Management Control Systems Professor Bob Madden March 3rd, 2011 Case 7-3: Quality Metal Service Center

Matt Stone (200706221) Bradley Morrison (200606309) Quality Metal Service Center is a metal distributor, which sells to smaller users of metal products than the big manufacturer/suppliers such as Bethlehem, Crucible, etc. To be competitive they must have shorter lead time and all around better customer service to cover the extra cost of small lot sales and make their product worthwhile to customers. Quality has three main strategic objectives. Their first objective is to focus sales efforts on targeted markets of specialty users. Quality metals focuses on sales of specialty metals and competes on differentiation of product rather than cost. This will help them avoid commoditized good markets where they cannot compete based on price. They aim to produce higher tech, higher return products and sell these to customers. These markets of high tech metals have less competition and better profit margins. Their second objective is to identify geographic markets where metals are being consumed. They use database technologies to have accurate, up to date, sales forecasts on hand and they service these needs by preparing for orders before they occur, which will shorten lead-time and improve the benefit of their services. They also use these to allocate products on hand by location and service each location in a manner that works best for the regions customers. Their third objective is to develop techniques and marketing programs that will increase market share. Their fast lead time allows customers to adopt JIT inventory avoiding high carrying costs and obsolescence. As quality has saved costs on their own JIT system through short lead time they can help customers achieve this cost savings as well. This helps customers to have the most up to date metal products available on the market as needed. In addition they offered a wide range of processing services. These modifications to products reduce need for customers to have and use specialty tools, as well as cut down on time they need to complete jobs.

The management Control systems should support the implementation of these three main strategies through influencing management behavior to act in accordance with these corporate goals in maintaining a superior quality of service to the consumer. Each of the four regions have a manager who is evaluated based on return on assets and aims to exceed a set goal of 90% of projected profit. Ken Richards, a district Manager is responsible to the vice president of the Midwest division and has a set of functional managers who report to him. While many of these functional managers operate independently of head office, the purchasing decisions of each division is influenced by the central database and the control in place that requires head office approval on any capital expenditures in excess of $10,000 have to be approved by central management. This makes the divisions heavily dependent on central management for investment decisions and they also must trust that they are instructed on the best possible data for their area. Within these regions the district manager are also evaluated on the ROA. This measurement allocation has a split of 75% weighted on district and 25% on region. This may cause dysfunctional behavior where a manager may wish to act in the best interest of his district rather than the region or company as a whole. An example of dysfunctional behavior is shown when Ken Richards from the Columbus District is reviewing a capital investment program. Ken is showing a large ROA over 30% and although taking more projects could improve the corporate profitability he may refuse these projects if his compensation is reduced by the current bonus program. As shown in exhibit 3 central offices assessment through their database shows that his divisions has demand for processed metal products. This will improve lead-time on orders further differentiating their product, as well as fulfill objectives 1 and 2. Terms of the deal are shown which are better summarized in exhibit 4 showing that all corporate criteria are met in terms of payback period internal rate of return and show a positive NPV showing that at this discount rate, and assuming that a better project is not available.

Also the manager must rely on central offices sales projections as if they are lower they could show a loss and an increased asset base quickly erasing any bonus they would have received. This dependence and added risk can cause the managers to be even more likely to turn down these prospective investments. As shown in exhibit five while this investment will improve profitability, even in the short term, Ken will be motivated to turn down this project. While it causes him to increase cash flows by $40,000 it will reduce his bonus by 6.28%. This will cause him to look at the district financials and reject the project although they benefit the company. The cash flows in exhibit 4 also show growth throughout this investment period. The key to fast growth is to generate returns and further reinvest the returns into additional high yield projects. To compete in this market and establish themselves as a growth firm Quality must generate high returns wherever possible and reinvest this money to further their ability to grow as a company according to their three main objectives. Issues

Control over capital expenditures Limit of $10,000 Evaluation on ROA and Bonus Incentive program Counter intuitive

ROA motivates managers to invest in positive NPV projects that will enhance future cash flows; The Compensation plan is not motivating the managers to make those investment decisions, rather to not invest at all as the payout rate would be decreased for more assets overplayed thus effecting bonus

Assets over-employed will increase change to profits and therefore reduce adjusted profits and the payout rate charged to the base salary Overall evaluation scheme is counterproductive towards organizational objectives, managers motivations. Bonus Plan Incentive deters managers from taking on investments that will require large asset employment and may have positive ROA or EVA results ROA as evaluation may work counterintuitive itself as, the Columbus division for example with high profitability will be hesitant to invest in opportunities with a lower ROA then their Target ROA, that would benefit organizational cash flows otherwise

Recommendations Management Control systems be made consistent with framework used for decisions about capital investments. o
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Currently inconsistent, Managers do not have full authority over investment decisions ROA evaluation and Bonus plan is inconsistent with objectives. Investment decisions should be made by division with less control from HQ if evaluated on that basis

EVA could be used for investment decisions

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EVA proposes multiple advantages over ROA, EVA on proposal will increase EVA supports the third organizational goal that the company has established to find techniques to increase market value As EVA has a strong correlation with changes in the company market value Using EVA as an evaluation on investments could help managers analyze if it will help grow EVA, and therefore enhance shareholder value

If they were to continue to use ROA as a basis for providing a bonus to managers, make it consistent with how the managers are evaluated One suggestion: Remove assets over-employed from equation or add flexibility, so that managers will not be penalized in their bonus on investment opportunities.