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

Chapter 19
Measuring and Rewarding Organizational Performance
Questions
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’ needs
through 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.

Chapter 19
Measuring and Rewarding Organizational Performance
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 compete
effectively on all competitive dimensions. Thus, this
information is necessary to deploy organizational resources to
yield 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 or
other quantitative measures. For example, to capture
performance in the dimensions of customer service, product and
service 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.


Chapter 19
Measuring and Rewarding Organizational Performance

249

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 and
understand the performance measures used, so that managers can

make 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
critical
needs to
Positive

15.

The traditional performance evaluation measures for cost
centers are standard cost variances. Traditional measures for
revenue 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.

is critical to improving performance. Negative or
feedback provides information about what the manager
change. It provides a focus for improvement.
feedback confirms what the manager is doing well.


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17.

Chapter 19
Measuring and Rewarding Organizational Performance
Net cash flow from operations, conceptually, measures the same
thing as net income. It may therefore be a useful measure in a
profit center or an investment center. The only difference
between net cash flow from operations and accounting income
are accounting accruals. Because many accounting accruals are
susceptible to manipulation by managers, net cash flow is less
prone 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
evaluated?
*
Is the measure susceptible to manipulation by the
manager?
*

Does the measure balance long-term and short-term
incentives?
*
Is the measure sufficiently related to overall
organizational goals?

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.


Chapter 19
Measuring and Rewarding Organizational Performance

251

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 and

captures 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 the
asset 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 necessarily
the 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 rate
that reflects the cost of capital. Economic value added
computations also include the effects of income taxes, which
are normally excluded in computing residual income.


252
25.

Chapter 19
Measuring and Rewarding Organizational Performance
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.


Chapter 19
Measuring and Rewarding Organizational Performance

253

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 becoming
more and more removed from the actual production activities
because of automation. This change makes it more difficult to
base 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.


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37.

Chapter 19
Measuring and Rewarding Organizational Performance
As workers get older, their needs and goals change. Young
workers are likely to have a very long-term orientation; older
workers 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 and
workers. 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 providing
employees 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-


Chapter 19
Measuring and Rewarding Organizational Performance

255

term performance measurement. To measure long-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 to
the 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, it
could 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.

Exercises

48.

a.
b.
c.
d.
e.
f.
g.
h.
i.

9
6
12
10
11
3
7
1
4

j.
k.
l.
m.
n.
o.
p.
q.

8
13
14
15
16
17
5
2


49.

Chapter 19
Measuring and Rewarding Organizational Performance
Division 1: $ 50,000 ÷ $ 200,000 = 25%
Division 2: $150,000 ÷ $1,000,000 = 15%
Division 3: $400,000 ÷ $4,000,000 = 10%

50.

a.

ROI =
=
=
=

b.

Profit margin = Income ÷ Sales
= $900,000 ÷ $13,200,000
= 6.82% rounded

c.

Asset turnover = Sales ÷ Assets invested
= $13,200,000 ÷ $3,600,000
= 3.67 rounded

d.

ROI = Asset turnover × Profit margin
= 3.67 × 6.82% = 25.03%

256

Income ÷ Assets Invested
($13,200,000 - $12,300,000) ÷ $3,600,000
$900,000 ÷ $3,600,000
25%

Note that (a). and (d). differ due to rounding error.
51.

52.

a.

Asset Turnover = Sales ÷ Average Assets

4 = $1,200,000 ÷ Average Assets
Average Assets = $1,200,000 ÷ 4
Average Assets = $300,000

b.

Profit Margin = Segment Margin ÷ Sales
.08 = Segment Margin ÷ $1,200,000
Segment Margin = $96,000

c.

ROI = 8% × 4 = 32%

Revenue
Expenses
Income
Target return (.12 × $11,200,000)
Residual income

$30,000,000
(28,000,000)
$ 2,000,000
(1,344,000)
$
656,000

Yes, because the residual income is positive, the division met
its target return.

Chapter 19
Measuring and Rewarding Organizational Performance
53.

a.
Sales
Variable costs
Fixed costs
Income
Target return:
$ 550,000 × .10
$1,525,000 × .10
Residual income

Division 1
$600,000
(150,000)
(350,000)
$100,000

257

Division 2
$1,050,000
(717,500)
(125,000)
$ 207,500

(55,000)

$ 45,000

$

(152,500)
55,000

According to the residual income measure, Division 2
outperformed Division 1.
b.
Division 1
Division 2
Sales
$690,000
$1,207,500
Variable 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
$ 104,875
Based 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 than
increased, 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
Target return (0.14 × $5,000,000)
Residual income

c.

Profit margin = Income ÷ Sales
= $2,750,000 ÷ $10,000,000
= 27.5%

$2,750,000
(700,000)
$2,050,000


258
d.

Chapter 19
Measuring and Rewarding Organizational Performance
Asset turnover = Sales ÷ Assets Invested
= $10,000,000 ÷ $5,000,000
= 2

55.

EVA = After-Tax Income - (Target Return × Invested Capital)
= $900,000 - (0.15 × $6,000,000)
= $900,000 - $900,000 = $0

56.

a.

EVA = After-tax Income - (Target Return × Invested
Capital)

$3,000,000 = After-Tax Profit - (0.12 × $19,000,000)
$3,000,000 = After-Tax Profit - $2,280,000
After-tax Profit = $5,280,000
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 by
the 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 as
the 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 of

the independent firm. A third approach would be to hire a
consulting firm to establish appraised values for each
division.


259

Chapter 19
Measuring and Rewarding Organizational Performance
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 major
objective of the division will be to obtain market share and
establish a high rate of growth in sales. It must accomplish
this 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 measures
established 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 is
similar 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
marketing strategy.

58.

Asset turnover Profit margin
a.
b.
c.
d.
e.
f.
g.
h.

IN
IN

IN
N
N
D
IN
D

D
D
D
IN
N
IN
I
IN

ROI
D
IN
I
IN
N
I
I
I

*As long as the target return < 100% of assets.
59.

No solution provided.

RI
D*
IN
I
IN
D
I
I
I


Chapter 19
Measuring and Rewarding Organizational Performance

260
60.

61.

62.

a.

MCE = Value-added time ÷ Total time
= 96,000 ÷ 288,000 = 33% (rounded)

b.

Process productivity = Total units ÷ Value-added time

= 14,000 ÷ 96,000 = 0.15 units per
hour (rounded)

c.

Process quality yield = Good units ÷ Total units
= 12,000 ÷ 14,000 = 85.7%

d.

Throughput = Good units ÷ Total time
= 12,000 ÷ 288,000 = 0.04 units per hour

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)

a.

MCE = Value-added time ÷ Total time
= 24,000 ÷ 36,000 = 67% (rounded)
Process productivity = Total units ÷ Value-added time
= 60,000 ÷ 24,000 = 2.5 units per
hour

b.

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)

Chapter 19
Measuring and Rewarding Organizational Performance

63.

64.

261

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.

a.

Year
Year
Year
Year
Year

1:

2:
3:
4:
5:

$100,000
$150,000
$190,000
$800,000
$800,000

b.

Year
Year
Year
Year
Year

1:
2:
3:
4:
5:

$(100,000)
$ (50,000)
$ (10,000)
$ 600,000
$ 600,000

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.

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.

-

($1,000,000
($1,000,000
($1,000,000
($1,000,000
($1,000,000
×
×
×
×
×

0.02
0.02
0.02
0.02
0.02

=
=
=
=
=

÷
÷
÷
÷
÷

5)
5)
5)
5)
5)

=
=
=
=
=

$(100,000)
$ (50,000)
$ (10,000)
$ 600,000
$ 600,000

$(2,000)
$(1,000)
$ (200)
$12,000
$12,000


Chapter 19
Measuring and Rewarding Organizational Performance

262

Problems
65.

a.
Sales
Variable costs
CM
Fixed costs
Pretax income

Actual
Amounts
$6,500,000
(4,875,000)
$1,625,000
(1,205,000)
$ 420,000

Flexible
Budget
$6,500,000
(4,550,000)
$1,950,000
(1,200,000)
$ 750,000

Master
Budget
$6,000,000
(4,200,000)
$1,800,000
(1,200,000)
$ 600,000

100%
70%
30%

The data show that the actual pretax income fell
short of
the expected amount by $180,000 ($600,000 $420,000).
This occurred despite the fact that the actual level
of
sales exceeded the expected level by $500,000. The
higher level of sales would have generated an
additional
$150,000 of income ($750,000 - $600,000) if costs
and

prices would have been maintained at the budgeted
level. However, this effect was overwhelmed by
either a
lower per unit sales price or a higher per unit
variable
cost. The budgeted contribution margin was to be
30% of
sales. The actual contribution margin was only 25%
of
sales ($1,625,000 ÷ $6,500,000). Without knowing
the
number of units that were sold, the price and
variable
cost effects cannot be disentangled. By having the
actual CM drop by 5%, pretax profits were lowered by
$325,000 ($1,950,000 - $1,625,000). This is the
principal cause of the drop in profits. A more
minor
effect was the increase in fixed costs. These
exceeded
the budgeted level by $5,000. These differences can
be
summarized as follows:
Effect of increase in volume
$
150,000
Effect of decrease in CM%
(325,000)
Effect of increase in fixed costs
(5,000)

Net effect on pretax income
$(180,000)


Chapter 19
Measuring and Rewarding Organizational Performance

66.

67.

263

b.

Complete income statements provide more information for
isolating the cause of differences between the budgeted
and expected levels of income. By comparing only the
actual and budgeted levels of pretax income, nothing is
learned about the cause of the difference.

a.

Accrual accounting measures are subject to manipulation.
Some of the more common manipulations involve increasing
or decreasing the level of discretionary expenses such as
maintenance and advertising; increasing or decreasing
production relative to sales; manipulating sales and
purchases around a period's cutoff date; and manipulating
estimates involving the life of assets, pension and

retirement obligations, and costs of settling legal
obligations.

b.

No. The cash measure is just as subject to manipulation.
For example, cash can be manipulated by adjusting
policies for credit sales, adjusting policies for
retiring accounts payable, and advancing or delaying the
payment of expenses around cutoff dates.

c.

If any two measures are less than 100% correlated (in
other words, the two items measure different things),
then a combination of the two measures will be less
subject to manipulation than either is separately. Such
is the case with cash flow and accrual income; some of
the sources of manipulation can be identified, and a more
complete picture of segment performance will be
presented.

d.

Yes. In theory, the accrual income probably provides a
better gauge of long-term profitability and is perhaps a
better predictor of future cash flows. The annual cash
flow measure provides more information on liquidity, cash
management, and the policies for credit sales and
purchases.

e.

Yes. One possibility would be to utilize a more detailed
budgeted income statement. Such a statement would
facilitate a line-by-line comparison with actual
performance. This comparison would yield more
information on both performance and manipulation.

a.

Analysis of the statement reveals a strong positive cash
flow from operations that has permitted acquisitions,
dividend payouts and debt reductions for the three years.

b.

Revised
Original
2003 Budget 2003 Budget
Net cash flows from Operating


Chapter 19
Measuring and Rewarding Organizational Performance
Activities:
Net income
$ 45,100
$ 45,100
Add reconciling items

4,000
4,000
Total
$ 49,100
$ 49,100
Net cash flows from Investing
Activities:
Sale (purchase) of PP&E
$(54,600)
$ (4,600)
Sale (purchase) of investments
18,400
(15,800)
Other inflows (outflows)
2,400
2,400
Total
$(33,800)
$(18,000)
Net cash flows from Financing
Activities:
Issuing notes for cash
$ (7,000)
$ (7,000)
Paying dividends
(8,000)
(20,000)
Total
$(15,000)
$(27,000)

Net increase (decrease) in cash
$
300
$ 4,100

264

68.

c.

No, the net increase in cash will be only $300. The
company would have to settle for that or change plans.

d.

The above comparison can quickly give the president an
overview of the impact of the $50,000 LAN project. From
the comparison, she can decide whether she is satisfied
with the proposed changes in cash flows. By observing
the cash flow effects of a particular project within the
context of all of the other cash flows of the entity, the
decision maker gains an appreciation of the significance
of the project and of the entity's ability to implement
the project.

a.

Actual income: $28,250,000 - $25,885,000 = $2,365,000
Average assets: ($10,200,000 + $12,300,000) ÷ 2 =

$11,250,000
Profit margin = $2,365,000 ÷ $28,250,000 = 8.37%
Asset turnover = $28,250,000 ÷ $11,250,000 = 2.51
ROI = 2.51 × 8.37% = 21%
For 2003, the stores slightly outperformed the industry.
The better performance was attributable to a higher
profit margin that dominated a slightly lower asset
turnover.

b.

Because the stores are already operating above industry
norms on profit margin, corporate management should
concentrate on improving the asset turnover ratio. Asset
turnover can be improved by either increasing sales or
decreasing assets. However, overall, the stores are
already exceeding the industry ROI so management must be
careful not to decrease profit margin while they strive
to increase sales or decrease assets.

c.

The advantage of setting performance measures at the
beginning of the year is that management knows what the


Chapter 19
Measuring and Rewarding Organizational Performance

265

benchmark figures are as the year unfolds. The main
disadvantage is that targets set at the beginning of the
year do not control for industry level factors’ influence
on results. Consequently, managers will be evaluated
partly on factors that they cannot control.


266
69.

a.

Chapter 19
Measuring and Rewarding Organizational Performance
Sales (100,000 × $30)
$3,000,000
CGS [(5,200 × $9 = $46,800) +
(94,800 × $10 = $948,000)]
(994,800)
Gross margin
$2,005,200
Expenses
Shipping (100,000 × $0.50)
$ 50,000
Advertising ($5,000 × 12)
60,000
Salaries
700,000
Other costs

590,000
Repairs
10,000
(1,410,000)
Net income before taxes
$ 595,200
Target income (0.16 × $4,500,000)$ 720,000
Projected income
595,200
Residual income
$(124,800)

b.

Sales (105,000 × $30)
CGS [(15,000 × $9 = $135,000) +
(90,000 × $10 = $900,000)]
Gross Margin
Expenses
Shipping (105,000 × $.50)
Advertising ($5,000 × 11)
Salaries
Other costs
Net income

$3,150,000
(1,035,000)
$2,115,000
$ 52,500
55,000

694,500
590,000

(1,392,000)
$ 723,000

$723,000 ÷ $4,500,000 = 16.07% return

70.

c.

If Ms. Rojas actually ships the delivery to the customer,
it may anger the customer and perhaps reduce future sales
to that customer. Should Ms. Rojas simply accrue the
revenue and expense of shipping but not actually ship the
goods, there is a possibility of misstating ending
inventory and/or the cancellation of the sale before
shipment. The failure to advertise, hire a personnel
manager, and make needed repairs could adversely affect
future operations. Finally, if Ms. Rojas's manager
determines that she has made such decisions for the sole
purpose of obtaining her bonus, she may find herself
without a job.

a.

Actual income: $12,000,000 - $11,280,000 = $720,000
Average assets: ($4,700,000 + $7,300,000) ÷ 2
=$6,000,000

Actual turnover = $12,000,000 ÷ $6,000,000 = 2
Actual profit margin: $720,000 ÷ $12,000,000 = 6%
Actual ROI = 2 × 6% = 12.00%
The division exceeded its objective for asset turnover.
However, the division failed to meet the target profit
margin and ROI (1.8 × 8% = 14.4%) levels.


Chapter 19
Measuring and Rewarding Organizational Performance

71.

267

b.

The division needs to improve its profit margin; i.e.,
the amount of profit generated for each dollar of sales.
Part of the poor performance may be due to the large
increase in assets ($7,300,000 - $4,700,000 = $2,600,000)
during the year. The return from the newly acquired
assets is likely to be reaped in future periods rather
than in the present period. Consequently, although most
of the expense of operating the new assets is fully
reflected in income, the revenues will be realized in
future periods.

c.

Income (from part a)
Target return ($6,000,000 × 0.14)
Residual income

a.

Power ROI = ($12,000,000 - $10,800,000) ÷ $10,000,000
= 12%
Sail ROI = ($48,000,000 - $42,000,000) ÷ $30,000,000
= 20%

b.

The manager of Power Boats is the most likely to invest
in a new project. Such an investment would increase the
overall ROI of the division. The manager of Sailboats
would not invest because the projected ROI on the new
project is lower than the projected divisional ROI.

c.

Such an outcome is inconsistent with overall corporate
goals. Companywide, the projected ROI is ($60,000,000 $52,800,000) ÷ $40,000,000 = 18%. Thus the company would
probably want the manager of Sailboats to make the
investment and would prefer that the manager of Power
Boats reject the investment.

d.

If the division managers were evaluated on the basis of

residual income, they would analyze how a new investment
would affect the projected overall RI level in their
divisions. The projected overall changes can be found as
follows:
Power Boats
Sailboats
Projected ROI on new project
14 %
18 %
Required target return
17 %
17 %
Residual return
(3)%
1 %

$ 720,000
( 840,000)
$(120,000)

The project under evaluation by the manager of Power
Boats would cause his/her overall residual income to
decline by an amount equal to 3% of the cost of the
investment. On the other hand, the project under
consideration by the manager of Sailboats would generate
an overall increase in RI by 1% of the cost of the new
investment.
72.

a.

Projected EVA = $1,750,000 - ($12,500,000 × 0.12)


Chapter 19
Measuring and Rewarding Organizational Performance
= $250,000

268

b.

You would not invest in the project if it would result in
a decline in your overall projected EVA. Therefore, the
maximum amount that you would invest would be the amount
that would leave your projected EVA unchanged:
Pretax additional earnings
$200,000
Taxes ($200,000 × 0.30)
(60,000)
After-tax change in earnings
$140,000
Maximum investment × .12 = $140,000
Maximum investment = $140,000 ÷ .12
Maximum investment = $1,166,667

c.

After-tax income = $1,750,000 + $140,000 = $1,890,000
Invested capital = $12,500,000 + $1,100,000

= $13,600,000
EVA = $1,890,000 - ($13,600,000 × .12) = $258,000

73.

To survive, firms need to manage effectively for both longterm survival and short-term profitability, which are separate
managerial concerns. Long-term survival is related to
acquiring the necessary mix of inputs to remain competitive.
Long-term management involves the hiring and training of
talented employees, acquisition of capital improvements and
technology, and the execution of strategies relative to
products and markets. Short-term management is concerned with
the effective and efficient management of resources (such as
current assets) over the near term.
Because long-term management has different objectives
than short-term management, a different set of performance
measures must be used to gauge success in each area. If no
performance measures are geared to evaluation of long-term
success, there is no incentive created for managers to be
long-term oriented in their decision making. By balancing
performance measurement relative to time horizons, managers
will be forced to consider both short-term and long-term
consequences of decisions made.

74.

a.

MCE = Value-added time ÷ Total time
= 16,000 ÷ 56,000 = 28.6% (rounded)

b.

Process productivity = Total units ÷ Value-added time
= 64,000 ÷ 16,000 = 4 units per hour


Chapter 19
Measuring and Rewarding Organizational Performance
c.

Process quality yield = Good units ÷ Total units
= 47,500 ÷ 64,000 = 74% (rounded)

d.

Throughput = Good units ÷ Total time
= 47,500 ÷ 56,000 = 0.85 units per hour

269

(rounded)
e.

Yes, throughput only counts units sold, not units
produced. Therefore, throughput would have been
considerably lower because the process yield would have
been lower.
Throughput
= Good units ÷ Total time

= 22,500 ÷ 56,000 = 0.40 units per hour
(rounded)
f.
Total time – Value-added time = Non-value-added time
56,000 – 16,000 = 40,000; 40,000 × 0.80 = 32,000 new time
32,000 + 16,000 = 48,000 total time
Throughput
= Good units ÷ Total time
= 47,500 ÷ 48,000 = 0.99 units per hour
(rounded)
g.
64,000 × .94 = 60,160 good units
(from part f) total time = 48,000 hours
Throughput
= Good units ÷ Total time
= 60,160 ÷ 48,000 = 1.25 units per hour
(rounded)
h.

75.

Porto could determine how the NVA time was being spent by
preparing a process map that would delineate all
activities associated with the production of the product.
One recommendation would be to implement an activitybased management system that would draw attention to the
NVA activities and to the costs associated with those
activities.

No solution provided.

Chapter 19
Measuring and Rewarding Organizational Performance

270
Cases
76. a.

b.

The calculation of the unit contribution for Reigis Steel
Division, assuming 1,484,000 units were produced and sold
during the year ended November 30, 2003, is presented
below.
Reigis Steel Division
Contribution Margin
For the Year Ended November 30, 2003
($000 Omitted)
Sales
$25,000
Less variable costs:
Costs of goods sold
$16,500
Selling expenses
($2,700 × 40%)
1,080
(17,580)
Contribution margin
$ 7,420
$7,420 ÷ 1,484 units = $5.00 unit contribution margin

Calculations of selected performance measures for 2003
for Reigis Steel Division are presented below.
1.
The pretax return on average investment in operating
assets employed is 12%, calculated as follows:
ROI = Income from operations before taxes ÷
average operating assets
= $1,845,000 ÷ $15,375,000*
= 0.12 or (12%)
*Average operating assets employed:
($15,750,000 + $15,000,000**) ÷ 2 = $15,375,000
**November 30, 2002 operating assets:
$15,750,000 ÷ 1.05 = $15,000,000.
2.

The calculation of residual income on the basis of
average operating assets employed is as follows.
Residual
Income
=
Income from operations before taxes
- minimum required return on
average assets
=
$1,845,000 - ($15,375,000 × 0.11)
=
$1,845,000 - $1,691,250 = $153,750


Chapter 19

Measuring and Rewarding Organizational Performance

77.

271

c.

The management of Reigis Steel would have been more
likely to accept the contemplated capital acquisition if
residual income were used as the performance measure
because the investment would have increased both the
division's residual income and the management bonus.
Using residual income, management would accept all
investments with a return higher than 11 percent because
these investments would all increase the dollar value of
residual income. When using ROI as a performance measure,
Reigis's management is likely to reject any investment
that would lower the overall ROI (12 percent for 2003),
even though the return is higher than the required
minimum, because this would lower bonus awards.

d.

Reigis must be able to control all items related to
profits and investment if it is to be evaluated fairly as
an investment center using either ROI or residual income
as performance measures. Reigis must control all
elements of the business except the cost of invested
capital, which is controlled by Paddington Industries.

(CMA adapted)

a.

Based on the conversation between Terry Travers and Bob
Christensen, it seems likely that their motivation would
be stifled by the variance reporting system at Aurora
Manufacturing Company. Their behavior may include any of
the following:
*
suboptimization, a condition in which individual
managers disregard major company goals and focus
their attention solely on their own division's
activities, and
*
frustration from untimely reports and formats that
are not useful in their daily activities.

b.

1.

*
*
*

The benefits that can be derived by both the
company and its employees from a properly
implemented variance reporting system include the
following:

Variance analysis can provide standards and
measures for incentive and performance evaluation
programs.
Variance reporting can emphasize teamwork and
interdepartmental dependence.
Timely reporting provides useful feedback, helps to
identify problems, and aids in solving these
problems. Responsibility can be assigned for the
resolution of problems.