In this and the next three chapters, we describe the nature of the management control process and the use of accounting information in that process. This chapter describes the environment in which management control takes place: the organization, the rules and procedures governing its work, the organization’s culture, and the organization’s exter- nal environment.

Management control focuses on organization units called responsibility centers. There are four types of responsibility centers that can be used: revenue centers, expense centers, profit centers, and investment centers. Profit centers and investment centers may require the use of transfer pricing, which this chapter also addresses.

Management Control

An organization has goals; it wants to accomplish certain things. It also has strategies for attaining these goals, which are developed through an activity called strategy formula- tion. Strategy formulation is not a systematic activity because strategies change when- ever a new opportunity to achieve the goals—or a new threat to attaining the goals—is perceived, and opportunities and threats do not appear according to a regular schedule.

Essentially, the management control process takes the goals and strategies as given and seeks to assure that the strategies are implemented by the organization. Formally, management control is defined as the process by which managers influence members of the organization to implement the organization’s strategies efficiently and effec- tively. The word control suggests activities that ensure the work of the organization proceed as planned, which is certainly part of the management control function. How- ever, management control also involves planning, which is deciding what should be done. The organization will not know how to implement strategies unless plans are de- veloped that indicate the best way of doing so.

These plans have essentially two parts: (1) a statement of objectives, which are the results that the managers should achieve in order to implement strategies, and (2) the

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resources required in order to attain these objectives. (The words goals and objectives are often used interchangeably. We use goals for broad, usually nonquantitative, long- run plans relating to the organization as a whole, and objectives for more specific, often quantitative, shorter-run plans for individual responsibility centers.)

Moreover, managers do not always seek planned results. If there is a better way than the one indicated in the plan, managers ordinarily should employ that better way. Therefore, the statement that management control seeks to assure desired results is more realistic than a reference to planned results.

With respect to a machine or other mechanical process, we can say that the process is either “in control” or out of control; that is, either the machine is doing what it is sup- posed to be doing, or it is not. In an organization, such a dichotomy is not appropriate. Although some organizations have been said to be “out of control,” it is usually more appropriate to judge an organization’s degree of control along a continuum ranging from excellent to poor.

Management control is a process (described in the succeeding three chapters) that takes place in an environment. This chapter discusses some of the important character- istics associated with this environment.

The Environment

Four facets of the management control environment discussed in this section are as follows: the nature of organizations; rules, guidelines, and procedures that govern the actions of the organization’s members; the organization’s culture; and the external environment.

A building with its equipment is not an organization. Rather, it is the people who work in the building that constitute the organization. A crowd walking down a street is not an organization, nor are the spectators at a football game when they are behaving as individual spectators. But the cheering section at a game is an organization; its mem- bers work together under the direction of the cheerleaders. An organization is a group of human beings who work together for one or more purposes. These purposes are called goals.

Management An organization has one or more leaders. Except in rare circumstances, a group of peo- ple can work together to accomplish the organization’s goals only if they are led. These leaders are called managers or, collectively, the management. An organization’s man- agers perform many important tasks, among these are the following:

• Deciding what the organization’s goals should be. • Deciding on the objectives that should be achieved in order to move toward these

goals. • Communicating these goals and objectives to members of the organization. • Deciding on the tasks that are to be performed in order to achieve these objectives

and on the resources that are to be used in carrying out these tasks. • Ensuring that the activities of the various organizational parts are coordinated. • Matching individuals to tasks for which they are suited. • Motivating these individuals to carry out their tasks.

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The Nature of Organizations

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• Observing how well these individuals are performing their tasks. • Taking corrective action when the need arises.

Just as the leader of a cheering section performs these functions, so too does the chief executive officer of General Electric Company.

Organization Hierarchy A manager can supervise only a limited number of subordinates. It follows that an or- ganization of substantial size must have several layers of managers in the organization structure. Authority runs from the top unit down through the successive layers. Such an arrangement is called an organization hierarchy.

The formal relationships among the various managers can be diagrammed in an organization chart. Illustration 22–1 shows a partial organization chart. A number of organization units report to the chief executive officer (CEO). Some of these are line units; that is, their activities are directly associated with achieving the objectives of the organization. They produce and market goods or services. Others are staff units, which exist to provide various support services to other units and to the chief executive officer. The principal line units are called divisions in the illustration. Each division contains a number of departments, and within each department are a number of sections. Different companies and nonbusiness organizations use different names for these layers of organization units. Also, in some companies, the chairman of the board is the chief executive officer and the president is the chief operating officer (COO).

Responsibility Centers All the units in Illustration 22–1 are organization units. Thus, Section A of Depart- ment 1 of Division A is an organization unit. Division A itself, including all of its de- partments and sections, is also an organization unit. Each of these units is headed by

652 Part 2 Management Accounting

President (Chief Executive Officer)

Board of Directors

Staff

Line

Manager, Division A

Manager, Division B

Manager, Division C Etc.

Etc.

Etc.Manager,Section C

Manager, Department 3

Manager, Section B

Manager, Department 2

Manager, Department 1

Manager, Section A

Manager, Control

Manager, Finance

Manager, Personnel

Manager, Legal

Manager, Research

Etc.

ILLUSTRATION 22–1 Partial Organization Chart

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a manager who is responsible for the work done by the unit; each unit, therefore, is called a responsibility center. Managers are responsible in the sense that they are held accountable for the activities of their organization units. These activities include not only the work done within the responsibility center but also its relationships with the external environment (described below). A description of how responsibility centers work and how responsibility choices should be made is provided later in the chapter.

An organization has a set of rules, guidelines, and procedures that influence the way its members behave. Some of these controls are written; others are less formal. They vary, depending in part on the size, complexity, and other characteristics of the organization and in part on the wishes of the organization’s senior management. These rules, guide- lines, and procedures exist until the organization changes them. Typically, such change comes slowly.

Some of these controls are physical, such as security guards and computer pass- words. Others are written in manuals, memoranda, or other documents. Still others are based on the oral instructions of managers. Some may even involve nonverbal com- munication, such as feelings developed about the appropriate mode of office attire: Since the boss wears casual clothes, you do too. An important set of rules is the writ- ten and unwritten rules relating to the rewards the organization offers for good perfor- mance or the penalties for substandard performance and prohibited activities.

Each organization has its own culture, with norms of behavior that are derived in part from tradition, in part from external influences (such as the norms of the community and of labor unions), and in part from the attitudes of senior management and the board of directors. Cultural factors are unwritten, and they are therefore difficult to identify. Nevertheless, they are important. For example, they explain why one entity has much better actual control than another, although both have seemingly adequate formal man- agement control systems.

An important aspect of culture is the attitude of senior management, particularly on the part of the chief executive officer and the chairman1 of the board, toward control. This has an important influence on the organization’s control environment. Some top managers prefer tight controls; others prefer loose controls. Either can work well in appropriate circumstances.

The external environment of an organization includes everything that is outside of the organization itself, including customers, suppliers, competitors, the community, regu- latory agencies, and others. The organization is continually involved in a two-way in- teraction with its external environment.

The nature of the environment in which an organization operates affects the nature of its management control system. Differences in environmental influences on the or- ganization can be summarized in one word: uncertainty. In an organization having rel- atively certain revenues and whose technology is not subject to rapid change (e.g., pulp-making), management control is considerably different from management control in an organization that operates in a fiercely competitive marketplace and whose prod- ucts must be changed frequently in order to take advantage of new technological break- throughs (e.g., computers). An organization that operates in a relatively uncertain

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1 The authors fully realize that the position of chairman of the board may be held by a woman. We use the term chairman because it is almost universally used in business practice irrespective of the po- sition holder’s gender (unlike in some universities and other nonprofit organizations, where the titles chairperson, chair, and chairwoman are also used).

Rules, Guidelines, and Procedures

External Environment

Culture

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environment relies more on the informal judgment of its managers than on its formal management control system. Also, managers at all levels in such an organization need prompt, accurate information about what is going on in the outside world.

Responsibility Centers and Responsibility Accounts

Illustration 22–2 provides a basis for describing the nature of responsibility centers. The top section depicts an electricity generating plant, which in some important respects is analogous to a responsibility center. Like a responsibility center, the plant (1) uses in- puts to (2) do work, which (3) results in outputs. In the case of the generating plant, the inputs are coal, water, and air, which the plant combines to do the work of turning a tur- bine connected to a generator rotor. The outputs are kilowatts of electricity.

As shown in part B of Illustration 22–2, a responsibility center also has inputs: physi- cal quantities of material, hours of various types of labor, and a variety of services. Usually, both current and noncurrent assets also are required. The responsibility center performs work with these resources. As a result of this work, it produces outputs: goods (if tangible) or services (if intangible). These products go either to other respon- sibility centers within the organization or to customers in the outside world.

Part C of the illustration shows information about these inputs, assets, and outputs. Although the resources used to produce outputs are mostly nonmonetary things such

654 Part 2 Management Accounting

Inputs and Outputs

Output

Electricity

Inputs

Coal, Air, Water

A. Analogy to a generating plantILLUSTRATION 22–2 Nature of a Respon- sibility Center

Inputs: Labor Material Services

Responsibility center

Outputs: Goods Services

Inputs to other responsibility

centers

Outside world

or to

B. In reality

Things, people

Inputs: 1. Cost and 2. Nonmonetary data

Responsibility center

Outputs: 1. Revenues 2. Nonmonetary information

C. As depicted by information

Assets

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as pounds of material and hours of labor, for purposes of management control, these things often are measured with a monetary common denominator so that the physically unlike elements of resources can be combined. The monetary measure of the resources used in a responsibility center is cost. In addition to cost information, nonaccounting information on such matters as the physical quantity of material used, its quality, and the skill level of the workforce is also useful.

If the outputs of a responsibility center are sold to an outside customer, accounting measures these outputs in terms of revenue. If, however, goods or services are trans- ferred to other responsibility centers within the organization, the measure of output may be either a monetary measure, such as the cost of the goods or services trans- ferred, or a nonmonetary measure, such as the number of units of output.

Responsibility center managers need information about what has taken place in their respective areas of responsibility. In addition to historical information about inputs (cost) and outputs, managers also need information about planned future inputs and outputs. The management accounting construct that deals with both planned and actual accounting information about the inputs and outputs of a responsibility center is called responsibility accounting. Responsibility accounting involves a continuous flow of information that corresponds to the continuous flow of inputs into, and outputs from, an organization’s responsibility centers.

Contrast with Full Cost Accounting An essential characteristic of responsibility accounting is that it focuses on responsi- bility centers. Full cost accounting focuses on goods and services (formally called products) rather than on responsibility centers. In making this distinction, we do not mean to imply that product cost accounting and responsibility accounting are two sep- arate accounting systems. In fact, they are two related parts of the management accounting system.

It is common for a given responsibility center in an organization to perform work related to several products. For example, the Ford Taurus and Mercury Sable automo- biles (products) are assembled in the same plants (responsibility centers). In each responsibility center, different inputs are consumed in order to produce the center’s output; these inputs are called cost elements (or, sometimes, line items). That is, there are three different dimensions of cost information, each of which answers a different question: (1) Where was the cost incurred (responsibility center dimension)? (2) For what output was the cost incurred (product dimension)? (3) What type of resource was used (cost element dimension)?

Illustration 22–3 shows how these three dimensions of cost information typically appear in an organization’s cost reporting system. For simplicity, it is assumed that this is a manufacturing company with only four departments: 1 and 2 are the produc- tion departments, fabrication and assembly; department 3 provides all production support functions; and department 4 performs all selling and administrative activities. Part A of the illustration shows the full costs of the organization’s two products for a one-month period, and the details of the cost elements that make up these full costs. Note that it is impossible to identify from the part A information what costs the man- agers of Departments 1, 2, and 3 were individually responsible for. In particular, the costs of Department 3 have been allocated first to the two production departments and then, through their overhead allocations (cost drivers), to the two products; hence, Department 3 costs are a portion of the amount shown as each product’s production overhead costs.

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Responsibility Accounting

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By contrast, responsibility accounting identifies the amount of costs that each of the four departmental managers is responsible for, as shown in part B of the illustration. Note that part B, however, does not show the costs of the two products. Both types of informa- tion are needed. Note also that the total product costs ($48,120) are equal to the total responsibility costs. The two parts are different arrangements of the same underlying data.

Full product costs and responsibility costs, then, are two different ways of “slicing the same pie.” This is depicted in part C of Illustration 22–3, which summarizes the cost data in a matrix format to show both product costs and responsibility costs, with- out including the cost element details. If cost information in the cells of the matrix is added across a row, the total is responsibility accounting data, which is useful for man- agement control purposes. If this information is instead added down a column, the total is product cost information, which is useful for pricing decisions and product prof- itability evaluation.

656 Part 2 Management Accounting

ILLUSTRATION 22–3 Contrast between Full Costs and Re- sponsibility Costs

A. Full Product Costs

Total Product X Product Y

Cost element: Direct material $20,000 $14,000 $ 6,000 Direct labor 13,000 8,000 5,000 Indirect production 9,620 5,920 3,700 Selling and administration 5,500 3,645 1,855_______ _______ _______

Total costs $48,120 $31,565 $16,555

B. Responsibility Costs

Departments (Responsibility Centers)

Total 1 2 3 4

Cost element: Direct material $20,000 $16,000 $ 4,000 Direct labor 13,000 4,000 9,000 Supervision 4,240 800 1,200 $ 840 $1,400 Other labor costs 6,970 1,500 170 2,200 3,100 Supplies 1,290 660 330 100 200 Other costs 2,620 880 440 500 800_______ _______ _______ ______ ______

Total costs $48,120 $23,840 $15,140 $3,640 $5,500

C. In Matrix Format

Product Responsibility X Y Costs

1 16,496 7,344 $23,840 2 9,184 5,956 15,140 3 2,240 1,400 3,640 4 3,645 1,855 5,500

Product Costs $31,565 $16,555 $48,120

D ep

ar tm

en t

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In addition to the department managers, some organizations have product managers who are responsible for the product costs in the columns of the matrix (as well as for their products’ revenues). Such organizations are called matrix organizations, and in them both the columns and rows of part C represent responsibility centers.

The performance of a responsibility center manager can be measured in terms of the effectiveness and efficiency of the work of the responsibility center. Effectiveness means how well the responsibility center does its job—that is, the extent to which it produces the intended or expected results. Efficiency is used in its engineering sense— that is, the amount of output per unit of input. An efficient operation either produces a given quantity of outputs with a minimum consumption of inputs or produces the largest possible outputs from a given quantity of inputs.

Effectiveness is always related to the organization’s objectives. Efficiency, per se, is not. An efficient responsibility center is one that does whatever it does with the low- est consumption of resources. However, if what it does (i.e., its output) is an inade- quate contribution to the accomplishment of the organization’s objectives, then it is ineffective.

If a department responsible for processing incoming sales orders does so at a low cost per order processed, it is efficient. If, however, the department is slow in answering customer queries about the status of orders, thus antagonizing customers to the point where they take their business elsewhere, the department is ineffective.

Stated informally, then, efficiency means “doing things right,” whereas effectiveness means “doing the right things.”

In many responsibility centers, a measure of efficiency can be developed that relates actual costs to a number that expresses what costs should be for a given amount of out- put (that is, to a standard or budget). Such a measure can be a useful indication, but never a perfect measure, of efficiency for at least two reasons: (1) Recorded costs are not a precisely accurate measure of resources consumed and (2) standards are, at best, only approximate measures of what resource consumption ideally should have been in the circumstances prevailing.

A responsibility center should be both effective and efficient; it is not a case of one or the other. In some situations, both effectiveness and efficiency can be encompassed within a single measure. For example, in profit-oriented organizations, profit measures the combined result of effectiveness and efficiency. When an overall measure does not exist, classifying the various performance measures used as relating either to effec- tiveness (e.g., warranty claims per 1,000 units sold) or efficiency (e.g., labor-hours per unit produced) is useful.

Types of Responsibility Centers

As previously noted, an important business goal is to earn a satisfactory return on in- vestment (ROI). Return on investment is the ratio

ROI �

The three elements of this ratio lead to definitions of the types of responsibility centers important in management control systems. These are (1) revenue centers, (2) expense centers, (3) profit centers, and (4) investment centers.

Revenues � Expenses ��

Investment

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Effectiveness and Efficiency

Example

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If a responsibility center manager is held accountable for the outputs of the center as measured in monetary terms (revenues) but is not responsible for the costs of the goods or services that the center sells, then the responsibility center is a revenue center. Many companies treat regional sales offices as revenue centers. In retailing companies, it is customary to treat each selling department as a revenue center.

A sales organization treated as a revenue center usually has the additional res- ponsibility for controlling its selling expenses (travel, advertising, point-of-purchase displays, and so on). Therefore, revenue centers are often expense centers as well. However, a revenue center manager is not responsible for the center’s major cost item—its cost of goods and services sold. Thus, subtracting just the selling expenses for which the manager is responsible from the center’s revenues does not result in a very meaningful number, and certainly does not measure the center’s profit.

If the control system measures the expenses (i.e., the costs) incurred by a responsibil- ity center but does not measure its outputs in terms of revenues, then the responsibility center is called an expense center. Every responsibility center has outputs; that is, it does something. In many cases, however, measuring these outputs in terms of revenues is neither feasible nor necessary. For example, it would be extremely difficult to mea- sure the monetary value of the accounting or legal department’s outputs. Although measuring the revenue value of the outputs of an individual production department generally is relatively easy to do, there is no reason for doing so if the responsibility of the department manager is to produce a stated quantity of outputs at the lowest feasi- ble cost. For these reasons, most individual production departments and most staff units are expense centers.

Expense centers are not quite the same as cost centers. Recall from Chapter 18 that a cost center (or cost pool) is a device used in a full cost accounting system to collect costs that are subsequently to be charged to cost objects. In a given company, most but not all cost centers are also expense centers. However, a cost center such as occupancy is not a responsibility center at all and, hence, is not an expense center.

There are two types of expense centers: standard cost centers and discretionary ex- pense centers. The differences between them relate to the types of costs involved. (These cost distinctions are discussed in more detail in Chapter 23.) In a standard cost center (also called an engineered expense center), standard costs have been set for many of the cost elements. Actual performance is measured by the variances between its actual costs and these standards (as was described in Chapter 20). Because standard cost systems are used in operations having a high degree of task repetition, such opera- tions are also the settings for standard cost centers. Examples include all kinds of assembly-line operations, fast-food restaurants, blood-testing laboratories, and automo- bile service facilities.

Discretionary expense centers (also called managed cost centers) are responsibil- ity centers where the output cannot be measured well in monetary terms. Examples are most production support and corporate staff departments (e.g., human resources, ac- counting, research and development). In these responsibility centers, the amount of ex- penses that should be incurred is a matter of management judgment. In discretionary expense centers, differences between actual and budgeted expenses are not indicators of efficiency, as is true in standard cost centers. They merely provide indications as to whether the responsibility center managers have adhered to budget spending guide- lines. Since the value of the output is not measured, it is impossible to say anything about the efficiency of performance.

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Expense Centers

Revenue Centers

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Revenue is a monetary measure of outputs; expense (or cost) is a monetary measure of inputs, or resources consumed. Profit is the difference between revenue and expense. If performance in a responsibility center is measured in terms of the difference between (1) the revenues it earns and (2) the expenses it incurs, the responsibility center is a profit center.

In financial accounting, revenue is recognized only when it is realized by a sale to an outside customer. By contrast, in responsibility accounting, revenue measures the outputs of a responsibility center in a given accounting period whether or not the com- pany realizes the revenue in that period. Thus, a factory is a profit center if it “sells” its output to the sales department and records the revenue and cost of such sales. Like- wise, a service department, such as the corporate information systems or training department, may “sell” its services to the responsibility centers that receive these ser- vices. These “sales” generate revenues for the service department. Since the difference between sales revenues and the cost of these sales is profit, the service department is a profit center if both of these elements are measured.2

A given responsibility center is a profit center only if management decides to mea- sure that center’s outputs in terms of revenues. Revenues for a company as a whole are automatically generated when the company makes sales to the outside world. By con- trast, revenues for an internal organization unit are recognized only if management de- cides that it is a good idea to do so. No accounting principle requires that revenues be measured for individual responsibility centers within a company. In recent years, many companies in their total quality management programs have been emphasizing that every department has customers: Some have external customers; others have internal customers. To reinforce this philosophy, many departments that formerly were expense centers have been converted to profit centers. With some ingenuity, practically any ex- pense center could be turned into a profit center because some way of putting a selling price on the output of most responsibility centers can usually be found. The question is whether there are sufficient benefits in doing so.

Advantages of Profit Centers A profit center resembles a business in miniature. Like a separate company, it has an income statement that shows revenues, expenses, and profit. Most of the decisions made by the profit center manager affect the numbers on this income statement. The income statement for a profit center is therefore a basic management control docu- ment. Because their performance is measured by profit, the managers of profit centers are motivated to make decisions about inputs and outputs that will increase the profit reported for their profit centers. Since they act somewhat as they would if they were running their own businesses, the profit center is a good training ground for general management responsibility. The use of the profit center concept is one of the impor- tant tools that has made possible the decentralization of profit responsibility in large companies.

Chapter 22 Control: The Management Control Environment 659

2 In some such service centers, the prices for the center’s services are set with the intent of recovering exactly the costs of the services—that is, breaking even. Even though the goal is to earn zero profit, the center is still a profit center because it is responsible for both its revenues and expenses. In fact, a profit center can even have a negative profit goal, indicating that its budgeted costs exceed its budgeted revenues.

Profit Centers

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Criteria for Profit Centers In deciding whether to treat a responsibility center as a profit center, the following points are relevant:

1. Using the profit center idea involves extra recordkeeping. The profit center itself has the extra work of measuring output in revenue terms; the responsibility centers that receive its outputs have the work of recording the cost of goods or services received.

2. If the manager of a responsibility center has little authority to decide on the quan- tity and quality of its outputs or on the relation of output to costs, then a profit cen- ter is usually of little use as a control device. This does not imply that the manager of a profit center must have complete control over outputs and inputs; few, if any, managers have such complete authority.

3. When senior management requires responsibility centers to use a service furnished by another responsibility center, the service usually is furnished at no charge, and the service unit therefore is not a profit center. For example, if senior management requires internal audits, the audited units usually are not asked to pay for the cost of the internal auditing service, and the internal auditing unit therefore is not a profit center.

4. If outputs are fairly homogeneous (e.g., cement), a nonmonetary measure of output (e.g., tons of cement produced) may be adequate, and no substantial advantage may be gained in converting these outputs to a monetary measure of revenue.

5. To the extent that the profit center technique puts managers in business for them- selves, it promotes a spirit of freedom and competition. In many situations, the free- dom provides a powerful incentive for good management. In other situations, how- ever, where organization units should cooperate closely with one another, the competition may generate excessive friction between profit centers, to the detriment of the company’s overall welfare. Also, it may generate too much interest in short- run profits to the detriment of long-run results.

A transfer price measures the value of products (i.e., goods or services) furnished by a profit center to other responsibility centers within a company. It is to be contrasted with a market price, which measures exchanges between a company and its outside customers. Internal exchanges that are measured by transfer prices result in (1) revenue for the responsibility center furnishing (i.e., selling) the product and (2) cost for the re- sponsibility center receiving (i.e., buying) the product. Whenever a company has profit centers, transfer prices usually are required. There are two general types of transfer prices: the market-based price and the cost-based price.

Market-Based Transfer Prices If a market price for the product exists, a market-based transfer price is usually prefer- able to a cost-based price. The buying responsibility center should ordinarily not be ex- pected to pay more internally than it would have to pay if it purchased from an outside vendor, nor should the selling center ordinarily be entitled to more revenue than it could obtain by selling to an outside customer. If the market price is abnormal, as when an out- side vendor sets a low “distress” price in order to use temporarily idle capacity, then such temporary aberrations are ordinarily disregarded in arriving at transfer prices. The mar- ket price may be adjusted downward to reflect the fact that credit costs (e.g., bad debt losses) and possibly certain selling costs are not incurred in an internal exchange. This downward adjustment, usually only a few percentage points, ensures that the buying center is not indifferent between buying within the company or on the outside.

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Transfer Prices

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Market-based prices, where available, are widely used.3 They have the benefit of being reasonably objective rather than a function of the relative negotiating skills of the selling and buying profit center managers. Also, many companies expect their profit centers to deal with one another almost literally at arm’s length as independent busi- nesses, and market-based prices add to the realism of this business relationship. In practice, however, the “true” market price is sometimes not clear, because different suppliers may set different prices on essentially identical items. A clearly stated policy (e.g., “the lowest available price, after consideration of supplier reliability and other factors such as warranty, delivery, and credit terms or an arbitration mechanism” (described below)) is needed to deal with these market-price ambiguities.

Cost-Based Transfer Prices In a great many situations, no reliable market price exists for use as a basis for the transfer price. In these situations, a cost-based transfer price is used. If feasible, the cost should be a standard cost. If it is an actual cost, the selling responsibility center has little incentive to control efficiency, because any cost increases will be automati- cally passed on to the buying center in the transfer price.

Senior management may specify the method of computing cost and the amount of profit to be included in the transfer price in order to lessen the chance of arguments. To avoid disputes, any policy statement on how costs and profit are to be computed must be thorough and carefully worded. In particular, short-term per-unit costs may be different from longer-term costs. There also can be questions about whether all of the cost ele- ments normally included in the seller’s definition of full cost should be included in the definition of cost used to determine internal prices. Also, disputes—or at least resent- ment on the part of the buyer—may occur if market conditions have squeezed the seller’s outside profit margins to a lower level than that specified in the policy statement.4

Negotiation and Arbitration Because of the potential areas for disagreement in both market-based and cost-based transfer pricing, such prices are sometimes negotiated between buyer and seller rather than being set by reference to outside prices or by a formula applied to the seller’s

Chapter 22 Control: The Management Control Environment 661

3 Based on a survey of 215 large corporations, S. C. Borkowski, “Environmental and Organizational Factors Affecting Transfer Pricing: A Survey,” Journal of Management Accounting Research 2 (Fall 1990), p. 87, reported the prevalence of various transfer-pricing policies as follows:

Basis of Transfer Price Percent

Market price 33 Negotiation 23 Full cost plus profit 17 Full cost 23 Variable costs 4____

100

These findings are consistent with those of a more recent study of 12 firms in the United States and United Kingdom. J. Elliott and C. R. Emmanuel, International Transfer Pricing: A Study of Cross-Border Transactions (London: Chartered Institute of Management Accountants, 2000). 4 If the buying and selling responsibility centers are located in different countries (e.g., GM selling items made in one of its U.S. parts plants to one of its European assembly plants), then the laws of either country may impact how the transfer price is set. The intent of the laws is to limit the extent to which profits can be shifted from a high-tax country to a low-tax country by manipulating the transfer price. Further discussion of these laws is beyond the scope of this introductory text.

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costs. Also, the seller is sometimes willing to depart from the normal company trans- fer price policy. For example, the selling responsibility center may be willing to sell below the normal market price rather than lose the business, which could happen if the buying responsibility center took advantage of a temporarily low outside price. In such circumstances, the two parties negotiate a deal.

If either responsibility center manager lacks complete freedom to act or the parties have unequal bargaining powers, these negotiations will not always lead to an equitable result. The prospective buying center may not have sourcing freedom—the power of threatening to take its business elsewhere—or the prospective seller may not have the power of refusing to do the work. When such conditions exist, there usually needs to be an arbitration mechanism to settle transfer pricing disputes. Such negotiations and ar- bitration can be very time-consuming.

A U.S.-based automobile company decided to market a car in the United States that would be manufactured in one of the company’s European plants. It took almost one full year for the European manufacturing profit center and the U.S. marketing profit center to reach agreement on the transfer price.

Risk of Suboptimization Usually, profit centers are not, in fact, legally independent business entities. (When they are legally separate, they have the same parent.) When they engage in transactions among themselves, there is sometimes the risk that a decision that will increase a given profit center’s reported income will not increase the total company’s income. This risk of suboptimization may exist when the selling profit center’s normal transfer price is higher than its short-run costs, which is almost always the case.

Division B buys Component X from Division A. Division B uses this component in Product Y. The current transfer price for X, which includes full costs plus a profit margin, is $50. Division B’s variable cost of Product Y, including the $50 for Component X, is $150 per unit (i.e., $100 of variable cost is added by B’s production and selling operations). Both currently have con- siderable excess capacity. This has led Division B to consider temporarily contribution pricing (described in Chapter 26) Product Y. Division B has the opportunity, without spoiling the market, to sell 1,000 units of Y to a new customer on a one-time basis for $145 per unit. Since this is less than B’s $150 per unit variable cost, B rejects this opportunity.

However, it happens that A’s variable cost for Component X is only $20 per unit, making the company’s variable cost for Product Y only $120 per unit ($20 variable cost in A plus $100 in B). Thus, the company could earn a contribution of $25 per unit ($145 price � $120 variable costs) on the deal that B has turned down. Adherence to the established transfer prices has therefore led to suboptimization for the company as a whole and for each division.

This example of suboptimization probably is found more often in textbooks than in practice. Since it is in the self-interest of both managers that the sale be made to the outside customer at a below-normal price, the sensible course of action is for them to get together and negotiate a mutually agreeable transfer price. This price would be higher than the selling division’s variable cost but lower than its normal transfer price. In effect, the contribution margin from the transaction would be divided fairly between the two divisions.

Multiple Criteria Companies seek many things in their transfer pricing policies: objectivity, realism, fairness to all parties involved, a minimum of time spent in negotiating and arbitrating, and minimum risk of suboptimization. They also want the prices eventually to result in

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Example

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measured profits that reflect the “true” economics of each of the profit centers in- volved. For example, if Division A sells to Division B on an ongoing basis, corporate management does not want Division B to look more profitable than it really is solely because unrealistically low transfer prices result in profit arbitrarily being shifted from A to B. Such a hidden subsidy could lead to a decision to increase investment in Divi- sion B when in fact the expansion is not warranted. The various criteria listed above, particularly realism versus risk of suboptimization, often conflict. Not surprisingly, therefore, one frequently hears profit center managers express dissatisfaction with the particular transfer pricing approach used in their company.

An investment center is a responsibility center in which the manager is held respon- sible for the use of assets as well as for profit.5 It is, therefore, the ultimate extension of the responsibility idea. In an investment center, the manager is expected to earn a sat- isfactory return on the assets employed in the responsibility center.

Many companies use a ratio of profit to investment to measure an investment cen- ter’s return on investment. Return on assets (profit divided by total assets) and return on “net assets” or invested capital (profit divided by assets net of certain or all current liabilities) are commonly used, in part because these ROI measures correspond to ra- tios calculated for the company as a whole by outside securities analysts. Other com- panies measure an investment center’s residual income (also more recently modified and called economic profit, economic value added, or EVA), which is defined as profit (before interest expense) minus a capital charge. The capital charge is calculated by applying a rate, typically equal to the company’s weighted average cost of capital, to the investment in the center’s assets or net assets.6

Division Z of ABC Corporation is an investment center. In 20x6 the division’s profit was $150,000 (net of interest expense of $30,000), and the division employed $1,000,000 of assets. For purposes of calculating residual income, ABC levies a 10 percent capital charge on assets employed. Division Z’s ROI and residual income for the year would be calculated as follows:

ROI � � � 15 percent

Residual income � Preinterest profit � (Capital charge * Investment)

� $180,000 � (0.10 * $1,000,000) � $80,000

Residual income is conceptually superior to ROI as a performance measure. Sup- pose the Division Z manager in the example above could increase profits by $12,000 a year by making an investment of $100,000. Because the 12 percent ($12,000 � $100,000) return on this investment is less than the 15 percent average return the divi- sion is already earning, the manager may shy away from making this investment.

$150,000 $1,000,000

Profit Investment

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Example

Investment Centers

5 Note that in an investment center, both profit and assets are measured. Many companies refer to both their profit centers and their investment centers as profit centers. 6 In a survey of the Fortune 1000 largest U.S. industrial firms, James S. Reece and William R. Cool found that of those companies having investment centers, 65 percent used only an ROI measure, 2 percent used only residual income, 28 percent used both ROI and residual income, and the remain- ing 5 percent either used some other method or did not disclose their method. (See “Measuring Investment Center Performance,” Harvard Business Review, May–June 1978.) A more recent study reported that the use of residual income had increased to 36 percent. (Source: Vijay Govindarajan, “Profit Center Measurement: An Empirical Study,” Working Paper, Amos Tuck School of Business Administration, Dartmouth College, 1994.)

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However, if the incremental capital cost rate is truly 10 percent, the investment would increase corporate “wealth” by the amount of additional annual residual income the investment would produce: $12,000 � (0.10 * $100,000) � $2,000.

Despite its conceptual advantage, many companies do not use residual income as an investment center measure for three reasons. First, ROI measures are scaled. ROI per- centages are ratios that can be used to compare investment centers of differing sizes, whereas residual income is an absolute dollar amount that is a function of the investment center’s size. Second, a company’s residual income is an internal figure that is not re- ported to shareholders and other outsiders. And third, using residual income measures often causes confusion. Many people, even experienced managers, do not understand the meaning of the residual income measure. The confusion is exacerbated because many companies, and indeed whole industries, have negative residual incomes. They are not earning returns on their existing investment bases that exceed their cost of capital.

Whether ROI or residual income is used, the measurement of assets employed—the investment base—poses many difficult problems. For example, consider cash. The cash balance of the company is a safety valve, or buffer, protecting the company against short-run fluctuations in funds requirements. Compared with an independent company, an investment center needs relatively little cash because it can obtain funds from head- quarters on short notice. Part of the headquarters cash balance therefore exists for the financial protection of the investment centers and can logically be allocated to them as part of their capital employed. This cash can be allocated to investment centers in any of several ways.

Similar problems arise with respect to each type of asset that the investment center uses. Valuation of plant and equipment is especially controversial: Alternatives include gross book value, net book value, and replacement cost. A discussion of these problems is outside the scope of this introductory treatment. For our present purpose, we need only state that many problems exist and that there is much disagreement about the best solu- tion. Despite these difficulties, a growing number of companies find it useful to create in- vestment centers.7

The investment center approach is normally used only for a relatively “free-standing” product division—that is, a division that both produces and markets a line of goods or a set of services and significantly influences its own level of assets. This approach has the effect of “putting managers in business for themselves” to an even greater extent than does the profit center. Reports on performance show not only the amount of profit that the investment center has earned, which is the case with reports for a profit center, but also relates the profit to the amount of assets used in generating it (through either an ROI measure or residual income). This is obviously a more encompassing report on perfor- mance than a report that does not take into account the assets employed. On the other hand, the possible disadvantages mentioned above for profit centers exist in a magnified form in investment centers.

Two Misconceptions Some people think that the principal reason for using the investment center approach is to enhance control over all assets. This is not the case. Most companies exercise con- trol over fixed assets via the capital investment procedures described in Chapter 27. This control precludes a responsibility center manager from unilaterally making large investments in fixed assets. Rather, the investment center approach primarily directs

664 Part 2 Management Accounting

7 Govindarajan’s 1994 survey (see footnote 6) found that 93 percent of the Fortune 1000 companies had two or more profit centers. Companies considerably smaller than these 1,000 also have adopted the investment center measurement approach.

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managers’ attention to the current assets under their day-to-day control, particularly in- ventories and receivables.

Second, many companies monitor the ROI or residual income of their profit centers to see if the company is continuing to earn a satisfactory return on the capital tied up in those units. This measurement process does not make those units investment centers. Such a unit is an investment center only if its manager is held accountable for the ROI or residual income of the unit.

The fact that each responsibility center is treated as either a revenue, expense, profit, or investment center does not mean that only monetary measures are used in monitoring its performance. Virtually all responsibility centers have important nonfinancial objectives: the quality of their goods or services, cycle times, customer satisfaction, employee morale, and so on. Particularly in expense centers such as staff units, these nonmonetary factors may be more important than monetary measures. Many companies employ, in addition to their monetary control systems, formal systems for establishing and measur- ing nonmonetary factors. Two systems in common use are management by objectives (MBO) systems and Balanced Scorecard systems; they are described in Chapter 24.

Summary An organization consists of responsibility centers. Management control involves the planning and control of these centers’activities so they make the desired contributions to- ward achieving the organization’s objectives. The management control environment in- cludes the nature of the organization; its rules, guidelines, and procedures; its culture; and its external environment.

Responsibility centers use inputs and assets to produce outputs. Responsibility account- ing focuses on planned and actual amounts for responsibility center inputs and outputs. It is to be contrasted with full cost accounting, which focuses on products rather than on re- sponsibility centers.

There are four types of responsibility centers: revenue centers, in which outputs are measured in monetary terms; expense centers, in which inputs are measured in monetary terms; profit centers, in which both inputs and outputs are measured in monetary terms; and investment centers, in which both profits and assets employed are measured and related to each other. In profit centers and investment centers, a transfer price is used to measure products furnished to other responsibility centers. Nonmonetary measures are also impor- tant in all types of responsibility centers.

Problems Problem 22–1.

Department 7 of the Arbia Company manufactures a variety of components for products, one of which is Part No. 211. Data on this part are as follows:

Monthly Actual Planned Cost Cost July

Per Unit Per Unit Total

Direct material and direct labor $30.17 $29.82 $29,820 Fixed costs, Department 7 6.49 6.88 6,880 Costs allocated to Department 7 13.83 14.29 14,290_______ _______ ________

Total $50.49 $50.99 $50,990_______ _______ _______________ _______ ________

Part No. 211 can be purchased from an outside vendor for $31.00.

Nonmonetary Measures

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666 Part 2 Management Accounting

Required: What costs are relevant for each of the following purposes?

a. For preparing financial statements for July?

b. For deciding whether to make or buy Part No. 211?

c. For assessing the performance of the manager of Department 7? Problem 22–2.

Golub Company manufactures three products, A, B, and C. It has three marketing man- agers, one for each product. During the first year of operations, the company allocated its $30,000 of actual advertising expense to products on the basis of the relative net sales of each product. In the second year, the advertising budget was increased to $60,000. Half was spent on general institutional advertising in the belief the company image would be enhanced. Of the other half, $10,000 was spent on Product A, $15,000 on Product B, and $5,000 on Product C. For purposes of income measurement, all advertising expenses continued to be allocated on the basis of sales. Certain data in the second year were as follows:

Total Product A Product B Product C

Net sales $460,000 $207,000 $128,800 $124,200 Advertising expense 60,000 27,000 16,800 16,200 Income 55,000 25,500 12,000 17,500

When the marketing manager of Product A received these figures, he complained that his department was charged with an unfair portion of advertising, and that he should be held responsible only for the actual amount spent to advertise Product A.

Required: a. Comment on the sales manager’s complaint.

b. In Golub’s responsibility accounting system, how much advertising expense should be charged to the department responsible for marketing Product A?

Problem 22–3. The Top Division of C. Can Company manufactures metal tops that are used by other divisions of C. Can Company and that also are sold to external customers. The Hardware Division of C. Can Company has requested the Top Division to supply a certain top, Style H, and the Top Division has computed a proposed transfer price per thousand tops, as follows:

Variable cost $195 Fixed cost 21_____

Total cost 216 Profit (to provide normal return on assets employed) 40_____

Transfer price $256

The Hardware Division is unwilling to accept this transfer price because Style H tops are regularly sold to outside customers for $239 per thousand. The Top Division points out, however, that competition for this top is unusually keen, and that this is why it cannot price the top to external customers so as to earn a normal return. Both divisions are profit centers.

Required: What should the transfer price be? (Explain your answer.)

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Chapter 22 Control: The Management Control Environment 667

Problem 22–4. Urban Services, Inc., a management consulting group, is in its fourth year of operation. It consists of three independent groups: (1) legal services, (2) accounting services, and (3) portfolio management. All its revenue comes from physicians and dentists. It has no plans to expand its services outside these markets. Clients are billed at hourly rates for ser- vices rendered to them.

One group often performs services for another group. For example, after the accounting services group has decided that a client physician needs to shelter some of his or her in- come, it requests the portfolio management group to match the needs of the client with the best shelter possible for this client.

Corporate policy allows each group manager to operate his or her group as if it were a separate company. The following is representative of pricing and cost information for each group:

Per Consulting Hours

Billing Variable Total Fixed Group Rate Cost Cost

Legal services $115 $35.00 $396,000 Accounting services 140 46.00 462,000 Portfolio management 104 57.00 330,000

Required: a. The staff of the portfolio management group is working at capacity with its own

outside clients. If the legal services group wants to buy consulting services from the portfolio management group, at what price per hour should the portfolio manage- ment group bill the legal services group?

b. Are there any conditions under which the portfolio management group should bill the legal services group at less than this price?

c. The accounting services group has been using about 1,400 hours per quarter of legal services group time at a rate of $115. If the legal services group manager de- cides to raise the rate 10 percent, should the accounting services group be forced by corporate management to pay the new rate in order to keep the business in the firm?

Cases

Case 22–1

Behavioral Implications of Airline Depreciation Accounting Policy Choices* Most managers have significant discretion in choosing their accounting policies. The managers of some companies choose sets of policies that are relatively “conservative”; others choose sets that are relatively “liberal.” Conservatism results in delay of the recogni-

tion of some revenues or gains and/or acceleration of the recognition of some expenses or losses. Liberal ac- counting policies do the opposite. The effect of con- servatism is that profits are reported later than they would have been had more liberal accounting policies been adopted.

If one wants to determine whether an airline com- pany is being conservative or liberal in its choice of

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accounting policies, one obvious place to look is in the area of accounting for property, plant, and equipment (PP&E). PP&E usually constitutes more than 50 per- cent of the total assets of an airline. Interestingly, air- lines’ accounting policies for PP&E vary significantly.

Consider, for example, the aircraft depreciation practices used at four major airlines:

DELTA AIRLINES1

• Straight-line over estimated useful lives;

• 20-year life (from the date the equipment was placed in service) on substantially all aircraft;

• Residual value � 5% of cost.

AMR CORPORATION (PARENT OF AMERICAN AIRLINES)2

• Straight-line;

• 25-year life (30-year life for Boeing 777s);

• Residual value � 10% of cost.

SINGAPORE AIRLINES3

• Straight-line;

• 15-year life;

• Residual value � 10% of cost.

LUFTHANSA • Straight-line;

• 12-year life;

• Residual value � 15% of cost.

OTHER FACTS 1. An aircraft can fly indefinitely, assuming the air-

craft is maintained properly.

2. The cost of maintaining an aircraft tends to increase over time. Exhibit 1 shows a typical function relat- ing the cost required to maintain the airframes of commercial jetliners, commonly referred to as the “maturity factor,” as the jetliners’ cumulative flight hours increase.

3. The useful economic life of an aircraft is finite, but it is often difficult to estimate. Some DC-3 aircraft

1 These policies were adopted on April 1, 1993. From July 1, 1986, to April 1, 1993, Delta’s policy had been to depreciate equipment to residual values (10% of cost) over a 15-year period. Prior to July 1, 1986, the company’s policy was to depreciate equipment to a 10% residual value over a 10-year period. 2 Prior to January 1, 1999, AMR used an estimated useful life of 20 years and a residual value of 5%. For the year ended December 31, 1999, the effect of this change was to reduce depreciation expense by approximately $158 million.

1.8

1.6

1.4

1.2

0.8

0.6

0.4

0.2

0 0 20 40 60 80 100 120

Cumulative Flight Hours (x 1000)

M at

ur it

y Fa

ct or

EXHIBIT 1 Airframe Labor and Material Maturity Factors

3 These policies were adopted on April 1, 2001. From April 1, 1989 to April 1, 2001, Singapore’s policy had been to depre- ciate over a 10-year period to a residual value of 20% of original cost. Prior to April 1, 1989 at Singapore Airlines, the operational lives of the aircraft were estimated to be 8 years with 10% residual values.

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are still flying cargo routes commercially, even though this aircraft made its debut in 1935. But these aircraft, and some that followed them, such as the Boeing 707, which had its maiden flight in 1957, are no longer competitive for use in passen- ger markets.

4. New aircraft prices tend to rise over time. Fair mar- ket values for used aircraft decrease over time, but unless the aircraft are made obsolete by a technolog- ical breakthrough in new aircraft, which is rare, the values tend to decrease slowly. Some aircraft main- tain 90 percent or more of their original value even after decades of use. Used aircraft values do fluctu- ate sometimes significantly depending on, for exam- ple, market demand and supply conditions in the air travel and aircraft production industries, technologi- cal innovations, and changes in laws (e.g., governing noise pollution or allowable tax deductions). How- ever, rarely do used aircraft market values drop below 50 percent of their original purchase price.

5. In many countries, including the United States, the rules governing the depreciation allowable for tax purposes are quite different from those that determine the depreciation that can be taken for financial report- ing purposes. The tax rules allow ultra-conservative accounting to ensure that companies do not have to pay the tax before they have collected cash from their customers. Corporations should and do take advan- tage of these rules and depreciate the aircraft as quickly as possible to defer the taxes that need to be paid (assuming positive income).

Questions

1. Assume that at least some rewards for the manage- ment team (and, hence, also other employees) are

based on performance measured in terms of ac- counting income and returns on net assets. Also as- sume that all of these airlines are growing; that is, they are adding to their fleet size.

What are the behavioral implications of each of the three depreciation-related accounting policy choices: (1) depreciation patterns (i.e., straight-line vs. accelerated, (2) estimated useful lives, and (3) residual values? Consider, at a minimum, the effects of each of these choices on decisions regarding:

a. replacements of aircraft in service;

b. pricing, assuming that prices are at least some- what dependent on costs;

c. evaluations of routes or lines of business;

d. evaluations of managers, assuming that negoti- ated budgets provide the primary standards of performance.

2. Assume that in a particular U.S. airline company there is a conflict between the benefits of conser- vatism vs. liberalism in depreciation accounting. That is, for this company conservatism in deprecia- tion accounting is greatly preferred for financial reporting purposes (for whatever reason) but for in- ternal purposes the company would be better off if the policies were more liberal, or vice versa. Would you recommend to the managers of this company that they adopt a third set of books? That is, should they maintain one set of books for financial ac- counting purposes, another set for tax purposes, and a third set for the purposes of running the business?

3. If the managers of a particular airline do not want to maintain a third set of books, should they tend to be conservative or liberal in their aircraft depreciation accounting? Explain.

Case 22–2

Shuman Automobiles, Inc.* Clark Shuman, owner and general manager of an auto- mobile dealership, was nearing retirement and wanted to begin relinquishing his personal control over the business’s operations. (See Exhibit 1 for current finan-

cial statements.) The reputation he had established in the community led him to believe that the recent growth in his business would continue. His long- standing policy of emphasizing new-car sales as the principal business of the dealership had paid off, in Shuman’s opinion. This, combined with close atten- tion to customer relations so that a substantial amount

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of repeat business was generated, had increased the company’s sales to a new high level. Therefore, he wanted to make organizational changes to cope with the new situation, especially given his desire to with- draw from any day-to-day managerial responsibilities.

Accordingly, Shuman divided up the business into three departments: new-car sales, used-car sales, and the service department. He then appointed three of his most trusted employees managers of the new depart- ments: Janet Moyer, new-car sales, Paul Fiedler, used- car sales; and Nate Bianci, service department. All of these people had been with the dealership for several years.

Each manager was told to run her or his department as if it were an independent business. In order to give the new managers an incentive, their remuneration

was to be calculated as a straight percentage of their department’s gross profit.

Soon after taking over as manager of new-car sales, Janet Moyer had to settle upon the amount to offer a particular customer who wanted to trade his old car as a part of the purchase price of a new one with a list price of $14,400. Before closing the sale, Moyer had to decide the amount she would offer the customer for the trade-in value of the old car. She knew that if no trade- in were involved, she would deduct about 8 percent from the list price of this model new car to be competi- tive with several other dealers in the area. However, she also wanted to make sure that she did not lose out on the sale by offering too low a trade-in allowance.

During her conversation with the customer, it had be- come apparent that the customer had an inflated view of

EXHIBIT 1

SHUMAN AUTOMOBILES, INC. Income Statement

For the Year Ended December 31

Sales of new cars $6,879,371

Cost of new-car sales* $6,221,522

Sales remuneration 137,470 6,358,992__________ __________ 520,379

Allowances on trade† 154,140__________ New-car gross profit 366,239

Sales of used cars 3,052,253

Cost of used-car sales* $2,623,100

Sales remuneration 92,815__________ 2,715,915__________

336,338

Allowances on trade† 56,010__________ Used-car gross profit 280,328__________

646,567

Service sales to customers 980,722

Cost of work* 726,461__________ 254,261

Service work on reconditioning:

Charge 238,183

Cost* 245,915 (7,732)__________ __________ Service work gross profit 246,529__________ Dealership gross profit 893,096

General and administrative expenses 345,078__________ Income before taxes $ 548,018____________________

* These amounts include all costs assignable directly to the department, but exclude allocated general dealership overhead. † Allowances on trade represent the excess of amounts allowed on cars taken in trade over their appraised value.

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the worth of his old car, a far from uncommon event. In this case, it probably meant that Moyer had to be pre- pared to make some sacrifices to close the sale. The new car had been in stock for some time, and the model was not selling very well, so she was rather anxious to make the sale if this could be done profitably.

In order to establish the trade-in value of the car, the used-car manager, Fiedler, accompanied Moyer and the customer out to the parking lot to examine the car. In the course of his appraisal, Fiedler estimated the car would require reconditioning work costing about $840, after which the car would retail for about $7,100. On a wholesale basis, he could either buy or sell such a car, after reconditioning, for about $6,100. The retail auto- mobile dealer’s handbook of used-car prices, the “Blue Book,” gave a cash buying price range of $5,500 to $5,800 for the trade-in model in good condition. This range represented the distribution of cash prices paid by automobile dealers for the model of car in the area in the past month. Fiedler estimated that he could get about $5,000 for the car “as is” (that is, without any work being done to it) at next week’s regional used car auction.

The new-car department manager had the right to buy any trade-in at any price she thought appropriate, but then it was her responsibility to dispose of the car. She had the alternative of either trying to persuade the used-car manager to take over the car and accepting the used-car manager’s appraisal price, or she herself could sell the car through wholesale channels or at auction. Whatever course Moyer adopted, it was her primary responsibility to make a profit for the dealer- ship on the new cars she sold, without affecting her performance through excessive allowances on trade- ins. This primary goal, Moyer said, had to be “bal- anced against the need to satisfy the customers and move the new cars out of inventory—and there is only a narrow line between allowing enough on a used car and allowing too much.”

After weighing all these factors, with particular emphasis on the personality of the customer, Moyer decided to allow $6,500 for the used car, provided the customer agreed to pay the list price for the new car. After a certain amount of haggling, during which the customer came down from a higher figure and Moyer came up from a lower one, the $6,500 allowance was agreed upon. The necessary papers were signed, and the customer drove off.

Moyer returned to the office and explained the situ- ation to Joanne Brunner, who had recently joined the

dealership as accountant. After listening with interest to Moyer’s explanation of the sale, Brunner set about recording the sale in the accounting records of the business. As soon as she saw that the new car had been purchased from the manufacturer for $12,240, she was uncertain as to the value she should place on the trade- in vehicle. Since the new car’s list price was $14,400 and it had cost $12,240, Brunner reasoned that the gross margin on the new-car sale was $2,160. Yet Moyer had allowed $6,500 for the old car, which needed $840 of repairs and could be sold retail for $7,100 or wholesale for $6,100. Did this mean that the new-car sale involved a loss? Brunner was not at all sure she knew the answer to this question. Also, she was uncertain about the value she should place on the used car for inventory valuation purposes. Brunner de- cided that she would put down a valuation of $6,500, and then await instructions from her superiors.

When Fiedler, the used-car manager, found out what Brunner had done, he stated forcefully that he would not accept $6,500 as the valuation of the used car. He commented as follows:

My used-car department has to get rid of that used car, unless Janet (Moyer) agrees to take it over herself. I would certainly never have allowed the customer $6,500 for that old tub. I wouldn’t have given anymore than $5,260, which is the whole- sale price less the cost of repairs. My department has to make a profit too, you know. My own in- come depends on the gross profit I show on the sale of used cars, and I won’t stand for having my income hurt because Janet is too generous toward her customers!

Brunner replied that she had not meant to cause trouble but had simply recorded the car at what seemed to be its cost of acquisition, because she had been taught that this was the best accounting practice. Whatever response Fiedler was about to make to this comment was cut off by the arrival of Clark Shuman, the general manager, and Nate Bianci, the service de- partment manager. Shuman picked up the phone and called Janet Moyer, asking her to come over right away.

“All right, Nate,” said Shuman, “now that we are all here, would you tell them what you just told me?”

Bianci said, “Clark, the trouble is with this trade-in. Janet and Paul were right in thinking that the repairs they thought necessary would cost about $840. Unfor- tunately, they failed to notice that the rear axle is cracked; it will have to be replaced before we can retail

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the car. This will probably use up parts and labor cost- ing about $640.

“Beside this,” Bianci continued, “there is another thing that is bothering me a good deal more. Under the accounting system we’ve been using, I can’t charge as much on an internal job as I would for the same job performed for an outside customer. As you can see from my department statement (Exhibit 2), I lost al- most $8,000 on internal work last year. On a recondi- tioning job like this, which costs out at $1,480, I don’t even break even. If I did work costing $1,480 for an outside customer, I would be able to charge about $2,000 for the job. The Blue Book gives a range of $1,960 to $2,040 for the work this car needs, and I have always aimed for about the middle of the Blue Book range.1 That would give my department a gross profit of $520, and my own income is now based on that gross profit. Since a large proportion of the work of my department is the reconditioning of trade-ins for resale, I figure that I should be able to make the same charge for repairing a trade-in as I would get for an outside re- pair job.”

Fiedler and Moyer both started to talk at once at this point. Fiedler managed to edge out Moyer: “This axle

business is unfortunate, all right; but it’s very hard to spot a cracked axle. Nate is likely to be just as lucky the other way next time. He has to take the rough with the smooth. It’s up to him to get the cars ready for me to sell.”

Moyer, after agreeing that the failure to spot the axle was unfortunate, added: “This error is hardly my fault, however. Anyway, it’s ridiculous that the service de- partment should make a profit on jobs it does for the rest of the dealership. The company can’t make money when its left hand sells to its right.”

At this point, Clark Shuman was getting a little confused about the situation. He thought there was a little truth in everything that had been said, but he was not sure how much. It was evident to him that some ac- tion was called for, both to sort out the present prob- lem and to prevent its recurrence. He instructed Ms. Brunner, the accountant, to “work out how much we are really going to make on this whole deal,” and then retired to his office to consider how best to get his managers to make a profit for the dealership.

A week after the events described above, Clark Shuman was still far from sure what action to take to motivate his managers to make a profit for the business. During the week, Bianci had reported to him that the repairs to the used car had cost $1,594, of which $741 represented the cost of those repairs that had been spot- ted at the time of purchase, and the remaining $853 the cost of supplying and fitting a replacement for the cracked axle. To support his own case for a higher

EXHIBIT 2

SHUMAN AUTOMOBILES, INC Analysis of Service Department Expenses

For the Year Ended December 31

Customer Reconditioning Jobs Jobs Total

Number of jobs 3,780 468 4,248 Direct labor $302,116 $ 98,820 $ 400,936 Supplies 103,966 32,755 136,721 Department overhead 84,592 27,670 112,262________ ________ __________

490,674 159,245 649,919 Parts 235,787 86,670 322,457________ ________ __________

726,461 245,915 972,376 Charges made for jobs to customers or other departments 980,722 238,183 1,218,905________ ________ __________ Gross profit (loss) 254,261 (7,732) 246,529 General overhead proportion 140,868__________ Departmental profit for the year $ 105,661____________________

1 In addition to the monthly Blue Book for used-car prices, there was a monthly Blue Book that gave the range of charges for various classes of repair work, based on the ac- tual charges made and reported by vehicle repair shops in the area.

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allowance on reconditioning jobs, Bianci had looked through the duplicate customer invoices over the last few months and had found examples of similar (but not identical) work to that which had been done on the trade-in car. The amounts of these invoices averaged $2,042, and the average of the costs assigned to these jobs was $1,512. (General overhead was not assigned to individual jobs.) In addition, Bianci had obtained from Ms. Brunner the cost analysis shown in Exhibit 2. Bianci told Shuman that this was a fairly typical distri- bution of the service department’s expenses.

Questions

1. Suppose the new-car deal is consummated, with the repaired used car being retailed for $7,100, the re- pairs costing Shuman $1,594. Assume that all sales personnel are on salary (no commissions) and that general overhead costs are fixed. What is the deal- ership incremental gross profit on the total transac- tion (i.e., new and repaired-used cars sold)?

2. Assume each department (new, used, service) is treated as a profit center, as described in the case.

Also assume in a–c that it is known with certainty beforehand that the repairs will cost $1,594.

a. In your opinion, at what value should this trade- in (unrepaired) be transferred from the new-car department to the used-car department? Why?

b. In your opinion, how much should the service department be able to charge the used-car de- partment for the repairs on this trade-in car? Why?

c. Given your responses to a and b, what will be each department’s incremental gross profit on this deal?

3. Is there a strategy in this instance that would give the dealership more profit than the one assumed above (i.e., repairing and retailing this trade-in used car)? Explain. In answering this question, assume the service department operates at capacity.

4. Do you feel the three-profit-center approach is appro- priate for Shuman? If so, explain why, including an explanation of how this is better than other specific al- ternatives. If not, propose a better alternative and ex- plain why it is better than three profit centers and any other alternatives you have considered.

Case 22–3

Zumwald AG* In August 2002, a pricing dispute arose between the managers of some of the divisions of Zumwald AG. Mr. Rolf Fettinger, the company’s managing director, had to decide whether to intervene in the dispute.

THE COMPANY Zumwald AG, headquartered in Cologne, Germany, produced and sold a range of medical diagnostic imag- ing systems and biomedical test equipment and instru- mentation. The company was organized into six oper- ating divisions. Total annual revenues were slightly more than €3 billion.

Zumwald managers ran the company on a highly de- centralized basis. The managers of each division were allowed considerable autonomy if their performances were at least on plan. Performance was evaluated, and

management bonuses were assigned, based on each divi- sion’s achievement of budgeted targets for return on in- vested capital (ROIC) and sales growth. Even though the company was partly vertically integrated, division man- agers were allowed to source their components from ex- ternal suppliers if they so chose.

Involved in the dispute mentioned above were three of the company’s divisions: the Imaging Systems Divi- sion (ISD), the Heidelberg Division (Heidelberg), and the Electronic Components Division (ECD).

• ISD sold complex ultrasound and magnetic resonance imaging systems. These systems were expensive, typ- ically selling for €500,000–€1 million.

• Heidelberg sold high-resolution monitors, graph- ics controllers and display subsystems. Approxi- mately half of its sales were made to outside cus- tomers. ISD was one of Heidelberg’s major inside customers.

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• ECD sold application-specific integrated circuits and subassemblies. ECD was originally established as a captive supplier to other Zumwald divisions, but in the last decade its managers had found exter- nal markets for some of the division’s products. Be- cause of this, ECD’s managers were given profit center responsibility.

THE DISPUTE In 2001, ISD designed a new ultrasound imaging sys- tem, called the X73. Hopes were high for X73. The new system offered users advantages in processing speed and cost, and it took up less space. Heidelberg engineers participated in the design of X73, but Heidelberg was compensated for the full cost of the time its employees spent on this project.

After the specifications were set, ISD managers so- licited bids for the materials needed to produce X73 components. Heidelberg was asked to bid to supply the displays needed for production of the X73 system. So were two outside companies. One was Bogardus NV, a Dutch company with a reputation for producing high quality products. Bogardus had been a long-time sup- plier to Zumwald, but it had never before supplied display units and systems to any Zumwald division. Display Technologies Plc, was a British company that had recently entered the market and was known to be pricing its products aggressively in order to buy market share. The quotes that ISD received were as follows:

Supplier Cost per X73 System (€)

Heidelberg Division 140,000 Bogardus NV 120,500 Display Technologies Plc 100,500

After discussing the bids with his management team, Conrad Bauer, ISD’s managing director, an- nounced that ISD would be buying its display systems from Display Technologies Plc. Paul Halperin, Heidel- berg’s general manager, was livid. He immediately complained to Mr. Bauer, but when he did not get the desired response, he took his complaint to Rolf Fet- tinger, Zumwald’s managing director. Mr. Fettinger agreed to look into the situation.

A meeting was called for August 29, 2002. Mr. Halperin asked Christian Schönberg, ECD’s GM, to attend this meeting to support his case. If Heidelberg got this order from ISD, it would buy all of its elec- tronic components from ECD.

At this meeting, Mr. Bauer immediately showed his anger:

Paul wants to charge his standard mark-up for these displays. I can’t afford to pay it. I’m trying to sell a new product (X73) in a very competitive market. How can I show a decent ROIC if I have to pay a price for a major component that is way above market? I can’t pass on those costs to my customers. Paul should really want this business. I know things have been relatively slow for him. But all he does is quote list prices and then com- plain when I do what is best for my division.

We’re wasting our time here. Let’s stop fighting amongst ourselves and instead spend our time fig- uring out how to survive in these difficult business conditions.

Mr. Fettinger asked Mr. Halperin why he couldn’t match Display Technologies’ price. Paul replied as follows:

Conrad is asking me to shave my price down to below cost. If we start pricing our jobs this way, it won’t be long before we’re out of business. We need to price our products so that we earn a fair return on our investment. You demand that of us; our plan is put together on that basis; and I have been pleading with my sales staff not to offer deals that will kill our margins. Conrad is forget- ting that my engineers helped him design X73, and we provided that help with no mark-up over our costs. Further, you can easily see that Zumwald is better off if we supply the display systems for this new product. The situation here is clear. If Conrad doesn’t want to be a team player, then you must order him to source inter- nally! That decision is in the best interest of all of us.

In the ensuing discussion, the following facts came out:

1. ISD’s tentative target price for the X73 system was €340,000.1

2. Heidelberg’s standard manufacturing cost (mater- ial, labor and overhead) for each display system was €105,000. When asked, Mr. Halperin esti- mated that the variable portion of this total cost was only €50,000. He treated Heidelberg’s labor costs as fixed because German laws did not allow him to

1 The cost of the other components that go into X73 is €72,000. ISD’s conversion cost for the X73 system is €144,000, of which €117,700 is fixed.

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lay off employees without incurring expenses that were “prohibitively” high.

3. Because of the global business slowdown, the pro- duction lines at Heidelberg that would produce the systems in question were operating at approxi- mately 70 percent of capacity. In the preceding year, monthly production had ranged from 60–90 percent of total capacity.

4. Heidelberg’s costs included €21,600 in electronic subassemblies to be supplied by ECD. ECD’s full manufacturing costs for the components included in each system were approximately €18,000, of which approximately half were out-of-pocket costs. ECD’s standard policy was to price its products internally at full manufacturing cost plus 20 percent. The mark-up was intended to give ECD an incentive to supply its product internally. ECD was currently op- erating at 90 percent capacity.

Near the end of the meeting, Mr. Bauer reminded everybody of the company’s policy of freedom of sourcing. He pointed out that this was not such a big deal, as the volume of business to be derived from this new product was only a small fraction (less than 5 per- cent) of the revenues for each of the divisions in- volved, at least for the first few years. And he also did not like the potential precedent of his being forced to source internally because it could adversely affect his

ability to get thoughtful quotes from outside suppliers in the future.

THE DECISION As he adjourned the meeting, Mr. Fettinger promised to consider all the points of view that had been expressed and to provide a speedy judgment. He wondered if there was a viable compromise or if, instead, there were some management principles involved here that should be considered inviolate.

Questions

1. What sourcing decision for the X73 materials is in the best interest of:

a. the Imaging Systems Division?

b. the Heidelberg Division?

c. the Electronic Components Division?

d. Zumwald AG?

2. What should Mr. Fettinger do regarding the X73 sourcing issue?

3. Can a system be designed to motivate each of Zumwald’s division managing directors to take ac- tions that are not only in the interest of their divi- sion but also in the best interest of Zumwald? Explain.

Case 22–4

Enager Industries, Inc.* I don’t get it. I’ve got a new product proposal that can’t help but make money, and top management turns thumbs down. No matter how we price this new item, we expect it to make $130,000 pretax. That would contribute 14 cents per share to our earnings after taxes, which is nearly as much as the 15-cent earnings-per-share increase in 1997 that the president made such a big thing about in the shareholders’ annual report. It just doesn’t make sense for the president to be touting e.p.s. while his subordinates are rejecting profitable projects like this one.

The frustrated speaker was Sarah McNeil, prod- uct development manager of the Consumer Products

Division of Enager Industries, Inc. Enager was a relatively young company, which had grown rapidly to its 1997 sales level of over $74 million. (See Exhibits 1–3 for financial data for 1996 and 1997.)

Enager had three divisions, Consumer Products, In- dustrial Products, and Professional Services, each of which accounted for about one-third of Enager’s total sales. Consumer Products, the oldest of the three divi- sions, designed, manufactured, and marketed a line of houseware items, primarily for use in the kitchen. The Industrial Products Division built one-of-a-kind ma- chine tools to customer specifications; for example, it was a large “job shop,” with the typical job taking sev- eral months to complete. The Professional Services Division, the newest of the three, had been added to* Copyright © by James S. Reece.

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Enager by acquiring a large firm that provided land planning, landscape architecture, structural architec- ture, and consulting engineering services. This divi- sion had grown rapidly, in part because of its capabil- ity to perform environmental impact studies.

Because of the differing nature of their activities, each division was treated as an essentially independent company. There were only a few corporate-level man- agers and staff people, whose job was to coordinate the activities of the three divisions. One aspect of this coordination was that all new project proposals requir- ing investment in excess of $500,000 had to be re- viewed by the corporate vice president of finance, Henry Hubbard. It was Hubbard who had recently re- jected McNeil’s new product proposal, the essentials of which are shown in Exhibit 4.

PERFORMANCE EVALUATION Prior to 1996, each division had been treated as a profit center, with annual division profit budgets negotiated between the president and the respective division general managers. In 1995, Enager’s president, Carl Randall, had become concerned about high interest rates and their impact on the company’s profitability. At the urging of Henry Hubbard, Randall had decided to begin treating each division as an investment center

so as to be able to relate each division’s profit to the as- sets the division used to generate its profits.

Starting in 1996, each division was measured based on its return on assets, which was defined as the divi- sion’s net income divided by its total assets. Net income for a division was calculated by taking the division’s “direct income before taxes” and then sub- tracting the division’s share of corporate administra- tive expenses (allocated on the basis of divisional revenues) and its share of income tax expense (the tax rate applied to the division’s “direct income before taxes” after subtraction of the allocated corporate ad- ministrative expenses). Although Hubbard realized there were other ways to define a division’s income, he and the president preferred this method since “it made the sum of the [divisional] parts equal to the [corpo- rate] whole.”

Similarly, Enager’s total assets were subdivided among the three divisions. Since each division operated in physically separate facilities, it was easy to attribute most assets, including receivables, to specific divisions. The corporate-office assets, including the centrally con- trolled cash account, were allocated to the divisions on the basis of divisional revenues. All fixed assets were recorded at their balance sheet values, that is, original cost less accumulated straight-line depreciation. Thus,

EXHIBIT 1

ENAGER INDUSTRIES, INC. Income Statements For 1996 and 1997

(thousands of dollars, except earnings per share figures)

Year Ended December 31

1996 1997

Sales $70,731 $74,225 Cost of sales 54,109 56,257________ ________ Gross margin 16,622 17,968 Other expenses:

Development 4,032 4,008 Selling and general 6,507 6,846 Interest 994 1,376________ ________

Total 11,533 12,230________ ________ Income before taxes 5,089 5,738 Income tax expense 2,036 2,295________ ________ Net income $ 3,053 $ 3,443________ ________________ ________ Earnings per share (500,000 and 550,000 shares

outstanding in 1996 and 1997, respectively) $ 6.11 $6.26

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the sum of the divisional assets was equal to the amount shown on the corporate balance sheet ($75,419,000 as of December 31, 1997).

In 1995 Enager had as its return on year-end assets (net income divided by total assets) a rate of 4.5 per- cent. According to Hubbard, this corresponded to a “gross return” of 9.3 percent; he defined gross return as equal to earnings before interest and taxes (EBIT) divided by assets. Hubbard felt that a company like Enager should have a gross EBIT return on assets of at least 12 percent, especially given the interest rates the corporation had paid on its recent borrowings. He therefore instructed each division manager that the

division was to try to earn a gross return of 12 per- cent in 1996 and 1997. In order to help pull the return up to this level, Hubbard decided that new investment proposals would have to show a return of at least 15 percent in order to be approved.

1996–1997 RESULTS Hubbard and Randall were moderately pleased with 1996’s results. The year was a particularly difficult one for some of Enager’s competitors, yet Enager had managed to increase its return on assets from 4.5 per- cent to 4.8 percent, and its gross return from 9.3 per- cent to 9.5 percent. The Professional Services Division

EXHIBIT 2

ENAGER INDUSTRIES, INC. Balance Sheets

For 1996 and 1997 (thousands of dollars)

As of December 31

1996 1997

Assets Current assets:

Cash and temporary investments $ 1,404 $ 1,469 Accounts receivable 13,688 15,607 Inventories 22,162 25,467________ ________

Total current assets 37,254 42,543________ ________ Plant and equipment:

Original cost 37,326 45,736 Accumulated depreciation (12,691) (15,979)________ _______ Net 24,635 29,757

Investments and other assets 2,143 3,119________ ________ Total assets $64,032 $75,419________ ________________ ________

Liabilities and Owners’ Equity Current liabilities:

Accounts payable $ 9,720 $12,286 Taxes payable 1,210 1,045 Current portion of long-term debt — 1,634________ ________

Total current liabilities 10,930 14,965 Deferred income taxes 559 985 Long-term debt 12,622 15,448________ ________

Total liabilities 24,111 31,398________ ________ Common stock 17,368 19,512 Retained earnings 22,553 24,509________ ________

Total owners’ equity 39,921 44,021________ ________ Total liabilities and owners’ equity $64,032 $75,419________ ________________ ________

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easily exceeded the 12 percent gross return target; Consumer Products’ gross return on assets was 8 percent; but Industrial Products’ return was only 5.5 percent.

At the end of 1996, the president put pressure on the general manager of the Industrial Products

Division to improve its return on investment, suggest- ing that this division was not “carrying its share of the load.” The division manager had taken exception to this comment, saying the division could get a higher return “if we had a lot of old machines the way Con- sumer Products does.” The president had responded

1996 1997

Net income � Sales 4.3% 4.6% Gross margin � Sales 23.5% 24.2% Development expenses � Sales 5.7% 5.4% Selling and general � Sales 9.2% 9.2% Interest � Sales 1.4% 1.9% Asset turnover* 1.10x 0.98x Current ratio 3.41 2.84 Quick ratio 1.38 1.14 Days’ cash* 7.9 7.9 Days’ receivables* 70.6 76.7 Days’ inventories* 149.5 165.2 EBIT � Assets* 9.5% 9.4% Return on invested capital*,†,‡ 6.9% 7.0% Return on owners’ equity* 7.6% 7.8% Net income � Assets*,§ 4.8% 4.6% Debt/capitalization* 24.0% 28.0%

* Ratio based on year-end balance sheet amount, not annual average amount. † Invested capital includes current portion of long-term debt, excludes deferred taxes. ‡ Adjusted for interest expense add-back. § Not adjusted for add-back of interest; if adjusted, 1996 and 1997 ROA are both 5.7 percent.

EXHIBIT 3 Ratio Analysis for 1996 and 1997

1. Projected asset investment* Cash $ 50,000 Accounts receivable 150,000 Inventories 300,000 Plant and equipment† 500,000__________

Total $1,000,000 2. Cost data:

Variable cost per unit $ 3.00 Differential fixed costs (per year)‡ $ 170,000

3. Price/market estimates (per year):

Unit Unit Break-Even Price Sales Volume

$6.00 100,000 units 56,667 units 7.00 75,000 42,500 8.00 60,000 34,000

* Assumes 100,000 units’ sales. † Annual capacity of 120,000 units. ‡ Includes straight-line depreciation on new plant and equipment.

EXHIBIT 4 Financial Data from New Product Proposal

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that he did not understand the relevance of the division manager’s remark, adding, “I don’t see why the return on an old asset should be higher than that on a new asset, just because the old one cost less.”

The 1997 results both disappointed and puzzled Carl Randall. Return on assets fell from 4.8 percent to 4.6 percent, and gross return dropped from 9.5 percent to 9.4 percent. At the same time, return on sales (net income divided by sales) rose from 4.3 percent to 4.6 percent, and return on owners’ equity also in- creased, from 7.6 percent to 7.8 percent. These results prompted Randall to say the following to Hubbard:

You know, Henry, I’ve been a marketer most of my career, but until recently I thought I under- stood the notion of return on investment. Now I see in 1997 our profit margin was up and our earnings per share were up; yet two of your return on investment figures were down while return on owners’ equity went up. I just don’t understand these discrepancies.

Moreover, there seems to be a lot more tension among our managers the last two years. The gen- eral manager of Professional Services seems to be doing a good job, and she seems pleased with the praise I’ve given her. But the general manager of

Industrial Products seems cool toward me every time we meet. And last week, when I was eating lunch with the division manager at Consumer Products, the product development manager came over to our table and expressed her frustration about your rejecting a new product proposal of hers the other day.

I’m wondering if I should follow up on the idea that Karen Kraus in HRM brought back from the organization development workshop she at- tended over at the university. She thinks we ought to have a one-day off-site “retreat” of all the cor- porate and divisional managers to talk over this entire return on investment matter.

Questions

1. Why was McNeil’s new product proposal rejected? Should it have been? Explain.

2. Evaluate the manner in which Randall and Hubbard have implemented their investment center concept. What pitfalls did they apparently not anticipate?

3. What, if anything, should Randall do now with regard to his investment center measurement approach?

Case 22–5

Piedmont University* When Hugh Scott was inaugurated as the 12th presi- dent of Piedmont University in 1991, the university was experiencing a financial crisis. For several years enroll- ments had been declining and costs had been increas- ing. The resulting deficit had been made up by using the principal of “quasi-endowment” funds. For true endow- ment funds, only the income could be used for operat- ing purposes; the principal legally could not be used. Quasi-endowment funds had been accumulated out of earlier years’ surpluses with the intention that only the income on these funds would be used for operating pur- poses; however, there was no legal prohibition on the use of the principal. The quasi-endowment funds were nearly exhausted.

Scott immediately instituted measures to turn the financial situation around. He raised tuition, froze

faculty and staff hirings, and curtailed operating costs. Although he had come from another university and was therefore viewed with some skepticism by the Piedmont faculty, Scott was a persuasive person, and the faculty and trustees generally agreed with his ac- tions. In the year ended June 30, 1993, there was a small operating surplus.

In 1993, Scott was approached by Neil Malcolm, a Piedmont alumnus and partner of a local management consulting firm. Malcolm volunteered to examine the situation and make recommendations for permanent measures to maintain the university’s financial health. Scott accepted this offer.

Malcolm spent about half of his time at Piedmont for the next several months and had many conversa- tions with Scott, other administrative officers, and trustees. Early in 1994 he submitted his report. It recommended increased recruiting and fundraising activities, but its most important and controversial

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CENTRAL ADMINISTRATIVE COSTS Currently, no university-wide administrative costs were charged to academic departments. The proposal was that these costs would be allocated to profit centers in proportion to the relative costs of each. The graduate school deans regarded this as unfair. Many costs in- curred by the administration were in fact closely related to the undergraduate school. Furthermore, they did not like the idea of being held responsible for an allocated cost that they could not control.

GIFTS AND ENDOWMENT The revenue from annual gifts would be reduced by the cost of fund-raising activities. The net amount of annual gifts plus endowment income (except gifts and income from endowment designated for a specified school) would be allocated by the president according to his decision as to the needs of each school, subject to the approval of the Board of Trustees. The deans thought this was giving the president too much au- thority. They did not have a specific alternative, but thought that some way of reducing the president’s dis- cretionary powers should be developed.

ATHLETICS Piedmont’s athletic teams did not generate enough rev- enue to cover the costs of operating the athletic

recommendation was that the university be reorga- nized into a set a profit centers.

At that time the principal means of financial control was an annual expenditure budget submitted by the deans of each of the schools and the administrative heads of support departments. After a dean or department head discussed a budget with the president and financial vice president, it was usually approved with only minor mod- ifications. There was a general understanding that each school would live within the faculty size and salary num- bers in its approved budget, but not much stress was placed on adhering to the other items.

Malcolm proposed that in the future the deans and other administrators submit budgets covering both the revenues and the expenditures for their activities. The proposal also involved some shift in responsibilities, and new procedures for crediting revenues to the profit centers that earned them and charging expenditures to the profit centers responsible for them. He made rough estimates of the resulting revenues and expenditures of each profit center using 1993 numbers; these are given in Exhibit 1.

Several discussions about the proposal were held in the University Council, which consisted of the presi- dent, academic deans, provost, and financial vice pres- ident. Although there was support for the general idea, there was disagreement on some of the specifics, as described below.

Revenues Expenditures

Profit center: Undergraduate liberal arts school $ 42.0 $ 40.9 Graduate liberal arts school 7.8 16.1 Business school 21.4 17.2 Engineering school 23.8 24.2 Law school 9.4 9.1 Theological school 1.7 4.8 Unallocated revenue* 7.0 —______ ______

Total, academic $113.1 $112.3______ ____________ ______ Other:

Central administration $ 14.1 $ 14.1 Athletics 3.6 3.6 Computers 4.8 4.8 Central maintenance 8.0 8.0 Library 4.8 4.8

* Unrestricted gifts and endowment revenue, to be allocated by the president.

EXHIBIT 1 Rough Estimates of 1993 Impact of the Proposals (millions of dollars)

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department. The proposal was to make this department self-sufficient by charging fees to students who partic- ipated in intramural sports or who used the swimming pool, tennis courts, gymnasium, and other facilities as individuals. Although there was no strong opposition, some felt that this would involve student dissatisfac- tion, as well as much new paperwork.

MAINTENANCE Each school had a maintenance department that was responsible for housekeeping in its section of the cam- pus and for minor maintenance jobs. Sizable jobs were performed at the school’s request by a central mainte- nance department. The proposal was that in the future the central maintenance department would charge schools and other profit centers for the work they did at the actual cost of this work, including both direct and overhead costs. The dean of the business school said that this would be acceptable provided that profit centers were authorized to have maintenance work done by an outside contractor if its price was lower than that charged by the maintenance department. Malcolm explained that he had discussed this possibil- ity with the head of maintenance, who opposed it on the grounds that outside contractors could not be held accountable for the high quality standards that Piedmont required.

COMPUTERS Currently, the principal mainframe computers and re- lated equipment were located in and supervised by the engineering school. Students and faculty members could use them as they wished, subject to an informal check on overuse by people in the computer rooms. About one-fourth of the capacity of these computers was used for administrative work. A few departmental mainframe computers and hundreds of microcomput- ers and word processors were located throughout the university, but there was no central record of how many there were.

The proposal was that each user of the engineering school computers would be charged a fee based on usage. The fee would recover the full cost of the equipment, including overhead. Each school would be responsible for regulating the amount of cost that could be incurred by its faculty and students so that the total cost did not exceed the approved item in the school’s budget. (The mainframe computers had soft-

ware that easily attributed the cost to each user.) Sev- eral deans objected to this plan. They pointed out that neither students nor faculty understood the potential value of computers and that they wanted to encourage computer usage as a significant part of the educa- tional and research experience. A charge would have the opposite effect, they maintained.

LIBRARY The university library was the main repository of books and other material, and there were small libraries in each of the schools. The proposal was that each student and faculty member who used the university library would be charged a fee, either on an annual basis, or on some basis related to the time spent in the library or the number of books withdrawn. (The library had a secure entrance at which a guard was stationed, so a record of who used it could be obtained without too much diffi- culty.) There was some dissatisfaction with the amount of paperwork that such a plan would require, but it was not regarded as being as important as some of the other items.

CROSS REGISTRATION Currently, students enrolled at one school could take courses at another school without charge. The proposal was that the school at which a course was taken would be reimbursed by the school in which the student was enrolled. The amount charged would be the total se- mester tuition of the school at which the course was taken, divided by the number of courses that a student normally would take in a semester, with adjustments for variations in credit hours.

Questions

1. How should each of the issues described above be resolved?

2. Do you see other problems with the introduction of profit centers? If so, how would you deal with them?

3. What are the alternatives to a profit center approach?

4. Assuming that most of the issues could be resolved to your satisfaction, would you recommend that the profit center idea be adopted, or is there an alterna- tive that you would prefer?

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23 Control: The Management Control Process

Chapter

The preceding chapter discussed factors in an organization’s environment that affect management control. In this and the next two chapters, we describe how the manage- ment control system works—the management control process. This chapter describes the principal steps in the process, the characteristics of accounting information used in the process, and behavioral aspects of management control.

Phases of Management Control

Much of the management control process involves informal communication and interactions. Informal communication occurs by means of memoranda, meetings, con- versations, and even by such signals as facial expressions. Although these informal ac- tivities are of great importance, they defy a systematic description. Besides these informal activities, most organizations also have a formal management control system consisting of the following phases, each of which is described briefly below and in more detail in succeeding chapters:

1. Strategic planning 2. Budgeting 3. Measurement and reporting 4. Evaluation

As shown in Illustration 23–1, each of these phases leads to the next. They recur in a regular cycle, constituting a “closed loop.”

Strategic planning is the process of deciding on the programs the organization will undertake and the approximate amount of resources to be allocated to each program. (Some organizations call this step programming or long-range planning.) Programs are the principal activities the organization has decided to undertake to implement the strategies chosen in the strategy formulation process. Program decisions, therefore, take an organization’s strategies as a given.

Strategic Planning

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In a profit-oriented company, each principal product or product line is a program. There are also various research and development (R&D) programs (some aimed at improving existing products or processes, others searching for marketable new products), human re- source development programs, public relations programs, and so on. In some organiza- tions, program decisions are made informally; in others, a formal planning system is used.

Budgeting, like strategic planning, is a planning process. An essential difference be- tween strategic planning and budgeting is that strategic planning looks forward several years into the future whereas budgeting focuses on the next year. A budget is a plan ex- pressed in quantitative, usually monetary, terms that covers a specified period of time, usually one year. Most organizations have a budget.

In preparing a budget, each program is translated into terms that correspond to the responsibility of those managers who have been charged with executing the program or some part of it. Thus, although plans are originally made in terms of individual pro- grams, the plans are translated into terms of responsibility centers in the budgeting process. The process of developing a budget is essentially one of negotiations between managers of responsibility centers and their superiors. The end product is an approved statement of the revenues expected during the budget year and of the resources to be used in each responsibility center for achieving the objectives of the organization. (Chapter 24 describes both strategic planning and budgeting in further detail.)

During the period of actual operations, records are kept of resources actually con- sumed (i.e., costs) and of revenues actually earned. These records are structured so that cost and revenue data are classified both by programs (i.e., by products, R&D projects, and the like) and by responsibility centers. Data classified according to programs are used as a basis for future strategic planning, and data classified by responsibility

Revise Budget

A djust

O perations

Information

Information Information4. Evaluation 2. Budgeting

1. Strategic planning

3. Measurement and reporting

Strategies

ILLUSTRATION 23–1 Phases of Management Control

Budgeting

Measurement and Reporting

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centers are used to measure the performance of responsibility center managers. For the latter purpose, data on actual results are reported in such a way that they can be com- pared with the budget so that variances can be calculated. (Techniques for calculating variances were described in Chapters 20 and 21.)

The management control system communicates both accounting and nonaccount- ing information to managers throughout the organization. Some of the nonaccounting information is generated within the organization, and some of it describes what is hap- pening in the external environment. This information, which keeps managers informed and helps to ensure that the work done by the separate responsibility centers is coordi- nated, is conveyed in the form of reports.

Reports also are used as a basis for control. Essentially, control reports are derived from an analysis that compares actual performance with planned (budgeted) perfor- mance and attempts to explain the difference (variance). (Control reports are discussed in Chapter 25.)

Task Control Much of the information about operations is a summary of the detailed operating in- formation generated in the course of performing specific tasks, such as producing a specific job order or entering customers’ orders in the order-processing system. The system used to control these specific tasks is called task control. Techniques for con- trolling a variety of tasks are well developed and, with the widespread use of comput- ers, increasingly automatic. A discussion of task control techniques is outside the scope of this book.

Based on these formal control reports, in conjunction with personal observations and other informally communicated information, managers evaluate what, if any, action should be taken. As indicated in Illustration 23–1, three types of responses (“feedback loops”) are possible. First, current operations may be adjusted in some way. For example, the purchasing agent may be instructed to locate a new source of supply for a material whose substandard quality is creating large unfavorable material usage variances. Second, operating budgets may be revised. For example, an unexpected, lengthy truckers’ strike may have caused plant shutdowns, with the result that both expense and revenue bud- gets need revision in order to be realistic under the new circumstances. Third, programs may need to be revised or eliminated. For example, a product may be discontinued because its profits are judged to be too small relative to the investment required to sup- port the product.

Accounting Information Used in Management Control

Full cost accounting information (described in Chapters 17–19) is used in the manage- ment control process as an aid in making program decisions. In preparing budgets and in measuring performance, the accounting information is structured by responsibil- ity centers, and when so structured is called responsibility accounting. Responsibility accounting is necessary because control can be exercised only through the managers of responsibility centers.

In explaining the nature and use of responsibility accounting information, we need to introduce two new ways of classifying costs: (1) as controllable or noncontrollable and (2) as engineered, discretionary, or committed.

An item of cost is a controllable cost if the amount assigned to a responsibility center is significantly influenced by the actions of someone within the responsibility center.

684 Part 2 Management Accounting

Evaluation

Controllable Costs

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Otherwise, it is noncontrollable. There are two important aspects of this definition: (1) It refers to a specific responsibility center and (2) it suggests that controllability re- sults from a significant influence rather than from a complete influence.

The word controllable must be used in the context of a specific responsibility center rather than as an innate characteristic of a given cost item. When an organization is viewed as a complete entity, almost every item of cost is controllable: Someone, some- where in the organization, can probably take actions that influence it. In the extreme case, costs for any segment of the organization can be reduced to zero by closing down that segment; costs incurred in producing a good or service can be changed by pur- chasing that good or service from an outside supplier; and so on. Thus, the important question is not what costs are controllable in general but rather what costs are control- lable in a specific responsibility center because it is these costs on which the manage- ment control system must focus.

Controllable refers to a significant rather than a complete influence because only in rare cases does one manager have complete control over all the factors that influence any item of cost. The influence that the manager of a department has over its labor costs may actually be quite limited; for example, wage rates may be established by the human resources department or by union negotiations; the amount of labor required for a unit of activity in the department (e.g., assembling one unit of a product) may have been determined by someone outside the department who specified the detailed steps of the process; and the level of activity (i.e., volume) of the department may be influ- enced by the actions of other departments, such as the sales group or some earlier de- partment in the production process. Nevertheless, department managers usually have a significant influence on the amount of labor cost incurred in their own departments. They have some control over the amount of workers’ idle time, the speed and efficiency with which work is done, whether labor-saving equipment is acquired, and other fac- tors that affect labor costs.

Direct material and labor costs in a given production responsibility center are usually controllable. Some elements of overhead cost are controllable by the responsibility cen- ter to which the costs are assigned, but others are not. Indirect labor, supplies, and power consumption are usually controllable. So are service centers’ charges that are based on services actually rendered. However, an allocated cost is not controllable by the respon- sibility center to which the allocation is made. The amount of cost allocated depends on the amount of costs incurred in the service center and the formula used to make the al- location rather than on the actions of the manager of the responsibility center receiving the allocation. This is the case unless the cost is actually a direct cost that is allocated only for convenience, as in the case of Social Security taxes on direct labor.

Controllable Contrasted with Direct Costs The cost items in a responsibility center may be classified as either direct or indirect with respect to that center. Indirect costs are allocated to the responsibility center and are therefore not controllable by it, as explained above. All controllable costs are there- fore direct costs. Not all direct costs are controllable, however.

Depreciation on major departmental equipment is a direct cost of the department. Never- theless, the depreciation charge is often noncontrollable by the departmental supervisor, who may have no authority to acquire or dispose of expensive equipment. The rental charge for rented premises is another example of a direct but noncontrollable cost.

Controllable Contrasted with Variable Costs Neither are controllable costs necessarily the same as variable costs—those costs that vary proportionately with the level of activity (volume). Some costs (such as

Chapter 23 Control: The Management Control Process 685

Example

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supervision, heat, light, and journal subscriptions) may be unaffected by volume, but they are nevertheless controllable. Conversely, although most variable costs are con- trollable, that is not always the case. In some situations, the cost of raw material and parts, whose consumption varies directly with volume, may be entirely outside the in- fluence of the departmental manager.

In an automobile assembly plant, one automobile requires an engine, a body, seats, and so on, and the plant manager can do nothing about it. Moreover, the plant manager cannot choose the source of these inputs; most of them come from other divisions of the automo- bile company. The manager is responsible for not damaging or wasting these items, but not for the main flow of the items.

Direct labor, usually thought of as an obvious example of a controllable cost, may be noncontrollable in certain types of responsibility centers. Situations of this type must be examined very carefully, however, because supervisors tend to argue that more costs are noncontrollable than actually is the case to avoid being held responsible for them.

If an assembly line has 20 workstations and cannot be operated unless it is staffed by 20 per- sons of specified skills having specified wage rates, direct labor cost on that assembly line may be noncontrollable. Nevertheless, the assumption that such costs are noncontrollable may be open to challenge: It may be possible to find ways to do the job with 19 persons, or with 20 persons who have a lower average skill classification and hence have lower wage rates.

Cultural norms also may affect controllability. For example, with some recent excep- tions, managers in most large Japanese companies cannot lay off employees because these companies provide their workers with career employment. However, the manager can have the employee transferred to another responsibility center, thus saving some labor cost in the manager’s department (but not for the company overall). Labor contract work rules also can affect controllability in unionized departments.

As described in Chapter 16, controllability also depends on the length of the time period used for planning budgeted performance and measuring actual performance. Because performance in many responsibility centers is measured monthly, controlla- bility in these circumstances is implicitly taken to refer to costs that are controllable during a month. (Of course, some costs, such as materials waste, are controllable within a much shorter time horizon.)

Converting Noncontrollable Costs to Controllable Costs A noncontrollable item of cost can be converted to a controllable cost in either of two related ways: (1) by changing the basis of cost assignment from an allocation to a di- rect assignment or (2) by changing the locus of responsibility for decisions—that is, decentralization.

Changing the Basis of Cost Assignment As noted above, allocated costs are noncon- trollable by the manager of the responsibility center to which they are allocated. Many costs allocated to responsibility centers could be converted to controllable costs simply by assigning the cost so that the amount of costs assigned is influenced by actions taken by the responsibility center’s manager.

If all electricity coming into a large building is measured by a single meter, there is no way of measuring the actual electrical consumption of each department in the building. The electrical cost is therefore necessarily allocated to each department and is noncontrollable. However, electricity cost can be changed to a controllable cost for the several departments in the building by installing meters in each department so that each department’s actual consumption of electricity is measured.

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