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ACCT3002 Enterprise Performance Management

Archive of problems, cases and readings


Contents 1 Olivers 2 Slater Diversified 3 Southern District Dairy 4 Cowmilka 5 Galaxy Hotel Group 6 Cowmilka (2) 7 The Boeing Company 8 Elsten Part A Part B 9 Synergy Clothing 10 Goldman, Mason and Vernon (GMV) 11 Rampage 12 Kilgors 13 Mountain Mist Brewery 14 Paiges Fashion House 15 Unilever 16 The Boeing Company [adapted] 17 Yahoo may shut some services 18 Starbucks to open China coffee farm: securing global supply 19 The Coffee Pot 20 Goliath Corporation 21 Kranworth 22 Shuster, P. & Clarke, P. 2010, Transfer Prices: Functions, Types and Behavioral Implications, Management Accounting Quarterly, 11, 2, 22-32. 23 Brewer, P. & Chandra, (1999), Economic Value Added: Its Uses and Limitations, SAM Advanced Management Journal, 64, 4, 2-11. 24 The Coors Case

Olivers
Olivers Ltd is a multi-divisional company with a focus in the wine, hospitality and entertainment industries. Olivers commenced in 1995 as a small wine company but over the years has expanded its operation and interests; predominantly through acquisitions. It listed on the stock exchange in 2003. In the early days, the company had an informal culture and strong belief system. Stefan, the original founder of Olivers operated Olivers as a family company where he knew the names of all employees and spent hours in conversations with all of them about the business direction, wine issues and plans for the future. As the company has grown, this Oliver-family way of doing business has been more difficult to maintain. At the time of listing Herb Barlow was appointed chief executive officer (CEO). Barlows first task was to execute a re-organisation of the company into three distinct divisions: Wine; Hospitality and Entertainment. Each division was classified as an investment centre. Barlow appointed divisional managers who had been with the company for some time in the hope they would continue in the role for the longer-term. The internal structure within each division was left to each divisional manager. Invariably, most sub-units within investment centres were either profit centres or cost centres, though some were also classified as investment centres. The current organizational strategy is growth by acquisition with the objective of being the number one high quality company in the industry. This broad strategy is evident in each of the divisions through their key strategic planks which drive divisional activity. While there are some interdependencies between divisions, this is not a central feature of the company. Performance Measurement Since listing on the stock exchange, the focus of the performance measurement system has remained unchanged. Barlow is aware of the need to evaluate the current performance measurement and incentive structures and is planning a review within the next twelve months. Barlow has some ideas which he might pursue with individual divisions but for the moment, he figures he has enough on his plate. Divisional managers are currently evaluated on the basis of two key criteria. First, Barlow conducts an appraisal of each manager with reference to individualized objectives and measures with links to organisational objectives. Second, the incentive payment to divisional managers and the top 6 senior executives is based on a bonus pool calculated on the basis of organizational profit and distributed to divisional managers according to divisional ROI performance. Divisional managers are expected to achieve ROI targets, which are set in consultation with Barlow. ROI has been used this way for some years. Recently, Barlow has introduced an adjustment to the incentive payment to encourage new investments in line with the growth objectives of the company. However, with the recent appointment of a new chief financial officer (CFO) to the company Caitlyn Wallis - the use of ROI in this way has been the subject of discussions at a number of senior management meetings. The following is an excerpt from a recent meeting. Caitlyn Wallis(CFO): We used ROI at my last firm (Sandover Limited) and I can tell you, it caused all sorts of problems. Admittedly we set the expectations high and divisional managers had little say in the targets. Nonetheless, we consistently had managers acting in their own self-interest, such as only pursuing investment projects that made them look good in the short-term. We had a lot of trouble getting managers to think and act from the company perspective. Herb Barlow (CEO): Well, ROI seems to have served us pretty well. We have used it now for some years and while I know it is not perfect, Im not sure what would be better. Caitlyn, I think you are going to have to convince us with some ideas and evidence that your suggestions would improve on what we currently do. Can you help us out with some other ideas and options Caitlyn; or, at least give us more examples of why we have got it so wrong with ROI?

Caitlyn Wallis: I dont have a lot in the way of specific examples. I guess at this stage I can only go by my experiences at other places I have worked, but I will have a look back over some of the recent performance data and divisional decision making and see what I can make of it. Wine Division The Wine Division (WD) is organised across six different business units. Most support functions are provided through a shared services function at headquarters, although there is some local support provided for accounting, information technology and marketing. The WD has a strategy of product differentiation and innovation through high quality premium wines and product development. The concept of high quality is promoted across all functions and activities from the vineyards to wine-making operations to customer-relations and post-sales support. A number of the sub-units in the division are classified as investment centres by the divisional manager Alex Bardin. Bardins reasoning is that if it is good enough for him to be evaluated on the basis of ROI it is good enough for each of the larger sub-units within the WD. The performance of the WD has traditionally been strong, averaging an ROI of 10% over recent years. However, a number of factors seem to be making good performance much more difficult to achieve. These include: 1) Supermarkets have been able to commission some winemakers to make generic label wines of reasonably high quality able to be sold at a relatively low retail price (around $10), which is about half the price of competitor wines of similar (if slightly higher) quality. 2) A recent internal audit of the divisions assets revealed that many were bordering on obsolete and were so old they were causing significant inefficiencies and restricting production. Upon further investigation this seemed common across the divisions. 3) Customer data that had usually been generated no longer seemed sufficient. The market seemed to be changing and the customer satisfaction data via surveys conducted by an external company seemed too general and basically, too late to be of much use. The WD had two broad sets of customers: retailers (wine shops) and end consumers. 4) There were a number of industry factors of concern. Over the last two years, prices for wine grapes have fallen dramatically for a number of varieties, resulting in some cases, in wine growers having to sell their grapes well below production costs. This is occurring at the same time as an oversupply of some grape varieties exists. Wine grape growers within the WD transfer internally about 70% of their production. The remaining 30% is sold either under contract to wine makers or on the open market. 5) It is becoming increasingly evident that innovation and people are critical in this industry. This had become more evident in the last six months as the WD had lost three key staff (including one winemaker) to competitors. Balanced scorecard pilot project: Wine Division (WD) Since joining Olivers, the new CFO Wallis has been busy raising new ideas to improve the performance measurement and control system. One of these has been the a pilot project of a balanced scorecard within the WD. Wallis held a number of introductory meetings with divisional manager Bardin as well as a number of other senior managers in the division. Following an initial presentation by an external consultant, Wallis made it clear how the project would proceed. Bardin would need to develop a number of key strategic planks (or levers) to guide the focus of BSC development (see Exhibit 1) within the WD; a series of meetings would follow with sub-unit managers with a view to developing a BSC at the level of the WD. Exhibit 1 Wine Division key priorities or strategic levers 1. 2. 3. 4. 5. 6. Grow revenue ahead of the market Increase market share across the product range Improve quality across all activities, functions and processes Maintain improvements in ROI each year Trade more effectively with customers (for example, wine shops) Develop the knowledge of all staff through training and knowledge sharing and ensure a safe working environment. 7. Become a leader in innovation and product development

Following a series of meetings within the WD, a number of common queries kept emerging. These are summarised below: 1. Is ROI a useful performance measure at sub-unit level within the division as well as at the divisional and organizational level, or is there something better. Why does it have to be the same ? At any rate, how do we know whats best at different levels of the company? Or, do we need to look at this another way? 2. If we are going to have a BSC, what does that mean for our incentives? How do we best link a set of BSC measures to our bonuses? 3. How is the BSC to be used? Obviously we can use it diagnostically, to provide feedback against pre-set targets and see if we are on-track? But is there more? Bardin wondered what he had got himself into!

Eltsen Part A
Eltsen is multi-divisional company operating in a range of locations around the globe. Product divisions are in the areas of: Milk and Dairy products; Confectionary; Nutrition and Water; and, Prepared Food. Elsten is a multi-billion dollar company with total sales in excess of $10b. The chief executive officer (CEO) is James Walsh who has been in the role for just two years. He has spent much of his early time at the company familiarizing himself with each of the divisional activities and understanding the structure and global reach of the company. A recent review resulted in the identification of the following strategies and objectives: Optimizing product performance through strong research and development, product innovation and market share growth. Enhanced financial performance through financial discipline and targeted capital expenditure. Walsh is hoping to review the structure of Elsten in the coming months. He has found that at present there seems to be a disconnection between the product-related divisions and the regions within which those products are sold. He is seeking the best way to structure Elsten to facilitate its strategies and objectives and meet the needs of the local regions in which the company operates, while at the same time encouraging collaboration and innovation across the company. Chief financial officer (CFO) Ruby Day has suggested to Walsh that consideration should be given to a matrix structure. Milk and Dairy Products Division The Milk and Dairy Products Division (MDP) focuses on such products as milk, ice-cream, yogurt and cheeses. The current divisional manager is Sonia Bassett who has been divisional manager for the last three years. Sonia has been able to grow the division in that time with current annual revenues of $3.8b representing an average annual increase of 6%. Currently, Sonias attention has been directed at the performance of ice-cream. She has become concerned about the market-related performance of ice-cream products across the globe. Increasing competition, some rationalization among competitors, product development and possible changes in consumer preferences, led Sonia to have the accounting department improve the data available to analyse performance for this product range. She has been quite pleased with the work of the accounting department. She believes this new market-related data provides a greater opportunity for understanding product performance. A recent report developed for the division from the Soho region is provided in Table 2. French Vanilla and Macademia twirl ice-creams are regarded as operating in the same market within the Soho region.

Table 2: Eltsen: MDP: Soho region: 2009


Budget
Volume Litres ('000) Sales Data Sales ice-cream (French Vanilla) Sales (Macadamia Twirl) Total Sales Cost of Goods Sold Cost ice-cream (French Vanilla) Dairy ingredients (litres) Other ingredients (100gr.) Labour (hours) Cost ice-cream (Macadamia Twirl) Dairy ingredients (litres) Other ingredients (100gr.) Labour (hours) Contribution margin Non-Variable Costs Net Profit 2,020 336 2,356 $ ('000) 28,076 8,570 36,646 Variance 1,168 357 1,525 Flexible Budget 29,244 8,927 38,171 Variance 39 -17 22

Actual
Volume Litres ('000) 2,104 350 2,454 $ ('000) 29,283 8,910 38,193

1,919 1,313 34.01 320 241 30.00

16,106 6,213 988 2,726 1,680 869 8,064 3,000 5,064

-670 -258 -41 -114 -70 -36 336 336

16,776 6,471 1,029 2,840 1,750 905 8,400 3,000 5,400

92 104 -52 165 51 66 448 500

1,934 1,335 37.10 318 244 28.79

16,684 6,367 1,081 2,675 1,699 839 8,848 3,500 5,348

Additional data: Budgeted Market Size Budgeted Market Share Actual Market Size Actual Market Share

19633.333 12.00% 20811.333 11.79%

Eltsen Part B
Nutrition Division The Nutrition Division (ND) focuses on health-related products. Historically, the ND has been an excellent contributor to group performance, with annual growth rates of up to 12% for the period 2000 to 2006, and revenues exceeding $2b. However, divisional manger Bruce Buncle has found maintaining divisional growth increasingly difficult to achieve. An increasingly crowded market for health and nutritional products seems to be the main driver of these difficulties. However, Buncle is conscious that he needs to develop new products and markets in line with company objectives. Buncle and his management team looking have been considering a range of investment opportunities and have decided on a major investment in the bottled water industry. While the industry has its challenges (for example, environmental opposition to the use of plastic bottles), Buncle and his management team see a lot of potential with such a strategic move. However, where significant capital expenditure is required, Buncle finds the company investment decision making processes frustrating. Elsten currently uses a common capital investment evaluation process for all investment projects in excess of $10 million. A summary of key criteria includes: Projects must generate a positive NPV over the life of the project. A minimum annual return-on-investment (ROI) of 12% must be achievable within two years of the project commencing. Project proposals must be presented in standard format with supporting calculations. Buncle cites the following example to illustrate his frustrations with the current process. The management team within ND has identified a new spring water source in a regional area Winnera County. The local authorities are in favour of the springs being used to supply ND with spring water for a new water bottling plant to be built in the region. In fact, the local authorities are willing to forego local taxes and provide subsidies to ND to ensure the plant is built. The region has experienced relatively high levels of unemployment in recent years and the new plant will generate some 100 local new jobs. While there is some local opposition to the new facility on environmental grounds, Buncle figures these are manageable. While he knows the projects financial benefit is greatest after the third year, he knows that the investment is a good strategic move for his division. A summary of the projects details is provided in Table 1 Table 1 Bottled water project at Winnera County Summary data

Life Cost NPV Average ROI over 10 years ROI in year 1 Average ROI over first three

10 years $28.2m $1.6m 14% 6% 8%

Buncle has raised his frustrations with senior management, arguing that projects such as his bottled water project are never going to meet the strict and somewhat narrow criteria currently used by Elsten.

Slater Diversified
Slater Diversified (Slater) is a multi-divisional, diversified company structured around three key divisions, namely: tourism, internet technologies and adventure retailing. The company chief executive officer (CEO) of the last five years Katherine Hui has been responsible for a recent restructure that resulted in the creation of the three divisions. The tourism division focuses on providing tourism packages to consumers; the internet technologies division focuses on web-based design and consults on internet usage and marketing; while the adventure retailing division operates in the outdoor, adventure clothing and equipment retailing sector. As the company has grown, the challenge has been to adequately structure such a diversified group. Moreover, developing a suitable managerial control system has proved difficult. For example, as the recently appointed chief financial officer (CFO) - Emma Govan - has stated: these divisions operate in completely different industries with different risks and competitive environments. This makes common, organizational-wide performance measurement and controls problematic, particularly when we believe so strongly in divisional autonomy and decentralised decision-making Nevertheless, over the years Slater management has tried to use relatively common control system tools. For example, a common planning and budgeting process applies across the organization. Structure and responsibility centre classification Each division is treated as an investment centre with residual income (RI) and sales growth used as key financial performance measures to which incentives are linked. Managers of divisions are also evaluated on the basis of a mix of non-financial measures, though these perform a relatively minor role in performance evaluation. The structure of the incentive and bonus plans within the divisions is up to the divisional manager in conjunction with the CFO. Tourism division and transfer pricing issue The Tourism division (TD) operates in various sectors of the regional tourism industry. TD sells a diverse range of products including guided tours, accommodation, bicycle hire, entry to key city and regional attractions, adventure activities, and organised group dinners at local restaurants. TD deals with a range of customers including international visitors, local residents and school groups. Currently Tourism is organised into five product-focused profit centres: Accommodation Vehicle hire (bikes and cars) Tours Adventure Dining and attractions Within TD, the performance of the managers of each of the five profit centres is evaluated on the profit performance of the individual profit centre. The divisional manager of TD Jenni Hargraves - estimates that about 30% of customers (representing approximately 30% of all business) buy a single product. The remainder typically seek a package deal which might incorporate a mix of two or more of the five tourism products offered by Tourism. For example local school groups buy tours. Country school groups tend to buy packages of tours + accommodation. International visitors tend to buy more comprehensive packages involving tours, adventure activities, accommodation, vehicle hire and entry to attractions. Local residents are less predictable in their purchasing patterns. Company policy is that whichever profit centre happens to secure the client, puts the package together and records the profit on the whole transaction. The company also mandates that if the package involves services available within Tourism that service must be bought internally. In this sense, there is no sourcing autonomy. The transfer price is set such that all transfers take place at full cost. This policy is designed to make sure that each participating profit centre gains some contribution margin out of each package arrangement, even if they did not directly service the client. At any point in time, all five profit centres have levels of idle capacity.

Olivia Lee, the manager of the tours profit centre is frequently asked by clients to put together weekend tour packages that include a guided tour component as well as car or bicycle hire and accommodation. She provides the following example of a package she recently put together:

Grampians Attractions 2-day tour for 2 Direct costs: Tour guide Costs transferred in from other profit centres: Bicycle hire Accommodation Overheads of Tours profit centre Full Cost Profit margin 25% Selling price

180 50 200 50 $480 120 $600

Olivia has identified an equivalent tour package offered by a competitor at $550. Olivia has recently experienced frustration at having to reduce her margin on these packages or lose sales. She has been able to obtain the following information from the accommodation and vehicle hire profit centres: Accommodation: Transferred at the amount the accommodation profit centre pays to the hotel, plus fixed overheads amounting to 25% of direct costs. Thus Olivia determined that the accommodation cost from the hotel must be $160 to arrive at a transfer price of $200. Bicycle hire: Costed at a direct cost of $10 per person per day for the use of the bicycle, plus fixed overheads amounting to 25% of direct cost. Thus for two people for two days the cost of bicycle hire is $40 + 25% = $50.

Internet technologies division and risk The internet technologies division (ITD) has evolved over the years through an expansion through acquisition program. Rather than necessarily develop their own businesses within this division, divisional manager Mal Reed - with the approval of head office has used his entrepreneurial skills to acquire a number of smaller companies in the internet technologies field. Reed reasoned that this was the best way to remain innovative rather than have the division try to develop its own innovative culture. The end result seems to be as the chief financial officer (CFO) Emma Govan commented: we seem to have a mix of all sorts of businesses in the ITD. Sure, they have a technology angle to them all but most seem unrelated to each other, have different cultures, and some are start-ups and others mature businesses. Moreover, because of the industry a lot of the staff, while strong technically, lack experience in a lot of business-related issues. Reeds response to this was that the growth by acquisition program within the division was mostly driven by head-office and its expectations as illustrated by key performance measures. He knew he had spent a significant portion of his time focusing on the acquisitions that had been made over the last few years, but felt the incentives in place gave him little choice. He felt there was strong competition between divisions particularly when it came to demonstrating growth of the division. Reed has tied to foster this competition within his own division. Performance measures and incentives are focused around revenue growth; and Reed benchmarks each unit within ITD against each other according to annual revenue growth.

Synergy Clothing 1
Background Synergy Clothing (Synergy) began operations as a clothing manufacturer in the 1940s. It has grown from a small firm into a multi-divisional diversified clothing company with three key divisions: Fashion, which focuses on shirts and jeans; Uniforms which focuses on corporate and uniform wear; and, Sportswear, which focuses on sports clothing with a specialty in custom sports uniforms. Until recently, the company had been owned by the same family. The grandson of the founder Tim Peseta - still occupied a senior management position, although significant changes have occurred since the company was listed on the stock exchange in 2003. Since becoming a public company a number of key structural and control system changes had been made by the new management team lead by CEO Noel Oliver. Structures Under the previous management control system, each of the Divisions was classified as a profit centre. Since being listed, Oliver changed this management control structure allowing each of the three divisions to operate as investment centres for the Group. He insisted the managers were to be autonomous, making decisions in the best interest of their respective businesses and Synergy as a whole. Each division would manage its own research, development and design activities, as well as marketing and distribution activities. The Group Head Office would coordinate purchasing and manage accounting, human resources and information technology services. Although this structure had not been in place very long, Oliver was contemplating further changes. As the company continued to grow it became clear that complete separation of the three divisions was compromising some corporate-wide efficiencies such as dealing with fabric and technology suppliers. Moreover, the fashion, uniform and sports clothing markets were becoming more specific. He was wondering if the adoption of a matrix structure might best capture these dynamics. Performance measures and reward system As part of divisional performance evaluation, Oliver replaced EBIT as the main evaluation metric with Return on Investment (ROI). ROI would be calculated on the basis of (operating profit before tax)/(Assets at gross book value). Included in these changes was the increase in divisional managers bonuses to 10% of annual salary, based on achievement of annual ROI targets. These targets were set in consultation with division managers. Moreover, the senior management team was rewarded on the basis of organisational ROI. The amount of bonus received by managers was determined as follows: The bonus pool, was determined on the basis of: ($100 000 + 10% of increases in annual combined return-on-investment). The bonus pool was shared: 15% to senior management (shared equally among ten managers on the basis of organisational ROI); 50% to divisional managers (shared among three managers according to divisional ROI); and, 35% to managers within the division (shared among twelve mangers according to divisional ROI). The bonus payment was in the form of cash. While some members of the management team expressed concerns about the use of ROI as the key performance metric, Oliver was intent on keeping things simple in that ROI was a good summary measure from which to base senior management and divisional performance. One of the senior managers Sonia Lee had become persistent in her objections to the current bonus scheme. She felt the bonus scheme needed to reflect shareholder interests with suitable measures at each level of the company which reflected managers span of control and the right mix of incentives.

This case has been adapted from Brooks, A. & Vesty, G. 2008, Double Two, Accounting Perspectives, 7,3, 257-170.

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Transfer pricing issue An early test for the more decentralised decision-making was a sourcing and transfer pricing conflict between the divisions. The newly formed Sportswear group was responsible for the manufacture and sales of specialised sports clothing (in particular, football uniforms). By 2008, their manufacturing capacity was almost fully utilised for a significant proportion of the year. The future prospects for Sportswear look rosy, even more so since winning a contract for the supply of football uniforms for a major international football event. Winning this contract was a major coup for Sportswear and the Group as a whole. As part of the football contract, the Sportswear division was asked to supply formal shirts for the officials. With minimal idle capacity left to manufacture the formal officials shirts the Sportswear manager, James, was faced with a dilemma. James asked the Fashion and Uniforms managers to help with the manufacture of these shirts. In the past, the three divisions have often shared manufacturing resources when capacity became constrained in one area. But now with increasing sales and demands in all areas of the Group, capacity constraints were becoming an issue for all of them. Furthermore, with an increase in their individual bonus plan based on specific divisional performance, the divisional managers did not seem to embrace this co-operative spirit as they used to. As part of the decentralisation process, Oliver argued that revenues, costs and investments should remain with the separate divisions and if any division required the manufacturing services of another, the requesting [buyer] division must cover a portion of all of the costs, and provide for some profit to the supplying division, depending on their capacity at the time. As far as the amount and type of transfer pricing method, Oliver was happy to leave it to the divisional mangers to sort out through negotiation. Senior management would not intervene. In addition, the Fashion, Uniforms and Sportswear managers are now allowed to seek bids from any supplier both internal as well as external to the Group, so long as the external supplier complies with Synergys quality program. Of course, Oliver expected that divisional managers would take into consideration the best interests of the firm during their negotiations. Sportswear decided to take advantage of this new sourcing arrangement and seek bids from external as well as internal manufacturers. The management of Sportswear were aware that within Synergy, Fashion was close to full capacity while Uniforms, after having an order cancelled had some spare capacity in the short-term. Sportswear management also understood that within the industry there appeared to be some spare capacity. They were hoping this might result in a low price bid from an external supplier as they had quoted a relatively low contract price on the uniforms. Thus, for completion of the football contract the successful tenderer for the officials shirts would provide Sportswear with the basic shirt manufactured to their specifications. Sportswear will finish the garment with the event logo and packaging. In December 2008 Sportswear approached Fashion and Uniforms as well as another reputable manufacturer from outside the Groups operations to quote on this business. The anticipated volume for the officials shirts was 10 000 units. The quotations, outlined in the following Exhibit were received from the 3 entities. Divisional management of Sportswear, while conscious of senior managements desire for goal congruent decisions, felt that the external bid would be their preference. In the early stage negotiations, Sportswear management has made this clear to the divisional managers of Fashion and Uniforms. The manager of Uniforms - has reacted angrily arguing that the best interests of the company should be the main driver of the decision taken. James found this a little odd..how could the best interests of the company by served by him paying a higher price than necessary.

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Quotes for the Officials Sport Shirts


Manufacturer Barnleys (external) Fashion Uniforms Bid price per shirt $25 $30 $32

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Southern District Dairy


Im really not sure our information systems are as well placed as they could be to help us drive our performance. The industry data and my own observations suggest we need to do better in this regard. I worry about how we can best drive revenue growth and what are the best tools we could be using to help us achieve this. The volatility in our markets means our data for monitoring performance and facilitating decision-making is the best it can be, particularly as it relates to our performance against industry trends and our competitiveness in the industry. Also, we need to improve our planning processes and Im really not too sure how to best plan for our expenditures in areas like R&D Brad McEwen (who has been CEO for three years) was reflecting on recently released industry information and his own experiences as CEO of Southern District Dairy (SDD). SDD, a privately-owned company, produces a variety of milk, cheese and yogurt products. Dairy ingredients for production are sourced largely from dairy farms owned by SDD. The company has a strategy of producing high quality products targeted at consumers prepared to pay a premium price. Seventy (70) percent of the companys output is exported to parts of Asia. SDD has three investment centres each run by a business unit manager. The dairy farms business unit provides much of the required raw materials for the other two divisions. These three investment centres are supported by four support cost centres (research and development; accounting and finance; human resources; and, marketing and logistics) as reflected in Figure 1. The investment centre (business unit) managers are responsible for meeting specified return-on-investment (ROI) targets, calculated for each business unit on the basis of profit divided by assets. Both profit and assets include allocations from central administration.

Figure 1: SDD Structure SDD Board and CEO

Cheese plant
BU manager: Scott Simpson

Milk and yogurt plant


BU manager: Prue Lee

Dairy farms
BU manager: Sam Pike

Research and development

Accounting and finance

Human resources

Marketing and logistics

The accounting and finance department is responsible for budget preparation and the preparation of variance reports across the various levels and activities of SDD. For example, at present flexible budgets are used to guide performance monitoring of production-related costs and activities. In addition, the flexible budget is used to identify sales variances but no further analysis is conducted. This reflects Brads frustration in the opening quote. For the support cost centres, budgeted versus actual cost is the key performance metric. The budget targets for the support cost centres are usually set on the basis of negotiation with Brad although the common starting point is always

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last years budget. For example, with the research and development (R&D) cost centre, Brad has linked the annual budget estimate to sales targets. The manager of R&D is then held accountable for managing the department within the annual budget estimate. SDD, and the dairy industry in general, experiences volatile demand for their dairy products from their major trading partners and extreme fluctuations in the price at which they can purchase milk for production of dairy products and sell milk produced on their dairy farms. For example, the price of milk per litre in June 2008 was 51.2 cents, while the corresponding price in April 2009 was 18 cents per litre. Brad has spent some time over the last few days reading and considering the latest industry report prepared in April 2009. Some of the items attracting his attention included: Annual industry milk production was 3.1% higher [at 6.3 billion litres] than the same time last year; Annual dairy exports were up in volume but cheddar cheese volumes were down by 29% and other cheeses were down by 43%; Annual exports of skim milk and whole milk powders were up by 33% and 27% respectively; and There had been some stabilization of world prices over the last few months of the year and some signs of recovery in global demand were emerging.

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Goldman, Mason and Vernon (GMV)


The importance of the upcoming annual management meeting of Goldman, Mason and Vernon (GMV) was playing on the minds of the two most senior board members: Sharon Goldman (daughter of founder Bill Goldman) and Bruce Clayton. The business model of GMV had worked well for the last twenty years, but increasing uncertainty in financial and product markets combined with a worldwide reduction in activity had resulted in the Board considering a number of changes within the organisation to ensure its continued success. The most contentious of these changes, a new incentive compensation plan, was to be debated by senior managers at the next senior management meeting. The Company GMV operates as a listed private-equity company. It was established in 1991 by Bill Goldman as a company making rather small strategic acquisitions. Bill had seen the company grow to what it is today, the only listed private-equity firm in Australia and New Zealand. GMV looks to make strategic acquisitions of un-related companies, where there is significant potential to make operational improvements. Each of the acquired entities operate as a separate autonomous business unit of GMV, although there are a number of key elements common across each entity, such as the budgeting, planning and incentive systems used. At present, GMV has six key business units. Each of the business units is led by a business unit manager. Each business unit manager reports to the CEO who in turn reports to the Board. The business units are highly decentralised, with business unit managers responsible for a range of functions including product or service development, manufacturing (where applicable) and marketing strategies. Innovation and limited risk taking are encouraged within an environment of open-mindedness. These concepts are captured in GMVs fundamental beliefs and values statement, which includes a description of beliefs relating to: decentralization; growth; communications; education; incentives and goals; and, innovation. Planning and control In line with its beliefs statement, GMV has relatively few corporate rules and allows each business unit to maintain its authority structure when acquired by GMV. However, GMV did implement its own planning and budgeting system. Three formal planning devices are used: 1. a rolling five-year strategic plan which is presented in October each year by the business unit managers. The main purpose of this is to force the managers to think strategically about their business units and serve as a basis of discussion with senior management. These discussions occur regularly during senior management visits to business unit sites and often focus on helping each business unit deal with emerging uncertainties within their markets. 2. an annual business plan which sets the benchmarks for performance on an annual basis in such areas as marketing and production strategy, staff planning, R&D and capital expenditures. This plan also provides details of expected operating profit increases. 3. monthly performance reports which focus on monthly and year-to-date performance against specified targets across a range of measures.

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The Incentive System Until recently, the reward system in place was relatively simple. All senior management (8 managers), business unit managers (6 managers) and the top 6 senior managers in each business unit (36 managers) shared in a common bonus pool. The bonus pool, was determined on the basis of: $100 000 + 10% of increases in combined divisional operating profits. The bonus pool was shared: 15% to senior management; 50% to business unit managers; and, 35% to managers within the business units. The bonus payment was in the form of cash. The proposal for a new incentive plan had been prepared by the chief financial officer, Sam Dementiava. Briefly, Sams proposal included: i. Senior managers being rewarded on the basis of organisational economic value-added (EVA). If annual targets (as set by a Board sub-committee) for EVA were met, then each of the senior managers would be eligible to receive a specified parcel of shares in the company. ii. Incentives for Business unit managers based on: - Corporate wide EVA (25%); - Business unit EVA (25%); and, - a mix of non-financial measures relevant to each individual business unit

as agreed with the CEO (50%).

Where targets were met, Business unit managers would receive their incentive in the form of company shares. iii. Incentives for senior managers within business units would be rewarded solely on the basis of business unit EVA. Incentives would be paid in cash. Sharon and Bruce knew the Board had some serious deliberations ahead. They were aware that incentive plans generally had attracted negative publicity lately. They were determined to have the Board make the right decisions with respect to GMVs incentive plan.

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COWMILKA
Cowmilka is an Australian dairy cooperative run jointly by over 1,000 Australian farmers and 900 employees. Both the farmers and employees are all committed professionals with a passion for dairy. This is formalized in the companys vision and belief statements and communicated widely to all employees. Cowmilka pays its farmer members the highest possible price for their milk and has developed a strategy based on growth, efficiency and innovation. It is a widely shared belief that value is created by: Growth in exports and value-added products; Efficiency in production and logistics; and Innovation in product development and processes. A relatively high proportion of Cowmilkas milk production is exported every year. Globally the dairy market is dynamic and current milk demand outstrips supply. However, in Australia the volumes have significantly reduced over the last few years as the ongoing drought has reduced milk yields. The butter market has come under threat as consumers have begun switching to vegetable-based products because of increasing dairy prices. Butter prices have increased by 100% over the last year to $8.00/kg. As a result of the drought and market price fluctuations it has been difficult for Cowmilka to fully realise their budgeted growth in volume over the last couple of years. Cowmilka has four core divisions, managed as profit centres and structured around the following product groups: Milk Products; Cheese and Butter; Yogurt; Ice-cream. Each division is functionally structured with specializations in research and development (R&D), marketing and customer sales. Cowmilka also has a centralized logistics division which among other things coordinates milk distribution. The raw ingredient, milk, is shared among the divisions and is transported from the farms to the closest manufacturing plant. Cowmilka has 6 manufacturing plants located in the dairy belts of Australia, one of which is entirely dedicated to ice-cream manufacture. The other 5 production sites jointly process cheese, butter, yogurt and/or milk products according to production schedules set by the other 3 profit centre managers. The profit centre managers meet weekly to discuss production planning and milk allocations. They are required to accurately forecast customer orders to optimise plant efficiency. The manufacturing plants are managed as cost centres and each plant manager is held accountable for production output. Wastage is expected to be close to zero and poor forecasting results in high production run set-up/change-over costs. The plants operate 24 hours a day for 7 days a week with capacity to produce around 680 million litres milk/year. Quality control is essential. A special board meeting has been called to consider several strategic planning and control issues. Three of the agenda items are:

1. 2.

Evaluation of the 3 capital investment proposals Review of the funding to the Logistics Cost Centre 17

3.

Review of the annual profit planning exercise

Agenda Item 1: Capital investment proposals review Proposal 1: The Logistics Manager requires investment in 3 new milk tankers to replace an aging fleet of tankers to improve the efficiency of the fleet. Currently they have high maintenance costs and an unacceptable number of tanker breakdowns. Total Cost: $324,000 Proposal 2: The Manufacturing Manager is required to purchase waste and water management equipment for each of the six production sites to meet new health and safety regulation guidelines. New legislation requires that this equipment be installed before the end of the following financial year. Total Cost: $350,000 Proposal 3: To achieve Cowmilkas desired goals of growth and strengthened international position the manager of the Cheese and Butter Division, Colin Way, was proposing to acquire a small New Zealand company called Fintona Buttergold. Cowmilkas Cheese and Butter division was currently pursuing a cost leadership position selling prepackaged cheese and butter into supermarkets on contract agreements. The supermarkets then sold the cheese and butter as their home brand products. Colin was keen to diversify his divisions product range and argued that growth into the niche markets would value-add to their existing range. Colin prepared the following information for the board: Fintona Buttergold Specialized butter plant with state-of-the-art butter manufacturing capabilities. They are known for their butter which is sold in small packages and 250 ml cartons for restaurants and gourmet supplies. They are highly regarded competitor in the New Zealand market; have loyal customers and a friendly sales team managed by a strong leader (the current owner of the firm, who may not stay with the company after it is sold). They have recently begun marketing their products internationally and sales forecasts indicate that sales will continue to grow and production will be at capacity. He attached a spreadsheet of calculations which projected reasonable returns for the next few years. Total Cost: $3,500,000. Agenda Item 2 (background) Cowmilkas logistics cost centre has 65 employees and a fleet of 25 milk tankers. It is a cross-functional cost centre and staff working here range from administrative (customer service and order processors) to mechanics and tanker drivers. Tanker drivers collect the milk daily from farmers and deliver it to the varying Cowmilka manufacturing plants. They also have a team of 10 human resource (HR) staff who oversee the health and safety training programs for all Cowmilkas operations. For example, nearly all Cowmilkas employees are required to have up-to-date food handling, health and safety qualifications and must pass a short computer generated health and safety test before entry is allowed onto any of Cowmilkas operational sites.

Agenda item 3 (background) Some members have expressed a little concern about the annual profit planning exercise. Their concern relates to whether the process is capturing all of the factors which may be impacting on profits and threatening Cowmilkas competitiveness. For example, butter prices are up but volumes are threatened, and certainly milk volumes have been under threat.

18

Rampage
Noah Day is the new CEO of Rampage Ltd, an up-market fashion house for men and women using the brandname Rampage. The key strategy of Rampage is one of innovation and high-quality clothing for men and women. Historically, the company has performed quite well financially although import competition is intense. The company has three main divisions which are treated as profit centres (see Exhibit 1) and a number of functional support areas including: human resources, information technology, accounting and finance, and marketing. These support areas are classified as cost centres within the structure. The managers of the profit centres are evaluated on the basis of divisional profit (against budget). Exhibit 1 Divisional Structures Rampage Limited

Rampage Limited

Design and textile development


Manager: Gail Adams Performs design and textile development work for internal and external clients

ManufacturingTextiles
Manager: Susan Zhang Manufactures textiles for both internal (Manufacturing-Clothes) and outside clients

Manufacturing Clothes
Manager: Pino Cianno Manufactures high-end fashion garments for high-end fashion distributors and retailers.

Rampage has built its reputation of innovation on a foundation of divisional autonomy and decision-making by divisional managers. For example, each division is able to choose where it sources its input resources from and whether it transacts internally or externally. However, wherever possible, transactions occur internally. As the new CEO, Noah has become a little concerned about a sourcing and pricing dispute that has recently emerged. The divisional manager of Manufacturing-Clothing; Pino Cianno had sought bids from the Manufacturing- Textiles division as well as two external textile manufacturers. The bids related to the supply of a new textile called CoolWool which is a special blend of cotton and wool, to be used in the manufacture of business suits for men and women. Each of the bids are shown in Exhibit 2. The divisional manager of Manufacturing-Textiles; Susan Zhang claims that her bid price represents her full cost to make (approximately $24) with a profit margin (representing 25% on full cost), and as such is reasonably representative of the market price. She claims that although there is available capacity to meet the production demands for CoolWool in her division, she ought to be able to price as though she was selling externally: after all, this is profit centreIm expected to make money The $24 cost price includes an allocation of existing fixed overhead of $2per unit. The Rampage group is fairly excited about the development of CoolWool as it is regarded as being at the cutting-edge of textiles technology. Market research has demonstrated that sales of both the textiles itself and the business suits are likely to be well accepted in the market-place. To this end the initial estimates are for relatively high volumes with an estimate of 82 000 metres of CoolWool required in the first year. 19

Exhibit 2: Bid prices on CoolWool

Internal bid
Bid-price Manufacturingtextiles $30 per metre Softcloth

External bids
Interwoven $25 per metre $24 per metre

Manufacturing-textiles internal bid of $30 per metre includes an on-going payment (cost) of $8 per metre to the design and textile development division for developmental work (the $8 per metre price includes a profit margin for the design and development division of $2 per metre). Similarly, the Interwoven bid contains a payment of $2 per metre to the design and textile development division for developmental work.

20

Galaxy Hotel Group


The Galaxy Hotel Group owns and operates a number of mid-level boutique hotels mostly in regional Australia. Galaxy is structured around regions with a regional general manager usually given the responsibility of working closely with the managers of the hotels within their region. Commonly, a regional general manager is responsible for around 6-8 hotels. Within Australia, Galaxy has six regional general managers. Galaxys strategy has focused on meeting the needs of business and holiday travelers seeking a 3-3 star accommodation for relatively short stays that are affordable but comfortable. One thing the Galaxy did enforce was its objective of having the same high-level of service at each hotel. To re-inforce the organizational view, Galaxy used a multi-item remuneration plan. This is outlined in Exhibit 1. Exhibit 1: Remuneration Plan Structure: Galaxy Hotels Base salary The base salary for each hotel manager is a function of: years of service and hotel size as measured by revenue. Revenue Incentive Each hotel manager will receive a bonus equal to 1% of any revenue increase over the previous years level. Should revenue decrease there is no bonus. Return on Investment bonus The ROI bonus formula = ROI * PF Where: ROI = (Profit before interest expense and taxes)/Assets at net book value PF = a performance factor which is used to differentiate between the different sizes of the hotels and to offset any inherent complexities of managing larger properties, as outlined below: Size of investment ($) in the Performance Factor hotel value 0 - $2.0 m $2.0m - $5m $5m - $10m $10 - $15 Above $15m $36 000 $45 000 $56 000 $65 000 $70 000

Fringe Benefits Each hotel manager receives a two-bedroom apartment on-site for their exclusive use.

In the last twelve months or so, regional mangers have been focusing their attention on those hotels where extra capacity could be added through an expansion plan. Helen Anderson, the regional general manager of the Victorian and Tasmanian hotels has identified two hotels as candidates for the additional capacity. One of these hotels is the Mitchelton Hotel, managed by Jason Plumb. While Plumb was initially enthusiastic about the increase in capacity for the hotel, he has become increasingly concerned at the impact it might have on his performance bonus over the next year or two. Anderson has been working closely with Plumb on the 21

different options for the expansion. The likely outcome will be a plan to increase the guest capacity by 25%. The expansion program has already been approved at senior management level, having met the companys capital investment hurdles. In recent years, Plumb has been quite happy with the hotels performance with ROI in the last two years equal to 27%. Because of Plumbs more recent resistance to the expansion, Anderson agreed to prepare an analysis of the impact of the proposed expansion on Plumbs remuneration for 2008. For comparison purposes, she also prepared a schedule of Plumbs expected remuneration in the current year (see Exhibit 2). Exhibit 2: Impact of planned expansion on remuneration plan of Jason Plumb Impact of and 23.5%. In recent weeks, Plumb has started to worry a little about the impact of the proposed expansion on his ROI bonus. He asked Helen Anderson to prepare some numbers showing the impact of the expansion on his ROI bonus for 2008. The information prepared by Anderson is shown in Exhibit 2.

Expected remuneration for 2007


Base salary Revenue incentive (2 051 500 1 904 556) * .01 ROI Bonus (497 500/1 842 592) * 36 000 = .27 * 36 000 Total Cash remuneration $65 000

Planned remuneration for 2008 (with expansion plan)*


Base salary $68 000

1 469

Revenue incentive (2 450 500 2 051 500) * .01 ROI Bonus (697 500/3 252 592) * 45 000 = .214 * 45 000 Total Cash remuneration * Based on a best-case scenario

3 990

9 720 $76 189

9 630 $81 620

22

Kilgors
Kilgors Lid is a multi-divisional company with a focus in the wine, hospitality and entertainment industries. Kilgors commenced in 1995 as a small wine company but over the years has expanded its operation and interests predominantly through acquisitions. It listed on the stock exchange in 2003. In the early days, the company had an informal culture and strong belief system. Kilgors organizational strategy relates to growth by acquisition with quality and differentiation the focus of divisional strategies. There are some interdependencies between divisions, though this is not a central feature of Kilgors. In 2005 a new chief executive officer (CEO) Herb Barlow - was appointed. Barlows first task was to execute a re-organisation of the company into three distinct divisions: Wine; Hospitality and Entertainment. Each division was classified as an investment centre. However, the internal structure within each division was left to the divisional manager. Invariably, most sub-units within investment centres were either profit centres or cost centres. Performance Measurement The key performance metric at the organisational and divisional level has always been return on investment (ROI); although a number of senior managers within the company are becoming increasingly uncomfortable with this focus around ROI. For example, chief financial officer (CFO) Roy Slaven argues that ROI is a useful broad-based measure that provides some useful information but wonders how well it works as an internal measure of value. Roy has been arguing for some time that the company needs a complete review of the performance measurement system. While some additional measures other than ROI have been used throughout the company, for the last 6 months Roy has been pushing for the introduction of a more formal integrated system in the form of a balanced scorecard (BSC). So far, he has gained approval at Board level to conduct a pilot study in the wine division of Kilgors, which he is hoping to execute in the next few months. Wine Division The Wine Division (WD) is organised across six different business units. Most support functions are provided through headquarters, although there is some local support provided for accounting, information technology and marketing. The WD has a strategy of product differentiation through high quality premium wines and innovative product development. The concept of high quality is promoted across all functions and activities from the vineyards to wine-making operations to customer-relations and post-sales support. All acquisitions within the division have complemented this strategy. A number of the sub-units in the division are classified as investment centres by the divisional manager Henk Berg. Henks reasoning is that if it is good enough for him to be evaluated on the basis of ROI it is good enough for each of the larger sub-units within the WD. The performance of the WD has traditionally been strong, averaging an ROI of 10% over recent years. However, a number of factors seem to be making good performance much more difficult to achieve. These include: 6) The supermarkets have been able to commission some winemakers to make generic label wines of reasonably high quality able to be sold at a relatively low retail price (around $10), which is about half the price of competitor wines of similar (if slightly higher) quality. 7) A recent internal audit of the divisions assets revealed that many were bordering on obsolete and were so old they were causing significant inefficiencies and restricting production. 8) The customer data that had usually been generated no longer seemed sufficient. The market seemed to be changing and the customer satisfaction data via surveys conducted by an external company seemed too general and basically too late to be of much use. The WD had two broad sets of customers: retailers (wine shops) and end consumers. 9) There were a number of industry factors of concern. Over the last two years, prices for wine grapes have crashed for a number of varieties, resulting in some cases, in wine growers having to sell their grapes well below production costs. This is occurring at the same time as an oversupply of some grape varieties exists. Wine grape growers within the WD transfer internally about 70% of their production. The remaining 30% is sold either under contract to wine makers or on the open market.

23

10) It was becoming increasingly evident that innovation and people were critical in this industry. This had become more evident in the last six months as the WD had lost three key staff (including one winemaker ) to competitors. The management meeting CFO Roy Slaven was keen to get the BSC project underway with an initial meeting with Henk Berg. A number of other senior managers were also in attendance. Following an initial presentation by an external consultant, Slaven made it clear how the project would proceed. Henk would need to develop 6-8 key priorities or strategic levers to guide the focus of BSC development (see Exhibit 1) within the WD; a series of meetings would follow with sub-unit managers with a view in the first instance of developing a BSC at the level of the WD. Exhibit 1 Wine Division key priorities or strategic levers 9. 10. 11. 12. 13. Increase market share across the product range Improve quality across all activities, functions and processes Maintain improvements in ROI each year Improve manufacturing cost per case of wine. Develop the knowledge of all staff through training and knowledge sharing and ensure a safe working environment. 14. Become a leader in innovation and product development 15. Ensure employees are participating in key organizational activities and contributing to company Following a series of meetings within the WD, a number of common queries kept emerging. These are summarised below: 4. Is ROI a useful performance measure at sub-unit level within the division as well as at the divisional and organizational level, or would economic value added (EVA) be better? How do we know which is best? Or, do we need to look at this another way? 5. Volumes across the industry are quite flat (although there is some increase expected over the next three years), particularly in some product ranges; so how can we best monitor this with respect to our own performance? At present, we really only look at our own broad-based historical data. We dont seem to know enough relative to the industry. 6. If we are going to have a BSC, what does that mean for our incentives? 7. How is the BSC to be used. Obviously we can use it diagnostically, to provide feedback against pre-set targets and see if we are on-track? But is there more?

Henk wondered just what he had agreed to!

24

Kilgors Part 2
The Incentive Plan With all that has been going on with the re-structuring and the development of the BSC project, little development has occurred with respect to the incentive plan. However, CFO Roy Slaven has begun a process of reviewing the current incentive plan as well. As he says: if we are going to the trouble of reviewing our performance measures it just makes sense to review the incentive plan as well. Our existing plan has been in place since the late 1990s but that was before we became a listed company. Things have changed The current incentive plan which has been in place for some years, is structured around a corporate-wide bonus pool delivered in the form of cash. The corporate-wide bonus pool was determined on the basis of: ($100 000 + 20% of annual increases in organisational profit before tax). The bonus pool was shared: 15% to senior management (shared equally among ten managers on the basis of organisational ROI); 50% to divisional managers (shared among three managers according to divisional ROI); and, 35% to managers within the division (shared among twelve mangers according to divisional ROI). In conjunction with staff in his office Slaven had developed some key parameters to guide the development of a new incentive plan proposal; although he knew it might be difficult to satisfy all of them. These parameters include the following: A focus on enhancing shareholder value Some consideration of performance relative to peers Make rewards fair and as inclusive as possible Use key financial and non-financial measures Encouraging both short-term and long-term view of the organisation Encourage goal congruence Reward good performance and penalize poor performance.

25

Mountain Mist Brewery2


Gillian Vesty Department of Accounting and Business Information Systems Part 1: Introduction to performance planning and control
In the early 1980s Albert Hancock built a small brewery on his 150 acre property in the Macedon Ranges. The brewery, named Mountain Mist Brewery was designed with ales in mind and Albert introduced a number of cutting edge and innovative technologies to make the well known popular pale ale, Misty Hop and others such as Hazy Heidi, Mountain Maid and Sunny Sherpa. Their biggest selling Misty Hop pale ale is widely recognized as a high quality boutique beer and is sold along with their other ales to clubs and restaurants around Australia. All Mountain Mist Brewery ales are distributed in kegs and 12 bottles cartons through their Victorian and National Wholesalers. They have continued to expand capacity on this site to meet their growing consumer demands. In 2009, the total Australian beer production was estimated at 1,736 megalitres with total revenues of $4,406 million. The Australian industry is concentrated around four key players - large nationals, like Fosters, Lion Nathan, Coopers and J Boag & Son, account for 80% of the industry revenue ($3,525 million); regional breweries, like Coopers and Little Creatures, collectively account for 10% of the industry revenue; Mountain Mist Brewery in Victoria follows, in seventh position, with 3% of the industry revenue. The remaining 7% comprise many small boutique microbreweries. Mountain Mist Brewerys capacity is currently running at 52 megalitres of beer per annum. While Albert strives for economies of scale, with investment in high tech brewing equipment and automated packaging machines, it is often difficult. He must carefully monitor all reports provided to him by his managers; particularly, the reports that detail the overall cost per litre of beer. Strict cost control means Albert has the income to invest in branding and advertising an expense he considers essential to ensure the Mountain Mist profile is maintained in the marketplace. In addition, as Mountain Mist is working in a high technology manufacturing environment, it means Mountain Mist is faced with on-going capital requirements. While state-of-the art equipment is expensive; downtime from aging, poorly maintained equipment is also costly. In addition, a significant issue for Mountain Mist, and the rest of the brewing industry, is the high transportation costs incurred with transporting beer around Australia. If Mountain Mist fails to adhere to strict quality standards on transportation and storage, they have the potential to significantly compromise the quality of the product reaching the final consumer. Albert associates the quality of his product directly with customer satisfaction, increased sales and corporate profile. Albert claims the main selling feature of his Mountain Mist ales is the use of specialty hop flowers, sourced from Tasmania and brewed according to their innovative brewing processes. The other major ingredient, malt, is sourced from Barley grown in the Northern parts of Victoria. The pale malt for Misty Hop is made according to strict Mountain Mist specifications. Albert claims that the natural spring water taken directly from the spring on their Mountain Mist brewery site offers superior tasting quality that will match, or better, the quality of any pale ale around the world. Alberts success has been realised in both sales and awards for his beer. Albert is proud of the national recognition for his ale. He is proud of the quality of his favourite pale ale which is free of preservatives and additives. As a result he is very attentive to the step-by-step ale production processes that use live-yeast conditioned bottles and kegs to ensure freshness and character.
2

This is a story of a fictitious brewery intermingled with actual Australian data sourced from IBIS world, 2009.

26

For Albert (and consumers) taste is crucial. Taste can deteriorate quickly, particularly for pasteurised lagers. As Mountain Mist Brewery ales are not pasteurised, but naturally conditioned, they offer an extended shelf life over many competitor lagers. However, in foregoing pasteurization, the Mountain Mist process requires high quality sterile filtration to remove the hops and prevent further chemical reaction. It also requires quality bottle conditioning to enable live yeast to mop up dissolved oxygen, thereby preventing oxidation. In addition to the high quality processing insisted upon by Albert, he also argues that Mountain Mist ales must be stored out of direct sunlight, be transported and kept in cold storage to slow down the oxidation process which is the cause of bad tasting ale. Albert has employed a team of technical experts (microbiologists) with the skills to continually analyse and test the ale at varying production stages to ensure quality control is maintained. Because of the attention to quality, Albert is able pitch the Mountain Mist product to the high-priced end of the boutique beer market. Consumers are willing to pay for product freshness and taste characteristics of Mountain Mist ale. From brewing to release, a batch of pale ale takes about six weeks, allowing for two weeks conditioning in the bottle after packaging. Albert walks through the Macedon Ranges brewery almost daily and takes time to chat with the staff working in his brewery. He knows many of Mountain Mists 135 staff members by name. When not onsite, he makes time to visit his key customers, in particular, the major wholesalers, large distributors and retailers throughout Australia (i.e. Coles and Woolworths owned distribution/retailing franchises, national pubs and hotel chains etc.) with his sales staff. Albert considers it essential to maintain a good relationship and long-term supply contracts with his distributors. In many pub and hotel venues space and convenience constrains the variety of beers on offer. To ensure their presence is maintained, Albert carefully monitors the number of distribution outlets that Mountain Mists Misty Hop pale ale is available on tap and in bottles. Alberts passion for the business is widely recognised by his staff and customers. Alberts employees all know that he does not like surprises. He insists on frequent meetings and detailed reports on both revenue and cost forecasts. Alberts vision for Mountain Mist Brewery is: 1. to grow profitably with incremental investment into selected markets to become one of the top six breweries in Australia; 2. to continuously elevate consumer perceived quality by improving taste, freshness, package integrity and package appearance; 3. to enhance distributor service with better lead-times, accurate order fills and less damage; 4. to continuously lower company costs per litre of beer so Mountain Mist can maintain resources for long-term productivity and success; 5. to continuously improve business performance though engaging and developing employees. To summarise thus far, Mountain Mist can boast a history of visionary leadership, quality products and dedicated staff. They have been able to withstand strong competition and grow the business in a highly competitive, albeit mature market. Albert wants to continue building on the foundation he has made. He wants to continue making great tasting ale, grow brand awareness as well as continue to provide superior service to Mountain Mist distributors, retailers and consumers. He values his dedicated staff and wants to contribute to their growth and job satisfaction with employee skill development.

27

Part 2: Mountain Mists profit performance


While Australian boutique beers, such as Misty Hop, are becoming more prominent in the market, overall volume growth for the entire industry is flat. The industry has also been faced with declining levels of consumption as well as increased competition from other beverages such as wine and spirits. In fact, industry growth overall for the brewing industry is lower than Australias GDP. In the following Table 1 details of the cost structure for Mountain Mist Brewery is provided. Albert regularly monitors their variances to budget. At the end of 2009, the Mountain Mist Brewery 2009 Budget information was compared with actual results. This is detailed below in the following Table 2. Table 1 Mountain Mist Brewery: Budget 2009 Item Budget/$ Mill % Total
Revenue Purchases* Wages** Taxation Depreciation Utilities Rent Other*** Profit 132.17 70.71 10.70 10.70 5.16 2.25 0.66 7.00 24.98 100% 53.5% 8.1% 8.1% 3.9% 1.7% 0.5% 5.3% 18.9%

Revenue is made up of budgeted sales of their four ales: Misty Hop, Hazy Heidi, Mountain Maid and Sunny Sherpa (although Misty Hops sales are far greater than the others, they are not differentiated in this analysis); the budgeted selling price per litre is $0.76 (keg) and $1.77 (bottle) respectively. The budgeted ratio of keg to bottle sales is 30% kegs to 70% bottles (30:70). *Purchases include: packaging (glass, aluminium, cardboard and kegs) representing 60% of material costs; malt (18%); refined sugar (4%); hops (2%) and water (1%). **Wages: Labour costs equivalent to 8.1% of revenue (this reflects the high levels of mechanisation); Labour was split according to factory labour 15%; supervisory labour 15%; sales and admin 70% ****Other costs include: promotions, research and development, administration and legal fees. Promotional activities are more frequent during the summer period, when beer consumption is highest. Taxation: Aside from taxing corporate earnings, the government has a beer excise up to $40.46 per litre of ale, which is passed on to the consumer and not included in this analysis. However, the increase in final price of beer has contributed to the flattening of the Australian beer market. Table 2 Mountain Mist Brewery: Results 2009*
Profit Plan Volume (megalitres)
Sales COGS CM Other Costs Selling and Admin EBIT 52.00 28.45

$Million
132.17 72.32 59.85 9.01 15.16 35.68

Volume (megalitres)
54.60 29.87

Actual $Million
140.10 74.25 65.85 9.28 15.58 40.99

Variance $Million
$7.93 F $1.93 U $6.00 F $0.27 U $0.42 U $5.31 F

*In this analysis, the budgeted market size for beer sales in Australia for 2009 was 1,736 megalitres. However, the actual market size was calculated as 1,730 megalitres.

Part 3: Expansion, incentives and risk management


28

Given the results of the 2009 market analysis, Albert was pleased he had made the decision to expand Mountain Mists production interstate. This decision was made in line with Alberts key objective to be one of the top six major national competitors. Mountain Mist currently holds seventh position. With their nearest competitor, Little Creatures expanding into the eastern market from their Western Australian base, Albert wanted to ensure Mountain Mist would not only maintain market share but grow in size to take Little Creatures sixth position. Albert wanted to improve their brand presence in the western region, as well as reduce transportation costs of moving beer across Australia. A local presence in Western Australia would also help reduce reliance on national retail distribution channels. A production site was selected. A production manager from the Macedon Ranges site was given the role to oversee the operational set up and to stay on and manage the new operations. Others, such as microbiologists from the Mountain Mist laboratory, were also offered the opportunity to move interstate. Thus, Albert moved some expertise from the Macedon Ranges and employed more staff at both sites to meet the new staffing requirements. As well as wanting a smooth manufacturing set-up, Albert argued that it was vital for the Mountain Mist beer to be 100 per cent comparable between manufacturing sites. For Albert, there were a lot of issues still to contend with in relation to sourcing raw materials. Albert also needed to employ a manager to oversee the sales part of the Western Australia venture. He offered the role of Western Australia sales manager to Matt Jerome. Matt was in his late 20s and had been working for Mountain Mist for about 4 years in the administration area as an accounts clerk. He had recently spent time on the administrative work for the new Western Australian operations. Albert was pleased with Matts work and knew he was keen to move from administration and account keeping into managing sales at the new facility. While he has not had any previous sales management experience, Albert was keen to offer Matt this personal development opportunity. Matts salary comprised a base salary and an incentive based on sales performance. While Mountain Mist had the corporate balanced scorecard (described earlier), they did not link scorecard results to their sales managers incentive plans. Albert was concerned that the balanced scorecard measures would not drive the innovation and risk he required of his sales team. For example, Albert wanted his sales team to continue to have the flexibility to make last minute changes if their customers required. He thought if they were influenced by rigid balanced scorecard performance measures, they might, in fact, be de-motivated. He was also worried that they would work to the measure rather than profit maximization through meeting customers unique, changeable and often immediate needs. Thus, Matt was able to earn a bonus based on the sales generated in the Western Australian region. Matt was also given the autonomy to hire his own sales and administration staff to help manage this new sales division. In addition, Albert left Matt responsible for overseeing both sales and bookkeeping roles. After all, Matt had excelled at his administrative role in the past. Albert had contemplated varying remuneration options for Matt. Although Matt had assets under his control, Albert decided to award Matt on the following incentive structure: 1. Base Salary - $120,000 per annum 2. Individual Bonus based on the Western Australian divisions EBIT (capped at $50,000 per annum) 3. Corporate Bonus - based on Mountain Mist corporate performance (2% share of above budget corporate profit pool) 4. Other 50% private health insurance; relocation expenses for Matts family Matt moved his family from the Macedon Ranges to Western Australia and began to promote Mountain Mist Brewery. The aim was to have manufacturing operations and sales in place for summer 2009/10. 29

Part 4: Strategic asset investment


Once the Western Australian operations had settled and sales were going well, Albert considered further expansion opportunities. Given the mature life cycle status of the brewery industry, declining consumption, strong competition from leading producers as well as competition from substitute products, Albert wanted to expand his business in other value-adding ways. He called on his management team for ideas. One potential idea worth pursuing came from Damien Poulsen, a long-term employee. Damien Poulsen has been Alberts one and only production manager in charge of Mountain Mists spring water. Albert has great respect for Damiens work ethic and long-standing commitment to Mountain Mist. Damien is also a qualified microbiologist and employs a team of experts to extract and process the Mountain Mist spring water for the brewing department. A large portion of the Spring Water Departments (SWD) activities relates to the quality control (QC) function for Mountain Mist Brewery. Their main requirement was to ensure the spring water continually met Mountain Mists strict specifications. The mix of sulphates, calcium, phosphorous and magnesium must be correct as excessive amounts can result in undesirably tasting ales. It can also lead to residue forming on the ale containers. As the spring water from Mountain Mists (Macedon Ranges) spring provides beautifully tasting spring water (free of excessive mineral content) and more than enough spring water for the beer manufacture, Damien Poulsen suggested to Albert that they expand production into bottled water sales. He pointed out that spring water is the fastest growing beverage type in Australia and Mountain Mist would be foolish not to take on the opportunity to participate in this market. Australians spent more than $500 million on bottled water last year. This is a 10% increase on the previous year. The current key competitors in the bottled water market include Coca-Cola Amatil Limited (33.0%); Cadbury Australia Limited (17.0%); P & N Beverages Austrlalia Pty Ltd (12.0%); other (38.0%). These key competitors owned prominent brands like Mount Franklin, Peats Ridge and Cool Ridge. Damien suggested to Albert that a niche marketing opportunity existed and that they should compete with the higher price sparkling and still water brands which included European imports such as San Pellegrino and Perrier. Damien was also aware of exploiting the growing market sensitivities towards increased water consumption. For instance, climate change has increased demand for bottled water (because of the extended hot summers). However, the demand remains high throughout the cooler seasons of the year for other sports and healthrelated reasons. The factors that significantly contribute to increasing demand for bottled water include general health awareness and greater knowledge of the benefits of adequate water consumption; the concerns about the microbiological condition and taste of tap water in some regions; and, many consumers are beginning to acknowledge bottled water as a healthy alternative to high sugar soft drink consumption. In Damiens proposal, he outlined the cost structure required for the bottled spring water proposal. He built on his figures from the following 2009 Bottled Water Industry report which he obtained from IBISWorld. He based his figures on the average retail price for 1 litre of bottled water - $2.53. Damien outlined the purchases that are most significant to this industry. They include containers, labels and other packaging materials. He explained how the costs for water extraction, such as pumping equipment, have been included in the depreciation cost (but mentions that these costs are currently paid for in full by the brewery). Water costs are relatively minor. That is, they do pay the Macedon Ranges Shire Council fees for ground water extraction; however, the fees are insignificant. In the proposal Damien also mentioned that he could draw on existing labour for the production processes, but will need a small number of additional staff to handle the clerical, sales and marketing functions. The total labour costs are equivalent to 14.7% of revenue. In this machine-intensive industry, approximately fifty three per cent (53%) of total labour is required for managerial, clerical, sales, marketing and other functions. The remaining 47% labour is involved in bottled water production. Damien included asset acquisitions and associated depreciation costs in his proposal. To begin, he included full depreciation costs on existing equipment required for the filtration, UV sterilisation and zonation 30

processes that remove undesirable compounds and organic elements from the spring water. Damien also included the purchase of new assets such as computerization and automated bottle production lines in his depreciation costs. In addition, he included the purchase and depreciation on two trucks required to transport the bottled water to distributors from its Mountain Mist source. In Damiens list of acquisitions required, he made mention of new legislative requirements associated with environmental emissions. With this impending legislation, Damien was required to allocate funds towards the newly implemented Carbon Pollution Reduction Scheme (CPRS) in order to measure, monitor and report on the Mountain Mist carbon emissions. For this legislative requirement, Damien would need to allocate a percentage of staff resources (15% of one fulltime employees wages) and equipment to correctly measure their carbon emissions. He did note that this additional cost would have been incurred regardless of the decision to invest in the bottled spring water project. Damien also included accounting, auditing, repair, maintenance, market research and advertising as a component of other costs. Marketing is a significant cost to the bottled-water industry given the need to differentiate a largely homogeneous product. He explained that, in Europe, for water to be designated natural it must be bottled at the spring. This could be an important marketing feature for Mountain Mist bottled spring water - even though Australia does not have such a labeling requirement. He mentioned how competitor water that has been transported in holding tanks to bottlers can risk contamination. As such, water that is not bottled on site may require chlorination which in turn reduces the taste. Mountain Mist water, as it is bottled on site, can truly offer the natural European equivalent marketing feature. Damien explained how they would pitch this style of marketing at the up-market hospitality channel representing pubs, restaurants, cafes, cinemas and arenas. They would also focus on marketing to supermarkets and convenience stores - the major outlets comprising 67% of total bottled water sales but, in this setting, would not compete on price. He pointed out that while price is important (that is, they will compete with house brands and generics), the image, particularly from the large brands, remains the most important factor in establishing market share. The niche market could bare additional costs for perceived additional quality and image created by their brewery arm. The main thrust of Damiens argument was for Mountain Mist to exploit their economies of scope by expanding their beverage offerings. He explained while materials and packaging are the main cost pressures, he was hoping to achieve up to 60% gross profit margin on their Mountain Mist private label bottle water sales. He argued that he could reduce many of the costs outlined in the industry-average table above. For example, their input costs would be reduced as they have the spring water on-site. Rent is not-applicable as Mountain Mist owns the Macedon Ranges facilities. In addition, wages, much of the depreciation and other costs can be allocated to the brewing division as they are currently paying for them anyway. As Albert evaluated Damiens $30million bottled water proposal, he also scanned the attached 2009 IBISWorld industry report which detailed the following key success factors in the bottled water manufacturing industry: control of distribution arrangements - arrangement of distribution ensure timely delivery, low costs and maximised product reach; economies of scope - economies of scope refers to the efficiencies in distribution, marketing and administration when a firm produces a wide range of beverage brands; having a good reputation - first movers have an advantage in this industry in that they can establish strong reputations, which new competitors need to spend heavily on marketing to match; market research and understanding - market research into consumer profiles, attitudes and preferences are important for informing both brand promotion and bottle and label design;

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marketing of differentiated products - product innovation and differentiation (including packaging) contributes significantly to selling the industry's products; economies of scale - scale economies are very important to a low value product since high volumes must be produced and sold to achieve reasonable profits; establishment of brand names - strong brand names contribute to the appeal of bottled water as an accessory, as well as building a product's reputation of quality. This allows bottlers to both win market share within particular consumer segments, and to charge premium prices; attractive product presentation - the design of the bottle is of importance in winning market share and justifying higher pricing in this competitive industry; effective product promotion - use of in-store merchandising can have a strong influence on consumer choice.

This all sounded quite interesting to Albert, but he did wonder at the impact of the carbon pollution reduction scheme and the more recent negative publicity bottled water was receiving. The following environmental statistics raised issues they could not ignore when evaluating this proposal: Tap water has only 1 per cent the environmental impact of bottled water. Bottled water production generated an estimated 600 times more CO2 than tap water. One bottle of water has the same impact on the environment as driving a car 1km. More than 65 per cent of water bottles actually end up as landfill. Australia's love affair with bottled water was costing the planet 314,000 barrels of oil a year Australias annual use of bottled water generates more than 60,000 tonnes of greenhouse gas emissions - the same amount that 13,000 cars generate over the course of a year. Albert wondered at the viability of Damiens $30million proposal.

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COWMILKA (2)
Gillian Vesty Department of Accounting and Business Information Systems Part 1: Introduction to strategy, planning and control at Cowmilka
Cowmilka3 is an Australian dairy co-operative run jointly by over 640 Australian farmers and 500 employees. It is situated in Victoria, where more than 60% of all Australian dairy farming is located. The western Victorian countryside with lush pastures has traditionally been recognised as a popular region for Australian dairy farming. Cowmilka originated in this region as part of a joint venture between 20 founding farmers. They were individually responsible for their own marketing and milk production, however, as competition intensified, the farmers came together in order to achieve economies of scale. Since formalising the Cowmilka Cooperative in 1928 Cowmilka now processes approximately 650 million litres of milk each year. Collectively Cowmilka has grown to become a well known medium-sized co-operative with a total herd of around 200,000 dairy cattle and exports amounting to 70,000 tonnes of manufactured dairy products annually. Currently Cowmilka operates and competes in the following markets: milk products (whole milk and skim milk powder; milk, cream and whey), cheese and butter. The farmers (who supply the raw ingredient, milk) and Cowmilka employees are all committed professionals with a passion for dairy. This is formalized in the companys vision (see below) and belief statements which are widely communicated to all employees: Cowmilkas vision is to be a leading Australian co-operative. We strive to offer quality products and embrace change through innovation. Most importantly we value our people, customers and community. We build for the future. Cowmilka prides itself on being able to pay its farmer members the highest possible price for their milk. As a joint initiative Cowmilka Co-operative have developed a strategy based on growth, efficiency and innovation. It is a widely shared belief that Cowmilka value is created by: Growth in exports and value-added products; Efficiency in production and logistics; and Innovation in product development and processes.
3

While this is a fictitious company, some actual industry facts have been obtained from sources such as IBISWorld 2009 dairy industry reports.

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Cowmilka Co-operative ensures their vision continues to be communicated to their stakeholders (farmers, customers, creditors, employees and the local community) through regular newsletters, email and intranet correspondence. They also have a well maintained website which helps formalise their vision. In addition, senior management conduct formal monthly staff meetings. Divisional executives from the two major product groups are encouraged by their Chief Executive Officer (CEO) to maintain informal discussions with their operational staff and undertake regular plant tours as part of their management control activities. As mentioned above, 70,000,000 kilograms (70,000 tonnes), or 60% of Cowmilkas manufactured milk products, are exported every year. The exports comprise cheese (18,000,000 kgs), butter (12,000,000 kgs) and powdered milk products (40,000,000). Cowmilkas export markets include Japan, Malaysia, Philippines, United States and China. Currently, Japan is the largest export destination for Australian powdered milk products and cheese with the expectation that there will be further export growth into other markets. Globally, the dairy market is dynamic and current milk demand outstrips supply. However, in Australia the volumes have significantly reduced over the last few years as the ongoing drought in Victoria has reduced milk yields. Dairy farming is a water intensive industry and requires irrigated pastures for plentiful milk supply. As a result, many farms now rely on purchased feed and irrigation with the number of dairy farms in Australia being substantially reduced. The cost of inputs in relation to output prices has risen dramatically because of the drought. To successfully achieve the necessary economies of scale required for international competitiveness, dairy farms are trending to larger size and scale. That is, on average there is a move towards larger fodder crops, greater herd numbers, increases in volume of milk production and milk yields per cow. Currently there is also an increase in purchased inputs per cow. Dairy products, like all commodities are impacted by world demand, supply, exchange rates and financial markets. In particular, milk, cheese and butter commodity prices have fluctuated over the past few years (refer Chart 1: World Dairy Product Price Fluctuations). As can be seen in Chart 1 below, all dairy commodity prices are down due to the current global commodity downturn. As a result of the drought and market price fluctuations it has been difficult for Cowmilka to fully realise their budgeted growth in volume over the last couple of years. In addition, the butter market has come under threat as consumers have begun switching to vegetable-based products (margarines). While this trend was turned around somewhat in the 1990s with innovations in butter blends (i.e. spreadable butter) in the long-run there remains to 34

be a gradual decline of butter consumption arguably due to consumer health concerns, taste changes and increasing dairy prices. Butter is now viewed, by retailers, to be a luxury commodity.

Chart 1: World dairy product price fluctuations

Source: abare.gov.au

The executive management team, run by Cowmilkas CEO, Murray Gray, had recently met to discuss their strategy going forward. Murray Gray had asked each of the division presidents to review their existing operations and strategic plans and consider further opportunities that might be more closely aligned with the overall Cowmilka strategy identified above. The meeting was conducted with the following executive management team: Murray Grey, CEO Curtis Way, C&B President Sandra Gretrudis, Milk Products President Angus Red, Logistics President Caruthers Bunga, Centralised Services President Freda Holstein, Centralised Services (Finance) Bart Galloway, Centralised Services (Marketing)

Part 2: Cowmilka structure and functions


As mentioned above Cowmilka has two core manufacturing divisions, managed as profit centres and structured around the following product groups: 35

Milk Products (MP); and Cheese and Butter (C&B); Each division is functionally structured with back-end specializations in research and development (R&D) and manufacturing. Cowmilka also have a large Logistics Centre (LC) and a large Centralised Services (CS) department both managed as cost centres. Managers from each division and cost centre report directly to the CEO. The CS centre operates the administration, finance and human resources (HR) functions. HR oversees recruitment, staffing and the health and safety training programs for all Cowmilkas operations. For example, nearly all Cowmilkas employees are required to have up-to-date food handling, health and safety qualifications and must pass a short computer generated health and safety test before entry is allowed onto any of Cowmilkas operational sites. The finance team perform a variety of internal management accounting functions, the most important being budgeting and performance measurement. They are also active in asset management, payroll as well as financial reporting functions. The administration role comprises a range of centralised support functions such as legal compliance, stakeholder communication, advertising, information systems support and website maintenance. The LC centre is a very large and important operation for Cowmilka. It is charged with managing milk supply (and other inputs), the refrigerated warehousing and delivery of the finished cheese, butter, fresh milk and other milk products. They also assist the two profit centres with the large customer order processing. They manage their own fleet of 25 milk tankers and refrigerated trucks. In addition to the LC administrative staff, they employ a large team of drivers and maintenance crew. To coincide with both morning and afternoon milking runs, the tanker drivers collect the milk, twice daily, from the co-operative farms and deliver it fresh to the Cowmilka manufacturing site which is located within a 30 kms radius of the majority of Cowmilka farms. Cowmilka has one large manufacturing plant, with five main production lines. One production line is dedicated entirely to the manufacture of butter; another to cheddar cheese production; while three lines are dedicated to the processes of milk, cream, milk powder and whey production. Angus Red, the LC manager oversees the entire Logistics Centre costs. He charges the two profit centres with the supply chain logistics costs from inputs to delivery of outputs. While he charges both the C&B and MP divisions according to the transfer pricing policy in place, both divisional managers continually voice their concerns at these actual full cost charges. For example, at a recent meeting with Murray Gray, Curtis Way and Sandra Gretrudis both pointed

36

out that they were a captive customer for the LC. They argued that they could probably have their deliveries conducted more cheaply by the local Western District Transport Company! In addition to the transfer pricing issue, Curtis and Sandra must meet regularly to negotiate production capacity issues and milk supply. They meet with their marketing teams at least once a week to discuss production planning and milk allocations among the varying Cowmilka products. At times these meeting can be strained. They are required to accurately forecast customer orders to optimise plant efficiency and ensure the adequate sharing of the scarce resource, milk. The manufacturing production lines are managed by the associated C&B or MP division and each line manager is held accountable for production output. Wastage is expected to be close to zero and poor forecasting results in high production run set-up/change-over costs; and, most importantly, milk wastage. At the moment all plants operate 24 hours a day for 7 days a week with capacity to produce around 650 million litres milk/year. Quality control is essential.

Part 3: Cowmilka Cheese and Butter Division


The C&B division, managed by Curtis Way, is under some pressure from the CEO to review their existing operations. Since the introduction of spreadable butter innovations in the 1990s, research and development (R&D) at the C&B division appears to have stagnated. Cowmilka C&B have tended to pursue a cost leadership position with their cheese production. They currently are a large supplier of packaged cheddar block cheese (250gm; 500gm; 1 kg) and shredded cheese packages into supermarkets on contract agreements. The supermarkets market the Cowmilka products under their home brand labels. Curtis Way realised the need to diversify, but he had to manage this in such a way that any new business would not compete or conflict with their existing important supermarket contracts. Of all the options Curtis had investigated one was the acquisition of a small New Zealand cheese company called Fintona Cheese. Curtis believed this acquisition would allow C&B to expand their existing product range into the previously untapped niche feta cheese market. Fintona Cheese is a specialized cheese plant with state-of-the-art manufacturing capabilities. They are known for their feta cheese, Fintona Feta, which is sold to specialty gourmet suppliers. Feta cheese is made of 70% sheep milk and 30% goat milk, so quite a different proposition for Cowmilka which has not previously considered diversifying from their traditional cow milk product range. Nevertheless, Curtis was not concerned about this difference. In fact he was excited by the opportunity presented by the Fintona Cheese acquisition. According to industry 37

analysts, the specialty fresh cheese market, of which feta is the significant product, is the market that is most likely to increase market share and offers a good way for manufacturers to add value (see IBISWorld Report, 2009). In Australia, specialty fresh cheese (i.e. feta) accounts for 23% of the total cheese market with cheddar cheese accounting for 49% of the total cheese market. This segmentation is detailed in the following Table 1 below.

Table 1: Australian Cheese Product Segmentation

Source: IBISWorld Cheese Manufacturing Report, 2009, p.6

Fintona Cheese is a highly regarded competitor in the New Zealand market; have loyal customers and a friendly sales team managed by a strong leader. Curtis has managed to negotiate a price of $30 million dollars with the current owner of the firm. The price requires the owner to stay and run the Fintona operations for a period of at least 12-months. The manager indicates he may not stay with the company after completion of this contract period. Curtis is hoping that one of Fintonas senior managers or someone from the Australian Cowmilka operations may be in a position to take over control at this time. In addition to strong local sales, Fintona has recently begun marketing their Fintona Feta internationally and sales forecasts indicate that sales will continue to grow and production will be at capacity. Curtiss calculations project reasonable returns from the Fintona Cheese operations for the next few years. Curtis added the Fintona Feta sales and cost of good sold data to his existing 2009 profit plan to come up with an average selling price and budgeted cost of goods sold for all cheese. He knew this information did not contain the level of detail required in long-run planning, but thought it would be enough to present to the board as part of his asset acquisition proposal. At an aggregate level this performance report (see Table 2 below) was also limited in information required for profit planning for the following 2010 production year. While he was broadly able to calculate the market size and market share variances, he could only do this for the combined 38

cheese manufacture. In addition, Curtis was also unable to discern any product mix variances from this level of aggregation. He would speak with the management accountant from the CS centre about developing more detailed reports for his analysis. In the meantime, he began gathering as much information as he could from his existing Cowmilka performance reports, the Fintona aggregate performance reports (collected during due diligence) and other external market information, such as that gathered from IBISWorld, 2009 Cheese Industry report.

Table 2: Cowmilka Cheddar & Fintona Feta combined performance report Cowmilka Cheese & Butter Division Cheese Group Performance Report 2009
Budgeted Volume (kg) 31,250,000 26,562,500 Budgeted Sales $ 125,000,000 79,687,500 45,312,500 30,000,000 15,312,500 Variance Flexible Budget 118,750,000 75,703,125 43,046,875 30,000,000 13,046,875 Variance 14,843,750 -9,203,125 5,640,625 5,000,000 640,625 Actual Volume (kg) 29,687,500 26,125,000 Actual Sales $ 133,593,750 84,906,250 48,687,500 35,000,000 13,687,500

Sales Data Cost of Goods Sold Contribution Margin Operating Costs Net Profit

-2,265,625 -2,265,625

Please Note: The numbers presented here are different to reality. In this table the budgeted volume = homogenous unit of expression for a heterogeneous units of input

Additional Information: 1. Market Size Budgeted market size for cheese Actual market size for cheese 625,000,000 kg 575,000,000 kg

2. Sales and COGS data Cheddar cheese accounts for 96% of sales; feta cheese accounts for 4% of sales (i.e. total budgeted cheese production for Cowmilka for 2009 before Fintona acquisition was 30,000,000 kgs). Feta cheese profit margins are 25% higher than cheddar cheese. Budgeted selling price Actual selling price $4.00 $4.50 Budgeted COGS per kg Actual COGS per kg $3.00 $3.25

The selling/COGS represents the average selling price or COGS for the combined Cowmilka Cheddar and Fintona Feta cheeses. Note: Curtis wants the sales/COGS information disaggregated into Cheddar and Feta

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3. COGS and Selling and Admin cost information Total cheese production costs include: Raw material purchases (cow milk; sheep milk and goat milk; packaging) Wages (divided as supervision and direct factory labour) Utilities (COGS and S&A related costs) Depreciation (COGS and S&A related costs) Tax Other*

75.8% 9.1% 3.0% 2.5% 0.6% 9.0%

*Other includes maintenance, deliveries, selling expenses, advertising, admin salaries. Curtis only has the total cost information. He will require this to be analysed in more detail by the accounting department 4. Average rainfall effect Finally, it was mentioned earlier that the average rainfall in Australia can impact the production of cheese due to changes in milk production. For example, unfavourable weather conditions reduces water availability, hence milk production because of reduced pasture availability. This in turn increases production costs because of the increased demand for supplementary feeding requirements. Curtis wants to include a weather effect in the final profit performance. As a rule of thumb, he estimates that for every month where there is a lower than average rainfall, the cheese production will be reduced by 0.8%. Curtis budgeted 8 months of below average rainfall for 2009. However, actual rainfall results demonstrated that the full 12 months of 2009 had below average rainfall. With this information, Curtis Way approached the management accounting team and asked them to, at the best of their ability, construct a spreadsheet that he could use to evaluate potential profit performance for his combined Cowmilka/Fintona entity.

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Paiges Fashion House


Paiges Fashion House is a small boutique clothing manufacturing and wholesale company; employing 100 staff in design, manufacturing, sales and marketing functions. Up until now, Paige has managed with a central oversight function, which required minimal planning and budgeting. However, her operations have grown and senior managers have been employed to manage each of the functional areas. Paige realises her simple budgeting processes need reviewing. Paige ensures that members of her staff regularly attend international fashion shows (for design ideas) as well as become involved in the Australian fashion shows. While these are costly events to attend, Paige considers them a necessary function of their business activities as it is important to maintain a high profile as an up and coming design group. The design team always work in advance; designing garments for the following seasons. A considerable proportion of their time is spent working on the formal collection. The formal garments are recognised in the industry as the haute couture range; highly expensive and exotic garments. They bring the wow factor to the fashion parades. Paige often dresses celebrities in her latest Formal range when they are attending high-profile Australian events (like the Logies, the Brownlow, DallyM, Allan Border Medal presentations and the Spring Racing Carnival). The Formal range is the signature style on which the other regular Street-Wear designs (i.e. the casual and denim jeans range) are created from. The Street-Wear range is the main income earner for Paiges Fashion House. Her design team also designs shoes and bags to match with every seasons range. These are made for Paiges Fashion House by a high-quality Chinese manufacturing company. The companys large expense items are the fashion show costs; advertising expenses as well as the cost of preparing sample garments for fashion parades and celebrity wear. Distribution is generally through a local transport company who will deliver both small and large customer orders. Paiges Fashion House sells their range in 20 fashion outlets around Australia. Two are very large national department stores and the other eighteen are fashion boutiques of varying sizes. Their credit terms vary depending on size of the store. The large department stores manage to stretch payment terms to 120 days; however Paige tries to enhance her cash flows with large deposits to be paid on order and 30-day balance payment terms at the smaller boutiques. Paiges Fashion House try to extend their own accounts payable as much as they can; but given they are not a large organisation they have trouble getting credit terms beyond 30 days. They also have to pay a considerable proportion of costs upfront to the bag and shoe manufacturer. In addition, they need to have inventories of raw materials (fabrics, threads, zips, buttons, labels, etc) well ahead of time to ensure they can supply once the product range is launched. This is also necessary for the bags and shoes which are ordered and shipped in advance. The spreadsheet below (Table 1) provides an overview of the proposed profit plan for the 2010 Spring Collection product range.

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Table 1: Profit Plan Paige Fashion House 2010 Paige's Fashion House - Spring Collection Profit Plan 2010 Fashion Line Street-Wear Denim Jeans Casual 8 10 Accessories Formal Bags 6 4 Shoes 8 1,386,000 1,026,300 359,700 95,955 263,745 23,776 79,925 17,985 43,955 16,978 28,970 211,589 52,156 15,000 14,250 5% 54,000 43,200 20% 15,000 12,000 20% Total

Income Statement No. of new lines

Total Sales 320,000 640,000 Cost of Sales 224,000 448,000 Contribution Margin 96,000 192,000 Fixed Manufacturing Costs Operating Margin Expenses R&D Marketing Fashion Shows Cost of Sample Garments Advertising and Other Distribution General & Administration Total Expenses Net Income Average Sales per line Average Cost of sales per line Gross Margin% (Target = 30%) Expenses % of sales (Target = 20%) Net Income Margin (Target = 10%) Balance Sheet (Selected items only) Current Assets Inventory Accounts Receivable A/R as % of sales Current Liabilities 40,000 28,000 30% 64,000 44,800 30%

90,000 216,000 120,000 85,500 172,800 96,000 4,500 43,200 24,000

19% 22% 4%

123,156 346,500 25% 42

Accounts Payable A/P as % of sales Shareholders' Equity ROE (Target = 8%)

207,900 15% 920,000 6%

This was the first time that Paige had prepared a profit plan. Before decentralisation, Paige had a pretty good idea about sales volumes, purchasing and manufacturing requirements. However, as the fashion house expanded, it became increasingly harder for Paige to keep on top of the accounting requirements. She agreed the profit planning exercise, while complex at the outset, had certainly made her job easier this year. Now the end of the 2010 financial year has arrived, Paige

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has decided to take her analysis further by having a closer look at her profit planning exercise.

Table 2: Paige Fashion House - Profit Plan 2010

Paige's Fashion House Street-Wear - Jeans Product Range - Profit Plan 2010 Budget Paige's Denim Jeans Range 2010 Sales Data Regular Jeans (6 lines) Designer 'Paige' Jeans (2 lines) Total Sales Cost of Goods Sold Cost regular jeans Denim (metres) Other materials - studs/zips/threads (kg) Labour (hours) Cost Designer 'Paige' Jeans Denim (metres) Other materials - studs/zips/threads (kg) Labour (hours) Total Costs Contribution margin Other Fixed Costs S,G & A Expenses 400 31 200 16,000 687 13,000 224,000 96,000 29,243 23,510 -3,200 -137 -2,600 3,055 19,200 824 15,600 99,056 29,243 23,510 480 -37 -240 1,411 -2,486 -1,646 480 37 240 18,720 861 15,840 196,832 100,468 31,729 25,156 6,250 266 1,563 112,500 2,125 79,688 10,116 191 7,166 102,384 1,934 72,522 20,477 -3,626 -1,422 5,119 242 1,422 81,907 5,560 73,944 3,125 200 3,325 250,000 70,000 320,000 -22,480 14,000 -8,480 227,520 84,000 311,520 -14,220 0 -14,220 2,844 240 3,084 213,300 84,000 297,300 Volume $ Variance Flexible Budget Variance Actual Volume $

Net Profit 43,247 3,055 46,303 43,583 *S, G & A Expenses (See Table1) are allocated evenly across the three revenue-generating downstream divisions (Street-Wear; Formal; Accessories). The decision for an even allocation across these divisions relates to the benefits each of the product groups have due to the successful reputation and branding of Paiges Fashion House. Other Fixed manufacturing costs are allocated only to the Street-Wear and Formal Divisions as they are responsible for manufacturing costs. The split is made according to total sales. Street-Wear further split their proportion across the denim and casual product lines according to sales.

Additional information: Budgeted Market Share 5%; Actual Market Size 70,490 units Paige has now begun the process of evaluating performance by mapping actual profit performance to that which she had budgeted for (see Table 2 above). Some areas have performed better than others. For example, the Street-Wear Denim range had just beaten budgeted estimates. As a start to her profit performance analytics she wondered at the details behind this result? 44

Figure 1: Paiges Fashion House

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The Boeing Company4

1. Introduction The Boeing Company was established by William Boeing in 1916. A merger with McDonnell Douglas in 1977 made Boeing the world's largest aerospace and defense company. Headquartered in Chicago, Boeing employs more than 158,000 people across the United States and in 70 countries. Boeing strives for diversity, talent and innovation from their employees. More than 123,000 of Boeings employees hold college degrees (including nearly 32,000 advanced degrees) in a wide range of business and technical fields. They also aim to leverage the talents of hundreds of thousands of skilled people working for Boeing suppliers worldwide. Boeing has customers in more than 90 countries around the world and is one of the largest U.S. exporters in terms of sales. Two-thirds of their sales are generated in the U.S. Other export revenues come from Europe (14%), China (3%) and the rest of Asia excluding China (12%). The Boeing Company have four major business segments. The operational segments include: Commercial Airplanes, Defense, Space and Security and a finance company, Boeing Capital Corporation (BCC). The Boeing Company also has a Shared Services Group (SSG) supporting the operational activities. Commercial Airplanes: Boeing Commercial Airplanes is committed to being the leader in commercial aviation by offering airplanes and services that deliver superior design, efficiency and value to customers around the world. There are more than 12,100 Boeing commercial jetliners in service, flying passengers and freight more efficiently than competing models in the market. Boeing's commercial airplanes are sold to airlines all over the world. This segment generates roughly half of group revenue and operating profits. The division (59% of revenues, 51% of operating profits and 7.5% profit margins) produces a full line of commercial aircraft, ranging from 100-passenger 717s to giant, 500-seat 747s. The single aisle Boeing 737 is viewed as the workhorse of the sky, accounting for about four out of every five jets that Boeing sells.

This case has been adapted by Gillian Vesty. Some of the information drawn upon has been changed, or embellished in parts for exam purposes. In preparing this the author has drawn heavily on several sources: (1) The Boeing Company website: www.boeing.com; (2) Paduano, R (2001), Boeing Commercial Airplane Group Wichita Division (Boeing Co.): Employing Activity Based Costing and Management Practices Within the Aerospace Industry: Sustaining the Drive for Lean; (3) Airbus v Boeing, Plane Poker, Airbus plays the new engine card, The Economist online, September 30, 2010 accessed at: http://www.economist.com/node/17155860?story_id=17155860.The final SSG section has been adapted from a 1998 IMA case study: (4) Ortega, W. (1998). Alternative Chargeback Systems for Shared Services Group at The Boeing Company: The Case of Voice Telecommunications Services.

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The worldwide commercial aircraft fleet is expected to grow to 20,100 planes by year-end 2020, which translates into a compound annual growth rate (CAGR) of 2.9%. Defense, Space and Security: Made up of varying segments including: military aircraft and missile systems contribute to over one-third of group revenue and operating profits. For this segment, the primary customer is the U.S. government. Boeing's military weapons-making segment primarily make the F-18 fighter jets, the C-17 troop and equipment transport planes, helicopters, the AH-64D Apache Longbow, refuelling planes, and various precision missiles. This segment is also a major producer of computer-based battle management systems used in missile defense applications. Higher margin fixed price production contracts accounts for about 80% of Boeing's defense revenues. Lower margin research & development (R&D) contracts accounts for the 20% balance.
The Space and Security business segment generates only modest profits. For this segment, the primary customer is again the U.S. government. Boeing is one of the world's largest makers of satellite-carrying rockets and satellites. While there is some industry overcapacity and cut-throat price competition Boeing is focusing on the space digital imagery architecture, missile defense, the current Delta IV launch vehicles and the 737 Airborne Early Warning and Control System programs. Since the late 1990s, Boeing has been attempting to transform itself from an aerospace manufacturer into a comprehensive aerospace manufacturing and service provider. Over the past decade, volatile yet maturing markets, intensifying competition, and the commoditization of jets, rockets and satellites, has affected the company's profitability. Boeing has attempted to use new equipment sales as a platform for selling high margin, long-term maintenance contracts, to generate more predictable earnings streams and higher returns. The following are Boeings major U.S. manufacturing sites:

Alabama: Huntsville Arizona: Mesa California: Anaheim, El Segundo, Huntington Beach and Boeing Defense, Space & Security's Long Beach operations Kansas: Wichita Missouri: St. Charles and St. Louis Oregon: Portland Pennsylvania: Philadelphia Texas: San Antonio and Houston Washington: Auburn, Developmental Centre, Everett, Frederickson, Kent Space Centre, North Boeing Field/Plant 2 and Renton

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Boeing Capital Corp: This division is primarily engaged in the financing of commercial and private aircraft, commercial equipment, and real estate. About 75% of the divisions revenues are derived from commercial aircraft and non-aerospace leasing and 25% relates to the financing activity.

Shared Services Group (SSG): This group provides the company's business units and corporate offices with innovative and effective common services that support the competitive design and manufacture of aerospace and defense products 5.

2. Strategy and Performance Measurement at Boeing


Boeing has been impacted by the unpredictable nature of the financial markets (particularly since September 11 and the Global Financial Crisis). Issues for Boeing currently relate to the volatility of aircraft fuel prices, global trade policies, worldwide political instability and impacts to economic growth, acts of aggression that had an impact on the perceived safety of commercial flight as well as competition from Airbus. Climate change concerns have also impacted the global airline industry, a heavy emitter of greenhouse gas emissions. 2.1 Financial Results and Projections Although the industry has been faced with uncertainty and market concerns as mentioned above, the Boeing Chairman, President and Chief Executive Officer, Jim McNerney reported in The Boeing Companys 2009 Annual Report that Boeing has strong 2009 revenue & cash flows based on solid core performance. Table 1 below is a summary of the statements found in Appendix 1(these results have been obtained from Boeings 2009 financial disclosures: www.Boeing.com). Table 2 highlights Boeings forecasts for 2010. "We put a strong finish on 2009 by getting the 787 in the air and generating solid core operating performance across the company," said Jim McNerney. He explains that: "focus areas for 2010 are to continue our strong operational performance, certify and deliver the 787 and 747-8, and further reposition our defense, space and security business. While the challenges ahead are significant, I believe we have the people and the resources we need to be successful and to begin consistently delivering on this company's great potential.

Shared Services Group also provides telecommunications services which become the focus for a detailed activityanalysis later in this case.

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Table 1: Boeings 2009 Summary Financial Results

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Table 2: Boeings 2010 Financial Forecasts

To achieve the desired results for 2010, Boeings senior management have reviewed their strategies in light of key market concerns. A significant change to Boeings strategy relates to the trends in the world-wide commercial airline business. Firstly, the market for the existing narrow-body jets is booming again as airline profits recover and as airline fleets age. The increased demand for single-aisle aircraft fleets has left Boeing with a big backlog of 737 orders. They are considering raising the production rate of 737s from 37 aircraft a month to 40. In a recent interview with the Economist, Mike Bair, in charge of developing Boeings 737 business, says a new aircraft ordered today might not be delivered until 2015 (Economist, Sept 30 2010). The second issue for Boeing is that the airline industry, in general, is faced with increasing fuel costs and tighter margins. There is a push by customers for more innovation or for Boeing to design planes with increased fuel economy. Rather than face a cost of more than $10billion to design new aircraft, Boeing (like its competitor Airbus) are looking at ways to modify engines for improved fuel economy. Mike Blair explains Boeing has squeezed 8% better fuel consumption out of its 737s in the past decade. He points

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out that more savings will be possible by modifications such as fitting larger engines (requiring some minor changes to the front undercarriage). At this stage he does not think it is worthwhile to re-engine the aircraft because the savings would be tiny compared with the extra costs of having two different engines on a fleet of aircraft. Boeing is still considering all its options on the 737even making a new aircraft. It will decide by the end of the year. But, adds Mike Bair, the decision could be to take no decision. By playing its hand close Boeing just might launch an all-new plane five years or so before that.

Thirdly, airlines are now required to disclose (and seek ways to offset) their carbon emissions to address global warming concerns. Boeings strategy and performance evaluation has been impacted as they seek ways to mitigate the wider stakeholder environmental concerns and calls for climate change issues to be addressed not only in their aircraft designs but also in their own production facilities. An influential stakeholder is the government and Boeings operations are increasingly subject to various federal, state (and international) environmental legislation. Boeings focus is on efficiency of processes and minimisation of waste (which includes the discharge of hazardous materials and remediation of their contaminated operational sites). Finally, with increasing pressures on the commercial airline division, Boeings senior executives have looked at expanding other revenue generating areas of their organisation. They are currently working at promoting and repositioning their other operational defense, space and security business segments. The link between strategy and control system design is articulated in The Boeing Companys vision and values. According to Jim McNerney The Boeing Company is a place full of amazing people working in one of the most exciting industries in the world. When you consider our many accomplishments -- from designing and building the earliest biplanes to creating and supporting today's supersonic aircraft and spacecraft -- you might think we would be content with how far we've come. But a company of our size and scope doesn't succeed by resting on its laurels; we are constantly re-examining our capabilities and processes to ensure that our company is as strong and vital as our heritage. In fact, our culture mirrors the heritage of aviation itself, built on a foundation of innovation, aspiration and imagination. The Boeing Companys values and vision are detailed further in the following sub-section.
2.2 Boeings Values and Vision

According to Jim McNerney at Boeing, we are committed to a set of core values that not only define who we are, but also serve as guideposts to help us become the company we would like to be. We truly live these values every day. He explains that this is through:
Leadership: We will be a world-class leader in every aspect of our business. For example, in developing our team leadership skills at every level, in our management performance, in the way we design, build and support our products, and in our financial results.

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Integrity: We will always take the high road by practicing the highest ethical standards, and by honouring our commitments. We will take personal responsibility for our actions, and treat everyone fairly and with trust and respect. Quality: We will strive for continuous quality improvement in all that we do, so that we will rank among the world's premier industrial firms in customer, employee and community satisfaction. Customer Satisfaction: Satisfied customers are essential to our success. We will achieve total customer satisfaction by understanding what the customer wants and delivering it flawlessly. People Working Together: We recognize our strength and our competitive advantage is -- and always will be -- people. We will continually learn, and share ideas and knowledge. We will encourage cooperative efforts at every level and across all activities in our company. A Diverse and Involved Team: We value the skills, strengths and perspectives of our diverse team. We will foster a participatory workplace that enables people to get involved in making decisions about their work that advance our common business objectives. Good Corporate Citizen: We will provide a safe workplace and protect the environment. We will promote the health and well-being of Boeing people and their families. We will work with our communities by volunteering and financially supporting education and other worthy causes. Enhancing Shareholder Value: Our business must produce a profit, and we must generate superior returns on the assets entrusted to us by our shareholders. We will ensure our success by satisfying our customers and increasing shareholder value.

Vision The Boeing Vision is about people working together as a global enterprise for aerospace leadership. Jim McNerney explains that they get there with the ability to:
Run healthy core businesses; Leverage our strengths into new products and services; and Open new frontiers.

Jim McNerney follows: In order to realize our vision, we consider where we are today and where we would like to be tomorrow. There are certain business imperatives on which Boeing places a very strong emphasis. The three important planks underpinning Boeings business practices include: Detailed customer knowledge and focus that understand, anticipate and respond to customer needs. Large-scale systems integration that continually develops and advances technical excellence. A lean enterprise characterized by efficiency, supplier management, short cycle times, high quality and low transaction costs.

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In order to monitor lean production processes at Boeing, Jim McNerney relies on several management accounting tools. For example, he relies on information from the balanced scorecard, a performance management tool that is cascaded throughout the entire Boeing organisation. He also relies on lean accounting techniques underpinned by activity-based costing/management (ABC/M). Current issues associated with the implementation and design of these accounting systems is briefly explained in the following sub-section. 2.3 Accounting system development at Boeing One of the contemporary concerns for Jim McNerney and the senior executive team relates to environmental performance at Boeing. Jim wants his senior executives to think about including their rigorous environmental performance targets in the corporate and cascaded balanced scorecards. For some time Boeing has responded to the serious challenges associated with global warming and has been committed to improving the environmental performance of its operations, products and services. Jim claims that their greatest contribution to meeting the challenge is to pioneer new technologies for environmentally progressive products and services -- and to design, develop and build them in an environmentally responsible manner. The management team (with the help of consultants) are currently working through a strategy mapping exercise to see where and how they might include these important sustainability goals. Boeing already have aggressive targets for improving environmental performance both for its operations and the lifecycle of its products, but these measures and targets are relatively long-term measures and have not yet been embedded in daily operational activities, nor have they become included in a meaningful way in the Boeing balanced scorecard. The enterprise-wide performance targets include the following: 25 percent reduction in greenhouse gas emissions (as a % of revenue); 25 percent reduction in energy consumption (as a % of revenue); 25 percent reduction in water consumption (as a % of revenue); 25 percent reduction in hazardous waste generation (as a % of revenue); and 25 percent improvement in solid waste recycling rates (on a total or "absolute" basis).

Boeing has set these targets for their major production facilities and is in the process of monitoring them over a 5-year period between 2007 and 2012. The Environmental Manager points out we are currently on track to achieve each of these targets. While aggressive, they will ensure that we conserve valuable resources. In 2009, we recycled 68 percent of the waste we generated, up from 64 percent the previous year. We outperformed our 2009 plan for hazardous waste reduction by 12 percent, and outperformed our plan for improving energy efficiency and reducing greenhouse gas emissions by 3 percent. They have also committed to continuing their dedication to environmental design innovation by: 53

Ensuring each new commercial airplane generation delivers at least a 15 percent improvement in carbon dioxide emissions and fuel efficiency; and Directing more than 75 percent of commercial airplanes research and development to benefit environmental performance.

This commitment is exemplified in the company's newest commercial airplanes, the 787 Dreamliner and the 747-8, which are both designed to be more fuel and CO-efficient than the airplanes they replace.
Jim McNerney explains that Boeing is committed to regulatory compliance and has a legacy of environmental performance improvements in its products and services. Jim is insistent that Boeing embed environmental thought and action into everything they do. Appropriate performance management design fosters this commitment and enables employees, through information sharing and learning, to then drive change throughout the entire organisation. A correctly managed design will ensure the sustainability strategy fits within Boeings desired lean methodology. For a long time now Boeing has implemented ABC/M at various sites throughout their operations. In the production facilities it is used to support the comprehensive lean production strategy which encompasses everything from asset management, to design for manufacturability, to cost of quality. Using ABC/M at Boeing encourages detailed analysis at the production level, providing mangers with better information to monitor set-up and running costs, costs of scheduled and unscheduled maintenance, costs of asset failure and costs of manufacturing capacity. ABC/M also provides analysis on the costs of design changes in configuration as impacted on the manufacturing floor; and, costs of incorporating complexity into a configuration design. The cost savings through using activity analysis is designed to uncover non-value added processes that depress value creation capabilities. It gives managers the power to target processes for elimination or improvement. In this way the manufacturing manager can identify specific activities with lean initiatives designed to reduce the cost of the non-value added activity. In Jim McNerneys opinion ABC/M ties together the whole organisation and nurtures a culture based on waste elimination, response time reduction, product and process design simplification, and quality improvement. However, ABC/M is mainly used in the manufacturing operations at Boeing. While this methodology has been drawn on sporadically by the Shared Services Group (SSG) ABC/M is still fragmented throughout Boeing and Jim knows it needs to be revisited again. Jim McNerneys attention has more recently been drawn to the SGG because of the grumbling from his divisional CEOs about the SSG chargeback rates as well as allocations coming from Boeings corporate offices. The main complaints have arisen out of the increasing charges for telecommunications which includes the supply and maintenance of computer, laptops, and fixed and mobile telecommunication equipment.

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And Jim thought it about time he reviewed some of the earlier decisions that had been made in relation to overhead allocations. With the rapid technological advances, the last ten to fifteen years at Boeing has seen considerable change. The SSG has not been immune to this change. Jim remembers, like it was yesterday, the digital and analogue telephone lines, the pagers (not mobile phones) that his executives and senior managers carried around with them. He remembered how important it was for messages to be left on office voice mail and the main tool for communication between Boeing employees and their customers and suppliers was the fax machine. Computers, emails and mobile phones were only beginning to impact. This was the area that Jim would start with.

3. Shared Services Group (SSG) at Boeing: Telecommunications service chargeback SSG provides The Boeing Company's business units and Corporate Offices with innovative and effective common services that support the competitive design and manufacture of aerospace and defense products. The group provides a broad range of services worldwide, including facilities services, employee benefits and services, recruitment, wellness programs, security, fire protection, site operations, disaster preparedness, construction, reclamation, conservation programs, virtual workplace, creative services, transportation, business continuity and the purchase of all nonproduction goods and services. It also offers comprehensive travel services to Boeing employees. In addition, SSG also manages the sale and acquisition of all leased and owned property. Jim points out that through better integration of services, SSG can deliver greater value, create "lean" processes and operations, leverage buying power and simplify access to services for all of Boeings employees and operational groups. The facilities department within SSG provides employees with telecommunications. This includes the provision of the communication infrastructure and direct support, in particular providing the Boeing Company employees with phones, mobile phones, desktop and laptop computers, and teleconferencing. They pride themselves on delivering an end-to-end telecommunications service, beginning with requirements analysis at the initial stage of the life cycle, carried through to the design, implementation, operation and maintenance of the infrastructure. Their service concludes with the retirement of all hardware. The elements of the services provided are shown in the following Table 3. Table 3: Telecommunication Service provision by SSG
Networking Component products Basic telephone service (local access only) Internet access Access to mobile telephone service Access to long distance service Voice mail (offsite email access to voice mail) Station telephone products

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Personal and Independent Products User Services

Computer workstation (PC and monitor) Teleconferencing system Security products Mobile phone services Computer/Laptop services Emergency satellite Facsimile machines Operator service Technical call assistance In-flight emergencies Teleconferencing support Add, move, and change for new and existing services Telecommunications consulting

In 2008 the monthly cost to provide telecommunication services was over $14 million. The grumbling about billing from shared services had gone on for years, for different reasons. In the late 1990s SSG used a detailed activity-based chargeback system for the provision of their telecommunications services to the Boeing Companys operating divisions. This was a complex billing system where costs were allocated to 421 different organisational units using 29 different rates. Each component of the service had its own rate which was calculated using a separate cost pool. By the mid 2000s this complex system was abandoned. SSG believed too much detail was being provided to the lowest level of the organisation and the cost associated with providing this detail just wasnt justified. Accordingly their charge for telecommunication service was simplified. A simple allocated cost system was introduced whereby Boeings total telecommunication costs were allocated according to the number of salaried employees in each division. Salaried headcount was chosen as the allocation base because it was viewed as the most significant driver of the telecommunication costs. In the new simplified system, costs were billed at a high level, with 24 organisational units receiving monthly cost allocations. In 2005, the rate was $76.84 per person. By 2009 the rate had increased to $91.84. In Table 4 below the 2009 telecommunication budget and the calculation of the 2009 rate is provided. The simplified billing procedures saved Boeing several million dollars a year in labour and non-labour costs (defined as soft and hard costs6). Organisation-wide it eliminated the need to track endusers budget numbers and over 50% of the routine reporting. The cost savings to the operational divisions was estimated to be $2.7 million. For SSG direct costs savings from the simplified system were estimated to be $1.4million a year.
6

Hard savings were savings that could easily be measured, such as headcount and computer time reduction. Soft savings were productivity-improvement items that were more difficult to quantify. For example, attending fewer meetings, reducing the time spent reviewing reports, and answering fewer questions from the internal customers.

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Table 4: 2009 Telecommunications Budget and Chargeback Rate Service Provided Monthly Budget Telephone Service Lines $2,910,976 Internet Hub $353,834 Computer Equipment $764,556 Telephone Equipment $520,703 Facsimile Machines $161,151 Mobile Phones $289,904 Internet data download $832,448 International long distance $643,455 Local calls $237,583 Telecommunication Services Support $115,846 Design and Build $252,973 Add, Move and Change $3,027,101 Operate, Sustain and Support $773,479 Common Product Support $1,787,840 Use and Occupancy $115,761 Taxes $790,614 SSG Administration $393,528 Other Administrative Costs $455,192 Total $14,428,061 2008 Salaried Workforce 157,100 Monthly Rate Per Salaried Employee ($14,428,061 $91.84 157,100) Changes to the simplified chargeback system During the simplification process, many managers raised concerns regarding the lack of detailed reporting associated with the simplified system. They believed that if telecommunication costs were billed at one average rate customers would over-consume the services provided. For example, some managers were concerned that everyone would order mobile phones and laptops because it would not affect their monthly cost allocation. Other managers were concerned that telephone usage and internet downloads would increase as employees would conduct personal business at work. The problem of overconsumption of service was to be controlled by establishing a companywide Telecommunication Standards Board that developed uniform standards and policies for the use of the telecommunications services. These policies were based on business needs and were to alleviate superfluous consumption of voice services. For 57

example, a person could have a mobile only if there was a bona fide business reason to have one. To curb the possible abuse of telephone or internet service, employees were told that detailed reports could be generated (but this would only be done on an exception basis or as a random audit). The philosophy of the simplified chargeback system was that SSG was responsible for managing the cost of telecommunication services as a whole (i.e. providing the required level of service at the lowest cost) and the customer was responsible for managing the consumption of services. However, the consumption of services was managed through standards and policies, rather than by detailed reports generated by the accounting system. When the simplified system was adopted, it was widely believed that the cost savings (both hard and soft) outweighed the fact that the new system was a reversion from an activity-based system that assigned costs on a causal basis to a simplified system that allocated costs using one average rate. By the late 2000s the complaints began again. This time it was the argument that monthly telecommunications services didnt reflect the amount actually consumed. And that the standards and policies developed by the Telecommunications Standards Board had not worked as originally intended and the consumption of services had gone up unimpeded. At the time, Mike Burton, Manager of Accounting Policy at The Boeing Company, agreed usage was increasing (see Table 5 below for details of the growth of the services over the last 4 years). But he wondered was this a reflection of the simplified chargeback system or was it due to a change in technology? Some managers argued it was normal to see the growth in services because these are increasingly important tools that employees need to conduct their jobs. He wasnt sure how much the existing simplified system distorted the cost allocations. Were employees over consuming telecommunication services because the existing system failed to charge them for it? Would the added cost of a newly proposed activity-based system be offset by reductions in consumption? What role should the chargeback system play in influencing employee behaviour? Table 5: Salaried workforce Levels and Telecommunication Services 2005-20098 Panel A: Salaried Workforce/ Services 2006 2007 2008 2009 (Volume) Salaried Workforce (number) 137,695 144,094 144,136 157,100 Phone lines and computer hubs (number) 114,096 122,329 129,449 135,068 Computers (number) 36,100 52,369 75,118 86,515 Additional computer monitors (number) 11,277 12,085 13,402 15,412 Local and mobile calls (minutes) 58,751,676 63,697,616 71,254,928 75,052,500 International long distance (minutes) 6,160,670 6,472,006 6,742,060 7,299,221 Mobile phones 14,400 21,400 34,641 40,355 Laptops 913 1,556 2,458 2,950 Add, move and change (# of orders) 119,211 146,040 185,880 217,187 Facsimile Machines (number) 2,180 2,319 2,684 2,713 58

Panel B: Percentage Increase

Salaried Workforce (number) Phone lines and computer hubs (number) Computers (number) Additional computer monitors (number) Local and mobile calls (minutes) International long distance (minutes) Mobile phones Laptops Add, move and change (# of orders) Facsimile Machines (number)

Cumulative increase 2006-2009 14.09% 18.38% 139.65% 36.67% 27.75% 18.48% 180.24% 223.11% 82.19% 24.45%

2006-7

2007-8

2008-9

4.65% 7.22% 45.07% 7.17% 8.42% 5.05% 48.61% 70.43% 22.51% 6.38%

0.03% 5.82% 43.44% 10.90% 11.86% 4.17% 61.87% 57.97% 27.28% 15.74%

8.99% 4.34% 15.17% 15.00% 5.33% 8.26% 16.49% 20.02% 16.84% 1.08%

The call for change came from managers who believed the simplified system had overcharged them. These managers are under pressures to reduce costs and see the telecommunications charge as a way of achieving this objective. For example, Steven Ryan, Manger of Boeings Huntsville Operation, has been furious with the magnitude of his telecommunication changes. He contends the existing system overcharges him by at least 200 percent. Steven is also attempting to slash his 2010 operating costs and has set aggressive consumption reduction goals for the upcoming year. He would like to see a chargeback system implemented that would translate reductions in services into reduced charges. See Table 6 for the current and proposed consumption levels of telecommunication services by the Huntsville Operation. Telecommunication Billing Changes A return to detailed billing The complaints resulted in the development of a proposed chargeback system that will assign costs on a cause-and-effect basis using multiple activity-based rates. Customers will be billed based on the quantity of the specific service used. The quantity of each voice service consumed will be multiplied by the chargeback rate per service to obtain the total cost of the specific service. Consequently, customers will pay for the telecommunication services they actually consumed. The proposed activity-based is as follows:
Companywide pools and rates for basic telephone. Rates include mobile calls; long distance and local calls. Costs assigned on a flat rate or per minute basis; Companywide pools and rates for internet service. Internet usage rates relate to data downloads. These costs are assigned on a flat rate basis; One companywide pool and rate for teleconferencing. Costs assigned on a 30 minute block basis;

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One companywide pool and rate for mobile phones. Costs assigned on a per-mobile basis One companywide pool for desktop PCs and monitors. Additional monitors charged at a permonitor rate; Regional pools and regional rates for add, move and change services. Separate rates will be used for each service offered. Costs will be based on the number of service orders for these services; Services that are unique or nonstandard will be billed directly to the using department at the cost of the service plus administrative charges. Fax machines are an example of items included in this category.

Table 6: Current and Proposed Consumption of Telecommunication Services by the Huntsville Operations (All Data on a Monthly Basis) 2009 2010 Actual Proposed Salaried Workforce 1596 1596 Telephone lines 814 814 Additional computer hubs 101 101 Total lines 915 915 Local/mobile calls 187,332 89,206 International long distance 1,892 901 Total Minutes 189,224 90,107 Computers 796 637 Laptops 150 15 Mobiles (standard) 698 228 Mobiles (special #2) 145 47 Mobiles (special #1) 12 4 Total Mobile Phones 855 279 Add, Move and Change 66 33 Facsimile Machines 52 26
Table 7 shows the proposed activity-based rates using the 2009 budgeted costs and the 2009 activity drivers. 7 The rates shown in Table 7 are preliminary rates developed to help assess the impact of
7

To develop rates, activity-based cost systems must translate the organisations general ledger accounts into the cost of activities performed. In this case, the activities performed correspond to the various telecommunication services provided. Many of the costs associated with these services were already captured in Boeings accounting system by budget code headings (See Table 3). This facilitates the development of the service cost pools shown in Table 7 where some of the cost pools and rates have been allocated to a limited number of cost pools (i.e computer and mobile phone charges include the data pack and calls).

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adopting the activity-based system. All of the rates shown in Table 7 are calculated on a companywide basis, even though the final system will use both companywide and regional rates, as noted above. The philosophy of the activity-based chargeback system is that SSG will be responsible for managing the unit cost of the individual telecommunication services and the customer will be responsible for managing the consumption of services. The consumption of services will now be monitored through detailed reports generated by the chargeback system. In contrast to the simplified chargeback system, users will now be charged for the services actually consumed.

Table 7: Proposed (2009) Activity-Based Rates for Telecommunication Services


Telecommunications Service Service Cost Pool Practical Level of Cost Driver Monthly Rate

Telephone lines Additional computer hubs Local/mobile calls International long distance Computers Laptops Mobiles (standard) Mobiles (special #2) Mobiles (special #1) Add, Move and Change Facsimile Machines

$6,350,148 $1,058,358 $1,222,908 $447,304 $770,744 $332,532 $144,602 $274,092 $185,831 $3,438,512 $203,031

267,416 lines $23.75 per line 30,431 hubs $34.78 per hub 12,382,794 minutes $0.10 per minute 1,712,877 minutes $0.26 per minute 19,637 computers $39.25 per computer 5,841 laptops $56.93 per laptop 4,205 mobiles $34.39 per mobile 3,240 mobiles $84.59 per mobile 544 mobiles $341.60 per mobile 35,833 service $95.96 per order orders 5,371 fax machines $37.80 per fax machine

When Mike Burton, Manager of Accounting Policy at The Boeing Company reported back to Jim McNerney he explained that unfortunately, this new philosophy cannot be implemented for free. Many of the savings (both hard and soft) that accrued from billing simplification would be eliminated. For SSG, the cost to develop and implement the detailed billing system is estimated to be $700,000. Ongoing support of the developed systems, including maintenance of charging 61

accuracy is estimated to be $1,200,000 per year. Similarly, the cost savings enjoyed by the other divisions from billing simplification will be eliminated when detailed billing is resumed. He also reminded Jim of the remuneration policy The Boeing Company in place for the senior executives of their operations. He said, No wonder Steven Ryan of Huntsville operations is complaining about overheads. Have a look at this. Mike showed Jim the breakdown of Stevens remuneration and the calculations, thus far, on his potential end of year bonus. Steven can earn 45% of his $250,000 base salary as a bonus if he achieves his adjusted financial operating performance goals. 8 Results to date of the Huntsville operations indicate that Steven might narrowly miss this years targets.

Refer to Appendix 2 for a detailed outline of Boeings short-term executive and non-executive remuneration plan. Note: Boeing has long-term incentive plans for employees which are linked to share options. Details are not included here.

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Unilever
Unilever is a large Dutch-British consumer product manufacturer with sites around the world including Australia and New Zealand. Currently, there are 2000 employees in the Australian and New Zealand operations with two factories in New South Wales and two in Victoria. Unilevers product range comprises well-known consumer product brands including personal hygiene products Dove, Ponds, Vaseline, Sunsilk, Lynx, Rexona; laundry detergents Radiant, Surf, Lux; food and nutrition products Bertoli (olive oil), Amora (salad dressings), Lipton (tea), Streets (ice cream, with Magnum their number 1 brand) and Knorr (Unilevers number 1 brand worldwide for flavourings and gravy). More recently, Unilevers management has reevaluated its strategic direction. It had made plans to sell its US laundry arm before 2010 and to cut about 11 per cent of the worldwide workforce of 179 000. It also launched six global strategic initiatives, one of them relating to business simplification. In response to the global strategic initiative, Jean-Lin Toulemonde (Unilever Australasia Chairman) launched a radical business simplification program at Unilever, designed to eliminate unnecessary work, make people more effective, and lift the company's business performance. Jean-Lin has a strong belief in business that simple is often best and has looked to simplify things wherever possible. If you ask yourself whether you can imagine an organisation that is successful, responsive, fun to work at, full of motivated people and that is also very bureaucratic, the answer is clear: you can't. The good news is your people can't either! Bureaucratic procedures develop slowly but inexorably. I use the analogy of the street signs you see on Sydney streets no doubt each of those sign placements made sense at one time, but the aggregate effect now is often chaos. Businesses need a periodic spring-cleaning, if they are to keep working effectively. Jean-Lin considered that part of that complexity came from the nature of the business. Unilever operate in many markets, with many product categories and many brands. In that type of environment its easy to end up trying to do too many things, rather than doing fewer things better. Its easy to become over-stretched, from both a process and resources point of view, and end up wasting opportunities. He explained how the senior management team called for a more focused approach to fit with Unilever's overall strategy which is essentially about fewer, but bigger brands, and fewer, but more important activities. He explained how they also identified problems with the Unilever organisational structure. They looked hard at the value-chain processes within Unilever to see where they could simplify them. They also evaluated their performance measurement control systems (PMCS). Jean-Lin argued that if you measure everything that moves in your business, you may simply be complicating your business. We had a concept of loose versus tight controls let things happen in the business, don't try to control everything, and trust our people to deliver the results. You don't need a lot of additional measures and KPIs [key performance indicators] you simply need to measure whether you are achieving your original objectives. He thought the biggest concern for divisional managers related to the delegation of control. He explained the questions coming from this layer of senior management was are you really prepared to give me responsibility and resources to simplify the way I operate, and will you punish me if I make mistakes? Once we convinced people we were serious, and that mistakes would not be treated unreasonably, then people became enthusiastic and prepared to take risks.

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Yahoo May Shut Down Some Services


By JENNA WORTHAM As part of its effort to streamline its beleaguered Web business, Yahoo may close down several well-known Web products, including Delicious, a social bookmarking tool, and Upcoming, a social calendar. The news surfaced online Thursday through what appears to be a leaked snapshot of a Yahoo presentation that shows several Yahoo services the company is apparently thinking about closing or merging with other services. The picture was first posted online by Eric Marcoullier, co-founder of MyBlogLog, a social network for bloggers that was acquired by Yahoo in 2007. Mr. Marcoullier no longer works at Yahoo and said on Twitter that he had found the slide on the Web. In addition to Delicious and Upcoming, the slide appears to show plans to merge or shrink several other standalone products, including Yahoo Buzz, a news aggregator, and AltaVista, a search tool. Dana Lengkeek, a Yahoo spokeswoman, said in an e-mail: Part of our organizational streamlining involves cutting our investment in underperforming or off-strategy products to put better focus on our core strengths and fund new innovation in the next year and beyond. We continuously evaluate and prioritize our portfolio of products and services, and do plan to shut down some products in the coming months such as Yahoo Buzz, our Traffic APIs, and others. We will communicate specific plans when appropriate. To many in Web land, the news is likely to cause dismay. Although Yahoo failed to capitalize on the social networking niche now dominated by Facebook and Twitter, many of the companys tools, including Delicious, which it acquired from its creator Joshua Schachter in 2005, were among the first wave of services aimed at the social Web and reinventing how people shared content online. Yahoo said Monday that it was looking to lay off 650 employees, roughly 5 percent of its workforce, as a way to trim costs amid sluggish growth. The cuts are expected to come largely from Yahoos products division, which oversees services like Delicious and Yahoo Buzz. Source: The Economist December 16, 2010, 3:49 pm

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Starbucks to Open China Coffee Farm, Securing Global Supply


By LAURIE BURKITT

PUER, ChinaStarbucks Corp. signed a deal with the Chinese provincial government of Yunnan to set up its first-ever coffee-bean farm in the world to cater to a rapidly growing population of coffee drinkers in China amid a global battle for quality coffee beans. In the southwest province steeped in thousands of years of tea production, the Seattle-based coffee chain is hiring and training local coffee growers. The hope is that Chinese-grown arabica beans, a bitter-earthy variety, will fill the cups of a culture that is acquiring a growing taste for coffee.

A new Yunnan province coffee-bean farm marks the first time Starbucks will grow its own coffee, as the U.S. chain eyes further expansion in China. Video courtesy of Reuters. Starbucks Chief Executive Howard Schultz said the company will work with farmers to improve yields and incomes. "This creates a significant statement about our commitment to doing business in China and doing business the right way," Mr. Schultz said. The first beans will be harvested in three years. Mr. Schultz declined to offer financial details of the investment. China's thirst for coffee is surging. Coffee sales climbed 9% last year to 4.6 billion yuan ($694 million), according to research company Euromonitor International. Starbucks currently operates 400 stores in mainland China and has plans to open a thousand more in the coming years, Mr. Schultz said, without being more specific. China is poised to become Starbucks' second-largest market behind the U.S., overtaking Canada, Japan and the U.K. Starbucks' 2010 revenue jumped to $10.7 billion, up 9.5% from 2009. International store sales increased 6%. The company, which has a nearly 70% market share in China, according to Euromonitor, declined to provide specific information on its growth in the country. Starbucks is in its second year of recovery after cutting $600 million from its operating costs. U.S. sales are picking up, but the company isn't opening new stores there. Starbucks is looking for new ways to grow. Some analysts say the company's recent decision to discontinue a supermarket distribution contract with Kraft Foods Inc. signals that it will further move from its retail roots into more packaged-goods production. Starbucks will begin selling coffee machines in the U.S. market, Mr. Schultz said, declining to give a timeline. Fierce competition is brewing in China. McDonald's Corp. is rolling out new McCafs and adding coffee bars to some existing outlets across China. China Resources Enterprise Ltd, a Hong Kong-based company that currently operates 90 Pacific Coffee chains in Asia, has 1,000 new China outlets in its pipeline, according to the company. Costa Coffee, owned by Britain's Whitbread, PLC, is cranking out more than 250 new stores in the next three years. Coffee distributors are all bidding against one another for a limited supply of high-quality beans. Aging trees farmed year-after-year in Central and South America are producing lackluster, bland yields, and companies are desperate for new supplies. Nestl SA is investing $487 million in a decade-long global effort to train and supply thousands of farmers across the globefrom Mexico to Indonesiawith new coffee trees, according to Nestl. Global arabica-bean prices are up more than 50% this year and are near 13-year highs due to bad weather and failing crops in Colombia and Central America. To absorb the higher costs, Starbucks in September raised the prices of some hard-to-make and larger-sized drinks, though in the U.S. only. Prices in China, which average $5 for a java chip frappuccino, didn't change.

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China exerts a big influence on markets for commodities such as oil, copper and soybeans, but isn't a focus for the coffee market. That looks set to change with Starbucks' foray. In addition, China's potential as a quality coffee producer is in sharp contrast to Asian nations' current reputation as suppliers of a low-quality robusta beans. Starbucks is hoping that the quality of its Yunnan-grown coffee will be good enough to sell globally. Despite high raw ingredient prices, the partnership with China's Yunnan provincial government isn't about buying cheaper quality, said Mr. Schultz. "We strongly believe it will be as good in the cup as the coffee we currently buy in other markets," he said. Elevating Yunnan's arabica quality may be a tall order. The company used Chinese beans to launch a special coffee line last year called "South of the Clouds," which is the literal translation of Yunnan. Due to lack of quality and quantity, "South of the Clouds" became a blend. It was offered only in China, Malaysia and Singapore. Company executives haven't determined how they will market the new coffee in China and internationally, Starbucks said. The Yunnan-grown beans will be shipped to the U.S. for roasting. A roasting plant in Asia is inevitable, though the timing hasn't yet been pegged, said Mr. Schultz. Until now, Yunnan's beans have been used only for lower-quality instant coffees. Nestl, which has a 68% share of the instant market, started buying beans from Yunnan in the late 1980s. Since then, other leading coffee companies, such as Kraft Foods and Maxwell House, have been buying China's arabica. Starbucks plans to offer its Via instant coffee in China, but Mr. Schultz said he hasn't settled on a date. "Consumers here need to develop a better understanding of the coffee culture first," he said. China has over the past decade encouraged farmers to swap out tea for coffee to bring in higher revenue and tax dollars. The Yunnan government plans to increase the amount of land it allocates for coffee growing and plans to invest three billion yuan in the next decade to increase coffee production to 200,000 tons annually from 38,000 tons. Starbucks' Chinese consumers have a long way to go to catch up to drinkers in other markets. Single-store sales in China average $600,000 compared to $1 million in the U.S., according to John Glass, a Morgan Stanley analyst. Growth in China won't be a problem, Mr. Schultz said. "We're watching growth in smaller cities mirror what happened in Beijing and Shanghai," he said. "It gives us confidence about long-term profitability." Sue Feng contributed to this article.

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Classroom Materials for


Goliath Corporation: An Instructional Case in Transfer Pricing Policy
Forthcoming in the Journal of Accounting Education, 2006

Charles D. Bailey School of Accountancy Fogelman College of Business University of Memphis Memphis, Tennessee 38152 (901) 678-5614 cbailey2@memphis.edu

and

Denton Collins School of Accountancy Fogelman College of Business University of Memphis Memphis, Tennessee 38152 (901) 678-4327 dlcollin@memphis.edu

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INSTRUCTIONS TO THE MANAGER OF THE PLASTIC PRODUCTS DIVISION


Congratulations! You have just been appointed manager of the of Goliath Corporation Plastics Division. Your annual bonus is an important part of your compensation and is tied to your total divisional income. Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering. Here are the possibilities that s/he is considering: Market-based: actual competitive prices that the buyer would have to pay outsiders, less 2% to adjust for the economies of dealing internally (less sales effort, no bad debts, etc.). Cost-based: actual full manufacturing cost. Negotiated: whatever price they can agree on. Dual: ! the selling division receives 120% of its full manufacturing costs. ! the buying division pays 98% (the market price they would pay outsiders).

Check the one that your CEO communicates to you.

OK! Now you are ready to negotiate with the other divisions. First, the Metals division wishes to purchase 5,000 equipment cases from you. Your cost/unit is as follows: Direct Material Direct Labor Variable Overhead Fixed Overhead Total $28.00 17.00 34.00 45.00 $124.00

Currently, you have enough excess capacity in your plant to produce 5,000 more units per month. You now are selling 12,000 similar units/month to an outside customer, at $174 apiece, but you currently have no additional outside market. The Metals Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEOs new policy. Please note the result of your negotiation below:

Q We completed the deal internally at $______________/unit. Q We could not complete a deal internally ______. Comments on your rationale and other observations:

Second, you need 2000 electronic sensors, which you could purchase from a reliable outside source for $75 each. The Electronics Division is also a potential supplier, with the price based on the CEOs new policy.

Please note the result of your negotiation below: Q We completed the deal internally at $______________/unit. Q We could not complete a deal internally ______. Comments on your rationale and other observations:

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INSTRUCTIONS TO THE MANAGER OF THE METAL PRODUCTS DIVISION


Congratulations! You have just been appointed manager of the of Goliath Corporation Metals Division. Your annual bonus is an important part of your compensation and is tied to your total divisional income. Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering. Here are the possibilities that s/he is considering: Market-based: actual competitive prices that the buyer would have to pay outsiders, less 2% to adjust for the economies of dealing internally (less sales effort, no bad debts, etc.). Cost-based: actual full manufacturing cost. Negotiated: whatever price they can agree on. Dual: ! the selling division receives 120% of its full manufacturing costs. ! the buying division pays 98% (the market price they would pay outsiders). Check the one that your CEO communicates to you.

OK! Now you are ready to negotiate with the other divisions. First, you need to purchase some equipment cases, either from the Plastics Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 5,000 units/month that you need for $115 each. You also should consider buying them from the Plastics Division, with the price to be determined in accordance with your CEOs new transfer price policy.

Please note the result of your negotiation below: Q We completed the deal internally at $______________/unit. Q We could not complete a deal internally ______. Comments on your rationale and other observations:

Second, the Electronics Division needs 8,000 brackets of an unusual design. Your costs to make and deliver these would be: Direct Material Direct Labor Variable Overhead Fixed Overhead Total $18.00 7.00 24.00 35.00 $84.00

Currently you have enough excess capacity in your plant to produce 8,000 more units per month. You now are selling 21,000 units/month to an outside customer, at $104 apiece. The Electronics Division manager will be contacting you with an offer to purchase 8,000 units. Remember that you may accept or reject the offer, and that the pricing will depend on the CEOs new policy. Please note the result of your negotiation below: Q We completed the deal internally at $______________/unit

Q We could not complete a deal internally ______ Comments on your rationale and other observations:

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INSTRUCTIONS TO THE MANAGER OF THE ELECTRONICS DIVISION


Congratulations! You have just been appointed manager of the of Goliath Corporation Electronics Division. Your annual bonus is an important part of your compensation and is tied to your total divisional income. Your CEO currently is deciding on transfer pricing policy affecting your income, and will soon communicate this to you. In keeping with maximum autonomy, each division may enter transactions with outsiders or insiders as it sees fit. However, when an internal transaction occurs, the price must follow guidelines that headquarters sets. It is these guidelines that the CEO is now considering. Here are the possibilities that s/he is considering: Market-based: actual competitive prices that the buyer would have to pay outsiders, less 2% to adjust for the economies of dealing internally (less sales effort, no bad debts, etc.). Cost-based: actual full manufacturing cost. Negotiated: whatever price they can agree on. Dual: ! the selling division receives 120% of its full manufacturing costs. ! the buying division pays 98% (the market price they would pay outsiders). Check the one that your CEO communicates to you.

OK! Now you are ready to negotiate with the other divisions. First, you need to purchase some brackets of an unusual design, either from the Metals Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 8,000 units/month that you need for $40 each. You also should consider buying them from the Metals Division, with the price to be determined in accordance with your new CEOs transfer price policy. Please note the result of your negotiation below:

Q We completed the deal internally at $______________/unit. Q We could not complete a deal internally ______. Comments on your rationale and other observations: Second, the Plastics Division needs 2,000 electronic sensors. Your costs to make and deliver these would be: Direct Material Direct Labor Variable Overhead Fixed Overhead Total $20.00 9.00 14.00 25.00 $68.00

Currently you have no excess capacity in your plant to produce these units per month. You now are selling 11,000 similar units/month to outside customers, at $80 apiece. The Plastics Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEOs new policy. Please note the result of your negotiation below:

Q We completed the deal internally at $______________/unit. Q We could not complete a deal internally ______. Comments on your rationale and other observations:

70

Tabulation of the Results


Results under Policy of: Market-Based Good for Goliath? A 1: Plastics Metals 2: Electronics Plastics 3: Metals Electronics Yes No No Cost-Based Negotiated Company (Student team) ... ... ... ... Dual-Pricing

Transaction

Company (Student team)


B C ...

Company (Student team)


... ... ... ...

Company (Student team)


... ... ... n

71

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Transaction Summary
PLASTICS TO METALS Plastics The Metals division wishes to purchase 5,000 equipment cases from you. Your cost/unit is as follows: Direct Material Direct Labor Variable Overhead Fixed Overhead Total $28.00 17.00 34.00 45.00 $124.00

Currently, you have enough excess capacity in your plant to produce 5,000 more units per month. You now are selling 12,000 similar units/month to an outside customer, at $174 apiece, but you currently have no additional outside market. The Metals Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEOs new policy. Metals You need to purchase some equipment cases, either from the Plastics Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 5,000 units/month that you need for $115 each. You also should consider buying them from the Plastics Division, with the price to be determined in accordance with your CEOs new transfer price policy. ELECTRONICS TO PLASTICS Electronics The Plastics Division needs 2,000 electronic sensors. Your costs to make and deliver these would be: Direct Material $20.00 Direct Labor 9.00 Variable Overhead 14.00 Fixed Overhead 25.00 Total $68.00 Currently you have no excess capacity in your plant to produce these units per month. You now are selling 11,000 similar units/month to outside customers, at $80 apiece. The Plastics Division manager will be contacting you with an offer to purchase the units. Remember that you may accept or reject, and that the pricing will depend on the CEOs new policy. Plastics You need 2000 electronic sensors, which you could purchase from a reliable outside source for $75 each. The Electronics Division is also a potential supplier, with the price based on the CEOs new policy. METALS TO ELECTRONICS Metals the Electronics Division needs 8,000 brackets of an unusual design. Your costs to make and deliver these would be: Direct Material Direct Labor $18.00 7.00 73

Variable Overhead Fixed Overhead Total

24.00 35.00 $84.00

Currently you have enough excess capacity in your plant to produce 8,000 more units per month. You now are selling 21,000 units/month to an outside customer, at $104 apiece. The Electronics Division manager will be contacting you with an offer to purchase 8,000 units. Remember that you may accept or reject the offer, and that the pricing will depend on the CEOs new policy. Electronics You need to purchase some brackets of an unusual design, either from the Metals Division or from an outside source. You have a bid from a reliable outside supplier who will provide the 8,000 units/month that you need for $40 each. You also should consider buying them from the Metals Division, with the price to be determined in accordance with your new CEOs transfer price policy.

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Transfer Prices: Winter Functions, Types, 2010 and Behavioral Implications


VOL.11 NO.2

BY PETER SCHUSTER, PH.D.,

AND

PETER CLARKE, PH.D.

TRANSFER

PRICES AFFECT THE PROFIT REPORTED IN EACH RESPONSIBILITY CENTER OF A

COMPANY AND CAN BE USED TO INFLUENCE DECISION MAKING.

SHOWING A VARIETY

OF

EXAMPLES, THE AUTHORS DESCRIBE THE FUNCTIONS AND TYPES OF TRANSFER PRICES AND DISCUSS THE POSSIBLE BEHAVIORAL CONSEQUENCES OF USING THEM.

ost companies now operate in an environment in which their products, markets, customers, employees, and technology are constantly changing. In such circumstances, the appropriate organizational form becomes important, and a decentralized organization is very common. The essence of decentralization is the freedom managers have at various levels to make decisions within their sphere of responsibility. This frequently involves determining a transfer price system within the company, which has the potential to become the most important and possibly the most interesting problem of management control. Decentralization can simulate market conditions within a company between autonomously acting subunitsi.e., they reflect competition. Managers in such subunits or business units have different degrees of autonomy and a range of company decisions for which they are responsible. The cost center manager is typically responsible for costs, the profit center manager for costs and revenues, and the investment center manager for generating an adequate return on investment.

Because of the decentralization of decision making, the role of performance measurement and performance assessment within these responsibility centers becomes important. These issues lead to discussion and systematic analysis of transfer price functions between segments.1 Companies often use transfer prices as substitutes for market prices either because market prices do not exist or because they do not facilitate internal trading and the synergies it creates. Even if synergies exist for internal trade, it is possible that market prices may not encourage this to happen. Thus top management often imposes a transfer price in order to benefit from these synergies. An added complication, however, is that sharing the synergistic benefits between responsibility centers is arbitrary, so the correct transfer price cannot exist. It is obvious that transfer prices affect the profit reported in each responsibility center, and, more importantly, companies can use transfer pricing to influence decision making. We will look at the functions and different types of transfer prices and their possible behavioral consequences. The analysis, which is from a managerial point

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of view, argues that neither a single true nor a fair price exists, but, rather, the transfer price is conditional on the decision context. Our article also highlights possible dysfunctional behavior. We outline some examples and propose possible solutions that we assess in the light of behavioral effects, highlighting how complex, difficult, and insolvable the issue of transfer pricing is in reality. In order to understand the effects resulting from asymmetric information and finding suitable transfer prices, we will first discuss the functions of transfer prices.
FUNCTIONS
OF

such responsibility units on the basis of reported profit as it is no longer an aspect for which companies can hold them directly responsible. There are additional functions for transfer prices. Besides the primary functions of profit allocation and coordination functions, transfer prices fulfill other tasks, such as complying with financial reporting regulations in addition to tax considerations.2 We will not discuss them here, however. Instead, we will concentrate on the two primary functions of transfer prices together with their behavioral consequences, which companies often do not understand.
TYPES
OF

TRANSFER PRICES TRANSFER PRICES


AND

The decentralized organization is a connection of partly independent business units. An important task for management is the performance measurement and assessment of these units. This requires, for example, that the reported profit figure for, say, profit or investment centers for the relevant period, should be reliable and trustworthy. Where these business units trade with each other, the transfer pricing system has the potential to distort reported profit performance. Therefore, the internal profit-allocation function and related performance measurement of business units are crucial elements of transfer pricing. Transfer prices should also influence managerial decision making because they should provide an incentive to maximize the business units profit targets. We refer to this as the coordination function. If managerial decisions lead to maximized profits within all the autonomous business units, then this should also maximize the total company or, in the following group, profits, ignoring tax and foreign exchange considerations. Business unit managers decisions then are identical to the decisions that the groups top managers would make if they had all the necessary information. There is a potential conflict between these two functions of transfer prices, namely the profit-allocation function (reliable and trustworthy prices and, thus, reported profits) and the coordination function (guiding behavior of decentralized managers by using the transfer prices). One solution is to reduce the discretion of subunit managers in setting transfer prices. This approach, however, partly defeats the original purpose of decentralization and reduces the validity of assessing

THEIR

D E T E R M I N AT I O N

Generally, companies can determine transfer prices three different ways: market-based transfer prices, costbased transfer prices, and negotiated transfer prices. Although each method provides a different answer, their commonality is that transfer prices represent an intracompany market mechanism. We will now discuss each type of transfer price.
Market-Based Transfer Prices

Market-based transfer prices represent market conditions and, therefore, simulate the market-within-thecompany idea. Their advantage is that they support and implement corporate strategy and allow performance measurement of responsibility centers using marketoriented data. A prerequisite for this method is a standardized, existing market of the product or a substitute. Companies can determine a market-based transfer price by comparing current prices if the business unit also sells to the market. Alternatively, they can obtain transfer prices from the marketplace if a comparable competitive product exists. Problems do occur with this approach, however, if, for example, a company uses marginal prices in order to use idle capacity. In such circumstances, the short-term price may not be equivalent to the long-term price. Furthermore, should one include special discounts? Another major problem with market-based prices is their trustworthiness, and this raises questions such as: x Who submits the information? x Who decides which suppliers are asked for an offer,

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Figure 1:

Case 1A Market-Based Transfer Price in a Perfect Market Situation


Input factors Supplier offer: Price = $240 SUBUNIT 2 Intermediate product Market for intermediate product: p1 = $125 Final product Costs: $80 (case 1) Regular market price of the final product: p = $300

Input factors

SUBUNIT 1 Costs: $100

and how often should the information be requested? x Should there be a favored clause for intracompany trading compared to market suppliers? Figure 1 shows a case of two responsibility units in the situation of a perfect market.3 The costs of the business units remain unaffected by their decisions whether to purchase externally in the marketplace or to engage in intracompany trading. The example shows that under normal circumstances subunit 1 produces an intermediate product and can sell it in the market at $125 or to subunit 2 for an agreed transfer price that the company will determine. Subunit 2 transforms this into a final product that it sells on the market at a normal price of $300. A supplier, however, has offered $240 for subunit 2s product, and this subunit has idle capacity to produce the product. Managers should base suggested transfer prices on how well they fulfill the two functions of profit allocation and coordination. In this example, the reported profits of both subunits are reliable and trustworthy because the company bases them on a transfer price equal to the market price of the intermediate product ($125). The selling division (subunit 1) always has the incentive to sell internally because the market-based transfer prices mirror current market conditions. Equal-

ly, the buying division (subunit 2) does not overpay for the intermediate product. Table 1 summarizes the decisions and profits of the two subunits. Both subunits have the incentive to trade internally using market prices to determine the transfer price and the overall group benefits accordingly. We now adapt this example to case 2, where the processing costs of subunit 2 are $120 per unit rather than $80 (see Figure 2). In case 2, subunit 2 still has the incentive to trade internally, but, with a transfer price of $125, subunit 2 will reject the supplementary offer. Table 2 summarizes the alternatives. By selling the product to the market, the market-based transfer price leads to subunit 1s profit of $25. In contrast, internal trading would result in an accounting loss of $5. Subunit 2 will not produce the final product, so subunit 2 will sell the intermediate product on the market. This, then, is also the profitmaximizing decision from the group perspective because it generates a total profit of $25 ($125 $100) compared to only $20 ($240 $100 $120) for a supplementary order. Figures 1 and 2 illustrate the fulfillment of the profit-allocation function as there is an obvious homogenous market price that can be the transfer price. Addi-

Table 1:
CASE

Decisions and Profits of the Subunits in Case 1


DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT GROUP

PROFIT SUBUNIT 1

Case 1

125

100 = 25

Produce and sell intermediate product (to subunit 2)

240

125

80 = 35

Buy intermediate product and produce and sell supplementary order

240

100

80 = 60

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Figure 2:

Case 2A Market-Based Transfer Price in a Perfect Market Situation


Input factors Supplier offer: price = $240 SUBUNIT 2 Intermediate product Market for intermediate product: p1 = $125 Final product Costs: $120 (case 2) Regular market price of the final product: p = $300

Input factors

SUBUNIT 1 Costs: $100

tionally, both subunits make the same decision as would top centralized management if they possessed all available information. This is highlighted by the decision about a one-off supplementary offer for an additional customer for a price of $240: In case 1, both subunits independently decide to trade internally, and top management would approve this in the company headquarters as the supplementary order increases company profit by $60. A variation of this, case 2, in which subunit 2 has production costs of $120, shows that it is preferable to sell the intermediate product in the market. Thus the subunits do not trade with each other when they use the market-based transfer price. This decision leads to an overall profit of $25. If interdivisional trading took place at a transfer price of $125, it would lead to additional group profit of only $20. Thus this also fulfills the coordination function. Top management would have made this decision if they had access to all the information. We can further adapt the previous example. Figure 3 indicates that subunit 1 incurs costs of $100 per unit when selling internally and costs of $116 when selling to the market. The incidence of selling and distribution costs could explain this phenomenon. In case 3, the production costs of subunit 2 are $120, which are the

same as in case 2, and the necessary intermediate product is bought internally from subunit 1. This example builds on the previous example with one exception: the existence of synergies, represented by a different cost situation when subunit 1 sells its product internally or to the market and when subunit 2 buys internally or from the market. This proves that the market-based transfer price will not fulfill the profit allocation and the coordination function when synergies exist. That is to say, the obvious solution for a transfer price of a decentralized organization will not work in the real world where synergies exist. As shown in the example, the two functions are not fulfilled because neither the correct profit can be reported by the use of the transfer price nor are the subunits decisions in the best interests of the company as a whole. Yet synergies can be seen as a reason for the existence of companies because companies then can produce something better and cheaper, i.e., in principle favorable to customers. Despite the fact that there is an obvious homogenous market price, the profit-allocation function is not fulfilled anymore because of synergies represented by the lower internal costs of subunit 1 when avoiding the use of the marketi.e., when selling the intermediate prod-

Table 2:
CASE

Decisions and Profits of the Subunits in Case 2


DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT GROUP

PROFIT SUBUNIT 1

Case 2

125

100 = 25

Produce and sell intermediate product (to market)

240

125

120 =

Decline supplementary order

125 100 = 25 (for intermediate product only)

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Figure 3:

Case 3A Market-Based Transfer Price in an Imperfect Market Situation


Input factors Supplier offer: price = $240 SUBUNIT 2 Intermediate product Market for intermediate product: p1 = $125 Final product Costs: Internal = $120 Market = $135

Input factors

SUBUNIT 1 Costs: Internal = $100 Market = $116

uct to subunit 2 rather than to the marketand by the additional costs of subunit 2 when utilizing the market. The synergies, therefore, comprise $16 (subunit 1) and $15 (subunit), which equals $31, symbolized by increased cost functions of both business units (e.g., for higher marketing costs of business unit 1 or higher quality-control costs of business unit 2). The reporting of the correct profit supposedly shows the correct division of the synergies, but any division of these advantages is arbitrary. So who should benefit from synergy when subunit 1 produces the intermediate product that it sells to subunit 2, who processes it into the final product sold as the supplementary order at the price of $240? For example, at a price of $110 for the intermediate product, both subunits end up with a profit of $10 each: Subunit 1 is $110 $100 = $10; subunit 2 is $240 $120 $110 = $10. Both share the maximum achievable profit, which equals $20 for an intracompany solution of the supplementary order versus a profit of $9 when subunit 1 sells the intermediate product to the market and when the supplementary order is rejected. At that price, both subunits report a profit, even though the amounts are arbitrary and not in accordance with the market

price of the intermediate product but $15 lower. An analysis of the next function, the coordination function, reveals that the companys decision is not identical to the subunits decisions: A company can achieve maximum profit by producing the supplementary order at a profit of $20 per product. Subunit 1 also prefers the profit of $25, but subunit 2 rejects this because of a loss of $5, so the only business consists of selling the intermediate product to the market with a combined profit of $9 for subunit 1 and the company. Because of synergistic effects, the market-based transfer price in the example is too high for both subunits to decide to accept the one-time order. A price that would lead both business units to decide positively about the order is in the range of $109 and $120. At a price of $109, subunit 1 earns a contribution margin internally in the amount of $9, which is identical to the amount it could earn at the market price. It is the minimum price it would ask for in case of internal business. At a price of $120, subunit 2 starts to earn a positive contribution margini.e., it is the maximum price subunit 2 is willing to pay. The rejection of the supplementary order cuts the possible company profit from $20 to $9, so the market-based transfer price does not support indepen-

Table 3:
Intracompany Market 125 125

Decisions and Profits of the Subunits in Case 3


DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT COMPANY

PROFIT SUBUNIT 1

100 = 25 116 = 9

Intracompany preferred

240 240

125 135

120 = 125 =

5 20

Reject supplementary order

240 125

100 120 = 20 116 = 9

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Decisions and Profits of the Subunits Based on a Marginal-Cost-Based Transfer Price with Linear Cost Functions
Table 4:
PROFIT SUBUNIT 1 DECISION SUBUNIT 1 PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT GROUP DECISION GROUP

0.3 x

100

0.3 x = 100

Irrelevant, as marginal costs = variable costs and thus profit always = a loss in the amount of the fixed costs 31 x 1.2 x2 0.3 x 30 x= 1.2 x2 + 29.7 x 30

x opt = 29.7/2.4 = 12.375 (Profitmax = 153.77) 31 x 1.2 x2 100 0.3 x 30 x= 1.2 x2 + 29.7 x 130 Identical to Subunit 2 (Profitmax = 53.77)

dent decisions in the companys best interests. In summary, the main advantage of market-based transfer prices is that they are objective and unbiased measures, although they might fluctuate because of market conditions over time. Further, they are difficult to manipulate. As case 3 shows, market-based transfer prices perform the profit-allocation function except when synergies and interdependencies exist. When an imperfect market exists, a company may not fulfill the coordination function. Further questions remain, such as: x What if the market price cannot be determined? x How often are market prices measured? x Will they be based on short-term single-productionrun offers or long-term high-volume offers? These questions indicate that using market-based transfer prices presents practical difficulties.
Cost-Based Transfer Prices

Depending on ones definition of cost, cost-based transfer prices can provide a variety of figures for determining intracompany trading. Cost-based prices are the most common type in practice, and they represent an alternative if a market price does not exist. In accounting terms, cost can be defined in a variety of ways, including actual versus budget (or standard); marginal versus absorbed (full) cost; and whether one uses pure cost or cost-plus to determine transfer prices. The first classification, actual versus standard costs, concerns the issue of who will take the risk of cost deviations and variances. Using actual costsi.e., ex-post price determinationtransfers the risk associated with cost deviations to the purchasing subunit. In contrast, standard costs require the ex-ante determination of the

prices and shift the risk to the supplying subunit. Marginal versus full cost represents the next category. Marginal costs fulfill the function of coordination because the marginal-cost-based transfer price leads to optimal decisions of the purchasing subunits, and the independence of the subunits remains unchanged. As a result, the supplying subunit makes an accounting loss by approximating the fixed costs per unit, assuming linearity of cost behavior. The purchasing subunit regularly earns high profits, and the issue of profit allocation is unresolved. This model, known as the Hirshleifer model, is the next example: The business units decisions are identical to the decisions of corporate headquarters if headquarters had all the information. It supports the academic logic of management accounting in which only marginal costs are relevant in the short-term view. To analyze this point and shed some light on the specific problems of it, we introduce a new example where the cost functions of subunits 1 and 2 are simple linear equations as follows: C1 = 100 + 0.3x and C2 = 30 + x. The demand curve for the final product is given as: p(x) = 31 1.2x. Based on profit-maximization theory, which equates marginal cost with marginal revenue, the optimal solution is an output of 12,375 units and a loss of $100 (subunit 1) and $153.77 (subunit 2). Table 4 summarizes profit functions and decisions. We assumed linear cost functions in the example. In a modification of the previous example, now we assume a nonlinear cost function of subunit 1 because this shows that the described solution of the Hirshleifer model will not work anymore. The cost function of the supplying business unit changes to C1 = 100 + 0.3 * x2,

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Decisions and Profits of the Subunits Based on a Marginal-Cost-Based Transfer Price with Nonlinear Cost Functions
Table 5:
PROFIT SUBUNIT 1 DECISION SUBUNIT 1

TP x

100

0.3 x2

Because of nonlinear cost function, headquarters has to set transfer price at 0.6 x (knowing x!): TP=6 (Profit = 70) xopt = 10 6x 30 x= 1.2 x2 + 24 x 30

PROFIT SUBUNIT 2 DECISION SUBUNIT 2 PROFIT COMPANY DECISION COMPANY

31 x

1.2 x2

xopt = 24/10 = 10 (Profitmax = 90) 31 x 1.2 x2 100 0.3 x2 30 x= 1.5 x2 + 30 x 130 xopt = 10 (Profitmax = 20)

and this Hirshleifer model proves that marginal-costbased transfer prices, while seemingly supporting the coordination function, provide an apparent solution. This is so because the company headquarters has to announce the transfer price (where TP= $6 (for xopt = 10); profit subunit 1 (2) = $70 ($90)). In the case of a nonlinear cost function, this requires the knowledge of x, the amounts of product units. Marginal costs of subunit 1 are 0.6 * x; i.e., x remains unknown, and, therefore, xoptimum must be known to determine xoptimum, and, with it, a circularity problem exists, and headquarters can find a solution by announcing the transfer price after determining xoptimum. In other words, only an apparent solution is found because independent subunits are not independent anymore as headquarters must know x and use it for presenting the transfer price. This problem is only linked to nonlinear cost

functions. Therefore, the example started with a linear cost function C1, and we then modified it to a nonlinear function to illustrate the unsuitability of transfer prices based on marginal costs. Another problem is that profit allocation is not performed because there is an arbitrary split of the profits between the business units that typically favors the purchasing business units. Table 5 shows the profits of both subunits, summarizes their decisions, and represents the subunits decisions (decentralized decisions) in comparison to the companys perspective as a whole (centralized decision). The decisions are identical in each case (xopt=10). In regard to behavioral effects, two problems become obvious: First, from the viewpoint of the supplying business unit, the unit probably will end up with a loss. The loss in the previous example is $70. Understanding

Figure 4:

Case 4A Marginal-Cost-Based Transfer Price with Nonlinear Cost Function


Input factors

Input factors

SUBUNIT 1 Costs: C1 = 100 + 0.3 x2 Intermediate product

SUBUNIT 2 Costs: C2 = 30 + x

Final product Market price of final product: p(x) = 31 1.2 x

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the procedure, the subunit can gain advantages by reporting a distorted cost function by, for instance, increasing the reported variable costs that lead to higher marginal costs and, thus, transfer price. In this example, the distortion to a cost function of C1= 100 + 0.4 * x2 changes the companys and business units decisions and reduces the loss from $70 to $64.84 (TP=$7.50, xopt. = 9.375). The total company profit falls by about 47% from $20 to $10.63 (by 88% for C1= 100 + 0.5 * x2, etc.). Second, from the viewpoint of the purchasing business unit, understanding the procedure changes the units profit function because the business unit realizes that the transfer price is not independent of the amount of products. The transfer price is a function of x and therefore maximizes the following profit function using the initial cost function: C1= 100 + 0.3 * x2: Profit2 = p(x) x TP(x) x K2(x) = (31 1.2x) x 0.6x2 30 x. As a result, a different optimum amount of units produced arises and is not consistent with the initial solution (x = 8.33 versus x = 10). The profit of subunit 2 rises from $90 to $95, exemplifying the dysfunctional incentive. Marginal-cost-based transfer prices cause other dysfunctional behavior. The supplying business unit has an incentive for untruthful reporting and, in general, to qualify the highest possible portion of the costs as being variable. Further, supplying business units will oppose investments that will lead to smaller variable and higher fixed costs, known in literature as the hold-up problem of investments.4 This example shows that the theoretical view of solutionsthe optimum achieved by applying marginal costsmay not work in company practice because of other considerations, such as behavioral effects. Theory, however, does provide insights for issues highly relevant in practice. In summary, using marginal-cost-based transfer prices leads to the central optimum in the short-term view, i.e., the fulfillment of the coordination function. This may only be an apparent solution and does not work in the case of nonlinear cost functions. The profit-allocation function is not fulfilled, and the supplying business unit usually ends up with a loss. This might be overcome by multitier schemes we will describe. The capacity limit of the marginal costs is the point that includes opportunity costs. Opportunity costs

increase with higher volume, and, in principle, this leads to an approximation toward the market-based transfer prices. As an alternative to marginal costs, companies can use fully absorbed cost-based transfer prices. The basic idea is that the supplying subunit should be able to meet all of its costs and should not incur an accounting loss on the internal transaction. Certain variations of costs exist, such as using production costs or, alternatively, total costs to include a portion of selling, distribution, and administrative overheads. A major problem of this type of transfer price is the distortion of the groups cost structure. The reason is we can regard the transfer price from the viewpoint of the purchasing unit, and it regards the transfer price as a variable cost even though it includes an element of fixed cost. Therefore, decisions made seemingly on variable cost actually include fixed-cost portions, and this distortion leads to suboptimal decisions. The problem that full cost includes irrelevant parts for short-term decisions highlights the problem that the allocation of fixed overhead costs is always arbitrary. The distortion intensifies if we use cost-plus transfer prices that include a surcharge, such as a percentage of full costs, the required return on capital employed (ROCE), or the return on investment (ROI). A step toward a solution may be the multitier transfer price. Figure 5 shows a two-tier scheme: a single periodic amount for reserving capacity as an equivalent to the fixed costs this capacity level causes and current products the company will buy at marginal (variable) costs. Effects arising from this two-tier scheme are that the

Figure 5:

Multitier Transfer Price (Two-Tier Scheme)

Marginal Costs/per unit Transfer Price

Single Payment/per period

Production Volume

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Figure 6:

Suggestions for Dual Transfer Prices


HEADQUARTERS Headquarters subsidizes supplying subunit

Supplying subunit receives the average net margin of the buying subunit SUPPLYING SUBUNIT

Purchasing subunit pays the average full costs of the supplying subunit PURCHASING SUBUNIT Market

supplying subunit is reimbursed for its full costs and can possibly even earn a profit and that the periodic payment does not affect short-term decisions about single product orders that are made based solely on marginal costs. The two-tier scheme achieves the coordination function. Yet problems arise for capacity planning because several questions come up, such as: x What happens with idle capacity? x What type of fixed costs will we use to determine the single paymentactual capacity use (known expost only), former average capacity use, or reported planned capacity use? x When will the payment be renegotiatedperiodically or when the capacity is adjusted? Another version of a cost-based transfer price is a dual transfer price. Its main idea is that two different transfer prices will be usedone for the supplying unit and another for the purchasing subunit. The example in Figure 6 suggests that the supplying subunit receives the average net margin of the purchasing subunit and that the purchasing subunit pays only the average full costs of the supplying subunit. As a result, the head office subsidizes the supplying subunit. One effect of negotiated transfer prices is that the subunits profits and the companys profits become identical. Therefore, the transfer prices fulfill the coordination function because the subunits maximize identical profit functions and will come to identical decisions, the decisions that headquarters would also come to if it had all the necessary information. The following example illustrates this with the data from Figure 6.

Through maximizing the total profit, the central solution leads to an output volume of 10 units and a profit of $20. The transfer price, TP1, as the sales price of the supplying subunit, is deducted from the average net margin of the purchasing subunit, and, in the example, TP1 is: 1.2x + 30 30/x. The maximized profit, P1, is identical to the companys total profit and, therefore, leads to an identical decision about units produced and sold. The transfer price, TP2, as the average full cost of the supplying subunit in this example, is 0.3x + 100/x, and the profit function, P2, is also identical to the previous profit functions, as are the decisions. This procedure is characterized by a subsidization of the supplying subunit. Because of increased subsidization, an untruthful reporting of cost functions can be beneficial to all subunits, provided that a collusive agreement between the subunits on combined distorted cost functions is made. In other words, the untruthfully reported cost functions relate to each other, with both subunits calculating identical unit numbers produced and sold. In summary, several problems arise with the dual transfer prices. The subunits profits appear to be too high because headquarters subsidizes them. There is a strong incentive to do internal business because headquarters pays a subsidy to each unit to increase the subunits profits. Both subunits report the same profit, which means the profit-allocation function is not achieved. Besides that, in general there is low acceptability because it is not obvious what the real or correct transfer price is. This type of transfer price involves a number of organizational efforts.

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Negotiated Transfer Prices

Finally, one can determine transfer prices by way of negotiation. Negotiated transfer prices simulate the market within the company. These prices can be determined in a situation that is characterized by highly autonomous and independent subunits. It implies that responsible managers have the option to refuse internal business, and the process is similar to negotiations with regular customers. Headquarters can have different ways of influencing decisions, such as requiring approval, having the right to reject, having veto rights, and establishing procedural rules. As a result, it is difficult to assess whether negotiated transfer prices fulfill the coordination and/or profitallocation function because they depend on the negotiating power and negotiating skills of the individuals involved. Results of negotiations, which top management can influence, depend on the alternatives available. If no market prices exist, it is especially challenging to find a workable way.5 Negotiations can be time-consuming and may lead to intracompany conflicts. Based on alternatives, these negotiated transfer prices typically fluctuate between marginal cost and market prices. Therefore, they will not generally fulfill the primary functions of transfer prices.
FURTHER THOUGHTS

consider the primary functions, namely profit allocation and coordination. Depending on the prioritized role, companies prefer certain transfer price types. Yet the possible dysfunctional behavioral effects arising from the transfer prices indicate how complex, difficult, and insolvable the issue of transfer pricing is in reality. Typically, a theoretical view presents a clear solution as a suggestion to practice; here it does not. This might be confusing, but it also shows how highly relevant the theoretical reasoning can be. At least with the perspective on prioritized functions, we showed some solutions, including the dangers that arise from including behavioral effects. s Peter Schuster, Ph.D., is a professor of management accounting and management control at Schmalkalden University of Applied Sciences in Schmalkalden, Germany. You can reach Peter at (0049) 3683 688 3112 or Schuster@Fh-Schmalkalden.de. Peter Clarke, Ph.D., is an associate professor of accountancy and director of the academic centre-accouting/taxation research at University College in Dublin, Ireland. You can reach Peter at (00353)1 7164700 or Peter.Clarke@ucd.ie.
E N D N OT E S 1 Transfer prices have received a great deal of attention at all times, and research on them goes back to the 1950s. See Jack Hirshleifer, On the Economics of Transfer Pricing, The Journal of Business, January 1956, pp. 172-184, and Economics of the Divisionalized Firm, The Journal of Business, January 1957, pp. 96-108. Also see Paul W. Cook, Decentralization and the Transfer-Price Problem, The Journal of Business, January 1955, pp. 87-94, and Williard E. Stone, Intracompany Pricing, The Accounting Review, October 1956, pp. 625-627. Eugen Schmalenbach, one of the founding researchers of management accounting in Germany, started his research as early as 1903. 2 For information on tax objectives, see, for example, Tim Baldenius, Nahum D. Melumad, and Stefan Reichelstein, Integrating Managerial and Tax Objectives in Transfer Pricing, The Accounting Review, July 2004, pp. 591-615. 3 Examples are adapted from Ralf Ewert, Alfred Wagenhofer, and Peter Schuster, Management Accounting, Springer-Verlag, Berlin, Germany, 2010. 4 Regina M. Anctil and Sunil Dutta, Negotiated Transfer Pricing and Divisional vs. Firm-Wide Performance Evaluation, The Accounting Review, January 1999, pp. 87-104. 5 For a suggestion in this situation in the form of a RenegotiateAny-Time system, see Joseph M. Cheng, A Breakthrough in Transfer Prices: The Renegotiate-Any-Time System, Management Accounting Quarterly, Winter 2002, pp. 1-8.

Decentralized organizations, such as those made up of a number of independent profit centers designed to improve the entrepreneurial conduct of managers, lead to increased motivation and better decision making. This leads to a consideration of transfer pricing. We argue, however, that there is no such thing as an ideal solution for transfer prices, nor even a correct or fair transfer price, as long as a perfect market condition applies. How should management accountants deal with this issue if none of the characteristics exists? We argue that the main point is to see that, despite company practices, demand is high for it, and there cannot be one solution for a transfer price system. So it is essential to understand that different functions require different, even contradictory, transfer prices. To determine a transfer price type, a company must

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REFERENCES Regina M. Anctil and Sunil Dutta, Negotiated Transfer Pricing and Divisional vs. Firm-Wide Performance Evaluation, The Accounting Review, January 1999, pp. 87-104. Bala V. Balachandran, Lode Li, and Robert P. Magee, On the Allocation of Fixed and Variable Costs from Service Departments, Contemporary Accounting Research, Autumn 1987, pp. 164-185. Tim Baldenius, Nahum D. Melumad, and Stefan Reichelstein, Integrating Managerial and Tax Objectives in Transfer Pricing, The Accounting Review, July 2004, pp. 591-615. Joseph M. Cheng, A Breakthrough in Transfer Prices: The Renegotiate-Any-Time System, Management Accounting Quarterly, Winter 2002, pp. 1-8. Paul W. Cook, Decentralization and the Transfer-Price Problem, The Journal of Business, January 1955, pp. 87-94. Robert G. Eccles, Control with Fairness in Transfer Pricing, Harvard Business Review, November/December 1983, pp. 146161; The Transfer Pricing Problem, Lexington Books, Lexington, Mass., 1985; The Performance Measurement Manifesto, Harvard Business Review, January/February 1991, pp. 13-137. Ralf Ewert, Alfred Wagenhofer, and Peter Schuster, Management Accounting, Springer-Verlag, Berlin, Germany, 2010. Robert Feinschreiber and Margaret Kent, A Guide to Global Transfer Pricing Strategy, Journal of Corporate Accounting & Finance, September/October 2001, pp. 29-34. Jack Hirshleifer, On the Economics of Transfer Pricing, The Journal of Business, January 1956, pp. 172-184, and Economics of the Divisionalized Firm, The Journal of Business, January 1957, pp. 96-108. Robert P. Magee, Advanced Managerial Accounting, John Wiley & Sons, New York, N.Y., 1986. Jeltje van der Meer-Kooistra, The Coordination of Internal Transactions: The Functioning of Transfer Pricing Systems in the Organizational Context, Management Accounting Research, June 1994, pp.123-152. Peter Schuster, Verrechnungspreise bei Profit Center-Organization, in Handbuch Marktorientiertes Kostenmanagement, edited by Werner Pepels and Hilmar J. Vollmuth, Renningen, Germany, 2003, pp. 71-80. Barry H. Spicer and Van Ballew, Management Accounting Systems and the Economics of Internal Organization, Accounting, Organizations and Society, Vol. 8, Issue 1, pp. 73-96. Barry H. Spicer, Towards an Organizational Theory of the Transfer Pricing Process, Accounting, Organizations and Society, Vol. 13, Issue 3, pp. 303-322. Williard E. Stone, Intracompany Pricing, The Accounting Review, October 1956, pp. 625-627.

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Supplementary Reading
Brewer, P., Chandra, G. & Hock, C. 1999, Economic ValueAdded: Its Uses and Limitations, SAM Advanced Management Journal, 64, 2, 4-11.

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ISSN 1940-204X

COORS BALANCED SCORECARD: A DECADE OF EXPERIENCE


Hugh Grove University of Denver Tom Cook University of Denver Ken Richter Coors Brewing Company

IntroductIon
By the end of 1997, Coors had finished the implementation of a three-year Computer Integrated Logistics (CIL) project to improve its supply chain management. Coors defined its supply chain as every activity involved in moving production from the suppliers supplier to the customers customer. (Since by Federal law, Coors cannot sell directly to consumers, Coors customers are its distributors whose customers are retailers whose customers are consumers.) Coors supply chain included the following processes: purchasing, research and development, engineering, brewing, conditioning, fermenting, packaging, warehouse, logistics, and transportation. This CIL project was a cross-functional initiative to reengineer the business processes by which Coors logistics or supply chain was managed. This reengineering project improved supply chain processes and applied information technology to provide timely and accurate information to those involved in supply chain management. The project objective was to increase company profitability by reducing cycle times and operating costs and increasing customer (distributor) satisfaction. The software vendor used for this project was the German company, Systems Applications & Products (SAP),
1

that provided the financial and materials planning software modules. The SAP planning software became Coors load configurator software that takes distributor demand forecasts and the production schedule and creates a shipping schedule for the following week. The following major supply chain problems were corrected by this CIL project:
1. meeting seasonal demand, 2. meeting demand surges from sales promotions, 3. supporting the introduction of more than three new

brands each year, 4. filling routine customer (distributor) orders, 5. filling rush orders, and 6. moving beer from production through warehouse to distributors before the beer spoiled. (The shelf lives for Coors products were 60 days for beer kegs and 112 days for all other beer packages.) Matt Vail, head of Coors Customer Service department, had been the CIL project leader since the inception of this project. He had developed such expertise with supply chain management that he had just been hired by a supply chain, consulting firm. In early 1998 on his last day of work for Coors, he was talking with Ken Rider, head of Coors Quality Assurance Department.

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VOL. 1, N O. 1, ART. 5, MARCH 2008

Ken had just been placed in charge of the new balanced scorecard (BSC) project at Coors. The initial motivation for this project was to assess whether the supply chain improvements were being maintained. However, the project was broadened to become a company-wide BSC. Accordingly, the project strategy was to implement a performance measurement process that: 1) focused upon continuous improvement, 2) rewarded reasonable risk taking and learning to improve performance and 3) enabled employees to understand the opportunity and reward for working productively. Matt: The supply chain management project was really challenging and rewarding. I hate to leave Coors but the consulting firm made me such an attractive offer that I could not refuse it. I hope you have such positive experiences with this follow-up balanced scorecard project. Ken: This new project will be a real challenge. We need to build upon all the improvements made by your supply chain project. Matt: My project team was excited to see that our CEO discussed the supply chain project in his 1997 shareholder letter. He said that significant productivity gains in 1997 were due to our project that streamlined purchasing, brewing, packaging, transportation, and administration of the supply chain. Ken: Perhaps an economic value added (EVA) analysis could be done to assess these supply chain productivity gains. Matt: Thats an interesting idea to analyze performance in the financial quadrant of the balanced scorecard with EVA. Ken: Another challenge for my project is how to translate the Coors vision statement and related business strategies into operational performance measures. Matt: You also need to identify any gaps between the vision statement, business strategies, and current performance. Ken: Do you have any experiences from your project that I could use? Matt: Well, we did obtain some benchmarking data to develop targets for some performance measures for our supply chain project. I can give you these measures but they are limited due to confidentiality problems in obtaining such data. Maybe Coors should join one of the commercial benchmarking databases. Ken: Thanks. I am also aware of certain employee resistance to developing a new set of performance measures for this balanced scorecard approach. Matt: We had similar employee resistance to changes in the business processes of the supply chain. We were able
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to use the following crisis motivation. At that time, Coors could not support all the new beer brand introductions proposed by our marketing people, due to the antiquated 1970s software that was then being used for our supply chain management. The marketing people wanted to introduce three new brands each quarter and we could only support three new brands each year! We also learned that we needed to get more employee involvement in the project. Ken: Thats a good idea. In fact, I have already developed a list of the most frequently asked questions (FAQs) about the balanced scorecard from initial meetings with employees involved in the supply chain. Matt: You have lots of challenges awaiting you. Good luck in your new project. Make sure that todays improvements in supply chain performance dont become tomorrows problems!

BALAncEd ScorEcArd BAckground


The balanced scorecard is a set of financial and non-financial measures relating to the companys mission, strategies, and critical success factors. The balanced scorecard puts vision and strategy at the center of the management control system. Vision and strategy drive performance measures, as opposed to the traditional performance measurement systems that provided their own, limited measures to management whether they were needed or not. The goal is to maintain an alignment among an organizations vision, strategy, programs, measurements, and rewards. An innovative aspect is that the components of the scorecard are designed in an integrative manner to reinforce each other as indicators of both current and future prospects for the company. The balanced scorecard enables management to measure key drivers of overall performance, rather than focusing on short-term, financial results. It helps management stay focused on the entire business process and helps ensure that actual current operating performance is in line with long-term strategy. Kaplan and Norton (1992) are generally given credit for creating the balanced scorecard in the early 1990s. One survey found that found that 60% of the Fortune 1,000 companies have or are experimenting with a balanced scorecard (Silk 1998). Such changes have been driven by the evolving focus on a team-based, process-oriented management control system. There are four perspectives or quadrants in the balanced scorecard that generate performance measures to assess the progress of a companys vision and strategy as follows:

VOL. 1, N O. 1, ART. 5, MARCH 2008

1. Customer perspective: how do customers see us? 2. Internal business perspective: what must we excel at? 3. Innovation and learning perspective: can we continue to

improve and create value?


4. Financial perspective: how do we look to shareholders?

The BSC is a set of discrete, linked measures that gives management a comprehensive and timely evaluation of performance. The BSC tries to minimize information overload by providing a limited number of measures that focus on key business processes by level of management. For example, top management needs summarized, comprehensive monetary measures while lower levels of management and employees may need both monetary and non-monetary measures on a more frequent basis. Also, such measures need to track progress concerning the gap between a companys performance and benchmarked targets. The BSC considers frequency of measurement depending upon the type of measure. Generally, nonmonetary measures are reported more frequently than monetary measures. For example, non-monetary, operating measures, such as machine downtime, percentage of capacity used, and deviations from schedule, may be measured daily. Other non-monetary measures, such as manufacturing cycle time, delivery accuracy, customer complaints, and spoilage, may be measured weekly. Some non-monetary and monetary measures, such as inventory days, accounts receivable days, product returns, and warranty costs, may be measured quarterly. Other non-monetary and monetary measures, such as new products introduced, market share, total cost of poor quality, return on investment and employee training, may be measured annually.

coMpAny BAckground
Coors had been a family owned and operated business from its inception in 1873 until 1993 when the first non-family member became President and Chief Operating Officer. However, Coors family members still held the positions of Chairman of the Board of Directors and Chief Executive Officer and all voting stock. Only nonvoting, Class B common stock was publicly traded. Coors has been financed primarily by equity and has only borrowed capital twice in its corporate history. The first long-term debt, $220 million, 8.5% notes, was issued in 1991 and the final $40 million of principal will be repaid by the end of 1999. The second long-term debt, $100 million, 7% unsecured notes, was issued in a 1995 private placement. $80 million of this principal is due in 2002 and the last $20 million is due in 2005.
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In the mid-1970s Coors was a regional brewery with an eleven-state market, selling one brand in a limited number of packages through approximately two hundred distributors. Traditionally, Coors beer had been a non-pasteurized, premium beer. (However, with a recently developed sterilization process, its products now have the same shelf life as its competitors pasteurized products.) Coors plant in Golden, Colorado was its only production facility and it had no other distribution centers. Over the next 25 years, Coors changed dramatically by expanding into all fifty states and various foreign markets. By the end of the twentieth century, Coors had production facilities in Golden, Colorado, Memphis, Tennessee, Elkton, Virginia, and Zaragoza, Spain. It had expanded to using twenty-one satellite redistribution centers in the United States before the CIL project reduced this number to eight. Beer shipments were made by both truck and railroad cars. Coors had approximately 650 domestic beer distributors although about 200 of them accounted for 80% of Coors total sales. Coors also had several joint ventures and international distributors in Canada, the Caribbean, Latin American, Europe, and the Pacific. Coors had sixteen beer brands, including a specialty line, Blue Moon that competed with the domestic micro brewing industry.However, Coors continued to focus upon its four key premium brands, Coors Light, Original Coors, Killians Irish Red, and Zima. Coors Light was the fourth largest selling beer in the U.S. In packaging, Coors had to compete with the major competitors value packaging, such as twelve-packs and thirty-packs. In 1959, Coors introduced the nations first all-aluminum beverage can and in the late 1990s, it had introduced a baseball bat bottle and a football pigskin bottle. There were also numerous state labeling laws to meet, such as returnable information, and packaging graphics to reinforce the Rocky Mountains image for Coors beer.

coMpEtItIon
Competition in the beer industry was strong, especially in the United States. Anheuser-Busch (A/B) was the market leader with approximately 50% of the U.S. market, 80 million barrels sold, $8 billion beer sales and $1 billion net profit. Due to its size, A/B was the acknowledged price leader in the industry. A/B also had thirteen domestic production plants, including one in Ft. Collins, Colorado, to achieve its customer service goal of having no major domestic distributor more than 500 miles away from one of its beer production plants. Number two in this market was Miller, owned by Philip Morris, with approximately 20% market share, 40 million
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barrels sold, $4 billion beer sales, and $460 million net profit. Miller also had seven domestic production plants. Coors was number three with an 10% market share, 20 million barrels sold, $2 billion beer sales, and $80 million net profit. Coors had three production plants in the United States. Its Colorado plant was the largest brewery in the world and served 70% of the U.S. market with its ten can lines, six bottle lines, and two keg lines. There were no other domestic brewers with market share in excess of 5%. In the late 1990s, there had been consolidation of the larger companies in the domestic beer industry. The most recent example was Stroh Brewing Company (SBC) with about 5% market share. SBC had signed agreements to sell its major brands to Miller and the remaining brands to Pabst Brewing Company and exited the beer industry by 2000. From 1983 through 1998, Coors was the only major U.S. brewer to increase its sales volume each year although industry sales had grown only about 1% per year in the 1990s. Coors had outpaced the industry volume growth rate by one or two percentage points each year. Coors had accomplished this growth by building its key premium brands in key markets and strengthening its distributor network, recently with improved supply chain management.

fundamentals in the future: 1. baseline growth: we will profitably grow key brands and key markets, 2. incremental growth: we will selectively invest to grow high potential markets, channels, demographics, and brands, 3. product quality: we will continuously elevate consumer perceived quality by improving taste, freshness, package integrity, and package appearance at point of purchase, 4. distributor service: we will significantly enhance distributor service as measured by improved freshness, less damage, increased on-time arrivals, and accurate order fill at a lower cost to Coors, 5. productivity gains: we will continuously lower total company costs per barrel so Coors can balance improved profitability, investments to grow volume, market share, and revenues, and funding for the resources needed to drive long-term productivity and success, and 6. people: we will continuously improve our business performance through engaging and developing our people. The Operations and Technology (O&T) department of Coors was in charge of the supply chain management and had developed its own vision to elaborate the overall Coors vision statement as follows: We are partners with our internal business stakeholders, with our suppliers and with our communities. With our partners, we have developed an aligned and integrated supply chain that delivers our commitments and meets the requirements that delight our distributors, retailers, and consumers, establishing our company as the supplier of choice. The processes required to design, safely produce, and deliver great tasting beer at its freshest, with superior packaging integrity, competitive cost, are well-defined, understood, consistently followed, and continually improved by every person in our organization. The quality and innovation we employ in all we do encourage beer drinkers to seek out our brands and make Coors the envy of our competition. Our use of current, accurate information and appropriate technology enables all individuals in our organization to monitor and control their work, be flexible and move with speed. We value learning and exercise a tenacious approach to eliminate waste and reduce cost. We realize that in a competitive world, we must bring value to our brands and continually aspire to a higher level of performance to compete successfully. The O&T department had also adopted and extended the following supply chain guiding principles from the work of the CIL supply chain project team to create its own business strategies:
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coorS VISIon StAtEMEnt And BuSInESS StrAtEgIES


Coors Vision Statement was as follows: Our company has a proud history of visionary leadership, quality products and dedicated people which has enabled us to succeed in a highly competitive and regulated industry. We must continue to build on this foundation and become even more effective by aligning and uniting the human, financial and physical aspects of our company to bring great tasting beer, great brands and superior service to our distributors, retailers and consumers and to be a valued neighbor in our communities. Our continued success will require teamwork and an even stronger dedication by every person in our organization to a common purpose, our Vision. Achieving our Vision requires that we begin this journey immediately and with urgency for it will require significant change for us to thrive and win in our industry. Using this vision statement, top management had decided to focus on four fundamentals: improving quality, improving service, boosting profitability, and developing employee skills. In the 1997 Coors annual report, both the CEO and the President discussed the following general business strategies or six planks to drive these
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1. Simplify and stabilize the process 2. Eliminate non-value added time and waste 3. Relentlessly pursue continuous improvement 4. Inventory is a liability, not an asset 5. People doing the work are critical to lasting improvement 6. Short cycle time + reliability = flexibility 7. Find and fix the root cause 8. Know your costs 9. Know your customers expectations 10. Make decisions where work is performed 11. Balance and optimize the overall process 12. What gets measured gets done

Thus, Kens project team had already added three new non-monetary performance measures as described below and created challenging performance targets for these measures to track anticipated additional efficiencies from the CIL project. Also, top management had created financial goals for the following key monetary performance measures in an attempt to become more competitive. These key performance measures indicated the following gaps in current performance at the end of 1997:

table 2 key performance Measures


CIL Project Performance Measure Pre 30% 90% 25% $56 $30 $3 Post 60% 95% 50% $55 $29 $4 non-Monetary Load Schedule (1) Load Item Accuracy (2) Production Stability (3) Monetary (per barrel) Manufacturing Cost S, G & A Cost Net Profit $53 $27 $6 $2 $2 $2 100% 100% 100% 40% 5% 50% Performance Target Gap

BEnchMArkIng And pErforMAncE gApS


Only limited benchmarking information was available since Coors had not yet decided to join any of the commercial benchmarking databases. (The largest one in the United States, the Hackett Group Study, sponsored by the American Institute of CPAs, has about 700 participating companies.) Performance gaps with Coors two major competitors were noted by the following financial information obtained from annual reports:

table 1 Benchmarking Analysis

Notes (these non-monetary performance targets are based upon weekly schedules generated by the supply chain software): (1) Truck or rail car loaded on time: within two hours of scheduled lead time (2) Commitments to distributors: exact product and exact quality (3) Production of scheduled product and quantity: at planned time

Beer Industry competitor Anheuser-Busch Miller Coors

Manufacturing cost per barrel $48.00 $50.00 $55.00

S,g & A cost per barrel $27.50 $27.00 $29.00

net profit per barrel $12.50 $11.00 $4.00

There were insignificant differences in price per barrel as A/B was the industry price leader and the other competitors closely followed A/Bs pricing decisions. A/B had this pricing power since its domestic market share was more than twice that of Miller and more than four times that of Coors. The major motivation for the CIL supply chain project came from the deficiencies in the supply chain performance. The CIL project had become fully operational by the end of 1997 but more time was needed to realize the full benefits of such a project. There was still a significant amount of volatility in the production process that contributed to the Colorado redistribution center being the largest bottleneck in the supply chain. For example, Coors often could not meet its goal to load beer product directly off the production line into waiting railroad cars.
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These performance gaps indicated problems with Coors traditional, cost-based performance measures. For example, direct labor variances were becoming less important due to the highly automated nature of the beer production lines. Also, current performance measures were fragmented and inconsistent between plants, unclear, not linking the separate business processes to the organization goals, not balanced to prevent over emphasis in one area at the expense of another, not actionable at all levels, and used to punish rather than incent continuous improvement.

BALAncEd ScorEcArd And chAngE MAnAgEMEnt ISSuES


Ken was thinking that he could develop a crisis motivation for his balanced scorecard project, similar to the strategy used by Matt for his CIL project. Ken knew that Coors traditional, cost-based performance measures were not driving desired results as indicated by the various performance gaps. From the vision statement and business strategy analysis, he thought that long-term sustainability and improvement in performance
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could be achieved by linking the balanced scorecard to the annual strategic planning process. He thought that continuous improvement required clearly defined, aligned business process and activity measures that support a BSC. Ken had already had preliminary meetings about this BSC project with employees who were involved in supply chain management. He had developed a list of frequently asked questions (FAQs). He thought that these FAQs might help guide him in implementing a balanced scorecard for Coors. These key FAQs are listed here:
1. Will the balanced scorecard be linked to any incentive 2.

12. How can you hold me responsible for a measure when I

am not the only one who can affect it?


13. How often will the scorecard be updated? 14. Will the scorecard be used as a club? 15. Who will put together this scorecard?

BALAncEd ScorEcArd proJEct: AddItIonAL thoughtS


Ken was wondering whether he should do an EVA analysis to demonstrate its potential for a BSC financial performance measure. Coors net operating profit before income taxes had increased from $75 million in 1996 to $105 million in 1997. According to both the CEOs shareholder letter and a Value Line analysis, the major reason for this increase was the productivity improvement from the supply chain management project that cost $20 million. This $30 million improvement in net operating profit before income taxes was also predicted to become a permanent improvement for both 1998 and 1999 operations. Kens project team had compiled the following five annual adjustments (all increases) and other financial information just in case Ken decided to do an EVA analysis.

3. 4.

5. 6.

7.

8.

9. 10.

11.

plans? What if a measure does not drive the correct behavior after implementation? What process will be used to evolve the scorecard? How will my input be heard? Wont the measures reduce our ability to be flexible with our distributors and make last minute changes for them? Why is the window on the Load Schedule Performance measure so tight? What difference does it make if we get a load out within plus/minus two hours? If we get it out the day it is scheduled, wont the load arrive at the distributor as planned? We already have plant measures that are working. Why would we want to change them? The Production Stability Measure does not incent the production lines to run ahead. Doesnt it make sense to allow us to run ahead on major brands as a cushion for those times when we have problems? So what should we do when we are more than an hour ahead, shut the line down? Why would you base Production Stability, Load Schedule Performance, and Load Item Accuracy on the initial weekly schedule? The schedule changes constantly. Why measure me against a weekly schedule that has changed as a result of something I had no control over? Will the balanced scorecard be used to compare the performance of the three U.S. plants? Since each plant is different, how can we be expected to use the same scorecard? Product mix can adversely affect the cost per barrel. Will this be taken into consideration in this measure? There may be some important measures excluded from the scorecard. If so, will they eventually be added to the scorecard? Will there be a throughput measure on the scorecard? I cannot affect the number of barrels coming through my plant. That is determined by sales and scheduling that shifts production between plants.
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table 3 EVA Adjustments


Adjustments (in millions) Advertising costs (three year life) LIFO reserve Deferred income tax liability Capitalization of operating leases Net interest expense capital $ 900 45 65 30 0 Income $300 3 10 5 12

At the end of 1997, Coors had total stockholder equity of $730 million and total liabilities of $670 million. Total liabilities included $170 million of interest bearing debt as well as current liabilities, deferred income taxes, and pension liabilities. Coors weighted average cost of capital was 10%. Ken was curious about what gaps might exist between vision statements and current business strategies for both Coors and the O&T department. However, he did not want this gap analysis to wind up overloading the BSC with too many performance measures. He was also concerned about what performance targets and reporting frequencies to establish for various BSC performance measures. Other challenges were how to link BSC performance measures and how to gain employee acceptance of the BSC.
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Ken realized that he had some serious challenges ahead of him in order to create and implement a balanced scorecard for Coors. It was now January 1998 and top management was pressing for a quick installation of the balanced scorecard in order to use it for evaluating performance in 1998.

BEEr InduStry: dEcAdE updAtES


Over the last ten years, Anheuser-Busch (A/B) has maintained its dominant market position in the U.S. beer industry at approximately 50% market share in the face of many mergers and acquisitions (M&As) by its major competitors. In 2004 the Miller brewing company was acquired by South African Breweries (SAB) and has maintained about a 20% U.S. market share. In 2004 Coors acquired the Carling & Bass Brewery in the United Kingdom. In 2005 Coors merged with the Canadian Molson company and has maintained about a 10% U.S. market share. The 1,500 U.S. craft brewers, other small U.S. brewers, and foreign brewers have the remaining 20% U.S. market share. The Coors merger with Molson has produced approximately $175 million of cost savings or synergies annually in 2006 and 2007, primarily from consolidating duplicate support functions (eliminating jobs) in the information technology, administration, finance, accounting and tax areas. In 2007 a proposed joint venture of SABMiller and Molson Coors was announced for their North American operations (for a combined 30% U.S. market share) to be effective in 2008, pending U.S. Justice Department approval concerning antitrust regulations. Ken and his fellow employees were coping with such M&A uncertainties by following the guideline: the nearer to the beer, the safer their jobs will be. SABMiller was a fully unionized company while Coors had no labor unions. Also, SABMiller has been a strong U.S. competitor to Coors over the years while Molson has not really been a direct U.S. competitor. To serve the U.S. market, A/B had thirteen U.S. breweries with no major distributor customer being more

than 500 miles away from an A/B brewery. SABMiller had nine U.S. beer plants. At the time of the case in 1998, Coors had three U.S. beer plants. Its Golden, Colorado brewery remained the largest one in the world. In 2005 Coors closed its Memphis, Tennessee plant due to continued inefficiencies in brewing Coors non-pasteurized beer. (The Memphis plant was originally purchased from the Strohs beer company which did not brew non-pasteurized beer.) To help offset this loss, in 2005 Coors expanded its existing operations at its Virginia brewery. In 2006 and 2007 Coors expanded its beer production capacities with joint operations at various Molsons Canadian breweries. Coors has estimated that each new brewery cost about $200 million to construct and was reluctant to commit such resources on its own prior to any mergers. Thus, on average, Coors has had to ship its beer eight to nine times further than its competitors. Also, Coors only has a maximum warehouse capacity in Golden, Colorado of 600,000 cases of beer which is equivalent to one 8-hour production shift. Thus, Coors has had to load per week about 1,500 beer trucks from 68 truck docks and about 400 railroad cars from 22 rail docks. This worked out to a beer shipment volume of about 60% trucks and 40% railroad cars. This information reinforced the importance of Coors supply chain project and the need to track such production and shipping performance with Coors balanced scorecard project.

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