Vershire Case Analysis - MCS

MANAGEMENT CONTROL SYSTEM Vershire Company “Performance Measurement and Organizational Control”

Prepared by: Andika Adikrishna Gunarjo Muhammad Zakky Alif Pramita Riskia Dhaliarti Putri Yeris Permata Octarina

Lecturer: Supriyadi, M.Sc., C.M.A., Ph.D. Magister of Management, UGM. International Class – 31 Executive B

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Case Summary Vershire Company is a large business in the packaging industry with several major divisions. The focus of this report is on the aluminum can division and its control systems including the budgeting process and performance measurement. This division is one of the largest manufacturers of aluminum beverages cans in the United States. However, if customers’ expectations for cost, quality, and service are not met, they can easily purchase from another manufacturer. Therefore, it is important for Vershire to keep tight control over their plants, budgets, and performance in terms of efficiency and effectiveness. The major concern currently facing Vershire Company is that each plant within the division is being treated as a profit centre, rather than an engineered expense centre. As a manufacturing plant, in which outputs produced are quantifiable in terms of units produced, there is a need to focus on expenses rather than profit. This error in classification is the root of many other control, communication, and performance measurement problems.

Main Issue When developing a budget or forecasting future performance, it is important to have a planning and control system. 1. Organization policy The division had plants scattered throughout the United States. Each plant served customers in its own geographic region. Most of these customers had between two and four suppliers and spread purchases among them. 2. Budget control system Divisions of Vershire Company were structured to encompass broad product categories. Divisional general managers were given full control of their businesses with two exceptions: the raising of capital and labor relations, which were both centralized at head office. The budget was used as the primary tool to direct each division’s efforts towards common corporate objectives. 3. Sales Budget In May, each divisional general manager submitted a preliminary report to corporate management summarizing the outlook for sales, income and capital requirements for the next budget year, and evaluating the trends anticipated in each category over the subsequent two years. A sales forecast was then prepared for each division; and these forecasts were combined to create a forecast for the entire company. 4. Manufacturing Budget At the plant level, the sales budget was then categorized according to price, volume, and use. Once the sales numbers were estimated, each plant budgeted gross profit, fixed expenses and pretax income. Profit was calculated as the sales budget less budgeted variable costs (including direct material, direct labour, and variable manufacturing overhead-each valued at a standard rate) and the fixed overhead budget. The plant manager was held responsible for this budgeted profit number even if actual sales fell below the projected level. 5. Performance Evaluation & Measurement On the second business day after the close of each month, every plant faxed certain critical operating variances which were combined into a “variance analysis sheet.” A compilation of all variance sheets was distributed the following morning

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to interested management. Plant managers were not supposed to wait until these monthly statements were prepared to identify unfavorable variances; rather they were expected to be aware of them (and to take corrective action) on a daily basis. Four business days after the close of every month, each plant submitted a report showing budgeted and actual results. Once these reports were received, corporate management reviewed the variances for those items where figures exceeded budgetary amounts, thus requiring plant managers to explain only the areas in which budgeted targets had not been met. The focus was on net sales, including price and mix changes, gross margin, and standard manufacturing costs. 6. Management Incentives The sales department had sole responsibility for the price, sales, mix, and delivery schedules. The plant manager had responsibility for plant operations and plant profits. Plant managers were motivated to meet their profit goals because only capable managers were promoted, with profit performance being a main factor in determining capability and plant managers’ compensation packages were tied to achieving profit budgets.

Problem Statement 1. 2. 3. 4. 5.

Strength and Weakness of Vershire Company’s Planning and Control System Profit Budgeting Process in Vershire Should Plant manager responsible for profits? How to assess performance evaluation system? Redesign Management control structure in Vershire

Analysis of Solution Alternatives 1. Strengths and Weaknesses of Vershire’s Planning and Control System Vershire uses a planning and control system that has strengths and weaknesses, which will be further analyzed below: Planning System Strengths: When formulating the sales budget, divisional managers are required to predict market conditions and capital expenditures five years out and prepare a forecast for the subsequent two years. This is a good way for the divisions and the company as a whole to anticipate sales, income, and capital requirements that are necessary to make future decisions and remain competitive. This forward looking approach allows the company to design its long-term goals and objectives. In addition, the forecasting is done at the corporate level and is then sent to the divisional managers for fine-tuning. This allows divisional managers to have input in the budget, which enhances the quality of the budget since divisional managers have a more realistic outlook on what sales will be for the coming year. As well, since their performance is tied to these budgets, it is important for them to feel involved in its preparation. Thirdly, corporate controllers visit each plant for half a day prior to the final submission of the budget. During this visit, plant managers have the opportunity to explain their

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situation and discuss in detail specifics that affect their plants. This will allow for a more accurate and complete budget to be produced. Weaknesses: The initial sales forecast uses assumptions such as inventory carryovers, forward buying, packing trends, etc., which are entirely derived from corporate headquarters’ analyses. As divisional managers are in charge of managing the operations of each division, they should be given the responsibility of making their own detailed sales forecast and getting approval from corporate head office on the final numbers. This will increase the overall accuracy of the initial forecast, making it less subject to change during subsequent reviews of the budget and creating a more efficient process. Secondly, the forecasting method is the same for all product lines. This is not an effective way of forecasting as each division or product line has different factors that affect its sales such as demand of customer base, industry trends, product characteristics, etc. Finally, plant managers do not come up with the sales budgets – the district sales managers do. After this is done, the budgeted sales are handed down to the plants after which each plant budgets gross profit and pretax income. However, plant managers are held responsible for the budgeted profit numbers as their performance is tied to the profit that their plant generates. This is a weakness as the plant managers are held accountable for profits when they do not have control over all the profit components, mainly the sales side of the equation. Control Systems Strengths : Divisional managers are given full control over their divisions except in the areas of raising capital and labor relations. This process is efficient as it allows the different divisional managers to take full responsibility for the divisions and make decisions that can best achieve the division’s goals, objectives, and performance forecast. Also, leaving labor relations and capital to the corporate head office allows the company to enjoy the benefits of operating as a large organization and economies of scale, such as the ability to obtain preferred interest rates from financial institutions. The divisions are then also able to focus on activities more central to the profit objectives emphasized by the company. Secondly, there is timely communication between the various hierarchies of the company as there are not that many tiers - plant managers report to the divisional managers who then report to the corporate office. Finally, there is constant oversight on meeting the budget, as plant managers are required to perform a variance analysis explaining differences each month and are expected to anticipate large variances on a daily basis. Weaknesses: Profit is the main measure for assessing plant managers’ performance and determining bonuses. This is not an effective incentive measurement since there are other factors that determine the capabilities of a plant manager. Even if sales fall below the budgeted levels, it is still the plant manager’s responsibility to achieve the budgeted profit levels. In addition, determining the efficiency of plant managers by

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comparing different divisions does not give accurate measures since plants have different product lines. This weakness in performance evaluation is discussed in more detail later in the report.

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2. Profit Budgeting Process in Vershire 3. The table below shows the profit budgeting process, with a rationale for each activity as well as who is responsible for that step. In addition, please refer to the Appendix for an overview diagram of this process at Vershire.

4. 5. Date 9. May

6. Re sponsibl 10. Di visional General Manager

21. C entral Market Resear ch Staff

37. Di visional General Manager 44. Distri ct

7. Action 11. 1) Summarize outlook for sales, income, and capital requirements for the next budget year 14. 2) Evaluate trends anticipated in each category over the subsequent two years

18. 3) Submit the preliminary report to Corporate Management 22. 1) Examine next budget year in detail 25. 2) Examine following two years in general terms 3) Prepare a sales forecast for each division:  Consider economic conditions and their impact on customers, and market share for different products by geographic area.  Make assumptions for price, new products, changes in particular accounts, new plants, inventory carryovers, forward buying, packaging trends, industry growth trends, weather 31. 4) Aggregate divisional forecast into a company forecast 34. 5) Submit forecasts to respective Divisional General Managers 38. 1) Compile new sales forecasts 41. 2) Request input from District Sales Managers 1) Estimate sales forecasts for the upcoming year  Request help from Head Office or divisional

8. Rationale  The Divisional General Manager has the broadest knowledge about his/her region; therefore, he/she is utilized to make the preliminary forecasts  By evaluating the outlook, areas for improvement or

19.

 Use the Divisional General Manager’s forecasts to develop a more formal market assessment  Ensure that basic assumptions are uniform throughout the entire company  Determine areas for additional capital expenditure  Assess competitive position and areas for improvement  Determine areas where market share can be increased  Determine opportunities Ensure thatany overall corporate for sales forecasts were reasonable and achievable

35.  Determine need for additional investments

42.  The District Sales Manager has the most knowledge about the sales so

45.

46.

47. 56. Divisional General

61. 66. Vice President of Marketing

80.

Corporate

48. staff (optional) 52. 53. Submit sales forecasts to Divisional 2) 58. General Manager sales forecasts 57. Consolidate 1) 62. 63. Submit to Vice President of Marketing 2) 67. 68. Review consolidated sales forecasts 1) 72. 71. Make amendments with approval of 2) district manager (if necessary) 76. 77. Submit to corporate level 3) 81. 82. Review consolidated sales forecasts 1) 86. 85. Make amendments with approval of 2) district manager (if necessary) 90. 91. Approve budget as a fixed objective 3) 95. 96. Translate consolidated budget into a sales 4) budget for each plant from which the finished goods would be shipped

103. Plant Manager

117. Industrial Engineering Department

126. Plant Manager 131. Head Office Controller

49. estimates can be made

54. 59. 64.  Ensure that the consolidated sales forecasts are consistent with the knowledge of the Vice President of Marketing, who has a broader view of the sales

78.

 Ensure that the forecasts are aligned to the corporate strategy and identify any areas for improvement

92.

 Sales budget is divided amongst the plants from which finished goods would be shipped, as these are where the revenue is generated. Performance is

99. 100. Submit plant sales budget to Plant 101. 5) Manager 104. 105. Categorize budget according to price, volume,  Separate product lines so that 1) and end use costs can be budgeted according 108. 109. Budget gross profit, fixed expenses, and pre110. 2) 114. tax income 113. Request cost budget from the plant’s 115. 3) Industrial Engineering Department 118. 119. Develop cost standards and cost  The Industrial Engineering 1) reduction targets including budgeted cost Department sets these costs for all reductions, allowances for unfavourable plants; therefore, the thresholds variances from standards, and fixed costs such should be consistent across all as maintenance labour. plants and makes them more 122. 123. Submit to Plant Manager 124. 2) 127. 128. Compile input from Industrial Engineering 129. 1) Department into budget 132. 133. Visit plant and walkthrough  Allow Controllers to familiarize 1) themselves with the plant processes

134.

135.

136.

146. Sept 147. Plant ember Manager 151. Divisi on Head Office 159. Divisional General Manager 166. Plant Manager

173. Divisional General Manager 181. Chief Executive Officer 187. Dece mber 192. Board of Directors

137. 2) Review budget with plant manager and  Provide Plant Managers to any supervisors explain the basis of their budgets  Ensure that Plant Managers are in 140. line with the corporate goals 144.  Reinforce plant connection and communication with 148. 1) Submit plant budgets to Division Head Office 149. 152. 1) Consolidate plant budgets to a division 153. 156.budget 2) Submit to Divisional General Manager 157. 160. 1) Review division budget 161. 164. 2) Return budget to Plant Manager for revisions  Determine areas where cost (if necessary) efficiency can be improved so that there is a larger gross margin 167. 1) Revise budget for any additional  Since the plant manager has the savings most knowledge of the operations, they should determine any areas for additional savings 170. 2) Submit to Divisional General Manager 171. 174. 1) Approve budget 175. 178. 2) Submit budget to the Chief Executive 179. 182.Officer 1) Request modifications to the budget (if  Ensure that the budget is consistent necessary) with the overall corporate strategy 185. 2) Approve budget 186. 189. 3) Submit final budget to Board of 190. 193.Directors 1) Approve final budget 194.

195. Should the Plant Managers be Held Responsible for Profits 196. Profit is made up of two components, revenue and expense. Plant managers should be responsible only for the measures that they can directly control, which are the expenses. This includes direct materials, direct labor, variable manufacturing and fixed overhead budget. The plant itself should be considered an engineering expense centre as there are no direct revenues generated from the plant rather the revenue is generated in the sales department. This is an important factor when monitoring management compensation for improved plant performance.

197. 198. “The plant manager was held responsible for the budgeted profit number even if actual sales fell below the projected level.” However, sales department has sole responsibility for the price, sales mix and delivery schedules and each of these components can have a direct impact on profitability, more specifically revenue. As well, any difference of opinions between sales and production is always favoured with the sales department as Vershire wants to satisfy the customer since they can easily switch to a competitor. This reduces the plant manager’s ability to maintain control over profitability in the plant since production can be disrupted by the sales manager and hurt efficiency of outputs; resulting in higher costs.

199. 200. Prior to budget submission, head office controller staff visits the plants and the plant manager has the opportunity to explain his/her situation. The plant managers can vocalize any concerns or unanticipated/unaccounted issues not captured in the current budget. The ability to express concerns helps to slightly mitigate the lack of control that plant managers have over the sales side of the budgeted profit.

201.

202. The incentive program for plant managers is as follows: ● Only capable managers were promoted with profit performance being the main factor ● Compensation package was tied to achieving profit budgets ● Plant efficiency reports were highly publicized even though different shops had different set up times

203.

204. These profit-oriented incentives motivate plant managers to act in the best interest of the corporation. For example, if the managers’ incentives focused only around output and cost, they might be inclined to refuse to accommodate the sales department when they had special orders that altered production schedules and output. The incentives are well aligned with the corporate goal of maximizing profit.

205.

206. However, as plant managers have little influence over revenue decisions, holding them entirely accountable for profitability is not appropriate. 207. How to assess performance evaluation system?

208. Four business days after the close of every month, each plant submitted a report showing budgeted and actual results. Once these reports were received, corporate management reviewed the variances for those items where figures exceeded budgetary amounts, thus requiring plant managers to explain only the areas in which budgeted targets had not been met. The focus was on net sales, including price and mix changes, gross margin, and standard manufacturing costs. 209. Table 1 : Performance Evaluation Report for a Plant for the Month of November. 211.

Items

215. 216. Total Sales 218. Variances due to 220. Sales price 222. Sales mix 224. Sales volume 226. Total Variable Cost of Sales 228. Variances due to 230. Material 232. Labour 234. Variable overhead 236. Total Fixed Manufacturing Cost 238. Variances in fixed cost 240. Net Profit 242. Capital Employed 244. Return on Capital Employed 246.

210. 212. Actu a l $

Month 213. Varian ce $

214.

Year – to Date Variance $

217. 219. 221. 223. 225. 227. 229. 231. 233. 235. 237. 239. 241. 243. 245.

247. The Table 1 shows main focus is net profit, which is influenced by both sales and expenses. The exhibit includes variances regarding sales price, sales mix, and sales volume. These are items that the sales department has responsibility over, rather than the plant manager. Therefore, they are evaluating plant managers based on metrics over which the plant managers have no direct control. Vershire fails to properly evaluate not only efficiency, but also effectiveness. In a manufacturing environment, both elements use output as a means of evaluation. By looking at

output in terms of profit rather than the quantity produced, the evaluations become irrelevant. While the cost variances present in Table 1 would be a more accurate performance measure, they are viewed in terms of sales rather than production. As plant managers cannot control sales, these variances then become irrelevant. Overall, the performance evaluators contained within Table 1 do not accurately measure the effectiveness or efficiency of the aluminum can manufacturing plants. 248.

Table 2 :

Supplemental Reports

249. Individual Plant Level Reports 250. Report 251. Content 252. Analysis of sales 253. Detailed analysis of sales volume, by customer groups sales dollars, profit dollars, and profit margin by end user customers (e.g., beer companies, soft drink companies). 254. Analysis of sales 255. More detailed backup analysis to Exhibit 2 regarding 256. Variances due to sales price, sales mix, and sales volume 257. Analysis of costs 258. More detailed backup analysis to Exhibit 2 regarding 259. Variances due to variable costs and fixed costs of manufacturing. 260. 261. Division Level Reports 262. Report 263. Content 264. Comparative 266. Comparison of sales and profits analysis of profit across plants 265. performance 267. Comparative 269. Comparison of efficiencies in variable analysis of and fixed costs across plants. manufacturing 268. Efficiency. 270. 271. The individual plant level reports contained in Table 2 give a more detailed analysis of the variances in Table 1. As stated above, these variances fail to properly evaluate plant managers, and as such further detail is just irrelevant. 272. The division level reports focus on net sales, including price and mix changes, as well as gross margin. As stated above, net sales are controlled by both sales and costs. Plant managers only have the ability to control costs, and as such these reports also lack relevance in terms of evaluating their performance. 273. The manufacturing division level report also is an inadequate performance evaluation report; as it compares plants that produce different products and that have varying setup times. This makes any analysis unreliable. 274. By using these performance evaluators to assess the plant managers’ performance in each plant, they are penalizing them for the shortfalls of the sales department and its inability to sell what is produced. Alternatively, the company is

also rewarding the plant managers when the sales department is able to negotiate favorable contracts for the company. When looking at the metrics within the exhibits, they would be excellent measures if they were used to evaluate the performance of those individuals that have direct control over the metrics. Given that they are used for the plant manager, they are nowhere near adequate. 275. 276. Redesign the Management Control Structure at Vershire Company 1. More communication and meetings between corporate HQ and among division general managers 277. Action: - Holding a company-wide meeting of division general managers and corporate HQ in order to discuss the upcoming year's sales budget - Having division marketing managers assist corporate HQ in developing division forecasts instead of HQ making general assumptions - Create more channels of communication among division general managers 278.

Benefits:

- Reminds division general managers of the overall goals of the company - Provides a holistic view of the company and the status quo - Facilitates brainstorming of new products or ideas - Discuss similar issues plaguing several divisions - Facilitates knowledge and resource sharing among divisions and corporate HQ - Facilitates the sales budgeting process by minimizing errors 2. Alter how plant managers are compensated and reassign responsibility over profits 279. Action: - Realign plant manager compensation packages so that it is tied largely to cost or manufacturing efficiency and a lesser extent to profit - Tie district sales managers' compensation packages to profit - Add adjustments for extra costs associated with sales manager or high level management decisions - Add adjustments for costs associated due to "acts of nature" such as a fire 280.

Benefits:

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Motivates plant managers to maximize profit using a variable they can control, which is cost - Protects the plant manager against adverse factors out of his/her control - Enables the plant managers and sales managers to collaborate towards maximizing the bottom line (profits) - Achieves better goal congruence 3. Improve comparisons of manufacturing efficiency between divisions and plants 281. Action: - Compare manufacturing efficiency between plants and divisions using a more comparable metric - If such a metric does not exist then a new metric could be developed to solve this issue - Reward most efficient plant and division 282.

Benefits:

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More efficient plants or divisions could be 'studied' and a knowledge base could be created Facilitates knowledge and resource sharing among plants and divisions Increase in efficiency will contribute to the corporate bottom line Achieves better goal congruence