Monoclean Ltd

Case 14.42 Langfield-Smith, Thorne, Smith and Hilton

Review of Chapters 12, 13 and 14: responsibility accounting, transfer pricing: reward
systems: manufacturer

Monoclean Ltd is a multinational company that manufactures and markets household

cleaners in a batch process-manufacturing environment, and activity-based costing
(ABC) is used to allocate overhead to production. Recently Monoclean has undergone
a major structural reorganisation to assist it to complete more effectively in the Sub-
Sahara African Region.

Under the old structure, the Sub-Sahara African region was divided into 12 business
units, along geographical lines. Each business unit had a managing director (MD) who

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was responsible for manufacturing as well as marketing and selling operations of the

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business unit’s products. Each MD was evaluated and remunerated on the business

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unit profitability, which was as reported in a monthly business unit profit statement.

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Managers within each business unit were evaluated and remunerated according to their

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personal, department and business unit performance.
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About a year ago, the number of manufacturing plants in the Sub-Sahara African
region were reduced from 12 to 5. The 12 business units continued to exist, except that
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7 were now responsible only for the marketing and selling of products. Only 5
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business units continued to include manufacturing plants, which were now responsible
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for supplying all of the business units in the Sub-Sahara African region. Each business
unit with a manufacturing plant has a manufacturing manager. While the MDs of those
business units have ultimate responsibility for the marketing and sales operations and
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all other aspects of the business unit, in practice the MD does not interfere with the
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manufacturing manager, who is given full responsibility for manufacturing in the

business unit. The MD is principally evaluated and remunerated on the profit
generated from marketing and sales activities. Marketing profit reflects actual sales
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revenues less standard manufacturing costs and actual sales and marketing costs. The
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manufacturing manager is evaluated on the profit from manufacturing. Manufacturing

profit consists of sales revenue less actual manufacturing costs. There is also a
manufacturing director for the region who has ultimate responsibility for all the
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manufacturing managers.

Under the new company structure, monthly profit statements are prepared for each
business unit. In addition to these reports, a manufacturing profit statement is prepared
for the region and a total-company profit statement is prepared. The transfer price for
goods transferred between manufacturing and marketing areas within the same
business is at standard manufacturing cost. The transfer price for goods transferred
between manufacturing and marketing, not within the same business unit, is at
standard costs plus 5 percent.

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 Some business unit managers have raised concerns about some of the decisions that
have been made since the restructure and wonder if the right incentives are in place.
Some specific examples and issues follow:

 Marketing and sales managers are in the best position to influence the level of
slow moving and obsolete inventory, through choosing whether to sell off these
products or to allow them to be scrapped. In recent months there have been high
levels of obsolete inventory. This affects the manufacturing profit statement. There
is little incentive for marketing staff to sell off or manage slow or old inventory, as
they simply purchase goods at standard cost from manufacturing as it is required.

 Inventory shipping and transportation is managed by manufacturing staff and the

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cost of this is charged to the manufacturing profit. However, the cost of these

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activities is heavily influenced by the deals that the sales force makes with their

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customers. Sales staff can negotiate three shipping and transportation options: the
purchaser can pick up the inventory from Monoclean’s warehouse, the inventory

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can be shipped by Monoclean to a central warehouse of the customer, or
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Monoclean can transport the inventory to the customers’ supermarkets. Each of
these options attracts different costs, which are treated as a component of the
manufacturing profit.
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 When there is a change in product or raw material sourcing, the business units that
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include manufacturing areas absorb the manufacturing variances from standard

cost (favourable or unfavourable). This results in an adjustment to standard costs
in subsequent periods and affects the profit of the marketing units. For example, if
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a favourable purchasing variance results from the activities of the manufacturing

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business unit, the transfer price will decrease.

 Another issue of concern is the role of the business unit MD in the capital
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expenditure approval process. If the manufacturing director, not the MD of each

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business unit, who initiates all capital expenditure requests. Capital expenditure
decisions affect business unit profits through the timing of cash flows, depreciation
on assets, maintenance cost and so on.
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Some business managers believe that there may be a problem in the alignment
between business unit responsibility, transfer pricing policy, performance evaluation
systems and management remuneration. The profits of some business units are below
budget and, in current competitive environment, head office management is
concerned.

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 Required:

You as part of a management consulting team have been asked by the regional finance
director of Monoclean Ltd to prepare a report outlining any issues that may be
working against effective performance measurement and incentive systems in the
business units. In your report, identify clearly any underlying problems and
recommend a solution that considers appropriate responsibility centre type, transfer
pricing policy, performance evaluation system and management remuneration
package.

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SOLUTIONS TO CASES CASE 14.42 Review of Chapters 12, 13 and 14;

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responsibility accounting, transfer pricing; reward systems: manufacturer Students

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answers to this question will vary.

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To: Regional Finance Director
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From: Management Consulting Department

Monoclean has adopted a very complex structure with overlapping responsibilities and
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this makes it difficult to design effective performance and remuneration systems. The
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incentives that are in place encourage managers to maximize their own performance at
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the expense of the other managers. This can lead to reduced profits for the company as
a whole.
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Organizational structure and responsibility centres

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In the past, the company consisted of 12 business units, established along geographical
lines. Each business unit had a managing director (MD) who was responsible for
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manufacturing, marketing and selling of the business units products. The MD’s were
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evaluated and remunerated based on business unit profitability and managers within
the business units were evaluated and remunerated according to their area of
responsibility.
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Under the new structure, the 12 business units continue to exist, but only five contain
manufacturing plants. These plants supply all business units in the region. The MD’s
of the five business units now have responsibility for marketing and sales for their
plant, but not the manufacturing function, which is now the full responsibility of the
manufacturing manager within the business unit. A manufacturing director has
ultimate responsibility for all manufacturing managers. The MD’s are evaluated on
marketing profit (actual sales revenues less standard manufacturing cost and actual
marketing and sales costs). The manufacturing managers are evaluated on

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 manufacturing profit (sales revenue less manufacturing cost). Products are transferred
within a business unit at standard manufacturing cost, and to other business units at
standard cost plus 5 per cent.

Under the new structure, manufacturing units and marketing units are profit centres.
This is to encourage managers to be sensitive to managing costs and generating a
profit. This would make sense if where managers are being held responsible for
revenues and costs that are within their control. However, in Monoclean, this is not
always the case. In addition, it is unclear why the manufacturing director, who is
outside of the business units, would be initiating capital expenditure requests, when
this affects the profits and the production capacity of the business units. This
responsibility should be reviewed.

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Transfer pricing

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Products are transferring within a business unit at standard cost, and this does not

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allow manufacturing managers to generate a profit on those sales. It is more profitable

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to transfer product to other business units. Sales staff in their own business unit would
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clearly prefer to buy from within their business unit, as it is cheaper than buying from
another business unit. Where there is limited capacity within a manufacturing plant,
this could cause conflict. The transfer pricing policy needs to be reviewed to make
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sure that an optimal price is being used.

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It seems that the manufacturing areas bear the cost of inventory, including obsolete
inventory. However, this can be the result of marketing decisions. Production planning
needs to be based on accurate forecasting of sales. Where there is excess production
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and costs then this might need to be shared by both the marketing and manufacturing
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areas. Similarly, where manufacturing incurs additional shipping and transportation

costs due to marketing activities, these costs may need to be passed on to the
marketing department.
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While there is an incentive to keep actual manufacturing costs close to standard cost,
there is little incentive for manufacturing managers to develop a tight standard cost.
Where there are increased raw materials or other costs, these are passed on to the
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marketing areas within the standard cost-based transfer price. Ultimately, this may
lead to an inflated external selling price for the products. Some reasonableness test
needs to be applied in the development of standard manufacturing costs. This could
involve some form of external cost benchmarking.

Performance evaluation and management remuneration

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 The overlapping responsibilities outlined above suggest that there is a problem with
the new organisational structure and the responsibilities and reporting structures. The
profit-based incentives motivate managers to pass on cost to other business units to
maximise their own profitability. The basis of managers remuneration should extend
beyond short-term profits. Remuneration could also be linked to inventory
management, forecasting accuracy, product quality, and so on, or to other measures of
strategic importance to encourage managers to focus on profit but not at the expense
of long-term performance.

Summary

The company should consider revising the structure and aligning managerial
responsibilities with a broad-based performance evaluation system and managerial

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remuneration package. The business units could be separated into manufacturing

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business units, and marketing and sales business units. This could be accompanied by

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changes in the transfer pricing policies. Alternatively, five business units could be

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formed along the lines of the old structure. The MDs could have responsibility for the

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entire operation of the business units, including manufacturing.
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