Solution manual cost and managerial accounting by barfield 3rd measuring and rewarding organizational performance

Performance measures have a role in • assessing organizational performance, • relating organizational goals and missions to managerial performance, • fostering the growth of subordinate

Measuring and Rewarding Organizational PerformanceQuestions

1 Performance measurement is necessary to gauge whether a firm

is pursuing its goals and objectives successfully Without performance measurement systems, managers, shareholders, and others would have no basis to assess the success of operations

or whether operations were being conducted efficiently

2 A mission statement expresses the organization’s purposes and

identifies how the organization will meet its customers’ needsthrough its products or services Alternatively, a vision statement expresses where the organization wants to be in the future The former is more short run oriented than the latter and should change periodically as customer preferences change

A values statement helps provide information on the firm’s organizational culture It indicates the areas of

organizational importance so that employees can internalize these beliefs and values

3 Organizational strategies and missions are devised to achieve

the goals and objectives of a firm Control systems,

including systems of performance measurement, are created to implement the missions and strategies of firms

4 In the absence of benchmarks, the performance measurements

will not be meaningful The performance measurements can be interpreted only when they are compared to benchmark

measurements such as industry performance or a firm’s

historical performance measurements

5 Performance measures have a role in

• assessing organizational performance,

• relating organizational goals and missions to managerial

performance,

• fostering the growth of subordinate managers,

• motivating managers,

• enhancing organizational communication,

• evaluating comparative managerial performance, and

• implementing organizational control

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6 Capital is one of the important resources that firms must

manage effectively and efficiently If they fail to do so, firms will be unable to attract the capital, at a reasonable cost, that is necessary to fund growth opportunities

Demonstrating to capital markets that the firm has been

successful in managing money is necessary to attract capital

7 Specific products and subunits are uniquely designed to

compete in their markets Further, every market has unique competitive dimensions, e.g., quality, price, functionality Managers must have the information that allows them to competeeffectively on all competitive dimensions Thus, this

information is necessary to deploy organizational resources toyield the maximum benefit

8 Only by linking managerial rewards to performance is the

welfare of managers linked to their success in achieving

organizational goals and objectives Because the goals and objectives of the firm are reflected in the performance

measurements, the performance measurements are, in a sense, reflections of managers’ contributions to the achievement of the organization’s goals and objectives By linking rewards

to the performance measurements, managers are made to be

vitally concerned with achieving those goals and objectives

9 In selecting bases for performance measurement, managers

should consider:

* whether the measures capture progress toward

organizational goals,

* the input of those being evaluated,

* whether proposed measures are appropriate for the skills

and authority of those being evaluated, and

* methods to provide appropriate feedback on performance

10 Performance measures should be both The measures chosen must

be reasonable proxies for the organization's critical success factors, many of which are not easily captured by financial orother quantitative measures For example, to capture

performance in the dimensions of customer service, product andservice quality, product innovation, advancement in job

skills, and effectiveness in communications, managers need to employ qualitative measures

11 No The measure must be consistent with the span of authority

and responsibility of the given manager This mandates that different responsibility centers be evaluated using different measures Further, the chosen measures must be consistent with the time horizon of decisions made by the manager

12 The balanced scorecard is a conceptual approach to measuring

performance that weighs performance from four perspectives Managers choosing to apply the balanced scorecard are

demonstrating a belief that traditional financial performance measures alone are insufficient to assess how the firm is doing and what specific actions must be taken to improve

performance The four perspectives in the balanced scorecard are financial, customers, learning/innovation, and internal process improvements

13 It is expected that people will act specifically in accordance

with how they are measured Thus, individuals must know of andunderstand the performance measures used, so that managers canmake decisions in light of the effects of alternative choices

on the performance measures Managers allowed to participate

in the development of the measures by which their performance

is assessed are more likely to accept the performance measures

as valid and fair and to understand how their actions

influence the measures

14 Feedback is critical to improving performance Negative or

critical feedback provides information about what the manager needs to change It provides a focus for improvement

Positive feedback confirms what the manager is doing well

15 The traditional performance evaluation measures for cost

centers are standard cost variances Traditional measures forrevenue centers are deviations from budgeted revenues

Historically, these measures have been used because they are

consistent with a financial evaluation of performance

16 Manipulation is an important concern because performance

measures should be designed to capture only real performance

and not manipulation of the performance measure If a

performance measure can be manipulated by managers, then

managers can achieve a high level of measured performance by either performing very well or by manipulating the measure External measures are far superior to interior measures in this respect because they are not susceptible to internal manipulation

17 Net cash flow from operations, conceptually, measures the same

thing as net income It may therefore be a useful measure in aprofit center or an investment center The only difference between net cash flow from operations and accounting income are accounting accruals Because many accounting accruals aresusceptible to manipulation by managers, net cash flow is lessprone to manipulation than alternative accounting measures However, it is not beyond manipulation because cash flow can

be manipulated to some extent by manipulating the timing of cash receipts and cash disbursements It is best if both an accounting income and a net cash flow measure are used to evaluate performance Each measure provides a quality

standard for the other measure

Like accounting income, net cash flow from operations is

a short-term measure and provides no long-term incentives This is its most significant weakness

18 No Although both measures provide information that explains

the change in the cash balance for the period, they are

otherwise very different The Statement of Cash Flows

provides information about the sources and uses of cash

according to three major categories of business activities: operating, investing, and financing The Statement of Cash Flows complements information on the income statement

(operating cash flows) Alternatively, the cash budget is an internal tool only; it is not a published external financial statement The purpose of the cash budget is to provide

information for the management of cash In particular, the cash budget helps the firm maintain liquidity by highlighting periods of cash shortages, and the need to invest during

periods of cash surpluses

19 In defining "income," managers have several major concerns

that need to be addressed:

* Is the measure wholly controllable by the person being

20 The major difference between a profit and an investment center

is that the investment center has control over costs,

revenues, and the level of assets that is employed

Accordingly, investment centers need to be evaluated based on their profitability relative to the value of assets used Profit centers have no responsibility for assets and can be evaluated based on profit alone

21 The Du Pont model is a formulation of the ROI ratio In the

Du Pont model, ROI is the product of profit margin multiplied

by asset turnover Each component ratio provides information

on a distinct dimension of performance The profit margin measures how much of each sales dollar is turned into profit; the asset turnover ratio is a measure of asset utilization andcaptures how many dollars of asset investment are required to generate each dollar of sales

22 Residual income, RI, is a derivative of ROI In many

respects the relationship between ROI and RI is parallel to the relationship between net present value, NPV, and internal rate of return, IRR RI provides a dollar measure of

divisional achievement whereas ROI provides a percentage

measure of achievement The principal strength of RI is that

it creates fewer problems with suboptimization than ROI In particular RI minimizes the suboptimization problems

associated with ROI in an environment where ROI varies

substantially across the divisions in a company

Economic value added, EVA, is similar to RI

The major distinction is that EVA uses invested capital as theasset base and the company’s cost of capital as the target rate of return This measure should more nearly correlate with effects on shareholder value than RI

23 They have three primary limitations:

* Each is subject to manipulation in terms of both the

income measurement and the asset measurement

* It is frequently difficult to obtain viable proxies for

both income and asset measures

* Both provide incentives at the division level only

There is no integration of division and organizational goals in using these measures alone

24 A weakness of the residual income measure is that it is

typically computed using book values of assets rather than market values and the target rate of return is not necessarilythe cost of capital Economic value added is conceptually similar to residual income in its computations but utilizes a market measure of asset value and applies a target return ratethat reflects the cost of capital Economic value added

computations also include the effects of income taxes, which are normally excluded in computing residual income

25 Suboptimization may be created in using ROI because the

divisional ROIs differ from the overall organization's ROI

In such a circumstance, a division may invest (fail to invest)

in new assets when, from the perspective of the overall

organization's ROI, it would have been better not to invest (to invest) ROI is most likely to create a suboptimization problem in firms that have target and achieved levels of ROI that vary substantially from one division to another This problem is likely to be minimized when there is little

variance among all the divisions' ROIs

26 Qualitative measures are sometimes difficult to use in

performance evaluation because the individuals being measured see those factors as subjective and “fuzzy.” Additionally, these measures may need to be varied from person to person or group to group because of individual or team differences that create noncomparability

27 These advantages are listed in Exhibit 19-7

28 Bases of comparison are necessary because a performance

measurement is meaningless unless it can be interpreted as good, average, or poor performance The comparison base is used as the benchmark against which actual performance is compared

29 Throughput is defined relative to units sold rather than

produced because producing units that are not currently in demand generates no revenue or profit from customers Thus, goods only create value for the firm when they are sold

30 Multinational companies have to deal with substantially more

issues than do companies operating only in a single country Among the important factors that may vary from country to country are culture, religion, labor laws, tax laws, work ethic, individual freedoms, market stability, political

stability, inflation and exchange rates, financing costs, and consumer wealth In designing performance evaluation measures,organizational goals as well as local conditions and

constraints must be considered Thus, performance measures (regardless of whether they are financial or nonfinancial) should be tailored to fit local circumstances

31 Strategies are successfully implemented only if employees and

managers are provided with correct incentives The reward structure is the source of motivation for managers and other employees to implement corporate strategies

32 The performance measurement and reward strategy for each level

of management must be consistent with the level of

responsibility and authority given to each level and the

contribution required of each individual manager Although the reward must be consistent with achievement of overall goals, it must also consider the individual contributions of

the managers and how effective they were in their sphere of

control Also, managers at higher levels are required to be more long-term oriented and managers at lower levels are

required to be more short-term oriented The performance and reward system must recognize these differences

33 To remain competitive, there has been a shift in American

industry toward performance-based compensation This shift can be attributed to two factors First, workers are becomingmore and more removed from the actual production activities because of automation This change makes it more difficult tobase compensation on direct observation Second, there is an effort to develop a tighter linkage between pay and reward to make workers more goal oriented and make them more aware of the contribution that is required of them for the organization

to be successful

34 The outcome is suboptimization When performance measures and

rewards of the individual, the organization, and its segments are compatible, workers maximize achievement of the

organization’s goals in pursuing achievement of their

individual goals When the performance measures and reward system of individuals are only loosely correlated with the organization’s goals, achievement of the individual’s goals may not result in achievement of the organization’s goals

35 There must be consistency between the time perspective of the

reward system and the performance measurement system If the time perspective of a performance-based pay plan is long-term,then the organization must select performance measures that capture long-term performance Otherwise, suboptimization will result because achievement of performance targets will not necessarily result in achievement of the desired

performance for the desired time frame

36 The organizational mission of each subunit can be unique If

so, the performance measures of each subunit should also be unique For example, if one subunit has a build mission and another subunit has a harvest mission, the former’s

performance measures should concentrate on market share and sales growth The latter’s performance measures should

concentrate on profit and cash flow performance

37 As workers get older, their needs and goals change Young

workers are likely to have a very long-term orientation; olderworkers have a shorter term orientation-up to retirement age Further, as workers age, their monetary needs may diminish as other needs (job security, for example) become more important

38 Workers may shirk Shirking occurs when employees perceive

their share of the group's reward as being inadequate to

compensate them for their effort This occurs because the entire group splits the benefits of a single worker's effort, whereas the individual worker bears all of the costs of the effort

39 In a performance-based pay plan, workers are evaluated based

on their achieved output The performance-based evaluations are riskier because the output of any production process is partly determined by factors beyond the control of the worker.Thus, workers’ compensation is partly determined by these factors which are beyond the workers’ control This makes performance-based pay riskier than pay based on workers’

inputs

40 If managers were also major shareholders, there would be a

natural consistency between their actions as managers and their actions as shareholders However, when managers and shareholders are different individuals, there is no natural compatibility in their goals and actions Consequently,

performance measures must be devised that cause managers to act in the best interest of shareholders To be effective, the performance measures must be highly correlated with

shareholders’ objective of wealth maximization

41 Performance-based rewards create risks for managers and

employees because part of the measured performance will be attributable to factors beyond the control of the managers andworkers The uncontrollable factors affect the measured

performance but their effects on performance cannot be managed

by the employees and workers

42 Feedback provides information to (1) improve the reward system

and (2) take action to improve future performance See

Exhibit 19-12 for a graphical display of both feedback loops

43 When employees hold stock, they will have personal incentives

to act in the best interest of the stockholders By providingemployees with stock, managers are creating a natural

incentive-compatible alliance between the employees and the stockholders of the firm As stockholders, workers are likely

to develop a broad view of the organization, rather than

viewing the organization relative to their narrow roles as employees

44 Financial performance measures are more appropriate for

short-term performance measurement To measure long-short-term

performance, the better measures are often nonfinancial For example, profit generated is a good short-term performance measure, but a poor long-term measure Growth in market share

is a better indicator of long-term performance

The time horizon of the performance measures is linked tothe subunit mission For example, performance measures should

be long term for growth missions and short term for harvest missions

45 Income taxes must be taken into account because employees can

only spend after-tax income By minimizing taxes, employees and employers can maximize the after-tax amount of

compensation The alternative tax treatments, ordered from least to most preferred, are fully and currently taxable, tax deferred, and tax exempt

46 Equity in the reward structure must be maintained from the top

of the organization to the bottom Equity requires a

consideration of the relative pay of top managers versus

lower-level managers and workers Ultimately, an equitable pay structure must balance the entitlement of labor,

management, and capital

A consideration of equity also requires that the reward system be sensitive to local differences (including living costs and tax effects) in global organizations Currently, itcould easily be argued that U.S firms have relatively

inequitable reward systems The inequity results from the large disparity between average worker pay and top executive pay Equity is necessary in the longer run to keep all

stakeholders motivated

47 In addition to the usual concerns, global enterprises must

address local tax differences, fluctuations in currency rates,and local cost of living differences

Note that (a) and (d) differ due to rounding error.

51 a Asset Turnover = Sales ÷ Average Assets

53 a Division 1 Division 2

Sales $600,000 $1,050,000Variable costs (150,000) (717,500)Fixed costs (350,000) (125,000)Income $100,000 $ 207,500Target return:

$ 550,000 × 10 (55,000)

$1,525,000 × 10 (152,500)Residual income $ 45,000 $ 55,000According to the residual income measure, Division 2

outperformed Division 1

b Division 1 Division 2

Sales $690,000 $1,207,500Variable costs (172,500) (825,125)Fixed costs (350,000) (125,000)Income $167,500 $ 257,375 Target return:

$ 550,000 × 10 (55,000)

$1,525,000 × 10 (152,500)Residual income $112,500 $ 104,875Based on the residual income, Division 1 is now outperforming Division 2

c Division 1 is using much more operating leverage (relatively more fixed costs than Division 2) and therefore benefits to a more significant extent from an increase in sales volume If sales decreased rather thanincreased, Division 1's residual income would have

decreased at a faster rate than Division 2's

54 a Income = Sales - Variable Costs - Fixed Costs

= $10,000,000 - ($10,000,000 × 0.35) - $3,750,000 = $2,750,000

ROI = Income ÷ Assets invested = $2,750,000 ÷ $5,000,000

= 55%

b Income $2,750,000

Target return (0.14 × $5,000,000) (700,000)Residual income $2,050,000

c Profit margin = Income ÷ Sales

= $2,750,000 ÷ $10,000,000

= 27.5%

d Asset turnover = Sales ÷ Assets Invested

b Determining the amount of capital invested in a particular division is difficult because divisions don’t issue debt or stock as do companies The challenge one faces is to divide the total value of a firm among its operating divisions

One would start by determining the amount of capital invested in the entire company and then apportion this amount among the divisions The established value would include both debt and equity The level of debt investment can be proxied by the face amount of the debt if market values are

unattainable If the debt is publicly traded, the market value can be determined readily The value of the stock can be found by multiplying the market value per share bythe number of shares outstanding This approach is

appropriate for both common and preferred stock

Next, the market value of the total firm must be divided among the operating divisions This step will involve some judgment One approach is to allocate market value to the divisions based on relative book value of assets A second approach is to establish the value of divisions by determining the value of

independent companies operating in the same industries asthe divisions The market value of a division is set by multiplying the ratio of book value of the division to book value of the independent firm by the market value ofthe independent firm A third approach would be to hire aconsulting firm to establish appraised values for each division

57 The new division will have a mission of “build.” When the

new division is established it will have only a potential

customer base but no existing sales Accordingly, the majorobjective of the division will be to obtain market share andestablish a high rate of growth in sales It must accomplishthis objective by adding value to existing services provided

to clients

The same performance measures are not appropriate across the entire life cycle of a division The performance measuresestablished at the outset for this new division should

emphasize growth Later in the life cycle, performance

measurements will be added/deleted to shift the focus to

generation of cash flow and profits Following are

performance measurements that would be useful initially:

• Percentage of existing clients that have video game

installations The emphasis would be on measuring the

annual growth in this number

• Sales growth Sales targets should be established and

compared to actual levels of sales generated

• Percentage of clients who have received sales calls

informing them of the services available from the new

division As an early life-cycle performance measure, this measure captures the extent to which the new division has made contact with the existing client base

• Number of face-to-face sales calls made to clients This issimilar to the prior measure but emphasizes personal

contact

• Sales and promotions budget A key device to increasing market share will be the appropriate use of advertising and promotions Budgets can be prepared for these expenditures,

by category, and can then be compared against actual

expenditures This is a useful tool for understanding and executing a comprehensive and internally consistent

60 a MCE = Value-added time ÷ Total time

d Throughput = Good units ÷ Total time

= 12,000 ÷ 288,000 = 0.04 units per hour

61 a MCE = Value-added time ÷ Total time

= 12,500 ÷ 48,000 = 26% (rounded)

b Process productivity = Total units ÷ Value-added time

= 37,500 ÷ 12,500 = 3 units per hour

c Process quality yield = Good units ÷ Total units

= 30,000 ÷ 37,500 = 80%

d Throughput = Good units ÷ Total time

= 30,000 ÷ 48,000 = 0.625 units per hour

e Throughput = MCE × Process productivity × Process quality yield = 26 × 3 × 8 = 0.624 units per hour

(difference due to rounding)

62 a MCE = Value-added time ÷ Total time

= 24,000 ÷ 36,000 = 67% (rounded)

b Process productivity = Total units ÷ Value-added time

= 60,000 ÷ 24,000 = 2.5 units per hour

c Process quality yield = Good units ÷ Total units

= 42,000 ÷ 60,000 = 70%

d Throughput = Good units ÷ Total time

= 42,000 ÷ 36,000 = 1.17 units per hour

(rounded)

e Enterprise management can increase throughput by

decreasing non-value-added activities, increasing total unit production and sales, decreasing the per-unit

processing time, or increasing the process quality yield.These changes can be generated by the adoption of newer technology, reorganization of the plant, implementation

of activity-based management concepts, or investment in prevention costs of quality

63 a Year 1: $100,000 - ($1,000,000 ÷ 5) = $(100,000)

Year 2: $150,000 - ($1,000,000 ÷ 5) = $ (50,000)

Year 3: $190,000 - ($1,000,000 ÷ 5) = $ (10,000)Year 4: $800,000 - ($1,000,000 ÷ 5) = $ 600,000Year 5: $800,000 - ($1,000,000 ÷ 5) = $ 600,000

b Year 1: $(100,000) × 0.02 = $(2,000)

Year 2: $ (50,000) × 0.02 = $(1,000)

Year 3: $ (10,000) × 0.02 = $ (200)Year 4: $ 600,000 × 0.02 = $12,000Year 5: $ 600,000 × 0.02 = $12,000

c Whether Mr Smith will be hesitant to invest depends

largely on his personal time horizon Although investing

in the project would reduce his compensation during the first three years, this reduction would be more than offset in the last two years If Mr Smith’s time horizon is three years or less, he is unlikely to invest

If his time horizon is four years or more, he is likely

to invest Also, Mr Smith must deal with the possibility that he’d be dismissed from his position in one of the first three years due to poor performance if

he invests in the project

d Yes Upper management would likely view the project

favorably Using any reasonable discount rate, the project has a positive NPV

64 a The high level of variable pay indicates compensation

committees and boards of directors believe that CFOs are

in position to substantially influence operations and results This is a very positive signal about the relative influence of the CFO in influencing financial and operational results

b There may be some risks to making CFO pay so dependent on

operating and financial results Particularly, because the CFO is in a position of authority over the record keeping and reporting functions, CFOs may be tempted to manipulate reports such that reported results align with thresholds of higher payoffs The variable pay creates

an incentive to report results that provide higher levels

of rewards