ACC 420 COURSEPACK

Management Accounting II

by Pablo Casas-Arce and Michal Matějka

 Table of Contents

WEEK 1 INTRODUCTION 3
Learning objectives, workload, deadlines
Online videos
Procter & Gamble Polska
Case questions
Case

WEEK 2 CAPACITY COSTING: FOUNDATION MODULES 21

Learning objectives, workload, deadlines
Online videos
Theoretical foundations
Module 1: Why should we allocate overhead costs?
Module 2: Overhead analysis
Module 3: Overhead rates at capacity

WEEK 3 CAPACITY COSTING: CASE 31

Learning objectives, workload, deadlines
Online videos
Remaking of Delhi Components
Case questions
Case

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WEEK 4 ACTIVITY-BASED COSTING: FOUNDATION MODULES 43
Learning objectives, workload, deadlines
Online videos
Theoretical foundations
Module 1: Why should costs be allocated in two stages?
Module 2: Cost drivers and cost hierarchy
Module 3: Activity-based costing
Module 4: Theory of constraints

WEEK 5 ACTIVITY-BASED COSTING: CASE 50

Learning objectives, workload, deadlines
Online videos
Saharis.cz
Case questions
Case

WEEK 6 PERFORMANCE MEASUREMENT: FOUNDATION MODULES 60

Learning objectives, workload, deadlines
Online videos
Theoretical foundations
Module 1: Design of control systems
Module 2: Performance measurement and cost allocations
Module 3: Choice of financial performance measures
Module 4: Return measures

WEEK 7 PERFORMANCE MEASUREMENT: CASE 70

Learning objectives, workload, deadlines
Online videos
Barrows Consumer Products
Case questions
Case

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WEEK 1 INTRODUCTION Learning Objectives

Week 1 Introduction
Learning Objectives

1) The single most important goal for the first week is to get used to learning from (online)
cases. You will be exposed to a real business situation and asked to make some decisions.
There may not be a single right answer to some of the case questions. There may not even
be enough information to know exactly what to do. There will be ambiguity… that’s the whole
point of cases. That’s how you get prepared for the real world.
2) You should also get used to the structure and formalities of the class. There will be online
material to work on, there will be deadlines, and there will be quizzes and tests. The first
week should get you comfortable with all that. Importantly, you should learn to relax about
grading. Real-world cases should be tough and ambiguous but quizzes and tests should not.
If you put in the effort, you will find them quite easy.
3) Is there anything accounting related to be learned during the first week? No, not really.
Well, maybe, just one thing to take away from this week’s case. Management accounting is
not about debits and credits it is about improving organizational performance.

Work Load

1) Watch introductory videos described on the next page.

2) Work on the Procter & Gamble Polska case
a. quickly read the case to get the big picture,
b. carefully read all the case questions,
c. go back to the case and spend as much time on it as you need to try and answer all
case questions. It is no problem if you do not understand or cannot answer the more
advanced question. Just take a note of what you should look for in the online videos.
3) Take Quiz A (see case questions just before the case for a list of topics).
4) Watch online videos with case solutions (available only after completing Quiz A).
5) Re-read the case questions and make sure you can easily answer all of them now. Go back
to the online videos if you need to. Double-check that you understand and can easily replicate
calculations from all online videos (likely to be part of Test 1).
6) Take Test 1.

Deadline

Sunday, March 14, 11:45 pm. Deliverables: (I) Quiz A, (II) Test 1.

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WEEK 1 INTRODUCTION Learning Objectives

Week 1 Online videos

Introductory videos

Before doing anything else this week, watch the following two videos:
Syllabus and Course Structure (22 min): In this video, I will introduce myself and “the grand
plan” for this class. I will also go over a few highlights from the syllabus such as work load,
learning from cases, performance expectations, grading, etc.
W1 Introduction (10 min): This is a brief introduction into what we are going to cover this
week and how it connects to what you know from prior accounting classes.
As a preparation for the case and some of the case questions, the following videos practice
basic concepts covered in your prior accounting classes.
Simple cost allocation (11 min): The basics of how to allocate costs between two divisions
using different allocation bases.
Simple cost allocation (11 min): Very similar to the above basic exercise.
Calculating an overhead rate (7 min): The basics of how to calculate product costs.
Cost-volume profit analysis (5 min): Example of a break-even analysis as in P&G Polska
Part 2 below.

Main videos

The following will be available once you study the P&G case and take Quiz A:
W1-1 P&G Polska (42 min): This is the first part of the discussion of the Procter & Gamble
case. It introduces the business environment in Poland and decisions facing Bill Brown. It
explains what type of information is available versus what type of information is need to
make the decisions.
W1-2 P&G Polska (39 min): The second part of the discussion goes over some concepts and
techniques that should be useful to Bill Brown when making the decision on van selling. This
includes the distinction between direct and indirect costs, cost allocations, and break-even
analysis.
W1-3 P&G Polska (25 min): The last part of the discussion focuses on efficiency of P&G
distributors in Poland and how to improve control systems in general and performance
measurement and incentives in particular.

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WEEK 1 INTRODUCTION Case Questions

Case Questions

Comprehension Questions
Carefully study the P&G Polska case and then take Quiz A, which tests comprehension of
basic case facts using simple multiple-choice questions. The following questions illustrate
the topics of Quiz A:
1. What was the strategy of P&G to gain market share in Poland?

2. What were the most important channels for P&G to reach their customers?

3. What were the main advantages and disadvantages of van selling?

4. How was the van selling initiative introduced and optimized over time?

5. How did Bill Brown know that exclusive distributors were inefficient?

6. What type of actions could be taken to improve distributor efficiency?

Advanced Questions
The following questions are more challenging. They are meant as “food for thought” to guide
your case preparation work. It is not expected that you know how to answer them before
watching the online case recording (these questions will not be part of Quiz A but why should
that stop you from trying to answer them anyway). However, after watching the online
videos available after taking Quiz A, you should absolutely be able to answer them. Test 1
will include calculations related to these questions.
7. How do you think Distributor “O” in Exhibit 4 allocated overhead costs to van sales?
Is it possible that some of the overhead allocations are inaccurate? Why?

8. Should the number of vans be increased or reduced?

9. Should P&G offer strong incentives to their distributors?

10. How should P&G measure performance of their distributors?

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WEEK 1 INTRODUCTION P&G Polska Case

Procter & Gamble Polska

The sales function’s job, no matter where you are in the world, is a very simple
one. We are responsible for delivering superior in-store presence of P&G
products. Everything turns on how to get more of my product in front of the
consumer, priced correctly, merchandised in a robust fashion that will allow the
great product development, market research, packaging and advertising to
work. Whether I’m leading a sophisticated customer development program for a
major retail chain in the U.S. or running the sales operation in Poland,
fundamentally the mission doesn’t change... but how you do it changes
dramatically.
Bill Brown
National Sales Manager, P&G Poland

Bill Brown arrived in Warsaw in July 1994 from the New York office of Procter & Gamble
(P&G) to become the National Sales Manager of Poland. He replaced Jim Wilen, who had been
promoted to Director of Sales-P&G Central & Eastern Europe. Brown was well-prepared to
enact P&G’s strategy of partnering with retailers to achieve lowest total cost and ‘value
pricing.’ However he was unaware of the unique challenges that awaited him in
implementing the strategy in an emerging market with distribution partners who were
budding entrepreneurs.
On reviewing the status of operations, Brown found a well-established network of regional
distributors. The distributors had exclusive rights to coordinate three major channels to
reach customers: (i) delivering directly to major retailers, (ii) delivering to subwholesalers
that could reach the large number of retail outlets in rural regions, and (iii) an emerging van
sales initiative (direct store delivery of P&G brands to medium-sized retailers—a major
departure from traditional P&G strategy). However, data on the performance of the Van
Selling Representatives (VSR’s) and the regional distributors revealed some disturbing
patterns. These data indicated wide discrepancies between the best and worst VSR’s
performance both within a region and among regions.
At the same time, the balance between the three major distribution channels had been
disrupted with recent expansions of the van selling fleet. Reviewing the trends of van sales
Copyright © 2004 Shannon Anderson, William Lanen. and Michal Matějka. This case was developed with
funding provided by the William Davidson Institute at the University of Michigan Business School and with
the cooperation of the Procter & Gamble Corporation. The case is intended for the purposes of classroom
discussion of business issues. All data and the names of the local managers in the case are fictitious.
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WEEK 1 INTRODUCTION P&G Polska Case

and subwholesaler sales volume growth, it appeared that about 70 percent of van sales
growth had been incremental on net; however, the balance reflected reductions in
subwholesaler sales. Brown was concerned that continued growth in van sales would result
in retaliation by subwholesalers (still a significant portion of the business). He also
wondered whether van sales had inadvertently expanded to the point of diminishing or
perhaps negative returns. As Brown described:
It was clearly time for our relationship with regional distributors to mature and
to be more focused on delivering value to all distribution channels. In the first
twelve months of the relationship everyone was working hand-in-hand, we were
all going to be millionaires and there was nothing that we couldn’t do. With
heightened competition we began to understand our limitations in using
dedicated regional distributors to supply the subwholesale channel.
In October, at our quarterly distributor symposium we instituted ‘tough love’
measures. The theme of the symposium was that the gap between the best and
worst distributors was becoming unacceptable. Distributors had to understand
that this was not a guaranteed marriage for life. They needed to perform well to
continue in partnership with P&G. Consistent with that theme was a second
message: that we needed to ensure competitive margins and look for cost
reduction opportunities wherever they existed. So you could say that the love-in
ended in October, and, if you talked with distributors they’d probably link it to
my arrival.

P&G Central & Eastern European Division

When P&G entered Poland in 1991, they found no retailing or distribution infrastructure and
more stores per capita than in any other country in Europe. Even Russia, with 150 million
people, had 25 percent fewer points of sale than Poland, with approximately 38 million
people. The retail industry structure was consistent with population demographics—45
percent of the population lived in outlying rural areas and relatively few households had
automobiles.
After three years of early developmental work in Poland, P&G faced a growing and significant
competitive threat from Western firms with premium branded products such as Lever (UK-
Holland), Benckiser (German), Henkel (German), Colgate-Palmolive (US), Johnson and
Johnson (US) and L’Oreal (French). At the same time, the quality of local products had
improved significantly creating additional competition from lower priced brands.
In June 1995, P&G had several hundred employees in Poland, of whom nearly all were Polish
nationals. The National Sales Group constituted over 20% of this number, the majority of
whom were in line grocery sales. Remaining sales employees were in two other groups,
pharmacy sales and national accounts, or in two corporate sales support functions, the sales
and merchandising organization (SMO) or customer business development (CBD). Exhibit 1
is an organization chart for the National Sales Group.
The line sales organization is responsible for sales to most supermarkets and cosmetics
shops, which account for the bulk of total sales. Line grocery sales is organized along

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WEEK 1 INTRODUCTION P&G Polska Case

geographic lines with District Managers responsible for regions of the country. Unit
Managers report to District Managers and are responsible for distributor sub-regions. P&G
Sales Representatives are assigned to either retail and wholesale accounts or to distributor
van sales. Vans are used to service mid-sized stores. While the vans are owned by P&G, they
are maintained and operated by regional distributors. Van sales representatives are
employees of the regional distributor. Employees of the regional distributor, including van
sales representatives, warehouse operators, and administrators, do not appear on the P&G
organization chart.
Pharmacy sales have to comply with state regulations and are handled by a separate
organization. The National Accounts Organization is another small sales organization, which
was established in April 1995 to serve an emerging sector of Western multinationals and the
state-owned company, Ruch, controlling 20,000 of the 40,000 small kiosks found on major
street corners throughout Poland.
Brown’s Group at the Warsaw headquarters of P&G Poland, includes two sales support
groups: the Sales Merchandising Organization (SMO) and Customer Business Development
(CBD). The SMO group is responsible for developing strategies for succeeding in local stores.
CBD works closely with retailers to achieve total system efficiency from product production
through the sale of the product to consumers. In Poland, where major retailers are the
exception rather than the rule, the CBD group has primarily supported regional distributors.
The CBD group is a multi-functional group that identifies barriers to distributor growth and
profitability by focusing on total systems efficiency. Having identified these barriers the
group works to identify best practices from current distributors, other P&G organizations,
or other companies and develops programs to implement these practices in all distributors.

Market Entry in Poland

Between 1991 and mid-1993, the typical Polish wholesaler of P&G products was a person
who owned a Polski Fiat (a domestically produced automobile) and stored inventory in their
home garage. A P&G sales representative would canvas an area gathering large retail orders
for products. Then he or she would try to find a wholesaler who had the product in stock and
was willing to deliver to the retail store. This process would take several days and typically
resulted in orders that were, at best, 50 percent complete. Small retailers bought inventory
on a cash basis directly from the wholesaler’s warehouse.
In the Fall of 1993, as a result of the extreme fragmentation of the Polish market, P&G took
what was for the company an atypical approach for achieving market share growth in
Poland. As Brown described:
We were going crazy trying to keep up with thousands of points of sale and trying
to work with hundreds of wholesalers—a third of whom went out of business
every day and a third of whom opened shop every day—all ‘entrepreneurs.’ In
order to get control of our physical transportation costs and, more importantly,
our receivables, we approached 15 of the most promising wholesalers and
invited them to become exclusive distributors of P&G products in their region.

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WEEK 1 INTRODUCTION P&G Polska Case

None of the competitors in Poland followed this strategy and none of the P&G groups in other
Central European countries went this far. While the regional distributors solved the problem
of dealing with several hundred wholesalers, the fundamental problem of achieving market
coverage with the large number of points of sale remained.
Jim Wilen, the first P&G National Sales Manager in Poland, described the structure of the
Polish grocery trade as a pyramid. At the top of the pyramid were the so-called ‘A’ stores,
high volume stores that were relatively few in number and typically found in the large cities.
In the middle of the pyramid, were the more common, mid-volume or ‘B’ stores. At the
bottom of the pyramid, were the low volume, or ‘C’ stores, that accounted for the large
number of grocers in outlying rural regions.
We found out quickly that conventional sales strategies weren’t going to work. A
manufacturer’s sales rep is an expensive commodity in a developing country. In
the West, you have a sales rep in every store who ‘owns’ the in-store presence of
your products for that store and influences your distribution, pricing and
merchandising. In Poland you can only break even on a sales rep in the ‘A’ stores,
and they represent less than 10 percent of countrywide sales. In the West the
pyramid is inverted—20 percent of the stores account for 80 percent of sales. In
Poland 90 percent of the stores represent 90 percent of sales. We were doing well
in these ‘A’ stores, the problem was that we weren’t affecting 90 percent of our
volume which was in small and medium-sized stores—the ‘B’ and ‘C’ stores.
In 1993, having established the regional distributors, Wilen turned to the more difficult issue
of establishing market coverage in the retail outlets. His best estimate (market research
databases did not exist and government statistics were suspect) was that the ‘A’ stores could
support intensive service from a senior P&G sales representative and large-scale delivery
from the regional distributor’s warehouse. These stores sold more than a sufficient number
of cases of P&G products each week for this distribution method to break-even and
represented about 10% of the total number of outlets.
The CBD group developed a proposal for servicing ‘B’ stores using a sales representative who
would make weekly calls on a number of stores using a small delivery van that would be
stocked by the regional distributors with P&G products. This strategy was expected to yield
the benefit of selling and marketing directly to grocers at lower cost than the traditional
direct retailing approach. Tony Romeo, Manager of CBD, believed that stores that sold at least
25% of the volume of ‘A’ stores in terms of cases each week could support a VSR and the best
market estimates suggested that about 25% of all retail outlets fit this description.
For the time being, Wilen decided to continue to serve the estimated 65% (‘C’ stores) through
regional subwholesalers. Subwholesalers are like ‘A’ customers, in that they receive
intensive sales support from P&G and deliveries from regional distributors; however, they
only sell to small grocers. Grocers buy products on a cash and carry basis at the
subwholesaler and stock their own stores.
Exhibit 2 compares the revenue and price implications of traditional distribution methods
used by leading competitors in the detergent business to P&G’s three-pronged approach of
distributing their leading detergent, Ariel, in the Polish market.

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WEEK 1 INTRODUCTION P&G Polska Case

The Launch of Van Selling

In August 1993, acting on the recommendation of the CBD group, Jim Wilen launched a pilot
study of van selling to ‘B’ stores. His objective was twofold: to increase retail market coverage
and distribution of P&G Stock Keeping Units (SKU’s) in Poland by penetrating the B-tier of
the retail pyramid and to do so at the same time that he increased overall profitability of the
Polish market. The pilot study started with two vans but quickly expanded to one in each of
the twelve best performing regions. Each Van Sales Representative (VSR) selected stores in
the region and devised a visitation plan that allowed retailers to be visited at regular, weekly
intervals with minimal travel time between stores. The job of the VSR combined the
traditional Sales Representative’s job of merchandising and promoting P&G products and
taking the grocer’s order with the distributor’s job of filling the order, stocking the shelves,
and collecting cash on delivery.
In the first month of the pilot study, the average sales were about 75% of the breakeven level
covering the costs of the van and VSR wages. Wilen felt confident that the van selling
approach would quickly surpass his breakeven goal, as grocers became accustomed to
regular deliveries and the VSR’s gained skills in merchandising and promoting the products.
The next question was, how many vans could Poland sustain? Wilen expected profitability to
decline as he moved down the pyramid of B tier stores; however, it was unclear whether the
break-even point initially estimated by CBD was appropriate and whether in fact 25% of the
stores fit this description. To test the water, Wilen more than doubled the number of vans in
November 1993. A van was assigned to a little over half of the 49 Polish provinces, called
voivodships. Because there was no list of retail outlets from which to plan strategic growth,
VSR’s were instructed to “go out and find the top stores in their province.”
With each month of improved performance, the CBD group continued to conduct saturation
tests to determine how many vans should be purchased. Saturation tests were conducted by
doubling the number of vans per retail outlet in a region and examining the performance
results. In doubling the number of vans in a region every effort was made to create selling
routes that equalized the number of available retail outlets in a region for each of the VSR’s.
The saturation tests were pushing the performance of the best performers ever-higher,
however, the worst performing regions showed little progress.
Just as van selling was beginning to show promising results, however, Brown began to hear
complaints from subwholesalers through the P&G sales representatives. With the expansion
of van selling, grocers who had previously purchased P&G products through subwholesalers
began to receive delivery service through VSR’s at no additional cost. This raised several
questions. First, had van selling gone too deep in the pyramid? If so, could van selling costs
be reduced to ensure future profitability of continued van selling expansion? Second, were
the trade terms that regional distributors offered wholesalers on P&G products and that P&G
offered distributors appropriate? Both issues were raised in the October quarterly meeting
and, as Brown described, the regional distributors reacted negatively. While Brown argued
that heightened competition demanded that regional distributors reduce their operating
costs to less than 3 percent of net outside sales (NOS), the distributors claimed that operating
costs as a percent of NOS were nearly double that and could not be reduced. Brown described
his strategy for beating the competition through lower costs of distribution:

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Today, our Regional Distributors get a certain discount off list price. My long-
term goal is to cut this discount in half structure while holding distributor profits
constant. The only way to do this is to reduce the cost structure

Efficiency of Distribution Channels

After the quarterly meeting, Brown called upon Tony Romeo’s CBD Group to examine
distributors’ costs, in particular, the relative costs of different distribution channels so that
he could evaluate possible courses of action. Romeo launched a pilot study of costs in two of
the better distributors.
In December 1994, Brown got a phone call from one of the top performing distributors.
“We’re in a lot of trouble. I’m hitting a financial wall and I need your advice and support,”
said the owner. Brown immediately scheduled a trip to meet him:
We have great risk in these people and it scared me to death to think what I’d
find. When I got there I met with the owner and the finance manager. I asked the
finance manager to help me understand where we stood. She pulled out a legal
pad with some notes on it. I asked to see the balance sheet... they don’t have one.
I asked what their major elements of cost were... they don’t know. This was bad.
We spent four hours creating a draft of a basic balance sheet of the company and
the overall elements of cost. I’m no accountant, I’m a sales manager, but it scared
me to death. After all, if this is how things were run in one of my best distributors
I didn’t even want to imagine what was going on in my worst ones.
The only records of financial performance that Brown found were the copies of statements
of income that the companies had prepared in compliance with state regulations. There was
no evidence that the distributor’s managers were monitoring or managing firm profitability:
It became very clear that the distributors had no cost accounting system.
Distributors had bills and they paid them. At the end of the month they hoped
that there was money left in the bank to make payroll. There was no
understanding of what made up their costs. They’d say ‘I think I have total costs
of around x percent of sales’. They knew that their biggest cost was payroll and
they’d know major costs because they wrote the checks, but there was no
systematic record of these charges.
Upon returning to Warsaw, Brown met with Tony Romeo and learned that the CBD team had
encountered similar problems during their pilot study of distributor costs in two other
distributors. To get an idea of the distributors’ cost structure, members of the CBD multi-
functional team had to set up a room with six tables and sort all invoices received in the last
12 months. Each table held a box with one of six labels: General Office Overhead, Product
Sales Organization Administration, Warehousing, Transportation, Van-Selling, and Other
(Exhibit 3). These categories were the basic structure of what came to be known as the cost
model template. Subcategories within these major categories were developed to create
greater visibility for minor cost components. The first five major cost categories were
summed to determine ‘total operating costs.’ The ‘Other’ category was treated as ‘below the
line’ of operating costs because it reflected costs of financial structure. The CBD team and the

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distributors’ accountants sorted the invoices into the six categories. Bookkeeping
procedures were established whereby accountants would classify costs each month using
the cost template.
From this simple categorization of costs, CBD could begin to assess the relative costs across
distributors. To address Brown’s concern about the relative costs of different distribution
channels, the CBD group created a second report, in which unique costs of a particular
distribution channel were assigned to that channel and shared costs were assigned in
proportion to sales in the channel (See Exhibit 4). For Distributor “O”, for example, this
report indicated that while all channels were profitable, van sales were far less profitable
than the other channels. This process was repeated at each of the 12 remaining distributors.
(In Fall 1994, on the basis of sustained under-performance, two distributors’ regions were
reassigned to two existing distributors).
When the cost model was completed, cost reports were added to the monthly performance
measures that distributors were required to provide to P&G. The 13 cost templates indicated
markedly different cost structures among the distributors in January 1995 (See Exhibit 5).
Brown viewed this variability as the single best source of potential cost reductions in the
distributors and decided to make the cost model the focus of the March quarterly distributor
symposium.
The vast portion of the three-day symposium in March was spent in break-out sessions with
groups of 3-4 distributors discussing practices that allowed them to attain low costs. Brown
viewed this as a major cultural shift, as distributors came to view one another as business
partners in a larger enterprise rather than competitors.
The biggest realization that occurred among the distributors was that there
were steps to get to the target cost structure, and while they were challenging,
they were achievable because the target was developed based on two real
distributors—every one of the target costs were real. Everyone showed up at the
symposium believing that they were operating as efficiently as they could and
that there was no room for improvement. Not a single distributor left the
symposium with that belief. More important, they finally realized that they could
learn something from working with one another.
Upon returning to their regions, distributors worked with the P&G Unit Managers to develop
cost reduction plans. A memo from Tony Romeo summarized the major cost reduction
initiatives that emerged from the symposium (Exhibit 6). Although each distributor used the
target percentage as an ‘ideal’ cost structure, for some this represented a greater challenge
than others. Unit Managers helped the distributors establish challenging cost targets. As
Brown described:
These are 12-month goals that the distributors believe they have a 50 percent
chance of achieving. There are no penalties for not achieving the goal; however,
since the goal is supported by detailed action plans, discussions of failure to
achieve the goal revolve around reasons that action plans fail. The whole process
of developing goals and plans for attaining them was unheard of before this, so
the process itself is increasing the distributors’ managerial expertise.

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In Brown’s opinion, the most important and immediate insight that emerged as the
distributors returned to their organizations and began investigating opportunities for cost
reduction with the help of the CBD team was a human resource issue.
When we really got into the books of these companies it became clear that all of
the decision making continued to reside with one person—the owner. These
distributors had grown from 2-3 to 250 employees in three years with sales of
about $10 million (US) a year and the owner still approved every expenditure
from paperclips to new equipment.
When we discovered this we launched a new CBD initiative, what we call the
‘human resource model’. Today we recommend that distributors have
departmental managers who are responsible for managing certain costs and
who have authority to make certain types of spending decisions. Upon involving
these managers in developing cost reduction plans we found that, where we
thought we’d exhausted the list of improvements, we’d barely scratched the
surface.
The natural question that follows out of this reorganization is how do you
evaluate and compensate these managers. We’re beginning to work on this
aspect of the human resource model in CBD.
Consistent with the new focus on costs and human resource management, in March 1995
P&G added cost reports and measures of organizational effectiveness to the list of monthly
performance measures provided by distributors. Typical performance measures reported by
regional distributors included: shipments; van productivity; market share; monthly costs;
customer service measures; and, employee turnover.

Future Plans and Outstanding Issues

By the end of 1994, total sales of P&G Poland had grown at 35 percent per year for three
consecutive years and, despite initial reservations about entering the market, P&G Poland
was a success by any benchmark measure. In his first year on the job, Brown reduced P&G
sales and administrative costs by over one-third. For the coming year, he faced two main
issues:
First, with the introduction of the human resource model in the distributors and the use of
the Distributor Scorecard to assess the performance of distributors, it was only natural for
P&G to take up the issue of rewarding outstanding performance by distributors. However,
this strategy ran the risk of undermining the cooperative relationship among the distributors
that had emerged in the March symposium.
Second, as van selling saturation tests continued and new initiatives examined ways to
increase VSR productivity, the question of how deep in the trade pyramid to go with van
sales remained. The cost model provided information that would allow Brown to equalize
the footing of van sales and subwholesalers through trade terms; however, the question of
the extent to which subwholesalers were a viable long term distribution channel remained.

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Exhibit 1
P&G Poland, National Sales Group
Organization Chart

National Sales Manager

Sales Manager Secretary

(Line Grocery Sales)

..... District
Managers*
..... CBD
Manager
SMO
Manager
Pharmacy
Manager
National
Accounts
Manager

Van Sales Manager Category

District Sales Reps
Specialists
Assistant
Fleet Specialist
. .
Multi-Functional . .
Unit Support Teams
Managers (Finance & Acctg,
POS
Human Resources,
Specialist
MSD, PSO)
SMO
Assistant
Retail and
Key Account
Representatives

*The same organizational structure is under each district manager.

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Exhibit 2*
Distribution price and revenue structure for detergent products in the Polish market
(For Every Dollar of Product Cost of the Base Product, Ariel)
ACV** Price/Mark-up Price/Margin

Retail 1.04 Consumer 1.17

25,000 VSR Direct Sales Stores
50% 4% 11%

Ariel P&G Dedicated Distrib. 1.00 Sub-whol 1.02 Retail 1.06 Consumer 1.19
600g 87% ACV (x 1.02) 35% 4% 11%

RAH Direct 1.02 Retail 1.06 Consumer 1.19

Sales (x 1.02) 15% 4% 11%
P&G Weighted Average Consumer Price= 1.18

10% = 2,000 Direct Retail Stores Retail 1.06 Consumer 1.19

20% Balance = Cash & Carry 30% 5% 11%
Product A
Preferred Wholesaler 1.01
600g Sub-whol 1.05 Retail 1.09 Consumer 1.23
90% ACV
(x 1.04) 70% 4% 11%

Competitor A Weighted Average Consumer Price= 1.22

10% = 2,000 Direct Retail Stores Retail 1.04 Consumer 1.17

20% Balance = Cash & Carry 30% 5% 11%
Product B
Preferred Wholesaler 0.99
600g
90% ACV
Sub-whol 1.03 Retail 1.07 Consumer 1.21
(x 1.04) 70% 4% 11%

1.19
Competitor B Weighted Average Consumer Price=

*All data in the case are fictitious.

** ACV (All Commodity Volume): The percentage of consumer sales for a product or group of products in a store or distribution channel.

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Exhibit 3
Cost Template for Distributor “O”
October 1994–January 1995
(All Figures Expressed As A Percentage of the Targeted Cost Plus Margin)
Target Oct-94 Nov-94 Dec-94 Jan-95
% % % % %
Distributor Cost and Margin 100% 119% 107.2% 125.8% 125.6%
Operating Costs:
General Office
#1 Materials & Energy 0.06% 0.11% 0.15% 0.20% 0.15%
#2 Contractors & Services 0.06% 0.10% 0.37% 0.14% 0.24%
#3 Payroll 0.38% 0.48% 0.46% 0.50% 0.47%
#4 Facilities Overhead 0.14% 0.14% 0.19% 0.20% 0.21%
#5 Travel 0.04% 0.06% 0.04% 0.06% 0.02%
#6 Entertainment 0.04% 0.06% 0.05% 0.05% 0.01%
#7 Advertisements 0.01% 0.05% 0.05% 0.05% 0.02%
Total G.O. 0.73% 1.00% 1.30% 1.21% 1.11%

PSO Administration
#8 Supplies & Materials 0.03% 0.03% 0.05% 0.04% 0.05%
#9 Telecommunication 0.05% 0.13% 0.11% 0.09% 0.09%
#10 Payroll 0.24% 0.33% 0.31% 0.27% 0.22%
Total PSO Admin. 0.32% 0.50% 0.46% 0.40% 0.37%

Warehousing
#11 Supplies & Materials 0.03% 0.28% 0.08% 0.05% 0.09%
#12 Contractors & Services 0.02% 0.04% 0.10% 0.06% 0.00%
#13 Payroll 0.24% 0.33% 0.29% 0.33% 0.31%
Total Warehousing 0.29% 0.65% 0.46% 0.44% 0.40%

Transportation
#14 Supplies & Materials 0.06% 0.06% 0.10% 0.14% 0.05%
#15 Telecommunication 0.03% 0.03% 0.08% 0.04% 0.02%
#16 Payroll 0.16% 0.18% 0.19% 0.13% 0.21%
Total Transportation 0.25% 0.28% 0.36% 0.31% 0.28%

Van Selling
#17 Supplies & Materials 0.17% 0.35% 0.31% 0.25% 0.12%
#18 Contractors & Services 0.08% 0.18% 0.23% 0.13% 0.22%
#19 Payroll 1.58% 1.52% 1.31% 1.28% 1.31%
Total Van Selling 1.83% 2.05% 1.85% 1.66% 1.65%

Total Operating Costs 3.24% 4.48% 4.44% 4.03% 3.82%

Other Costs
#20 Depreciation 0.19% 0.08% 0.14% 0.28% 0.28%
#21 M&E Leasing 0.04% 0.06% 0.05% 0.07% 0.06%
#22 Interest on Loan 0.00% 0.00% 0.00% 0.00% 0.00%

Total Costs 3.48% 4.61% 4.98% 4.38% 4.15%

Net Margin 1.53% 1.33% 0.78% 1.91% 2.13%

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Exhibit 4
Channel Profitability for Distributor “O”
Sales and Cost Breakdown as a Percent of Total Delivered Cost

Channel RAH Retail Van Selling Wholesale Total

Share of Volume 9% 36% 55% 100%

Net Outside Sales 9.1% 36.6% 55.9% 101.6%

Interests on Credit to Trade 0.1% 0.0% 0.4% 0.5%
Total Income from Sales 9.2% 36.6% 56.3% 102.1%

Product Cost P&G List Price 8.6% 35.0% 54.0% 97.6%

Cash Discount 0.1% 1.0% 0.7% 1.8%

Net Cost After Discount 8.5% 34.0% 53.3% 95.8%

Gross Profit Margin 0.7% 2.6% 3.0% 6.3%

Operating Costs G.O. 0.09% 0.41% 0.63% 1.13%

PSO 0.02% 0.14% 0.21% 0.37%
Warehousing 0.03% 0.15% 0.23% 0.41%
Transportation 0.03% 0.00% 0.25% 0.28%
Van Selling 0.00% 1.68% 0.00% 1.68%

Other Costs Depreciation 0.02% 0.10% 0.15% 0.27%

M&E Leasing 0.01% 0.02% 0.03% 0.06%
Total Costs 0.20% 2.50% 1.50% 4.20%

Percent of Total Delivered Costs 8.7% 36.5% 54.8% 100.0%

Profit Margin 0.5% 0.1% 1.5% 2.1%

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Exhibit 5
Cost Templates for 13 Regional Distributors
Distributor "A" "H" "K" "L" "C" "G" "I" "E" "F" "D" "N" "B" "O" Total
Sales Rank 1 2 3 4 5 6 7 8 9 10 11 12 13 NA
Costs (as a % of Total Cost)
General Office 26.11% 31.82% 24.90% 39.16% 31.25% 32.23% 24.85% 43.84% 15.17% 30.56% 26.31% 44.44% 26.86% 29.91%
PSO 10.06% 9.09% 8.65% 9.21% 17.02% 8.70% 10.38% 12.76% 5.91% 9.81% 5.47% 8.73% 8.88% 9.25%
Warehouse 6.71% 9.85% 6.41% 7.72% 12.24% 10.85% 8.11% 11.71% 15.10% 9.46% 7.61% 8.73% 9.72% 9.94%
Transportation 9.22% 9.09% 4.32% 6.44% 4.99% 9.03% 15.08% 6.87% 8.27% 10.68% 5.28% 5.16% 6.78% 7.39%
Van-Selling 21.08% 14.39% 24.10% 15.92% 17.07% 21.38% 17.05% 21.48% 14.11% 31.77% 13.99% 20.63% 39.66% 21.38%
Operating Costs 73.17% 74.24% 68.37% 78.46% 82.56% 82.19% 75.45% 96.65% 58.55% 92.27% 58.66% 87.70% 91.90% 77.88%
Other Costs 26.83% 25.76% 31.63% 21.54% 17.44% 17.81% 24.55% 3.35% 41.45% 7.73% 41.34% 12.30% 8.10% 22.12%
Total Costs 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% 100.00%
Total Cost (as a % of "D") 193% 225% 171% 187% 239% 150% 161% 136% 253% 100% 176% 142% 127% 165%
Note: The largest distributor is 8 times the smallest in terms of sales.

300.0%

250.0%

200.0%

Oper ating Cos ts

150.0%
Total Cos ts

100.0%

50.0%

0.0%
"D" "N" "O" "K" "I" "G" "B" "E" "A" "L" "F" "H" "C"

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Exhibit 6
Summary of Cost Reduction Action Plans

To: Bill Brown, National Sales Manager Warszawa May 31, 1995
From: Tony Romeo, CBD Manager
Subject: Distributor Cost Model (CM) Action Plans

I. Program Description
With the completion of Cost Model implementation, the CBD Multi-Functional Team has worked with regional
distributors to develop action plans for achieving the cost structure goal. In the next six months, we will deploy these
plans at all distributors.
II. Action Plans from February Distributor Symposium
1. Develop Cost Template w/codes to track all detailed operating cost elements. The current profit and loss account is
relatively simple and easy to get total revenues and expenses but too many expenses are hidden. The cost template
will group items by department in a much more detailed form (e.g. warehouse wages, transportation fuel, PSO
materials etc.). This will help distributors and P&G analyze and cut costs due to a greater understanding and
accountability. The template draws distributor’s current data base and forecasts potential distributor costs from
historical performance of customers with similar characteristics (medium and large).
2. Redesign the Organizational Chart w/functional responsibilities and salaries to maximize employee contribution.
The current distributor organizational charts do not fit the cost model. Distributor employees are doing double work,
job roles are overlapping, and many functions are not developed. In addition, the salary structures do not maximize
employee effectiveness. Magda Kalinowska will develop the optimal organization, salary, and reward structure to
motivate employees in all departments.
3. Institutionalize the Information Flow Chart. This is a tool which establishes the most efficient document and product
flow in the distributors. The information is full of overlap and lost data. The proposed information and product flow
chart will protect data from being lost and make the process more efficient.
4. Maximize warehouse productivity. We will establish a sequential picking system and picker travel controls. The
order picking represents the highest cost element in a distributor warehouse. Traveling accounts for 60% of a typical
pickers time. Labour accounts for 60% of total operating costs in average warehouse. We will assign popular products
to positions nearest the order collation area, issue picking instructions in location sequence, implement a one-way
system, provide pickers with target times and incentives for faster time and accuracy. This will save 36% of total
warehousing costs per distributor.
5. Maximize Transportation Efficiency. Drivers are not maximizing available space on vehicles. We will work with
distributors to develop an incentive program rewarding drivers to maximize use of this space. Transportation accounts
for 0.36% of total costs. This project can save 0.15% of total costs.
6. Effective inventory and product mix to maximize inventory turns and minimize out-of-stocks. Develop inventory
management software to forecast product needs and automatically generate new orders. The forecast will be based on
historical sales, current inventory, and projected sales. Excessive inventory has a negative effect on the system and
adds costs which are passed through the supply chain to the consumer. The program will smooth the negative effect
on the system by matching product flow to distributors’ sales levels.
7. Sell-off non-P&G products. Before the distributor program was introduced, non-P&G products accounted for 60%
of sales and 70% of the inventory in an average distributor. Currently, non-P&G products account for less than 10%
of sales but 30% of inventory. By selling-off these products, distributors will release warehouse space, reduce
operating costs, and concentrate efforts on higher turns and a more productive SKU line-up.

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8. Maximize Efficiencies of Distributor Systems. The customer’s distribution system from point of shipment (P&G)
to retail outlet account for most operating costs (80% or 3.6% of total costs). We will reduce warehouse and
transportation “legs” by proactively moving to more direct deliveries and Distribution Center-Sub wholesaler
deliveries. This should result in 0.9% total cost savings.
9. Reduce office expenses. Office materials are being purchased from many suppliers (up to 600). We will establish a
Control Buying Function to choose the best suppliers and negotiate better terms. We will track office expenses in
more detail and assign a control person to manage the budget. Also, we will announce Central Measurement
Accountability to control phone bills. We will also check the necessity of current equipment usage (cellular phones)
and extend a network for better utilisation of hardware (printers, terminals, servers). Distributors’ employees will be
charged for any private use of phones, copy machines, and computers.
10. Develop/Implement Continuous Replenishment Program (CRP). Purchasing P&G products takes a lot of
administrative efforts and often is inaccurate. CRP will provide effective, efficient, and paperless information and
business transaction system. P&G will analyze customer inventory on a daily basis to determine product needs and
generate new replenishment order for the customer.
11. Central Purchasing is the procedure intended to eliminate shortages of the materials and rationalize purchases.
Any purchasing requirements authorized by department heads will be submitted to Central Buying Person, which will
choose the best suppliers.
III. Measurements
Monthly Cost Template Reports
Monthly letter from MFT

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Week 2 Capacity Costing

Learning Objectives

After working on this week’s material, you should be able to answer the following questions:
1) Why should overhead costs be allocated? External reporting rules mandate that overhead
be allocated to products/services but that does not mean it has to be done for internal
decision making purposes.
2) How do overhead allocations affect managerial decisions? What can go wrong if managers
do not understand how and why overhead costs are allocated?
3) How can an overhead analysis help predict the impact of a major strategic action on future
earnings?
4) All of the above should help with the preparation for next week’s case.

Work Load

1) Watch introductory videos described on the next page.

2) Watch main videos on new topics. Double-check that you understand and can easily
replicate all calculations from the main videos (likely to be part of Test 2).
3) Read a summary of the main theoretical concepts “Foundation Modules” (after the next
page). Go back to the main videos if you do not understand some of the concepts.
4) Take Test 2.

Deadline

Sunday, March 21, 11:45 pm. Deliverable: Test 2.

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Week 2 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W2 Introduction (12 min): A quick review of the main ideas covered last week and a brief
introduction into the topics of this week.
The following few basic exercises introduce the main topics of this week. If they do not seem
familiar, watch the main videos (in particular W2-1 and W2-2 below) and come back to give
them another try:
Cost classification – fixed vs. variable (9 min): A quick illustration of what we mean by
variable versus fixed costs and product versus period costs.
Dropping a product line (5 min): A basic example illustrating what happens to profitability
when a company decides to drop one of its products.

Main videos

The following videos go beyond the basics of cost behavior and cost allocations. The focus is
not so much on how to allocate costs but why it is useful and how it affects decision making.
They should be helpful when working on next week’s case.
W2-1 Should we allocate overhead costs? (32 min)
W2-2 Overhead analysis and future earnings (31 min)
W2-3 Overhead rates at capacity (28 min)

Additional exercises

If you need more practice, watch the following additional exercises:

Pricing a special order (6 min): This exercise looks at how much discount a company can
offer to a customer who makes a large order.
Make-or-buy decisions (5 min): Another company wonders whether they should outsource
one of their processes.
Dropping a product line (9 min): The company here considers dropping one of its products
and wonders about the impact on profitability. This is a more comprehensive version of the
above exercise.

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WEEK 2 Capacity Costing Foundation Modules

Theoretical Foundations
The following modules go over the ideas from the main videos (listed on the previous page)
once more and should be helpful as review material in preparing for Test 2. My
recommendation is to watch the videos first and then read through the modules.

Module 1: Why should we allocate overhead costs?

Having taken a financial accounting class, the answer may seem obvious to you. GAAP rules
generally require that manufacturing overhead be allocated to products. The accounting
definition of product costs is:
Product costs = Direct labor + direct material + allocated overhead.
If auditors, investors, and other external stakeholders demand overhead be allocated, then
we should do it, right? No, absolutely wrong! Remember, our goal is to produce relevant
information for internal decision making. Investors and outside stakeholders will not get to
see our internal reports. We should only allocate overhead costs if it leads to better decisions.
Overhead allocations can make cost information more relevant and improve decisions only
if they capture something real and economically important or, in other words, only if they
represent the opportunity costs.
What on earth are opportunity costs? Consider the economic definition of product costs:
Product costs = financial value of all resources used in production, where the value of each
resource is measured by its opportunity cost, which is the value of a resource when
employed for its next best alternative use.
Nice, that is a very helpful definition, but what does it really mean?
Example: One way to illustrate the difference between accounting costs and opportunity
costs is to consider direct labor. In good old times, when production workers queued up in
front of the factory at 5 am every morning and the foreman let in only those needed for the
day (and everybody else earned nothing), the opportunity costs of labor was simply what
the employer paid at the end of the day. If Product X used $10 in labor, it had to be charged
that much for it because workers could always be reassigned to Product Y or not even invited
to come in the morning and $10 would be saved.
In contrast, nowadays strict labor laws in some countries make it impossible to lay off
employees and companies can easily end up with more labor capacity than needed. The
opportunity costs of asking an idle worker to work on Product X is zero because the worker
has nothing else to do. Idle workers get paid the same wages regardless whether they work
on Product X or not, so it does not cost anything to make them less idle.

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In both the above scenarios, financial accountants take direct labor costs and spread them
over products regardless whether some workers are idle or not. If there is $10 in hourly
wages, some product gets charged for them. The definition of opportunity costs stresses that
products should get charged only if labor has some alternative use. If workers cannot be laid
off and their wages are guaranteed even if there is no work on them, they are no longer a
scarce resource that is costly to use. The opportunity costs of using otherwise idle workers
is zero because they are a free resource with no alternative use.
In most examples and cases in this class, we are going to assume that available labor hours
are relatively easy to adjust to capacity needs. Labor capacity can be reduced not just by lay-
offs but also by eliminating a production shift, cutting overtime hours, retraining or
reassigning idle workers, relying on contractors or temporary employees whose contracts
can easily be cancelled, etc. This assumption implies that opportunity costs of labor is no
different that opportunity costs of material or any other resources that we pay for only when
we need it.
The difference between financial accounting costs and opportunity costs (which I sometimes
call real economic costs or management accounting costs) is twofold. Some costs are
reported as financial accounting costs but are not part of opportunity costs. They are called
sunk cost. There are also opportunity costs do that do not get reported as financial accounting
costs. The terminology varies here; they are often called foregone profits but sometimes
simply opportunity costs.
Sunk costs = financial obligations resulting from acquisition of a resource that cannot be
cancelled, transferred, or otherwise discontinued in the near future.
Foregone profits = economic benefits given up by committing a resource to a specific use.
These benefits are difficult to precisely quantify in financial terms and therefore are not
tracked for external reporting purposes.
Example: The above example of idle workers who cannot be laid off because of strict labor
describes sunk costs. Worker wages are committed, there is no way to avoid paying them in
the foreseeable future, which also means labor costs are irrelevant for any economic
decision. It does not matter how much workers get paid because no action can be taken to
reduce these costs.
As an example of foregone profits, recall the cost of alienating subwholesalers in the Procter
& Gamble case. Clearly, these costs are real and can hurt P&G business. However, it is difficult
to estimate the magnitude of these costs because there is no invoice, no objective data on
these costs. No financial accounting administration would ever track this type of costs or
benefits. However, if Bill Brown decides to reduce the number of vans in Poland, there is a
foregone or hidden benefit of improving relations with subwholesalers and lowering the
likelihood that they start carrying more of competitors’ products.
So, it should be clear now that assigning costs to products or services is not as simple as your
financial accounting professors wanted you to believe (what do they know, right?). The
problem is that costs cannot always easily be traced to products responsible for them. Direct
labor and material costs are normally easy to trace to products, although as you saw with the
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example of idle workers even direct labor costs can sometimes be tricky. It becomes even
more difficult with overhead resources such as production equipment, facilities,
warehouses, delivery trucks, computers, etc. Let’s call them capacity resources. They have to
be purchased in advance (even if they are leased and paid for in monthly installments, the
resulting long-term commitment to pay makes it economically little different from an
advance purchase) and their costs do not depend on production volume up to some point.
What makes capacity resources special is that it takes a long time to adjust them to
production needs. Exactly how long it takes depends on the resource type but it is important
to make a distinction between short-term and long-term costs:
Short-term costs = opportunity costs of a capacity resource during a time period that
capacity is fixed and cannot be adjusted to production needs.
Long-term costs = opportunity costs of a capacity resource after there has been enough time
to adjust capacity to production needs.
Example: Suppose we buy a machine for $50,000 that produces up to 10,000 units of
Products X, Y or Z in one year and over its whole lifetime up to 100,000 machine hours. The
machine cannot be returned, so we can produce any number of units between 0 and 10,000
and the cost of the machine stay the same in that year. Producing more than 10,000 units is
possible only after purchasing and installing another machine. Suppose it takes one year to
order the new machine, hire more workers, train them in, rearrange the production floor,
install the machine, etc.
Short-term costs of using one machine hour are measured as the profit we can make with
one machine hour while our capacity is up to 10,000 units and cannot be increased. If the
machine is often idle, we simply cannot make any additional profit from one machine hour,
so the short-term costs are zero. In contrast, if the machine is fully used and we produce as
many Products Y and Z as we possibly can, then the short-term costs of one machine hour to
make Product X can be very large. By committing the machine to Product X we are giving up
profits we would have made from Products Y or Z. It does not matter how much we paid for
the machine, the short-term costs depend on the profits we give up.
Long-term costs of using one machine hour are very different. After one year, we can adjust
capacity to production needs. We will buy and install as many machines as needed and pay
$50,000 for every 100,000 machine hours needed. So, long-term costs of one machine hour
are $50,000 / 100,000 = $0.50.
What if we need to enlarge our plant and it takes three years before it starts producing? Then
any decision with a horizon less than three years needs to be based on short-term costs and
long-term costs should only be used for decisions with a horizon of three years or more.
So, finally, we can answer the question we started with. Why should we allocate overhead
costs and in particular the costs of fixed overhead resources? Because we try to estimate the
opportunity costs of production and we want product costs (after allocation) to have some
real economic meaning. The meaning of product costs can be one of two things:
Short-term product costs = what is the minimum we need to charge for our product to make
exactly zero profit now (e.g., this week, this month, this year) that our capacity is fixed and
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cannot be changed. In other words, if we need to reduce price, how low can we go without
incurring an economic loss. Importantly, there is no need to allocate any fixed overhead in
this case! Short-term costs of using a capacity resource do not depend on how much we paid
for the resource in the past. The short-term costs of a fixed resource will either be zero (if
there is unused capacity) or some possibly large number (foregone profits if capacity is fully
used) but they have nothing to do with how much it cost to acquire the resource. Fixed costs
should NEVER be allocated for the purpose of making short-term decisions!
Long-term product costs = what is the minimum we need to charge for our product to stay in
business forever. In the long term, all capacity resources will have to be replaced. If we do not
accumulate enough profits to pay for new machines, trucks, or for refurbishing of the old
production plant, there is no economic reason to stay in business. We should allocate fixed
overhead to products because the allocation approximates future costs of capacity resources.
Therefore, in situations when past costs do not approximate well the future costs of capacity
resources, overhead allocations should be adjusted to better represent future costs.
In summary, we should always charge products for all their variable costs (direct labor,
material, and variable overhead). For short-term decisions, that is all we should charge, any
allocation of fixed overhead destroys the meaning of short-term product cost. For long-term
decisions, we should charge products their variable costs plus an allocation of fixed overhead
costs so that we have the right benchmark for deciding whether to stay in business. If the
market price permanently drops below our long-term product cost, we should stop replacing
capacity resources and get ready to exit the business.

Module 2: Overhead analysis

Real life is more complicated than the theory in Module 1. Overhead costs are rarely perfectly
variable or perfectly fixed. Moreover, we are typically interested in understanding the impact
of a decision on our future costs and profits. Any decision can create a potential for overhead
savings even for fixed costs. It is therefore useful to make a distinction between three types
of overhead costs:
Variable overhead costs = all indirect costs (resources used by multiple products that
cannot be traced to any individual product) that vary proportionately with production
volume. In other words, producing more automatically drives variable overhead up and
producing less automatically drives it down.
Fixed avoidable overhead costs = indirect costs that do not vary with production volume.
Producing less does not automatically drive these costs down but it does create a potential
for savings if managers take the right actions to eliminate slack.
Fixed non-avoidable overhead costs = indirect costs that stay the same regardless of
production volume and managerial actions. These costs cannot be reduced as long as a
company stays in business.
Example: What type of overhead are electricity costs? It could be any of the three types,
really. Suppose, there is a production facility with machines that consume a lot of energy.

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Electricity is variable overhead then—producing more means more machine hours, which
means a higher electricity bill.
Alternatively, suppose there is some other labor-intensive production facility with little or
no equipment. Electricity is used mainly for heating and cooling of the facility, which makes
it fixed non-avoidable cost. No matter what we do in that labor-intensive facility, the
electricity bill will be largely the same.
Finally, suppose there are two production facilities that are very labor intensive and have
little or no equipment. Electricity is still largely a fixed cost but reducing production volume
can create a potential for savings. At some point, it will be possible to close down one of the
facilities and operate only one. Closing down one of the facilities, reduces the electricity bill,
so it is avoidable overhead. However, management has to realize first that one of the facilities
is no longer needed and close it. The savings in electricity do not happen automatically as
production volume goes down (it is not variable overhead) but only after a cost-cutting
action is taken.
Why is this classification useful? Separating overhead into the above three categories makes
it easier to predict how downsizing (outsourcing or dropping products) affects future profits.
Remember overhead allocations approximate long-term costs but they do not say anything
about what happens next year if a product gets dropped. To predict next-year’s costs and
profits, we need to ignore allocations of fixed costs. We know that dropping a product
reduces all its variable costs (labor, material, variable overhead) proportionately with
volume, but it has no effect on fixed non-avoidable overhead. The only thing left to estimate
is potential savings in fixed avoidable overhead. These estimates may be imprecise but it is
possible to make some educated guesses. Fixed costs will go down less than production
volume (only variable overhead costs go down by about the same percentage) but there will
be at least some savings. The first round of downsizing may find a lot of avoidable overhead
but it will be increasingly difficult in the next rounds of downsizing after the low-hanging
fruit has been picked. At some point there is also no potential for further savings for example
because there are only so many facilities that can be closed down.

Module 3: Overhead rates at capacity

Putting the ideas of Modules 1 and 2 together, you must surely be asking now: Why would
we ever allocate fixed non-avoidable overhead? The salary of a few key managers, some
administrative support, depreciation of the main facility, fixed renewable license and
business permit fees, etc. We need to pay for these no matter what we do, so why should we
allocate them to products?
Excellent question, you are really getting the hang of it. The simple answer is the same as
before—we allocate all overhead to estimate long-term product costs, i.e., the minimum we
need to charge to stay in business forever. If we do not accumulate even profit margin to pay
salaries of our top managers, we will be out of business very quickly.
The little more refined answer is that it often makes little difference whether fixed non-
avoidable overhead is allocated or not. If we do not allocate them, our decision making will
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not be adversely affected. The only thing that happens is that the meaning of product cost
changes slightly. Specifically, our definition of long-term product costs is a bit simplified
because no business will operate forever if shareholders keep earning zero profits year after
year. To stay in business forever, we need to cover our long-term costs plus generate some
healthy profits. Non-avoidable fixed overhead costs are very similar to profit shareholders
demand to keep their capital tied up in the business forever. It is perfectly fine not to allocate
these costs as long as it is very clear that long-term product costs have be accompanied by a
markup (to pay for non-avoidable overhead and shareholder profits) that keeps the business
operating forever.
OK, I get it, it makes no difference whether fixed non-avoidable overhead is allocated or not,
right? Not so fast. There is one tremendously important exception for which it makes a big
difference—the cost of unused capacity. As explained below, unused capacity is perhaps
the most common type of non-avoidable overhead and it should never be allocated to
products!
Example: Suppose we pay $80,000 for a machine that can produce 10,000 units annually for
four years. Direct labor and material costs are $3 per unit. Straight-line depreciation is
$20,000 per year.
The first two years after opening business everything goes as planned. We sell all 10,000
units we can produce. We have $20,000 in depreciation (fixed overhead) to be allocated over
10,000 units a year, so that the overhead rate is 20,000 / 10,000 = $2 per unit. The long-term
products costs are $3 (direct variable costs) + $2 (fixed overhead) = $5 per unit.
In the third year, a global recession hits and consumers suddenly spend less on our products.
We can only sell 5,000 units that year, even after offering generous discounts to all ASU
students. How does it affect our product costs? Financial accountants would calculate them
as follows: the same $20,000 in depreciation is allocated over 5,000 units a year, so that the
overhead rate is 20,000 / 5,000 = $4 per unit and product costs are $3 +$4 =$7 per unit. They
want us to believe that our product costs went up from $5 to $7 during the recession.
But we know better than financial accountants! We produce the same product with the same
machine, in the same facility, employing the same people. Nothing in the real economics of
production has changed so why should product costs be different? They should not, of
course. The only meaningful benchmark here, long-term product costs, are unaffected by the
recession. Long-term product costs are forward-looking and independent of any temporary
downturn that is not going to persist in the future. If in a normal business environment the
sales volume is 10,000 units a year, then the overhead rate should stay constant at 20,000 /
10,000 = $2 per unit even during the recession year.
What is really troubling to financial accountants is that we do not end up allocating all of the
$20,000 in depreciation. Using the same overhead rate of $2 as before, only one half of the
deprecation is allocated: $2 times 5,000 units sold during the recession which is $10,000 or
50% of annual depreciation. But that is the whole point of keeping the overhead rate
constant! We want to charge products for the machine capacity they use and then separately
report the costs of unused capacity: $20,000 – $2 · 5,000 = $10,000.

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WEEK 2 Capacity Costing Foundation Modules

In summary, during a recession 50% of the machine capacity is unused, so 50% of annual
depreciation becomes the cost of unused capacity. This is fixed non-avoidable overhead that
year because reducing production even further would not reduce this non-avoidable
overhead. In fact, it would lead to an increase in the cost of unused capacity. Allocating this
non-avoidable overhead could bias our decisions. We would essentially end up charging our
products for depreciation twice—a $2 charge for machine hours used in production (which
is OK), and then another $2 charge for unused capacity (which is absolutely NOT OK). Seeing
an increase in product costs, we would probably be tempted to increase prices, which would
be the wrong move during a recession.
This gets us to the last but perhaps most important idea of this week. The only way to avoid
allocating the cost of unused capacity to products is to calculate overhead rates at capacity.
The following definitions contrast these rates with overhead rates based on actual volume
of production as used by financial accountants (actual rates).
Actual overhead rate = Overhead costs this year / Allocation base (actual volume this year)
Overhead rate at capacity = Overhead costs this year / Allocation base at full capacity,
where full capacity means the highest practically achievable volume of production. In
particular, it means the highest volume achieved in the last few years; not the actual and
possibly depressed production volume this year, not the physical maximum, and not the
long-run average volume.
Example: Suppose overhead costs of $90,000 annually are all fixed costs to be allocated
based on direct labor costs. Production volumes and corresponding direct labor costs in the
last five years are as follows:
2012 2013 2014 2015 2016
Units produced 500 600 900 500 600
Direct labor $20,000 $24,000 $36,000 $20,000 $24,000
Actual overhead rates fluctuate significantly from year to year: 450%, 375%, 250%, 450%,
375% in 2012–2016, respectively. For example, the actual rate in 2016 can be calculated as
90,000 / 24,000 = 375%.
The overhead rate at capacity in 90,000 / 36,000 = 250%. That is true not just in 2016 but in
all years because our production facility has enough capacity to produce 900 units in 2016.
We know that for sure because we produced this many in 2014. If we do not produce this
many in 2016, it must be there is not enough demand and consequently there is unused
capacity. How much does it cost to have unused capacity in 2016? The full capacity based on
recent history is 900 and we only produced two thirds of that 600 / 900 = 2 / 3 = 67%. The
remaining one third is unused capacity so the cost of unused capacity are 33% · 90,000 =
$30,000.
The economically most sensible way to measure products costs in this example is to use the
constant overhead rate at capacity of 250% and not allocate all of the $90,000 to products.
Consequently product costs stay the same every year and the fluctuation affects costs of
unused capacity: $40,000, $30,000, 0, $40,000, $30,000 in years 2012–2016, respectively.
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WEEK 2 Capacity Costing Foundation Modules

In summary, the cost of unused capacity is sunk and should not be allocated to products. The
best way to eliminate this type of sunk costs from product costs is to always calculate
overhead rates at capacity (not actual rates as used in financial accounting). Rates at capacity
separate out the part of fixed overhead costs due to unused capacity. Rates at capacity also
keep product cost relatively constant over time and prevent them from going up or down
only because capacity usage changes.

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WEEK 3 Capacity Costing Learning Objectives

Week 3 Capacity Costing Case

Learning Objectives

1) This week’s case illustrates that cost accounting is just a tool; the ultimate purpose is to
make decisions that improve organizational performance. Learn to think like a consultant.
After working on this week’s case, you should be able to do the following:
2) Interpret product profitability reports and understand how they can get biased due to
overhead allocations.
3) Use the principles covered last week to estimate the impact of strategic decisions such as
discontinuing a product line on next-year’s profitability.
4) Consider the long-term impact of a strategic decision and identify additional costs and
benefits that go beyond estimates of the impact on short-term profitability.

Work Load

1) Watch the introductory recording.

2) Work on the Remaking of Delhi Components case
a. quickly read the case to get the big picture,
b. carefully read all the case questions (see the page just before the case),
c. go back to the case and spend as much time on it as you need to answer the case
questions,
d. upload a memo answering case questions 1.–7. to Blackboard
(see the Syllabus for additional information on case memos).
3) Take Quiz B.
4) Watch online videos with case solutions (available only after completing Quiz B).
5) Read the case summary posted online.
6) Re-read the case questions and make sure you can easily answer all of them now. Go back
to the online videos and/or the case summary if you need to. Double-check that you
understand and can easily replicate calculations from all online videos (likely to be part of
Test 3).
7) Take Test 3.

Deadline

Sunday, March 28, 11:45 pm. Deliverables: (I) Quiz B, (II) Test 3, (III) case memo.

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WEEK 3 Capacity Costing Learning Objectives

Week 3 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W3 Introduction (9 min): This is a brief introduction into what we are going to cover this
week and how it connects to what you know from prior accounting classes.

Main videos

The following will be available once you study the Delhi case and take Quiz B:
W3-1 Delhi product portfolio (26 min): This recording discusses the business environment
of Delhi and the relative profitability of its four product lines. It shows how to calculate
profitability of each product line and how it is affected by downsizing and eliminating other
product lines. It provides answer to case questions 1.–4. (see next page).
W3-2 Delhi predicting earnings (36 min): The second Delhi recording goes over the analysis
performed by the consultant. It examines the implications of discontinuing a product line on
next year’s earnings as well as some broader strategic implications, which answers the
remaining case questions 5.–7.

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WEEK 3 Capacity Costing Case Questions

Case Questions

Carefully study the case Remaking of Delhi Components and upload a memo with answers
to all of the questions below:
1. Calculate the overhead allocation rate for each of the years 2008–2014. Why has the
rate gone up significantly in 2010?
2. Consider two products in the same product area:
Product 1 Product 2
Sales price (per unit) $62 $78
Direct material cost 16 34
Direct labor cost 14 12
Assuming the above unit price and costs remain unchanged, calculate the net
operating profit margins of these products in 2009 and 2010 using the overhead
allocation method as in the case. Which of the two products is more profitable?
3. Thermal systems were profitable during the recession but ended up with a relatively
large loss in 2010. Why was that?
4. Is net operating income by product area (reported in Exhibit 4) an appropriate
measure of profitability for Susan’s strategic analysis?
5. Estimate the impact of discontinuing any one product line area on net operating
income.
a. Assume 2015 sales and direct material and labor costs remain unchanged from
2014 except for elimination of sales and direct costs related to the product line area
of your choice. Calculate the 2015 contribution margin (i.e., sales – direct costs).
b. Consider each of the overhead cost items and how likely it is to change if a product
line area is discontinued. Prepare a rough estimate of 2015 overhead costs assuming
the product line area of your choice gets discontinued.
c. Use the 2015 contribution margin and the estimate of overhead costs to calculate
net operating income.
6. Except for the impact on net operating income, what are some additional advantages
and disadvantages of discontinuing a product line area?

7. If you were Susan, what would you recommend to Delhi management?

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WEEK 3 Capacity Costing Delhi Case

Remaking of Delhi Components

The official assignment is to evaluate the product portfolio and advise on

strategic actions but I have done this often enough to know that they want cuts.
Products will get eliminated, facilities will get shut, people will lose jobs… That’s
painful but often necessary so they need an objective, independent, tough look at
the data and a sound analysis to support their decision. And this is where we
come in…
Susan Delaney, McWaters Consulting

During her successful career as a consultant Susan Delaney advised companies on

restructuring and strategic repositioning in a variety of industries. Her latest client, Delhi
Components, engaged her team to evaluate their strategic options before finalizing the major
pillars of the FutureNow initiative, which was planned to be publicly released at the next
quarterly earnings release.
Delhi was one of the major North American car parts supplier that evolved into a global
industry leader with cutting-edge technologies and manufacturing presence in 33 countries.
All 25 of the largest car makers in the world were customers and 18 of the 20 top-selling
models world-wide used Delhi parts. But it took a while to get there.

Origins and Recent History

Delhi was originally a division within one of the Big-Three Detroit car manufacturer
producing a wide range of parts such as batteries, brakes, fuel tanks, mufflers, catalytic
converters, doors, steering wheels, suspensions, or ignition components. It was spun off
during the 1990’s into an independent company but for several years continued operating
largely as a captive supplier conducting most of its business with the former parent
company. Thus, unlike virtually all other Tier 1 suppliers, Delhi had a very narrow customer
base and an extremely broad product portfolio.

© 2017 by Michal Matějka. All rights reserved. No part of this publication may be reproduced, electronically stored, or
transmitted in any form by any means without permission. This case has been developed as a basis for class discussion.
Although it has been inspired by real events, data presented here are not meant to accurately describe any specific industry
or organization or represent the views of any real person.

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WEEK 3 Capacity Costing Delhi Case

The main competitive advantage of Delhi was engineering expertise and ability to
continuously innovate and bring new products to the market. It employed a vast network of
scientists, engineers, and technicians who developed advanced products using the latest
technologies, materials, and processes. The main challenge was competing on price in an
industry where margins were constantly under pressure and competitors had an advantage
of lower labor cost and economies of scale resulting from greater specialization.
The reason for the relatively high labor costs went back to Delhi’s origins as a division of a
Detroit car manufacturer. Many of its manufacturing facilities were located in areas with
strong labor union representation. Moreover, generous labor agreements negotiated with
the unions by its former parent fully carried over when Delhi became independent. Although
all parties anticipated a gradual renegotiation of those labor agreements to bring them in
line with the terms prevailing in the automotive parts industry, management wanted to
proceed cautiously and avoid antagonizing the unions and potentially costly and disruptive
labor actions.
A major impetus for change came when Delhi acquired Carco Electronics in 1995 which
brought in expertise in the design and manufacturing of key electrical and electronic car
components. It was a leap forward in the trend to move away from selling “stand-alone parts”
that could easily be substituted with competitors’ products to selling “an architecture of
parts” or systems of seamlessly interconnected components. It also increased the focus on
high-margin, technologically advanced components which allowed Delhi to greatly expand
its customer base. Finally, many of the newly acquired product lines needed a different type
of expertise. Design of microprocessor-based components such as engine management
controllers, collision warning systems, custom integrated circuits, and data communication
systems required mechanical engineers to closely work together with software engineers. In
other words, the acquisition was the beginning of an era during which lines of code would
become a new key competitive weapon.
And then came the global financial crisis of 2008–2009. New car sales in the U.S. dropped
from 17.2 million in 2007 to 9.2 million in 2009. Two of the Big-Three U.S. manufacturers
filed for bankruptcy protection and had to be bailed out by the government. Delhi sales
dropped more than 50% during the crisis and radical restructuring became the only way to
survive. The outcomes were drastic. More than 60,000 employees (about 40% of the
workforce) lost their jobs, close to a half of all manufacturing facilities were closed, and
dozens of products were divested or discontinued.
In the words of Mark Taylor who was Vice President of Global Operations at that time:
We underwent a complete model redo: wall-to-wall, floor-to-ceiling and top-to-
bottom, there was nothing that wasn’t touched. We went from 119 product lines
to 33 based on one rule—all divisions and all regions would carry their own
weight and perform at the same high level, no excuses, no ifs or buts. Everything
we picked was picked for a reason and each of the product lines had to make
money. All the sacred cows… well, we turned them into steaks.”
Labor union were largely cooperative during this restructuring and no major strikes were
called. Delhi was able to renegotiate its labor agreements and most importantly shed some
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WEEK 3 Capacity Costing Delhi Case

its pension obligations which were assumed by the labor unions in exchange for an equity
stake. The specter of liquidation aligned the interests of shareholders, creditors, employees
and their unions, which allowed for a fresh new start.

On Making of the Connected Car

By the time Susan Delaney was brought in as a consultant in 2015, Delhi was a different
company. It supplied all major car manufacturers in the world and its former parent
accounted for only 14% of sales. It specialized in four product line areas: electronics and
safety, powertrain systems, electrical architecture, and thermal systems. It became a global
leader in so called “fully-engineered solutions,” which meant that it assumed many of the
research and development, design, and assembly functions traditionally performed by car
manufacturers.
The transformation was the result of significant investments and continued focus on high-
margin, high-tech products. Despite closing many of its manufacturing plans during the
recession, Delhi kept the number of technical centers designing new products largely
unchanged (see Exhibit 1). The number of engineers employed worldwide dropped during
the worst of the crisis from about 17,000 to 12,000. However, much of this drop resulted
from offering early retirement packages and shifting away from mechanical to software
engineering. Employment of engineers went quickly back up to 17,000 in 2011 and
continued growing because engineering expertise was Delhi’s most valuable asset.
Delhi also made significant investments in advanced manufacturing capabilities. For
example, a completely new facility in Georgia spanned the length of two football fields and
was churning out 2.1 billion electrical connectors annually for companies such as Tesla.
Much of the work was done by unmanned robots called “froggers” scurrying among bins and
rows of machines. In contrast, most of Delhi’s older plants in the Midwest, which produced
mainly powertrain and thermal system components, saw little investment in automation and
remained labor intensive, even though their hourly wages for unionized employees were
relatively high.
The industry mega-trend was to build the “Connected Car.” Consumers were increasingly
willing to pay for greater safety, infotainment, productivity, and convenience in their cars.
Manufacturers wanted to simplify assembly, enhance fuel economy, lower emissions, and
improve performance by reducing car weight and mechanical complexity. All of this required
augmenting traditional mechanical components with products and systems that combined
integrated circuits, sensor technologies, and software algorithms, which in turn increased
demand for a sophisticated electrical architecture as a foundation. As a part of this trend, it
became necessary to enable on-going software support services to continuously upgrade
cars with new features and performance enhancements.
Although recent financial performance was satisfactory, 2015 was going to be another
milestone in remaking of the company. Mark Taylor was appointed as new CEO and
immediately launched a strategic review of the product portfolio. Corporate staff branded it
as the FutureNow project and planned to use it as a platform to publicly communicate with

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WEEK 3 Capacity Costing Delhi Case

investors. The aim was to layout a five-year action plan as well as a vision for the long term.
Mark wanted a detailed blueprint of actions to be taken now to make that vision happen—
investments in new products (in-house R&D as well as acquisitions) and sources of funding
(long-term loans, seasoned equity offerings, and potential divestitures). He explained the
need for such blueprint as follows:
Our engineers have the future all figured out. Cars will be self-driving. Internal-
combustion engines will be replaced by electric ones. They will be powered by
batteries or fuel cells. The amount of data generated and processed by cars will
exceed data generation of any other device known to mankind now… I get all
that. But I also know that engineers are dreamers, as they should be… The point
is not so much what the future holds, it is much more about how to get there. We
cannot invent everything ourselves, we have to make choices and we have to
hedge our bets. That’s where it gets tough. What steps should we take next year
and the year after and so on.
His concerns were echoed by industry experts. It was not at all clear how quickly new
automotive technologies would be adopted. According to Morningstar Inc. auto-parts analyst
Richard Hilgert: “If these technologies aren’t embraced like they think it will, that could be a
huge problem… While auto makers have talked about adding more, adoption rates could be
slower than expected and some products not adopted at all leaving the suppliers to hold the
bag on research and development costs.” Moreover, Delhi was facing a new breed of
competitors: “It is Detroit against Silicon Valley. Who do you think is going to be better at
integration of software, artificial intelligence, and automotive engineering? I am not going to
bet on Detroit.” (Thomas Salanczik, managing director Star Venture Capital).
Mark was confident that Delhi would do well in the future with an increased focus on the
right portfolio of products. He hired Susan Delaney’s team because he valued “her ability to
balance the healthy tension between a vision and financial reality.”

Product Portfolio

The obvious start was to look at the profitability of the four product line areas and get a sense
of the trends (see Exhibits 2–5). Susan quickly gleaned the following big picture:
The first area, electrical architecture components, included product lines such as connectors,
cables, wiring assemblies and harnesses, electrical centers, circuit protection and switching
devices, and hybrid high voltage distribution systems. This area was the largest in terms of
sales and accounted for virtually all profits in recent years.
The second area, powertrain systems, included gasoline and diesel engine architectures with
components for ignition, fuel handling, fuel injection, combustion, transmission, and
emission control. It also included electronic control modules with software, algorithms, and
automatic calibration. This area used to be the main strength of Delhi but went through a
severe downturn during the recession. Although sales recovered quickly, the powertrain
business was loss making in all but one of the recent years.

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WEEK 3 Capacity Costing Delhi Case

The third area, electronics & safety, included body computers, sensors, security systems,
infotainment and driver interface products such as audio/digital/satellite receivers,
navigation systems, displays as well as occupant detection systems, collision warning
systems, advanced cruise control technologies, collision sensing and auto braking. Sales in
this area have not reached pre-recession levels yet but severe losses during the recession
turned into solid profits in recent years.
The fourth area, thermal systems, included components for powertrain thermal
management such as condensers, radiators, fans and heat exchangers as well as cabin
thermal comfort such as HVAC modules and air conditioning compressors. This was not only
the smallest area in terms of sales, it also experienced no growth and losses in several years.
Susan thought that two of the four product line areas were ripe for a significant overhaul to
improve the bottom line. The math seemed relatively simple. Direct material costs could not
be reduced without significantly increasing production volumes. Given little or no organic
growth in these areas, volume increases would require investments in acquisitions or
development of new product lines. The more likely path forward was to reduce labor costs
or raise prices.
Reducing labor costs in many of the unionized plants in the Midwest seemed both necessary
and difficult to implement. Labor unions yielded a lot of ground during the recession because
survival was at stake. This time around, Delhi was making decent profits and it would be
much harder to explain why shareholders were given priority over long-time employees.
Closing plants and moving production to Mexico or oversees could trigger strikes, let alone
the political backlash and reputation damage. However, labor union leaders were more
amenable to discussion if labor cost savings came together with significant new investments
into upgrading and automating their outdated plants. In essence, some lost jobs could be
exchanged for a guarantee of job stability and wage growth for the remaining employees.
Raising prices in a super-competitive and price-sensitive industry also seemed like wishful
thinking. Both powertrain and thermal system manufacturing facilities were still plagued by
overcapacity issues following the painful adjustments during the recession. Higher prices
and the resulting lower sales and production volumes could aggravate these issues. The only
way to increase prices was to make the product lines more unique. Although this resonated
well with Delhi’s strategy of investing in engineering expertise and innovation, the R&D
budget was inevitably constrained and technical centers needed guidance as to which design
and development projects should be prioritized.
Susan knew that she was hired to translate this big picture into an actionable plan. The tasks
for her team were clear now:
We need to prepare a detailed analysis of discontinuing or selling one of the two
under-performing product line areas. We should be very clear about the impact
on the following year’s operating profit. Bad surprises could ruin our reputation.
Let’s start with a thorough at the overhead costs. We really need to figure out
how much we can save by discontinuing a product line area. Let’s run the
numbers and then we can prepare a report on the broader strategic implications
of our recommendations.
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WEEK 3 Capacity Costing Delhi Case

Exhibit 1
Employment and Properties

2014 2013 2012 2011 2010 2009 2008

Employees (total in thousands) 164 161 155 143 110 117 167
Contract & temporary 37 44 37 39 10 12 20
Hourly 101 91 93 80 78 80 114
Engineering 20 19 18 17 12 13 17
Other salaried 6 7 7 7 10 12 16

Manufacturing facilities 129 126 126 114 97 135 175

Sales offices & customer centers 96 94 90 82 74 91 136

Technical centers 15 15 15 15 14 15 16

Exhibit 2
Delhi Components
Statement of Operations (in billions)

2014 2013 2012 2011 2010 2009 2008

Sales 16.69 15.75 16.30 14.03 11.14 17.63 22.03
Electronics & safety 2.83 2.73 2.93 2.72 2.56 3.34 4.04
Powertrain systems 4.42 4.66 4.97 4.09 2.91 3.67 4.66
Electrical architecture 7.97 6.82 6.64 5.62 4.30 4.65 4.97
Thermal systems 1.47 1.54 1.76 1.60 1.37 2.12 2.41
Automotive holdings group 3.85 5.95

Direct costs 7.48 7.24 7.44 6.78 6.12 12.12 16.41

Overhead costs 7.55 7.19 7.11 6.41 5.98 7.43 9.14

Net operating income 1.66 1.32 1.75 0.84 -0.96 -1.92 -3.52

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WEEK 3 Capacity Costing Delhi Case

Exhibit 3
Direct Cost by Product Line Area (in billions)

2014 2013 2012 2011 2010 2009 2008

Direct labor costs 3.95 3.81 3.92 3.53 3.20 6.41 8.35
Electronics & safety 0.71 0.70 0.73 0.73 0.78 1.38 1.77
Powertrain systems 1.14 1.19 1.22 1.08 0.90 1.25 1.61
Electrical architecture 1.66 1.48 1.51 1.27 1.10 1.34 1.54
Thermal systems 0.44 0.44 0.46 0.45 0.42 0.70 0.82
Automotive holdings group 1.74 2.61

Direct materials 3.53 3.43 3.52 3.25 2.92 5.71 8.06

Electronics & safety 0.54 0.53 0.55 0.56 0.68 0.99 1.27
Powertrain systems 1.31 1.38 1.40 1.26 0.94 1.48 2.06
Electrical architecture 1.38 1.22 1.24 1.11 0.99 1.22 1.57
Thermal systems 0.30 0.30 0.33 0.32 0.31 0.47 0.64
Automotive holdings group 1.55 2.52

Exhibit 4
Net Operating Income by Product Line Area (in billions)

2014 2013 2012 2011 2010 2009 2008

Net operating income 1.66 1.32 1.75 0.84 -0.96 -1.92 -3.52
Electronics & safety 0.22 0.18 0.33 0.10 -0.36 -0.63 -0.94
Powertrain systems -0.21 -0.16 0.14 -0.21 -0.61 -0.51 -0.77
Electrical architecture 1.76 1.33 1.15 0.93 0.15 0.54 0.17
Thermal systems -0.11 -0.03 0.14 0.01 -0.14 0.14 0.05
Automotive holdings group -1.46 -2.04

Net operating income = Sales – Direct Costs – Allocated Overhead Costs. Overhead is allocated proportional to direct labor
costs. Total net operating income may not exactly equal the sum of net operating income by line area because of rounding.

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WEEK 3 Capacity Costing Delhi Case

Exhibit 5
Overhead Costs Break-Down (in billions)

2014 2013 2012 2011 2010 2009 2008

Overhead costs 7.55 7.19 7.11 6.41 5.98 7.43 9.14
Indirect labor, tools, supplies 0.78 0.77 0.78 0.70 0.81 0.94 1.28
Warehousing, receiving, shipping 0.52 0.52 0.54 0.50 0.50 0.71 0.96
Utilities 0.33 0.32 0.35 0.31 0.28 0.48 0.60
Manufacturing depreciation 1.40 1.30 1.40 1.30 1.20 1.60 1.80
Maintenance and plant services 0.42 0.39 0.42 0.43 0.47 0.49 0.52
Warranty costs 0.42 0.35 0.28 0.21 0.10 0.32 0.41
Product design & development 1.65 1.60 1.40 1.20 1.10 1.00 1.40
Depreciation & amortization 0.80 0.72 0.75 0.61 0.54 0.45 0.60
Pension, health care obligations 0.58 0.57 0.57 0.56 0.56 0.99 1.05
Selling, general & administration 0.65 0.65 0.62 0.59 0.42 0.45 0.52

Exhibit 6
Overhead Costs Description

Indirect labor, tools, supplies: production supervisors and other salaried plant personnel
directly involved in machine setup, production, and quality control; tools such as drills,
screw drivers, wrenches, handheld power equipment; safety supplies such as goggles,
gloves, masks, vests.

Warehousing, receiving, shipping: including labor, tools, and supplies such as packing
material; third-party freight related costs; gas and maintenance of own trucks, forklifts, and
other warehousing equipment.

Manufacturing depreciation: depreciation of all manufacturing and warehousing related

property, plant, and equipment. Manufacturing assets are depreciated relatively quickly so
that the largest depreciation charges are incurred within the first few years of asset
activation.

Maintenance and plant services: janitors, nonskilled hourly personnel, third-party

maintenance and security contracts, on-site dedicated staff and administration.

(continued on next page)

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WEEK 3 Capacity Costing Delhi Case

Warranty costs: annual provisions for the cost of recalls, repairs and related legal expenses;
includes reimbursements of authorized service shops and consumer claims.

Product design & development: all costs associated with operation of technical centers
(except for depreciation which is included below); a large majority of these costs are salaries
of scientists, engineers, and technicians.

Depreciation & amortization: all other depreciation (except of manufacturing

depreciation), amortization of intangible assets, changes in the valuation of acquisition-
related goodwill.

Pension, health care obligations: benefits of all hourly and salaried employees,
contributions to union-operated pension funds specified in labor union agreements. Pension
obligations increase considerably after ten years of employment. Contract and temporary
workers are typically not eligible for benefits.

Selling, general & administration: sales and marketing expenses (except for depreciation);
executive stock-based compensation; IT support, human resource administration,
accounting & finance, PR & investor relations.

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WEEK 4 Activity-Based Costing Learning Objectives

Week 4 Activity-Based Costing

Learning Objectives

After working on this week’s material, you should be able to answer the following questions:
1) What are the main principles of cost system design?
2) Why should overhead costs be allocated in two stages?
3) What is the cost hierarchy and how can it be used to measure the cost of low-volume
production?
4) What exactly is activity-based costing? How and why does it estimate long-term costs?
5) What exactly is the theory of constraints? How and why does it estimate short-term costs?

Work Load

1) Watch introductory videos described on the next page.

2) Watch main videos on new topics. Double-check that you understand and can easily
replicate all calculations from the main videos (likely to be part of Test 4).
3) Read a summary of the main theoretical concepts “Foundation Modules” (after the next
page). Go back to the main videos if you do not understand some of the concepts.
4) Take Test 4.

Deadline

Sunday, April 4, 11:45 pm. Deliverable: Test 4.

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Week 4 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W4 Introduction (6 min): A quick review of the main ideas covered last week and a brief
introduction into the topics of this week.
Before we work on the main topics of this week, let’s practice a few basic exercises. If they
do not seem easy, watch the main videos (in particular W4-1 and W4-2 below) and come
back to give them another try:
Simple product costing (8 min): A quick illustration of how to allocate overhead in two stages
using multiple cost pools.
ABC vs. traditional costing (8 min): A review of the basic mechanics behind ABC and how it
compares to traditional costing methods.

Main videos

The following videos describe the principles of activity-based costing (ABC) in more detail.
They should be helpful when working on next week’s case.
W4-1 ABC principles (50 min)
W4-2 ABC comprehensive example (32 min)
W4-3 Theory of constraints (30 min)

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WEEK 4 Activity-Based Costing Foundation Modules

Theoretical Foundations
The following modules go over the ideas from the main videos (listed on the previous page)
once more and should be helpful as review material in preparing for Test 4. My
recommendation is to watch the videos first and then read through the modules.

Module 1: Why should costs be allocated in two stages?

It is unlikely that all overhead costs are driven by the same cause. For example, some part of
overhead costs such as salaries of production supervisors may be driven by (explained by)
the amount of direct labor as measured by direct labor hours whereas other overhead costs
such as machine deprecation may be driven by machine usage as measured by machine
hours. To the extent that there are multiple causes of overhead, it is impossible to allocate it
properly using just one allocation rates.
Figure 4-1: Two-stage cost system diagram

Overhead

first stage

Cost Pool 1 Cost Pool 2 Cost Pool 3

second stage

Products /Services

Figure 4-1 illustrates a two-stage allocation system which instead of using one allocation rate
breaks-up total overhead costs into multiple cost pools, each with its own allocation rate.

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Module 2: Cost drivers and cost hierarchy

When designing a two-stage allocation system, the obvious question is how many cost pools
do we need? The simple answer is at least one cost pool for each of the different cost drivers.
Cost driver = the real cause of overhead costs (e.g., machine hours or material weight). A
reduction in cost driver usage always leads to a reduction in overhead costs.
Allocation base = whatever we use in the denominator of a rate used to allocate overhead,
i.e., overhead rate equals overhead $ / allocation base. Allocation base can be anything we
can directly measure for each product (service) unit.
Example: We could allocate machine deprecation overhead using material weight as an
allocation base. However, products using heavy material do not necessarily use up a lot of
time on the machines. Usage as reflected by machine hours seems a more appropriate
allocation base in this case. In other words, the best possible allocation base is the cost driver
of overhead. Nevertheless, the cost driver may not always be known and sometimes it is
necessary to use other allocation bases that only approximate the real cost drivers.
Back to square one, how many different cost drives (and cost pools) do we need? How do we
know we have identified all the different cost drivers? The above examples pick all the low-
hanging fruit—direct labor $, machine hours, material $ or material weight are all likely to
drive at least some overhead costs. However, as illustrated in the following example, they
are unlikely to drive all of overhead costs.
Example: Publisher X prints and sells 100,000 copies of a textbook every year. Publisher Y
also prints and sells 100,000 copies but these include five different textbooks (each has an
average sales volume of 20,000 units a year). Which published has higher overhead costs?
Overhead cost of printing (production plant and equipment depreciation, indirect labor,
warehousing) will likely be similar for both publishers because their main cost driver is the
volume of production, i.e., the number of textbooks printed per year.
All other overhead will be much higher for Publisher Y because the textbook acquisition,
design, marketing, editing, and many other costs are driven by the number of different types
of textbooks sold rather than by the units in print. If Publisher Y sells five times the number
of textbooks carried by Publisher X, then some of these costs could also be five time as large
even if both print the same number of copies (100,000).
The above example illustrate the concept of cost hierarchy. Some overhead costs are driven
by (vary with) the number of units produced and other overhead costs vary at some higher
level. Thus, when deciding how many cost pools to use and how many cost drivers to identify,
the best starting point is to think of all the different levels of a cost hierarchy. Different
industries will have different cost hierarchies but in many setting it is useful to think of the
following levels:
Unit-level costs = overhead is directly proportional to the number of units produced (e.g.,
benefits, production supervisors, machine depreciation), assuming there is enough time to
adjust production capacity to demand.

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Batch-level costs = overhead is proportional to the number of batches produced but it does
not depend on the number of units in a batch (e.g., setup costs, just-in-time material handling
costs).
Product-level costs = overhead is proportional to the number of different types of products
sold but it does not depend on the number of units or batches produced (e.g., engineering or
marketing costs).
Facility-level costs = overhead does not depend on anything that can easily be measured, it
is fixed non-avoidable overhead that has no clear cost drivers (e.g., general administration
costs).
For purposes of cost allocation, there must be at least one cost pool at each of the different
levels of cost hierarchy. In other words, combining costs at different levels into the same cost
pool leads to a misallocation because one allocation base cannot represent cost drivers at
different levels of a cost hierarchy.

Module 3: Activity-based costing

Activity-based costing (ABC) is a two-stage allocation system that implements three ideas:
First, the cost pools identified in the first stage (see Figure 1) represent real operational
activities. Thus, ABC moves away from classification based on cost similarity (e.g.,
depreciation, utilities) to a classification based on cost purpose (warehousing, material
handling, machine setup, production, packaging, delivery, etc.).
Example: What is a good cost driver of equipment depreciation? Should all equipment be
included in the same cost pool? Absolutely not! Having the same account number in the
general ledger (financial accounting administration) does not mean it is used for the same
purpose. Depreciation of forklifts used in the warehouse should be allocated together with
other warehousing costs because it has a very different cost driver than deprecation of
production equipment or depreciation of computers used by administrative staff. Similarly,
heating and cooling of the warehouse should be allocated separately from gas and electricity
costs used up in production.
Second, and perhaps most importantly, ABC implements the cost hierarchy discussed above.
The first-stage cost pools should not only represent different operational activities but also
be detailed enough to include activities at each of the different levels of the hierarchy.
Product-level and batch-level costs do not vary with the number of units produced and
consequently ABC correctly shows that high-volume products can be much cheaper than
similar products produced in smaller quantities.
Example: Consider a setting where a company produces pens of two different colors. Blue is
the most common color with about 10 million units sold in a year. In contrast, yellow pen is
a specialty product, selling only about 1 million units a year. Given the large number of blue
pens sold, the average batch size is about 200,000 units (50 batches a year). In contrast,
yellow pens are produced in smaller batches of about 10,000 units (100 batches a year) to
avoid oversized inventory.
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Suppose an ABC analysis reveals that each set-up incurs about $400 costs due to machine
down-time, salary of production engineers performing the set-up and re-programing the
equipment, logistics costs associated with material handling before and after each batch, etc.
Compare the costs of producing blue vs. yellow pens.
Blue pens incur $20,000 in set-up costs (50 batches at $400 per batch), which is a negligible
charge of ¢0.2 per pen ($20,000 / 10,000,000 = $0.002 = ¢0.2). In contrast, yellow pens incur
20 times that much per unit. Specifically, yellow pens incur $40,000 in set-up costs (100
batches at $400 per batch), which is ¢4 per pen ($40,000 / 1,000,000 = $0.04 = ¢4).
Third, ABC measures the long-term costs of production. It assumes a very long time horizon
and consequently the need to replace all production equipment and other assets. Thus, if the
time horizon is long enough, all costs become variable even those that are fixed in the short-
term (such as depreciation). ABC should therefore be used for long-term decisions, such as
decisions on which products to discontinue or which products to invest in or how to
negotiate long-term contracts.

Module 4: Theory of constraints

ABC is not meant for short-term decisions, such as decisions how to price a special order or
which products to produce this week to maximize profitability (given that all equipment is
fully booked). As discussed in Week 2, the only costs that matter for the purposes of short-
term decisions are variable costs, all fixed costs are sunk. Thus, there is typically no need for
sophisticated cost allocations when short-term decisions are concerned.
Variable costs may include direct labor, direct material, a typically small amount of variable
overhead (such as electricity consumed by production equipment or gas consumed by
delivery trucks). In some settings, even direct labor can be fixed cost to a large extent. For
example, some workers may have highly specialized skills, be entitled to high severance pay,
or be otherwise protected by labor union agreements and consequently they will not be laid
off even if there is less work for them during a prolonged economic downturn.
Theory of constraints (TOC) takes the somewhat extreme position and assumes that the only
variable costs are direct material costs. This implies an extremely short time horizon (e.g.,
today, this week) when all overhead and direct labor is fixed or essentially pre-paid (even
people laid off today will be paid their wages at least through the end of the week). The
purpose of TOC is to maximize profitability (sales – direct material costs) for short-term
decisions.
Example: Product A sells for $100 and uses $10 in material and 1 hour of machine time.
Product B sells for $80 and uses $20 in material and 0.5 of machine time. Product C uses $40
of material. What is the short-term cost of producing Product C? Assume labor and overhead
costs are fixed in the short-term.
If there is available capacity, the short-term costs of Product C are $40.
If production equipment is at capacity, then producing one unit of C means producing fewer
of the other products. Product A makes $90 in profits per machine hour ($100 of sales – $10
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in material). Product B makes $120 in profits per machine hour ($80 of sales – $20 in
material = $60 in profits for every 0.5 machine hour, i.e., $120 = 2*$60 per hour). Since we
can remove either A or B form the production schedule to make space for C, we will remove
the least profitable product per unit of constrained capacity (machine hour), which is
Product A. The profits we would have made from product A become part of the short-term
costs of producing Product C. The short-term costs of Product C, when machines are at
capacity, is therefore $130 ($40 in material and $90 in foregone profits).
Note that in both scenarios (full capacity or not), the short-term costs do not include
depreciation of the production equipment. It is irrelevant what we paid for the equipment
many years ago, how quickly we depreciate, and how we allocate the overhead costs. In the
short term, the opportunity costs of using the equipment is either zero (if capacity available)
or the foregone profits (if at full capacity and some profitable products have to be removed
from the production schedule).

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WEEK 5 Activity-Based Costing Learning Objectives

Week 5 Activity-Based Costing Case

Learning Objectives

After working on this week’s case, you should be able to do the following:
1) Understand the main steps of designing an activity-based costing system.
2) Calculate multiple allocation rates for different levels of the cost hierarchy.
3) Analyze customer profitability.
4) Recommend various actions to increase customer profitability and use cost data to
support these recommendations.

Work Load

1) Watch the introductory videos (including the concept review video).

2) Work on the Saharis.cz case
a. quickly read the case to get the big picture,
b. carefully read all the case questions,
c. go back to the case and spend as much time on it as you need to answer the case
questions,
d. upload a memo answering case questions 1.–4. to Blackboard
(see the Syllabus for additional information on case memos).
3) Take Quiz C.
4) Watch online videos with case solutions (available only after completing Quiz C).
5) Read the case summary posted online.
6) Re-read the case questions and make sure you can easily answer all of them now. Go back
to the online videos and/or the case summary if you need to. Double-check that you
understand and can easily replicate calculations from all online videos (likely to be part of
Test 5).
7) Take Test 5.

Deadline

Sunday, April 11, 11:45 pm. Deliverables: (I) Quiz C, (II) Test 5, (III) case memo.

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Week 5 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W5 Introduction (5 min): A quick review of the main ideas covered last week and a brief
introduction into the topics of this week.
Before you start working on this week’s case, the following video may be helpful:
Cost system design review (30 min): This is a summary of all the important concepts we have
covered so far (all you want to know about cost system design in half an hour).

Main videos

The following will be available once you study the Saharis case and take Quiz C:
W5-1 Saharis cost system design (25 min)
W5-2 Saharis customer profitability (47 min)
W5-3 Saharis time-driven ABC (20 min)

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WEEK 5 Activity-Based Costing Case Questions

Case Questions

Carefully study the Saharis.cz case and upload a memo with answers to all of the questions
below:
1. Why is the current cost system inadequate? Why is it necessary to report on customer
profitability?
2. Develop a cost system for SCE based on Year 2012 data.
a. Identify major activities. (Hint: The major activities in any distribution center
are warehousing, shipping, order processing, and administration). Subdivide
these major categories into more detailed activities if necessary to improve
the accuracy of the cost system.
b. Calculate the cost-driver rate for each activity identified in 2a.
3. Combine your answers to question 2 with the information in Exhibit 4 to calculate the
profitability of the average User, Subscriber, and Elite Team member. What explains
the difference between the profitability of the different types of customers?
4. What actions should SCE management take based on the cost analysis?

Also, have a quick look at the Saharis.cz (B) case (immediately following the main case) and
think about how the additional information could be used to better allocate the call center
costs.

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WEEK 5 Activity-Based Costing Saharis Case

Saharis.cz

In 2010, Patrick Roman was transferred from corporate headquarters of Saharis.com in

Seattle, WA to spearhead expansion efforts in Central and Eastern Europe. He was appointed
general manager of a newly created business unit, Saharis Central Europe (SCE), and charged
with developing a newly created Saharis.cz domain and replicating the successful U.S. online
retailing model, which was already taking foothold in several major European countries.
The business opportunities and challenges facing SCE were quite different from those
encountered in other countries. The heavy discounting strategy of Saharis appealed to price-
conscious customers in the region. Another strategic advantage was access to low-cost labor
and an efficient warehouse just outside Brno, Czech Republic. The warehouse was the largest
of its kind in Central Europe and was located within two-hour drive of four metropolitan
areas with population of around 3 million, including the capitals of the Czech Republic and
Slovakia. Given that no other online retailer established a major presence in the region, SCE
competed against brick-and-mortar retail chains relying on stores in expensive downtown
locations and charging higher prices. Bigger malls outside of downtown areas were gaining
in popularity but were less common than in the U.S. because of the relatively high cost of
owning a car.
However, much of the infrastructure Saharis relied on in other countries was
underdeveloped. Slow postal service by Česká Pošta took 4 to 6 business days to deliver a
package. Premium services such as next day or second business day delivery, offered by DHL
and FedEx, were expensive because the business volume in the region was still relatively
low. SCE considered fast service critical to their success and set up their own delivery in
selected areas. Members of the “Elite Team” loyalty program who made sufficiently large
orders qualified for second (business) day delivery. SCE charged a 5% shipping fee for this
premium service or offered free shipping by postal service. Non-members paid the standard
5% shipping fee for the slower postal service.
SCE enticed customers into the Elite Team program by offering online perks such as
unlimited streaming of movies and music for a monthly fee of CZK 299 in the Czech Republic
and €9 in Slovakia. A large majority of customers in the metropolitan areas had access to

© 2014 by Michal Matějka. All rights reserved. No part of this publication may be reproduced, electronically stored, or
transmitted in any form by any means without permission. This case has been developed as a basis for class discussion.
Although it has been inspired by real events, data presented here are not meant to accurately describe any specific
industry or organization or represent the views of any real person.

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sufficiently fast Internet connections to make these perks attractive. However, many
customers did not take full advantage of the perks and only streamed movies to their small-
screen devices because smart TVs or set-top boxes enabling streaming from the Internet
were only beginning to penetrate the market. Moreover, content distribution contracts in
Europe were less favorable than in the U.S. Although Elite Team customers enjoyed
unlimited streaming, Saharis had to pay copyright fees based on the number of customers
and their online content consumption. How much to charge for Elite Team membership was
a point of continuous debate within SCE.
Patrick Roman was willing to subsidize Elite Team membership to get customers used to
online transactions, to win their loyalty, and to increase capacity and utilization of internal
delivery services. The membership program was critical in changing the local habit of
ordering by phone and/or seeking the support of customer representatives to process
payments, arrange for returns, etc. This habit had roots in the past when mail order
catalogues relied on phone communication to win customer trust. SCE adjusted to customer
expectations and set up a call center but the goal was to wean customers off this expensive
service. A clause in the Elite Team membership contract limited the number of free phone
transactions.
Another initiative launched in 2011 was to sign up customers into “Subscriber” services.
Close cooperation and exclusive distribution contracts with consumer product companies
such as Procter & Gamble and Unilever allowed SCE to offer a large number of everyday
consumption items at 5–15% discounts relative to competition. Subscribers committed to a
minimum order size and selected a day for regular monthly or quarterly deliveries. Although
Subscriber orders were typically larger and/or heavier than other orders, SCE only charged
the standard 5% shipping and handling fee and used their internal delivery service to fulfill
these orders. This service attracted a new type of clientele. Most Subscribers were not Elite
Team members but an increasing percentage of customers with a year or more of active
Subscriber service signed up for the Elite Team program. Also, many Subscribes quickly grew
accustomed to online transactions even if they chose not to become Elite Team members.
Patrick described the customer base and business growth opportunities as follows:
We have essentially three major types of customers—the Users, the Subscribers,
and the Elite Team. The Users demand call center support and, for now, we are
happy to provide it at the right price. We make money on some of the bigger
purchases such as electronics or jewelry. We are willing to sacrifice profitability
of many other items to get them accustomed to the great deals we offer and to
the reliable service. The Subscribers are an unremarkable but steady source of
revenues. They also help us reach delivery volumes that make the second day
service feasible. The Elite Team is where we see our future. Our vision is to offer
free second or even next day delivery and make online shopping the default
choice for most purchases of our customers.
Now, the big question is how to make it happen. We can sacrifice profitability in
the short term but we are already dealing with huge start-up costs and we
cannot afford to lose too much money. We are lucky that Seattle does not push

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us to break even quickly but, you know, their patience is going to run out at some
point…
Exhibit 1 provides more details on actual and forecasted growth in sales and customer
acquisitions (internal reporting and consolidation guidelines call for financial results to be
reported in Euros). Patrick strongly felt that the strategy of emphasizing sales growth at the
cost of short-term profits was justified. At the same time, he knew that it is time to increase
the focus on the bottom line. The current cost system was not much of a help because it
allocated all overhead as a percentage of sales and thus made all sales look equally profitable.
Patrick needed to better understand profitability of different types of customers. He hired a
new business controller, Petr Mládek, to design a better cost system.

Overhead Cost Analysis

Petr could retrieve revenue and cost of goods sold per customer using income statement
data (see Exhibit 2 and 3). The challenge was to how to assign overhead costs related to
warehouse personnel, warehouse depreciation and equipment, shipping, call center support,
marketing, technology, and administration. Petr collected additional information in the
following areas.

Warehousing

The main warehouse processes were receiving, inspecting, storing, picking, packaging, and
preparing customer orders for shipment. The warehouse featured robots, conveyor belts,
and other automated equipment to deliver ordered items from shelves to packaging staff,
although some items still had to be picked up manually. A warehouse supervisor commented
as follows:
Most of what we do is managing “loads.” Each manual pickup or each container
being transported automatically from the shelves to the packaging area is one
load. Multiple smaller items can fit into one load, e.g., multiple items of the same
SKU1 or different SKUs that are on nearby shelves. Most orders have multiple
loads as customer maximize order size to reduce shipping costs. We can typically
fit each order into one package for shipping but sometimes it is more than one
package, especially if it is passed on to our second day delivery guys—they rather
move two regular size packages than one big one. If you think in terms of costs,
the more loads we have, the busier we are, and the more people I have to hire
and schedule. Over the last couple of years the number has been increasing
steadily.
The total number of items and loads processed in 2012 was 18 and 11 million, respectively.
The warehouse supervisor suggested that his staff was busy processing loads most of the
time; the average downtime was only around 10% and could not be reduced much further.
Small increases in loads could be accommodated but sizeable increases meant additional

1
SKU or stock keeping unit is a unique code that identifies each distinct item available for purchase.
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hiring. In contrast, only about 60% of the warehouse space and equipment capacity was
utilized because SCE built in slack for future growth. The goal was to reach an industry
standard of about 80% within a year or two.

Shipping

Packaged items were shipped either by standard postal service or by internal second day
service in case of qualifying orders by Elite Team customers. In total, 5 million packages were
shipped in 2012, of which 2 million went by postal service. SCE negotiated discounted
postage rates that varied slightly depending on size and weight but were about the same for
most packages. The remaining 3 million packages were shipped internally through 2.5
million deliveries. Delivery vans operated by SCE were underutilized when travelling to
other than the most popular destinations. Managers estimated that they could accommodate
50% more deliveries with the same van fleet if they could increase the demand in some areas.

Call Center

Petr struggled to learn about call center operations. Ana Navrátilová, the department
manager was not very cooperative. She expressed her frustrations:
I do not think our work is appreciated very much. We are squeezed in the
smallest facility they could find and there are budget cuts every year. I am sure
they would outsource us to India if only they could… It is very stressful to handle
calls all day long with almost no downtime. Employee turnover is very high…
In the end, Ana helped Petr collect 2012 data on call center processes. They identified three
main activities. The first one accounted for 30% of call center capacity and involved phone
order set up including the recording of customer name, address, shipping and payment
preferences, explaining of return policies, etc. In total, the call center processed 1.2 million
phone orders. The second activity accounted for 40% of call center capacity and involved
processing of SKU choices, which included looking up item codes, verifying availability,
explaining product features, refining choices (e.g. item size or color), recommending
alternative products in case of stock-outs, etc. The amount of work associated with this
activity reflected the number of SKUs, i.e., no additional work was necessary when customers
ordered multiple items of the same SKU. In total, 2.4 million SKUs were processed over the
phone. The third activity, general inquiries, accounted for the remaining 30% of the call
center’s capacity. It resulted in no new orders and included for example advising of
customers not yet ready to make a purchase or processing of returns. In total, there were
about 500,000 such calls.

Other Expenses

Finally, Petr combed through expenses related to technology, marketing and selling, and
general administration. He was not quite sure yet which expense subcategories would be
relevant for his customer profitability analysis. Nevertheless, he identified the following
2012 expenses as potentially important: content licensing fees (€12 million); website

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development and maintenance (€3 million); IT support of internal operations (€1 million);
marketing expenses related to promotion of Elite Team Membership (€3 million);
administration, coordination, and support of internal delivery service (€2 million).
Now it was time to put it all together and report back to Patrick Roman with
recommendations on how to increase customer profitability without losing track of sales
growth targets.

Exhibit 1
Actual and Forecasted Growth

Actual Results Forecasts

2010 2011 2012 2013 2014 2015

Sales (in thousands) €110,000 €160,000 €250,000 €350,000 €450,000 €550,000

Number of customers
Elite Team 100,000 140,000 200,000 280,000 370,000 450,000
Subscribers 12,000 20,000 25,000 30,000 35,000
Users 140,000 150,000 157,000 170,000 180,000 190,000
Marketing of Elite Team
Program (in thousands) €5,000 €4,000 €3,000 €2,000 €1,000 €1,000

Exhibit 2
2012 Average Annual Gross Margin per Customer (in €)

User Subscriber Team Elite

Product Sales 400 500 800
Service Sales (Shipping & Handling) 20 25 20
Service Sales (Membership Programs) 0 0 108
Cost of Goods Sold 328 390 640
Gross Margin 92 135 288

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Exhibit 3
2012 Income Statement (in € thousands)

Product Sales 232,800

Service Sales 29,240
Cost of Goods Sold 187,296
Gross Margin 74,744

Salaries & Benefits of Warehouse Staff 9,600

Depreciation of Warehouse and Equipment 11,000
Postal Service Shipping 9,800
Internal Delivery Related Expenses 18,000
Call Center Expenses 5,400
Technology 17,000
Marketing and Selling 6,000
General and Administrative 13,000

Operating Income -15,056

Exhibit 4
2012 Annual Service Usage per Representative Customer

User Subscriber Team Elite

Number of items ordered 15 60 70

Number of loads in the warehouse 12 20 40
Number of packages 10 20 20
Number of deliveries 10 10 16
by postal service 10 0 8
by internal second day service 0 10 8
Number of phone orders 8 2 0
Number of SKUs on phone orders 15 4 0

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Saharis.cz (B)

After a few weeks on the job Petr Mládek established a good working relationship with Ana
Navrátilová, the call center manager. She helped him collect additional data on call center
operations. First, he summarized the information obtained earlier. The 2012 costs of call
center operations was €5.4 million and the three main activities were as follows:

Percentage Volume

Phone order set up 30% 1.2 million orders

SKU processing 40% 2.4 million SKUs

General inquiries 30% 157,000 non-members

Second, he put together all additional information he could collect:

• SCE employed 275 call center agents.
• On average, it took 7 minutes to set up an order for a new customer, i.e., to collect
shipping address and payment information, to explain return policies, etc. Orders of
returning customers could take as little as 3 minutes to set up if they had their
payment information stored or 5 minutes if it had to be re-typed.
• About 50% of phone orders came from new customers and 50% of orders were from
returning customers. One out of five returning customers had agreed to have their
payment information stored for future use.
• It took 4 minutes on average to look up each SKU.
• There were 500,000 general inquiries in 2012. The average inquiry took 14 minutes
to process.
Petr planned to use this information to get an even better insight into the call center costs.
The idea was to set up a simple time-based activity-based costing system, which would also
allow a better management of capacity utilization, an issue Ana Navrátilová kept complaining
about.

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WEEK 6 Performance Measurement Learning Objectives

Week 6 Performance Measurement

Learning Objectives

After working on this week’s material, you should be able to answer the following questions:
1) Why is it important to measure managerial performance?
2) How can performance be measured?
3) Which performance measures should be used?
4) How to make sense of even some of the most complex financial performance measures
such as Return on Investment or Economic Value Added.

Work Load

1) Watch the videos described on the next page. Double-check that you understand and can
easily replicate all calculations from the videos (likely to be part of Test 6).
2) Read a summary of the main theoretical concepts “Foundation Modules” (after the next
page). Go back to the videos if you do not understand some of the concepts.
3) Take Test 6.

Deadline

Sunday, April 18, 11:45 pm. Deliverable: Test 6.

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Week 6 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W6 Introduction (4 min): This is a brief introduction into what we are going to cover this
week and how it is different from what we have done so far.

Main videos

W6-1 Design of control systems (25 min)

W6-2a Performance measurement choices (12 min)
W6-2b Corporate cost allocations (24 min)
W6-3 Choice of financial performance measures (13 min)
W6-4 Return measures (34 min)

Additional exercises

Watch the following for additional practice:

Return measures calculation (8 min): This exercise illustrates how to calculate ROI and EVA
of an investment that increases income in several years.
Return measures and investment (11 min): This exercise shows how and why ROI and EVA
affect incentives to invest.

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Theoretical Foundations
The following modules go over the ideas from the main videos (listed on the previous page)
once more and should be helpful as review material in preparing for Test 6. My
recommendation is to watch the videos first and then read through the modules.

Module 1: Design of control systems

Ever wondered why this class is called Management Accounting? We have spent five weeks
studying design of cost systems so why not just call it Cost Accounting? The answer is that
accounting information and internal reporting can be used for other purposes, not just for
costing. The most common alternative use of internal accounting information is performance
measurement. Financial accounting is concerned with how to report aggregate performance
of the whole organization to outside stakeholders. Management accounting is concerned
with how to measure and report performance at lower organizational levels, such as
division, unit, plant, department, team, or even individual performance. Why would anybody
want to do that?
To answer this question, let’s go back to what we did in the last few weeks. We worked hard
to produce relevant information for decision making. The assumption was that if managers
have the right information, they will make the right decision and improve organizational
performance. That seems like a reasonable assumption but unfortunately it does not always
hold. Think of a large company with many managers and employees. The owners would
always do what is right for the company and maximize its performance. But the owners are
not the ones actually making most of the decisions—they have hired managers to run the
company for them. Managers have incentives to do what is right for them and that may or
may not be the same as what is right for the company.
In short, we need good information for decision making but we also need information for
control. Broadly speaking, the purpose of control is to assure that managers’ interests are
aligned with organizational goals, i.e., to assure that managers have incentives to do what is
right for the organization.
How exactly does this work? What do we need to do to exercise control? Briefly, any control
system involves three fundamental choices:
Decentralization = definition of decision rights and responsibilities. At one extreme, most
decision are made at the top of the hierarchy and lower-level managers just implement them.
At the other extreme, operating decisions could almost completely be delegated to lower-
level managers and top executives would only remain in charge of major strategic decisions.
Incentives = definition of rewards for good performance and penalties for poor
performance. Call it the sticks and carrots, if you want, but there must be consequences to
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both good and bad performance. Incentives can take various forms ranging from implicit
incentives (such as promotion, job security, job satisfaction, recognition, perks) to cash
bonuses (large or small) to sophisticated compensation plans including equity grants such
as stock options or restricted stock.
Performance measurement = definition of what we expect from managers. If we give them
decision rights, make them responsible for important decisions, and promise rewards for
good performance, we must also clarify what performance means and how exactly are we
going to determine whether it is good or bad performance.
One way to think about the design of a control system is to picture it as a three-legged stool.
Each of the three fundamental choices discussed above is one leg supporting a stool. For
optimal performance it does not matter whether a leg is short or tall (sometime you may
need a short stool and other times a tall one), the important issue is whether the three legs
are aligned. This idea is captured in Figure 6-1, which also shows what happens when one of
the legs is shorter than the other two.
Figure 6-1: Control system as a three-legged stool

Balanced Unbalanced

Performance Incentives
Measurement
Decentralization
The general idea is that there is no single “right” way of measuring performance. Different
settings call for different ways of measuring performance. Most important of all, the extent
of decentralization and the choice of incentives have implications for how performance
should be measured. Put differently, anytime an organization changes the extent of
decentralization and/or incentives offered, it should also change how performance is
measured to make sure the control system remains balanced.
Example: Consider a company that designs and sells CoolBoxes which need much smaller
amounts of ice for cooling than competing products. The company can charge high prices
because its innovative design is protected by patents. The owner and founder is in his office
every day and he makes all important operation and strategic decisions. Reporting to him
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are managers interfacing with different customer segments (retail, wholesale, corporate, and
custom products). There is hardly any formal performance evaluation and reward system.
The only performance measure systematically tracked is sales. Bonuses are relatively small
in magnitude and to a large extent determined at the discretion of the owner.
Is this a balanced control system?
What do you expect to happen two years from now when the owner plans to retire and put
his daughter in charge? They both want CoolBoxes to remain a family business but they both
know that she has many other interests and will no longer be involved in operational
decisions. There must be some way to promote current managers or hire new managers to
take care of the business. What kind of a control system should be put in place then?
Let’s tackle the first question of the above example. Is the control system balanced, i.e., does
it assure that managers and employees do what is right for the company? It does not appear
very sophisticated—bonuses seem small and sales cannot be the only important dimension
of company performance (how about profitability, quality, customer satisfaction?). Do
managers have incentives to do what is right? Sure they do. The best incentive out there is
to hang on to your job and your annual salary. The owner is around all the time, he tells
people what to do, and then checks whether they did it. There is very little decentralization
because there is no need for it as long as the company remains relatively small and the owner
is greatly involved. Fixed salaries are just fine in a setting where managers do not make
important decisions. Also, defining performance as sales is simplistic but it works here. It
would be very difficult for managers to boost their sales by actions that somehow hurt
company performance on other dimensions. As long as the owner is around and understands
what actions are taken and why, managers will do the right thing for the company.
What happens when his daughter takes over and hires professional managers to run the
company? The first thing to note is that one fundamental dimension of the control system
changes—there will be decentralization, the owner can no longer make all the important
decisions. Can bonuses remain relatively small? No because the new managers would have
little incentive to work hard for the company. Also, it would be difficult to hire the right
managers because the most competent ones are looking for jobs where they can earn more
for their competence and high effort. So, let’s decentralize and hire the right people by
promising them large bonuses for good performance. Can we continue to measure
performance in terms of sales only? No because we would end up with a lot of gaming, which
means performance that is good only on the surface because managers took shortcuts to
inflate sales e.g. by reducing prices, spending too much on advertising, cutting investments
in future projects, etc. If the owner or his daughter are not going to be around to prevent
some of these gaming activities, they need to develop a much more comprehensive system
of performance measurement that tracks not only sales but also profitability and various
other financial and nonfinancial dimensions of performance.

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Performance measurement choices

So, now we can finally talk about one of the legs of the three-legged stool in more detail. What
exactly is performance measurement? Continuing the example above, what options does the
owner and his daughter have when designing a system to measure performance of managers
running their company? Later we will discuss various specific, accounting-related choices,
but before we get there it is important to see the big picture. Performance measurement is
much broader than the use accounting information. Think of the following major groups of
choices:
Subjective vs. formula-based evaluation. Who says that performance needs to be
measured in objective, quantifiable terms, i.e., by means of a formula? The alternative is to
evaluate performance ex post (at the end of the period) in a holistic way that takes into
account everything important that happened, not just what we thought would be important
and what we included in a formula at the beginning of the period.
Choice of performance measures. Although it is important to leave room for subjective
evaluations in many settings, performance measurement almost always involves some
objective formula. However, the formula should not necessarily be single-dimensional. It
should include a few of the most important dimensions of performance (e.g., sales,
profitability, return on capital). Also, there is no reason to measure all dimensions of
performance in financial terms; oftentimes nonfinancial performance measures are also
important (e.g., market share, quality, customer satisfaction). To aggregate multiple measure
into an overall measure performance, it is necessary to set weights on different dimensions
(e.g., 50% net income, 30% growth in sales, 20% market share).
Choice of performance targets. Performance measures have no meaning on their own.
They can only be interpreted when compared to a benchmark or performance target, which
defines what constitutes good and bad performance (e.g. above/below target). These
benchmarks can be based on past results, performance of internal peers or external peers in
the same industry or in a similar line of business. It is common to use multiple targets to
minimize gaming. For example, one target often defines the minimum level of performance
(e.g. 90% of expected sales), below which no bonuses are paid. Another target would then
define maximum performance (e.g. 120% of sales), when the maximum bonus is earned and
performance above the maximum does not increase the bonus any more.
Example: To see how a single target can lead to gaming, consider the following bonus plan.
If sales reach the target of $100 million, the manager earns a $50,000 bonus, if sales fall
below the target, the manager earns no bonus. If due to some unforeseen events during the
period, performance is expected to end up in the range $110–120 million, the manager has
no incentive to work hard because the target is going to be met anyway. Similarly, if
performance is expected to end up in the range $70–80 million, the manager has no incentive
to work either because the target of $100 million is unrealistically difficult to achieve. Worst
of all, if in the last few days of the year performance ends up being $99.5 million, the manager
has very strong incentives to do “whatever it takes” to book an additional $0.5 million in
sales. This single-target bonus plan puts people under a lot of pressure to resort to unwise,
unethical, and possibly even illegal behavior to meet the target that is so close.
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That’s all great but at the end of the day how do I know that a performance measure, or more
broadly a performance measurement system, works? The theoretically ideal measure or
system should be incentive compatible = when managers myopically maximize this measure
(ignoring everything else that is not measured), they actually end up doing what is right for
the company. A few remarks about incentive compatibility.
First, there is no such thing as a perfectly incentive compatible measure. It is a theoretical
ideal that does not exist in practice. All measures can and will be gamed to some extent,
however, some measures are more susceptible to gaming than others. The notion of
incentive compatibility makes this salient and stresses the importance of precaution—the
type of actions managers will take to maximize any given performance measure can be
anticipated and performance measures can be adjusted if they encourage undesirable
actions.
Second, incentive compatibility is context-dependent. What works well in one company may
not work in another company. This gets us back to square one, or at least back to Module 1.
The type of gaming managers can engage in depends on their decision-making authority and
incentives. Therefore organizations with different levels of decentralization and different
types of incentives should also use different performance measures. When performance
measures are incentive compatible, “the three-legged stool” of a control system is balanced
(see Figure 6-1) in the sense that it encourages productive actions and minimizes the extent
of gaming.

Module 2: Cost allocations and performance measurement

Now that you get the big picture, let’s talk about the nitty-gritty details of accounting-based
performance measures. The point of this discussion is not to be comprehensive and cover all
the details but to illustrate how seemingly mundane accounting choices affect managers’
behavior. We have spent several weeks discussing cost allocations, so let’s have a look at how
cost allocations affect performance measurement and evaluation. The specific example
covered in this module is whether and how corporate overhead should be allocated to
divisions or business units reporting to corporate headquarters.
Figure 6-2: Corporate headquarters and divisions

Corporate
Headquarters

Division A Division B Division C

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As an illustration, Figure 6-2 shows an organization with three divisions reporting to

corporate headquarters. The issue is whether $1 million in overhead incurred at the
corporate level (on administration, research & development, advertising, etc.) should be
allocated to the divisions and affect performance evaluations of division managers. Higher
corporate overhead allocation means lower profitability of the divisions. How much of the
corporate overhead should the divisions pay for? What is a fair cost allocation?
There are at least three different ways of thinking about the allocations. The first approach
is not to think about it much and allocate in some arbitrary way, e.g. each division pays for
33% of the corporate overhead. Although this sounds very arbitrary, it could work quite well
if implemented right. It is simple and transparent in that it admits that we have no idea how
much to allocate and that even much more complicated allocations are likely to be arbitrary.
The obvious downside is that at least some division managers will rightly complain that they
pay too much—it is always the other division that causes high overhead costs, not theirs,
why should they pay the same share. The elegant way of dealing with these complaints is to
adjust performance targets. The arbitrary corporate allocation (e.g. $333,333 to each
division) reduces divisional earnings but if we reduce the earnings target by the same
amount, then performance relative to target is unaffected by allocations and managers have
no reason to complain. Essentially, this approach is equivalent to not allocating the overhead,
which is not a bad solution.
The second approach is what we have done in the past weeks—figure out the causes of
overhead and allocate proportional to divisional consumption. This amounts to doing an
activity-based costing analysis for each of the different corporate overhead items. For
example, think of the cost hierarchy behind research and development (R&D) costs. Some of
it maybe facility-level and therefore difficult to allocate (some basic research that is done for
the benefit of the whole company). Other R&D costs may vary at division-level (custom
development for customers of one of the divisions) or at lower levels such as customer,
project, hour, etc. We already know how to allocate costs that vary at different levels but it is
a lot of work, right? Do we really want to spend so much time figuring out how to allocate
what could end up being relatively small overhead charges? Is there no way to simplify this?
The third approach is the most common one. It allocates overhead in some largely arbitrary
manner, using allocation bases such as sales or the number of employees. The idea is that
these allocation bases may be related to consumption of overhead but even if they are not it
is OK to have “inaccurate” allocations as long as they motivate the right behavior. The point
is not to spend too much time on figuring out the causes of overhead consumption but to
allocate in a way that is incentive compatible (i.e. to encourage productive actions and
minimize the extent of gaming). The following example illustrates why different allocations
motivate different behavior.
Example: What happens when we allocate $1 million in corporate overhead based on the
number of employees at the division? Allocations essentially act as a “tax” on employees, they
make it incrementally more costly to hire people and they magnify the savings from lay-offs.
This allocation then minimizes the risk that divisional managers hire too many people and
encourages lay-offs. This allocation may work well in a division that is inefficient and needs

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to be trimmed down. In contrast, it is not a good idea in a growing business where investment
in employees and tolerating some slack is important for future growth.
How about allocating the $1 million in corporate overhead based on divisional sales then?
On the surface, it seems a very bad idea, right? Should a successful division that achieved
high growth in sales be “punished” by higher allocations? Well, we can assume that division
manager have strong incentives to increase sales and that corporate allocations are not going
to change that by much. Could there be an upside to cost allocations based on sales then?
Absolutely, it increases incentives to cooperate. Suppose division A helps division B grow
their sales (e.g. by sharing personnel or equipment). Division A does not directly benefit from
being cooperative and helping a sister division. However, allocations based on sales create
an indirect benefit. If division B indeed benefits from cooperation and increases its sales, it
will also end up paying for a greater share of corporate overhead, which means that
division A pays less and benefits from helping out others.
The above discussion should illustrate that cost allocations are not just a technical
accounting issue where we have to “get the numbers right.” Cost allocations have
implications for managerial performance evaluations and sometimes “the wrong numbers”
get the job done. At the end of the day, we do not care whether corporate overhead
allocations are right or wrong, the important thing is that they motivate managers to do the
right thing.
There are many variations of the three different approaches to corporate overhead
allocations. One of the online videos (see W6-2b Corporate cost allocations) walks you
through the details of the so called dual rate method that is not as complicated as activity-
based costing but not as arbitrary as some of the alternatives. The main idea is to separate
overhead into two cost pools based on whether it is variable or fixed. Divisions are charged
for actual consumption of overhead using a low variable cost rate. Separately, divisions also
pay for fixed capacity commitments by means of a fixed cost rate. This method is still quite
simple but it motivates the right behavior (see the video for details).

Module 3: Choice of financial performance measures

Cost, sales, and various measures of profitability are some of the most common financial
performance measures. The previous module illustrates that cost can be measured in
different ways (depending on various allocations). The same applies to sales and earnings
but there is no need for further illustrations of such details. The more important question is
when to use some cost-based measures and when it is more appropriate to use sales-based
or earnings-based measures.
The simple answer is that managers should be evaluated based on what they can control (the
so called controllability principle). That is another way of saying that performance
measurement depends on the decision rights and responsibilities of the evaluated managers
(decentralization). Costs are used to evaluate performance of managers responsible for a
relative small part of the business. For example, production managers, R&D managers,
advertising managers, warehouse managers have very specific operational tasks and their

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role is to perform them cost effectively. They are typically evaluated based on whether they
achieved their tasks and stayed within their cost budget. The objective is to increase
efficiency and reduce wasteful spending in their area of responsibility. There is no point
evaluating these functional managers based on sales or earnings because those are largely
outside of their control, determined by decision of other managers.
It is easy to see that evaluating managers only based on costs is incomplete. For example,
inefficient production managers could prevent cost overruns by reducing quality. R&D
managers could delay completion of important projects to stay within their cost budget.
These are all examples of gaming a simple formula-based evaluation. Similar issues apply
when evaluating sales people.
Sales people are also responsible for a relative small part of the business. The controllability
principle applies again—they should be evaluated based on what they can control. They only
control sales not costs, so we should evaluate them only based on sales, right? Actually, this
turns out to be wrong very often. As illustrated in the example below, it is often important to
evaluate sales people not just based on sales but also on “the quality of sales” which is often
reflected in margins (sales profitability).
Example: Should sales people of a used-car dealer be evaluated based on their sales only?
Let’s think this through. What happens if a monthly goal of $800,000 in sales is not quite
reached in the last few days of the month? A sales person could easily reach the goal by
offering “smoking deals” (cutting prices a lot) to every customer who visits the dealer. The
sales person would earn a monthly bonus but the dealership could end up losing money on
the sales in the last few days of the months.
The obvious insight that sales people who have control over prices should also be by
evaluated by average sales margin or equivalently by total profits generated from their sales.
Example: Consider a sales person in the appliances department of Sears. They do not control
prices so sales should be appropriate, right? Not so fast. Even with fixed prices sales people
can take actions to increase profitability of sales. Sales of the brand owned by Sears
(Kenmore) are likely to be a lot more profitable than sales of competing brands. Sales people
should have incentives to encourage customers to purchase Kenmore products. Moreover,
the highest-margin sales come from add-on products and services such as extended
warranties and accessories. Sales people should have incentives to promote these high-
margin products and services.
Thus, sales people who have control over product choice and can influence whether
customers buy high-margin products should also be by evaluated by profitability of their
sales. In other words, the only time when sales are an incentive compatible measure of sales
people performance is when they have no control over prices or product choice and their
only responsibility is to increase sales volume.
It is then no surprise that senior managers who have control over prices, product choice,
production, and marketing have to be evaluated with more aggregate measures of financial
performance. Earnings-based measures aggregate both costs and sales and are therefore
almost always used to evaluated unit or divisional managers with broad responsibilities.
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Again, the controllability principle suggests that the more decision rights managers have the
more “all-encompassing” a measure of performance should be.
Can earnings-based measures be gamed? Can senior managers take actions that increase
earnings but somehow make the company worse-off? Of course—earnings are a measure of
short-term financial performance, it is easy to envision actions that sacrifice long-term
performance to achieve short-term targets (e.g. cutting R&D or advertising expenditures and
undermining brand recognition and innovation, using cheaper materials and damaging
quality). This issue can only be addressed by also using nonfinancial performance measures
that are forward-looking in that they show now whether we are on track to meet long-term
goals (e.g. market share, brand recognition, quality, on-time delivery, customer satisfaction).
So, earnings measures plus some nonfinancial performance measures are the best way to go
for senior managers, right? Almost right. More specifically, this is true for all division
managers who have broad operational decision rights but limited influence on strategic
choices such as how much capital their division gets to invest. If corporate headquarters
tightly controls the capital investment budget and insists on approving any major
investments, then division managers should focus on how to find the most profitable use of
those investments. Earnings plus some nonfinancial measures will work well in those
setting.
How about the most decentralized setting you can think of? Suppose divisional managers
operate in different countries and corporate managers do not know enough to assess how
much investment is needed. In such settings, corporate managers have to rely on division
managers to invest in the right projects. It is no longer sufficient just to look at earnings
because division managers might be tempted to overinvest—build too many warehouses or
spend too much on advertising—because additional investments often increase earnings but
such increases are not necessarily justified when the cost of capital is high. That is the reason
why some organizations use return measures (such as return on assets, return on
investment), which take into account profitability of invested capital.
Example: The Americas division of a global company generates annual earnings of $3 billion
using an asset base of $15 billion. The return on investment (ROI) is therefore 3/15 = 20%.
Building an additional warehouse would cost $200 million and result in an annual earnings
increase of $10 million. The return on the warehouse seems low (10/200 = 5%) relative to
the overall ROI of 20%. If managers are evaluated only on earnings, they might want to build
the additional warehouse. If they are evaluated on ROI, they would probably not build the
warehouse because it would reduce their aggregate ROI.

Module 4: Residual income and EVA®

The above example of divisional managers operating in different countries and having a
great deal of autonomy is important because it gets at the issue of how shareholders should
motivate the highest-level of executives in a company (e.g., chief executive officers, chief
financial officers, or vice president of operations). These so called C-suite executives make
all the important decisions including how much of the shareholders’ capital should be

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(re)invested in their company. To maximize shareholders returns, these executives need to

have incentives to make the right investment choices (invest neither too much nor too little).
So, let’s look at the choice of performance measures in this context more carefully.
We already know that it is not enough to use earnings-based measures and that we need
some kind of return measures. Is ROI discussed in the above example the right choice? How
about other similar ratio measures such as return on assets (ROA) or return on equity (ROE)?
How do we even assess whether we have the right return measure? Let’s start by looking at
the definition as well as the advantages and disadvantages of the return on investment (ROI).
Return on Investment = Income / Investments.
First, there are different ways to measure “Income”. For example, it could be before-tax or
after-tax income. Which one should we use? There is no right or wrong answer here. Just
think about how managers will respond. Do you want managers to pursue aggressive tax
strategies and minimize taxable income? If so, use after-tax income. If not, because you are
concerned about running afoul of the tax code, use before-tax income.
Second, there are different ways of measuring “Investments”. It could be a very broad
measure including all assets invested. Alternatively, it could be a rather narrow measure only
including shareholder capital. Excluding some items such as bank loans or current liabilities
(which mainly include accounts payable) motivates managers to try and finance their
operations though those excluded items.
Advantages of ratio measures. As we saw in the previous example, ROI and other similar
ratios penalize managers who use a lot of capital and only generate small returns with it.
Thus, these measure prevent the problem of overinvestment. Moreover, they are simple
percentages which are relatively easy to compare across business groups of different size.
Disadvantages of ratio measures. The problem with ratios is that they do not take into
account the real cost of capital to shareholders. In settings where shareholders can obtain
capital relatively cheaply but managers have high current returns, we could end up with an
underinvestment problem as illustrated in the next example.
Example: CloudSys sells business software for cloud applications around the world. Few
years ago a successful bond sale brought in new capital at a relatively low cost of 8%. It was
used to finance a business expansion in Europe (investing in sales force, technical support,
marketing, etc.). The Vice President of CloudSys Europe considers entering the developing
markets in Central Europe, which would require a 60 million investment in new assets but
it would also permanently increase income by around 6 million. Will the VP approve entering
Central Europe if his performance target is ROI of 19%, current income is 100 million, and
assets are 500 million? Will CloudSys shareholders want to enter the market?
Note that the ROI of the new investment is relatively low 6 / 60 = 10%. The rest of Europe
makes ROI of 100 / 500 = 20%. The ROI after entering Central Europe would be (100 + 6) /
(500 + 60) = 18.9%, which would put the VP at risk of not meeting his target. The VP will be
reluctant to do the investment. In contrast, CloudSys shareholders can tap new capital at a
cost of 8%. The new investment seems to be low risk and generates returns of 10% so the
shareholders would want to do it.
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Put simply, ratio measures solve the overinvestment problem but in doing so they create
an underinvestment problem. There must be a better way of doing this, right? Yes, there is.
There is a measure called Residual Income (RI), which takes into account the shareholders’
cost of capital.
Residual Income = Income – Cost of Capital (%) · Assets.
The key difference is that RI is not a ratio. Instead of dividing “Income” by a measures of
“Assets” (or investments), RI subtracts out what is essentially interest costs of capital. How
on earth could this possibly make any difference? Let’s continue the earlier example.
Example: Calculate RI of CloudSys Europe and the incremental RI of Central Europe. Does RI
motivate the VP to invest?
RI of Europe = 100 – 8% · 500 = 60. The incremental RI of Central Europe would be
6 – 8% · 60 = 1.2. The VP wants to enter Central Europe now because the overall RI will go
up by 1.2 million. This can be double-checked by combining all of Europe into
RI = (100 + 6) - 8% · (500 + 60) = 61.2 = RI of Europe (60) + RI of Central Europe.
Advantages of Residual Income. RI solves both the under- and over-investment problems.
Managers evaluated on RI have the right incentives to invest as long as the estimate of the
Cost of Capital % is reasonably correct (it can be very difficult to get the precise %).
Moreover, RI easily adjusts for different risks in different divisions because the Cost of
Capital % can be set higher in more risky environments.
Disadvantages of Residual Income. One practical problem is that RI is difficult to compare
across divisions of different size. Large divisions tend to have large RI because there is no
scaling as in a ratio measure. A bigger problem that affects all financial measures is that they
are based on accounting number that have to comply with GAAP (Generally Accepted
Accounting Principles). We already know that this introduces biases because GAAP is
conservative and tends underestimate income and assets. This on its own results into
underinvestment. For example, why should managers invest in advertising if they have to
expense all of it immediately? If the benefits of advertising last for several years, why not
treat it as an investment?
This is how a whole consulting industry was born and fancy sounding measures such as
Economic Value Added or Shareholder Value Added and the like started to proliferate. All of
these measures are some version of the Residual Income, except that they adjust “Income”
and “Assets” for conservatism in GAAP. For example, all improperly expensed investments
that increase future income (e.g., adverting, employee training, research and development
costs) are treated as assets not as expenses. Depreciation of fixed assets is recalculated to
better match useful life of equipment (if a machine lasts for 15 years at least, why depreciate
it in 4 or 8 years using GAAP depreciation tables?). Some consulting firms are recommending
(and billing companies for) hundreds of different adjustments.

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Economic Value Added = Adjusted Income – Cost of Capital (%) · Adjusted Assets.
Advantages of Residual Income. Much like RI, EVA® solves both the under- and over-
investment problems. It is even an improvement over the RI in that the measures of “Income”
and “Assets” are no longer underestimated due to GAAP conservatism.
Disadvantages of Residual Income. EVA® also has the same disadvantage as RI in that it is
difficult to compare across divisions of different size. Far more important, however, is the
issue of maintaining two sets of accounting numbers, one set that is GAAP based and
reported to investors and another set that is adjusted in various ways and used only for
internal performance measurement purposes. Many companies tried out EVA® and gave up
on it because they got tired of dealing with the two sets of numbers.
Summary
There is no single right way of measuring performance—not for sales people, not for
division managers, not for highest-level executives. However, it should be clear now that
managers who have more decision rights should be evaluated with more aggregate
measures (not just sales but also profit margins in case of sales people; not just income but
also investment levels in case of executives).
The objective of performance measurement is not to find “the right metric” the objective is
to find something that “works,” something that motivates the right behavior and minimizes
the potential for gaming. In this spirit, various technical accounting issues such as overhead
cost allocations can be simplified by using a method that “works” and motivates the right
behavior rather than by complicated methods that try to get the numbers right.
Finally, no single performance measure or a formula consisting of multiple measures is
ever going to be perfectly incentive compatible. There will always be at least some
potential for gaming. This can often be addressed by combining formula-based and
subjective performance evaluation. Nevertheless, in settings where even the best available
measures are highly imperfect and susceptible to gaming the whole control system needs
to be adjusted. In particular, imperfect measures or newly introduced performance
measures (that still need to be fine-tuned) should only be combined with small rewards
and penalties to reduce the pressure on managers to pursue the wrong goals. This is yet
another way of assuring that the “three-legged stool” of control is balanced.

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WEEK 7 PERFORMANCE MEASUREMENT Learning Objectives

Week 7 Performance Measurement Case

Learning Objectives

After working on this week’s case, you should be able to do the following:
1) Understand the advantages and disadvantages of financial performance measures.
2) Calculate various return measures.
3) Adjust performance measures for conservatism in GAAP.
4) Evaluate executives operating independently in foreign countries.

Work Load

1) Watch the introductory recording.

2) Work on the Barrows case
a. quickly read the case to get the big picture,
b. carefully read all the case questions,
c. go back to the case and spend as much time on it as you need to answer the case
questions,
d. upload a memo answering case questions 1.–4. to Blackboard
(see the Syllabus for additional information on case memos).
3) Take Quiz D.
4) Watch online videos with case solutions (available only after completing Quiz D).
5) Read the case summary posted online.
6) Re-read the case questions and make sure you can easily answer all of them now. Go back
to the online videos and/or the case summary if you need to. Double-check that you
understand and can easily replicate calculations from all online videos (likely to be part of
Test 7).
7) Take Test 7.

Deadline

Friday, April 25, 11:45 pm. Deliverables: (I) Quiz D, (II) Test 7, (III) case memo.

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WEEK 7 PERFORMANCE MEASUREMENT Learning Objectives

Week 7 Online videos

Introductory videos

Before doing anything else this week, watch the following recording:
W7 Introduction (5 min): A quick review of the main ideas covered last week and a brief
introduction into the topics of this week.

Main videos

The following will be available once you study the Barrows case and take Quiz D:
W7-1 Barrows Consumer Products (34 min): This is the first part of the discussion of the
Barrows case. It introduces the business environment in Southeast Asia and decisions facing
Ms Karlskint. It describes the control system of Barrows and the key issues of performance
measurement.
W7-2 Barrows Consumer Products (25 min): Provides the technical details of how to adjust
income and assets when calculating Economic Value Added.
W7-3 Barrows Consumer Products (15 min): Discusses the broader issue of who the best
performer is and why it may not always be easy to determine.

Final review recording (optional)

W7 Final Review and Farewell (9 min): A big-picture summary of what we have learned in
this course and a suggestion for what could come next...

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WEEK 7 PERFORMANCE MEASUREMENT Case Questions

Case Questions

Carefully study the Barrows Consumer Products case and upload a memo with answers to
all of the questions below:
1. Describe the control system in barrows. What are the key control choices?
2. Should Ms. Karleskint evaluate managers in the three countries subjectively or using
an objective formula? What are the advantages and disadvantages of formula-based
performance evaluation?
3. Rank the three countries using each of the following measures of performance:
a. Country profit
b. Return on investment
c. EVA®
4. Which of the country managers performed best? Explain your reasoning.

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 77

Barrows Consumer Products

I have three vice-presidents operating the same business in three

di↵erent countries and I need to be able to compare them in
order to prepare compensation recommendations to the board.
The problem is that there are so many variables that each of the
managers can make some claim to having the best performance.
I hope our consultant can help me sort this out.

Alice Karleskint,
Executive Vice-President
Southeast Asia Emerging Markets Sector
Barrows Consumer Products

Organization
Barrows Consumer Products is a large, multinational consumer products
firm based in the United States. In the mid-1990’s, Barrows made a strate-
gic decision to enter transitional and emerging markets. Each of the new
markets was led by an Executive Vice-President and organized along country
lines. Barrows believed this form of organization made it easier to evaluate
each country and also made it easier to exit from a country it identified as
unprofitable.
One of the new regional markets developed by Barrows was Southeast
Asia. Although there was significant competition in the region from other
Asian and European competitors, the management of Barrows believed their
advantage was in the portfolio of products with widely recognized brand
names. Barrows chose three countries to enter initially: Indonesia, The
Philippines, and Viet Nam. At the time of the decision, all three appeared
to represent significant growth opportunities.
Barrows policy in these new markets was to install a Barrows manager
originally from the country who was willing to return and manage the busi-
ness. Barrows believed that this policy resulted in additional goodwill and
also allowed the managers to use their knowledge of local business customs.
(They also hoped to take advantage of any personal ties the managers may
have in business and government, but this was not included in their policy
statement.) A simplified organization chart for the Southeast Asia Emerging
Markets Sector is provided in Exhibit 1.

This case was prepared as the basis for class discussion rather than to illustrate either
e↵ective or ine↵ective handling of an administrative situation.
©William N. Lanen, July 2003, University of Michigan Business School. Permission is
hereby granted to reproduce and distribute this case for classroom instruction provided
this copyright statement is included on the first page of any such reproduction.
 78

Although all three countries could be classified as emerging or transi-

tional economies, there are considerable di↵erences among them. Indone-
sia has a very large population, while the Philippines and Viet Nam are
smaller. The Philippines, however, has a higher per capita income; Viet
Nam is among the poorest countries. Selected demographic data for the
three countries is shown in Exhibit 2.

Performance Evaluation
Barrows has a well-developed set of performance measures that is used for
managerial evaluation. The two primary measures that are used for groups
in the US, Canada, Western Europe, and Japan are Division (or Country)
Profit and Return on Investment (ROI). Return on Investment is computed
by dividing Division (or Country) Operating Income (essentially, income be-
fore taxes) by beginning-of-year Division (or Country) Total Assets. While
profit and ROI are commonly used in much of the company, the Executive
Vice-Presidents in Emerging Market Sectors are given considerable leeway
in evaluating their individual country vice-presidents. This performance
evaluation is important to these managers. Compensation in the Southeast
Asia consists of salary and bonus. The total bonus pool for the three man-
agers is dictated by Corporate Headquarters of Barrows in the US. The bonus
pool formula is not explicitly defined although there is a clear correlation
between the size of the pool and the profitability of the Sector, however
measured.
The allocation of the pool to the individual country managers is at the
discretion of Ms. Karlskint, the Sector Executive Vice-President. In March of
1999, the financial results from the three countries have been tabulated and
she is now evaluating them. Because this is her first year in this position,
she has not had to perform this task in the past. She has hired a local
compensation consultant to advise her on the relative performance of the
three managers.
The financial sta↵ at Sector headquarters receives the financial state-
ments from the controller’s sta↵ in each of the three countries and ensures
that the statements are consistently prepared in a common currency (US
dollars). The income statements and balance sheets for 1998 each of the
countries are shown in Exhibits 3 - 5. Ms. Karlskint discusses the source of
her concern.

When I look at the financial statements, I can see immediately

that Ade [Darmadi, V.P. - Indonesia] has outperformed Isadore
[Real, V.P. - Philippines]. But Indonesia is a much larger market
than the Philippines. So I calculate ROI to try and adjust for size
and now Isadore is outperforming Ade. When I mention this to
Ade, she counters that while Indonesia is larger, it is also poorer
 79

and geographically more dispersed, leading to higher distribu-

tion costs. The only thing I can say for sure is that Binh has not
developed much of a market in Viet Nam.
I also wonder whether Headquarters is looking at the right per-
formance measure. I recently attended a seminar on new perfor-
mance evaluation measures and the seminar speaker spent quite
a bit of time on something called economic value added (EVA™).
The way I understand it, EVA™ adjusts profit first by eliminating
distortions introduced by accounting rules and then subtracting
a capital charge from the adjusted after-tax operating income.
The capital charge is the cost of capital multiplied by the net
assets (total assets less current liabilities) employed. I guess I
would use the cost of capital of 20% after-tax that Corporate pol-
icy requires I use for investment decisions. The problem I have is
I am not sure how to adjust income, which is an accounting mea-
sure, into something more meaningful. We don’t do any R&D
here, so the only item on our financial statements statements
that was mentioned at the seminar is advertising. When I was
working in the US, I came across a study stating that advertising
expenditures in our industry have an expected life of about three
years. If that’s true, then clearly the way we account for adver-
tising is wrong and I should adjust these results accordingly.
Some of this confusion, of course, would probably go away if
I had more of a financial background. There are other issues,
though, that I think are more ambiguous. For one thing, Binh
developed a new approach to delivering products that really cut
the distribution costs two years ago. At an annual retreat, he
worked with both Ade and Isadore on how they could adapt his
innovation to their markets. As a result, their distribution costs
are much lower this year. I don’t know how any performance
measurement system can incorporate that kind of information.
At the same time, Binh tells me that many of his customers are
being supplied from warehouses in Indonesia and so Ade gets
credit for it. We don’t have a solid quantitative measure of this
yet, but I will need to factor this in when I repeat the analysis
next year.
 80

Exhibit 1
Organization Chart

Alice Karleskint
Executive Vice-President
Southeast Asia
Emerging Markets

Ade Darmadi Isadore Real Binh Tran

V.P.—Indonesia V.P. — The Philippines V.P. — Viet Nam

Exhibit 2

Selected Demographic Data

Indonesia The Philippines Viet Nam

Population (Millions) 206 77 79

(2001 Estimate)

GDP/Capita (US $) $2,800 $3,600 $1,850

(1999 Estimate)
 81

Exhibit 3
Country Level Income Statements and Balance Sheets
(Indonesia)
Income Statement for the Year 1998 ($ 000)

Revenue $18,000
Cost of sales 8,650
Allocated corporate overhead 432
Local advertising* 5,100
Other general and admin 868
Operating income $2,950
Tax expense 885
Net income $2,065

*Advertising expenses were $4,500 in 1995, $4,200 in 1996, and $5,100 in

1997

Balance Sheet as of January 1

1998 1999

Assets
Cash $750 $900
Accounts Receivable 1,600 1,800
Inventory 1,350 1,300
Total current assets $3,700 $4,000
Plant (net) 3,500 3,400
Total assets $7,200 $7,400

Equities
Accounts payable $575 $620
Other current liabilities 680 720
Total current liabilities $1,255 $1,340
Long-term debt 0 0
Total liabilities $1,255 $1,340
Common stock 745 745
Retained earnings 5,200 5,315
Total shareholders’ equity $5,945 $6,060
Total equities $7,200 $7,400
 82

Exhibit 4
Country Level Income Statements and Balance Sheets
(The Philippines)
Income Statement for the Year 1998 ($ 000)

Revenue $9,500
Cost of sales 4,200
Allocated corporate overhead 228
Local advertising* 2,955
Other general and admin 437
Operating income $1,680
Tax expense 504
Net income $1,176

*Advertising expenses were $2,700 in 1995, $2,400 in 1996, and $2,502 in

1997

Balance Sheet as of January 1

1998 1999

Assets
Cash $500 $510
Accounts Receivable 450 600
Inventory 500 900
Total current assets $1,450 $2,010
Plant (net) 2,550 2,402
Total assets $4,000 $4,412

Equities
Accounts payable $250 $315
Other current liabilities 454 450
Total current liabilities $704 $765
Long-term debt 0 0
Total liabilities $704 $765
Common stock 496 496
Retained earnings 2,800 3,151
Total shareholders’ equity $3,296 $3,647
Total equities $4,000 $4,412
 83

Exhibit 5
Country Level Income Statements and Balance Sheets
(Viet Nam)
Income Statement for the Year 1998 ($ 000)

Revenue $2,500
Cost of sales 1,100
Allocated corporate overhead 60
Local advertising* 960
Other general and admin 350
Operating income $30
Tax expense 9
Net income $21

*Advertising expenses were $570 in 1995, $549 in 1996, and $600 in 1997

Balance Sheet as of January 1

1998 1999

Assets
Cash $320 $300
Accounts Receivable 500 640
Inventory 320 490
Total current assets $1,140 $1,430
Plant (net) 740 810
Total assets $1,880 $2,240

Equities
Accounts payable $190 $380
Other current liabilities 560 709
Total current liabilities $750 $1,089
Long-term debt 0 0
Total liabilities $750 $1,089
Common stock 450 450
Retained earnings 680 701
Total shareholders’ equity $1,130 $1,151
Total equities $1,880 $2,240
© Michal Matějka
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