978-0078025532 Chapter 18 Lecture Note

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-1

Chapter 18

Strategic Performance Measurement: Cost Centers, Profit Centers,

and the Balanced Scorecard

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 Did” that ICC created a new biotechnology segment, and a new biotechnology product

products for the firm into 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

responsible for profitability has a tendency to spend too much time on intellectually stimulating, but

commercially irrelevant, projects. Holding a profit SBU responsible for R&D will also discourage

overspending on R&D (low-potential projects are likely to be abandoned more quickly). However,

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.

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-2

Periodically they should be evaluated by the personnel doing the research, by other scientists, and by

operating managers for progress and commercial potential. These evaluations should form the basis for

reasonable.

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

allocated as a corporate charge from 15 % of corporate R&D costs to just 3 %.

Because of the firm’s strategic emphasis on biotechnology, a new segment, biotechnology product

development was established in the corporate R&D unit. This segment has no profit responsibility or

specific products. Rather it will concentrate on basic and applied biotechnology that could lead to

products in any of the firm’s segments.

The firm also implemented a five year budget for each research project. This budget not only

contained estimates of costs to be incurred, but also required management to explicitly rank projects by

priority, estimate the odds of commercial success, the date by which commercial products could be

expected, and the range of additional gross profit that might result. While everyone is aware that these

estimates are rough, it nonetheless provides an objective basis for comparing projects. The firm intends to

track the accuracy of these budgets and evaluations.

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-3

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

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-4

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

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.

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-5

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.

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-6

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 problem⎯paid 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.

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-7

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

Rent $60,000 ÷ .40 Given District A $150,000 x .30

District expense Given $ 180,000 x .40 $ 180,000 x .35

Chapter 18 – Strategic Performance Measurement: Cost Centers, Profit Centers, and the Balanced Scorecard

18-8

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.

18-9

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

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.