Cases From Management Accounting Practices

8/9/2019 Cases From Management Accounting Practices

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CASES FROM MANAGEMENT ACCOUNTING PRACTICES

Table of Contents

Case 1: Bal Seal Engineering

Robin Cooper

Case 2: Bills Custom Planters

William StammerjohanDeborah Seifert

Case 3: Dublin Shirt Company

Peter Clarke in assoc. within assoc. with Paul Juras

Wayne Bremser

Case 4: ECN.WWilliam Lawler

Case 5: Endesa

Gary M. Cunningham

Scott Ericksen

Francisco J. Lopez LubianAntonio Pareja

Case 6: Kincaid Manufacturing

Jon Yarusso

Ram Ramanan

Case 7: Osram.NA

John Shank

Lawrence Carr

William Lawler

Case 8: Pleasant Run Childrens Home

Brooke E. SmithMark A. McFatridge

Susan B Hughes


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Editors Remarks

I am pleased to present the nine teaching cases presented at the 2002 Conference of theManagement Accounting Section of the American Accounting Association. These casesprovide a wide range of topics and contexts for use in upper level undergraduate andMBA classes. Here is a list of the cases, authors and topics discussed.

Bal Seal Engineering, by Robin Cooper, discusses alternative cost managementapproaches: traditional, ABC, and TOC.

Bills Custom Planters, by William Stammerjohan and Deborah Seifert, discussesproduction and cash flow projections, developingpro forma statements and sensitivityanalysis.

Dublin Shirt Company, by Peter Clarke in association with Paul Juras and WayneBremser, 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 andAntonio Pareja, discusses strategy and control issues in a changing organization.

Kincaid Manufacturing, by Jon Yarusso and Ram Ramanan, discusses supply chainmanagement.

Osram.NA, by John Shank, Lawrence Carr, and William Lawler, discusses economicvalue to customer and related life cycle costing issues.

Pleasant Run Childrens Home, by Brooke E. 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 tothe conference. I also thank members of the editorial board for their helpin reviewing cases: Tom Albright, Wayne Bremser, Paul Juras, KenM h t G S d d i ll L C d Ji M k I


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Bal Seal Engineering Company, Inc.Peter Balsells and his late wife Joan founded Bal Seal Engineering Company, Inc in1958. From humble beginnings, the firm grew steadily primarily based upon a strategy ofselling the most innovative products in the industry. In particular, Bal Seals productswere characterized both by the high value they provided and the technical manufacturingchallenges they overcame. The initial invention that formed the basis for the firms

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 toproduce near uniform force over its operating range. In contrast, a conventional springprovided a linearly increasing force as deflection increased (Figure 2). This property of acanted coil spring was critical in ensuring both an effective seal and an extendedoperating 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, overits 40-year life, had created in excess of 60 active patents and numerous other innovationsthat had helped shape the seal and spring industry. This innovative history had providedthe firm with, what top management considered a sustainable competitive advantage. Thefirms profit margins were historically higher than industry average reflecting both itsadvantageous patent position and high level of engineering skills.

In 2000, sales were just under $25 million. The companys customers were primarily in

the medical equipment, analytic equipment, industrial OEM, and semiconductorindustries. The company sold directly from the factory with the assistance of independentmanufacturers representatives who covered the territories of Canada and the UnitedStates. Internationally, the company had a sales office in Western Europe and hadcontracted with several distributors who provided coverage of the Japanese andAustralian markets.

Product Development

The firm had developed its own approach to product development that consisted of threesteps; design, fast prototyping, and production. In the design phase, the firms engineersconcentrated on understanding the customers requirements. The firms products were

d i id i t f li ti d t t d i d M f th


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guidelines for cost-efficient production. The final step, production consisted of ensuringthat very high quality products were produced on a timely basis. The firms commitment

to quality was necessarily extreme because its products were relatively inexpensivecompared to the customers end products in which they were used. However, since sealmalfunction could lead to disastrous failure of the customers product, long-termconsistent performance of the firms products was essential. Consequently, Bal Sealsmanufacturing process was geared to produce products that had exceptionally long mean-times between failures.

Production Process

A spring-energized seal consisted of a plastic U-cup ring and a canted-coil spring. Thepurpose of the plastic ring was to ensure that metal to metal contact did not occurbetween a piston and its housing. In addition, the seal was often designed to provide thepiston 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 manufacturedindependently 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 finishedgoods inventory. For small orders, only one production run was required. However, forlarger orders it was necessary to break production into multiple production runs so thatother 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 powderedPTFE and mixing it. Subsequently the mixture was placed in an oven where it waspressed under high pressure to form the desired shape. The shaped pipe was thenremoved from the mold and cooked in a sintering oven to harden it. After sintering, thesintered 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 computernumerically controlled (CNC) machines. Blanks are machined to customer specificationsto create rings soon after receipt of the customer order.

Spring production was proprietary and only senior executives and the specially trainedworkers were allowed to enter the area of the factory where springs were produced. Bal


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Computer numerically controlled (CNC) equipment was used to create the seal. The partwas 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 completedproduct. In the second step, the part was inspected to ensure that it met specifications. Inthe final step, the completed seal was tested to ensure that it provided the near uniformresistance that was characteristic of canted coil spring technology. The completed partwas then released to shipping and sufficiently early to insure on-time delivery. Only afew standard parts were maintained in finished goods inventory to ensure that unexpecteddemand for such items was met in a timely fashion. Total finished goods inventoryaccounted 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 manageconstrained resources and hence increase firm profits. Bal Seal had adopted the theory ofconstraints 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 asthe bottleneck. The bottleneck machine or machine class is the one that limits the overalllevel of production of a product, product family, or product line. To maintain maximumoutput, the bottleneck machine, or as it is more formally known the capacity constrainedresource, is kept busy at all times. Any other machine or production operation could beidle 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 totallyvariable costs associated with it.

Throughput Contribution = Throughput Totally Variable Costs

The operating expenses are all of the costs that are not totally variable with productionvolume. Profit is given by subtracting operating expenses from total throughputcontribution:

Profit = Total Throughput Contribution Operating Expenses


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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 throughputmargin per constrained minute as possible, while keeping the bottleneck machine fullyloaded. If this objective is achieved, according to the theory of constraints, profits will bemaximized.

Five simple rules govern the approach:

1. Identify the constraint.2. Decide how to exploit the constraint.3. Subordinate everything else to the above decision.4. Elevate the constraint.5. If the constraint has been broken, go back to step 1

Under these five rules, the majority of continuous improvement efforts are focused uponincreasing the output of the bottleneck resource; only reduced attention is paid to makingthe non-constraint activities more efficient.

At the heart of theory of constraints is the drum-buffer-rope scheduling system. In thisapproach to scheduling, a protective buffer is maintained in front of the machine thatcreates the constraint. This capacity constrained resource (CCR) buffer is designed to besufficiently large that it ensures that the bottleneck is never starved. Theoretically, thesize of the buffer is determined as a trade-off between security versus lead-time. Inpractice, 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 andwithin three months the firms manufacturing performance had improved dramaticallywith overall production levels higher and production costs lower. As the firm smoothedout its production process, the firms cash flow became more predictable. Senior

management was very pleased with the ease of the transition to theory of constraints andidentified it as one of the major strengths of the approach. For example, they comparedtheir experience favorably to the length of time other firms had taken to shift to leanproduction. In their opinion, the shift to lean production, typically took longer because itrequired balancing most, if not all, of the firms production processes, not just thebottleneck ones. In addition, they felt that the cultural changes under the theory of


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variable with the number of units produced, all other costs (operating expenses) areassumed 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 runthe machines are typically ignored as they are small compared to material costs andinstead, 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 fromrevenues to give the throughput contribution for the period. In the firms traditional costsystem, the freight and sales commission costs were treated as indirect costs and assignedto products using direct labor dollars.

Activity-Based Costing

Activity-based costing emerged in the mid 1980s as a way to report more accurateproduct costs than was possible by traditional cost systems. Activity-based cost systemsdiffered from their traditional counterparts in two ways. First, the cost pools representedactivities performed and not types of production processes. Second, the way costs wereassigned to products was more sophisticated. In traditional systems only unit-level costdrivers were utilized. Unit level drivers were those drivers whose driver quantitiesdoubled when the number of units produced of a product doubled. Examples offrequently used unit-level cost drivers in traditional systems include direct labor hoursand dollars, machine hours, and material dollars. In contrast, in activity-based cost systemtwo other types of cost drivers were utilized. The first type was batch-level drivers andthe second type was product-level drivers. Batch-level drivers were used to assign thecosts 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 ofbatches or production runs. Product-level drivers were used to assign the cost of activitiesthat were performed to sustain the ability to manufacture particular products. Examplesof product-level activities include parts administration, process engineering, and bill-of-material 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 thecost of the resources consumed by different products than traditional cost systems. Inparticular, activity-based cost systems are sensitive to batch size and overall productionvolume and thus report higher costs for the same product if it is made in small batches oroverall low volume than if it is manufactured in large batches or high overall volume. Incontrast, traditional systems reported the same product costs irrespective of the batch size


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In 2000, Bal Seal did not utilize either traditional or activity-based costing to determineproduct 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 directassignment of material, labor, and setup costs and the indirect assignment of all othercosts. The indirect costs were assigned to the products using a single cost pool usingdirect labor dollars as the cost driver. In 1999, the overhead burden rate that would havebeen used in the traditional costing system was 500%. Bal Seals traditional costingsystem 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 theunitized setup cost was the total unit cost of the product. The advantage of this approachwas that it reported different costs for the same product depending upon batch size withreported unit costs dropping as batch size increased. Thus, Bal Seals old traditionalcosting model, because of the way it incorporated setup costs, was somewhat sensitive tobatch size. However, since it ignored the implications of non-setup related batch-levelcosts and all of the product-sustaining costs, it was at best a partial activity-based costsystem.

In 1999, a specialist in activity-based costing visited Bal Seal. He was interested in therelationship between theory of constraints and activity-based costing and wanted to studyan active theory of constraints implementation. Many theory of constraints advocatesbelieved that activity-based costing was a misleading costing approach that led to poordecisions. At the heart of this perspective was the inability of the activity-based costingapproach to identify bottlenecks and thus ensure that they were kept fully loaded. Sinceany 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-basedcosting led to inferior performance. In contrast, most activity-based costing advocateshad a different opinion; they believed that theory of constraints was the appropriatesolution for short-term decisions in which the firms infrastructure (their term foroperating expenses) could not be modified. However, they believed that over the longrun, the firms infrastructure could be modified in ways that led to overall superiorperformance. 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 identifiedfive orders that the firm had recently received for different members of its Mark IVfamily of Balance Seal products (Exhibit 1). The primary difference between the orderswas the number of units ordered. He chose these five orders because he felt that, despite


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accurate estimates of probable selling prices to be developed. Such detailed informationwas not available for many of the firms other product families.

The specialist asked Bal Seal management to determine the profitability of the five ordersusing the theory of constraints. To provide a basis for comparison, he designed a simpleactivity-based cost system for Bal Seal. This system identified two additional indirectcost pools to the one that was used in the firms old traditional cost system. The firstadditional cost pool was a batch-level one. It captured the costs of ensuring that aproduction order was processed. The second additional cost pool captured the cost of theproduct-level activities. In particular, it identified the parts administration costs

associated with each member of the Mark IV family. Removing the batch-level andproduct-level costs from the direct labor cost pool reduced the direct labor dollar burdenrate to 115%. This burden rate also excluded the freight and sales commission costswhich the expert felt should be treated as costs of the order in addition to the setup andorder processing costs.

Managements Reaction

Bal Seal top management was not convinced that even experimenting with activity-basedcosting was a good idea. They justified this perspective based upon several deeply heldviews. First, the success of theory of constraints, at Bal Seal, was such that they wereunwilling to risk disrupting it with even an experiment. Second, they believed that thetheory of constraints approach was philosophically superior and that activity-basedcosting would simply cause people to focus excessive attention on non-bottleneck

resources. Attention that they felt was better directed to increasing the throughput of thecapacity constrained resource. Third, they believed that it would be confusing to havetwo sets of reported product costs floating around the firm one based on theory ofconstraints and the other based on activity-based costing. In particular, they felt that thisconfusion would be particularly serious if one of the two approaches recommendedselling 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 ofthe calculations are identical except for the price list. The following graphs will also bebeneficial in helping you gain insights into the capabilities of the various costingapproaches; traditional profit margin versus ABC profit margin, unit contribution orprofit versus volume, and ABC unit profit versus TOC unit contribution per minute.


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by the visiting specialist.

2. Bal Seal has only a small amount of bottleneck resource available. It receives anorder for 1,000 P5 Mark IVs and 35 orders for 10 units each of 35 differentproducts that have the same overall production characteristics as the P1 Mark IVBalance Seal. The high volume order or all of the small volume orders willconsume the remaining bottleneck resources. Which of the orders would the threecosting 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

P1 10 $100.00

P2 50 $20.00

P3 200 $4.75

P4 500 $3.00

P5 1,000 $2.50

Would your recommendations about which orders to accept change?

4. Analyze the pricing strategies that are being used in this industry based upon thetwo sets of prices. Hint, it will help if you look at the rankings of profit in eachpricing scenario.

Price ListsPair 2

5. Repeat the calculations assuming that the selling prices are:


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P5 1,000 $8.25


6. Repeat the calculations assuming that the selling prices are:

Product Identification Order VolumeSelling Price

P1 10 $47.50

P2 50 $22.40

P3 200 $19.25

P4 500 $18.00

P5 1,000 $17.75


7. What is the best way to integrate TOC and ABC?

8. If your recommendations include computing both TOC and ABC costs, howwould you explain your solution to Bal Seal management given their concernsabout the potential resulting confusion?

9. Analyze the pricing strategies that are being used in this industry based upon thelast two sets of prices. Hint, it will help if you compare the unit ABC profits andTOC contributions generated in each price scenario.


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Exhibit 1

Information on the Mark IV Family of Balanced Seals

Order Information

ProductIdentification

Number

OrderVolume

UnitSellingPrice

NumberOf Production

Runs for Order

Estimated AnnualProduction

Volume

P1 10 $50.00 1 10

P2 50 $9.00 1 75

P3 200 $5.00 2 500

P4 500 $4.00 3 2000

P5 1,000 $3.75 5 5000

Cost Information

Material Costs $0.40Labor Costs $0.33Order Processing Costs $75.00Set-Up Cost/Run $45.00Parts Administration/Product $500.00Freight 5% of selling price

Sales Commission 10% of selling price

Processing Time Informationfor CNC Machines

Run time per unit 1.5 minutesSetup Time per run 30 minutes


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Figure 1:

Bal Seal Engineering Company Inc.Canted-Coil Spring Seal


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Canted-Coil

Spring

Conventional;

Spring

Figure 2:

Bal Seal Engineering Company Inc.Canted-Coil Spring Performance

Normal Working

Deflection

Force

5% Deflection 35%


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Figure 3:

Bal Seal Engineering Company Inc.Piston Mounted Seal

Piston


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Figure 4:

Bal Seal Engineering Company Inc.Housing Mounted Seal

Piston


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Figure 5:

Bal Seal Engineering Company Inc.Production Process

Final Shipping

Proprietary

Inspection

Spring Production Ring Production Material Production


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Figure 6:

Bal Seal Engineering Company Inc.Production Timeline

Shipping

Buffer

Post-Constraint

Processing

Constraint

Process

Constraint

Buffer

Pre-Constraint

Processing


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Bills Custom Planters1

William Stammerjohan, Washington State UniversityDeborah Seifert, Washington State University

Bills Custom Planters (BCP) manufactures a line of decorative wooden planter

boxes that are sold to both retail and wholesale customers. Dr. Bill started buildingcustom planter boxes in his garage as a hobby/business about ten years ago. His customplanter boxes were so popular that he quit his day job seven years ago and began tomanufacture 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, andbookkeeper. The word custom no longer truly describes the planter boxes because BCPnow offers only one model that is available in four, very similar, variations.

Several factors have contributed to increased popularity, increased demand, andincreased production volume for the planters over the last few years. A feature article in aregional home improvement magazine, Northwest Home and Garden got the ballrolling for the planters a couple of years after Dr. Bill went into business full-time. Amonthly display ad in the same magazine appears to have contributed to increases in bothretail sales and wholesale customer demand. Dr. Bill significantly increased productioncapacity almost four years ago when he moved BCP into a new rented building andbought all new equipment.

Like many small businesses, BCPs growth has not been without setbacks. Thesale 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 ofgarden supply products. The custom planters that BCP was building at that time werepriced a lot higher than the current more generic model. The market seemed to becomeprice sensitive overnight and the sales volume dropped precipitously. It took Dr. Billseveral months to realize that he had to simplify his product line and become competitiveif BCP was going to survive.

It seems that BCP has now weathered this storm, but there are some lingering

scars from this period. Dr. Bills credit rating is now far from perfect. This is the result ofseveral very late interest and principal payments on the equipment loan, and an inabilityto make timely interest payments on a former credit line balance. After his former bankcanceled 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 BCPs darkest days and has grudgingly


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outstanding credit line balance, whichever is greater. NHTC requires a minimumpayment 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 $2,000plus accrued interest on the last day of the month (8% annual rate).The key factors describing BCPs current operations include the fact that all retail

sales are mail order and the wholesale customers are either home improvement or gardensupply stores. Retail customers pay for their purchases by credit card and all wholesalesales 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 allwholesale 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 eachmonth and are given terms of 2%-10th/net 30. Forty percent of all credit sales arecollected 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 haseight employees that each work 160 hours per month performing direct labor. Wood ispurchased from a local supplier on an as-needed basis. The local supplier has a verygood 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 payBCPs bills on a timely basis. While Dr. Bill has re-established credit with the hardwaresupplier, 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 thehardware. Selling and Administrative expenses are $2,500 per month plus $3.40 perplanter sold. All cash overhead costs, rent, shipping and handling costs, and selling andadministrative expenses are paid in the month incurred.

Dr. Bills current estimation of the cost per planter is as follows:

Bill

s Custom PlantersSchedule of Planter CostFor 2003

Direct Materials:Wood $10.00


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The shipping and handling cost per planter sold retail is $6.00. The $4,200 permonth 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.

BCPs expected financial condition is reflected in the 12/31/02 Pro FormaBalance Sheet. Although Dr. Bill has returned BCP to profitability, and although all theinterest and other liabilities are now current, the equity balance is mostly the result ofmoney that Dr. Bill contributed to the corporation when he cashed out, his former dayjob retirement account. Dr. Bill does not draw a regular salary, but was able to take amodest dividend in September 2002

Bills Custom Planters

Pro Forma Balance SheetAs of 12/31/02

Cash $ 6,000Accounts Receivable $ 43,750

Less: Allowance 2,250 41,500Finished Goods Inventory (500 planters) 20,000Hardware Inventory (1,200 sets) 6,000

Equipment $288,000Less: Accumulated Depreciation 92,000 196,000

Total Assets $ 269,500

Accounts Payable (hardware) $ 7,500Credit Line 30,000Equipment Loan 190,000Equity 42,000Total Liabilities and Equity $ 269,500

The current accounts receivable balance results from credit sales over the lastthree months of 2002 and from a few chronically past due accounts. Credit sales forOctober, November, and December were $25,000, $20,000, and $30,000 respectively. Asusual, business has been up and down during the winter months. Dr. Bill generally tries toincrease the finished goods inventory over the late fall and early winter to be prepared forthe big sales months that follow The expected sales for January through May 2002 are


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Dr. Bill is proud of the fact that he has returned his business to profitability, but isperplexed 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 businessschool in late December 2002 and asked for help and guidance. You have been assignedthe task of fulfilling his request. Your first task is to complete a production plan for thefirst quarter of 2003. Given his credit history, Dr. Bill is particularly concerned with cashneeds. He is also concerned with staffing decisions during the upcoming busy season.This assignment requires that you analyze information and make recommendations. Besure that you use all the information given, all the accounting and business knowledgeyou possess, and your imagination when necessary.

You will find this to be a holistic process, i.e., you must consider the staffingdecisions and cash needs before making your final recommendation on a productionschedule. You may find it necessary to try several combinations of staffing andproduction before you arrive at what you believe to be the best solution. Your task is towrite a memo to Dr. Bill that addresses each of the following questions. Your memo mustbe supported by the schedules and pro forma financial statements listed after thequestions.

1. Address the general question of scheduling production. Explain why, or why not,you recommend scheduling the excess production evenly each month? What isthe expected finished goods inventory at the end of each month if BCP followsyour production schedule? Do you believe that these inventories are adequateand/or necessary? Why or why not?

2. Briefly discuss your recommended scheduling of hardware orders. What kind ofsafety stock are you recommending? Why?

3. There are two options of providing the extra direct labor. BCP can ask theexisting employees to work overtime, or hire temporary employees during thebusy season. Existing employees would have to be paid time and a half to workovertime, but can be expected to maintain their normal level of efficiency whenworking up to about 200 hours per month each. Temporary employees can behired for $8.00 per hour, but their lack of experience and training is expected tomean much less production per hour. It is expected that these employees will takeabout 2.5 hours to build each planter. Be sure to include a discussion of both thequantitative issues, cost per planter, and the qualitative issues driving thisrecommendation. You can choose to fulfill the excess labor needs with anycombination of existing employees and/or temporary employees that you feel willbest serve the needs of BCP.


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month to 1,120 planters per month under the following conditions: the wholesalediscount on all planters sold to wholesalers would need to be increased to $24 perplanter; the extra 560 units could be produced by a night shift with fullyproductive 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 $1.00per hour.

Would you recommend increasing the discount? Why or why not? Be sure todiscuss the quantitative issues, expected profit, and the qualitative issues behindthis 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, requiredproduction, expected sales, and ending inventory for each month, Januarythrough March 2003. Also show the quarterly totals. The following is asuggested format:


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Bills Custom Planters

Three-Month Rolling Production ScheduleFor January through March, 2003

January February March QuarterBeginning Inventory. 500 500Required ProductionExpected SalesEnding Inventory

2. Prepare a schedule that indicates the order dates for hardware, theexpected arrival dates, the payment dates, the expected inventory prior toarrival, the order quantity, and the expected inventory following arrival ofeach order.

Bills Custom PlantersHardware Order, Arrival, and Payment Schedule

For January through March, 2003

Expected Order ExpectedOrder Date Arrival Date Payment Date Inventory Quantity Inventory

3. Prepare a cash budget with columns for each month, January throughMarch 2003, and a fourth column for the quarterly totals. Include separatelines for: expected cash collections from retail sales, expected cashcollections during the discount period, expected cash collections duringthe net 30 period, and expected cash collections during each of the twolate periods. Include separate lines for each type of cash payment, e.g.,wood, hardware, rent, interest, etc. Include separate lines for the beginningcash balance, the ending cash balance, and the ending credit-line balance.

4. Prepare a pro forma schedule of the cost of goods manufactured, proforma income statement and pro forma balance sheet for the quarterending March 31, 2003. Assume that between January 1 and March 31,2003, two wholesale accounts with combined balances of $1,450 are


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the proposed wholesale discount.


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THE DUBLIN SHIRT COMPANY *

by

Peter Clarke (University College Dublin), Paul Juras and Paul Dierks (Wake ForestUniversity).

* This case has been heavily adapted by Peter Clarke, with permission, from anearlier case Blue Ridge Manufacturing prepared by Paul Juras and Paul Dierksof Wake Forest University. The original version appeared in ManagementAccounting, December 1993, pp. 57 59.

Address for correspondence: Peter Clarke, Department of Accountancy,University College Dublin, Belfield Campus, Dublin 4, Ireland

E mail address: [email protected]

Keywords: Activity based costing and customer profitability analysis; targetcosting; 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.
mailto:[email protected]:[email protected]


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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 toclose down their operations and those that survived have had to find ways of gaining acompetitive 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 multinationalslooking for a European manufacturing base with access to the European EconomicCommunity (now, the European Union). While a small number of multinational

companies remain in Ireland, many have closed and moved on as cost structures madethem uncompetitive. Morocco, Asian and Eastern European countries are becoming keyoutsource locations. Employment in the clothing industry in Ireland currently stands atabout 8,000, which compares with an all-time high for the sector of approximately 15,000ten years ago.

TheDublin 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 hadthe lowest corporate tax rate in the European Union and a regulatory regime that wasunambiguously pro-business. The political system was stable and the population hadstrong 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 shirtmarket. (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 arecalled 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 usedto promote the specific event itself.

The company is located in a small provincial town on the outskirts of Dublin. It is a


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everyone knew that making losses in a low tax regime was bad tax management for theGroup! (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 percentcapacity. There are approximately 100 employees, and most of these are female machineoperatives who are paid on an hourly basis. The weekly payroll calculations consume agreat deal of resources since they are done manually. Because of the high investment incapital 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 productproduced by the company is a white sports shirt (in different sizes). Shirts are made inthree mens sizes: medium, large and extra large (XL). The company does notmanufacture small sized shirts as it considers this size to be suitable only for children andit believes this market segment to be rather small. The normal production cycle for anorder 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 productioncost and extends the production cycle of an order by about three days. In addition, acharacteristic 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 machineembroidered. In the majority of cases, the text is usually printed and this is referred to asthe printing process. The technical term used is that of stamping whereby theappropriate 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 andpeels off. A small but increasing number of shirts (about 15%) have the text or logo ofthe 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 inadvance of dispatch so that there will always be a certain amount of finished goods instock at the end of each fiscal period.


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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 greatdeal of TV coverage. Typical examples are the British Open, Wimbledon, Super Bowletc. Shop customers are single shop operations (such as pro shops at golf courses), andteam customers are typically associated with specific teams or clubs. It is companypolicy 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. Thelow amount of bad debts is also partly due to the speed by which invoices are issued tocustomers, together with a regular and frequent follow-up of all unpaid invoices. Table 1gives product and customer classification statistics for 2001.

The Company has a different marketing approach to customers in each of its threecategories. A small group of in-house sales-people sells directly to buyers in the prioritycustomer category. Independent salespersons, paid on a commission only basis, call onthe licensing agent of customers classified in the team category. Advertisements placedin regional magazines and newspapers target customers primarily in the "shop" customersegment, who telephone or post in their orders. Not surprisingly, a significant cost for allcategories 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, seniormanagers recently identified its main competitive strengths and weaknesses.Management believes that the critical strength of the company is in the quality of theproduct, and that the weakness in recent years has been in customer service, particularlyin 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 toshareholders by providing high quality products to customers, delivered on time and atthe lowest cost. However, due to more pressing matters no discussion took place. Thus,little progress has been made in modifying the management accounting and informationsystem to monitor progress in relation to these critical success factors. Production costsare accumulated as outlined below in Exhibit 1.

Exhibit 1: Production and cost accumulation processProduction process Cost informationBasic manufacture of white shirt Direct material (per unit)

Direct labour (per unit)Manufacturing overhead (per unit)


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Costs are accumulated separately for the basic manufacturing process i.e. themanufacture of white shirts, and also for the customization process. The former processaccumulates costs as direct materials, direct labour or manufacturing overhead. In this process, production overheads are absorbed on the basis of direct labour cost and thisapproach has been in use for a number of years. Costs associated with customizing shirtsare accumulated separately under the heading of direct costs (for dyeing) and conversioncosts for stamping/printing or, alternatively for embroidery. Table 2 shows the firmsunit 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 scheduleof aged accounts receivable. The profit and loss account in Table 3 shows the reportedloss for the recent fiscal year.

In order to restore profitability to the company, management would first like to ascertainthe profitability of the customers in its three customer categories priority, team andshop. 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 thatdifferent customers demand different levels of support. Management is aware that theuse of ABC information would enable a type of customer profitability analysis to beapplied. They have recently obtained data on how the selling and distribution, andadministrative expenses could be incorporated into a customer profitability analysis byidentifying cost pools and cost drivers for various customer related activities (Tables4a/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 itsquality inspection costs by reducing inspections, which will improve on-time deliveryrates. This proposal is to be discussed at the next Board meeting.

Second, last week, the Sales Director proposed that the company should enter theAmerican market for womens sports shirts, where comparable shirts sell for theequivalent of 9.75. This is considered to be an excellent selling price, given the smallsize of the shirt involved. Overall production costs would be similar to medium-sized


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Feature required by

the lady wearer

Cost (per unit) to add Importance ranking

(5 = most important)

Hanger (on inside of collar) 0.02 2

Hanger (on outside of shoulder) 0.04 3

Patch (breast) pocket 0.10 3

Embroidery on single sleeve 0.25 5

Double stitching (on V-neck etc.) 0.08 4

It is anticipated that theDublin 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 sellingcosts in the US, equivalent to 1 per shirt. The Dublin Shirt Company requires acontribution of 2 per unit but the goods are to be invoiced in US dollars unlike currentsales 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 apresentation for the companys board of directors to include the following:

(1) A calculation of break-even point (in units) for the year ended 2001. For the purposesof simplifying this calculation, you should assume that ONLY direct material and directlabour costs are considered variable with respect to changes in volume. Clearly identifyyour assumption regarding the sales mix in your calculation and specify why thisassumption 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.

20 marks

(4) An identification and discussion of the strategic issues that may arise from the resultsof your customer profitability analysis.


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(6) A listing and brief justification of other potential cost pools and cost drivers that couldbe used for selling and administration costs, in addition to the cost pools and cost driverslisted in Table 4b.

5 marks

(7) Explain how a Balanced Scorecard might help a firm like the Dublin ShirtCompany.Give examples of performance measures that might be included under each of thefollowing 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 youagree with this proposal?

10 marks

(9) TheDublin Shirt Company is considering entering the womens sports shirt market inthe US. What is the target manufacturing cost for these shirts? Indicate what features, ifany, should be added to the shirts already produced, in keeping with your target costcalculations. Identify the strategic and international business factors that the managementof theDublin Shirt Company should consider in making this decision.

10 marks

TOTAL: 100 MARKS


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TABLE 1: PRODUCT & CUSTOMER STATISTICS FOR 2001

Sales in units by customer categoryShirt size: Priority Team Shop Total

X large 272,500 166,000 105,500 544,000

Large 366,000 186,000 103,000 655,000

Medium 360,000 190,000 960,000 1,510,000

Total units sold 998,500 542,000 1,168,500 2,709,000

Sales revenue () 6,029,700 3,284,300 6,566,900 15,880,900

No. of units dyed 750,000 400,000 550,000 1,700,000

No. of units stamped 698,500 472,000 1,138,500 2,309,000

No. of units embroidered 300,000 70,000 30,000 400,000

No. of orders received 2,330 11,450 57,909 71,689

No. of shipments made 1,470 9,230 49,286 59,986

TABLE 2: COST AND REVENUE DATA FOR 2001

Basicmanufacture

Quantity Averagesales price

Directmaterial

Directlabour

Manufgoverhead

X large 544,000 6.60 0.60 0.40 0.24

Large 655,000 6.20 0.55 0.35 0.21

Medium 1,510,000 5.45 0.39 0.30 0.18

2,709,000

Customising Quantity Directcost (unit)

Conversioncost (unit)

Totalcost


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TABLE 3: PROFIT AND LOSS ACCOUNT THE YEAR END 2001

units

Sales: X large 544,000 3,590,400

Large 655,000 4,061,000

Medium 1,510,000 8,229,500

2,709,000 15,880,900

Less: Cost of goods manufactured

Basic manufacturing costs 2,715,310

Customising 3,823,600 6,538,910

Gross profit 9,341,990

Less: Non-manufacturing overheads

Selling and distribution expenses 5,761,600

Administration expenses 3,584,450 9,346,050 Net loss for year (4,060)

Retained profit brought forward 1,537,810

Retained profit at end of year 1,533,750

BALANCE SHEET AT YEAR END 2001

Fixed assets

Buildings (net) 2,450,000Plant and equipment (net) 1,740,000 4,190,000

Current AssetsStock (inventory) 550,000

Debtors (accounts receivable) 2,600,000

3,150,000

Less: Current LiabilitiesTrade and other creditors (4,406,250)

Net current assets (1,256,250)

Total assets less current liabilities 2,933,750

Financed by:


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TABLE 4A: THE ASSIGNMENT OF SELLING, DISTRIBUTION ANDADMINISTRATION COSTS TO CUSTOMER RELATED ACTIVITIES

Percentage distribution to:Selling & distribution Administration

Customer related activitiesAccounts maintenance Nil 70%

Sales commission 5% Nil

Shipping activities i.e. deliveries 50% 10%

Sales visits 15% NilTracking misplaced/lost items 20% 20%

Marketing/promotion 10% Nil

100% 100%

TABLE 4B: CUSTOMER RELATED ACTIVITIES AND ASSUMED

COST DRIVERS

Customer related activity Assumed cost driver

Accounts maintenance Number of orders received

Sales commission Direct allocation to team customers only

Shipping activities (i.e. deliveries) Number of shipments (deliveries) made

Sales visits Direct allocation to priority customers onlyTracking misplaced/lost items Number of units sold

Marketing/promotion Management estimate 1

1Decided as: 20% to team customers and 80% to shop customers


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ECN.W

Dave Roger, an experienced consultant from the e-commerce space, started

Electronic Commerce Network (ECN.W) 18 months ago. In studying this emergingbusiness model, he found the one area that caused the most problems for web merchantswas transaction processing. Although few people understood this, each seemingly simpleweb 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. Ifboth were answered in the affirmative, the transaction would then be made. This, then,entailed a further logistics transaction and an accompanying tracking transaction. Inaddition, 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 cometo 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 asCybersource provided the credit confirmation software systems; Yantra the fulfillmentand 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 theseinterfaces was a nightmare. To make matters worse for the web merchants, experiencedIT personnel in this area were scarce. And when one did gain the prerequisiteexperience, 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

i i i


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to customers and clients2. You should avoid spending both scarcemanagerial talent and investor capital on any activity that could best beperformed by third-party partners such as ECN.W. Do investors see the

value in you building transaction-processing systems with theirinvestment dollars that are sub-optimal in scale and soon obsolete? In youhiring and training high-cost personnel to run these inefficient systems?In you spending much of your creative energy trying to manage theseinefficient systems? The answer is clearly NO.

Join our network and get all these services seamlessly provided withstate-of-the-art applications run by highly trained IT professionals (see

Exhibit 2). We will convert a difficult-to-manage fixed infrastructurecost into a totally scaleable variable one since you pay only on a per-transaction basis. With us as your partner, you can spend your creativeenergies where your investors expect.

Dave Roger had no problem obtaining initial funding. Within eighteen months hehad 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, findingfunds was much more difficult. Unlike many of these failed companies, ECN.W hadsatisfied customers and the growth potential was strong. Nonetheless. his investors werenow seeking more details than he could provide. Specifically, they wanted clarity of hisfinancial model. Exactly what did it cost him to "run" his business and how would hecreate 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 tofacilitate this analysis. She had come highly recommended. She quickly pulled togethera 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 processesthat best defined ECN.W. -- Customer Capture, Customer Loading and TransactionProcessing. 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 trade-

show attendance, trade show preparation and advertising.Through tracing of travel itineraries and such, it was established that in


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the past 12 months, ECN.W had spent approximately $875,000 onthese activities.

3This 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.

4The

other 70 had exited this activity prior to a signed contract either bytheir own choice or ECN.W's. Appendix A has additional data forthis activity.

2. Customer Loading entailed all the activities necessary to enter the webmerchant and its fulfillers onto the ECN.W network. Over the past 12 monthsthe equivalent of 7 customers went through this whole process. The relevantactivities were identified as:

Business Operations Review -- outsourced to a number ofsubcontractors who documented the operational flow of the

web merchant. ECN.W had spent about $3,600 each on the 7reports. System Design -- the writing by ECN.W technical staff of all

the software interfaces and configuration of hardware linkagesfor transaction processing. It cost ECN.W about $5,000 eachon the seven systems.

Implementation & Certification -- installation and testing toensure system is working as designed. Although there was

minimal variation in the effort for the first two activities, thisone varied greatly depending upon a number of factors (seeAppendix B).

APPENDIX A

Customer Sale analysis detail

3


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The approximate $520,000 total cost for this activity pool came from across thecompany. 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 largeraccounts also expected to meet with ECN.W top management just to ensure themselvesof the professional caliber of the company to which they were going to entrust a crucialpart 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 thatunderstood the customer value proposition and the inherent costs of transactionprocessing and those where the customer value proposition had to be demonstrated. Forthe former, the process was as follows:

A visit to the potential customer site by a sales person and atechnician. This trip took approximately three days -- one for travel, one toreach agreement between client and ECN.W on how transaction processingwas currently being done by the client, and one to demonstrate the advantagesof the hosted network approach.

A follow-on visit by the sales person to "close" the deal whichtook on average two days -- one for travel and one for negotiation.

Sometime in between these two trips, Dave Roger would callthe customer to talk "CEO to CEO" after a thorough briefing on the customerby the sales person. This took about a half-day of effort from both the salesperson and Dave Roger.

For the latter group, the sales process was more complicated due to the skepticism of thecustomer. Unfortunately, 7 of the original 10 fell into this group.

An initial visit to the potential customer by the sales person justto introduce ECN.W and explain in detail the customer value proposition.

This took on average two days -- one for travel and one for the customermeeting 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 theclient on how transaction processing was currently being done internally andits costs, and one to demonstrate the advantages of the hosted networkapproach.

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 -- onefor travel and one for discussion


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for and responsive to ECN.W's implementation team, and had only one fulfiller; andthose that were neither competent nor responsive and had many fulfillers -- four, onaverage. 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 twodays -- one for travel and one for implementation. Most of the work was performed byclient and fulfiller IT personnel. Certification was done at ECN.W and required only oneadditional day for minor debugging. For the latter group, however, the process was muchmore difficult. Typically, it required a team of three technicians and two trips to thecustomer site -- an initial three-day visit by two technicians and a second two-day trip bya single technician for major revisions due to unforeseeable problems. Likewise, dealingwith multiple fulfillers that were less than prepared meant more and longer site visits forthe third technician, usually three days in duration -- one for travel and two for on-sitework. 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 sourcesthe 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; twodays, 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 forCustomer Capture and Customer Loadingprocesses intotal. 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


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Exhibit 1

E-Commerce Transaction Detail

R

e

a

l

-

T

i

m

e

Web

MerchantCustomer

Transactions

#1#2#3#4

#5#6#7#8#9#10#11#12

Credit check

In stock check

Ship if #1 & #2 Yes

Track

Charge customer

Update customer profile

Transaction summary tocustomer

credit company

fulfiller

fulfiller

common carrier

credit company

Exhibit 2ECN.W Value System

Web-Merchant

Customer ECN.W

Visa,AmExpMasterCard

Fulfiller

FedEx, UPS


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Exhibit 3General Ledger Account Balances

(Last 12 Months)

Sales Salaries 250,000$

Marketing Salaries 200,000$

Technical Salaries 900,000$

Administrative Salaries 200,000$

CEO Salary 750,000$Payroll Benefits 460,000$

Training & Development 182,500$

Travel Expenses 340,000$

Meals and Lodging 387,000$

Consultants 287,000$

Advertising 350,000$

Other Marketing Expenses 180,000$


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ENDESA: MEASURING AND CONTROLING VALUE CREATED IN ENDESA

By

Gary M. Cunningham, Ph.D., CPA*

SCOTT ERIKSEN, PH.D., CPA, CMA,CFM*

Francisco J. Lpez Lubin, Ph.D.*

Antonio Pareja**


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MEASURING AND CONTROLING VALUE CREATED IN ENDESA:A CASE STUDY

In early March 2000, ENDESAs corporate management presented its future vision

for the company to financial analysts. ENDESAs 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 aglobal energy operator, centered on the needs of our customers and the development ofour abilities and intangibles, our international presence, and at the same timestrengthening our presence in related businesses like new technologies andtelecommunications.

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 Andaluca and

Extremadura; 71% in Aragn; 5.2% in Cantabria, Asturias, and Galicia; and 10.9% in the

Canary and Balearic Islands. In addition, ENDESA has substantial operations in suchdiverse 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.

ENDESAs web site in English can be viewed at www.endesa.es/english/ which provides

more details about all these activities.


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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.


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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 thecompany. ENDESAs 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. ENDESAs 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


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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 minorityshareholders 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 ENDESAs 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.

ENDESAs 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


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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 isaccepted and understood relatively well by the operating levels. After three years, allpersons know what are the rules of the game and what their individual objectives are inline with them.

In the Group, 1,200 managers have variable compensation based on achieving theirobjectives. On average, this variable part can be 25% of annual compensation.

The only ways to fight against initial rejection have been to establish clearcommunication from the beginning, and to count on the support of upper management.

On another hand, a great communication effort has been achieved with the financialmarkets through regular presentations of our results and future plans. We are convincedthat the market values this information and transparency very positively.

Among the areas we have pending is development of a complete and flexibleinformation system with a standard data base that facilitates decision making by differentmanagers.


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PART A

MEASURING ENDESAS COMMITMENT TO VALUE

In 1997, ENDESAs 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 isessential to be able to measure the contribution of each unit to creation of value andusing this measurement to be able to set management objectives directed towardmaximizing it. We would get a value measurement that has a high correlation withmarket value added and on the other hand that is easy enough to be applied andunderstood 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, butwhich 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 unitsoperating in distinct markets.

It integrates aspects of both operating and financial management, but allows themto 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 managementobjectives.


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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 capitalAfter 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 ENDESAs 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 creationdifficult. Incorporating a large number of accounting adjustments makes the model lessclose to operating reality and therefore to the understanding that our managers have ofit. I do not want the persons responsible for the generating plants in Peru or Colombiato begin calling me saying that they do not understand the calculation we have made andthat 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.e.:

EVC = FOCF (IC * WACC)

WACC W i ht d A C t f C it l


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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 andafter 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


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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 FITLOW HIGH

LOW POTENTIAL EVC Sell SellHIGH POTENTIAL EVC Hold Expand

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.

ENDESAs current strategy is to expand further into Europe, including Eastern Europe,

and in the Americas, including the US. Thus, ENDESAs 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 4.5% return, which is considered to be the minimum acceptable return to

the shareholders.

Discussion Questions for Part A

2 Why does EVC as computed by ENDESA reflect an economic rather than an


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2. Why does EVC as computed by ENDESA reflect an economic rather than anaccounting perspective? What are the advantages and disadvantages of using acash flow perspective vs. an accounting perspective for financial management

tools?

3. From a financial management perspective, the depreciation charge is sometimesviewed as a source of cash and as maintaining capital. Evaluate these claimedpurposes in general, and specifically with respect to ENDESA. EvaluateENDESAs comment that cash flow is a superior to accounting measures of profitbecause it does include the depreciation tax shield effect but not the depreciationexpense.

4. Why is the computation of IC different at the business unit level from thecorporate and subsidiary level?

5. Evaluate ENDESAs policy of assigning risk premiums to industry segments andto specific countries or geographic areas. What types of risks exist for industrysegments and for countries or geographic regions? Which macroeconomic factorsshould ENDESA include in its model to determine the two types of riskpremiums? Evaluate ENDESAs comment that the focus is on the risk that thefactor contributes to the overall risk of ENDESA group, referring to portfoliotheory in your evaluation. Evaluate ENDESAs approach of assigning differentrisk premiums to eq

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