Reference no: EM13495259

1. IS PADDING THE BUDGET UNETHICAL?

A departmental or divisional budget often is used as the basis for evaluating a manager's performance. Actual results are compared with budgeted performance levels, and those who outperform the budget often are rewarded with promotions or salary increases. In many cases, bonuses are tied explicitly to performance relative to a budget. For example, the top-management personnel of a division may receive a bonus if divisional profit exceeds budgeted profit by a certain percentage. Serious ethical issues can arise in situations where a budget is the basis for rewarding managers. For example, suppose a division's top-management personnel will split a bonus equal to 10 percent of the amount by which actual divisional profit exceeds the budget. This may create an incentive for the divisional budget officer, or other managers supplying data, to pad the divisional profit budget. Such padding would make the budget easier to achieve, thus increasing the chance of a bonus. Alternatively, there may be an incentive to manipulate the actual divisional results in order to maximize management's bonus. For example, year-end sales could be shifted between years to increase reported revenue in a particular year. Budget personnel could have such incentives for either of two reasons: (1) they might share in the bonus or (2) they might feel pressure from the managers who would share in the bonus.

Put yourself in the position of the division controller. Your bonus, and that of your boss, the division vice president, will be determined in part by the division's income in comparison to the budget. When your division has submitted budgets in the past, the corporate management has usually cut your budgeted expenses, thereby increasing the division's budgeted profit. This, of course, makes it more difficult for your division to achieve the budgeted profit. Moreover, it makes it less likely that you and your divisional colleagues will earn a bonus. Now your boss is pressuring you to pad the expense budget, because "the budgeted expenses will just be cut anyway at the corporate level."

Question:Is padding the budget ethical under these circumstances? What do you think? And how could you resolve the situation?

 

2. SACRIFICING QUALITY TO CUT STANDARD COSTS

Pressures to control costs, coupled with bonus systems based on adherence to standards, can present a temptation to engage in ethical lapses. The following hypothetical scenario describes such a situation. Keystone Company manufactures small wooden household items such as cutting boards and knife racks. Keystone's controller, Marc Rigas, recently completed the installation of a new standard-costing system, which has been in place now for six months. Jack Smith, the purchasing manager, is about to place an order for wood to be used in Keystone's cutting boards. Smith has found a supplier that will furnish the necessary wood at $2.00 per board foot, rather than the standard cost of $3.00.

This is very appealing to Smith, since his annual bonus is influenced by any favorable price variances he is able to obtain. Smith is due to be transferred at the end of the year to Keystone's Allentown Division, which manufactures metal kitchen utensils. The transfer is a promotion for Smith. After further discussions with the potential supplier, Smith realized that the wood being offered would not be well-suited for use in cutting boards. Although the wood would seem fine in the manufacturing process, and it would result in an attractive product, it would not hold up well over time. This particular type of wood, after repeated cycles of getting wet and then drying out, would tend to crack. Smith figured that it would take about a year for the cutting boards to deteriorate, and then Keystone Company would be beset with customer complaints.

Smith mulled over the situation for a while and then decided to accept the new supplier's offer. The $2.00 price would help him get a nice annual bonus, which he could use to help with the down payment on a new home. By the time the cutting boards cracked and customers started to complain, he would be long gone. Someone else could worry about the problem then, he reasoned. After all, he thought, people shouldn't expect a cutting board to last forever. Several weeks later, when the invoice for the first shipment of wood came through, Rigas noticed the large, favorable price variance. When he ran into Smith on the golf course, Rigas congratulated Smith on the purchase.

The following conversation resulted.

Rigas (C): "That was quite a price break on that wood, Jack. How'd you swing it?"

Smith (PM): "Hard-ball negotiating, Marc. It's as simple as that."

Rigas (C): "Is it good wood? And how about the supplier, Jack? Will they deliver on time?"

Smith (PM): "This supplier is very timely in their deliveries. I made sure of that."

Rigas (C): "How about the quality, Jack? Did you check into that?"

Smith (PM): "Sure I did, Marc. Hey, what is this? An interrogation? I thought we were here to play golf."

Rigas was left feeling puzzled and disconcerted by Smith's evasiveness. The next day, Rigas talked to the production manager, Amy Wilcox, about his concerns. Later that day, Wilcox raised the issue with Smith. After a lengthy and sometimes heated exchange, the story came out.

Question.

1. Discuss the ethical issues involved in this scenario.

2. Did the purchasing manager, Jack Smith, act ethically?

3. Did the controller, Marc Rigas, act ethically when he asked Smith about the quality of the wood?

4. Did Rigas act ethically when he went to the production manager with his concerns?

5. What should the controller do now?

3. Misstated Standards Affect Accuracy of Reports

The scenario described here, while placed in the context of a fictitious enterprise, is based on an actual situation that occurred at NuTone Housing Group, which at the time was a subsidiary of Scoville, Inc.^*

To set the stage, consider these facts about the standard-costing system in place at Shrood Division, a subsidiary of Gigantic Enterprises, Inc. Shrood Division manufactures a wide range of electric household products, such as lighting, fans, water pumps, and security systems. The division manufactures approximately 10,000 products, made from over 70,000 components. Tom Cleverly has run the division in what he calls a hands-on manner for over a quarter century. When Shrood Division was acquired by Gigantic Enterprises a decade ago, Cleverly was at first unhappy with the merger, but it soon became apparent that Gigantic's top management would let him run the business the way he was used to running it. Three aspects of Cleverly's management style are noteworthy. First, he insists on being involved in all major pricing decisions; he's not a delegator. Second, he has developed a second-level management that is loyal and supportive of his approach. Third, he has refused to lower the direct-labor time standards for years, even though many productivity improvements have been made. At present, the actual direct-labor times are on average only about a third of the standard times. Moreover, since manufacturing overhead is applied on the basis of direct labor, both the standard direct-labor and the standard overhead costs are inflated relative to actual costs.

The implications of this practice are that huge favorable variances are experienced all year long in both direct labor and overhead. Cleverly has used these favorable variances to "manage the quarterly earnings" reported by Shrood Division to corporate. Cleverly has instructed his manager of accounting, Evan Twixt, to release just enough of the favorable variances into Cost of Goods Sold (CGS) on a quarterly basis to ensure that Shrood Division just meets its earnings target in the budget. Then, at the end of the year, the remainder of this large favorable variance is released into CGS, with the result that Shrood Division ends each year with fourth-quarter earnings far in excess of the target. Like a knight in shining white armor, Shrood Division saves the day for Gigantic Enterprises year after year. Shrood has come to be known in corporate circles as "the jewel in the crown of Gigantic Enterprises."

Now for the conflict. Gigantic has hired a new corporate controller, Jeffrey Fixit, whose charge is to introduce more consistency in the reporting methods of Gigantic's various divisions. When Fixit visited Shrood Division and discovered what was going on, he tried to get Tom Cleverly to instruct Evan Twixt to correct the direct-labor standards to reflect attainable results (i.e., reality). Cleverly has refused, though, and Fixit doesn't have the power to force him to do so. Meanwhile, poor Twixt is caught in the middle.

Here is what each of them had to say about the situation.

• Cleverly (division manager): "I've been running this business for 25 years. And you know what? We've been profitable for 25 years! The high labor standards help me make sure that neither I nor my salespeople shave prices too much. It's like setting the clock 10 minutes ahead to make sure you're not late. We always make budget. We always report the highest profits in the company. And we are, in fact, the 'jewel in the crown.'"
• Fixit (corporate controller): "This is a really bad situation. Shrood is reporting fictitious numbers to corporate on a quarterly basis, which then get rolled up into Gigantic's quarterly results. Then these numbers get published to the shareholders. We're misleading them. I don't have the authority to get Tom Cleverly to fix the problem. I can, however, go to the board of directors and explain to them that they need to get Cleverly to do what needs to be done."
• Twixt (Shrood's accounting manager): "I'm caught in the middle. We basically have two sets of books: the ones based on Mr. Cleverly's labor standards, and the ones based on the more accurate results that Mr. Fixit wants. I can report either set of results. I feel like I'm serving two gods-and so far I'm getting away with it."

Question.

• What do you make of this situation?

• Can a company that keeps two sets of books be well managed?

• What ethical issues do you see here?

• What actions should Cleverly, Twixt, and Fixit take?