Explore BrainMass

Gaming for a bonus, absorption costing; dcf; scorecard

Learning Community: In the past several weeks, you have been exposed to fundamental managerial accounting problems and were tasked to complete various calculations and comment on their application. We've covered topics such as: the nature of costs, capital budgeting, organizational architecture, flexible budgeting, cost allocation, and absorption costing. lhe ability to understand and demonstrate the application of these tools are critical to not only your professional success but to the financial success of the organization that you will manage.

You have just been hired by the Board of Directors as COO of a mid-sized manufacturing company.The Board, as well as the stakeholders, are eager to see the company grow and have found two similar organizations that they want you to consider purchasing. These same Board members are not familiar with discounting future cash flows and rely on the payback method to choose investments.

Another area of concern is that senior management does not understand nor do they support a Balanced Scorecard approach to performance measurement. They do not know the four measurement perspectives in the Balanced Scorecard or how it fits into long range strategic planning.

To compound matters, you have noticed that the organization uses static budgets to gauge the effectiveness of its operations. Admittedly they are frustrated that actual vs. budget comparisons never line up due to the changes in units sold.

Two other issues keep you up at nights. The head of the cost accounting department doesn't understand the intricacies of direct vs. step down cost allocation of overhead departments or the impact that switching to absorption cost system.

You have decided to call a meeting of all management personnel and explain in detail, with examples such as charts and/or numerical tables why; discounted cash flow is the best way to choose between two mutually exclusive projects, a Balanced Scorecard is a preferred method for strategic planning and performance review, using flexible budgets can be adapted to show price and efficiency variances when sales units change from initially budgeted levels, and finally how costs can be accumulated and allocated. You are keenly aware that you must point out to the bean counters that you know how absorption costing can be gamed to achieve bonuses and that is something that you just will not tolerate.

Solution Preview

See the attached file.

Board of Directors:

I would like to show you that adopt four new practices will enhance our competitiveness and improve our ability to study our own performance. And then I would like to warn against a common "gaming" of cost per unit which I will not tolerate. First, let's review the new practices.

1. Discounted Cash Flow.

While payback method ensures that you don't take on a project with cash flows well beyond a reasonable forecast length, it has some weaknesses. First, it treats all cash flows as if they are received today. This is a problem because cash received today can be invested now and grow while cash received later cannot grow, that is be reinvested, until it is received. Therefore, you may select a lesser investment using the payback method. Take the example below:

See Excel for better formatting

Yellow Green
Investment $ (60,000) $ (60,000)
Year 1 $ 50,000 $ 5,000
Year 2 $ 5,000 $ 5,000
Year 3 $ 5,000 $ 50,000 < -- both projects have identical 3 yr payback
Year 4 $ 5,000 $ 5,000
Year 5 $ 5,000 $ 5,000

PV of future cash flows $ 63,515 $ 58,845
discount rate 6% 6%

Net present value $ 3,515 $ (1,155)

These projects are identical in terms of payback. Both have a three-year payback, returning exactly the initial $60,000 over the first three years. But the timing of the cash flows differs. And so the present value of the future cash flows differs. In the above, I calculated the present value at 6% (discount rate). Here, the Yellow project would be approved with a 6% hurdle rate but the Green Project would not! The discounted cash flow practice includes an assessment for not only the total amount of returns in later years but also the length of delay until the returns available for reinvestment.

2. Balanced Scorecard.

There are some classic performance metrics that businesses use and they can be very information. For instance, many firms use return on assets. While these measures can be useful in reviewing outcomes, they have two limitations. First, they are narrow in focus and give managers an incentive to skimp on activities that would actually improve the long term performance. For instance, if your bonus is dependent on your return on asset percent, are you going to be eager to invest in a new project if it only give average returns? Or might take two years before it starts to perform? At the least, the manager may hesitate if not ignore the new idea. Why? Before performance is concentrated on the final outcome and there are no incentives to invest in the capacity or the leading indicators which would move the organization closer to the outcome.

The second issue is that return on assets does not inform the manager about the critical success factors identified in the strategic plan and therefore provides no guidance on how the return on asset should best be orchestrated to harmonize with others on the team and the vision of the leadership. A balanced scorecard, however, does provide these and puts return on assets into context as an outcome of strategic initiatives, all of which can be tracked and rewarded to ensure that the strategic plan is communicated and monitored.

The balanced scorecard contains four perspectives, or categories, which contains measures to monitor activities that "lead" to better results at the next level. For instance:

Learning and Growth (technology, workforce ability, new product, research)
Leads to better: Internal Business Process (quality, on-time delivery, right products, low errors, process ...

Solution Summary

Your tutorial is 2,309 words including four schedules completed in Excel (click in cells to see computations). This explains how discounted cash flow is superior to payback, how a balanced scorecard helps improve performance, how flexible budgets are a better measure of performance, how overhead costs can be allocated to operating departments and how absorption costing can lead to gaming of per unit costs.