Assignment Material

Questions

1. 24-1. Give examples of financial and nonfinancial performance measures that can be found in each of the four perspectives of the balanced scorecard.
2. 24-2. What are the three steps in designing accounting-based performance measures?
3. 24-3. What factors affecting ROI does the DuPont method of profitability analysis highlight?
4. 24-4. “RI is not identical to ROI, although both measures incorporate income and investment into their computations.” Do you agree? Explain.
5. 24-5. Describe EVA.
6. 24-6. Give three definitions of investment used in practice when computing ROI.
7. 24-7. Distinguish between measuring assets based on current cost and historical cost.
8. 24-8. What special problems arise when evaluating performance in multinational companies?
9. 24-9. Why is it important to distinguish between the performance of a manager and the performance of the organization subunit for which the manager is responsible? Give an example.
10. 24-10. Describe moral hazard.
11. 24-11. “Managers should be rewarded only on the basis of their performance measures. They should be paid no salary.” Do you agree? Explain.
12. 24-12. Explain the role of benchmarking in evaluating managers.
13. 24-13. Explain the incentive problems that can arise when employees must perform multiple tasks as part of their jobs.
14. 24-14. Describe two disclosures required by the SEC with respect to executive compensation.
15. 24-15. Describe the four levers of control.

Multiple-Choice Questions

1. 24-16. During the current year, a strategic business unit (SBU) within Roke Inc. saw costs increase by $2 million, revenues increase by $4 million, and assets decrease by $1 million. SBUs are set up by Roke as follows:
   1. I. Cost SBU
   2. II. Revenue SBU
   3. III. Profit SBU
   4. IV. Investment SBU
2. Given the preceding numbers, an SBU manager will receive a favorable performance review if she is responsible for
   1. a. I or IV only.
   2. b. II or III only.
   3. c. I, II, or IV only.
   4. d. II, III, or IV only.
3. 24-17. Assuming an increase in price levels over time, which of the following asset valuations will produce the highest return on assets?
   1. a. Net book value
   2. b. Gross book value
   3. c. Replacement cost
   4. d. Depreciated replacement cost
4. 24-18. If ROI is used to evaluate a manager’s performance for a relatively new division, which of the following measures for assets (or investment) will increase ROI?
   1. a. Gross book value used instead of net book value.
   2. b. Net book value using accelerated rather than straight-line depreciation.
   3. c. Gross book value used instead of replacement cost, if gross book value is higher.
   4. d. Replacement cost used instead of liquidation value, if replacement cost is higher.
5. 24-19. The Long Haul Trucking Company is developing metrics for its drivers. The company computes variable costs of each load based upon miles driven and allocates fixed costs based upon time consumed. Load costing standards consider safe driving speeds and Department of Transportation regulations on hours of service (the amount of time the driver can be on duty or drive). The most effective metric for driver performance would likely be
   1. a. Contribution per mile driven.
   2. b. Gross margin per mile driven.
   3. c. Achievement of delivered loads in allowed times.
   4. d. Percentage increase in delivered loads below standard.
6. 24-20. ABC Inc. wants to maintain a capital structure of 80% equity and 20% debt. They currently have an effective tax rate of 30%. The company’s cost of equity capital is 12%. To obtain their debt financing, they issue bonds with an interest rate of 10%. What is the company’s weighted average cost of capital?
   1. a. 8.0%
   2. b. 10.4%
   3. c. 11.0%
   4. d. 11.6%

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Exercises

1. 24-21. ROI, COMPARISONS OF THREE COMPANIES. (CMA, adapted) Return on investment (ROI) is often expressed as follows:

1. Required

1. What advantages are there in the breakdown of the computation into two separate components?

2. Fill in the blanks for the following table:

1. After filling in the blanks, comment on the relative performance of these companies as thoroughly as the data permit.
2. 24-22. ANALYSIS OF RETURN ON INVESTED ASSETS, COMPARISON OF TWO DIVISIONS, DUPONT METHOD. Online Learning, Inc. has two divisions: Test Preparation and Language Arts. Results (in millions) for the past 3 years are partially displayed here:

1. Required

1. Complete the table by filling in the blanks.

2. Use the DuPont method of profitability analysis to explain changes in the operating-income-to-total-assets ratios over the 2018–2020 period for each division and for Online Learning as a whole. Comment on the results.

1. 24-23. ROI AND RI. (D. Kleespie, adapted) The Quality Athletics Company produces a wide variety of sports equipment. Its newest division, Golf Technology, manufactures and sells a single product—AccuDriver, a golf club that uses global positioning satellite technology to improve the accuracy of golfers’ shots. The demand for AccuDriver is relatively insensitive to price changes. The following data are available for Golf Technology, which is an investment center for Quality Athletics:

1. Required

1. Compute Golf Technology’s ROI if the selling price of AccuDrivers is $930 per club.

2. If management requires an ROI of at least 25% from the division, what is the minimum selling price that the Golf Technology Division should charge per AccuDriver club?

3. Assume that Quality Athletics judges the performance of its investment centers on the basis of RI rather than ROI. What is the minimum selling price that Golf Technology should charge per AccuDriver if the company’s required rate of return is 20%?

1. 24-24. ROI, RI, MEASUREMENT OF ASSETS. Carter Corporation recently announced a bonus plan to be awarded to the manager of its most profitable division. The three division managers are to choose whether ROI or RI will be used to measure profitability. In addition, they must decide whether investment will be measured using gross book value or net book value of assets. Carter defines income as operating income and investment as total assets. The following information is available for the year just ended:

1. Carter uses a required rate of return of 10% on investment to calculate RI.
2. Required
3. Each division manager has selected a method of bonus calculation that ranks his or her division number one. Identify the method for calculating profitability that each manager selected, supporting your answer with appropriate calculations. Comment on the strengths and weaknesses of the methods chosen by each manager.
4. 24-25. ROI AND RI WITH MANUFACTURING COSTS. Fabulous Motor Company makes electric model cars and has two products, the Simplegreen and the Fabulousgreen. To produce the Simplegreen, Fabulous Motor employed assets of $11,250,000 at the beginning of 2020 and $4,790,000 of assets at the end of 2020. Other costs to manufacture the Simplegreen include the following:

1. General administration and selling costs for Simplegreen total $6,230,000 in 2020. During the year, Fabulous Motor produced 16,000 Simplegreen cars using 5,000 setup-hours and 178,500 machine-hours. It sold these cars for $6,000 each.
   1. Required
   2. 1. Assuming that Fabulous Motor defines investment as average assets during the period, what is the return on investment for the Simplegreen division?
   3. 2. Calculate the residual income for Simplegreen if Fabulous Motor has a required rate of return of 8% on investments.
2. 24-26. ROI, RI, EVA. Hamilton Corp. is a reinsurance and financial services company. Hamilton strongly believes in evaluating the performance of its stand-alone divisions using financial metrics such as ROI and residual income. For the year ended December 31, 2020, Hamilton’s chief financial officer (CFO) received the following information about the performance of the property/casualty division:

1. For the purposes of divisional performance evaluation, Hamilton defines investment as total assets and income as operating income (that is, income before interest and taxes). The firm pays a flat rate of 25% in taxes on its income.
   1. Required
   2. 1. What was the net income after taxes of the property/casualty division?
   3. 2. What was the division’s ROI for the year?
   4. 3. Based on Hamilton’s required rate of return of 8%, what was the property/casualty division’s residual income for 2020?
   5. 4. Hamilton’s CFO has heard about EVA and is curious about whether it might be a better measure to use for evaluating division managers. Hamilton’s four divisions have similar risk characteristics. Hamilton’s debt trades at book value while its equity has a market value approximately 150% that of its book value. The company’s cost of equity capital is 10%. Calculate each of the following components of EVA for the property/casualty division, as well as the final EVA figure:
      1. a. Net operating profit after taxes
      2. b. Weighted-average cost of capital
      3. c. Investment, as measured for EVA calculations

1. 24-27. ROI, LOSS-MAKING DIVISION. Mary Jane is an upscale retailer for women’s clothing with stores in many high-end shopping centers across the United States. In recent years, sales in most of the stores, especially the company’s flagship store in the midtown of Manhattan, have been declining since Mary Jane is increasingly selling its clothing through its website. Not willing to give up on its flagship store, senior management at headquarters hired Susan Marcos 2 years ago to turn around the New York City store. The company is currently evaluating all its division managers using return on investment. The flagship store’s financial performance in 2019 and 2020 was as follows (in thousands):

1. Required

1. Calculate the flagship store’s ROI for 2020.

2. The company has a corporate-wide policy of not paying out a bonus when a division’s ROI is negative. Do you think that the company is making a mistake by not paying Susan Marcos a bonus for 2020?

3. How could the company change its bonus program so that Susan Marcos could receive a bonus for 2020?

1. 24-28. GOAL INCONGRUENCE AND ROI. McCall Corporation manufactures furniture in several divisions, including the patio furniture division. The manager of the patio furniture division plans to retire in 2 years. The manager receives a bonus based on the division’s ROI, which is currently 15%.
2. One of the machines that the patio furniture division uses to manufacture the furniture is rather old, and the manager must decide whether to replace it. The new machine would cost $30,000 and would last 10 years. It would have no salvage value. The old machine is fully depreciated and has no trade-in value. McCall uses straight-line depreciation for all assets. The new machine, being new and more efficient, would save the company $6,000 per year in cash operating costs. The only difference between cash flow and net income is depreciation. The internal rate of return of the project is approximately 15%. McCall Corporation’s weighted-average cost of capital is 6%. McCall is not subject to any income taxes.
   1. Required
   2. 1. Should McCall Corporation replace the machine? Why or why not?
   3. 2. Assume that “investment” is defined as average net long-term assets (that is, after depreciation) during the year. Compute the project’s ROI for each of its first 5 years. If the patio furniture manager is interested in maximizing his bonus, would he replace the machine before he retires? Why or why not?
   4. 3. What can McCall do to entice the manager to replace the machine before retiring?
3. 24-29. ROI, RI, EVA. Accelerate Auto Company operates a new car division (that sells high-performance sports cars) and a performance parts division (that sells performance-improvement parts for family cars). Some division financial measures for 2020 are as follows:

1. Required

1. Calculate return on investment (ROI) for each division using operating income as a measure of income and total assets as a measure of investment.

2. Calculate residual income (RI) for each division using operating income as a measure of income and total assets minus current liabilities as a measure of investment.

3. William Abraham, the new car division manager, argues that the performance parts division has “loaded up on a lot of short-term debt” to boost its RI. Calculate an alternative RI for each division that is not sensitive to the amount of short-term debt taken on by the performance parts division. Comment on the result.

4. Accelerate Auto Company, whose tax rate is 30%, has two sources of funds: long-term debt with a market value of $16,000,000 at an interest rate of 10% and equity capital with a market value of $9,000,000 and a cost of equity of 14%. Applying the same weighted-average cost of capital (WACC) to each division, calculate EVA for each division.

5. Use your preceding calculations to comment on the relative performance of each division.

1. 24-30. CAPITAL BUDGETING, RI. Ryan Alcoa, a new associate at Jonas Partners, has compiled the following data for a potential investment for the firm:
2. Investment: $300,000
5. 4-year useful life, no salvage value
6. Jonas Partners faces a 30% tax rate on income and is aware that the tax authorities will only permit straight-line depreciation for tax purposes. The firm has an after-tax required rate of return of 8%.
   1. Required
   2. 1. Based on net present value considerations, is this a project Jonas Partners would want to take?
   3. 2. Jonas Partners uses straight-line depreciation for internal accounting and measures investment as the net book value of assets at the start of the year. Calculate the residual income in each year if the project were adopted.
   4. 3. Demonstrate that the conservation property of residual income, as described in section Alternative Definitions of Investment, holds in this example.
   5. 4. If Ryan Alcoa is evaluated on the residual income of the projects he undertakes, would he take this project? Explain.
7. 24-31. MULTINATIONAL PERFORMANCE MEASUREMENT, ROI, RI. The Mountainside Corporation manufactures similar products in the United States and Norway. The U.S. and Norwegian operations are organized as decentralized divisions. The following information is available for 2020; ROI is calculated as operating income divided by total assets:

1. Both investments were made on December 31, 2019. The exchange rate at the time of Mountainside’s investment in Norway on December 31, 2019, was $8\hspace{0.17em}\text{kroner}=\mathrm{\$}1\mathrm{.}$ During 2020, the Norwegian kroner decreased steadily in value so that the exchange rate on December 31, 2020, is $9\hspace{0.17em}\text{kroner}=\mathrm{\$}1\mathrm{.}$ The average exchange rate during 2020 is $[(8+9)÷2]=8.5\hspace{0.17em}\text{kroner}=\$1.$  
   1. Required
   2. 1. 
      1. a. Calculate the U.S. division’s operating income for 2020.
      2. b. Calculate the Norwegian division’s ROI for 2020 in kroner.
   3. 2. Top management wants to know which division earned a better ROI in 2020. What would you tell them? Explain your answer.
   4. 3. Which division do you think had the better RI performance? Explain your answer. The required rate of return on investment (calculated in U.S. dollars) is 12%.

1. 24-32. ROI, RI, EVA, AND PERFORMANCE EVALUATION. Isla Manufacturing makes fashion products and competes on the basis of quality and leading-edge designs. The company has two divisions, clothing and cosmetics. Isla has $2,500,000 invested in assets in its clothing division. After-tax operating income from sales of clothing this year is $550,000. The cosmetics division has $11,000,000 invested in assets and an after-tax operating income this year of $1,650,000. The weighted-average cost of capital for Isla is 8%. The CEO of Isla has told the manager of each division that the division that “performs best” this year will get a bonus.
   1. Required
   2. 1. Calculate the ROI and residual income for each division of Isla Manufacturing, and briefly explain which manager will get the bonus. What are the advantages and disadvantages of each measure?
   3. 2. The CEO of Isla Manufacturing has recently heard of another measure similar to residual income called EVA. The CEO has the accountant calculate adjusted incomes for clothing and cosmetics, and finds that the adjusted after-tax operating incomes are $401,400 and $2,067,200, respectively. Also, the clothing division has $270,000 of current liabilities, while the cosmetics division has only $120,000 of current liabilities. Using the preceding information, calculate the EVA for each division and discuss which manager will get the bonus.
   4. 3. What nonfinancial measures could Isla use to evaluate divisional performances?

1. 24-33. RISK SHARING, INCENTIVES, BENCHMARKING, MULTIPLE TASKS. Estancia, Inc. is a large company that owns restaurants and has a wine division and a frozen food division. Management of the company gives its division managers autonomy in running their divisions for both operating and investment decisions. Estancia is considering how it should compensate Mr. Jim Beam, the general manager of the frozen food division.
   1. • Proposal 1 calls for paying Beam a fixed salary.
   2. • Proposal 2 calls for paying Beam no salary and compensating him only on the basis of the division’s RI, calculated based on operating income before any bonus payments.
   3. • Proposal 3 calls for paying Beam some salary and some bonus based on RI.
   4. Required
   5. 1. Evaluate the three proposals, specifying the advantages and disadvantages of each.
   6. 2. Estancia competes against Starship Industries in the frozen food business. Starship is approximately the same size as Estancia’s frozen food division and operates in a similar business environment. Top management of Estancia is considering evaluating Beam on the basis of his division’s RI minus Starship’s RI. Of course, Beam complains that this approach is unfair because the performance of another company, over which he has no control, is included in his performance evaluation measure. Is Beam’s complaint valid? Why or why not?
   7. 3. Now suppose that Beam has no authority for making capital-investment decisions. Corporate management makes these decisions. Is RI a good performance measure to use to evaluate Beam? Is RI a good measure to evaluate the economic viability of the frozen food division? Explain.
   8. 4. The salespeople for the frozen food division of Estancia, Inc. are responsible for selling and for providing customer service and support. Sales are easy to measure. Although customer service is important to the frozen food division in the long run, the division has not yet implemented customer-service measures. Beam wants to compensate his sales force only on the basis of sales commissions paid for each unit of product sold. He cites two advantages to this plan:
      1. a. It creates strong incentives for the sales force to work hard.
      2. b. The company pays salespeople only when the company itself is earning revenues.
   9. Do you agree with this plan? Why or why not?

Problems

1. 24-34. RESIDUAL INCOME AND EVA; TIMING ISSUES. Doorharmony Company makes doorbells. It has a weighted-average cost of capital of 7% and total assets of $5,630,000. Doorharmony has current liabilities of $750,000. Its operating income for the year was $620,000. Doorharmony does not have to pay any income taxes. One of the expenses for accounting purposes was a $150,000 advertising campaign run in early January. The entire amount was deducted this year, although the Doorharmony CEO believes the beneficial effects of this advertising will last 4 years.
   1. Required
   2. 1. Calculate residual income, assuming Doorharmony defines investment as total assets.
   3. 2. Calculate EVA for the year. Adjust both the year-end assets and operating income for advertising assuming that for the purposes of economic value added the advertising is capitalized and amortized on a straight-line basis over 4 years.
   4. 3. Discuss the difference between the outcomes of requirements 1 and 2. Which measure would you recommend, and why?
2. 24-35. ROI PERFORMANCE MEASURES BASED ON HISTORICAL AND CURRENT COST. Blue Fish owns and operates coffee shops in three large cities on the West Coast: Seattle, San Francisco, and Los Angeles. The three geographic areas are considered separate divisions. Each division owns the buildings of the coffee shops, which are considered long-term assets. The buildings are all 10 years old and have a total useful life of 20 years. Current assets are considered negligible in each division. Division managers at Blue Fish are evaluated on the basis of ROI, which traditionally has been calculated as the ratio of operating income divided by the net book value of assets, measured at historical costs. The following information refers to the three divisions at the end of 2020:

1. Senior management at Blue Fish wants to switch to calculating ROI based on current costs. Costs of new constructions have exploded all along the West Cost and would now be twice as expensive as they were 10 years ago. In other words, the construction cost index has doubled in all three cities. (The useful life of new constructions is still 20 years).
   1. Required
   2. 1. Explain how the numerator of the ROI measure, operating income, has to be adjusted to reflect current costs and do the calculation for the three divisions (see Exhibit 24-2).
   3. 2. Explain how the denominator of the ROI measure, net book value of assets, has to be adjusted to reflect current costs and do the calculations for the three divisions (see Exhibit 24-2).
   4. 3. Calculate ROI based on current costs for the three divisions and compare to the ROI measures based on historical costs (see Exhibit 24-2).
2. 24-36. ROI PERFORMANCE MEASURES BASED ON HISTORICAL COST AND CURRENT COST. Natural Bounty Corporation operates three divisions that process and bottle natural fruit juices. The historical-cost accounting system reports the following information for 2020:

1. Natural Bounty estimates the useful life of each plant to be 12 years, with no terminal disposal value. The straight-line depreciation method is used. At the end of 2020, the passion fruit plant is 10 years old, the kiwi fruit plant is 4 years old, and the mango fruit plant is 2 years old. An index of construction costs over the 10-year period that Natural Bounty has been operating $(2010\hspace{0.17em}\text{year-end}=100)$ is as follows:

1. Given the high turnover of current assets, management believes that the historical-cost and current-cost measures of current assets are approximately the same.
   1. Required
   2. 1. Compute the ROI ratio (operating income to total assets) of each division using historical-cost measures. Comment on the results.
   3. 2. Use the approach in Exhibit 24-2 to compute the ROI of each division, incorporating current-cost estimates as of 2020 for depreciation expenses and long-term assets. Comment on the results.
   4. 3. What advantages might arise from using current-cost asset measures as compared with historical-cost measures for evaluating the performance of the managers of the three divisions?
2. 24-37.  MULTINATIONAL FIRMS, DIFFERING RISK, COMPARISON OF PROFIT, ROI, AND RI. Newmann, Inc. has divisions in the United States, France, and Australia. The U.S. division is the oldest and most established of the three and has a cost of capital of 6%. The French division was started 4 years ago when the exchange rate for the euro was $\mathrm{€}1=\mathrm{\$}1.34$ USD. The French division has a cost of capital of 8%. The division in Australia was started this year, when the exchange rate was 1 Australian Dollar (AUD) = $0.87 USD. Its cost of capital is 11%. Average exchange rates for the current year are $\mathrm{€}1=\mathrm{\$}1.07$ USD and $1 \text{AUD}=\mathrm{\$}0.74 \text{USD}$. Other information for the three divisions includes the following:

1. Required

1. Translate the French and Australian information into dollars to make the divisions comparable. Find the after-tax operating income for each division and compare the profits.

2. Calculate ROI using after-tax operating income. Compare among divisions.

3. Use after-tax operating income and the individual cost of capital of each division to calculate residual income and compare.

Financial and nonfinancial performance4. Redo requirement 2 using pretax operating income instead of net income. Why is there a big difference, and what does this mean for performance evaluation?

1. 24-38. ROI, RI, DUPONT METHOD, INVESTMENT DECISIONS, BALANCED SCORECARD. News Report Group has two major divisions: print and Internet. Summary financial data (in millions) for 2019 and 2020 are as follows:

1. The two division managers’ annual bonuses are based on division ROI (defined as operating income divided by total assets). If a division reports an increase in ROI from the previous year, its management is automatically eligible for a bonus; however, the management of a division reporting a decline in ROI has to present an explanation to the News Report Group board and is unlikely to get any bonus.
2. Carol Mays, manager of the print division, is considering a proposal to invest $2,580 million in a new computerized news reporting and printing system. It is estimated that the new system’s state-of-the-art graphics and ability to quickly incorporate late-breaking news into papers will increase 2021 division operating income by $360 million. News Report Group uses a 10% required rate of return on investment for each division.
   1. Required
   2. 1. Use the DuPont method of profitability analysis to explain differences in 2020 ROIs between the two divisions. Use 2020 total assets as the investment base.
   3. 2. Why might Mays be less than enthusiastic about accepting the investment proposal for the new system despite her belief in the benefits of the new technology?
   4. 3. John Mendenhall, CEO of News Report Group, is considering a proposal to base division executive compensation on division RI.
      1. a. Compute the 2020 RI of each division.
      2. b. Would adoption of an RI measure reduce Mays’ reluctance to adopt the investment proposal for the new computerized system?
   5. 4. Mendenhall is concerned that the focus on annual ROI could have an adverse long-run effect on News Report Group’s customers. What other measurements, if any, do you recommend that Mendenhall use? Explain briefly.

1. 24-39. DIVISION MANAGERS’ COMPENSATION, LEVERS OF CONTROL (CONTINUATION OF 24-38). John Mendenhall seeks your advice on revising the existing bonus plan for division managers of News Report Group. Assume division managers do not like bearing risk. Mendenhall is considering three ideas:
   1. • Make each division manager’s compensation depend on division RI.
   2. • Make each division manager’s compensation depend on company-wide RI.
   3. • Use benchmarking and compensate division managers on the basis of their division’s RI minus the RI of the other division.
   4. Required
   5. 1. Evaluate the three ideas Mendenhall has put forth using performance-evaluation concepts described in this chapter. Indicate the positive and negative features of each proposal.
   6. 2. Mendenhall is concerned that the pressure for short-run performance may cause managers to cut corners. What systems might Mendenhall introduce to avoid this problem? Explain briefly.
   7. 3. Mendenhall is also concerned that the pressure for short-run performance might cause managers to ignore emerging threats and opportunities. What system might Mendenhall introduce to prevent this problem? Explain briefly.
2. 24-40. EXECUTIVE COMPENSATION, BALANCED SCORECARD. Kroger Company recently introduced a new bonus plan for its corporate executives. The company believes that current profitability and customer satisfaction levels are equally important to the company’s long-term success. As a result, the new plan awards a bonus equal to 0.5% of salary for each 1% increase in business unit net income or 1% increase in the business unit’s customer satisfaction index. For example, increasing net income from $1 million to $1.1 million (or 10% from its initial value) leads to a bonus of 5% of salary, while increasing the business unit’s customer satisfaction index from 50 to 60 (or 20% from its initial value) leads to a bonus of 10% of salary. There is no bonus penalty when net income or customer satisfaction declines. In 2019 and 2020, Kroger’s three business units reported the following performance results:

1. Required

1. Compute the bonus as a percent of salary earned by each business unit executive in 2020.

2. What factors might explain the differences between improvement rates for net income and those for customer satisfaction in the three units? Are increases in customer satisfaction likely to result in increased net income right away?

3. Kroger’s board of directors is concerned that the 2020 bonus awards may not accurately reflect the executives’ overall performance. In particular, the board is concerned that executives can earn large bonuses by doing well on one performance dimension but underperforming on the other. What changes can it make to the bonus plan to prevent this from happening in the future? Explain briefly.

1. 24-41. FINANCIAL AND NONFINANCIAL PERFORMANCE MEASURES, GOAL CONGRUENCE. (CMA, adapted) Precision Equipment specializes in the manufacture of medical equipment, a field that has become increasingly competitive. Approximately 2 years ago, Pedro Mendez, president of Precision, decided to revise the bonus plan (based, at the time, entirely on operating income) to encourage division managers to focus on areas that were important to customers and that added value without increasing cost. In addition to a profitability incentive, the revised plan includes incentives for reduced rework costs, reduced sales returns, and on-time deliveries. The company calculates and rewards bonuses semiannually on the following basis: A base bonus is calculated at 2% of operating income; this amount is then adjusted as follows:
   1. a. 
      1. i. Reduced by excess of rework costs over and above 2% of operating income
      2. ii. No adjustment if rework costs are less than or equal to 2% of operating income
   2. b. 
      1. i. Increased by $4,000 if more than 98% of deliveries are on time and by $1,500 if 96–98% of deliveries are on time
      2. ii. No adjustment if on-time deliveries are below 96%
   3. c. 
      1. i. Increased by $2,500 if sales returns are less than or equal to 1.5% of sales
      2. ii. Decreased by 50% of excess of sales returns over 1.5% of sales
2. If the calculation of the bonus results in a negative amount for a particular period, the manager simply receives no bonus, and the negative amount is not carried forward to the next period.
3. Results for Precision’s Central division and Western division for 2020, the first year under the new bonus plan, follow. In 2019, under the old bonus plan, the Central division manager earned a bonus of $20,295 and the Western division manager received a bonus of $15,830.

Required

1. Why did Mendez need to introduce these new performance measures? That is, why does Mendez need to use these performance measures in addition to the operating-income numbers for the period?

2. Calculate the bonus earned by each manager for each 6-month period and for 2020 overall.

3. What effect did the change in the bonus plan have on each manager’s behavior? Did the new bonus plan achieve what Mendez wanted? What changes, if any, would you make to the new bonus plan?

1. 24-42. ETHICS, LEVERS OF CONTROL. Channels is a manufacturer of flatware that is grade-rolled rather than stamped. The flatware is sold in upscale stores as a high-quality item. The company sells the goods that are within specifications at regular prices to the stores. If a piece doesn’t pass inspection, it is put through a second inspection, and if useable, is sold at a highly discounted price to low-end stores.
2. In recent years, the company’s average yield as been 93% of first-quality products. Last year, the company put in place a performance-evaluation system that utilizes both profit numbers vs. budget and budgeted yield, which had been set at 93% based on recent year history.
3. When Fannie May, the company controller, was reviewing the performance evaluation results, she noted that the yield percentage was 96% in the year just ended, which resulted in significantly better than budgeted profits. Ms. May decided to investigate.
4. The supervisor in the quality control department was happy to show Ms. May what changes were made that resulted in the improved yield percentage. In short, the supervisor of the department, following the manager’s instructions, had changed the measuring procedure to determine what was “within specification” such that more pieces were in compliance than before. Ms. May worried that the customers would be unhappy with the lower quality of the pieces they would be receiving.
   1. Required
   2. 1. What should Ms. May do? You may want to refer to the IMA Statement of Ethical Professional Practice, page 17.
   3. 2. Which lever of control is Channels emphasizing? What changes, if any, should be made?
5. 24-43. RI, EVA, MEASUREMENT ALTERNATIVES, GOAL CONGRUENCE. Refresh Resorts, Inc., operates health spas in Key West, Florida; Phoenix, Arizona; and Carmel, California. The Key West spa was the company’s first and opened in 1994. The Phoenix spa opened in 2007, and the Carmel spa opened in 2016. Refresh Resorts has previously evaluated divisions based on RI, but the company is considering changing to an EVA approach. All spas are assumed to face similar risks. Data for 2020 are shown below:

1. Required

1. Calculate RI for each of the spas based on operating income and using total assets as the measure of investment. Suppose that the Key West spa is considering adding a new group of saunas from Finland that will cost $225,000. The saunas are expected to bring in operating income of $22,000. What effect would this project have on the RI of the Key West spa? Based on RI, would the Key West manager accept or reject this project? Without resorting to calculations, would the other managers accept or reject the project? Why?

2. Why might Refresh Resorts want to use EVA instead of RI for evaluating the performance of the three spas?

3. Refer back to the original data. Calculate the WACC for Refresh Resorts.

4. Refer back to the original data. Calculate EVA for each of the spas, using net book value of long-term assets. Calculate EVA again, this time using gross book value of long-term assets. Comment on the differences between the two methods.

5. How does the selection of asset measurement method affect goal congruence?