MAGISTER MANAJEMEN

UNIVERSITAS INDONESIA

MANAGEMENT CONTROL SYSTEM

TASK
Quality Metal Service Case

KELOMPOK 1

1. Adisty Lirasha (1606850431)

2. Anggara Mastangi
(1606850495)
3. Cynthia Anggi M.
(1606938076)
4. Efendi (1606938164)

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 QUALITY METAL SERVICE CENTER

Case Summary

Quality Metal Service Center is a metal distributor, who sells to smaller users
of metal products. To be competitive they have to have a shorter lead time and
better customer service to cover their costs and make their products a good
investment for the customers. They have 3 main objectives: first is to focus sales
efforts on markets of specialty users. Quality focuses sales on specialty high tech
metals. The second objective is to find geographic markets where these metals are
used. They are using database technologies so they have an accurate, up to date
sales forecast, which helps them prepare for orders before they occur, which will
shorten lead time and improve services. The third objective is to develop
techniques and marketing programs that will increase their market share. Their fast
lead allows customers to use a JIT (just in time) inventory that avoids high carrying
cost. Quality has saved costs using their own JIT system, and can help customers
achieve these savings as well. Quality also offers a wide range of processing
services which reduces the need for customers to have their own specialty tools and
saves time.

Management control systems should support implementation of the 3 goals

and influence managers to work toward these goals while maintaining superior
quality service to the consumers. Each of the 4 regions has a manager who is
evaluated based on ROA and wants to exceed the set goal of 90% projected profit.
A set of functional managers report to Ken Richards, the district manager, who
reports to the VP of the Midwest division. Any capital expenditure of more than
$10,000 has to be approved by central management; this makes divisions
dependent on central management for investment decisions. The district managers
are evaluated based on ROA, and the allocation is split 75% weighted on district and
25% region. This split may cause a manager to act in the best interest of the
district rather than the region or company.

Issues:

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1. The $10,000 upper limit on capital expenditures without approval

2. Evaluation based on ROA and bonus program:

ROA motivates managers to invest in positive NPV projects that will increase
future cash flows, and
The bonus plan is not motivating managers to make those investment
decisions, but not investing may be of more benefit to them.

3. Assets over-employed will reduce adjusted profits and the payout rate charged to
base salary.

4. Evaluation scheme is counterproductive towards organizational goals, and

managers motivation

5. Bonus plan incentive deters managers from making investments that require
large asset usage and may have a positive ROA or EVA result.

6. ROA as an evaluation is counterintuitive, as in the Columbus division, which

shows a high profit, but is hesitant to invest in opportunities with a lower ROA than
their target, that would otherwise benefit from cash flows for the company.

Questions:
1. Is the capital investment proposal described in Exhibit 3 an
attractive one for Quality Metal Service Center?

Yes, the capital investment proposal is an attractive one for Quality

Metal Service Center based on the following reasons:

1. The project will solve customers complains by reducing lead times

and satisfy demand for special processed products which produce
higher margin.
2. The project is in line with Quality Metals strategies:
To focus sales efforts on targeted markets of specialty metal
users;
To identify those industries and geographic markets where
these metal were consumed;

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 To develop technique and marketing programs that would
increase market share.
3. Based on the financial projection analysis, the project gives:

Positive NPV (Net Present Value) = $286,000;

Payback = 4.5 years (below company criterion of 10 years);

IRR = 21.8% (higher than the company cost of capital of

15%).

2. Should Ken Richards send the proposal to home office for

approval?

Yes, Ken should send the proposal to home for approval since based on
the companys policy, capital expenditure in excess of $10,000 require
corporate approval.

3. Comment on the general usefulness of ROA as the basis of

evaluating district managers performance. Could this
performance measure be made more effective?

Return on Asset (ROA) is one of tools used to measure performance in

investment center (to relate profit to assets employed).

As mentioned in the text book, there are advantages in using ROI

(ROA):
a. The ratio captures anything that affects financial statements;
b. The ratio is easy to calculate and to be understood;
c. The data used to calculate ROI (ROA) is readily available so it is
easy if the company plans to compare the ratio with its
competitors (benchmark);

However, there are some disadvantages in using ROI (ROA) as

measurement tool:

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 Manager may be reluctant to expand the business because the
business earns ROI below its targeted ROI even though the
business is profitable;
Manager may make bad decisions for the whole company by
selecting project that increases ROI but decreases overall
company profits;
ROI (ROA) calculated on gross book value always understates the
true return.

As an alternative of ROI (ROA), Economic Value Added (EVA) can be

used to measure district managers performance. In fact, the text book
suggested to use EVA since it is conceptually superior.

There are some advantages in using EVA:

a. EVA measures investment in more objective views. District
managers will have same profit objective for comparable
investment;
b. EVA enables the company to charge different interest rates to
different types of assets in order to consider different risk profiles
of different type of assets;
c. EVA is the best proxy for shareholder value at business unit level;
d. EVA is more favorable to companys long term goals;

4. In deciding the investment base for evaluating managers of

investment centers, the general question is: What practices
will motivate the district managers to use their assets most
efficiently, and to acquire the proper being measured, the
district manager will try to increase his ROA, and we desire
that the actions he takes toward this end be actions that are in
the best interest of the whole corporation. Given this general
line of reasoning, evaluate the way Quality computes the
investment base for its districts. For each asset category,
discuss whether the basis of measurement used by the
company is the best for the purpose of measuring districts
return of assets. What are the likely motivational problems

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that could arise in such a system? What can you recommend
to overcome such dysfunctional effects?

1. Land, warehouse building and equipment were included in the asset

base at gross book value

If asset is based on gross book value, ROI (ROA) will understate the
true return. Under this approach, manager will likely to replace old
equipment with new equipment even replacement is not
economically justified or old equipments still have some usefulness.

To overcome such shortcoming, top management need to set

guidelines of under what circumstances, assets can be replaced
such as the assets have to pass certain useful life (age), asset is not
repairable, etc.

2. Leased building and equipment (except for leased trucks) were

included in the asset base at the capitalized lease value.

If leased assets are included in the investment base, manager will

prefer to lease rather than to own whenever interest charge built
into rental cost is less than capital charge. Of course, there is time
leasing is better than owning. But, there is also time that owning is
better than leasing. Thus, a separate study will be needed in order
to justify whether leasing or owning is better.

In fact, quite common, leasing cost is higher than depreciation

expenses which at the end may decrease the profit of the whole
company.

3. Average inventory, in units, was calculated. Replacement cost,

based on current mill price schedules, were determined for these
units and included in the asset base.

The problem with using average for inventory valuation is this

inventory cost will be average with older costs. During the rising
price, the inventory balance may seem lower.

Valuing inventory using replacement cost will ensure the inventory

value is at the current price.

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 4. Average account receivable balance for the period was included in
the asset base (Cash was excluded from districts assets; the
amount were trivial).

Using average account receivable balance may conceal the current

problem related to account receivables since the balance was based
on simple average between current A/R and previous month A/R.
The problem that may happen, manager may not promptly know
that there is current problem with its A/R.
Despite its shortcoming, average account receivable is a better
measure compared to end of period balance.

5. Account payable was not deducted from the asset base. However,
an adjustment was made if the negotiated credit period was greater
than the company standard of 30 days.

Account payable actually represent financing by vendor at zero

cost. By not deducting account payable from the asset base, this
will make capital tied up with the business seems high.

By including account payable in the calculation, manager will be

encourage to look for better terms with vendors.

5. While computing district profits for performance evaluation

purposes, should there be a charge for income taxes? Should
corporate overheads be allocated to districts? Should profits
be computed on the basis of historical costs or on the basis of
replacement costs? Evaluate these issues from the standpoint
of their motivational impact on the district managers.

Income tax should be included while computing district profits for

performance evaluation purposes since district manager have been
given authorities for activities affecting tax income.

By including income tax in the district performance calculation, district

manager hopefully would also consider tax implication when making
any investment / business decisions. Thus, better tax planning will be
implemented.

Not all corporate overhead can be allocated to districts. Only overhead

directly related to district may be allocated to district. District
manager may object if all corporate overhead is allocated to district

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 under reasons that district managers do not have control in the
corporate overhead.

Historical cost is used for profit calculation because it is easiest to do.

Nevertheless, Quality Metal may use replacement cost if it wants to be
more accurate. For practically reason, we suggest Quality Metal use
historical because:
Historical data is readily available and easy to compute;
Quality Metal does not need to appoint third party to estimate
replacement cost. Thus, the company does not need to pay
external third party to conduct the study (cost saving).

6. Evaluate Qualitys incentive compensation system. Does the

present system motivate district managers to make decisions
which are consistent with the strategy of the firm? If not,
make specific recommendations to improve the system.

As discussed in the textbook, current incentive compensation system

(using ROI/ ROA) may create misalignment between district manager
interest and the whole company strategy.

The disadvantages in using ROI/ ROA as performance measurement

have been discussed in answers of number 3 above as follows:
Manager may be reluctant to expand the business even though
the business is profitable since the business earns ROI below its
targeted ROI;
Manager may make bad decisions for the whole company by
selecting project that increases ROI but decreases overall
company profits;
ROI (ROA) calculated on gross book value always understates the
true return.

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Alignment between performance measurement and the whole
company strategies need to be done. The Quality Metals strategies
are:
To focus sales efforts on targeted markets of specialty metal
users;
To identify those industries and geographic markets where these
metal were consumed;
To develop technique and marketing programs that would
increase market share.

Combination of Economic Value Added (EVA) and some non-accounting

performance measure may be applied such as market share growth,
quality enhancement program, etc in order to make sure business unit
objectives align with whole company objectives.

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