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Cases from Management Accounting PracticeVolume 14 Edited by Paul E. Juras, Ph.D. Paul A. Dierks, Ph.D. Wake Forest University The American Accounting Association (Management Accounting Section) Institute of Management Accountants (Committee on Academic Relations) Published by Institute of Management Accountants 10 Paragon Drive, Montvale, NJ 07645-1760 Claire Barth, editor and compositor Mandel & Wagreich, Inc., cover Copyright ©1998 by Institute of Management Accountants. All rights reserved. IMA publication number 99339 ISBN 0-86641-275-1 Table of Contents Case 1 The Aristocrat Furniture Company Case: Performance Measurement and Business Valuation ............................................................................................................. 1 Case 2 Ciba Specialty Chemicals: Unlocking Significant Shareholder Value........................................ 15 Case 3 Letsgo Travel Trailers: A Case for Incorporating the New Model of the Organization into the Teaching of Budgeting............................................................................................... 33 Case 4 Using EVA at OutSource, Inc. ......................................................................................................... 39 Case 5 (A) RVF Systems Inc. .............................................................................................................................. 45 Case 5 (B) RVF Systems Inc. .............................................................................................................................. 65 Case 6 Evaluating Product Line Performance: The Case of Wellesley Paint ......................................... 73 Addendum to Volume 12, Cases from Management Accounting Practice Destin Rides Again ........................................................................................................................... 79 Cases from Management Accounting Practice Volume 14 1 Case 1 The Aristocrat Furniture Company Case Performance Measurement and Business Valuation Frank C. Evans, CBA, CPA, ABV, American Business Appraisers John H. Evans III, Katz Graduate School of Business, University of Pittsburgh Wethank David M. Bishop, president of American Business Appraisers, Inc., and theparticipants in the14th IMA Management Accounting Symposium, especially Paul Juras, for helpful comments and suggestions. We also thank Margaret Horneand NicoleThibodeau-Morin for excellent research assistance. Family and Business Background Marsten Richardson, president of the Aristocrat Furniture Company, pondered the condition of his family’s business with mixed emotions. Just completing the end of the second genera- tion of ownership, the Richardson family had taken a business started by Marsten’s father, Randolph, and expanded it during the last 60 years into a much larger enterprise, serving the eastern half of the United States. In Marsten’s personal opinion, Aristocrat’s performance to date had been very good. For him, performance was measured in terms of the firm’s historical record of healthy annual profits and the very significant current market value of the business, plus what it had contributed to his family’s wealth and security (see Exhibits 1-1 and 1-2 for income statement and balance sheet data for Aristocrat for the last five years, where H1 is the first historical year, i.e., five years ago; H2 is the second historical year, four years ago; etc.). However, Marsten was aware that Aristocrat’s performance was measured very differ- ently by the firm’s director of operations, Philip Dhurt. Philip relied on a series of nonfinan- cial performance measures, which pointed to a variety of operational weaknesses and raised doubts about whether Aristocrat was really performing so well. In addition, Marsten was also concerned about the increasing competition that Aristocrat faced in all markets, as well as by his lack of a clear blueprint for management succession within the firm. Finally, he was confronting the realization that he might be unable to pass on the business to the next genera- tion of Richardsons, as his father had done. First, there was the competition, particularly Global Corporation, headquartered in Dela- ware. Marsten and his father had carefully followed their attorney’s advice and had patented several processes they had developed that provided higher quality and lower costs in the production of their line of high-quality sofas and chairs. They had also registered their trade- mark and brand names to protect the reputation and customer base that the company had built throughout its history. Global, with its huge volume and market share, had continually encroached on Aristocrat’s processes and designs in a way that Marsten and his father felt were outright theft. They had fought Global in court over this situation for the last eight years, but the cost and attention required to maintain this battle were becoming prohibitive. Copyright ©1998 Institute of Management Accountants, Montvale, NJ 2 Global is a fully integrated manufacturer and distributor of a broad line of dining room, bedroom, and hotel furniture and related products. They have always coveted Aristocrat’s name, products, and reputation because Global has been unable to develop or acquire suit- able products, including sofas, love seats, couches, and chairs, to compete in the high-end home furniture market. Marsten is also concerned about Phoenix Furniture Corporation, for whom he has much more respect. Headquartered in Arizona and about three times the size of Aristocrat, Phoenix produces an excellent line of high-quality products primarily for the office furniture market. Like Aristocrat, they have developed proprietary processes and brand names and have at- tempted to protect them. Marsten Richardson understands, however, that Phoenix wants to expand its product line to include the chairs and couches that are the mainstay of Aristocrat’s product line. Phoenix intends to diversify gradually into the home furniture market and ex- pand geographically to the New England and mid-Atlantic states. Like Aristocrat, Phoenix is a closely held business, a majority of which is owned by the White family. Marsten first met the Phoenix CEO, Harry White, at a trade show more than 30 years ago, and they have kept in touch ever since. One philosophical difference that always separated the two is organized labor. While Aristocrat has employed primarily union labor for the last 30 years, Harry White strongly opposes unions and has never dealt with one even though Phoenix has four locations. Harry has avoided union organizing by having a very open policy on employee relations and strong employee benefits and a profit-sharing plan. While organized labor has never held a dominant position in the furniture industry, particularly in the South and West, employees of many firms in the North and East are repre- sented by unions. Organized labor’s overall decline in the United States during the latter part of the 20th century also occurred in the furniture manufacturing industry. The number of employees represented by unions in that industry has declined from a high of 22% in 1968 to about half of that at present. Global has both union and nonunion shops. And while the total cost for an hour of labor does not vary substantially from Aristocrat to Global or Phoenix, Marsten believes that both Aristocrat and Phoenix have enjoyed lower labor costs as a per- centage of sales because of their more efficient production techniques. Even with a successful history and a loyal customer base, Marsten viewed Aristocrat’s substantial interest-bearing debt as a significant burden for the firm. In addition to the con- tinuing litigation with Global over patent and design infringement, he has seen Aristocrat’s profit margins gradually erode over the last 10 years as competitors have slowly developed competing production technologies and improvements in product design. Aristocrat is threatened even more with a changing market structure and merchandising techniques. They have always sold through major distributors and a network of specialty dealers who handled their high-quality product lines. New merchandising techniques, how- ever, have cut into the market share of both of these distribution channels, rendering each a declining force in sales. Mass merchandisers, home centers, direct mail distributors, and cata- log wholesalers are all growing distribution channels that are becoming increasingly price competitive. Some of the major players in the market are particularly effective at advertising and creating the image that they are the high-quality or low-price leaders when this is not always the case. Aristocrat lacks both the market share and size and the distribution channels to adequately present their message—high product quality, strong customer service and war- ranties, and competitive prices. Aristocrat also faces the continuing disadvantage of Global’s ability to obtain quantity discounts in their purchase of specialty items such as fabrics, hard- 3 ware components, and laminates. In addition, Global’s status as a fully integrated manufac- turer brings them cost savings in raw material commodities such as wood products. Given this series of competitive threats facing Aristocrat, Marsten felt it was essential to track Aristocrat’s progress in meeting the competition. To do so, he had always relied on a combination of overall firm profitability and Aristocrat’s market share data in key markets. Specifically, he followed Aristocrat’s annual market share in its three largest local markets based on trade association data. More recently, Philip Dhurt, director of operations, had con- vinced Marsten to add a series of nonfinancial performance measures in the operations area to his key set of indicators. Philip explained that these cycle time measures would reflect asset efficiency, and that as asset efficiency improved, so would Aristocrat’s financial performance. Besides the issue of competitive threats, Marsten has also recently been forced to recog- nize management succession concerns within Aristocrat. While his oldest of four children, Dudley, is very bright, he has always lacked the ambition and discipline required to excel in an executive position. His second oldest, Penelope, possesses excellent technical skills and entrepreneurial spirit but had personal and philosophical differences with her father. After six years in the family business, she sold her 8% interest back to the company as treasury stock and left five years ago to start her own company, which manufactures a line of specialty furniture products aimed at the restaurant and tavern market. Her firm, known as Pene Company, though small, is now turning a profit and has shown more than 20% sales growth for the last two years. Marsten’s third child, Blakely, is both loyal and ambitious but has demonstrated poor judgment in both personal and business matters. Two years ago he went through a particu- larly acrimonious divorce in which the value of his stock in the company was agreed to be- tween the parties as a trade-off; i.e., Blakely got the shares in the family company and his spouse received other assets of the marriage. Blakely and Dudley both carry the title and salary of vice president at Aristocrat, but neither contributes significantly to the company’s success. The fourth child, Bisby, has been mentally handicapped since birth, and his shares are held in trust for him. The trustee is his sister, Penelope. At 63, Marsten recognizes his need to develop and implement a succession plan for Aristocrat as soon as possible. He was recently diagnosed with prostate cancer, but his doctor assured him that, with proper care and attention, his life was not threatened. His lifestyle, however, was expected to change, and the company’s present lack of executive-level manage- ment was more apparent then ever before. In light of both the competitive and succession concerns, Marsten recently decided to have a valuation of the business performed for strate- gic planning purposes. The valuation was to assess the fair market value of 100% of the vot- ing and non-voting common stock of Aristocrat. Marsten was curious about how an option that he was considering—to sell a tract of land carried on the company’s books at $500,000 but recently appraised at $4 million—might affect the valuation of Aristocrat. The land originally had been been acquired as a site for future development, but its market value had grown so rapidly that this opportunity cost rendered it uneconomical for its original purpose. The company is presently renting it to a retailer and recording the rent as “other income” on the income statement; in 19H5 the rent was $120,000. Through continuing improvements in design and manufacturing processing, the company had developed adequate capacity in their existing facility for the foreseeable future. Ownership of the company at the end of 19H5 (H is for historical and 19H5 is the most recent historical year) was as follows: 4 * Marsten Richardson’s older brother and only sibling who, along with Marsten, first acquired shares in their father’s initial capitalization of the company. Shareholder Voting Stock Non-Voting Stock Total Shares Number % Number % Marsten Richardson 100,000 100.00% 410,000 50.0 510,000 Dudley Richardson 0.00 0.00 80,000 9.56 80,000 Blakely Richardson 0.00 0.00 80,000 9.56 80,000 Bisby Richardson 0.00 0.00 80,000 9.56 80,000 Smedley Richardson, IV* 0.00 0.00 170,000 20.73 170,000 Total shares issued and outstanding 100,000 100.00% 820,000 100.00% 920,000 Treasury stock 0.00 80,000 80,000 Total shares issued 100,000 900,000 1,000,000 Marsten’s wife, Emily, is a very capable associate who has worked with him in the busi- ness for many years without drawing a salary. She is in charge of sales and marketing and has personal contacts with several key accounts that are critical to the company. Although Emily is in good health, she is distraught over Marsten’s health problems and wants to start imme- diately to enjoy the fruits of their many years of hard labor. The company was recently approached by Inverness Investments, a mutual fund with a portfolio of blue chip companies. Inverness occasionally buys a controlling interest in high- growth specialty companies. The management of Inverness have no investment experience in the home furniture industry but were impressed with the information they could gather about Aristocrat. They contacted Marsten three months ago through an intermediary to ex- plore a sale of the company to their mutual fund. Because of his concerns about succession, Marsten had resisted his initial reaction, which was to decline Inverness’ expression of interest. Instead, he instructed his attorneys to pre- pare appropriate nondisclosure agreements and to proceed with an initial exchange of infor- mation. As Marsten pondered his options, including a potential sale of the company, he was continually tempted to maintain his ownership. He had always worked long hours and was uncertain if he could be happy in retirement. Marsten and Emily already owned a vacation home in the South where Emily now wanted to extend their annual vacation from one to six months. Marsten knew he would grow bored. He was also intrigued by Penelope’s success with her new company. He suspected that if they could just learn to get along, she would be an excellent CEO for Aristocrat. Further, he continued to enjoy the challenges associated with important operational deci- sions facing the firm. In fact, he was giving considerable thought to two proposals brought to him by Philip Dhurt, a trusted and long-time member of Aristocrat’s top management team. Philip was known to have an excellent knowledge of the latest operating trends in the busi- ness, plus a knack for exploiting opportunities in imaginative ways. 5 Proposal to Invest in Technology Philip’s first proposal stemmed from his belief that Aristocrat could not maintain its industry position, let alone grow, unless they invested heavily in improved manufacturing and distri- bution technology. Philip was particularly concerned with the recent innovations introduced by Global Corporation in both production and distribution. In a meeting with Marsten, Philip explained the results of a study he had done comparing certain operational features of Global and Aristocrat. The analysis included the following comparative data. Comparison of Global and Aristocrat ($mil) Global Aristocrat Annual sales 1,970.8 72.0 Fixed assets (net) 616.7 22.5 Inventory 425.2 13.3 Total assets 1,255.0 52.3 Net income 146.0 4.7 Order cycle 1.7 days 9.1 days Production cycle 3.1 days 14.8 days Delivery cycle 5.8 days 25.2 days Total cycle 10.6 days 49.1 days Philip’s study found, first, that Global uses a computerized order system that allows their stores to communicate immediately with the factory concerning products in short sup- ply. This system is represented by Global’s much lower order cycle time than Aristocrat’s (1.7 days versus 9.1 days for Aristocrat). This short order cycle time in turn has contributed to their program to reduce inventory. Second, Global uses an innovative production technology in their factories that allows them to minimize the time necessary to convert from production of one product to another. This is reflected in Global’s advantage of a much lower production cycle time (3.1 days versus 14.8 days for Aristocrat). Reducing production setup time in this way again contributes to Global’s inventory reduction program. It enables them to match production closely to de- mand, thereby avoiding the need to carry extensive inventory in their warehouse facilities. Third, Global’s automated technology links their factories to their warehouses and the warehouses to the retail facilities that carry their products. The advantage conferred by this technology is reflected in Global’s shorter distribution cycle time (5.8 days versus 25.2 days for Aristocrat), with the result that Global has less invested in inventory that is in transit between factory and warehouse and warehouse and retail facilities. Philip emphasized to Marsten that Global’s technological superiority in production and distribution was enabling Global to achieve a corresponding advantage in generating returns from operational assets. To counter this advantage, Philip’s proposal called for introducing a “three-day special” program that guaranteed delivery to the retailer or wholesaler within three days of receipt of an order. Philip designed this program based on similar initiatives in the office furniture business segment that he learned about in trade association conventions and publications. His research indicated that for office furniture, the standard lead time had fallen from 20 weeks in the late 1970s to 2–6 weeks in the mid-1990s. Standard lead time is the sum of order placement time, manufacturing time, and delivery time. Some furniture manu- facturers, however, offered premium service in as short a period as two days. For example, 6 Steelcase’s 48-hour special delivery program promises delivery of some 250 products in popular colors and finishes to a specified location within two working days. Philip believed that a corresponding three-day special program for Aristocrat’s sofas and chairs would offer several important advantages. First, it would appeal to retailers who could now tailor their inventory more effectively to the latest trends in customer demand while simultaneously reducing the retailer’s total inventory and related carrying costs. Second, and more important, the three-day special would form part of a flexible manufacturing strategy for Aristocrat in which they would reduce their own overall standard lead time from 42 days to 14 days. The 14-day overall average would include programs such as the three-day special with very short standard lead times, as well as other products with longer lead times, but none would exceed 24 days. Philip saw the great benefit to Aristocrat of the three-fold reduc- tion from 42 to 14 days as being the corresponding increase that it would produce in Aristocrat’s effective production capacity. He believed that even if not all of this increase in capacity would become effective in the first few years, Aristocrat’s effective production capacity would con- servatively be doubled. In turn, Aristocrat’s healthy profit margins would enable the firm to double its net income, thereby earning enough to cover the cost of the investment in flexible manufacturing technology within a relatively short time. More specifically, Philip estimated an investment of $10 million would be required for the flexible manufacturing equipment and related support. In turn, if doubling production capacity produced a proportional increase in revenue, the result would be additional revenue of $70 million. He believed that at Aristocrat’s current profit margin, the addition to the bot- tom line would mean that the investment would pay for itself within two or three years. Philip had studied the innovations made in the office furniture segment of the industry carefully. His conclusion was that the key to competing effectively in the future rested with effective use of technology in production and distribution. Technology promised to enable Aristocrat to do more with the resources it had, and in Philip’s mind, this was the key. He emphasized to his staff that every dollar of Aristocrat’s assets must double its production in sales to meet his targets over the next five years. In turn, these targets were externally gener- ated benchmarks. They were based on where he saw the industry going over the next several years. To help focus production department personnel on the needed improvements in asset efficiency, Philip had devised a series of nonfinancial performance measures. These measures tracked Aristocrat’s progress in generating more sales from its assets. Specifically, Philip be- gan by dividing standard lead time into three components: order time, manufacturing time, and delivery time. Next, each of these major components was further divided into five to 10 major subcomponents. These nonfinancial performance measures were calculated daily and posted prominently in the central operations area of the unit responsible for the measure. Aristocrat employees took the measures very seriously and devoted considerable time and attention to improving them because a growing portion of their pay and bonus was deter- mined by an incentive compensation system tied to these performance measures. After listening to Philip’s first proposal, Marsten was excited at how the projected boost in profitability would help secure Aristocrat’s long-term industry position. At the same time, experience had taught him that Philip’s enthusiasm for operational superiority could some- times cloud his financial judgment. In addition, Marsten had several questions to raise with Philip in their next meeting. First, given what he estimated as a five-fold advantage in total cycle time enjoyed by Global, why didn’t Global have an even greater superiority relative to Aristocrat in generating sales 7 from their assets? Second, Marsten wondered about how well the efficiency focus of the new production and distribution technology would coordinate with Aristocrat’s current market niche at the top end of the furniture market. Likewise, would these changes be compatible with Aristocrat’s unionized labor force, which was suspicious of change and not as techni- cally sophisticated as that of other competitors such as Phoenix or Global? For example, Marsten had seen demonstrations of automated production and distribution in one of Phoenix’s pro- duction hubs, and he was struck by how small in number the labor force was and by how individual production employees appeared very comfortable with a computerized production and scheduling system. In contrast, Aristocrat’s production philosophy historically had been built around a tradition of skilled woodworking with important reliance even today on hand craftsmanship. Finally, would this investment in new technology make Aristocrat more attrac- tive to a buyer if Marsten decided to sell the firm at some point after making the investment? Proposal to Sell the Custom Cabinetry Division While Philip’s first proposal generated excitement and curiosity from Marsten, his second proposal received a much less favorable reaction. Philip proposed that Marsten should sell off Aristocrat’s Custom Cabinetry Division (CD), the original line of business around which the firm was founded. Philip’s proposal emphasized that CD’s financial results had lagged be- hind those of the rest of the firm for at least five years, and its production facility was the oldest in the firm. Further, Philip argued that while Aristocrat’s reputation for quality had originally been established by CD, that had been some 40 years earlier. Today, Aristocrat’s reputation stemmed more from the excellence of its products over a wide range of products and markets, with CD holding no particularly preeminent position. Philip’s second proposal made Marsten uncomfortable for a number of reasons. Most fundamentally, he felt allegiance to his father’s original development of CD. It seemed that selling CD would cut the firm off from its roots and tradition of excellence in its products. Anticipating that even considering such a move would be quite controversial and would raise strong emotions, Marsten and Philip had agreed not to share the idea widely, even among top management. However, Marsten felt that fairness required that he discuss the matter with his son Blakely, who currently was associated with CD. As Marsten expected, Blakely reacted strongly and negatively to the proposal. He ques- tioned Philip’s loyalty to the firm, emphasizing that not being a family member, Philip might be much less reluctant to move to a competitor, perhaps even to the organization that ac- quired CD. At the same time, Marsten was pleased that Blakely’s reaction was not limited to an emotional response. He insisted to Marsten that within a few days he could provide a careful analysis of why selling CD would be a financial mistake. In fact, two days later he called Marsten and arranged to present the results of his study. Marsten was further impressed when Blakely arrived at the meeting with copies of a financial analysis spreadsheet detailing his calculations. Perhaps he had underestimated Blakely’s potential. Blakely began, “Dad, I’ve prepared an analysis of what losing CD would mean to Aristo- crat. To show the effect of losing CD, I’ve compared our actual results for the last five years with what we would have achieved without CD. As you can see, the effect would have been disastrous. Instead of being the fourth-largest firm in the home furniture industry, with a 12% market share, we would have been eighth, with only a 7% market share. Analysts, our cus- tomers, our competitors, and our bankers would see us as a shrinking firm, diminished in importance and relegated to the second or third tier in the industry. Not only that, but our 8 earnings per share would have been an average of 40% less, producing a proportional drop in our stock price.” As the discussion moved into specific details, Marsten was further impressed at Blakely’s ability to provide a careful, objective reconstruction of what losing CD would have done to the firm. For example, Blakely described how the age of CD’s production facility actually worked to Aristocrat’s advantage. Much of the plant and equipment was already fully depre- ciated, and the remainder was close to it, with the result that Aristocrat enjoyed a significant cost advantage via the lower overhead that resulted. Marsten himself had recognized that CD was still profitable, although at a diminished level, but he had apparently underestimated how much CD contributed to the firm’s overall financial health. When Marsten met again with Philip the next day to review Blakely’s case for keeping CD, the primary result was confusion, at least for Marsten. Philip rejected Blakely’s entire analysis, saying that it “couldn’t be more incorrect.” In place of Blakely’s careful spreadsheets that Marsten could follow easily, Philip proposed what he called an “EVA perspective.” Based on the EVA perspective, Philip concluded that operating CD was destroying value for Aristo- crat, despite being profitable. The EVA concept was new to Marsten, and he felt himself begin- ning to agree with Blakely’s suggestion that Philip might have some ulterior motive for trying to persuade Marsten to part with what was obviously a very big part of Aristocrat’s success. Philip attempted to explain that EVA stood for economic value added and that it measured how much value a company created or destroyed in a given year. To do so, it charged the firm a certain cost of capital for all employed capital. Either value was created by generating re- turns beyond the cost of capital, or value was destroyed if the firm’s returns failed to cover the cost of capital. Marsten had difficulty appreciating what EVA added to the usual accounting measure of a firm’s profit. Offers to Purchase Aristocrat Marsten also had to consider Global’s recent preliminary offer to him. In a conversation over dinner with Myrtle Street, president of Global’s dining room furniture division, Marsten learned that Global was concerned about Marsten’s lawsuits over patent infringement. Myrtle admit- ted that Global had not succeeded in matching Aristocrat’s quality or reputation. She ex- plained that Aristocrat’s product line would fit perfectly into Global’s existing product lines, would expand their presence in the high end of the sofa and chair market, and would comple- ment Global’s overall acquisition strategy that had begun several years before. She explained that for these reasons, subject to due diligence, she had been authorized to offer $27 million cash plus assumption of all interest-bearing debt for a 100% ownership interest in Aristocrat. After the sale, Global would assume management of Aristocrat, and Marsten and Emily could retire immediately. Marsten was more comfortable with the discussions that he had recently engaged in with Phoenix CEO Harry White. Their businesses and philosophies were similar in many respects, despite their differences on organized labor. Harry tentatively made an offer of $20 million in Phoenix stock, plus assumption of interest-bearing debt, to acquire the family’s 100% interest in Aristocrat. This agreement would require Marsten to work 10 months per year for three years at a salary of $600,000, with an option to phase out over the following three years at a pro rata salary. In these discussions, Marsten could never secure from Harry a promise that he would not eventually move the company to break the union. Marsten did not believe that Phoenix could achieve many of the integration benefits, synergies, and economies that were available to Global. Phoenix’s primary focus had always 9 been office furniture, so the merged companies would have two distinct customer bases. Fur- thermore, their product lines and production processes were different enough that they did not expect to be able to consolidate operations quickly. Like Aristocrat, Phoenix was strug- gling with the changing merchandising trends in the industry. Even with the acquisition of Aristocrat, they would lack the buying power of Global, and short-term marketing or distri- bution synergies appeared to be limited. Also because Phoenix ran like Aristocrat, they had a thin management structure and, at least in the short term, would have to rely on Marsten’s and Emily’s expertise and contacts. General Economic and Specific Industry Conditions As of the end of 19H5, the economy was moving into the fourth year of an economic expan- sion. Long-term interest rates had been moderate and stable at 8.0% during 19H5, but contin- ued growth and expansion were beginning to place pressure on both short- and long-term rates. Fueling this situation in particular was an anticipation of wage inflation as low unem- ployment created labor shortages in several key markets. Productivity growth had been strong and helped to fuel the expansion of the economy over the last several years. “Busi- ness greed” had been the topic of much debate during last year’s presidential election, and the winning candidate had promised to raise taxes on both high-income individuals and corporations. Aristocrat’s sales followed the residential real estate markets in particular, in which three consecutive years of higher than long-term average growth had occurred. The general con- sensus among economists at the end of 19H5 was that a downturn was to be anticipated. To a lesser extent, Aristocrat’s sales followed consumer durable spending in general. This sector, too, had been strong for several years, and most forecasts suggested that a softening in de- mand should occur in this market in 19F1 (F is for forecasted). The home and office furniture industries had seen a pattern of consolidation among manufacturers over the last five years. For at least 10 years, the industry had experienced excess capacity, which had put continual downward pressure on prices. This situation con- tributed to weak profits throughout the industry and had gradually driven out the marginal performers. As of the end of 19H5, the trend of consolidation had not ended and overall profits remained weak. Profits had benefited from continued technological improvements and general imple- mentation of just-in-time inventory processing. Larger players in the industry were also tak- ing advantage of the emerging distribution channels that tended to be unavailable to the smaller competitors. Brand names such as Aristocrat continued to command strong customer loyalty, particu- larly among the higher-quality product lines. Several of the medium and lower-quality prod- ucts were being converted to a commodity status through the new merchandising and distri- bution patterns, which tended to drive down prices on these products and reward the higher- volume, more efficient manufacturers and retailers. Guidelines for Business Valuation The typical business valuation process requires adjustments as part of the process of deter- mining the entity’s economic performance or benefit stream. Risk drivers and growth factors are key variables that determine the rate of return in the valuation computation. Details of the adjustments, risk drivers, and growth factors for Aristocrat are provided next. 10 Adjustment Issues Marsten’s compensation. Marsten Richardson’s compensation package exceeds market rate. A human resources expert’s research indicated that the total cost of market-rate compensa- tion paid to an arms’-length CEO of a furniture manufacturer the size of Aristocrat over the past five years would have provided the following savings, inclusive of payroll-related bur- dens: 19H1 and 19H2, $500,000; 19H3, $400,000; 19H4 and 19H5, $480,000. Blakely’s and Dudley’s VP compensation. The compensation paid to these two related par- ties is more than market, given their level of competence. A likely buyer would have them report to its executive staff with the expectation that either they would upgrade their perfor- mance or be replaced. These positions are necessary, and the market cost of the positions will be similar to what these two insiders are paid. Litigation expenses (nonrecurring). The company has been spending considerable amounts over the past several years in efforts to stop what it considers to be patent infringements by Global Furniture, Inc. Marsten has indicated a decision was made at the end of last year to stop this litigation to avoid the ongoing costs. This situation may be revisited in the event Aristocrat is not sold. Over the past five years these expenses have been as follows: 19H2, $56,000; 19H4, $224,000; and 19H5, $610,000; in the other two years there were none. Facilities. The building and land are leased on an arms’-length basis at a market rate. The current lease term has two years to go, and there are four five-year options. All options have stipulated terms and conditions, which are reasonable in light of market conditions. Land (nonoperating). The $4 million-valued nonoperating land has been rented out for the following rents: 19H5, $120,000; 19H4 and 19H3, $110,000; 19H2, $95,000; and 19H1, $75,000. Risk Drivers and Rates of Return Sales concentration. Approximately 20% of sales are to one customer, a regional retail furniture chain. The chain is successful and solvent. There is no known reason to believe they will cease doing business with the company; however, the customer is not contractually com- mitted to continue to buy from Aristocrat. (Emily’s relationship with this customer is very strong.) Industry and competition considerations. The industry is concerned about increased foreign competition resulting from the North American Free Trade Agreement and possible similar agreements that would include other developing countries with lower labor costs, lower wood and fabric costs, and fewer environmental/ regulatory costs. (To some degree a merger would increase the acquirer’s ability to meet this challenge as a result of the economies of scale.) Financial condition. The company’s debt is roughly equal to one-third of sales. Rates of return. The following rates of return are as of the appraisal date: • 20-year U.S. treasury bond yield (risk-free rate): 7.00% • Equity risk premium (long-term common stock return in excess of long-term risk-freerate): 6.50% • Small company risk premium: 6.1% The above rates, which total 19.6%, reflect the average market return, adjusted for size. That is, in the long term, small, publicly traded stock has generated a return of 19.6% on average. In addition, factors specific to the subject company that make it more risky must be considered. If the subject company appears to have greater risk than the typical small, pub- licly traded company, the discount rate should be increased accordingly. Assume that an ad- ditional specific risk adjustment factor for Aristocrat is 7.0%. 11 Taxes Assume that Aristocrat’s combined federal and state corporate tax rate is 40%. Growth Factors Marsten Richardson expects that Aristocrat, if it continues without being sold, can achieve a 4% growth rate, roughly equal to inflation. Given the industry’s excess capacity, this expec- tation is consistent with the industry forecasts for the near to intermediate term. It is reason- ably consistent with Aristocrat’s performance over the past five years, during which it has achieved a slightly higher growth rate. This growth rate may become harder to maintain given the competitive challenges previously detailed and the fact that Marsten is getting tired and has health concerns. Aristocrat’s lack of a management succession plan adds to doubts about the company’s growth potential. Case Requirements Performance Measurement and Business Decisions 1. Evaluate Philip’s proposal for Aristocrat to invest heavily in technology. In your analy- sis, you can assume that the operational improvements that Philip envisions are technically feasible. That is, the proposed investments will be able to generate the improvements in the operational measures that Philip emphasizes. However, is this necessarily sufficient to make the investment worthwhile? Pay particular attention to what Aristocrat is likely to be able to achieve from these operational improvements. Are they likely to be able to turn the improve- ments in nonfinancial performance measures into correspondingly positive financial results? 2. Evaluate Philip’s proposal to sell the Custom Cabinetry Division. What do you think of Blakely’s arguments that such a sale would have crippling effects not only on the firm’s profitability but also on its prestige? What is the argument that Philip is apparently making, based on an EVA perspective, to suggest that Blakely’s conclusions are fundamentally flawed? Business Valuation 3. Surveys in the middle and latter part of the 1990s have indicated that business valua- tion is considered among the most important and fastest growing areas of public accounting practice. Increasingly, the profession recognizes the need for management and owners of closely held companies to monitor shareholder value and manage the company to maximize this value. This should be done whether the company is preparing for a sale or simply to enhance value on an ongoing basis. Before management can evaluate acquisition offers made by potential buyers, they must first clearly understand the shareholder’s present position. That is, management must first determine the company’s fair market value on a stand-alone basis before it can properly evaluate its investment value to one or more strategic buyers. This case presents computation of fair market value as the beginning of this process. The income approach to business valuation is based on the theory that the value of a company can be determined by computing the present value of the future returns of that business discounted at a rate of return that reflects the riskiness of the business. While this theory is both simple and convincing, its application is far more complex. The appraiser must first derive the rate of return, which begins with the estimate of a discount rate, usually for the next period’s net cash flow for equity. This rate can then be applied in a multiperiod discount- ing method. Alternatively, a single period capitalization method can be employed, which 12 involves converting a discount rate to a cap (capitalization) rate. The benefit or return stream employed can be other than net cash flow. When a different return stream is used, as illus- trated in this case, which uses net income to invested capital, the rate of return must be ad- justed accordingly. The appraiser most often determines either the value of the equity of the business or the value of the invested capital, which is commonly defined as the interest- bearing debt and equity. In the merger and acquisition setting, buyers and sellers are usually interested in determining the value of the entire enterprise because this is the investment usually sold. This quantity is referred to as “invested capital.” Because invested capital in- cludes both interest-bearing debt and equity, the corresponding return measure is the firm’s weighted average cost of capital. This portion of the case is intended to illustrate the valuation process. Estimate the value of a 100% controlling interest in Aristocrat on a stand-alone basis, i.e., its fair market value without consideration of any possiblesynergies. Likewise, for this part of the case, useonly theoriginal historical financial statement data, i.e., do not consider theoutcomeof the proposals madeby Philip Dhurt. Using the single period capitalization method and net income to invested capital, first develop your estimate of the value of the invested capital of Aristo- crat and then convert this estimate to a value for equity. 4. After having developed your answer to the previous question, answer the following discussion questions: • Why was an asset method not used? • Could the market approach have been used? • Why was net income to invested capital, instead of net income to equity, selected for this assignment? • Why was the single period capitalization method and not a multiyear discounting method selected for computation of this stand-alone value? • Why was the build-up method used to determine the discount rate for equity as op- posed to use of the modified capital asset pricing model (CAPM)? • How should Aristocrat’s real estate, which has a cost basis on the company’s books of $500,000 and an appraised value of $4 million, be handled in the valuation of the com- pany? This real estate has not been used in Aristocrat’s operations and is not expected to be needed in the foreseeable future. General Management 5. Discuss how the management succession issues facing Aristocrat are likely to influ- ence, first, Marsten’s response to the two specific proposals addressed in questions 1 and 2 above and, second, the value of Aristocrat, which is the focus of questions 3 and 4 above. How should Marsten handle the succession issue? 6. Should Marsten’s decision with respect to the two proposals in questions 1 and 2 depend on his decisions with respect to whether to sell the company? If so, in what ways? 13 T H E A R I S T O C R A T F U R N I T U R E C O M P A N Y — S T A T E M E N T S O F I N C O M E F o r t h e H i s t o r i c a l Y e a r s 1 9 H 1 , 1 9 H 2 , 1 9 H 3 , 1 9 H 4 , a n d 1 9 H 5 A l l a m o u n t s s h o w n i n 1 , 0 0 0 s 1 9 H 1 % 1 9 H 2 % 1 9 H 3 % 1 9 H 4 % 1 9 H 5 % A C T U A L S a l e s 4 7 , 2 8 0 1 0 0 . 0 % 5 4 , 6 8 1 1 0 0 . 0 % 6 1 , 5 2 4 1 0 0 . 0 % 6 7 , 9 8 3 1 0 0 . 0 % 7 2 , 0 3 5 1 0 0 . 0 % C o s t o f s a l e s 2 9 , 7 8 6 6 3 . 0 % 3 4 , 9 9 6 6 4 . 0 % 3 9 , 9 9 1 6 5 . 0 % 4 4 , 1 8 9 6 5 . 0 % 4 8 , 2 6 3 6 7 . 0 % G r o s s p r o f i t 1 7 , 4 9 4 3 7 . 0 % 1 9 , 6 8 5 3 6 . 0 % 2 1 , 5 3 3 3 5 . 0 % 2 3 , 7 9 4 3 5 . 0 % 2 3 , 7 7 2 3 3 . 0 % O p e r a t i n g e x p e n s e s 1 0 , 4 0 2 2 2 . 0 % 1 2 , 0 3 0 2 2 . 0 % 1 3 , 2 2 8 2 1 . 5 % 1 4 , 2 7 6 2 1 . 0 % 1 4 , 4 0 7 2 0 . 0 % O p e r a t i n g i n c o m e 7 , 0 9 2 1 5 . 0 % 7 , 6 5 5 1 4 . 0 % 8 , 3 0 5 1 3 . 5 % 9 , 5 1 8 1 4 . 0 % 9 , 3 6 5 1 3 . 0 % O t h e r i n c o m e ( e x p e n s e ) 2 1 2 0 . 4 % 1 8 9 0 . 3 % 2 4 1 0 . 9 % 2 4 8 0 . 4 % 2 6 6 0 . 4 % E a r n i n g s b e f o r e i n t e r e s t a n d t a x e s ( E B I T ) 7 , 3 0 4 1 5 . 4 % 7 , 8 4 4 1 4 . 3 % 8 , 5 4 6 1 3 . 9 % 9 , 7 6 6 1 4 . 4 % 9 , 6 3 1 1 3 . 4 % I n t e r e s t e x p e n s e ( 1 , 8 9 1 ) - 4 . 0 % ( 2 , 0 0 2 ) - 3 . 7 % ( 2 , 1 3 4 ) - 3 . 5 % ( 1 , 9 8 6 ) - 2 . 9 % ( 1 , 8 7 2 ) - 2 . 6 % E a r n i n g s b e f o r e t a x e s ( E B T ) 5 , 4 1 3 1 1 . 4 % 5 , 8 4 2 1 0 . 7 % 6 , 4 1 2 1 0 . 4 % 7 , 7 8 0 1 1 . 4 % 7 , 7 5 9 1 0 . 8 % I n c o m e t a x e s 2 , 1 6 5 4 . 6 % 2 , 3 3 7 4 . 3 % 2 , 5 6 5 4 . 2 % 3 , 1 1 2 4 . 6 % 3 , 1 0 3 4 . 3 % N e t i n c o m e 3 , 2 4 8 6 . 9 % 3 , 5 0 5 6 . 4 % 3 , 8 4 7 6 . 3 % 4 , 6 6 8 6 . 9 % 4 , 6 5 5 6 . 5 % F I N A N C I A L R A T I O S — U N A D J U S T E D C u r r e n t a s s e t s / c u r r e n t l i a b i l i t i e s 2 . 1 5 2 . 1 9 2 . 0 3 2 . 3 8 2 . 2 6 S a l e s / w o r k i n g c a p i t a l 4 . 5 6 4 . 8 1 5 . 7 8 4 . 2 8 4 . 8 0 S a l e s / r e c e i v a b l e s 8 . 3 5 7 . 5 1 7 . 5 6 5 . 8 7 6 . 3 4 C o s t o f s a l e s / i n v e n t o r y 5 . 8 3 6 . 5 3 4 . 8 7 3 . 7 6 3 . 6 2 S a l e s / n e t f i x e d a s s e t s 2 . 3 3 2 . 7 0 2 . 8 0 2 . 9 4 3 . 2 0 S a l e s / t o t a l a s s e t s 1 . 1 1 1 . 2 4 1 . 3 4 1 . 2 7 1 . 3 8 N e t i n c o m e / s a l e s 0 . 0 7 0 . 0 6 0 . 0 6 0 . 0 7 0 . 0 6 N e t i n c o m e / a s s e t s 0 . 0 8 0 . 0 8 0 . 0 8 0 . 0 9 0 . 0 9 N e t i n c o m e / e q u i t y 0 . 2 2 0 . 2 2 0 . 2 3 0 . 2 6 0 . 2 7 I n t e r e s t b e a r i n g d e b t / t o t a l e q u i t y 1 . 2 2 1 . 1 4 1 . 1 0 1 . 3 3 1 . 3 1 5 - y e a r c o m p o u n d s a l e s g r o w t h 1 1 . 1 0 5 - y e a r c o m p o u n d n e t I n c o m e g r o w t h 9 . 4 0 E x h i b i t 1 - 1 14 T H E A R I S T O C R A T F U R N I T U R E C O M P A N Y B A L A N C E S H E E T S E n d o f E n d o f E n d o f E n d o f E n d o f A l l a m o u n t s s h o w n i n 1 , 0 0 0 s Y e a r H 1 % Y e a r H 2 % Y e a r H 3 % Y e a r H 4 % Y e a r H 5 % A C T U A L C a s h a n d m a r k e t a b l e s e c u r i t i e s 5 , 1 5 0 1 2 . 1 % 5 , 3 1 0 1 2 . 0 % 1 , 8 3 0 4 . 0 % 1 , 0 6 0 2 . 0 % 1 4 0 0 . 3 % A c c o u n t s r e c e i v a b l e 5 , 6 6 0 1 3 . 3 % 7 , 2 8 0 1 6 . 5 % 8 , 1 4 0 1 7 . 8 % 1 1 , 5 9 0 2 1 . 7 % 1 1 , 3 6 0 2 1 . 7 % I n v e n t o r y 5 , 1 1 0 1 2 . 0 % 5 , 3 6 0 1 2 . 2 % 8 , 2 2 0 1 7 . 9 % 1 1 , 7 5 0 2 2 . 0 % 1 3 , 3 2 0 2 5 . 5 % O t h e r c u r r e n t a s s e t s 3 , 4 6 0 8 . 1 % 2 , 9 5 0 6 . 7 % 2 , 8 0 0 6 . 1 % 3 , 0 1 0 5 . 6 % 2 , 0 8 0 4 . 0 % T o t a l c u r r e n t a s s e t s 1 9 , 3 8 0 4 5 . 5 % 2 0 , 9 0 0 4 7 . 4 % 2 0 , 9 9 0 4 5 . 8 % 2 7 , 4 1 0 5 1 . 3 % 2 6 , 9 0 0 5 1 . 4 % F i x e d a s s e t s 3 0 , 5 6 0 7 1 . 7 % 3 2 , 2 3 0 7 3 . 1 % 3 5 , 6 5 0 7 7 . 8 % 3 7 , 7 9 0 7 0 . 8 % 3 7 , 6 4 0 7 1 . 9 % L e s s : a c c u m u l a t e d d e p r e c i a t i o n ( 1 0 , 2 3 0 ) - 2 4 . 0 % ( 1 1 , 9 6 0 ) - 2 7 . 1 % ( 1 3 , 7 1 0 ) - 2 9 . 9 % ( 1 4 , 6 9 0 ) - 2 7 . 5 % ( 1 5 , 1 2 0 ) - 2 8 . 9 % N e t f i x e d a s s e t s 2 0 , 3 3 0 4 7 . 7 % 2 0 , 2 7 0 4 6 . 0 % 2 1 , 9 4 0 4 7 . 9 % 2 3 , 1 0 0 4 3 . 3 % 2 2 , 5 2 0 4 3 . 0 % O t h e r a s s e t s 2 , 9 0 0 6 . 8 % 2 , 9 0 0 6 . 6 % 2 , 9 0 0 6 . 3 % 2 , 9 0 0 5 . 4 % 2 , 9 0 0 5 . 5 % T o t a l a s s e t s 4 2 , 6 1 0 1 0 0 . 0 % 4 4 , 0 7 0 1 0 0 . 0 % 4 5 , 8 3 0 1 0 0 . 0 % 5 3 , 4 1 0 1 0 0 . 0 % 5 2 , 3 2 0 1 0 0 . 0 % A c c o u n t s p a y a b l e 5 , 9 6 0 1 4 . 0 % 6 , 4 5 0 1 4 . 6 % 6 , 8 8 0 1 5 . 0 % 7 , 8 7 0 1 4 . 7 % 8 , 1 4 0 1 5 . 6 % A c c r u e d p a y a b l e s 3 , 0 6 0 7 . 2 % 3 , 0 9 0 7 . 0 % 3 , 4 6 0 7 . 5 % 3 , 6 4 0 6 . 8 % 3 , 7 6 0 7 . 2 % T o t a l c u r r e n t l i a b i l i t i e s 9 , 0 2 0 2 1 . 2 % 9 , 5 4 0 2 1 . 6 % 1 0 , 3 4 0 2 2 . 6 % 1 1 , 5 1 0 2 1 . 6 % 1 1 , 9 0 0 2 2 . 7 % L o n g - t e r m d e b t 1 8 , 4 9 0 4 3 . 4 % 1 8 , 4 3 0 4 1 . 8 % 1 8 , 6 3 0 4 0 . 7 % 2 3 , 9 3 0 4 4 . 8 % 2 2 , 9 1 0 4 3 . 8 % T o t a l l i a b i l i t i e s 2 7 , 5 1 0 6 4 . 6 % 2 7 , 9 7 0 6 3 . 5 % 2 8 , 9 7 0 6 3 . 2 % 3 5 , 4 4 0 6 6 . 4 % 3 4 , 8 1 0 6 6 . 5 % C o m m o n s t o c k 4 , 8 0 0 1 1 . 3 % 4 , 8 0 0 1 0 . 9 % 4 , 8 0 0 1 0 . 5 % 4 , 8 0 0 9 . 0 % 4 , 8 0 0 9 . 2 % R e t a i n e d e a r n i n g s 1 1 , 1 0 0 2 6 . 1 % 1 2 , 1 0 0 2 7 . 5 % 1 2 , 8 6 0 2 8 . 1 % 1 3 , 9 7 0 2 6 . 2 % 1 3 , 5 1 0 2 5 . 8 % T r e a s u r y s t o c k ( 8 0 0 ) - 1 . 9 % ( 8 0 0 ) - 1 . 8 % ( 8 0 0 ) - 1 . 7 % ( 8 0 0 ) - 1 . 5 % ( 8 0 0 ) - 1 . 5 % T o t a l e q u i t y 1 5 , 1 0 0 3 5 . 4 % 1 6 , 1 0 0 3 6 . 5 % 1 6 , 8 6 0 3 6 . 8 % 1 7 , 9 7 0 3 3 . 6 % 1 7 , 5 1 0 3 3 . 5 % T o t a l l i a b i l i t i e s a n d e q u i t y 4 2 , 6 1 0 1 0 0 . 0 % 4 4 , 0 7 0 1 0 0 . 0 % 4 5 , 8 3 0 1 0 0 . 0 % 5 3 , 4 1 0 1 0 0 . 0 % 5 2 , 3 2 0 1 0 0 . 0 % E x h i b i t 1 - 2 15 Case 2 Ciba Specialty Chemicals: Unlocking Significant Shareholder Value This casewas prepared by Professor Leif Sjöblom as a basis for class discussion rather than to illustrate either effective or ineffective handling of a business situation. The spin-off of Ciba Specialty Chemicals is already energizing the organization, encourag- ing entrepreneurial behavior and increasing our competitiveness. We believe that we are creating optimal conditions for sustained success. Dr. Rolf A. Meyer, Chairman On March 6, 1996, Ciba-Geigy and Sandoz announced a surprise merger that created the world’s second-largest life sciences conglomerate, Novartis. With SFr36 billion in sales and SFr100 billion ($83 billion) in market value, this was the world’s biggest merger. To many employees of Ciba’s industrial sector, the announcement came as a shock. Ciba-Geigy had underperformed the Swiss stock market for several years. But since the company was considered conservative, nobody ex- pected a move as drastic as a merger with archrival Sandoz. In the months after the merger, initial disbelief gradually gave way to cautious optimism. In the largest corporate spin-off ever, Ciba’s industrial sector would become an independent com- pany, with annual sales of SFr6.7 billion. The new company would focus on the specialty chemi- cals market, its core business; Novartis would be a pure “life sciences” company. For Ciba Spe- cialty Chemicals people, the prospects of an independent company were a source of anxiety and motivation. In 1997, with Ciba SC completely on its own, chairman Dr. Rolf Meyer and CEO Dr. Hermann Vodicka faced both opportunities and challenges. After the spin-off from Novartis, Ciba SC was left with a strong product portfolio and an excellent market position but, historically, a mediocre financial performance. Ciba SC’s 7.5% operating profit margin fell way short of the 15% industry benchmark, and only two of the five divisions earned their cost of capital. The SFr8 billion market value of the new company (right after the spin-off) could be justified only by a major restructur- ing, cost cutting, and aggressive growth to regain market share lost through past inappropriate strategies. Completely new structures had to be put in place, and the company needed to position itself in the market. Still, on the up side, Ciba employees were energetic, proud, and motivated. The Specialty Chemicals Industry Specialty chemicals are complex chemicals of medium to high value. They typically are sold in small quantities to industrial buyers. Many are patent protected, although that share is de- creasing. Usually, they are key intermediate components of a wide variety of consumer and in- dustrial products. Specialty chemicals give specific properties and enhance the performance of thousands of products such as detergents (whiteners), toothpaste, colors in fashion items, paint, and almost every item made of plastic. Thus, although most consumers are not aware of it, spe- cialty chemicals are part of our everyday life. Because of this, pricing and volume are driven by end-user applications rather than by the general economic environment. Copyright ©1997 by IMD–International Institute for Management Development, Lausanne, Switzerland. All rights reserved. Not to be used or reproduced without written permission directly from IMD. 16 Ciba Specialty Chemicals is organized into five divisions. Two of them are turnaround busi- nesses. Each division is a global market leader in its chosen field. However, although the divi- sions have superior products and very high market shares, their financial performance has been weaker than that of their competitors. (See Exhibit 2-1 for details of the strategy and competitive position of the divisions.) The divisions were: • Additives. This was the most successful of Ciba's divisions, bringing in about 50% of the contribution. The key challenge was to defend its margins and its strong market position. • Pigments. With the exception of 1996, this division also performed very well. • Performance Polymers. After a problem year in 1991, restructuring had improved the situa- tion. The turnaround was almost achieved, and the division was now a strong performer whose main challenge was to maintain growth and further improve performance. • Consumer Care and Textile Dyes. After difficult years in 1993–95, the turnaround of these divisions was well underway. The Old Ciba and the New Ciba The Ciba SC management team remembered “old Ciba” fondly. Though it could be argued that the company acted conservatively and resisted radical moves, it had been very successful. It had had a very strong culture—people joined the company, became part of the culture, and stayed until retirement. The challenge was clear: Preserve Ciba’s good aspects, avoid the old limitations. The major problem with old Ciba had stemmed from its diversification. The company’s business portfolio had gotten so big and broad that it lacked focus. And decision making was slow. The specialty chemicals business was practically a Cinderella story—long neglected, it had not been allowed to reach its potential. Chemicals had been only one small piece of a large busi- ness portfolio dominated by Pharmaceuticals. The Pharma division, with its history of high prof- its, had always received more capital and management attention than the highly competitive specialty chemicals business, with its history of lower margins and several turnarounds. Clearly, the primary role of the industrial sector had been to provide cash to fuel further Pharma growth. This left little capital or management attention to develop the chemicals business. Since Ciba’s core business was Pharma, all the systems, objectives, and performance evalu- ations had been inherited and revamped, rather than tailored to the needs of the chemicals busi- ness. Lines of responsibility were fuzzy. Decision making was slow, since most of the business units lacked a direct channel of communication to top management and large central units were responsible for key business processes. Working capital and fixed assets were at typical Pharma levels but way above the levels appropriate for industrial products. The company was neither performance oriented nor fast to react. At the same time, the industry was becoming more and more competitive. One senior executive described the situation this way: You could do things if you wanted to make things happen, but the fact is that very few did. And there were no direct and visible consequences of lack of performance. Mediocrity was tolerated for far too long, and this diluted people’s interest in excelling. A lot more energy was available, and people were ready to give a lot more, but we had no systems in place to encourage it. Mr. Franz Gerny, head of Human Resources, saw these challenges for the people: We want to keep the good aspects of old Ciba. However, in certain areas we must be tougher. People who don’t deliver and who don’t get results do not belong in the new company. 17 In the past, we didn’t walk the talk. We didn’t react quick enough, when younger people where looking for more challenge. Now we need to learn to fight harder—not to find ex- cuses for not reaching an objective. The Shareholder Value Strategy For several years, Ciba-Geigy’s position in the pharmaceuticals industry had been sliding. The company had underperformed the stock market and its peers. A strategic review, based on the shareholder value concept (see Figure 2-1), 1 had already been initiated by Chairman Rolf Meyer several years before the merger. The review had shown that several of Ciba’s businesses seemed to be undervalued by the market. To close the “perception gap” and provide a fair and full valu- ation, the company had aligned itself more closely with shareholders’ needs and increased disclo- sure; this included switching to international accounting standards. Figure 2-1. McKinsey Framework for Shareholder Value Creation Current market value Company value as is Potential value with internal improvements Potential value with internal and external improvements Optimal restructured value Strategic and operating opportunities Perception gap Disposals and acquisitions Financial engineering Source: Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing theValueof Companies, 2nd ed., New York: John Wiley & Sons, Inc., 1996. This was not enough, however, to sway the investors. Ciba still underperformed the market. And shareholders still perceived the business portfolio as too broad and the company as unfo- cused. The market clearly preferred focused businesses, and Sandoz had been rewarded for its decision to spin off Clariant, their specialty chemicals business, in 1995. Before the merger with Sandoz, the estimated shareholder value benefits from breaking up the business portfolio and managing the units as separate, focused businesses were estimated at several billion Swiss francs. The decision to spin off the specialty chemicals business had already been made before the merger. (See Exhibit 2-2 for stock market reactions to the merger.) 1 A company is creating shareholder value if its after-tax operating return is higher than its cost of capital. A number of investment banks estimated Ciba’s WACC (weighted average cost of capital) to be approximately 7% (see Ex- hibit 2-1 for examples). 18 After the merger and subsequent spin-off, Ciba Specialty Chemicals was expected to create additional shareholder value by streamlining operations and by gaining focus due to managing a homogeneous business. Geographic expansion and new product development would bring the newly focused business faster and more profitable growth. Now, after the divorce, Ciba was in the unique position of being able to start with a clean slate, in effect, to create from scratch the optimal structures and conditions for success. Organizing for Shareholder Value Old Ciba had both strong divisions and strong corporate headquarters, but the final word always rested at HQ. It was a “grown” structure that had evolved before shareholder value thinking. Some people advised us to “copy the old structure and reorganize afterward.” That would have been the easy way out, but it would have been a mistake. The basic principle is simple: We want to simplify the structures to create more focus. First, a job should always get done at the right place, where it makes the most sense. Second, we should avoid the trap that we centralize too much, and the divisions lose their ability to run the business. Third, we need to use synergies—but only where they really exist. Dr. Michael Jacobi, CFO Like old Ciba, the new organization had five divisions. The old organization had been func- tional, with partly centralized R&D and purchasing and shared manufacturing, but now the divi- sions were fully accountable for strategy, R&D, marketing, and the whole supply chain, includ- ing purchasing. Moving Ciba away from their old product management focus, the new structure created fully integrated, segmented business units (see Figure 2-2 and Exhibit 2-3). Figure 2-2. Organization of Ciba Specialty Chemicals Additives Pigments Performance Polymers Consumer Care Textile Dyes 16 Geographic Regions Shared services Research Board Customer Value Board (Key account management) Manufacturing council Supply chain council Source: Ciba company document. The business support functions also went through a major change, based on an efficient “shared services” concept. The country organizations, with 72 country heads, were replaced by 16 regional presidents. Group services would be provided from 14 regional business support centers. Costly duplications in finance, IT, HR, and administration were avoided. In IT, for ex- ample, 25 people now performed a broader array of tasks than 170 people had before. Common accounting and the introduction of shared computer systems supported the structure. The objective of the new organization was simple: a clear distribution of tasks, driven by efficiency, while maintaining the local know-how. Dr. Jacobi commented: 19 We want to avoid unproductive discussions about who does what and who pays. The old planning and reporting process was very complex. We spent lots of energy fighting internal cost allocations. For example, one-third of our mainframe capacity was used for calculating internal charges. On the other hand, there was also too much duplication in execution. Our new structure is based on very standardized systems, clear interfaces, but, most impor- tantly, on a clear definition of responsibilities and execution tasks. We simplified the structure because we just could not afford the old structure…this type of change was long overdue, and the reaction was very positive. But we had the right people, and we were able to make the most of the situation. Corporate Functions and Cross-Divisional Coordination The common view was that the new organization would centralize only what made sense, i.e., treasury and accounting, backbone IT services, legal services, investor relations, and commu- nications. The central organization would be less powerful than in Ciba-Geigy, and the level of service would match what the business could afford. In the view of Ciba management, centralization was bad, but a coordination of central com- petencies made sense. To achieve the benefits of a more centralized organizational structure, without jeopardizing divisional accountability, cross-divisional coordination and synergies would be cap- tured by a Research Board, a Manufacturing Council, a Supply Chain Council, and a Customer Value Board. For the Research Board, the underlying principle was that the divisions closest to the cus- tomer would develop the products, but the company would own the technologies and competen- cies. The Research Board would ensure that skills, know-how, and experience were available and shared and would assess research projects and the global project portfolio and provide due long- term R&D perspective. The Manufacturing Council would coordinate a site strategy, capacity utilization, and capi- tal expenditure. The Supply Chain Council would identify and exploit synergy between divi- sions—for example, by sharing development work and best practice, providing competence cen- ters, and sharing transport or warehousing. The Customer Value Board would be concerned with key account management systems, the optimal deployment and motivation of the sales force, customer satisfaction benchmarking, and best practice marketing tools and database marketing. Considerable cross-divisional coordination was also needed in marketing, particularly in key account management. The role of the regional organization was to integrate the activities of the divisions in a certain market. Brendan Cummins, regional president in China, put it this way: In China, in the old Ciba-Geigy, we used to have nine divisions constructing or managing 11 joint ventures. Because we were operating in divisional silos, we lost many opportuni- ties. We need much stronger coordination and experience sharing, particularly in develop- ing countries. We are one company, and we want to present only one face to government and our stakeholders. Positioning the New Company Despite the high emphasis on divisional autonomy, Ciba wanted to harness the benefits of a unified corporate image: one company, one vision, one identity. This corporate identity would create recognition in world markets, support business processes, raise the profile and enhance the perceived value of Ciba, and distinguish it clearly from the old company. Like many of the other changes taking place at the time, the new Ciba Specialty Chemicals vision—deliver value, perform to win, and shape the future—was created by a very small team in record time. The company’s new slogan, “value beyond chemistry,” reinforced the idea that from 20 now on, future business drivers would be excellent products plus all the things that contributed to customer value (see Exhibit 2-4). During its long history, the Ciba brand name had established a very strong position in the market. As one customer remarked, “I perceive Ciba to mean high quality and outstanding ser- vice.” Another said, “Ciba is a label, and we trust this label because we know what the Ciba quality is worth. That’s very important.” The strength of the bond Ciba had established with its main customers showed that the Ciba brand had considerable brand value that would translate into shareholder value. So the Ciba name was kept. But to differentiate Ciba from other compa- nies and to express the strengths and values of the new company, a new visual identity was conceived—a butterfly (see Exhibit 2-5). Ciba’s positioning was very well received among customers, investors, and employees. Brendan Cummins said: For the first time, we have a name, a vision, and clear systems aligned to support the busi- ness strategy. The new mission is focused, punchy, and conveys a specific message. It will be THE driving force of the culture of the new company. It was a tremendous boost to morale when we found out that we could retain the name of Ciba. Most employees felt that Ciba stood for something. This was especially the case in China, where we had a strong brand name and more than 100 years of tradition. And the butterfly met with unexpected positive response from the customers. Everyone is visually impacted by the new symbol. For our employees, it is indicative of the new culture—it is light and quick. Financial Incentives To link management with shareholder interest, Ciba came up with an innovative compensa- tion package. The base salary was set at or below the average market level. In certain cases, this resulted in a lower fixed salary for some managers. A short-term incentive plan for the top 700 people moved the total compensation to the upper 25 industry percentile if certain shareholder- oriented targets such as sales growth and operating profits were met. The executive committee and board members had to join a leveraged executive asset program (LEAP). They had to make a commitment to invest one year’s salary in Ciba stock and hold on to it for at least five years. Stock options provided upside leverage if the share price increased, but any downside risk was as- sumed by the individual. The share plan was offered on a voluntary basis, and with a smaller amount, to an additional top 250 executives, of whom 99% subscribed to the plan. In addition, to motivate the workforce, each of the 20,000 people working for the company received one free “virtual” share. Additives: The Flagship Division In 1996, the Additives division was Ciba’s flagship, contributing almost 50% of the profits. Only 35 years old, it was Ciba’s youngest division. With a dominant market position, the key challenge was to retain market share and profitability. Division head Dr. Reinhard Neubeck commented: Traditionally we have had very good products—all patent protected—that have sold them- selves. We had almost a monopoly until the early 1980s. We produced products, not focus- ing too much on marketing and PR. The customers perceived us as arrogant. Today, this has all changed. We still have excellent, innovative products, but only 30% of our products are patent protected. Consequently we are now much more proactive and more aggressive in the market. 21 The future drivers of value were expected to come from end-user applications developed closely with customers. Technical customer services and consultative selling were going to be critical to understanding the end user’s needs. The globalization of the customers was going to require focused account teams, wide geographic reach, and a wide range of products. With prod- uct life cycles getting increasingly shorter, time to market was now critical. Ciba SC needed to move from a tradition of sequential product innovation to a concurrent, but financially more risky, product development process. Consumer Care and Textile Dyes: The “Turnaround” Divisions The two “turnaround” divisions, Consumer Care and Textile Dyes, were expected to gener- ate increased profits and shareholder value. In Consumer Care, the appointment of Dr. Martin Riediker had already heralded the turnaround: This is simply an old business with a new focus. The old Chemicals division was the left- over of all the other divisions—all the pieces that nobody else wanted. What does it mean to be a chemicals division in a chemicals company? The first step was to choose a name that describes the future—not what we are today. Now people realize that there is a different future for our division. Consumer Care was reorganized into business segments with responsibility for product and production-related strategies and assets, including R&D, production, marketing, supply chain management, and four business areas responsible for sales. This reorganization provided new focus and a new identity by breaking out of traditional markets and segments. All we did was to open up space and provide a window of opportunity by moving the necessary resources to the point where people are accountable. The energy was already there, and we just had to release it. The restructuring of the mature and very fragmented Textile Dyes business had already started with the appointment of Dr. Jean-Luc Schwitzguébel as division head in 1995. The basic problems were an obsolete, reactive business structure that wasn’t driving the business forward, too many products, underutilized capacities, and a lack of momentum due to market share losses. Most management practice is based on cost control. It is true that we cannot be in business if we don’t have the right cost structure. However, we lost SFr300 million in sales between 1993–95, and there is no way we could reduce cost that fast. Instead, we need to focus on growth and new business development. Everything is driven by revenue. The old Ciba, with its pharma mentality, had always followed a premium pricing strategy. But although Textile Dyes’ products and technical service were excellent, customers were no longer willing to pay a premium. Costs were too high, and asset utilization was too low. A certain technical arrogance had ensued from the company’s being in a leading market position so long. In addition to the necessary cost cutting, the new organization unleashed the sales people and created a clear focus on selected core segments. Prices were reduced to reflect a competitive, value-based pricing strategy, and a major product development program was initiated. As a re- sult, 60 new products had been introduced in the last 12 months, while unattractive product lines had been eliminated. The Future On June 10, 1997, Ciba SC’s stock price reached SFr140. The share price reflected shareholders’ expectations of significantly higher future profits (see Exhibit 2-6). To live up to these expecta- tions, Ciba had to grapple with a number of challenges. 22 First, above-average growth would not be achieved with a traditional product management approach. Ciba wanted to enter the market segments where research mattered, which meant becoming much more focused on innovation. To be on the leading edge, one must either be faster than competitors or develop more patents. According to CEO Dr. Hermann Vodicka, a key chal- lenge was to manage the product portfolio effectively in a constantly changing environment. Second, the industry was expected to undergo major changes. As a supplier to many compa- nies that ultimately created and marketed branded consumer products, Ciba SC’s business was affected by consumer trends. Consumers expected increasingly higher quality at lower prices. At the same time, the global retailers were becoming increasingly powerful. Ciba’s major clients, the consumer goods producers, were putting increasing pressure on their suppliers to deliver value. As an alternative to a protection approach (i.e., patents), Ciba could respond by “co-branding.” Ciba already had limited branding experience with its Araldite products. Several other products, such as the UV protection fabric finish, had very high potential for being branded. However, retailers generally disliked “too many labels,” and Ciba had neither the experience nor the adver- tising budgets to support a major brand. The third challenge was that the battle was likely to move into emerging markets, such as Asia, that had an altogether different cost structure and philosophy. Ciba had already moved some activities, such as formulation, to these markets. 2 However, with the customer base becom- ing ever more global, both opportunities and risks were looming. Ciba Specialty Chemicals intended to address these challenges within the shareholder value framework. The balance sheet was strong, and the spirit was high. Meanwhile, the stock price kept rising, and expectations in the capital markets kept going up. 2 Formulation is the step after the chemical synthesis where customer-specific products are created. 23 Exhibit 2-1. Ciba’s Position in the Chemicals Industry A. Top Ten Chemical Companies in 1996 1996 Sales in US$ billions 0 5 10 15 20 25 30 35 40 D u P o n t H o e c h s t B A S F B a y e r D o w R h ô n e - P o u l e n c I m p e r i a l C h e m . M i t s u b i s h i C h e m i c a l s A k z o N o b e l N o r s k H y d r o B. Top Fifteen Specialty Chemicals Companies in 1996 1996 Sales in USD billions 0.00 1.00 2.00 3.00 4.00 5.00 6.00 C l a r i a n t - H o e c h s t C i b a S C B A S F A k z o N o b e l B a y e r D a i n i p p o n R o h m H a a s S o l u t i a ( M o n s a n t o ) W . R . G r a c e E a s t m a n C h e m i c a l s D o w C o r n i n g G r e a t L a k e s H e r c u l e s M o r t o n D S M Source: “The Fortune Global 5 Hundred Ranked Within Industries,” Fortune, August 4, 1997, p. F-16. Chart includes specialty chemicals sales only. Clariant and Hoechst merged their operations in 1997. Source: Kerri A. Walsh and Andrew Wood, “Specialties New Lineup,” Chemical Week, April 30, 1997, pp. 37–48. 24 E x h i b i t 2 - 1 ( c o n t i n u e d ) S o u r c e : I M D a n a l y s i s o f C i b a p r o s p e c t u s . 25 Exhibit 2-2. Stock Market Reaction to Ciba-Sandoz Merger A. Stock Market Reaction to Merger 500 700 900 1100 1300 1500 1700 1900 2100 1 / 9 5 4 / 9 5 7 / 9 5 1 0 / 9 5 1 / 9 6 4 / 9 6 7 / 9 6 1 0 / 9 6 1 / 9 7 4 / 9 7 Ciba bearer Sandoz bearer Novartis bearer Index merger announced B. Shareholder Value Created by Spin-Off of Ciba Specialty Chemicals 1400 1500 1600 1700 1800 1900 2000 2100 2200 3 . 1 . 9 7 3 1 . 1 . 9 7 2 8 . 2 . 9 7 1 . 4 . 9 7 3 0 . 4 . 9 7 2 6 . 5 . 9 7 CSC+Novartis Novartis Index Start of premarketing Price range announced First day of rights trading Shareholder value Source: Public Information (Swiss Stock Exchange). 26 Exhibit 2-3. The New Organization Divisions: • strategy • marketing • production • R&D • purchasing • supply chain management • communication Regions: • sales • communication • representation • information technology • finance • legal structures • safety • environment Corporate: • global portfolio strategy • acquisitions • treasury • communication • safety • environment • legal services Old structure • divisions • geographic countries • corporate services “large risk of duplication” • strong independent divisions • strong corporate checking • grown structure • clear focus on product management • slowness New structure • divisions • geographic regions • limited corporate services “only what makes sense” One company One team One chance • green field approach • clear focus on our needs • speed 27 Exhibit 2-4. Mission Statement Deliver Value: We deliver value for customers, employees, and shareholders. Value is created through innovation, productive relationships with customers, and speed and simplicity in every- thing we do. We achieve this in balance with our responsibilities to society and the environment. Perform to Win: We appreciate and recognise competence and performance. As empowered in- dividuals and teams in a networked company we focus on results. The perceptions and actions of our stakeholders are crucial for our success. We want to win by being their partner of choice. Shape the Future: We shape the future of our company and industry. We take the initiative and make things happen, always embracing change as a source for new opportunities. Innovative, entrepreneurial and action-oriented Committed to customers and operational excellence Respect the environment Deliver value beyond chemistry to maximize valuation Embrace change as a source of new opportunities Excel in competence and performance Create and support an inspiring team work environment The leading global specialty chemicals company Our Direction: We have a strong global operational basis with target-oriented initiatives in place and a high level of customer orientation. We have a worldwide network of excellent, motivated people and management whose compen- sation is linked to target achievement. We will continuously measure progress against the best in class and improve our business. While we are determined to reduce our asset base and cost structures, we will outgrow our mar- kets with innovative products geared to create value for our customers. All divisions have committed to outperform their competitors. Source: Ciba company documents. 28 The Power of Transformation We have chosen the butterfly as our new symbol because it is a vivid and universal symbol which immediately differentiates Ciba Specialty Chemicals from all other companies. It expresses our unique strengths, character, values and products on many levels. It offers endless possibilities for interpretation to reflect our evolution over the years ahead. The butterfly is widely regarded as a symbol of transforma- tion. As such, it is a particularly appropriate symbol for a company that has just emerged in new form—and which will continue to trans- form itself to meet changing needs. Despite its apparent fragility, the butterfly lives in most parts of the world and travels vast distances across continents. It is light but strong at the same time. The universality of the symbol repre- sents Ciba Specialty Chemicals’ presence around the world. The five colors symbolize the five divisions of Ciba Specialty Chemicals all acting together towards one goal, one vision with one corporate culture. By adopting a colorful image, we will communi- Exhibit 2-5. The Power of Transformation 29 E x h i b i t 2 - 6 . A . H i s t o r i c a l F i n a n c i a l S o u r c e : C i b a c o m p a n y d o c u m e n t s . 30 Exhibit 2-6 (continued) B. Divisional Financial Performance Source: Ciba company document. DIVISIONAL DATA 1991 1992 1993 1994 1995 1996 First half, 1997 Sales: Additives 1,980 2,066 2,097 2,222 2,067 2,065 1,184 Consumer Care 1,269 1,297 1,295 1,216 1,081 1,108 590 Perf. polymers 1,301 1,303 1,245 1,238 1,239 1,322 797 Pigments 945 1,046 1,074 1,091 1,026 1,073 657 Textile Dyes 1,421 1,423 1,419 1,316 1,083 1,173 729 Total 6,916 7,135 7,130 7,083 6,496 6,741 3,957 Op. profits (EBIT) Additives 376 453 438 346 194 Consumer Care 155 110 28 50 63 Perf. polymers 54 74 135 75 91 Pigments 158 188 186 122 107 Textile Dyes 103 3 (36) 40 73 Corporate (358) (265) (252) (132) (51) Total 488 563 499 501 477 Net oper. assets Additives 2,274 2,141 2,072 ND 2,345 Consumer Care 1,377 1,286 1,197 ND 1,139 Perf. polymers 1,265 1,215 1,147 ND 1,460 Pigments 1,189 1,182 1,227 ND 1,518 Textile Dyes 1,918 1,736 1,570 ND 1,619 Shared op. assets 805 772 874 ND 744 Total op. assets 8,828 8,332 8,087 ND 8,825 Non-operating assets 1,244 1,283 1,284 ND 1,393 Total assets 10,072 9,615 9,371 ND 10,218 Depreciation (amortization) Additives 115 110 108 118 60 Consumer Care 73 78 87 71 32 Perf. polymers 89 53 61 52 27 Pigments 65 53 55 60 26 Textile Dyes 95 91 80 71 35 Non-divisional 59 28 7 12 53 Total 496 413 398 384 233 Capital expenditure Additives 169 124 126 144 47 Consumer Care 75 72 69 62 22 Perf. polymers 67 69 60 95 37 Pigments 87 74 111 166 67 Textile Dyes 120 78 68 71 31 Non-divisional 38 51 28 21 16 Total 556 468 462 559 220 Personnel Additives 4,254 4,366 4,379 ND ND Consumer Care 3,813 3,997 3,886 ND ND Perf. polymers 2,811 2,893 2,933 ND ND Pigments 2,838 2,896 2,959 ND ND Textile Dyes 5,519 4,954 4,586 ND ND Corporate 4,684 4,799 4,589 ND ND Total 23,919 23,905 23,332 ND ND R&D expenditure Additives 87 94 99 111 ND Consumer Care 42 47 45 37 ND Perf. polymers 64 63 59 56 ND Pigments 34 37 41 44 ND Textile Dyes 48 46 43 49 ND Corporate 26 28 26 28 ND Total 301 315 313 325 ND ND = not disclosed 31 BENCHMARK DATA: Ciba SC versus Clariant (before merger with Hoechst) Clariant Ciba SC 1994 1995 1996 1994 1995 1996 Sales (CHF millions) 2,333 2,145 2,337 7,083 6,496 6,741 Op. profit (EBIT) 214 211 235 563 499 501 Net income 103 106 133 352 305 311 Total Assets 2,441 2,406 2,774 9,615 9,371 10,023 Equity 959 923 1,115 5,041 4,886 4,389 Personnel 8,678 8,410 8,554 23,905 23,332 ND Sales growth -5.0% -8.1% 9.0% -0.7% -8.3% 3.8% Gross profit % 37.9% 39.0% 37.9% 37.1% 36.6% 36.4% Operating profit % 9.2% 9.8% 10.1% 7.9% 7.7% 7.4% Sales/Assets 0.96 0.89 0.84 0.74 0.69 0.67 ROE 10.7% 11.5% 11.9% 7.0% 6.2% 7.1% Mkt costs (% of sales) 20.3% 20.1% 19.2% 10.5% 10.8% 10.9% Admin (% of sales) 5.7% 5.9% 5.9% 14.2% 13.3% 13.3% R&D (% of sales) 3.2% 3.2% 2.7% 4.4% 4.8% 4.8% Labor (% of sales) 24.9% 24.5% 23.3% 27.3% 29.9% ND Capex (% of sales) 5.1% 4.2% 4.2% 5.8% 6.8% 8.0% Working capital (% of sales) 42.5% 49.6% 49.5% 35.9% 39.6% 45.9% - inventory (days) 177 188 164 155 180 177 - accounts receivable (days) 73 74 86 63 63 73 - accounts payable (days) 51 45 45 107 114 140 Sales growth Q1/97-Q1/96 (in local currencies): - Clariant + 11 % - Ciba SC + 4 % EPS 26.50 33.25 4.87 4.22 4.38 BV/share 231 279 70 68 61 Stock price (low/high) 346/396 367/586 NA NA NA General benchmarks: US Specialty Chemicals European chemicals Croda chemicals (UK) Akzo Nobel (Holland) Best practice benchmark Gross margin 18% 39% 40% Operating profit (%, 1995) 13.4% 10.8% 8.7% 9.1% 15% Working capital (% of sales) 18.0% 29.7% - inventory (days) 66 99 - accounts receivable (days) 48 53 - accounts payable (days) 46 54 Sales/Assets 1.09 1.16 1.20 ROE 33% 20% Clariant-Hoechst merger: Clariant (1996) Hoechst (1996) Sales 2,337 6,565 EBITDA 371 844 EBIT 235 490 Capex 98 425 Exhibit 2-6 (continued) C. Financial Benchmarks Source: Ciba company document. 32 Exhibit 2-6 (continued) D. Supplementary Information Restructuring (SFr millions): 1996 1997 Separation cost (paid by Novartis) 340 Environmental provisions 202 Restructuring 535 300 • reduction of workforce • reduced number of production sites • formulation moved closer to customer Estimated annual savings are SFr80 million in 1997 and SFr150 million annually thereafter. Clariant’s cost-reduction target is SFr180 million annually within three years. Capital Expenditure: Ciba SC’s target capital expenditure is 6% of sales. I nvestment Expenditure: In 1997–2000, Ciba SC intends to invest SFr600–650 million in major investments. The expected breakdown is: Additives 50 % Asia 30 % Pigments 25 % Europe 25 % Performance Polymers 15 % USA 25 % Textile Dyes and Consumer Care 10 % Switzerland 20 % Source: Ciba company prospectus. Ciba SC Stock Market Performance 100 110 120 130 140 150 160 2 8 . 2 . 9 7 1 . 4 . 9 7 3 0 . 4 . 9 7 2 9 . 5 . 9 7 Index Ciba SC Source: Public information (Swiss stock exchange). 33 Case 3 Letsgo Travel Trailers: A Case for Incorporating the New Model of the Organization into the Teaching of Budgeting Sally Wright, University of Massachusetts-Boston Letsgo Travel Trailers Letsgo manufactures travel trailers bought primarily by young families and retirees interested in a light, low-cost trailer that can easily be pulled by a mid-sized family car. The market for travel trailers has expanded nicely over the past few years due to the number of families seeking a relatively low-cost, outdoor vacation experience. But in the view of Letsgo’s president, Mark Newman, the real growth in the future is in the retiree market. Newman believes the vigorous health of the average retiree, coupled with the national trend toward a return to nature, will translate into continuing sales growth for Letsgo. As Newman loves to say, “camping recently moved from number seven to number six on the list of top 10 leisure activities in the United States, and the baby boomers are getting older every day.” The Retiree Market Baby boomers (born between 1/ 1/ 46 and 12/ 31/ 64) carry a lot of consumer clout. Research indicates that for an organization to meet the needs of the senior market, including baby boomers, the following must be addressed: • Independence and control, • Intellectual stimulation and self-expression, • Security and peace of mind, • Quality and value. According to the National Opinion Research Center at the University of Chicago, 78% of boomers (aged 33–51) own their own home, 45% are satisfied with their financial situation, 67% have not been hospitalized in the past five years, 73% are married, and 69% of their households have two wage earners. By the year 2000, boomers are expected to have an estimated $1 trillion to spend. By 2010, the United States will be home to 53 million people 55 and older, with eight states expected to double their elderly population: Alaska, Arizona, California, Colorado, Georgia, Ne- vada, Utah, and Washington. Seniors respond to benefit-driven messages; to attract them, adver- tising has to communicate tangible benefits rather than features and amenities. Marketing and Sales The forecasted increase in Letsgo’s sales can be seen in the company’s sales projections pre- sented in Exhibit 3-1 (actual for the years 1992 through 1997 and projected for the years 1998 through 2002). Although the weather can have a significant impact on the travel trailer industry (i.e., Copyright ©1998 Institute of Management Accountants, Montvale, NJ 34 hurricane season, flooding, and even droughts have had negative effects on the sales and rentals of travel trailers), Letsgo’s management believes these problems will be mitigated in the future by global warming. All sales projections are done by Mark Newman in his role as Letsgo’s president. To keep from losing sales, the company maintains finished goods inventory on hand at the end of each month equal to 300 trailers plus 20% of the next month’s sales. The finished goods inventory on December 31, 1997, was budgeted to be 1,000 trailers. Jim West, Letsgo’s vice presi- dent of marketing and sales, would rather see a minimum finished goods inventory of no less than 1,500 trailers. Jim refuses to talk to Tom Sloan, Letsgo’s production manager. Tom is always trying to get Jim to consider adopting flexible inventory levels, which Jim is certain would affect his yearly bonus. The vice president of sales and marketing is eligible for a 20% bonus based on sales. Unfortunately, Jim did not receive a bonus in 1997. Sales were up, but Mark refused to give Jim the bonus, although it was earned, due to the high number of customer complaints. Jim was really steamed when he heard “no bonus.” Didn’t Mark know those complaints were for poor quality? All of Jim’s efforts to grow sales and attract customers were, once again, destroyed by Tom Sloan and his production failures. Trailer Production Sheet aluminum represents the company’s single most expensive raw material. Each travel trailer requires 30 square yards of sheet aluminum. The wholesale cost of sheet aluminum varies dra- matically by time of year. The cost per square yard can vary from $13 in the spring, when new construction tends to start, to $6 in December and January, when demand is lowest. In September 1997, the Department of Energy and the aluminum industry launched a collaboration to pursue technologies to improve energy efficiency and production processes. “This pact will increase glo- bal competitiveness and enhance the environmental performances of a key manufacturing sector by applying advanced scientific know-how to day-to-day industry needs” (Secretary of Energy Hazel R. O’Leary, September 1997). This collaboration will increase the aluminum industry’s com- petitiveness and thus help businesses that rely on aluminum to reduce costs. Manufacturers re- quiring aluminum as a raw material potentially should be able to negotiate better purchase prices from suppliers. Aluminum promises to be the construction material of the future. The use of aluminum in vehicles, including travel trailers, is increasing rapidly due to a heightened need for fuel-efficient, environmentally friendly vehicles. Aluminum can provide a weight savings of up to 55% compared to an equivalent steel structure, improving gas mileage significantly. The aluminum industry and suppliers are dispersed across four-fifths of the country, yet they are largely concentrated in four regions: the Pacific Northwest, industrial Midwest, northeastern seaboard, and mid-South. Although this is a broad geographic presence, Letsgo Travel Trailers will be affected by distribution costs. Vicky Draper, Letsgo’s vice president of purchasing and materials handling, is eager to imple- ment just-in-time as a way of lowering Letsgo’s aluminum cost, to offset the expense of distribu- tion—Letsgo is located in Pennsylvania. Vicky’s projected 20% bonus, recently announced by Mark and effective for year-end 1998, is based on her ability to lower total material cost. Initially enthusiastic about her job and ability to earn a significant bonus, Vicky has become discouraged and angry. She is unable to convince Letsgo’s current aluminum supplier to sign a prime vendor contract, and her efforts to locate an alternative vendor willing to accept the conditions of a just- in-time contract have similarly failed. She blames Tom Sloan. Letsgo’s current aluminum vendor refuses to sign a just-in-time prime vendor contract due to Tom’s uneven production schedule and his refusal to pay on time. Tom has been seen reading the help wanted ads, and Vicky over- heard him talking to an employment agency. 35 In keeping with the policy set by Tom as Letsgo’s production manager, the amount of sheet aluminum on hand at the end of each month must be equal to one-half of the following month’s production needs for sheet aluminum. The raw materials inventory on December 31, 1997, was budgeted to be 39,000 square yards. The company does not keep track of work-in-process inven- tories. Total budgeted merchandise purchases (of which the sheet aluminum is a significant part) and budgeted expenses for wages, heat, light and power, equipment rental, equipment purchases, depreciation, and selling and administrative for the first six months of 1998 are given below: January February March Merchandise purchases $870,000 $1,320,000 $1,110,000 Wages 624,000 1,008,000 1,104,000 Heat, light, & power 130,000 195,000 220,000 Equipment rental 390,000 390,000 390,000 Equipment purchases 300,000 300,000 300,000 Depreciation 250,000 250,000 250,000 Selling & admin. 400,000 400,000 400,000 April May June Merchandise purchases $690,000 $420,000 $330,000 Wages 672,000 432,000 240,000 Heat, light, & power 135,000 110,000 110,000 Equipment rental 340,000 340,000 340,000 Equipment purchases 300,000 300,000 300,000 Depreciation 275,000 275,000 275,000 Selling & admin. 400,000 400,000 400,000 Merchandise purchases are paid in full during the month following purchase. Accounts payable for merchandise purchases on December 31, 1997, which will be paid during January, total $850,000. Competition All forms of vacation and leisure activities, including theme parks, beach or cabin rentals, health spas, resorts, and cruise vacations compete with Letsgo Travel Trailers for the consumer dollar. Other recreational purchases such as automobiles, snowmobiles, boats, and jet-skis are indirect competitors. Travel trailer manufacturers such as Rexhall Industries, Coachman Industries, Winnebago Industries, Foremost Corporation of America, and Thor Sales Industries also offer a moderate-to- low-priced trailer. Manufacturers that offer more diverse product lines such as high-end trailers with luxury accommodations could compete for the fairly affluent senior market. Coachman Industries, a direct Letsgo competitor, has become a leader in the recreational ve- hicle, motor home, and travel trailer industry through a commitment to quality and value based on excellence in engineering and attention to detail. Creative engineering, combined with high-accu- racy analysis, reduced material costs at Coachman by more than 60% and labor costs by 78%. Budget Preparation To minimize company time lost on clerical work, Letsgo’s accounting department prepares and distributes all budgets to the various departments every six months. Per Mark Newman, “Free- ing departmental managers from the budgeting process allows them to concentrate on more pressing matters.” In keeping with the recently announced bonus plan for the vice president of 36 purchasing and materials handling, Newman has instructed the accounting department to bud- get aluminum at $6 per square foot. The accounting manager recently received a 20% bonus for having prepared the budgets on time with little or no help from the other functional areas. Cash Letsgo’s vice president of finance, Becky Newman, has requested a $800,000, 90-day loan from the bank at a yet to be determined interest rate. Since Letsgo has experienced difficulty in paying off its loans in the past, the loan officer at the bank has asked the company to prepare a cash budget for the six months ending June 30, 1998, to support the requested loan amount. The cash balance on January 1, 1998, is budgeted at $100,000 (the minimum cash balance required by Letsgo’s board of directors). Human Resources To accomplish the company’s corporate strategic goals, Letsgo Travel Trailers encourages up- ward communication among all its employees, from senior management to line employees. Deci- sion making, although not an entirely democratic process, is based on a team approach. Newman, as Letsgo’s president, encourages managers to think in terms of the marketplace and to look at the business of travel trailers as a whole rather than as functional department successes and decisions. In fact, Newman is so committed to the idea of cooperative management and team- work that he has hired three separate human resource consultants in the past six months to lead the company’s managers through team-building exercises. Required 1. Discuss the validity and reasonableness of Letsgo’s sales projections. 2. Prepare production, purchasing, and cash budgets for Letsgo for the first six months of 1998 using the following formats (hint: spreadsheet programs are wonderful!): Production Budget Six Jan Feb March April May June Months Budgeted sales Add: desired ending inventory ____ ____ ____ ____ ____ ____ ____ Total needs Less: beginning inventory ____ ____ ____ ____ ____ ____ ____ Trailer production Purchases Budget Six Jan Feb March April May June Months Trailer production Sheet metal needs per trailer _____ _____ _____ _____ _____ _____ ____ Total production needs Add: desired ending inventory _____ _____ _____ _____ _____ _____ ____ Total material needs Less: beginning inventory _____ _____ _____ _____ _____ _____ ____ Total sheet metal purchases Cost per square yard $____ $____ $____ $____ $____ $____ $____ Total cost $ $ $ $ $ $ $ 37 Cash Budget Six Jan Feb March April May June Months Cash beginning balance $____ $____ $____ $____ $____ $____ $____ Add: cash collections Total cash available Less: cash disbursements xxxxxxx xxxxxxx xxxxxxx etc. ____ ____ ____ ____ ____ ____ ____ Total cash disbursements Excess (deficiency) ____ ____ ____ ____ ____ ____ ____ Financing: Borrowings Repayments Interest ____ ____ ____ ____ ____ ____ ____ Total financing Cash balance ending $ $ $ $ $ $ $ Discuss the advantages and disadvantages of the budgets you have prepared. Whom in the company does the budget help and whom, potentially, does it hurt. Does the budget help or hurt the sales department? What about production and finance? How are the various functional areas affected and why? 3. Andy Baxter, newly hired by Letsgo from a competitor, suggests preparing the produc- tion budget assuming stable production. Prepare a second and third set of production, purchas- ing, and cash budgets with production held to a constant 3,000 trailers per month for the second set of budgets and 3,500 trailers per month for the third set of budgets, using the following ap- proach for the production budget (the purchasing and cash budget format remain as presented in question 2): Six Jan Feb March April May June Months Production (trailers) 3,000 3,000 3,000 3,000 3,000 3,000 18,000 Add: beginning inventory ____ ____ ____ ____ ____ ____ ____ Total available Less: budgeted sales ____ ____ ____ ____ ____ ____ ____ Ending inventory Discuss the advantages and disadvantages of the second and third sets of production, pur- chasing, and cash budgets you have prepared. Whom in the company do these budgets help and whom, potentially, do they hurt? Do these budgets help or hurt the sales department? What about production and finance? How are the various functional areas affected, and why? 4. What should Letsgo use to measure performance for each of the managers in the case? What bonus system would you suggest that incorporates these measures and also encourages the managers to work as a team? 38 Exhibit 3-1. Actual and Projected Sales in Number of Trailers Actual sales 1992 1993 1994 1995 1996 1997 13,765 14,880 15,991 17,809 19,634 23,322 Projected sales 1998 1999 2000 2001 2002 28,000 33,600 40,320 48,384 58,060 The detail sales for 1997 (actual) and 1998 (projected) by month are as follows: 1997 1998 Actual Projected January 1,983 2,500 February 3,218 4,000 March 3,981 5,000 April 3,240 3,000 May 1,755 2,000 June 901 1,000 July 763 1,000 August 611 1,000 September 1,622 2,000 October 1,678 2,000 November 1,439 2,000 December 2,131 2,500 Total number of trailers 23,322 28,000 Actual sales in dollars for the last two months of 1997 and budgeted sales for the first six months of 1998 follow: November 1997 (actual) $1,439,000 December 1997 (actual) 2,131,000 January 1998 (budgeted) 2,500,000 February 1998 (budgeted) 4,000,000 March 1998 (budgeted) 5,000,000 April 1998 (budgeted) 3,000,000 May 1998 (budgeted) 2,200,000 June 1998 (budgeted) 1,100,000 Past experience shows that 25% of a month’s sales are collected in the month of sale, 10% in the month following the sale, and 60% in the second month following the sale. The remainder is uncollectible. 39 Case 4 Using EVA at OutSource, Inc. Paul A. Dierks, Wake Forest University “I’ve been hearing a lot lately about something called MVA, which stands for market value added, and I was curious whether it is something we can use at OSI,” Keith Martin said. Keith is president and CEO of OutSource, Inc. His guest for lunch that day was a computer industry analyst from a local brokerage firm. Keith had invited him to lunch so he could get more information on MVA and its uses. “Yes,” the analyst replied, “I’ve heard a great deal about EVA and MVA. EVA is a re- sidual income approach in which a firm’s net operating profit after taxes—called NOPAT—is compared to a minimum level of return a firm must earn on the total amount of capital placed at its disposal. MVA represents the difference between the market and book value of a com- pany over a period of time.” “Have you seen the most recent issue of Fortune?” he continued, handing Keith a copy. “It has an article 1 in it updating Stern Stewart’s list of the top 1,000 firms ranked by MVA. You will also be interested in an earlier Fortune article 2 on EVA, or economic value added. EVA is closely related to MVA. However, don’t be misled by the simplicity of the EVA calculations in that article. The after-tax operating profit—NOPAT, as you called it—and the amount used for capital don’t come directly off the financial statements. You have to analyze the footnotes to determine the adjustments that have to be made to come up with those amounts—Bennett Stewart calls them equity equivalents, or ‘EEs,’ in his book, The Quest for Value.“ 3 “Those articles sound like very interesting reading for me, especially at this point,” Keith said. “Can you send me copies?” “Sure,” said the analyst. “But tell me, what is it about MVA and EVA that piqued your interest in trying them at OSI?” “In tracking our industry,” Keith replied, “I see the stock prices of some of our key com- petitors, like Equifax, increasing. Yet when I compare OSI’s recent growth in sales and earn- ings, our return on equity and earnings per share compare well to those firms, but our stock price doesn’t achieve nearly the same rate of increase, and I don’t understand why.” The analyst replied, “Some of those firms might be benefiting from using EVA already, and the market value of their stock probably reflects the results of their efforts. It has been shown that a higher level of correlation exists between EVA and a stock’s market value than has been found with the traditional accounting performance measures, like ROE or EPS.” “But the MVA 1,000 ranking probably includes only large firms,” Keith observed after looking over the article the analyst gave him. “Will EVA work in a small service firm like OSI?” 1 Ronald B. Lieber, “Who Are the Real Wealth Creators?,” Fortune, December 9, 1996, pp. 107–108, 110, 112, 114. 2 Shawn Tully, “The Real Key to Creating Wealth,” Fortune, September 20, 1993, pp. 38–40, 44–45, 48, 50. 3 TheQuest for Value, G. Bennett Stewart III, New York: HarperCollins Publishers, Inc., 1991. Copyright ©1998 by Institute of Management Accountants, Montvale, NJ 40 “Most of the largest U.S. firms are in the Stern Stewart MVA ranking,” the analyst said, “but I’ve read about EVA being used at smaller firms. And some firms in the ranking are service firms, such as AT&T, McDonald’s, Marriott International, and Dun & Bradstreet. I’m not an expert on MVA or EVA, but I don’t see any reason why it wouldn’t work at OSI.” “I’d like to find out more about MVA and EVA and how we can use them at OSI. For example, we’ve talked about a new incentive plan—will EVA work in that area? And, if so, will it help us in deciding how we should organize and manage our operations as we expand and grow? Can you get me more information on these things?” “An application EVA is touted for is its use in incentive plans,” the analyst replied. “A team of students from Capital University has been assigned to me this fall to do an industry-related project, and I was looking for something ‘meaty’ for them to do. This looks like just the ticket. I’ll brief them on it and have them come over to get the necessary information and interview you.” “Great! I look forward to meeting them,” Keith said. Company Information OutSource, Inc. (OSI) is a computer service bureau that provides basic data processing and general business support services to a number of business firms, including several large firms in their immediate area. Its offices are in a large city in the mid-Atlantic region, and it serves client firms in several Mid-Atlantic states. OSI’s revenues have grown fairly rapidly in recent years as businesses have downsized and outsourced many of their basic support services. The CorpInfo Data Service (CIDS) classifies OSI as an information services firm (SIC 7374). This group is composed, in large part, of smaller, independent entrepreneurs that pro- vide a variety of often-disparate services to both corporate and government clients. Market analysts feel a continuously healthy economy translates into strong potential for higher earn- ings by members of this group. A factor sustaining an extended period of growth is the in- creased attention of firms to controlling costs and outsourcing their non-core functions, such as personnel placement, payroll, human resources, insurance, and data processing. This trend is expected to continue to the end of the decade, probably at an increasing rate. Several firms in this industry have capitalized on their growth and geographic expansion to win lucrative contracts with large clients that previously had been awarded on a market-by- market basis. Although OSI operates out of its own facilities, which include some computing equip- ment and furniture, the bulk of its computer processing power is obtained from excess computer capacity in the local area, primarily rented time during third-shift operations at a large local bank. To be successful in the long term, however, OSI management knows it must expand its business considerably, and, to ensure full control over its operations, it must set up its own large-scale computing facility in-house. These items are included in OSI’s long-range strategic plan. As OSI’s reputation for accurate, reliable, and quick response service has spread, the firm has found new business coming its way in a variety of data processing and support services. The issue has been deciding which services to take on or stay out of in light of the current limitations on OSI’s computing resources, to ensure it can continue to provide high- quality service to its customers. Things definitely are looking up for OSI, and industry market analysts have recently begun to look more favorably on its stock. In 1993, OSI’s board decided to pursue additional opportunities in payroll processing and tax filing services. OSI purchased a medium-sized firm that had an established market 41 providing payroll calculation, processing, and reporting services for several Fortune 500 firms on the East Coast. Now OSI is in the midst of developing a new payroll processing system, called PayNet, to replace the outmoded system originally created by the firm it acquired. Once PayNet is developed, it will give users an integrated payroll solution with a sim- pler, more familiar graphical user interface. From an administrative perspective, it will allow OSI to reduce its manual data entry hiring, to speed data compilation and analysis, and to simplify administrative tasks and the updating of customer files for adds, moves, and changes. PayNet will serve as the backbone for OSI’s service bureau payroll processing operations in the future, but, at present, developmental and programming costs have proved higher than expected and will delay the rollout of the final version of the new payroll engine. Beta testing of the production version of PayNet was delayed from the second to the third quarter of 1996. Additional Accounting Information OSI’s financial statements for 1995 appear in Exhibits 4-1 and 4-2. The following list of infor- mation, extracted from the footnotes to OSI’s annual report for 1995, is pertinent to calculat- ing a firm’s EVA. A. Inventories are stated principally at cost (last in, first out), which is not in excess of market. Re- placement cost would be $2,796 more than the 1994 inventory balance and $3,613 more than the 1995 inventory balance. B. Deferred tax expense results from timing differences in recognizing revenue and expense for tax and reporting purposes. C. On July 1, 1993, the company acquired CompuPay, a payroll processing and reporting service firm. The acquisition was accounted for as a purchase, and the excess of cost over the fair value of net assets acquired was $109,200, which is being amortized on a straight-line basis over 13 years. One- half year of goodwill amortization was recorded in 1993. D. Research and development costs related to software development are expensed as incurred. Soft- ware development costs are capitalized from the point in time when the technological feasibility of a piece of software has been determined until it is ready to be put on line to process customer data. The cost of purchased software, which is ready for service, is capitalized on acquisition. Software development costs and purchased software costs are amortized using the straight-line method over periods ranging from three to seven years. A history of the accounting treatment of software devel- opment costs and purchased software costs follows: Expensed Capitalized Amortized 1993 $166,430 $ 9,585 0 1994 211,852 5,362 $4,511 1995 89,089 18,813 5,111 $467,371 $33,760 $9,622 Additional Financial Information OSI’s common stock is currently trading at $2 per share. A preferred dividend of $11 per share was paid in 1995, and the current price of the preferred stock is approximately at its par value. Other information pertaining to OSI’s debt and stock follows. 42 Short-term debt: $8,889 Rate: 8.0% Long-term debt: Current portion $18,411 Rate: 10.0% Long-term portion $98,744 Rate: 10.0% Total long-term debt $117,155 Stock market risk-free rate (90 day T-bills) = 5.0% Expected return on the market = 12.5% Beta value of OSI’s common stock = 1.20 Expected growth rate of dividends = 8.0% Income tax rate = 35.0% Requirements The management of OutSource, Inc. has asked you to prepare a report explaining EVA (eco- nomic value added) and MVA (market value added), how they are calculated, and how they compare to traditional measures of a firm’s financial performance. OSI’s management also would like to know the advantages and disadvantages of using EVA to evaluate the firm’s performance on an on-going basis, as well as in assessing the performance of individual man- agers throughout its organization. As part of your report, calculate EVA and MVA from OutSource, Inc’s financial statements for 1995 using both the operating approach and the financing approach as described in Bennett Stewart’s book, TheQuest for Value. Finally, OSI’s management would like to know if EVA can be used as part of an incentive system for its employees and how it should proceed to implement such an incentive system at OutSource, Inc. You are to prepare a 20-minute video presentation covering these points. 43 EXHIBIT 1 OutSource, Inc. Balance Sheet December 31, 1995 1994 ASSETS Current Assets: Cash $144,724 $169,838 Trade and other receivables (net) 217,085 192,645 Inventories 15,829 23,750 Other 61,047 49,239 ----------- ----------- Total current assets $438,685 $435,472 Non-current Assets: Property, plant and equipment $123,135 $109,600 Software and development costs 33,760 14,947 Data processing equipment and furniture 151,357 141,892 Other non-current assets 3,650 8,844 ----------- ----------- $311,902 $275,283 Less-Accumulated depreciation 85,018 57,929 ----------- ----------- Total non-current assets $226,884 $217,354 Goodwill 88,200 96,600 ----------- ----------- $753,769 $749,426 ======== ======== LIABILITIES AND SHAREHOLDER'S EQUITY Current liabilities Short-term debt and current portion of long-term note $27,300 $31,438 Accounts payable 67,085 57,483 Deferred income 45,050 32,250 Income taxes payable 19,936 12,100 Employee compensation and benefits payable 30,155 28,950 Other accrued expenses 28,458 27,553 Other current liabilities 17,192 29,769 ----------- ----------- Total current liabilities $235,176 $219,543 Long-term debt less current portion 98,744 117,155 Deferred income taxes 6,784 4,850 Shareholders' Equity: Cumulative Non-Convertible Preferred Stock, $100 par value, authorized 5,000 shares, issued and outstanding 1,000 shares 100,000 100,000 Common stock, $1 par value; 300,000 shares authorized; 219,884 shares issued and outstanding 219,884 219,884 Additional paid-in capital 32,056 32,056 Retained earnings 61,125 55,938 ----------- ----------- Total shareholders' equity $413,065 $407,878 ----------- ----------- $753,769 $749,426 ======== ======== Exhibit 4-1. OutSource, Inc. Balance Sheet 44 EXHIBIT 1 (Continued) OutSource, Inc. Statement of Income for The Year Ended December 31 1995 Operating revenue $2,604,530 Costs of services 1,466,350 --------------- Gross profit $1,138,180 Less: Operating expenses Selling, general and administrative $902,388 Research and development 89,089 Other expense (income) 59,288 Write-off of goodwill and other intangibles 13,511 --------------- Earnings (Loss) before interest and taxes $73,904 Interest income $1,009 Interest expense 12,427 --------------- Earnings (Loss) before income taxes 62,486 Income tax provision 21,870 --------------- Earnings (Loss) $40,616 ======= OutSource, Inc. Statement of Cash Flows for The Year Ended December 31 1995 Cash Flows from Operating Activities Net Earnings (Loss) $40,616 Depreciation 21,978 Amortization of software & development costs 5,111 Decrease (Increase) in accounts receivable (24,440) Decrease (Increase) in inventories 7,921 Decrease (Increase) in other current assets (11,808) Increase (Decrease) in deferred income 9,602 Increase (Decrease) in accounts payable 12,800 Increase (Decrease) in income taxes payable 7,836 Increase (Decrease) in employee compensation and benefits payable 1,205 Increase (Decrease) in other accrued expenses 905 Increase (Decrease) in other current liabilities (12,577) Increase (Decrease) in deferred income taxes 1,934 ----------- Net cash provided by (used for) operating activities $61,083 Cash Flows from Investing Activities Expended for capital assets ($36,619) Goodwill amortized 8,400 ----------- Net cash provided by (used for) investing activities ($28,219) Cash Flows from Financing Activities Payment of long-term note ($4,138) Payment of short-term note (18,411) Preferred dividends (11,000) Common stock dividends (24,429) ----------- Net cash provided by (used for) financing activities ($57,978) Net Cash Flows Provided (Used) ($25,114) Cash at beginning of year $169,838 Cash at end of year $144,724 ========= Exhibit 4-2. OutSource, Inc. Statement of Income 45 Case 5 (A) RVF Systems Inc. F. Giraud, V. Lerville-Anger, and R. Zrihen École Supérieure de Commerce de Paris (Paris School of Management) Management Control Department Executive Committee, Quarterly Meeting It’s October 15, 1987. RVF Systems Inc., a company that manufactures and distributes computer hardware, is holding its quarterly executive committee meeting. Present are: • Mr. Piazzolo, managing director, a recent newcomer to the company; • Mr. Artaud, sales manager; • Ms. Roquevaire, human resources director; • Mr. Zerbib, financial officer; • Mr. Breton, customer service manager; • Mr. Bonnot, production manager. The meeting agenda focuses on analyzing the last quarter’s results and preparing the 1988 budget. This is the fourth meeting dedicated to this topic. In the executive committee room, the chief directors are poring over the thick printouts of budget results and are desperately trying to explain the budget discrepancy that appeared in Mr. Piazzolo’s global results. Piazzolo (highly pragmatic): We really need to understand what happened, and act. Zerbib: It’s simple. Look at our production costs. We can tell that’s where the problems are because production costs rose 12% over the last quarter. Bonnot: We’re going to have to deal with that situation, but we can’t forget our other objec- tives. Often we incur higher costs to meet our customers’ demands in terms of quality. I think the budget constraints lead us to focus excessively on cost reduction and that we should maintain a more balanced view of our problems. Artaud: To manage my sales personnel, I need concrete data linked to my activity. Since the current system doesn’t fill my needs, I have built my own database to track the type of equipment my department sells, who our prospects are, the discounts we grant, and so on. It’s not always accurate, but I have information on my desk every week that lets me make decisions quickly. Breton: It’s true we don’t get a lot of information from these budget reports. We spend time explaining budget discrepancies and sending information to the controller’s department, and we don’t get anything in return. This system doesn’t help me in everyday management. Piazzolo: I understand that you need information you feel is “field-based,” but I would like us to keep in mind our long-term objectives, even if our horizon is more and more limited. If we want to succeed, we have to work toward the same goal. Copyright ©1998 by F. Giraud, V. Lerville-Anger, and R. Zrihen 46 The current management accounting system was developed by Mr. Zerbib, and he’s very proud of it. Every month, on the 11th day after the end of the previous month, he circulates a detailed account statement, with a comparison to the budget and the corresponding discrepan- cies. This document is sent to committee members with the balance sheet. Mr. Zerbib’s precision and dependability were the basis for his previous promotions in an American company where he worked before joining RVF. Piazzolo: We need to look at these management tools seriously. The budget reporting is very well done, but I don’t think it covers all our needs. We’ll study the problem. Right now I suggest that we spend the rest of this meeting on 1988 perspectives and strategies. The Economic Context and Environment in 1987 We will present an overview of the general economic environment, followed by a brief history of RVF’s business sector. This historic overview will be followed by an review of the company’s competitors as well as the markets linked to its main business sectors. The French Economic Environment 1988, provides bright horizons (see Exhibit 5(A)-1). Economic growth is anticipated, both in France and worldwide, and inflation is down in European Economic Community (EEC) countries. Despite high unemployment, economic growth benefits both households and businesses, particularly industry. The economy is sending a green light: increased productivity, investment growth, economic profitability, and improved balance sheets. Information technology equipment (hardware), software, and services should post $190 bil- lion worldwide in 1988. This field is to become the world’s second-largest industry, behind the auto industry. Exhibit 5(A)-1. Forecasts for 1988 Overall Environment The year 1988 should be characterized by growth in France and worldwide. For EEC countries, the GDP should vary in volume by +4% compared with 1987. This growth should be accompanied by inflation, at a tolerable level, of approximately 3.6%. France should profit from this worldwide growth (GDP growth in volume is equal to +4.5%). Inflation will be controlled (+3.1% over the year), but unemployment will remain high (10% of the active population). Purchasing power linked to French household revenue (+3.4% preceding year) and their consumption (+3.5%) should rise substantially. Moreover, a survey carried out by the Crédit National among 970 companies shows the year to be exceptional on the following six points: • Industrial expansion is exceeding expansion in other economic sectors. • Work productivity is growing exceptionally well, while personnel expenses are remain- ing constant, in part because employee participation is increasing as well. • Physical and financial investments could reach noteworthy growth levels (+11% for physical investment in 1988) but are hardly enough to meet needs. • Enhanced margins and a drop in nominal interest rates are affecting economic and fi- nancial profitability. • Balance sheet structure is focusing on consolidation by reducing debt and by equity capital growth. • The difference between large and small companies is decreasing in almost all areas. 47 The Rise of Information Technology The computer era began in the 1940s in both Europe and the United States. Computers were developed under the protective wing of the military and public markets. In 1965, 50% of R&D in computer technology was financed by the United States government, with most companies fo- cusing on military applications. In 1966, there were approximately 50,000 computers worldwide, 2,500 of them in the Eastern block. This equipment represented a total investment of $20 billion. Six countries (USA, France, Great Britain, Germany, Japan, Italy) had participated in the beginning of the computer technol- ogy age, but in 1987, 90% of world production was divided among eight behemoths, all Ameri- can. Today, only two non-American companies offer a complete product range (ICL in the U. K. and Fujitsu in Japan). Information technology is currently broken down into three sectors: hardware, software, and services (mainly customer service or client relations). The breakdown of the world computer hard- ware market per national manufacturer and per market sector is illustrated in Exhibit 5(A)-2. Rest of world 13% Europe 32% United States 37% J apan 18% PC 39% Minisystems 18% Mainframe 24% Mid-range systems 19% Exhibit 5(A)-2. World Computer Hardware Market in 1988 World computer hardware market breakdown in 1988 (in value) World computer hardware market in 1988 48 Sector Segmentation In reality, software can be viewed as a highly specialized business sector, while services other than customer service are provided by a few distributors. The following breakdown consequently appears more logical: scientific supercomputers, mainframes (the segment in which RVF is posi- tioned), minicomputers (where DEC acquired a substantial market share with PDP), and micro- computers and workstations. Last, there is another specialized sector, peripherals (hard disks, tape drives, printers, and light tables). This sector is little known. Consequently, little information is available, although we know that for some makers, peripherals offer an excellent way to reach major customers already equipped with mainframes. The Information Technology Market in France French computer consumption (evaluated by number of units sold) shows a steady and buoy- ant growth. Average growth in demand tops 10% a year for mainframes and mid-range systems. This figure is also very high for microcomputers (see Exhibit 5(A)-3). Apparent consumption has risen 30% a year since 1986 and should be stable in 1988. Sector Features RVF Systems is present in the mainframe market as well as in the peripherals market (hard disk drives). Contrary to popular belief, the success of this sector’s major companies is not linked to technological progress, which consequently does not offer a competitive edge. In reality, the companies that have been successful in this sector relied on solid sales networks already set up for older data processing technologies and for office machines. This is true for companies such as IBM, Remington Rand, NCR, etc. In regard to the technology factor, RVF and its products offer a technology equivalent to, if not superior to, the technology of IBM, the eternal market leader. Nonetheless, despite the lead- ers’ efforts to streamline and regulate innovation, it would be highly imprudent to make a hy- pothesis regarding product stability, technology, markets, and/ or prices. In 1985, RVF held 2.8% of the world’s mainframe market. Worldwide market shares are shown in Exhibit 5(A)-4. 1986 1987 Est.1988 88/87 Estimated average annual growth Micro-computers ($2K/$26K) 360.5 479.6 618.2 28.9% 31.0% Very small ($26K/$50K) 10.9 11.9 14.3 20.2% 14.5% Small ($50K/$320K) 13.9 16.6 18.7 12.7% 16.0% Middle ($320K/$1,400K) 0.8 0.8 1.1 37.5% 17.3% Mainframe (>$1,400K) 0.4 0.4 0.5 25.0% 11.8% Delivery total 386.5 509.3 652.8 28.2% 30.0% Exhibit 5(A)-3. Computer Consumption (in thousands of units) 49 IBM’s market share is being nibbled away each year (in 1978 IBM’s market share stood at 60%) by the Japanese (NEC, Hitachi, Fujitsu), as well as by new competitors such as RVF. A shot at surviving in this sector entails growth. Indeed, RVF’s margins in the 1980s were very comfortable (profit before interest and taxes was greater than 20%; revenue and cash flow were twice the industry average). The learning experience curve had a significant impact. In com- parison with industrial sector companies, service companies lagged in equipment acquisition. Acquiring a mainframe represents a key capital outlay, so in their relations with a potential client, computer manufacturers frequently find themselves in the following situation: (1) either they rent out the system to their client (on a four-year basis), in which case they recover the value of the equipment sold in their own required working capital (the average price of a mainframe is around $8 million), or (2) they offer their client the means to finance this acquisition. In the 1960s and 70s, IBM established a dominant market position. With its market share topping 70% of the world market, “Big Blue” had carved out a quasi monopoly, largely focused on a global sales presence that was consistent and efficient (permanent identification and communi- cation with decision makers). The impact of IBM’s dominance was so great that one computer systems director hesitated three times before deciding to purchase a central unit from a competi- tor, even though the competitor’s technology was more advanced. Thus, to justify a non-IBM equipment decision, the competitor’s price has to be distinctly lower. For a computer systems director, forgoing IBM means taking an individual risk. Therefore, it is very difficult for RVF to solicit IBM’s customers. An indirect path is via pe- ripheral supplies (disk drives). Peripheral supplies provide the opportunity to prove one’s tech- nology and service quality, in the hopes of one day selling a mainframe. Given the context, manu- facturers must hold on to their customers for a long time. Until 1975, IBM’s software policy was proprietary, making its software incompatible with all other machines. A client who had an IBM system couldn’t change central units and manufacturers IBM 49% UNISYS 8,20% FUJITS U 8,20% NEC 4,80% HITACHI 4% CONTROL DATA 5,10% BULL 4,10% AMDAHL 2,60% AUTRES 14% IBM 49% UNISYS 8% NEC 5% HITACHI 4% CONTROL DATA 5% BULL 4% AMDAHL 3% OTHERS 14% FUJITSU 8% Japanese = 17 % TOTAL = 21 billion dollars Exhibit 5(A)-4. Worldwide Mainframe Market Shares in 1985 50 without also changing software. This policy led to an antitrust lawsuit against Big Blue instigated by Control Data. The trial ended 12 years later with IBM’s acquittal. Nonetheless, as early as 1975 nonproprietary software began to appear (Unix), and IBM was obliged to reveal its compatibility protocol, which helped spawn compatible competitors. When competing with IBM, a chance to sign a contract involves: • Offering equipment that is totally compatible with that of the market leaders, Big Blue; • Reassuring high-level decision makers technologically; these decision makers include com- puter system directors and managing directors, so a personal relationship is key and could involve hosting a visit to the manufacturer’s plant or research unit; • Providing impeccable service quality, even for peripherals, especially in regard to customer service and repairs; • Positioning oneself with a better technology, a much lower price, and a solution to the aforementioned financing problem. The RVF Company RVF Systems was created in 1977 by a handful of engineers, including former IBM employees. As experienced researchers, encompassing a broad international spectrum, this group viewed IBM’s strategy as too market based and lacking in technological innovation. IBM had always refused to diversify its products, frightened of cannibalization. So this group of engineers created their own structure, funded by American venture capital. In the beginning, RVF set up a main factory and research center in Sweden, with two distribution units—one in Sweden, the other in France. The first challenge was positioning the company in a market where IBM ruled. Operating systems were proprietary, and the brand was unavoidable. The market was essentially composed of large corporations and banks that required both quality and security and were willing to pay a steep price. Nevertheless, the more modest-size companies, especially in the industrial sector, were not always satisfied with this monopolistic situation. The corporate leaders of these compa- nies were much more affected by the price variable than the computer services per se and sought a way to reduce computer investments. IBM, however, never granted discounts, giving RVF an opportunity to differentiate. Thus, RVF decided to offer equipment that was cheaper and used better technology, guaranteeing full compatibility with IBM. The first computer was sold after three years. In 1987, RVF was listed on the New York Stock Exchange and posted a sales volume of more than 20 units a year, sold mainly to large customer accounts. This growth can be accounted for by client loyalty and attention to satisfying the first customers’ needs rather than conquering new markets. In 1987, despite technological advance- ments some customers were still using the first RVF computer version, the famous model 2, which helped establish the RVF name. Sales stemming from equipment generated a corollary business of computer customer service, representing 25% of revenue in 1987 ($80 million). In the early 1980s a third business was born, with the development of peripherals such as disk drives and telecommunications processors. RVF set up a small assembly unit in the south of France (200 employees). RVF France, which had been a mere distribution entity, now became a full-fledged profit center. As the most experienced engineer, Mr. Piazzolo was named managing director. Computers were still purchased from the Swedish plant for a sale price that covered the production cost plus a slight margin (3%). In 1987, RVF France purchased half of the peripherals it sold to customers; the other half were assembled in the plant. Sales of peripherals in France reached $72 million in 1987 (see Ex- hibit 5(A)-5, Schedule 2). 51 The French Organization The French unit comprises five departments. The sales and marketing department consists of engineers who head the large client accounts. They are assisted by sales engineers and a market- ing team. The team is very well established in the industry, thanks to its competitive prices, but lacks a market presence in services (banking and insurance). Recently, however, management has spoken of hiring a sales director to work on this neglected business. In addition to a high base salary, the salesmen also receive commissions linked to their sales. If a salesman makes a deal, the commission can be substantial. Sales representatives consider sales to be the company’s main objective and believe that they are the corporate motor. Within the company, they often are viewed as condescending and uncooperative, especially by customer services. For the most part the customer services department is composed of on-site technicians, orga- nized by regions. Servicing (maintenance) generally involves going to the client’s site at night or on weekends. These technicians feel that they are not respected, especially by the sales engineers. Customer services feels that to close a deal, sales representatives offer customers short service delays, leaving customer services personnel to work with very short deadlines. Linked to the customer services department, the services department is very small; it handles a few system integration missions for customers. This activity is very marginal (revenue of $7.2 million in 1987). The production department oversees operations of the peripheral assembly plant. Finally, these departments rely on support services (financeand administration), which have been downsized to provide the necessary margins for research. Mr. Piazzolo, the managing director, often says that RVF doesn’t “waste its time on management. We are first and foremost research- ers, our products are the market’s best, and we have to pursue this track if we want to develop our business. We can’t burden ourselves with a large and costly administrative structure.” Budget Meeting for 1988 The October 15th meeting focusing on the budget went well. All the participants agreed that the main target should be the mainframe market. Given their customers’ increasing information tech- nology needs, RVF management anticipate major developments in this business. Fortunately, microcomputer development has not been carried out at the expense of mainframe development. Possible competition from minicomputers with a network architecture is viewed as unlikely, as it would mean that customers would have to revamp their entire architecture. In 1988 RVF must develop sales, particularly for the most recent model, model 5, a very powerful computer welcomed by the market in 1987. The overall objective for 1988 is to take IBM market share. In terms of units, the company is planning to maintain the current total volume (24 units) but would like to emphasize the new models, which are much more powerful and much more expensive. These sales currently number two units; the company would like this number to reach 14. Consequently, RVF’s strategy is to penetrate the service sector (banking and insurance). Cur- rently the company has no presence in this area. A new department with 15 salesmen will be created. Its objective is to generate additional revenue of $40 million. Emphasis will also be placed on increasing margins to pursue research. Despite an estimated 5% drop in sales prices in this market, margins could be enhanced by developing sales volumes, leading to better distribution of fixed costs. The budgeted operating results total 18% of revenue versus 17% in 1987. 52 Questions 1. Clearly state the problems RVF is encountering in terms of the management accounting system. 2. Build the main axes of the Tableau de Bord (see Exhibit 5(A)-6 for design process): • After analyzing the environment (opportunities/ threats) and the company (strengths/ weaknesses), spell out the company’s mission and strategy for 1988 (in two sentences). • Translate this mission and strategy into quantified objectives (two or three objectives). • Define the action variables (or key success factors) corresponding to each objective (a maximum of seven). • Identify the managers involved for each action variable (see blank document in Ex- hibit 5(A)-7). 3. Using this base, build a Tableau de Bord for the customer service department and then build one for the managing director (use the blank documents in Exhibit 5(A)-8). Include: • Objectives; • Action plans corresponding to the previously identified action variables (specific ac- tions to be carried out by the manager and actions delegated to his subordinates); • Indicators corresponding to the objectives and to the action plans. Exhibit 5(A)-5 Schedule 1. Revenue and margins by product 2. Profit and loss account 3. Headcount 4. Operating expenses (detail) 5. Ratios 53 Exhibit 5(A)-5, Schedule 1. Revenue and Margins by Product (000 $) 88/87 % of unit sales price decrease -5% 1987 1988 Products Actual Forecast CPU model 4 (old one) Quantity 22 10 Sales price per unit $6,600 $6,270 Revenue $145,200 $62,700 % cost/sales price per unit 70% 55% Unit cost $4,620 $3,449 Margin per unit $1,980 $2,822 Total margin $43,560 $28,215 1987 1988 CPU model 5 Actual Forecast Quantity 2 14 Sales price per unit $12,000 $11,400 Revenue $24,000 $159,600 % cost/sales price per unit 90% 80% Unit cost $10,800 $9,120 Margin per unit $1,200 $2,280 Total margin $2,400 $31,920 1987 1988 Services Actual Forecast Quantity 6 7 Sales price per contract $1,200 $1,240 Revenue $7,200 $8,680 % cost/sales price per unit 80% 80% Unit cost $960 $992 Margin per unit $240 $248 Total margin $1,440 $1,736 1987 1988 Maintenance Actual Forecast Quantity 100 115 Sales price per contract $800 $800 Revenue $80,000 $92,000 % cost/sales price per unit 60% 60% Unit cost $480 $480 Margin per unit $320 $320 Total margin $32,000 $36,800 1987 1988 TOTAL HARDWARE Actual Forecast CPU quantity 24 24 Sales price per unit Revenue $241,200 $302,100 % cost/sales price per unit 69% 70% Unit cost Margin per unit Total margin $74,760 $92,055 54 1987 1988 TOTAL SOFTWARE Actual Forecast Revenue $87,200 $100,680 % cost/sales price per unit 62% 62% Total margin $33,440 $38,536 1987 1988 GENERAL TOTAL Actual Forecast Revenue $328,400 $402,780 %cost/salesprice per unit 67% 68% Total margin $108,200 $130,591 Exhibit 5(A)-5, Schedule 2. Profit & Loss Account (in 000 $) 1987 1988 Actual Forecast Revenue - computers $169,200 $222,300 - peripherals 72,000 79,800 - maintenance 80,000 92,000 - services 7,200 8,680 Total revenue 328,400 402,780 Cost : - computers 123,240 162,165 - peripherals 43,200 47,880 - maintenance 48,000 55,200 - services 5,760 6,944 Cost of revenue 220,200 272,189 Gross margin - computers 45,960 60,135 - peripherals 28,800 31,920 - maintenance 32,000 36,800 - services 1,440 1,736 Gross margin 108,200 130,591 Operating expenses - Sales & marketing 42,204 48,275 - General & administration 8,888 9,679 Operating expenses 51,092 57,954 Operating income $57,108 $72,637 Exhibit 5(A)-5, Schedule 1 (continued) 55 Exhibit 5(A)-5, Schedule 3. Headcount 1987 1988 Actual Forecast Sales and Marketing Account executives 50 60 Technicians 80 85 Marketing 25 25 Others 10 10 Total 165 180 Maintenance Hardware technicians 300 350 Software technicians 25 30 Engineers & managers 24 28 Others 15 15 Total 364 423 Software & Services Software technicians 6 10 Engineers & managers 2 6 Others 3 4 Total 11 20 Production Workers 220 250 Technicians 45 50 Engineers & managers 14 17 Others 20 25 Total 299 342 Finance & Administration Employees 40 40 Managers 15 17 Total 55 57 GENERAL TOTAL Workers 220 250 Technicians 376 440 Engineers & managers 210 238 Others 88 94 GENERAL TOTAL 894 1,022 56 Exhibit 5(A)-5, Schedule 4. Operating Expenses (in 000 $) 1987 1988 Actual Forecast Sales and Marketing Direct cost $38,404 $44,475 Indirect cost 3,800 3,800 Total cost $42,204 $48,275 Maintenance Direct cost $33,549 $40,612 Indirect cost (includ. spare parts) 14,451 14,588 Total cost $ 48,000 $55,200 Software & Services Direct cost $1,407 $ 2,907 Indirect cost (includ. subcontract.) 4,353 4,037 Total cost $5,760 $6,944 Production Direct cost 23,994 28,578 Indirect cost 19,206 19,302 Total cost $43,200 $47,880 General & Administration Direct cost 6,888 7,679 Indirect cost 2,000 2,000 Total cost $8,888 $9,679 GENERAL TOTAL Direct cost 104,242 124,251 Indirect cost 43,810 43,727 Total cost $148,052 $167,978 57 Exhibit 5(A)-5, Schedule 5 1987 1988 RATIOS Actual Forecast Revenue Revenue increase 23% Hardware rev./total rev. in % 73% 75% Maintenance rev./total rev. in % 22% 20% Services rev./total rev. in % 2% 2% Computer gross margin/revenue in % 27% 27% Peripheral gross margin/revenue in % 40% 40% Maintenance gross margin/revenue in % 40% 40% Services gross margin/revenue in % 20% 20% (Marketing and G&A expenses) / revenue 23% 21% Operating income/revenue in % 17% 18% Revenue by head in 000$ 367 394 Revenue by A.E. in 000$ 6,568 6,713 Av. CPU sold by 10 A.E. 5 4 No. of sales support by 10 A.E. 7 7 G&A headcount/total headcount 6% 6% Expense by person (in 000 $) - Sales & mktg $256 $268 - Maintenance $132 $130 - Services $524 $347 - G&A $162 $170 - Production $144 $140 - Total $166 $164 58 Exhibit 5(A)-6. “Tableau de Bord” Design Process 59 Exhibit 5(A)-7. Responsibility Flow Chart Global Action Detailed Action Managing Customer Sales/ Human Variables Variables Director Services Marketing Finance Resources Production 60 Exhibit 5(A)-8. Customer Services Tableau de Bord a/ Result indicators 1 Objectives Indicators Reference Value 1 General level action variables (see Exhibit 5(A)-6) for which C.S. relations have been identified. These variables should answer a specific goal at C.S. level (strategy implementation). Due to this fact, deciding to design a Tableau de Bord may show inconsisten- cies between the overall strategy and local orientation. 61 Exhibit 5(A)-8 (continued) Customer Services Tableau de Bord b/ Indicators for action plans specific to customer service Objective Action Variables Action Plan Indicators Reference Value 62 Exhibit 5(A)-8 (continued) Managing Director Tableau de Bord a/ Result indicators Global Objectives Indicators Reference Value 63 b/ Indicators for action plans specific to the managing director Action Variables Action Plans Indicators Reference Values Exhibit 5(A)-8 (continued) Managing Director Tableau de Bord 64 c/ Indicators for delegated activities Related Departments Indicators Reference Value Customer Service Sales Human Resources Production Exhibit 5(A)-8 (continued) 65 Case 5 (B) RVF Systems Inc. F. Giraud, V. Lerville-Anger, and R. Zrihen École Supérieure de Commerce de Paris (Paris School of Management) Management Control Department On December 1, 1992, provisional results are reported to the general management. The report shows negative operating results, and after financial costs have been deducted, it shows an even greater loss. Management is quite concerned, and Mr. Piazzolo consequently has gathered his team to try and get a better picture of the situation. The goal is to reach the breakeven point. At the beginning of the meeting, the sales manager, Mr. Artaud, highlights the key evolu- tions of the past few years. “First, we were confronted with an all-out price war, which since 1988 has led to a free fall of 55% of the price per MIPS. 1 We believe this trend will be accentuated in 1993 with a drop in prices of 25%. The surge in minicomputers has been detrimental to mainframe sales. The peripheral sector has also been hit, with prices slashed in half. How can we survive in such an environment? How should we place ourselves strategically? Should we pursue our business manufacturing computers?” Bonnot (production manager): I don’t understand. We’ve always made computers that have the world’s best technology and have always met our clients’ needs. Are we going to cut off the branch we are sitting on? Zerbib (financedirector): Come, come, the figures speak for themselves! Hardware margins don’t even cover the overhead costs, and that doesn’t include clients who are more and more reluctant to pay maintenance fees. How can we reach a balance? The situation is untenable, and we should be asking some serious questions. Piazzolo (managing director): What’s clear is that we can’t refuse sales contracts on the grounds that our margins are too low. We’ve lost so many customers that our market share has slipped more than 25%. The priorities are crystal clear—we need to boost volume and gain market share. To do this, we need to track market trends and develop services. Breton (customer servicemanager): We fully back your idea, which is a normal evolution for our department. Given our successful zero default policy on all our computers, we’ve gained real experience. If we get the necessary financial support, we have the means to develop the offerings. Zerbib: The debate is more basic. I agree that given our goals, we need to take additional measures. But we’re not talking about reallocating resources. I’m not talking about developing what already exists but taking on a new branch involving a completely different structure. This new branch means another culture in both focus and structure. It’s practically the antithesis of our 1 MIPS: millions of instructions per second. Copyright ©1998 by F. Giraud, V. Lerville-Anger, and R. Zrihen 66 mainframe culture. For example, integrating mainframes requires project management and fol- low-up, employees who are focused on other applications and equipment. Our current values are structured around our equipment’s technological superiority. Moreover, the current salary struc- ture won’t allow us to be competitive in terms of clients. Maybe we should think of setting up a separate company to handle this specific branch. Piazzolo: Take it easy, gentlemen. The strategy is clear: develop sales mainly via our services. The Performance Scorecard (Tableau de Bord) needs to underline this new priority and account for directing performance. Zerbib: The strategy may be clear, but if we want the Tableau de Bord to be realistic, the responsibilities must be well defined, which isn’t the case now. Piazzolo: You’re right. I thought I could put off the decision making, but I think it’s worth clearing up the problem now. Setting up a separate entity doesn’t seem like the right idea if we want to pursue synergy with our current activities. On the other hand, weighing down client relations compromises our mainframe branch, and we need all our skills focused there. So we need to create a new division to develop services. This department will be managed as a separate entity and should be self-sufficient financially. Its objective will be to reach critical mass very quickly. In a year, revenue should be twofold. Questions 1. Why must the Tableau de Bord be changed? 2. Analyze the December 1 meeting. What are the issues that will affect the future design of the Tableau de Bord? Why is Mr. Piazzolo’s final intervention important? Exhibit 5(B)-1. Budget Documents for 1993 Schedule 1 Revenue and Margins by Product 2 Profit and Loss Account 3 Headcount 4 Operating Expenses (detail) 5 Ratios 67 Exhibit 5(B)-1, Schedule 1. Revenue and Margins by Product (000 $) 1992/1988 1993/1992 % of unit sales price decrease -55% -25% Products 1992 1993 CPU model 4 (old one) Actual Forecast Quantity 1 0 Sales price per unit $1,822 - Revenue $1,822 - % cost/sales price per unit 55% 0% Unit cost $1,002 - Margin per unit $820 - Total margin $820 - 1992 1993 CPU model 5 Actual Forecast Quantity 29 24 Sales price per unit $5,130 $3,848 Revenue $148,770 $92,340 % cost/sales price per unit 80% 78% Unit cost $4,104 $3,001 Margin per unit $1,026 $846 Total margin $29,754 $20,315 1992 1993 CPU modeI 6 Actual Forecast Quantity 3 14 Sales price per unit $6,200 $4,650 Revenue $18,600 $65,100 % cost/sales price per unit 86% 87% Unit cost $5,332 $4,046 Margin per unit $868 $605 Total margin $2,604 $8,463 1992 1993 DASD (peripherals) Actual Forecast Quantity 150 170 Sales price per unit $342 $257 Revenue $51,300 $43,605 % cost/sales price per unit 78% 80% Unit cost $267 $205 Margin per unit $75 $51 Total margin $11,286 $8,721 68 Exhibit 5(B)-1, Schedule 1 (continued) 1992 1993 Services Actual Forecast Quantity 50 100 Sales price per contract $1,800 $1,800 Revenue $90,000 $180,000 % cost/sales price per unit 90% 86% Unit cost $1,620 $1,548 Margin per unit $180 $252 Total margin $9,000 $25,200 1992 1993 Maintenance Actual Forecast Quantity 165 180 Sales price per contract $560 $540 Revenue $92,400 $97,200 % cost/sales price per unit 79% 68% Unit cost $442 $367 Margin per unit $118 $173 Total margin $19,404 $31,104 1992 1993 TOTAL HARDWARE Actual Forecast CPU quantity 33 38 Sales price per unit Revenue $220,492 $201,045 % cost/sales price per unit 80% 81% Unit cost Margin per unit Total margin $44,464 $37,499 1992 1993 TOTAL SOFTWARE Actual Forecast Revenue $182,400 $277,200 % cost/sales price per unit 84% 80% Total margin $28,404 $56,304 1992 1993 GENERAL TOTAL Actual Forecast Revenue $402,892 $478,245 % cost/sales price per unit 82% 80% Total margin $72,868 $93,803 69 Exhibit 5(B)-1, Schedule 2. Profit and Loss Account (in 000 $) 1992 1993 Actual Forecast Revenue: - computers $169,192 $157,440 - peripherals 51,300 43,605 - maintenance 92,400 97,200 - services 90,000 180,000 Total revenue $402,892 $478,245 Cost: - computers $136,014 $128,662 - peripherals 40,014 34,884 - maintenance 72,996 66,096 - services 81,000 154,800 Cost of revenue $330,024 $384,442 Gross margin: - computers $33,178 $28,778 - peripherals 11,286 8,721 - maintenance 19,404 31,104 - services 9,000 25,200 Gross margin $72,868 $93,803 Operating expenses: - Sales & marketing $59,724 $65,618 - General & administration 13,257 13,500 Operating expenses $72,980 $79,117 Operating income -$ 113 $14,686 70 Exhibit 5(B)-1, Schedule 3. Headcount 1992 1993 Actual Forecast Sales and marketing Account executives 61 65 Technicians 90 95 Marketing 25 28 Others 10 9 Total 186 197 Maintenance Hardware technicians 400 220 Software technicians 40 50 Engineers and managers 30 45 Others 15 15 Total 485 330 Software & services Software technicians 130 320 Engineers & managers 80 320 Others 15 25 Total 225 665 Production Workers 100 95 Technicians 55 50 Engineers & managers 20 20 Others 50 10 Total 225 175 Finance & administration Employees 44 42 Managers 22 22 Total 66 64 General total Workers 100 95 Technicians 625 640 Engineers & managers 328 595 Others 134 101 GENERAL TOTAL 1,187 1,431 71 Exhibit 5(B)-1, Schedule 4. Operating Expenses (in 000 $) 1992 1993 Actual Forecast Sales and Marketing Direct cost $55,524 $61,418 Indirect cost 4,200 4,200 Total cost $59,724 $65,618 Maintenance Direct cost $56,659 $41,533 Indirect cost (including spares parts) 16,337 24,563 Total cost $72,996 $66,096 Software and Services Direct cost $42,557 $139,656 Indirect cost (including subcontract) 38,443 15,144 Total cost $81,000 $154,800 Production Direct cost $24,960 $21,831 Indirect cost 15,054 13,053 Total cost $40,014 $34,884 General and Administrative Direct cost $11,257 $11,500 Indirect cost 2,000 2,000 Total cost $13,257 $13,500 GENERAL TOTAL Direct cost $190,956 $275,938 Indirect cost 76,034 58,959 Total cost $266,990 $334,897 72 Exhibit 5(B)-1, Schedule 5. Ratios 1992 1993 Actual Forecast Revenue Revenue increase 19% Hardware revenue/total revenue in % 55% 42% Maintenance revenue/total revenue in % 22% 17% Services revenue/total revenue in % 22% 38% Computer gross margin/revenue in % 20% 18% Peripheral gross margin/revenue in % 22% 20% Maintenance gross margin/revenue in % 21% 32% Services gross margin/revenue in % 10% 14% (Marketing and G & A expenses)/revenue 22% 21% Operating income/revenue in % 0% 3% Revenue by head in 000 $ 339 334 Revenue by A.E. in 000 $ 6,605 7,358 Average CPU sold by 10 A.E. 5 6 Number of sales support by 10 A.E. 7 7 G & A headcount/total headcount 6% 4% Expense by person (in 000 $) - Sales & marketing 321 333 - Maintenance 151 200 - Services 360 233 - G & A 201 211 - Production 178 199 - Total 225 234 73 Case 6 Evaluating Product Line Performance: The Case of Wellesley Paint 1 Carol M. Lawrence, University of Richmond Diane Hotchkiss Tiller, CPA “I’m not looking forward to breaking the news to Mrs. W. She’s going to take this pretty hard,” groaned Charlie Oliver, the controller of Wellesley Paint Company. He and Don Smith, state liai- son for the firm, were returning from a meeting with representatives of the Virginia General Ser- vices Administration (GSA), the agency that administers bidding on state contracts. Charlie and Don had expected to get the specifications to bid on the traffic paint contract, soon to be renewed. Instead of picking up the bid sheets and renewing old friendships at the GSA, however, they were stunned to learn that Wellesley’s paint samples had performed poorly on the road test and the firm was not eligible to bid on the contract. Charlie and Don were on their way to report to the president of the company, Victoria Wellesley. “Mrs. W.,” as the employees fondly refer to her, is the 70-year-old widow of the company’s founder and has served as president of the company since his death in 1987. “Mrs. W.” is very proud of the quality of the firm’s products and also of its close ties with the state of Virginia, where her family have been prominent citizens since before the Civil War. The label on cans of Wellesley’s house paint features a picture of her ante bellum home. Wellesley’s two main product lines are traffic paint, used for painting yellow and white lines on highways, and commercial paints, sold through local retail outlets. Because of the small size of the firm, all employees handle multiple tasks. For example, Don Smith’s official job title is state liaison, and during contract negotiations he is the firm’s main contact with state officials. When no negotiations are pending, however, he often drives a forklift in the warehouse or travels to road test sites where he operates the striping equipment used to apply traffic paint to the high- way. Production Process The paint production process is fairly simple. Raw materials are kept in the storage area that occupies approximately half of the plant space. Large tanks that resemble silos are used to store the latex that is the main ingredient in their paint. These tanks are located on the loading dock just outside the plant so that when a shipment of latex arrives, it can be pumped directly from the tank truck into these storage tanks. Latex is extremely sensitive to cold. It cannot be stored outside or even shipped in the winter without heated trucks, which are prohibitively expensive for a small firm such as Wellesley. 1 The company and situation described in this case are real. The names of the firm and all individuals have been changed to protect their privacy. Copyright ©1998 by Institute of Management Accountants, Montvale, NJ 74 Paint is mixed and packaged at six identical production stations. Each station has two 1,000- gallon mixing vats so that while the first batch of paint is being pumped into drums, another batch of paint can be mixed. An employee pours ingredients into a mixing vat according to a predetermined formula. When the mixing is complete, a sample is tested by the technical director for color, thickness, texture, and drying time. He issues directions for any additional ingredients or approves the batch. Workers then pump the paint into 55-gallon drums from a hose attached to the mixing vat. The amount of paint that can be produced is limited by the available equipment and production space. Traffic Paint Currently, Wellesley has the traffic paint contracts for the states of Pennsylvania, North Caro- lina, Delaware, and Virginia. Of last year’s total production of 380,000 gallons, 90% was traffic paint. Of this amount, 88,000 gallons were for the Virginia contract. Each state has unique specifi- cations for color, thickness, texture, drying time, and other characteristics of the paint. For ex- ample, paint sold to Pennsylvania must withstand heavy use of salt on roads during the winter. Paint for North Carolina highways must tolerate extended periods of intense heat during sum- mer months. The process of bidding on a traffic paint contract begins with a road test under the supervi- sion of the National Association of Highway Paints (NAHP), an independent organization sup- ported by state funds. NAHP designates a certain stretch of highway to serve as the road test site. Any paint manufacturer may apply stripes of their paint at the test site. NAHP monitors the test site and reports the results to the state highway department. State personnel review the reports and invite the manufacturers of the best-performing paints to submit bids. The firm that submits the lowest bid wins the contract. Contracts, which normally cover a five-year period, specify only the price per gallon and quality requirements such as drying time and road-life. The timing of deliveries is determined later based on state work schedules and weather constraints. Demand is highly seasonal, as states do most of their highway painting in June, July, and August. The total amount of paint a state will order is not determined until spring, when the states know how much of their highway budget remains after winter snow removal costs have been paid. After the paint is produced, the state must test the paint before approving it for shipment. A sample is sent to the state laboratory, which may take up to two months to perform the testing. In the meantime, Wellesley must store all the manufactured paint in its warehouse. At times, the warehouse has been filled to capacity, and drums of paint are stored in the aisles, production areas, and any available inch of space. Due to the high cost of shipping paint, most paint producers can be competitive on price only in locations fairly close to their production facilities. Accordingly, Wellesley has enjoyed an advantage in bidding on contracts in the eastern states close to Virginia. However, one of their biggest competitors, Heron Paint Company of Houston, Texas, is building a new plant in North Carolina. With lower costs due to their efficient new facility and their proximity, Heron will be- come a major competitive threat. Commercial Paint Wellesley’s commercial paint line includes interior and exterior house paints in a wide range of colors formulated to approximate authentic colonial colors. Because of the historical associa- tion, the line has been well received in Virginia. Most of these paints are sold through paint and hardware stores as the stores’ second or third line of paint. The large national firms such as Ben- jamin Moore or Sherwin Williams provide extensive services to paint retailers such as computer- 75 ized color matching equipment. Partly because they lack the resources to provide such amenities and partly because they have always considered the commercial paint a sideline, Wellesley has never tried to market their commercial line aggressively. Mrs. W. is worried about the future of the company. The firm’s strategic goal is to provide a quality product at the lowest possible cost and in a timely fashion. After absorbing the shock of losing the Virginia contract, Mrs. W. wondered whether the firm should consider increasing pro- duction of commercial paints to lessen the company’s dependence on traffic paint contracts. Her son, who manages the day-to-day operation of the firm, believes they can double their sales of commercial paint if they undertake a promotional campaign estimated to cost $15,000. The aver- age price of traffic paint sold last year was $9 per gallon. For commercial paint, the average price was $11. Cost Data Charlie Oliver has assembled the following data to evaluate the financial performance of the two lines of paint. The primary raw material used in paint production is latex. The list price for latex is $13.50 per pound. If the firm uses more than 150,000 pounds annually they qualify for a 10% discount; 450 pounds of latex are needed to produce 1,000 gallons of traffic paint. Commer- cial paint requires 325 pounds of latex per 1,000 gallons of paint. In addition to the cost of the latex, other variable costs are as shown below. Raw materials cost per gallon of paint: Traffic Commercial Camelcarb (limestone) 0.38 0.54 Silica 0.37 0.52 Pigment 0.12 0.38 Other ingredients 0.06 0.03 Direct labor cost per gallon 0.46 0.85 Freight cost per gallon 0.78 0.43 Last year, overhead costs attributable to the traffic paint totaled $85,000, including an esti- mated $25,000 of costs directly associated with the Virginia contract. Overhead costs attributable to the commercial paint are $13,000. Other manufacturing overhead costs total $110,000. Charlie estimates that $9,000 of this amount is inventory handling costs that will be avoided due to the loss of the Virginia contract. Both the remaining manufacturing overhead and the general and administrative costs of $140,000 are allocated equally to all gallons of paint produced. Required 1. The firm’s strategic goal is to provide a high-quality product to customers at a reasonable cost and in a timely fashion. What specific quality, cost, and time issues are relevant to traffic paint? To commercial paint? What information does the firm need to assess the performance of each product line on the three strategic dimensions of quality, cost, and time? 2. Calculate the contribution margin (selling price minus variable costs) and gross margin (selling price minus all manufacturing costs) per gallon for each type of paint and total firm-wide profit under each of the following scenarios: Scenario A Current production, including the Virginia contract Scenario B Without either the Virginia contract or the promotion to expand sales of com- mercial paint Scenario C Without the Virginia contract but assuming the promotional campaign is un- dertaken and sales of commercial paint do in fact double 76 What insight is provided by a comparison of Scenarios A and B? What insight is provided by a comparison of Scenarios B and C? 3. The Balanced Scorecard is a multidimensional approach to performance measurement that recognizes four dimensions of organizational performance, as shown in the table below. Dimension Key Concern Financial perspective How do we look to stockholders? Customer perspective How do customers see us? Internal business perspective How do we look to employees? Innovation and learning perspective Continuous improvement To implement the Balanced Scorecard, a firm first sets goals for each dimension and then defines performance measures to assess progress toward these goals. Suppose Charlie has asked your help in designing a Balanced Scorecard for Wellesley Paint. What goals might be appropriate for each of the four dimensions, in light of the firm’s strategic (quality, cost, time) objectives? What performance measures would you suggest for each of the four dimensions? 4. Based on your answers to questions 1 through 3, what should the firm do?