Even Semester (2012-2013)

Universitas Bina Nusantara Binus International

Assignment Cover Letter (Group Assignment)

Student Information

Name

: Felicia Juliani Putri Michelle Raissa Hadisaputra : AC403 : 05PAB

(1401088406) (1401089453) (1401088513) Course Name Name of Lecturer : Management Control System : Dr. Ancella Hermawan

Course Code Class Title of Assignment Type of Assignment Submission Pattern Due Date

: Armco, Inc.: Midwestern Steel Division : Group Assignment : Hard Copy : March 6th, 2013 Submission Date : March 6th, 2013

The assignment should meet the below requirements. 1. Assignment (hard copy) is required to be submitted on clean paper, and (soft copy) as per lecturers instructions. 2. Soft copy assignment also requires the signed (hardcopy) submission of this form, which automatically validates the softcopy submission. 3. The above information is complete and legible. 4. Compiled pages are firmly attached. 5. Assignment has been copied (soft copy and hard copy) for each student ahead of the submission. Plagiarism/Cheating BiNus International seriously regards all forms of plagiarism, cheating and collusion as academic offenses which may result in severe penalties, including loss/drop of marks, course/class discontinuity and other possible penalties executed by the university. Please refer to the related course syllabus for further information. Declaration of Originality By signing this assignment, we understand, accept and consent to BiNus International terms and policy on plagiarism. We hereby declare that this work represents my own effort, and that all text and code have been written by me and has not been submitted for the use of assessment in another course or class, except where this has been notified and accepted in advance. Signatures of Students: 1. Felicia Juliani Putri 2. 3. Michelle Raissa Hadisaputra

Background
Early in 1991, management of Kansas City Works of Armco began to implement new performance measurement for Midwestern Steel Division. Bob Nenni, Director of Finance for the division explained that managers spent more time explaining why changes in costs were caused by problems with the accounting system in the old system. After they fixed the problem, new performance measurement is found. It is designed to give better management focus on things that are most important for them to worry about. Furthermore, it also helps them to warn any potential problems incurred and improve commitment to achieve objectives. In the summer of 1991, the new system was still being implemented. However, Bob believed that the new system would be successful and he hoped that its use would spread throughout Armco. Background of Armco and the Kansas City Works Armco, Inc. was a producer of stainless, electrical and carbon steels and steel products. It also produced coated, high strength and low-carbon flat rolled steels and oil field machinery and equipment as the result of joint venture. In 1990, Armco was successful in becoming the 6th largest steel manufacturer in United States with over $1.7 billion in net sales and $77 million operating profits. Midwestern Steel Division could generate $550 million of sales in 1990. Kansas City Works was the largest entity, accounting for approximately $250 million in sales. Like that of most of the firms in US steel industry, business at the Kansas City Works had declined significantly in the last decade. Armco, Inc. experienced decrease in sales and operating profits. Moreover, the employment was down from 5,000 employees in 1980 to 1,000 in 1990. It recorded significant losses in 1980s, but it had been marginally profitable since 1988. Kansas City Works produced two primary products: grinding media and carbon wire rod. Grinding media were steel balls used for crushing ore in mining operations, whereas carbon wire rod was used to make shopping carts, bed springs, coat hangers, and other products. In 1990, the Kansas City Works sold 500,000 tons of rods and 200,000 tons of grinding media. Armco was recognized as the leading supplier of its grinding media products in United States. It was proved by being the most durable, and it received fewer complaints than its competitors. Conversely, its

carbon wire rods, as a commodity product, were not a profitable product since the production still used old technology. The usage of the old technology caused it did not become cost competitive. However, the rods generated volume and helped cover some of the fixed costs of the plant. The Works was not a low-cost manufacturer caused by several reasons, such as the higher of union labor costs and inefficient plant infrastructure. The cost of union labor was higher than some of its nonunion competitors. In addition, inefficient plant infrastructure was caused by the usage of many employees about five times higher. As the result of its cost disadvantage, the Works managers were intended to substitute the weakness by differentiating the offered products. It developed the new higher-value products and success in selling approximately 10% of new higher value products each year. According to Rob Cushman, division presidents evaluation, all salaried employees in Works had chances to get incentives ranging 5-30% of annual salary as awards based on performance measurement. The incentives were affected by individuals organization le vel and subjective measurement. There were three measurements that applicable for these awards. For instance Rob Cushman explained the criteria to evaluate the performance of Charlie Bradshaw, Works Manager, as being based on one third on plant safety, one third on hard production numbers, and one third on his evaluation of Charlies leadership. Critical Success Factors in the Works A. The melt shop The shops goal was to run three shifts a day, seven days a week, 50 weeks a year, excluding eight hours a week used for preventive maintenance. The rest 2 weeks of the year were used for the extensive preventive maintenance and installation of new equipment. Theoretically speaking, the shop would produce 110 heats/week. However, the best average result was 99 heats/week. The performance of this melt shop affected the performance of the Kansas City as a whole. It was because the output from the meat shops production would determine the output of the plant as a whole. Moreover, the meat shop costs accounted for nearly 40% of total steel conversion costs incurred in the plant. The largest expenditures in the melt shop were for

production material, labor, and energy. Energy itself accounted for 10% melt shop costs. In 1988 Armco made an $8 million investment in a new ladle arc furnace that significantly changed the melting furnace technology used in the plant, and costs were declining as the managers learned how best to use the new technology. In addition, the quality of raw steel produced was a significant component in determining whether the quality met the specific requirements. It was affected by the grades of scrap steel and nonmetallic materials being used. Some production processes were standardized, with the addition of some nonmetallic done either by automated equipment or by production employees following standardized recipes. B. Rolling and Finishing The significant costs incurred in this phase were for labor, energy, maintenance, and yield losses. This areas were heavily capital intensive. Based on the customer s actual testing on grinding operations, Armcos ball were more than competitive; they lasted up to 15% longer than did its closest competitors balls. C. Maintenance The goal of maintenance was to maximize equipment uptime while controlling maintenance expenditures. The maintenance activities were divided into three groups. There was an assignment of electrical and mechanical maintenance employees to each manufacturing cost center. A third group operated a centralized maintenance shop. The cost in the maintenance was mostly for maintaining workers. The Old Performance Measurement System The manufacturing areas of Kansas City Works were divided into five responsibility areas: melting, casting, the 19 mill, the rod mill department, and the grinding media depa rtment. Each responsibility center was comprised of one or more cost centers. Before the changes were made in 1991, the performances of these cost center managers and superiors were evaluated in terms of cost control and safety. The key cost performance m easure, which was called Cost Above, included the cost added per ton of steel at each production stage and for the entire plant. The costs were reported to manufacturing managers on an Operating Statistics Report that was produced on approximately the 15th day following each month end.

The Operating Statistic Reports provided a five-year history, monthly, and year-to-date actual, and monthly and year-to-date objectives and variances form objective for each of the factors that determined total Cost Above for each cost center. The reports used the same accounting information that was used in the financial reporting and inventory valuation purposes, so the figures included allocations of indirect manufacturing costs. The New Performance Measurement System A. The goals of the new system As the director of finance, Bob Nenni had been working on a performance measurement system since 1989. However, he had been unable to design and implement the new system while keeping the old system going due to staff constrains. Therefore, on November 1, 1990, Rob Cushman was appointed as Midwestern Steel Division and sponsored the implementation of a new performance measurement system. Moreover, he allowed Bob to discontinue the usage of Operating Statistics Report in January 1991 in order to implement the new system. The new system was designed both to provide the middle and lower-level managers with a greater understanding of how their actions related to the implementation of the divisions business strategies and as an improved method for managers at all levels to assess the extent to which the desired results were being achieved. Then, the vision and goal were compared with the actual results. Bob and Rob thought that the implementation of new system promised two major improvements. First, the new system was designed for managers to focus on few key objectives that largely determined the Kansas City Works success and not get involved in the detail until problems incurred. Second, the new system was designed to provide an improved basis for evaluating operating managers and manufacturing supervisors. It included a balanced set of performance measures, including quality, schedule achievement, and safety, in addition to costs. In addition, the cost reports would improve because it only included the cost which deemed controllable by each individual operating manager. B. The design of the new system There were 10 key performance measures were defined as the new system design for Kansas City Works, including:

1. Heats per week, which was only relevant to the melt shop. This measurement was a critical measure since the melt shop was a bottleneck operation. 2. Tons per man hour, which was a productivity measure 3. Disabling injury index, which was a safety measure 4. Total quality index, which was the product of three measures: physical yield, percentage of product meeting specification, and percentage on-time shipment 5. Spending, which was the accumulation of all expenses incurred by the people reporting directly to a manager 6. Maintenance performance, had not yet been clearly defined by the middle of 1991, but maintenance labor cost and material cost were being measured 7. Cash flow, was measured monthly for the plant 8. Product mix, was the percentage of high carbon products sold compared to low carbon 9. Inventory days on hand, was tracked monthly 10. Sales price minus cost of net metal, a measure of value added which was tracked monthly In the new system, Cost Above measure was eliminated. Production managers were no longer cost center managers. The cost detail in the new system was reduced. Moreover, the cost considered in the new system was only the expenditure by the employees in the organizations. C. The implementation process The new system focused on first on heats per week, tons per man hour, physical yield, and spending as the entire task could not be accomplished immediately. The operating managers initial reaction to the sample reports was dissatisfaction. The early reports did not provide the line-item expense detail to which they had become accustomed. Several managers complained because of incompleteness of the reports. In late April, the accounting group started to provide spending numbers for the entire cost center. This change allowed managers to compare their budgeted spending targets which had been prepared using old performance philosophy. Starting in 1992, they promised that the reports would reflect only the new performance philosophy. In June 1991, Bob Nenni was convinced that company was on the right track even though some managers were uncomfortable with the new system. And he knew that the delays in

implementation process had frustrated both information users and his accounting staff. Accounting division felt that they spend only 20% spending of their time in accounting on the non-value-added chores of inventory valuation for financial reporting purposes. Remaining Issues In 1990, there were two issues related to incentives and performance measurement. First, the issue was about how to evaluate managers performances for uncontrollable factors. For instance, early in 1991, the melt shop suffered two transformer failures because of fluctuations in the line voltages provided by local utility, Kansas City Power and Light. The failures had happened every year, but melt shop managers had recently upgraded some electrical switches to try to eliminate the problem. However, the failures occurred again and it was impossible to have an average of 101 heats per week. It could be concluded that this issue led to unaccomplished goal planned for 1991. Second, the issue was about whether to increase proportion of total compensation that was linked to individual performance evaluations or not. In other words, how much the total compensation should be provided in fixed salary, how much should be paid only to those who were good at getting things done and done well.

Analysis
The strength of old performance measurement system: 1. Based on critical success factors in the Works, action control did exist in determining whether the finished products met the required specifications. In fact, there was a standardized production process for the company to alleviate the lack of direction. The melt shop determined the grades of scrap steel and nonmetallic materials used in the process since the quality of finished products was affected significantly by those components. Moreover, some nonmetallic done either by automated equipment or by production employees. Although it was done by production employees, standardized recipes were provided to maintain the quality of finished product. It proved that the company had a strength action control in the melt shops production process. 2. In addition, the shops goal was really clear that to run three shifts a day, seven days a week, and 50 weeks a year, excluding eight hours a week used for preventive maintenance. The maintenance was maintained properly in order to maximize equipment uptime while controlling maintenance expenditures. The existence of regular maintenance would prevent the Works to spend money if there were trouble in the equipment. The potential cost occurred because of problems in equipment was high because the problems in the melt shop, as the bottleneck operation, would affect the entire manufacturing process. 3. All salaries employees in the Works were eligible for cash incentive awards based on performance evaluation made by supervisors and Rob Cushman, division president. This is an indication of applying result controls. The incentive award potentials ranged from approximately 5-30% of annual salary depending on the individuals organization level. The incentives would influence the employees performance. It would provide a positive motivational impact to develop them in achieving the goal. The implementation of result control in terms of cash incentives would be greatly interesting for some people.

The weakness of old performance measurement system: 1. Managers did not know how performance of the company as a whole. They only focused on achieving their own objectives. Therefore, the problem may occur due to different objectives between low, middle and top managers. 2. The operating statistic report provided too much information. Moreover, it was inconvenient to be read. The melting operation managers, Gary Downmey, also mentioned that the some items in report were quite small in dollar amounts. 3. The report was produced on 15th day following each month end. It took longer time for managers in correcting the previous actions, which produced an unsatisfactory result.

The strength of the implementation of new performance measurement system: 1. The new systems were designed in order to provide the most important information as the result on focusing on certain significant data. The new system caused them to focus on five or six things that cause 80% of costs instead of 40. The managers were focused on their objectives rather than the performance of the overall performance that might cause the objectives of top management and those in the middle and lower managers are not the same. Therefore, the new system was created in order to increase the competitiveness and to avoid unnecessary expenses. 2. The setting of performance targets was a significant element of result control system. The new system defined the performance targets, for instance for the melt shop, the company provided the target heats per week. Those targets would affect the behavior of the employees in two ways. First, they would stimulate the employee to improve their performances by providing conscious goals to strive for. It was because most people preferred to be given a specific target to shoot for to direct them and measure their own performance. Second, they can compare how they performed based on comparison of actual and budgeted result. The failure in achieving the targets warned the managers to change their actions and think other ways or strategy in order to achieve the targets.

3. One of conditions that are present in determining the effectiveness the result controls is the employees whose behaviors are being controlled have significant influence on the results for which they are being held accountable. The new measurement performance evaluation systems involve the controllable factors which enable managers to compare between the actual and budgeted targets. As provided in Exhibit 6 about the new system pilot performance report, the report provided not only the actual and planned amount, but also the variance.

In the implementation of new performance measurement system, several problems still occurred. 1. Lack of communication between the creator of new system, such as Rob Cushman, Charlie Bradshaw, Bob Nenni, Gil Smith, and others, to managers, the users of new key performance measures. In fact, in early April 1991, Charlie Bradshaw complained to Bob Nenni that he received nothing of use from other departments since the old reports had been discontinued. There was a possibility that the lack of communication led to misinterpretation the implementation of the new systems. Moreover, other operating managers stated that eventually the operating mangers understood the old reports which made them aware to change it. The statement proved that there were lack of understanding of the purpose in creating reports and unable to acknowledge the importance of specific information in the reports. Those problems caused the employees perform poorly and the likelihood of the desired behaviors occurring is relatively small. As they were lack of direction, they did not understand clearly what the organization wants form them. 2. Lack of motivation which occurred because of the lack of direction. As stated in the case, the implementation process had frustrated the employees. In addit ion, the operating managers was disappointed with the sample reports which did not provide the line-item expense detail to which they had become accustomed. The lack of direction would lead to unwillingness to change and move from their comfort zone. It c aused the lack of employees motivation to develop themselves in order to improve their performance. 3. Unclear key performance measures. One of the 10-key performance measures was maintenance performance. It was stated that the maintenance performance measures had not

yet been clearly defined. This issue would lead the measurement not congruent with the organizations objectives and encourage the employees to do the wrong things. 4. Occurrence of uncontrollable factors. In 1991, there was an issue related to the evaluation of managers performances. The situation was the evaluation involved uncontrollable factors, which was transformer failure. The failure was caused by the unstable line voltage provided by local utility, Kansas City Power and Light. As the result, the average heats per week were above 101 as had been stated in the goal of new system. Therefore, the difficulties would occur in the implementation of new performance evaluation systems as the result of the uncontrollable factors. The occurrence of uncontrollable factor created a dilemma for Rob Cushman, division president, whether to consider this issue affecting the evaluations of his operating managers. This was a significant issue since the performance in melt shop, which was measured by heats per week, would affect the performance of Kansas City Works as a whole. 5. There was a consideration related to increase proportion of total compensation that was linked to individual performance evaluations. How much of total compensation should be provided in fixed salary along with how much should be paid only to those who were good at getting things done and done well? There were no specific criteria determined yet in calculating the percentage increase.

Recommendations
1. In order to solve the miscommunication between employees, there should be a regular meeting for several months. For instance, the company conducts a regular meeting with managers every Monday in order to announce what is the expected performance dimensions. Furthermore, the progress of implementation is also discussed during the meeting. Any problems and limitations are delivered to get the solution. Therefore, the developer of new system will help to avoid the lack of direction during the implementation. In addition, the activities and evaluation of activities should be supervised properly. Rob Cushman has to make sure that the new systems were implemented according to the expectations or companys objectives. Besides providing reward for those who can achieve their targets, the company can give any punishment to motivate the employees in implementing new system rather than staying with the old standard. 2. In order to support the implementation of the new system, Bob Nenni as the director may discontinue the Operating Statistics Report System (old system). As stated in the case, Bob Nenni believed that if the managers kept using the old data, they would not considered what improvements could be made from the new one. Furthermore, lack of direction because of the new system implementation can be solved by conducting a weekly training in a month for all of the employees so that the employees could understand what the purpose of this new system implementation is, how this new system actually works, so they might be willing to move from their comfort zone. 3. Key performance measures should be measureable by numbers or a countable amount. In this case, it is stated that one of the ten key performance measures which was maintenance performance had not yet been clearly defined. Maintenance performance actually can be measured by, for instance, the numbers of the system down in a month. By measuring the maintenance performance, it can indicate whether the companys maintenance performance had been running well or not; and whether the maintenance activities had been adequate or not. If the measurement performance does not perform good result, company can decide whether to intensify the maintenance activities or to find out the problems which cause the system down more often.

4. Company may consider purchasing new equipment with more advanced technology. Armcos rod mill used relatively old technology, which was not cost competitive. Even though the sales volume of rod mill was high, but the sales helped to cover some of fixed costs of the plant. Therefore, although it is costly to buy new technology machine, however it will give benefit in long run. This advantage can also be seen in the melt shop, the cost declined because company invested $8 million for new melting furnace technology used in the plant. 5. Certain percentage multiplied total salary of employee may be applied in determining the compensation given. If the desired results are achieved in several months, company may increase the compensation in order to motivate employees. Salary range, job position, and performance evaluation are factors in selecting the amount percentage used. For instance, company may give higher compensation to higher level of manager or salary.