Chapter 18 – Management Control and Strategic Performance Measurement
Chapter 18
Management Control and Strategic Performance Measurement
Teaching Notes for Cases
18-1 Industrial Chemical Company; Decentralization; Cost SBUs; International
Background
To begin class discussion you may wish to point out to your students that most of our study in
management accounting typically concerns the budgeting, control, and evaluation of rather routine
manufacturing or service operations. For these activities the use of flexible budgets and standard costs are
relatively common. The classroom discussion of this question should be led to identify the following
points.
1. To use a flexible budget we need to have a uniform measure of output. No such measure exists for
R&D as no two projects will be the same.
2. Standards imply a known relationship between inputs and outputs. With R&D we often do not know
before the fact what the output will be. Even after a project is successfully completed, it is difficult to
determine if it was completed efficiently.
3. R&D effort is essential for long-term survival, but we do not know what the optimal amount of effort
should be.
4. In the early stages of a research project the financial and qualitative evaluations of a doomed and a
successful project will look the same.
5. R&D projects take a long time to complete (the average for the chemicals company is 5-7 years; and
for the pharmaceutical company, the average project takes 10 years). Hence cost projections are little
better than educated guesses.
Answers to Questions
1. R&D is critical to the firm’s strategy, especially in biotechnology. Note under “What the Firm Actually
the future.
2. There are benefits and costs involved with centralizing or decentralizing R&D. If R&D is
decentralized, there will be more emphasis on the commercial potential of projects. A centralized unit not
Also it is likely for R&D expenditures to be cut in times of low profitability. The firm should maintain its
R&D responsibility by giving the operating units responsibility for Class I and II research and performing
Class III research centrally.
3. As mentioned above, budgeting and controlling activities such as R&D is difficult. Nonetheless some
control must be exercised. The firm should attempt to track the costs and progress of individual projects.
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Chapter 18 – Management Control and Strategic Performance Measurement
setting priorities on existing projects. For new projects the firm might use a proposal system. Researchers
4. The global operations of the company complicate the R&D function considerably. For example, patent
protection must be maintained in all countries in which the firm does business. Moreover, ICC must
consider its risks of theft or improper use of its patented technology in countries which have ineffective
What the Firm Actually Did
The firm retained a separate corporate research and development unit. However they also made a
greater effort to identify which business segments were being supported by specific corporate R&D. The
cost of these projects were then charged to the appropriate segment. This places corporate R&D under
greater operating unit scrutiny and should help eliminate any redundancies. It also reduced the R&D
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Chapter 18 – Management Control and Strategic Performance Measurement
18-2. Variable and Full Costing; Ethics
(Note: This case can also be used in Chapter 20, to discuss compensation issues)
1.
Units sold 140,000
Price $75
Variable selling/unit 15
Variable Mfg/unit 25
OH Rate ($2,100,000/175,000) 12.00
Full absorption cost per unit 37.00
Overhead Variance, units 0
FULL COST INCOME STATEMENT
Sales $10,500,000
Cost of Sales
Beginning Inv. $ 0
Mfg Cost 6,475,000
Ending Inv 1,295,000 5,180,000
Gross Margin 5,320,000
Selling and Administrative
Variable 2,240,000
Fixed 2,750,000 4,990,000
Net Income $ 330,000
2. VARIABLE COST INCOME STATEMENT
Sales $10,500,000
Variable Costs
Cost of Sales $3,500,000
Selling 2,240,000 5,740,000
Contribution Margin 4,760,000
Fixed Costs
Manufacturing 2,100,000
Selling 2,750,000 4,850,000
Net Loss ($ 90,000)
Difference between Income statements:
Favoring Absorption Cost $420,000 = $330,000 – ($90,000)
Explanation for the difference in Income:
Inventory increase by 35,000 units
35,000 x $12 = $420,000
3. The new COO should not receive a bonus, since as shown in the variable cost income statement, there
is very little income earned in 2008. The large amount of income under the full costing income statement
is due almost entirely to the large build up of inventory, with the effect that $420,000 of fixed
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Chapter 18 – Management Control and Strategic Performance Measurement
manufacturing costs are inventoried. These fixed costs will come through the absorption cost income
statement later, when the inventory level decreases, perhaps under the management of a successor COO.
The use of inventory build up under absorption costing is one of the ways a manager can manipulate
income to appear more favorable. The variable cost income statement is an effective means to avoid this
type of manipulation. Thus, when bonus arrangements such as this are determined, the arrangement
should include a provision that income is determined using variable costing, or alternatively, there are
some restrictions on the amount of inventory change allowed under the agreement.
4. The ethical issue in this case has to do with the COO’s apparent attempt to manipulate the financial
statements so as to earn a higher bonus than is appropriate, as explained above. Again, a good way to
remove this temptation to the COO is to design bonus contracts on the basis of variable cost income.
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18-3. Determination of Strategic Performance Measurement Systems; International
1. The choice of a profit SBU is a good choice for the retail divisions in Johnson Supply. The contribution
income statement illustrated in the chapter can provide a useful means to develop in-depth analysis of the
profits of the divisions. Johnson should also consider whether the divisions should report income on the
basis of variable cost statements, even though this presentation of income is not accepted for financial
reporting and tax purposes. The advantage would be to remove the potential bias due to inventory
changes. If inventory levels are stable in all the divisions, the issue may not be an important one.
Another consideration is if the divisions are of significantly different size, or if they have
somewhat different operations, division net income might not be an appropriate strategic performance
measure. In this case, management might consider an investment SBU (Chapter 19). The investment
SBU, which commonly uses return on investment (income divided by investment) more effectively deals
with issues such as differences in size and in the nature of operations.
2. Many will argue that the firm has done the right thing in separating international issues such as foreign
currency and taxes from the determination of net income. The argument would be that taxes and currency
fluctuations are not controllable by the division managers, and thus should not affect their divisional
profit. However, a closer look would show that the division managers can usually take steps to effectively
manage the effects of differences in tax rates and possible changes in currency values by adjusting their
operations and investments in such a way as to minimize the effect of these changes on the firm.
Managers who are more effective at limiting the unfavorable effects of taxes and currency changes should
be rewarded since these efforts improve the firm’s overall net income. Thus, there is a good argument for
including both taxes and foreign currency effects in the determination of division net income.
3. The change of the IT department to a profit SBU from a cost SBU can have an important strategic
advantage. The likely effects include a much stronger motivation for IT to provide excellent customer
service at a low cost inside the firm, since it will now have to compete with outside providers of IT. A
potential negative consequence is that since the IT department will now be competing with other IT firms,
there will be less time and less incentive for the IT department to engage in projects with a potential long-
term return (e.g., the development of new operating systems, and new applications). That is, there will be
less emphasis on IT projects which might dramatically improve the IT function in the coming years, since
the competition with other IT firms will tend to drive out all but short-term efforts. Perhaps Johnson
Supply should provide special funding, upon negotiation with the IT manager, which will be spent solely
upon long-term, research-oriented projects which might provide better service in the coming years. If the
IT department at Johnson Supply is a particularly strong department with highly talented people, then this
latter option is particularly important, because without it, some of the best people might leave (these are
the ones most likely to insist on longer-term, research-oriented activities), and because the presence of the
talented staff gives greater promise of favorable results from the expenditures on longer-term projects.
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Chapter 18 – Management Control and Strategic Performance Measurement
18-4. Determination of Strategic Performance Measurement Systems: Employee Benefits
Mount Drake should not change the performance measurement system. The profit SBU approach
should continue to serve them well. It provides the desired motivation for division managers, and because
the nature of the operations for each division is somewhat similar and because investment in fixed assets
is not a large concern in this industry, there is no need to consider a more elaborate system, such as the
investment SBU approach.
The main issue now facing the firm is how to attract and retain competent employees in an
industry where their skills are in short supply. There are a number of possible approaches for achieving
this goal, including some of the ideas proposed in the problempaid vacation, stock investment
programs, better health benefits, and training. The key issue then, is how to charge these additional costs
to the divisions, that is, cost allocation. Training, paid vacations, and stock investment programs can be
traced directly to the divisions, so they should be directly charged. The difficulty comes with the health
benefits program, which, because the program is funded firm-wide, may be difficult to trace to the
divisions. If the premiums for the extended health coverage are based on the number of employees, then
the cost can be properly charged to the divisions in this way. Alternatively, if the premiums are based on a
negotiated amount, Mount Drake may use a different allocation base. Headcount may still be most
acceptable, though revenues (or profits) in the divisions might also be acceptable.
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Chapter 18 – Management Control and Strategic Performance Measurement
18-5 Contribution Income Statement
1. The performance report for District A and Stores 1 & 2 of Cathy’s Classic Clothes, for May 2013,
is presented below.
Cathy’s Classic Clothes
Northeast Region Performance Report
May 2013
District A Store 1 Store 2
Sales $1,500,000 $ 600,000 $
525,000
Cost of goods sold 633,750 252,000
220,500
Gross margin 866,250 348,000
304,500
Operating expenses:
Variable selling 90,000 36,000
31,500
Variable administration 37,500 15,000
13,125
Other direct expenses:
Store maintenance 12,600 7,500
600
Advertising 75,000 50,000
5,000
Rent and other costs 150,000 60,000
45,000
District expense (allocated) 180,000 72,000
63,000
Regional expenses (allocates) 165,000 55,000
55,000
Total expenses 710,000 295,500
213,225
Net income $ 156,150 $ 52,500 $
91,275
Supporting Calculations
District A Store 1 Store 2
Sales Given $1,500,000 x .40 $1,500,000 x .35
Cost of goods sold Given $ 600,000 x .42 $ 525,000 x .42
Variable selling $1,500,000 x .06 $ 600,000 x .06 $ 525,000 x .06
Variable administration $1,500,000 x .025 $ 600,000 x .025 $ 525,000 x .
025
Advertising Given 2 ($75,000 ÷ 3) Store 1 $50,000 ÷
10
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Chapter 18 – Management Control and Strategic Performance Measurement
Rent $60,000 ÷ .40 Given District A
$150,000 x .30
District expense Given $ 180,000 x .40 $ 180,000 x .
35
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Chapter 18 – Management Control and Strategic Performance Measurement
2. The impact of the responsibility accounting system and bonus structure on the managers’
behavior and the effect of this behavior on the financial results for Stores 1 and 2 includes the
following.
a. Store 1
Because the bonus is based on sales over $570,000, the manager has
concentrated on maximizing sales and paid little attention to controllable costs.
As a result, the store’s net income was less than 9 percent of sales and only 34
percent of total net income.
In an effort to maximize sales, Store 1 spent ten times more than Store 2 on
advertising but generated only $75,000 more in sales. This would indicate that
the advertising was not very effective and should be better controlled.
b. Store 2
Because the manager of Store 2 is motivated to maximize net income, there
appears to be a tendency to cut back on discretionary expenses such as store
maintenance and advertising. While management is seeking cost control by
implementing a bonus based on net income, the lack of spending on these
discretionary items may have an adverse long-term effect.
The manager of Store 2 will be unhappy with the inclusion of allocated district
and regional expenses in the calculation of net income. These expenses are not
likely to be controlled by the store managers and will serve to reduce the bonus
received by the manager of Store 2.
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Chapter 18 – Management Control and Strategic Performance Measurement
18-6 Manipulating the Balanced Scorecard
This dilemma highlights the role of subjectivity and the necessity for ethical judgment in a
corporate environment where a reward system with multiple performance measures–such as the
balanced scorecard (BSC)–is used. The balanced scorecard includes a variety of nonfinancial
metrics–such as employee and customer survey results–as performance benchmarks for
evaluating managerial success and calculating employee bonuses. Advocates of the balanced
scorecard point out that such an approach motivates management to focus on long-term
performance rather than on short-term financial results. Its critics, however, stress the
subjectivity involved in choosing the specific nonfinancial metrics and the weights applied in
order to transform the variety of metrics into the single final number. This creates opportunities
for “game-playing,” and results in novel ethical dilemmas specifically applicable to management
accounting settings.
This case might be used in undergraduate and graduate courses in cost accounting, MBA
courses in management accounting, courses in business ethics, and IMA chapter continuing
educational programs. It presents professionals with a valuable opportunity to discuss a case that
doesn’t have an obvious “right” answer but instead has several potential solutions–none of
which are ideal. As such, the dilemma is useful not just for developing ethical judgment (i.e.,
reasoning about ethical issues) but also ethical sensitivity (i.e., recognition of ethical content in
work situations). This dilemma involves issues directly related to all four of the ethical standards
within IMA’s Statement of Ethical Professional Practice: competence, confidentiality, integrity,
and credibility.
Learning Objectives and Assignment Suggestions
Mary is faced with an ethical dilemma that pits her personal judgment against the wishes of her
immediate boss. This case offers an excellent opportunity for exploring the impact of
performance measurement and bonus systems on individual behavior. Usually thought of as a
method for assessing and rewarding actions, these systems often cause unwanted behavior and
generate serious ethical dilemmas. It’s critical that students (1) recognize the potentially
unintended consequences of the balanced scorecard or any performance measurement system
and (2) understand that the success of such methods is dependent upon the ethical behavior of the
individuals. The case requires that students first understand the mechanics of a performance
measurement system (the BSC) in order to recognize the potential abuses. Students must then
brainstorm all the possible solutions, identify the stakeholders, and analyze the consequences in
order to select their preferred solution. IMA’s Statement of Ethical Professional Practice are
used as a framework to evaluate the situation.
I. Learning Objective: Establishment of the facts
Students should understand the objectives of a performance measurement and bonus system and
recognize the positive and negative impacts of the system.
Suggested Questions:
1. Research the balanced scorecard method. What are the objectives of the method, its
advantages, and disadvantages? Why did IFS switch to the balanced scorecard? Was
this a good decision?
2. Analyze the choices of Karl and Michael in implementing the BSC. Are their
methods “right” or “wrong”? Defend your answer.