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Chapter 14 141

CHAPTER 14

PERFORMANCE MEASUREMENT, BALANCED


SCORECARDS, AND
PERFORMANCE REWARDS
QUESTIONS

1. A mission statement expresses the organization’s purposes and identifies how
the organization will meet its customers’ needs through its products or services.
Alternatively, a values statement expresses  the basic organizational identity and
fundamental beliefs.  The   former   is   more   short­run   oriented   than   the   latter   and
should change periodically  as customer preferences  change. A values  statement
helps provide information on the firm’s organizational culture. It indicates the areas
of organizational importance so that employees can internalize these beliefs and
values.

Organizational   strategies   and   missions   are   devised   to   achieve   the   goals   and
objectives   of   a   firm.   Control   systems,   including   systems   of   performance
measurement, are created to implement the missions and strategies of firms.

2. Performance   measurement   is   necessary   to   gauge   whether   a   firm   is


pursuing its goals and objectives successfully. Without performance measurement
systems, managers, shareholders, and others would have no basis to assess the
success of operations or whether operations were being conducted efficiently and
effectively.

Performance measures should be both qualitative and quantitative. The measures
chosen must be reasonable proxies for the organization’s critical success factors,
many of which are not easily captured by financial or other quantitative measures.
For   example,   managers   need   to   employ   qualitative   measures   to   capture
performance in the dimensions of customer service, product and service quality,
product   innovation,   advancement   in   job   skills,   and   effectiveness   in
communications.

In   the   absence   of   benchmarks,   the   performance   measurements   will   not   be


meaningful. The performance measurements can be interpreted only when they
are   compared   to   benchmark   measurements   such   as   industry   performance   or   a
firm’s historical performance measurements.

3. It is expected that people will act specifically in accordance with how they
are   measured.   Thus,   individuals   must   know   of   and   understand   the   performance
measures   used,   so   that   managers   can   make   decisions   in   light   of   the   effects   of
alternative   choices   on   the   performance   measures.   Managers   who   are   allowed   to

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142 Chapter 14

participate   in   the   development   of   the   measures   by   which   their   performance   is


assessed are more likely to accept the performance measures as valid and fair and to
understand how their actions influence the measures.

4. In   selecting   bases   for   performance   measurement,   managers   should


consider:
 whether the measures capture progress toward organizational
goals,
 the input of those being evaluated,
 whether proposed measures are appropriate for the skills and
authority of those being evaluated, and
 methods to provide appropriate feedback on performance.
The traditional performance evaluation measures for cost centers are standard cost
variances. Traditional measures for revenue centers are deviations from budgeted
revenues. Historically, these measures have been used because they are consistent
with a financial evaluation of performance. The major difference between a profit
and  an  investment   center  is   that  the  investment  center   has  control   over  costs,
revenues,  and  the   level   of   assets   that   is   employed.   Accordingly,   investment
centers need to be evaluated based on their profitability relative to the value of
assets used. Profit centers have no responsibility for assets and can be evaluated
based on profit alone.

Because   the   measures   must   be   consistent   with   the   span   of   authority   and
responsibility of each manager, different responsibility centers must be evaluated
using different measures. Further, the chosen measures must be consistent with
the time horizon of decisions made by the manager.

5. Conceptually, net cash flow from operations measures the same thing
as net income.

Thus, cash flow may be a useful measure in a profit or an investment center. The
only difference between net cash flow from operations and accounting income are
accounting   accruals.   Because   many   accounting   accruals   are   susceptible   to
manipulation   by   managers,   net   cash   flow   is   less   prone   to   manipulation   than
alternative accounting measures. However, it is not beyond manipulation because
cash flow can be affected to some extent by adjusting the timing of cash receipts
and cash disbursements. It is best if both an accounting income and a net cash
flow measure are used to evaluate performance. Each measure provides a quality
standard for the other measure.

The most significant weakness of net cash flow from operations is that it, like
accounting   income,   is   a   short­term   measure   and,   thus,   provides   no   long­term
incentives.
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Chapter 14 143

6. In defining “income,” managers have several major concerns that need
to be addressed:
 Is   the   measure   wholly   controllable   by   the   person   being
evaluated?
 Is   the   measure   susceptible   to   manipulation   by   the   person
being evaluated?
 Does   the   measure   balance   long­term   and   short­term
incentives?
 Is the measure sufficiently  related to overall organizational
goals?

Manipulation is an important concern because performance measures should be
designed   to   capture   only  real  performance   and   not   manipulation   of   the
performance measure. If a performance measure can be manipulated by managers,
then they can achieve a high level of performance by either performing very well
or   manipulating   the   measure.   External   measures   are   far   superior   to   internal
measures   in   this   respect   because  external measures cannot be internally
manipulated.

7. Residual income (RI) is a derivative of return on investment (ROI). In
many ways, the relationship between RI and ROI is parallel to the relationship
between net present value (NPV) and internal rate of return (IRR). RI provides a
dollar   measure   of   divisional   achievement   whereas   ROI   provides   a   percentage
measure   of   achievement.   The   principal   strength   of   RI   is   that   it   creates   fewer
problems with suboptimization than ROI, particularly in an environment in which
ROI varies substantially across company divisions.

Economic value added (EVA®) is similar to RI. The major distinction is that EVA
uses invested capital as the asset base and the company’s cost of capital as the
target  rate  of return.  Thus, EVA  should  more nearly  correlate  with effects  on
shareholder value than RI. A weakness of RI is that it is typically computed using
book values of assets rather than market values and the target rate of return is not
necessarily   the   cost   of   capital.   EVA   is   conceptually   similar   to   RI   in   its
computations but utilizes  a market measure of asset value and applies a target
return rate that reflects the cost of capital. EVA computations also include the
effects of income taxes, which are normally excluded in computing RI.

8. By   linking   managerial   rewards   to   performance,   the   welfare   of


managers   is   linked   to   their   success   in   achieving   organizational   goals   and
objectives. Because a firm’s goals and objectives are reflected in the performance
measurements,   these   measures   are,   in   a   sense,   reflections   of   managers’

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144 Chapter 14

contributions to the achievement of the organization’s goals and objectives. The
linkage forces managers to be directly concerned with achieving those goals and
objectives.

The   performance   measurement   and   reward   strategy   for   each   managerial   level
must be consistent with the level of responsibility and authority given to each
level   and   the   contribution   required   of   each   individual   manager.   Although   the
reward must be consistent with achievement of overall goals, it must also consider
the individual contributions of the managers and how effective they were in their
sphere of control. Also, managers at higher levels are required to be more long­
term oriented and managers at lower levels are required to be more short­term
oriented. The performance and reward system must recognize these differences.

9. The balanced scorecard (BSC) is a conceptual approach to measuring performance


that weighs performance from four perspectives. Managers choosing to apply the
BSC are demonstrating a belief that traditional financial performance measures
alone are insufficient to assess how the firm is doing and what specific actions
must be taken to improve performance. The four perspectives in the BSC are
financial, customers, learning/innovation, and internal processes. Each of these
perspectives is important because they coordinate to make a business successful:
not considering any one of these perspectives will, in the long run, cause an
organization to fail.

10. The benefit of including sustainability into a BSC is that the organization
can visualize how the concept affects its short­term and long­term viability. Inclusion
also   emphasizes   the   importance   of   sustainability   in   the   organization’s   goals   and
objectives. By showing performance measurements relative to sustainability in the
BSC, the value of that concept can be indicated and improved upon. Once the effect
an intangible concept such as sustainability can be seen in relationship to an
organization’s bottom line, it is less likely that the organizational employees will view
that concept as a buzzword and more likely they will see it as a natural way to
improve business.

11. To   remain   competitive,   there   has   been   a   shift   in   American   industry


toward   performance­based   compensation   for   two   reasons.  First,   workers   are
becoming removed from the actual production activities because of automation,
making it more difficult to base compensation on direct observation. Second, there
is an effort to develop a tighter linkage between pay and reward to make workers
more goal oriented and make them more aware of the contribution required of
them for the organization to be successful.

12. The   outcome   is   suboptimization.   When   performance   measures   and


rewards   of   the   individual,   the   organization,   and   its   segments   are   compatible,
workers   maximize   achievement   of   the   organization’s   goals   while   pursuing

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Chapter 14 145

achievement   of   individual   goals.   When   performance   measures   and   rewards   of


individuals   are   only   loosely   correlated   with   the   organization’s   and   segment’s
goals, achievement of the individual’s goals may not result in achievement of the
organization’s goals.

13. There must be consistency between the time perspective of the reward
system and the performance measurement system. If the time perspective of a
performance­based   pay   plan   is   long   term,   then   the   organization   must   select
performance   measures   that   capture   long­term   performance.   Otherwise,
suboptimization will result because achievement of performance targets will not
necessarily result in achievement of the desired performance for the desired time
frame.

14. If   the   organizational   mission   of   each   subunit   is   unique,   the


performance measures of each subunit should also be unique. For example, if one
subunit   has   a   build   mission   and   another   subunit   has   a   harvest   mission,   the
former’s   performance   measures   should   concentrate   on   market   share   and   sales
growth. The latter’s performance measures should concentrate on profit and cash
flow performance.

Financial performance measures are more appropriate for short­term performance
measurement. To measure long­term performance, the better measures are often
nonfinancial.   For   example,   profit   generated   is   a   good   short­term   performance
measure, but a poor long­term measure. Growth in market share is often a better
indicator of long­term performance.

The time horizon of the performance measures is linked to the subunit mission.
For example, performance measures should be long term for growth missions and
short term for harvest missions.

15. Feedback   is   critical   to   improving   performance.   Negative   or   critical   feedback


provides information about what the manager needs to change. It provides a focus
for improvement. Positive feedback confirms what the manager is doing well and
encourages   continuation   of   behavior.   Feedback   provides   information   to   (1)
improve the reward system and (2) take action to improve future performance.

16. When employees hold stock, they have personal incentives to act in the
best interest of the stockholders. By providing employees with stock, managers are
creating a natural incentive­compatible alliance between a firm’s employees and its
stockholders. As stockholders, workers are likely to develop a broad view of the
organization, rather than viewing the organization relative to their narrow roles as
employees.

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146 Chapter 14

If managers are also shareholders, there is a natural consistency between their actions
as managers and their actions as shareholders. This situation is not necessarily true
when managers hold no stock. Consequently, performance measures must be devised
that cause managers to act in the best interest of shareholders. To be effective, the
performance   measures   must   be   highly   correlated   with   shareholders’   objective   of
wealth maximization.

17. Equity   in   the   reward   structure   must   be   maintained   throughout   the


organization. Equity requires consideration of the relative pay of top managers
versus lower­level managers and workers. Ultimately, an equitable pay structure
must balance the entitlements of labor, management, and capital.

A consideration of equity also requires that the reward system be sensitive to local
differences   (including   living   costs   and   tax   effects)   in   global   organizations.
Currently, it could easily be argued that U.S. firms have relatively inequitable
reward systems. The inequity  results from the large disparity between average
worker pay and top executive pay. Equity is necessary in the long run to keep all
stakeholders motivated.

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Chapter 14 147

EXERCISES

18. The   new   division   will   have   a   mission   of   “build.”   When   the   new   division   is
established,   it   will   have   only   a   potential   customer   base   but   no   existing   sales.
Accordingly, the division’s major objective will be to obtain market share and
establish a high rate of sales growth. This objective must be accomplished by adding
value to existing services provided to clients. The same performance measures are not
appropriate across a division’s entire life cycle. Performance measures established at
the   outset  for  this   new   division  should  promote  growth.  Later  in   the  life  cycle,
performance measurements will be added or deleted to shift the focus to generation of
cash flow and profits. Following are measurements that would be useful initially:

 Percentage   of   existing   clients   that   have   video   game   installations.   The


emphasis would be on measuring the annual growth in this number.
 Sales   growth.   Sales   targets   should   be   established   and   compared   to   actual
levels of sales generated.
 Percentage of clients who have received sales calls providing information on
the   services   available   from   the   new   division.   As   an   early   life­cycle
performance   measure,   this   measure   captures   the   extent   to   which   the   new
division has made contact with the existing client base.
 Number of face­to­face sales calls made to clients. This is similar to the prior
measure but emphasizes personal contact.
 Sales and promotions budget. A key device to increasing market share will be
the appropriate use of advertising and promotions. Budgets can be prepared
for these expenditures, by category, and can then be compared against actual
expenditures.   This   is   a   useful   tool   for   understanding   and   executing   a
comprehensive and internally consistent marketing strategy.

19. No solution provided. Each student will have a different answer.

20. No solution provided. Each student will have a different answer.

21. No solution provided. Each student will have a different answer.

22. To survive, firms need to manage effectively for both long­term survival and short­
term profitability,  which are separate managerial  concerns. Long­term survival is
related to acquiring the necessary mix of inputs to remain competitive. Long­term
management involves the hiring and training of talented employees, acquisition of
capital   improvements   and  technology,   and   the   execution   of  strategies   relative   to
products and markets. Short­term management is concerned with the effective and
efficient management of resources (such as current assets) over the near term.

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148 Chapter 14

Long­term   and   short­term   management   have   different   objectives,   so   different


performance measures must be used to gauge success in each area. If no performance
measures are designed to evaluate long­term success, managers have no incentive to
be   long­term   oriented   in   their   decision­making.   Balancing   performance
measurements relative to time horizons forces managers to consider both short­term
and long­term consequences of decisions made.

23. Division 1: $   320,000 ÷ $  2,700,000 = 11.9%
Division 2: $   450,000 ÷ $  2,000,000 = 22.5%
Division 3: $4,850,000 ÷ $30,200,000 = 16.1%

24. a. Asset turnover = Sales ÷ Average assets
 5 = $3,950,000 ÷ Average assets
 Average assets = $3,950,000 ÷ 5
 Average assets = $790,000

b.      Profit margin = Segment margin ÷ Sales
 0.06 = Segment margin ÷ $3,950,000
Segment margin = $3,950,000 × 0.06
Segment margin = $237,000

c. ROI = 0.06 × 5 = 30%

25. a. ROI = Income ÷ Assets invested
= ($31,400,000  $27,600,000) ÷ $8,200,000
= $3,800,000 ÷ $8,200,000
= 46.3% (rounded)
b. Profit margin = Income ÷ Sales
= $3,800,000 ÷ $31,400,000
= 12.1% (rounded)
c. Asset turnover = Sales ÷ Assets invested
= $31,400,000 ÷ $8,200,000
= 3.8 (rounded)
d. ROI = Asset turnover × Profit margin
= 3.8 × 12.1% = 46.0% (off due to rounding)
e. RI = Income – (Target rate × Asset base)
 = $3,800,000 – (0.14 × $8,200,000) 
 = $3,800,000 – $1,148,000 
 = $2,652,000

26. Revenue             $ 28,000,000

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Chapter 14 149

  Expenses               
  (26,500,000)
  Income             $   1,500,000
  Target return (0.12 × $14,200,000)                 
   (1,704,000)
  Residual income             $     (204,000)

The residual income is negative; thus, the division did not meet its target return.

27. a.     Division 1   Division 2


 Sales $  5,200,000 $1,850,000
 Variable costs    (2,630,000)     (330,000)
 Fixed costs       
   (490,000)     
   (840,000)
 Income $  2,080,000 $   680,000
 Target return:
$7,180,000 × 0.13       (933,400)
$875,000 × 0.13  
                   
           
   (113,750)
 Residual income $  1,146,600 $   566,250
According to the residual income measure, Division 1 outperformed Division 2.

b.     Division 1   Division 2
Sales $  6,240,000 $2,220,000
Variable costs     (3,156,000)      (396,000)
Fixed costs        
   (490,000)      
   (840,000)
Income $  2,594,000 $   984,000
Target return:
$7,180,000 × 0.13        (933,400)
$875,000 × 0.13                             
   (113,750)
Residual income $  1,660,600 $   870,250

Based on the residual income, Division 1 will outperform Division 2 in the
absolute amount of residual income generated. However, one should note that
Division   2   actually   had   greater   percentage   improvement   than   Division   1   in
residual   income   from   the   base   case   in   (a).   Division   1’s   residual   income
increased by $514,000 compared to Division 2’s increase of $304,000. But, the
percentage increase in residual income for Division 2 was 53.7 percent, while
the   percentage   increase   in   residual   income   in   Division   1   was   merely   44.8
percent.

c. Division   2   has   more   operating   leverage   (relatively   more   fixed   costs   than
Division 1) and, therefore, benefits to a more significant extent from an increase
in sales volume. If sales decreased rather than increased, Division 2’s residual
income would have decreased at a faster rate than Division 1’s.

28. a. Income = Sales  Variable costs  Fixed costs

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150 Chapter 14

 = $39,000,000  ($39,000,000 × 0.45)  $6,750,000
 = $39,000,000  $17,550,000  $6,750,000
 = $14,700,000

ROI = Income ÷ Assets invested
= $14,700,000 ÷ $25,000,000
= 58.8%

b. Income $14,700,000
Target return (0.18 × $25,000,000)      
  (4,500,000)
Residual income $10,200,000

c. Profit margin = Income ÷ Sales
= $14,700,000 ÷ $39,000,000
= 37.7% (rounded)

d. Asset turnover = Sales ÷ Assets invested
= $39,000,000 ÷ $25,000,000
= 1.6

29. a. EVA = After­tax income – (Cost of capital  FMV of capital)
$1,130,000 = After­tax income – (0.11  $29,500,000)
$1,130,000 = After­tax income – $3,245,000
After­tax income = $4,375,000

30. a. EVA = After­tax income – (Cost of capital × FMV of capital)
 = $2,260,000 – (0.11 × $8,900,000)
 = $2,260,000 – $979,000
 = $1,281,000

b. Determining the amount of capital invested in a particular division is difficult
because divisions do not issue debt or stock as companies do. The challenge
faced is to divide the firm’s total value among its operating divisions.

One would start by determining the amount of capital invested in the entire
company and then apportion this amount among the divisions. The established
value would include both debt and equity.

The level of debt investment can be estimated by the face amount of the debt if
market values cannot be obtained. If the debt is publicly traded, the market
value can be determined readily. The stock value can be found by multiplying
the market value per share by the number of shares outstanding. This approach
is appropriate for both common and preferred stock.

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Chapter 14 151

Next, the firm’s total market value must be divided among the operating divisions.
This step will involve some judgment. One approach is to allocate market value to
the divisions based on relative book value of assets. A second approach is to
establish the value of divisions by determining the value of independent companies
operating in the same industries as the divisions. The market value of a division is
set by multiplying the ratio of book value of the division to book value of the
independent firm by the market value of the independent firm. A third approach
would be to hire a consulting firm to establish appraised values for each division.

31. Asset Turnover Profit Margin ROI RI


a. N I I I
  b. D I ? ?
    c. I D ? ?
    d. I D I D*
    e.   D** I ? ?
   f. N N N I
    g. I D I I
    h. I ? ? ?
*As long as the target return < 100% of assets.
**Assuming that the automation created an increase in the asset base.

32. a. MCE = Value­added time ÷ Total time
= 650 ÷ 2,750
= 23.6% (rounded)

b. Process productivity = Total units ÷ Value­added time
= 742,040 ÷ 650
= 1,141.6 units per hour (rounded)

c. Process quality yield = Good units ÷ Total units
= 700,000 ÷ 742,040
= 94.3% (rounded)

d. Throughput = Good units ÷ Total time
= 700,000 ÷ 2,750
= 254.5 units per hour (rounded)

e. Throughput = MCE × PP × PQY
= 0.236 × 1,141.6 × 0.943
= 254.1 units per hour (off due to rounding)

33. a. MCE = Value­added time ÷ Total time
= 50,300 ÷ 144,000
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152 Chapter 14

= 34.9%

b. Process productivity = Total units ÷ Value­added time
= 3,460,000 ÷ 50,300
= 68.8 units per hour

c. Process quality yield = Good units ÷ Total units
= 2,923,200 ÷ 3,460,000
= 84.5%

d. Throughput = Good units ÷ Total time
= 2,923,200 ÷ 144,000
= 20.3 units per hour

e. Management can increase throughput by decreasing non­value­added activities,
increasing total unit production and sales, decreasing the per­unit processing time,
or   increasing   the   process   quality   yield.   These   changes   can   be   generated   by
adopting newer technology, reorganizing the plant, implementing activity­based
management concepts, or investing in prevention costs of quality.

34. a. MCE = Value­added time ÷ Total time
                    = 15,160 ÷ 25,000
= 60.6%

b. Process productivity = Total units ÷ Value­added time
= 104,500 ÷ 15,160
= 6.9 units per hour

c. Process quality yield = Good units ÷ Total units
= 98,400 ÷ 104,500
= 94.2% 

d. Throughput = Good units ÷ Total time
= 98,400 ÷ 25,000
= 3.9 units per hour

e. Throughput would be useful in a job shop because most jobs are typically taken
with   customer   agreements   as   to   quality   of   production/service   and   time   of
delivery. Calculation of throughput would provide useful information for future
contracts.

There would be an expectation of high process quality yield in a job shop because
employees   are   more   likely   to   be   directly   engaged   in   the   production/service
process and, thus, able to spot and correct defects as they occur.

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Chapter 14 153

Carolina Division might have a low MCE because there is a significant amount
of move distance between operations or idle time.

35. Each student will have a different answer. Some suggestions follow.

Financial Perspective:
 Increase revenue from new customers by 15 percent
 Increase revenue from repeat customers by 20 percent
 Lower marketing costs by 5 percent (higher use of social media)
 Increase employee wages by 10 percent

36. Each student will have a different answer. Some suggestions follow.

Customer Perspective:
 Reduce customer returns by 10 percent
 Extend store hours on weekends by six hours
 Offer in­house credit to customers buying over $300 per month

37. Each student will have a different answer. Some suggestions follow.

Internal Perspective:
 Increase number of suppliers by ten
 Provide three hours of training to new salespersons
 Raise social media profile of store (increase “likes” by 25 percent)
 Have four employees create positive blogs about store
 Reduce time­to­market of clothing purchases by two weeks

38. Each student will have a different answer. Some suggestions follow.

Sustainability Perspective:
 Reduce the use of plastic bags by 75 percent
 Increase the number of products carried made from recycled materials by 10
percent
 Use 100 percent compact fluorescent light bulbs in store
 Install programmable thermostat to manage heating and cooling needs
 Install low­flow toilets in restrooms

39. a. Annual pre­tax profits = Income increase – Depreciation
Annual depreciation = $4,000,000 ÷ 5 = $800,000

Year 1: $   300,000 – $800,000 = $ (500,000)
Year 2: $   500,000 – $800,000 = $ (300,000)
Year 3: $   760,000 – $800,000 = $   (40,000)
Year 4: $3,200,000 – $800,000 = $2,400,000
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154 Chapter 14

Year 5: $2,900,000 – $800,000 = $2,100,000

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Chapter 14 155

b. Year 1: $(500,000) × 0.02 = $(10,000)
Year 2: $(300,000) × 0.02 = $  (6,000)
Year 3: $  (40,000) × 0.02 = $     (800)
Year 4: $2,400,000 × 0.02 = $  48,000
Year 5: $2,100,000 × 0.02 = $  42,000

c. Whether   Owan   will   want   to   invest   depends   largely   on   his   personal   time
horizon.   Although   investing   in   the   project   would   reduce   his   compensation
during the first three years, this reduction would be more than offset in the last
two years (not considering the time value of money). If Owan’s time horizon is
three years or less, he is unlikely to invest. If his time horizon is four years or
more, he is likely to invest. Also, Owan must deal with the possibility that he’d
be   dismissed   from   his   position   in   one   of   the   first   three   years   due   to   poor
performance if he invests in the project.

d. Yes. Upper management would likely view the project favorably. Using any
reasonable discount rate, the project has a positive NPV.

40. a. The high level of variable pay indicates compensation committees and boards
of   directors   believe   that   CFOs   are   in   position   to   substantially   influence
operations and results. This is a very positive signal about the relative influence
of the CFO in influencing financial and operational results.

b. There may be some risks to making CFO pay so dependent on operating and
financial results. Because the CFO is in a position of authority over the record
keeping and reporting functions, CFOs may be tempted to manipulate reports
such that reported results align with thresholds of higher payoffs. The variable
pay creates an incentive to report results that provide higher levels of rewards.

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156 Chapter 14

PROBLEMS

41. a. Actual Flexible Master


Amounts Budget Budget
Sales  $ 39,000,000 $ 39,000,000  $ 36,000,000 100%
Var. costs       (29,230,000)   (27,300,000)
     (25,200,000)
    70%
CM  $   9,770,000 $ 11,700,000  $ 10,800,000  30%
Fixed costs        
   (7,230,000)       (7,200,000)       (7,200,000)
Pre­tax income  $   2,540,000 $   4,500,000  $   3,600,000

Actual   pre­tax   income   fell   short   of   the   expected   amount   by   $1,060,000


($3,600,000    $2,540,000),   despite   the   fact   that   the   actual   level   of   sales
exceeded the expected level by $3,000,000. The higher sales revenue should
have generated an additional $900,000 of income ($4,500,000  $3,600,000) if
costs and prices had been maintained at the budgeted level. However, this effect
was overwhelmed by either a lower per unit sales price or a higher per unit
variable cost. Budgeted contribution margin was 30 percent of sales. 

The   actual   CM   was   only   25.05   percent   of   sales   ($9,770,000   ÷   $39,000,000).


Without knowing the number of units that were sold, the price and variable cost
effects cannot be determined. By having the actual CM drop by nearly 5 percent,
pre­tax income was lowered by $1,930,000 ($11,700,000  $9,770,000).  A more
minor effect was the increase in fixed costs, which exceeded the budgeted level by
$30,000. These differences can be summarized as follows:

Effect of increase in sales $ 3,000,000
Effect of increase in variable costs/price decrease (4,030,000)
Effect of increase in fixed costs         
   (30,000)
Net effect on pre­tax income $(1,060,000)

b. Complete income statements provide more information for isolating the cause
of   differences   between   the   budgeted   and   expected   levels   of   income.   By
comparing only the actual and budgeted levels of pre­tax income, nothing is
learned about the cause of the difference.

42. a. Analysis of the statement reveals a strong positive cash flow from operations
that has permitted acquisitions, dividend payouts and debt reductions for the
three years.

b. Revised Original
2014 Budget 2014 Budget
Net CF from Operating Activities:
Net income $ 45,100 $ 45,100

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Chapter 14 157

Add reconciling items       
   4,000        4,000
Total $ 49,100 $ 49,100
Net CF from Investing Activities:
Sale (purchase) of PP&E  $(54,600)       $  (4,600)
Sale (purchase) of investments    18,400          (15,800)
Other inflows (outflows)        2,400       
   2,400
Total  $(33,800)       $(18,000)

Net CF from Financing Activities:
Issuing notes for cash $  (7,000) $  (7,000)
Paying dividends       (8,000)   (20,000)
  
Total $(15,000) $(27,000)
Net increase (decrease) in cash $      300 $   4,100

c. No, the net increase in cash will be only $300. The company would have to
settle for that or change plans.

d. The above comparison can quickly give the president an overview of the impact
of the $50,000 LAN project. From the comparison, she can decide whether she
is satisfied with the proposed changes in cash flows. By observing the cash flow
effects of a particular project within the context of all of the other cash flows of
the entity, the decision maker gains an appreciation of the significance of the
project and of the entity’s ability to implement the project.

43. a. Accrual   accounting   measures   are   subject   to   manipulation.   Some   of   the   more
common manipulations involve increasing or decreasing the level of discretionary
expenses such as maintenance and advertising; increasing or decreasing production
relative to sales; manipulating sales and purchases around a period’s cutoff date;
and manipulating estimates involving the life of assets, pension and retirement
obligations, and costs of settling legal obligations.

b. The cash measure is just as subject to manipulation. For example, cash can be
manipulated by adjusting policies for credit sales, adjusting policies for retiring
accounts payable, and advancing or delaying the payment of expenses around
cutoff dates.

c. If any two measures are less than 100 percent correlated (in other words, the
two items measure different things), then a combination of the two measures
will be less subject to manipulation than either is separately. Such is the case
with cash flow and accrual income; some of the sources of manipulation can be
identified,   and   a   more   complete   picture   of   segment   performance   will   be
presented.

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158 Chapter 14

d. Yes. In theory, the accrual income probably provides a better gauge of long­
term profitability and is perhaps a better predictor of future cash flows. The
annual   cash   flow   measure   provides   more   information   on   liquidity,   cash
management, and the policies for credit sales and purchases.

e. One possibility would be to utilize a more detailed budgeted income statement,
which would allow a line­by­line comparison with actual  performance. This
comparison   would   yield   more   information   on   both   performance   and
manipulation.

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accessible website, in whole or in part.
Chapter 14 159

44. a. Actual income: $28,250,000  $25,885,000 = $2,365,000

Average assets: ($10,200,000 + $12,300,000) ÷ 2 = $11,250,000

Profit margin = $2,365,000 ÷ $28,250,000 = 8.4% (rounded)

Asset turnover = $28,250,000 ÷ $11,250,000 = 2.5 (rounded)
ROI = 2.51  8.37% = 21% (rounded)
Industry ROI = 1.9 × 7.0% = 13.3%

For   2013,   the   company’s   stores   significantly   outperformed   the   industry   (21
percent versus 13.3 percent). The better performance was largely attributable to
a   higher   asset   turnover   relative   to   the   industry   standard   (2.5   versus   1.9).
Although the profit margin also exceeded the industry standard, the difference
was smaller (8.4 percent versus 7 percent).

b. Because the stores are already operating significantly above industry norms on
asset   turnover,   corporate   management   should   concentrate   on   improving   the
profit margin ratio. Profit margin can be improved by either increasing sales
price or decreasing costs. However, overall, the stores are already exceeding the
industry ROI, so management must be careful not to decrease asset turnover
while they strive to increase sales price or decrease costs.

c. The advantage of setting performance measures at the beginning of the year is
that management knows what the benchmark figures are as the year unfolds.

The main disadvantage is that targets set at the beginning of the year do not
control for industry level factors’ influence on results. Consequently, managers
will be evaluated partly on factors that they cannot control.

45. a. Actual income: $25,000,000  $23,160,000 = $1,840,000

Average assets: ($8,400,000 + $9,900,000) ÷ 2 = $9,150,000

Asset turnover = $25,000,000 ÷ $9,150,000 = 2.7 

Actual profit margin: $1,840,000 ÷ $25,000,000 = 7.4%

Actual ROI = 2.7  7.4% = 20% 

The   division   slightly   missed   its   objective   for   asset   turnover.   However,   the
division was significantly above its target profit margin and ROI (3.0 × 5.5% =
16.5%) levels.

b. The division needs to improve its asset turnover. Part of the poor performance

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160 Chapter 14

may   be   caused   by   the   large   increase   in   assets   ($9,900,000    $8,400,000   =


$1,500,000) during the year. Returns from the newly acquired assets are likely to
be reaped in future periods rather than in the present period.

c. Income [(from (a)]  $ 1,840,000
Target return ($9,150,000  0.13)    (1,189,500)
Residual income     $    650,500
46. a. Sales (100,000 × $30) $ 3,000,000
CGS (5,200  $9) + (94,800 × $10)          
   (994,800)
Gross margin $ 2,005,200
Expenses:
Shipping (100,000 × $0.50) $   50,000
Advertising ($5,000 × 12)     60,000
Salaries   700,000
Other costs   590,000
Repairs        10,000       (1,410,000)
Net income before taxes $    595,200

Projected income $ 595,200
Desired return on investment
(0.13  $4,500,000)        (585,000)
Residual income $   10,200

b. Sales (105,000 × $30) $ 3,150,000
CGS (15,000 × $9) + (90,000 × $10)       
  (1,035,000)
Gross margin $ 2,115,000
Expenses
Shipping (105,000 × $0.50) $   52,500
Advertising ($5,000 × 11)     55,000
Salaries [$700,000 – ($66,000 × 1/12)]    694,500
Other costs      590,000        (1,392,000)
Net income $    723,000

$723,000 ÷ $4,500,000 = 16.07% return

c. If   Sanchez   actually   ships   the   delivery   to   the   customer,   it   may   anger   the
customer   and perhaps  reduce  future  sales  to  that  customer.   Should  Sanchez
simply accrue the revenue and expense of shipping but not actually ship the
goods,   there   is   a   possibility   of   misstating   ending   inventory   and/or   the
cancellation   of   the   sale   before   shipment.   The   failure   to   advertise,   hire   a
personnel   manager,   and   make   needed   repairs   could   adversely   affect   future
operations. Finally, if Sanchez’s supervisor determines that she has made such
decisions  for the sole purpose of obtaining her bonus, she may find herself

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Chapter 14 161

without a job.

47. a.                                    Lancaster Division
Contribution Margin
For the Year Ended November 30, 2013
($000 omitted)
Sales (1,484,000 units) $ 25,000
Less variable costs:
Costs of goods sold $16,500
Selling expenses ($2,700 × 40%)       1,080     
  (17,580)
Contribution margin $   7,420

$7,420,000 ÷ 1,484,000 units = $5 per unit CM

b. (1) The pre­tax return on average investment in operating assets employed is 12
percent, calculated as follows:

ROI = Pre­tax operating income ÷ Average assets
= $1,845,000 ÷ $15,375,000*
= 0.12 or 12%
*
November 30, 2012 assets: $15,750,000 ÷ 1.05 = $15,000,000 
Average assets employed: ($15,750,000 + $15,000,000) ÷ 2 = $15,375,000

(2) RI = Pre­tax operating income – (Target rate  Average assets)
 = $1,845,000  (0.10  $15,375,000)
 = $1,845,000  $1,537,500
 = $307,500

c. Lancaster  Division management  would have been  more  likely  to accept  the


contemplated   capital   acquisition   if   residual   income   were   used   as   the
performance measure because the investment would have increased both the
division’s residual income and the management bonus. Using residual income,
management would accept all investments with a return higher than 10 percent
because these investments would increase the dollar value of residual income.
When using ROI as a performance measure, Lancaster’s management is likely
to reject any investment that would lower the overall ROI (12 percent for 2013),
even though the return is higher than the required minimum, because this would
lower bonus awards.

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162 Chapter 14

d. Lancaster   Division   must   be   able   to   control   all   items   related   to   profits   and
investment if it is to be evaluated fairly as an investment center using either
ROI or residual income as performance measures. Lancaster must control all
elements of the business except the cost of invested capital, which is controlled
by Morton Industrial.
        (CMA
adapted)

48. a. Powerboats ROI = ($18,000,000  $16,200,000) ÷ $15,000,000 = 12% 
Sailboats ROI = ($48,000,000  $42,000,000) ÷ $30,000,000 = 20%

b. The Powerboats manager is the most likely to invest in a new project. Such an
investment   would   increase   the   overall   ROI   of   the   division.   The   Sailboats
manager  would not invest because the projected ROI on the new  project  is
lower than the projected divisional ROI.

c. Such an outcome is inconsistent with overall corporate goals. Companywide,
the   projected   ROI   is   ($66,000,000    $58,200,000)   ÷   $45,000,000   =   17%
(rounded). Thus, the company would want the Sailboats manager to make the
investment   and   would   prefer   that   the   Powerboats   manager   reject   the
investment.

d. If the division managers were evaluated on the basis of residual income, they
would analyze how a new investment would affect  the projected  overall RI
level in their divisions. The projected overall changes can be found as follows:

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Chapter 14 163

Powerboats Sailboats
Projected ROI on new project 14% 18%
Required target return 15% 15%
Residual return        (1)%   3%

The project under evaluation by the Powerboats manager would cause his/her
overall   residual   income   to   decline   by   an   amount   equal   to   1   percent   of   the
investment’s cost. On the other hand, the project under consideration by the
Sailboats manager would generate an overall increase in RI by 3 percent of the
new investment’s cost.

49. a. Projected EVA = $2,250,000  (0.10 × $20,000,000) = $250,000

b. You would not invest in the project if it would result in a decline in your overall
projected EVA. Therefore, the maximum amount that you would invest would
be the amount that would leave your projected EVA unchanged:

Pre­tax additional earnings $ 600,000
Taxes ($600,000 × 0.40)                 (240,000)
After­tax change in earnings $ 360,000

Maximum investment × 0.10 = $360,000
Maximum investment = $360,000 ÷ 0.10
Maximum investment = $3,600,000

c. After­tax income = $2,250,000 + $360,000 = $2,610,000
Invested capital = $20,000,000 + $3,100,000 = $23,100,000
EVA = $2,610,000  ($23,100,000  0.10) = $300,000

50. a. MCE = Value­added time ÷ Total time
    = 18,600 ÷ 62,000
= 30%

b. Process productivity = Total units ÷ Value­added time
= 1,023,000 ÷ 18,600
= 55 units per hour 

c. Process quality yield = Good units ÷ Total units
= 838,860 ÷ 1,023,000
= 82%

d. Throughput = Good units ÷ Total time
= 838,860 ÷ 62,000

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164 Chapter 14

                              = 13.5 units per hour (rounded)

e. Yes, throughput should only consider units sold, not units produced. Therefore,
throughput   would   have   been   considerably   lower   because   the   process   yield
would have been lower.

Throughput = Good units ÷ Total time
= 660,000 ÷ 62,000
= 10.6 units per hour (rounded)

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Chapter 14 165

f. Total time – Value­added time = Non­value­added time
 62,000 – 18,600 = 43,400
 43,400 × 0.80 = 34,720 new NVA time

34,720 + 18,600 = 53,320 total new time

Throughput = Good units ÷ Total time
= 660,000 ÷ 53,320
= 12.4 units per hour (rounded)

g. 1,023,000 × 0.90 = 920,700 good units

Total new time [(from (f)] = 53,320 hours
Throughput = Good units ÷ Total time
= 920,700 ÷ 53,320
= 17.3 units per hour (rounded)

h. Fawber could determine how the NVA time was being spent by preparing a
process map that would delineate all activities associated with the production of
the   product.  One  recommendation   would   be  to  implement  an   activity­based
management system that would draw attention to the NVA activities and to the
costs associated with those activities.

51. a. Based   on   the   conversation   between   Terry   Travers   and   Bob   Christensen,   it
seems likely that their motivation would be stifled by the variance reporting
system at Aurora Manufacturing Company. Their behavior may include any of
the following:

 suboptimization, a condition in which individual managers disregard major
company   goals   and   focus   their   attention   solely   on   their   own   division’s
activities, and
 frustration from untimely reports and formats that are not useful in their
daily activities.

b.(1) The benefits that can be derived by both the company and its employees
from   a   properly   implemented   variance   reporting   system   include   the
following:

 Variance analysis can provide standards and measures for incentive and
performance evaluation programs.
 Variance   reporting   can   emphasize   teamwork   and   interdepartmental
dependence.

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166 Chapter 14

 Timely reporting provides useful feedback, helps to identify problems,
and aids in solving these problems. Responsibility can be assigned for
the resolution of problems.

(2) Aurora   Manufacturing   Company   could   improve   its   variance   reporting


system   so   as   to   increase   employee   motivation,   by   implementing   the
following:

 Introduce a flexible budgeting system that relates actual expenditures to
actual   levels   of   production   on   a   monthly   basis.   In   addition,   the
budgeting process should be participative rather than imposed.
 Only those costs that are controllable by managers should be included in
the variance analysis.
 Distribute   reports   on   a   timelier   basis   to   allow   quick   resolution   of
problems.
 Reports should be stated in terms that are most understandable to the
users (i.e., units of output, hours, etc.).
                (CMA adapted)

52. a. Quality (Internal Business Perspective)
defects per million
cost of quality (prevention, appraisal, internal and external failures)
supplier certification or certified items
reduction of supplier base
hours of employee quality training
hours of preventive maintenance
mean time between failures
certification of internal operations
unscheduled machine downtime
number of customer complaints, warranty claims, and recalls
unscheduled service call
percentage of lots rejected in error

b. Cost (Financial Perspective)
 reduction in data transactions
 materials shipped to point of use by supplier
 dollars of product output per employee
 throughput times from supplier to customer
 budgeting expense trends
 projects operating within budget

c. Production line flexibility (Internal Business Perspective)
 reduction in cycle time

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Chapter 14 167

 reduction in setup time
 reduction in lot or batch size
 increase in standard materials used per product
 number of parts and levels in bills of material
 degree of cross­training of production personnel

d. People   productivity   and   development  (Internal   Business   Perspective   and


Learning and Growth Perspective)
 sales per person
 value added per person
 employee turnover ratios
 number of employees participating in improvement teams
 competitive compensation packages
 accident rates
 absentee rates
 training hours per employee
 employee grievances
 work days lost due to accidents
 percentage of appraisals completed on time
 percentage of positions filled from within the organization
 percentage of employees with personal development plans
 number of recognition events and awards

e. Inventory management (Internal Business Perspective)
 inventory turnover by product and group
 inventory days on hand
 inventory record accuracy
 items above or below target limits
 physical inventory variances
 number of adjustments to inventory records

f. Lead time (Internal Business Perspective and Customer Perspective)
 delivery time to customers
 setup reduction trends
 in­house transit time
 supplier delivery performance
 throughput times
 work in process investment
 ratio of promised customer delivery lead time to cumulative production lead
time
 administrative process times

g. Responsive after­sale service (Customer Perspective)

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168 Chapter 14

 number of hours of field service training
 average response time to service calls
 time to repair
 availability of spare parts
 warranty expense
 overstocked field supplies

h. Customer satisfaction and retention (Customer Perspective)
 average customer response time
 reduction in customer response time × number of complete items delivered
on time
 time from customer’s recognition of need to delivery
 quoted lead time
 customer order processing time
 time from receipt of order to start of manufacturing
 number of customer promises met
 percentage of customer orders shipped on customer’s request date
 customer returns or complaints
 backorder rate
 degree of satisfaction with complaint resolution
 number of customer partnerships established
 number of certifications received from customers
 enhanced customer value via added product features or reduced costs

i. Product and process design (Learning and Growth Perspective)
 time from idea to market
 rate of new product introduction
 percentage first firm to market
 number of engineering changes after design
 reduction in new product introduction lead time
 new product sales revenue as a percent of total sale revenue
 project completion cycle times
 number of errors found during design review and evaluation

j. Manufacturing planning process (Internal Business Perspective)
 master schedule items achieved per week
 final assembly schedule items achieved per week
 material requirement plans achieved per week
 manufacturing orders released on time
 data accuracy of inventory, bills of materials, routings, and forecast
 material and tooling availability
 master production schedule on­time performance
 number and types of changes made to MPS
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Chapter 14 169

k. Procurement process (Internal Business Perspective)
 average procurement cycle time
 on­time performance of deliveries
 reduction in purchasing lead time
 purchase orders released on time
 reduction of supplier lead times
 purchase order errors
 downtime because of shortages
 excess inventory
 percentage of parts from certified vendors

l. Manufacturing process (Internal Business Perspective)
 reduction of manufacturing lead time
 percentage queue time in manufacturing lead time
 percentage value­added time in manufacturing lead time
 shop orders completed on time
 manufacturing cycle times
 unscheduled machine downtime
 number of past due operations
 yield and scrap rates
 transactions per person

m. Management accomplishments (Financial Perspective)
 net income/number of employees
 total sales/number of employees
 net income/total direct labor payroll
 net income/total factory payroll
 total earned hours direct labor/total factory payroll

n. Marketing/Sales and customer service (Customer Perspective)
 total sales/number of employees
 average lead time in backlog
 lead time performance
 premium freight outbound/total freight outbound
 performance to sales plan
 accuracy of forecast assumptions
 number of incorrect order entries
 credit request processing time

o. Delivery performance (Customer Perspective)
 timeliness and accuracy of supplier order placement and delivery
 accuracy of shop floor schedule to customer requirements

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170 Chapter 14

 ability to meet, but not exceed, MPS
 correct quality and quantity delivery to customer per customer requirements
 analysis of lost sales due to delivery deficiencies

p. Financial accounting services (Internal Business Perspective)
 amount of non­value­added activity (scrap, rework, excess queue, and move
time)
 total value of usable finished product produced per period per employee
 total cost and output value ratios
 time­based overhead usage
 performance to budget
 percentage of late payments
 number of billing errors
 number of incorrect accounting entries
 number of payroll errors
 time to respond to customer requests

Measurement examples in this problem were taken from Ann Willis, “Aligning
Performance Measurements with Organizational Strategies,” Hospital Material
Management Quarterly (February 2001), pp. 54–63.

53. No solution provided. Each student will have a different answer, much of which
will   likely   depend   on   personal   experience   with   Subway.   However,   because
significant   discussion   is   provided   on   the   Web   site   about   social   responsibility,
students  should be certain  to have a sustainability  element  in their  discussion.
Sustainability   items   may   be   in   a   separate   perspective   or   included   within   the
traditional four perspectives. Additionally, the customer perspective should take
into consideration the company’s discussion of nutritional leadership.

54. No solution provided. Each student will have a different answer.

55. No solution provided. Each student will have a different answer.

56. No solution provided. Each student will have a different answer. However, the
following information was obtained from BSCs developed by the City of West
Des Moines.
FINANCIAL PERSPECTIVE
Strategy Measures
Provide positive customer relationships • Approval scale in citizen survey
Pursue beneficial alliances • Number of intergovernmental
agreements
Strengthen sense of community • Number of hours for community

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accessible website, in whole or in part.
Chapter 14 171

involvement
Provide sufficient infrastructure • Average level of service (LOS) at
major intersections
• Approval scale on citizen survey
Provide a well-maintained community • Number of code enforcement
citizen complaints
• Approval scale on citizen survey
Provide a safe community • Approval scale on citizen survey
• Reduce crime statistics
• Increase traffic safety
Provide sufficient service and program • Approval scale on citizen survey
delivery
CUSTOMER PERSPECTIVE
Strategy Measures
Facilitate balanced economic • Property tax valuation
development • Ratio of full-time employees working
in city to the population of city
• Building permit valuation
Maintain/Improve bond rating • Standard and Poor’s and Moody’s bond
rating
• Maximize cost/benefit of resources
Diversification of revenue sources • Percent of operating revenue not from
operating tax
INTERNAL PROCESSES PERSPECTIVE
Strategy Measures
Advance the quality initiative • Percent of PATs (process action teams)
recommendations implemented
• Percent of PATs completed in less
than nine months
• Number of active PATs and citywide
process teams
Simplify customer processes • Percent of online parks and recreation
registrations
• Percent of water bills paid by
nontraditional methods
Facilitate community-based problem • Number of hours where non-mandated
solving public input is sought

57. a. EVA   could   discourage   a   high­growth   strategy   because   this   strategy   almost
always requires that current profitability be reduced to achieve acceleration in
sales. The reduction in profitability can be associated with increased costs of
marketing and promotion and research and development.

b. Yes. The balanced scorecard could be used to provide incentives other
than high current profitability. Specifically, some performance measures (and
rewards) could be devised for the customer perspective:
 market share or growth in market share,

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accessible website, in whole or in part.
172 Chapter 14

 customer satisfaction,
 sales growth,
 customer complaint frequency, and
 perceived product quality.

Still other measures could be devised for the innovation/learning perspective:
 number of new products developed,
 research and development accomplishments,
 number of new product ideas generated, and
 increase in employee training.

The key to encouraging a division to grow, even if growth is to be achieved at
the expense of reducing current profits, is to link rewards of managers to the
correct performance measures. By linking rewards to EVA, managers may be
discouraged   from   investing   in   new   assets   that   don’t   provide   an   immediate
return. Alternatively,  by focusing measures  on innovation and sales  growth,
incentives can be created for achieving a high growth rate.

58. No solution provided. Each student will have a different answer.

59. a. No solution provided. Each student will have a different answer. The seven core
areas   are:   beverage   benefits,   active   healthy   living,   community,   energy
efficiency   and   climate   protection,   sustainable   packaging,   water   stewardship,
and workplace.

b. No solution provided. Each student will have a different answer. It is, however,
likely that students will indicate there will be more difficulty in working toward the
goals in some countries over others—especially in relationship to issues such as
human rights.

60. No solution provided. Each student will have a different answer.

61. a. The evaluation measures are probably having a large effect on his decision. By
revealing the information about the obsolete inventory to the market, the stock
price is likely to fall. Also, both the income statement and the balance sheet will
suffer from the write­down. Both the income statement effect and the stock
market effect will reduce the compensation paid to the company president, at
least in the short run.

b. It   is   not   an   ethical   treatment   of   either   the   existing   shareholders   or


potential   shareholders.   In   the   long   run,   both   groups   would   be   better   off
financially if the information about the obsolete inventory were revealed to the
capital markets. Only in the short run are the existing shareholders better off
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accessible website, in whole or in part.
Chapter 14 173

from   not   revealing   the   information.   However,   one   can   easily   anticipate   the
lawsuits that would be filed upon the market discovering the obsolete inventory
after  the new stock is issued. After the fallout, all parties would be worse off
than   they   would   have   been   with   an   honest   and   timely   disclosure   of   the
inventory information. Furthermore, the company would find it very difficult to
make credible assertions about its financial position when it needed to return to
the stock market in the future.

c. The decision to defer disclosure until after the issuance of the stock is
clearly   an   inappropriate   course   of   action   for   the   company.   If   the   president
persists in this view, the controller should go to the audit committee and reveal
the   problem   to   them.   This   committee   could   take   action   to   disclose   the
information. Another alternative would be to take the information to the firm’s
public auditors, or as a last resort the controller could go to the SEC with the
information.

62. The most important point to be made in the arguments is that increases in pay
should be related to increases in performance. The minimum wage bestows larger
pay   without   requiring   a   greater   contribution   of   effort   or   talent.   The   likely
consequence   is   a   reduction   in   employment   because   the   benefits   of   employing
certain workers will no longer exceed the costs. It is unreasonable to believe that
when higher costs are imposed on businesses with no compensating benefits, they
will maintain the status quo in operations.

Some firms will attempt to substitute automated systems for manual systems to
reduce labor bills, and other firms will find it is now more desirable to employ
higher   skilled,   more   productive   workers   rather   than   lower   skilled   workers.   In
either case, some of the employees who were intended to be beneficiaries of the
higher minimum wage will be unemployed.

A more productive way to achieve higher income for workers at the bottom of the
wage scale would be to find ways to improve their productivity and then reward
them for it.  For example, subsidized training could be given to minimum­wage
workers to allow them to improve their skills and abilities. Alternatively, simply
creating   an   incentive   structure   that   rewards   employees   for   higher   productivity
encourages the workers to work harder, improve their abilities, and acquire higher­
level skills. These incentives could be offered in the form of bonuses, profit sharing,
or other types of variable pay.

Two helpful Wall Street Journal articles related to this question were written by
Gwendolyn Bounds: “Argument for Minimum­Wage Boost” (July 27, 2004), p.
B3; “The Case Against a Higher Minimum­Wage” (August 3, 2004), p. B8.

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174 Chapter 14

63. a. Year 1: $600,000 salary
Year 2: $600,000 salary + $  75,000 bonus = $675,000
Year 3: $600,000 salary + $350,000 bonus = $950,000

b. If the university goals go substantially beyond winning football games,
conference   championships,   and   bowl   games,   the   coach’s   contract   certainly
failed to promote goal congruence.

c. In designing contracts, wealth­maximizing managers will commonly
attempt to maximize the performance measures that are the basis of the contract
(subject to legal and ethical constraints). If the performance measures had been
different in the coach’s contract, it is reasonable to assume that his behavior
would have been different.

d. Many   different   performance   features   could   be   considered.   For


example, wage penalties could be included for any NCAA rules infraction or
violation of school policy. In addition, performance measures could be added
that would reward the coach for improvement in graduation rates and grade
point averages of football players, and involvement of the football coaches and
players   in   university   and   other   civic   activities.   In   any   case,   if   the   coach’s
compensation and job security are less directly tied to winning, violations of
school policy and NCAA rules are much less likely to occur.

64. No solution provided. Each student will have a different answer.

65. a. When managers take actions that reduce long­term growth and profitability so
that   higher   short­term   profits   are   reported,   they   are   stealing   value   from
shareholders and other stakeholders. Because these actions are taken to enrich
themselves at the expense of others, these acts are unethical.

b. The   board   of   directors   should   anticipate   how   various   elements   of


compensation will cause managers to act in their self interest. The tighter the
incentives  can be aligned between managers  and shareholders, the less self­
serving   managers   will   behave.   Thus,   the   board   of   directors   should   design
compensation elements that are both short­term (cash) and long­term (stock)
oriented.

66. a. Asset turnover is defined as Sales ÷ Average total assets. If the numerator is
held   constant   and   the   denominator   is   reduced,   the   resulting   quotient   (asset
turnover) must be, mathematically, larger. Dumping causes one of the assets
(raw materials) to be smaller.

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accessible website, in whole or in part.
Chapter 14 175

b. Top   management   would   expect   the   plant   manager   to   try   to   recover


something from the inventory he discarded, if it were indeed obsolete. It is
highly unlikely that they intended that asset turnover be improved by discarding
assets without benefit. It appears that the plant manager breached an implied
understanding   that   his   efforts   be   directed   toward   efficient   operations.   Other
ethical considerations include unauthorized dumping on public lands and the
possibility that the materials are toxic.

c. Jensen’s options include the following:
 Remain silent.
 Discuss the matter with the plant manager.
 Hold a confidential meeting with someone high enough in the organization to
assess the problem and take any required action.

If Jensen remains silent, he can be considered an accomplice to the dumping
and, thus, would be as unethical as the plant manager. If he tries to talk to the
plant manager, Jensen may be able to convince the manager of the impropriety
of the dumping. Of course, it is also possible that the manager would ignore
Jensen’s concerns and possibly fire Jensen. If Jensen talks to someone with the
expertise and power to ascertain if there is a problem, Jensen may be convinced
that the dumping is acceptable to both the company and (if legitimate) may
even be considered good for the public in that it is clean landfill. If instead, the
dumping is a problem,  Jensen has done his  ethical  duty. (Jensen should, of
course, attempt to talk to the plant manager first to determine all the facts and to
avoid the implication of “going over the boss’s head.”)

67. a. For 2013, FFV generated an ROI of 25 percent, as calculated below:

ROI = Operating income ÷ Total assets
= $4,000,000 ÷ $16,000,000
= 25% (rounded)

For 2013, assuming FFV paid $6.4 million for GGI, GGI would have generated
an ROI of less than 20 percent, as calculated below:

ROI = Operating income ÷ Total assets
= $1,200,000 ÷ $6,400,000
= 18.8% (rounded)

Peach would have expected that his bonus would be lost or reduced if he had
invested in GGI. The investment would have caused the ROI of FFV to drop as
indicated below:

Combined ROI = Operating income ÷ Total assets

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176 Chapter 14

 = $5,200,000 ÷ $22,400,000
 = 23.2% (rounded)

b. To determine the effect of the acquisition, one only needs to determine
the amount of residual income generated by GGI:

Operating income $1,200,000
Target return ($6,400,000  0.15)        960,000
Residual income generated by GGI $   240,000

Because the residual income is positive, the acquisition of GGI would have had
a positive effect on Peach’s bonus expectations.

c. No, it is the duty of top management to provide incentives to Peach
such that if it is in the best interest of Drummondville Automotive to invest, it is
also in the best interest of Peach to invest. Such is not the case with the ROI
performance measure.

d. No,   the   present   system   heavily   biases   against   new   investment   in


anything. The best way managers can protect their current ROI levels is to not
invest.

68. To induce the candidate to accept the Buenos Aires assignment, she should be offered
incentives  that make the assignment attractive relative  to her current assignment.
Because she is married and has children, there are significant issues regarding child
care, education of the children, and spousal employment. The company could include
among the offered incentives placement services for the spouse, child care and private
education   for   the   children,   and   even   maid   services   for   the   home.   Further,   the
company   could   provide   housing   for   the   family   in   Buenos   Aires   and   assist   the
candidate in selling her New York apartment. In addition to these incentives, the
compensation  package offered to the candidate  should significantly  exceed the
compensation package she currently enjoys.

To ensure that the candidate  would perform at a high level if she accepts  the


position, she should be offered incentive compensation. It would be appropriate to
structure   the   compensation   such   that   the   candidate   would   be   protected   from
currency fluctuations. The compensation package should be sensitive to cost of
living differences between New York and Buenos Aires, and her contract could
provide  for price­level  adjustments.  Some of the  pay should be contingent  on
performance so that the candidate has an incentive to achieve the goals of the
company.   Some   of   these   incentives   should   be   tied   to   specific   performance
measures of the operation in Buenos Aires.

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Chapter 14 177

69. Each  student  will have  a different  answer. No solution  is  provided.  However,


students should be certain to discuss the fact the differences between countries
makes it essential that nonfinancial measurements exist. Focusing solely on the
reduced   costs   and,   thus,   increased   profits,   ignores   the   critical   issues   of
sweatshops, child labor, and pollution. Also, in defending lower wages, students
should address the concept of wages versus no wages, benefits to local economies,
and significantly lower cost of living in developing countries.

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