CPTG 31149

MANAGEMENT CONTROL

T2 2016-2017

COURSE DOCUMENTS

Course coordinator : Adrian Zicari

 CPTG 31149 Management Control

Syllabus

COURSE OBJECTIVES AND CONTENT

Management Control has developed into one of the key instruments in both profit-
oriented as well as non-profit/public organizations over the past decades. The
competences and skills taught in this course are basic to all managers in order to fulfill
their responsibilities. Understanding management control thus is an essential
underpinning for future managers from all kinds of functions including but not limited
to the finance and accounting function, marketing and sales, strategy and corporate
development, HR, organization, and R&D.

This course presents and critically discusses the basic concepts, practices and
instruments of management control. It will not cover the management accounting
concepts and techniques already studied in prerequisite courses.

Neither the profession nor the discipline of management control has a single, strict,
simple definition. The field is understood in varying ways depending on the country, the
company, and the industry sector. While it calls on a set of techniques, it has an essential
managerial component, as the techniques are at the service of management rather than
vice versa. This combination of management and techniques, the formal and the
informal, is what this course sets out to present. Management control methods are
examined not only from a technical angle, but also in terms of their impact on the
behaviour of actors and the socio-organisational conditions of application.

Management control principles, practices and instruments will be studied from two
perspectives that co-exist within companies:
1. From the "traditional", financial perspective (budget control reliant on
segmentation of the company into responsibility centres, internal transfer prices,
financial performance indicators, etc),
2. From a broader, more recently-developed strategic perspective (design of
balanced scorecard ("tableaux de bord"), integration of the cross-functional
dimension of performance, etc)

The course also aims at providing students with an arena for enhancing personal
competences while at the same time acquiring business and management knowledge. It
thus offers the opportunity for further-developing key personal competences such as
critical reasoning, scientific approach, and presenting ideas to an audience.

TEACHING METHODS

The teaching will be based on lectures and student presentations of readings and/or
cases and following plenum discussions based on the readings/cases. The emphasis in
class is on 2-way dialogue rather than a one-way communication from teacher to
student. Thus, students are expected to prepare the readings/cases in advance, to
answer questions in class, and to participate actively in discussions.

Before each class, students must prepare the case study and be up-to-date with
required readings; otherwise most of the benefit of these methods will be lost.

Students analyses of the assigned cases/summaries of readings must be submitted at

least 48hs before the class to the teacher, who will then choose one or two groups to
give an in-class presentation of their case analyses/summaries. These in-class

CPTG31149
presentations provide the starting point for further in-class discussions incorporating all
class members.

SESSION STRUCTURE

Each class will include a presentation by the lecturer, student presentations) of case
studies, collective work on a case and student presentations of and/or class discussion of
the assigned text. Sessions end with a wrap-up of the content and the key learnings.

READINGS & CASES

The course will rely to a large extent on one of the most widely used textbooks on
management control:

Anthony, R. and V. Govindarajan (2007),

Management Control Systems,
12th edition, McGraw-Hill.

There is also an updated version (2014) of the same book; both of them are available in
the library (IV 32 ANT). Any of the two versions can be used for this course. A large part
of the readings and some of the cases used can be found in this textbook. Besides the
textbook, the course will draw on a set of other required assignments consisting of
journal articles and specific case studies.

Occasionally, suggestions for additional (optional) readings will be provided.

Students MUST:
Be up-to-date with the assigned (required) readings,
Prepare the case studies indicated for each session

SOME VIDEOS ABOUT MANAGEMENT CONTROL

A Controller in Asia: https://www.youtube.com/watch?v=5BFg3g8-xdk

A Controller in the US: https://www.youtube.com/watch?v=j8OgPZOh49I

EVALUATION

The student's final mark is determined

40% by the continuous assessment,
40% by final examination, and
20% by active in-class participation.

Continuous assessment is based on one or more of the following (each lecturer is free
to choose):

Intermediate occasional 10-15 minute tests on a point covered in class, the case
study prepared for the class, or the required reading.

Presentations concerning a text or case study. These are generally prepared in

teams of two students, and a summary report should be submitted to the
lecturer. Evaluation is based on the following criteria:
o Reasoning and ideas, and examples discussed,
o Oral presentation skills (plan, any handouts, clarity, keeping to the time
allotted)
o Understanding of the text discussed,
o Contribution of bibliographical references or new examples.

CPTG31149
 Summaries of the text studied, containing a personal commentary on the topics
and methodology explained ("fiches de lecture").

The final examination will comprise an end-of-course case study or a series of

exercises, designed to test "active" understanding of (capacity to reapply) what has been
learned in class as well as to evaluate knowledge acquired.

CPTG31149
 CPTG31149 Core Course of Management Control

Topic of the Session Readings in the Other readings Cases to prepare (concerning the
Anthony & concepts discussed during
Session Govindarajan previous class)
textbook
1 Introduction & Overview (incl. presentation of the course, Chapter 1 Technobat
work methods, prerequisites etc.) Chapter 3 Cartelec factory
Presentation of management control (from cost accounting
to management control, the need for management control,
typology of management control etc.)
2 The links between strategy and control Chapter 8 Atkinson, Kaplan & Young (2004), excerpt from Mica-Serra
The planning and budgeting cycle forecast, analysis and Chapter 9 Chapter 10 SoftPro
control Chapter 13
Criticism of budgeting
3 Responsibility, controllability and accountability Chapter 4 Libby and Lindsay (2010) Blackhole
Typology of responsibility centers, Business Units Chapter 5 Merchant (1987), How and why firms disregard COGEL
Chapter 6 controllability.

4 Organizational models Chapter 7 Dearden (1969), The case against ROI (HBR Prochim A
Make or buy Chapter 11 classic) Prochim B
Transfer prices Lo Vazquez

5 Reporting & control of Business Units: financial performance Chapter 11 Immo 3000B
criteria (ROI, Residual Income, Value Creation indicators, ...) E.N. Industries, (ENARGER)
Limits of financial management control

6 (Key-)Performance Indicators Chapter 11 Kaplan & Norton (1992), HBR Boston Lyric Opera
Balanced Scorecard Kaplan (2010)

7 Multi-criteria deployment of strategy Champy - Reingeneering the corporation Stream International

Management by processes Chapter 1
8 Social Responsibility of the firm, multiple stakeholders and Chapter 3 Porter & Kramer (2011), Shared Value (HBR) Antel
multiple performance criteria Chapter 12
Management control systems and CSR
9 Control in different industries and for different strategies Chapter 14 Clean Sweep
Expected and unexpected effects of management control SPARC
systems and function
Course wrap-up & exam preparation
10 final exercise : Creation of a balance scorecard

CPTG31149
Please note:
For the readings in the Anthony and Govindarajan book, we referenced the 2007 version. If you want to use the 2014 version (both of them are
equivalents for our course) you should consider these chapters:

Session Chapters in the 2014 version

1 Chapters 1 & 3

2 Chapters 2 & 9 (plus the Chapter 13 from the older version, which you have in your reading booklet)

3 Chapters 6, 7 & 8

4 Chapter 10

5 Chapter 10

6 Chapter 10

7 no Chapter

8 Chapter 3 & 11

9 Chapter 12

10 no Chapter (final exam)

CPTG31149
 Some useful online references

For session 5
https://www.youtube.com/watch?v=fMNuDZYiqTY

For session 6
https://www.youtube.com/watch?v=M_IlOlywryw
https://www.youtube.com/watch?v=AdXt8BfiGJg

For session 8
https://www.youtube.com/watch?v=bIRUaLcvPe8
https://www.youtube.com/watch?v=9JHgmul9F4M
http://www.wsj.com/news/articles/SB1000142405274870333800457523011266
4504890

CPTG31149
 Session 1

CASES

Technobat
Cartelec Factroy

2
Case

Technobat
 TECHNOBAT

Technobat is a fast-expanding, medium-sized company that manufactures special state-of-the-art technology

products for the building industry, on a made-to-order basis only. The management is very young: the
management controller is 28, and the general manager 38.

The following conversation took place at the budget preparation meeting:

The general manager: "We should be pleased, because we have achieved our objectives for growth,
turnover and market share, and we must do the same next year. The same goes for our aim to keep at the
forefront of technological advances in our field. But profitability is down again. This is a serious problem!
What do you think?"

The technical manager: "Our laboratories have developed new state-of-the-art techniques, and we've cut
back considerably on production costs by improving general organisation and bringing in better supply
sources. What more can we do?"

The sales manager: "Sales volumes and market share have never been so high, and we've raised our prices
up to the maximum. What more can we do?"

The management controller: "We've reduced overheads as far as they can possibly be reduced. What more
can we do?"

The general manager: "I know you've all done your jobs. I'm not blaming anyone. I can only see one
solution: the controller must get together with each of you to examine the extra efforts needed, and draw up
a budget on that basis."

A budget was established, forecasting a profit, and accepted by all with fewer difficulties than expected.

The following year saw a further increase in sales, more technological advances, and a bigger operating
loss.

The general manager: "Gentlemen, the loss has increased. Something must be done. What do you propose?"

Analyse this situation.

Technobat 1/1 CPTG31149

 Case

Cartelec factory
 PERFORMANCE MONITORING PROBLEMS AT THE CARTELEC PRINTED
CIRCUIT BOARD PLANT, ANGERS

The plant

The US electronics group Comtronics bought the Bull group's principal factory at
Angers (France), to use it as one of its manufacturing units for PCBs (printed circuit
boards) which are used in PCs and business IT systems. In fact, it comprises two
industrial units:

An upstream unit makes bare PCBs, i.e. rectangular boards with sides
measuring approximately 30-50cm. These boards are pressed, treated in
chemical baths, photoengraved with microscopic electronic circuits, and drilled
with minuscule (sometimes invisible) holes.

The second unit receives these PCBs and mounts electronic components onto
them (microprocessors, memories, diodes, etc) to make motherboards for a PC or
system. The completed boards are tested in test machines.

The existing management control

The two units are managed in the same way. At the start of the year, an output and
expense budget is prepared. The output budget is expressed in product quantities
(number of PCBs per model), immediately translated into standard production hours
(each product has a routing plan showing how many labour hours and machine hours
are normally required to make it = standard hours).

For each unit, the expense budget is extrapolated from the previous year, taking into
account absorption of new investments, foreseeable pay rises, and trends in
production. The expenses budgeted are compared to the output budget in standard
hours (see above) to calculate a ratio called the standard hourly rate:

standard hourly rate = units forecast expenses / units forecast output,

measured in standard hours

During the year, management controllers monitors the units actual hourly rate:

actual hourly rate = units actual expenses / units actual output, in standard
hours

Output is always measured in standard hours.

The management control team calculates variances between the actual and standard
hourly rate. If the actual hourly rate goes off course, i.e. rises above the standard
hourly rate, the operational staff concerned must explain and justify the difference. Of
course, this is an unpleasant situation they wish to avoid.
The problems of the PCB unit

Smooth operation at the PCB unit is hindered by recurring problems to do with

control of production flows. These problems appear take the two classic forms for
flow problems. The upstream PCB unit is often late in delivering PCBs to the
downstream unit that makes electronic cards, and the downstream unit is unhappy
about this. Also, poorly-managed work in process and uncontrolled stocks build up
and very visibly take up space in the PCB plant. Finally, there are recurring
conflicts between the operational heads of PCB production and the companys
production management/flow management departments.

The new head office management controller for the production department decides to
visit the plant and investigate these flow problems. He begins by collecting
information on the units strategic environment and the key performance issues
identified by the Management.

Transition from a high-output policy to a just-in-time policy

A. PAST SITUATION

The unit originated in lucrative markets with high production costs, largely due to
use of costly resources with high overheads, sometimes highly specialised
(particularly the presses and the chemical treatment lines) applied to highly
customised and therefore small-series products. The resulting basic economic
problem was the intensive use of these costly resources, and therefore their
productivity, which depended on effects of mass production or batch size. To
make the very expenses presses profitable, what was needed was high volumes,
and therefore high output.

Generally, the plant worked on orders that had been placed a long time in
advance, so there was no sense of urgency and the workload could be smoothed
over the year (as the industry has a certain seasonal cycle, registering greater
numbers of orders at the end of the year), by producing boards in advance during
the slow periods and keeping some output in stock for use in high-demand
periods.

B. NEW SITUATION

In the new situation, contracts come through a network of distributors and

resellers. As a result, market fluctuations are perceived with a slight delay, as
contact with the market is indirect. This means it is vital to be able to respond
quickly to quantitative or qualitative fluctuation in the market. Given the high
exposure to competition, delayed reaction to a market change can have serious
consequences, since commercial positions are completely volatile. Market share
can easily be taken over by any competitor.

Rapid renewal of PCB models also engenders growing risks of stock

obsolescence, and large quantities of unsalable products are scrapped.
 The faster pace of technological progress is also reflected in regularly falling
prices, on both components and finished products.

As a result it is terribly costly to hold working capital, particularly stocks. The cost of
holding stocks is estimated to represent an annual interest rate equivalent to 30%
(in other words, having 10 million of stocks costs 3 million each year) - and this
does not include sales lost due to delays in supplying the distributor network (the
larger the stocks, the longer it takes to respond to changes in demand). These costs
are certainly high, but difficult to measure.

The importance of costs related to stocks and delays has become much greater than
the importance of machine output. This explains why the PCB unit has adopted a
clearly declared flow tension (zero stock, just-in-time) strategy. The aim of this type
of strategy is to systematically reduce times for supplies, production and distribution,
and therefore reduce stocks and response times, eliminate delays, and accelerate
and facilitate flows.

Performance monitoring in practice

The new management controller takes as an example the plants first operation,
pressing printed circuits. This operation involves non-negligible setup time for the
presses (20-35% of the total time) before each batch is processed. He tries to identify
the true logic underlying monitoring of this operation by questioning the supervision
staff, the engineer, and the operators. His questions chiefly concern the following
situation: if there is a queue of batches of printed circuits awaiting pressing, which is
often the case, what order are they pressed in? What criteria are used to determine
that order?

The answer is clear and simple: the first to be pressed are the batches that pay (an
expression frequently used by the production technicians), i.e. batches that will make
the most intensive use possible of the presses: this means that the longest batches
go first, to achieve the optimum output from the machine preparation time for a large
series. Shorter batches have to wait: similar batches are put together to form larger-
volume groups.

This criterion relates to an unambiguous monitoring approach: maximising output

(profitability) of presses and labour.
 Analyze if this type of performance monitoring is coherent with a just-in-time
strategy. Explain why or why not.
If your answer is no, can you explain the incoherence between the declared
strategy and the performance monitoring approach actually applied through
the existing management control?
If your answer is yes, what causes do you see for the apparent economic
problems?
What should be done to remedy the situation?
 Session 2
READING

Atkinson, Kaplan & Young (2004)

CASES

Mica-Serra
SoftPro

4
 Reading

Atkinson, Kaplan & Young (2004)

Excerpt from Chapter 10
Case

Mica-Serra
 Serra-Mica Case
Evaluation of leaders performance

Serra-Mica company manufactures coffee cups made of earthenware. It prints company logos and
other inscriptions on the cups intended for business gifts or to be sold to wholesalers. Annual
production capacity amounts to 3 million cups, but economic recession made production and sales
slow down. Last year, sales only reached 1,5 million cups. Year N, P&L is summarized as follows:
Sales (2 X I 500 000) : + 3 000 000
Complete cost of manufactured goods : - 2 700 000
Gross Margin : + 300 000
SG&A (fixed) : - 400 000
Loss : - 100 000
Cost of manufactured goods includes variable expenses (750 000 , i.e. 0,50 per cup) and fixed
expenses (1 950 000 ). There was inventory of finished goods neither at the beginning nor at the end
of year N.
Worried by the financial loss, the Board appoints a new executive officer, Antoine Pirelle, and
proposes him a compensation plan which includes a variable part (15% of operating profit), and a
fixed part (50 000 per year), this last one being same as for the previous EO.
As a result of Antoine Pirelles action in year N+1:
a. Production increased to 2 500 000 cups.
b. Sales volume increased to 1 800 000 cups.
c. Sales, general and administration expenses (SG&A) were 650 000 (including the fixed salary
of the executive officer: 50 000).
Sale price for cups (2 per unit), variable cost per unit (0,50 ) and the total amount of fixed
expenses (1 950 000) did not change from year N to year N+1.
At the end of year N+1, Antoine Pirelle informs the Board that he resigns. His comment: I
turned the company around; I thank the Board for their trust. I will now try to solve the crisis of
another firm.
Questions:
1. What is Serra-Mica profit in year N+1?
2. How much will be paid to Mr Pirelle as variable part of his compensation for year N+1?
3. You are a member of the Board, in which you represent a bank. You arrived in the Board
in year N+1. How do you react to the P&L statement, the profit achieved in year N+1 and
the resignation of Mr Pirelle?
Case

Softpro
 SOFT PRO CASE

A large business software company, Soft Pro, recently decided to accelerate the decentralization of
its sales network. The corporate leadership aimed at motivating local agency managers, who faced an
increasingly fierce competition. By decentralizing some decision-making processes, the corporate
leaders hoped to get more flexibility on the operation field. As a first step, it was decided to limit this
decentralization policy to the Small and Medium Business (SMB) market, which seemed particularly
promising. So far Soft Pro had been very weak on this market, since it had concentrated investment
and development efforts on the markets of large corporations and government services.

product line A product line B product line C

solutions for solutions for solutions for

large government small and
companies and public medium
services business

local local local local local local

sale sale sale sale sale sale
agency agency agency agency agency agency

So far, agencies had been evaluated on the basis of their sales. In the newly adopted organization,
each agency was still evaluated on the basis of its sales for the large business and the government
service markets. But each agency was considered as an autonomous profit centre for the SMB market,
with its own P&L statement and bottom line. Some measurement of its annual profit (the
contribution, as we shall see further) would be the new agency performance indicator for the SMB
market to be evaluated in the formal reporting process of the company. Agency managers benefited
from new powers and action levers.
In the previous situation, agencies budgeted their sales volume and direct cost annually. Monthly
reporting for the two items (sales and direct cost) helped monitoring the agencies situation and
allowed consolidating results at the corporate level. Agency managers received an annual bonus equal
to 5% of sales generated over a target level, which was negotiated each year by headquarters and
agencies. Situation did not change for large business and government services markets, but, in the
SMB market, as a profit centre, each agency would now have greater leeway and would make
autonomous decisions upon the following issues:
-They would determine selling prices; they would be free to discount prices within a range of 5 to
22% of the published catalogue price. This range is determined by the corporate sales department,
according to a client breakdown that will be constantly fine-tuned. Previously, agencies did not have
the power to negotiate selling prices. They were only allowed discounts for large volume orders, as
specified in the catalogue. Agencies did know neither production cost nor procurement costs for the
products they sold.
- They would determine client payment schedules, within a maximum limit of 90 days. Previously,
payment schedules were defined centrally, and scheduling rules depended upon a typology of five
groups of customers, which was managed by the corporate sales department jointly with the financial
department. These rules established normal payment delays between 30 and 90 days, with a possibility
of spreading out payments over a period of up to 120 days. In addition, billing was managed centrally,
with detailed data about the customer (e.g. previous payment problems) helping to automatically adapt
payment conditions. This centralization had caused quite a bit of tensions between headquarters and
agencies, particularly in the case of SMB. Sometimes, after a deal had been considered closed, clients
had to be called back by the agency to modify aspects of payment conditions. This could then result in
sale losses and customer dissatisfaction.

-They would be allowed to complete the Soft Pro SMB product line by offering competitors
products (software in particular).

-A marketing and advertising budget was allocated to each agency for ads in local media,
participation in local events, etc.
- Agencies paid royalties to the headquarters for the software they sold on the SMB market, when it
was Softpro proprietary software, and, when they sold competitors software, agencies had to buy it by
themselves.
-The agencies got almost total freedom to manage their direct cost: staff, rent, maintenance. Any
change, however, had to be approved first by corporate management. Along with this decentralization,
the corporate management control modified the monthly reporting of agencies. Now the agency
"contribution", instead of sales, would become the key measurement to be reported for the SMB
market. It was decided that this contribution would be calculated in a very simple manner, so that
agency managers would not be "drowned in administrative paperwork".
 Contribution calculation

+ Sales
- Agency direct cost (including royalties on Softpro software and the software purchases when
they sold competitors' products)
- Agency marketing cost
= Contribution

Customer debt collection remained centralized at headquarters as well as the management of cash
flow. In addition, corporate management control kept all financial interests and other financial
expenses as corporate charges, since they were directly negotiated by the corporate finance department
at headquarters.

The annual bonus for each agency manager would now be based on sales for large business and
government service markets and the agency's annual contribution for the SMB market. The concerned
parties agreed to set this bonus at 6% of the agency's full-year SMB contribution.

The new situation

After several months of operations under this new management system, the Corporate Financial
Officer sounded the alarm for the CEO and the controller: interest expenses had skyrocketed. They
would probably deteriorate the semester results in a substantial proportion. The Corporate Sales
Director had just informed the CEO that he was very satisfied with sales over the past few months.
Sales had increased more than 15% compared to the two previous half years. He was concerned,
however, with the worrisome problem of collecting client debt. Debts had ballooned (20% increase in
accounts receivable, compared to the two previous half years). He was also worried that the new
freedom for agencies was not being quite properly used: "the price weapon was only supposed to be
used on the SMB market, but I'm afraid that's not the case". The CEO, for the interim result forecast,
wondered how he would explain to analysts and shareholders that, despite the fact that sales rose
substantially, earnings would be lower.
Agency managers, however, were satisfied with the new system.
Analyze separately what was happening (customer payment schedules, debt collection,
inventory, selling prices and discounts):
o on the large business and government service markets (particularly concerning the
actual selling prices),
o on the SMB market.
Is the controllability principle respected?
 How do agency managers behave as concerns the pricing of sales on the respective markets?
What does it reveal about the existing management control system, in particular about sales
control?
Were you the CEO, what would you think? What would you say? What would you do?
 Session 3
READINGS

Libby and Lindsay (2010) (See course

Website)
Merchant (1987)

CASES

Blackhole
Cogel

6
 Reading

Merchant (1987)
How and Why firms disregard controllability
Case

Blakhole
 Blackhole with stocks (industrial company)

James Thriftless was the head of financial control at the industrial company Blackhole, a small
company that manufactures a single part used in the automobile industry, and had held this
position ever since the company was formed. He had always had the full confidence of the
companys founder and manager Mr Blackhole. When the business was set up, it was the first to
use an ultra-durable polymer for the product it made: when blended with rubber, this made the
part more hardwearing. In fact he called his product the Stamina, and for a long time it was the
only one of its kind on this market. But in recent years other competitors had seized on the same
manufacturing process, slowly eroding Blackholes sales and profits.
On November 15, year N, Mr Blackhole announced that his son Harpagon would succeed him as
chairman of the company from January 1 the following year. Harpagon, an engineer by training,
had rounded off his education with an MBA from Boston and then spent several years with a
large strategy consulting firm. During their discussions, Mr Blackhole had warned his son about
the companys commercial and strategic difficulties; however, Mr Blackhole showed little
interest in financial matters and James Thriftless was given great autonomy in such areas. It was
true that for a long time, the companys healthy profits had spared Mr Blackhole any cash flow
difficulties.
When Harpagon joined the company on December 16, year N, he looked at the internal
management reports and observed that Blackhole had no cash budget, and financial planning was
rather succinct. Harpagon expressed his concern about the situation to James Thriftless. James
replied that Blackhole was managed under a set of decision rules that worked perfectly well, and
that as a result no cash budget was necessary: when the financial position became tight, Mr
Blackhole transferred money from his account to the companys account. Harpagon reacted
immediately and firmly: My father is a millionaire but I am not.
When Harpagon asked James to introduce a budget for the coming year without delay, James
looked uncomfortable; he said he knew little about budget management and that he would
certainly need to hire an assistant to establish a budget.
Harpagon then decided to call his old friend Henry Knowledge. Knowledge was working on
several major budget management projects in a consulting firm, and Harpagon knew he was
considered an expert in the field for small and medium businesses. Fortunately for Harpagon,
Knowledge was not too busy and he came round to Blackhole that very week.
He spent two days in the companys offices examining the accounts, memos and all available
reports. On Friday morning, Harpagon found the following note on his desk:

Dear Harpagon,
I had to leave last night for Pittsburgh. During the two days Ive spent at your company, Ive
noted the following:
1. You have no budget or control system.
2. James Thriftless is a good accountant.

1
3. Thriftless knows nothing about basic management rules, and is not interested in production,
strategy or sales.
Ill be back on Monday morning to talk things over with you. I recommend that you contact
Penny Pincher, a financial controller I know. Ive left her contact details with your secretary.
Regards, Henry.

Harpagon was perplexed by this note and decided to find out who Penny Pincher was. He
telephoned her. She explained that she had a MS (Masters degree) in management and had
worked for several years in a small company where she had set up the entire management control
system. It was all running smoothly now and she was in fact planning to look for another job.
Henry Knowledge arrived on Monday morning as promised. Swift as ever, Henry told his friend:
You must hire Penny as your financial manager, youre heading for disaster. What's more, I
think she can come and help straight away. James has got to go, hes too expensive for what he
does. And that very afternoon, James was dismissed with an indemnity. The same evening,
Penny agreed to work for Harpagon. She could start next Monday after negotiations with her
current employer.
When she arrived the following week, Penny set to work without delay. Constructing a budget
from scratch was not easy, but that did not worry Penny unduly.
She began by an interview with Mr Blackhole senior, who was still working in the company. He
explained the companys past and present context: the market for the Stamina product, the main
competitors and the main customers. She collected further information by reading about the
automobile market and the automotive companies, which were Blackhole customers. Then she
talked to Harpagon, who explained the strategy he intended to adopt: in his opinion, the product
was a good one but not sufficiently differentiated from competitors products. He was
considering two areas for action: production cost must be reduced in order to restore margins, and
meanwhile, other outlets must be found to boost sales. This type of part could, for example, be
used in the railway or aeronautic industries, but these markets had never been approached.
For the time being, Harpagon gave Penny a forecast for the number of parts that could reasonably
be sold in the coming month:
Actual sales: Estimated sales
October N: 1,500 units December N: 1,800 units
November N: 2,300 units January N+1: 2,000 units
February N+1: 2,200 units
March N+1: 1,900 units
April N+1: 2,100 units
She then visited the head of production to find out about the manufacturing process. In fact, the
companys manufacturing process for its only product, the Stamina, was particularly simple. It
was produced from a unique raw material (a polymer/rubber blend) supplied to the production
line every morning from a safety stock. The various operations involved in production took place
during the day, and at the end of the day all the finished parts were stored in a warehouse. Since
parts were finished by the end of the day, there were never any products in process overnight.
With his excellent knowledge of the workshop, the head of production was able to tell her the
variable cost of different items and fixed workshop costs per product unit:

2
Direct variable costs
Materials costs per unit 0.75
Direct labour costs per unit 1.25
Total 2.00
Variable overheads
Indirect labour costs per unit 0.20
Energy costs per unit 0.10
Other indirect costs per unit 0.50
Total 0.80

Fixed costs (weekly amounts)

Employees 100
Procurement overhead 300
Electricity 75
Factory insurance 125
Other overheads 110
Total 710
Penny decided to check this information against the accounts, which were up to date at the end of
November. In the general accounts, she managed to identify the costs related to the workshop.
Identifying the variable and fixed costs, she was able to compare total variable costs to variable
costs for the units produced over the period and see that the estimates for unit costs were
accurate. She also found the amount of fixed costs as stated by the head of production.
She noted that sales and management costs amounted to approximately 781 per week. This
amount comprised the following:
Payroll (including benefits in kind and payroll taxes): 400
Rental 200
Depreciation of office equipment 100
Other functional services 81
Total 781
Penny returned to see Harpagon with these initial figures, to discuss the assumptions to be
applied in the budget. Together they defined a certain number of general principles:
1. The estimations for variable production costs were certainly accurate; given the objective
of reducing these costs, but taking a cautious approach for the first quarter, it was decided
to leave them as they were.
2. Fixed production costs were certainly 710; however, this amount did not include
estimated depreciation; therefore, fixed production costs should be increased by the
amount of depreciation; the value of the factory and machinery and equipment could
reasonably be estimated at 70,000; the machinery and equipment probably had a
recoverable value of 25,000; depreciation was to be calculated monthly over a 5-year
useful life, on a straight-line basis. All these expenses were part of the production cost of
goods sold.
3. As the figures supplied for fixed production costs, distribution costs and management
costs were for one week, it was decided to apply a coefficient of 4.5 to estimate the
monthly amount.

3
 4. To take into account the new strategic orientation, Harpagon asked Penny to budget 900
in expenses per month to develop sales (direct marketing to potential customers).
5. It was decided that the sale price would remain fixed at 7 per unit for the first quarter;
sales commissions were set at 10% of sales revenues.
Lastly, Penny asked Harpagon what he wished to do with the shareholders current account. He
told her his father was going to recover his money (30,000). Harpagon decided to pay 10,000
into this current account, but wished to withdraw 1,400 per month from the companys accounts
for his own requirements.
Penny gathered some more information she was going to need:
The time schedule of invoice settlement by customers was as follows:
o During the month of sale 30%
o Month following the month of sale 40%
o Second month following the month of sale 20%
o Third month following the month of sale 10%
Materials purchases were payable in 30 days. Consequently, settlements were made in the
month after the month of purchase. According to forecasts, 1,700 units of raw materials
were to be purchased during December N.
All other expenses (payroll, overheads, commission, rental, etc) were paid in the month of
purchase.
The stock of raw materials had been estimated at 800 units at December 31 N, and there
were 750 units of finished products.
Finally, Penny drew up a projected balance sheet at January 1, N+1 based on the documents
analysed and the accounting position at the end of November:

Assets Equity and Liabilities

Land 5000 Share capital 85687
Factory machinery 70000 Current accounts 30000
Office equipment 13122
Stock of finished products (4.72 3540
per unit)
Stock of raw materials 600
Accounts receivable 14700 Accounts payable 1275
10000
Cash
TOTAL 116962 TOTAL 116962

Penny got down to work. She prepared a forecast budget for the first quarter (projected income
statement, cash budget and projected balance sheet at March 31, N+1) in the following stages:

4
1. Sales budget
The first stage was to establish the sales budget in monthly figures and for the first quarter. To do
so, she completed the table attached in the appendix.
2. Production budget
The second important stage in Pennys work was to establish a production plan and a materials
procurement plan (tables in the appendix) for the first quarter of N+1.
As no production or stock plans existed, the head of production supplied some operating rules
based on experience acquired in the company:
(1) production for a given month should be scheduled such that the stock of finished products at
the end of the month is equal to half of the expected sales level for the following month;
(2) materials purchases should be scheduled such that the company has enough raw materials
available to make 700 products. Consequently, the minimum month-end stock must contain 700
units in raw materials.
Based on these production plans, Pennys next task was to calculate the production cost that
would then be used to establish the projected income statement. To do so, she completed the table
attached in the appendix.
3. Stock accounts
To complete the income statement, Penny next had to establish the accounts for the raw materials
and finished product stocks. She used the weighted average cost per unit method already used in
the company (see table in appendix).
4. Projected income statement
Based on the previous calculations, Penny was able to draw up a projected income statement for
the first quarter of N (format supplied in appendix).
5. Cash budget
After constructing the income statement, Penny decided to turn her attention to the cash position.
She prepared the monthly cash forecasts for the first quarter by filling in the table shown in the
appendix.
6. Projected balance sheet
The final stage in the budget process applied by Penny was the establishment of the projected
balance sheet at March 31, N+1 (format in appendix).
7. Finally, based on all the budget statements drawn up, Penny decided to issue a short summary
memo on the principal components of the companys financial position, and some
recommendations for Harpagon.

5
 Management control and business
supervision
Session 2: forecast budget and monitoring process,
links with strategy

Budget case tables to complete

ESSEC 1
 1) Sales budget

Unit
January February March TOTAL selling
price
Units sold
Sales revenues

ESSEC 2
 Budget case study
2a) Production plan

Beginning Production Ending

inventory Sales S = EI BI + S Inventory
(BI) (EI)

December

January

February

March

TOTAL

ESSEC 3
 2b) Procurement plan

Planned
Beginning Purchases = Final
production
inventory BI EI BI + PP inventory EI
PP

December

January

February

March

TOTAL

ESSEC 4
 2c) Production budget

Unit
January February March TOTAL
Cost
Units produced
Raw materials
Direct labour
Indirect labour
Energy
Other indirect costs
Fixed costs
Depreciation
TOTAL
Per unit

ESSEC 5
 3a) Raw materials inventories

Unit Unit
Units Amount Units Amount
Cost Cost
Beginning
inventory Production
BI
Ending
Purchases
inventory EI

Total in Total out

Chg in
EI BI inventory
= BI - EI

ESSEC 6
 3b) Finished product inventories

Units UC Amount Units UC Amount

Sales in
Beginning weighted
inventory average
cost per unit
Ending
Production
inventory

Total in Total out

Chg in
EI BI inventory
= BI - EI

ESSEC 7
 4a) Income statement management method

Units Per unit Amount

Sales revenue

Production cost of
sales

Overheads

Promotion cost
Commissions
on sales
Profit

ESSEC 8
 4b) Income statement accounting method

EXPENSES INCOME

Purch raw materials Sales

Raw mat inventory Finished products
variation inventory variation
Other prod costs

Overheads

Promotion costs
Commissions
on sales
TOTAL

Profit

Grand total

ESSEC 9
 5) Cash budget
cash in budget
B/S total
January February March
March 31
Accts recvbl
B/S, N
Sales, 01

Sales, 02

Sales, 03

Current
account

TOTAL

ESSEC 10
 5) Cash budget
cash out budget

B/S total
January February March
March 31
Current
account

Raw materials
Other production
costs (production
budget raw mat
depreciation)
Other overheads
(budgeted overhead
depreciation)
Promotion costs
Commissions on
sales
Withdrawals from
current account
TOTAL
ESSEC 11
 5) Cash budget
cash out budget

B/S total
January February March
March 31
Current
account

Raw materials
Other production
costs (production
budget raw mat
depreciation)
Other overheads
(budgeted overhead
depreciation)
Promotion costs
Commissions on
sales
Withdrawals from
current account
TOTAL
ESSEC 11
 5) Cash budget
Summary

January February March

Cash in

Cash out

Beginning cash

Ending cash

ESSEC 12
 6) Forecast balance statement

ASSETS EQUITY & LIABILITIES

Gross Deprec. Net Net

Equity (beginning balance
Land statement)

Factory Profit (income statement)

machinery

Current account
Office
(beginning + in out)
equipment

Inventory of
Accounts payable (budget
finished cash out)
products
Bank short run debt
Inventory of raw
(cash budget summary)
materials

Accounts
receivable
TOTAL

ESSEC 13
Case

Cogel
 COGEL

1. THE COMPANY

Founded in France years ago to manufacture transformers and circuit breakers, the Compagnie Gnrale
d'Electricit (COGEL), had always been a leader in the European market and had gradually built up a vast
empire by acquiring a number of competitors of all sizes and by moving into the business of high-tension
electricity production and electronics.

2. RESTRUCTURING

Last year (year N-1), COGEL restructured its organisation completely, changing from a structure by function
(Annex 1) to one by product (Annex 2) based on 3 main business units:

Production of High-Tension (H.T.) in which COGEL has enjoyed a dominant position in Europe for
many years. Its main customers were EDF (electricity utility) and SNCF (railways) in France, and large
European electricity and railway companies. The annual growth rate of this market is around 3% in
sales volume. COGELs market share in Europe has remained stable at 40% while its two main rivals
have market shares of 25% and 20% respectively. The HT business currently makes up for 55 % of
COGELs total sales turnover.

Production of Low-tension (L.T.), This business is stable and competitive. For several years, COGEL
has held a dominant position in the oil, chemical and steel industries in Europe. The annual growth rate
of these markets is around 1% in sales volume. COGELs market share in Europe is stable at 30 %,
while its two main competitors have market shares of 15% and 12% respectively. The BT business
currently accounts for 38% COGELs total sales turnover.

Industrial electronics (I.E.) is a rapidly growing and highly competitive business sector. The main
feature of this market is the vast number of products with short life cycles. The annual growth rate of
the market is roughly 17 % in volume. COGEL does not have a dominant position in this market. In
France its market share is only 10%, and has been unchanged for the last four years. Its two biggest
competitors have market shares of 35 % and 30 % respectively. The IE business in France currently
accounts for 7 % of COGELs annual turnover, while its IE business in Europe is starting this year.

A decentralisation policy was introduced by setting up six divisions corresponding to the six product-market
pairs (HT, LT, IE / each in France and Europe). These divisions were profit centres. At the same time, the
Marketing and R&D departments were organised according to the three product groups. The corporate
Marketing and R&D functions continued to report to the Managing Director.

From a strategic point of view, the corporate leaders considered HT and LT as "milk cows". Their profitability
and their competitive position were strong, but their growth perspectives were low. It was then necessary to base
the future development of the group on the promising IE activities, whose market was bound to grow quickly. To
face that challenge, it was vital that COGEL IE business unit increase its market share quickly, since the present
market share was too low to hope any significant role in that sector.

3. INDUSTRIAL ELECTRONICS DIVISION, FRANCE

J. PRINCE, a thirty-eight year-old engineer, was appointed head of the division. The division annual turnover
was 22 M in year N-1. Prince was in charge of production (in three plants) and sales (divided into 5 areas), and
he could call on the services of the research staff from the R&D department. He was in charge of his own sales
policy, of new product development and the management and coordination of the teams that reported to him.

Industrial Electronics targeted a great number of businesses. There was frequent demand for new components
based on miniaturisation and reliability. These new needs resulted in a substantial renewal of products and
pressure being put on the sales people to study new applications and find solutions to satisfy specific demands.
Cogel 1/7 CPTG31149
By and large, the modifications required were rather simple to carry out. However, the division had to respond to
demand quickly as well as meeting agreed deadlines.

4. THE BUDGET

The budget (cost, sales, profit: a planned P&L) for each of the 6 divisions was the cornerstone of the new
organisation. It served three purposes:
For top management to coordinate the COGELs various businesses, devise a five-year plan and
measure the performance of the divisions.
For the Director of Operations to allocate resources between the three product groups.
For the Industrial Electronics to measure the performance of the divisions.

In year N-1, each manager played an active part in establishing the budget of year N. This was done according to
the following stages:

1. Sales estimate: on the basis of overall forecasts complied by the Marketing department, J. PRINCE et
H. GAUDE worked out the sales forecasts for each product line and sought to compare them to the
estimates made by the sales force. The latter were based on customers needs. After a phase of
adjustment, comparing and checking figures, they came up with a figure of 26 M, which seemed to
them a reasonable one, given the growth of this market.

2. Estimating manufacturing costs: by using sales estimates for each product range, D. MONNET and the
plant managers devised a monthly production schedule, calculated the new resources required to meet
the assumed increase in business and estimated the direct production costs (purchased materials and
direct labour) according to product specifications. Then, by using the usual ratios, they worked out the
main overhead costs (maintenance, general overhead, supervision etc)

This took a long time and involved much discussion and debate, which sometimes became quite heated as it was
the first time such a detailed plan had been put into operation at COGEL. Moreover, the accounting system was
ill suited to the task and the rise in turnover was mainly due to the introduction of new products.

3. Calculating administrative and sales costs: it was quite easy for R. GAUDE to work out the sales costs.
H. JEANTET and J. PRINCE met A. BRAMI et B. DOLTO to study the appropriate keys for allocating
R & D and administrative costs to the French and European Divisions.

On several occasions, S TAUBAL, head of the group, had to arbitrate between two divisional directors, J.
PRINCE and H. JEANTET. On the whole, however, there were no major differences between the four managers.

Having gathered all the necessary figures, J. PRINCE was able to draw up the first draft of the budget (Annex 3),
which set his divisions contribution at 5.9 M.

This budget forecast was submitted to the Financial Department, which consolidated the figures with those of the
five other divisions and then compared them to the objectives laid down in COGELs five-year plan. After much
discussion with the Director of Operations, X. MARCEAU and the three group heads, the figures were put up.
The Financial Department, supported by the members of the corporate executive committee, thought that the IE
divisions should bring their contribution to the corporate profitability in the same way as "old" divisions HT et
LT. The Managing Director also demanded that, for strategic reasons, IE divisions significantly increase their
market share in year N.

The next step was a meeting between S. TAUBAL, J. PRINCE and H. JEANTET the purpose of which was to
review the budget forecast. A revised budget was presented to the management, which, in turn, made other
changes. Finally after several weeks discussing the issue, J PRINCE agreed to a revised version which set sales

Cogel 2/7 CPTG31149

at 28.4 M, and the contribution at 7 M, i.e. a 24.6 % ratio of contribution to sales, close to the contribution rate
of the other COGEL businesses (Annex 3) COGEL management thought it was important to keep an equal and
fair distribution of objectives between divisions. It was felt that the forecast was difficult to achieve but
attainable.

5. YEAR N RESULTS

Halfway through July, J. PRINCE received a run-down of the results for the first half of the financial year and
the comparison with the corresponding budget (Annex 4). The figures showed that sales were 9% lower than
objectives and the overall result was even worse, 14 % lower than objectives.

Worried by the disappointing results, J. PRINCE asked the Production Manager D. MONNET and the Sales
Manager R. GAUDE to meet him to study in detail the differences between the half-year objective and the
results. They analyzed the figures carefully. They eliminated the effect of sales volume. They also highlighted
the raw material yield, the efficiency of the production schedule and the quality of the management of each
workshop or sales area. While trying to be as objective as possible, they consulted their assistant managers in
production and sales. However, with the exception of a few isolated or unimportant mistakes, they could not find
significant problems neither in the performance of the plants or in the performance of sales teams. The variances
were mainly due to overheads and R & D costs, which did not come under the control of the division.

It was clear to them that sales were below expectations because of the unrealistic figures imposed in the revised
budget by the top management. The market had continued to grow quickly and COGEL had managed to keep the
same market share for most of its markets despite the pressures of international competition. In year N-1,
turnover for the first half of the year was only 10 M while it reached 11.8 M in year N without any addition to
the workforce. To achieve this growth, it had been necessary to acquire modern equipment, and staff in
production and sales had to work miracles day after day.

The managers working under J. PRINCE were unanimous in attaching no value whatsoever to the half-year
figures as they showed only the short-term operational results, whereas they were working for the long-term
results, looking to develop new products and new markets to defend COGELs image and position in Europe.

6. POSSIBLE COURSES OF ACTION

J. PRINCE was relieved by the conclusions of their analysis. He wrote a detailed report to S. TAUBAL.

Nevertheless, he took the precaution of planning several measures designed to turn around the situation before
the end of the year and to achieve the 7 M budgeted objective. Though the new organisation set up in year N-1
was in its infancy and using the budget as a performance measure was not yet clear for the operational managers,
the general management did expect budget targets to be met. They also expected that each manager would take
all the necessary steps to achieve the contribution targeted at the start of the year. It was clear that success in
reaching these profit objectives was the condition for granting greater autonomy to the Divisions in their
operations. It followed, therefore, that the main criterion for performance appraisal was budgeted profit
objectives and that these, in turn, would determine the compensation, promotion and career of the managers.

Bearing in mind these considerations, J. PRINCE studied three measures he felt would enable the division to
reach the end of the year without suffering any major setbacks:

Discontinue advertising in technical trade journals. As a rule, COGEL, along with its main rivals, allocated
approximately 1% of sales turnover to the advertising budget. However, no real estimation of its effectiveness
had ever been made. The sales people themselves disagreed as to the utility of this type of advertising. Because it
was not clear how effective this spending was and with only one third of the original budget used up in the first
half of the year, J. PRINCE decided not to commit the remaining 2/3.

Postponed recruitment of three engineers. It was planned to recruit three engineers to strengthen the production
planning and scheduling of the two plants, with a view to improving production, inventory turnover, machine
utilization rate and production runs, in order to cut costs. J. PRINCE did not expect the re-organisation to
achieve substantial gains immediately, which explains why he envisaged putting off hiring the engineers until

Cogel 3/7 CPTG31149

the beginning of year N+1. By doing this, he calculated that he would save the company almost 0.12 million in
the financial year N.

Cutting component inventory. Purchased components inventory made up 30% of the divisions assets and
covered up to one years needs given current use. While having a limited effect on costs and therefore the
divisions results, cutting back stock levels would have an immediate impact on return on invested capital. J.
PRINCE was convinced that this would enhance his own performance appraisal. The company would run the
risk of running out of inventory since suppliers require four or five months for specialised items, which
accounted for most of the stock, but it was a risk Prince was ready to assume. By selecting the items to cut
carefully, J. PRINCE believed he would be able to reduce stock value by at least one third and thereby avoid
endangering timely stock replenishment.

These three measures were by no means exclusive and having given the matter some thought J. PRINCE felt he
had done well to leave himself some room for manoeuvre.

QUESTIONS

Carry out a thorough analysis of the budgeting and budget control processes, as it really works; consider
especially their coherence with corporate strategic objectives. For that purpose, do not judge on the basis of
"impressions", but make "numbers tell the story":
1. what are the significant differences (from a strategic point of view) between traditional divisions (HT
and LT) and the new IE division? What is the key strategic performance objective for LT and HT
divisions to ensure the future development of the group? Same question for the IE divisions
2. what other economic objective is assigned to the IE division by the Financial Department?
3. what did Prince's first budget proposal involve for the division market share? If you had been the
Managing Director, what would you have thought of it?
4. what problems do the IE division and its managers face? Has the budget which was finally adopted been
really appropriated by IE division managers? Why is it difficult to achieve?
5. using answers to questions 1 to 4, analyze and criticize the budgeting and budget control processes and
the management information system on which it rests.
o what about the objectives assigned to divisions?
o what about the communication between actors?
o what is the tacit perception of priorities by IE division managers, including Prince?
o is the coherence of the budget with the corporate strategy correctly achieved?
6. what realistic recommendations could be made to solve the problems identified? Should procedures,
I.S., missions, persons be changed?

Cogel 4/7 CPTG31149

Cogel
ANNEXE 1

ORGANISATION BY FUNCTION (in use until year N-1)

Managing Director

Financial Managing Marketing Management Technical Director Personnel Managerl

R&D Production

5/7
Planning France International Hight Low Industrial
dept. Tension Tension Electronics

Man. Man. Man.

Sales Force Plants) Plants) Plants)
HT BT EI

Sales Force

CPTG31149
Cogel
ANNEXE 2

ORGANISATION BY PRODUCT

Managing Director

Head Office Head Office

R&D Marketing

Operational Director
Financial Personnel Manager
Management X. MARCEAU

6/7
HT Products L.T Products Industrial Electronics
Group Group Group

Division products French Division R&D Administration

H. JEANTET J. PRINCE A. BRAMI B. DOLTO

Production Sales Prod.Manager Sales Manager

Manager Manager. D.MONNET R.GAUDE

Plants Sales Force Plants Force Sales

CPTG31149
 ANNEXE 3

BUDGET FIGURES YEAR N

Initial Budget Revised Budget

(12 months) (12 months)

Sales 26 28,4
Direct labour costs 2,2 2,4
Raw Mats. 9 9,8
Production Overheads 4,2 4,3
Sales costs 1,9 2,1
Admin. costs 1,2 1,2
R&D 1,6 1,6
Total costs 20,1 21,4
Contribution 5,9 7

ANNEXE 4

BUDGET FIGURES 1ST HALF-YEAR N

Initial Budget Revised Budget Result

(6 months) (6 months) (6 months)
Sales 11,9 13 11,8
Direct labour costs 1 1,1 0,98
Raw Mats. 4,12 4,5 4,06
Production Overheads 1,96 2 1,8
Sales costs 0,9 1 0,86
Admin. costs 0,6 0,6 0,62
R&D 0,8 0,8 0,9
Total costs 9,38 10 9,22
Contribution 2,52 3 2,58

Cogel 7/7 CPTG31149

 Session 4
READING

Dearden (1969)

CASES

Prochim A
Prochim B
Lo Vazquez

8
Reading

Dearden (1969)
The case against ROI
Case

Prochim A
 PROCHIM A : The Information Technology
Department
The Prochim Group

In 2003, the PROCHIM Group employed 6,000 people and operated 12 factories in France, of which the biggest, located in
Grenoble, employed over 2,000. It specializes in the manufacture of base products for mineral and organic chemistry and
accounts for 5% of the total chemical industry output in France. For certain products it is a leader not only in France but also
in Europe.

Grenoble Factory

The Grenoble factory manufactured several hundred products, amongst which were:
Basic products, (chlorine, sodium carbonate, phenol, acetone, sulphuric acid, etc...) manufactured in quantities of
over 100,000 tons / year and sold mostly to industrial customers.
Derived products, in much smaller quantities, using the basic products, either for other factories in the group or for
industrial customers.
Each production unit was considered as an independent entity with its own installations, workforce and management. Insofar
as was possible, common expenses such as General Administration, Maintenance, IT, Design and Engineering, Laboratories
etc., had been directly assigned to each unit, using counters or work vouchers where necessary. Thus, indirect General
Factory Expenses which were arbitrarily distributed (mostly administration) were kept at a minimum, and most units were
treated as profit centres.

The Information Technology Department (ITD)

ITD had been in existence for some time, and used fairly efficient high performance computers, with 9 experts (specific
software development, system updating, users training) and operators. Located in the Grenoble factory, it carried out the
data processing for this and the Group's Research Centre, some ten kilometers away, which employed 800 people.
Roughly speaking, the data processing needed by the factory could be divided into two activities:
1. Processing specific to PROCHIM, with software tailored to Group needs for technical and scientific calculation,
dimensioning of apparatus such as distillation columns, exchangers etc., chemical kinetics calculations, industrial
process control and optimization, R&D specific calculations, specific models for technical and quality testing.
2. Applications requiring standard software, such as PERT planning, return on investment calculation, accounting, staff
wages and salaries, management of raw material inventory and supplies, production planning for the larger units,
sales administration, etc.
On applications type 1, specific software was permanently developed on the basis of users specifications (particularly for
the R&D, quality and engineering departments). On applications type 2, standard software parameters were often updated to
take into account users' requirements, but the core of software was stable. In any case, the IT department charged its actual
full cost to users:
- processing was evaluated in processing hours,
- each month, the total volume of processing hours was calculated,
- the total expenses of the month were divided by the amount of processing hours, to get an average cost of the
processing hour,
- each service was billed as number of hours supplied to the user * average actual cost of the processing hour this
month.
The IT department is considered as a cost centre, whose key performance indicators are: average cost of the processing hour,
average response time to customers demands.
The activity of the IT department was fairly irregular and difficult to schedule. On one side, most standard applications took
place with a regular periodicity, each at its own individual rhythm (annual, monthly, weekly, daily). On the other side,
calculations carried out on request depended on research and engineering design or quality needs, which were inherently
unpredictable and generally urgent.
Even if, on the whole, the IT department capacity was not sufficient to undertake all the processing requested over the year,
it was nevertheless under-employed at certain periods, because of this irregular flow of work. At other times, however,
overtime and night work were required, resulting in many complaints from the users as regards both cost (overtime and night
work of course were more expensive) and delays.
Owing to several unfortunate occurrences, some users began systematically to outsource all their calculations to the IBM
office services in Grenoble, even when the PROCHIM computer was under-employed. On average, almost half of
processing activity was outplaced, even though the IT department was only working at 70% capacity.
Because the situation was getting worse, the Factory Manager (FM) called a meeting with
The Information Manager (IT)
The Controller (C)
The Research and Development Manager (R & D)
The Engineering Manager (ENG)
to study which work should be done by the IT department and which be contracted out.

The IT Meeting

FM : " Even though the IT department work quality is excellent, and the IT team has developed software perfectly
adapted to PROCHIM's needs, it appears necessary to develop a systematic policy as regards relationships
with user departments. Until now, decisions were taken on a contingent basis, as a result of which more and
more work was contracted out, and the IT department has had more and more free time. As a result, our best
experts have low morale and are threatening to leave."
R&D: "There are two problems: prices and deadlines.
Generally, when the deadline is respected, the price is exorbitant compared to IBM. On the other hand, when
the price is competitive, there is often a delay of several days for the results, which is unacceptable for our
researchers."
IT : "Wait a minute; let us not confuse the two problems.
That of delay is now solved, with the three processing procedures, normal, urgent and flash, which flash
guaranteeing results within a half day."
R & D: "I very much doubt it. It will only take a few weeks for the great majority of requests to be for flash
processing! In any case, the problem of price remains, and I think we should sub contract to IBM every time
the cost of processing is cheaper there than the total in-house cost for us at the moment."
IT : "That is not fair. First of all, my department has to pay a substantial proportion of General Expenses which are
totally out of my control, and second, you cannot compare IBM's costs with mine. IBM can make such
economies of scale that it is impossible to compete with them. My department is powerless to control this
situation. Moreover, the "true cost" policy obliges us to invoice our services to users at their true cost, i.e. at
full actual cost. May I remind you that we invoice no margin whatever to internal customers!"
C: "In theory, it would be possible to allow users to pay only the variable cost of the IT service. However, the
analysts and experts and machine depreciation are unavoidable fixed overheads. What varies is the machine
time used, and the variable cost which varies with machine time is very low: energy, overtime, paper, ink...
90% of the IT cost is fixed. If the transfer price was the variable cost, at such a low price, all the processing
would be done here, and when the department is saturated, even the flash work would have to be contracted
out, with all the disadvantages that would entail. A more logical solution would be to compare the direct cost of
processing with the price invoiced by IBM. In this direct cost we would not count the firm's general costs,
which the department is expected to pay.
ENG : "The only drawback of direct cost is that, as full cost, it also varies according to the rate of activity, since it is
mostly fixed. Under your principle of true costs, we users get a nasty shock when we find ourselves from one
month to the next paying double for machine time all of a sudden! At IBM, at least, the customer has no
unpleasant surprises. It is the standard cost of processing which should be compared to the IBM price."
FM : "It also seems to me that we should distinguish the selection criterion according to whether the IT department
is working flat out or if it is under employed. Mr. Controller, please prepare a proposal that we can discuss
next week.".

Questions

1. Analyze:
a. the cost structure of the IT department,
b. the behaviors generated by the different cost notions and solutions mentioned by the managers taking part into this
meeting,
c. how they correspond to the specific interests of each actor and to the general interest of the company.
2. What are the problems identified by the IT users, the IT department and the corporate leaders? Do they have a focal and
common cause? If so, which one?
3. What criteria should be taken into account to make the "make or buy" decision for IT treatments?
4. What transfer price system would you recommend?
5. What performance measurements would you recommend? Take into account the strategic context (objectives and
positioning of the IT department).
Case

Prochim B
 PROCHIM B: DETERGIX DIVISION

The PROCHIM Group

In 2003, the Prochim group had 6,000 employees and 12 plants in France, the largest being in Grenoble
with over 2,000 employees.

Prochim specialises in the manufacture of base products in the field of mineral and organic chemicals. It
represented approximately 5% of the total turnover of French chemicals industry, but certain products
occupied important positions not only in France, but also in other European countries.

The Grenoble plant

The Grenoble plant manufactured several hundred products, including:

1. base products (chlorine, soda, phenol, acetone, sulphuric acid, etc.) for which production exceeded
100,000 tonnes/year, sold mainly to industrial customers.

2. by-products, in much lower quantities, derived from base products and used either by other Group
plants or industrial customers.

Each production unit was considered as an independent unit with its own facilities, its own workforce
and its own management. As far as possible, support costs (General Overhead, maintenance, IT,
research, laboratory expenses, etc) had been assigned directly to each unit via appropriate use of
meters or job tickets. This meant that indirect Factory Overhead allocated on an arbitrary basis (mainly
relating to administration departments) had been reduced to a minimum, and each unit was treated as a
profit centre.

The DETERGIX S.A. unit

This unit, separate from the Grenoble plant, was set up in 1988 to produce detergent from phenol and
sell it to washing powder manufacturers. Formed as an SA (socit anonyme limited liability company)
with Prochim controlling 70% of shares and its 3 main customers, producers of washing powder, 10%
each, Detergix employed some thirty people working continuously on a 3-shift basis.

Without going into detail, the manufacturing process can be schematised as follows:

1. Purchase of raw material: the main material, phenol, was supplied by the neighbouring Prochim
unit.

2. High-temperature catalytic reaction.

3. Distillation, yielding detergent at the head of the column, which was then processed before being
dispatched to customers by train, and a heavy product, NNP, at the foot of the column, which was
stocked before being sold.

In this process, 80% of the processed volume was drawn from the head of the column in the form of
detergent, and 20% was drawn from the foot in the form of NNP.

Prochim B 1/7 CPTG31149

THE NNP PROBLEM

While detergent was an easily-marketed product, with a fast-expanding market and a stable market
price of 140/ton in 2003, NNP had a very restricted market as its only direct use was as a high-
temperature heating fluid in the oil and chemicals industries. Production of NNP was well above
demand level, and this led to a widely fluctuating, constantly declining market price that fell to 40/tonne
by the end of 2003, from 80/tonne just two years earlier. Detergix therefore sold its NNP exclusively to
Prochim group plants, taking advantage of this captive market to maintain its price at 80/tonne, and
even then the margin was low (see Table 2).

In the first few years, internal sales of NNP more or less kept pace with production, but this year sales
had reached a plateau, resulting in a large excess volume of NNP that looked likely to grow in 2004 and
caused a serious storage problem.
(see Table 1).

TABLE 1: THE DETERGIX BUSINESS IN TONS

1999 2000 2001 2002 2003 2004

Estimation
Production of detergent 2 000 4 000 5 000 6 800 10 000 14 000

Production of NNP 500 1 000 1250 1 700 2 500 3 500

Internal sales of NNP 400 900 1 300 1 600 1 700 2 000

Stock of NNP at Dec 100 200 150 250 1 050 2 550

31

Costs and Cost Price

Costs for 2003 could be schematised as follows:

Detergent : 10,000 T External market

Costs (2) 20 K + 8 /T
Purchases of raw Production 12,500 T = 100K
materials
12,500 T at 24
= 300 K
Costs (1) 350 K + 20 /T Internal
NNP : 2,500 T
= 600 K transfer
Costs (2) 5 K + 1 /T
= 7,5 K

Nature of costs:

1) = Depreciation, direct labour and management costs, maintenance, energy and overheads

2) = Direct processing and storage costs

Prochim B 2/7 CPTG31149

In calculating the respective costs of the detergent and NNP, shared Purchasing and Manufacturing
costs were assigned in proportion to the two products' respective tonnages. This logical approach was
widely used by Prochim, particularly for the large phenol-acetone and chlorine-soda units.

The detergent thus absorbed 80% of shared costs, leaving only 20% to be absorbed by the NNP. The
resulting cost were as follows (see Table 2):

TABLE 2: 2003 costs in K

Costs Detergent NNP Total

Purchased raw 240 60 300

materials
Manufacturing 480 120 600

Specific costs 100 7.5 107.5

_______________ _____________ _______________ _______________

TOTAL 820 187.5 1 007.5
Factory cost 82 /T 75 /T

Sale price 140 /T 80 /T

Margin 41.4% 6.2%

In 2003, sales of detergent had developed considerably, and the gross operating margin was as follows
(see Table 3):

TABLE 3: P & L for 2003 in K

Opening Stock Closing Stock

Raw materials 400 T x 24 = 9.6 K Raw materials 400 T x 24 = 9.6 K

Detergent 200 T x 82 = 16.4 K Detergent 100 T x 82 = 8.2 K

NNP 250 T x 75 = 18.75 K NNP 1 050 T x 75 = 78.75 K

Sales
Purchases 12 500 T x 24 = 300 K
Detergent 10 100 T x 140 = 1 414 K
NNP 1 700 T x 80 = 136 K
Manufacturing costs =
707.50 K
Gross margin =
594.30 K

1 1 646.55 K
646.55 K

Prochim B 3/7 CPTG31149

This was three times higher than the gross margin for 2002, and Mr Patron, the manager, was pleased
to be in such a buoyant market.

But Mr Fabri, the Head of Manufacturing, was worried about 2 storage containers being tied up with
stocks of NNP, and talked about the problem with his Manager.

Conversation between Mr Fabri and Mr Patron

3
FABRI The storage situation is becoming very worrying. 2 of the 4 large 600m storage containers I
can use are already full of NNP, and the quantities are increasing all the time. At this rate all
4 containers will be used for NNP by the end of the year. I think an active sales campaign is
urgently needed to get rid of the NNP and solve this problem.

PATRON That would be very difficult. The market for NNP is very depressed, and if we wanted to sell
off more than 1000 tonnes all at once, the price would collapse to well below the current
40/tonne. And even at that price we would make a considerable loss, and our gross margin
would be seriously reduced. You know how much the General Management values
profitability; we are a profit centre and it is out of the question to sell products at a loss.

FABRI But the NNP is already losing us money now. I only have small containers left to keep
stocks for sales, I'm always juggling to meet urgent customer orders and I can't even use
the quiet times to build up a buffer stock. I'm operating practically on a day-to-day basis and
I've had to refuse last-minute orders on several occasions. Overall, I think I lost almost 800
tonnes of detergent sales last year because I didn't have enough storage space available.
3
One 600m storage container costs around 70 K, and is totally depreciated in 10 years.
Just to see, I drew up a simulated P & L statement (see Table 4) on the assumption that we
could have sold 800 additional tonnes of detergent if we had had an extra container.

TABLE 4: pro forma P & L for 2003 in K

Opening stock Closing stock

Raw materials 400 T x 24 = 9.6 K Raw materials 400 T x 24 = 9.6 K

Detergent 200 T x 82 = 16.4 K Detergent 100 T x 82 = 8.2 K

NNP 250 T x 75 = 18.75 K NNP 1 250 T x 75 = 93.75 K

Sales
Purchases 13 500 T x 24 = 324 K
Detergent 10 900 T x 140 = 1 526 K
NNP 1 700 T x 80 = 136 K
Manufacturing costs =
734.10 K

Depreciation of the container =

7 K

Gross margin =
663.70 K

Prochim B 4/7 CPTG31149

 1 1
773.55 K 773.55 K

The gross margin would have been nearly 12% higher, and the extra cash flow would have
reached 76.4 K, which means the investment in the new container would be recovered in
under a year.

PATRON Now that's very interesting: a positive approach to the problem, looking for a way to
increase sales of the noble product rather than trying to sell off our by-products, which
doesn't get us anywhere.

I could invest in a new container immediately, since it will pay for itself in less than a year,
and in fact I think we should prepare for the future and ask for another 2 or 3 containers as
well. The General Management are keen on these small investments with short pay-off
periods, and I have no objections to raising my investment budget a little. It shouldn't be a
problem, and from your point of view, all your difficulties would be solved.

At more or less the same time, Mr Souprod, head of sales of all the Grenoble plant's by-products
(including the NNP) met his colleague Mr Detere, head of detergent sales, and Mr Conta, the factory's
accountant.

SOUPROD As long as NNP is at 75/tonne, I can't sell any on the market, and the stocks will carry
on building up. Since Mr Patron won't sell at a loss, one simple answer could be to
change the cost of NNP. Most of its cost results from the assignment of shared
manufacturing costs. We made the arbitrary choice of weight as a basis for allocating
those costs, and it should be easy to change that basis in order to arrive at a fairer
price.

CONTA Hold on a minute, the current basis isn't all that arbitrary: most production costs
(purchases, storage, heating and pumping) are linked to tonnage, which makes it logical
to allocate costs in proportion to the 2 products' weights.

SOUPROD All right, but that reasoning seriously penalizes NNP, whose price per kilo is not the
same as for detergent. I think it would be better to allocate costs based on each
product's economic value.

DETERE But how would you measure their economic values?

SOUPROD Well, we could allocate common costs in proportion to income on the 2 products.

DETERE That's meaningless, you know very well that your transfer prices are totally unrealistic!

SOUPROD So let's value NNP at market price.

DETERE What market price? You know it's plummeting, and changes every month!

SOUPROD Then let's value NNP at zero. After all, the factory was built to make detergent. NNP is
just a necessary evil in the production process, so logically the principal product should
bear all costs, including the costs of NNP.

DETERE You're getting carried away! With your method, the cost of detergent would be
100.80/tonne and the margin would drop from 41% to 28%! You're forgetting Im a
profit centre, and I get judged on my margin. Detergent is extremely competitive and

Prochim B 5/7 CPTG31149

 unlike you, I can't make up for losses by selling to the group's other plants at
extravagant prices. Stop playing your own private game and trying to make Detergix's
flagship product carry the can!

CONTA He's right, all those changes wouldn't make any difference to the end result. We're
dealing with communicating vessels, and anything we take away from NNP will be
passed on to the detergent. There must be a more active, sales rather than accounts
based, way of reducing our stocks of NNP.

Prochim B 6/7 CPTG31149

 Questions

1) Make a critical diagnosis of the accounting segmentation used in the Prochim Group and
applicable to Dtergix. What dynamics does the performance assessment system
generate?

2) Following this reasoning, examine the impact of the 2 possible strategies:

- sell the excess NNP at market price,
- keep the NNP in stock and purchase an extra container (Mr Fabri's proposal).

NB. Examining these 2 strategies requires prior establishment of the profit and loss
statement for the 2 products.

3) What is the optimum strategy for Dtergix?

4) What other cost calculation could help the company make the right decision?

Prochim B 7/7 CPTG31149

Case

Lo Vazquez
 Lo Vasquez Vineyards
You are the newly appointed controller of Lo Vasquez Vineyards, a very traditional firm in Chile
founded by Hermenegildo Frei in 1873. Operative costs for 2014 were EUR 210 million, while the firm
has an asset base of EUR 300 million. Total liabilities are EUR 100 million, and their cost is 15%. Lo
Vasquez had sales of EUR 250 million during 2014. Weighted Average Cost of Capital (WAAC) was
10%. Chilean government has recently exempted vineyards of all taxes.

Amrico Errzuriz (General Manager) is discussing with Edgardo Frei, fifth-generation owner in the
firm. Amrico insists in that his performance as a manager has to be measured in terms of ROA: Mr.
Frei, it is you - not me - who decide how much debt the company has. You know banks are charging
higher interests all the time

Mr. Frei has a very different opinion; My dear Amrico, we have been here for some time in this
business. I see no point in using your ROA. After all, what matters to my family is our wealth invested
in the firm. You should focus on ROI instead

Both Amrico and Mr. Frei ask you for your advice. They have full confidence in you: they know that
you took the course avec moi

a- Calculate ROA and ROI

b- What is your opinion about the firms performance
c- Please explain why each person has a different viewpoint
d- Amrico is interested in growing a new wine grape. New assets needed would be EUR 10
million and the project would give 1,10 million of profits yearly. Calculate the ROA and the
EVA of this project. Would Amrico take it or reject it? Please explain your advice.

Glossary

ROA = Return On Assets = (Operating Profits / Total assets)

Operating Profits = Sales Operating Costs (both variable and fixed)

Same as EBIT (Earnings before Interest and Taxes)
It represents the performance of the local manager who is not responsible of how the company is
financed (Controllability principle)

Net Profits = Operating Profits Interests Taxes = what shareholders are entitled to receive as
dividends. Maybe they do not take all Net Profits as dividends: they leave some reserves (thus, Equity
increases).

ROI = Return over Investment (almost equivalent to ROE) = Net Profits / Equity
It represents the performance of the corporation as a whole

Equity = Assets - Liabilities

Residual Benefit (from which EVA is an approximation) = Operating Profits (Assets x WACC)

Otherwise said, EVA = Economic Value Added, is close to Residual Benefit (after taxes)
 Session 5
CASES

IMMO 300B
E.N. Industries

10
Case

Immo 3000B
 IMMO 3000 (B)

The real estate group IMMO 3000 has a network of agencies that act as intermediaries in property sales and
rentals. The decision to open any new agencies is made by the head office, in view of the opportunities and
competition in the local market concerned.

Each agency is considered as a profit centre and has its own personnel, premises and vehicles. Head office
expenses are reinvoiced to the agencies in proportion to their turnover. The agency managers are evaluated based
on the agency's return on investment (ROI). To stimulate performance, the group's general manager has decided
to publish a "league table" of agencies based on ROI.

The data concerning the agencies at Chalon and Vercourt are as follows: the Chalon agency is long-established
and operates mainly in the residential property market, which has been depressed for the last few years; the
Vercourt agency was opened much more recently, and operates in the currently expanding market of office sales
and rentals.

CHALON VERCOURT
1997 1996 1995 1997 1996 1995
Gross assets at December 31 20000 20000 20000 150000 150000 150000
Net assets at December 31 4000 5000 6000 127500 135000 142500

Turnover 15800 15000 15000 50000 30000 20000

Operating expenses 12500 12400 12400 25000 17000 14000
Operating margin 3300 2600 2600 25000 13000 6000
Share of head office expenses 1027 975 975 3250 1950 1300
Profit 2273 1625 1625 21750 11050 4700

Questions

1. The general manager asks you to prepare information for the decision on how ROI, or a similar
indicator, should be defined 1. What alternatives are possible? Draw up a table presenting all the figures
that can be calculated using the above data. Comment on these figures, and make a recommendation as
to the "best" indicator.

2. Does this indicator provide a satisfactory image of the two agencies' performances?

3. How would you suggest the performance control system should be reviewed?

1
Cost of capital: 7%

Immo 3000 B 1/1 CPTG31149

 Case

E.N. Industries
 E.N. INDUSTRIES, INC.

I don't get it. I've got a nifty new product proposal that can't help but
make money, and top management turns thumbs down. No matter how
we price this new item, we expect to make $ 390.000 on it pretax. That
would contribute over 15 cents per share to our earnings after taxes,
which is more than the 10 cent earnings-per-share (EPS) increase in
Year 2 that the president made such a big thing about in the
shareholders' annual report. It just doesn't make sense for the
president to be touting EPS while his subordinates are rejecting
profitable projects like this one.

The frustrated speaker was Sarah McNeil, product development manager of the Consumer
Products Division of E.N. Industries, Inc. E.N. was a relatively young company, which had
grown rapidly to its Year 2 sales level of over $222 million (See Exhibits 2 and 3 for financial
data for Year 1 and Year 2).

E.N. had three divisions Consumer Products, Industrial Products, and Professional Services
each of which accounted for about one-third of E.N.'s total sales. Consumer Products, the
oldest of the three divisions, designed, manufactured, and marketed a line of houseware items,
primarily for use in the kitchen. The Industrial Products Division built one-of-a-kind machine
tools to customer specifications, with a typical job taking several months to complete. The
Professional Services Division, the newest of the three, had been added to E.N. by acquiring a
large firm that provided land planning, landscape architecture, structural architecture, and
consulting engineering services. This division has grown rapidly, in part because of its
capability to perform "environmental impact" studies, as required by law on many new land
development projects.

Because of the differing nature of their activities, each division was treated as an essentially
independent company. There were only a few corporate-level managers and staff people,
whose job was to coordinate the activities of the three divisions. One aspect of this
coordination was that all new project proposals requiring investment in excess of $1,5 million
had to be reviewed by the chief financial officer, Henry Hubbard. It was Hubbard who had
recently rejected McNeil's new product proposal, the essentials of which are shown in Exhibit
4.

Performance Evaluation

Prior to Year 1, each division had been treated as a profit center, with annual division profit
budgets negotiated between the president and the respective division general managers. At the
urging of Hubbard, E.N.'s president, Carl Randall, had decided to begin treating each division
as an investment center, so as to be able to relate each division's profit to the assets the
division used to generate its profits.

Starting Year 1, each division was evaluated with its return on assets (ROA) performance,
which was defined to be the division's net income divided by its total assets. Net income for a

EN Industries 1/10 ESSEC

division was calculated by taking the division's "direct income before taxes" (DIBT), then
subtracting the division's share of corporate administrative expenses (allocated on the basis of
divisional revenues) and its share of income tax expense (the tax rate applied to the division's
"direct income before taxes" after subtraction of the allocated corporate administrative
expenses). Although Hubbard realized there were other ways to define a division's income, he
and the president preferred this method since "it made the sum of the (divisional) parts equal
to the (corporate) whole".

Similarly, E.N.'s total assets were subdivided among its three divisions. Since each division
operated in physically separate facilities, it was easy to attribute most assets, including
receivables, to specific divisions. The corporate-office assets, including the centrally
controlled cash account, were allocated to the divisions on the basis of divisional revenues.
All fixed assets were recorded at their balance sheet values that is, original cost less
accumulated straight-line depreciation. Thus, the sum of the divisional assets was equal to the
amount shown on the corporate balance sheet ($226.257 as of December 31, Year 2).

In Year 0, E.N. had a ROA of 5.2 percent. According to Hubbard, this corresponded to a
"gross return" of 9.3 percent; he defined gross return as equal to earnings before interest and
taxes (EBIT) 1 divided by assets. Hubbard felt that a company like E.N. should have a gross
(EBIT) return on assets of at least 12 percent, especially given the interest rates the
corporation had to pay on its recent borrowing. He was all the more demanding on this return
on assets issue as he knew that E.N. was facing important regulatory requirements to achieve
fairly low return investments. E. N. had to adjust to environmental, labor and safety standards,
which led to unavoidable projects which were expensive and not very profitable. He therefore
instructed each division manager that the division was to try to earn a gross return of 12
percent in Year 1 and Year 2.

Considering that many investments are already mandatory for E.N. due to regulatory reasons
(notably environmental, safety, traceability issues) and that their profitability is often low,
Hubbard decided that new investment proposals would have to show a return of at least 15
percent in order to be approved. In his mind that is a way to help pull the return up to this
12% level. He applied this rule to McNeils project.

Year 1 & Year 2 Results

Hubbard and Randall were moderately pleased with Year 1 results. The year was a
particularly difficult one for some of E.N.s competitors, yet E.N. had managed to increase its
ROA from 5.2 to 5.7 percent, and its gross return from 9.3 to 9.5 percent.

At the end of Year 1, the president put pressure on the general manager of the Industrial
Products Division to improve its return on investment, suggesting that this division was not
"carrying its share of the load". The division manager had bristled at this comment, saying the
division could get a higher return "if we had a lot of old machines the way Consumer
Products does". The president had responded that he did not understand the relevance of the
division manager's remark, adding "I don't see why the return on an old asset should be higher
than that on a new asset, just because the old one costs less".

1
See the summary of E.N. financial indicators in Exhibit 1.

EN Industries 2/10 ESSEC

The Year 2 results both disappointed and puzzled Randall. ROA fell from 5.7 to 5.4 percent,
and gross return dropped from 9.5 to 9.4 percent. At the same time, return on sales (net
income divided by sales) rose from 5.1 to 5.5 percent, and return on owners' equity also
increased from 9.1 to 9.2 percent. The Professional Services Division easily exceeded the 12
percent gross return target; Consumer Products' gross return on assets was 10.8 percent; but
Industrial Products' return was only 6.9 percent (see Exhibit 5).

These results prompted Randall to say to Hubbard:

You know, Henry, I've been a marketer most of my career, but, until recently, I thought I
understood the notion of return on investment. Now I see in Year 2 our profit margin was up
and our earnings-per-share were up; yet two of your return on investment figures were down;
return on invested capital went down, and return on owners' equity went up. I just don't
understand these discrepancies.

Moreover, there seems to be a lot more tension among our managers the last two years. The
general manager of Professional Services seems to be doing a good job, and she's happy as a
lark about the praise I've given her. But the general manager of Industrial Products looks
daggers at me every time we meet. And last week, when I was eating lunch with the division
manager at Consumer Products, the product development manager came over to our table
and really burned my ears over a new product proposal of hers you rejected the other day.

I'm wondering if I should follow up on the idea that Karen Kraus in Personnel brought back
from the two-day organization development workshop she attended over at the university. She
thinks we ought to have a one-day off-site retreat of all the corporate and divisional
managers to talk over this entire return on investment matter.

Questions

1. What do you think about the general principles of EN Industries new control system, in
particular about : the definition of Business Units (is controllability principle respected), their
characterization as investment centers, and the choice of a kind of ROI as key performance
indicator?

2. Based on Exhibit 5, can you explain the reactions of the three divisions' managers?

3. Why was Mc Neil's new product proposal rejected (see exhibit 4)? Do you think it is a
good decision to reject it?

4. Using Exhibit 2 & 3, compare Year 1 and year 2. Can you evaluate the overall performance
of EN?

EN Industries 3/10 ESSEC

- In particular compare the evolution of sales (P&L) with the evolution of accounts receivable
and inventories (balance sheet). What could this comparison indicate about E.N. products?

- Compare also the evolution of "plant and equipment" assets and the evolution of net income.
What does it indicate about the profitability of the more recent investments?

- How can we conciliate three data which could seem contradictory: quick growth of plant
investment, low return, Mr. Hubbard's very strict profitability requirements for new
investments?

5. Evaluate the manner in which Randall and Hubbard have implemented their investment
center concept. What pitfalls did they apparently not anticipate? What should they do now?"

N.B.: For the notion of WACC, which can be useful to treat question 3 and 4, see Exhibit 6.
In the case of E.N. basic calculations done by some of Hubbards staff led to a WACC of
approximately 10% as explained in Exhibit 6.

EN Industries 4/10 ESSEC

 Exhibit 1
E.N. financial indicators

DIBT = Direct Income Before Taxes =

+ Sales
- Cost of goods sold (=production cost)
- Development cost
- Selling & General expenses
- Interest

Income After Corporate Expenses (IACE) =

+ DIBT
- (division sales / total sales) * (corporate administrative expenses)

Net Income (NI) = + IACE - IACE * tax rate

Sum of divisional Net Incomes = Corporate Net Income

Division Total Assets (DTA) =

+ Division direct assets
+ Allocated Assets [= (division sales / total sales) * (corporate office assets)]

Sum of Division Total Assets = Corporate total assets

Gross Return on Assets (ROA) = NI / DTA

EBIT = Income before taxes, before interest, before corporate administrative expenses =
+ Sales
- Cost of goods sold (=production cost)
- Development cost
- Selling & General expenses

Gross Return = EBIT / DTA

ROA Year 0 = 5,2 % equivalent to 9,3 % Gross Return

Objective: Gross return = 12%
Objective for each project = Gross Return > 15%

EN Industries 5/10 ESSEC

 Exhibit 2

Income Statements ($000's, except earnings-per-share figures)

Year Ended (Dec. 31)

Year 1 Year 2 Evolution

Sales 212 193 222 675 4,9%
Cost of goods sold 162 327 168 771 4,0%
Gross Margin 49 866 53 904 8,1%
Development 12 096 12 024 -0,6%
Selling and General 19 521 20 538 5,2%
Interest 1 728 2 928 69,4% A
Total 33 345 35 490 6,4%
Income before taxes (DIBT) 16 521 18 414 11,5%
B
Income tax expense 5 617 6 261 11,5%
Net income (NI) 10 904 12 153 11,5%

Number of shares outstanding 1 500 000 1 650 000 10,0%

Earnings-per-share 7,27 7,37 1,3%

EN Industries 6/10 ESSEC

 Exhibit 3

Balance Sheet ($000s)

As of December 31

Year 1 Year 2 Evolution

Assets
Cash 4 212 4 407 4,6%
Accounts receivable 41 064 46 821 14,0%
X
Inventories 66 486 76 401 14,9%
Total current assets 111 762 127 629 14,2%
Plant and equipment original cost 111 978 137 208 22,5% Z
Accumulated depreciation 38 073 47 937 25,9% Y
Net 73 905 89 271 20,8%
Other assets (net value) 6 429 9 357 45,5%
Total assets 192 096 226 257 17,8%
Liabilities and Owners' Equity
Accounts payable 29 160 36 858 26,4%
Taxes payable 3 630 3 135 -13,6%
Current portion of long-term debt - 4 902
Total current liabilities 32 790 44 895 36,9%
Deferred income taxes 1 677 2 955 76,2%
Long-term debt 37 866 46 344 22,4%
Total liabilities 72 333 94 194 30,2%
Common stock 52 104 58 536 12,3%
Retained earnings 67 659 73 527 8,7%
Total owners' equity 119 763 132 063 10,3%
Total liabilities and owners' equity 192 096 226 257 17,8%

EN Industries 7/10 ESSEC

 Exhibit 4

Financial Data from New Product Proposal

1. Projected asset investment*
Cash $ 150.000
Accounts receivable 450.000
Inventories 900.000
Plant and equipment** 1.500.000
Total $ 3.000.000

2. Cost Data
Variable cost per unit $9
Differential fixed costs (per year)*** $ 510.000

3. Price/market estimates (per year)

Unit price Unit Sales Break-Even

Volume
$ 18 100.000 units 56.667 units
21 75.000 42.500
24 60.000 34.000

* assumes 100.000 units sales

** annual capacity of 120.000 units
*** includes straight-line depreciation on new plant and equipment

Exhibit 5

Calculation of Gross Return on Assets, Year 2

Divisions Sales EBIT Working Fixed Fixed Allocated Total Gross ROA
Capital (Acc. Assets (Net) Assets Assets (cash
Receivable & (Original & other
Inventories) cost) assets)
Consumer 74,3 10,8 60,8 34,6 75,2 4,6 100,0 10,8%
Industrial 74,2 7,2 44,4 54,6 61,0 4,6 103,6 6,9%
Professional Services 74,2 3,3 18,0 0,0 1,0 4,6 22,6 14,6%
Total 222,7 21,3 123,2 89,2 137,2 13,8 226,2 9,4%

A+B X Y Z W (A+B) / W

EN Industries 8/10 ESSEC

 Exhibit 6

A useful notion: WACC (Weighted Average Cost of Capital)

WACC (Weighted Average Cost of Capital) is a calculation of a firm's cost of capital in

which each category of capital is proportionately weighted. All capital sources - common
stock, preferred stock, bonds and any other long-term debt - are included in a WACC
calculation.

WACC is calculated by multiplying the cost of each capital component by its proportional
weight and then summing:

Where:
Re = cost of equity
Rd = cost of debt
E = market value of the firm's equity
D = market value of the firm's debt
V=E+D
E/V = percentage of financing that is equity
D/V = percentage of financing that is debt
Tc = corporate tax rate

Broadly speaking, a companys assets are financed by either debt or equity. WACC is the
average of the costs of these sources of financing, each of which is weighted by its respective
use in the given situation. By taking a weighted average, we can see how much interest the
company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is often
used internally by company directors to determine the economic feasibility of expansionary
opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk
that is similar to that of the overall firm and as a minimum return rate to select investment
projects.

EN Industries 9/10 ESSEC

 WACC calculation for E.N. Industries

interest growth from year N to N+1 = 2928 - 1728 = 1200

long-term debt growth = 46344 - 37 866 = 8478
interest rate on last borrowing = 1200 / 8478 = 14,2 %
income tax rate = 6261/18414 = 34%
common stock = 58536
dividend paid year N+1 = income - growth of retained earnings = 12153 - (73527 - 67659) =
6285
cost of equity = 6285 / 58536 = 10,74 %
long term debt = 46344
common stock = 58536
total = 104880
WACC = 14,2 % * (46344 / 104880) (1-0,34) + 10,7 % * (58536/104880) = 4,14 + 6 = 10,1%

EN Industries 10/10 ESSEC

 Session 6
READINGS

Kaplan & Norton (1992)

Kaplan (2010) (See course Website)

CASE

Boston Lyric Opera

12
 Reading

Kaplan & Norton (1992)

 Case

Boston Lyric Opera

 Session 7
READING

Champy

CASE

Stream International

14
 Reading

Champy
Reingeneering the corporation
Chapter 1
 Case

Stream International
 Session 8
READING

Porter & Kramer (2011)

CASE

Antel

16
 Reading

Porter & Kramer (2011)

Shared Value
Case

Antel
ANTEL and the Fourth Financial Statement

Draft

Note: this pedagogical case does not pretend to present facts as they actually
happened. Thus, dialogues were prepared only to serve as a basis for class
discussion.

March 2009. It was a splendid autumn afternoon in Montevideo, the capital city of Uruguay.
The monthly Board of Directors meeting of ANTEL (a telecommunications company) was
about to begin. As always, this meeting was taking place at the top floor of the ANTEL
tower, the largest, more modern corporate building in Montevideo. From the large windows
of the corporate boardroom, there was a magnificent view of the River Plate.

Directors had reasons to be proud about ANTEL. The company has been found by the State
in 1974 with the mission to provide high-quality and affordable communication services all
over the country. The firm was widely considered as one of the leading firms in the country;
not only for its relative size (i.e. its sales correspond to nearly 2% of the countrys GDP), but
also for its commitment to world-class standards. The firm has continuously made large
investments in order to keep pace with the latest technology improvements. Besides, ANTEL
has made efforts to attract the best local talent and to follow the practices of comparable
telephone firms abroad. The Board of Directors was designed by the government; however,
there was few if any interference from government with day-to-day business decisions.

After some initial discussions, the CSR manager was invited to make his presentation:

CSR Manager: Thank you for this opportunity to discuss with you. As you know well, I was
recently hired to explore a CSR agenda for ANTEL. When the idea of CSR began to catch on
in Uruguay, it was obvious for most people that ANTEL had to take a leadership role in CSR.

CEO: Yes, indeed. Let me emphasize that ANTEL is in an uncommon situation. It is the
State-owned telephone company, you understand, we have a social mission. We are not a
company like any other. But at the same time, we are a commercial firm. And we are in a
highly technological field. Citizens deserve world-class service, nothing less!

Director A: In fact, I always felt that tension between social and commercial mission. You
may see that in our communications. On one hand we have a classical financial report, as any
other company would do. But on the other hand we struggle to explain our involvement with
society.

Director B: If we could only make a link between our financial statements (a document that
everyone knows well) with our communication on CSR
Director C: We may be convinced that CSR is necessary, but many people in Uruguay still
think that CSR is just nice words.

CSR Manager: In any case, ANTEL began its involvement with CSR some years ago. We
were among the first to participate in collaborative CSR network of State-owned companies
(Red de Empresas Pblicas), I think it was in 2005.

Director B: Not to mention that last year we were among the first Uruguayan companies to
adhere to the Global Compact.

Director A: Well, I am not so convinced about the Global Compact and all those international
standards. After all, most of these international models were thought for large American
companies, most frequently quoted in stock exchanges. Many people in the US think that the
power of shareholders needs to be compensated by the social pressure of civil society thats
one of the reasons for CSR there.

CSR Manager: You mean that things are different in Uruguay?

Director A: Well, many of the largest companies in Uruguay are State-owned. Not only our
firm, but also ANCAP (the oil company), AFE (the train company) and Banco Repblica (the
main commercial bank) are State-owned. Of course, there are many privately-owned firms,
and a few of them are quoted in the Bolsa de Montevideo (the local stock exchange). But to a
large extent, the Uruguayan economy is led by State-owned firms.

Director B: We know the story. Instead of privatizing large State-owned companies, as Brazil
and Argentina did, Uruguay chose to keep State-ownership over these firms.

CEO: In any case, this State ownership policy enjoys a wide consensus in society. Nobody
imagines privatizations in the years to come.

CSR manager: OK, I agree that Uruguay is different. And I also agree that we have to be
careful about CSR models created in a different context. Anyway, the Global Compact still
makes perfect sense for us. As you know, it is a Decalogue of commitments about
environment, society and governance. But there is no prescription for a particular practice.

Director A: Otherwise said, when we signed the Global Compact we made a public
engagement to CSR. But it is up to us to decide how to implement those CSR practices

CSR manager: yes, I would say the Global Compact is a wide framework that can be adapted
to different situations, including ours.

CEO: Anyway, I remember we have to provide some documents to the Global Compact

CSR manager: Yes, we have to present an annual COP (Communication of Progress). It is a

report about how the company progressed in the different areas of the Global Compact. The
content of the COP is largely up to us.
CEO: Let me thinkThat could be an opportunity! Why not to use the COP as a way of
linking our communication on CSR with our financial reports? Can we prepare a COP with
CSR and financial data together?

CSR manager: Well, we have recently organized a workshop with Luis Perera. Some of you
may remember him from university. He has been many years abroad, as he is a partner of an
auditing firm. Luis has been developing a social reporting model that analyzes financial data
from a social viewpoint.

Director A: Yes, Luis! I read his book once: The Fourth Financial Statement. I have the
book somewhere in my office.

CEO: It is late and we have to go on with other points in the agenda. I think we can ask our
Financial Director to explore the issue. Would everyone agree?

April 2009

It is the midday of a sunny day. At the restaurant of the Montevideo Rowing Club, close to
ANTELs headquarters, the Financial Director and a Management Consultant are discussing
their ideas about CSR

Financial Director: I am still unconvinced about how we do CSR in ANTEL. In spite of the
best intentions of everybody, most of discussion about CSR remains superficial.

Management Consultant: But ANTEL does a lot of CSR

Financial Director: Of course, it is fine to give a donation to some NGO or to support a social
program, and that kind of engagement has to continue. But at the end of the day, all that
remains external to the company. It is still difficult to understand and to explain the social
contribution of the company as a whole.

Management Consultant: Yes, I understand. And this issue is particularly pressing for
ANTEL, because of its corporate mission and its State ownership.

Financial Director: Indeed! As a State-owned firm, we need to make a case for continual,
long-term State ownership. We need to do things well and at the same time to do them
differently from what a private owner would have done. How can we explain the
contributions of ANTEL to the Uruguayan economy? I am thinking of employment,
investments, development of suppliers, payment of taxes.

Management Consultant: In any case ANTEL is very involved in CSR, it is one of the few
firms in Uruguay that signed the Global Compact.

Financial Director: Yes, thats where you can help us. You know, we have to present an
annual COP to the Global Compact. And we think that this could be the occasion present our
financial numbers from a social viewpoint. Perhaps the Fourth Financial Statement may do
the trick. Please tell me about it

Management Consultant: In fact, it is quite simple (the Consultant took a white paper and
wrote this graph):

WEALTH GENERATION WEALTH DISTRIBUTION

+ SALES People

- DIRECT COST + Government

Domestic
Foreign + Financing Agents

GENERATED VALUE ADDED

+ Community & Environment

+ Reinvestment

+ Shareholders

DISTRIBUTED VALUE ADDED

Sept. 2009

Management Consultant continues: As you see, it is the same information you have in the
Profit & Loss report, only that you display it according to different stakeholders. Instead of
focusing only on shareholders, you can now explain how much value is given to each
stakeholder.

Financial Director: You mean that data is already in our accounting systems

Management Consultant: Yes, only that youll have to classify your accounts differently. For
instance, you may find that payments to employees appear in different accounts, not only as
salaries. This re-classification may be an effort at the beginning in the first year but then it
becomes almost automatic.

Financial Director: Let me think about it. You remember about my new assistant? This
morning he was wondering about his thesis as he is about to graduate. Maybe he could take
this FFS as his project.

The rest is history the young assistant prepared the first prototype for an FFS at ANTEL,
using data from 2007. And the results were so conclusive that the Financial Director
approved the launching of the FFS at ANTEL. As a consequence the FFSs for both 2008 and
2009 were published as part of ANTELs sustainability reports.

March 2010. The Financial Director was looking at from the windows of his office. It was
late and most people were already gone. The Financial Director was alone, collecting his
thoughts for a presentation he would do soon to the Board. The Board was interested in
evaluating the role of the FFS, after two years of implementation.

The Financial Director had reasons for being comfortable about the FFS. The document was
clear, easy to understand, and now that the initial effort was done, the cost of keeping doing it
was marginal. Besides, the FFS helped to raise awareness about long term trends how the
corporate created value is shared about different stakeholders. However, The Financial
Director still felt that the FFS was not profited at its most. Inside ANTEL, the FFS was read
and analyzed, and perhaps it could someday be used for decision-making and planning, as it
was already the case in some companies abroad. Curiously, few people outside ANTEL
seemed to be interested in it, despite the fact that ANTEL represents a relatively high
proportion of the countrys economy.

While The Financial Director was pondering these issues, his cell phone rang. It was the
trainer of his marathon team the Financial Director was preparing himself for the next
Montevideo marathon. Yes the Financial Director thought to himself- it was high time to go
running. Tomorrow Ill see these issues more clearly.

ANNEX Data from FFS 2007 to 2009

2007 2008 2009

Sales 100 100 100
Direct Costs 35,94 41,91 29,94
Created Value 64,06 58,09 70,06

(base 100 = sales

for that year)

Reinvestment 31,53 38,87 35,14

Employees 28,6 31,94 28,48
Owners 21,72 22,22 17,02
Taxes 16,12 4,84 16,33
Community 2,03 2,13 3,03
100 100 100

(base 100 = value to distribute for that year)

 Session 9

CASES

Clean Sweep
SPARC

18
Case

Clean Sweep
Case

SPARC
 1/7

SPARC
Socit Parisienne de Chauffage
(Paris heating firm)

Belying its name, SPARC was founded by a coal merchant in Cantal, central France, who
developed his father's business after the war, took over several competitors in western France,
and finally moved to Paris, creating SPARC at the end of the Fifties.

SPARC Activities
SPARC had one main activity: it supplied heating maintenance services, including running,
supervising and maintaining heating equipment for institutions such as hospitals, schools and
prisons, usually old buildings in the centre of cities, and for projects such as blocks of flats,
ZUPs (zone d'urbanisation prioritaire, areas earmarked for urgent urban development), new
towns etc., built in recent years and which had modern installations at the edge of the large
cities. It also supplied the necessary fuel to those heating installations.

Thus SPARC operated over 1,500 heating installations throughout the western area of France,
from the Midi-Pyrnes region to Normandy.

Organisation
SPARC created five regional centres, at Toulouse, Limoges, Nantes, Caen and Paris. Each
centre comprised some forty people, one centre manager, occasionally with an assistant
manager, a few sales staff, a shop manager with his assistant, several repair teams with
mechanical, heating, electrical and regulation specialists, drivers for delivery vans and an
administrative department for accounting, dealing with orders, monitoring deliveries,
invoicing and secretarial work.

Each centre in turn controlled 30 to 40 units in the main towns of the region it covered. The
unit manager had a delivery team and a mini-administrative team. He was required to deal
with the fuel depot management, fuel supplies, customer canvassing and supervision of the
heating staff in his sector.

Each unit thus supervised from 2 to 20 heating installations, the stokers of which were
SPARC employees. Each technician had a small stock of basic tools and emergency repair
equipment, and could call either the SPARC local unit for fuel supplies or the regional
SPARC centre for major repairs and overhauls.

Thus, in addition to the headquarters in Paris, SPARC had some 2,800 workers in the field,
who, for both geographical and historical reasons, all had considerable autonomy and freedom
of action.

ESSEC Sparc Case

 2/7
Stokers

These were mainly recruited from the merchant navy and were usually former boilermen on
ships who, reaching the age of 40, sought a more stable occupation. They had considerable
experience and excellent qualifications, and above all, outstanding professional standards. In
some areas, however, SPARC found it difficult to recruit such people and used unqualified
foreign workers, who were quick and dirty trained on the job. Their competence was much
lower, but so was their salary too.

Whether for municipal installations or groups of buildings, the stokers had virtually no contact
with the customers. The latter had no wish, time or qualification for monitoring heating
regulation, fuel consumption or boiler maintenance, and were only interested in the
temperature of the buildings and the amount of the bill. Thus, the boilermen were left entirely
free and rendered account only to their local unit manager, to whom they addressed a monthly
report including:

- record of fuel consumption,

- inventory,
- consumption of stocks other than fuel,
- records of inside and outside temperatures,
- repairs effectively carried out,
- requests for equipment and refuelling,
- maintenance forecasts,
- etc. ...

Local unit Managers

These were all self-taught, with a talent for sales, and were very well established locally, since
they had for the most part worked in fuel businesses bought up by SPARC and kept their jobs
after the mergers. In many cases, even the name of the firm had been kept, and integration into
SPARC Group had not changed a great deal in the management methods of these bought-out
firms. As previously, they spent most of their time in customer relations, supervising the
heating technicians via the monthly reports and themselves writing monthly activity reports
for the centre managers. This report made mention of, amongst others:
- fuel consumption,
- inventory,
- forecast fuel needs,
- customer relations and canvassing,
- a short summary of the boilermen's activity,
- where necessary, labour shortages,
- etc. ...

Centre managers

These were all engineers, sales staff or self-taught, with considerable experience in the field.
They had been chosen on the basis of this experience, either as SPARC employees, or in the
main businesses bought up. Each centre was considered as a completely autonomous profit
centre. Every year, each centre manager negotiated a profit budget with SPARC general
management, and could then manage his centre as he wished. While centre managers
occasionally went to Paris, it was virtually unheard-of for general management to tour

ESSEC Sparc Case

 3/7
regional centres in the provinces. Centre managers were local bosses with a very large
autonomy.

Regional centres and profit budget

This profit budget, by which centre managers were judged, was made up of two parts, revenue
and expense.

a) revenue : this was from 2 main types of 5-year contracts:

all-inclusive fixed price heating contracts. In these contracts, SPARC undertook to
guarantee a temperature of 20 in buildings for an all-inclusive yearly sum, re-negotiable
on the basis of the building industry price index.
"actual cost" heating contracts. In these, SPARC invoiced the customer for all actual
costs of fuel and equipment, labour and maintenance and stoker's salary, plus a margin
whose level was fixed by SPARC central headquarters and was the same for all centers..

While customer canvassing was the responsibility of the centre manager, it was SPARC head
office in Paris which established standard contracts with price formulas for both fixed price
and actual cost contracts. For fixed price contracts, the central services fixed an all
inclusive fixed price imposed to all centres. For actual cost contracts, the central services
fixed a margin rate applicable to the actual full cost of the maintenance service:

final selling price to the customer = actual full cost (actual fuel cost + actual spare parts cost +
actual labour cost) * (1 + margin rate fixed by headquarters)

For many years, "actual cost" contracts had been in the majority, but more recently the fixed
price ones had become more popular, especially in certain regions where many customers
had complained of the "actual cost" contracts, too expensive. Many had switched to fixed
price, and some had actually discontinued business after their five year contracts with
SPARC and gone over to the competition, fingering to the excessive price they had paid for
years for "actual cost" contracts.

b) expense : this was all the direct outlay of the centre, not counting that of headquarters or
financial expense. The main headings were:

salaries of all staff employed in the regional centre, local units and heating installations of
this centre (hiring and remuneration of staff was entirely the responsibility of the centre
manager).
consumed fuel purchases from SPARC-Paris.
amortization and depreciation of fixed assets, equipment and vehicles.
purchase of maintenance supplies and equipment.
administrative costs.

All this expenditure could be checked by the centre manager, who was not, however,
responsible for investment in storage tanks and tankers, which was overseen by the general
management in Paris.

ESSEC Sparc Case

 4/7
Performance measurement
The profit budget for each centre was discussed in detail with the head office, and once
approved, it became the goal to be attained by the centre manager at all costs. In order to knit
the group and gain some control of centre managers' activity, SPARC had set up a complex
incentive system under which a centre manager remaining within budget could earn up to 6
months' salary in end-of year bonus.

The Caen Centre

As he had for the previous five years, Mr. Calva had remained well within his budget and had
earned his 6 month-salary bonus. Mr. Calva was a man of 44 with business qualifications who
had been working in the Socit Normande de Chauffage when it was taken over by SPARC
in 1972. An active, resourceful (some said unscrupulous) man, Mr. Calva managed his centre
with great authority. He moved around a great deal, checked everything, and often went up to
Paris, where his "rows" were notorious. It was in his region that several unsatisfied customers
had left SPARC, but his energetic canvassing had brought new customers and he had built up
new business with the fixed price contracts which customers favoured, and which gave him
regular profits.

Over the previous 3 years he had had difficulty in finding stokers. Several qualified ones had
left, and Mr. Calva had not been able to recruit former merchant sailors to replace them. He
therefore fell back on foreign workers. Naturally, they demanded less salary, but since they
were less skilled, technical standards had fallen and maintenance was not always as it should
have been.

Mr. Calva had chivvied his local unit managers, had inspected the "problem" installations
several times, and had taken personal control of the repair and maintenance teams, so that,
despite a few extra expenses, he had remained within budget. (cf. Appendix I, partial results,
Caen Centre).

Because of his good results, Mr. Calva secretly hoped that he would soon receive promotion
to Paris to succeed to Mr. Sarcelle, who was due to retire in June 1979.

The Nantes Centre

The Nantes centre was virtually of the same size and structure as Caen as regards customers,
but its profits were far from being as good.

Unlike Mr. Calva, Mr Loirat, in charge of the Nantes region, had worked at SPARC for 35
years. He had begun as a heating technician and had risen up the ladder with each merger. He
had always been very conscientious and gradually built up a team of hard working staff,
mostly technicians, whom he left to take initiatives. His activity was steadily growing and he
had no difficulty in finding qualified stokers. However, he did not remain within budget and
despite his efforts, he had received no annual bonus for the previous two years (cf. Appendix
II). His failures had depressed him and he wondered if it would not be better to copy his
colleagues and shift part of his fuel and maintenance expense from the "fixed price" to the
"actual cost" contracts, to boost his profits.

ESSEC Sparc Case

 5/7
Despite his repeated protests, Paris continued to conclude " fixed price" contracts at
ridiculously low rates on which it was almost impossible for him to make profit. He was
therefore obliged to cut costs very closely on "actual cost" contracts, otherwise all his
customers would have gone over to " fixed price" and his margins would have gone down
even more.

As things stood, there looked to be no solution, and Mr. Loirat thought bitterly that he would
have liked to finish his career in Mr. Sarcelle's old job in Paris.

QUESTIONS

1. Compare Caen and Nantes performances, by using the figures you are given, and from
them calculating significant indicators such as:
- average selling price per type of contract (fixed price and actual cost) in each
centre,
- average full direct cost (heating labour, fuel, maintenance) per contract in each centre,
- average cost of labour per contract,
- average cost of fuel per contract,
- average cost of maintenance per contract
- net increase in the number of customers between year 1 and year 5.
What conclusions can you draw as regards Caen and Nantes performances?
Can you have some hints about: employees turnover in both centres, quality of service?
Are margin objectives similar in both centres, or are objectives more demanding in one of
them? If so, why?
2. Focus on the comparison between both centres for: full direct cost per contract, and selling
price per actual cost contract. According to the pricing formula for the "actual cost"
contracts, the selling price for those contracts should be exactly proportional to the actual full
cost. Is that the case (compare the average selling price for actual cost contracts in Caen and
Nantes, at the beginning and at the end of the period)? What can we deduce as regards the
invoicing practices of those centres?
3. Where does the higher margin in Caen mainly come from?
4. What indicators could be used to evaluate the value of SPARC services? Analyse the
present system overall: structure - budget - performance measurement. Does it give a fair
account of cost versus value? What attitudes does it foster in managers? What medium-term
consequences can be imagined?
5. The controlling function is not mentioned in the case. What reasonable guess can we make
about it? Would it be necessary to have a strong controlling function at SPARC? Justify your
answer.
6. What actions do you suggest?

ESSEC Sparc Case

 6/7

ANNEXE I

CAEN Centre
Data in constant K (inflation calculated)

5 4 3 2 1
Heating installation revenues
"fixed price" contracts 71,800 57,300 50,200 42,500 36,100
"actual cost" contracts 61,200 63,600 64,000 57,300 52,200
TOTAL 133,000 120,900 114,200 99,800 88,300
Heating installation direct expenditure
Labour complete costs 15,800 15,600 15,300 14,600 14,000
Fuel costs 81,800 73,800 69,200 58,000 50,200
Maintenance (supplies) 6,500 5,300 4,900 4 ,400 3,800
TOTAL 104,100 94,700 89,400 77,000 68,000
Gross margin on direct costs 28,900 26,200 24,800 22,800 20,300
Difference from budget + 1% + 1.1% + 2% + 1.3% + 1%

Number "fixed price" contracts 171 135 111 93 82

Number "actual cost" contracts 116 126 132 131 120
Recruitment new stokers 65 68 44 39 33
Stokers leaving 38 30 23 14 11
Number employees 1st January 336 298 277 252 230

ESSEC Sparc Case

 7/7

ANNEXE II

NANTES Centre
Data in constant K (inflation calculated)

5 4 3 2 1
Heating installation revenues
"fixed price" contracts 50,800 45,800 44,800 41,600 35,200
"actual cost" contracts 76,900 69,000 65,200 59,100 53,100
TOTAL 127,700 114,800 110,000 100,700 88,300
Heating installation direct expenditure
Labour complete costs 21,100 18,900 17,450 15,900 14,140
Fuel costs 76,300 68,000 64,000 57,400 50,000
Maintenance (supplies) 5,500 5,000 4,550 4,200 3,760
TOTAL 102,900 91,900 86,000 77,500 67,900
Gross margin on direct costs 24,800 22,900 24,000 23,200 20,400
Difference with budget - 18.2% - 16% - 4.8% + 3.1% + 1%

Number "fixed price" contracts 121 108 99 91 80

Number "actual cost" contracts 180 162 150 136 122
Recruitment new stokers 38 35 33 35 32
Stokers leaving 15 15 14 12 11
Number employees 1st January 313 293 274 251 230

ESSEC Sparc Case