Chapter §- Control System Costs CASE STUDY Fit Food, Inc. Our shareholders are demanding better performance from us, Our market valuation has been basically flat for most of the last decade. At the same time, we need to be making larger investments in our future, to develop new products and to augment our sources of organic ingredients. So we need to ratchet up the performance pressure. We need to do better. Sean Wright, CEO, Ft Food, In. Sean made this pronouncement in May 2008 at a management meeting held just after the Fit Food annual shareholders’ meeting. The division managers responded to Sean’s call to action, but not all of their responses were what Sean had in mind. The company Sean Wright founded Fit Food, Inc. (FFI) in 1972, Sean had been working as the VP R&D in a large food com- pany, but he had always wanted to start his own busi- ness. In his spare time, he developed a new line of cookies, called “Smart Cookies,” that he could adver- tise as being healthier because they were lower in fat and calories. After many struggles to get Smart Cookies placed in major supermarket chains, by 2000, Sean and his growing team were able to declare proudly that the Smart Cookie brand was being distributed nationally. ‘With more products in development, and taking advan- tage of the good stock market environment in 2000, Sean launched an FFI IPO, The company’s stock was listed on NASDAQ. By the year 2009, FFI was a medium-sized food com- pany that targeted “tasty-but-healthier” market seg- ments. In 2001, Sean introduced several new snack products and started a Savory Snacks Division. In 2003, he acquired an energy drink company, which became FFI’s Sport and Energy Drinks division. By 2009, FFI’s annual revenues were approaching $500 million. The company was consistently profitable but heavily leveraged, as Sean had funded the energy- drink acquisition by increasing the company’s debt load significantly. 206 FFI used a divisionalized organizational structure (see Exhibic 1). The general managers of the three rela- tively autonomous divisions—Cookies & Crackers, Savory Snacks, and Sports & Energy Drinks ~ reported directly to Sean, the CEO. Each division had its own sales and marketing, production, and R&D departments and a controller. The corporate staff included human resources, MIS, finance, R&D, and legal departments, FFI did not have an internal auditing function. It had outsourced the documentation and testing work needed to comply with the Section 404 requirements of the Sarbanes-Oxley Act. Recently, however, Joe Jellison, FFI's CFO, had suggested that the company was becoming large enough that iz should start bringing this work in house. in 2008, Kristine Trodden was assigned as the exter nal auditing firm partner on the FFI account. Kristine considered FFI not to be a particularly desirable client because of persistent requests to reduce auditing fees amid threats to solicit bids from competing firms. FFTs board of directors included five members, Sean was the chair. The other outside directors included 2 small-company CEO, a CFO of a medium-sized public company, a vice president of marketing ata large super. market chain, and a practitioner in holistie nutrition. All of the outside directors had been suggested by Sean but approved by the board's nominating and govern- ance committee. The board met in person four times a year and also by conference call as needed. Plans, reviews, and incentives FET’s planning process began in August when corporate managers sent to each division economic forecasts, other planning assumptions, and preliminary sales tar gets. The sales targets reflected investor expectations ofsteady growth. Typically, each division was expected to increase annual revenues and profits by at least 5%. Over the following two months, division manage- meat created formal strategic plans, which included both a strategic narrative and a high-level summary profit and loss statement. The strategic plans wereI ___ approved by corporate managers in early October. Then division managers developed the elements of their Annual Operating Plans (AOP) for the coming year, which included detailed marketing and new prod- uct development plans and pro forma income state- ments and balance sheets. Developing the AOPs required many discussions between corporate and division management. The divi sion managers typically argued that they needed to increase their expense budgets to be able to achieve their sales goals, and corporate typically wanted to squeeze expenses to generate increased profits. A fairly standard planning exercise was to ask each division what pro- grams or plans they would cut if their profit budget was cut by 109%. Once these programs were identified, the division managers had to justify adding them back into the budget. Tensions between division and corporate management increased in 2008 because corporate was asking the divisions to increase their growth rates to 7% to allow some new corporate investment initiatives tobe fanded internally. At the end of the negotiation pro- cesses, the AOPs were presented to the board of directors for approval at its meeting held in early December. During the year, performance review meetings were held quarterly. The focus of the meetings tended to be on explaining variances between revenue and profit performance goals and actual performance. The meet- ings were quick and painless when performance matched or exceeded expectations, but the tone was dramatically different when the quarterly profit goals were not achieved. Catherine Elliott (marketing man- ager, Cookies & Crackers Division) explained: Corporate pushes us hard to make our numbers. There is never a good reason for net making our goals. We're paid to be creative and come up with solutions, not excuses. Sean calls it “no excuses management.” Division presidents and their direct management reports could earn annual bonuses based on achieve- ment of AOP profit targets. The target bonuses ranged from 25% to 100% of the manager's base salary, depending on organization level. No bonuses were paid if division profits fell below 85% of AOP plans. Maxi- mum bonuses of 150% of the target bonus amounts were paid if profits exceeded AOP by 25%. Average bonuses exceeded target bonus levels in seven of the first eight years of FFI’s history as a public corporation, Some corporate managers and division presidents were also included in a stock option plan. FFI stock had Fit Food, Inc. performed well in the early 2000s, but virtually all of the gains were lost in the stock market downtura of 2008-2009, Most of the options were underwater. The recession of 2008-2009 stressed company oper- ations at the same time that Sean was calling for better financial performance. The Savory Snacks Division performed well and achieved the higher growth rates called for in both 2008 and 2009. The other two divi- sions experienced more challenges, however, as is explained below. (Summary income statements for these divisions are shown in Exhibit 2.) Sports & Energy Drink Division The Sports & Energy Drinks Division (Drink Division) was formed in 2003 when FFI acquired a successfui, regional energy drink brand. s part of the deal, Jack Masters, the former CEO of the acquired company, became president of the division, Performance in the first few years after the acquisition was good. The tar- geted drink categories continued to grow; two brand extensions were successfully launched; and Drink Divi- sion sales nearly doubied between 2003 and 2006. The division achieved its AOP profit targets easily, and Jack was able to operate without much interference from corporate. By early 2007, however, Jack saw some clouds on the horizon. The energy drink category was becoming more and more competitive as more players, including some large, well-capitalized corporations, entered the category. At the same time, retailers were consolidat- ing and becoming more powerful, increasing pressure on manufacturers to lower prices, Jack began to Worry thathe might not be able to deliver the growth that was expected of his division. 2007 Despite Jack's worries, 2007 was another stellar year, with sales growth exceeding even Sean's increased expectations. The category momentum continued, and Jack’s brands gained market share, due in part toa stte- cessful grassroots advertising campaign. With performance far exceeding the AOP targets and excellent bonuses assured for the year 2007, Jack thought it would be prudent to try to position the divi- sion for success in the future. He met with his manage- ment team to discuss his concerns and to come up with ideas to get better control over reported profits. Jack and his team decided on three courses of action. The first was to declare a shipping moratorium at the end of 207Chapter 5 + Control System Costs the year, which shifted some sales that would normally have been recorded in 2007 into 2008. Notall of Jack’s managers were happy with the ship- ping-moratorium plan of action. The production team was unhappy because the moratorium would cause scheduling problems. Some employees would have to be furloughed temporarily at the end of the year to minimize the buildup in inventory. Then, in early 2008, they would have to incur some overtime costs both to accelerate production and to ship the orders that had accumulated. The sales department was concerned that they would have to deal with customer complaints about shipment delays and product outages. Neverthe- less, Jack decided to move forward with the shipping moratorium regardless of the costs, which he consid- ered relatively minor. The second plan was to build up accounting reserves, against accounts receivable and inventory balances. In 2007, the Drink Division controller was able to provide a justification for increasing reserves by $1 million over 2006 levels. ‘The third plan was to prepay some expenses that would have normally been incurred in 2008. Among other things, some facility maintenance programs were accelerated, and supplies inventories were replenished before the end of the year. These items were not material, amounting to expenditures of only about $100,000. But, as Jack noted, “Every little bit helps” 2008 In 2008, some of Jack’s fears were realized. As the economy slowed down, consumers became more fru- gal. The once-exploding energy drink category began to stagnate; competition for market share grew fierce; and margins declined, In addition, there were rum- lings of an impending soft drink “obesity” tax that could put even more pressure on profits. The division was able to make its annual revenue targets in 2008, but the division managers did so by offering an “early order program” developed by the Sales and Marketing Department. Customers were offered discounts and liberal payment terms if they placed orders scheduled to be delivered before the year ended, Discounts ranged from 5% to 20% and custom- ers were given 120 days to pay their invoices without incurring interest, rather than the traditional 30 days. However, Jack learned later that some of the more aggressive salespeople had told customers to accept the 208 shipments now and “just pay us whenever you sell the product.” While sales remained strong, profit margins decreased significantly. In order to make sure the divi- sion would hit its AOP profit target, Jack and his con- troller began to liquidate some of its accounting reserves in the third quarter, and by the end of the year, the reserves were reduced by a total of $1.7 million. ‘The auditors noticed and questioned the change, and broughtit to the attention of Joe Jellison, FFI's CFO. Joe looked into the issue and concluded that the new reserve levels seemed justified based on historical per formance levels. 2009 Sales started out slowly in 2009, but in the second quar- ter, the sales team landed a major new national account. Because of the uptake in demand, Jack had now become more concerned about meeting production schedules than he was about achieving sales goals. Thus, the early order program and almost all other promotions and discounts were eliminated. Jack also told his controller to rebuild reserves, and a total of $2 million in reserves were restored in 2009. Once again the auditors questioned the change, but the controller provided a justification based on uncertainty in the economy and irregularities in some new custom- ers’ payment patterns, Jack believed that his di was well positioned for success going into 2010. Cookies & Crackers Division The Cookies & Crackers Division (Cookie Division) was built around the “Smart Cookie” product, once FFI’s flagship brand. But the Smart Cookie product had been struggling for the last several years. Gookies was a low- growth, low-margin product category with a strong private label presence, though quality health-oriented brands commanded a small price premium. The biggest problem for the Cookie Division, however, was a shift in consumer mindset. In recent years, “healthy” was less likely to be associated with low fat, and more likely to be associated with healthful ingredients such as whole grains, nuts, and natural antioxidants, a trend that the Cookie Division management had largely missed. Scott Hoyt, the Cookie Division president, had been ‘with FFI since its inception. Scott had a strong back- ground in sales and was credited with selling SmartCookie to national accounts, but he was perceived as resistant to change, and his accounting and finance knowledge was relatively weak. The Cookie Division traditionally relied heavily on a variety of seasonal trade promotions to achieve their volume targets. By 2008, Catherine Elliott, head of the Marketing Department, was concerned that the new required 7% growth rate was probably not attainable without both some aggressive marketing and develop- ment of some good new products. During the annual planning process, she made a case for increasing the division's advertising and new product development budgets, but her requests were denied, Sean explained that he did not think the advertising was necessary. He also believed that the projects being funded at the cor- porate level would yield better returns than the pro- posed investments in Cookies, and FFI could not afford both investments. 2008 ‘It became obvious early in the first quarter of 2008 that Cookie sales were falling well below the levels forecast in the AOP. The Cookie sales department initiated a promotion to meet the first quarter goals. The specifies of the program were similar to those of the early order program being used in the Drink Division - generous discounts and extended payment terms for early orders. The early order program was implemented aggressively. The sales team was told to contact all of their customers and convince them to take early deliv- ery of product, Many of these contacts were successful. In most eases, the sales staff received written authori- zation from their customers, but in some cases the authorizations were only verbal. In the final days of the first quarter, Catherine and Mitch Michaels, head of the Sales Department, asked shipping to work around the clock to ship as much prod- uuctas possible before the quarter end. In the last hours of the quarter, trucks filled with cookies drove a few blocks away from the loading docks and parked, so that product was technically “shipped” and sales could be booked. The heavy sales volume at the end of the quarter attracted the auditors’ attention. They concluded, how- ever, that rhe accounting treatment conformed to GAAP (generally accepted accounting principles) since ownership of the product officially changed at the time of shipment. In the second quarter of 2008, Scott, Catherine, and Mitch knew they had a problem. Second-quarter orders Fit Food, Inc. were predictably slow given the amount of extra prod- uct that had been shipped in the firsc quarter. The three managers then decided to ship additional, unordered product to their customers. The additional order vol- umes were generated either by increasing the quanti- ties of actual orders or by entering orders into the company’s billing system twice. When customers com- plained about the unordered shipments, blame was attributed to human errors, and the sales team was charged with the task of making the unordered ship- ments “stick.” They were offered a number of tools toward that end, such as special pricing and credit terms and product exchanges. The program worked surprisingly well. Returns increased, but the program still effectively increased revenue by $2.3 million and profit by $460,000. Scott, Catherine, and Mitch were encouraged by the results and praised the sales team for their heroic efforts. They continued the program throughout 2008, being careful to rotate the “mistaken” shipments between customers. At the end of the year, the team managed to deliver 97% of the AOP sales and profits. 2009 During the 2009 AOP process, Scott, along with Cathe- rine and Mitch, made a strong plea to reduce the Cookie Division’s revenue goals. They argued that given the weak economy and sluggish category growth, a flat rev- enue goal, orat most 2% growth, was a more reasonable target. However, Sean was unwilling to lower the goal. He understood the difficulties in the category, but he believed that the setting of aggressive goals and a com- mitment to achieve them were cornerstones of FFTs sue- cess aver the years, and he knew that FFT shareholders would be demanding better performance than that. After the disappointing AOP meeting, Scott called a meeting with his management team to develop new ideas for increasing sales. He thought if the division could make it through 2009 successfully, they would face smoother sailing in 2010 because some new, prom- ising products would be ready for launching. A decision was made to continue the programs used in 2008. Irene Packard, head of the Production Department, came up with another idea. She thought she could decrease expenses significantly by rewriting contracts with suppliers who supplied both machines and parts. If she could convince suppliers to decrease the costs of parts, and charge the difference to machines, she ‘would be able to capitalize costs that would otherwise 208Chapter 5 - Control System Costs have been expensed. Irene estimated that she could reduce expenses by $2.3 million, or $2 million after depreciation, Scott thought this was a good idea, He noted that the cost savings could bring them within striking range of the division’s proft goals. In September, however, one of the junior account- ants in the division was feeling unduly pressured to make accounting entries that she felt were not good practice, particularly related to some of the billings that seemed to lack adequate supporting documenta- tion. The managers’ justifications for these entries Exhibit 1 Fit Food, Inc.: Organization chart seemed to her to be capricious rather than facts-based. She took it upon herself to discuss the issue with Joe Jellison, FFI’s CFO. Joe had one of his assistant conttal- lers examine the accounting practices in the Cookie Division, and he reported finding multiple problems with potentially material financial statement effects. Joe had to decide what to do next. Should he have his people calculate the size of the errors, make the adjust- ing entries, and fix the processes, or should he, at this point, inform the external auditors and/or the audit committee of the board of directors? CEO Sean Wright Corporate statt: CFO (Joe Jeliison) Sports 8 | Cookies & Human resources Energy Drinks ee Onc Crackers Information Systems Division | rip Hartman Division Research & Development Jack Masters ee Scoit Hoy! General Counsel Sales & Marketing Sales Production | Meet Production |/ | Controller Catherine ‘its rene Controller | np Eliot =|) | Michaels Packard |) | 210Fit Food, Exhibit 2. Fit Food, Inc.: Income statements for Sports & Energy Drinks and Cookies & Crackers Divisions, FYs en Revenue Cost of goods Gross margin PAD expense SGBA expense Operating Profit Revenue Gost of goods Gross margin FAD expense SGBA expense Operating profit 1g December 31 ($ millions) $110.0 64.0 $46.0 08 48.0 $28.2 $130.0 20.6 $49.4 0.8 20.8 $28.2 $125.8 738 tz 10 20.9 ‘307 1245 722 473 08 188 28.2 $130.3 75.5 54.8 10 20.0 33.8 131.0 81.2 49.8 o4. 20.0 29.4 $130.5 $137.0 768 79.5 53.9 875 08 14 19.2 21.0 33.9 SBA 4273, 133.0 80.2 82.5 474 50.5, 03 o4 4183 19.0 28.5 311 1274 787. 50.4 0.3 192 30.9 Inc. This case was prepared by Professor Kenneth A. Merchant and research assistant Michelle Spaulding, Copyright © by Kenneth A. Merchant. an