To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15 Performance Evaluation and Compensation LEARNING OBJECTIVES Chapter 15 addresses the following questions: Q1 What is agency theory? Q2 How are decision-making responsibility and authority related to performance evaluation? Q3 How are responsibility centers used to measure, monitor, and motivate performance? Q4 What are the uses and limitations of return on investment, residual income, and economic value added for monitoring performance? Q5 How is compensation used to motivate performance? Q6 What prices are used for transferring goods and services within an organization? Q7 What are the uses and limitations of transfer pricing? These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual exercises and problems COMPLEXITY SYMBOLS The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems Questions Having a Single Correct Answer: No Symbol This question requires students to recall or apply knowledge as shown in the textbook This question requires students to extend knowledge beyond the applications e shown in the textbook Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):  Step skills (Identifying)  Step skills (Exploring)  Step skills (Prioritizing)  Step skills (Envisioning) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-2 Cost Management QUESTIONS 15.1 ROI is calculated by dividing operating income by average assets, or income/assets It can be decomposed as follows: ROI = sales/assets x income/sales 15.2 ROI can be increased by cutting costs or reducing assets Cost cutting can improve shortterm results but harm long-term results if discretionary expenditures such as advertising and research and development are cut Similarly, reducing investment in new projects could improve ROI in the short term, but harm the organization in the long term 15.3 Residual income = operating income – (required rate of return * average operating assets) Many organizations have a minimum return that is expected on operations and new investments, this is their required rate of return 15.4 The size of investment affects residual income less than ROI because it is used only to value the dollar amount of expected return, not as a denominator Residual income is therefore less influenced than ROI by changes in investment, but it is still subject to the same disadvantages as ROI that affect the operating income – such as cost cutting to discretionary expenditures 15.5 General knowledge is usually easy to transfer throughout an organization Specific knowledge is more detailed and is therefore more costly to transfer throughout an organization General knowledge is needed in the food and beverage manufacturing, in clothing manufacture, and in restaurants and bars, among others Specific knowledge is important to software companies, bio-tech organizations, and healthcare organizations, among others 15.6 If general knowledge is required for success within an organization, a centralized form is usually best because knowledge can easily be transferred to headquarters where decision making can be done from the perspective of the overall organization If specific knowledge is required, it is costly to transfer to headquarters, so a decentralized form is usually best because the decision-making authority lies with the people with specific knowledge to make the best decision 15.7 Agency costs arise when agents not act in the interest of principals because they not put in the effort required, or not have the same tolerance for risk that principals have Examples of agency costs include the cost of forgoing appropriate projects because managers perceive them to be too risky, and poor decision making because of lack of effort to search for high quality information and high quality decision making processes 15.8 EVA is very similar to residual income because both subtract from operating income some measure of interest times investment EVA is different than residual income because many adjustments are made to all parts of the calculation For example, after tax operating income is usually used in EVA, whereas before tax operating income is usually used in RI The assets are also adjusted under EVA, for example long-term leases are usually capitalized There are over 160 possible adjustments that can be made to RI under EVA To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-3 15.9 The four responsibility center descriptions and objectives follow Cost Centers: In cost centers, managers are held responsible only for the costs under their control Some cost centers provide support services that are relatively easy to monitor because their outputs are measurable Cost centers are also used for subunits that produce goods or services that eventually will be sold by others Managers in these cost centers are responsible for producing their goods or services efficiently In discretionary cost centers (marketing, research and development, for example), the output is not easily measurable in dollars or activities Cost centers are found in for-profit, not-for-profit, and government organizations Cost center managers are expected either to minimize costs for a certain level of output or to maximize output for a certain level of cost Revenue Centers: In revenue centers, managers are held responsible for the revenues under their control Revenue centers frequently sell products from manufacturing subunits Managers are expected to maximize revenues Profit Centers: Managers in profit centers are held responsible for both revenues and costs under their control Profits centers produce and sell goods or services, and may include one or several cost centers Profit center managers are responsible for decisions about inputs, product mix, pricing, and volume of goods or services produced The objective of profit centers is to maximize profits Investment Centers: Managers of investment centers are held responsible for the revenues, costs, and investments under their control Investments include any assets related to the investment center, such as fixed assets, inventory, intangible assets, and accounts receivable Investment centers resemble profit centers, where profitability is related to the assets used to generate the profits The objective of investment centers is to maximize the return on investments made by the organization This means the most profitable projects must be identified and selected for investment 15.10 From the overall organization’s point of view, it does not matter which branch pays for shipping However, if each branch is held responsible for their own costs, each would prefer to have the other one pay for shipping charges because costs in the paying branch will be increased 15.11 Advantages of decentralization for this company: Because expansion is into other countries, decision making will be timelier and probably more appropriate because local managers understand the local markets The need to communicate detailed information up and down the organization will be reduced The people making the decisions have the most knowledge and expertise Disadvantages: The decision makers may have objectives that are different from the overall company’s objectives Decisions need to be coordinated among all of the divisions to reduce non-optimal behavior such as duplication of products or services Investment in new projects may not reflect the best opportunities, but instead reflect the most persuasive decision maker To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-4 Cost Management 15.12 A suboptimal decision is one in which the overall organization does not receive as high a contribution as is possible If it is cheaper to produce the product or service internally, but the transfer price is set so that the incentive is to purchase externally, more is being paid for the good or service than should be, and a suboptimal decision has been made 15.13 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or variable and a fully allocated fixed cost), or based on market price for the good or service (and there may be a variety of ways to estimate the market price) Alternatively, transfer prices can be negotiated between two divisions The seller could receive market price and the buyer could receive variable cost under a dual-rate method Lastly, an organization could decide not to charge for transfers To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-5 EXERCISES 15.14 Brother’s Coffee Cart Business A Each cart is a profit center because the employees who operate the carts buy baked goods and other items and are responsible for selling them—i.e., they are responsible for both costs and revenues B My brother is the principal because he owns the business The coffee cart employees are his agents; they make decisions on his behalf The interests of the coffee cart employees may be different from my brother’s interests For example, the employees may want to purchase baked goods that they prefer to eat, rather than the baked goods that sell well or that earn the highest profit Or, they may not want to be too busy because it is tiring to wait on a lot of people all day My brother would prefer to have satisfied customers, keep volumes are as high as possible, and also keep costs under control He would like to have the largest contribution margin possible, and to provide high quality service so that return business is stable Agency theory also applies because my brother cannot perfectly observe his employees’ efforts or the quality of their work This inability provides an opportunity for the employees to shirk their responsibilities or to otherwise fail to work toward my brother’s best interests C My brother could use measures that focus on revenues, costs, or profit Here are some possible measures: total revenue, revenue per hour, revenue growth, cost of goods sold as a percent of revenue, supplies cost as a percent of revenue, and profit margin (operating profit divided by revenue) D Number or percentage of return customers is very important because a small cart cannot survive without regular customers Customer satisfaction is also important Cleanliness of the cart could be an issue Students may think of other factors 15.15 Brannard Company A Residual income = operating income – (rate of return x average assets0 = ($2,000,000 - $1,200,000 - $200,000) – (15% x $3,000,000) = $600,000 - $450,000 = $150,000 B ROI = operating income / average investment = $600,000/$3,000,000 = 20% To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-6 Cost Management C EVA = adjusted after-tax income – [weighted average cost of capital x (adjusted total assets – current liabilities)] = [$600,000 x (1-0.36)] – [12% x ($3,000,000 - $200,000)] = $384,000 - $336,000 = $48,000 15.16 Oslo Company [Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 3.] A Before calculating ROI, it is first necessary to calculate income: Sales (300,000 @ $2) Variable costs Fixed costs Income $600,000 (450,000) (90,000) $ 60,000 ROI = $60,000/[($500,000 + $700,000)/2] = 10% B Residual income: Income Minimum return [($500,000 + $700,000)/2 x 0.15] Residual income $ 60,000 (90,000) $(30,000) C Variable cost per unit: $450,000/300,000 = $1.50 Breakeven number of units: $2Q - $1.50Q - $90,000 = $0.50Q = 90,000 Q = 180,000 units D Sales Variable costs Contribution margin $600,000 450,000 $150,000 15.17 Fulcrum Company Segment C has the highest EVA: Segment A EVA = after-tax income – WACC*(assets – current liabilities) = [€8,000,000*(1-0.30)] – [10%*(€32,000,000 + €8,000,000 – €4,000,000)] = €5,600,000 – €3,600,000 = €2,000,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-7 Segment B EVA = [€4,000,000*(1-0.30)] – [10%*(€30,0000,000)] = = €2,800,000 – €3,000,000 = (€200,000) Segment C EVA = [€6,000,000*(1-0.30)] – [10%*€21,000,000] = €4,200,000 – €2,100,000 = €2,100,000 15.18 Fowler Electronics A ROI if the screens are transferred at variable cost: Windsor Revenue (10,000 x $2,500) Variable production costs: (10,000 x $350) (10,000 x $110) Fixed production costs Transfer price (10,000 x $350) Pretax income (loss) Income taxes (a) Net income (loss) Total assets ROI (Net income / Investment) Detroit $25,000,000 $(3,500,000) (2,000,000) 3,500,000 (2,000,000) $(2,000,000) (1,100,000) (4,000,000) (3,500,000) 16,400,000 (7,380,000) $ 9,020,000 $20,000,000 $30,000,000 (10)% 30% (a) Income tax calculations: The Windsor plant has a loss The problem provides no information about whether Canadian tax law allows companies to carry losses back against prior income or forward against future income However, if the Windsor plant does not sell to outside customers, then it might always incur a loss if variable cost is used as the transfer price Therefore, the income tax effect is estimated as zero Tax for Detroit plant = $16,400,000 x 45% = $7,380,000 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-8 Cost Management B ROI if the screens are transferred at market price: Windsor Revenue (10,000 x $2,500) Variable production costs: (10,000 x $350) (10,000 x $110) Fixed production costs Transfer price (10,000 x $750) Pretax income (loss) Income taxes (a) Net income (loss) Detroit $25,000,000 $(3,500,000) (2,000,000) 7,500,000 2,000,000 (600,000) $ 1,400,000 (1,100,000) (4,000,000) (7,500,000) 12,400,000 (5,580,000) $ 6,820,000 Total assets $20,000,000 $30,000,000 ROI (Net income / Investment) 7% 23% (a) Income tax calculations: Tax for Windsor plant: $2,000,000 x 30% = $600,000 Tax for Detroit plant = $12,400,000 x 45% = $6,820,000 C The firm will prefer the market transfer price because it maximizes company income Total income is increased through tax rate differences between Canada and the United States In addition, if variable costs are used, then there is a tax loss in Canada for which no tax benefit is received The net tax advantage of using market value for the transfer price is: Taxes if transfer price is the variable cost: Windsor Detroit Total Taxes if transfer price is the market value: Windsor Detroit Total Difference $ 7,380,000 $7,380,000 $ 600,000 5,580,000 6,180,000 $1,200,000 D The Windsor plant manager will prefer to transfer at the market price, and the Detroit plant manager will prefer variable cost because these transfer prices make their operations look best E Use of either the dual rate or the negotiation method would give managers the information they need to make the best decisions for the overall corporation A problem with the dual rate method is that both plants appear to be more profitable than they really are A problem with negotiating is that manager time can be tied up on activities that not necessarily add value to the overall firm To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-9 15.19 Hand Held A The contribution margin is $8 for the Cell Phone Division, so they will only be willing to pay what they pay now ($12) plus up to $8 more or $20, although they may not want to assemble the cell phones at break even B Chips should be sold in the division that has a $12 contribution margin rather than $8 contribution margin If market price is used for the transfer price, units will always be sold externally instead of internally C If the Chip Division has plenty of excess capacity, the transfer price should be the variable cost because the Chip Division could not sell the chips otherwise 15.20 Prem International A Fixed costs are not relevant because it is unlikely that they would change under the two options Following is a calculation of the contribution margin under each option Contribution margin for each pound of gasoline: Selling price Crude oil Variable production costs Net $ 0.16 (0.06) (0.02) $ 0.08 Contribution margin for each pound of polystyrene: Selling price Chemical variable production costs Crude oil Oil variable production costs Net $ 0.30 (0.03) (0.06) (0.04) $ 0.17 Additional contribution margin for each pound of polystyrene Times expected quantity of polystyrene sold Expected increase in pretax profit from selling polystyrene $0.09 100 million pounds $9 million B Using the usual quantitative rules for short term decisions, the maximum transfer price Chemical would be willing to pay is the price at which Chemical’s contribution margin for Benzene would be zero, calculated as follows: Per Pound Selling price $ 0.30 Chemical variable production costs (0.03) Contribution margin before cost of Benzene $ 0.27 Chemical’s managers would be willing to pay up to $0.27 per pound for the Benzene To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-10 Cost Management C At a price of $0.27, the subsidiary would earn zero contribution margin, and it would report a net loss equal to its fixed costs Assuming that the fixed cost of $0.05 per pound was based on 100 million pounds of production, this means that Chemical would report an operating loss on Benzene of $5 million At the same time, Oil would report a sizeable profit on the Benzene: Per Pound Transfer price $ 0.27 Crude oil (0.06) Oil variable production costs (0.04) Additional contribution margin $ 0.17 In #1 above, the contribution margin of selling gasoline was calculated to be $0.08 per pound Thus, Oil would report an incremental contribution margin of $0.09 ($0.17 $0.08) per pound of Benzene produced In other words, Oil would receive all of the company-wide benefit of selling Benzene Chemical’s managers would be unhappy with this arrangement, because they would be responsible for selling the product but would receive none of the company-wide incremental profit D Using the usual quantitative rules for short term decisions, the minimum transfer price Oil would be willing to receive is the price equal to the contribution margin that Oil gives up ($0.08 per pound) plus the additional variable cost that Oil will incur if it produces Benzene (incremental variable production cost of $0.02 per pound), or $0.10 per pound E Oil’s managers probably would not be willing to accept the transfer price of $0.10 per pound, because in this case Chemical would receive all of the company-wide incremental profit Because Oil can sell all of the gasoline it produces, its managers have no incentive to produce a product for which they receive no incremental profit F The most fair transfer price would be somewhere between $0.10 and $0.27 per pound (i.e., between the prices calculated in #2 and #4 above) In negotiations, however, the managers of Oil could have the upper hand Because Oil is operating at full capacity and can sell all of its production elsewhere, its managers might be able to require a transfer price of $0.27 In this case, Chemical’s managers may have no option but to accept a transfer price of $0.27 (and to report operating losses every year because of its fixed costs) Sometimes companies establish transfer prices that reflect the degree of risk assumed by each responsibility center In the Prem International problem, this might mean that Chemical would receive most of the benefit, because it is assuming the risk of selling polystyrene to outside customers Oil might be given a transfer price sufficient to ensure that it does not report an operating loss from the sale of Benzene ($0.10 plus fixed costs of $0.04 per pound) To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-11 15.21 Carlyle Corporation There are several ways to solve this problem Here is one approach: First, consider the per-unit differences in cost and revenue for the two options Ajax’s variable cost per unit is $45 If Ajax sells to outsiders at $75 per unit, the contribution margin is $30 to Ajax, so its gross margin improves by $600,000 ($30 x 20,000 units) If Bradley replaces Ajax’s units with $85 units from an outside supplier, the total cost per unit is $55 ($85 cost from outside vendor less the $30 contribution margin from outside customer) The variable cost of these units is $45 each, so Carlyle’s gross margin is maximized only by transferring the units internally at a savings of $10 per unit Here is another approach: Notice that none of Ajax division’s costs will change if it accepts the new opportunity; the division will continue to operate at full capacity The only change in its gross margin will be the difference in revenue: Revenue from new customer (20,000 x $75) Current revenue from Bradley division Increase in revenue $1,500,000 900,000 $ 600,000 Based on the preceding calculation, the Ajax division will be better off if it accepts the new order However, the company as a whole will not be better off The company will receive outside revenue of $75 per unit and it will pay an outside supplier $85 per unit, for a net decrease in gross margin of $10 per unit To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-12 Cost Management PROBLEMS 15.22 Midwest Mining A ROI = $65,000/$500,000 = 13% B Residual income = $65,000 – (0.10*$500,000) = $65,000 - $50,000 = $15,000 C There are many different ways this memo could be written However, the memo would need to explain the behavioral implications of ROI: (1) the tendency to forego profitable projects that are less than the current ROI, and (2) that cutting costs that lead to long-term benefit improves the measure In addition, it does not incorporate any measure of risk 15.23 Midwest Mining (continued) A Lease ROI New operating income = $65,000 + $40,000 – (12 x $2,000) = $93,000 ROI = $93,000/$500,000 = 18.6% Purchase ROI New operating income = $65,000 + $40,000 = $105,000 Total assets including new = $650,000 ROI = $105,000/$650,000 = 16.2% B Lease residual income RI = $93,000 – (0.10*$500,000) = $93,000 - $50,000 = $43,000 Purchase residual income RI = $105,000 – (0.10*$650,000) = $40,000 C If the performance measure causes managers to be indifferent (from the perspective of their compensation) to leasing or purchasing, they are more likely to base the decision on factors that create more value for the firm 15.24 International Woodworking A No because at a price of $150, the variable cost to the furniture division under the current transfer price policy is $155 and the Furniture Division would lose $5 per chair To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-13 B If the Furniture Division buys from Port Angeles, the contribution margin is as follows Price Variable Costs Transfer Manufacturing Selling Contribution margin $155 (40) (75) (10) $ 30 The total contribution margin is 800 x $30 = $24,000 C If Port Angeles always has excess capacity, the transfer price should be variable cost because Port Angeles has no other opportunities to sell the lumber This transfer price policy would motivate the Furniture Division to purchase internally The mill would want to keep its workers busy and be satisfied to transfer at variable cost because there are no other alternative outlets for the lumber D If there is no idle capacity, Port Angeles Mill would forego revenue from outside sales when units were transferred internally Therefore they would not transfer except at the market price 15.25 Avra Valley Services A External revenues Internal transfer: $50 x 3,000 hours $60 x 1,200 hours Total costs Operating Income Computer Services $400,000 150,000 (72,000) (220,000) $258,000 Management Advisory $700,000 (150,000) 72,000 (480,000) $142,000 B Net income for the company currently = $400,000 ($258,000 + $142,000) The new income would be $340,000 [$400,000 – ($50 x $1,200)] C Avra Valley could use an opportunity cost for the transfer price This could be the variable costs for services Although labor is guaranteed a wage, the hourly labor rate and cost of any supplies used in these services would approximate an opportunity cost This way, the department that provides services receives credit for its work, but the department purchasing services is not charged as much as outsourcing would cost D Qualitative factors would include quality of service or level of technical expertise Managers need to determine whether better quality of service or expertise would be provided inside the organization or by outsourcing Another potential qualitative factor is the possible effect on employee moral if the outsourcing option is taken and the firm lays employees off To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-14 Cost Management 15.26 Strong Welding Equipment Company A ROI ROI Brazil = $1,000,000/$4,000,000 = 25% ROI US = $120,000/$400,000 = 30% B Residual income RI Brazil = $1,000,000 – (10%*4,000,000) = $600,000 RI US = $120,000 – (10%*400,000) = $80,000 C EVA EVA Brazil = $600,000 – [9%*($4,000,000 - $80,000)] = $600,000- $352,800 = $247,200 EVA US = $80,000 – [9%*($400,000 – 10,000)] = $80,000 - $35,100 = $44,900 D Current ROI is 25% New ROI = ($1,000,000 + $500,000)/($4,000,000 + $3,500,000) = 20%, which is lower than the current ROI of 25% Therefore, the division manager would probably forego the opportunity E EVA with appropriate adjustments would be the best performance evaluation measure EVA overcomes many of the disadvantages of ROI and residual income 15.27 ATCO Company A Return on investment is not a good performance measure for the division because division management has very little control over either net income or investment Sales revenue is totally controlled by central management (they control both prices and quantities) In addition, it appears that division management does not have authority to alter the level of investment in the firm While one might also mention problems with the allocation of costs and working capital on the basis of sales, and the use of net book value, these problems are trivial relative to the division manager’s lack of authority and lack of control over factors in the performance measure B The division should be treated as a cost center (it is not a profit center) Apparently, the division management has control only over providing products at an efficient cost, given timing and quality constraints The division's performance should thus be measured relative to a well prepared flexible budget If quality is important, quality performance measures should be included To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-15 15.28 Xerox A Agency costs may or may not involve ethics An organization incurs costs to monitor and reward appropriate behavior to align goals Agents and employees are not necessarily unethical; they just may have different goals and objectives than owners For example, an employee may favor a project using his or her judgment of risk when the owner might choose a different project On the other hand, agent goals could be unethical For example, an employee may prefer to exert low work effort or take office supplies home B There are many possible answers to this question The purpose of this question is to ensure students recognize that indemnification of officer and director costs may occur in situations where no wrongdoing has occurred Here is one possible scenario: A hospital administrator could be sued by a patient or patient’s family for malpractice when the patient’s physician made all of the treatment decisions for the patient The hospital may have a policy of settling these cases to minimize publicity about lawsuits and to reduce the administrator time needed to work with lawyers and appear in court C Pros: Some lawsuits brought against Xerox’s officers might have nothing to with the officers and directors decisions directly If the officers and directors may be unwilling to work for the company if they believe they will be held liable for all employees’ actions Alternatively, their compensation would need to be high for them to accept this risk The bylaw could lower Xerox’s costs and improve its ability to attract high quality officers and directors Cons: Many people are likely to view the indemnification as inappropriate when officers and directors are sued because of decisions they have made, or because of unethical or illegal actions The indemnification reduces the officers’ incentives to use thoughtful judgment in their decisions, and the directors may not monitor as effectively D There are at least two different ways to think about this question One approach is to consider how the existence of insurance affects behavior Moral hazard problems are the changes in behavior that occur because people have insurance For example, people with health insurance may be willing to participate in sports such as skiing and rock climbing that expose them to risk of injury They know that someone else will pay for their medical bills Uninsured people may choose not to participate in such sports When payments are made by an insurance company, Xerox officers and directors may behave differently than if the payments are made directly by Xerox A second approach is to consider the ethics associated with the financial effects Does it matter whether money is paid by Xerox or by its insurance company? In the long run, insurance companies charge premiums to cover the cost of expected claims and earn a profit Thus, the payments made by Xerox’s insurance company were covered by Xerox and other companies’ insurance premiums It is possible to argue that it was unfair for companies other than Xerox to share in the cost of its officer indemnification It is also possible to argue that this type of agency cost is exactly why companies buy indemnification insurance to begin with To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-16 Cost Management E There is no one answer to this part Sample solutions and a discussion of typical student responses will be included in assessment guidance on the Instructor’s web site for the textbook (available at www.wiley.com/college/eldenburg) 15.29 Peerless Load Levelers Company A Four characteristics and requirements for a responsibility accounting system include the following Each level of management is responsible for their department’s operations as well as the employees within their department Costs must be clearly identifiable and controllable by the manager Responsibility for performance according to budget must be linked to authority to what is necessary to fulfill this responsibility The system should encourage employee involvement and participation, as well as improve morale, motivation, and communication B The cost center is an organizational unit charged with achieving its operational function at a minimum cost In cost centers, managers have authority over and are responsible for costs incurred Reports focus on the variance of those costs from the plan or budget The variances from controllable costs are used to measure the performance of the departmental manger The objective of a profit center is to maximize profits Managers of profit centers are responsible for revenues as well as controllable costs The objective of an investment center is to maximize return on investment Managers in investment centers are responsible for and have authority over costs and revenues as well as investments Measurement is based on assets employed C At least three advantages that may be gained from a responsibility accounting system include Systematic planning and reporting of controllable costs Budget setting participation that motivates managers to feel ownership, and increases their accountability and sense of responsibility Timely reports that allow corrections of difficulties before they affect financial results A major risk involved in responsibility accounting systems is that managers may focus only on the costs for which they are responsible and not on the overall goals of the organization The good of the department may be placed ahead of the good of the organization, thus making goal congruence difficult To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-17 D There are many possible answers to this question Below are examples of possible operational performance measures that Klein-Robb could implement for each of the three managers John Richards, purchasing manager: Total cash discounts earned, or cash discounts as a percent of gross purchase cost: This measure would encourage the purchasing manager to negotiate favorable cash discount terms with suppliers Number of purchases rejected from quality inspection: This measure would encourage the purchasing manager to ensure that vendors supply raw materials meeting the company’s quality specifications Price variance for direct materials: This measure would encourage the purchasing manager to seek favorable price changes Karl Willis, production manager: Achievement of budget goals as follows: o Variances from standard labor and direct material rates: These measures provide incentives to control costs through managing purchase prices and efficiency Average job set-up time: This measure would encourage the production manager to seek ways to reduce the production time lost due to job set-up Percent of production rejected at final inspection: This measure would encourage the production manager to ensure that production quality standards are maintained or improved Susan Lyle, quality manager: Variance of actual warranty costs compared to budget: This measure would encourage the quality manager to maintain or reduce the number of defective units that are sold to customers Percent of products returned: This measure would encourage the quality manager to maintain or reduce the number of defective units that are sold to customers Summary of reasons for product returns: This measure would provide the quality manager with information about what caused product returns, which in turn could be used to reduce future return rates To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-18 Cost Management BUILD YOUR PROFESSIONAL COMPETENCIES 15.30 Focus on Professional Competency: Risk Analysis A Agency theory suggests that some managers and employees may be self-interested, which can lead to errors and poor decisions through carelessness and inattention Self interest may also lead to fraudulent behavior—theft of assets or false and misleading financial reporting These types of risks are one reason why organizations institute internal controls Responsibility accounting and performance-based compensation help align the incentives of agents with those of principals, and they also establish ways to measure and monitor agent performance However, it is not possible to perfectly observe or to perfectly measure agent behavior Also, the costs of better monitoring may exceed the benefit Therefore, agency costs associated with inappropriate behavior can never be completely eliminated In addition, agency costs include the cost of monitoring (which can never be eliminated) Pros: When bonuses are based on reported earnings, managers and employees have incentives to increase sales and decrease costs, increasing the profits of the company If agents plan to continue working for the organization, they are more likely to choose actions that increase earnings over time In addition, earnings are often used by outsiders, such as analysts and shareholders of public companies, to evaluate company performance Basing bonuses on reported earnings helps focus manager and employee attention on a measure that drives a significant part of shareholder value Cons: When managers and employees plan to work only a short time for a particular company or when they are nearing retirement, they may increase short-term earnings through actions that would decrease long-term earnings For example, they may cut costs by reducing investments in marketing or research and development These actions could harm the company in the long run There is also a tendency to manipulate the numbers so that the accounting details and reported earnings are misleading If managers are held responsible for results and are rewarded for good performance, the value of the company should increase over time In addition, performance measurement allows problems in performance to be quickly detected Then corrective actions can be taken However, it is likely that managers and employees will monitor the results of their efforts and take corrective actions on their own, before an annual performance evaluation B Other risks include changes in customer demand, uncertainties about costs or the viability and efficiency of new technologies, and risks that are specific to certain locations such inflation, currency fluctuation, employee demands, or political unrest To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-19 Organizations also face risk of financial failure and loss of reputation—e.g., as a good place to work, as a high quality producer of goods or services, as an ethical organization, as an environmentally-friendly organization, or as a socially conscientious organization There are also risks of legal actions by employees, customers, and regulatory agencies Investors and others require a higher rate of return to compensate them for assuming risk For example, riskier investment projects require a higher cost of capital than less risky projects When evaluating potential projects, managers may choose to accept a project with higher risk, but only if the project is expected to earn a higher return For example, we learned in Chapter 12 that a higher discount rate is used to evaluate capital budgeting projects having higher risk Employees also require higher compensation to assume higher risk For example, accounting researchers have shown that CEOs who work for companies that could potentially face penalties for poor environmental performance and whose CEOs could be held personally liable for these types of problems receive higher compensation Organizations and individuals who are not willing to assume risk can invest in projects or take jobs that carry less risk, but that pay a lower return Opportunities offering the lowest rates of return are the ones that carry little or no risk The management of risk does not mean that risk should be eliminated As discussed in subpart above, greater risk is associated with greater return, on average In addition, it is impossible to eliminate risk completely because we compete in a dynamic business environment and live in a country with civil laws that protect employees and consumers, so we will always be at risk for actions of employees and also some frivolous lawsuits For example, it probably did not occur to Jack-in-theBox or McDonald’s officers that children might die from e-coli bacterial poisoning after eating their food However, once such a problem arises, policies are put into place to ensure that these types of problems could rarely occur again Even with policies in place, every employee cannot be continually monitored to know for certain that all hamburgers will be cooked thoroughly enough to avoid these types of problems Thus, risk management entails recognizing and planning for business risks—not necessarily eliminating them Managing risk over time means that managers will act to minimize the effects of risks For example, in all organizations employees sometimes are injured on the job To manage this risk, many companies provide employee safety training and ask employees who lift heavy things to wear special back braces to help protect their backs Over time, managers can learn to better manage risk by measuring and monitoring results and by using past experience to improve future decisions The policies that fast food stores enforce for hygiene and food preparation practices, such as thoroughly cooking beef as mentioned above are ways to manage risk over time Organizations that are international often use hedging methods to protect themselves from currency exchange risk C Unmitigated means ―unrelieved,‖ or without exception Unmitigated risk is risk that cannot be easily reduced In the chapter, we learned that agency costs cannot be To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-20 Cost Management completely eliminated, and some risk always exists that managers and employees fail to take actions that are in the best interests of the organization Although performance evaluation systems help to reduce agency costs, unmitigated risks always exist Performance evaluation involves measuring manager or employee performance, drawing conclusions from the results, and holding agents responsible for the results Thus, it assesses whether or not agents appear to be performing in the best interests of the principal, and it helps to control manager and employee behavior (i.e., to reduce unmitigated risk) 15.31 Integrating Across the Curriculum: Business Law A On its Web site, the SEC explains its major purpose in requiring companies to disclose various types of information as follows:1 The laws and rules that govern the securities industry in the United States derive from a simple and straightforward concept: all investors, whether large institutions or private individuals, should have access to certain basic facts about an investment prior to buying it To achieve this, the SEC requires public companies to disclose meaningful financial and other information to the public, which provides a common pool of knowledge for all investors to use to judge for themselves if a company's securities are a good investment Only through the steady flow of timely, comprehensive and accurate information can people make sound investment decisions In its Executive Compensation: A Guide for Investors, the SEC expands upon the purpose of its compensation disclosure requirements It states that the purpose of current disclosure requirements is ―to furnish a more understandable presentation of the nature and extent of compensation to executive officers and directors.‖2 It goes on to say: The linchpin of the Commission's executive compensation disclosure is the Summary Compensation Table… It provides an easily understood overview of executive compensation from which investors can review a company's executive compensation for the last three fiscal years, identify trends, and compare those trends with industry trends …A company also must disclose the criteria used in reaching compensation decisions and the degree of the relationship between the company's compensation practices and corporate performance ―Introduction – The SEC: Who We Are, What We Do,‖ excerpt from The Investor's Advocate: How the SEC Protects Investors and Maintains Market Integrity, U.S Securities and Exchange Commission, available at www.sec.gov/about/whatwedo.shtml ―II What Information about Executive Compensation Is Filed with the SEC?‖ and ―III Where Can I Find Information about Executive Compensation?‖ in Executive Compensation: A Guide for Investors, U.S Securities and Exchange Commission, available at www.sec.gov/investor/pubs/execomp0803.htm To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-21 The SEC focuses on executive compensation because executives often have the ability and incentive to influence their own compensation, to the potential detriment of investors B Student answers will vary depending on the report and company they choose Below are answers to this problem for the April 2004 CEO Compensation report issued by Forbes magazine Compensation for the CEO of EI du Pont de Nemours (DuPont) is used in the following sample solution because that company was highlighted in the opening vignette for Chapter 15 Forbes publishes an annual ―CEO Compensation‖ special report, typically during April The April 2004 report ranks CEOs according to a pay/performance measure; gives each CEO a grade: A+, A, B, C, D, or F; and provides summary information for executive pay at each of the largest 500 American companies.3 Summary information includes the following for the CEO of DuPont: Name Total compensation 5-year compensation Market value of shares owned Age Efficiency grade Rank Charles O Holliday, Jr $3,443,000 $15,240,000 $19,500,000 56 years D 248 (out of 500) The CEO of DuPont, Charles O Holliday, was given two types of ratings One was an efficiency grade of ―D‖; the other was a rank of 248 (out of 500) Forbes does not provide many details about how these ratings were developed Here is the information provided in the special report: Rank is based on total compensation for latest fiscal year Efficiency grade is based on our chief executive's pay/performance score We gave an "A+" to the most efficient boss in delivering performance/pay and "F" for the least efficient C Disclosures about 2003 executive compensation for DuPont was provided in the company’s Definitive Proxy Statement (Form DEF 14A), filed with the SEC on March 19, 2004 As explained in the SEC publication, Executive Compensation: A Guide for Investors, most companies provide details of executive compensation in the annual proxy statement Therefore, the proxy statement was examined first, and information was readily available there DuPont provides its proxy statement under ―Investor Center‖ and then ―SEC Filings‖ on its web site (www.dupont.com) The proxy statement could also be obtained from the Edgar database on the SEC web site (www.sec.gov/edgar/searchedgar/webusers.htm) ―Special Report: CEO Compensation,‖ Forbes.com, April 23, 2004, available at www.forbes.com/2004/04/21/04ceoland.html To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-22 Cost Management Student opinions are likely to vary about whether a company’s information is clear, concise, and understandable Students who have not previously read these types of disclosures will probably think they are confusing and difficult to understand, partly because of new terminology However, most companies (such as DuPont) closely follow the format of disclosure found in SEC publications If students study these publications, particularly Executive Compensation: A Guide for Investors, they will find the disclosures easier to read Disclosures are often vague in their explanations of the relationship between pay and performance During 2003, Charles O Holliday, Jr at DuPont received the following types of pay: Salary Variable compensation Stock options granted Other compensation, primarily savings plan contributions $1,118,000 $2,200,000 464,200 shares $33,293 The value of the stock options depends on future appreciation of DuPont’s stock If the stock does not appreciate, the value will be $0; if it appreciates by 5% per year the value will be $11,029,192; and at a 10% rate the value will be $27,935,556 During 2003, Holliday exercised 3,808 options granted in prior years and realized value of $63,556 DuPont uses several types of performance-based pay for top executives Here is a summary: Variable compensation: The company has a variable compensation plan in which a total pool of compensation varies with the performance of the company as a whole The maximum compensation is calculated as 20% of consolidated net income after deducting 6% of net capital employed Special items are removed from income for this calculation (In other words, the maximum is based on a version of residual income or EVA.) The compensation committee establishes the specific formula for each year’s compensation under the plan During 2003, the committee’s formula included EPS compared to the prior year and return on investors’ capital (ROIC) compared to the average of a peer group The committee considers both quantitative and qualitative factors The performance pay of executives depends on the overall company performance as well as the performance of their units 25% of the variable compensation is typically paid in stock Stock options: These are granted based on ―future potential and individual performance, including achievement of critical operating tasks in such areas as organizational capacity and strategic positioning.‖ To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 15: Performance Evaluation and Compensation 15-23 Restricted stock units: Grants are made in 3-year cycles, and payouts vary depending on ―pre-established performance-based objectives in both revenue growth and ROIC vs the peer group…‖ The proxy statement provides the following justification for the level of variable compensation paid to the CEO for 2003: In reaching its decision on Mr Holliday's 2003 variable compensation award, the Committee noted Mr Holliday's leadership in the Company's revenue growth broadly across businesses and regions, and an especially strong finish for 2003 In addition, the Committee recognized the successful integration of recent acquisitions, solid progress on separation of the fibers businesses and bold steps to launch the new DuPont, with significant actions planned to improve 2005 pretax earnings by $900 million through variable margin improvements, fixed cost reductions and organizational actions D Evaluation of the CEO compensation at DuPont is subject to the same types of uncertainties that exist about the reasonableness of CEO compensation at any company The performance of a CEO cannot be perfectly observed, so it is impossible to determine whether the CEO has exerted appropriate effort, established appropriate strategies and operating plans, or effectively managed the company In addition, uncertainties exist about the specific results for which the CEO should be held accountable Part of the CEO’s job is to anticipate economic conditions, competitor actions, and so forth However, it is not reasonable to expect a CEO to be able to anticipate all future conditions In addition, uncertainties exist about the appropriate targeted level for CEO compensation or about the best combination of compensation types What is the value of a CEO compared to other company employees? How much and what type of compensation must the company pay to attract high-quality managers? Which types of compensation will provide the best incentives for performance? E Many answers are possible for this question A student who evaluates the pay of DuPont’s CEO should consider evidence before reaching a conclusion Potential evidence includes DuPont’s CEO pay compared to: Some measure of reported or adjusted DuPont earnings (e.g., level of income, ROI, residual income, EVA) DuPont shareholder stock returns DuPont’s earnings and/or shareholder returns relative to one or more other companies (In its proxy statement, DuPont’s compensation committee identifies the following ―peer‖ companies: Alcoa, BASF, Dow Chemical, Eastman Kodak, Ford, General Electric, Hewlett-Packard, Minnesota Mining and Manufacturing, Monsanto, Motorola, PPG Industries, Rohm & Haas, and United Technologies) Levels of CEO pay in other companies Levels and changes in pay for other DuPont employee groups Students might also consider the opinion of others, such as the ratings of DuPont CEO pay in the Forbes compensation survey Once students have presented and evaluated To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-24 Cost Management evidence, they should identify the criteria/values used to draw conclusions For example, should CEO pay ever exceed some multiple of pay for the average employee? Should CEO pay include a portion that varies with each year’s company performance or with performance over several years? Should CEO pay remain within some percentage of the CEO pay at other companies? 15.32 Integrating Across the Curriculum: Finance A Under generally accepted accounting principles (GAAP), debt and equity accounts are typically recorded at cost and are not adjusted for fair market value Over time, fair market value can deviate substantially from book values For a company such as Amazon, whose value relies heavily on intangible assets, the fair market value can be considerably higher than the book value B The weighted average cost of capital computation typically includes only long-term debt and equity For Amazon, this would most likely include the following: 4.75% Convertible Subordinated Notes 6.875% PEACS 10% Senior Discount Notes Long-term restructuring liabilities Capital lease obligations Common stockholders’ equity Each of the preceding appears to be a source of long-term capital Excluded from this list are Euro currency swap liabilities and other long-term debt, which are assumed to be simple long-term liabilities rather than sources of capital C Possible sources of information for estimating the weighted average cost of capital are as follows; students may think of additional sources of information Market value of common stock: Quoted market prices for publicly-traded stock; estimated value using expected future earnings for non-publicly-traded stock Cost of equity capital: Long-term rate of return on the stock market for companies having similar risk Market value for each type of debt: Quoted market prices for publicly traded debt; net present value of future cash flows using current discount rates for other forms of debt Pretax interest rates: Effective interest rate imputed from market values of publiclytraded debt; discount rates used to estimate net present values for other forms of debt Income tax rate: Effective income tax rate from income tax footnote ... download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-16 Cost Management E There is no one answer to this part Sample solutions and a discussion of typical... learned that agency costs cannot be To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com 15-20 Cost Management completely eliminated, and some risk always... should be, and a suboptimal decision has been made 15.13 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or variable and a fully allocated fixed cost) , or based