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									                       Chapter 15
         Performance Evaluation and Compensation

LEARNING OBJECTIVES
Chapter 15 addresses the following questions:

   Q1 What is agency theory?
   Q2 How are decision-making responsibility and authority related to performance
      evaluation?
   Q3 How are responsibility centers used to measure, monitor, and motivate performance?
   Q4 What are the uses and limitations of return on investment, residual income, and
      economic value added for monitoring performance?
   Q5 How is compensation used to motivate performance?
   Q6 What prices are used for transferring goods and services within an organization?
   Q7 What are the uses and limitations of transfer pricing?

These learning questions (Q1 through Q7) are cross-referenced in the textbook to individual
exercises and problems.


COMPLEXITY SYMBOLS
The textbook uses a coding system to identify the complexity of individual requirements in the
exercises and problems.

Questions Having a Single Correct Answer:
     No Symbol    This question requires students to recall or apply knowledge as shown in the
                  textbook.
          e       This question requires students to extend knowledge beyond the applications
                  shown in the textbook.


Open-ended questions are coded according to the skills described in Steps for Better Thinking
(Exhibit 1.10):
               Step 1 skills (Identifying)
               Step 2 skills (Exploring)
               Step 3 skills (Prioritizing)
               Step 4 skills (Envisioning)
15-2 Cost Management


                                       QUESTIONS
15.1   ROI is calculated by dividing operating income by average assets, or income/assets. It
       can be decomposed as follows: ROI = sales/assets x income/sales.

15.2   ROI can be increased by cutting costs or reducing assets. Cost cutting can improve short-
       term results but harm long-term results if discretionary expenditures such as advertising
       and research and development are cut. Similarly, reducing investment in new projects
       could improve ROI in the short term, but harm the organization in the long term.

15.3   Residual income = operating income – (required rate of return * average operating
       assets). Many organizations have a minimum return that is expected on operations and
       new investments, this is their required rate of return.

15.4   The size of investment affects residual income less than ROI because it is used only to
       value the dollar amount of expected return, not as a denominator. Residual income is
       therefore less influenced than ROI by changes in investment, but it is still subject to the
       same disadvantages as ROI that affect the operating income – such as cost cutting to
       discretionary expenditures.

15.5   General knowledge is usually easy to transfer throughout an organization. Specific
       knowledge is more detailed and is therefore more costly to transfer throughout an
       organization. General knowledge is needed in the food and beverage manufacturing, in
       clothing manufacture, and in restaurants and bars, among others. Specific knowledge is
       important to software companies, bio-tech organizations, and healthcare organizations,
       among others.

15.6   If general knowledge is required for success within an organization, a centralized form is
       usually best because knowledge can easily be transferred to headquarters where decision
       making can be done from the perspective of the overall organization. If specific
       knowledge is required, it is costly to transfer to headquarters, so a decentralized form is
       usually best because the decision-making authority lies with the people with specific
       knowledge to make the best decision.

15.7   Agency costs arise when agents do not act in the interest of principals because they do
       not put in the effort required, or do not have the same tolerance for risk that principals
       have. Examples of agency costs include the cost of forgoing appropriate projects because
       managers perceive them to be too risky, and poor decision making because of lack of
       effort to search for high quality information and high quality decision making processes.

15.8   EVA is very similar to residual income because both subtract from operating income
       some measure of interest times investment. EVA is different than residual income
       because many adjustments are made to all parts of the calculation. For example, after tax
       operating income is usually used in EVA, whereas before tax operating income is usually
       used in RI. The assets are also adjusted under EVA, for example long-term leases are
       usually capitalized. There are over 160 possible adjustments that can be made to RI
       under EVA.
                                    Chapter 15: Performance Evaluation and Compensation 15-3


15.9   The four responsibility center descriptions and objectives follow.

       Cost Centers: In cost centers, managers are held responsible only for the costs under
       their control. Some cost centers provide support services that are relatively easy to
       monitor because their outputs are measurable. Cost centers are also used for subunits that
       produce goods or services that eventually will be sold by others. Managers in these cost
       centers are responsible for producing their goods or services efficiently. In discretionary
       cost centers (marketing, research and development, for example), the output is not easily
       measurable in dollars or activities. Cost centers are found in for-profit, not-for-profit, and
       government organizations. Cost center managers are expected either to minimize costs
       for a certain level of output or to maximize output for a certain level of cost.

       Revenue Centers: In revenue centers, managers are held responsible for the revenues
       under their control. Revenue centers frequently sell products from manufacturing
       subunits. Managers are expected to maximize revenues.

       Profit Centers: Managers in profit centers are held responsible for both revenues and
       costs under their control. Profits centers produce and sell goods or services, and may
       include one or several cost centers. Profit center managers are responsible for decisions
       about inputs, product mix, pricing, and volume of goods or services produced. The
       objective of profit centers is to maximize profits.

       Investment Centers: Managers of investment centers are held responsible for the
       revenues, costs, and investments under their control. Investments include any assets
       related to the investment center, such as fixed assets, inventory, intangible assets, and
       accounts receivable. Investment centers resemble profit centers, where profitability is
       related to the assets used to generate the profits. The objective of investment centers is to
       maximize the return on investments made by the organization. This means the most
       profitable projects must be identified and selected for investment.

15.10 From the overall organization’s point of view, it does not matter which branch pays for
      shipping. However, if each branch is held responsible for their own costs, each would
      prefer to have the other one pay for shipping charges because costs in the paying branch
      will be increased.

15.11 Advantages of decentralization for this company: Because expansion is into other
      countries, decision making will be timelier and probably more appropriate because local
      managers understand the local markets. The need to communicate detailed information
      up and down the organization will be reduced. The people making the decisions have the
      most knowledge and expertise.

       Disadvantages: The decision makers may have objectives that are different from the
       overall company’s objectives. Decisions need to be coordinated among all of the
       divisions to reduce non-optimal behavior such as duplication of products or services.
       Investment in new projects may not reflect the best opportunities, but instead reflect the
       most persuasive decision maker.
15-4 Cost Management


15.12 A suboptimal decision is one in which the overall organization does not receive as high a
      contribution as is possible. If it is cheaper to produce the product or service internally,
      but the transfer price is set so that the incentive is to purchase externally, more is being
      paid for the good or service than should be, and a suboptimal decision has been made.

15.13 Transfer prices can be set based on cost (variable, variable plus some fixed costs, or
      variable and a fully allocated fixed cost), or based on market price for the good or service
      (and there may be a variety of ways to estimate the market price). Alternatively, transfer
      prices can be negotiated between two divisions. The seller could receive market price
      and the buyer could receive variable cost under a dual-rate method. Lastly, an
      organization could decide not to charge for transfers.
                                  Chapter 15: Performance Evaluation and Compensation 15-5


                                      EXERCISES
15.14 Brother’s Coffee Cart Business

   A. Each cart is a profit center because the employees who operate the carts buy baked goods
      and other items and are responsible for selling them—i.e., they are responsible for both
      costs and revenues.

   B. My brother is the principal because he owns the business. The coffee cart employees are
      his agents; they make decisions on his behalf. The interests of the coffee cart employees
      may be different from my brother’s interests. For example, the employees may want to
      purchase baked goods that they prefer to eat, rather than the baked goods that sell well or
      that earn the highest profit. Or, they may not want to be too busy because it is tiring to
      wait on a lot of people all day. My brother would prefer to have satisfied customers,
      keep volumes are as high as possible, and also keep costs under control. He would like to
      have the largest contribution margin possible, and to provide high quality service so that
      return business is stable. Agency theory also applies because my brother cannot perfectly
      observe his employees’ efforts or the quality of their work. This inability provides an
      opportunity for the employees to shirk their responsibilities or to otherwise fail to work
      toward my brother’s best interests.

   C. My brother could use measures that focus on revenues, costs, or profit. Here are some
      possible measures: total revenue, revenue per hour, revenue growth, cost of goods sold
      as a percent of revenue, supplies cost as a percent of revenue, and profit margin
      (operating profit divided by revenue).

   D. Number or percentage of return customers is very important because a small cart cannot
      survive without regular customers. Customer satisfaction is also important. Cleanliness
      of the cart could be an issue. Students may think of other factors.


15.15 Brannard Company

   A. Residual income
             = operating income – (rate of return x average assets0
             = ($2,000,000 - $1,200,000 - $200,000) – (15% x $3,000,000)
             = $600,000 - $450,000
             = $150,000

   B. ROI
              = operating income / average investment
              = $600,000/$3,000,000
              = 20%
15-6 Cost Management


   C. EVA
              = adjusted after-tax income – [weighted average cost of capital x (adjusted total
                  assets – current liabilities)]
              = [$600,000 x (1-0.36)] – [12% x ($3,000,000 - $200,000)]
              = $384,000 - $336,000
              = $48,000


15.16 Oslo Company

[Note: Part C of this problem requires knowledge of breakeven analysis from Chapter 3.]

   A. Before calculating ROI, it is first necessary to calculate income:

              Sales (300,000 @ $2)                                         $600,000
              Variable costs                                               (450,000)
              Fixed costs                                                   (90,000)
                  Income                                                   $ 60,000

       ROI = $60,000/[($500,000 + $700,000)/2] = 10%

   B. Residual income:
             Income                                                        $ 60,000
             Minimum return [($500,000 + $700,000)/2 x 0.15]                (90,000)
                 Residual income                                           $(30,000)

   C. Variable cost per unit: $450,000/300,000 = $1.50

       Breakeven number of units:
             $2Q - $1.50Q - $90,000 = 0
             $0.50Q = 90,000
             Q = 180,000 units

   D. Sales                                                                $600,000
      Variable costs                                                        450,000
          Contribution margin                                              $150,000


15.17 Fulcrum Company

       Segment C has the highest EVA:

       Segment A
             EVA = after-tax income – WACC*(assets – current liabilities)
                 = [€8,000,000*(1-0.30)] – [10%*(€32,000,000 + €8,000,000 – €4,000,000)]
                 = €5,600,000 – €3,600,000
                 = €2,000,000
                                   Chapter 15: Performance Evaluation and Compensation 15-7



      Segment B
            EVA = [€4,000,000*(1-0.30)] – [10%*(€30,0000,000)] =
                = €2,800,000 – €3,000,000
                = (€200,000)

      Segment C
            EVA = [€6,000,000*(1-0.30)] – [10%*€21,000,000]
                = €4,200,000 – €2,100,000
                = €2,100,000


15.18 Fowler Electronics

   A. ROI if the screens are transferred at variable cost:

                                                                 Windsor                Detroit
              Revenue (10,000 x $2,500)                                              $25,000,000
              Variable production costs:
                 (10,000 x $350)                              $(3,500,000)
                 (10,000 x $110)                                                      (1,100,000)
              Fixed production costs                           (2,000,000)            (4,000,000)
              Transfer price (10,000 x $350)                    3,500,000             (3,500,000)
                     Pretax income (loss)                      (2,000,000)            16,400,000
              Income taxes (a)                                          0             (7,380,000)
                     Net income (loss)                        $(2,000,000)           $ 9,020,000

              Total assets                                   $20,000,000             $30,000,000

              ROI (Net income / Investment)                         (10)%                    30%

              (a) Income tax calculations:
                  The Windsor plant has a loss. The problem provides no information about
                  whether Canadian tax law allows companies to carry losses back against prior
                  income or forward against future income. However, if the Windsor plant does
                  not sell to outside customers, then it might always incur a loss if variable cost
                  is used as the transfer price. Therefore, the income tax effect is estimated as
                  zero.

                  Tax for Detroit plant = $16,400,000 x 45% = $7,380,000
15-8 Cost Management


   B. ROI if the screens are transferred at market price:

                                                                 Windsor                Detroit
              Revenue (10,000 x $2,500)                                              $25,000,000
              Variable production costs:
                 (10,000 x $350)                              $(3,500,000)
                 (10,000 x $110)                                                      (1,100,000)
              Fixed production costs                            (2,000,000)           (4,000,000)
              Transfer price (10,000 x $750)                     7,500,000            (7,500,000)
                     Pretax income (loss)                        2,000,000            12,400,000
              Income taxes (a)                                    (600,000)           (5,580,000)
                     Net income (loss)                         $ 1,400,000           $ 6,820,000

              Total assets                                    $20,000,000            $30,000,000

              ROI (Net income / Investment)                             7%                    23%

              (a) Income tax calculations:
                  Tax for Windsor plant: $2,000,000 x 30% = $600,000
                  Tax for Detroit plant = $12,400,000 x 45% = $6,820,000

   C. The firm will prefer the market transfer price because it maximizes company income.
      Total income is increased through tax rate differences between Canada and the United
      States. In addition, if variable costs are used, then there is a tax loss in Canada for which
      no tax benefit is received. The net tax advantage of using market value for the transfer
      price is:

              Taxes if transfer price is the variable cost:
                     Windsor                                           $        0
                     Detroit                                            7,380,000
                          Total                                                        $7,380,000
              Taxes if transfer price is the market value:
                     Windsor                                           $ 600,000
                     Detroit                                            5,580,000
                          Total                                                         6,180,000
              Difference                                                               $1,200,000

   D. The Windsor plant manager will prefer to transfer at the market price, and the Detroit
      plant manager will prefer variable cost because these transfer prices make their
      operations look best.

   E. Use of either the dual rate or the negotiation method would give managers the
      information they need to make the best decisions for the overall corporation. A problem
      with the dual rate method is that both plants appear to be more profitable than they really
      are. A problem with negotiating is that manager time can be tied up on activities that do
      not necessarily add value to the overall firm.
                                   Chapter 15: Performance Evaluation and Compensation 15-9


15.19 Hand Held

   A. The contribution margin is $8 for the Cell Phone Division, so they will only be willing to
      pay what they pay now ($12) plus up to $8 more or $20, although they may not want to
      assemble the cell phones at break even.

   B. Chips should be sold in the division that has a $12 contribution margin rather than $8
      contribution margin. If market price is used for the transfer price, units will always be
      sold externally instead of internally.

   C. If the Chip Division has plenty of excess capacity, the transfer price should be the
      variable cost because the Chip Division could not sell the chips otherwise.


15.20 Prem International

   A. Fixed costs are not relevant because it is unlikely that they would change under the two
      options. Following is a calculation of the contribution margin under each option

      Contribution margin for each pound of gasoline:
             Selling price                                                      $ 0.16
             Crude oil                                                           (0.06)
             Variable production costs                                           (0.02)
                     Net                                                        $ 0.08

      Contribution margin for each pound of polystyrene:
             Selling price                                                      $ 0.30
             Chemical variable production costs                                  (0.03)
             Crude oil                                                           (0.06)
             Oil variable production costs                                       (0.04)
                     Net                                                        $ 0.17

      Additional contribution margin for each pound of polystyrene              $0.09

      Times expected quantity of polystyrene sold                        100 million pounds

      Expected increase in pretax profit from selling polystyrene             $9 million

   B. Using the usual quantitative rules for short term decisions, the maximum transfer price
      Chemical would be willing to pay is the price at which Chemical’s contribution margin
      for Benzene would be zero, calculated as follows:
                                                                            Per Pound
             Selling price                                                    $ 0.30
             Chemical variable production costs                                (0.03)
                     Contribution margin before cost of Benzene               $ 0.27

      Chemical’s managers would be willing to pay up to $0.27 per pound for the Benzene.
15-10 Cost Management



   C. At a price of $0.27, the subsidiary would earn zero contribution margin, and it would
      report a net loss equal to its fixed costs. Assuming that the fixed cost of $0.05 per pound
      was based on 100 million pounds of production, this means that Chemical would report
      an operating loss on Benzene of $5 million. At the same time, Oil would report a
      sizeable profit on the Benzene:
                                                                               Per Pound
              Transfer price                                                     $ 0.27
              Crude oil                                                           (0.06)
              Oil variable production costs                                       (0.04)
                      Additional contribution margin                             $ 0.17

      In #1 above, the contribution margin of selling gasoline was calculated to be $0.08 per
      pound. Thus, Oil would report an incremental contribution margin of $0.09 ($0.17 -
      $0.08) per pound of Benzene produced. In other words, Oil would receive all of the
      company-wide benefit of selling Benzene.

      Chemical’s managers would be unhappy with this arrangement, because they would be
      responsible for selling the product but would receive none of the company-wide
      incremental profit.

   D. Using the usual quantitative rules for short term decisions, the minimum transfer price
      Oil would be willing to receive is the price equal to the contribution margin that Oil gives
      up ($0.08 per pound) plus the additional variable cost that Oil will incur if it produces
      Benzene (incremental variable production cost of $0.02 per pound), or $0.10 per pound.

   E. Oil’s managers probably would not be willing to accept the transfer price of $0.10 per
      pound, because in this case Chemical would receive all of the company-wide incremental
      profit. Because Oil can sell all of the gasoline it produces, its managers have no incentive
      to produce a product for which they receive no incremental profit.

   F. The most fair transfer price would be somewhere between $0.10 and $0.27 per pound
      (i.e., between the prices calculated in #2 and #4 above). In negotiations, however, the
      managers of Oil could have the upper hand. Because Oil is operating at full capacity and
      can sell all of its production elsewhere, its managers might be able to require a transfer
      price of $0.27. In this case, Chemical’s managers may have no option but to accept a
      transfer price of $0.27 (and to report operating losses every year because of its fixed
      costs).

      Sometimes companies establish transfer prices that reflect the degree of risk assumed by
      each responsibility center. In the Prem International problem, this might mean that
      Chemical would receive most of the benefit, because it is assuming the risk of selling
      polystyrene to outside customers. Oil might be given a transfer price sufficient to ensure
      that it does not report an operating loss from the sale of Benzene ($0.10 plus fixed costs
      of $0.04 per pound).
                                   Chapter 15: Performance Evaluation and Compensation 15-11


15.21 Carlyle Corporation

There are several ways to solve this problem. Here is one approach:

       First, consider the per-unit differences in cost and revenue for the two options. Ajax’s
       variable cost per unit is $45. If Ajax sells to outsiders at $75 per unit, the contribution
       margin is $30 to Ajax, so its gross margin improves by $600,000 ($30 x 20,000 units). If
       Bradley replaces Ajax’s units with $85 units from an outside supplier, the total cost per
       unit is $55 ($85 cost from outside vendor less the $30 contribution margin from outside
       customer). The variable cost of these units is $45 each, so Carlyle’s gross margin is
       maximized only by transferring the units internally at a savings of $10 per unit.

Here is another approach:

       Notice that none of Ajax division’s costs will change if it accepts the new opportunity;
       the division will continue to operate at full capacity. The only change in its gross margin
       will be the difference in revenue:

              Revenue from new customer (20,000 x $75)                           $1,500,000
              Current revenue from Bradley division                                 900,000
                     Increase in revenue                                         $ 600,000

       Based on the preceding calculation, the Ajax division will be better off if it accepts the
       new order.

       However, the company as a whole will not be better off. The company will receive
       outside revenue of $75 per unit and it will pay an outside supplier $85 per unit, for a net
       decrease in gross margin of $10 per unit.
15-12 Cost Management


                                       PROBLEMS
15.22 Midwest Mining

   A. ROI = $65,000/$500,000 = 13%

   B. Residual income = $65,000 – (0.10*$500,000) = $65,000 - $50,000 = $15,000

   C. There are many different ways this memo could be written. However, the memo would
      need to explain the behavioral implications of ROI: (1) the tendency to forego profitable
      projects that are less than the current ROI, and (2) that cutting costs that lead to long-term
      benefit improves the measure. In addition, it does not incorporate any measure of risk.


15.23 Midwest Mining (continued)

   A. Lease ROI
             New operating income = $65,000 + $40,000 – (12 x $2,000) = $93,000
             ROI = $93,000/$500,000 = 18.6%

      Purchase ROI
             New operating income = $65,000 + $40,000 = $105,000
             Total assets including new = $650,000
             ROI = $105,000/$650,000 = 16.2%

   B. Lease residual income
             RI = $93,000 – (0.10*$500,000) = $93,000 - $50,000 = $43,000

      Purchase residual income
             RI = $105,000 – (0.10*$650,000) = $40,000

   C. If the performance measure causes managers to be indifferent (from the perspective of
      their compensation) to leasing or purchasing, they are more likely to base the decision on
      factors that create more value for the firm.


15.24 International Woodworking

   A. No because at a price of $150, the variable cost to the furniture division under the current
      transfer price policy is $155 and the Furniture Division would lose $5 per chair.
                                   Chapter 15: Performance Evaluation and Compensation 15-13


   B. If the Furniture Division buys from Port Angeles, the contribution margin is as follows

               Price                                   $155
               Variable Costs
                   Transfer                             (40)
                   Manufacturing                        (75)
                   Selling                              (10)
               Contribution margin                     $ 30

        The total contribution margin is 800 x $30 = $24,000

   C. If Port Angeles always has excess capacity, the transfer price should be variable cost
      because Port Angeles has no other opportunities to sell the lumber. This transfer price
      policy would motivate the Furniture Division to purchase internally. The mill would
      want to keep its workers busy and be satisfied to transfer at variable cost because there
      are no other alternative outlets for the lumber.

   D. If there is no idle capacity, Port Angeles Mill would forego revenue from outside sales
      when units were transferred internally. Therefore they would not transfer except at the
      market price.


15.25 Avra Valley Services

   A.
                                                   Computer Services       Management Advisory
               External revenues                       $400,000                $700,000
               Internal transfer:
                   $50 x 3,000 hours                       150,000               (150,000)
                   $60 x 1,200 hours                       (72,000)                72,000
               Total costs                                (220,000)              (480,000)
                       Operating Income                   $258,000               $142,000

   B. Net income for the company currently = $400,000 ($258,000 + $142,000). The new
      income would be $340,000 [$400,000 – ($50 x $1,200)].

   C. Avra Valley could use an opportunity cost for the transfer price. This could be the
      variable costs for services. Although labor is guaranteed a wage, the hourly labor rate
      and cost of any supplies used in these services would approximate an opportunity cost.
      This way, the department that provides services receives credit for its work, but the
      department purchasing services is not charged as much as outsourcing would cost.

   D. Qualitative factors would include quality of service or level of technical expertise.
      Managers need to determine whether better quality of service or expertise would be
      provided inside the organization or by outsourcing. Another potential qualitative factor is
      the possible effect on employee moral if the outsourcing option is taken and the firm lays
      employees off.
15-14 Cost Management



15.26 Strong Welding Equipment Company

   A. ROI
              ROI Brazil = $1,000,000/$4,000,000 = 25%
              ROI US = $120,000/$400,000 = 30%

   B. Residual income
             RI Brazil = $1,000,000 – (10%*4,000,000) = $600,000
             RI US = $120,000 – (10%*400,000) = $80,000

   C. EVA
              EVA Brazil = $600,000 – [9%*($4,000,000 - $80,000)]
                = $600,000- $352,800 = $247,200
              EVA US = $80,000 – [9%*($400,000 – 10,000)]
                = $80,000 - $35,100 = $44,900

   D. Current ROI is 25%

      New ROI = ($1,000,000 + $500,000)/($4,000,000 + $3,500,000) = 20%, which is lower
      than the current ROI of 25%. Therefore, the division manager would probably forego the
      opportunity.

   E. EVA with appropriate adjustments would be the best performance evaluation measure.
      EVA overcomes many of the disadvantages of ROI and residual income.


15.27 ATCO Company

   A. Return on investment is not a good performance measure for the division because
      division management has very little control over either net income or investment. Sales
      revenue is totally controlled by central management (they control both prices and
      quantities). In addition, it appears that division management does not have authority to
      alter the level of investment in the firm. While one might also mention problems with the
      allocation of costs and working capital on the basis of sales, and the use of net book
      value, these problems are trivial relative to the division manager’s lack of authority and
      lack of control over factors in the performance measure.

   B. The division should be treated as a cost center (it is not a profit center). Apparently, the
      division management has control only over providing products at an efficient cost, given
      timing and quality constraints. The division's performance should thus be measured
      relative to a well prepared flexible budget. If quality is important, quality performance
      measures should be included.
                                   Chapter 15: Performance Evaluation and Compensation 15-15


15.28 Xerox

   A. Agency costs may or may not involve ethics. An organization incurs costs to monitor
      and reward appropriate behavior to align goals. Agents and employees are not
      necessarily unethical; they just may have different goals and objectives than owners. For
      example, an employee may favor a project using his or her judgment of risk when the
      owner might choose a different project. On the other hand, agent goals could be
      unethical. For example, an employee may prefer to exert low work effort or take office
      supplies home.

   B. There are many possible answers to this question. The purpose of this question is to
      ensure students recognize that indemnification of officer and director costs may occur in
      situations where no wrongdoing has occurred. Here is one possible scenario: A hospital
      administrator could be sued by a patient or patient’s family for malpractice when the
      patient’s physician made all of the treatment decisions for the patient. The hospital may
      have a policy of settling these cases to minimize publicity about lawsuits and to reduce
      the administrator time needed to work with lawyers and appear in court.

   C. Pros: Some lawsuits brought against Xerox’s officers might have nothing to do with the
      officers and directors decisions directly. If the officers and directors may be unwilling to
      work for the company if they believe they will be held liable for all employees’ actions.
      Alternatively, their compensation would need to be high for them to accept this risk. The
      bylaw could lower Xerox’s costs and improve its ability to attract high quality officers
      and directors.

      Cons: Many people are likely to view the indemnification as inappropriate when officers
      and directors are sued because of decisions they have made, or because of unethical or
      illegal actions. The indemnification reduces the officers’ incentives to use thoughtful
      judgment in their decisions, and the directors may not monitor as effectively.

   D. There are at least two different ways to think about this question. One approach is to
      consider how the existence of insurance affects behavior. Moral hazard problems are the
      changes in behavior that occur because people have insurance. For example, people with
      health insurance may be willing to participate in sports such as skiing and rock climbing
      that expose them to risk of injury. They know that someone else will pay for their
      medical bills. Uninsured people may choose not to participate in such sports. When
      payments are made by an insurance company, Xerox officers and directors may behave
      differently than if the payments are made directly by Xerox.

      A second approach is to consider the ethics associated with the financial effects. Does it
      matter whether money is paid by Xerox or by its insurance company? In the long run,
      insurance companies charge premiums to cover the cost of expected claims and earn a
      profit. Thus, the payments made by Xerox’s insurance company were covered by Xerox
      and other companies’ insurance premiums. It is possible to argue that it was unfair for
      companies other than Xerox to share in the cost of its officer indemnification. It is also
      possible to argue that this type of agency cost is exactly why companies buy
      indemnification insurance to begin with.
15-16 Cost Management


   E. There is no one answer to this part. Sample solutions and a discussion of typical student
      responses will be included in assessment guidance on the Instructor’s web site for the
      textbook (available at www.wiley.com/college/eldenburg).


15.29 Peerless Load Levelers Company

   A. Four characteristics and requirements for a responsibility accounting system include the
      following.

              Each level of management is responsible for their department’s operations as well
               as the employees within their department.
              Costs must be clearly identifiable and controllable by the manager.
              Responsibility for performance according to budget must be linked to authority to
               do what is necessary to fulfill this responsibility
              The system should encourage employee involvement and participation, as well as
               improve morale, motivation, and communication.

   B.
        1. The cost center is an organizational unit charged with achieving its operational
           function at a minimum cost. In cost centers, managers have authority over and are
           responsible for costs incurred. Reports focus on the variance of those costs from the
           plan or budget. The variances from controllable costs are used to measure the
           performance of the departmental manger.

        2. The objective of a profit center is to maximize profits. Managers of profit centers are
           responsible for revenues as well as controllable costs.

        3. The objective of an investment center is to maximize return on investment. Managers
           in investment centers are responsible for and have authority over costs and revenues
           as well as investments. Measurement is based on assets employed.

   C.
        1. At least three advantages that may be gained from a responsibility accounting system
           include

                  Systematic planning and reporting of controllable costs
                  Budget setting participation that motivates managers to feel ownership, and
                   increases their accountability and sense of responsibility
                  Timely reports that allow corrections of difficulties before they affect
                   financial results

        2. A major risk involved in responsibility accounting systems is that managers may
           focus only on the costs for which they are responsible and not on the overall goals of
           the organization. The good of the department may be placed ahead of the good of the
           organization, thus making goal congruence difficult.
                              Chapter 15: Performance Evaluation and Compensation 15-17


D. There are many possible answers to this question. Below are examples of possible
   operational performance measures that Klein-Robb could implement for each of the three
   managers.

   John Richards, purchasing manager:
       Total cash discounts earned, or cash discounts as a percent of gross purchase cost:
          This measure would encourage the purchasing manager to negotiate favorable
          cash discount terms with suppliers.
       Number of purchases rejected from quality inspection: This measure would
          encourage the purchasing manager to ensure that vendors supply raw materials
          meeting the company’s quality specifications.
       Price variance for direct materials: This measure would encourage the purchasing
          manager to seek favorable price changes.

   Karl Willis, production manager:
       Achievement of budget goals as follows:
              o Variances from standard labor and direct material rates: These measures
                  provide incentives to control costs through managing purchase prices and
                  efficiency.
       Average job set-up time: This measure would encourage the production manager
         to seek ways to reduce the production time lost due to job set-up.
       Percent of production rejected at final inspection: This measure would encourage
         the production manager to ensure that production quality standards are maintained
         or improved.

   Susan Lyle, quality manager:
       Variance of actual warranty costs compared to budget: This measure would
          encourage the quality manager to maintain or reduce the number of defective
          units that are sold to customers.
       Percent of products returned: This measure would encourage the quality manager
          to maintain or reduce the number of defective units that are sold to customers.
       Summary of reasons for product returns: This measure would provide the quality
          manager with information about what caused product returns, which in turn could
          be used to reduce future return rates.
15-18 Cost Management


           BUILD YOUR PROFESSIONAL COMPETENCIES
15.30 Focus on Professional Competency: Risk Analysis

   A.
        1. Agency theory suggests that some managers and employees may be self-interested,
           which can lead to errors and poor decisions through carelessness and inattention. Self
           interest may also lead to fraudulent behavior—theft of assets or false and misleading
           financial reporting. These types of risks are one reason why organizations institute
           internal controls.

        2. Responsibility accounting and performance-based compensation help align the
           incentives of agents with those of principals, and they also establish ways to measure
           and monitor agent performance. However, it is not possible to perfectly observe or to
           perfectly measure agent behavior. Also, the costs of better monitoring may exceed
           the benefit. Therefore, agency costs associated with inappropriate behavior can never
           be completely eliminated. In addition, agency costs include the cost of monitoring
           (which can never be eliminated).

        3. Pros: When bonuses are based on reported earnings, managers and employees have
           incentives to increase sales and decrease costs, increasing the profits of the company.
           If agents plan to continue working for the organization, they are more likely to choose
           actions that increase earnings over time. In addition, earnings are often used by
           outsiders, such as analysts and shareholders of public companies, to evaluate
           company performance. Basing bonuses on reported earnings helps focus manager
           and employee attention on a measure that drives a significant part of shareholder
           value.

           Cons: When managers and employees plan to work only a short time for a particular
           company or when they are nearing retirement, they may increase short-term earnings
           through actions that would decrease long-term earnings. For example, they may cut
           costs by reducing investments in marketing or research and development. These
           actions could harm the company in the long run. There is also a tendency to
           manipulate the numbers so that the accounting details and reported earnings are
           misleading.

        4. If managers are held responsible for results and are rewarded for good performance,
           the value of the company should increase over time. In addition, performance
           measurement allows problems in performance to be quickly detected. Then
           corrective actions can be taken. However, it is likely that managers and employees
           will monitor the results of their efforts and take corrective actions on their own,
           before an annual performance evaluation.

   B.
        1. Other risks include changes in customer demand, uncertainties about costs or the
           viability and efficiency of new technologies, and risks that are specific to certain
           locations such inflation, currency fluctuation, employee demands, or political unrest.
                                 Chapter 15: Performance Evaluation and Compensation 15-19


        Organizations also face risk of financial failure and loss of reputation—e.g., as a good
        place to work, as a high quality producer of goods or services, as an ethical
        organization, as an environmentally-friendly organization, or as a socially
        conscientious organization. There are also risks of legal actions by employees,
        customers, and regulatory agencies.

     2. Investors and others require a higher rate of return to compensate them for assuming
        risk. For example, riskier investment projects require a higher cost of capital than
        less risky projects. When evaluating potential projects, managers may choose to
        accept a project with higher risk, but only if the project is expected to earn a higher
        return. For example, we learned in Chapter 12 that a higher discount rate is used to
        evaluate capital budgeting projects having higher risk. Employees also require higher
        compensation to assume higher risk. For example, accounting researchers have
        shown that CEOs who work for companies that could potentially face penalties for
        poor environmental performance and whose CEOs could be held personally liable for
        these types of problems receive higher compensation. Organizations and individuals
        who are not willing to assume risk can invest in projects or take jobs that carry less
        risk, but that pay a lower return. Opportunities offering the lowest rates of return are
        the ones that carry little or no risk.

     3. The management of risk does not mean that risk should be eliminated. As discussed
        in subpart 2 above, greater risk is associated with greater return, on average. In
        addition, it is impossible to eliminate risk completely because we compete in a
        dynamic business environment and live in a country with civil laws that protect
        employees and consumers, so we will always be at risk for actions of employees and
        also some frivolous lawsuits. For example, it probably did not occur to Jack-in-the-
        Box or McDonald’s officers that children might die from e-coli bacterial poisoning
        after eating their food. However, once such a problem arises, policies are put into
        place to ensure that these types of problems could rarely occur again. Even with
        policies in place, every employee cannot be continually monitored to know for certain
        that all hamburgers will be cooked thoroughly enough to avoid these types of
        problems. Thus, risk management entails recognizing and planning for business
        risks—not necessarily eliminating them.

     4. Managing risk over time means that managers will act to minimize the effects of
        risks. For example, in all organizations employees sometimes are injured on the job.
        To manage this risk, many companies provide employee safety training and ask
        employees who lift heavy things to wear special back braces to help protect their
        backs. Over time, managers can learn to better manage risk by measuring and
        monitoring results and by using past experience to improve future decisions. The
        policies that fast food stores enforce for hygiene and food preparation practices, such
        as thoroughly cooking beef as mentioned above are ways to manage risk over time.
        Organizations that are international often use hedging methods to protect themselves
        from currency exchange risk.

C.
     1. Unmitigated means ―unrelieved,‖ or without exception. Unmitigated risk is risk that
        cannot be easily reduced. In the chapter, we learned that agency costs cannot be
15-20 Cost Management


            completely eliminated, and some risk always exists that managers and employees fail
            to take actions that are in the best interests of the organization. Although
            performance evaluation systems help to reduce agency costs, unmitigated risks
            always exist.

        2. Performance evaluation involves measuring manager or employee performance,
           drawing conclusions from the results, and holding agents responsible for the results.
           Thus, it assesses whether or not agents appear to be performing in the best interests of
           the principal, and it helps to control manager and employee behavior (i.e., to reduce
           unmitigated risk).


15.31 Integrating Across the Curriculum: Business Law

    A. On its Web site, the SEC explains its major purpose in requiring companies to disclose
       various types of information as follows:1

                 The laws and rules that govern the securities industry in the United States derive
                 from a simple and straightforward concept: all investors, whether large
                 institutions or private individuals, should have access to certain basic facts about
                 an investment prior to buying it. To achieve this, the SEC requires public
                 companies to disclose meaningful financial and other information to the public,
                 which provides a common pool of knowledge for all investors to use to judge for
                 themselves if a company's securities are a good investment. Only through the
                 steady flow of timely, comprehensive and accurate information can people make
                 sound investment decisions.

        In its Executive Compensation: A Guide for Investors, the SEC expands upon the
        purpose of its compensation disclosure requirements. It states that the purpose of current
        disclosure requirements is ―to furnish a more understandable presentation of the nature
        and extent of compensation to executive officers and directors.‖2 It goes on to say:

                 The linchpin of the Commission's executive compensation disclosure is the
                 Summary Compensation Table… It provides an easily understood overview of
                 executive compensation from which investors can review a company's executive
                 compensation for the last three fiscal years, identify trends, and compare those
                 trends with industry trends.

                 …A company also must disclose the criteria used in reaching compensation
                 decisions and the degree of the relationship between the company's compensation
                 practices and corporate performance.


1
  ―Introduction – The SEC: Who We Are, What We Do,‖ excerpt from The Investor's Advocate: How the SEC
Protects Investors and Maintains Market Integrity, U.S. Securities and Exchange Commission, available at
www.sec.gov/about/whatwedo.shtml.
2
  ―II. What Information about Executive Compensation Is Filed with the SEC?‖ and ―III. Where Can I Find
Information about Executive Compensation?‖ in Executive Compensation: A Guide for Investors, U.S. Securities
and Exchange Commission, available at www.sec.gov/investor/pubs/execomp0803.htm.
                                       Chapter 15: Performance Evaluation and Compensation 15-21


        The SEC focuses on executive compensation because executives often have the ability
        and incentive to influence their own compensation, to the potential detriment of investors.

    B. Student answers will vary depending on the report and company they choose. Below are
       answers to this problem for the April 2004 CEO Compensation report issued by Forbes
       magazine. Compensation for the CEO of EI du Pont de Nemours (DuPont) is used in the
       following sample solution because that company was highlighted in the opening vignette
       for Chapter 15.

        1. Forbes publishes an annual ―CEO Compensation‖ special report, typically during
           April. The April 2004 report ranks CEOs according to a pay/performance measure;
           gives each CEO a grade: A+, A, B, C, D, or F; and provides summary information for
           executive pay at each of the largest 500 American companies.3 Summary information
           includes the following for the CEO of DuPont:

                    Name                                          Charles O. Holliday, Jr.
                    Total compensation                            $3,443,000
                    5-year compensation                           $15,240,000
                    Market value of shares owned                  $19,500,000
                    Age                                           56 years
                    Efficiency grade                              D
                    Rank                                          248 (out of 500)

        2. The CEO of DuPont, Charles O. Holliday, was given two types of ratings. One was
           an efficiency grade of ―D‖; the other was a rank of 248 (out of 500). Forbes does not
           provide many details about how these ratings were developed. Here is the
           information provided in the special report:

                    Rank is based on total compensation for latest fiscal year. Efficiency grade is
                    based on our chief executive's pay/performance score. We gave an "A+" to the
                    most efficient boss in delivering performance/pay and "F" for the least
                    efficient.

    C. Disclosures about 2003 executive compensation for DuPont was provided in the
       company’s Definitive Proxy Statement (Form DEF 14A), filed with the SEC on March
       19, 2004.

        1. As explained in the SEC publication, Executive Compensation: A Guide for Investors,
           most companies provide details of executive compensation in the annual proxy
           statement. Therefore, the proxy statement was examined first, and information was
           readily available there. DuPont provides its proxy statement under ―Investor Center‖
           and then ―SEC Filings‖ on its web site (www.dupont.com). The proxy statement
           could also be obtained from the Edgar database on the SEC web site
           (www.sec.gov/edgar/searchedgar/webusers.htm).


3
 ―Special Report: CEO Compensation,‖ Forbes.com, April 23, 2004, available at
www.forbes.com/2004/04/21/04ceoland.html.
15-22 Cost Management


      2. Student opinions are likely to vary about whether a company’s information is clear,
         concise, and understandable. Students who have not previously read these types of
         disclosures will probably think they are confusing and difficult to understand, partly
         because of new terminology. However, most companies (such as DuPont) closely
         follow the format of disclosure found in SEC publications. If students study these
         publications, particularly Executive Compensation: A Guide for Investors, they will
         find the disclosures easier to read.

         Disclosures are often vague in their explanations of the relationship between pay and
         performance.

      3. During 2003, Charles O. Holliday, Jr. at DuPont received the following types of pay:

                 Salary                                                   $1,118,000
                 Variable compensation                                    $2,200,000
                 Stock options granted                                       464,200 shares
                 Other compensation, primarily savings plan contributions    $33,293

         The value of the stock options depends on future appreciation of DuPont’s stock. If
         the stock does not appreciate, the value will be $0; if it appreciates by 5% per year the
         value will be $11,029,192; and at a 10% rate the value will be $27,935,556.

         During 2003, Holliday exercised 3,808 options granted in prior years and realized
         value of $63,556.

      4. DuPont uses several types of performance-based pay for top executives. Here is a
         summary:

                Variable compensation: The company has a variable compensation plan in
                 which a total pool of compensation varies with the performance of the
                 company as a whole. The maximum compensation is calculated as 20% of
                 consolidated net income after deducting 6% of net capital employed. Special
                 items are removed from income for this calculation. (In other words, the
                 maximum is based on a version of residual income or EVA.) The
                 compensation committee establishes the specific formula for each year’s
                 compensation under the plan. During 2003, the committee’s formula included
                 EPS compared to the prior year and return on investors’ capital (ROIC)
                 compared to the average of a peer group. The committee considers both
                 quantitative and qualitative factors. The performance pay of executives
                 depends on the overall company performance as well as the performance of
                 their units. 25% of the variable compensation is typically paid in stock.

                Stock options: These are granted based on ―future potential and individual
                 performance, including achievement of critical operating tasks in such areas
                 as organizational capacity and strategic positioning.‖
                               Chapter 15: Performance Evaluation and Compensation 15-23


              Restricted stock units: Grants are made in 3-year cycles, and payouts vary
               depending on ―pre-established performance-based objectives in both revenue
               growth and ROIC vs. the peer group…‖

       The proxy statement provides the following justification for the level of variable
       compensation paid to the CEO for 2003:

               In reaching its decision on Mr. Holliday's 2003 variable compensation award,
               the Committee noted Mr. Holliday's leadership in the Company's revenue
               growth broadly across businesses and regions, and an especially strong finish
               for 2003. In addition, the Committee recognized the successful integration of
               recent acquisitions, solid progress on separation of the fibers businesses and
               bold steps to launch the new DuPont, with significant actions planned to
               improve 2005 pretax earnings by $900 million through variable margin
               improvements, fixed cost reductions and organizational actions.

D. Evaluation of the CEO compensation at DuPont is subject to the same types of
   uncertainties that exist about the reasonableness of CEO compensation at any company.
   The performance of a CEO cannot be perfectly observed, so it is impossible to determine
   whether the CEO has exerted appropriate effort, established appropriate strategies and
   operating plans, or effectively managed the company. In addition, uncertainties exist
   about the specific results for which the CEO should be held accountable. Part of the
   CEO’s job is to anticipate economic conditions, competitor actions, and so forth.
   However, it is not reasonable to expect a CEO to be able to anticipate all future
   conditions. In addition, uncertainties exist about the appropriate targeted level for CEO
   compensation or about the best combination of compensation types. What is the value of
   a CEO compared to other company employees? How much and what type of
   compensation must the company pay to attract high-quality managers? Which types of
   compensation will provide the best incentives for performance?

E. Many answers are possible for this question. A student who evaluates the pay of
   DuPont’s CEO should consider evidence before reaching a conclusion. Potential
   evidence includes DuPont’s CEO pay compared to:

          Some measure of reported or adjusted DuPont earnings (e.g., level of income,
           ROI, residual income, EVA)
          DuPont shareholder stock returns
          DuPont’s earnings and/or shareholder returns relative to one or more other
           companies (In its proxy statement, DuPont’s compensation committee identifies
           the following ―peer‖ companies: Alcoa, BASF, Dow Chemical, Eastman Kodak,
           Ford, General Electric, Hewlett-Packard, Minnesota Mining and Manufacturing,
           Monsanto, Motorola, PPG Industries, Rohm & Haas, and United Technologies)
          Levels of CEO pay in other companies
          Levels and changes in pay for other DuPont employee groups

   Students might also consider the opinion of others, such as the ratings of DuPont CEO
   pay in the Forbes compensation survey. Once students have presented and evaluated
15-24 Cost Management


      evidence, they should identify the criteria/values used to draw conclusions. For example,
      should CEO pay ever exceed some multiple of pay for the average employee? Should
      CEO pay include a portion that varies with each year’s company performance or with
      performance over several years? Should CEO pay remain within some percentage of the
      CEO pay at other companies?


15.32 Integrating Across the Curriculum: Finance

   A. Under generally accepted accounting principles (GAAP), debt and equity accounts are
      typically recorded at cost and are not adjusted for fair market value. Over time, fair
      market value can deviate substantially from book values. For a company such as
      Amazon, whose value relies heavily on intangible assets, the fair market value can be
      considerably higher than the book value.

   B. The weighted average cost of capital computation typically includes only long-term debt
      and equity. For Amazon, this would most likely include the following:

             4.75% Convertible Subordinated Notes
             6.875% PEACS
             10% Senior Discount Notes
             Long-term restructuring liabilities
             Capital lease obligations
             Common stockholders’ equity

      Each of the preceding appears to be a source of long-term capital. Excluded from this list
      are Euro currency swap liabilities and other long-term debt, which are assumed to be
      simple long-term liabilities rather than sources of capital.

   C. Possible sources of information for estimating the weighted average cost of capital are as
      follows; students may think of additional sources of information.

      1. Market value of common stock: Quoted market prices for publicly-traded stock;
         estimated value using expected future earnings for non-publicly-traded stock

      2. Cost of equity capital: Long-term rate of return on the stock market for companies
         having similar risk

      3. Market value for each type of debt: Quoted market prices for publicly traded debt;
         net present value of future cash flows using current discount rates for other forms of
         debt

      4. Pretax interest rates: Effective interest rate imputed from market values of publicly-
         traded debt; discount rates used to estimate net present values for other forms of debt

      5. Income tax rate: Effective income tax rate from income tax footnote

								
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