CHAPTER 23

PERFORMANCE MEASUREMENT, COMPENSATION, AND

MULTINATIONAL CONSIDERATIONS
23-1 Examples of financial and nonfinancial measures of performance are:
Financial
: ROI, residual income, economic value added, and return on sales.
Nonfinancial : Customer perspective: Market share, customer satisfaction.
Internal-business-processes perspective: Manufacturing lead time, yield, on-time performance,
number of new product launches, and number of new patents filed.
Learning-and-growth perspective: employee satisfaction, information-system availability.
23-2 The three steps in designing an accounting-based performance measure are:
1. Choose performance measures that align with top managements financial goals
2. Choose the details of each performance measure in Step 1, including the time horizon and
measurement of various aspects of the measure
3. Choose a target level of performance and feedback mechanism for each performance measure
in Step 1
23-3 The DuPont method highlights that ROI is increased by any action that increases return on
sales or investment turnover. ROI increases with:
1. increases in revenues,
2. decreases in costs, or
3. decreases in investments,
while holding the other two factors constant.
23-4 Yes. Residual income (RI) is not identical to return on investment (ROI). ROI is a
percentage with investment as the denominator of the computation. RI is an absolute monetary
amount which includes an imputed interest charge based on investment.
23-5 Economic value added (EVA) is a specific type of residual income measure that is calculated
as follows:
Economic value added (EVA) = After-tax operating income (Total assets minus Weighted x
average cost of capital current liabilities)
23-6 Definitions of investment used in practice when computing ROI are:
1. Total assets available
2. Total assets employed
3. Total assets employed minus current liabilities
4. Stockholders equity
23-7 Current cost is the cost of purchasing an asset today identical to the one currently held if an
identical asset can currently be purchased; it is the cost of purchasing an asset that provides
services like the one currently held if an identical asset cannot be purchased. Historical-costbased measures of ROI compute the asset base as the original purchase cost of an asset minus any
accumulated depreciation.

Some commentators argue that current cost is oriented to current prices, while historical cost is
past-oriented.
23-8 Special problems arise when evaluating the performance of divisions in multinational
companies because
a. The economic, legal, political, social, and cultural environments differ significantly across
countries.
b. Governments in some countries may impose controls and limit selling prices of products.
c. Availability of materials and skilled labor, as well as costs of materials, labor, and infrastructure
may differ significantly across countries.
d. Divisions operating in different countries keep score of their performance in different
currencies.
23-9 In some cases, the subunits performance may not be a good indicator of a managers
performance. For example, companies often put the most skillful division manager in charge of
the weakest division in an attempt to improve the performance of the weak division. Such an
effort may yield results in years, not months. The division may continue to perform poorly with
respect to other divisions of the company. But it would be a mistake to conclude from the poor
performance of the division that the manager is performing poorly.
A second example of the distinction between the performance of the manager and the
performance of the subunit is the use of historical cost-based ROIs to evaluate the manager even
though historical cost-based ROIs may be unsatisfactory for evaluating the economic returns
earned by the organization subunit. Historical cost-based ROI can be used to evaluate a manager
by comparing actual results to budgeted historical cost-based ROIs.
23-10 Moral hazard describes situations in which an employee prefers to exert less effort (or to
report distorted information) compared with the effort (or accurate information) desired by the
owner because the employees effort (or validity of the reported information) cannot be
accurately monitored and enforced.
23-11 No, rewarding managers on the basis of their performance measures only, such as ROI,
subjects them to uncontrollable risk because managers performance measures are also affected
by random factors over which they have no control. A manager may put in a great deal of effort
but her performance measure may not reflect this effort if it is negatively affected by various
random factors. Thus, when managers are compensated on the basis of performance measures,
they will need to be compensated for taking on extra risk. Therefore, when performance-based
incentives are used, they are generally more costly to the owner. The motivation for having some
salary and some performance-based bonus in compensation arrangements is to balance the
benefits of incentives against the extra costs of imposing uncontrollable risk on the manager.
23-12 Benchmarking or relative performance evaluation is the process of evaluating a managers
performance against the performance of other similar operations. The ideal benchmark is another
operation that is affected by the same noncontrollable factors that affect the managers
performance. Benchmarking cancels the effects of the common noncontrollable factors and
provides better information about the manager's performance.

23-13 When employees have to perform multiple tasks as part of their jobs, incentive problems
can arise when one task is easy to monitor and measure while the other task is more difficult to
evaluate. Employers want employees to intelligently allocate time and effort among various tasks.
If, however, employees are rewarded on the basis of the task that is more easily measured, they
will tend to focus their efforts on that task and ignore the others.
23-14 Disclosures required by the Securities and Exchange Commission are:
a. A summary compensation table showing the salary, bonus, stock options, other stock awards,
and other compensation earned by the five top officers in the previous three years
b. The principles underlying the executive compensation plans, and the performance criteria, such
as profitability, sales growth, and market share used in determining compensation
c. How well a companys stock performed relative to the stocks of other companies in the same
industry
23-15 The four levers of control in an organization are diagnostic control systems, boundary
systems, belief systems and interactive control systems.
Diagnostic control systems are the set of critical performance variables that help managers track
progress toward the strategic goal. These measures are periodically monitored and action is
usually only taken if a measure is outside its acceptable limits.
Boundary systems describe standards of behavior and codes of conduct expected of all
employees, particularly by defining actions that are off-limits. Boundary systems prevent
employees from performing harmful actions.
Belief systems articulate the mission, purpose and core values of a company. They describe the
accepted norms and patterns of behavior expected of all managers and other employees with
respect to each other, shareholders, customers and communities.
Interactive control systems are formal information systems that managers use to focus an
organization's attention and learning on key strategic issues. They form the basis of ongoing
discussion and debate about strategic uncertainties that the business faces and help position the
organization for the opportunities and threats of tomorrow.
CHAPTER 22
MANAGEMENT CONTROL SYSTEMS, TRANSFER PRICING,
AND MULTINATIONAL CONSIDERATIONS
22-1 A management control system is a means of gathering and using information to aid and
coordinate the planning and control decisions throughout an organization and to guide the
behavior of its managers and employees. The goal of the system is to improve the collective
decisions within an organization.
22-2 To be effective, management control systems should be (a) closely aligned to an
organization's strategies and goals, (b) designed to support the organizational responsibilities of
individual managers, and (c) able to motivate managers and employees to put in effort to attain
selected goals desired by top management.

22-3 Motivation combines goal congruence and effort. Motivation is the desire to attain a selected
goal specified by top management (the goal-congruence aspect) combined with the resulting
pursuit of that goal (the effort aspect).
22-4 The chapter cites five benefits of decentralization:
1. Creates greater responsiveness to local needs
2. Leads to gains from faster decision making
3. Increases motivation of subunit managers
4. Assists management development and learning
5. Sharpens the focus of subunit managers
The chapter cites four costs of decentralization:
1. Leads to suboptimal decision making
2. Focuses managers attention on the subunit rather than the company as a whole
3. Increases costs of gathering information
4. Results in duplication of activities
22-5 No. Organizations typically compare the benefits and costs of decentralization on a
function-by-function basis. For example, companies with highly decentralized operating divisions
frequently have centralized income tax strategies.
22-6 No. A transfer price is the price one subunit of an organization charges for a product or
service supplied to another subunit of the same organization. The two segments can be cost
centers, profit centers, or investment centers. For example, the allocation of service department
costs to production departments that are set up as either cost centers or investment centers is an
example of transfer pricing.
22-7 The three general methods for determining transfer prices are:
1. Market-based transfer prices
2. Cost-based transfer prices
3. Hybrid transfer prices

22-8 Transfer prices should have the following properties. They should
1. promote goal congruence,
2. be useful for evaluating subunit performance,
3. motivate management effort, and
4. preserve a high level of subunit autonomy in decision making.
22-9 No, the chapter illustration demonstrates how division operating incomes differ dramatically
under the variable-cost, full-cost, and market-price methods of transfer pricing.
22-10 Transferring products or services at market prices generally leads to optimal decisions
when (a) the market for the intermediate product market is perfectly competitive, (b)
interdependencies of subunits are minimal, and (c) there are no additional costs or benefits to the
company as a whole from buying or selling in the external market instead of transacting
internally.
22-11 One potential limitation of full-cost-based transfer prices is that they can lead to suboptimal
decisions for the company as a whole. An example of a conflict between divisional action and
overall company profitability resulting from an inappropriate transfer-pricing policy is buying
products or services outside the company when it is beneficial to overall company profitability to
source them internally. This situation often arises where full-cost-based transfer prices are used.
This situation can make the fixed costs of the supplying division appear to be variable costs of the
purchasing division. Another limitation is that the supplying division may not have sufficient
incentives to control costs if the full-cost-based transfer price uses actual costs rather than
standard costs.
The purchasing division sources externally if market prices are lower than full costs. From the
viewpoint of the company as a whole, the purchasing division should source from outside only if
market prices are less than variable costs of production, not full costs of production.
22-12 Reasons why a dual-pricing approach to transfer pricing is not widely used in practice
include:
1. In this approach, the manager of the supplying division uses a cost-based method to record
revenues and does not have sufficient incentives to control costs.
2. This approach does not provide clear signals to division managers about the level of
decentralization top management wants.
3. This approach tends to insulate managers from the frictions of the marketplace because costs,
not market prices, affect the revenues of the supplying division.
4. It leads to problems in computing the taxable income of subunits located in different tax
jurisdictions.
22-13 Disagree. Cost and price information are often useful starting points in the negotiation
process. Costs, particularly variable costs of the selling division, serve as a floor below which
the selling division would be unwilling to sell. Prices that the buying division would pay to
purchase products from the outside market serves as a ceiling above which the buying division
would be unwilling to buy. The price negotiated by the two divisions will, in general, have no

specific relationship to either costs or prices. But the negotiated price will generally fall between
the variable costs-based floor and the market price-based ceiling.
22-14 Yes. The general transfer-pricing guideline specifies that the minimum transfer price equals
the incremental cost per unit incurred up to the point of transfer plus the opportunity cost per unit
to the supplying division. When the supplying division has idle capacity, its opportunity cost per
unit is zero; when the supplying division has no idle capacity, its opportunity cost per unit is
positive. Hence, the minimum transfer price will vary depending on whether the supplying
division has idle capacity or not.
22-15 Alternative transfer-pricing methods can result in sizable differences in the reported
operating income of divisions in different income tax jurisdictions. If these jurisdictions have
different tax rates or deductions, the net income of the company as a whole is significantly
affected by the choice of the transfer-pricing method.

CHAPTER 21
CAPITAL BUDGETING AND COST ANALYSIS
21-1 No. Capital budgeting focuses on an individual investment project throughout its life,
recognizing the time value of money. The life of a project is often longer than a year. Accrual
accounting focuses on a particular accounting period, often a year, with an emphasis on income
determination.
21-2 The five stages in capital budgeting are the following:
1. An identification stage to determine which types of capital investments are available to
accomplish organization objectives and strategies.
2. An information-acquisition stage to gather data from all parts of the value chain in order to
evaluate alternative capital investments.
3. A forecasting stage to project the future cash flows attributable to the various capital projects.
4. An evaluation stage where capital budgeting methods are used to choose the best alternative
for the firm.
5. A financing, implementation and control stage to fund projects, get them under way and
monitor their performance.
21-3 In essence, the discounted cash-flow method calculates the expected cash inflows and
outflows of a project as if they occurred at a single point in time so that they can be aggregated
(added, subtracted, etc.) in an appropriate way. This enables comparison with cash flows from
other projects that might occur over different time periods.
21-4 No. Only quantitative outcomes are formally analyzed in capital budgeting decisions. Many
effects of capital budgeting decisions, however, are difficult to quantify in financial terms. These
nonfinancial or qualitative factors (for example, the number of accidents in a manufacturing plant
or employee morale) are important to consider in making capital budgeting decisions.

21-5 Sensitivity analysis can be incorporated into DCF analysis by examining how the DCF of
each project changes with changes in the inputs used. These could include changes in revenue
assumptions, cost assumptions, tax rate assumptions, and discount rates.
21-6 The payback method measures the time it will take to recoup, in the form of expected future
net cash inflows, the net initial investment in a project. The payback method is simple and easy to
understand. It is a handy method when screening many proposals and particularly when predicted
cash flows in later years are highly uncertain. The main weaknesses of the payback method are its
neglect of the time value of money and of the cash flows after the payback period. The first
drawback, but not the second, can be addressed by using the discounted payback method.
21-7 The accrual accounting rate-of-return (AARR) method divides an accrual accounting
measure of average annual income of a project by an accrual accounting measure of investment.
The strengths of the accrual accounting rate of return method are that it is simple, easy to
understand, and considers profitability. Its weaknesses are that it ignores the time value of money
and does not consider the cash flows for a project.
21-8 No. The discounted cash-flow techniques implicitly consider depreciation in rate of return
computations; the compound interest tables automatically allow for recovery of investment. The
net initial investment of an asset is usually regarded as a lump-sum outflow at time zero. Where
taxes are included in the DCF analysis, depreciation costs are included in the computation of the
taxable income number that is used to compute the tax payment cash flow.
21-9 A point of agreement is that an exclusive attachment to the mechanisms of any single
method examining only quantitative data is likely to result in overlooking important aspects of a
decision.
Two points of disagreement are (1) DCF can incorporate those strategic considerations that can
be expressed in financial terms, and (2) Practical considerations of strategy not expressed in
financial terms can be incorporated into decisions after DCF analysis.
21-10 All overhead costs are not relevant in NPV analysis. Overhead costs are relevant only if the
capital investment results in a change in total overhead cash flows. Overhead costs are not
relevant if total overhead cash flows remain the same but the overhead allocated to the particular
capital investment changes.
21-11 The Division Y manager should consider why the Division X project was accepted and the
Division Y project rejected by the president. Possible explanations are:
a. The president considers qualitative factors not incorporated into the IRR computation and this
leads to the acceptance of the X project and rejection of the Y project.
b. The president believes that Division Y has a history of overstating cash inflows and
understating cash outflows.
c. The president has a preference for the manager of Division X over the manager of Division Y
this is a corporate politics issue.

Factor a. means qualitative factors should be emphasized more in proposals. Factor b. means
Division Y needs to document whether its past projections have been relatively accurate. Factor c.
means the manager of Division Y has to play the corporate politics game better.
21-12 The categories of cash flow that should be considered in an equipment-replacement
decision are:
1a. Initial machine investment,
b. Initial working-capital investment,
c. After-tax cash flow from current disposal of old machine,
2a. Annual after-tax cash flow from operations (excluding the depreciation effect),
b. Income tax cash savings from annual depreciation deductions,
3a. After-tax cash flow from terminal disposal of machines, and
b. After-tax cash flow from terminal recovery of working-capital investment.
21-13 Income taxes can affect the cash inflows or outflows in a motor vehicle replacement
decision as follows:
a. Tax is payable on gain or loss on disposal of the existing motor vehicle,
b. Tax is payable on any change in the operating costs of the new vehicle vis--vis the existing
vehicle, and
c. Tax is payable on gain or loss on the sale of the new vehicle at the project termination date.
d. Additional depreciation deductions for the new vehicle result in tax cash savings.
21-14 A cellular telephone company manager responsible for retaining customers needs to
consider the expected future revenues and the expected future costs of different investments to
retain customers. One such investment could be a special price discount. An alternative
investment is offering loyalty club benefits to long-time customers.
21-15 These two rates of return differ in their elements:
Real-rate of return
1. Risk-free element
2. Business-risk element
Nominal rate of return
1. Risk-free element
2. Business-risk element
3. Inflation element
The inflation element is the premium above the real rate of return that is demanded for the
anticipated decline in the general purchasing power of the monetary unit.
CHAPTER 20
INVENTORY MANAGEMENT, JUST-IN-TIME, AND SIMPLIFIED COSTING
METHODS
20-1 Cost of goods sold (in retail organizations) or direct materials costs (in organizations with a
manufacturing function) as a percentage of sales frequently exceeds net income as a percentage

of sales by many orders of magnitude. In the Kroger grocery store example cited in the text, cost
of goods sold to sales is 76.8%, and net income to sales is 0.1%. Thus, a 10% reduction in the
ratio of cost of goods sold to sales (76.8 to 69.1% equal to 7.7%) without any other changes can
result in a 7800% increase in net income to sales (0.1% plus 7.7% equal to 7.8%).
20-2 Six cost categories important in managing goods for sale in a retail organization are the
following:
1. purchasing costs;
2. ordering costs;
3. carrying costs;
4. stockout costs;
5. costs of quality; and
6. shrinkage costs
20-3 Five assumptions made when using the simplest version of the EOQ model are:
1. The same quantity is ordered at each reorder point.
2. Demand, ordering costs, carrying costs, and the purchase-order lead time are certain.
3. Purchasing cost per unit is unaffected by the quantity ordered.
4. No stockouts occur.
5. Costs of quality and shrinkage costs are considered only to the extent that these costs affect
ordering costs or carrying costs.
20-4 Costs included in the carrying costs of inventory are incremental costs for such items as
insurance, rent, obsolescence, spoilage, and breakage plus the opportunity cost of capital (or
required return on investment).
20-5 Examples of opportunity costs relevant to the EOQ decision model but typically not
recorded in accounting systems are the following:
1. the return forgone by investing capital in inventory;
2. lost contribution margin on existing sales when a stockout occurs; and
3. lost contribution margin on potential future sales that will not be made to disgruntled
customers.
20-6 The steps in computing the costs of a prediction error when using the EOQ decision model
are:
Step 1: Compute the monetary outcome from the best action that could be taken, given the actual
amount of the cost input.
Step 2: Compute the monetary outcome from the best action based on the incorrect amount of the
predicted cost input.
Step 3: Compute the difference between the monetary outcomes from Steps 1 and 2.
20-7 Goal congruence issues arise when there is an inconsistency between the EOQ decision
model and the model used for evaluating the performance of the person implementing the model.
For example, if opportunity costs are ignored in performance evaluation, the manager may be
induced to purchase in a quantity larger than the EOQ model indicates is optimal.

20-8 Just-in-time (JIT) purchasing is the purchase of materials (or goods) so that they are
delivered just as needed for production (or sales). Benefits include lower inventory holdings
(reduced warehouse space required and less money tied up in inventory) and less risk of
inventory obsolescence and spoilage.
20-9 Factors causing reductions in the cost to place purchase orders of materials are:
Companies are establishing long-run purchasing agreements that define price and quality terms
over an extended period.
Companies are using electronic links, such as the Internet, to place purchase orders.
Companies are increasing the use of purchase-order cards.
20-10 Disagree. Choosing the supplier who offers the lowest price will not necessarily result in
the lowest total purchase cost to the buyer. This is because the price or purchase cost of the goods
is only oneand perhaps, most obviouselement of cost associated with purchasing and
managing inventories. Other relevant cost items are ordering costs, carrying costs, stockout costs,
quality costs, and shrinkage costs. A low-cost supplier may well impose conditions on the buyer
such as poor quality, or frequent stockouts, or excessively high inventoriesthat result in high
total costs of purchase. Buyers must examine all the elements of costs relevant to inventory
management, not just the purchase price.
20-11 Supply-chain analysis describes the flow of goods, services, and information from the
initial sources of materials and services to the delivery of products to consumers, regardless of
whether those activities occur in the same company or in other companies. Sharing of
information across companies enables a reduction in inventory levels at all stages, fewer
stockouts at the retail level, reduced manufacture of product not subsequently demanded by
retailers, and a reduction in expedited manufacturing orders.
20-12 Just-in-time (JIT) production is a demand-pull manufacturing system that has the
following features:
Organize production in manufacturing cells,
Hire and retain workers who are multi-skilled,
Aggressively pursue total quality management (TQM) to eliminate defects,
Place emphasis on reducing both setup time and manufacturing cycle time, and
Carefully select suppliers who are capable of delivering quality materials in a timely manner.
20-13 Traditional normal and standard costing systems use sequential tracking, in which journal
entries are recorded in the same order as actual purchases and progress in production, typically at
four different trigger points in the process.
Backflush costing omits recording some of the journal entries relating to the cycle from purchase
of direct materials to sale of finished goods, i.e., it has fewer trigger points at which journal
entries are made. When journal entries for one or more stages in the cycle are omitted, the journal
entries for a subsequent stage use normal or standard costs to work backward to flush out the
costs in the cycle for which journal entries were not made.
20-15 Traditional accounting systems cost individual products, and separate product costs from
selling, general, and administrative costs. Lean accounting costs the entire value stream instead of

individual products. Rework costs, unused capacity costs, and common costs that cannot be
reasonably assigned to value streams are excluded from value stream costs. In addition, many
lean accounting systems expense material costs the period they are purchased, rather than storing
them on the balance sheet until the products using the material are sold.