and in the attached exhibits to create
responses to the following questions.
1. What are the major issues facing the functional areas of manufacturing, engineering,
and purchasing at Kincaid? Which of these issues are unique to each functional area
and which reach across functional boundaries?
2. How might Kincaid address these issues? What organizational and operational
changes should Mike Peters pursue and why?
3. What purchasing strategies (JIT2, strategic alliances, joint ventures, eCommerce, etc.)
should Kincaid implement to improve Kincaid's overall business operations? If
multiple strategies are recommended, discuss how they relate to each other.
4. What commodity areas should Kincaid focus its initial efforts on to reduce the
unfavorable PPV? What factors should be considered in making this decision?
- 13 -
OSRAM, North America
Larry Carter was feeling very optimistic about the new product he wanted
to introduce in the US market, the “Dulux” Compact Fluorescent Lamp
(CFL). He had lined up two potential test market sites, pending a final
pricing decision. Larry’s problem now was to determine how to price the
Dulux bulbs to provide good value to both end use customers and
OSRAM’s distributors while also earning as good a profit as possible. His
compensation as President of OSRAM, North America (ONA) was largely
based on the profitability of the business.
OSRAM, NA’s parent company, OSRAM GmbH, is a German-based lighting firm with
$1.5 billion in annual sales. It is part of the German electrical giant, Siemens AG ($70
billion in sales). OSRAM competes in a $12 billion worldwide light bulb market with a
very strong position in Europe and South America. In 1984, OSRAM started a new
subsidiary, OSRAM North America (ONA), to try to compete in the very attractive US
market. The US represents 50% of world lighting demand, but it is dominated by three
major competitors, GE, Sylvania, and Phillips. ONA grew very rapidly (25% per year)
during its first 10 years, pursuing a niche strategy. Using OSRAM’s technical superiority
in theatrical and scientific lighting, ONA focused on these small, specialty markets. They
built a distribution network and developed very strong customer relationships with OEMs
(original equipment manufacturers). ONA, however, was only participating on the very
fringe of the market. The three dominant players focused primarily on large segments in
both the consumer and commercial light bulb markets. Sales for ONA peaked in 1994 and
seemed stuck at $60 million in 1996. This was only 4% of the total US commercial market
for 1996, but it was 50% of the specialty segments in which ONA concentrated.
Carter felt it was unlikely he could do better than a 50% SOM, so his only realistic hope
for further high growth, which Siemens expected of him, was to tackle new segments.
A New Product Opportunity

In 1996, during a factory visit in Germany, the ONA management team was introduced to
a patented, innovative light source called Compact Fluorescent Lamps (CFL). Similar in
size to an incandescent bulb, CFL bulbs emit the same “color” of light (color temperature,
2800 degrees Kelvin). The big differences with CFL are that they last about ten times as
long and consume only about 1/5 the energy. For example, an 18-watt CFL bulb provides
the light of a 100-watt incandescent bulb, while consuming only 18% of the energy and
lasting 10,000 hours, versus about 1,000 hours. Of course, this kind of performance comes
at a price. The normal incandescent 100-watt bulb costs about 18 cents to manufacture and
sells retail for about $1.20. The CFL 18-watt bulb costs well over $2.00 to manufacture.
The retail selling price is yet-to-be-determined. Typically, bulb prices did not vary with
wattage. The ten times life and 80% energy savings factors were thought to more than
justify a substantially higher price that would more than compensate for the significantly
higher manufacturing cost.
“Customer value” for an 18-watt CFL bulb, replacing 10,000 hrs of use with a 100-watt
incandescent bulb (at $.14 per kwh) is $78.00, as shown below:
Annual cost for the incandescent bulb = $1.20 + power cost (1000 hrs
× 100 watts = 100 kwh × $.14 = $14.00) = $15.20
10 year PV (10%) of $15.20 = $93.40
For the 18-watt CFL bulb, 10 years of energy cost has a present value
of $15.40 as shown below:
1000 hrs/yr × 18 watts = 18 kwh × $.14 = $2.50/yr
10 year PV (10%) of $2.50/yr = $15.40
Customer value of the CFL bulb = $93.40 - $15.40 = $78.00
In theory, a consumer should be willing to pay up to $78.00 for the alternative CFL bulb.
In theory!
ONA management was confident that the CFL product had high potential in the U.S.
market. They were pleased to have a proprietary technology to compete against the big
three in larger segments. The technological superiority would give them immediate
credibility with end-users and distributors. Phillips North America owned the US
distribution rights to CFL bulbs manufactured in Germany through joint venture
agreements with Siemens. ONA could pay Phillips a royalty on imported CFL bulbs, or
manufacture bulbs in the US to avoid the royalty. Siemens would license the
manufacturing patent to ONA for a nominal fee. Carter was reluctant to commit to US
manufacturing until he was surer of the demand. He wanted to do some test marketing,
using bulbs imported from Germany, to introduce the new product.
Market Segmentation
The US lighting market can be divided into two basic segments: commercial and
consumer. The latter is the channel for retail sales for home use. The product is ultimately
purchased from supermarkets, drugstores, hardware stores, lighting stores or mass
merchandisers. Mass merchandisers buy bulbs direct from manufacturers. Other outlets
use wholesale distributors.
The commercial segment provides lighting for hotels, factories, hospitals, offices, schools,
theatres, scientific laboratories, street and sign lighting, and retail lighting fixture
salesrooms. Eighty percent of commercial bulbs are bought through wholesale
distributors. Governments and lighting equipment manufacturers usually buy direct from
the manufacturers. Also, larger customers in some smaller markets deal directly with
manufacturers.
Because GE, Sylvania and Phillips are so well established with the major distribution
companies, Carter thought his best bet for introducing CFL was to target segments that do
not use distributors. He thought that selling a new technology would be easier if he could
go to customers who work directly with manufacturers and buy bulbs in high volume.
Because ONA is far too small to deal with the mass merchandisers or the government,
Carter decided to explore two particular niches within the commercial segment: (1) energy
saving companies (ESCO’s), which are not currently large buyers of light bulbs; and (2)
lighting maintenance companies which supply and maintain bulbs for businesses such as
hotels, offices or casinos.
Because the CFL bulbs require a special socket which no US company made as yet, ONA
would need to penetrate fixture manufacturers before they could expect wholesalers to try
to sell the bulbs in the general commercial lighting market. In the two targeted segments,
the cost of retrofitting existing fixtures for CFL bulbs would be part of the financial
analysis.
The Energy Savings Converters (ESCO) Market
Babson Energy Savers (BES) is a successful ESCO located in Wooster, MA. Its business
is energy saving remodeling projects, such as heating and air conditioning systems, low
voltage versus high voltage power conversions, and automatic switching controls. A small
part of their current business involves saving building owners energy costs through
conversion to fluorescent fixtures. For example, a fluorescent lamp, which consumes
about 32 watts of power, provides the equivalent of 150 watts of incandescent light. The
major drawbacks to fluorescent light are the high cost of the bulb, the harsh light and glare,
and the bulky fixtures, which are awkward to install and service, and are very unattractive.
CFL bulbs could create a new business opportunity for firms such as BES. CFL’s small
size and simple ballasting allow a much wider range of fixture design options than with
fluorescent, as well as the huge energy savings and long life advantages. Once the idea
was explained to them, the BES engineers shared ONA management’s enthusiasm for the
compact fluorescent lamp. BES felt that with proper pricing of the CFL lamp, the cost
savings would be very attractive for many of their customers.
In order to test the new product in this segment, ONA convinced BES to propose using
CFL lighting as part of an overall energy savings project for one of Boston’s old classic
hotels, the Copley Grand. ONA would provide financing to the hotel for the cost of
retrofitting existing fixtures (12% annual rate and payments over 15 years) through
Siemens’ captive finance subsidiary. ONA would guarantee the hotel annual savings in
power cost at least double the annual payment on the retrofitting loan.
The hotel lighting configuration is as follows:
Rooms: 10 floors with 25 rooms per floor. Each room averages 200
occupied days per years. There are nine lights in each room (4
table or vanity, 3 overhead, and 2 wall) at 100 watts each (cost =
$1.20 each). Average usage per room rental is a total of 7 hours.
Halls: 10 floors with 24 overhead lights per floor (one 50 watt bulb
each). Average usage of 24 hours per day.
Bulb life for the hotel, using incandescent bulbs was 800 hours for
room lamps and 1400 hours for hall lights. Turning bulbs on an
off shortens the useful life.
The cost of electricity in Boston is high, averaging $.14 per kilowatt-
hour (kwh). In other parts of North America, power costs can be
half that rate.
The hotel was currently buying about 1900 bulbs/yr:
2250 room bulbs (250 × 9) at 5 year life per bulb (200 × 7 = 1400
÷ 9 = 155 vs. 800) = 450 bulbs/year
240 hall bulbs at 6 changes per year (8760 hrs ÷ 1400) = 1440
bulbs/year
450 + 1440 = ~1900 bulbs
Bulbs are changed by the hotel maintenance staff as they burn out.
BES Cost to Retrofit the Hotel Light Fixtures is as follows:
A typical incandescent or fluorescent overhead fixture costs $7
for material (reflector, ballast, igniter and housing modifications)
and one half hour of electrical technician labor at $18 per hour to
retrofit for CFL use. To retrofit a table or vanity fixture costs
$2.50 for material and one quarter hour of labor. Wall fixtures
cost $3 for material and 40 minutes to retrofit.
BES electrical technicians would do the conversion job. Lighting fixtures
typically have a life of 15 years.
The Lighting Maintenance Contractors (LMC) Market

The second niche market that looked attractive to ONA for CFL bulbs was Lighting
Maintenance Contractors (LMCs). This segment bought $144 million in incandescent and
fluorescent bulbs in 1996 and was supplied directly by the big three. The ESCO segment
was buying only about $36 million in fluorescent bulbs in 1996. Even if ONA could
double the ESCO market by switching it to CFL bulbs, the potential was only half that of
LMCs.
Farnham Lighting Service (FLS) is based in Atlantic City, New Jersey. FLS contracts with
building managers to change the many thousands of light bulbs that illuminate casino
interiors, exterior signs and parking lots. A typical job could have 12,000 to 18,000 bulbs.
For the Villagio casino in Las Vegas, the marquee billboard alone has 33,000 bulbs.
FLS charges the casino a set monthly fee based on the number of light sources. The fee
includes labor, equipment usage, and the cost of the light bulbs themselves. Access to the
light bulb can be very difficult, requiring lifts and other power equipment for changes.
This is a key factor in determining the monthly fee. Normally, longer-life light sources
(fluorescent) are chosen for the least accessible locations.
Research showed that burned-out lighting is very unattractive, keeping customers away
from the casinos. The standard practice for lighting service companies is to totally re-lamp
a section, known as “group relamping,” at 80% of the bulbs’ expected life. This virtually
eliminates burned out lights.
In order to test the new product in this segment, ONA convinced FLS to propose a
conversion to CFL bulbs for one large customer, the Stardust Casino. The casino has
15,000 incandescent fixtures (50- and 100-watt) with an expected life of 800 or 1400
hours, similar to a hotel, and 2,000 25-watt fluorescent fixtures with a rated life of 8,000
hours. The casino stays open 24 hours a day. FLS does not relamp the hotel room bulbs,
which are changed as they burn out by the regular maintenance staff. They relamp the hall
and casino incandescent bulbs 8 times per year (8,760 hrs ÷ 1,400 × .8) and the fluorescent
fixtures approximately 1.4 times per year (8,760 ÷ 8,000 × .8). With an average labor rate
of $20 per hour, an average of 5 minutes to change each bulb, and equipment rental at
about $300/day, the CFL story is very appealing to Farnham.
The CFL bulb offers lower power cost to the casino (18-watt bulbs vs. 100-watt, and 9-
watt vs 25- or 50-watt). CFL bulbs offer lower changeover cost to the service company
due to longer bulb lives. The casino would also enjoy less downtime for their 24-hour
gambling operation. Sometimes bulbs could be changed without closing down the
gambling, but not always. Downtime means lost revenue from the gamblers who move to
a different casino. Once they move, players usually don’t return right away once the bulb
change is complete. The Stardust Casino, which grosses $250 million a year, once
estimated that lost time from light bulb changes costs about $100,000 each year in lost
revenue at, probably, 75% gross margin.
The changeover requires the purchase of more expensive bulbs and a one time retrofitting
of all fixtures to accommodate CFL-compatible sockets. The lighting configuration for the
Stardust Casino is as follows:
A 1,000-room hotel with 9 bulbs (100-watt) per room and 1,000 hall
lights (50-watt). This is a total of 10,000 incandescent bulbs.
The casino, with 5,000 100-watt incandescent bulbs and 2,000 25-
watt fluorescent bulbs.
The casino and the hotel halls were lighted 24 hours a day. The hotel
rooms average 200 occupied nights per year with 7 hours of bulb
usage, combined, per stay.
The one-time retrofitting cost for light fixtures would be:
3,000 wall fixtures @ $30 each
5,000 overhead fixtures @ $35 each
Power cost is $.12 per kwh in Atlantic City
FLS uses an 8-person crew at the Stardust Casino. The crew averages 7 working hours on
each eight-hour shift. The crew is scheduled to spend about 76 days a year on site. The
monthly fee is $20,500 ($246,000 per year), which breaks down as follows:
Bulbs: 48,000 incandescent bulbs at $1.00 each = $48,000
2,800 fluorescent bulbs at $6.00 = $16,800
Labor: 50,800 bulb changes at 5 minutes (average) per bulb = 4,234 hours
Paid hours = 76 days × 8 hrs × 8 persons = 4,864 hours × $20/hr = $97,280
Equipment rental (at $300 per crew day): = $300 × 76 = $22,800
Subtotal $184,880
Mark up to cover overhead and profit $61,120
TOTAL $246,000
The CFL bulbs exhibit much tighter variation in bulb life, versus incandescent, whether
bulbs are frequently turned on and off or left burning. FLS could go to “group relamping”
at 90% of the 10,000 hour rated CFL life with very little chance of burned out bulbs.
Assignment
1. a) For the ESCO test market job, what is the present value of CFL bulbs to the hotel
over the 15 years life of the fixtures? Energy savings and labor saving on bulb
replacements, less the cost to retrofit all the fixtures, plus current expenditures
for bulb replacement. This is the maximum price the hotel should be willing to
pay BES for the conversion job.
b) What price should ONA charge BES for the CFL bulbs for the Copley Grand Hotel
job?
c) What price should ONA charge the hotel for replacement bulbs?
2. a) For the LMC test market, what is the value to FLS in the first year
from the Stardust Casino contract if FLS switched to CFL bulbs? Labor
and equipment rental savings from longer bulb life. This is the
maximum amount, which FLS might pay to ONA for the 8,000 new CFL
bulbs (5,000 18-watt bulbs and 3,000 9-watt bulbs). Of course, FLS would
also know that the casino was achieving large savings which might be
shared with FLS and ONA.
b) What is the average annual saving to the Stardust Casino, over the fifteen year life
of the retrofitted fixtures, of switching to CFL bulbs? Energy savings, less the
retrofit charge, plus the value of reduced casino downtime. Assume the retrofit
contractor earns a 40% gross margin and Siemens’ captive finance subsidiary will
finance the retrofit with a 15-year installment loan at 12% interest.
This is the maximum amount, which the casino might be willing to pay to FLS for
using CFL bulbs. Of course, the casino would also know that FLS was saving on
changeover costs.
c) What price should ONA charge FLS for the 8,000 replacement bulbs each year?
3. Which of these two markets should ONA pursue? Both?

Osram 1
The basic idea is to study the customer’s

cost for buying and using a product over its useful
life (Life Cycle Cost) as a basis for establishing
selling price, product positioning, and marketing
strategy. This is a very different way of viewing
“cost-based pricing.” The focus is the customer’s
costs, not the manufacturer’s costs.
Osram 2
Annual Power Cost for the

Hotel
Incandescent: 100-watt bulbs—250 rooms 7 hrs/day x 200 days/yr
= 35 million watt-hours/yr
at $.14/kwh = $4,900/yr
50-watt bulbs—240 bulbs x 24 hrs/day x 365 days/yr
= 105,120,000 watt-hours/yr
at $.14/kwh = $14,717/yr
Total = $4,900 + $14,717 = $19,617
CFL: 18-watt bulbs = $4,900 x .18 = $882

9-watt bulbs = $14,717 x .18 = $2,649
Total = $882 + $2,649 = $3,531
Savings: $19,617 - $3,531 = $16,086/yr

Osram 3
Fixtures Retrofit
Cost:
Rooms: 4 table/vanity x $7.00 = $28
2 wall x $15 = $30 $106/room
3 overhead x $16 = $48
Total = $106 x 250 rooms $26,500
Halls: 24 overhead x $16 = $384/hall

Total = 10 x $384 $3,840
TOTAL $26,500 + $3,840 $30,340
Price to the Hotel (40% gross margin to the ESCO) $30,340 ÷ .60 =
~$50,600
Loan Payment = $7,425 (15 years/12%)
Osram 4
Net Annual Advantage: $16,086 - $7,425 = $8,661,

before considering cost of replacement
bulbs.
The hotel is currently paying $2,280 per year for incandescent

bulbs (1,900 x $1.20) and will use about 215 CFL bulbs/year (240 x
8,760/~10,000).
Osram 5
Let X = value to the hotel of one CFL bulb. Then:
15
($8, 661 + $2,280 - 215(X))
∑ = 2, 490X
i−1 (1.15)i
15 15
∑ ( )∑
($8,661 + $2,280) 1
- 215X = 2, 490X
(1.15)
i
(1.15) i
61,345 - 215X (~5.85) = 2,490X

61,345 = (215 • 5.85 + 2,490) X
61,345 = (1,258 + 2,490) X
61,345 = 3,748X
X = ~16.40
Osram 6
The very good student will note that the value of

the hotel room bulbs is not as high as the hall bulbs,
because of much less frequent replacement. A clue
to this split is that, for the casino, the LMC does not
work with hotel room bulbs—only the heavy-use
bulbs.
If we split the proposal into 2 parts:
The Hall Lights

The Hotel Room Lights
Osram 7
Then, the value of the hotel room bulbs is
1. Retrofitting $26,500 ÷ .6 = $44,167

Annual payment = $6,485 (15 years/12%)
2. Energy savings = $4,900 - 882 = $4,018/year
3. Net saving is negative! That is, it does not pay the

hotel to convert the hotel rooms.
Osram 8
But, the value of the hall bulbs, alone, is:
1. Retrofitting = $3,840 ÷ .6 = $6,400

Annual payment = $940 (15 years/12%)
2. Energy savings = $14,717 - 2,649 = $12,068
3. The PV of one CFL bulb is:
15
($12,068 - $940 + 1,440 • $1.20 - 215X )
∑ = 240X
i (1.15)
i
15 15
∑ ($12, 856)
- 215X ∑ 1
= 240X
i (1.15)i
i (1.15)i
$75,174 - 215 (5.85) = 240X

$75,174 - 1,257X = 240X
75,174 = 1,497X
X = $50.20
Osram 9
Question 1-b
The value to BES of the first round of CFL bulbs

for the halls = $50.20 each, for a total of $12,048
($50.20 x 240). The challenge for ONA is how much of
this value to try to capture and how much to “leave on
the table” for BES as the “value proposition.” The
brightest students may see that there really is no reason
to let BES in on any of the EVC to the hotel, assuming
the 40% gross margin on the retrofit job is normal profit
for BES.
Osram 10
Question 1-c
The challenge for ONA is how much of the

customer value of about $50 per CFL bulb to try to
capture and how much to “leave on the table” as the
“value proposition” to the hotel.
The hotel has been paying $1,728/yr for hall

bulbs. A price of $50/bulb means an annual outlay
of $10,750, against energy savings, net of
retrofitting, of $11,128. This should look marginally
good to the hotel, but not much of the value
proposed is being left for the hotel. But, pricing the
bulbs at 50% of EVC (an equal split of EVC between
customer and producer) should make it a very
attractive deal to the hotel.
Osram 11
Question 2-a
Current changeover time = 4,864 scheduled hours

(4,234 working hours)
With CFL bulbs, and still using “group relamping,” but

with 90% of rated life:
8,000 hallway and casino bulbs at 8,760 hrs

usage a year and 9,000 hrs life. Change each bulb
once a year, at 12/hr = 667 hours.
This translates to 83.33 crew hours (8 person

crew). At 7 usable hours per shift, this is 12 scheduled
shifts. The labor cost is $15,360 (12 x 8 x 8 x $20).
The annual savings in labor cost is $97,280 - $15,360 =

$81,920. This is 64 saved days on site (64 x 8 hours x 8
persons x $20/hr).
Osram 12
The savings in equipment rental is another $19,200 (64 saved

visits at $300 visit).
FLS is currently spending $64,800 on bulbs each year.
The value to FLS of the conversion (8,000 CFL bulbs) is:
Let X = Value of one CFL bulb. Then,

$81,920 + $19,200 + $64,800 = 8,000X
$165,920 = 8,000X
X = $20.70
But, as in Question 1, why should FLS get any of this value which
really accrues to the hotel’s benefit? Does OSRAM really need
FLS at all with the new bulbs? Since FLS loses 5/6 of its
business, it may well go out of business! The casino should find
someone to change the bulbs without giving any of the EVC to
the maintenance contractor!
Osram 13
Annual Power Cost to the Casino
Incandescent bulbs:
1,000 hall lamps x 50w x 365 days/yr x 24 hrs/day x $.12/kwh = $52,560/yr
5,000 casino bulbs x 100w x 365 x 24 x $.12 = $525,600/yr
Fluorescent bulbs:
2,000 casino bulbs x 25w x 365 x 24 x $.12 = $52,560/yr
Total Current Power Cost = $630,720 ($52,560 + $525,600 + $52,560)
With CFL bulbs:

3,000 hall and casino bulbs x 9w x 365 x 24 x $.12 = $28,382
5,000 casino bulbs x 18w x 365 x 24 x $.12 = $94,608
Total CFL power cost = $122,990 ($28,382 + $94,608)
Power cost savings = $630,720 - $122,990 = $507,730

Osram 14
One-time Retrofit Cost:
3,000 wall fixtures x $30 = $ 90,000

5,000 overhead fixtures x $35 = $175,000
Subtotal $265,000
Mark up* $177,000
Total $442,000
*The mark up is to provide about 40% gross margin to the retrofit

contractor.
The annual installment loan payment is $64,900 (15 years @ 12%)
Reduced casino downtime:

Profit impact = $75,000 gross margin • (76 - 12)/76 = ~$63,000/yr
Net impact = $507,730 - $64,900 + $63,000 = ~$506,000/yr

The value per CFL bulb is $63.50 ($506,000 ÷ 8,000)
Osram 15
Question 3
Both segments are very attractive for ONA, although

the LMC segment is better (EVC per bulb of $63.50 versus
$50.20). If it is possible to price discriminate between the
two segments, ONA can serve both. If price discrimination
is not deemed feasible, the question is whether to walk
away from $13+ of potential customer value to LMCs by
charging a price based on the $50 EVC in both markets or
drop the ESCO segment in order to charge a higher price in
the casino market segment.
Pricing at some percent of customer value (50%?)

reduces this split, but the concept is the same.
Osram 16
In class, I go through the questions in order, trying to get

students to see the very different EVCs involved:
Per CFL Bulb
For the hotel, combining rooms and halls ~$16
For the hotel, for halls only ~$50
For FLS ~$21
For the casino ~$64

Pleasant Run Children’s Home
By
Brooke E. Smith
Vice President
B. Smith & Company, Inc.
5136 North Delaware Street
Indianapolis, IN 46205
(317) 259-8152
Fax (317) 259-9002
Email: bsmith@in.net
Mark A. McFatridge
Chief Operating Officer
Nonprofit Financial Solutions
40 Executive Drive, Suite C
Carmel, IN 46032
Susan B. Hughes
Associate Professor of Accounting
College of Business Administration
Butler University
4600 Sunset Avenue
Indianapolis, IN 46208
(317) 940-9843
Fax (317) 940-9455
Email: shughes@butler.edu
Pleasant Run Children’s Home
Brooke E. Smith, B. Smith & Company, Inc.
Mark A. McFatridge, Nonprofit Financial Solutions
Susan B. Hughes, Butler University
Introduction
Pleasant Run, Inc. was founded in 1867 to care for children orphaned
during the Civil War. As time passed, Pleasant Run changed its focus from
caring for orphans to caring for children suffering from abuse and neglect.
By 2000, Pleasant Run served children and their families through a 72-bed
residential treatment facility in Indianapolis, three group homes, home-
based services for 19 counties in the State of Indiana, and a therapeutic
foster care program. In June 2000, Pleasant Run Children’s Home received
the highest accreditation award from CARF, The Rehabilitation
Accreditation Commission.
Pleasant Run serves children in need of services (CHINS). Many CHINS are
victims of domestic and community violence.5 The children are referred to Pleasant Run by
county welfare caseworkers, probation officers, state special education officials, juvenile
court officers, and parents cooperating with their health insurance providers. (For
background on child welfare funding, see Appendix 1.) CHINS vary in their needs. Some
children only require in home treatment options, while others with more severe problems
require care by another family member (kinship care) or are placed temporarily in foster
homes. Children in need of close supervision are placed in group homes, and children with
the most behavioral difficulties and treatment needs are placed in residential treatment
5
L. I. Lenares, Community violence: The effects on children. www.aboutourkids.org. (New
York University Child Study Center, 2001); D. Satcher, The Surgeon General’s Report
2000. The National Action Agenda. Washington, DC, (US Government Printing Office,
2000).
centers where their behavior can be closely monitored and the most intense forms of
treatment can be undertaken.

Part I – 1993 to 1994
The City of Indianapolis is located in Marion County, Indiana’s largest county.
Within Indiana, 54,863 cases of abuse and neglect were reported in 1992.6 In 1995 the
county had 700 children who needed residential treatment; 45 of these were placed in
treatment centers outside the state of Indiana.7 When a child was placed in an in-state
facility, the average cost per child per year was $76,650 (an average estimated cost of $210
per child per day). When a Marion County child was treated within Indiana, but outside
Marion County, the cost of treatment remained at $210 per day, but additional
transportation costs were incurred. The length of stay also increased, as it was more
difficult for parents to travel to the treatment center for their treatment sessions. If the child
was placed out of state, the cost rose to $86,000 per year. Obviously, it was much more
cost-effective and efficient to keep the children of Marion County in a facility within
Marion County.
In 1993 Pleasant Run operated five group homes with an average daily census of
38 children and approximately 50 licensed foster care homes with a total average daily
census of 35 children. As shown in Table 1, Pleasant Run’s operating results were close to
the break-even point, and the organization was generating positive cash flows.
In the same year, Marion County authorities explored the possibility of establishing
a local residential treatment facility. The Marion County Juvenile Court Judge, the
Directors of the Marion County Department of Public Welfare and the Marion County
Division of Family and Children, and the Mayor of the City of Indianapolis were in strong
6
Indiana Family and Social Services Administration Division of Family and Children, Fiscal Year
1992 Report (State of Indiana, 1992) 167.
7
United Way of Central Indiana, Pleasant Run Children’s Home Brief Draft, (February 12, 2001),
6.
support of Pleasant Run building and operating the facility.8 Pleasant Run undertook a
feasibility study that was completed early in 1994. The study relied on a revenue estimate
of $210 per child per day, and estimated costs of housing and feeding a child of $150 per
day. The estimated cost of building a facility that could provide housing, recreational
facilities and treatment locations for 72 children was approximately $5,000,000. Pleasant
Run planned to finance the facility with a 20-year loan that required quarterly principle and
interest payments.
Required:
a) Pleasant Run estimated a cost per child per day of $150. Use your best judgement (and
your residence hall or overnight camp experiences) to estimate how much of the $150
is variable and how much is fixed.
b) What are the risks/ramifications of this breakdown between fixed and variable costs?
c) Use your estimates in part (a) to determine the estimated total fixed costs and the
treatment center breakeven point in terms of children per day.
d) Use Pleasant Run’s 1993 operating results shown in Table 1 and the information
obtained from requirements a and b to compute the maximum interest rate Pleasant
Run can afford, assuming the proposed residential treatment facility maintains
occupancy levels of 60, 80 and 100 percent. That is, calculate excess revenues over all
expenses other than interest expense at each of these occupancy levels.
8
M. Roth, S. Gaylord, and J. DeVito, Letter to Dan Duncan, United Way of Central Indiana,
Pleasant Run, Inc., (January 5, 2001), attachment 1.
Part II – 1994 to 1998
In 1994, Pleasant Run negotiated the purchase of a 75,000 square-foot school
building for $1.7 million. Capital improvements, including the cost of adding living units,
were estimated at $4.8 million. In 1995, the City of Indianapolis issued a $4.7 million
variable rate bond to finance the purchase and capital improvements of the new Pleasant
Run Residential Facility. The bond was issued by the City of Indianapolis to Pleasant Run
Children’s Home, and secured with a letter of credit issued by Fifth Third Bank. Under this
agreement, Fifth Third Bank assumed the credit risk for the loan. The remaining $1.8
million needed for the building acquisition and capital improvements was financed with
cash reserves of the organization. The annual estimated costs of running the facility were
$4,088,000, including approximately $400,000 of depreciation.
To help fund the facility, the Pleasant Run Children’s Home Board of Directors
established the Pleasant Run Children’s Home Foundation (PRCHF). PRCHF’s sole
mission was to raise capital contributions for Pleasant Run Children’s Home. In 1994, the
PRCHF began a capital campaign to raise money to support many of the programs and
renovations taking place at the new facility. By 1996 the capital campaign raised $1.3
million.
During 1997, the capital campaign was completed. More than $7.2 million had
been raised over three years through pledges, contributions and planned gifts. The majority
of the gifts were deferred in the wills of two elderly individuals.9 The little over $2.2
million received in cash was used to pay for the building acquisition ($1.8 million) and a
classroom project ($0.4 million).
9
United Way of Central Indiana, Pleasant Run Children’s Home Brief Draft, (February 12, 2001),
4.
By mid 1996, Pleasant Run opened three of its six living units of its
residential treatment facility. During the six months the facility was open in
1996, 65 children were served. The Marion County court system and
Marion County Office of Family and Children (MCOFC) had referred 39 of
these clients. The average length of stay was 180 days. The remaining three
living areas were opened in 1997, bringing the facility to its operating
capacity of 72 children. During the year, 160 children were served, the
average daily census increased to 66, and the average length of stay
decreased to approximately 150 days.
By 1997, the mortgages on the five group homes were paid off. Pleasant Run sold
one of the group homes due to a decline in the demand for residential treatment as a result
of a shift toward at-home care. The shift away from residential treatment was in part
caused by the 1997 passage of Public Law No. 105-89, the Adoption and Safe Families
Act, that required children be placed in a permanent home as rapidly as possible. The
Marion County Juvenile Court had also changed its treatment philosophy toward in-home
care, kinship care and foster care. This shift partially resulted from changing perceptions of
effective treatment options and partially from budget constraints.
Pleasant Run’s home-based services increased during 1998 to serve 538 children in
15 counties, up from 265 children in nine counties in 1997. The average child received
services for 180 days. Home-based services were billed at a rate of $45 per hour. Each
case manager was expected to maintain a caseload of 11 children, and to be billable at least
50% of the time. The average annual salary for a case-manager was $30,000; taxes and
benefits added another $8,500. Overhead for home-based services was 17% of home-based
revenue. The financial impact of home-based services is shown on Table 2.

Also during 1998, Pleasant Run completed a $400,000, four-classroom addition,
financed by proceeds of the capital campaign. Indianapolis Public School teachers staffed
the classrooms. During 1998, the treatment center served 197 children; on average, 58
children were served each day.
Required:
e) Table 3 presents Pleasant Run’s operating results for 1996 through 1998. Determine
the annual debt payments, under the assumption that the 20-year bond was issued at an
annual rate of 6.25%. Use the operating results and your calculations to estimate the
net cash flow for 1998.
f) Analyze Pleasant Run’s financial condition at the end of 1998. Prepare a one-page
memo addressed to Pleasant Run’s board of directors explaining the outlook for 1999.
Address any problems you identify and suggest courses of action, where appropriate.
Part III – 1999 to 2000
During 1999 and 2000, the Marion County Office of Family and Children
(MCOFC) continued to shift clients from residential treatment programs to in-home
services. During 1999, the average daily census was 58.7 (budget was 57.1); during 2000,
the average daily census dropped to 54.6 (budget was 56.7).
Over the years it had been open, the treatment center experienced seasonal
fluctuations in its census level. Teachers and schools typically make reports of abuse and
neglect. As a result, the census typically peaked in January and reached a low in August,
as reports of neglect and abuse declined. After school resumed, referrals, and census
numbers, typically increased. As shown in the graph in Figure 1, actual census numbers
during 2000 tracked very close to budget, until October when the budgeted number of
residents increased and the actual number continued to decline.
The per diem rate paid by the county ($210 per child per day) covered the costs of
the children’s care and housing at the treatment center. This fee did not cover the costs of
the children’s treatments, such as case management, individual, family and group
therapies, crisis intervention, psychological analysis, and activities related to daily living
skills. These treatments were eligible for Medicaid reimbursements, and the vast majority
of Pleasant Run’s children (98%) qualified for Medicaid. The pool of dollars within the
Medicaid system available for these reimbursements is called Medicaid Rehabilitation
Option (MRO) Funding.
In Indiana, only community mental health centers (CMHC) could access
MRO funding. To be classified as a CMHC, the center must provide
programs to all populations including children, adults, people with
substance abuse, and the developmentally disabled. An agency such as

Pleasant Run, that served only children, was not considered to be a CMHC.
A complete explanation of Indiana’s MRO Funding is included in Appendix
2.
To access MRO funding for the services it provided to its residents, Pleasant Run
formed a joint venture in 1997 with Hamilton Center, Inc., a CMHC. Under the joint
venture, Pleasant Run transferred its 42 case and therapy staff members to a new
subsidiary of Hamilton Center, Inc. called Alliance Family Services (AFS). These
caseworkers and therapists were still hired, trained, and supervised by Pleasant Run. AFS
recorded Pleasant Run’s Medicaid billings and all of the associated staff and service
expenses. Hamilton Center and Pleasant Run were charged administrative fees by AFS of
11% and 16%, respectively. AFS’s net surplus or deficit was split evenly between
Hamilton Center and Pleasant Run on an annual basis.
As AFS grew (at the end of 1999 it had more than 200 employees), the profitability
of the venture decreased from a surplus of $96,791 in 1997 to deficits of $265,894 and
$181,109 in 1998 and 1999, respectively. The joint venture also suffered from differences
in the two organizational cultures. On December 26, 1999, AFS was dissolved.
Pleasant Run ended 1999 with a net surplus (Table 4) and $349,000 in cash (Table
5). At the end of December 1999, Pleasant Run entered into a new venture with a different
CMHC, Edgewater Systems for Balanced Living (Edgewater). Under this new
arrangement, Pleasant Run leased its employees to Edgewater. Pleasant Run provided the
services, and provided billing information and case management documentation to
Edgewater on a weekly basis. Edgewater in turn billed Medicaid. When correct
documentation was received, Medicaid paid Edgewater within ten days and Edgewater
typically paid Pleasant Run within 17 days. Pleasant Run paid Edgewater a processing fee
that ranged from 2% to 4% of net Medicaid revenues.

The new contract with Edgewater placed the 200-plus Pleasant Run employees
back on Pleasant Run’s payroll. Pleasant Run knew Medicaid reimbursements would be
delayed during the conversion from Hamilton Center to Edgewater. To deal with that
anticipated cash shortage, Pleasant Run borrowed $830,000 on their pre-established line of
credit with Fifth Third Bank and took out a $500,000 loan from the PRCH Foundation.
Unfortunately, the cash receipts from Edgewater were delayed longer than expected
because of discrepancies regarding administrative fees, and technology and communication
issues between the two agencies’ billing systems. Pleasant Run did not receive the
reimbursements for services provided in December 1999 until April 2000.
In July 2000, there was a difference of opinion between Edgewater and Pleasant
Run as to the specific services being provided by Pleasant Run. Edgewater submitted no
billings to Medicaid until October 2000; as a result, Pleasant Run received no cash for
these Medicaid reimbursed services until November 2000.
In November 2000, Pleasant Run cut 27 staff positions as a result of the declining
treatment center census and delayed Medicaid reimbursements. The staff cuts were
expected to realize a projected annual savings of approximately $300,000. Pleasant Run
also worked to develop more revenue generating programs such as emergency shelter care,
and specialized units serving the mentally retarded, developmentally disabled children, and
children with addictions. Pleasant Run also submitted proposals to other counties to
provide residential treatment for their children at fixed rates.
For the eleven months ended November 30, 2000, Pleasant Run, Inc. had an
operating deficit of $466,275. December revenues were projected to equal $1,051,867.18
and expenses were estimated at $1,096,915.68, leaving Pleasant Run with an anticipated
December deficit of $45,048.50. The December interest expense was estimated at $31,000
and depreciation expense was $47,255.

At the end of November, Pleasant Run had $7.5 million of debt on its books.
Quarterly bond principal and interest payments were $65,765 and $40,000, respectively.
Accounts receivable totaled $3,240,418. Pleasant Run estimated that 80% of the
receivables would be collected. Approximately $1.3 million of the receivables were due
from Edgewater. The majority of the remaining receivables were due from counties other
than Marion County. Marion County consistently paid on a timely basis. Collections from
other counties slowed at the end of each six-month property tax collection period as county
funds were depleted.
Required:
g) Use the information in Tables 4 and 5 to estimate Pleasant Run’s net cash flow for
1999. Is positive cash flow generated from operating activities or from other sources?
h) Greenlee and Trussel10 developed a model that predicts a not-for-profit organization’s

financial vulnerability. The model11 focuses on four ratios:
Equity to total revenues (EQUITY) = Total equity/total revenues;

Revenue concentration (CONCEN) = Σ(Revenue source/Total revenues)2
Administrative expenses (ADMIN) = Administrative expenses/Total expenses
Margin (MARGIN) = (Revenue – expenses)/Revenue
Similar to Altman12, the computations result in a Z-score. Within the Greenlee and Trussel
model,
Z = -3.0610 + 0.1153(EQUITY) + 1.2528 (CONCEN) – 2.2639 (ADMIN) – 3.4289

(MARGIN)
and the probability of financial vulnerability is defined as 1/(1 + e-(z)).
If the probability is greater than 0.10 there is a “strong indication of financial

vulnerability”, if the probability is less than 0.07, there is “a strong indication of no
financial vulnerability.”
Determine Pleasant Run’s probability of financial failure at the end of 1999 using the
financial results on Tables 4 and 5.
10
J. S. Greenlee and J. M. Trussel, “Predicting the financial vulnerability of charitable
organizations,” Nonprofit Management and Leadership, 2000 vol 11, 199-209.
11
Ibid., p. 207.
12
E. Altman, “Financial ratios, discriminant analysis and the prediction of corporate
bankruptcy,” Journal of Finance, 1968 vol. 23, 589-609.
i) Estimate Pleasant Run’s net cash flow for 2000. Based upon the Greenlee and Trussel
model above and your cash flow projections, make recommendations to the Board of
Directors.
Table 1
Pleasant Run, Inc.
Operating Results and Financial Position
For the Year Ended December 31, 1993
Revenues $2,608,923
Program Expenses*
Group Homes $1,612,233
Foster Care 220,896
Transitional living (for children age 18- 14,563
21) 119,650
Home Based Services 1,967,342
Total Program Expenses

Management and General 493,148
Fund Raising 150,820
$2,611,310
Total
Expenses
$( 2,387)
Net Increase/Decrease in Net Assets
*Program Expenses include approximately $50,000 of depreciation expense
Assets
Cash $ 343,098
Net Accounts Receivable 369,261
Other 11,477
Net Property and Plant and Equipment 1,057,317
$1,781,153
Total Assets
Liabilities
Accounts Payable $ 182,994
Net Assets
Unrestricted $ 452,553
Restricted 15,169
Land, Buildings and Equipment 1,130,437
Total Net Assets $1,598,159
$1,781,153
Total Liabilities and Net Assets
Table 2
Financial Impact of Home-Based Services
Average Annual Figures
Hours per Year 2080

Number of Children Served per year 538
Average Duration of Service (in days) 180
Average Daily Census 265.32
Revenue
Rate per Hour $ 45.00
Utilization 50%
Average # of Children per Case Manager 11
Estimated # of Case Managers Needed 24.12
Costs
Rate per Hour $ 15.00
Taxes 7.7%
Benefits 15.0%
Overhead 17.0%
Total Revenue $ 1,128,795.02

Expenses:
Salary and benefits $ 922,978.06
Overhead 191,895.15
Total Expenses $ 1,114,873.21
Table 3
Pleasant Run, Inc.
Financial Operating Results13
For the periods ending December 31, 1996 though 1998
(page below)
13
Financial results of not-for-profit companies can be located from Form 990 filings at
www.guidestar.com.
1996 1997 1998
Revenues
Residential treatment center $1,476,570 $3,803,341 $4,290,784
Group homes 1,535,339 1,558,185 1,592,409
Therapeutic foster care 1,040,453 1,294,577 1,141,987
Marion County community based 944,447 654,372 0
Other government fees 0 0 21,170
Medicaid revenues:
Residential treatment center 22,743 50,033 0
Group homes 38,912 33,317 0
Therapeutic foster care 38,685 17,697 0
Deductions from revenue 2,163 (11,842) 0
Net service revenue 5,099,315 7,399,682 7,046,350
United Way 367,041 340,852 340,149
Contributions 697,108 230,206 121,205
Special events revenue 63,459 (1,357) 13,556
Restricted revenue 1,360,547 317,707 32,409
AFS revenue 0 96,794 (265,894)
Investment/interest income 42,656 1,332 7,118
Miscellaneous income 198,069 (144,277) 95,602
Total revenue 7,828,198 8,240,940 7,390,497
Expenses
Salaries 3,557,773 4,211,123 3,591,415
Employee benefits 264,215 378,234 375,884
Payroll taxes 267,756 319,620 266,020
Contract services 366,181 295,707 473,940
Supplies 148,838 162,222 136,383
Telephone 61,487 67,831 64,326
Postage 32,053 38,650 36,293
Utilities 147,301 164,052 143,642
Maintenance and leases 113,554 82,308 184,370
Printing, marketing and
122,129 127,689 225,629
recruiting
Travel and meals 69,002 39,397 56,064
Education and conferences 53,774 46,153 77,069
Specific assistance 881,379 1,062,291 1,132,886
Memberships and dues 43,610 27,325 27,073
Interest expense 159,019 212,763 240,604
Insurance expense 80,944 91,384 96,719
Miscellaneous expenses 14,009 21,739 134,860
Depreciation expenses 317,430 462,799 549,858
Total expenses 6,700,464 7,811,296 7,813,044
Net surplus (deficit) $ 1,127,733 429,644 ($422,546)
Table 4
Pleasant Run, Inc.
Operating Results for the period ending December 31, 1999
Revenue
Government fees
Residential treatment center $4,248,601
Group homes $1,256,373
Therapeutic foster care $1,227,007
Other government fees $50,900
Residential treatment center $56,984
Net service revenue $6,839,866
Grants $1,069,929
United Way $311,217
Contributions $170,686
Special events revenue $30,507
Restricted revenue $132,510
AFS revenue ($181,109)
Investment and interest income $3,709
Miscellaneous income $183,627
Total revenue $8,560,946
Expenses14
Salaries $4,039,275
Employee benefits $475,922
Payroll taxes $300,060
Contract services $714,058
Supplies $112,528
Telephone $86,067
Postage $23,204
Utilities $139,750
Maintenance and leases $204,415
Printing, marketing and recruiting $204,947
Travel and meals $58,595
Education and conferences $80,026
Specific assistance $1,099,220
Memberships and dues $27,011
Interest expense $252,775
Insurance expense $81,182
Miscellaneous expenses $59,205
Depreciation expenses $554,305
Total expenses $8,512,425
Net surplus (deficit) $48,520
14
Per Form 990, management and general expenses were $2,202,509.
Table 5
Pleasant Run, Inc.
Balance Sheet
December 31, 1999
Assets
Cash $ 348,880
Net accounts receivable 52,141
Prepaid expenses and deferred charges 22,847
Investments 146,267
Land, buildings & equipment, net 6,481,577
Other 3,607,932
Total Assets $10,859,644
Liabilities
Accounts payable $ 336,943
Mortgages and other notes payable 5,040,116
Other liabilities 212,274
Total Liabilities 5,589,333
Net Assets
Unrestricted 2,944,877
Temporarily restricted 2,325,434
Total Net Assets 5,270,311
Total Liabilities and Net Assets $ 10,859,644

Figure 1
Pleasant Run Residential Treatment Center Client Census
(Roth et al. 2001, attachment 6)
2000 Census Numbers

January through October
70.00
60.00
50.00
40.00 Budget
30.00 Actual
20.00
10.00
0.00
ay
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Appendix 1
Summary of Funding Sources
Funding Environment. In the child welfare arena, limited funding
sources exist for foster care, home based, and residential services. These
sources include county Offices of Family and Children, private pay, private
insurance and Medicaid.
Offices of Family and Children. When a child is designated as a child in need of
service (CHINS), the county Office of Family and Children (OFC) becomes responsible
for the child’s care. OFCs receive their budgetary monies from personal property taxes.
These monies are collected by the counties and distributed to many funds within their
county. Public safety and education are just two examples of other budgets that are funded
by property taxes within each county. Property tax revenues are limited and must be
stretched among several different budgets for each county. The OFC budget pays for
services like foster care, residential treatment, community based services, and prevention
services. The OFC budget is a fixed amount. Therefore, the Directors of an OFC are
pressured into cost containment. Depending on the OFC’s budget, several children in long
term residential care could dominate that OFC’s budget forcing the OFC to make treatment
decisions based on available finances, not the best treatment for the child.
Private Pay. Typically, children placed with agencies like Pleasant Run have been
designated by the courts as Children in Need of Services (CHINS). This designation
means that the children have been designated as wards of the court, placing care and
payment in the hands of the specific county’s Office of Family and Children. For those
parents who are concerned with their child’s well-being and wish to voluntarily enroll their
child in a residential treatment program, the costs (up to $300 per day) are prohibitive.
Private Insurance. Private insurance places severe limits on mental health related
programming. If an insurance program does allow mental health coverage, standard
coverages do not match with social service programming. This creates a challenging
environment for everyone involved. Insurance companies must work within their
guidelines, service providers wish to provide treatment in accordance with their treatment
plans, and parents want the services provided to their children.
Medicaid. Financial requirements must be met to qualify for Medicaid. Once
those requirements are met, children must then have services provided by a Medicaid
provider. As mentioned in Part III of the case, Medicaid Rehabilitation Option (MRO)
covers case management and the treatment of activities of daily living, and individual,
group, and family therapy. In the State of Indiana, this segment of Medicaid can only be
billed directly by Community Mental Health Centers (CMHC). Other providers are either
not reimbursed for these services or are forced to collaborate with CMHCs to access MRO.
Medicaid does not typically pay for long-term residential per diems. (See Appendix 2 for
more details on MRO Funding.)

Appendix 2
Public Welfare in Indiana
Indiana is one of a few states that funds public welfare at the county level. This
results in 92 separately funded programs solely dependent upon appropriations from
property taxes. In Marion County, the property tax dollars available to the Marion County
Office of Family and Children (MCOFC), which funds the Marion County Juvenile Court
System and their programs, including all treatment facilities and programs for children,
decreased from $0.44 per $1,000 of assessed value in 1995 to $0.22 per $1,000 of assessed
value in 1999. Over the same time period, the number of children in need of care
increased. With fewer dollars to treat more children, changes in the treatment method were
required to stretch the budget. The cash flow problems were exacerbated by the way
Indiana handles Medicaid reimbursements.
Medicaid Rehabilitation Option (MRO)
Medicaid Rehabilitation Option (MRO) is a procedure-specific funding source for
eligible Medicaid clients. In the State of Indiana, Community Mental Health Centers
(CMHC) are the only entities authorized to bill Medicaid for MRO related procedures.
Because of the CMHC requirement, providers of service must be a CMHC employee.
The following procedures are eligible for MRO funding:
• Outpatient Diagnostic Assessment/Pre-hospitalization Screening

• Individualized Counseling/Psychotherapy
• Conjoint Counseling/Psychotherapy
• Family counseling/Psychotherapy
• Group Counseling/Psychotherapy
• Crisis Intervention
• Medication/Somatic Treatment
• Training in Activities of Daily Living – Individual
• Training in Activities of Daily Living – Group
• Partial Hospitalization Services
• Case Management Services
Obviously, the above referenced procedures are provided by many entities other
than CMHCs. These other entities are required to bill either the client or the client’s
private insurance directly. Many clients are unable to pay the rates charged out of their
own pocket and must rely on their private insurance for coverage. However, most of the
above referenced services are not covered by private insurance to the extent necessary for
proper treatment. Clients must then apply for and receive Medicaid or go without needed
services.
Many providers have entered into contractual relationships with CMHCs to access
MRO reimbursement for MRO services that they are already providing. At this time, two
types of contractual arrangements exist in the State of Indiana. The first is a joint venture
agreement in which employees of the non-CMHC organization that will be providing
MRO services are transferred to the CMHC under a specially designated cost center
(similar to the Pleasant Run Children’s Home (PRCH) and Hamilton Center arrangement).
The employees then provide MRO services, the CMHC bills Medicaid, and the two
organizations split profits of the venture. The second type of contractual relationship that
exists in the State of Indiana occurs when the non-CMHC organization leases MRO
service providers to the CMHC (similar to the PRCH and Edgewater arrangement). The
employees perform MRO services; the CMHC is billed at an agreed-upon rate (usually the
net MRO reimbursement rate), and the CMHC bills Medicaid. Once payment is received
by the CMHC, an agreed-upon service fee is retained and the remaining payment is
forwarded to the non-CMHC partner.
To be reimbursed by Medicaid, MRO procedures must be provided within the
context of a client’s treatment plan. As defined in the Indiana Medical Assistance
Programs Supplemental Provider Manual regarding MROs, “A treatment plan is an
individualized plan of care developed by the provider for medical or remedial services
aimed at the maximum reductions of the disability and/or maintenance of the recipient at
the best possible functioning level. The treatment plan is developed after a clinical
assessment . . .” Among other requirements, treatment plans must:
• Delineate goals directed at the treatment of mental illness;

• Dictate time limitations for service;
• Be reviewed at least quarterly; and
• Be certified by the supervising physician.
Procedures are billed to Medicaid on a per unit basis. A unit is equal to 15 minutes.
Example reimbursement rates include:
• Diagnostic Assessment $11.50/unit

• Case Management $12.11/unit
• Crisis Intervention $15.33/unit
• Individual Counseling $ 9.91/unit
• Family Counseling $ 8.00/unit
Medicaid has placed significant emphasis on ensuring that all procedures administered to
clients are medically necessary and fall within the confines of the client’s treatment plan. As such,
documentation is vital to an MRO program. A company’s dedication to its quality assurance
program, provider-training program, record-keeping system, and fiscal management are imperative
to the success in this type of endeavor. Additionally, because of the demands of the program,
Medicaid requires the oversight of a licensed psychiatrist.
Billing Medicaid for MRO services also requires updated financial systems and record-
keeping processes. As Medicaid is the payer of last resort, a client’s private insurance must be
billed first. Only after denial from the private insurance company may the entity bill Medicaid.
Clearly, processing claims becomes very involved. To ensure timely payment of a claim, an entity
must adhere to all Medicaid requirements including time limits for submitting claims, proper
authorization, and the determination of client eligibility.

Finding the Bottom Line in a University
Enrico Uliana
Professor of Accounting and Executive Director of Finance, University of Cape Town
Finance Department
308 Bremner Building
University of Cape Town
Private Bag
7700 Rondebosch
South Africa
euliana@bremner.uct.ac.za
Finding the bottom line in a university
Enrico Uliana - University of Cape Town
The deans of the University of Cape Town (UCT) had invited

the Finance Director, Elvira Uys, to one their periodic
informal meetings to share concerns about the management of
the faculty finances. Spending had been frozen, yet quality,
development and responding to opportunities were still
expected. A few bottles of good Cape wine were open and the
atmosphere was collegial. Present were Don Retief (Science),
Daleep Prabakah (Commerce), Charles Ogilvy (Engineering),
Roberta Chaimowitz (Humanities), Ndlama Phosa (Health)
and Norberto Sciavelli (Business School).
DR - SCIENCE: Elvira, last year you got us to buy into a 0% increase in our budget allocation,
while I appreciate the need for fiscal discipline to pull us out of the squeeze how am I supposed to
deal with inflation, pay increased salaries and appoint the staff I need to run a first class science
faculty. We also need bigger laboratories.
EU - FINANCE: I understand your worries Don but there are limited resources, you know we
simply have to bring spending into line. Of course don’t forget we agreed that you would have a 3-
year budget and be able to carry forward savings and so take actions that will realize efficiencies in
future years.
DR - SCIENCE: Yes, sometimes I do slip into the old mind-set and think in a one-year budget
frame. Nevertheless we’ve taken your suggestions to heart and appreciate the greater autonomy we
have over our budgets, your 3-year plan was a fantastic move. But the fact of the matter is that I
have too many staff in some areas and too few in others. For example, in Statistical Sciences we
have the same problem you had when you were the head of Accounting, students coming out of our
ears but insufficient staff to service them. Quality will suffer unless we appoint more staff now.
EU - FINANCE: OK, but what about Astrophysics where you have three full chairs and struggle
to attract students.
DR - SCIENCE: That’s true, but each of these physicists is at the cutting edge of the discipline and
world renowned in the field, the prestige they bring to us must be taken into account.
EU - FINANCE: I accept that, but not all your researchers are at that level of excellence, surely
there must be some assessment of the value the individual or department brings.
DR - SCIENCE: Not everything reduces to a financial bottom line.
EU - FINANCE: But it does capture the financial reality and enables us to identify the extent to
which we wish to back or cross-subsidize those that generate intellectual or social value but little
monetary value. In any event I think we haven’t begun to lever the intellectual capital to the extent
we could. If we have a decent bottom line measure the onus would be on you to translate your
astrophysicists’ efforts into money. If you cannot do so and cannot meet the financial target, you
must decide how you plan to create the space to carry them, you could try to be more efficient in
your operations, or curtail some other activity.
DR - SCIENCE: Politically that would be very difficult to do.
EU - FINANCE: Absolutely, but who better than you? You are the CEO of this division, surely
you don’t want me to make these choices. I’m not qualified to judge the relative contributions of
an astrophysicist as opposed to a geologist, or chose between an inspirational teacher in
mathematics and a top researcher in chemistry.
DP - COMMERCE: I think you’re being too lenient. Everybody must carry their fair share; if
what they do doesn’t add tangible value they cannot expect other faculties to support them.
RC - HUMANITIES: Easy for you to say, you have popular programs, more demand than you can
handle, while this is great financially it does have a negative effect on your research output.
CO - ENGINEERING: No I agree with Daleep, we have smaller numbers of students and have an
active research agenda. We run a lean operation and sell our research to generate income. Our
research income is almost as much as Science but with a fraction of the resources (Exhibit 1), I
wonder if your people aren’t giving away their research. We make our choices in the faculty, for
example we decided to drop Materials Engineering because there were few students and while the
staff was competent and publishing actively in good journals they were not regarded as world
authorities therefore we chose not to carry them. It took almost two years to re-deploy some and
retrench others but we’re better off for it. We've channeled those savings into our water
purification work where we are regarded as leaders, attract graduate students and post-doctoral
fellows from all over the globe, and we sell our research to governments and industry.
DR - SCIENCE: It’s easy for guys like you and Daleep to take these views, you are profitable but
it’s tougher for Humanities and us. We have staff who believe they have total freedom to do what
they will while the university must provide the resources; on the other hand we have greater
intellectual wealth. In Science we also have a lot of laboratory requirements which make our
operating costs higher.
RC - HUMANITIES: Actually I don’t totally agree with you Don. I think the issue is the
credibility of that bottom line. I’m not sure the measures used capture the dynamics of the faculties
adequately. For example, we are the result of the faculties being reduced from eleven to six; an
amalgamation of liberal arts, social sciences, education, drama, music and fine art. While I can
accept that the first three form some sort of logical unit, the others are quite a different story.
Tuition is largely one-on-one, equipment is exceedingly costly, yet our bottom line doesn’t
recognize this and we are collectively tainted with an inefficient label. The state subsidy formula
fails to recognize the cost of the performing arts by rating them in the same category as all other
non-science courses.
Other deans also suggested that their units were somehow different. For example;
NS - BUSINESS SCHOOL: At the business school we have the added dimensions that we also run
an hotel, and an extensive executive program, besides which our teaching model is very expensive
to run.
NP - HEALTH SCIENCES: Don’t forget our relationship with the hospital causes added costs,
and student intake is regulated by the state.
EU - FINANCE: Interestingly I’ve been working on getting to a bottom line for a while now.
Thinking about what an appropriate approach should be, given the unfortunate history at prior
attempts to measure a faculty profit, and the inadequacy of the current approach. There are two
really important issues in measuring a bottom line. The first is the allocation problem, which
overheads if any should be charged to the faculty, and how should state subsidy be allocated. Then
we need a basis to determine what an appropriate bottom line is. Most importantly, will the
measure help you manage your faculties in a better manner?
DP - COMMERCE: I’m glad to hear you’re serious about trying to get a handle on this. One of
my concerns is that we can take on more students but this does not translate into additional budget
allocation, I hope your measure will cater for this. Currently we have little incentive to increase
student numbers or activities, in fact these actions while profitable for the university will only draw
on the faculty resources.
BACKGROUND
UCT's mission is to be an outstanding teaching and research university, educating for life and
addressing the challenges facing South African society.
UCT has considerable developed strengths and is well placed to have a significant impact on
social, economic and technological development of the country. These strengths derive from its
long history as South Africa's oldest university and a tradition of regarding excellence as the key
benchmark. This has established UCT as one of the most recognized research universities on the
African continent (in the period 1981 to 1994, publications from UCT authors received over 18,000
citations in ISI journals, and over 50% more than the next South African university).
UCT had its origin in 1829 as the South African College and was established as a national
university in 1918. For most of the period up to the early part of the twentieth century, UCT was
closely associated with British Colonial society and was overwhelmingly white and male. From
1981 UCT had frequent confrontations with the apartheid Government over the increasing demand
for entrance from Black students. This was part of the widespread resistance to the apartheid
system that reflected through vigorous student activity and unrest, which were intensified after the
national uprisings of June 1976. In the post-apartheid era, from 1994 onwards, UCT embarked
upon an ambitious programme of transformation, transforming its student body composition as
well as restructuring its academic programmes in order to meet the needs of all South Africans and
of the African continent.
During the past ten years the UCT student body has changed from approximately 10% to 50%
Black. Moreover, the student profile is now very diverse, incorporating the full span of regional,
ethnic and other population groupings in South Africa. This trend is continuing and the university
is fully committed to its full development as a national university. The UCT of today is truly an
international research university with more than 18,000 students, of which 30% are at the
postgraduate level and 11% are international students drawn from 72 countries, a large proportion
being from the Southern Africa Development Community regions.
Unfortunately, UCT has not enjoyed comparable success in the racial transformation of its
academic staff. Other historically white universities experience similar difficulties. The reasons
for this include the low turnover rate for staff compared to students, intense competition for
talented Black graduates from commerce and government, and the poorly developed pool of well
prepared candidates. Increased recruitment of Black staff, and strategies aimed at encouraging
Black students to remain in the postgraduate track and eventually to join the ranks of the staff, are
high on the list of institutional priorities.
FINANCIAL MANAGEMENT
Deans have traditionally had responsibility only for spending. Requests were made for budget and
allocated centrally. The task was to contain spending within budget, but appeals to central finance
for additional budget to cover unexpected events were common. As costs escalated and state
support fell (Exhibit 2), it became clear that the financial management system was inadequate for
the circumstances. Management of the university was devolved to the operating units and the
deans held responsible for the academic and financial outputs of their faculties. As part of the
effort to increase revenue, research income was charged a 10% levy. For example, a research unit
in the Health Sciences contracted to carry out medical trials earning R1 million. An amount of
R100,000 would be charged to that unit and credited to the Health Sciences income. Deans had the
discretion to waive the levy, which they usually did.
In 1999 the university tried to calculate a profit measure for each faculty. To enable a bottom line
to be measured for each faculty, income was attributed and overheads were allocated to the
faculties. The overhead allocation was done on several different bases, but each generated results
that were unacceptable to certain faculties. In the end one basis was taken as definitive and certain
deans told to reduce costs significantly. One dean resigned and another indicated that it was
impossible to achieve the cost savings within a year.
In the midst of the near crisis, the vice-chancellor “asked” Elvira Uys to take over as finance
director in mid 2000. Elvira had a successful academic career and was then head of the
Accounting Department, one of the largest academic departments in the university. Her
consultative management style and the fact that she had academic credibility quickly gained the
confidence of the deans and she was able to engage with them in a positive manner.
After the wine with the deans, Elvira applied her mind more vigorously to the issue of the bottom
line. She stared at the dismal picture of the budgeted deficit for the year (Exhibit 3). In fact the
situation had deteriorated to the extent that the surplus on general operating activities had
decreased from a comfortable surplus in the mid 1990's to a deficit of R45 million in 2000 and a
budgeted deficit of R83 million in 2001.
Once she had cleared her thoughts she called a meeting with her two senior colleagues in the
central finance department and the faculty finance managers. The faculty finance managers
reported to the deans and were responsible for the financial management of their faculties. Elvira
brought them up to date and shared her thoughts with them. They worked together for a day
exploring ideas, gathering data, and gradually building an approach. At the end of the exercise
they had developed the basis for the approach, which would now be tested with each dean
individually. One of the financial managers commented:
I’m quite excited by what is emerging, I think it provides some useful insights, but we also see
some harsh messages.
EU - FINANCE: Given that we are expected to run on sound business principles I’ve tried to
break the mould of not-for-profit accounting and adopt a business-like approach. I think there is
scope for cross-subsidization, to me the question is how much, and developing a sound basis for
that. By the way that also implies that the profitable faculties may be inefficient, perhaps they
should be generating more surplus.
In arriving at the model, Elvira and her colleagues had reclassified total operating costs into the
following four categories (Exhibit 4):
1. Costs in the profit centres comprised direct costs, mainly staff, under the control of profit
centres. A space charge had been included in the faculty budget for 2000, the deans had not
been uncomfortable with the concept. Consequently, a space charge based on planned property
maintenance (managed by the Properties and Services department) costs was included as a
direct cost in the profit centres. Elvira wanted the faculties to be accountable for the space they
occupied.
2. Costs managed centrally but demand for the resource was partly at the discretion of the faculty.
For example a large part of information technology depends on the number of staff, number of
students and method of teaching in the faculty.
3. Discretionary costs which resulted from a choice rather than directly flowing from core
activities. For example, the equity promotion budget of R3 million (Exhibit 4) provides the
funding for a promising black candidate to be employed, without burdening the faculty budget.
4. Central administration costs over which faculties had little influence.
This simple split had proved useful in understanding the cost structures at the university. A note
(Exhibit 5) was distributed to the deans that summarized the thinking in developing the model.
Elvira then arranged to visit each dean to discus the faculty results, primarily to understand if the
model adequately captured the operations of the faculty. Then to make the deans aware of some of
the messages emanating from the faculty results in relation to the overall university result (Exhibit
6).
She was acutely aware that the university average was well below the return she regarded as
necessary. Elvira arrived at the required return by taking the total costs of the cost centres less the
revenues they generated, and added 10% of total costs as a cushion against fluctuations and to
provide capacity to fund new initiatives and other strategic needs. This total was expressed as a
return on faculty assets (Exhibit 7).
QUESTIONS
1. Evaluate the computation of the Return on Assets, specifically consider the following:
1.1. The state subsidy has been attributed, as earned, other options are to re-allocate according
to the cost of running courses, or not to allocate at all and treat it as central income.
1.2. Only direct costs and an allocation of space costs have been charged to the faculties.
1.3. The bulk of the asset base is imputed.
2. What do you think of the required rate of return, should the same rate be used
across all faculties? What is the meaning of intellectual or social value? Does
this mean that the required return can be reduced?
3. Does charging for space and capitalizing the property constitute a double count?
4. Is capitalizing staff sensible, as the university does not own them?
5. Should ABC be used to fully allocate overheads? How should central overheads be controlled?
6. Each dean made an argument that his faculty was different, how should this be dealt with?
7. What advise would you give the university?
Exhibit 1
Expected Research Income 2001
Rm
Business School 2
Commerce 9
Engineering 41
Health Science 60
Humanities 17
Law 3
Science 46
Total 178
Note: Research income falls outside the budgets presented in Exhibits 3 and 6.
Exhibit 2
Extract from the ANNUAL FINANCIAL REVIEW FOR THE YEAR ENDED 31
DECEMBER 2000
The annual financial statements cover three main areas of activity: teaching (undergraduate
and postgraduate); research; and community extension services. There have been no major
changes in the operations for the year. The table below presents a four-year summary of
the operations. It includes only recurring items and excludes investment income and
financing costs.
Compound 2000 1999 1998 1997

Growth %
% % % %
State subsidy and 8 40 43 44 44
grants
Fee income 12 26 27 27 26
Income from private sources 16 34 30 29 30
Recurrent operating income 12 100 100 100 100
Staffing 11 49 52 54 56
Operating costs 22 44 42 39 37
Bursaries and financial aid 15 7 7 7 7
Recurrent operating 16 100 100 100 100
expenditure
The summary shows that state support comprises a decreasing proportion of our funding, while
there is an increasing reliance on income from private sources. The growth in state support has
lagged other sources of revenue as well as expenditure. Student fees were increased by 9% for the
2000 academic year (1999: 10%). Expenditure has increased at a faster rate than fee income,
mainly in the non-staffing costs. Some of this is as a result of outsourcing cleaning and security,
and the growing practice of employing staff indirectly. The effect is to reduce staffing costs and
increase operating expenses.
Our commitment to supporting financially disadvantaged undergraduate and postgraduate students

was strengthened in 2000 with financial assistance increasing from R55 million in 1999 to R64
million. The R64 million includes R23.6 million from funds allocated by council for operating
purposes and R40.4 million of funds specifically designated for bursary purposes.
The results for 2000 reflect an operating deficit on council controlled operations of R45.1
million. The income statement shows that the university’s core activities rely heavily on
funding other than fees and the state.
Exhibit 3
Budgeted operating loss for the year ended 31 December 2001
(All amounts in R millions) Staff &
Bus Student
Faculty Comm Eng Health Human Law Science School Accom Total
Subsidy 46 64 78 46 19 80 4 337
Fees 52 22 23 54 15 36 31 73 306
Other income 0 0 5 4 0 9 24 42
Total Operating Income 98 86 106 104 34 125 59 73 685
Permanent academic st 22 23 22 48 11 41 5 171

Permanent other staff 8 10 25 8 2 19 6 10 88
Contract staff 10 4 3 7 2 3 9 3 41
Space charge 10 11 14 16 3 22 4 0 80
Other operating costs 9 7 7 8 1 9 38 52 131
Total Operating Expend 59 55 71 87 19 94 61 65 511
Contribution 39 31 35 17 15 31 -2 8 174
Overheads 258
Deficit -83
Exhibit 4
Cost breakdown by type of responsibility centre
Rm
Profit centres 511
Faculties 429
Staff and student housing 65
Hotel 17
Faculty related centrally managed cost centres 205

Libraries 43
Information technolgy 35
Financial aid 27
Centre for higher education 20
Additional staff costs 18
Grants and scholarships 16
Student development and services 15
Development & alumni 10
International liaison 7
Marketing and communication 6
Research development 5
Insurance 4
Discretionery cost centres 39

Capital projects 21
Contingency 10
Management projects 4
Equity promotion 3
Baxter theatre 2
Central administration cost centres 60

Finance 13
Financial services 12
Human resources 11
Registrar and academic administration 8
Executive offices 7
Planning 2
Other costs 7
Total costs 815
Income generated by cost centres 46

Faculty related centrally managed cost centres 22
Discretionery cost centres 0
Central administration cost centres 24
Net Cost 769

Exhibit 5
Getting to a Measure of Financial Performance
Not-for-profit organizations are typically managed on a basis of budget allocation. A set amount is
available and operating units compete for a share. The allocation is often made on the strength of
the motivation and with reference to the previous year's allocation (budget) and hopefully to the
actual. This approach generates a variety of dysfunctional activities.
The modern not-for-profit organization is expected to operate in a more business-like manner. This
is not to imply that the financial performance is the most important goal, but that the finances are
actively managed and not treated as a fixed sum or, worse still, regarded as a passive residual,
whereby activities are undertaken on the assumption that the finances will simply appear.
For-profit organizations manage on the basis of a Return on Assets (ROA), a measure of operating
efficiency. It relates operating surplus to the assets used to generate that surplus. The ROA is
arrived at as follows:
Operating income 1000

Operating expenses 600
Operating surplus 400
Total operating assets 1200
ROA = Operating surplus/operating assets = 400/1200 = .33
The ROA may be compared to a benchmark and evaluated accordingly. It may also be usefully
decomposed:
ROA = Surplus/Assets = Surplus/Income * Income/Assets

In this case: ROA = .33 = .40 * .83
The decomposition provides analytical insight:

- Surplus/Income is known as the operating margin, it reflects the ability to price well and
control costs.
- Income/Assets is known as the asset turn, it reflects the efficiency of asset usage, and
shows the income earned for each Rand invested in assets. It asks if too many assets are
carried for the income generated.
Applying these principles to the measure and management of UCT's activities

Consider the faculties, which form the core of the activities. The variables required are expenditure,
income and assets.
Expenditure - Currently we measure direct expenditure but attempts at allocating overheads have
not been too successful. A number of alternative approaches may be adopted:
- Do not allocate overheads at all
- Devise a method of charging for overheads/service for which (or part of which) there is a
reasonably well-defined usage or service, examples could include, library, information
technology, education development, development office, communications
- Allocate all overheads on an activity-based approach
Income - Fee income is readily measured per faculty, as is subsidy income. Issues are:
- The re-allocation of income for teaching in other faculties.
- Whether subsidy income should be redistributed.
- The recognition of research income. Currently research income falls outside the faculty
budgets except for the levy, which, as described earlier, is usually waived. As a result there is
virtually no contribution from the research activity to the university infrastructure.
Assets - Currently teaching and computer equipment, laboratories, furniture and such items are
recorded per faculty. The economic reality is that each faculty uses two other major categories of
assets; property and people. It is worth exploring whether we can impute an asset base so as to be
able to derive a meaningful ROA measure.
- A charge is made for maintenance of property but this in no way recognises the investment
in property. If the faculty were operating as an independent business it would either need to
buy a property or pay market related rentals.
- Our single largest expenditure is on staffing, yet we expect our staff on average to spend
only a fraction of their time on teaching. It seems that we have invested in a substantial asset
base which is not recognised in our reported assets.
With these principles in mind, some exploratory work was done to see how the numbers looked for
each faculty and whether there seemed to be merit in this approach.
The 2001 budget figures were used for illustrative purposes (Exhibit 6) as follows:
1. Fees and subsidy were taken at budget.
2. Only staff and direct operating expenditure was charged to faculties.
3. Performing arts were removed from the Humanities figures and shown separately.
4. The hotel was removed from the business school and shown separately.
5. The asset value of property was based on space occupied, capitalised at 5% on maintenance
cost, being an estimate of planned maintenance in relation to the value of property. The
resulting computed value of property approximates the insured value.
6. Human capital was based on recurrent academic staff cost, capitalised at 20%. Staff spend
only a part of their time on formal teaching, and a substantial investment is made in the
development of staff, thus it was assumed that the investment is five times the annual salary for
permanent academic staff.
7. Other assets were taken at actual cost as reflected in the general ledger.
8. A 50% cost recovery was applied to research income (Exhibit 1) and credited to faculty
income. The university community generally agrees that research activities consume
resources. Yet there is no mechanism for research to pay its fair share of costs, other than the
abortive 10% levy. An appropriate cost recovery system is currently being developed. It is
also acknowledged that we do not generate as much revenue as we could from current research
activity. For the purposes of this exploratory exercise it was assumed that 50% of current
research income (Exhibit 1) would reasonably approximate an appropriate cost recovery on
enhanced research income.
Exhibit 6
Draft Target Return Model
(All amounts in R millions) Staff &
Bus Perf Total Student
Faculty Com Eng Health Hum Law Science School Arts Academic Accom Hotel Total
Subsidy 46 64 78 40 19 80 4 6 337 337
Fees 52 22 23 48 15 36 31 6 233 73 306
Other income 0 0 5 4 0 9 0 0 18 18
Accommodation 0 24 24
Research 5 21 30 8 2 23 1 1 89 89
Total Operating Income 103 107 136 99 36 148 36 13 677 73 24 774
Permanent academic sta 22 23 22 41 11 41 5 7 171 171

Permanent other staff 8 10 25 7 2 19 6 1 78 10 88
Contract staff 10 4 3 4 2 3 9 3 38 3 41
Space charge 10 11 14 9 3 22 4 7 80 0 80
Other operating costs 9 7 7 7 1 9 21 1 62 52 17 131
Total Operating Expendit 59 55 71 68 19 94 44 19 429 65 17 511
Contribution 44 52 65 31 17 54 -8 -6 248 8 7 263
ASSETS
Computer equipment 3 2 8 5 1 7 2 1 29 29
Equipment - other 1 23 51 2 1 50 4 4 135 135
Property 200 220 280 180 60 440 120 140 1640 100 60 1800
Human capital 110 114 110 206 55 204 23 34 855 0 855
Assets 314 359 449 394 117 700 149 179 2659 100 60 2819
ROA 14.0 14.4 14.5 7.9 14.3 7.7 -5.2 -3.4 9.3 8.0 11.7 9.3
Operating Margin 0.43 0.48 0.48 0.31 0.47 0.36 -0.21 -0.46 0.37 0.11 0.29 0.34
Asset turn 0.33 0.30 0.30 0.25 0.31 0.21 0.24 0.07 0.25 0.73 0.40 0.27

Cases From Management Accounting Practices

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Cases From Management Accounting Practices

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CASES FROM MANAGEMENT ACCOUNTING PRACTICES

Case 1: Bal Seal Engineering

Case 2: Bill’s Custom Planters

Case 3: Dublin Shirt Company

Case 6: Kincaid Manufacturing

Case 8: Pleasant Run Children’s Home

Bal Seal Engineering, by Robin Cooper, discusses alternative cost management

Bill’s Custom Planters, by William Stammerjohan and Deborah Seifert, discusses

ECN.W, by William Lawler, discusses ABC in a service organization.

Endesa, by Gary M. Cunningham, Scott Ericksen, Francisco J. Lopez Lubian and

University Bottom Line, by Enrico Uliana, discusses management control issues in a

The theory of constraints emerged in the mid-eighties as a way to better manage

Throughput Contribution = Throughput – Totally Variable Costs

Profit = Total Throughput Contribution – Operating Expenses

Throughput Contribution / Time on Bottleneck Machine

The objective of the theory of constraints is to maintain as high an average throughput

Five simple rules govern the approach:

1. Identify the constraint.

At the heart of theory of constraints is the drum-buffer-rope scheduling system. In this

Product Costing at Bal Seal

Bal Seal Assignments

Price Lists – Pair 1

3. Which orders would you recommend be accepted?

Product Identification Order Volume Selling

Would your recommendations about which orders to accept change?

5. Repeat the calculations assuming that the selling prices are:

Product Identification Order Volume

Would your recommendations about which orders to accept change?

6. Repeat the calculations assuming that the selling prices are:

Product Identification Order Volume

Would your recommendations about which orders to accept change?

7. What is the best way to integrate TOC and ABC?

Information on the Mark IV Family of Balanced Seals

Product Order Unit Number Estimated Annual

Material Costs $0.40

Processing Time Information for CNC Machines

Run time per unit 1.5 minutes

Spring Production Ring Production Material Production

Bill’s Custom Planters (BCP) manufactures a line of decorative wooden planter

Several factors have contributed to increased popularity, increased demand, and

Dr. Bill’s current estimation of the cost per planter is as follows:

Bill’s Custom Planters

BCP’s expected financial condition is reflected in the 12/31/02 Pro Forma

Bill’s Custom Planters

Accounts Payable (hardware) $ 7,500

2. Briefly discuss your recommended scheduling of hardware orders. What kind of

1. Prepare a schedule that shows the beginning inventory, required

January February March Quarter

Bill’s Custom Planters

Expected Order Expected

4. Prepare a pro forma schedule of the cost of goods manufactured, pro

5. Prepare a schedule or pro forma income statement that estimates the

Address for correspondence: Peter Clarke, Department of Accountancy,

Keywords: Activity based costing and customer profitability analysis; target

THE DUBLIN SHIRT COMPANY

The company is located in a small provincial town on the outskirts of Dublin. It is a

Depending on the client requirements, the shirt may be customized to order.

INFORMATION & PERFORMANCE

Exhibit 1: Production and cost accumulation process

The typical monthly management-reporting package consists of a summarized profit and

(3) A determination of the profitability of each of the three customer groups.

TOTAL: 100 MARKS

Sales in units by customer category

Sales revenue (€) €6,029,700 €3,284,300 €6,566,900 €15,880,900