Case Study for Management Accounting

Editor’s Remarks I am pleased to present the nine teaching cases presented at the 2002 Conference of the Management Accounting Section of the American Accounting Association. These cases provide a wide range of topics and contexts for use in upper level undergraduate and MBA classes. Here is a list of the cases, authors and topics discussed. Bal Seal Engineering, by Robin Cooper, discusses alternative cost management approaches: traditional, ABC, and TOC. Bill’s Custom Planters, by William Stammerjohan and Deborah Seifert, discusses production and cash flow projections, developing pro forma statements and sensitivity analysis.

Dublin Shirt Company, by Peter Clarke in association with Paul Juras and Wayne Bremser, discusses customer profitability analysis. ECN. W, by William Lawler, discusses ABC in a service organization. Endesa, by Gary M. Cunningham, Scott Ericksen, Francisco J. Lopez Lubian and Antonio Pareja, discusses strategy and control issues in a changing organization. Kincaid Manufacturing, by Jon Yarusso and Ram Ramanan, discusses supply chain management. Osram. NA, by John Shank, Lawrence Carr, and William Lawler, discusses economic value to customer and related life cycle costing issues. Pleasant Run Children’s Home, by Brooke E.

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Smith, Mark A. McFatridge, and Susan B. Hughes, discusses dealing with the financial condition of a not-for-profit organization. University Bottom Line, by Enrico Uliana, discusses management control issues in a university. I thank these authors and all of the other authors who submitted cases to the conference. I also thank members of the editorial board for their help in reviewing cases: Tom Albright, Wayne Bremser, Paul Juras, Ken Merchant, Gary Sundem and, especially, Larry Carr and Jim Mackey. I am grateful to the other conference organizers, Steve Hansen, K. Sivaramakrishnan and Naomi Soderstrom for their advice and help.

I am grateful for the help of Leslie Estelle at the IMA for her work in putting these cases into Management Accounting Quarterly. And on behalf of the members of the Management Accounting Section of the AAA, I thank the IMA for its support. Bal Seal Engineering Company, Inc. Peter Balsells and his late wife Joan founded Bal Seal Engineering Company, Inc in 1958. From humble beginnings, the firm grew steadily primarily based upon a strategy of selling the most innovative products in the industry. In particular, Bal Seal’s products were characterized both by the high value they provided and the technical manufacturing challenges they overcame.

The initial invention that formed the basis for the firm’s success was a canted-coil spring in a polytetrafluoroethylene (PTFE) jacket (Figure 1). The advantage of the canted-steel coil spring, over a conventional one, was its ability to produce near uniform force over its operating range. In contrast, a conventional spring provided a linearly increasing force as deflection increased (Figure 2). This property of a canted coil spring was critical in ensuring both an effective seal and an extended operating life.

The firm considered itself an industry leader and standard setter in providing customers worldwide with innovative solutions to their industrial sealing problems. The firm, over its 40-year life, had created in excess of 60 active patents and numerous other innovations that had helped shape the seal and spring industry. This innovative history had provided the firm with, what top management considered a sustainable competitive advantage. The firm’s profit margins were historically higher than industry average reflecting both its advantageous patent position and high level of engineering skills.

In 2000, sales were just under $25 million. The company’s customers were primarily in the medical equipment, analytic equipment, industrial OEM, and semiconductor industries. The company sold directly from the factory with the assistance of independent manufacturer’s representatives who covered the territories of Canada and the United States. Internationally, the company had a sales office in Western Europe and had contracted with several distributors who provided coverage of the Japanese and Australian markets. Product Development

The firm had developed its own approach to product development that consisted of three steps; design, fast prototyping, and production. In the design phase, the firm’s engineers concentrated on understanding the customer’s requirements. The firm’s products were used in a wide variety of applications and most were custom designed. Many of these applications presented state-of-the-art challenges in sealing technology. Without careful attention to the underlying requirements, the firm could easily fail to design an effective seal.

Fast prototyping consisted of rapidly creating a working example of the new product. Fast prototyping had two advantages. First, the customer could, early in its own product development process, test the new seal to ensure that it would be effective in the specific application for which it was designed. Second, the fast prototype enabled the manufacturing engineers to designate specific quality control steps and to establish guidelines for cost-efficient production. The final step, production consisted of ensuring that very high quality products were produced on a timely basis.

The firm’s commitment to quality was necessarily extreme because its products were relatively inexpensive compared to the customers’ end products in which they were used. However, since seal malfunction could lead to disastrous failure of the customer’s product, long-term consistent performance of the firm’s products was essential. Consequently, Bal Seal’s manufacturing process was geared to produce products that had exceptionally long meantimes between failures. Production Process A spring-energized seal consisted of a plastic U-cup ring and a canted-coil spring.

The purpose of the plastic ring was to ensure that metal to metal contact did not occur between a piston and its housing. In addition, the seal was often designed to provide the piston with both support and guidance. The seal could either be mounted on the piston (Figure 3) or on the housing (Figure 4). The springs and plastic rings were manufactured independently and then assembled to create the seal. While springs were sold separately, plastic rings were only sold as part of a completed seal. Products were produced to order, only a small number of items were retained in finished goods inventory.

For small orders, only one production run was required. However, for larger orders it was necessary to break production into multiple production runs so that other orders were not excessively delayed. The production process consisted of three major stages; spring production, ring production, and final production and assembly (Figure 5). Ring production required 5 major steps. The first step consisted of taking powdered PTFE and mixing it. Subsequently the mixture was placed in an oven where it was pressed under high pressure to form the desired shape.

The shaped pipe was then removed from the mold and cooked in a sintering oven to harden it. After sintering, the sintered pipe was ground to the desired size and specifications. The completed seal blank was then placed in the buffer inventory that was maintained before the computer numerically controlled (CNC) machines. Blanks are machined to customer specifications to create rings soon after receipt of the customer order. Spring production was proprietary and only senior executives and the specially trained workers were allowed to enter the area of the factory where springs were produced.

Bal Seal senior management was convinced that the firm had created a sustainable competitive advantage from the proprietary technology associated with spring production. Consequently, intense security was applied to this production area to ensure that competitors could not learn anything from visiting Bal Seal or hiring its normally trained employees. Computer numerically controlled (CNC) equipment was used to create the seal. The part was then inspected to ensure that it was up to specifications. Assembly consisted of three major steps.

In the first step, the spring and seal were assembled to create the completed product. In the second step, the part was inspected to ensure that it met specifications. In the final step, the completed seal was tested to ensure that it provided the near uniform resistance that was characteristic of canted coil spring technology. The completed part was then released to shipping and sufficiently early to insure on-time delivery. Only a few standard parts were maintained in finished goods inventory to ensure that unexpected demand for such items was met in a timely fashion.

Total finished goods inventory accounted for only two days of average production of stocked items. Theory of Constraints The theory of constraints emerged in the mid-eighties as a way to better manage constrained resources and hence increase firm profits. Bal Seal had adopted the theory of constraints as both its production philosophy and its product costing methodology in 1997. In the theory of constraints, a single machine, or class of machines, is identified as the bottleneck. The bottleneck machine or machine class is the one that limits the overall level of production of a product, product family, or product line.

To maintain maximum output, the bottleneck machine, or as it is more formally known the capacity constrained resource, is kept busy at all times. Any other machine or production operation could be idle as long as it does not lead to the bottleneck machine being starved. The theory of constraints has its own language. The throughput of a system is the revenue generated in the period of analysis. Throughput = Revenue The throughput contribution is the revenue generated by an order minus the totally variable costs associated with it.

Throughput Contribution = Throughput – Totally Variable Costs The operating expenses are all of the costs that are not totally variable with production volume. Profit is given by subtracting operating expenses from total throughput contribution: Profit = Total Throughput Contribution – Operating Expenses Ensuring that the maximum throughput contribution is generated maximizes the profit generated. That objective is achieved by manufacturing products that have the highest throughput contribution per constrained minute for which bottleneck capacity is available.

The throughput contribution margin per constrained minute is the throughput margin generated by the order divided by the time it takes on the bottleneck machine measured in minutes. Throughput Contribution/ Constrained Minute = © 2001 by Robin Cooper 3 Throughput Contribution / Time on Bottleneck Machine The objective of the theory of constraints is to maintain as high an average throughput margin per constrained minute as possible, while keeping the bottleneck machine fully loaded. If this objective is achieved, according to the theory of constraints, profits will be maximized. Five simple rules govern the approach: 1. . 3. 4. 5. Identify the constraint. Decide how to exploit the constraint. Subordinate everything else to the above decision. Elevate the constraint. If the constraint has been broken, go back to step 1 Under these five rules, the majority of continuous improvement efforts are focused upon increasing the output of the bottleneck resource; only reduced attention is paid to making the non-constraint activities more efficient. At the heart of theory of constraints is the drum-buffer-rope scheduling system. In this approach to scheduling, a protective buffer is maintained in front of the machine that creates the constraint.

This capacity constrained resource (CCR) buffer is designed to be sufficiently large that it ensures that the bottleneck is never starved. Theoretically, the size of the buffer is determined as a trade-off between security versus lead-time. In practice, as was the case at Bal Seal, it is often determined from experience. At Bal Seal, the conversion to the theory of constraints went extremely smoothly and within three months the firm’s manufacturing performance had improved dramatically with overall production levels higher and production costs lower.

As the firm smoothed out its production process, the firm’s cash flow became more predictable. Senior management was very pleased with the ease of the transition to theory of constraints and identified it as one of the major strengths of the approach. For example, they compared their experience favorably to the length of time other firms had taken to shift to lean production. In their opinion, the shift to lean production, typically took longer because it required balancing most, if not all, of the firm’s production processes, not just the bottleneck ones.

In addition, they felt that the cultural changes under the theory of constraints approach were much less demanding than those required by the adoption of lean production. The non-bottleneck resources could be managed much the same as they always had been thus reducing the amount of learning that had to be achieved to bring the new production approach on line. The theory of constraints was also adopted, at Bal Seal, as the basis for product costing. Under the theory of constraint approach, with the exception of the costs that are totally ariable with the number of units produced, all other costs (operating expenses) are assumed to be fixed in the short term. In most settings, the only significant totally variable cost is material, other totally variable costs such as the electricity required to run the machines are typically ignored as they are small compared to material costs and instead, they are treated as part of operating expenses. At Bal Seal only material, freight, and sales commissions were treated as totally variable costs and hence subtracted from revenues to give the throughput contribution for the period.

In the firm’s traditional cost system, the freight and sales commission costs were treated as indirect costs and assigned to products using direct labor dollars. Activity-Based Costing Activity-based costing emerged in the mid 1980s as a way to report more accurate product costs than was possible by traditional cost systems. Activity-based cost systems differed from their traditional counterparts in two ways. First, the cost pools represented activities performed and not types of production processes. Second, the way costs were assigned to products was more sophisticated.

In traditional systems only unit-level cost drivers were utilized. Unit level drivers were those drivers whose driver quantities doubled when the number of units produced of a product doubled. Examples of frequently used unit-level cost drivers in traditional systems include direct labor hours and dollars, machine hours, and material dollars. In contrast, in activity-based cost system two other types of cost drivers were utilized. The first type was batch-level drivers and the second type was product-level drivers.

Batch-level drivers were used to assign the costs of activities that were performed every time a batch was produced. Examples of this type of activity include machine setup, material movement, and production scheduling. Examples of batch-level drivers include setup hours, number of setups, and number of batches or production runs. Product-level drivers were used to assign the cost of activities that were performed to sustain the ability to manufacture particular products. Examples of product-level activities include parts administration, process engineering, and bill-ofmaterial maintenance.

Examples of product-level cost drivers include number of parts, number of part numbers, and number of engineering change notices. Proponents of activity-based costing argue that it provides a more accurate picture of the cost of the resources consumed by different products than traditional cost systems. In particular, activity-based cost systems are sensitive to batch size and overall production volume and thus report higher costs for the same product if it is made in small batches or overall low volume than if it is manufactured in large batches or high overall volume.

In contrast, traditional systems reported the same product costs irrespective of the batch size or overall production volume of a product. Thus, activity-based cost systems were sensitive to scale economies while their traditional counterparts were not. Product Costing at Bal Seal In 2000, Bal Seal did not utilize either traditional or activity-based costing to determine product costs; instead it relied solely upon its theory of constraints system to support its pricing and order acceptance decisions. Prior to the adoption of the theory of constraints, the firm had developed a traditional costing system.

This system consisted of the direct assignment of material, labor, and setup costs and the indirect assignment of all other costs. The indirect costs were assigned to the products using a single cost pool using direct labor dollars as the cost driver. In 1999, the overhead burden rate that would have been used in the traditional costing system was 500%. Bal Seal’s traditional costing system was slightly unusual in that it isolated the costs of setups from normal run costs. Setup costs were assigned to the batch as a lump sum and then divided by the number of units in the batch to develop a unitized setup cost.

The sum of the run cost and the unitized setup cost was the total unit cost of the product. The advantage of this approach was that it reported different costs for the same product depending upon batch size with reported unit costs dropping as batch size increased. Thus, Bal Seals’ old traditional costing model, because of the way it incorporated setup costs, was somewhat sensitive to batch size. However, since it ignored the implications of non-setup related batch-level costs and all of the product-sustaining costs, it was at best a partial activity-based cost system.

In 1999, a specialist in activity-based costing visited Bal Seal. He was interested in the relationship between theory of constraints and activity-based costing and wanted to study an active theory of constraints implementation. Many theory of constraints advocates believed that activity-based costing was a misleading costing approach that led to poor decisions. At the heart of this perspective was the inability of the activity-based costing approach to identify bottlenecks and thus ensure that they were kept fully loaded.

Since any failure to keep the bottleneck fully and efficiently loaded resulted in lower profits, the position adopted by advocates of the theory of constraints was that activity-based costing led to inferior performance. In contrast, most activity-based costing advocates had a different opinion; they believed that theory of constraints was the appropriate solution for short-term decisions in which the firm’s infrastructure (their term for operating expenses) could not be modified. However, they believed that over the long run, the firm’s infrastructure could be modified in ways that led to overall superior performance.

Thus, they perceived the optimum solution to be to use theory of constraints for short-term decisions and activity-based costing for long-term decisions. To help understand the relationship between the two approaches, the specialist identified five orders that the firm had recently received for different members of its Mark IV family of Balance Seal products (Exhibit 1). The primary difference between the orders was the number of units ordered. He chose these five orders because he felt that, despite being from the same family of products, they covered the entire spectrum of orders received by the firm.

In particular, they captured small, medium, and large volume orders. Furthermore, the selling prices of the Mark IV product family were relatively easy to estimate despite being dependent upon the size of the order and the industry in which seals were to be utilized. Mark IV seals were primarily used in medical equipment industry and the historical bidding information was sufficiently detailed to enable quite accurate estimates of probable selling prices to be developed. Such detailed information was not available for many of the firm’s other product families.

The specialist asked Bal Seal management to determine the profitability of the five orders using the theory of constraints. To provide a basis for comparison, he designed a simple activity-based cost system for Bal Seal. This system identified two additional indirect cost pools to the one that was used in the firm’s old traditional cost system. The first additional cost pool was a batch-level one. It captured the costs of ensuring that a production order was processed. The second additional cost pool captured the cost of the product-level activities.

In particular, it identified the parts administration costs associated with each member of the Mark IV family. Removing the batch-level and product-level costs from the direct labor cost pool reduced the direct labor dollar burden rate to 115%. This burden rate also excluded the freight and sales commission costs which the expert felt should be treated as costs of the order in addition to the setup and order processing costs. Management’s Reaction Bal Seal top management was not convinced that even experimenting with activity-based costing was a good idea.

They justified this perspective based upon several deeply held views. First, the success of theory of constraints, at Bal Seal, was such that they were unwilling to risk disrupting it with even an experiment. Second, they believed that the theory of constraints approach was philosophically superior and that activity-based costing would simply cause people to focus excessive attention on non-bottleneck resources. Attention that they felt was better directed to increasing the throughput of the capacity constrained resource.

Third, they believed that it would be confusing to have two sets of reported product costs “floating” around the firm – one based on theory of constraints and the other based on activity-based costing. In particular, they felt that this confusion would be particularly serious if one of the two approaches recommended selling a product that the other indicated was unprofitable. Bal Seal Assignments It will help considerably to work in Excel or another spread sheet program, as many of the calculations are identical except for the price list.

The following graphs will also be beneficial in helping you gain insights into the capabilities of the various costing approaches; traditional profit margin versus ABC profit margin, unit contribution or profit versus volume, and ABC unit profit versus TOC unit contribution per minute. Price Lists – Pair 1 1. Determine the cost and profitability of the five selected orders using the firm’s traditional cost system, TOC system, and the activity-based cost system proposed by the visiting specialist. 2. Bal Seal has only a small amount of bottleneck resource available.

It receives an order for 1,000 P5 Mark IVs and 35 orders for 10 units each of 35 different products that have the same overall production characteristics as the P1 Mark IV Balance Seal. The high volume order or all of the small volume orders will consume the remaining bottleneck resources. Which of the orders would the three costing approaches suggest accepting? 3. Which orders would you recommend be accepted? Repeat the above calculations assuming that the selling prices are: Product Identification Order Volume Selling Price $100. 00 $20. 00 $4. 75 $3. 00 $2. 0 P1 P2 P3 P4 P5 10 50 200 500 1,000 Would your recommendations about which orders to accept change? 4. Analyze the pricing strategies that are being used in this industry based upon the two sets of prices. Hint, it will help if you look at the rankings of profit in each pricing scenario. Price Lists—Pair 2 5. Repeat the calculations assuming that the selling prices are: Product Identification Order Volume Selling Price $69. 50 $16. 50 $9. 50 $8. 50 P1 P2 P3 P4 10 50 200 500 P5 1,000 $8. 25 Would your recommendations about which orders to accept change? 6.

Repeat the calculations assuming that the selling prices are: Product Identification Order Volume Selling Price $47. 50 $22. 40 $19. 25 $18. 00 $17. 75 P1 P2 P3 P4 P5 10 50 200 500 1,000 Would your recommendations about which orders to accept change? 7. What is the best way to integrate TOC and ABC? 8. If your recommendations include computing both TOC and ABC costs, how would you explain your solution to Bal Seal management given their concerns about the potential resulting confusion? 9. Analyze the pricing strategies that are being used in this industry based upon the last two sets of prices.

Hint, it will help if you compare the unit ABC profits and TOC contributions generated in each price scenario. Exhibit 1 Information on the Mark IV Family of Balanced Seals Order Information Product Identification Number Order Volume Unit Selling Price $50. 00 $9. 00 $5. 00 $4. 00 $3. 75 Number Of Production Runs for Order 1 1 2 3 5 Estimated Annual Production Volume 10 75 500 2000 5000 P1 P2 P3 P4 P5 10 50 200 500 1,000 Cost Information Material Costs Labor Costs Order Processing Costs Set-Up Cost/Run Parts Administration/Product Freight Sales Commission $0. 40 $0. 33 $75. 00 $45. 00 $500. 0 5% of selling price 10% of selling price Processing Time Information for CNC Machines Run time per unit Setup Time per run 1. 5 minutes 30 minutes Figure 1: Bal Seal Engineering Company Inc. Canted-Coil Spring Seal Figure 2: Bal Seal Engineering Company Inc. Canted-Coil Spring Performance Normal Working Deflection Force Conventional; Spring Canted-Coil Spring 5% Deflection 35% Figure 3: Bal Seal Engineering Company Inc. Piston Mounted Seal Piston Figure 4: Bal Seal Engineering Company Inc. Housing Mounted Seal Piston Figure 5: Bal Seal Engineering Company Inc. Production Process

Final Proprietary Inspection Spring Production Ring Production Shipping Material Production Figure 6: Bal Seal Engineering Company Inc. Production Timeline Shipping Buffer Post-Constraint Processing Constraint Process Constraint Buffer Pre-Constraint Processing Bill’s Custom Planters1 William Stammerjohan, Washington State University Deborah Seifert, Washington State University Bill’s Custom Planters (BCP) manufactures a line of decorative wooden planter boxes that are sold to both retail and wholesale customers. Dr. Bill started building custom planter boxes in his garage as a hobby/business about ten years ago.

His custom planter boxes were so popular that he quit his “day job” seven years ago and began to manufacture planter boxes full-time. Dr. Bill rarely builds a planter box himself anymore because he is now the full time manager, production supervisor, sales force, and bookkeeper. The word “custom” no longer truly describes the planter boxes because BCP now offers only one model that is available in four, very similar, variations. Several factors have contributed to increased popularity, increased demand, and increased production volume for the planters over the last few years.

A feature article in a regional home improvement magazine, “Northwest Home and Garden” got the ball rolling for the planters a couple of years after Dr. Bill went into business full-time. A monthly display ad in the same magazine appears to have contributed to increases in both retail sales and wholesale customer demand. Dr. Bill significantly increased production capacity almost four years ago when he moved BCP into a new rented building and bought all new equipment. Like many small businesses, BCP’s growth has not been without setbacks.

The sale of planters is seasonal by nature and shortly after the move into the new building, BCP was suddenly faced with new price competition from a much larger supplier of garden supply products. The “custom” planters that BCP was building at that time were priced a lot higher than the current more generic model. The market seemed to become “price sensitive” overnight and the sales volume dropped precipitously. It took Dr. Bill several months to realize that he had to simplify his product line and become competitive if BCP was going to survive.

It seems that BCP has now weathered this storm, but there are some lingering scars from this period. Dr. Bill’s credit rating is now far from perfect. This is the result of several very late interest and principal payments on the equipment loan, and an inability to make timely interest payments on a former credit line balance. After his former bank canceled his credit line, several other local banks refused to extend credit to either Dr. Bill or BCP. Dr. Bill feels fortunate that his current bank, No Heart Trust Co. NHTC), agreed to extend a small line of credit during BCP’s darkest days and has grudgingly agreed to some small increases in the credit limit over the last two years. The NHTC credit line currently has a $60,000 credit limit. NHTC requires BCP to maintain a minimum cash (checking account) balance of $6,000, or 15% of the We would like to thank Tom Albright for his insightful discussion comments at the 2002 AAA-MAS Conference. 1 outstanding credit line balance, whichever is greater. NHTC requires a minimum payment of the accrued credit line interest on the last day of each month (12% annual rate).

The now current equipment loan requires a minimum principal payment of $2,000 plus accrued interest on the last day of the month (8% annual rate). The key factors describing BCP’s current operations include the fact that all retail sales are mail order and the wholesale customers are either home improvement or garden supply stores. Retail customers pay for their purchases by credit card and all wholesale sales are on account. The retail price is $70. 00 plus $8. 00 shipping and handling. Wholesale customers receive a $20 per planter discount off the retail price and all wholesale shipments are sent freight collect.

On an annual basis, about 30% of the planters are sold retail and 70% are sold wholesale. NHTC deducts a 3% service charge on credit card sales and credits BCP=s account almost instantaneously. Wholesale customers are billed on the last day of each month and are given terms of 2%-10th/net 30. Forty percent of all credit sales are collected during the discount period, 20% within the net 30 period, 25% one month late, and 13% two months late. Roughly 2% of credit sales are never collected. BCP has the capacity to produce 800 planters per month using one shift.

BCP has eight employees that each work 160 hours per month performing direct labor. Wood is purchased from a local supplier on an “as-needed” basis. The local supplier has a very good record for both quality and on-time delivery, but will only deliver on a COD basis. The COD arrangement is another remnant of the period when Dr. Bill was not able pay BCP’s bills on a timely basis. While Dr. Bill has re-established credit with the hardware supplier, BCP must buy hardware in lots of 1,500 sets to receive competitive pricing. Hardware delivery takes about one month from the time an order is placed.

The hardware supplier pays the shipping cost, but requires full payment within ten days of receipt of the hardware. Selling and Administrative expenses are $2,500 per month plus $3. 40 per planter sold. All cash overhead costs, rent, shipping and handling costs, and selling and administrative expenses are paid in the month incurred. Dr. Bill’s current estimation of the cost per planter is as follows: Bill’s Custom Planters Schedule of Planter Cost For 2003 Direct Materials: Wood Hardware (1 set per planter) Direct Labor: (1. 6 hours @ $11. 00 per hour) Variable Overhead ($2. 00 per direct labor hour) Fixed Overhead (based on 800 lanters per month) Cost Per Planter $10. 00 5. 00 17. 60 3. 20 5. 25 $41. 05 The shipping and handling cost per planter sold retail is $6. 00. The $4,200 per month in fixed overhead is comprised of: building rent, $1,000; equipment depreciation (12 year/straight-line), $2,000; and casualty and liability insurance, $1,200. BCP’s expected financial condition is reflected in the 12/31/02 Pro Forma Balance Sheet. Although Dr. Bill has returned BCP to profitability, and although all the interest and other liabilities are now current, the equity balance is mostly the result of money that Dr.

Bill contributed to the corporation when he “cashed out,” his former day job retirement account. Dr. Bill does not draw a regular salary, but was able to take a modest dividend in September 2002… Bill’s Custom Planters Pro Forma Balance Sheet As of 12/31/02 Cash Accounts Receivable $ 43,750 Less: Allowance 2,250 Finished Goods Inventory (500 planters) Hardware Inventory (1,200 sets) Equipment $288,000 Less: Accumulated Depreciation 92,000 Total Assets Accounts Payable (hardware) Credit Line Equipment Loan Equity Total Liabilities and Equity $ 6,000 41,500 20,000 6,000 196,000 $ 269,500 $ 7,500 30,000 190,000 42,000 $ 269,500

The current accounts receivable balance results from credit sales over the last three months of 2002 and from a few chronically past due accounts. Credit sales for October, November, and December were $25,000, $20,000, and $30,000 respectively. As usual, business has been up and down during the winter months. Dr. Bill generally tries to increase the finished goods inventory over the late fall and early winter to be prepared for the big sales months that follow. The expected sales for January through May 2002 are 900, 1,200, 1,400, 1,200, and 1,000 planters, respectively.

Sales are expected to return to a normal level of 800 planters per month by June. Dr. Bill expects 90% of the January and February sales and 80% of the March sales to be to wholesale customers preparing for their own spring sales. Dr Bill likes to start each month with enough finished goods to supply at least 2 of that month’s sales requirements. Dr. Bill is proud of the fact that he has returned his business to profitability, but is perplexed by the fact that the business is not more profitable. He is also troubled by business decisions he must make in the near future. Dr.

Bill has approached your business school in late December 2002 and asked for help and guidance. You have been assigned the task of fulfilling his request. Your first task is to complete a production plan for the first quarter of 2003. Given his credit history, Dr. Bill is particularly concerned with cash needs. He is also concerned with staffing decisions during the upcoming busy season. This assignment requires that you analyze information and make recommendations. Be sure that you use all the information given, all the accounting and business knowledge you possess, and your imagination when necessary.

You will find this to be a holistic process, i. e. , you must consider the staffing decisions and cash needs before making your final recommendation on a production schedule. You may find it necessary to try several combinations of staffing and production before you arrive at what you believe to be the “best solution. ” Your task is to write a memo to Dr. Bill that addresses each of the following questions. Your memo must be supported by the schedules and pro forma financial statements listed after the questions. 1. Address the general question of scheduling production.

Explain why, or why not, you recommend scheduling the excess production evenly each month? What is the expected finished goods inventory at the end of each month if BCP follows your production schedule? Do you believe that these inventories are adequate and/or necessary? Why or why not? Briefly discuss your recommended scheduling of hardware orders. What kind of safety stock are you recommending? Why? There are two options of providing the extra direct labor. BCP can ask the existing employees to work overtime, or hire temporary employees during the busy season.

Existing employees would have to be paid time and a half to work overtime, but can be expected to maintain their normal level of efficiency when working up to about 200 hours per month each. Temporary employees can be hired for $8. 00 per hour, but their lack of experience and training is expected to mean much less production per hour. It is expected that these employees will take about 2. 5 hours to build each planter. Be sure to include a discussion of both the quantitative issues, cost per planter, and the qualitative issues driving this recommendation.

You can choose to fulfill the excess labor needs with any combination of existing employees and/or temporary employees that you feel will best serve the needs of BCP. Does it appear that the $60,000 limit on the credit line is going to be adequate? If not, what steps must BCP take and when will they need to be taken? Although the expected wholesale sales for early 2003 look strong at this point in time, the wholesale market remains very price conscious. Over the long run, Dr. Bill believes BCP could double normal wholesale sales from 560 planters per 2. 3. 4. 5. onth to 1,120 planters per month under the following conditions: the wholesale discount on all planters sold to wholesalers would need to be increased to $24 per planter; the extra 560 units could be produced by a night shift with fully productive employees that would be capable of producing a planter in 1. 6 hours; and the night shift could be staffed by paying these employees an additional $1. 00 per hour. Would you recommend increasing the discount? Why or why not? Be sure to discuss the quantitative issues, expected profit, and the qualitative issues behind this recommendation.

You can assume that BCP would be able to sell the same number of retail planters per month under either wholesale option. The required schedules and pro forma financial statements are as follows: 1. Prepare a schedule that shows the beginning inventory, required production, expected sales, and ending inventory for each month, January through March 2003. Also show the quarterly totals. The following is a suggested format: Bill’s Custom Planters Three-Month Rolling Production Schedule For January through March, 2003 Beginning Inventory. Required Production Expected Sales Ending Inventory January 500 February March Quarter 500 . Prepare a schedule that indicates the order dates for hardware, the expected arrival dates, the payment dates, the expected inventory prior to arrival, the order quantity, and the expected inventory following arrival of each order. Bill’s Custom Planters Hardware Order, Arrival, and Payment Schedule For January through March, 2003 Order Date Arrival Date Payment Date Expected Inventory Order Quantity Expected Inventory 3. Prepare a cash budget with columns for each month, January through March 2003, and a fourth column for the quarterly totals.

Include separate lines for: expected cash collections from retail sales, expected cash collections during the discount period, expected cash collections during the net 30 period, and expected cash collections during each of the two late periods. Include separate lines for each type of cash payment, e. g. , wood, hardware, rent, interest, etc. Include separate lines for the beginning cash balance, the ending cash balance, and the ending credit-line balance. 4. Prepare a pro forma schedule of the cost of goods manufactured, pro forma income statement and pro forma balance sheet for the quarter ending March 31, 2003.

Assume that between January 1 and March 31, 2003, two wholesale accounts with combined balances of $1,450 are identified as uncollectable. BCP capitalizes finished goods inventory at the actual cost of production and uses the FIFO cost flow assumption. 5. Prepare a schedule or pro forma income statement that estimates the differences in expected profit between the current wholesale discount and the proposed wholesale discount. THE DUBLIN SHIRT COMPANY * by Peter Clarke (University College Dublin), Paul Juras and Paul Dierks (Wake Forest University). This case has been heavily adapted by Peter Clarke, with permission, from an earlier case “Blue Ridge Manufacturing” prepared by Paul Juras and Paul Dierks of Wake Forest University. The original version appeared in Management Accounting, December 1993, pp. 57 – 59. Address for correspondence: Peter Clarke, Department of Accountancy, University College Dublin, Belfield Campus, Dublin 4, Ireland E mail address: Peter. [email protected] ie Keywords: Activity based costing and customer profitability analysis; target costing; strategic issues and considerations.

This case has benefited from the helpful comments of James Mackey and Ella Mae Matsumura and other participants at the Management Accounting Section Research and Case Conference of the American Accounting Association, Austin 2002. “For accounting professors who like hard sums and soft issues” May 2002 THE DUBLIN SHIRT COMPANY INTRODUCTION The Irish clothing industry has changed beyond recognition over the past decade. High cost structures have forced many indigenous and multinational clothing companies to close down their operations and those that survived have had to find ways of gaining a competitive advantage.

Some have achieved this through switching to niche markets, while others have begun to outsource garment production to cheaper overseas locations. Such alternatives have been vital in ensuring the survival of the Irish clothing industry. Ireland was, traditionally, an outsource location itself, especially for US multinationals looking for a European manufacturing base with access to the European Economic Community (now, the European Union). While a small number of multinational companies remain in Ireland, many have closed and moved on as cost structures made them uncompetitive.

Morocco, Asian and Eastern European countries are becoming key outsource locations. Employment in the clothing industry in Ireland currently stands at about 8,000, which compares with an all-time high for the sector of approximately 15,000 ten years ago. The Dublin Shirt Company was established in Ireland about a decade ago by its American parent. It is a wholly owed subsidiary. At that time the Republic of Ireland had an abundant supply of cheap, well-educated and English-speaking labour. In addition, it had the lowest corporate tax rate in the European Union and a regulatory regime that was unambiguously pro-business.

The political system was stable and the population had strong links to the US – the primary source of foreign direct investment (FDI) in Ireland. The company manufactures polo-type sports shirts for the growing worldwide sports shirt market. (The company presented former US president, Bill Clinton, with one of its shirts, on his recent visit to Ireland, which included a game of golf in Ballybunion). They are called sports shirts because their most popular use is for various sporting activities including major sporting events such as the British Open, Ryder Cup, Super Bowl, Wimbledon, etc.

In addition to being sold to spectators at each event, they are also used to promote the specific event itself. The company is located in a small provincial town on the outskirts of Dublin. It is a medium sized firm (by Irish standards) with annual sales of just under €16 million and an investment base (i. e. net assets) of some €3 million. For the most recent fiscal year (2001), the company budgeted for and generated a small loss. A small profit was budgeted for and reported for the previous year.

The CEO of the US parent has already issued warnings about the continued operation of the company in Ireland due to its precarious financial position. Obtaining a significant amount of interest-free, short-term loans from its parent company recently averted a cash flow crisis. If nothing else, everyone knew that making losses in a low tax regime was bad tax management for the Group! (The average return on sales is about 4 percent for similar companies in Ireland). The Company has a modern knitting plant and is currently operating at 70 percent capacity.

There are approximately 100 employees, and most of these are female machine operatives who are paid on an hourly basis. The weekly payroll calculations consume a great deal of resources since they are done manually. Because of the high investment in capital equipment in previous years, together with the loss reported for the current year, no provision for taxation need be made. MANUFACTURING The Dublin Shirt Company knits (i. e. manufactures) all its shirts. The basic product produced by the company is a white sports shirt (in different sizes).

Shirts are made in three men’s sizes: medium, large and extra large (XL). The company does not manufacture small sized shirts as it considers this size to be suitable only for children and it believes this market segment to be rather small. The normal production cycle for an order of white shirts is five days. Depending on the client requirements, the shirt may be customized to order. Customization involves three processes although each process is not, necessarily, required for each shirt. The three processes are, in sequence, dyeing, stamping or, alternatively printing, and embroidery.

Nearly two-thirds of the shirts are dyed in various colours. This increases the production cost and extends the production cycle of an order by about three days. In addition, a characteristic feature of the “sports shirt” is the promotional text and/or logo that is added to each shirt. The promotional text and/or logo can be either printed on or machine embroidered. In the majority of cases, the text is usually printed and this is referred to as the printing process. The technical term used is that of “stamping” whereby the appropriate text/logo is added to each sports shirt using a special printing machine.

Recently, the firm has had some difficulty with the “staying power” of the material printed on these shirts. Customers have complained that the ink eventually cracks and peels off. A small but increasing number of shirts (about 15%) have the text or logo of the sports event embroidered rather than “stamped”. This embroidery work adds enormously to the appeal of the product. The company tries to product each order well in advance of dispatch so that there will always be a certain amount of finished goods in stock at the end of each fiscal period.

CUSTOMERS The Company’s sales are all on credit and are predominantly made to England and the United States – countries that are outside the Euro zone. (To avoid foreign exchange fluctuations, the company invoices all its sales in Euro). Typically, customers take about 60 days to pay their account. Currently, the company has 986 active customers. These customers differ primarily in the volume and type of their purchase order, so management classifies each customer in one of three groups – priority (8), team (154) and shop (824). Priority customers are typically the large; international sports events that generate a great deal of TV coverage.

Typical examples are the British Open, Wimbledon, Super Bowl etc. Shop customers are single shop operations (such as pro shops at golf courses), and team customers are typically associated with specific teams or clubs. It is company policy to conduct a full credit check on new customers to avoid the potential of bad debts. As a result, the amount of bad debts incurred has been insignificant in recent times. The low amount of bad debts is also partly due to the speed by which invoices are issued to customers, together with a regular and frequent follow-up of all unpaid invoices.

Table 1 gives product and customer classification statistics for 2001. The Company has a different marketing approach to customers in each of its three categories. A small group of in-house sales-people sells directly to buyers in the priority customer category. Independent salespersons, paid on a commission only basis, call on the licensing agent of customers classified in the team category. Advertisements placed in regional magazines and newspapers target customers primarily in the “shop” customer segment, who telephone or post in their orders.

Not surprisingly, a significant cost for all categories is the provision of sample shirts to potential clients. INFORMATION & PERFORMANCE In an attempt to start some sort of strategic planning exercise within the Irish plant, senior managers recently identified its main competitive strengths and weaknesses. Management believes that the critical strength of the company is in the quality of the product, and that the weakness in recent years has been in customer service, particularly in meeting scheduled deliveries.

A mission statement for the company was recently circulated for discussion by the Irish Board and read “to provide a reasonable return to shareholders by providing high quality products to customers, delivered on time and at the lowest cost”. However, due to more pressing matters no discussion took place. Thus, little progress has been made in modifying the management accounting and information system to monitor progress in relation to these critical success factors. Production costs are accumulated as outlined below in Exhibit 1.

Exhibit 1: Production and cost accumulation process Production process Cost information Direct material (per unit) Basic manufacture of white shirt Direct labour (per unit) Manufacturing overhead (per unit) Customisation of shirt (a) Dyeing (about 63% of shirts) = Direct costs (outsourcing) (b) Stamping/printing (about 85% of = Conversion cost (per unit) shirts) (c) Embroidery (about 15% of shirts) = Conversion cost (per unit) Costs are accumulated separately for the basic manufacturing process i. e. the manufacture of white shirts, and also for the customization process.

The former process accumulates costs as direct materials, direct labour or manufacturing overhead. In this process, production overheads are absorbed on the basis of direct labour cost and this approach has been in use for a number of years. Costs associated with customizing shirts are accumulated separately under the heading of direct costs (for dyeing) and conversion costs for stamping/printing or, alternatively for embroidery. Table 2 shows the firm’s unit costs and sales price for various items for the most recent period.

The typical monthly management-reporting package consists of a summarized profit and loss account and summarized balance sheet (Table 3), together with a detailed schedule of aged accounts receivable. The profit and loss account in Table 3 shows the reported loss for the recent fiscal year. In order to restore profitability to the company, management would first like to ascertain the profitability of the customers in its three customer categories – priority, team and shop. At the moment, management has no basis for assessing customer profitability.

Yet, it is intuitive that some customers generate high profits while others do not generate enough revenues to cover the expenses to support them. The basic problem here is that different customers demand different levels of support. Management is aware that the use of ABC information would enable a type of customer profitability analysis to be applied. They have recently obtained data on how the selling and distribution, and administrative expenses could be incorporated into a customer profitability analysis by identifying cost pools and cost drivers for various customer related activities (Tables 4a/4b).

RECENT DEVELOPMENTS Two recent developments that may have an impact on the company should be noted. First, in the present climate, the Dublin Shirt Company can only afford to reduce its prices if it can cut costs. The Sales Director suggests that the company can lower its quality inspection costs by reducing inspections, which will improve on-time delivery rates. This proposal is to be discussed at the next Board meeting. Second, last week, the Sales Director proposed that the company should enter the American market for women’s sports shirts, where comparable shirts sell for the equivalent of €9. 5. This is considered to be an excellent selling price, given the small size of the shirt involved. Overall production costs would be similar to medium-sized shirts and normal selling, distribution and administration costs would amount to €3 per unit. Each shirt would require dyeing and also normal embroidery. A marketing consultant has obtained information about specific features required for the lady wearer. Working in conjunction with the firm’s cost accountant, he has presented information on these features and approximate cost as follows:

Feature required by the lady wearer Hanger (on inside of collar) Hanger (on outside of shoulder) Patch (breast) pocket Embroidery on single sleeve Double stitching (on V-neck etc. ) Cost (per unit) to add €0. 02 €0. 04 €0. 10 €0. 25 €0. 08 Importance ranking (5 = most important) 2 3 3 5 4 It is anticipated that the Dublin Shirt Company will sell these products through an agent, with whom they have never dealt but who would like to place an order for 100,000 shirts this year. The company recognises that this (new) market will require additional selling costs in the US, equivalent to €1 per shirt.

The Dublin Shirt Company requires a contribution of €2 per unit but the goods are to be invoiced in US dollars unlike current sales that are invoiced in Euro. REQUIREMENTS The management of Dublin Shirt Company has hired your consultancy firm to advise them on the current situation and potential future developments. You are to prepare a presentation for the company’s board of directors to include the following: (1) A calculation of break-even point (in units) for the year ended 2001.

For the purposes of simplifying this calculation, you should assume that ONLY direct material and direct labour costs are considered variable with respect to changes in volume. Clearly identify your assumption regarding the sales mix in your calculation and specify why this assumption is important in the context of CVP analysis. 5 marks (2) A brief overview of what strategy you think the Dublin Shirt Company should adopt. What do you consider to be the critical success factors in achieving this strategy? 10 marks (3) A determination of the profitability of each of the three customer groups. 0 marks (4) An identification and discussion of the strategic issues that may arise from the results of your customer profitability analysis. 10 marks (5) A description of the potential behavioural implications on the sales and administration personnel arising from the implementation of ABC information. 15 marks (6) A listing and brief justification of other potential cost pools and cost drivers that could be used for selling and administration costs, in addition to the cost pools and cost drivers listed in Table 4b. marks (7) Explain how a Balanced Scorecard might help a firm like the Dublin Shirt Company. Give examples of performance measures that might be included under each of the following five perspectives, namely: (i) financial, (ii) customer, (iii) internal business process, (iv) learning and growth, and (v) community. 15 marks (8) The Sales Director suggests that the company can reduce its inspection costs. Do you agree with this proposal? 10 marks (9) The Dublin Shirt Company is considering entering the women’s sports shirt market in the US.

What is the target manufacturing cost for these shirts? Indicate what features, if any, should be added to the shirts already produced, in keeping with your target cost calculations. Identify the strategic and international business factors that the management of the Dublin Shirt Company should consider in making this decision. 10 marks TOTAL: 100 MARKS TABLE 1: PRODUCT & CUSTOMER STATISTICS FOR 2001 Shirt size: X large Large Medium Total units sold Sales revenue (€) No. of units dyed No. of units stamped No. of units embroidered No. f orders received No. of shipments made Sales in units by customer category Priority Team Shop 272,500 166,000 105,500 366,000 186,000 103,000 360,000 190,000 960,000 998,500 542,000 1,168,500 €6,029,700 750,000 698,500 300,000 2,330 1,470 €3,284,300 400,000 472,000 70,000 11,450 9,230 €6,566,900 550,000 1,138,500 30,000 57,909 49,286 Total 544,000 655,000 1,510,000 2,709,000 €15,880,900 1,700,000 2,309,000 400,000 71,689 59,986 TABLE 2: COST AND REVENUE DATA FOR 2001 Basic manufacture X large Large Medium Quantity Average sales price €6. 60 €6. 20 €5. 5 Direct material €0. 60 €0. 55 €0. 39 Direct labour €0. 40 €0. 35 €0. 30 Manuf’g overhead €0. 24 €0. 21 €0. 18 544,000 655,000 1,510,000 2,709,000 Quantity 1,700,000 2,309,000 400,000 Customising Dyeing Stamping Embroidery Direct cost (unit) €1. 40 N/A N/A Conversion cost (unit) N/A €0. 40 €1. 30 Total cost €2,380,000 € 923,600 € 520,000 €3,823,600 TABLE 3: PROFIT AND LOSS ACCOUNT THE YEAR END 2001 units 544,000 655,000 1,510,000 2,709,000 € 2,715,310 3,823,600 5,761,600 3,584,450 € 3,590,400 4,061,000 8,229,500 15,880,900 Sales: X large Large Medium

Less: Cost of goods manufactured Basic manufacturing costs Customising Gross profit Less: Non-manufacturing overheads Selling and distribution expenses Administration expenses Net loss for year Retained profit brought forward Retained profit at end of year BALANCE SHEET AT YEAR END 2001 Fixed assets Buildings (net) Plant and equipment (net) Current Assets Stock (inventory) Debtors (accounts receivable) Less: Current Liabilities Trade and other creditors Net current assets Total assets less current liabilities Financed by: Ordinary share capital Retained profits Shareholders’ funds ,538,910 9,341,990 9,346,050 (4,060) 1,537,810 1,533,750 2,450,000 1,740,000 550,000 2,600,000 3,150,000 (4,406,250) 4,190,000 (1,256,250) 2,933,750 1,400,000 1,533,750 2,933,750 TABLE 4A: THE ASSIGNMENT OF SELLING, DISTRIBUTION AND ADMINISTRATION COSTS TO CUSTOMER RELATED ACTIVITIES Percentage distribution to: Selling & distribution Administration Customer related activities Accounts maintenance Sales commission Shipping activities i. e. deliveries Sales visits Tracking misplaced/lost items Marketing/promotion Nil 5% 50% 15% 20% 10% 100% 70% Nil 10% Nil 20% Nil 100%

TABLE 4B: CUSTOMER RELATED ACTIVITIES AND ASSUMED COST DRIVERS Customer related activity Accounts maintenance Sales commission Shipping activities (i. e. deliveries) Sales visits Tracking misplaced/lost items Marketing/promotion 1 Assumed cost driver Number of orders received Direct allocation to team customers only Number of shipments (deliveries) made Direct allocation to priority customers only Number of units sold Management estimate 1 Decided as: 20% to “team” customers and 80% to “shop” customers ECN. W Dave Roger, an experienced consultant from the e-commerce space, started Electronic Commerce Network (ECN.

W) 18 months ago. In studying this emerging business model, he found the one area that caused the most problems for web merchants was transaction processing. Although few people understood this, each seemingly simple web sale involved some 12 underlying transactions (see Figure 1). Before the sale could be transacted both credit worthiness and product availability had to be ascertained. If both were answered in the affirmative, the transaction would then be made. This, then, entailed a further logistics transaction and an accompanying tracking transaction.

In addition, the customer buying profile on the web merchant’s data-base had to be updated. These all had to be done seamlessly and on a real-time basis. Web customers had come to assume instantaneous service. The prevailing business model was that each web merchant would build (or buy) an integrated software platform for transaction processing. Companies such as Cybersource provided the credit confirmation software systems; Yantra the fulfillment and inventory management systems; and Oracle the database management systems. Interfaces had to be built to allow these systems to “talk” to one another.

Since each of these software systems was being upgraded on a regular basis, the maintenance of these interfaces was a nightmare. To make matters worse for the web merchants, experienced IT personnel in this area were scarce. And when one did gain the prerequisite experience, head-hunters for large companies were quick to hire these IT people away. As a result, web merchants found that they spent more time then they cared to on transaction processing issues. Dave Roger crafted a business model based upon a hosted network concept. The ECN.

W customer value proposition was as follows: Web-merchants should spend the majority of their time on their primary mission, value-creation through innovative marketing and sales offerings to customers and clients2. You should avoid spending both scarce managerial talent and investor capital on any activity that could best be performed by third-party partners such as ECN. W. Do investors see the value in you building transaction-processing systems with their investment dollars that are sub-optimal in scale and soon obsolete? In you hiring and training high-cost personnel to run these inefficient systems?

In you spending much of your creative energy trying to manage these inefficient systems? The answer is clearly “NO. ” Join our network and get all these services seamlessly provided with state-of-the-art applications run by highly trained IT professionals (see Exhibit 2). We will convert a difficult-to-manage fixed infrastructure cost into a totally scaleable variable one since you pay only on a pertransaction basis. With us as your partner, you can spend your creative energies where your investors expect. Dave Roger had no problem obtaining initial funding.

Within eighteen months he had 10 merchants and their fulfillment partners loaded onto his network. His problem was obtaining the next round of financing. Since the collapse of the Internet market, finding funds was much more difficult. Unlike many of these failed companies, ECN. W had satisfied customers and the growth potential was strong. Nonetheless. his investors were now seeking more details than he could provide. Specifically, they wanted clarity of his financial model. Exactly what did it cost him to “run” his business and how would he create the return necessary to satisfy them?

They suggested that he provide them with “more detail and less vision” using an activity analysis. Since Dave was not sure exactly what was necessary, Denise Pizzi was hired to facilitate this analysis. She had come highly recommended. She quickly pulled together a cross-functional team of ECN. W personnel to develop the required activity analysis. Within a month, the group established that there were three high-level processes that best defined ECN. W. — Customer Capture, Customer Loading and Transaction Processing. They had studied the first two in detail and arrived at the following: 1.

Customer Capture involved all the activities that culminated in a signed contract. These activities were identified as: Customer Identification — involved here were sub-activities tradeshow attendance, trade show preparation and advertising. Through tracing of travel itineraries and such, it was established that in Clients all also called fulfillers. An apt analogy is the role Wal-Mart, a brick and mortar rather than web merchant, plays for its suppliers (or fulfillers in the e-commerce world) such as a Procter & Gamble. 2 the past 12 months, ECN.

W had spent approximately $875,000 on these activities. 3 This resulted in 1,200 customer leads. Customer Qualification — basic research to identify that high-potential sub-set of the customer leads with enough size and credit worthiness to pursue. ECN. W had out-sourced this activity to a credit agency, paying approximately $175 per credit report. Customer Sale — telephone calls and site visits to pursue and, hopefully, close the sale to those high-potentials. Of the 1,200 leads, ECN. W had pursued 80, and successfully closed on 10 of the 80. The other 70 had exited this activity prior to a signed contract either by their own choice or ECN. W’s. Appendix A has additional data for this activity. 2. Customer Loading entailed all the activities necessary to enter the web merchant and its fulfillers onto the ECN. W network. Over the past 12 months the equivalent of 7 customers went through this whole process. The relevant activities were identified as: Business Operations Review — outsourced to a number of subcontractors who documented the operational flow of the web merchant. ECN.

W had spent about $3,600 each on the 7 reports. System Design — the writing by ECN. W technical staff of all the software interfaces and configuration of hardware linkages for transaction processing. It cost ECN. W about $5,000 each on the seven systems. Implementation & Certification — installation and testing to ensure system is working as designed. Although there was minimal variation in the effort for the first two activities, this one varied greatly depending upon a number of factors (see Appendix B). APPENDIX A Customer Sale analysis detail Initially, these activities were analyzed separately but since they were not mutually exclusive (i. e. , advertising resulted in trade show booth visits and trade show exposure made advertising more effective, they were then aggregated. 4 Since all of the activity did not fall neatly into the twelve-month analysis window, these numbers are expressed in full-time equivalents. Although some of the sales activity had begun prior to the start of the past 12 months and some would continue on into the following months, it was estimated that ECN.

W pursued the equivalent of 80 and closed 10 in this time period. The approximate $520,000 total cost for this activity pool came from across the company. When a high potential customer expressed continued interest in that initial phone call, site visits were organized. This meant flying out sales people as well as technicians to demonstrate how the system worked. Top management of the larger accounts also expected to meet with ECN. W top management just to ensure themselves of the professional caliber of the company to which they were going to entrust a crucial part of their business.

The group found that there was much variability in this activity -there was no “typical” account. Generally, they fell into two groups — those that understood the customer value proposition and the inherent costs of transaction processing and those where the customer value proposition had to be demonstrated. For the former, the process was as follows: A visit to the potential customer site by a sales person and a technician. This trip took approximately three days — one for travel, one to reach agreement between client and ECN. W on how transaction processing as currently being done by the client, and one to demonstrate the advantages of the hosted network approach. A follow-on visit by the sales person to “close” the deal which took on average two days — one for travel and one for negotiation. Sometime in between these two trips, Dave Roger would call the customer to talk “CEO to CEO” after a thorough briefing on the customer by the sales person. This took about a half-day of effort from both the sales person and Dave Roger. For the latter group, the sales process was more complicated due to the skepticism of the customer.

Unfortunately, 7 of the original 10 fell into this group. An initial visit to the potential customer by the sales person just to introduce ECN. W and explain in detail the customer value proposition. This took on average two days — one for travel and one for the customer meeting and product demonstration. A follow-on site-visit by the sales person and a technician. This trip took approximately five days — one for travel, three to educate the client on how transaction processing was currently being done internally and its costs, and one to demonstrate the advantages of the hosted network approach.

A follow-on visit by the sales person to “close” the deal which took on average two days — one for travel and one for negotiation. A site-visit by Dave Roger to demonstrate ECN. W’s commitment to customer satisfaction which took on average two days — one for travel and one for discussion APPENDIX B Implementation & Certification analysis detail Like the other activities, costs for this activity pool came from across the company and like the Customer Sale activity, there was high variability in this activity. Customers fell into two broad groups: those that had a competent IT staff, were prepared or and responsive to ECN. W’s implementation team, and had only one fulfiller; and those that were neither competent nor responsive and had many fulfillers — four, on average. For the former group, the installation and test procedure required a team of two technicians, one at the customer site and the other at the fulfiller, for a total of only two days — one for travel and one for implementation. Most of the work was performed by client and fulfiller IT personnel. Certification was done at ECN. W and required only one additional day for minor debugging.

For the latter group, however, the process was much more difficult. Typically, it required a team of three technicians and two trips to the customer site — an initial three-day visit by two technicians and a second two-day trip by a single technician for major revisions due to unforeseeable problems. Likewise, dealing with multiple fulfillers that were less than prepared meant more and longer site visits for the third technician, usually three days in duration — one for travel and two for on-site work. Certifying the system also took twice as long at ECN. W.

Assignment: From the General Ledger (see Exhibit 3), travel expense reports and other varied sources the group gathered the following data: Number of sales people at ECN. W — 2 Number of marketing people at ECN. W — 2 Number of technicians at ECN. W — 9 Training & Development expense detail – $25,000 for sales and rest for technicians Payroll benefits — averaged 20% of salaries for all functions Average round-trip airfare and related transportation costs per person, $2,000 Typically a three-day trip meant three nights in a hotel; two days, two nights; and so on at an average cost of $500 per night per person.

A) Prepare an activity cost estimate for Customer Sale and Implementation ; Certification. B) Prepare a cost estimate for Customer Capture and Customer Loading processes in total. Assume a 250-day work-year for all salaries. Be prepared to discuss your logic regarding: 1. The proper definition of the object you are trying to cost, 2. Whether the cost pools for the activities you are costing are predominately fixed or variable and how this effects your answer, 3. Assume that the group found that the costs associated with the 70 high potential customers that withdrew from the sales process before signed contract totalled $232,000.

How would you treat this cost? Exhibit 1 E-Commerce Transaction Detail Transactions #1 #2 #3 #4 #5 #6 #7 #8 #9 #10 #11 #12 credit company fulfiller fulfiller common carrier credit company Credit check In stock check Ship if #1 ; #2 “Yes” Track Charge customer Update customer profile Transaction summary to customer R e a l T i m e Customer Web Merchant Exhibit 2 ECN. W Value System Visa,AmExp MasterCard Customer WebMerchant Fulfiller ECN. W FedEx, UPS Transaction flow Physical flow Exhibit 3 General Ledger Account Balances (Last 12 Months)

Sales Salaries Marketing Salaries Technical Salaries Administrative Salaries CEO Salary Payroll Benefits Training ; Development Travel Expenses Meals and Lodging Consultants Advertising Other Marketing Expenses $ $ $ $ $ $ $ $ $ $ $ $ 250,000 200,000 900,000 200,000 750,000 460,000 182,500 340,000 387,000 287,000 350,000 180,000 ENDESA: MEASURING AND CONTROLING VALUE CREATED IN ENDESA By Gary M. Cunningham, Ph. D. , CPA* SCOTT ERIKSEN, PH. D. , CPA, CMA, CFM* Francisco J. Lopez Lubian, Ph. D. * Antonio Pareja** Instituto de Empresa, Madrid, Spain ** ENDESA SA, Madrid, Spain MEASURING AND CONTROLING VALUE CREATED IN ENDESA: A CASE STUDY In early March 2000, ENDESA’s corporate management presented its future vision for the company to financial analysts. ENDESA’s commitment was to construct a diversified portfolio of business units in the energy, telecommunications, and new technologies sectors drawing on an existing customer base of more than 27 million and exploiting geographic and operating synergies of the group. The ENDESA Group is no longer a simple electricity company. Our objective is to be a global energy operator, centered on the needs of our customers and the development of our abilities and intangibles, our international presence, and at the same time strengthening our presence in related businesses like new technologies and telecommunications. At the end of 2000, ENDESA was the leading company in the Spanish electric sector with market shares of 47% of the wholesale generation market and 43% of the electricity distribution market.

The distribution market is spread over a wide geographic area in Spain with market shares of 45% in Catalonia; 31. 6% in Andalucia and Extremadura; 71% in Aragon; 5. 2% in Cantabria, Asturias, and Galicia; and 10. 9% in the Canary and Balearic Islands. In addition, ENDESA has substantial operations in such diverse areas as telecommunications, natural gas distribution, co-generated and renewable electric energy, and the treatment and distribution of water and wastewater, and new technologies services for business and individuals (See Figure I).

Its current geographic scope covers 12 countries in Europe, Latin America, and North Africa following a major globalization strategy. ENDESA currently has over 20 million customers divided roughly equally between Spain and international locations. ENDESA’s web site in English can be viewed at www. endesa. es/english/ which provides more details about all these activities. BRIEF HISTORY OF ENDESA, S. A. The enterprise that is now ENDESA was founded in 1944 as a basic state-owned electric utility in Spain.

It grew substantially starting in 1972 when it merged with a hydroelectric generating company in Galicia in northwestern Spain, acquired mining facilities all over Spain, and constructed large coal-fired electric generating plants in remote areas of central, southern, and northwestern Spain. ENDESA Group was created in 1983 when the enterprise acquired majority interests in several regional electric distribution companies and established its position as a nation-wide electric utility company.

In 1991, ENDESA continued acquiring majority and minority interests in regional electric generating and distribution companies in Spain. In 1992, ENDESA Group began to expand internationally by acquiring companies involved in the generation, transportation, and distribution of electric energy. It became the one of largest Spanish companies in foreign investment, with business units in France and Portugal in Europe, Morocco in North Africa, and Chile, Peru, Argentina, Brazil, and Central America in Latin America.

At the same time as the international expansion, ENDESA began its diversification strategy by acquiring hydroelectric generating plants, a major coal production and marketing company in North America, and by creating ELCOGAS, the largest installation in the world that uses coal gasification to produce electric energy. It thus moved into renewable energy and new technologies. In addition, it acquired water treatment and distribution utilities and wastewater treatment facilities in major Spanish cities and in Latin America.

In the late 1990s, ENDESA acquired a major telecommunications firm in Spain. In 2000, ENDESA became the largest shareholder and manager of a joint venture with an Italian telecommunications company and another Spanish energy company to operate the second largest fixed-line telephone company in Spain, the second largest mobile telephone company in Spain, substantial other telecommunications in both Spain and in Latin America. Also in the late 1990s, ENDESA acquired natural gas distribution utilities in Spain and Portugal making it one of the largest in the natural gas market as well.

NEW CHALLENGES, NEW SOLUTIONS Changes in the Spanish electricity market began in 1998 with substantial changes in laws designed to liberalize the system, introduce price competition, and improve the quality of service. These changes made Spain the most liberal electric utility market in Europe and among the most liberal in the world. A major feature of this liberalization was giving customers that use more than 15GWH of electricity per year the right to select the electricity provider. ENDESA was the first Spanish company to serve such customers and now serves over 40% of this market.

Changes occurred in the financial environment as well. In 1988, an initial public offering of shares occurred when the Spanish state disposed of 24. 4% of the capital of ENDESA, starting the process of privatization. In 1998, the privatization process of ENDESA, S. A. was completed with the fourth public offering of the shares of the company. ENDESA’s shares are now listed on the New York Stock Exchange as well as on other exchanges in Europe. With all of these changes, there has been a major change in management orientation towards creating value.

The vision of the company was redefined as that of a global operator in the energy business and related services, with vertical integration to cover the risks, horizontal integration to capture the synergies, a high level of technological innovation, and effective adaptation to the new conditions and demands of the markets. The value creation strategy of ENDESA is to continuously evaluate its portfolio of business units, dispose of those that do not create sufficient value, and expand into new businesses where value-creation potential is high.

As a result, in 2001, ENDESA consolidated all of its electricity assets in the northwest of Spain into VIESGO and announced plans to sell VIESGO. ENDESA’s new business activities include such things as providing high-value services to existing customers in addition to basic electricity. For example, ENDESA provides such energy-related services as heating, air conditioning, steam, and security to major customers who have selected ENDESA as their electricity supplier in the liberalized Spanish market.

ENDESA also sells consulting services for expertise it has acquired in basic business systems like communications information system technology. In 2001, ENDESA announced a joint venture with Accenture, a major management consulting company, to offer systems consulting services in Latin America. In addition, ENDESA seeks to leverage its intangibles through such things as selling mobile telephone services to existing electric customers and offering home security and maintenance services to existing residential electric customers.

ENDESA is also changing its financial management strategy to include such things as optimizing leverage and replacing relatively high-cost Latin American debt with lower-cost European and North American debt. Techniques described in parts A and B of this case are used as management tools to measure and control this value creation. ORGANIZATION STRUCTURE In 1999, the general meeting of the shareholders of ENDESA and its participating electric enterprises in Spain approved a merger in which ENDESA absorbed the minority shareholders of the participating companies.

After privatization and merger, the ENDESA Group structured itself into subsidiaries along business lines, each of which focuses on creation of economic value according to the type of business. The major subsidiaries and their value creation activities are shown in Figure 2. Additional smaller subsidiaries include ENDESA’s power trading activities, mostly through its ten percent ownership of the Amsterdam Power Exchange; and its innovative new on-line business and personal buying services.

The structure, which also the legal framework, is used for financial management and financial control as described in parts A and B of the case. Each subsidiary is further divided into business units. The legal structure of the business units varies considerably, though, and does not necessarily follow the lines of business. Measurements of economic value and related parameters are explicitly carried down to the business unit level. In the view of ENDESA management, it is essential that the business units consider themselves as value creation centers, rather than as cost or revenue centers.

The financial management and management control approaches described in Parts A and B are designed specifically to communicate to business units that they are indeed value creation centers. ENDESA’s annual report for the year 2000, along with other information about ENDESA can be obtained from the web site: www. endesa. es/english/ . To access the financial reports, click on stockholders and then on annual report. Financial statements are found in the section with legal documents. MANAGEMENT EVALUATION By April 2000, ENDESA Group had three years’ experience in applying its new strategies and implementing new management tools.

It had dedicated a considerable quantity of economic resources and time of its managers. In reflection, there was a general agreement about the advantages that this effort had accomplished. There was also consciousness of the long road that still remained to be traveled. Some comments of managers are: “The most difficult part of this process has been to be sure this management model is accepted and understood relatively well by the operating levels. After three years, all persons know what are the rules of the game and what their individual objectives are in line with them. “In the Group, 1,200 managers have variable compensation based on achieving their objectives. On average, this variable part can be 25% of annual compensation. ” “The only ways to fight against initial rejection have been to establish clear communication from the beginning, and to count on the support of upper management. ” “On another hand, a great communication effort has been achieved with the financial markets through regular presentations of our results and future plans. We are convinced that the market values this information and transparency very positively. “Among the areas we have pending is development of a complete and flexible information system with a standard data base that facilitates decision making by different managers. PART A MEASURING ENDESA’S COMMITMENT TO VALUE In 1997, ENDESA’s corporate office of planning and control was charged with implementing the value-creation project that would ultimately involve a change in culture that would affect the entire organization. The need was apparent from the outset to develop a measurement of value created.

In the opinion of a high executive in charge of this task: ? In a group like ours, with a presence in different businesses and in different markets, it is essential to be able to measure the contribution of each unit to creation of value and using this measurement to be able to set management objectives directed toward maximizing it. We would get a value measurement that has a high correlation with market value added and on the other hand that is easy enough to be applied and understood in all the organization. The measurement that was selected, economic value created (EVC), is a form of residual income, that in the opinion of the Group management presented the following advantages compared to the traditional measurements like return on investment (ROI) and return on equity (ROE): • It is an economic rather than an accounting measurement because it is based on free operating cash flow which includes the depreciation tax shield effect, but which is not reduced by the depreciation expense as is traditional operating profit.

It allows the same measure of value created to be used by all business units operating in distinct markets. It integrates aspects of both operating and financial management, but allows them to be differentiated through decomposition into return on invested capital (ROIC) and the weighted average cost of capital (WACC). The decomposition also integrates short-, medium-, and long-term management objectives. • • • Also, compared to other value-creation measurements, EVC is very simple to apply and easily understandable by all the members of the organization, although they do not have financial knowledge.

FORMULATING THE MEASUREMENT As a point of departure, ENDESA began with the definition of Economic Value Added (EVA) (c) of Stern Stewart ; Co. : EVA = NOPAT- (WACC * IC) in which: NOPAT is the net operating profit after taxes, WACC is weighted average cost of capital, and IC is invested capital After several meetings with members of the consulting firm, the company concluded it could best develop the measurement it needed in-house. Contributing to this decision was the degree of complexity that the adjustments required by the EVA (c) measurement and the requirement that ENDESA? model must be simple. The persons responsible for developing the measurement in ENDESA believed that the measurement should not be based on accounting profit because, in addition to the possibility of manipulating the results, the company is very capital intensive and has a high depreciation charge that reduces accounting profit. Therefore, a measurement based on cash flow was developed. In the words of a high executive in the Management Information and Control Systems department: “We cannot establish a formulation that makes the computation of value creation difficult.

Incorporating a large number of accounting adjustments makes the model less close to operating reality and therefore to the understanding that our managers have of it. I do not want the persons responsible for the generating plants in Peru or Colombia to begin calling me saying that they do not understand the calculation we have made and that it gives nothing to them. The first objective should be simplicity of computation. ENDESA decided on an annual value-creation measurement that is the difference between cash flow obtained and that needed to keep the resources profitable, i. . : EVC = FOCF – (IC * WACC) in which EVC = Economic Value Created FOCF = Free Operating Cash Flow IC = Invested Capital, and WACC = Weighted Average Cost of Capital The computation of these parameters is presented in Figures 3, 4, and 5. Note that the computation of FOCF does not include dividends or interest paid by ENDESA. ENDESA believes that the effect of payments to suppliers of equity and debt capital on EVC is captured in the factors used to compute WACC so that it is not appropriate to deduct dividends and interest in the computation of FOCF.

EVC is computed at corporate, subsidiary, and business unit levels, clearly reinforcing the idea that business units are value creation centers. At the corporate level, EVC is computed both before and after minority interests, which are primarily in the Latin American business units. The WACC at the business unit level must be further adjusted to add two additional risk premiums. The first premium reflects the additional risk associated with different industry sectors in which a business unit operates.

Even though investments in sectors other than electric utilities offer benefits of synergy and diversification, the difference in the maturities of the markets and degree of competition present different degrees of risk among the industry sectors that should be recognized. The second premium represents risks associated with the different countries in which the company operates or is considering investments due to differences in interest rates from local borrowing, currency exchange rates, inflation, political factors, and other specific local factors.

In particular, investments in Latin American countries face systematic risks that cannot be diversified away and for which the WACC must be adjusted. The company has developed a multi-factorial model, which uses additional macroeconomic variables for the sector and country in which a unit operates. The focus is on the risk the business unit contributes to the group as a whole. A different set of risk premiums is used for equity capital and for debt capital.

INVESTMENT AND DISINVESTMENT ANALYSIS As part of its new financial management strategy, ENDESA has created a matrix of its investment and disinvestment strategy for business units as shown based on potential EVC and strategic fit as shown below: STRATEGIC FIT LOW HIGH Sell Sell Hold Expand LOW POTENTIAL EVC HIGH POTENTIAL EVC Units with a high strategic fit are those in the core public utility sector; low strategic fit represents those in the related areas where ENDESA has expanded.

Business units with low potential EVC, including those in the core electricity sector, such as VIESGO mentioned in the introduction, will be sold to other investors with the expectation that the unit will be more valuable to another owner. Units outside the core area with high potential EVC will be held. The proceeds from the sale of business units will be used to expand father in the public utility sector by acquiring units with high potential EVC. ENDESA’s current strategy is to expand further into Europe, including Eastern Europe, and in the Americas, including the US.

Thus, ENDESA’s strategy is one of acquiring business units, using its expertise to develop as much value in the unit as possible, and then to hold or sell the unit depending on its EVC potential. In evaluating investment opportunities, ENDESA estimates future cash flows using procedures described above to determine FOCF. The minimum IRR is based on the WACC which includes risk premiums for the specific industry sector and geographic area, as described above. The minimum internal rate of return (IRR) is the WACC plus an additional 4. % return, which is considered to be the minimum acceptable return to the shareholders. Discussion Questions for Part A 1. Refer to ENDESA’s current business strategy. In what primary economic activity is ENDESA engaged? (HINT: the primary economic activity is not the generation and sale of electricity or related activities). Why is it necessary to understand the strategy and primary economic activity in order to manage ENDESA’s financial activities? 2. Why does EVC as computed by ENDESA reflect an economic rather than an accounting perspective?

What are the advantages and disadvantages of using a cash flow perspective vs. an accounting perspective for financial management tools? From a financial management perspective, the depreciation charge is sometimes viewed as a source of cash and as maintaining capital. Evaluate these claimed purposes in general, and specifically with respect to ENDESA. Evaluate ENDESA’s comment that cash flow is a superior to accounting measures of profit because it does include the depreciation tax shield effect but not the depreciation expense.

Why is the computation of IC different at the business unit level from the corporate and subsidiary level? Evaluate ENDESA’s policy of assigning risk premiums to industry segments and to specific countries or geographic areas. What types of risks exist for industry segments and for countries or geographic regions? Which macroeconomic factors should ENDESA include in its model to determine the two types of risk premiums? Evaluate ENDESA’s comment that the focus is on the risk that the factor contributes to the overall risk of ENDESA group, referring to portfolio theory in your evaluation.

Evaluate ENDESA’s approach of assigning different risk premiums to equity capital and debt capital. Evaluate ENDESA’s policy of measuring EVC both before and after minority interests. Why would such a distinction be important for ENDESA’s financial management? Evaluate ENDESA’s position that the effect of interest and dividend payments to debt and equity suppliers on EVC is captured in the factors used to determine WACC so that it is inappropriate to deduct these items in determining FOCF. Evaluate ENDESA’s over-all financial management approach.

What are the strengths and weaknesses of this approach? 3. 4. 5. 6. 7. 8. PART B IMPLEMENTING VALUE-ORIENTED MANAGEMENT TOOLS. Review the measurement of EVC and its parameters presented in Part A. The EVC computation and its component parts are used as control devices at the corporate, subsidiary, and business unit levels. Budgets are prepared for all of the parameters of the EVC computation and variances are determined and analyzed for these parameters. A template used to measure EVC and its variances at the corporate level is presented in Figure 6.

An example of a more detailed variance analysis of WACC is presented in Figure 7. At the corporate and subsidiary level, even though EVC is viewed as superior to ROI alone, EVC can also be related to a measurement of ROI that ENDESA calls return on invested capital (ROIC) where ROIC = FOCF / IC so that EVC = (ROIC – WACC) * IC In this form, the measurement permits control of different types of management in which ROIC reflects commercial management and industrial productivity and WACC reflects financial and fiscal management.

This form of the EVC measurement also integrates short-, medium- and long-term management objectives with ROIC and EVC reflecting short-term; WACC the medium term; and FOCF the long term. EVC is also decomposed in a value tree with variances as shown in Figure 8. In this value tree, the individual component parts that make up the EVC measurement can be identified down to the business unit level. This tree allows each component part to be controlled at an appropriate level. The tree also communicates clearly to business units that they are value centers and not mere cost or revenue centers.

VALUE DRIVERS Once the EVC measurement was developed, ENDESA viewed its next challenge was to be identifying the key factors that contribute to value creation and eventually develop them into management tools such as the balanced scorecard. In the words on a major executive: … it is important to implant value-oriented management as deeply as possible into the organization. The measurement of EVC, though, is not applicable to everyone in the organization. Instead, there should be a series of operating-oriented indicators that affect value, leaving EVC for those persons who have responsibility to account for the results.

All managers should know how their decisions affect value creation. If they are to be rewarded based on value creation, then they should know clearly which items create value and which do not. After prolonged discussion and debate, ENDESA identified five value drivers for which operating objectives can be developed that will eventually lead to a balanced scorecard as follows: Profitability is essentially the same value driver that companies have traditionally used as the primary control device. In ENDESA it remains as a primary, but not the only value driver.

EVC and the value tree analysis described above relate to this driver. Strategy relates to ENDESA’s current strategy of managing the combination of EVC and strategic fit of each business unit as described in Part A. The strategic fit describes the degree to which a business unit fits with the core electric business. Units with low EVC and low strategic fit are sold to provide funds for expansion. Units with low EVC and high strategic fit will also be sold. ENDESA proposes to develop as much value as it can in these units because of its management expertise and then sell them to other electric companies for whom the unit ill create future value. ENDESA’s strategy is clearly one of holding and developing units with high or potentially high EVC. Intangibles management relates to exploiting ENDESA’s intangible assets as well as leveraging their systems expertise. Two major examples are selling additional services to established customer bases such as mobile telephones to electricity customers and selling consulting services for the expertise it has acquired in telecommunications, information and control systems, and other management activities.

Optimizing WACC to achieve greater EVC involves such activities as optimizing financial leverage and exchanging high-interest-rate Latin American debt with lowerrate European and US debt. The substitution of European and US debt for Latin American debt could substantially reduce the country risk premium. Expansion involves investments in core businesses, mostly electricity related, in other European countries and in the U. S. to achieve greater EVC through improved management. ENDESA has identified some 20 operating objectives related to these value drivers that are being incorporated into a balanced scorecard.

The balanced scorecard is being implemented in 2001 at the corporate level and will be implemented at the subsidiary and business unit level in the near future. Discussion Questions for Part B 1. Refer to ENDESA’s current business strategy. In what primary economic activity is ENDESA engaged? (HINT: the primary economic activity is not the generation and sale of electricity or related activities). Why is it necessary to understand the strategy and primary economic activity in order to evaluate ENDESA’s management control systems?

The computation of EVA (c) which is developed and promoted by Stern Stewart and Co. is based on net income as reported under US GAAP, from which adjustments are made. Evaluate the suitability of this measurement for ENDESA and similar companies outside the US that do not use US GAAP. Evaluate ENDESA’s arguments that accounting-based measures of profit are not suitable for measuring value created for purposes of management control. Specific guidelines exist under US GAAP for the public reporting of cash flow.

Evaluate ENDESA’s cash flow computation with respect to the requirements of US GAAP. Evaluate ENDESA’s position that it is inappropriate to deduct interest and dividends in computing FOCF as would be required by US GAAP. A significant departure from US GAAP is the inclusion of a portion of the equity in earnings of subsidiaries that is not paid in cash dividends. Why do you think ENDESA has included this item in its FOCF? Why is depreciation computed and reported on the income statement under US GAAP and under the accounting policies of most Anglo-Saxon countries?

Evaluate ENDESA’s decision to select a measurement of value created that specifically excludes a depreciation charge. Evaluate ENDESA’s policy of computing variances for all component parts of EVC, including WACC and IC. How would you interpret the quantity and mix variance for IC? How does the decomposition of EVC into ROIC and WACC allow ENDESA to separate operating and commercial management from financial and fiscal management and to integrate short-, medium- and long-term objectives. Evaluate this process from a management control perspective.

Traditional management control approaches have focused almost exclusively on profitability as a control device. Yet, ENDESA has five value drivers that it attempts to control. Evaluate ENDESA’s focus on additional value drivers. Based on the information in the introduction and in Parts A and B of the case, develop balanced scorecards that you would recommend for ENDESA at the corporate, subsidiary, and business unit levels. 2. 3. 4. 5. 6. 7. 8. 9 10. Evaluate from a management control perspective ENDESA’s policy of ariable compensation in which up to 25% of a manager’s compensation can depend on meeting objectives Figure 1 ENDESA’s Lines of Business Energy and Related Businesses Electricity: Generation Distribution Trading Cogeneration Renewable energies Gas Water and waste treatment ENDESA Group Telecommunications Fixed lines Mobile telephones Internet access Telecommunications via cable Digital land television Telecommunications engineering New Technologies Commercial buying and selling systems Personal buying and selling systems Business internet consulting services Power line voice and data communication

For more details about each line of business, see ENDESA’s English-language web site at http://www. endesa. es/english/. Figure 2 Lines of Business and Organization Structure of ENDESA ENDESA GENERACION manages the generating and mining assets of ENDESA in Spain. It aims to compete with better quantity, quality, and prices in the electricity generation market. A major part of the value creation comes from the easy access to raw materials; from proximity to gas pipelines, private customers, and interconnections with other systems; and from the ability to expand the capacities.

ENDESA DISTRIBUCION is a subsidiary holding company for the various companies located all over Spain that transport and distribute electricity to customers who cannot yet choose their electricity provider and for whom rates are set by regulatory authorities. The business units are the original companies created or purchased by ENDESA which continue to distribute electricity under their original names.

Value comes from the ability to adapt to variations in the market, long traditions, and commercial names recognized in the market. ENDESA ENERGIA was founded as a subsidiary corporation in 1998 to cater to the liberalized Spanish electricity market. It provides electricity to customers that can select their energy provider because of the quantity of annual consumption with long-term contracts in a competitive environment.

This subsidiary also provides high-value-added services to these customers by supplying and managing all energy-related activities such as cooling, refrigeration, and air conditioning; heating and steam generation; and security. In addition, this subsidiary sells technical and consulting services to other electric utilities in all parts of the world, for example in planning and constructing new electric generating plants and distribution networks.

Business units are the individual customers and projects. Value comes from catering to the needs of customers, and providing additional high-value services with minimal additional capital investment. ENDESA DIVERSIFICACION is a subsidiary that invests in related businesses, such as natural gas distribution, water and wastewater treatment and distribution, telecommunications, renewable energy, and cogeneration, that have growth expectations.

Value comes through synergies, strategic alliances, and ENDESA’s serving as the managing industrial partner bringing its business background and human capital. ENDESA INTERNACIONAL is a subsidiary that manages ENDESA’s diverse operations in markets outside of Spain: elsewhere in Europe, North Africa, and Latin America. Value comes from diversification into other markets, applying ENDESA’s management and technical expertise in areas of its core competencies, and growth potential.

In the very near future, ENDESA Europe will be created to manage European operations. ENDESA SERVICES was formed in 1999 as a subsidiary to handle the internal needs of ENDESA in telecommunications, information and control systems, and supplies. It also provides comprehensive consulting services in these areas to outside customers. Value comes from ENDESA’s ability to sell services in areas in which it has acquired considerable expertise with minimal additional capital investment and thus leverage a part of the investment required to obtain the expertise.

Figure 3 Computation of Free Operating Cash Flow in ENDESA Business Units: Earnings before interest, taxes and depreciation allowance (EBITDA) – Normal recurring capital expenditures – Income taxes on operating income +/- Changes in working capital = Operating cash flow + Dividends received, or equity in earnings of controlled affiliates = Free operating cash flow EBITDA can be further divided as: Operating revenues – Variable costs = Contribution margin – Fixed operations and maintenance costs = EBITDA Subsidiaries and Corporate Level: Free operating cash flow from the business units is aggregated for the subsidiaries and corporate level with appropriate eliminations for inter-company transactions. Figure 4 Computation of Invested Capital in ENDESA Corporate and subsidiary IC: + + + = Long-term debt Provision for pensions and similar items Shareholders’ equity Minority interest Invested capital Business unit IC: Fixed Assets + Working capital = Invested capital

Figure 5 Computation of Weighted Average Cost of Capital in ENDESA Corporate WACC: WACC = Ke (E/D+E) + Kd*(D/D+E) In which Ke is the cost of equity capital and is determined by the formula: Ke = Rf + {b}*(Rm – Rf) and in which Rf is the risk free rate of return based on the return of a ten-year Spanish treasury obligation, Rm is the market rate of return so that (Rm – Rf) is the risk premium of the market above the risk free rate of return. This premium is currently set at four points. {b} is beta, the factor representing the extent to which ENDESA’s stock varies with respect to the market and is based on data published by financial analysts. Currently the beta is 0. 7. Kd is the after-tax cost of debt determined by the formula: Kd=(IB+M)*(1-Tx) in which: IB is the appropriate inter-bank interest rate.

M is a margin that reflects ENDESA’s financial rating, and Tx is the average effective tax rate, which is currently set at 28% Business Unit WACC: WACC = Ke (E/D+E) + Kd*(D/D+E) In which Ke is the cost of equity capital and is determined by the formula: Ke = Rf + {b}*(Rm – Rf) + PMi + PMc, and Kd is the after-tax cost of debt determined by the formula: Kd=(IB + PMi + PMc + M) * (1 – Tx) in which PMi is the risk premium for the industry sector, and PMc is the risk premium for the country, and Tx is the effective tax rate for the country. At the corporate level and in most business units the IB is the European interbank interest rate (EURIBOR). Business units in some other locations, notably in the Americas, use the London interbank interest rate (LIBOR). Figure 6 Variance Analysis of EVC in ENDESA EVC

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