Maloof Tool Works LLC produces craftsman-quality woodworking hand tools. The Maloof Saw is a 12-inch brass backed tenon saw that is considered “the best of the best” by woodworking enthusiasts. The management team developed the following annual budget for the Maloof Saw:

Sales and production (# of saws)		6,000
Sales price per saw		$275
Variable Materials Costs per Saw:
	Spring Steel – 20 inches @ $2.00 per inch	$40
	Slotted Brass Billet – 12 inches @ $1.50 per inch	$18
	Curly Maple Handle Blank – 1 per saw @ $7.00	$7
Variable Labor costs (4 hours per saw @ $25.00 per hour)		$100
Fixed costs per unit (based on budgeted production)		$50

Sam, the head of the management team, had two proposals to increase company profits from the Maloof saw (note that these two changes are NOT reflected in the above budget):

1. Increase selling price per saw.
2. Rent a new steel shearing machine.

The shearing machine rental would cost $60,000 in fixed costs for the year, but Sam anticipates the new machine will reduce the labor time associated with producing each saw. He further expects the new machine will reduce materials waste – although each finished saw only has a 12-inch blade, the production process using the existing shearing machine involves 8 inches of waste (i.e., 20 inches input – 12 inches output = 8 inches steel waste).

Sam and team implemented both of these proposals and the actual results for the year are as follows:

Sales and production (# of saws)		5,500
Sales price per saw		$290
Variable Materials Costs per Saw:
	Spring Steel – 16 inches @ $2.25 per inch	$36
	Slotted Brass Billet – 12 inches @ $1.50 per inch	$18
	Curly Maple Handle Blank – 1 per saw @ $8.00	$8
Variable Labor costs (3 hours per saw @ $25.00 per hour)		$75
Fixed costs (for the year)		$400,000

Required:

1. Determine the static budgeted profit based on the original expected sales volume, the flexible budgeted profit based on the actual sales volume, and actual profit. Be sure your answer includes a line for revenue and a line for each cost item. (10 points)

1. For total profit, calculate the static budget variance, flexible budget variance, and sales-activity variance. Be sure to indicate whether the variance is favorable or unfavorable. Explain what each of these profit variances represents. Be specific. (10 points)

1. Assuming that the higher price caused the lower sales volume, what is the effect on total profit of the sales price increasing to $290? For this calculation of the incremental effect of higher selling price, assume that cost behavior for fixed costs and variable cost per unit remained as specified in the originally prepared budget. (5 points) 

1. a) Which variances would help Sam assess whether renting the new shearing machine reduced material waste and labor time required to produce the saws? Calculate these variances and explain in words what each means.
    b) Do your calculations indicate it was “a good decision” to rent the shearing machine? (10 points) 

 

Problem 2: Siebach Farm-All Group (35 points)

Siebach Farm-All Group operates organic produce farms in Vernal, Utah and Yakima, Washington. Siebach Farm-All currently evaluates division managers based on return on investment (ROI), but the company is considering changing their performance evaluation system to an EVA approach. Data for 2022 are as follows:

	Vernal Farm	Yakima Farm	Total
Revenues	$3,900,000	$3,130,000	$7,030,000
Leasing and other costs	2,300,000	1,655,000	3,955,000
Advertising costs	575,000	830,000	1,405,000
Operating income	1,025,000	645,000	1,670,000
Interest and taxes	462,600	437,000	899,600
Net income	562,400	208,000	770,400
Net book value at 2022 year-end:
Current assets	$1,280,000	$600,000	$1,880,000
Long-term assets	5,375,000	6,535,000	11,910,000
Total assets	6,655,000	7,135,000	13,790,000
Current liabilities	$330,000	$84,000	$414,000
Long-term debt	4,600,000	5,500,000	10,100,000
Stockholders' equity	1,725,000	1,551,000	3,276,000
Total liabilities and equity	6,655,000	7,135,000	13,790,000
WACC			9.5%
Accumulated depreciation	$2,220,000	$220,000

• Siebach Farm-All pays a 22% tax rate on net operating profits after deducting interest expense.
• Siebach Farm-All believes that advertising provides benefits over 2 years and therefore for EVA purposes should be amortized on a straight-line basis over a 2-year useful life (beginning with the year of the expenditure). Advertising for 2022 is shown in the table above. Advertising for 2021 for the Vernal and Yakima farms was $550,000, and $450,000, respectively.

Required:

1. For each of the farms, calculate 2022 ROI using operating income as the numerator measure of income and total assets as the denominator measure of investment. Do not make any non-GAAP adjustments for this calculation. (5 points)

1. Suppose that Siebach Farm-All is considering adding new tractors from Kubota. For each farm, the new tractors would cost $425,000 and would be expected to result in an incremental increase in operating income of $60,000. 
   1. What is the incremental ROI and what effect would the addition of the tractors at the Vernal farm have had on 2022 ROI for Vernal? If performance evaluation is based on ROI, would the Vernal farm manager have an incentive to accept or reject this project? Explain your answer. (3 points)
   2. What is the incremental ROI and what effect would the addition of the tractors at the Yakima farm have had on 2022 ROI for Yakima? If performance evaluation is based on ROI, would the Yakima farm manager have an incentive to accept or reject this project? Explain your answer. (2 points)
       
       

1. Assume Siebach Farm-All did not add the tractors from part 2. Calculate 2022 EVA for each of the farms. (15 points)

1. Refer back to the information and assumptions about adding the tractors in part 2. For each farm, explain whether the manager has an incentive to add the new tractors if they are evaluated based on EVA instead of ROI. Assume that the managers receive incentive compensation equal to 10% of EVA. (5 points)

1. The management team at Siebach Farm-All has asked for your recommendation about whether they should continue to use ROI for performance evaluation or if they should shift their focus to EVA. Provide one advantage and one disadvantage to making the switch, and an overall recommendation (no more than 3-4 sentences). (5 points)

 

Problem 3: Performance Management at Birders4Life (30 points)

Birders4Life sells birding supplies to birding enthusiasts. The business is majority owned by the Hickman family, headed by Madeline Hickman. Madeline is in retirement and largely hands-off with the company, and she has hired an external CEO (Joshua Bones) to manage ongoing operations. Madeline set a “stretch target” of a 15% increase in profit for 2022 (total target profit of $1,374,250 = 1.15 x $1,195,000 profit in 2021) to incentivize growth. Madeline also structured Joshua’s compensation with a base pay of $250,000 and incentive pay equal to 10% of profit between $1,195,000 and $1,374,250 plus 20% of all profits greater than the stretch target of $1,374,250. To Madeline’s surprise, profit in 2022 was $2,000,000, giving Joshua Bones a total compensation of $393,075 for the year. 

After analyzing the company’s financial statements to learn what strategies Bones used to generate the strong profits shown in 2022, here is what Madeline found: 

• Bones generated additional sales by changing the credit terms from payment due 30 days after sale to payment due 6 months after the sale (interest free) for all approved, creditworthy customers. This action increased Accounts Receivable significantly from the prior year.
• The company had been operating at approximately 70 percent of available capacity. Bones greatly increased production to meet the demand generated by allowing customers to pay in 6 months. He also ordered an additional buildup in inventory. According to Bones, the buildup was needed to deal with large and rush orders. Madeline suspects that the buildup was an effort to reduce unit costs (the more units produced, the lower the cost per unit because some manufacturing costs are fixed).
• Bones reduced R&D expenditures.
• Bones paid off all company debt reducing interest expense.

Required:

1. Explain why each of the four actions Bones took is motivated by the existing compensation plan (4 points).

1. Discuss some potential implications of each of the four actions on the firm’s current and future performance (no more than 2-3 sentences each) (8 points).

1. Suppose that Bones’ compensation had been linked to EVA. Would that have mitigated and/or prevented any of the four actions that Bones took? Limit your response to 2-3 sentences (6 points). 

1. Now suppose that instead of the compensation scheme given in the problem, Madeline decided to use a Balanced Scorecard to manage performance in future years. She identified the two major goals listed below, and underlying objectives for each:

• Maintain strong financial health.
  • Keep sufficient cash reserves to assure financial stability.
  • Achieve consistent growth in sales and income.

• Provide excellent service to customers.
  • Provide products that meet the needs of customers.
  • Meet customer needs on a timely basis.
  • Meet customer quality requirements.

     For each of the five objectives above, propose and explain one measure that could be used in the Birders4Life Balanced Scorecard to assess whether the objective is being achieved (12 points).

 

Problem 4: Free Response (20 points)

Evaluate the validity of each of the following prompts, and justify your response clearly, using terminology from Cost Basics and Terminology, Costing Methodologies and Their Limitations, Transfer Pricing, Relevant Costs and Operational Decisions, Cost Allocations and Context, Budgets and Variances, Performance Metrics, Incentives, and Control Systems. Maximum total answer length of 50 words per prompt. 

1. Earnout agreements used as part of acquisition agreements are important, in part, to reduce moral hazard. (3 points)

1. EBITDA is an effective financial metric for performance measurement in part because it creates incentives for managers to limit capital expenditures. (3 points)

1. If sales volume exceeds that expected per the static budget, then sales activity variances will always be unfavorable both for variable costs and for fixed costs. (3 points)

1. Non-linear compensation plans are best, since linear compensation plans create incentives for gamesmanship by managers who will over-produce and over-sell in order to maximize their compensation. (3 points)

1. Managers should discontinue all unprofitable product lines. (3 points)

1. The net book value of a piece of equipment is relevant financial information when considering whether to sell it. (3 points)

1. I promise to never erroneously unitize fixed costs and will always “Beware the Red Lines.” (2 points)