Solution manual cost management measuring monitoring and motivating performance 1st by wolcott ch15

To download more slides, ebook, solutions and test bank, visit

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.
This question requires students to extend knowledge beyond the applications
e
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)


To download more slides, ebook, solutions and test bank, visit

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 shortterm 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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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%

To download more slides, ebook, solutions and test bank, visit

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)
Variable costs
Fixed costs
Income

$600,000
(450,000)
(90,000)
$ 60,000

ROI = $60,000/[($500,000 + $700,000)/2] = 10%
B. Residual income:
Income
Minimum return [($500,000 + $700,000)/2 x 0.15]
Residual income

$ 60,000

(90,000)
$(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
Variable costs
Contribution margin

$600,000
450,000
$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


To download more slides, ebook, solutions and test bank, visit

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
Revenue (10,000 x $2,500)
Variable production costs:
(10,000 x $350)
(10,000 x $110)
Fixed production costs
Transfer price (10,000 x $350)
Pretax income (loss)
Income taxes (a)
Net income (loss)
Total assets
ROI (Net income / Investment)

Detroit
$25,000,000

$(3,500,000)
(2,000,000)
3,500,000
(2,000,000)

0
$(2,000,000)

(1,100,000)
(4,000,000)
(3,500,000)
16,400,000
(7,380,000)
$ 9,020,000

$20,000,000

$30,000,000

(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


To download more slides, ebook, solutions and test bank, visit

15-8 Cost Management
B. ROI if the screens are transferred at market price:
Windsor
Revenue (10,000 x $2,500)
Variable production costs:
(10,000 x $350)
(10,000 x $110)
Fixed production costs
Transfer price (10,000 x $750)
Pretax income (loss)
Income taxes (a)
Net income (loss)

Detroit
$25,000,000

$(3,500,000)
(2,000,000)
7,500,000
2,000,000
(600,000)
$ 1,400,000

(1,100,000)
(4,000,000)
(7,500,000)
12,400,000
(5,580,000)
$ 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
Detroit
Total
Taxes if transfer price is the market value:
Windsor
Detroit
Total
Difference

$

0
7,380,000
$7,380,000
$ 600,000
5,580,000
6,180,000
$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.


To download more slides, ebook, solutions and test bank, visit

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
Crude oil
Variable production costs
Net

$ 0.16
(0.06)
(0.02)
$ 0.08

Contribution margin for each pound of polystyrene:
Selling price
Chemical variable production costs
Crude oil
Oil variable production costs
Net

$ 0.30
(0.03)
(0.06)
(0.04)
$ 0.17

Additional contribution margin for each pound of polystyrene
Times expected quantity of polystyrene sold
Expected increase in pretax profit from selling polystyrene

$0.09
100 million pounds
$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.


To download more slides, ebook, solutions and test bank, visit

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).


To download more slides, ebook, solutions and test bank, visit

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)
Current revenue from Bradley division
Increase in revenue

$1,500,000
900,000

$ 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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

Chapter 15: Performance Evaluation and Compensation 15-13
B. If the Furniture Division buys from Port Angeles, the contribution margin is as follows
Price
Variable Costs
Transfer
Manufacturing
Selling
Contribution margin

$155
(40)
(75)
(10)
$ 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.
External revenues
Internal transfer:
$50 x 3,000 hours
$60 x 1,200 hours
Total costs
Operating Income

Computer Services
$400,000
150,000
(72,000)
(220,000)
$258,000

Management Advisory
$700,000
(150,000)
72,000

(480,000)
$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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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.

To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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-theBox 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


To download more slides, ebook, solutions and test bank, visit

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.


To download more slides, ebook, solutions and test bank, visit

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
Total compensation
5-year compensation
Market value of shares owned
Age
Efficiency grade
Rank

Charles O. Holliday, Jr.
$3,443,000
$15,240,000
$19,500,000
56 years
D
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.


To download more slides, ebook, solutions and test bank, visit

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
Variable compensation
Stock options granted
Other compensation, primarily savings plan contributions

$1,118,000
$2,200,000
464,200 shares
$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.‖


To download more slides, ebook, solutions and test bank, visit

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


To download more slides, ebook, solutions and test bank, visit

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 publiclytraded 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