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This paper is exclusively submitted to Supriyadi, M.Sc., C.M.A., Ph.D.


Management Control System Course

GADJAH MADA UNIVERSITY | MBA |


INTERNATIONAL CLASS
October, 2016

By:
Ahmad Fahmi Mubarok

Case 7-6, Industrial Products Corporation


A. Problems
In 1996, the Industrial Product Corporation manufactured variety of industrial
products. Plants were located throughout the country, one or more to a division and
company headquarter was in large Eastern city. Each division was run by a division by a
division manager and had its own balance sheet and income statement. Performance
measurement is performed by using Return on investment (ROI) indicator.
B. Reasoning
The purpose of measuring assets employed are analogous to the purposes for profit
centers. The purpose being to provide information that is useful in making sound
decisions about assets employed and to motivate managers make these sound decisions
that are in the best interests of the company. Also, to measure the performance of business
units as an economic entity. Measuring assets employed:
Cash. Central control, most companies control cash centrally because central control
permits use of a smaller cash balance than would be the case if each business unit held
the cash balances it needed to weather the unevenness of its cash inflows and
outflows.
Receivables. Business Unit managers can influence the level of receivables by their
ability to generate sales and directly by establishing credit terms and approving
individual credit accounts and credit limits and by their vigor in collecting overdue
amounts. whether to include accounts receivable at selling prices or at cost of goods
sold is debatable. One could agree that the business unit's real investment in account
receivable is only the cost of good sold and that a satisfactory return on this
investment is probably enough.
Inventories. Recorded at end-of-period amount. treated in a manner similar to
receivable, that is recorded at the end-of-period amounts even though intra-period
averages would be preferable conceptually. ex: advance payments and accounts
payable.
Working capital. Sound from a motivational standpoint if the business units cannot
influence accounts payable or other current liabilities. (eg: Gross working capital and
net working capital
Fixed Assets. Initially recorded at their acquisition cost, and this cost is written off
over the asset's useful life through depreciation. (acquisition of new equipment, Gross
book value, disposition of assets, annuity depreciation, other valuation methods).
Leased assets, Idle assets, Intangible assets, non-current liabilities, the capital charge.

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A manager should invest in assets only if the assets will produce adequate returns.
Second, when an asset is not providing adequate return (the expected return could change
over the years), it is time to disinvest or reduce further investments into this asset. Two
ways to relate profits and investments and to compare investment alternatives:
Return on Investments (ROI)
A performance measure used to evaluate the efficiency of an investment or to
compare the efficiency of a number of different investments. To calculate ROI, the
benefit (return) of an investment is divided by the cost of the investment; the result is
expressed as a percentage or a ratio. The return on investment formula:
ROI = (Gain from Investment Cost of Investment) / Cost of Investment
There are three apparent benefits with ROI:
It is a comprehensive measure in that anything that affects financial statements is
reflected in this ratio.
It is simple to calculate, easy to understand and meaningful on an absolute scale. It
is a common denominator regardless of size or type of business.
The performance of different business units may be compared directly to one
another.
ROI is available for competitors and may be used a basis for comparisons.
Economic Value Added (EVA)
A measure of a company's financial performance based on the residual wealth
calculated by deducting cost of capital from its operating profit (adjusted for taxes on
a cash basis). (Also referred to as "economic profit")
EVA = Net Operating Profit After Taxes (NOPAT) - (Capital * Cost of Capital)
Advantages of using EVA:
EVA ranks project on profits in excess of the cost of capital (EVA increases).
All business units have the same profit objective for comparable investments.
EVA permits the use of different interest rates for different investment projects.
EVA has greater correlation with a firms market value (it optimizes shareholder
value).
The minimum return an organization must earn on its investments to meet investor
expectations. Cost of capital is specific to each organization and depends on several
factors such as the type of industry in which it operates, how risky the organization is, the
rate at which it can borrow from outside and more (borrowing, in this context, refers to
both debt and equity). If an investment returns more than the cost of its capital, the
investment is positive and if not, it is negative and as well not invested. Encourages
division managers to retain assets beyond their optimal life and not to invest in new assets
which would increase the denominator. Can cause corporate managers to over- allocate
resources to divisions with older assets because they appear to be relatively more
profitable. Capital may be allocated towards least profitable divisions, at the expense of
the most profitable divisions.
C. Case Evidence
Cash: 8% of total assets
The Banker Division maintained a cash account in a local bank, to which company
headquarters transferred funds as they were needed. The cash influence by deduction
of 40% of income for tax purpose, payment of dividend by the division to
headquarter, and if cash declined below the minimum or if extensive capital
expenditure had been approved.
Accounts receivable: 21% of total assets

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All accounts receivable for the Baker Division were collected at company head
quarter. In late 1996, accounts receivable made up 21% of total assets because 45 days
of sales. There is no control for accounts receivable.

Inventory:
1. Raw material metal stock: 3% of total investment
Inventory show the raw material (7%), work in process (9%), and finished goods
(2%). Purchases depended on the amounts on hand, expected consumption and
current delivery time and price expectations.
2. Purchased parts and manufactured parts: 10% of total assets, 4% in raw material,
6% in work in process.
Using data on part usage.
The forecast could then be adjusted by a factor entered to reflect known trends
for a specific part or as a constant for all parts.
The program then computed the EOQ in dollars and in units.
3. Floor stocks (3% of total investment)
Floor stock inventory consisted of parts and components which were being
worked on assembled. Items became parts of the floor stock inventory when they
were requisitioned from the storage areas or when delivered directly to the
production floor.
4. Finished goods: 2% of investment
Finished goods inventory consisted of those few pumps on which shipment was
delayed.
Land, buildings, and machinery (53% of total investment)
Since the Baker Division fixed assets stated at gross comprised 53% of total asstes at
the end of 1996. The capital budgeting procedure were described in planning manual,
they are: headquarters forecasts economic conditions, the divisions plan long-term
objectives, supporting programs are submitted, and annual objective submitted.

D. Conclusion & Recommendation


Industrial Product Corporation should set tactic to achieve the short-term and the
long term goals, because this is important thing to make company profitable and sustain
for long run. And the performance to achieve the goals should be could measure by ROI
or other indicators.
1. Influence of Mr. Brandit in the level of investment in each asset category
Cash Issue
Not significant case because Baker division has independent cash that managed by
itself and the amount always above the minimum level for the operation.
Account Receivable Issue
Significant, so the company should reduce the account receivable by increasing
the sales with short term credit and the company should often ask the customer to
pay their account payable, and give penalty cost to overdue account receivables.
Inventory Issue
Not significant problem, because the company delivery the finished goods based
on order. For work in process goods, the company should reduce the investment
with establish the payment installment in advance and reduce the value to gross
inventory. So the company will be more efficiently and do not cover the high
capital.
2. The function of ROI as a measure of divisional company:

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To show the relation between profit and investment or the return of investment.
ROI show the comparison between income and assets.
Return on Investment has some advantages. All aspects that influence financial
statement is reflected in this ratio and it is not difficult to calculate ROI.