ACCOUNTING FOR DECISION MAKING AND CONTROL

EVALUATING INVESTMENT CENTER PERFORMANCE

King Conglomerate[1]

Background

King Conglomerate was a large multinational firm with many different lines of business spread across the globe. The company was organized into divisions. The King board of directors met with the new CEO to develop a compensation scheme to reward division heads for increasing profitability. Because of the diversity of product lines and geographic locations, it was very important to find a universal yardstick that could measure performance without any biases. The board considered two proposals: return on investment (ROI) and residual income (RI).

Most of the board members preferred to use ROI because of its popularity and international use. One of the directors indicated that he didnt like RI because each year the firm would be required to calculate the cost of capital. Also, they would have to use the identical costs of capital for the entire firm if they didnt want to spend months arguing with the division heads. Because of this they would fail to reward a division head who borrows locally at a favorable rate to finance a local investment. By using ROI, division heads would be encouraged to search for favorable financing because it allowed them to increase their ROI. In the end, the board voted to use ROI to measure performance and to reward division heads based on the increase in their ROI from the previous year.

Year One

Jill and Jack were the two most successful senior managers at King Conglomerate. Each managers division had 24 segments. Both Jill and Jack had an investment of about $3.5 billion. Because King used the ROI method to reward managers, both senior managers carefully chose their investments to maximize their ROI. Jills ROI was 19.27% and Jacks ROI was 5.09%. See Table 1.

This year, however, Jill and Jack were not happy. It was one month before the end of the fiscal year, and neither had been able to improve their ROI from last year. Jill and Jack knew that they would receive no bonus if they could not show an increase in their respective ROIs. To solve their problem, Jill and Jack decided to transfer segments and convinced the CEO to allow segment transfers between divisions based on the following arguments:

1. Similar segments in different divisions mean company-wide duplication of costs. By combining similar segments, it would be possible to reduce overhead costs.

2. Intercompany segment transfers allow a division to grow without incurring the substantial costs of acquiring an outside business.

3. Finally, because each manager was rewarded for improving his or her own ROI, no manager

would give up or take a division that would lower his or her ROI. Thus, two managers would agree to a transfer only if both believed that the transfer would improve both their ROI.

Year Two

Jill and Jack were not happy. It was one month before the end of the fiscal year, and neither Jill nor Jack was able to improve over last years ROI. Year two figures were identical to last years (after the year 1 transfer). Jill and Jack decide once again to transfer segments.

Year Three

Jill and Jack were not happy. It was one month before the end of the fiscal year, and neither was able to improve over last years ROI. Year three figures were identical to last years (after the year 2 transfer). It is not clear whether Jill and Jack can transfer segments.

Requirements

Answer the following questions. Data is available on Blackboard.

Which segments would Jill and Jack transfer in year 1? Why? Assume they will 1) both transfer in ways that maximizes their bonus and 2) both transfer the fewest segments possible.

Which segments would Jill and Jack transfer in year 2? Why? Assume they will 1) both transfer in ways that maximizes their bonus and 2) both transfer the fewest segments possible.

Would Jill and Jack transfer segments in year 3? Think hard. The answer is not as obvious as it may appear.

At the end of year 3, the board of directors fired the CEO? Why? To answer this question consider 1) why firms pay bonuses and 2) the firms ROI before the first transfer in year 1 and each year thereafter.

How is it possible (in Year 0) that Jacks division might be considered as successful as Jills even though Jacks ROI is so much smaller Jills?

[1] Adopted from: Free Lunches and ROI: A Modern Fable, Management Accounting Quarterly, Winter 2008, Vol. 9, No. 2, by Harry Z. Davis, Ph.D.: Solomon Appel; and Gordon Cohn, Ph.D.