You are on page 1of 17

Chapter 25 - Reporting and Evaluation

CHAPTER 25
REPORTING AND EVALUATION
Changes from the Twelfth Edition
All changes to Chapter 25 were minor.
Approach
Students should get a general idea of the difference between economic and managerial performance
measurement, the nature of control reports, the criteria for good reports, and a beginning of an
understanding of how to read such reports. A full understanding of the meaning of control reports reuires
!ears of e"perience and it also reuires a thorough #nowledge of the specific environment to which the
reports pertain, so students should not be disturbed if the! do not understand all the nuances of the sample
reports included in the chapter. $evertheless, the! should acuire some abilit! to distinguish between
what is significant and what is not significant, as well as an abilit! to spot fairl! obvious %red flags,& that
is, items reuiring further investigation.
'oth of the last two sections can be somewhat controversial. (hereas some companies are significantl!
reducing )or even eliminating* formerl! intensive variance anal!sis processes, most still hew to this
approach. Also, the total amounts of man! e"ecutives+ incentive awards have prompted considerable
criticism from certain uarters in recent !ears.
Cases
Harwood Medical Instruments PLC allows students to consider how a change in a bonus plan affects two
divisions with uite different operating characteristics.
Armco Inc., Midwestern Steel Division illustrates a performance measurement s!stem with measures
%cascading& from strategic priorities down to the lowest organi-ation levels.
Formosa Plastics Group describes a compan! that has an elaborate planning and performance
measurement s!stem but that uses mostl! sub.ective evaluations of performance and highl! %smoothed&
bonus pa!ments.
25-/
Chapter 25 - Reporting and Evaluation
Problems
Problem 25-1: Greene Enterprises
Performance Report
A! "! A - "! C! " - C!
"#dget Act#al $ifference
"#dgeted
at Act#al
%ol#me $ifference
Sales..................................................................................................................................................................................................... 051,222 013,222 04,222 013,222 0 2
Cost of goods sold................................................................................................................................................................................ 35,222 34,622 /,722 )b* 77,/22 1,322
8ross margin........................................................................................................................................................................................ /1,622 25,222 6,722 /6,522 1,322
9irect operating e"penses,
:ariable................................................................................................................................................................................................ )a* 1,422 6,222 )/,262* )c* 4,512 )772*
;i"ed.................................................................................................................................................................................................... /2,222 /2,222 2 /2,222 2
Contribution to indirect costs............................................................................................................................................................... 0 62 0 4,222 04,/22 0 /,372 05,612
)a* 9irect operating e"penses.................................................................................................................................................................... 0/1,422
<ess, ;i"ed e"pense............................................................................................................................................................................. /2,222
:ariable e"pense.................................................................................................................................................................................. 0 1,422
)b* Cost of sales 035,222=budgeted sales 051,222 > 42?
.42 " 013,222 > 077,/22, the cost of goods sold budgeted for actual volume.
)c* 'udgeted variable costs 01,422=budgeted sales 051,222 > /2?
./2 " 013,222 > 04,512, the direct operating e"penses budgeted at actual volume.
Sales increased substantiall! and were 04,222 more than e"pected. @he indirect costs were 0772 more
than e"pected, but the cost of sales was onl! 12? of sales, rather than the budgeted 42?. @hese two
factors account for the 05,612 difference between actual contribution to indirect costs and that e"pected at
the actual sales volume. )@he fairness of such an appraisal depends upon whether the predicted behavior
of costs was realistic and reasonable.*
Problem 25-2: &atson Compan'
a. Performance Report$i(ision A
C#rrent )ear *ast )ear
$et sales............................................................................................................................................................................................... 0252,222 02/1,222
Cost of goods sold,
:ariable costs................................................................................................................................................................................... 042,222 042,222
9ivision fi"ed costs......................................................................................................................................................................... 25,222 /2/,222 25,222 /2/,222
8ross margin........................................................................................................................................................................................ /5/,222 //5,222
Selling and administrative e"penses,
:ariable e"pense.............................................................................................................................................................................. 22,222 /5,222
9ivision fi"ed e"penses................................................................................................................................................................... 25,222 74,222 22,222 7/,222
Contribution to allocated costs and e"penses....................................................................................................................................... 0/27,222 0 47,222
25-2
Chapter 25 - Reporting and Evaluation
b. 9ivision A performed better in the current !ear than in the last !ear when the ratios of contribution to
allocated costs to sales are made. )0/27,222=0252,222 > 7/? and 047,222=02/1,222 > 37?.* 9ivision
managers cannot control allocated costs, and their performance should not be .udged on the basis of
net income=sales because the net income figure includes allocated costs. '! comparing division
contributions to allocated costs, the amount which each 9ivision Aanager contributes toward the
overall compan! profits can be clearl! seen. 'onuses based on division contributions would be in the
best interest of both the managers and the compan!.
Problem 25-+: ,achine -hop
a. Bf the report is meant to be a control report, the onl! two items strictl! within the direct control of the
machine shop supervisor are probabl! materials handling costs and supplies. 9epreciation of machine
shop euipment is a departmental direct cost, but the supervisor ma! not have much control over the
amount. @he costs for buildings and grounds, and general plant are allocated costs and cannot be
controlled b! the supervisor. Aaintenance is controllable to the e"tent of the number of hours of
maintenance time, but the supervisor cannot control the standard rate applied to these hours. @raining
costs might be similar to maintenance costs in that the supervisor might be able to control the amount
of training time, but not the cost attributed to training.
b. Performance Report
,achine -hop
"#dget Act#al
Act#al
o(er #nder!
9irect costs
Aaterials handling............................................................................................................................................................................ 0 6,222 0 6,/52 0/52
Supplies............................................................................................................................................................................................ 5,222 5,222 )222*
9epreciation- euipment.................................................................................................................................................................. 1,222 1,222 2
/5,222 /5,/52 )52*
Bndirect costs
@raining............................................................................................................................................................................................ 7,522 5,322
Aaintenance..................................................................................................................................................................................... 5,222 5,622
'uilding and grounds........................................................................................................................................................................ 3,422 3,422
8eneral plant e"pense....................................................................................................................................................................... 2,522 2,122
/5,422 /4,722
@otal direct and indirect costs............................................................................................................................................................... 037,522 031,552
Problem 25-.: /opedale Compan'
25-3
Chapter 25 - Reporting and Evaluation
a. Performance Report - ,onth of April
Act#al "#dget a!
%ariance
0a(orable or
1nfa(orable!
Controllable costs,
Salaries............................................................................................................................................................................................. 0/2,322 0/2,222 0)322*
Bndirect labor.................................................................................................................................................................................... 22,522 /5,172 )b* )612*
Bndirect materials.............................................................................................................................................................................. 2,552 2,172 )c* 52
Cther costs........................................................................................................................................................................................ 5,5/2 5,152 )d* /72
077,612 073,532 0)532*
)a* 'udgeted costs at actual volume of 33,222 direct machine-hours consist of both fi"ed costs
and variable costs calculated for the actual volume.
;i"ed costs, Salaries................................................................................................................................................................................................. 0/2,222
Bndirect labor........................................................................................................................................................................................ /4,222
Cther costs........................................................................................................................................................................................... 6,222
)@hese are the same at an! volume, because the! are given as a fi"ed amount per month.*
)b* :ariable indirect labor > 0.26 " 33,222>02,172
@otal indirect labor costs budgeted > 0/4,222 D 02,172>0/5,172
)c* :ariable indirect materials > 0.26 " 33,222>02,172
)d* :ariable other costs > 0.25 " 33,222>0/,152
@otal indirect other costs budgeted > 06,222 D 0/,152>05,152
b. @otal actual costs for Aarch were 0532 higher than budgeted, with salaries and indirect
labor higher than budgeted. Aore labor was probabl! used than e"pected, due to the
greater volume than formerl! budgeted.
@he increase of 0322 in salaries cost probabl! caused the increase in indirect labor cost
also, perhaps for such as increased .anitorial costs or routine maintenance.
)@he e"pected volume was 25,222 machine-hours and was later revised to 37,222
machine-hours.* Although the actual volume of activit! at 33,222 machine-hours was less
than the revised budgeted 37,222 machine-hours, the favorable variances still resulted
because the original budget was apparentl! based on a total !earl! volume which is
proving to be low. @here seems to be good cost control over indirect material cost, as less
was spent than budgeted.
Cases
Case 25-1: Harwood Medical Instruments PLC
2ote: This case is new for the Thirteenth edition
25-7
Chapter 25 - Reporting and Evaluation
Approach
@he Earwood Aedical Bnstruments case was written in response to reuests from instructors who want
more short cases. Bt is also useful in an e"am setting where multiple cases are used to test different sub.ect
materials.
@he case describes a compan! whose manager is concerned that the operating profit measure included in
the compan!+s bonus plan was too narrowl! focused. Ee implemented a new bonus plan that reduced the
weighting of importance placed on operating profit and that included more measures, including on-time
deliveries, sales returns, patent applications, scrap and rewor# costs, and customer satisfaction.
Fresumabl! these factors were considered as critical success factors.
-#ggested Assignment 3#estions
/. (hat was the purpose of the changeG
2. Calculate the bonus earned b! each manager for each si"-month period and for the !ear 2224.
3. Evaluate the new plan. Bs there an! evidence that it produced the desired effectsG (hat changes to the
new plan would !ou suggest, if an!G
Case Anal!sis and Fedagog!
/. @he change was made because managers believed that operating income was not a good summar!
measure of short-term financial performance.
2. @he calculation of the bonuses earned in each division is shown in the tables below.
4555! -#rgical 6nstr#ments 1ltraso#nd $iagnostic
E7#ipment
/ 2 @otal / 2 @otal
'ase bonus 71.2 77.2 37.2 72.1
9eliver! ad.ustment 2.2 2.2 2.2 -
Sales returns
ad.ustment
)/5.2* 5.2 )3.2* 5.2
Fatents - /.2 7.2 6.2
Scrap=rewor# )7.5* )/.2* )5.5* -
Customer Satisfaction )5.2* )5.2* )5.2* -
@otal 23.3 71.2 15.3 21.4 53.1 62.3
25-5
Chapter 25 - Reporting and Evaluation
Sales returns,
-#rgical 6nstr#ments 1ltraso#nd $iagnostic
E7#ipment
)H222* / 2 / 2
Std., /? sales
returns
722 772 265 252
Actual 752 722 25/ 264
I )32* 22 )1* 3
'onus )/5* 5 )3* 5
Scrap=rewor#,
-#rgical 6nstr#ments 1ltraso#nd $iagnostic
E7#ipment
)H222* / 2 / 2
Std., /? of operating
profit
71.2 77.2 37.2 72.1
Actual 5/./ 75.2 35.4 36.2
I )7.5* )/.2* )5.5* 2.7
'onus )7.5* )/.2* )5.5* -
3. @here is evidence that the plan is producing some of the desired effects. Bn both divisions, as
managers have gotten accustomed to the new bonus plan )2
nd
half of 2224*, sales returns have
declined, patent applications have increased, scrap and rewor# costs have declined, and customer
satisfaction has increased. Cn-time deliveries have increased in the surgical instruments division, but
not in the ultrasound diagnostic euipment division. As a result, the bonuses to be paid increased
significantl! in the second half of the !ear.
Bs this improvement goodG Bt is if the performance factors added to the plan are trul! critical success
factors. @he small incremental bonuses paid would seem to be mone! well spent. @he mone! should
be uite meaningful to the managers and, hence, uite motivating, !et not ver! e"pensive for the
compan!.
'ut the two divisions seem to so different. Someone should consider whether the same factors should
appl! to both divisions and in the same weightings of importance.
25-1
Chapter 25 - Reporting and Evaluation
Each of the individual factors should be sub.ected to critical scrutin!. ;or e"ample, are patents
important in a division that sells such mundane products as scissors and clampsG And for that matter,
does including patents applications in a bonus plan .ust encourage patent applications that never get
approved, or even if the! do, that never provide an! real economic benefit to the division and
compan!. And several of the factors have ver! specific performance constraints. Should the pa!off
functions be linear, rather than based on perhaps arbitrar! performance constraints, such as 55?
deliveries on time or 52? average customer satisfactionG
@he case does not provide enough information to answer these uestions, but students should be able
to identif! the issues.
Case 25-2: Armco Inc.: Midwestern Steel Division


2ote: This case is unchan!ed from the Twelfth "dition
Approach
@he Armco case was designed to illustrate a performance measurement s!stem with measures
%cascading& from strategic priorities down to the lowest organi-ation levels. @he s!stem is not tightl!
lin#ed with incentive compensation, although that is being discussed. Still, the focus on measured results
promises to change managerial behaviors significantl!.
@he case is particularl! interesting because it describes a ma.or change from an old measurement s!stem
which was primaril! designed for standard financial reporting purposes and was not perceived, at least b!
top management, to be effective for management control purposes. @he new performance measurement
s!stem eliminated most of the allocations of indirect costs and helped managers understand the critical
success factors in their areas.
Bn this case, then, students can understand two performance measurement s!stems and the compan!+s
reasons for changing from one to the other. @he! can evaluate the new s!stem and decide whether the
division managers have made optimal choices in designing their new s!stem, and the! can ma#e a
.udgment as to whether the s!stem should be used to increase the proportion of total compensation lin#ed
to performance.
Aost of the students will conclude the new s!stem is a substantive change for the better. 'ut then the!
will get a dose of realit! as the! see the problems Armco is having getting managers to adapt to the new
s!stem.
-#ggested Assignment 3#estions
/. (hat was wrong with the Aidwestern Steel 9ivision+s old s!stemG )As part of !our anal!sis, stud!
E"hibit 3 carefull! and figure out what the columns tell !ou, individuall! and in total.*
2. Bf the old s!stem was so bad, wh! did the operating managers seem to li#e itG
*
@his teaching note was prepared b! Frofessor Jenneth A. Aerchant. Cop!right K /556 Jenneth A. Aerchant.
25-4
Chapter 25 - Reporting and Evaluation
3.
7. Evaluate the new s!stem and the wa! in which it was being implemented. (hat changes would !ou
recommend, if an!G (h!G
5. (hat should Rob Cushman do about the two items described in the Remaining Bssues section of the
caseG
Case Anal'sis and Pedagog'
7. (hat factors most determine the success or failure of the Aidwestern Steel 9ivisionG Bn particular,
how important is cost controlG
Carbon wire rod is a commodit! product, so cost control is critical for this line of business.
@here is some product differentiation in grinding media. Customers can measure how long the steel
balls last, and the! value long-lasting balls. Armco believes it has a superior manufacturing
technolog! that causes its balls to last longer. ;urther manufacturing technolog! innovations would
provide additional profits to the division.
Cost control is also important for grinding media, as Armco is the high cost producer in this mar#et.
Flant throughput )productivit!* is one #e! to cost control. Armco can sell all the product it ma#es.
)@he plant has been operating at capacit! for three !ears straight.*
Among the cost control challenges in the plant are the fact that the plant has old euipment, generall!
poor preventative maintenance practices )72? of the 422 hourl! wor#ers in the plant were
maintenance wor#ers*, and less than optimum wor#er productivit!.
@he people left in the plan are the most senior. @he! would not be hurt that much b! a shutdown.
@he! have pensions. Cost control is not that important to them. Bt would cost the compan! about 0222
million to shut down the plant )environmental clean-up, pensions, etc.*.
Students might as# wh! Armco does not put more people or more euipment in the melt shop so it
wouldn+t be a bottlenec#. @he answer is that the! would have to add a furnace, ma#ing an investment
of appro"imatel! 0/22 million. @his would add capacit! which is not needed in the industr!.
5. Eow were managers controlling performance with the old s!stemG (hat were the strengths and
wea#nesses of the old s!stemG
25-6
Chapter 25 - Reporting and Evaluation
1.
-trengths &ea8nesses
/. Aanagers e"press need for detail so the! can trac#
month-to-month trends.
2. Eas value in identif!ing problem areas.
3. Aeasured performance was based on managers+
abilit! to control cost above. S!stem gave
managers information consistent with ob.ective
the! were given.
/. @oo much detail. Some numbers didn+t change.
Some ver! small.
2. S!stem designed for inventor! costing purposes.
Eave to allocate costs. ;or performance
measurement purposes, not sure if the allocations
mean an!thing.
3. Source of some of the data is unclear.
7. Reports were delivered /5 da!s after month-end.
@his is too late.
5. S!stem too focused on cost reductions, to the
e"clusion of other critical success factors.
1. Aanagers+ performances .udged on things over
which the! had no control. Aan! costs were
caused b! people who did not report to the
managers )e.g., capital spending, salaries,
maintenance*. Eas! to blame poor performance
on uncontrollables.
4. S!stem not encouraging managers to wor#
together. Auch %local data.& Contributes to
suboptimi-ation.
6. $ot graphic.
5. Accounting accruals distort the costs. E"ampleL
annual August maintenance shutdown accruals
start in Manuar!.
Bt is important to wal# students through E"hibit 3. Fic# some representative columns and have
students tal# about what the! mean or don+t mean. Among the useful e"amples to discuss are
nonmetallics, salaries, electricit!, lubricants, and loco cranes. Students should see the t!pes of costs
that ma#e up total cost above. (hich are the big itemsG (hich items are variable and which are
fi"edG )@he important ones are fi"ed. Costs per net ton are driven b! tons produced.* Foint out the
distorting effect of the August maintenance shutdown.
S-orders represent e"traordinar! maintenance. Bt is accrued for. Bt is fi"ed in the short-run )a month*,
but it can var! over the !ear.
4. (h! did the operating managers seem to li#e the old s!stemG
;amiliarit!
Reports were related to budget
Aanagers can+t be held accountable because the! alwa!s had an e"cuse for poor performance.
)$enni, %@he traditional wa! we ran our operating review meetings was that the managers would
find some items that didn+t ma#e sense. @hen the! would discredit the report and the accountants.
(e never got to the items the managers can and should control.&*
8ives managers a false sense that the! can control costs. 8ives a global picture. )@he managers
would have li#ed to have the information ever! wee#.*
25-5
Chapter 25 - Reporting and Evaluation

8ives managers a sense that the! are responsible for a large number )e.g., melt shop manager
responsible for 052 million per !ear*
After the students have had their crac# at the anal!sis, if it hasn+t come up, the instructor might
usefull! point their attention to 'ob $enni+s uote about the problem with non-value-added chores
under the new s!stem and the difference between value-added and non-value-added wor#. )$on-
value-added wor# includes ever!thing customers are not willing to pa! for.* Cne prominent e"ample
of the non-value-added wor# associated with the old s!stem )which is 'ob $enni+s focus* is the
administrative burden reuired to #eep it going. @he old s!stem too# five accountants to operate. @he
new s!stem reuired onl! three, even in start-up modeN most of the accountants+ time was spent
designing new reports. @o what e"tent does 'ob $enni consider accounting to be %value-added&
wor#G
6. (hat were the #e! features of the new s!stem and what improvements did it promiseG
Eit the #e! design choices and discuss themN for e"ample,
Strategic )not .ust financial* focus. /2 #e! measures.
Friorities must come from the general manager and his direct reports. Friorities must cascade
from above so that ever!bod! is wor#ing on the right things.
Ever!bod! agrees with the top four prioritiessafet!, productivit!, ualit!, and up-time.
Safet! is the O/ priorit! because managers do not want people to get hurt. Bt is not O/ because
it is the largest cost.
Elimination of cost above measure
$ew s!stem does not do a trend anal!sis )e.g., performance vs. a !ear ago or vs. last rolling /2
months*. (hat is #e! is whether manager did in Manuar! what he said he would do )vs. agreed-to
benchmar#*.
;ocuses attention on important categories and provides more detail on those
;ocuses on controllables. ;or e"ample, melt shop manager controls J(E=@, not electricit!
dollars=@. Furchasing negotiates the price.
;ocuses more on productivit! than costs.
Standardardi-es ever!thing. Ever!thing is not driven b! tons.
Apparent reduction in the manufacturing managers+ financial responsibilit!. )@he new s!stem
reported onl! what the emplo!ees reporting to each manager spent. @hose are the dollars that can
be controlled.*
5. (hat are the wea#nesses of the new s!stemG
Bt+s not a cost s!stem. Compan! still needs a cost s!stem. @he compan! still does not have a
handle on what costs are controllable, what are fi"ed and variable, etc.
25-/2
Chapter 25 - Reporting and Evaluation

Should show consumption, not purchases. )@here is still a problem with the source of the data.*
@he performance standards are not benchmar#ed with the best in the industr!. );irms in the steel
industr! do not share much operating performance information.*
Seasonal factors are ignored.
Pncontrollables still not handled well. ;or e"ample, what happens if the plant shuts down for a
few hoursG Should this be segregated from the managers+ performance reportsG
@he s!stem is not complete. @hree measuresmaintenance, on-time deliver!, and
inspectionare not !et implemented.
Should the s!stem focus on e"ception reporting, rather than provide all the detailG
/2. @he implementation process.
9ivision managers decided to discontinue the old s!stem immediatel!G (hat are the advantages
and disadvantages of that decisionG
Aanagers would never adapt to new s!stem if old s!stem was still running. After the switch to
the new s!stem, the! were freuentl! in Rob Cushman+s office %begging& for their old reports.
)Actuall! the old s!stem is still being run, for inventor! valuation and product costing purposes.
'ut the operating managers have not been told that the old s!stem is still running.*
@he ris# of the immediate switch-over is that uninformed decisions will be made, Aanagers don+t
have their old information, and the! don+t !et understand the new information. 'ut the new
s!stem seemed to wor#. @he periods after the switch-over to the new s!stem were the best in the
histor! of the plant.
9epartment managers had no input into the design of the new s!stemG (as that wiseG
Bdeall! it should be the operating managers, not the accountants, who identif! what is critical to
their areas. 'ut the operating managers were consulted, and the! said onl!, %(e want the old
s!stem.& Cnl! three managers in the division wanted the new s!stemthe general manager, the
director of finance, and the manager of cost accounting. @he other 554 people in the plant were
%indifferent to overtl! combative.&
(hat can be done to get operating managers to ta#e the leadG @rainingG EiringG Should
accountants have a role in measuring ualit!, on-time deliver!, etc.G
(h! did 'ob $enni devote so much energ! to the performance measurement s!stem instead of
wor#ing on, for e"ample, an activit!-based costing s!stem, which Armco does not !et haveG
Ee thought the performance measurement s!stem, with its lin# to strategic priorities, was much
more important than an accurate costing s!stem.
//. Remaining issues,
(hen should something be considered %uncontrollable&G
25-//
Chapter 25 - Reporting and Evaluation

Pnder the new s!stem at Armco, the handling of uncontrollables is at the discretion of the
individual superior. @he lines between controllables and uncontrollables are tough to define. @he
compan! has a culture of ma#ing e"cuses.
Should larger bonuses be lin#ed to the new s!stem measuresG
@he answer to this uestion is comple". Among other things, it depends on the trust people have
in the measures and the compan!+s compensation strateg! )e.g., compensation competitiveness,
amount of ris# the! want managers to bear*.
/2. (hat has happened since the case was writtenG
Aan! things have happened since the case was written. @here was significant management turnover.
;irst, the manufacturing cost manager )Scott Aolaro* resigned. Ee got frustrated b! the operating
managers+ resistance to change. @hen there was significant turnover among the operating managers.
@he wor#s manager )Charlie 'radshaw* was as#ed to retire. @he maintenance manager )Ed 8raves*
was fired. @he rolling=finishing manager )Faul Fhillips* retired.
Bn April /552, Armco Bnc. acuired C!clops Bndustries, Bnc., another specialt! steel manufacturer.
@he combined compan! needed capital, so the! spun off the Aidwestern Steel 9ivision. Bt is now a
privatel! held, freestanding business.
As of Aarch /553, the new performance measurement s!stem was still operating. @he three missing
measures were still not implemented. Rob Cushman was not sure the on-time deliver! measures
would be worth the cost of developing them. Aanagers were not sure how best to develop the
maintenance measures. And the! had not gotten around to developing the inspection measures.
Case 25-!: "ormosa Plastics #rou$


Approach
@he ;ormosa Flastics 8roup );F8* case describes the reporting and evaluation s!stem used b! the largest
private corporation in @aiwan. @he case describes the compan!+s organi-ation and responsibilit! centers,
budgeting processes and, particularl!, methods of evaluating the performances of profit center managers
when profit is to a large e"tent uncontrollable. @he s!stem is somewhat unusual in that the planning and
reporting processes are uite detailed and costl!, !et performance evaluations are highl! sub.ective, and
bonuses do not var! much from period to period.
-#ggested Assignment 3#estions
/. Bdentif! the ma.or elements of ;ormosa Flastics 8roup+s control s!stem.
2. Bs the Fol!olefin division a profit centerG
3. Aanagers at ;ormosa Flastics 8roup use sub.ectivit! to eliminate some of the effects of
uncontrollable factors from performance evaluations. Evaluate this choice. 9id the! have an!
alternativesG
*
@his teaching note was prepared b! Frofessor Jenneth A. Aerchant. Assistance from Frofessors @homas (. <in and 9an
Elnathan is gratefull! ac#nowledged. Cop!right K /556 Jenneth A. Aerchant.
25-/2
Chapter 25 - Reporting and Evaluation
7.
5. Evaluate ;F8+s incentive compensation s!stem. (hat are the advantages and disadvantages of
%smoothing& incentive compensationG
Case Anal'sis and Possible $isc#ssion 3#estions
/. 9escribe the ;ormosa Flastics 8roup );F8*.
;F8 is a @aiwan-based conglomerate consisting of more than /2 different companies located in
@aiwan, China, and the Pnited States. Bt includes several chemical, plastics, electronic, and te"tile
companies, as well as a modern hospital, a nursing school, a technical college, and a medical college.
Aore facts about the compan! can be pulled from the case. Eere is some more recent information,
a. Bn /557, ;F8 completed a 02./ billion petrochemical and plastics-ma#ing plant in Foint Comfort,
@e"as. @his was the largest investment b! a privatel! held corporation in @e"as+s histor!.
b. @aiwanese law does not include a holding compan!-t!pe organi-ation. ;F8 actuall! has a
comple" ownership structure. @he dominant shareholders are a famil! of two brothers, Q.C.
(ang )chairman, 62 !ears old in /554* and Q.@. (ang )president, about 43 !ears old*. @he two
brothers own at least 22? of all companies in ;F8.
c. @he case does not ma#e it obvious, but the actual running of ;F8 is in the hands of the Chairman,
not the Fresident. Staff in the Fresident+s Cffice ta#e orders both from the Chairman and the
Fresident directl!. @he Chairman has a dictatorial management st!le. Ee was raised b! a poor
village famil! and had to uit school after the si"th grade. 'ut he taught himself how to master a
comple" compan!. Eis !oung brother )the ;F8 Fresident* is more of a human relations-oriented
person. Aost people in @aiwan believe the two brothers ma#e an e"cellent management team.
d. As an indication of the centralit! of ;F8 in the @aiwanese econom! and of the significance of the
Chairman, in particular, it is interesting to note that the @aiwanese stoc# inde" fell 5? in one da!
in earl! /557 when a rumor circulated that Chairman Q.C. (ang had died.
2. (hat are the ma.or t!pes of financial responsibilit! centers in ;F8G
a. Companies and 9ivisions, investment centers )RCB measure*
b. Flants and Froduct 8roups, profit centers
c. Froduction Frocesses and 8roup of Aachines, cost centers
d. $on-production-oriented units, such as sales, technolog!, management, revenue or discretionar!
e"pense centers
3. (hat are the ma.or problems facing ;F8 management in the earl! /552sG
<abor shortages and rising wages. At ;F8, labor costs are significant, but less than 22? of total
production cost. @he! are actuall! much smaller in some divisions )e.g., pol!eth!lene*. <abor costs in
the Pnited States are appro"imatel! 52? higher than in @aiwan. @aiwanese wages are higher than in
other producing countries )e.g., Bndonesia, Ae"ico*, but @aiwan has higher productivit! than most
developing countries.
25-/3
Chapter 25 - Reporting and Evaluation
Aan! ;F8 divisions compete on price, but the! cannot raise prices because their products are
commodities. At the same time, most raw material prices )e.g., petrochemicals* are volatile and not
controllable. @hus, profits go up and down. @he goal of man! of the divisions is simpl! to produce at
full capacit!.
A growing problem which is not directl! relevant to this case is the radicali-ation of the
environmental movement in @aiwan.
At the Fol!olefin division, specific problems include uncertaint! in the raw material mar#ets with
respect both to prices and availabilit! and uncertaint! in the mar#ets for its own products.
7. 9escribe and evaluate the ma.or elements of ;F8+s control s!stem.
a. Each compan! and division has a target RCB. RCB is defined as profit before ta"es but after
allocation of corporate e"penses divided b! divisional investment onl!.
b. ;F8 uses a target costing )with benchmar#ing from Mapanese companies* approach to the budget
planning. Standard costs are revised promptl! when conditions so warrant. @hese changing target
costs are used to motivate continuous improvement.
c. An e"tensive set of monthl! performance reports )E"hibit 3*.
d. Chairman and Fresident+s monthl! detailed performance review meetings with 32 senior
managers.
e. 'onus plans. @hese plans have some uniue features,
i. ;F8 bonus pools are determined at the time of budgeting, not after actual profit has been
measured.
ii. @he bonus potentials var! b! organi-ation level and role. (or#ers below section chief level
receive a performance bonus program about 22-21? of their base salaries. Aanagement has a
special performance-based bonus fund. @echnical people such as RR9 have %incentive
rewards& for good ideas.
iii. @otal ;F8 bonus amounts paid per !ear did not var! much over time due to the %Reserve
'an#& s!stem. '! creating %reserves& for bonuses, the compan! is smoothing the emplo!ees+
bonus stream.
iv. Ever! emplo!ee automaticall! gets 3-5 months of base salar! as a so-called bonus each !ear.
@his is cultural. Bt is traditional in @aiwanese for ever! emplo!ee )even government
emplo!ees and universit! professors* to get a minimum of two months+ pa! as a !ear-end
bonus. )Aan! Mapanese firms give their emplo!ees at least four months+ pa! as a !ear-end
bonus.* @hese pa!ments are not performance-dependent.
f. @he Fresident+s Cffice
@he Fresident+s Cffice )or %Red 8uard&* is composed of /5 %teams )372 emplo!ees* of
specialists whose role is to collect information and to %help& division management. @he
Fresident+s Cffice has three levels. @he top level staff usuall! have e"perience serving as division
managers. @he second level staff usuall! have e"perience serving as plants or product group
managers. @he third level staff usuall! have e"perience serving as department heads or section
chiefs. @he Fresidents Cffice staff and some line managers will rotate ever! few !ears.
25-/7
Chapter 25 - Reporting and Evaluation
@his Cffice is a ver! costl! s!stem feature, but it serves three purposes, )/* helping the Chairman
and the Fresident to control and evaluate line managers, )2* helping different divisions, plants,
and product groups to continuousl! improve their performance, and )3* serving as the training
ground for these staff persons for future higher line positions. Aan! Mapanese companies also
rotate people through different functions in their career, so that b! the time a Mapanese manager
gets into a top level position, he #nows almost all the compan!+s functions=processes=products.
Bt is interesting to note that the Chairman and the Fresident also have man! relatives wor#ing in
different parts of ;F8. @hrough regular famil! gatherings, relatives also provide some inside
information on particular divisions or departments.
5. 9escribe ;F8+s annual planning process. Bs it more a top-down or bottom-up processG
a. ;our-month planning process, begins in September and ends in 9ecember.
b. Bt starts with a bottom-up planning. 9ivision level managers submitted their sales plan and
production plan. @hen the top management made suggested revisions. @he revision process
iterates two or three rounds.
c. @op management uses the targeting pricing=costing approach. Continuous improvement is
stressed. Each division is e"pected to use improvement pro.ects to reduce costs each !ear. ;unds
are available for these pro.ects.
d. @op management is prone to re.ect the initial budget proposals, to as# for %more& profit. @his
procedure adds a top-down dimension to the process, and it creates some %gaming& behavior. @he
lower-level managers e"pect their initial plan to come bac# for revision, so the! produce a
%conservative& plan which leaves some room for improvements in future round)s*.
1. 9escribe ;F8+s performance evaluation process.
a. Frimaril! sub.ective, but ob.ective numbers form a basis for the sub.ective evaluations.
b. @he budget is used as the basis for evaluation. @he probabilit! of achieving targets is around 62-
52?. Ferformance targets are sometimes revised due to environmental changes.
c. Aanagers are evaluated b! considering controllable factors, both financial and nonfinancial
measures, such as uantit! of product sold, production efficienc!, production schedules,
consumption of materials, cost control, inventor! control, leadership, and product ualit!.
d. Changes in results due to activities that were approved b! top management after the budget was
approved )e.g., improvement pro.ects* are ad.usted for in the evaluations.
e. @hose ma#ing evaluations and assigning bonuses also ta#e into consideration the person+s abilit!
and potential for the future, !ears in the compan!, teamwor#, cooperation, and the situation the
person faced. Bt is ver! sub.ective. ;F8 emplo!ees must trust their evaluators.
4. Bs the Fol!olefin division a profit centerG
Qes and no. Frofit of the entit! is measured, but the manager, Ar. Esaio, is not held accountable for
profit. ;F8 managers have concluded that he does not control significant elements in the profit
calculation. Bn particular, eth!lene accounts for 12-15? of the division+s total product costN there is
onl! one local eth!lene supplier owned b! the governmentN eth!lene prices are set b! the governmentN
eth!lene prices fluctuate significantl!N and prices of the division+s output )pol!eth!lene* do not
fluctuate with the input )eth!lene* prices.
25-/5
Chapter 25 - Reporting and Evaluation
6. So what is Ar. Esaio held accountable forG
Ee is responsible for all aspects of his division+s performance e"cept material price variances. Bn most
of ;F8+s chemical businesses, particularl! those which sell in commodit! mar#ets, material price
variances are factored out as being largel! uncontrollable.
Aanagers of other ;F8+s divisions are held substantiall! accountable for profits. (here the managers
have substantial control over profits, profits are used as a ma.or component of the performance
evaluation. Bn such cases, the evaluations will be more transparent even though the! are still
sub.ective.
5. Bs ;F8+s choice to allow high sub.ectivit! in performance evaluations a good oneG
Bt seems to wor# at ;F8. @he managers are comfortable with the s!stem, and the compan! has been
uite successful for a long period of time.
/2. Are an! of ;F8 managers+ control choices affected b! national or cultural factorsG Bf so, which
choices were affected and which factors affected themG
;F8+s control s!stem differs in several significant wa!s from most (estern companies,
a. Bt is a large compan! which is substantiall! owned and dominated b! one famil!. @he large
Fresident+s Cffice and the detailed monthl! performance reviews are two of the methods the top
managers use. (hile seemingl! ever!one in ;F8 was satisfied that the current management
control s!stems were effective, some managers wondered whether the s!stem would continue to
serve the compan! well in the future. Aost important, the! were concerned about a shift in
management st!le if the current top-level managers retired. And man! managers e"pected that
research and new product development would become more important to ;F8 in the future, and
this change could force the compan! to have a longer-term focus because the t!pical research and
development c!cle in the chemical industr! was 7 to 5 !ears.
b. @he heav! use of sub.ectivit! in performance evaluations is more common in Asian companies
than in (estern companies. Aost American managers and emplo!ees, for e"ample, prefer a more
ob.ective evaluation s!stem. @he! are less comfortable with giving their superior that much
evaluation discretion and power )the power distance concept discussed in Chapter /5*. @he!
worr! that a high degree of sub.ectivit! in evaluations will cause unfairness and bias.
c. ;F8+s s!stem, with its detailed monthl! performance reviews and no long-term incentive
program, appears ver! short-term oriented. A!opia danger is minimi-ed, however, because most
of the emplo!ees spend their whole career with the compan!. @hus, the! are not able to avoid the
harmful effects of their short-term actions. ;urther, ;F8 li#es to have its bonus pa!ments be
relativel! constant over time. A total bonus figure is put in the budget and is not varied b! the
actual amount of profit earned. As one manager e"plained, %Bf this !ear is no good and ne"t !ear
is no good, ma!be we will consider a lower bonus in the third !ear. 'ut it is difficult to
distinguish good and bad performance in the short-run, and we li#e to ma#e the situation more
stead!.& @his philosoph! contrasts with the tendenc! in most (estern companies to ma#e bonus
pa!ments ever more variable with short-term performance.
d. @he use of !ear-end emplo!ee %bonuses& is traditional in @aiwan )and other Asian countries*.
)Emplo!ees also receive S month salar! on each of two national holida!s.* @hese bonuses are not
motivational, however, because the! are not performance-dependent. @hus, the! are not part of
the compan!+s control s!stem.
25-/1
Chapter 25 - Reporting and Evaluation
e.
//. (hat happens when the chairman and president retireG
@his is a ma.or concern for ;F8 emplo!ees. Eere is a representative comment from one manager,
As long as chairman (ang sta!s, fundamentall! there will be no change. Ee is the founder, and
he #nows ever!thing ver! well. Cur s!stem is good, and our goals will be the same. B don+t even
#now how man! of us have contemplated change because Chinese people believe their leaders
will be long-lived. 'ut when our chairman changes, things will be different. Cne man+s
leadership can have a significant effect.
Bf Chairman (ang retires, who will be the new leaderG (ould we change our strategic
direction awa! from commodit! chemicals in favor of creation of higher value added
productsG Bf that happened, would the s!stem have to changeG B guess it depends on the
needs of the compan! and the philosoph! of the new managers. Bt is clear that the second
generation of managers will be different. @he! have been educated in (estern Europe and
the Pnited States and have been less influenced b! the Mapanese.
/2. 9oes an!thing else threaten ;F8+s s!stemG
Some managers were also concerned that ;F8+s success might be threatened, ironicall!, b! the
advancing @aiwanese standard of living. @he! noted that the cost of labor was increasing, and it was
becoming harder to motivate emplo!ees. Cne manager said, %@he !ounger generation li#es leisure,
and the older generation is getting la-!. @he! have more mone! and more time to spend it.&
25-/4