Nehru Gupta is the controller at the Acme Shoe Company, a large manufacturing company located in Franklin, Pennsylvania. Acme has many divisions, and the performance of each division has typically been evaluated using a return on investment (ROI) formula. The return on investment is calculated by dividing profit by the book value of total assets. In a meeting yesterday with Bob Burn, the company president, Nehru warned that this return on investment measure might not be accurately reflecting how well the divisions are doing. Nehru is concerned that by using profits and the book value of assets, division managers might be engaging in some short-term finagling to show the highest possible return. Bob concurred and asked what other numbers they could use to evaluate division performance. Nehru said, ‘‘I’m not sure, Bob. Net income isn’t a good number for evaluation purposes. Because we allocate a lot of overhead costs to the divisions on what some managers consider an arbitrary basis, net income won’t work as a performance measure in place of return on investment.’’ Bob told Nehru to give some thought to this problem and report back to him.
Requirements
1. Explain what managers can do in the short run to maximize return on investment as calculated at Acme. What other accounting measures could Acme use to evaluate the performance of its divisional managers?
2. Describe other instances in which accounting numbers might lead to dysfunctional behavior in an organization.
3. Search the Internet and find at least one company that offers an information system (or software) that might help Nehru evaluate his company’s performance.
SOLUTION
This problem focuses on the human side of organizations—especially ways that employees might devise to “beat the system.” This problem is therefore especially useful in alerting students to the importance of designing and using systems that employees perceive as “fair,” and classroom discussions should reveal that employees can sabotage even the most cleverly-designed accounting systems.
Organizations often use accounting measures such as return on investment (ROI) for performance evaluation. Unfortunately, managers can manipulate these measures, at least in the short run, by either artificially increasing profits (the numerator) or decreasing assets (the denominator). Some ways to accomplish this are to (1) defer expenses, (2) maximize sales, (3) postpone maintenance on assets, (4) postpone investments in assets, or (5) using historical cost-based assets, adjusted by depreciation instead of market costs (which can result in an infinite return on investment once all the organization's assets have been fully depreciated). Where net profit is used in the calculation, Nehru's comment about including allocated overhead in deriving profit, is another argument against using return on investment.
There are many different performance measures that Acme might use—some quantitative and some qualitative. Other accounting measures include (1) segment margins, (2) units of sales, (3) increases in the number of customers, (4) increases in new customers, (5) measures of customer satisfaction, (6) decreases in sales returns, (7) employee complaints, or (8) employee turnover.
Accounting numbers can frequently lead to dysfunctional behavior if their limitations are not universally understood. For example, if the incentives are large enough or the penalties for underperformance are harsh enough, managers might be tempted to record “potential sales” as “actual sales” in a given time period, accelerate the depreciation of assets using alternate depreciation schedules, “forget” to subtract costs in computing returns, or sabotage the “returns” of other managers in order to improve their own performance values. Dysfunctional behavior may also surface if one number is used in isolation. For instance, return on investment discriminates against entities with larger investment bases. It also has the shortcomings mentioned above. However, ROI adjusted for overhead allocations and current asset values might be a good measure when used in conjunction with other measures.
This part of the problem requires Internet research. However, “residual income” might be a better measure to use in this company. This measure counteracts some of the problems associated with return on investment, although it has shortcomings of its own. Profitability, as mentioned, is problematic where allocations are used. Allocations are really never quite "fair." For instance, rent in a department store might be allocated to departments based on square footage. Certainly, this would lead to complaints by the department located in back on the sixth floor if they pay more than the department just inside the front door!