Kan Enterprises is a case about management accounting and control, and the problems that may arise when businesses are large, and divisions managed at a distance. The case, presented in three parts that build on each other, is viewed from the perspective of the CEO of a holding company in Hong Kong, and the directors of a recently-acquired business based in the UK. The technical accounting covered includes cost behaviour, standard costing and variance analysis, and return on assets. The discursive questions cover management incentives and other performance measures, and issues surrounding management behaviour and management decision-making. The case tests the abilities of students to manipulate accounting data and work in groups to propose solutions to management problems.

Case

Learning Outcomes

Students should gain improved skill and understanding of the following areas by working through Parts A, B, and C in turn:

• Management incentive schemes and management decision-making.
• Calculations of profits as sales output changes, calculations of a performance measure (return on assets), and of bonuses based on performance.
• Alternatives to financial performance measures.
• Interpretation of flexed budgets and variances.
• Controllability and responsibility accounting.

Part A: Background

In January, Gloria Kan, CEO of Kan Enterprises, sat in her corner office overlooking Hong Kong harbour, puzzling over the group's most recent acquisition, Maple Products ("MP"). This business, which operates out of Leeds, UK, should have resulted in a good return for the Kan group, but something did not seem quite right.

Kan Enterprises is a conglomerate with subsidiaries and joint ventures in more than 60 countries; its operations include construction, manufacturing, and telecommunications. The primary business of MP is to sell air conditioning pumps, which it does throughout Europe. MP also sells accessories to repair and maintain the pumps, but around 90% of turnover and profits are from the pumps themselves. MP purchases kits for making the air conditioning pumps, mainly from East Asia, and assembles them at its factory in Leeds. Kan Enterprises purchased MP 15 months ago and agreed on budgets with the managing director shortly after that. Gloria Kan had expected the business to generate annual profits of between 10 and 12 million GBP.

Management Incentives

Bonuses for the directors of MP were set at the start of the budget year based on return on assets (ROA), as shown in

Table 1

. ROA is calculated as the profit for the year divided by the average of the opening and closing asset base (total assets less current liabilities), as recorded in the management accounts.

Maple Products owns its premises in Leeds outright and the land and buildings were revalued three years ago; the revalued amount is recorded in the management accounts (net of depreciation). The plant and machinery in Leeds is old but serviceable and currently has a very low net book value. Due to frequent shipping delays, MP holds high levels of raw materials inventory; trade receivable levels are also high because MP sells to major wholesalers who negotiate long periods of credit. All these factors contribute to the asset base used in the calculation of ROA.

ROA is the standard measure used by Kan Enterprises for all its divisions. The median ROA in the air conditioning sector is 14%. The top quartile reports a ROA of 17% or more.

Table 1. Return on Assets
Asset	GBP
Budgeted profits for the year	10,575,000
Asset base at the start of the year	58,925,000
Budgeted asset base at the end of the year	69,500,000
Average asset base	64,212,500
ROA (using average of opening and closing assets)	16.5%

Note: ROA: Return on assets

Bonus Ratchet

The agreement Kan Enterprises established with the team at MP was that when the ROA exceeds 15%, the Maple Products directors receive a bonus equal to 10% of salary. There is also an incentive ratchet, with a bonus of 15% of salary if ROA exceeds 18.5%, or a bonus of 20% of salary if ROA exceeds 22%.

The base bonus (10% of salary) results in directors' total remuneration being around the median for the sector. A bonus of 15% of salary puts the directors just below the top quartile for the sector, while a bonus of 20% of salary puts the directors just below the top decile for the sector.

Detail of Budgeted Profit for the Year

Gloria Kan inspected the detailed original budget for Maple Products (

Table 2

), prepared the previous January.

Table 2. Original Budgeted Profit for Year Ended 31 December
Units sold		3,900,000
Budget item (GBP)	Per unit	Total
Sales revenues - Europe	25.00	97,500,000
Variable costs
Direct materials	4.68	18,252,000
Direct labour	5.90	23,010,000
Variable production overhead	3.90	15,210,000
Variable selling expenses	2.00	7,800,000
Total variable costs	16.48	64,272,000
Income
Contribution from pumps	8.52	33,228,000
Net income from repairs and maintenance		1,050,000
Profits before fixed costs		34,278,000
Fixed costs
Fixed production overhead		5,551,000
Fixed selling expenses		8,567,000
Fixed administration costs		9,585,000
Total fixed costs		23,703,000
Budgeted profit for the year		10,575,000

The managing director of MP has overall responsibility for achieving the profit for the year; this director is also responsible for MP investment decisions.

EMEA Regional Report

The team in charge of businesses in the EMEA (Europe, the Middle East, and Africa) region also prepared business notes, which include details on Maple Products. Some events had occurred after the original budget was drawn up and were not reflected in the figures in

Table 2

.

The EMEA report noted that a new sales office had been set up in April for Maple Products using unoccupied space at Kan Enterprises' headquarters in Hong Kong, to take advantage of Kan Enterprises' contacts in the Asia-Pacific region. The estimate for sales in the Asia-Pacific region at the time of this development was in the order of 300,000 units from April to December (this would have resulted in 4,200,000 total units sold for the year). However, the sales office had been enormously successful, resulting in 600,000 units sold in the Asia-Pacific region, and therefore worldwide sales of 4,500,000 units for the year.

Part A Discussion Questions

Complete these tasks before moving on.

• #1 Taking on the role of a director in Maple Products, how might the incentive scheme affect your behaviour as a director throughout the year? Would you have been largely in favour or against the expansion into the Asia-Pacific region? Working in teams, collate your views to share with the class.
• #2 Using the budgeted data in Table 2
  • calculate (a) the total budgeted profits for sales of 4,200,000 units and 4,500,000 units and (b) the sales volume variance (differences in profits from the original budgeted profits) for sales of 4,200,000 units and 4,500,000 units. Note: Net income from repairs and maintenance is not expected to change with the increase in output because most new units do not require repairs or maintenance in the first year.