Reference no: EM13495134

1. 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?

 

2. SHORT-SIGHTED VIEW OF COST CUTTING

Jamie Ericsson, the controller for Handico, has just compiled a cost report for the second quarter. The reportis prepared each quarter for corporate headquarters. She has taken particular notice of several major cost categories that show significant reductionsin expenditures when compared to the first quarter. She made the followinglist of the major cost cuts:

Cost Item Cost Reduction ($) Cost Reduction (%)

General employee training $12,000 25%

Routine machine maintenance 13,500 20

Process improvement 12,000 12

Quality training 18,000 8

Raw-material inspection 6,500 9

Concerned that there may have been errorsin compiling the data, Ericsson scheduled an appointment with her supervisor, Les Winters, the divisional vice president. At the meeting, the conversation wentlike this.

Ericsson (C): "Les, I'm concerned about these cost cuts. Are these mistakes, or are we really making such substantial cutsin these areas?"

Winters (VP): "Your numbers look right, Jamie. I ordered these cutbacks myself. I think there's a lot of fatin this operation that can be cut, and I'm just getting started."

Ericsson (C): "But these are allimportant areas toinvest in, Les. I see theinvoices for these costs every month, and I don't think its wasted money at all."

Winters (VP): "Corporate wants a lean company, Jamie. I'm just trying to give them one."

Ericsson (C): "Have you thought through theimplications, Les? Cutting general employee training will eventually take a toll on our productivity gains. Same thing for the cuts?n process?improvements. And cutting routine machine maintenance could mean breakdowns later on. Maybe not for a year or so, but eventually it'll takeits toll."

Winters (VP): Becoming annoyed, "Those are my concerns, Ms. Ericsson, not yours."

Ericsson (C): "Look, Les, we're all on the same team. I'm just concerned, that's all. I feel as though I need to highlight these cost cutsin my report to corporate. They should at least be made aware of theseissues. I'll need your authorization for that."

Winters (VP): "No can do, Jamie. You are instructed to make your usual quarterly report using the standard format." After the meeting, Ericsson was commiserating with her close friend, Amy Long, the chief of engineering.

Ericsson (C): "Amy, I just had a very unsatisfactory meeting with Les Winters. I shouldn't gointo the details, but I'm concerned about some things."

Ling (E): "Well, I have good news for you then. The grapevine hasit that Lesis on the very short list for taking over as president of our Japanese subsidiary. That would be a huge promotion for him. Wordis that all he's got to dois turnin a good performance for the year here. If he does that, the job's his."

Ericsson (C): "That explains a lot, Amy. Thanks for the heads up. I've got some thinking to do."

Question: What do you think is going on here? Whatis the VP, Les Winters, up to? Is he acting ethically? What steps should the controller, Jamie Ericsson, take? (Refer to the "Resolution of Ethical Conflict" section of the IMA Statement of Ethical Professional Practice.) How could a balanced scorecard help mitigate the problems apparentin this scenario?