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Final Exam

ACCT 502

Summer B 2021

Problem I:  Bell Helicopter

Bell Helicopter, a division of Textron Inc., builds military helicopters for, among other customers, the U.S. military.  Given the highly customized nature of the product, one important concern for the military is ensuring that while they pay a fair price for the equipment that they purchase, they don’t overpay.  Traditionally, many defense contracts have been done on a cost-plus basis – the contractor is paid for the costs that they incur, plus an agreed upon profit margin.  Government auditors check the numbers to ensure that the costs incurred are correct.

Several years ago, I read an article in the Economist, noting that “The Pentagon has moved away from conventional “cost-plus” contracts, … [but] the alternative, fixed-price contracts, has not always proved better.”

Under a fixed-price contract, the Pentagon and the contractor agree upon a given price at the signing of the contract.

For this question, I want to compare the two approaches (which are, effectively, control systems) on the final cost of the helicopter.  For purposes of the question, assume that issues other than cost (quality, timeliness, functionality, etc.) are all set and that the approach taken will have no effect.  This is probably not true, but I want to focus on cost issues here.  Hint: One can think of this relationship as a principal-agent relationship, with the government in the role of the principal.

1)  Briefly explain one reason why conventional cost-plus contracts could lead to the government being systematically (*) overcharged.  Be brief, but be specific.

(*)  By “systematically” here, I mean that I’m not looking for “one-off” answers, along the lines of:  “For a particular type of helicopter the costs may just turn out to be much higher or much lower than expected.”  On average, assume that forecasting errors should be zero.

2) Briefly explain one reason why fixed-price contracts could lead to the government being systematically (*) overcharged (in the sense that the contractor could earn a very high margin).  Again, be brief but specific.

Problem II: Cleveland Clinic

Cleveland Clinic is a large hospital group based in Ohio.  Cleveland Clinic pays most of its doctors and surgeons a flat annual salary, but also tracks each doctors’ “output”, measured in RVUs (relative value units).  RVUs are a weighted measure of output (allowing one to add and/or compare heart transplants to knee surgeries), that are set by a board of the American Medical Association.  While not paid directly for RVUs, doctors with higher RVUs are more likely to be promoted, while less productive doctors may not be renewed.

A growing trend in health care is the emergence of patient reviews of doctors; Medicare has begun to link payments to hospitals based on patient feedback, and Cleveland Clinic has begun using this data as an input into its decision making.  

Briefly discuss the usefulness of patient feedback as a performance measure, using the criteria discussed in class.  Then provide a recommendation for how (if at all) such a measure should be used by Cleveland Clinic in evaluating their doctors.  Be as specific as possible, and justify your recommendation.  You should be able to do this in a couple of paragraphs.

Problem III:  Wainwright Heavy Equipment

Wainwright Heavy Equipment’s Underground division sells tunnel boring machines (TBMs), which are used to excavate tunnels with circular cross sections in the mining and civil engineering industries.  Wainwright has three salespeople who develop leads on potential sales, and then work to sell the TBMs.  Due to the nature of the industry, the division makes only a fairly small number of sales each year.  For purposes of simplicity, assume that each sale generates $200,000 in gross contribution margin for Wainwright, which is realized by Wainwright immediately.  The only cost not included in the above is the selling cost, which varies from customer to customer.

When a salesperson develops a lead, they bring the information to Wainwright’s management and request funds for selling costs in order to pursue the lead.  The funds will be spent for certain, but the lead may or may not actually generate a sale.  Based on Wainwright’s experience, and its understanding of current market conditions, it believes that during the current year, there will be three types of sales leads:

Easy sale: With an upfront selling cost of $5,000, the lead generates a sale 50% of the time.

Hard sale: With an upfront selling cost of $10,000, the lead generates a sale 30% of the time.

Long shot:  With an upfront selling cost of $15,000, the lead generates a sale 10% of the time.

Wainwright believes that during the year, 20% of the leads will be easy sales, 60% will be hard sales and 20% will be long shots.  Note that if Wainwright decides to pursue a given lead, it must spend the selling cost regardless of whether it makes the sale or not.  So, for example, with easy sale lead, the expected value of pursuing the lead is 50%x$200,000 - $5,000 = $95,000. Not pursuing the lead, obviously has an expected value of $0, as there is neither any revenue nor any cost.

While the salespeople are able to identify which type of lead they have, Wainwright’s management lacks the ability to do so – to them, all leads look the same both initially, and after the fact.  Assume that all participants here are risk neutral, and that the salespeople can benefit from additional selling costs, but that additional selling costs have no effect on the probability of generating a sale (e.g., if a salesperson receives $15,000 for an easy sale, they can take advantage of that, but the probability of a sale is still 50%).  With insufficient funds, no sale will occur (a salesperson who spends $5,000 on a long shot has a zero percent chance of making the sale).

1. Briefly (one or two sentences) explain the goal congruence problem between Wainwright’s management and the salespeople.

2. In the absence of any goal congruence problem (i.e., if the salespeople somehow ignored their own incentives, and simply did what was best for the company), which types of leads would be profitable for the firm to pursue?

3. In the problem as described (i.e., with the goal congruence problem), which types of leads should the firm pursue?  Assume that the firm can announce this policy at the start of the year.

4. What is the cost of goal congruence at Wainwright?  That is, how much does the goal congruence problem cost the company on average per lead?

Problem IV:  Missouri Instrument Company

The Missouri Instrument Company (MIC) makes high quality guitars which it sells through marketing divisions in other countries.  Direct sales in the United States can be made for $800, and the guitars cost $500 to manufacture.  In the US, MIC pays a marginal income tax rate of 35%.  

If MIC ships the guitars to Canada, shipping costs are $10 (paid by the US division; for direct sales there are no shipping costs), but in Canada the guitars sell for $900.  Canada charges the importing division an import duty of 5% of the transfer price of imported musical instruments (before shipping), and this import duty is NOT deductible for purposes of Canadian income tax.  The marginal tax rate on MIC’s income in Canada is 30%.

Relevant agreements between the US and Canada require that the transfer price be between $510 and $900.

1. If the transfer price between the two divisions is set at $700, what is the net, after-tax profit from the transaction, for MIC as a whole?

2. If MIC is a centralized organization, what transfer price maximizes MICs net, after-tax profit, and what is that profit?

3. If MIC is a decentralized organization (i.e., each division has the right to refuse to cooperate with the other division), will the answer in 2 be feasible?  Why or why not?

4. If MIC is a decentralized organization, what is the most tax-efficient, goal-congruent transfer price that they can choose?  What is the cost of goal congruence per guitar?

Problem V:  Zappos.com

Zappos.com, which is owned by Amazon, but run as a separate company, sells shoes online.  A recent (July 5^th, 2014) article in the Economist notes that Zappos is the first sizeable company (with 1,500 employees) to embrace “holacracy”.  This is a management idea/fad that involves “replacing [a firm’s] hierarchy with a more democratic system of overlapping, self-organizing teams”, according to the Economist.  Zappos believes that this reorganization will lead to happier, more productive employees, which will reduce costs, increase customer satisfaction, and thus increase profits (through a combination of higher margins, higher sales, and lower costs).  

See the below and page 12 for a number of performance measures that Zappos has collected, covering a sampling of functional areas, in which departments have been replaced by teams at the start of 2014.  Before making the change, Zappos was predicting an increase in sales volume of 10%, and no significant change in pricing, product mix or costs (assume that cost of goods sold is primarily a variable cost, but that SG&A is primarily fixed).

Accounting:  Accounting records information for financial reporting, internal reporting and tax reporting.  They do not directly impact revenues, but are a necessary cost center in order for the business to function.  A key metric in accounting is the number of errors that are made, which have to be corrected later, divided by the total number of accounting entries.  In 2013, the error rate was 0.42%, and in 2014, it was 0.43%.

Marketing: Marketing is involved in the direct contact with the customers, through the website and customer support.  They have a large impact on sales volume, and are evaluated through customer metrics such as customer satisfaction, customer returns and repeat customer numbers (see page 12).

Purchasing:  Purchasing negotiates the contracts through which shoes are acquired from their manufacturers, though they do NOT choose which shoes are acquired – that is the role of the style department.  Purchasing does have a large impact on the cost of the shoes acquired, as well as the logistics of acquiring shoes.  A key metric that they use is the number of “supplier issues”, which could be disputes over delivery dates, quality or pricing.  In 2013, there were 74 disputes, and in 2014, there were 85 disputes.

Style: Style chooses the shoes which will be sold on Zappos’ site.  Their goal is to increase the sales price of shoes, by selecting shoes that will be the most popular in the coming weeks and months.

1.   Draw a simple strategy map for Zappos, using, as much as possible, goals that can be measured by the metrics provided on the following page.  Briefly discuss the logic behind your strategy map.  For each objective on the strategy map, suggest one performance measure which you might use to measure it (most, if not all, should come from the list on the following page).

(a) In millions of dollars.  These numbers are included (along with other departments) in the SG&A line on the income statement below.  Note that for the purchasing department, this number does NOT include the cost of goods purchased for resale during the year.  The cost of goods sold number is separately reported on the income statement.

(b) Based on surveys of employees (1 = very unsatisfied; 10 = very satisfied).

(c) Percentage of employees in the department on January 1, who were employed by Zappos on December 31.

(d) Percentage of employees in the department with education beyond an undergraduate college degree (including MBAs, Masters of Fine Arts, Masters of Accounting, etc.).

(e) Based on surveys of employees (1 = The use of Holacracy in my department has had no impact on my job; 10 = The use of Holacracy in my department has completely changed my job).  As the change began in 2014, there is no data for 2013.

(f) This is an index of steps taken to implement Holacracy in the department, as filled out by an outside Holacracy auditor.  A score of 1 indicates that the department has made little progress in implementing Holacracy, while a score of 10 indicates that the department has effectively completed the implementation.  As the change began in 2014, there is no data for 2013.

(g) Average number of employees who work in the department over the course of the year.

(h) Proportion of sales that are returned (note that due to the online nature of Zappos’ sales, high returns have long been a problem at the firm).

(i) Based on on-line surveys of customers (1 = very unhappy; 10 = very happy).

(j) Proportion of customer who make another purchase within six months.

2. By comparing this year’s numbers to last year’s numbers, what can you conclude about the effectiveness holacracy at Zappos?  Be as specific as you can as to what part or parts of the strategy are effective or ineffective.  You should be able to do this without any formal statistics.