Question & Answer

Balanced scorecard; incentives

Many organisations use a balanced scorecard set of measures to determine the short-term incentive for senior managers and executives.

Required

Outline any potential difficulties associated with using a set of balanced scorecard measures to determine the short-term incentive.

(LO2 and 3)

Structuring a compensation plan

Required

Describe the factors that need to be considered when structuring a compensation plan for executives.

(LO2 and 4)

Explain why boards of directors will often employ independent             remuneration consultants to assist in developing and assessing      compensation plans.

            (LO5)

            Why would a company restrict when a senior executive can exercise their         share options?

            (LO2, 3 and 5)

What role does the ASX Corporate Governance Council’s Corporate    government principles and recommendations, and the    Corporations Act have in executive remuneration?

            (LO5)

            What are the advantages and disadvantages of having an individual’s   remuneration linked to performance outcomes?

            (LO4 and 5)

Should a remuneration plan include a cash bonus or share options?      Under which circumstances would either be appropriate?

            (LO3 and 4)

            Describe two disclosures required by the Corporations Act with respect to       executive remuneration.

            (LO4 and 5)

            ‘Executives should only be compensated based upon the achievement of           targets.  They should not receive a fixed salary component’. Discuss.

            (LO4 and 5)

Identify why RPE would be used t the company level.     

The use of RPE systems for the evaluation of individual managers has been abandoned by many organisations.  Microsoft is one example.  Given this can be conclude that RPE is no good?

What is the role of rewards and incentives for executives in reducing    agency costs?

            Describe agency costs and give several examples of them.

            How can target measures be used to promote either short-term or long-            term performance?

Describe the advantages and disadvantages of equity rewards.

            (LO3)

Discuss why an incentive package might include individual, divisional and        corporate-level performance targets.

What are the arguments for reward systems at the executive level to      contain a longer-term component?

            (LO3)

Explain the difference between shares and share options.

            (LO2)

Explain agency theory and how it relates to reward systems.

Ethical decision making: the right thing to do⁸⁴

In the past, drug makers have been reluctant to invest in cures for diseases in developing countries such as Africa and South America. Most people in these countries cannot afford to pay for treatments, and managers have typically invested in other long-term projects having higher returns. However, a few pharmaceutical companies have chosen to invest in neglected diseases, including tuberculosis, malaria and other tropical diseases. As an example, GlaxoSmithKline formed a joint venture with the World Health Organization to develop a malaria drug that costs less than 50 cents for a three-day treatment.

This type of investment has several goals. From a reputation perspective, managers accused of keeping drug prices artificially high may believe that providing low-cost cures will alleviate pressure from regulators and consumers to lower prices for drugs sold in the United States and other developed countries. Furthermore, people from some less-developed countries will eventually have the ability to pay for cures. Finally, ‘it is the right thing to do,’ according to journalist Robert Langreth. Novartis chairman Daniel Vasella says, ‘If you only look at maximizing short-term profit, you may not survive in the long term’.

Required

Using figure 19.7, address the following question for this ethical dilemma to improve your skills in making ethical decisions. Think about your answers to these questions and discuss them with others: Does an ethical problem arise if pharmaceutical companies charge lower prices for drugs in developing countries than in developed countries? Why?

            (LO2)

            Ethical Decision-Making — Wasted Soup⁸³

While she was watching operations at a food processing plant, a consultant noticed a large amount of soup on the floor under a filling machine. An operator washed this soup away each day. When asked about the loss of soup, the production manager replied that no losses occurred. In this manager’s view, no problem existed because the production line operating costs were below budgeted costs. Later, a productivity team analysed the amount of soup wasted over a given time period. The team estimated the cost of the leak to be $750 000 a year. To correct the problem, the company installed a set of valves costing $50 000. The new valves eliminated the loss of soup.

Instead of measuring performance against expected budget levels, managers could compare actual profits to ideal profits that could be earned if operations were to run at their true potential. By focusing on the gap between ideal and actual profits, managers are encouraged to identify lost profit potential and to reconsider critical processes. Once gaps are identified, managers rank them according to their value to the organisation and correct them in priority order.

Required

(a)     Is it an ethical problem when employees observe inefficiencies in the workplace, such as the loss of soup in this case? Why?

(b)     Why is it common for employees to do nothing when they observe inefficiencies? Compare the responsibility of operation workers to the responsibility of the operating manager with respect to identifying and correcting inefficiencies. In what ways are the responsibilities the same? In what ways are they different?

(c)     Is it ethical for employees to ignore inefficiencies? Why? What values did you use to arrive at the conclusion?

(d)     People do not always seek to achieve their best performance. For example, students sometimes apply minimum effort to achieve a targeted grade. What does it mean for individuals to seek continuous improvement?

(LO2)

            Ethical decision-making timely reporting of sustainability budget problems

A dilemma that individuals face is whether to be truthful when it appears that a project is over budget. Being over budget typically means that actual costs exceed budgeted costs or that a planned timeline will not be met. People often delay reporting an over-budget condition either because they believe they can catch up later or because they wish to delay negative repercussions. Unfortunately, information delays prevent managers from responding rapidly and decisively to delays in project timing and cost overruns, leading to additional dissatisfaction and inefficiencies.

Suppose an energy company establishes a budget of professional hours for a particular sustainability audit job. The hours are broken down by audit area with one area being the valuation of ‘clean energy’ inventory and cost of goods sold. During the last year, the audit client adopted new procedures for assigning product costs to individual units. The audit budget includes extra hours for the estimated time needed to document and assess the reasonableness of the new method.

Many factors could cause this part of the audit to be over budget. Consider the following two scenarios:

1.       The client failed to establish appropriate records needed to easily audit the new method, and this part of the audit will require more than the budgeted time to complete.

2.       The auditor assigned to this part of the audit is inexperienced and is unable to complete the work in the budgeted time.

Regardless of the reason for the overage, managers in charge of the audit need to be notified as soon as possible so that they can consider possible ways to realign staff and complete the total job on time. In addition, in the first scenario the audit entity might be able to bill the client for the extra work involved if the audit contract includes a provision for such price adjustments. However, this scenario would most likely require the client to be notified promptly, while the work is still being performed. In the second scenario, the overage may result in a poor performance evaluation, especially if the auditor has similar problems in other audit areas. Yet the overage may be considered reasonable in light of the auditor’s inexperience. Even so, the auditor should be able to accomplish the following:

·           develop alternative estimates of time and resource requirements for a project

·           effectively facilitate and control the project process and take corrective action as needed

Therefore, the auditor must quickly recognise an impending overage and formulate appropriate strategies for completing the task as efficiently as possible. The auditor also needs to keep her supervisor apprised of the situation and seek help, when needed.

Required

(a)     Have you ever failed to meet a deadline on a group project? If so, what were the reasons for the delay? When and how did you report the delay to your team members? Has someone else ever failed to meet a deadline? Does a failure to meet an agreed-upon deadline create an ethical problem? Why?

(b)     Explore the responsibilities, expectations, assumptions, incentives, and consequences for this problem from different perspectives, including:

§  the team member who is late

§  other team members

§  the team’s client.

(c)     Draft a policy statement that you could adopt with future team members to handle project delays. How might this policy lead to improved team performance?

(d)     Think about your future career. How can you work toward developing your professional responsibility as a member of a work team?

(LO 2 and 5)

            Ethical Decision making – inappropriate allocation of underapplied overhead⁸²

The Australian government has contracted with alternative energy industry organisations to develop new energy technologies. These contracts are sometimes based on cost. Because these organisations are also developing technologies for non-government entities, incentives exist to shift overhead costs to the government, so that commercial operations become more competitive. Because cost allocations are private information, research provides only indirect evidence that this cost shifting occurs. The following vignette is fictional, but it illustrates potential ethical problems that arise when governments use cost-based contracts for product development.

Deep Water Hydro is an hydro-electricity energy company that focuses on innovative research and development solutions for alternative energy supply for both commercial and government agencies. Because one of its commercial contracts fell through last year, the company had fewer jobs than anticipated. Consequently, the company’s overhead costs were underapplied at the end of the year, so an adjustment was made to increase cost of goods sold (also called cost of sales).

Deep Water’s policy is to allocate production overhead as a percentage of direct labour costs for each contract. One of the government contracts completed last year was to develop a hydroelectricity generator that would supply energy from sea water entering Port Philip Bay in Melbourne. The job contract was based on cost-plus-fixed-fee for a total cost of $245 million. The hydro-electricity project was Deep Water’s only government contract last year. Commercial business completed was $105 million, so cost of goods sold (COGS) totalled $350 million.

Disagreement about underapplied overhead adjustment

The government official in charge of the contract complained to the federal contract auditor that Deep Water’s underapplied overhead should not have been closed to COGS. Instead, he argued that it should have been allocated on a pro rata basis among the contracts in progress, finished goods, and COGS. The auditor asked to see the cost accounting records and financial statements for the period. Following is an analysis of the direct costs and cost allocations (in millions):

The $350 million in COGS included $245 million for the government contract. When the underapplied overhead ($100 million) was closed to COGS, the government portion of underapplied overhead was $70 million [$100 ´ ($245 ¸ $350)]. Because the contract specified that the government would pay costs plus a fixed amount, the overhead adjustment effectively increased the revenue under the contract by $70 million.

Actual direct labour costs were $150 million, and the pre-adjustment allocated overhead was $300 million. Therefore, the original allocation rate was 200 per cent ($300 ¸ $150) of direct labour cost. Total actual overhead turned out to be $400 million (the $300 million plus the $100 million underapplied). If Deep Water accountants could have perfectly estimated overhead at $400 million and direct labour cost at $150 million, they would have used 267 per cent ($400 ¸ $150) as the allocation rate.

The underapplied overhead amount was material ($100 million out of $400 million, or 25 per cent). Therefore, the government auditor decided that it should have been allocated on a pro rata basis among the three accounts that reflected work done this period: contracts in progress, finished goods, and cost of goods sold. Had this method been used, the adjustment would have been prorated as follows:

The government's share of the COGS adjustment would be ($245 ¸ $350) ´ $29.4 million = $20.6 million. When the auditor compared this to the original adjustment of $70 million, she knew the government had been overcharged.

Alternative methods for allocating overapplied or underapplied overhead

The auditor offered Deep Water three alternatives for allocating the overhead adjustment. Under governmental contracts, underapplied overhead could be allocated based on direct materials cost, direct labour cost, or total direct costs. If Deep Water uses direct materials, COGS is increased by $25 million, of which the government portion is $17.5 million. If direct labour cost is used, COGS is increased by $33.3 million, of which the government portion is $23.3 million. If total direct cost is used, COGS is increased by $27.3 million, of which the government portion is $20.1 million.

The government and Deep Water must now negotiate to determine the most appropriate proration method.

Required

(a)     Is allocating proportionately more cost to government contracts an ethical problem for Deep Water? Why?

(b)     When the government pays more than commercial customers pay for work done, does this situation pose a business problem, a social problem or both? Explain.

(c)     Discuss the preferences of various stakeholders for this problem, including:

·                     Deep Water managers

·                     Deep Water shareholders

·                     Deep Water commercial customers

·                     Deep Water governmental customers

·                     Deep Water competitors

·                     Australian taxpayers

(d)     Is it fair for the government to pay more for products and services than commercial customers pay? Is it fair for taxes to subsidise the overhead costs for a private business?

(e)     How can an organisation monitor whether its accounting practices are ethical?

            (LO2, 3 and 4)

            Sustainability and job costing in a service sector

Green and Greener Co., a law firm specialising in environmental litigation, had the following costs last year:

The following costs were included in overhead:

The entity recently improved its ability to document and trace costs to individual cases. Revised bookkeeping procedures now allow it to trace fringe benefit costs for direct professional labour, paralegal costs, telephone charges, computer time, and photocopying costs to each case individually. The managing partner needs to decide whether more costs than just direct professional labour should be traced directly to jobs to allow the entity to better justify billings to clients.

During the last year, more costs were traced to client engagements. Two of the case records showed the following:

Three methods are being considered for allocating overhead this year:

·           Method 1: Allocate overhead based on direct professional labour cost. Calculate the allocation rate using last year’s direct professional labour costs of $15 million and overhead costs of $21 million.

·           Method 2: Allocate overhead based on direct professional labour cost. Calculate the allocation rate using last year’s direct professional labour costs of $15 million and overhead costs of $10 million ($21 million less $11 million in direct costs that are traced this year).

·           Method 3: Allocate the $10 million overhead based on total direct costs. Calculate the allocation rate using last year’s direct costs (professional labour of $15 million plus other direct costs of $11 million).

Required

(a)     Calculate the overhead allocation rate for method 1.

(b)     Calculate the overhead allocation rate for method 2.

(c)     Calculate the overhead allocation rate for method 3.

(d)     Using each of the three rates calculated in parts (a), (b) and (c), calculate the total costs of cases 875 and 876.

(e)     Explain why the total costs allocated to cases 875 and 876 are not the same under the three methods.

(f)      Explain why method 1 would be inappropriate.

(g)     Would method 2 or method 3 be better? Explain.

(h)     Explain how professional service firms, like law firms might engage in sustainability practices.

(LO1 and 4)