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Suppose the new-car deal is consummated, with the repaired used car being retailed for $7,100, the re- pairs costing Shuman $1,594.

Management Control Environment

Moyer returned to the office and explained the situ- ation to Joanne Brunner, who had recently joined the

dealership as accountant. After listening with interest to Moyer’s explanation of the sale, Brunner set about recording the sale in the accounting records of the business. As soon as she saw that the new car had been purchased from the manufacturer for $12,240, she was uncertain as to the value she should place on the trade- in vehicle. Since the new car’s list price was $14,400 and it had cost $12,240, Brunner reasoned that the gross margin on the new-car sale was $2,160. Yet Moyer had allowed $6,500 for the old car, which needed $840 of repairs and could be sold retail for $7,100 or wholesale for $6,100. Did this mean that the new-car sale involved a loss? Brunner was not at all sure she knew the answer to this question. Also, she was uncertain about the value she should place on the used car for inventory valuation purposes. Brunner de- cided that she would put down a valuation of $6,500, and then await instructions from her superiors.

When Fiedler, the used-car manager, found out what Brunner had done, he stated forcefully that he would not accept $6,500 as the valuation of the used car. He commented as follows:

My used-car department has to get rid of that used car, unless Janet (Moyer) agrees to take it over herself. I would certainly never have allowed the customer $6,500 for that old tub. I wouldn’t have given anymore than $5,260, which is the whole- sale price less the cost of repairs. My department has to make a profit too, you know. My own in- come depends on the gross profit I show on the sale of used cars, and I won’t stand for having my income hurt because Janet is too generous toward her customers!

Brunner replied that she had not meant to cause trouble but had simply recorded the car at what seemed to be its cost of acquisition, because she had been taught that this was the best accounting practice. Whatever response Fiedler was about to make to this comment was cut off by the arrival of Clark Shuman, the general manager, and Nate Bianci, the service de- partment manager. Shuman picked up the phone and called Janet Moyer, asking her to come over right away.

“All right, Nate,” said Shuman, “now that we are all here, would you tell them what you just told me?”

Bianci said, “Clark, the trouble is with this trade-in. Janet and Paul were right in thinking that the repairs they thought necessary would cost about $840. Unfor- tunately, they failed to notice that the rear axle is cracked; it will have to be replaced before we can retail

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the car. This will probably use up parts and labor cost- ing about $640.

“Beside this,” Bianci continued, “there is another thing that is bothering me a good deal more. Under the accounting system we’ve been using, I can’t charge as much on an internal job as I would for the same job performed for an outside customer. As you can see from my department statement (Exhibit 2), I lost al- most $8,000 on internal work last year. On a recondi- tioning job like this, which costs out at $1,480, I don’t even break even. If I did work costing $1,480 for an outside customer, I would be able to charge about $2,000 for the job. The Blue Book gives a range of $1,960 to $2,040 for the work this car needs, and I have always aimed for about the middle of the Blue Book range.1 That would give my department a gross profit of $520, and my own income is now based on that gross profit. Since a large proportion of the work of my department is the reconditioning of trade-ins for resale, I figure that I should be able to make the same charge for repairing a trade-in as I would get for an outside re- pair job.”

Fiedler and Moyer both started to talk at once at this point. Fiedler managed to edge out Moyer: “This axle

business is unfortunate, all right; but it’s very hard to spot a cracked axle. Nate is likely to be just as lucky the other way next time. He has to take the rough with the smooth. It’s up to him to get the cars ready for me to sell.”

Moyer, after agreeing that the failure to spot the axle was unfortunate, added: “This error is hardly my fault, however. Anyway, it’s ridiculous that the service de- partment should make a profit on jobs it does for the rest of the dealership. The company can’t make money when its left hand sells to its right.”

At this point, Clark Shuman was getting a little confused about the situation. He thought there was a little truth in everything that had been said, but he was not sure how much. It was evident to him that some ac- tion was called for, both to sort out the present prob- lem and to prevent its recurrence. He instructed Ms. Brunner, the accountant, to “work out how much we are really going to make on this whole deal,” and then retired to his office to consider how best to get his managers to make a profit for the dealership.

A week after the events described above, Clark Shuman was still far from sure what action to take to motivate his managers to make a profit for the business. During the week, Bianci had reported to him that the repairs to the used car had cost $1,594, of which $741 represented the cost of those repairs that had been spot- ted at the time of purchase, and the remaining $853 the cost of supplying and fitting a replacement for the cracked axle. To support his own case for a higher


SHUMAN AUTOMOBILES, INC Analysis of Service Department Expenses

For the Year Ended December 31

Customer Reconditioning Jobs Jobs Total

Number of jobs 3,780 468 4,248 Direct labor $302,116 $ 98,820 $ 400,936 Supplies 103,966 32,755 136,721 Department overhead 84,592 27,670 112,262________ __

490,674 159,245 649,919 Parts 235,787 86,670 322,457________ __

726,461 245,915 972,376 Charges made for jobs to customers or other departments 980,722 238,183 1,218,905________ _ Gross profit (loss) 254,261 (7,732) 246,529 General overhead proportion 140,868_________ Departmental profit for the year $ 105,661____________________

1 In addition to the monthly Blue Book for used-car prices, there was a monthly Blue Book that gave the range of charges for various classes of repair work, based on the ac- tual charges made and reported by vehicle repair shops in the area.

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allowance on reconditioning jobs, Bianci had looked through the duplicate customer invoices over the last few months and had found examples of similar (but not identical) work to that which had been done on the trade-in car. The amounts of these invoices averaged $2,042, and the average of the costs assigned to these jobs was $1,512. (General overhead was not assigned to individual jobs.) In addition, Bianci had obtained from Ms. Brunner the cost analysis shown in Exhibit 2. Bianci told Shuman that this was a fairly typical distri- bution of the service department’s expenses.


  1. Suppose the new-car deal is consummated, with the repaired used car being retailed for $7,100, the re- pairs costing Shuman $1,594. Assume that all sales personnel are on salary (no commissions) and that general overhead costs are fixed. What is the deal- ership incremental gross profit on the total transac- tion (i.e., new and repaired-used cars sold)?
  2. Assume each department (new, used, service) is treated as a profit center, as described in the case.

Also assume in a–c that it is known with certainty beforehand that the repairs will cost $1,594.

a. In your opinion, at what value should this trade- in (unrepaired) be transferred from the new-car department to the used-car department? Why?

b. In your opinion, how much should the service department be able to charge the used-car de- partment for the repairs on this trade-in car? Why?

c. Given your responses to a and b, what will be each department’s incremental gross profit on this deal?

  1. Is there a strategy in this instance that would give the dealership more profit than the one assumed above (i.e., repairing and retailing this trade-in used car)? Explain. In answering this question, assume the service department operates at capacity.
  2. Do you feel the three-profit-center approach is appro- priate for Shuman? If so, explain why, including an explanation of how this is better than other specific al- ternatives. If not, propose a better alternative and ex- plain why it is better than three profit centers and any other alternatives you have considered.

Case 22–3

Zumwald AG* In August 2002, a pricing dispute arose between the managers of some of the divisions of Zumwald AG. Mr. Rolf Fettinger, the company’s managing director, had to decide whether to intervene in the dispute.

THE COMPANY Zumwald AG, headquartered in Cologne, Germany, produced and sold a range of medical diagnostic imag- ing systems and biomedical test equipment and instru- mentation. The company was organized into six oper- ating divisions. Total annual revenues were slightly more than €3 billion.

Zumwald managers ran the company on a highly de- centralized basis. The managers of each division were allowed considerable autonomy if their performances were at least on plan. Performance was evaluated, and

management bonuses were assigned, based on each divi- sion’s achievement of budgeted targets for return on in- vested capital (ROIC) and sales growth. Even though the company was partly vertically integrated, division man- agers were allowed to source their components from ex- ternal suppliers if they so chose.

Involved in the dispute mentioned above were three of the company’s divisions: the Imaging Systems Divi- sion (ISD), the Heidelberg Division (Heidelberg), and the Electronic Components Division (ECD).

• ISD sold complex ultrasound and magnetic resonance imaging systems. These systems were expensive, typ- ically selling for €500,000–€1 million.

• Heidelberg sold high-resolution monitors, graph- ics controllers and display subsystems. Approxi- mately half of its sales were made to outside cus- tomers. ISD was one of Heidelberg’s major inside customers.

  • Copyright © by Kenneth A. Merchant and Wim A. Van der Stede, University of Southern California.

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• ECD sold application-specific integrated circuits and subassemblies. ECD was originally established as a captive supplier to other Zumwald divisions, but in the last decade its managers had found exter- nal markets for some of the division’s products. Be- cause of this, ECD’s managers were given profit center responsibility.

THE DISPUTE In 2001, ISD designed a new ultrasound imaging sys- tem, called the X73. Hopes were high for X73. The new system offered users advantages in processing speed and cost, and it took up less space. Heidelberg engineers participated in the design of X73, but Heidelberg was compensated for the full cost of the time its employees spent on this project.

After the specifications were set, ISD managers so- licited bids for the materials needed to produce X73 components. Heidelberg was asked to bid to supply the displays needed for production of the X73 system. So were two outside companies. One was Bogardus NV, a Dutch company with a reputation for producing high quality products. Bogardus had been a long-time sup- plier to Zumwald, but it had never before supplied display units and systems to any Zumwald division. Display Technologies Plc, was a British company that had recently entered the market and was known to be pricing its products aggressively in order to buy market share. The quotes that ISD received were as follows:

Supplier Cost per X73 System (€)

Heidelberg Division 140,000 Bogardus NV 120,500 Display Technologies Plc 100,500

After discussing the bids with his management team, Conrad Bauer, ISD’s managing director, an- nounced that ISD would be buying its display systems from Display Technologies Plc. Paul Halperin, Heidel- berg’s general manager, was livid. He immediately complained to Mr. Bauer, but when he did not get the desired response, he took his complaint to Rolf Fet- tinger, Zumwald’s managing director. Mr. Fettinger agreed to look into the situation.

A meeting was called for August 29, 2002. Mr. Halperin asked Christian Schönberg, ECD’s GM, to attend this meeting to support his case. If Heidelberg got this order from ISD, it would buy all of its elec- tronic components from ECD.

At this meeting, Mr. Bauer immediately showed his anger:

Paul wants to charge his standard mark-up for these displays. I can’t afford to pay it. I’m trying to sell a new product (X73) in a very competitive market. How can I show a decent ROIC if I have to pay a price for a major component that is way above market? I can’t pass on those costs to my customers. Paul should really want this business. I know things have been relatively slow for him. But all he does is quote list prices and then com- plain when I do what is best for my division.

We’re wasting our time here. Let’s stop fighting amongst ourselves and instead spend our time fig- uring out how to survive in these difficult business conditions.

Mr. Fettinger asked Mr. Halperin why he couldn’t match Display Technologies’ price. Paul replied as follows:

Conrad is asking me to shave my price down to below cost. If we start pricing our jobs this way, it won’t be long before we’re out of business. We need to price our products so that we earn a fair return on our investment. You demand that of us; our plan is put together on that basis; and I have been pleading with my sales staff not to offer deals that will kill our margins. Conrad is forget- ting that my engineers helped him design X73, and we provided that help with no mark-up over our costs. Further, you can easily see that Zumwald is better off if we supply the display systems for this new product. The situation here is clear. If Conrad doesn’t want to be a team player, then you must order him to source inter- nally! That decision is in the best interest of all of us.

In the ensuing discussion, the following facts came out:

  1. ISD’s tentative target price for the X73 system was €340,000.1
  2. Heidelberg’s standard manufacturing cost (mater- ial, labor and overhead) for each display system was €105,000. When asked, Mr. Halperin esti- mated that the variable portion of this total cost was only €50,000. He treated Heidelberg’s labor costs as fixed because German laws did not allow him to

1 The cost of the other components that go into X73 is €72,000. ISD’s conversion cost for the X73 system is €144,000, of which €117,700 is fixed.

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lay off employees without incurring expenses that were “prohibitively” high.

  1. Because of the global business slowdown, the pro- duction lines at Heidelberg that would produce the systems in question were operating at approxi- mately 70 percent of capacity. In the preceding year, monthly production had ranged from 60–90 percent of total capacity.
  2. Heidelberg’s costs included €21,600 in electronic subassemblies to be supplied by ECD. ECD’s full manufacturing costs for the components included in each system were approximately €18,000, of which approximately half were out-of-pocket costs. ECD’s standard policy was to price its products internally at full manufacturing cost plus 20 percent. The mark-up was intended to give ECD an incentive to supply its product internally. ECD was currently op- erating at 90 percent capacity.

Near the end of the meeting, Mr. Bauer reminded everybody of the company’s policy of freedom of sourcing. He pointed out that this was not such a big deal, as the volume of business to be derived from this new product was only a small fraction (less than 5 per- cent) of the revenues for each of the divisions in- volved, at least for the first few years. And he also did not like the potential precedent of his being forced to source internally because it could adversely affect his

ability to get thoughtful quotes from outside suppliers in the future.

THE DECISION As he adjourned the meeting, Mr. Fettinger promised to consider all the points of view that had been expressed and to provide a speedy judgment. He wondered if there was a viable compromise or if, instead, there were some management principles involved here that should be considered inviolate.


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

a. the Imaging Systems Division?

b. the Heidelberg Division?

c. the Electronic Components Division?

d. Zumwald AG?

  1. What should Mr. Fettinger do regarding the X73 sourcing issue?
  2. Can a system be designed to motivate each of Zumwald’s division managing directors to take ac- tions that are not only in the interest of their divi- sion but also in the best interest of Zumwald? Explain.

Case 22–4

Enager Industries, Inc.* I don’t get it. I’ve got a new product proposal that can’t help but make money, and top management turns thumbs down. No matter how we price this new item, we expect it to make $130,000 pretax. That would contribute 14 cents per share to our earnings after taxes, which is nearly as much as the 15-cent earnings-per-share increase in 1997 that the president made such a big thing about in the shareholders’ annual report. It just doesn’t make sense for the president to be touting e.p.s. while his subordinates are rejecting profitable projects like this one.

The frustrated speaker was Sarah McNeil, prod- uct development manager of the Consumer Products

Division of Enager Industries, Inc. Enager was a relatively young company, which had grown rapidly to its 1997 sales level of over $74 million. (See Exhibits 1–3 for financial data for 1996 and 1997.)

Enager had three divisions, Consumer Products, In- dustrial Products, and Professional Services, each of which accounted for about one-third of Enager’s total sales. Consumer Products, the oldest of the three divi- sions, designed, manufactured, and marketed a line of houseware items, primarily for use in the kitchen. The Industrial Products Division built one-of-a-kind ma- chine tools to customer specifications; for example, it was a large “job shop,” with the typical job taking sev- eral months to complete. The Professional Services Division, the newest of the three, had been added to* Copyright © by James S. Reece.

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Enager by acquiring a large firm that provided land planning, landscape architecture, structural architec- ture, and consulting engineering services. This divi- sion had grown rapidly, in part because of its capabil- ity to perform environmental impact studies.

Because of the differing nature of their activities, each division was treated as an essentially independent company. There were only a few corporate-level man- agers and staff people, whose job was to coordinate the activities of the three divisions. One aspect of this coordination was that all new project proposals requir- ing investment in excess of $500,000 had to be re- viewed by the corporate vice president of finance, Henry Hubbard. It was Hubbard who had recently re- jected McNeil’s new product proposal, the essentials of which are shown in Exhibit 4.

PERFORMANCE EVALUATION Prior to 1996, each division had been treated as a profit center, with annual division profit budgets negotiated between the president and the respective division general managers. In 1995, Enager’s president, Carl Randall, had become concerned about high interest rates and their impact on the company’s profitability. At the urging of Henry Hubbard, Randall had decided to begin treating each division as an investment center

so as to be able to relate each division’s profit to the as- sets the division used to generate its profits.

Starting in 1996, each division was measured based on its return on assets, which was defined as the divi- sion’s net income divided by its total assets. Net income for a division was calculated by taking the division’s “direct income before taxes” and then sub- tracting the division’s share of corporate administra- tive expenses (allocated on the basis of divisional revenues) and its share of income tax expense (the tax rate applied to the division’s “direct income before taxes” after subtraction of the allocated corporate ad- ministrative expenses). Although Hubbard realized there were other ways to define a division’s income, he and the president preferred this method since “it made the sum of the [divisional] parts equal to the [corpo- rate] whole.”

Similarly, Enager’s total assets were subdivided among the three divisions. Since each division operated in physically separate facilities, it was easy to attribute most assets, including receivables, to specific divisions. The corporate-office assets, including the centrally con- trolled cash account, were allocated to the divisions on the basis of divisional revenues. All fixed assets were recorded at their balance sheet values, that is, original cost less accumulated straight-line depreciation. Thus,


ENAGER INDUSTRIES, INC. Income Statements For 1996 and 1997

(thousands of dollars, except earnings per share figures)

Year Ended December 31

1996 1997

Sales $70,731 $74,225 Cost of sales 54,109 56,257________ __ Gross margin 16,622 17,968 Other expenses:

Development 4,032 4,008 Selling and general 6,507 6,846 Interest 994 1,376________ __

Total 11,533 12,230________ Income before taxes 5,089 5,738 Income tax expense 2,036 2,295______ Net income $ 3,053 $ 3,443______ ____ __ Earnings per share (500,000 and 550,000 shares

outstanding in 1996 and 1997, respectively) $ 6.11 $6.26

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the sum of the divisional assets was equal to the amount shown on the corporate balance sheet ($75,419,000 as of December 31, 1997).

In 1995 Enager had as its return on year-end assets (net income divided by total assets) a rate of 4.5 per- cent. According to Hubbard, this corresponded to a “gross return” of 9.3 percent; he defined gross return as equal to earnings before interest and taxes (EBIT) divided by assets. Hubbard felt that a company like Enager should have a gross EBIT return on assets of at least 12 percent, especially given the interest rates the corporation had paid on its recent borrowings. He therefore instructed each division manager that the

division was to try to earn a gross return of 12 per- cent in 1996 and 1997. In order to help pull the return up to this level, Hubbard decided that new investment proposals would have to show a return of at least 15 percent in order to be approved.

1996–1997 RESULTS Hubbard and Randall were moderately pleased with 1996’s results. The year was a particularly difficult one for some of Enager’s competitors, yet Enager had managed to increase its return on assets from 4.5 per- cent to 4.8 percent, and its gross return from 9.3 per- cent to 9.5 percent. The Professional Services Division



For 1996 and 1997 (thousands of dollars)

As of December 31

1996 1997

Assets Current assets:

Cash and temporary investments $ 1,404 $ 1,469 Accounts receivable 13,688 15,607 Inventories 22,162 25,467________ __

Total current assets 37,254 42,543________ __ Plant and equipment:

Original cost 37,326 45,736 Accumulated depreciation (12,691) (15,979)_ Net 24,635 29,757

Investments and other assets 2,143 3,119________ Total assets $64,032 $75,419______ ____ __

Liabilities and Owners’ Equity Current liabilities:

Accounts payable $ 9,720 $12,286 Taxes payable 1,210 1,045 Current portion of long-term debt — 1,634________ __

Total current liabilities 10,930 14,965 Deferred income taxes 559 985 Long-term debt 12,622 15,448________ __

Total liabilities 24,111 31,398________ Common stock 17,368 19,512 Retained earnings 22,553 24,509______ __

Total owners’ equity 39,921 44,021________ Total liabilities and owners’ equity $64,032 $75,419______ ____ __

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easily exceeded the 12 percent gross return target; Consumer Products’ gross return on assets was 8 percent; but Industrial Products’ return was only 5.5 percent.

At the end of 1996, the president put pressure on the general manager of the Industrial Products

Division to improve its return on investment, suggest- ing that this division was not “carrying its share of the load.” The division manager had taken exception to this comment, saying the division could get a higher return “if we had a lot of old machines the way Con- sumer Products does.” The president had responded

1996 1997

Net income � Sales 4.3% 4.6% Gross margin � Sales 23.5% 24.2% Development expenses � Sales 5.7% 5.4% Selling and general � Sales 9.2% 9.2% Interest � Sales 1.4% 1.9% Asset turnover* 1.10x 0.98x Current ratio 3.41 2.84 Quick ratio 1.38 1.14 Days’ cash* 7.9 7.9 Days’ receivables* 70.6 76.7 Days’ inventories* 149.5 165.2 EBIT � Assets* 9.5% 9.4% Return on invested capital,†,‡ 6.9% 7.0% Return on owners’ equity 7.6% 7.8% Net income � Assets,§ 4.8% 4.6% Debt/capitalization 24.0% 28.0%

  • Ratio based on year-end balance sheet amount, not annual average amount. † Invested capital includes current portion of long-term debt, excludes deferred taxes. ‡ Adjusted for interest expense add-back. § Not adjusted for add-back of interest; if adjusted, 1996 and 1997 ROA are both 5.7 percent.

EXHIBIT 3 Ratio Analysis for 1996 and 1997

  1. Projected asset investment* Cash $ 50,000 Accounts receivable 150,000 Inventories 300,000 Plant and equipment† 500,000__________

Total $1,000,000 2. Cost data:

Variable cost per unit $ 3.00 Differential fixed costs (per year)‡ $ 170,000

  1. Price/market estimates (per year):

Unit Unit Break-Even Price Sales Volume

$6.00 100,000 units 56,667 units 7.00 75,000 42,500 8.00 60,000 34,000

  • Assumes 100,000 units’ sales. † Annual capacity of 120,000 units. ‡ Includes straight-line depreciation on new plant and equipment.

EXHIBIT 4 Financial Data from New Product Proposal

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that he did not understand the relevance of the division manager’s remark, adding, “I don’t see why the return on an old asset should be higher than that on a new asset, just because the old one cost less.”

The 1997 results both disappointed and puzzled Carl Randall. Return on assets fell from 4.8 percent to 4.6 percent, and gross return dropped from 9.5 percent to 9.4 percent. At the same time, return on sales (net income divided by sales) rose from 4.3 percent to 4.6 percent, and return on owners’ equity also in- creased, from 7.6 percent to 7.8 percent. These results prompted Randall to say the following to Hubbard:

You know, Henry, I’ve been a marketer most of my career, but until recently I thought I under- stood the notion of return on investment. Now I see in 1997 our profit margin was up and our earnings per share were up; yet two of your return on investment figures were down while return on owners’ equity went up. I just don’t understand these discrepancies.

Moreover, there seems to be a lot more tension among our managers the last two years. The gen- eral manager of Professional Services seems to be doing a good job, and she seems pleased with the praise I’ve given her. But the general manager of

Industrial Products seems cool toward me every time we meet. And last week, when I was eating lunch with the division manager at Consumer Products, the product development manager came over to our table and expressed her frustration about your rejecting a new product proposal of hers the other day.

I’m wondering if I should follow up on the idea that Karen Kraus in HRM brought back from the organization development workshop she at- tended over at the university. She thinks we ought to have a one-day off-site “retreat” of all the cor- porate and divisional managers to talk over this entire return on investment matter.


  1. Why was McNeil’s new product proposal rejected? Should it have been? Explain.
  2. Evaluate the manner in which Randall and Hubbard have implemented their investment center concept. What pitfalls did they apparently not anticipate?
  3. What, if anything, should Randall do now with regard to his investment center measurement approach?

Case 22–5

Piedmont University* When Hugh Scott was inaugurated as the 12th presi- dent of Piedmont University in 1991, the university was experiencing a financial crisis. For several years enroll- ments had been declining and costs had been increas- ing. The resulting deficit had been made up by using the principal of “quasi-endowment” funds. For true endow- ment funds, only the income could be used for operat- ing purposes; the principal legally could not be used. Quasi-endowment funds had been accumulated out of earlier years’ surpluses with the intention that only the income on these funds would be used for operating pur- poses; however, there was no legal prohibition on the use of the principal. The quasi-endowment funds were nearly exhausted.

Scott immediately instituted measures to turn the financial situation around. He raised tuition, froze

faculty and staff hirings, and curtailed operating costs. Although he had come from another university and was therefore viewed with some skepticism by the Piedmont faculty, Scott was a persuasive person, and the faculty and trustees generally agreed with his ac- tions. In the year ended June 30, 1993, there was a small operating surplus.

In 1993, Scott was approached by Neil Malcolm, a Piedmont alumnus and partner of a local management consulting firm. Malcolm volunteered to examine the situation and make recommendations for permanent measures to maintain the university’s financial health. Scott accepted this offer.

Malcolm spent about half of his time at Piedmont for the next several months and had many conversa- tions with Scott, other administrative officers, and trustees. Early in 1994 he submitted his report. It recommended increased recruiting and fundraising activities, but its most important and controversial

  • Copyright © by Professor Robert N. Anthony, Harvard Business School.

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CENTRAL ADMINISTRATIVE COSTS Currently, no university-wide administrative costs were charged to academic departments. The proposal was that these costs would be allocated to profit centers in proportion to the relative costs of each. The graduate school deans regarded this as unfair. Many costs in- curred by the administration were in fact closely related to the undergraduate school. Furthermore, they did not like the idea of being held responsible for an allocated cost that they could not control.

GIFTS AND ENDOWMENT The revenue from annual gifts would be reduced by the cost of fund-raising activities. The net amount of annual gifts plus endowment income (except gifts and income from endowment designated for a specified school) would be allocated by the president according to his decision as to the needs of each school, subject to the approval of the Board of Trustees. The deans thought this was giving the president too much au- thority. They did not have a specific alternative, but thought that some way of reducing the president’s dis- cretionary powers should be developed.

ATHLETICS Piedmont’s athletic teams did not generate enough rev- enue to cover the costs of operating the athletic

recommendation was that the university be reorga- nized into a set a profit centers.

At that time the principal means of financial control was an annual expenditure budget submitted by the deans of each of the schools and the administrative heads of support departments. After a dean or department head discussed a budget with the president and financial vice president, it was usually approved with only minor mod- ifications. There was a general understanding that each school would live within the faculty size and salary num- bers in its approved budget, but not much stress was placed on adhering to the other items.

Malcolm proposed that in the future the deans and other administrators submit budgets covering both the revenues and the expenditures for their activities. The proposal also involved some shift in responsibilities, and new procedures for crediting revenues to the profit centers that earned them and charging expenditures to the profit centers responsible for them. He made rough estimates of the resulting revenues and expenditures of each profit center using 1993 numbers; these are given in Exhibit 1.

Several discussions about the proposal were held in the University Council, which consisted of the presi- dent, academic deans, provost, and financial vice pres- ident. Although there was support for the general idea, there was disagreement on some of the specifics, as described below.

Revenues Expenditures

Profit center: Undergraduate liberal arts school $ 42.0 $ 40.9 Graduate liberal arts school 7.8 16.1 Business school 21.4 17.2 Engineering school 23.8 24.2 Law school 9.4 9.1 Theological school 1.7 4.8 Unallocated revenue* 7.0 —_ _

Total, academic $113.1 $112.3______ _ _ Other:

Central administration $ 14.1 $ 14.1 Athletics 3.6 3.6 Computers 4.8 4.8 Central maintenance 8.0 8.0 Library 4.8 4.8

  • Unrestricted gifts and endowment revenue, to be allocated by the president.

EXHIBIT 1 Rough Estimates of 1993 Impact of the Proposals (millions of dollars)

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department. The proposal was to make this department self-sufficient by charging fees to students who partic- ipated in intramural sports or who used the swimming pool, tennis courts, gymnasium, and other facilities as individuals. Although there was no strong opposition, some felt that this would involve student dissatisfac- tion, as well as much new paperwork.

MAINTENANCE Each school had a maintenance department that was responsible for housekeeping in its section of the cam- pus and for minor maintenance jobs. Sizable jobs were performed at the school’s request by a central mainte- nance department. The proposal was that in the future the central maintenance department would charge schools and other profit centers for the work they did at the actual cost of this work, including both direct and overhead costs. The dean of the business school said that this would be acceptable provided that profit centers were authorized to have maintenance work done by an outside contractor if its price was lower than that charged by the maintenance department. Malcolm explained that he had discussed this possibil- ity with the head of maintenance, who opposed it on the grounds that outside contractors could not be held accountable for the high quality standards that Piedmont required.

COMPUTERS Currently, the principal mainframe computers and re- lated equipment were located in and supervised by the engineering school. Students and faculty members could use them as they wished, subject to an informal check on overuse by people in the computer rooms. About one-fourth of the capacity of these computers was used for administrative work. A few departmental mainframe computers and hundreds of microcomput- ers and word processors were located throughout the university, but there was no central record of how many there were.

The proposal was that each user of the engineering school computers would be charged a fee based on usage. The fee would recover the full cost of the equipment, including overhead. Each school would be responsible for regulating the amount of cost that could be incurred by its faculty and students so that the total cost did not exceed the approved item in the school’s budget. (The mainframe computers had soft-

ware that easily attributed the cost to each user.) Sev- eral deans objected to this plan. They pointed out that neither students nor faculty understood the potential value of computers and that they wanted to encourage computer usage as a significant part of the educa- tional and research experience. A charge would have the opposite effect, they maintained.

LIBRARY The university library was the main repository of books and other material, and there were small libraries in each of the schools. The proposal was that each student and faculty member who used the university library would be charged a fee, either on an annual basis, or on some basis related to the time spent in the library or the number of books withdrawn. (The library had a secure entrance at which a guard was stationed, so a record of who used it could be obtained without too much diffi- culty.) There was some dissatisfaction with the amount of paperwork that such a plan would require, but it was not regarded as being as important as some of the other items.

CROSS REGISTRATION Currently, students enrolled at one school could take courses at another school without charge. The proposal was that the school at which a course was taken would be reimbursed by the school in which the student was enrolled. The amount charged would be the total se- mester tuition of the school at which the course was taken, divided by the number of courses that a student normally would take in a semester, with adjustments for variations in credit hours.


  1. How should each of the issues described above be resolved?
  2. Do you see other problems with the introduction of profit centers? If so, how would you deal with them?
  3. What are the alternatives to a profit center approach?
  4. Assuming that most of the issues could be resolved to your satisfaction, would you recommend that the profit center idea be adopted, or is there an alterna- tive that you would prefer?

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23 Control: The Management Control Process


The preceding chapter discussed factors in an organization’s environment that affect management control. In this and the next two chapters, we describe how the manage- ment control system works—the management control process. This chapter describes the principal steps in the process, the characteristics of accounting information used in the process, and behavioral aspects of management control.

Phases of Management Control

Much of the management control process involves informal communication and interactions. Informal communication occurs by means of memoranda, meetings, con- versations, and even by such signals as facial expressions. Although these informal ac- tivities are of great importance, they defy a systematic description. Besides these informal activities, most organizations also have a formal management control system consisting of the following phases, each of which is described briefly below and in more detail in succeeding chapters:

  1. Strategic planning 2. Budgeting 3. Measurement and reporting 4. Evaluation

As shown in Illustration 23–1, each of these phases leads to the next. They recur in a regular cycle, constituting a “closed loop.”

Strategic planning is the process of deciding on the programs the organization will undertake and the approximate amount of resources to be allocated to each program. (Some organizations call this step programming or long-range planning.) Programs are the principal activities the organization has decided to undertake to implement the strategies chosen in the strategy formulation process. Program decisions, therefore, take an organization’s strategies as a given.

Strategic Planning

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In a profit-oriented company, each principal product or product line is a program. There are also various research and development (R&D) programs (some aimed at improving existing products or processes, others searching for marketable new products), human re- source development programs, public relations programs, and so on. In some organiza- tions, program decisions are made informally; in others, a formal planning system is used.

Budgeting, like strategic planning, is a planning process. An essential difference be- tween strategic planning and budgeting is that strategic planning looks forward several years into the future whereas budgeting focuses on the next year. A budget is a plan ex- pressed in quantitative, usually monetary, terms that covers a specified period of time, usually one year. Most organizations have a budget.

In preparing a budget, each program is translated into terms that correspond to the responsibility of those managers who have been charged with executing the program or some part of it. Thus, although plans are originally made in terms of individual pro- grams, the plans are translated into terms of responsibility centers in the budgeting process. The process of developing a budget is essentially one of negotiations between managers of responsibility centers and their superiors. The end product is an approved statement of the revenues expected during the budget year and of the resources to be used in each responsibility center for achieving the objectives of the organization. (Chapter 24 describes both strategic planning and budgeting in further detail.)

During the period of actual operations, records are kept of resources actually con- sumed (i.e., costs) and of revenues actually earned. These records are structured so that cost and revenue data are classified both by programs (i.e., by products, R&D projects, and the like) and by responsibility centers. Data classified according to programs are used as a basis for future strategic planning, and data classified by responsibility

Revise Budget

A djust

O perations



Information Information4. Evaluation 2. Budgeting

  1. Strategic planning
  2. Measurement and reporting


ILLUSTRATION 23–1 Phases of Management Control


Measurement and Reporting

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centers are used to measure the performance of responsibility center managers. For the latter purpose, data on actual results are reported in such a way that they can be com- pared with the budget so that variances can be calculated. (Techniques for calculating variances were described in Chapters 20 and 21.)

The management control system communicates both accounting and nonaccount- ing information to managers throughout the organization. Some of the nonaccounting information is generated within the organization, and some of it describes what is hap- pening in the external environment. This information, which keeps managers informed and helps to ensure that the work done by the separate responsibility centers is coordi- nated, is conveyed in the form of reports.

Reports also are used as a basis for control. Essentially, control reports are derived from an analysis that compares actual performance with planned (budgeted) perfor- mance and attempts to explain the difference (variance). (Control reports are discussed in Chapter 25.)

Task Control Much of the information about operations is a summary of the detailed operating in- formation generated in the course of performing specific tasks, such as producing a specific job order or entering customers’ orders in the order-processing system. The system used to control these specific tasks is called task control. Techniques for con- trolling a variety of tasks are well developed and, with the widespread use of comput- ers, increasingly automatic. A discussion of task control techniques is outside the scope of this book.

Based on these formal control reports, in conjunction with personal observations and other informally communicated information, managers evaluate what, if any, action should be taken. As indicated in Illustration 23–1, three types of responses (“feedback loops”) are possible. First, current operations may be adjusted in some way. For example, the purchasing agent may be instructed to locate a new source of supply for a material whose substandard quality is creating large unfavorable material usage variances. Second, operating budgets may be revised. For example, an unexpected, lengthy truckers’ strike may have caused plant shutdowns, with the result that both expense and revenue bud- gets need revision in order to be realistic under the new circumstances. Third, programs may need to be revised or eliminated. For example, a product may be discontinued because its profits are judged to be too small relative to the investment required to sup- port the product.

Accounting Information Used in Management Control

Full cost accounting information (described in Chapters 17–19) is used in the manage- ment control process as an aid in making program decisions. In preparing budgets and in measuring performance, the accounting information is structured by responsibil- ity centers, and when so structured is called responsibility accounting. Responsibility accounting is necessary because control can be exercised only through the managers of responsibility centers.

In explaining the nature and use of responsibility accounting information, we need to introduce two new ways of classifying costs: (1) as controllable or noncontrollable and (2) as engineered, discretionary, or committed.

An item of cost is a controllable cost if the amount assigned to a responsibility center is significantly influenced by the actions of someone within the responsibility center.

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Controllable Costs

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Otherwise, it is noncontrollable. There are two important aspects of this definition: (1) It refers to a specific responsibility center and (2) it suggests that controllability re- sults from a significant influence rather than from a complete influence.

The word controllable must be used in the context of a specific responsibility center rather than as an innate characteristic of a given cost item. When an organization is viewed as a complete entity, almost every item of cost is controllable: Someone, some- where in the organization, can probably take actions that influence it. In the extreme case, costs for any segment of the organization can be reduced to zero by closing down that segment; costs incurred in producing a good or service can be changed by pur- chasing that good or service from an outside supplier; and so on. Thus, the important question is not what costs are controllable in general but rather what costs are control- lable in a specific responsibility center because it is these costs on which the manage- ment control system must focus.

Controllable refers to a significant rather than a complete influence because only in rare cases does one manager have complete control over all the factors that influence any item of cost. The influence that the manager of a department has over its labor costs may actually be quite limited; for example, wage rates may be established by the human resources department or by union negotiations; the amount of labor required for a unit of activity in the department (e.g., assembling one unit of a product) may have been determined by someone outside the department who specified the detailed steps of the process; and the level of activity (i.e., volume) of the department may be influ- enced by the actions of other departments, such as the sales group or some earlier de- partment in the production process. Nevertheless, department managers usually have a significant influence on the amount of labor cost incurred in their own departments. They have some control over the amount of workers’ idle time, the speed and efficiency with which work is done, whether labor-saving equipment is acquired, and other fac- tors that affect labor costs.

Direct material and labor costs in a given production responsibility center are usually controllable. Some elements of overhead cost are controllable by the responsibility cen- ter to which the costs are assigned, but others are not. Indirect labor, supplies, and power consumption are usually controllable. So are service centers’ charges that are based on services actually rendered. However, an allocated cost is not controllable by the respon- sibility center to which the allocation is made. The amount of cost allocated depends on the amount of costs incurred in the service center and the formula used to make the al- location rather than on the actions of the manager of the responsibility center receiving the allocation. This is the case unless the cost is actually a direct cost that is allocated only for convenience, as in the case of Social Security taxes on direct labor.

Controllable Contrasted with Direct Costs The cost items in a responsibility center may be classified as either direct or indirect with respect to that center. Indirect costs are allocated to the responsibility center and are therefore not controllable by it, as explained above. All controllable costs are there- fore direct costs. Not all direct costs are controllable, however.

Depreciation on major departmental equipment is a direct cost of the department. Never- theless, the depreciation charge is often noncontrollable by the departmental supervisor, who may have no authority to acquire or dispose of expensive equipment. The rental charge for rented premises is another example of a direct but noncontrollable cost.

Controllable Contrasted with Variable Costs Neither are controllable costs necessarily the same as variable costs—those costs that vary proportionately with the level of activity (volume). Some costs (such as

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supervision, heat, light, and journal subscriptions) may be unaffected by volume, but they are nevertheless controllable. Conversely, although most variable costs are con- trollable, that is not always the case. In some situations, the cost of raw material and parts, whose consumption varies directly with volume, may be entirely outside the in- fluence of the departmental manager.

In an automobile assembly plant, one automobile requires an engine, a body, seats, and so on, and the plant manager can do nothing about it. Moreover, the plant manager cannot choose the source of these inputs; most of them come from other divisions of the automo- bile company. The manager is responsible for not damaging or wasting these items, but not for the main flow of the items.

Direct labor, usually thought of as an obvious example of a controllable cost, may be noncontrollable in certain types of responsibility centers. Situations of this type must be examined very carefully, however, because supervisors tend to argue that more costs are noncontrollable than actually is the case to avoid being held responsible for them.

If an assembly line has 20 workstations and cannot be operated unless it is staffed by 20 per- sons of specified skills having specified wage rates, direct labor cost on that assembly line may be noncontrollable. Nevertheless, the assumption that such costs are noncontrollable may be open to challenge: It may be possible to find ways to do the job with 19 persons, or with 20 persons who have a lower average skill classification and hence have lower wage rates.

Cultural norms also may affect controllability. For example, with some recent excep- tions, managers in most large Japanese companies cannot lay off employees because these companies provide their workers with career employment. However, the manager can have the employee transferred to another responsibility center, thus saving some labor cost in the manager’s department (but not for the company overall). Labor contract work rules also can affect controllability in unionized departments.

As described in Chapter 16, controllability also depends on the length of the time period used for planning budgeted performance and measuring actual performance. Because performance in many responsibility centers is measured monthly, controlla- bility in these circumstances is implicitly taken to refer to costs that are controllable during a month. (Of course, some costs, such as materials waste, are controllable within a much shorter time horizon.)

Converting Noncontrollable Costs to Controllable Costs A noncontrollable item of cost can be converted to a controllable cost in either of two related ways: (1) by changing the basis of cost assignment from an allocation to a di- rect assignment or (2) by changing the locus of responsibility for decisions—that is, decentralization.

Changing the Basis of Cost Assignment As noted above, allocated costs are noncon- trollable by the manager of the responsibility center to which they are allocated. Many costs allocated to responsibility centers could be converted to controllable costs simply by assigning the cost so that the amount of costs assigned is influenced by actions taken by the responsibility center’s manager.

If all electricity coming into a large building is measured by a single meter, there is no way of measuring the actual electrical consumption of each department in the building. The electrical cost is therefore necessarily allocated to each department and is noncontrollable. However, electricity cost can be changed to a controllable cost for the several departments in the building by installing meters in each department so that each department’s actual consumption of electricity is measured.

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Services that a responsibility center receives from service units can be converted from allocated to controllable costs by assigning the cost of services to the benefiting responsibility centers on some basis that measures the amount or quality of services actually rendered.

If maintenance department costs are charged to production responsibility centers as a part of an overhead rate, they are noncontrollable. But if a responsibility center is charged on the basis of an hourly rate for each hour that a maintenance employee works there and if the head of the responsibility center can influence the requests for maintenance work, then maintenance is a controllable element of the cost of the center. When costs are assigned in this fashion, the amount is the transfer price, as described in Chapter 22.

Practically any item of indirect cost conceivably could be converted to a direct and controllable cost. For some (such as charging the corporate officers’ salaries on the basis of the amount of the officers’ time spent on the problems of various parts of the business), however, the effort involved in doing so clearly is not worthwhile. There are nevertheless a great many unexploited opportunities in many organizations to con- vert noncontrollable costs to controllable costs.

The same principle applies to costs that are actually incurred in responsibility cen- ters but are not assigned to the responsibility centers at all, even on an allocated basis. Under these circumstances, the materials or services are “free” insofar as the heads of the responsibility centers are concerned. Since these managers do not have to “pay” for these services (as part of the costs for which they are held responsible), they are un- likely to be concerned about careful use of these materials or services.

For many years, New York City did not charge residents for the amount of water that they used. When water meters were installed and residents were required to pay for their own use of water, the total quantity of water used in the city decreased by a sizable amount.

Decentralization Changing the locus of responsibility for cost incurrence is another way to convert noncontrollable costs to controllable costs. Although the most impor- tant decisions affecting costs are made at or near the top of an organization, the further removed these decisions are from where resources are actually used, the less respon- sive the decisions may be to conditions currently existing at that place. An organization in which managers at the top make a relatively high proportion of decisions is said to be centralized; one in which lower-level managers make relatively more decisions is said to be decentralized.

A decentralized organization is one in which a relatively large portion of total costs is control

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