Reference no: EM133157719

Accounting, Control, Management Decision-Making, and Performance in a Newly-Acquired Business Case

Learning Outcome 1: Management incentive schemes and management decision-making.
Learning Outcome 2: Calculations of profits as sales output changes, calculations of a performance measure (return on assets), and of bonuses based on performance.
Learning Outcome 3: Alternatives to financial performance measures.
Learning Outcome 4: Interpretation of flexed budgets and variances.
Learning Outcome 5: Controllability and responsibility accounting.

Part A: Background

In January, Gloria Kan, CEO of Kan Enterprises, sat in her corner office overlooking Hong Kong harbour, puz- zling over the group's most recent acquisition, Maple Products ("MP"). This business, which operates out of Leeds, UK, should have resulted in a good return for the Kan group, but something did not seem quite right.

Kan Enterprises is a conglomerate with subsidiaries and joint ventures in more than 60 countries; its oper- ations include construction, manufacturing, and telecommunications. The primary business of MP is to sell air conditioning pumps, which it does throughout Europe. MP also sells accessories to repair and maintain the pumps, but around 90% of turnover and profits are from the pumps themselves. MP purchases kits for making the air conditioning pumps, mainly from East Asia, and assembles them at its factory in Leeds. Kan Enterprises purchased MP 15 months ago and agreed on budgets with the managing director shortly after that. Gloria Kan had expected the business to generate annual profits of between 10 and 12 million GBP.

Management Incentives
Bonuses for the directors of MP were set at the start of the budget year based on return on assets (ROA), as shown in Table 1. ROA is calculated as the profit for the year divided by the average of the opening and closing asset base (total assets less current liabilities), as recorded in the management accounts.

Maple Products owns its premises in Leeds outright and the land and buildings were revalued three years ago; the revalued amount is recorded in the management accounts (net of depreciation). The plant and ma- chinery in Leeds is old but serviceable and currently has a very low net book value. Due to frequent shipping delays, MP holds high levels of raw materials inventory; trade receivable levels are also high because MP sells to major wholesalers who negotiate long periods of credit. All these factors contribute to the asset base used in the calculation of ROA.

ROA is the standard measure used by Kan Enterprises for all its divisions. The median ROA in the air condi- tioning sector is 14%. The top quartile reports a ROA of 17% or more.

Bonus Ratchet
The agreement Kan Enterprises established with the team at MP was that when the ROA exceeds 15%, the Maple Products directors receive a bonus equal to 10% of salary. There is also an incentive ratchet, with a bonus of 15% of salary if ROA exceeds 18.5%, or a bonus of 20% of salary if ROA exceeds 22%.

The base bonus (10% of salary) results in directors' total remuneration being around the median for the sec- tor. A bonus of 15% of salary puts the directors just below the top quartile for the sector, while a bonus of 20% of salary puts the directors just below the top decile for the sector.

Detail of Budgeted Profit for the Year

Gloria Kan inspected the detailed original budget for Maple Products (Table 2), prepared the previous Janu- ary.

EMEA Regional Report
The team in charge of businesses in the EMEA (Europe, the Middle East, and Africa) region also prepared business notes, which include details on Maple Products. Some events had occurred after the original budget was drawn up and were not reflected in the figures in Table 2.

The EMEA report noted that a new sales office had been set up in April for Maple Products using unoccupied space at Kan Enterprises' headquarters in Hong Kong, to take advantage of Kan Enterprises' contacts in the Asia-Pacific region. The estimate for sales in the Asia-Pacific region at the time of this development was in the order of 300,000 units from April to December (this would have resulted in 4,200,000 total units sold for the year). However, the sales office had been enormously successful, resulting in 600,000 units sold in the Asia-Pacific region, and therefore worldwide sales of 4,500,000 units for the year.

Part A Discussion Questions
Complete these tasks before moving on.

1. Breakout session: Taking on the role of a director in Maple Products, how might the in- centive scheme affect your behaviour as a director throughout the year? Would you have been largely in favour or against the expansion into the Asia-Pacific region? Working in teams, collate your views to share with the class.
2. Using the budgeted data in Table 2, calculate (a) the total budgeted profits for sales of 4,200,000 units and 4,500,000 units and (b) the sales volume variance (differences in profits from the original budgeted profits) for sales of 4,200,000 units and 4,500,000 units. Note: Net income from repairs and maintenance is not expected to change with the in- crease in output because most new units do not require repairs or maintenance in the first year.
3. Calculate the budgeted ROA for sales outputs of 4,200,000 and 4,500,000 units. Assume that any additional profits over the original budget will be invested in the business and therefore increase the budgeted closing asset base.
4. State the budgeted directors' bonuses as a percentage of salary, for sales of 4,200,000 units and 4,500,000 units, based on your calculations in Question 3. Briefly comment on your results in the light of your answers to Question 1.

Part B: Further Details From the Report of the EMEA Senior Management Team
In March, the executive team for the EMEA region put forward a proposal to Maple Products to invest 10 million GBP to upgrade antiquated machinery in Leeds, to cope with the anticipated increases in output and sales in the Asia-Pacific region. Despite being very positive about the opening of the new sales office, the management team of Maple Products had been unwilling to invest. The current machinery, being very old, has a current net book value of zero and no scrap value.

Part B Discussion Questions
Complete these tasks before moving on.

• 5. Breakout session: In teams, take the position of the directors of Maple Products. Discuss why you might be reluctant to invest in new machinery. Collate the views of team members to share with the class.
• 6. Assume that MP accepted the investment of 10 million GBP from Kan Enterprises and purchased new machinery to support additional sales. As a result of this investment, the asset base at the end of the year increases by 9 million GBP because depreciation of 1 million GBP on the new machinery is to be charged against profits. For output levels of 4,200,000 units and 4,500,000 units, respective- ly, and starting with your data from Questions 2 and 3 from Part A, calculate the revised budgeted ROA and budgeted directors' bonuses, and comment on your results. Are they as you had expected, based on your discussion in relation to Question 5?
• 7. Breakout session: In teams, put yourself in the position of Gloria Kan, CEO of Kan Enterprises, and consider the following questions:
a. How might you have overcome the reluctance of the management team of MP to invest and upgrade their machinery, assuming that you wish to maintain some form of ROA measure?
b. How would you measure the overall performance of the directors of MP (instead of using ROA)? Is there any other information you would need before deciding on your proposed measures? Discuss the advantages and disadvantages of each mea- sure suggested by team members.

Collate all the views of the team to share with the class.

Part C: Results for the Year for Maple Products
Gloria Kan opened a file that contained the actual results for the year (Table 3) with a comparison with a flexed budget for 4,500,000 units. She had heard that the directors of Maple Products were demotivated after failing to reach their target for their annual bonus, achieving a ROA of less than 15%. The management accountant of MP had also provided more detailed financial information, shown in Tables 4, 5, and 6. Gloria noted the effects of the opening of the new sales office, and some of the problems that appeared to have arisen as a result of not investing in the new machinery.

Changes to Variable Selling Expenses
The sales director at Maple Products reported that variable selling expenses had reduced from 2.00 GBP to
1.80 GBP per unit on average because customers in the Asia-Pacific region were attracted by the lower sell- ing price per unit, making sales easier to close; there was also good cost control in the European region.

Performance Appraisal
According to the management accountant, the following directors were required to account for their perfor- mance as measured in the areas indicated, as part of their annual appraisal.

• Managing director: overall performance.
• Sales director: sales volume variance, sales price variance, variable selling expenses variance, and fixed selling expenses variance.
• Purchasing director: material price variance and variable production overhead rate variance.
• Production director: materials usage variance, labour efficiency variance, variable production over- head efficiency variance, and fixed production overhead variance.
• Operations and human resources director: labour rate variance, net income from repairs and main- tenance variance, and fixed administration overhead variance.

Part C Discussion Questions
• 8. Calculate the ROA based on the actual results for the year, and state the level of bonus that direc- tors of Maple Products can expect.
• 9. Explain why the management accountant compared the flexed budget with the actual results to calculate the variances (and did not compare the original budget with the actual results). Use the ex- amples of the sales price variance, the materials usage variance, and the labour efficiency variance to illustrate your answer.
• 10. Calculate the total of the variances that are the responsibility of each of the following director roles:
a. Sales director
b. Purchasing director
c. Production director
d. Operations and human resources director
• Breakout session: The EMEA team believes that the responsibility for poor performance lies firmly with the directors of Maple Products and, in particular, the managing director of Maple Products. In teams, propose explanations for each of the variances that are the responsibility of the directors. Do you think the EMEA team is correct in its views? How did the managing director perform? How would you view each director if you were conducting their performance appraisal? Specifically consider the total variances (favourable or unfavourable) that are assigned to each director and your explanations for those variances. Collate all the views of the team to share with the class.

Attachment:- Management Decision-Making.rar