4 Miramar Industries Quinn Snyder, the 1|v'ice President of Miramar lndustries' Earthworks and Excavation Division, located in Wellington. New Zealand, sat at his desk trying to make sense of the numbers that lay before him. Tomorrow morning he was due to make his year-end divisional report to the company's Board of Directors. Based on the numbers themselves. he could see that he would face an uphill battle trying to convince the Board that he and his division had performed well. Although his sales had increased significantly (see Exhibit 4.1], his division recorded a loss for the year. Since the company used ROI to evaluate performance, he realized that his performance for the year would look particularly bad. Although Quinn had always been suspicious of the utility of the company's ROI system, he was especially perturbed this year. Looking at the numbers, he could see that there had been a substantial increase in the amount of corporate service costs allocated. Part of the reason was due to the five'week power outage suffered in Auckland during February 1998, which caused the shutdown of the corporate services unit for nearly a month. A significant amount of overtime was incurred getting the unit current again. Just then the phone rang. It was Denise Green. the Vice President of the Landscape Design Division. She asked Quinn if he had seen the latest corporate results (see Exhibits 4.1 and 4.2). Denise went on to crow about how this year's results represented the fourth straight year that her pre-tax ROI was at or above 45 per cent. and this was after her division had paid a massive NZS300.000 dividend to the parent company during 1998. Quinn groaned to himself. "Why," he asked himself, "does Denise always come out smelling so sweet?" Quinn wished his conversation with Denise would end, and the sooner the better. Company background Miramar Industries was formed in 1982 to provide earthmoving and excavation work throughout the North Island. The company enjoyed good growth throughout the 1980s and early 1990s. In fact, by 1994 the company's cash reserves were at such a high level that the company's founder and president, Ben Gooding, began looking for ways to productively use this cash. Initially his goal was to acquire another earthmoving and excavation company. But his search failed to identify a suitable company. Then, by sheer chance, he met Nigel Evans. Nigel was an investment banker, who specialized in the construction industry. As it happened, Ben and Nigel were seated together on the same plane. Ben warmed to Nigel right away. As they left the aeroplane, Ben invited Nigel to come to his office and discuss how Nigel might assist Ben in his search for a company to buy. Nigel visited Ben the following week. He listened patiently as Ben discussed his attempts to date. When Ben had finished, Nigel asked Ben to elaborate on how Miramar's strategy related to his choice of a firm to acquire. Ben appeared puzzled by the question, so Nigel went on to explain the three corporate strategies of single business firms, related-diversified firms, and unrelated-diversified firms. He noted that Ben's approach to date had been narrowly focused on pursuing the strategy of a single business firm, but wondered whether he shouldn't branch out into a related-diversified firm strategy. Ben said that he was unaware of the issue and asked Nigel to elaborate further. Accordingly, Nigel told him the following: Companies that pursue a single business firm strategy choose to commit themselves to a single segment of a particular industry. They seek to focus and concentrate their energies in one area. Meanwhile, companies that pursue a related-diversified strategy choose to participate across a range of business segments in a given industry and sometimes across industry boundaries. It is always the case, however, that a common set of core competencies and operating synergies underlies the related-diversified's business nexus. Companies that adopt the related-diversified strategy seek to benefit from risk diversification, economies of scale, and economies of scope. The idea of pursuing a related-diversified strategy intrigued and interested Ben. When Nigel mentioned that he knew the managing director of an Auckland-based landscape design firm, who was looking to sell his business and retire, Ben became even more intrigued and interested. He felt that an excellent opportunity presented itself for growing the firm and leveraging its core competencies. Furthermore, he could see great potential for business referrals between the two companies. Not only would there probably be a flow on of business from landscape design to earthworks, but also the major task of finding and disposing of fill would probably be facilitated by the combined operation of the two businesses.Immediately following his meeting with Nigel. Ben was on the phone to his accountant and then his lawyer. He told them of his desire to buy the landscape design firm and instructed them to research. appraise. and value the potential acquisition. Within a month. Ben had completed the purchase of the landscape business. Following the acquisition. Miramar structured the two businesses (earthmoving and excavation and landscape design] as autonomous divisions and left them to operate from their original locations (Wellington and Auckland]. Although the Earthworks and Excavation Division continued to operate from an office and warehouse building that had been purchased in 1982. the Landscape Design Division rented its office space. Furthermore. since Ben knew he had much to learn about the business of landscape design. he moved himself and his support staff - consisting of human resources. law. accounting. and tax - up to Auckland. This corporate services unit rented office space that adjoined the Landscape Design Division. The next couple of years proved to be especially challenging for Ben and his staff as they tried to come to grips with the landscape design business. Ben recalls those days as follows: My staff and l were terribly naive when we first entered the landscape design business. We found ourselves on a steep part of the learning curve during the first couple of years. At times I felt we were totally out of our depth. But we devoted a lot of time and energy to understanding the landscape design business. Today we are feeling more confident and a lot better about the decision. although I would be the first to admit that we still have more learning to do. Performance evafuatfon The two divisions were evaluated using ROI. When calculating ROI. all corporate service expenses were allocated to each of the divisions. These corporate service costs were allocated based on the percentage of each division's sales to the combined divisions' sales. Top management's stated reasons for doing this was that it gave the divisional managers a clearer perspective of the true costs of doing business. it provided greater insight into each division's contribution to the corporate bottom line. and it made comparisons between outside standalone companies easier. All assets were included as part of the investment base. As shown in the balance sheet. these assets were comprised of cash. marketable securities. and accounts receivable. Additionally. in the case of the Earthmoving and Excavation Division. the investment base also included machinery and equipment and land and buildings. A more detailed description of these assets is provided below. Cash and marketable securities Each Miramar division maintained a cash account in a local bank. These bank accounts were used for divisional payroll and to pay other. typically minor. local bills. The company's corporate controller monitored the two divisions' bank balances. with cash either being added to or transferred out as deemed necessary by the controller. In general, these accounts had minimal balances. All supplier invoices were routed to the corporate controller's office and paid out of an account maintained by corporate headquarters. Likewise, as is discussed more fully below, the collection of accounts receivable was also performed by the corporate controller's office. It was believed that the central control of cash would lead to a better matching of cash inflows and outflows than if each division maintained its own separate cash balances. This in turn would minimize the amount of cash needed. Accounts receivable All accounts receivable were collected and managed by the corporate controller's office. The company's terms on accounts receivable were 2/10, E.O.M. (i.e., 2 per cent discount if paid within 10 days of the end of the month). It was the responsibility of the corporate controller's office to check the credit worthiness and risk of customers. There was a firm company policy that no sales contracts could be entered into prior to the undertaking of a customer credit check and the issuance of a satisfactory credit report. Furthermore, company policy did not permit cash sales in situations of poor credit. Around the twentieth of each month, an accounts receivable report was prepared by the corporate controller's office and sent to each division. This report was titled "An Analysis of Accounts Receivable by Age." It included a grand total of each customer's accounts receivable and an ageing of this total. Machinery and equipment Machinery and equipment were depreciated over their estimated useful lives using straight- line depreciation. The average piece of machinery and equipment had an estimated useful life of 10 years. When calculating ROI, the assets' gross values were used. Ideas for buying or selling machinery and equipment had to be approved by the corporate controller's office. The company had a standard form that accompanied all such requests. This form highlighted details about the rationale for the request, how the request would fit with the division's strategy, and the effect the request would have on the division's set of key performance indicators. The only exceptions to the above rules were if the idea involved the purchase of an asset that cost less than NZ$10,000 or the sale of an asset with a book value of less than NZ$10,000. Land and buildings The Earthworks and Excavation Division operated from an office and warehouse building that were purchased in 1982. The Landscape Design Division rented its office space. Therefore no amount was recorded for either land or buildings. The buildings of the Earthworks and Excavation Division were depreciated on a straight- line basis using a useful life of 50 years. When calculating ROI, the gross book value for buildings was used and the market value for land was used. Company management believedthat this use of gross book values and market values allowed clearer comparisons to be made between the company's divisions and outside companies by reducing the distortions that different aged assets create. Similar to the rules pertaining to machinery and equipment. any acquisitions or dispositions to the Division's land and buildings had to have the corporate controller's prior approval. The company felt that such a safeguard was needed to prevent a manager from scrapping relatively old. but otherwise perfectly good assets. Questions 1 How would you rate the respective performances of Quinn and Denise? 2 Do you feel that the accounting system adequately captures the managers' performance? 3 What weaknesses. if any. do you believe exist in Miramar's management control system? 4 Do you have any suggestions for improving the management control system of Miramar? Exhibit 4.1 Income Statement Income Statement (in NZ$'0005) [in NZ$'0005} 199? 1998 Earth-moving Landscape Earth-moving Landscape if. excavation design ii excavation design Sales 6.000 4.000 7.000 3.000 Cost of sales 4,500 2.000 5.200 E Gross margin 1.500 2.000 1.800 1.350 General 8 administration LE gm Net income before taxes 300 1.200 {300} 450 Taxes m w (m: m Net income @ E w E Exhibit 4.2 Balance Sheet Balance Sheet [in NZS'DDDs) (in NZS'DODs} 1997 1998 Earthmoving Landscape Earthmoving Landscape 5'. excavation design a; excavation design Cash & S-T mrkt securities 120 80 120 175 Accounts receivable 900 600 890 525 Machinery. equip.. leasehold impr. 4.630 320 4.530 300 Land and buildings 3.000 _ 2.960 _ Total 3.10.11 @ 3.59.11 @ Accounts payable 50 2D 50 20 Debt 4.000 4.000 lEllwners' equity 4,650 980 4.450 930 El Total 3.10.0 11E asoo