CHAPTER 22

CONTROL: THE MANAGEMENT CONTROL ENVIRONMENT

Changes from the Eleventh Edition

All changes were minor.

Approach
This chapter and the following one are a sharp change of pace from the preceding chapters because there
are no numerical techniques or procedures to be learned. Instead, the chapters establish a framework and
describe concepts that are essential to an understanding of the chapters that follow. It is probably
desirable to point out this change of pace in assigning the chapter so that students will know what to
expect.

Since the text expands on material that was introduced in Chapter 15, it may be desirable to ask students
to reread Chapter 15 at this point. Points that were obscure when Chapter 15 was first assigned should
now be clearer.

Although the topic has come up several times previously, it probably is desirable to emphasize again the
fact that there are three types of management accounting information, each of which is appropriate to
certain types of problems but not to others, and that mistakes are made when the wrong type of data is
used. Illustration 22-3 is designed to make this point, particularly with reference to the differences
between responsibility accounting and full cost accounting. It may be well to discuss this exhibit in detail.
There is sometimes a tendency to play down the importance of full cost accounting because it is not
useful in the control of responsibility centers, but this reflects an erroneous “either-or” attitude. It is not a
case of choosing either one approach or the other, each approach is needed in a company, and each has its
own uses.

Cases

Behavioral Implications of Airline Depreciation Accounting Policy Choices shows students that
companies’ measurement choices vary widely and motivates a discussion as to whether these choices
affect manager’s decisions, and if so how.

Shuman Automobiles Inc. introduces the concepts of responsibility centers and transfer prices in a setting
that students can easily understand.

Zumwald AG is a transfer pricing case, with the emphasis on the behavioral effects of the transfer pricing
alternatives.

Enager Industries, Inc., is a case on the introduction of an ROI measurement scheme for business
divisions. It can be used to discuss almost any aspect of investment centers.

Piedmont University deals with several management control issues in a nonprofit organization, especially

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the use of profit centers.

Problems
Problem 22-1: Arbia Company
Relevant Costs

a. For financial statements—full costs of Department 7:

$50,990, or $50.99 per unit for units sold or left in inventory.

b. Decisions to make or buy Part No. 105—differential costs:

Purchase cost..........................................................................................................................................................................
$31.00 per unit

Materials and labor cost if make............................................................................................................................................

29.82 per unit

Savings if make......................................................................................................................................................................
$1.18 (assuming no fixed costs are differential)

c. Assessing performance of manager of Department 7:

Costs for which the manager is responsible are the variable and fixed costs of Department 7, $36,700.
Costs allocated to Department 7, $14,290, cannot be controlled by the manager. Nevertheless, they
are often shown on responsibility center reports to indicate their magnitude.
Problem 22-2: Golub Company
a. The sales manager's complaint is justified. Product A has the largest net sales of the three products
and under the allocation method used in the first year would, therefore, be charged the largest amount
for advertising expense. However, the actual amount of advertising expense incurred on behalf of
Product A, and hence the responsibility of the manager of Product A, is smaller than that incurred on
behalf of Product B.

b. Product A should be charged $10,000 because that is the amount spent on behalf of Product A. It
would be acceptable to charge Product A with an allocated portion of the institutional advertising,
based on sales volume, but this amount should be separated from the $10,000 for which Product A is
responsible.

Problem 22-3
The transfer price should probably be $240 per thousand boxes because the Hardware Division “buying”
the boxes should not be expected to pay more than if it bought from an outside supplier at $239. This
price from an outside supplier is likely because of the keen competition mentioned in the problem.

Problem 22-4: Urban Services, Inc.

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a. The billing rate should be $104 per hour which is the same rate charged to outside clients since
Portfolio Management is working at capacity. Any price less than this would reduce Portfolio Group
profits, the criterion by which management evaluates performance.

b. If the Portfolio Management Group were not working at capacity, it would be to its advantage to hire
its staff out to any internal group at a billing rate which could go as low as $57.00, its variable cost.

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c. No, the Accounting Services Group ought to have the option of going outside to satisfy its consulting
needs if it can do so at a rate lower than that demanded by the Legal Services Group. If the Legal
Services Group does not have a bona fide outside business at $126.50, it will 1ikely return to the $115
rate. However, the option should remain with each manager to maintain an autonomous management
environment.

Cases
Case 22-1: Behavioral Implications of Airline Depreciation Accounting Policy Choices
Note: This case is unchanged from the Eleventh Edition.

Purpose of Case
It seems obvious that firms’ choices of accounting policies will affect managers’ decision-making. But
somehow when accounting choices are being considered, the financial reporting implications of the
choices seem to dominate.
This case was written to force students to consider the decision-making implications of one seemingly
important accounting policy choice decision. The example is of aircraft depreciation accounting for
airlines. This example was chosen because property, plant and equipment (PP&E) comprises more than
50% of the total assets of an airline, and aircraft are a large proportion of the PP&E. Further, airlines
depreciation policies vary significantly.

Suggested Assignment Questions

This case was used successfully as part of a final exam. The exam questions, which are shown below
(importance weightings in parentheses), can be adapted for use in a classroom setting.
(50%) 1. Assume that at least some rewards for the management team (and, hence, also other
employees) are based on performance measured in terms of accounting income and returns on
net assets. Also assume that all of these airlines are growing; that is, they are adding to their
fleet size.

What are the behavioral implications of each of the three depreciation-related accounting
policy choices: (1) depreciation patterns (i.e., straight-line vs. accelerated); (2) estimated
useful lives; and (3) residual values? Consider, at a minimum, the effects of each of these
choices on decisions regarding:

a. Replacements of aircraft in service;

b. Pricing, assuming that prices are at least somewhat dependent on costs;

c. Evaluations of routes or lines of business;

d. Evaluations of managers, assuming that negotiated budgets provide the primary standards of
performance.

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(20%) 2. Assume that in a particular U.S. airline company there is a conflict between the benefits of
conservatism vs. liberalism in depreciation accounting. That is, for this company
conservatism in depreciation accounting is greatly preferred for financial reporting purposes
(for whatever reason) but for internal purposes the company would be better off if the policies
were more liberal, or vice versa. Would you recommend to the managers of this company that
they adopt a third set of books? That is, should they maintain one set of books for financial
accounting purposes, another set for tax purposes, and a third set for the purposes of running
the business?

(30%) 3. If the managers of a particular airline do not want to maintain a third set of books, should
they tend to be conservative or liberal in their aircraft depreciation accounting? Explain.

Case Analysis
One question that can be usefully posed is: Why do airline companies choose different depreciation
policies? These decisions seem to be driven primarily by financial reporting concerns. More liberal
depreciation policies can be used to slow the recognition of expenses, perhaps to hide losses. More
conservative policies can be used to create hidden reserves that facilitate managers’ management of
earnings.

To a lesser extent, difference in aircraft depreciation policy choices might be driven by different
economic realities. Some aircraft depreciate faster than others. These effects are generally smaller than
most people assume, however. The major airlines fly the same types of planes, for the most part. And in
any case, virtually every aircraft can fly almost indefinitely with proper maintenance.

Students should understand that the lives of aircraft can be greatly affected by management decisions.
Aircraft lives are longer (a) if the airline cannot afford to, or chooses not to, replace the aircraft; (b) if
there is an economic downturn that causes the aircraft to be used less intensively; and (c) if there are no
new technological developments (e.g., fuel efficiency, noise, comfort). One issue that can be usefully
explored in this class is: Which comes first, the accounting policy or the management decisions? Each can
have a causal effect on the other.

Another useful question is to ask students which of the airlines mentioned in the case uses the most liberal
accounting policy for its aircraft? Which uses the most conservative? Looking at the assumptions of
aircraft lives will suggest to all that Lufthansa is the most conservative. American (AMR) is the most
liberal.

Question 1
What are the effects of this accounting policy choice on managerial decisions? More rapid depreciation
causes higher expense on the income statement but reduces aircraft book values on the balance sheet
more quickly. But, interestingly, the reality does not change at all! In the U.S., there are no tax effects and
no cash flow effects, and the economic value of the company does not change. Academic studies have
shown that the stock market is very good at seeing through fully disclosed differences such as these.
Some students get confused about this issue because they do not realize that in the books U.S. firms keep
for tax purposes firms will depreciate their aircraft as quickly as possible, assuming that the company is

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profitable. The case tries to make this clear, in item #5 in the list of “other facts.” In some other countries
the allowed disparities between the financial reporting and tax books of record are not as significant.
While there are no direct effects of this accounting policy choice on real firm value, value can be affected
because managers’ decisions can be affected. Managers do make decisions based on accounting numbers.
One of the clearest behavioral implications of depreciation accounting policies is in the replacement-of-
aircraft decision. Managers in firms that depreciate aircraft slowly tend to be slow to replace their aircraft
because they have to absorb the write-off of the remaining book value. This is a known empirical
regularity. For example, Singapore Airlines and Lufthansa have quite young fleets (e.g., Lufthansa
average age is 3.9 years), while companies such as AMR and Delta have fleets over twice as old.
Similarly, more rapid depreciation will yield higher full costs in cost analyses and can affect pricing
decisions and route/line of business analyses. Management evaluations, on the other hand, should not be
affected because whatever depreciation policies are chosen are built into the budgets that are the primary
performance standard.
In theory, management decision-making should be improved if the accounting records reflect the
economic reality. We know, for example, that the early U.S. railroad companies did not depreciate their
fixed assets. As a consequence, the railroads overstated their income and assets, and the railroad
managers were misled by their own financial statements. Ultimately about 50% of the track put in place
before 1900 was placed in receivership.
But what is the “real” economic depreciation of aircraft? The reality will vary somewhat with the type of
plane and the aircraft’s usage. In general, airframes depreciate based on the number of cycles—takeoffs
and landings—to which they are subjected. The engines depreciate based on the number of hours of
usage. In theory, maintenance could affect aircraft’s real economic depreciation, but there is not much
variation in airlines’ maintenance procedures. The procedures are largely determined by law.
Because used aircraft prices decline very slowly, the economic depreciation is likely to be much slower
than any policy any airline currently uses. So all airlines’ aircraft depreciation policies are conservative, at
least in relatively good economic times. Some are more conservative than others. What is the
management decision-making implication of this conservatism?

Question 2
This question requires students to consider the benefits and costs of having, potentially, a third set of
books. In theory, at least, keeping a set of books that better reflects the economic reality of the declining
value of the aircraft assets should lead to better decision-making. Some companies have changed their
depreciation policies exactly for this purpose, to better reflect the value declines in fixed assets and,
hence, to better match costs and revenues. 1 It is possible that a company’s financial reporting strategy is
not best served by a relatively accurate reflection of economic reality. Almost certainly a company’s cash
flow will be served by being conservative (rapid depreciation) in its tax records. So, in theory, at least, a
company may be best served by maintaining three sets of book.
However, there is a cost of maintaining three sets of books. One cost is monetary. The charts of accounts
and the processing systems must be established, and some transactions must be recorded three different
ways. There is also a possible confusion cost, as not all employees will understand the differences in and
the purposes for the three books of record.

Question 3
This question was posed to force students to reach a conclusion as to what one single accounting policy
choice might be best. They might usefully make observations about each of four sometimes-conflicting
1
For example, see L. Hall and J. Lambert, “Cummins Engine Changes Its Depreciation,” Management Accounting
(July 1996), pp. 30-36.

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concerns—good economic decision-making, financial reporting effects, potentials for asset write-offs (if
assets are depreciated too slowly), and potentials for gameplaying.

Pedagogy

This case should only be used with students who have studied the mechanics of depreciation accounting.
Generally, this is not a constraint because the depreciation topic seems to be included in every
introductory financial accounting course.
Unless the instructor wishes to provide a tutorial on depreciation accounting or replacement cost
depreciation, the discussion of this case can probably be completed in 50-60 minutes. One useful way to
organize the discussion is to follow the order of the assignment questions.
Case 22-2: Shuman Automobiles Inc.
Note: This case is unchanged from the Eleventh Edition.

Approach
In this version of the old Bultman Automobiles case, I have added explicit questions to be certain the
students understand the economics of the illustrative transaction, and how certain measurement
approaches may cause similar future deals to be rejected. The discussion will generate a number of
alternatives, which I force the students to analyze, not just identify. I sometimes find it fruitful in the
midst of this discussion to reiterate the nature of the four different types of responsibility centers in terms
of how inputs, outputs, and assets are measured with each approach. In the last few minutes of class, I
suggest that the “right” measurement approach here is the one that is most congruent with Mr. Shuman's
strategy for the dealership (see comments on question 4).

Comments on Questions
Question 1
The incremental profit on this transaction is as follows (alternate formats are possible):

Revenues: New car................................................................................................................

$7,900 ($14,400 - $6,500)

Used car...............................................................................................................
7,100

15,000

Expenses: New car................................................................................................................

12,240

Repairs.................................................................................................................
1,594

13,834

Incremental profit $1,166

I then point out that all any transfer price proposal does is allocate this $1,166 to the departments in a
certain way. Although this should be obvious, in this introductory case some students do not realize it
without it being made explicit.

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Question 2
Various students will propose essentially every conceivable transfer price for the unrepaired trade-in. I
ask for each proposal to be stated as a policy, since that is what will be needed to implement profit
centers, and then to say what number would result from that policy in this particular instance. I avoid
having students be evaluative of the proposals at this point; rather, I encourage the proliferation of ideas. I
then do the same thing for the repair cost transfer price, although now the list usually amounts essentially
to only four items: incremental cost, full cost, market price, and market price less a discount (justified by
the used car department being service's biggest customer or by giving reconditioning work second
priority).

With both lists on the board, I suggest that to save time in choosing from among all of the alternatives we
first agree on some criteria or objectives that a “good” transfer pricing scheme should meet. A full list is
given in the chapter's text under the heading “multiple criteria.” The three that I think absolutely must be
brought out are (1) perceived as fair by the managers involved (this is almost always the first one
mentioned when I teach this case in executive seminars), (2) leads to the managers' making decisions in
the overall best interest of the dealership (i.e., goal congruence), and (3) does not distort departmental
profitability (see the postscript at the end of this note for the rationale and illustrative numbers). In my
experience, the first criterion alone tends to eliminate all options on the trade-in transfer price except
auction, wholesale, and Blue Book: these are all market prices, and in a given instance auction and
wholesale tend to be mutually exclusive. With respect to the repairs, the consensus usually is for market
price less, perhaps, a volume discount; sometimes negotiating on a case-by-case basis is favored if the
students’ perception is that this won't become too time-consuming for the two managers involved. I think
that the issue of sourcing freedom for the used car manager should also be brought out, especially if the
price is negotiated, the used car manager needs to have a legitimate option if the negotiation is to be
meaningful.

So that the other issues can be discussed, at some point I cut off this discussion, explaining why I favor
$5,000: it is Moyer's responsibility to dispose of the trade-in, and since we do not want in effect to put her
in the used car business in competition with Fiedler, her only real option is the “as-is” market price; the
$5,000 she could get by sending the car to the next auction. (Were this a “cream-puff” trade-in, she could
probably wholesale iti.e., sell it to another dealer.)

For the service department repairs, the price should be $2,152, an imputed market price. This is 135
percent of the $1,594 costs, the same markup as is illustrated several places in the case: $2,000/$1,480;
$2,042 / $1,512; and $980,722/ $726,461-all equal 1.35. To the students arguing for an incremental-cost
transfer price, I point out that Bianci could lower the usual markup if the service department has excess
capacity and Fiedler is able to get a better price outside the dealership. I leave open the possibility of a
discount, but say that we don't have time or information to reach a consensus on how large it should be.

With my favored transferred prices, the three departments will have contributions as shown in the table
below. This makes it clear that if each manager is to run his or her department as an independent business
(which is exactly what Shuman has told them, and reinforced by compensating them based on a
percentage of department gross profit), Fiedler will not pay $5,000 for the used car. This means Moyer
will sell it at auction, putting all dealership margin on the deal ($660) in the new car department. Whether

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this is good or bad depends on whether the service department is effectively at capacity without
reconditioning work; I don't bring this up explicitly, but let the students discover it in answering question

3.

New Cars Used Cars Service

Revenues......................................................................................................................................................
$ 7,900 new

5,000 used $ 7,100 used $ 2,152 repairs

12,900 7,100 2,152

Expenses.......................................................................................................................................................
12,240 new 5,000 used 1,594

______ 2,152 repairs ______

12,240 7,152 1,594

Increment profit............................................................................................................................................
$ 660 $ (52) $ 558

$1,166

Question 3
This question asks the student to assume the service department is at capacity (which seems to be the case
with most car dealerships I've dealt with). The implication of this is that if the reconditioning work is
performed, other work will be turned away; or, equivalently, if the reconditioning work is not performed,
the service department will earn its $558 gross profit on outside work. In this case, if Fiedler rejects the
trade-in, total dealership contribution will be $1,218 ($660 + $558), or $52 more than if Fiedler agreed (or
were forced) to accept the trade-in. Thus, with the service department at capacity, the market-based
transfer prices I argued for above will, with each manager trying to maximize his or her department's
profit, also maximize dealership profit.

Question 4
Discussion of the previous two questions causes some students to realize that the best management
control structure cannot be agreed upon without first deciding what role Mr. Shuman expects the service
department to play in the overall strategy of the dealership. If Mr. Shuman views the service department
essentially as an independent repair shop, then treating it as a profit center and charging cost plus 35
percent for internal work is appropriate. If he wants to keep the service department at capacity but give
preference to customer work (as opposed to reconditioning), the department can be a profit center, but
with a lower-than-market price for internal reconditioning work, so that such work is used to fill slack
time. Finally, if he feels that car dealerships are differentiated from one another primarily by the
accessibility and quality of work of their service departments, then he should downplay service
profitability and tolerate occasional slack capacity so that a Shuman new or used car customer doesn't

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have to wait several days for repair work. This argues for an expense center approach, with an explicit
effort made to measure service department customer satisfaction.

In my opinion, the first paragraph of the case makes it clear that it is this last strategy that Mr. Shuman
has chosen. Thus, he should reconsider his proposal, which so greatly emphasizes the profitability of the
service department. The case illustrates that the success of the dealership rests somewhat on the three
managers' cooperating with one another and being willing to make quick decisions (the potential
customer will only wait so long while a decision is made on a trade-in allowance) in the best interests of
the overall dealership without being overly concerned about the impact of a decision on specific
departments. (As an aside, I am told that one of the “Big Three” automobile manufacturers is having
second thoughts about its past advice to dealers to set up service as a profit center, because the service
departments are not concerned enough about being supportive of the sales departments.) My own
preference, then, is to treat each sales department as a profit center and service as an expense center. I
would pay each manager a salary, perhaps a bonus tied to one or more department-specific objectives,
and definitely a percentage of dealership profits to encourage cooperation in the best interests of the
dealership.

Postscript
One year an alert student pointed out that if 135 percent of reconditioning cost is used in Exhibit 1 for
service department revenues and used car department costs (to reflect market prices for reconditioning
work, rather than the former transfer prices), then service department gross profit becomes $340,331, and
used car drops to $186,526. This completely alters the apparent relative profitability of the three
departments, making service more profitable than new carsbut of course, this doesn't alter the need for
careful interpretation of such interdependent figures. [The student had auto industry experience, and said
Mr. Shuman was unusual if he really believed that new car sales (looked at in isolation) was more
profitable than service work.] This also illustrates one reason for so many companies’ using market-based
transfer prices: to avoid “hidden subsidies” that distort subunit profitability and, if not recognized, can
lead to incorrect major resource allocation decisions.

Case 22-3: Zumwald AG

Note: This case is unchanged from the Eleventh Edition.

Purpose of Case
This case describes a transfer pricing issue that is common in decentralized, divisionalized firms. The
case raises issues about internal pricing and, more generally, the operation of a decentralized management
structure.

Suggested Assignment Questions

1. What sourcing decision for the X73 materials is in the best interest of:

a. The Imaging Systems Division?

b. The Heidelberg Division?

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c. The Electronic Components Division?

d. Zumwald AG?

2. What should Mr. Fettinger do?

Case Analysis
The suggested assignment points students in the right direction. Zumwald’s ISD division is sourcing
displays for its X73 system. The division solicited three quotes. The lowest quote, for €100,500 was from
a British company, Display Technologies PLC. Another quote, for €120,500, came from a Dutch
company, Bogardus NV. The high quote, for €140,000, came from Zumwald’s Heidelberg Division.
Should ISD choose the Display Technologies quote? Possibly yes. But the Display Technologies quote
causes some worries. One is about quality. Display Technologies is a new entrant to the market, and it has
not yet had a chance to demonstrate the high quality that Bogardus, and presumably Heidelberg, has
demonstrated. And the Display Technologies bid may be a low-ball bid to enter the market. For
subsequent orders, they might have to raise the price significantly to maintain viability. This could cause
ISD to incur some costs of switching suppliers at some time in the future. But the manager of ISD should
be aware of these issues, and he decided to choose the Display Technologies quote.
The issue in the case arises because the manager of Heidelberg complained about not getting the ISD
order. His arguments are the following:
1. Zumwald is better off if Heidelberg supplies the displays to ISD. Students should do the
calculation to understand this conclusion.

The Heidelberg quote to ISD is better for Zumwald taken as a whole because it includes some
contribution both for Heidelberg and for ECD, Zumwald’s internal electronic subassembly
supplier. The variable costs for Heidelberg are €50,000. The fixed costs are not relevant because
Heidelberg is not operating at full capacity. So there is a contribution of €90,000 to Heidelberg in
the €140,000 quote to ISD. Students might question the treatment of labor costs as fixed on the
downside, but this is common in Germany.
In addition, there is a contribution of €12,600 for ECD built into this quote. This is ECD’s
internal price of €21,600 minus the variable costs of €9,000. (ECD is also operating below
capacity.)
The advantage to ISD of sourcing from Display Technologies rather than Heidelberg is €39,500.
This is far smaller than the total contribution to Zumwald divisions of €102,600 that would be
foregone if Heidelberg does not get this order. The difference is €63,100. Financially, Zumwald
is clearly better off if ISD sources the displays internally.
This calculation can be shown in different ways. Another method is to consider the net cash
outflow to Zumwald of the sourcing alternatives. If the displays are bought from Display
Technologies, the cash outflow for the displays is €100,500. If they are sourced internally, the
total Zumwald cash outflow is:

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Cash outflow if sourced from Display Technologies.............................................€100,500

Cash outflow if sourced internally:

Heidelberg variable costs excluding the ECD-supplied materials.....€28,400

ECD variable costs.............................................................................€9,000 €37,400

Difference.............................................................................................................. €63,100

2. Heidelberg engineers helped ISD develop the X73. Heidelberg was reimbursed for the cost of
those engineers, but it earned no profit for this work. Does this assistance imply a partnership
that would include future sourcing of parts?

Students presenting this analysis showing the advantage to Zumwald of internal sourcing should be
asked whether this means that Mr. Fettinger should order ISD to source the displays from Heidelberg.
They will almost assuredly say yes. But then the issue is the price at which the transaction should be
made.
The case has enough information to show that this X73 business promises to be highly profitable for
ISD:
Revenue for one X73 system.................................................................................€340,000

Non-display material costs €72,000

Variable conversion costs....................................................................€26,300......€98,300

Contribution before display costs..........................................................................€241,700

Fixed conversion costs..........................................................................................€117,700

Gross margin before display costs.........................................................................€124,000

ISD contribution if sourced from Display Technologies.......................................€141,200

ISD contribution if sourced at Heidelberg’s price of €140,000.............................€101,700

Clearly there is room to force ISD to pay Heidelberg more than the Display Technologies’ price. That
extra cost could provide additional margin to Heidelberg and ECD. But, alternatively, any price
greater than €37,400 provides a contribution to Heidelberg and/or ECD. Why shouldn’t Heidelberg
shave its price to get this internal business? And if Heidelberg shaves its price, then it might well ask
ECD to shave its price below its normal 20% mark-up. So in some sense, these transfer prices are just
moving profits from one division to another. What is fair to all parties?
Heidelberg’s manager, Paul Bauer, claims that he has been pleading with his salespeople not to shave
prices, that he needs full margin business in order to achieve his plan. Does Mr. Bauer just not want to
acknowledge the price competition in this segment of the market? Is he ignorant of the marginal cost and
contribution margin concepts? Should he be fired?

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Or is Mr. Bauer merely willing to lose this business in order to emphasize the importance of his pricing
policy to his salespeople? This latter possibility can be illustrated with the following hypothetical figures:

Price Unit Total

Price policy (000) Volume Contribution Contribution

Full price 140 70 90 6,300

Cut price 100 100 50 5,000

Maybe because of market conditions and customer price sensitivities, Heidelberg is better off giving up
some business to retain higher margins, even though they are operating in a below-capacity condition.

So what should Mr. Fettinger do? Mr. Fettinger should probably listen to the arguments in order to
learn the managers’ thinking processes? Are they all aware of the key facts in the situation? Does Mr.
Bauer, in particular, understand the concept of marginal cost pricing and contribution margin?
If the managers are all making rational arguments, then strong arguments can be made here for having
Mr. Fettinger do nothing. Zumwald operates in a highly decentralized fashion. Why not let it continue to
do so? Let the managers have their autonomy and freedom of sourcing. If there is a deal to be made, let
the managers work it out themselves. If Mr. Fettinger gets involved here, he will probably also have to get
involved in many other similar disputes. If this deal were a more substantial part of Zumwald’s total
business, then a stronger argument could be made for intervention. But this deal, by itself, is worth less
than 5% of each division’s revenues. Heidelberg can probably earn the business by cutting its price to
Display Technologies, but maybe it is not in its best interest to do so, even though internal sourcing of
this deal seems to be in Zumwald’s best interest.

The final question that can be explored is the systemic question. Is the Zumwald responsibility
center/performance measurement system faulty in that it motivates managers to make decisions that are
not in the best interest of the corporation as a whole? There is no easy answer to this question. In most
situations where local knowledge and fast decision-making is important, a highly decentralized system
has great advantages. But with decentralization comes risks of suboptimization. This case provides one
common example of suboptimization. Zumwald could establish a transfer pricing policy to try to induce
better transfer pricing and, hence, sourcing decisions. Such a policy could require internal transfers to be,
for example, at best outside market price, or at full (or variable) cost plus a normal markup. But would
such policies really lead to better organizational decision-making?

Pedagogy
This case is relatively short and straightforward. Students do not need a lot of guidance to reach the
conclusion that Zumwald is better off if the sourcing is done internally. Then, we suggest letting the
students provide suggestions as to the best transfer price. The learning will come from the discussion

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of alternatives. Instructors should only intervene if students fail to recognize the advantages of
decentralization.

Case 22-4: Enager Industries, Inc.*

Note: This case is unchanged from the Eleventh Edition.

This case was written for use in a required one-semester course in management accounting, where usually
only a single session is devoted to investment centers. Whereas most available cases on investment
centers focus in detail on narrower issues, such as proper valuation of fixed asses for an investment
center, this case is intended to raise both the rationale for having investment centers and some of the
broader issues surrounding ROI and an investment center structure for a responsibility center.

Broad Case Issues

As different instructors will choose to emphasize different aspects of this case, I will simply describe
sequentially the various issues the case raises.

1. Profit verse profitability. I raise the issue by asking, “What is the overriding economic objective of a
business?” Typically the first answer is “profit maximization.” I then ask if that means a firm earning
$100 million net income is twice as profitable as one earning $50 million? Students soon realize that
the profit should be 1inked with the investment required to generate it, and we arrive at the
conclusion that return on investment is a more meaningful measure of a firm's profitability.

2. Use of investment centers. Having established that ROI is a measure of interest to top corporate
management, it is easy to see that responsibility for earning a reasonable return can be segmented and
delegated, just as is profit responsibility delegated to profit center managers. However, if the measure
is to be used in evaluating the investment center manager's performance, equitability requires that the
manager be able to significantly influence both profit and investment. In many companies, this degree
of responsibility is found only at the “division” level and above (where I am using “division” to
connote an essentially self-contained business within the corporation).

At this point, I draw the very important distinction between using ROI to measure economic
performance of a responsibility center and using it to measure the performance of the center's
manager. (In my experience, this distinction is too frequently missing in industry.) There is really no
need to treat a responsibility center as an investment center if the manager doesn't influence asset
levels; this does not mean, of course, that the center's ROI can't be computed for analytical purposes
(e.g., for consideration for discontinuing that responsibility center's activities)—but this computation
does not need to be performed frequently, or perhaps even regularly.
I also tell the students that the profit center/investment center distinction appears more in textbooks
than in practice: most managers I have met call both types of responsibility center simply “profit
centers. “
3. Definition of ROI. By now, the students are aware that ROI is (simplistically) defined as profits

This teaching note was prepared by Professor James S. Reece. Copyright © by James S. Reece.
**

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divided by investment. I now ask, “What is investment?” I am not trying at this point to get into
valuation of specific assets, but rather the broader notion that to business people the word
“investment” variously means total assets, assets less current liabilities or invested capital
(equivalently, long-term liabilities plus owners' equity, or owners' equity.

I point out that none of these concepts is right or wrongit depends on the perspective of the person
considering ROI. A shareholder (and probably also securities analysts) would be most interested in
return on equity. Corporate financial officers seem to focus on return on invested capital (the apparent
notion being that current liabilities are both “free” and “take care of themselves”). Operating
managers don't really care how the assets they manage were financed (nor can they usually tell, since
“all money is green”); they (and their superiors) are concerned about how well the assets are utilized,
leading to a return-on-assets (perhaps net of some or all current liabilities) perspective.
Exhibit 4 contains several ROI measures, to highlight the fact that the term ROI itself is extremely
ambiguous. The calculation of return on invested capital has been adjusted for interest, whereas return
on assets has not (because this is the way Enager is calculating ROA).
4. ROI growth and EPS growth not necessarily equivalent. I point out to students that it is possible to
increase earnings per share while decreasing ROI. Indeed, Enager presents an example of this: from
1996 to 1997 EPS increased, but return on assets (ROA) went down.

One possible cause of this phenomenon is the fact that generally accepted accounting principles
ignore the cost of equity capital in calculating net income. For example, a project returning (before
interest) 6 percent on assets, which was financed with 8 percent debt, would diminish EPS But the
same project financed by retention of internally generated funds would increase reported EPS, even if
the project's ROA were less than the overall ROA would have been without the project (thus reducing
overall ROA despite the increase in EPS). In Enager's case, this phenomenon occurred because
EBIT ($1,031) exceeded interest ($382), thus increasing EPS; but EBIT / Assets= 9.1%, which
was lower than the previous year's average of 9.5%.
5. Setting ROI targets. Although it is seemingly self-evident that different investment centers will have
different risk profiles and ROI potentials, it is, nevertheless true that some companies use the same
“across-the board” ROI target percentage for divisions in quite different businesses, as was done by
Mr. Hubbard of Enager. I think this phenomenon occurs for a reason alluded to earlier—confusing
what is a desirable economic return for the overall company with what is a reasonable return for the
manager to achieve, given conditions in the industry, efficiency of the division's equipment, and so
on. For purposes of managerial evaluation, a division's ROI target should be negotiated between the
division manager and his or her superior, as part of the budgeting process.

6. Defining “profit” in ROI. Whatever degree of detail the instructor wishes to get into here, at a
minimum students should realize that defining “profit” as “net income calculated using the same
generally accepted accounting principles as are used for reporting to shareholders” is only one of
many ways of defining profit for ROI computations. For example, income taxes can be omitted;
depreciation can be based on replacement costs rather than historical costs; or a variable costing
approach can be used instead of full costing. Also, a company can use the notion of controllable profit
for calculating ROI.

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In general, I think a definition involving controllable profit is best for calculating ROI for purposes of
managerial evaluation, but that a “net” figure after including noncontrollable allocations is better for
economic performance analyses. Again, in my experience, companies usually do not make this
distinction and tend to use a GAAP net income figure in the ROI calculations. (See James S. Reece
and William R. Cool, “Measuring Investment Center Performance,” Harvard Business Review, May-
June 1978.)
7. Valuing “investment” in ROI. Whether one regards “investment” as total assets, invested capital, or
owners’ equity, asset valuation affects the indicated amount of investment. Once again, in my
experience, companies tend to value assets for ROI computation the same way they report asset
amounts to shareholders. Students should realize that this alternative causes ROI to increase solely
with the passage of time (as depreciation reduces the asset base) and may indicate improving
performance when in fact the manager is “running the business into the ground.”

8. ROI versus residual income (EVA). While I feel this is too advanced for a one-session shot at ROI,
some of my colleagues feel that residual income (now called economic value added by some
consultants) should be introduced here. If so, an attempt should be made to convey the conceptual
advantage of RI over ROI—that having to do with how a division manager would react to a project
whose projected ROI is higher than the cost of capital but lower than the investment center's overall
targeted ROI. This RI concept could also be raised earlier in the context of how to define “profit,”
since RI essentially corresponds to the economist's view of what constitutes profit. Since it is the
presence of GAAP-valued fixed assets in the formula that causes either ROI or RI to increase solely
with the passage of time, I favor for managerial evaluation what I call “partial RI,” which is profit
excluding interest less holding-cost rates applied to receivables and inventories.

9. New project proposals in an ROI system. This is the “lead-off” issue in Enager. If your students have
been exposed to capital budgeting techniques, they quickly will point out that a discounting technique
should be used to evaluate Ms. McNeil's new product proposal. Despite the normative truth of that
statement, it is nevertheless quite conceivable that a manager might feel that a project that will
improve EPS (and accounting ROI!) should be acceptable.

Another aspect of capital budgeting in an investment center setting (or companywide setting, for that
matter) that often puzzles students is this: Why is the “hurdle rate” used in evaluating a new project
higher than the division's ROI target? One reason is that a significant portion of a company's capital
budget funds must be used for projects that will not (in any obvious way) increase profitse.g.,
pollution control equipment. Thus, projects that will improve profits have “to carry more than their
fair share of profitability contribution” in order to compensate the nondiscretionary (necessity)
investments that tend to lower ROI. Other reasons include allowance for risk/uncertainty and the
desire to improve ROI fairly rapidly.
10. Overall “moral.” ROI is conceptually simple, but complex to implement (if one recognizes the
pitfalls, as Hubbard and Randall did not). Students should not be left with the feeling that ROI
necessarily should be avoided, but rather that its implementation should be approached with “great
care.

Issues Specific to Enager

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1. What is the incremental ROI on the proposed project? The case numbers are “rigged” so that the
incremental EBIT percentage at any of the three prices is 13 percent ($130,000 / $1,000,000). A
variation on this calculation is to say that, at least in an accounting sense, the average plant and
equipment investment over the life of the project is only $250,000, giving an ROI of 17.3 percent
($130,000 / $750,000). We do not know the potential life of this project; its payback period is less
than 4 years (we can't tell how much less: cash flow per year will be greater than the $130,000
income because the $170,000 fixed costs include depreciation).

I ask the students this question: Suppose Enager was committed to go ahead with this projectwould
you suggest a price per unit of $6, $7, or $8? Students cannot choose on the basis of incremental
profit, which we have seen is the same ($300,000 contribution less $170,000 fixed costs = $130,000)
at all three prices. Some will say $6 because it gives the largest market share (a point of view which
may have validity, if one believes the Boston Consulting Group's experience curve hypothesis).
Others will say $8, since that has the lowest break-even volume; however, in my opinion, one cannot
choose based on break-even volume, since at each of the three prices the break-even volume is 56 2/3
percent of the estimated sales volume at that price, and profits are the same at the three estimated
sales volumes.
Eventually, a student will realize that the current asset investment should not be assumed to be the
same at all three prices (as I have let them implicitly assume to this point in the discussion): certainly
a volume of 100,000 units ($600,000 revenues) will require more cash on hand, receivables, and
inventories than would a volume of 60,000 units ($480,000). Therefore, the price chosen on short-
term ROI analysis should be $8.
This discussion of variability of current assets with volume may also cause some students to notice
that the projected level of current assets seems excessive. If volume = 100,000 units, average unit cost
= $4.70; $50,000 cash is 39 days' expenses (really more, after considering depreciation); $150,000
receivables is 3 months' sales; and $300,000 inventories is 233 days’ worth. Based on the company's
average ratios in Exhibit 3, the current asset picture at a price of $6 and volume of 100,000 units
would be: (rounded)

$470,000
Cash= x 8 days' cash
365 days $ 10,300
..........................................................................................................................

$ 600,000
Re ceivables= x 75 days' A/R
365 days 123,300
.............................................................................................................

$100,000 units
Inventories= x 160 days x $4.70
365 days 206,000
...............................................................................................
Total current assets...............................................................................................................................................
$339,600

$130,000
Avg . ROI.= =22.8% ( vs. 17 .3%)
$339,600+$230,000

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Not only does projected ROI improve, but the three current asset utilization ratios used in this
adjusted projection do not represent very laudatory current asset management. And again, the ROI
(short-run, at least) would be still higher at the higher, price-lower volume combinations.
2. Explain Enager's 1997 versus 1996 results. This is best done, I feel using a “duPont chart” approach.
(See, for example, Chapter 13 of the text.) Essentially all of the numbers for this analysis (on a return-
on-assets basis) are included in Exhibit 3 of the case. This is a very useful approach, in my opinion,
because it demonstrates how ROI is impacted by decisions made throughout the organization.

3. Enager's implementation of ROI. The preceding discussion in this commentary should make it rather
clear that Enager's top management (i.e., Hubbard and Randall) fell into essentially every trap lurking
behind the simplicity of the ROI fraction. In addition to the conceptual flaws, the top-down
imposition of the new approach with little explanation or training for the managers was not a good
way to introduce a major organizational change, and it's no wonder that “there seems to be a lot more
tension among our managers the last two years.”

Personally, I feel Ms. Kraus has a good idea in the off-site retreat. However, it appears that Hubbard
and Randall first should engage a consultant to discuss ROI and investment center implementation
complexities with them and help them understand the causes of the current “tension”; perhaps this
same person could then be engaged to play a major role in the retreat and subsequent training
sessions.

Case 22-5: Piedmont University

Note: This case is unchanged from the Eleventh Edition.

Approach
The idea of profit centers in universities dates back many decades, probably to President A. Lawrence
Lowell's dictum to the Harvard deans: “Every tub on its own bottom.” Although he did not use the term
“profit center” (and for selling purposes this term may create resentment on the part of faculty and deans),
he clearly meant that each school's revenues should be adequate to pay for its operating costs. This idea
continues to influence the management control system at Harvard and is increasingly being considered by
other universities.

The case provides an opportunity to discuss the principal problems that arise in implementing a profit
center structure, and the situations described range from those for which a strong case can be made to
those for which the results would be clearly dysfunctional. In discussing the several issues, two questions
provide a central focus: (1) How would the recommended practice affect the motivation and attitude of
the two parties: the party that receives the charge and the party that receives the revenue? (2) Are the
benefits greater than the bookkeeping cost?

The case also permits a discussion of certain behavioral problems in management control: the danger that
management runs in accepting an offer from a well-meaning, but perhaps not skilled, volunteer (and the
difficulty of finding a graceful way of declining such help); the proper approach to gaining acceptance of
ideas; the indication that a strong-minded president can “turn an organization around,” especially during a

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honeymoon period when the seriousness of the situation is recognized.

Question 1
General administrative costs. Charging these costs to individual schools would result in an operating
statement that would report the extent to which the school's revenues were adequate to pay for its own
costs plus a fair share of the central costs. The sum of the net incomes reported for each school would be
the net income of the university. This charge might get the deans to recognize that the university
necessarily incurs costs on their behalf, which must be met from some source. The practice might also
cause the deans to question whether the central costs were too high, which would be one way of
exercising control. Perhaps the central administration would be reluctant to tolerate such questions.

An alternative is to not charge these costs, or to charge only those that can be specifically identified with
a given school (such as accounting, purchasing, personnel). This would reduce the technical and
behavioral problems associated with the allocation of indirect costs.

Any basis of allocating indirect costs can be criticized because there is no “scientific” way of doing this,
by definition. The criticism that the administration probably spends more than a proportional amount of
time on the undergraduate school is probably justified, but there does not seem to be a feasible way of
correcting this inequity.

If these costs are charged, the charge should probably be a budgeted amount, rather than the actual costs
incurred. Allocating actual costs permits the central administration to pass costs that are greater than
budgeted to the individual schools.

Gifts and endowment. The deans quite naturally would not favor giving the president authority to
distribute $7 million as he chooses. Actually, the process would require that the schools put in their
requests and the president allocate the funds in a way that causes the minimum amount of dissatisfaction.
The president could not allocate the funds in a way that is perceived to be grossly unfair; he would lose
the support of the deans if he did this. Moreover, the “each tub on its own bottom” idea can't work
perfectly. The theological school, for example, does not cover its costs by some $3.1 million (Exhibit 1),
whereas the business school has a surplus of $4.2 million, reflecting the attractiveness of its program to
donors, the ability of its students to pay tuition, the need for financial aid, the opportunity to obtain
research grants, and so on.

The business school surplus can lead to a discussion concerning the question of whether the president
should have the authority to allocate such surpluses to other schools. Currently, this is a hot topic in many
universities. Also, if it is decided that the library should not generate its own revenue, the central
administration must make up the shortfall.
This topic provides an opportunity to discuss the question: should each part of an educational institution
pay its own way? Carried to the extreme, less popular courses (Latin, Greek, advanced seminars) would
be eliminated, even though they may make an important contribution to the university's total reason for
being. Few would argue that each course should pay its own way, and by extension, the argument can be
made that certain schools should be subsidized. On the other hand, if a given school does not obtain
resources sufficient to cover its costs, questions can be raised occasionally (not every year) about the
desirability of condoning it.

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Athletics. Overall, this is one of the less sensible of the consultant's proposals. A case can be made for
charging a fee for scarce resources (such as tennis courts, golf courses, or ski lifts) as a way of rationing
these resources (but the case is not particularly strong). Presumably, however, the university wants to
encourage intramural athletics, and charging a fee would not indicate such encouragement. The rationing
argument is not applicable to intramural athletics. Also, there is an indication that intramural and
individual athletics should be asked to subsidize intercollegiate athletics, which does not make much
sense.
Maintenance. Permission for schools to use outside contractors is an important aspect of this proposal.
The maintenance department's concern about the decline in maintenance quality has some merit, but it
should be possible to exercise adequate quality control. The maintenance department should be given the
authority to do this.

If schools can use outside contractors, the maintenance department must compete with them, which tends
to motivate it to be efficient. It must control its costs and obtain enough work so that it breaks even, or
there is an indication of poor management or that the department is too large. There should be a proviso
that if the maintenance department is willing to do the work at not more than the outside price, it should
be given the job. Furthermore, if the schools are not permitted to go outside, they are at the mercy of the
maintenance department with respect to the priority of meeting their requests and the amounts spent. The
pros and cons for maintenance are also applicable to other support departments: purchasing, accounting,
and aspects of the personnel department (but not university personnel policy).

Computers. A few years ago, many colleges and universities did not charge students and faculty members
for the use of computers (except possibly for faculty members working on cost-reimbursable contracts).
The primary reason was that they wanted to encourage the use of computers. The tendency now seems to
be in the other direction with respect to mainframe computers, on the grounds that the usefulness of
computers is now generally recognized; the practice of charging for computer usage is by no means
universal, however. (It is somewhat ironic that many universities keep careful controls over the use of
postage and long-distance telephone cards, which involve much less cost than computers.)

Probably most computer work within a school, especially work done on personal computers, is done
without charge. The issue here, however, is charging for work done on the engineering school computers
by faculty and students at other schools. Assuming that usefulness is adequately recognized, the
arguments here are essentially the same as those for maintenance.

A special circumstance about computers is that they have software that can supply detailed information
about usage at low cost, so recordkeeping cost is not as important a factor as is the case with some of the
other services discussed in the case.

I doubt that time will permit the class to get into the details of how a charge should be calculated. There is
much discussion about this in the literature: a low charge for off-peak usage; a charge for setup time and
assistance from computer personnel that is separate from the charge per minute of running time; a charge
for plotters and other peripheral equipment; and so on. There may be advantages in detailed, possibly
elaborate, charging systems; the question often is whether they are worth the cost.

Library. This is the extreme case of a situation in which charging for services rendered is likely to be

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counterproductive (but an outside consultant may not appreciate this). The university wants to encourage
library usage, and charging a fee would tend to have the opposite effect. As the case states, the
recordkeeping involved would be considerable, with thousands of transactions, each involving only a few
pennies of cost. (As is the case with computers, library costs might be charged to cost-reimbursable
contracts, but the charge can be arrived at by approximations derived from sample tests or other methods
that are less expensive than keeping detailed records.)

Cross registration. On the one hand, it can be argued that if a course is offered, a few additional students
do not cause any increase in costs. The argument against this is that a fair share of the cost of the course
should be charged to each student, more specifically to the school from which the student comes.
Opinions will differ as to the relative weight to be given to each side of the argument There is also the
question of whether such a charge has a motivating influence on either the school from which the student
comes or the school in which the class is located. If a charge is made, the method suggested in the case
seems reasonable, with the possible exception that tuition may be considerably lower than the real cost of
education, with the difference being made up from gifts and endowment earnings.

Question 2
Probably the difficulties with profit centers will come up in the discussion of question 1, and this question
is intended merely as a means of catching gaps. In particular, the bad impression given by the term “profit
center” should not be minimized; charging for services rendered is a more acceptable way of putting it.
The taste of educating people when a new system is introduced should not be minimized. In particular,
there tends to be friction and more arguments about how the charges are to be calculated than is
warranted. Senior management should try to keep these arguments from becoming acrimonious.
Otherwise, the deans and faculty will claim that the university is now being run for the benefit of
accountants.

Question 3
One alternative to the profit center approach is, of course, to keep the present system. The pros and cons
of this should come out in the discussion of question 1.

Students may propose other alternatives. It would be possible to charge certain expenses to the individual
schools for information purposes, but not include them in the formal budgets nor make the corresponding
credits to the departments that furnish the services. The idea would be to give the schools a better idea of
the real cost of their operations without the work and possible friction that arises when these costs and
revenue are included in the formal accounting system. This proposal, although similar to actual practice in
some organizations (including the federal government), does not accomplish much, in my opinion.
Without the motivation provided by inclusion of these costs in their budgets and the requirement that they
live within these budgets, deans are unlikely to pay much attention to these memorandum records.

Question 4
The discussion of this question can get bogged down because of differences in the recommended
treatment of the issues in question 1. It may be well to avoid it by asking for a resolution of each of these
issues and then debating the question of whether this consensuspresumably the most desirable
application of the profit-center ideais better than the alternative.

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As a strictly personal opinion (given here only as something to shoot at), I would definitely charge for
maintenance work and similar support services (including the support functions of the central office). I
would give the president authority to parcel out undesignated gifts and endowment earnings. I would
probably charge for the use of the mainframe computers. I would probably not charge for tennis, golf, and
skiing in order to ration scarce resources (on the grounds that a sign-up system is a better way of
rationing). I would not charge for intramural athletics or for the library. I would charge for cross
registration only if there was a substantial amount of it with the net transfers not washing out. Otherwise,
the recordkeeping costs would exceed the benefits.

Also, I would not ask the deans to approve the proposal, or any part of it, as it comes from an outside
consultant. I would say that the consultant's proposal was submitted solely to stimulate discussion. (The
weaknesses of certain aspects of the proposal are so apparent that the whole idea may be rejected.)
Having had the initial discussion, I would assign the job of developing a new proposal to someone in the
administration (or possibly to a committee) so that the next version would be given to the deans as
coming from within the institution and taking account of their concerns. If handled properly, I hope that
the deans' reaction would be: we had an unrealistic proposal from a consultant which the president wisely
rejected; we now have a practical one that is worth taking seriously.

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