Module 45: Performance Measures and Management Techniques

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Overview

Organizational performance measures (including financial and nonfinancial measures) are used for a variety of purposes including: resource allocation, incentive compensation, divisional and business unit evaluation, budgeting and planning, and setting targets. Performance measures are used to manage and monitor performance in many areas of the organization including: financial, customer, internal processes, employees, and suppliers.

Organizational performance measures should be aligned to the strategy of the organization and useful in executing that strategy.

Strategy describes how an organization uses its activities and resources to achieve its objectives. For a business, the objective is to ethically maximize financial value. Execution includes the performance measures used (1) to ensure the strategy of the organization is being executed and (2) to monitor performance. To be successful, an organization must have an effective strategy and an effective execution system in place, including performance measures that closely link to the strategy. Before beginning the reading you should review the key terms at the end of the module.

A. Financial and Nonfinancial Performance Measures

Both financial and nonfinancial performance measures are needed to manage an organization. Financial measures gauge performance, profitability, or costs and are expressed as dollar amounts, ratios, or other forms. Nonfinancial performance measures are expressed in nonmonetary terms and include measures of customer satisfaction, customer retention, on-time delivery, quality, employee satisfaction, etc.

B. Balanced Scorecard and Performance Measures

The balanced scorecard, a performance measurement system that includes financial and nonfinancial performance measures, was developed by Kaplan and Norton.

1. What Is the Balanced Scorecard?

   The balanced scorecard is a strategic performance measurement and management framework for implementing strategy by translating an organization's mission and strategy into a set of performance measures. These performance measures are generally in four primary perspectives: financial, customer, internal business processes, and learning and growth.

2. Four Perspectives of the Balanced Scorecard
   1. Financial perspective. This perspective focuses on return on investment and other supporting financial performance measures. Example performance measures include profitability, return on invested capital, and revenue growth.
   2. Customer perspective. This perspective focuses on performance in areas that are most critical to the customer. Example performance measures include customer satisfaction and customer retention.
   3. Internal business processes perspective. This perspective focuses on operating effectively and efficiently and includes performance measures on cost, quality and time for processes that are critical to the customers. It focuses on business processes, which are the structured activities of an organization that produce a product or service. Example performance measures include number of defects and cycle time.
   4. Learning and growth perspective. This perspective focuses on performance measures relating to employees, infrastructure, teaming and capabilities necessary for the internal processes to achieve customer and financial objectives. Example performance measures include employee satisfaction, hours of training per employee, and information technology expenditures per employee.
3. Components of the Balanced Scorecard
   1. Strategic objectives. A statement of what the strategy must achieve and what is critical to its success.
   2. Performance measures. Describe how success in achieving the strategy will be measured and tracked.
   3. Baseline performance. The current level of performance for the performance measure.
   4. Targets. The level of performance or rate of improvement needed in the performance measure.
   5. Strategic initiatives. Key action programs required to achieve strategic objectives.

      Strategic objectives focus on what is to be achieved. Strategic initiatives focus on how it will be achieved and performance measures, baseline performance and targets relate to how it will be measured.

      The value chain in the balanced scorecard framework is the sequence of business processes in which usefulness is added to the products or services of a company and includes the innovation process, operations process, and post-sales process. The value chain is one way to describe the internal process perspective in the balanced scorecard and its performance measures.

4. Characteristics of the Balanced Scorecard

   Characteristic of the balanced scorecard include the following:

   • Strategy-focused. Performance measures are driven by mission, vision and strategy. The balanced scorecard communicates the strategy to all members of the organization.
   • Balanced. Performance measures are “balanced” in terms of financial and nonfinancial measures, leading and lagging measures and internal (internal processes) and external (customer) measures. Accordingly, the scorecard highlights suboptimal tradeoffs that managers may make when they fail to consider operational and financial measures together.
   • Includes both financial and nonfinancial measures. Performance measures include traditional financial measures, as well as nonfinancial measures.
   • Cause-and-effect linkages. Performance measures are connected using cause-and-effect linkages. Performance measures include performance drivers (leading indicators) and outcome performance measures (lagging indicators). The focus on cause and effect linkages limits the number of measures used by identifying the most critical ones.
   • Unique to the strategy. Performance measures are unique and customized to an organization's strategy.
5. Strategy Maps and Cause-and-Effect Linkages

   Strategy maps are diagrams of the cause-and-effect relationships between strategic objectives. When looking at cause and effect linkages in the balanced scorecard framework, it is important to remember that the classification of performance measures as leading or lagging is not a dichotomy, but rather must be considered as a continuum. For example, customer satisfaction may be a leading indicator (performance driver) to return on investment (the lagging indicator or outcome measure). However, customer satisfaction may be a lagging indicator to on-time delivery (the leading indicator).

   EXAMPLE

   Balanced scorecard

   The following is a simple example of a balanced scorecard. Within each of the four perspectives are key strategic objectives and related performance measures.

   Financial perspective

   Strategic objective	Performance measure
   Increase return on investment (ROI)	ROI
   Revenue growth	Percent growth in revenue
   Increase profitability	Net income as a percentage of sales

   Customer perspective

   Strategic objective	Performance measure
   Increase customer satisfaction	Customer satisfaction ratings
   Increase customer share	Revenue per customer
   Attract new customers	Number of new customers
   	Revenue from new customers

   Internal business processes perspective

   Strategic objective	Performance measure
   Improve on-time delivery	Percentage of on-time deliveries
   Improve quality performance	Number of rejects

   Learning and growth perspective

   Strategic objective	Performance measure
   Train employees on quality tools	Hours of training on quality tools
   Use information systems to manage on-time delivery status	Percent of employees using information system

   In this example, we see possible cause-and-effect relationships. Increasing the training in the use of quality tools may improve on-time delivery performance which may improve customer satisfaction and therefore increase return on investment. The connection between customer satisfaction and return on investment at some companies is based on the following observation: more satisfied customers pay invoices faster, therefore accounts receivable turnover (a component of return on assets) increases and return on investment increases.

6. Performance Measures in the Balanced Scorecard

   Here are examples of performance measures that are classified within the four perspectives of the balanced scorecard.

   Financial perspective

   Return on investment

   Economic profit

   Economic value added

   Cash flow ROI

   Free cash flow

   Net income/sales ratio

   Sales/asset ratio

   Revenue growth

   Revenue from new products (existing customers)

   Revenue from new products (new customers)

   Cost of sales %

   Customer perspective

   Customer satisfaction

   Customer retention

   Customer acquisition

   Percentage of highly satisfied customers

   Depth of relationship

   Percentage of business from customer referrals

   Customer satisfaction with new product/service offerings

   Internal process perspective

   On-time delivery

   Cost per unit

   Percentage of late orders

   Total cost of quality

   Cycle time

   Process efficiency

   Capacity utilization

   Inventory turnover

   Lead times (order to delivery)

   Internal process perspective

   Percentage of on-time deliveries

   Time to resolve customer complaints

   Inventory obsolescence

   Order backlog

   Number of leads/conversion rate

   Hours with customers

   Time spent with target accounts

   Number of new projects based on client input

   Number of joint projects

   Number of technology and product partners

   Number of patents

   Total time from concept to market

   Time from pilot to full production

   Manufacturing-process yield

   Number of failures, defects, and customer returns

   Warranty costs

   Number of safety incidents

   Learning and growth perspective

   Employee satisfaction and engagement

   Employee turnover

   Employee objectives linked to the balanced scorecard

   Employee awareness of the strategy

   Percentage of employees trained in total quality management

   Number of six-sigma black belts

   Performance improvement from employees' suggestions

   Percentage of ideas and best practices shared across organization

   Percentage of R&D employees to total employees

   R&D expenditure as a percent of sales revenue

C. Value-Based Management (VBM) and Financial Performance Measures

VBM involves the use of value-based metrics (performance measures) in a strategic management system and as such may be viewed as a financial scorecard. The spectrum of value-based metrics include performance measures such as: return on investment (ROI), economic profit, economic value added (EVA), cash flow ROI, and residual income.

When is it appropriate to use economic value added measures (EVA) (or other value-based metrics) as a performance measure? EVA is particularly useful for incentive compensation, resource allocation and investor relations. Executive compensation and incentive compensation firmwide have been the most popular target of EVA. The premise is “pay for performance” where performance is defined as creating financial value (earning a return above the cost of capital). Using EVA alone can have certain disadvantages by failing to reflect all the pathways to value creation. This limitation can be minimized by integrating EVA with a balanced scorecard framework which would avoid the temptation to focus only on low-hanging fruit (cost reduction and increased asset intensity) but miss the opportunity to create additional value through growth strategies.

1. Return on Investment (ROI)

   Return on investment is the ratio of a measure of “return” divided by a measure of “investment.” There are various ways to measure ROI including: return on assets (ROA), return on net assets (RONA) and return on equity (ROE). ROI is most often computed using net income (income after interest and taxes) but it also may be computed using operating income or operating income after taxes.

2. DuPont ROI Analysis

   DuPont ROI analysis looks at ROI as driven by two factors: return on sales (net income/sales) and asset turnover (sales/total assets). The calculation of DuPont ROI is as follows:

   

   The DuPont method highlights the two basic ways to improve profits: (1) increasing income per dollar of sales, and (2) using assets to generate more sales.

   EXAMPLE

   The following selected data pertain to the Amy Division of Cara Products, Inc. for 2012:

   Sales	$20,000,000
   Average invested capital (total assets)	5,000,000
   Net income	1,250,000
   Cost of capital	10%

   ROI (based on total assets) and DuPont ROI would be calculated as follows:

   

   The return on sales of 6.25% times the asset turnover ratio of 4.0 equals the ROI of 25%.

3. Residual Income

   Residual income is net income (or operating income after taxes) minus a cost of capital based on capital invested in a division or project.

   

   EXAMPLE

   Using the data from the previous example for Amy Division

   

   Remember that the ROI was 25% for this company and the required interest rate is 10%. The difference between the ROI and the required interest rate (cost of capital) is sometimes called the spread. In this case the spread can be computed as follows:

   

   Notice that the residual income of $750,000 divided by the invested capital of $5,000,000 equals the spread of 15%.

4. Residual Income Profile

   The residual income profile is a graphical way to look at the relationship between residual income and ROI.

   The residual income profile shows the interrelationship between residual income and ROI. The vertical axis shows residual income in dollars. The horizontal axis shows the implicit cost of capital and ROI.

   The formula for the residual income profile is

   Residual income = Net income − i (invested capital)

   Where: i = cost of capital or required rate of return for computing residual income

   The formula for the residual income profile is the same as the formula for residual income with the required rate of return as the coefficient. As the required rate of return increases, residual income decreases. Where residual income is zero, the required rate of return equals the ROI.

   

   EXAMPLE

   The following information is available for Iceman, Inc. for 2012:

   Net income	$ 300,000
   Average invested capital	$2,000,000
   Cost of capital	12%

   The ROI and residual income are computed below.

   

   

   Notice that at an interest rate of 15%, the residual income is zero.

5. Economic Profit and EVA

   Economic profit and economic value added measures stress the importance of making investments only when the return exceeds cost and, in the process, value to the stockholder is maximized. Economic profit is accounting profit minus the cost of capital. EVA is a variation of economic profit. Economic Value Added (EVA) is net operating profit (income) after taxes (NOPAT) minus the after-tax weighted-average cost of capital (WACC) multiplied by total assets (TA) minus current liabilities (CL) (net assets).

   EVA = Net operating profit after taxes (NOPAT) − [(TA − CL) × WACC]

   Market value added is the difference between the market value of a company (both equity and debt) and the capital that lenders and shareholders have entrusted to it over the years in the form of loans, retained earnings and paid-in capital. Market value added is a measure of the difference between “cash in” (what investors have contributed) and “cash out” (what they could get by selling at today's prices).

6. Free Cash Flow

   Free cash flow can be computed as follows:

   

   EXAMPLE

   

7. Cash Flow ROI

   Cash flow ROI represents the average real cash return of all existing projects as reflected in the financial statements. The cash flow ROI performance metric is an approximation of the average real internal rate of return earned by a firm on all its operating assets. As discussed in Module 43, the internal rate of return (IRR) is the discount rate that equates the present value of inflows with the present value of outflows.

8. Determination of the Amount of Invested Capital

   The amount of invested capital for computation of performance measures generally is determined in two ways: current cost or historical cost. Current cost is the current replacement cost of the existing investment and provides a better measure of the economic returns from the investment. The drawback to using current cost is that the estimates of current cost may be difficult and costly to obtain. When using historical cost the firm either uses the gross book value (original cost) or the net book value (original cost less accumulated depreciation). Advocates of gross book value indicate that it results in measures that are more comparable across business units. If net book value is used, ROI increases simply due to the effects of annual depreciation.

   Advocates of net book value indicate that it is consistent with the amount of assets shown on the balance sheet and with net income that is calculated after the deprecation deduction. Most firms use net book value to measure investment but may compensate by establishing target ROIs that adjust for the effects of the limitations of historical cost measures of investment.

D. Choosing among Different Performance Measures

1. Choosing among different performance measures involves understanding how the performance measure will be used. Is it being used for executive compensation, resource allocation or business unit performance evaluation? It also involves understanding how well the performance measure enables management to execute business strategy and monitor how well it is being executed. Here are some guidelines for choosing among different performance measures.
   1. Strategy-focused. How well does the performance measure reflect the strategy of the organization? This is where the balanced scorecard framework and the performance measures within the balanced scorecard framework can be useful. A well-designed balanced scorecard will include the right mix of performance measures to communicate and operationalize the strategy.
   2. Economic reality and cash flow. How well does the performance measure reflect the economic reality that a firm must earn a return on capital invested in excess of its cost of capital in order to create financial value? Here is where value-based management and its metrics (ROI, economic profit, free cash flow, and cash flow ROI) can be useful.
   3. Quality of the performance measure. The relevance and reliability of the performance measures also should be considered. For example, relevant and reliable manager performance measures are ones that are sensitive to factors within the control of the manager and not sensitive to factors beyond the manager's control.
2. The most common financial measures used for performance measurement include return on investment (ROI), residual income (RI), economic value added (EVA), and return on sales (ROS). It is important to distinguish between those measures that are used to evaluate the business unit and those that are used to evaluate a manager's performance.
3. Performance measures should not encourage decisions that maximize the measure in the short run but are in conflict with the long-term goals of the firm. For example, a manager could decide to postpone machine maintenance to make ROI for a particular year look better, but the decision may cause long-run profits to suffer. The focus on short-run performance may be mitigated by using measures with multiple-year time horizons or by using a combination of financial and nonfinancial measures. Compensation tied to changes in the value of the firm's stock also encourages managers to take a long-run perspective, because stock prices reflect the future value of current management decisions.
4. A focus on ROI as a performance measure may cause a lack of goal congruence. As an example, managers of very profitable business units may reject projects that from a firm-wide perspective should be accepted. In such situations, RI rather than ROI provides a performance measure that better aligns the goals of business unit managers with the goals of the overall organization.

E. Traditional Financial Statement Analysis

One type of commonly used set of financial measures is derived from traditional financial statement analysis. Financial statement analysis involves the calculation and comparison of financial statement ratios. Financial ratios used to evaluate the financial position and operations of firms typically are classified into the following five categories:

1. Profitability ratios
   • Gross margin
   • Operating profit margin
   • Return on assets
   • Return on equity
   • Dividend payout ratio
2. Asset utilization ratios
   • Receivable turnover
   • Average collection period
   • Inventory turnover
   • Fixed asset turnover
   • Total asset turnover
3. Liquidity ratios
   • Current ratio
   • Quick or acid ratio
4. Debt utilization ratios
   • Debt to total assets
   • Debt to equity
   • Times interest earned
5. Market ratios
   • Price/earnings ratio
   • Market/book ratio

The calculation of these ratios will be illustrated using the following financial statements from Home Depot.

The Home Depot, Inc. and Subsidiaries

CONSOLIDATED BALANCE SHEETS

The Home Depot, Inc. and Subsidiaries

CONSOLIDATED STATEMENTS OF EARNINGS

1. Profitability Ratios

   Profitability ratios measure how effective a firm is at generating profit from operations. They are some of the most closely watched and widely quoted financial ratios. Management attempts to maximize these ratios to maximize firm value.

   1. Gross margin measures the percentage of each sales dollar remaining after payment for the goods sold.

      

      Remember that gross profit is equal to net sales minus cost of goods sold.

   2. To find the proportion of revenue that finds its way into profits, analysts look at profit margin. Profit margin is calculated as net income divided by net sales, as shown below.

      

   3. Operating profit margin measures the percentage of each sales dollar that remains after the payment of all costs and expenses except for interest and taxes. This ratio is followed closely by analysts because it focuses on operating results. Operating profit is often referred to as earnings before interest and taxes or EBIT.

      

   4. Return on assets (return on investment) measures the percentage return generated on the assets available (investment). This ratio may be calculated as

      

      As discussed previously, return on investment is calculated and dissected in a number of ways and is very important to value-based management.

   5. Return on equity measures the percentage return generated to common stockholders.

      

   6. The dividend payout ratio measures the dividend paid in relation to net earnings. If Home Depot's dividend for the year was $0.22, the dividend payout is calculated as

      

2. Asset Utilization (Activity) Ratios

   Asset utilization ratios measure the time it takes to convert various assets to sales or cash. Asset utilization ratios are used to measure the efficiency with which assets are managed. For this reason, they are often called asset management ratios.

   1. Receivables turnover measures the number of times per year the balance of receivables is collected. This is a very important measure of the efficiency with which management is managing accounts receivable.

      

      This ratio cannot be computed for Home Depot since the company does not break out the amount of credit sales.

   2. The average collection period measures the average number of days it takes to collect an account receivable. This ratio is also referred to as the number of days of receivable and the number of days' sales in receivables.

      

      Again, this ratio cannot be calculated for Home Depot because the company does not break out the amount of credit sales.

   3. Inventory turnover measures the efficiency with which a firm utilizes (manages) its inventory.

      

   4. A related measure is the number of days' sales in inventory.

      

   5. Fixed asset turnover measures the efficiency with which the firm uses its fixed assets.

      

   6. Total asset turnover measures the efficiency with which the firm uses its total assets.

      

3. Liquidity Ratios

   Liquidity ratios measure the firm's ability to meet its short-term obligations as they come due.

   1. The current ratio is the most common measure of short-term liquidity. It is sometimes referred to as the working capital ratio because net working capital is the difference between current assets and current liabilities.

      

      • Current assets include cash and cash equivalents, net accounts receivable, marketable securities classified as current, inventories and prepaid expenses.
      • Current liabilities include accounts payable, short-term notes payable, current maturities of long-term debt, unearned revenue, and other accrued liabilities.

        Changes in the current ratio can be misleading. As an example, if management simply borrows money from a bank and invests the funds in marketable securities, both current assets and current liabilities go up by an identical amount. Net working capital is unaffected but the current ratio changes. Thus the current ratio is subject to “window dressing” by management.

   2. The quick (acid) ratio provides a more conservative measure of short-term liquidity. It takes out inventory because in times of financial difficulty inventory may be saleable only at liquidation value.

      

4. Debt Utilization Ratios

   Debt utilization ratios measure the effectiveness with which management finances the assets of the firm. They are used to evaluate the financial leverage of the firm.

   1. The debt to total assets measures the proportion of total assets financed with debt and, therefore, the extent of financial leverage.

      

   2. The debt to equity ratio also measures the extent of the firm's financial leverage.

      

   3. The times interest earned measures the firm's ability to make contractual interest payments.

      

5. Market Ratios

   Market ratios involve measures that consider the market value of the firm's common stock.

   1. The price/earnings (PE) ratio is the most commonly quoted market measure. Assuming that Home Depot's stock price is $34.00, the price/earnings ratio would be computed as follows:

      

   2. The market/book ratio provides another evaluation of how investors view the firm's past and future performance. To calculate the ratio, the book value per share of the firm's stock must first be calculated.

      

      Again, assuming a $34 market price per share of common stock, the market/book ratio is calculated as follows:

      

6. Interpreting Financial Ratios

   How does one decide whether a particular ratio is good or bad? To get value from ratio analysis, the measures must be compared to benchmarks. There are two basic approaches to this analysis, horizontal analysis and cross-sectional analysis. While horizontal analysis involves an evaluation of the firm's ratios and trends over time, cross-sectional analysis involves benchmarking the ratios against ratios of similar firms at a point in time. Industry averages are often used for cross-sectional analysis. Averages for industries are published by the US Department of Commerce, Dun & Bradstreet, Robert Morris Associates, and others. Researching data on firms in the same industry is facilitated through the Standard Industrial Classification (SIC) system.

   The figure below illustrates horizontal (trend) and cross-sectional analysis of a firm's income statement. The figure also illustrates a common-size income statement, in which all revenues and expenses are presented as a percentage of net sales. A common-size balance sheet presents all assets, liabilities and stockholders' equity as a percentage of total assets. The development of common-size financial statements is also known as vertical analysis.

   CARSON CORPORATION

   

   To use ratio analysis effectively, analysts must be aware of the relationship between the items used in calculating the ratio. For example, in comparing the gross margin of a company over time, it should be remembered that this ratio may be affected by the fact that cost of goods sold is made up of fixed and variable costs or the fact that the sales mix has changed.

7. Limitations of Financial Ratios

   While comparing the firm's ratios with those of similar firms in the same industry provides information about the performance of the firm, it does have limitations.

   1. Other firms in the industry may not be comparable due to differences in size, diversification of operations, accounting principles used, different year-ends, etc.
   2. Industry averages may not be reliable (e.g., based on too small a sample of firms).
   3. There are variations in the way ratios are calculated.
   4. Financial statements contain estimates that might distort results.
   5. Ratios are only financial measures and do not provide a balanced view of performance.

F. Benchmarking and Best Practices

Benchmarking is the continuous process of comparing the levels of performance in producing products and services and executing activities against the best levels of performance. It is the search for and implementation of “best practices.” There are different types of benchmarking including:

• Internal benchmarking compares similar operations within different units of the same organization.
• Competitive benchmarking targets processes and methods used by an organization's direct competitors.
• Functional or industry benchmarking compares similar functions within the same broad industry.
• Generic benchmarking compares processes that are independent of industry.

Best practices are the best ways to perform a process. Best practices represent the means by which world-class organizations have achieved superior performance. However, no practice can be considered a “best practice” for all organizations or in all situations. The advice of Dr. W. Edwards Deming applies to benchmarking: “Adapt, don't adopt.”

Benchmarks are the performance metrics used in benchmarking.

G. Quality Control Principles and Tools

1. Total Quality Management (TQM) focuses on managing the organization to excel in quality in all dimensions of products and services for customers.
2. Six-Sigma Quality

   What is six-sigma? A statistical measure expressing how close a product comes to its quality goal. One-sigma means 68% of products are acceptable; three-sigma means 99.7%. Six-sigma is 99.999997% perfect: 3.4 defects per million parts.

   Six-sigma black belts must attend a minimum of four months of training in statistical and other quality improvement methods. Six-sigma black belts are experts in the six-sigma methodology. They learn and demonstrate proficiency in the DMAIC methodology and statistical process control (SPC) techniques within that methodology. DMAIC is the structured methodology for process improvement within the six-sigma framework. It stands for define, measure, analyze, improve, and control.

3. Quality Award Programs

   There are a number of quality award programs. Here is a summary of some of the major programs.

   • Malcolm Baldrige National Quality Award is an award that was established in 1987 to recognize total quality management in American industry. The Baldrige award is given to businesses—manufacturing and service, small and large—and to education and health care organizations that apply and are judged to be outstanding in seven areas: leadership, strategic planning, customer and market focus, information and analysis, human resource focus, process management, and business results. Congress established the award program in 1987 to recognize US organizations for their achievements in quality and performance and to raise awareness about the importance of quality and performance excellence as a competitive edge. The award is not given for specific products or services. Three awards may be given annually in each of these categories: manufacturing, service, small business, education, and health care.
   • The Deming Prize is named after American statistician Dr. W. Edwards Deming, who developed the quality concepts for Japanese industry after World War II.
   • European Quality Award. The European Quality Award is Europe's most prestigious award for organizational excellence. It is open to every high-performing organization in Europe and focuses on recognizing excellence and providing detailed, independent feedback to all applicants to help them on their continuing journey to excellence.
4. ISO Quality Standards

   ISO 9000 Series is a series of standards agreed upon by the International Organization for Standardization (ISO) and adopted in 1987. ISO 9000 evolved in Europe. The ISO Series consists of five parts numbered 9000 through 9004.

   ISO 14000 series was developed to control the impact of an organization's activities on the environment and focuses on reducing the cost of waste management, conserving energy and materials, and lowering distribution costs.

5. Quality Tools and Methods
   1. Total quality control (TQC). The application of quality principles to all company activities. Also known as total quality management (TQM).
   2. Continuous improvement and Kaizen

      Continuous improvement (CI) seeks continual improvement of machinery, materials, labor, and production methods, through various means including suggestions and ideas from employees and customers.

      Kaizen is the Japanese art of continuous improvement. A philosophy of continuous improvement of working practices that underlies total quality management and just-in-time business techniques.

      PDCA (Plan-Do-Check-Act), also called the Deming Wheel, focuses on the sequential and continual nature of the CI process.

   3. Cause-and-effect analysis

      Cause-and-effect (fishbone or Ishikawa) diagrams identify the potential causes of defects. Four categories of potential causes of failure are: human factors, methods and design factors, machine-related factors, and materials and components factors. Cause-and-effect diagrams are used to systematically list the different causes that can be attributed to a problem (or an effect). A cause-and-effect diagram can aid in identifying the reasons why a process goes out of control.

      A Pareto chart is a bar graph that ranks causes of process variations by the degree of impact on quality. The Pareto chart is a specialized version of a histogram that ranks the categories in the chart from most frequent to least frequent. A related concept, the “Pareto Principle” states that 80% of the problems come from 20% of the causes. The Pareto Principle states that: “Not all of the causes of a particular phenomenon occur with the same frequency or with the same impact.”

   4. Control charts and robust design

      Control charts are statistical plots derived from measuring factory processes; they help detect “process drift,” or deviation, before it generates defects. Control charts also help spot inherent variations in manufacturing processes that designers must account for to achieve “robust design.”

      Robust design is a discipline for making designs “production-proof” by building in tolerances for manufacturing variables that are known to be unavoidable.

   5. Poka-yoke (mistake-proofing). Poka-yoke involves making the workplace mistake-proof. For example, a machine fitted with guide rails permits a part to be worked on in just one way.

H. Cost of Quality

Cost of quality is based on the philosophy that failures have an underlying cause, prevention is cheaper than failures, and cost of quality performance can be measured. Cost of quality consists of four components.

• Prevention cost
• Appraisal cost
• Internal failure cost
• External failure cost

1. Prevention cost. The cost of prevention is the cost of any quality activity designed to help do the job right the first time. Examples of prevention cost include:
   • Quality engineering
   • Quality training
   • Quality circles
   • Statistical process control activities
   • Supervision of prevention activities
   • Quality data gathering, analysis, and reporting
   • Quality improvement projects
   • Technical support provided to suppliers
   • Audits of the effectiveness of the quality system
2. Appraisal cost. The cost of quality control including testing and inspection. It involves any activity designed to appraise, test, or check for defective products. Examples of appraisal costs include:
   • Testing and inspection of incoming materials
   • Testing and inspection of in-process goods
   • Final product testing and inspection
   • Supplies used in testing and inspection
   • Supervision of testing and inspection activities
   • Depreciation of test equipment
   • Maintenance of test equipment
   • Plant utilities in the inspection area
   • Field testing and appraisal at customer site
3. Internal failure cost. The costs incurred when substandard products are produced but discovered before shipment to the customer. Examples of internal failure costs include:
   • Scrap
   • Spoilage
   • Rework
   • Rework labor and overhead
   • Reinspection of reworked products
   • Retesting of reworked products
   • Downtime caused by quality problems
   • Disposal of defective products
   • Analysis of the cause of defects in production
   • Reentering data because of keying errors
   • Debugging software errors
4. External failure cost. The cost incurred for products that do not meet requirements of the customer and have reached the customer. Examples of external failure costs include
   • Cost of field servicing and handling complaints
   • Warranty repairs and replacements
   • Product recalls
   • Liability arising from defective products
   • Returns and allowances arising from quality problems
   • Lost sales arising from reputation for poor quality

I. Business Process Management

Business process management focuses on continuously improving processes to align all activities with the desires and needs of the customer. As a managerial approach, business process management views processes as strategic assets that must be understood, managed, and improved. To improve processes, management focuses on both the human and technological aspect of processes, and the interaction of the two. Many organizations are finding it productive to improve processes by focusing on this human—technology interaction, as they try to develop technology that is designed for a task and the way the particular individual works.

The life cycle of business process management includes design, modeling, execution, monitoring, and optimization.

1. Design

   The design phase involves identification of existing processes and design of process improvements. Good process design is critical to preventing problems over the life of the process.

2. Modeling

   In the modeling phase management simulates the process in a test environment and performs “what if” analysis to try to determine how it will work under varying conditions.

3. Execution

   Execution involves installing software, training personnel, and implementing the new processes. It also involves testing the new processes.

4. Monitoring

   The monitoring phase is continuous after the execution phase. It involves tracking the processes with performance statistics.

5. Optimization

   This phase of the life cycle involves retrieving performance statistics from modeling or monitoring and identifying potential bottlenecks or other problems for additional improvement of the process.

   As processes are analyzed for improvement, it is sometime discovered that processes that were once performed by several departments should be centralized in one department. For example, employee training might become a centralized process to improve efficiency and effectiveness. Alternatively, management may decide to outsource a process to an external organization, or even outsource a process to an organization in another country (often referred to as off-shoring). There are a number of reasons that an organization may decide to outsource or off-shore, including costs saving, quality improvement, tax benefit, scalability, or to focus on core competencies. However, such strategy may present additional risks, including

   • Quality risk. The company may have less control over the quality of outsourced or off-shored activities.
   • Language risk. Control over activities and customer service may be affected by language issues.
   • Information security risk. Control over confidential company or customer information may be put at risk.
   • Intellectual property risk. Information about the company's products and processes may be put at risk.
   • Public opinion risk. The company's reputation may be put at risk because it is off-shoring jobs.
   • Social responsibility risk. The company's reputation may be put at risk based on the practices of the organizations used in other countries.

   Obviously, the company can implement policies and controls, including requiring effective operating agreements, to mitigate these risks.

6. Other techniques that focus on improving processes include
   1. Reengineering (business process reengineering) is the fundamental rethinking and redesign of business processes to achieve improvements in critical measures of performance such as cost, quality, service speed and customer satisfaction. The scope of reengineering can affect operations and manufacturing processes, as well as financial and administrative processes such as accounts payable and procurement and can impact internal controls.
   2. Lean manufacturing philosophy. Lean manufacturing is an operational strategy focused on achieving the shortest possible cycle time by eliminating waste. It is based on increasing the value-added work by eliminating waste and reducing incidental work. The technique often decreases the time between a customer order and shipment, and it is designed to improve profitability, customer satisfaction, throughput time, and employee morale.
   3. Theory of constraints (TOC) refers to methods to maximize operating income when faced with some bottleneck operations. Bottleneck resources are any resource or operation where the capacity is less than the demand placed upon it. Nonbottleneck resources have capacity greater than demand. The objective of TOC is to increase throughput contribution while decreasing investment and operating costs. Throughput contribution is revenues minus the direct materials cost of goods sold. Investment is the sum of materials, cost in direct materials, work in process and finished goods inventories; research and development costs; and the costs of equipment and buildings. Operating costs include the salaries and wages, rental expense, utilities, and depreciation.
   4. Workflow Analysis examines the overall flow of work to find ways to improve the flow. It focuses on identifying non-value-added activities and interdependence among various departments. By eliminating non-value-added activities and improving the coordination among departments, efficiencies may be achieved.

J. Project Management

A project is a series of activities and tasks that

• Have specific definable objectives,
• Have defined start and end dates,
• Are subject to funding constraints,
• Consume resources, people, equipment, etc., and
• Cut across various functional areas of the organization.

Projects are usually planned and executed by multidisciplinary teams, consisting of individuals from different functional areas and led by a project manager. Team members must be knowledgeable and able to work together to plan and execute work in a team setting. Some projects are assigned a project oversight or steering group which takes responsibility for the business issues related to the project. These committees are responsible for approving budgetary strategy, defining and realizing benefits, and monitoring risks, quality and timeliness.

Effective project management involves efficiently achieving the project objectives within time and cost constraints. To achieve effective project management, the project leader must manage the four basic elements of a project, including

1. Resources—people, equipment, materials, etc.
2. Time—task durations, task interdependencies, the critical path, etc.
3. Money—costs, contingencies, profit, etc.
4. Scope—project size, goals, requirements, etc.

The processes involved in project management include project initiation, project planning, project execution, project monitoring and control, and project closure.

1. Project initiation includes
   1. Selection of the best project given resource constraints.
   2. Recognizing the benefits of the project.
   3. Authorizing the project. The project must have full support of management of the organization. Since projects often cross functional lines, a commitment by top management of the organization is critical to the success of any project.
   4. Assigning the project manager (leader). The project manager should be competent and have sufficient authority to get access to needed resources and people the project manager should have planning skills, organizational skills, negotiating skills, administration skills, resource allocation skills, and entrepreneurial skills. A project charter authorizes the project, and sets forth the project manager's authority and responsibility.
2. Project planning involves determining the activities that need to be performed, who should perform them, and when the activities need to be completed. Planning includes
   1. Defining the work requirements.
   2. Defining the quality and quantity of the work.
   3. Indentifying the needed resources.
   4. Scheduling the activities and tasks.
   5. Indentifying and assessing risks.

   The planning process results in a number of documents. The scope of the work is often set forth in a statement of work (SOW), which is a narrative description of the work to be performed to complete the project, including the deliverables. One of the most common reasons for a scope change in a project is a poorly defined statement of work.

   The statement of work often includes the project specifications, which is a detailed listing of the man-hour, equipment, and materials requirements. The milestone schedule sets forth the start date, the end date and other major milestones involved in completing the project. Finally, the work breakdown structure (WBS) breaks the project into manageable, independent, and measureable elements that can be budgeted and for which responsibility can be assigned. The WBS provides a basis for costing, risk analysis, control, and scheduling the project.

   Many companies use a life-cycle approach in planning, in which project planning is divided into defined phases, such as conceptualization, feasibility study, etc. At the end of each phase an assessment is done to evaluate the success of the phase and determine whether the next phase should be undertaken.

3. Many different techniques are used to schedule and control a project, including
   1. Gantt chart—a type of bar chart that illustrates the scheduled start and finish of elements of a project over time.
   2. Milestone chart—a type of chart that illustrates the milestones for a project over time.
   3. Line of balance—a type of chart that illustrates the series of activities that are related. It is appropriate where a project has a series of repetitive activities.
   4. Network diagram—illustrates the logical representation of activities that defines the sequence of the work of a project. It illustrates the path of a project. A network diagram has advantages over other forms of techniques because it (1) illustrates the interdependencies between activities, (2) identifies critical paths in a project, (3) facilitates risk analysis for the activities in the project, and (4) enables management to evaluate the effect of an activity delay on the project completion date.
   5. Program Evaluation and Review Technique (PERT)—PERT is a network technique that formally focuses on the interdependency of activities and the time required to complete an activity to schedule and control the project. This technique focuses on the critical path, which is the shortest amount of time necessary to accomplish the project. Any slippage in the time of performing the activities along the critical path will result in a delay in completion of the project. Therefore, management knows which activities and events are most critical to timely completion of the project. PERT uses three time estimates (optimistic, most likely, and pessimistic) to derive expected time to complete a particular task. In PERT analysis slack time is the difference between the expected time and the latest time the activity can be completed without delaying the project. PERT is probabilistic in nature which allows the calculation of the risk in completing the project. PERT is typically used where there is a high variability of completion times, such as research and development projects.
   6. PERT cost—allows the addition of resource cost considerations to the schedule produced by the PERT technique. This allows the inclusion of cost uncertainty into the analysis.
   7. Critical Path Method (CPM)—CPM is similar to PERT but it only uses one time estimate that represents the normal time to complete an activity. CPM is used for projects where there is less variability in time estimates. CPM includes a procedure for time/cost tradeoff to minimize the sum of direct and indirect project costs.
   8. Graphical Evaluation and Review Technique (GERT)—GERT is similar to PERT but it has the advantage of allowing looping and branching based on the results of a particular activity. It is appropriate for projects that may be completed in a number of ways.
   9. Project crashing is a term used to describe the practice of adding resources to shorten selected activity time on the critical path of a project. In effect, the manager is trading off money for time. Therefore, each activity may be viewed as having two types—a normal (planned) time and the crash time (the shortest possible time).
   10. Another technique that is often used in conjunction with any of these scheduling techniques is ABC analysis. ABC analysis involves the categorization of tasks into groups. These groups are often marked A, B, and C—hence the name. Activities are ranked upon the following general criteria:

       A—Tasks that are perceived as being urgent and important.

       B—Tasks that are important but not urgent.

       C—Tasks that are neither urgent nor important.

       Then, each group is rank-ordered in priority. This technique is particularly applicable to project management because it focuses attention on the critical activities or tasks.

       Risk management is also applicable to project management. Project risks include those related to costs overruns, time slippage, inappropriately defined scope, and dissatisfaction with the deliverables. The steps in the risk management of a project include (1) identification of risks, (2) quantifying the risks, (3) prioritizing risks, and (4) developing a risk response. Like any type of risk management the response may involve such activates as developing controls or shifting the risk to another party.

4. Project execution includes
   1. Negotiating for the team members.
   2. Directing the work.
   3. Managing team members to improve performance.

   Management of a project requires much the same skills as managing any function. However, if the project crosses functional lines, the management process becomes complicated. Problems in project management typically arise from one of the following:

   • Organizational uncertainty. The working relationship between the project manager and the functional managers has not been adequately defined by senior management.
   • Unusual decision pressures. Project managers must make quick decisions in uncertain situations and with incomplete information. Senior management must recognize these difficulties and support the project manager's decisions.
   • Inadequate senior management support. Delays in approval, inability to resolve reporting conflicts, and delays in providing resources can significantly delay or derail projects.
5. Project monitoring and control includes
   1. Tracking progress of the project.
   2. Comparing actual outcomes to predicted outcomes.
   3. Analyzing variances and their effects.
   4. Making adjustments.

   Many of the typical management techniques are used to control projects, including budgets, variance analysis, and status analysis. The scheduling techniques discussed above also facilitate control of the project by allowing management to focus its attention on critical activities.

6. Project closure includes
   1. Determining that all work has been completed.
   2. Closure of the contract, financial charges, and paperwork.

KEY TERMS

Balanced scorecard. A strategic performance measurement system that includes financial and nonfinancial performance measures. The measures are in the four perspectives of financial, customer, internal business processes, and learning and growth.

Cash flow ROI. The average real cash return on all existing projects as reflected in the financial statements.

Continuous improvement. Seeks continual improvement of machinery, materials, labor, and production methods by soliciting suggestions and ideas from employees and customers.

Cost of quality. A technique that is based on the philosophy that failures have an underlying cause, prevention is cheaper than failures, and cost of quality performance can be measured.

Cross-sectional analysis. Involves benchmarking the firm's ratios against ratios of similar firms at a point in time.

Economic profit. Accounting profit minus the cost of capital.

Economic value added. Net operating profit after taxes minus the after-tax weighted-average cost of capital multiplied by total assets minus current liabilities.

Free cash flow. Net operating profit after taxes plus depreciation and amortization minus capital expenditures minus the change in working capital requirements.

Horizontal analysis. Involves an evaluation of the firm's ratios and trends over time.

Kaizen. The Japanese art of continuous improvement.

Pareto chart. A bar graph that ranks causes of process variations by the degree of impact on quality.

Strategy maps. Diagrams of the cause and effect relationships between strategic objectives.

Residual income. Net income minus a cost of capital based on capital invested in the project or division.

Residual income profile. A graphical way to look at the relationship between residual income and return on investment.

Total quality management. Focuses on managing the firm to excel in quality in all dimensions of products and services for customers.

Value-based management. Involves the use of value-based metrics in a strategic management system.

Multiple-Choice Questions (1–76)

Balanced Scorecard and Performance Measures

1. What is the most important purpose of a balanced scorecard?

1. Develop strategy.
2. Measure performance.
3. Develop cause-and-effect linkages.
4. Set priorities.

2. Which of the following is not one of the four perspectives of the balanced scorecard?

1. Investment in resources perspective.
2. Customer perspective.
3. Learning and growth perspective.
4. Financial perspective.

3. The balanced scorecard generally uses performance measures with four different perspectives. Which of the following performance measures would be part of those used for the internal business processes perspective?

1. Cycle time.
2. Employee satisfaction.
3. Hours of training per employee.
4. Customer retention.

4. The balanced scorecard has been adopted by many corporations. Which of the following best describes the balanced scorecard?

1. A strategy that meets management's objectives.
2. A diagram illustrating cause and effect relationships.
3. A table of key actions to achieve strategic objectives.
4. A strategic performance measurement and management framework.

5. The balanced scorecard and value-based management are techniques that are being used by a number of corporations. In comparison to the balanced scorecard, value-based management focuses on

1. Nonfinancial measures.
2. Financial measures.
3. Both financial and nonfinancial measures.
4. Quality measures.

6. Management has identified a relationship between customer satisfaction and return on investment. This relationship could be depicted in a

1. Strategy map.
2. Value chain.
3. Customer perspectives chart.
4. Strategic initiatives list.

7. Which of the following is not a component of the balanced scorecard?

1. Strategic objectives.
2. Targets.
3. Strategy initiatives.
4. Assessment of human resources.

8. Which of the following best describes a value chain in the balanced scorecard framework?

1. The cause-and-effect linkages.
2. The baseline level of performance.
3. The sequence of business processes in which usefulness is added to products or services.
4. The chain of financial and nonfinancial measures.

9. Which of the following is not a characteristic of the balanced scorecard?

1. Both financial and nonfinancial performance measures are included.
2. Cause-and-effect linkages between strategic objectives.
3. Customer performance measures are excluded.
4. Internal process performance measures are included.

10. In the balanced scorecard framework, a survey of employee satisfaction is a potential measure in which of the four perspectives?

1. Financial.
2. Customer.
3. Internal business processes.
4. Learning and growth.

*11. Which of the following is an example of an efficiency measure?

1. The rate of absenteeism.
2. The goal of becoming a leading manufacturer.
3. The number of insurance claims processed per day.
4. The rate of customer complaints.

12. A strategy objective in the balanced scorecard framework is

1. A statement of what the strategy must achieve and what is critical to its success.
2. Key action programs required to achieve strategic objectives.
3. Diagrams of the cause-and-effect relationships between strategic objectives.
4. The level of performance or rate of improvement needed in the performance measure.

13. A target in the balanced scorecard framework is

1. A statement of what the strategy must achieve and what is critical to its success.
2. A key action program required to achieve strategic objectives.
3. A diagram of the cause-and-effect relationships between strategic objectives.
4. The level of performance or rate of improvement needed in the performance measure.

Value-Based Management: ROI and Residual Income

Items 14 through 18 are based on the following information:

The following is selected data for the Consumer Products division of Arron Corporations for 200X:

Sales	$50,000,000
Average invested capital (assets)	20,000,000
Net income	2,000,000
Cost of capital	8%

14. What is the return on sales (ROS) for the division?

1. 8%
2. 4%
3. 10%
4. 20%

15. What is the asset turnover ratio for the division?

1. .25
2. 10
3. 2.5
4. 8

16. What is the return on investment (ROI) for the division?

1. 10%
2. 8%
3. 4%
4. 2%

17. What is the amount of residual income (RI) for the division?

1. $2,000,000
2. $1,600,000
3. $1,000,000
4. $400,000

18. What is the amount of interest rate spread for the division?

1. 8%
2. 10%
3. 2%
4. 20%

Items 19 and 20 are based on the following information:

The following data is available for Cara Corp. for 2012:

Sales	$2,000,000
Average invested capital	500,000
Net income	300,000
Required rate of return	18%

19. What is the return on investment at Cara Corp.?

1. 60%
2. 33%
3. 18%
4. 15%

20. What is the residual income for Cara Corp.?

1. $0
2. $200,000
3. $210,000
4. $246,000

Items 21 and 22 are based on the following information:

On the graph below, the line (A-B-C) illustrates residual income (measured on the vertical axis in dollars) at various interest rates. Point D is the cost of capital or the required rate of return. Point E is the residual income at the cost of capital.

21. What does point B represent?

1. Return on sales.
2. Return on investment.
3. Asset turnover.
4. Operating income.

22. What does point A represent?

1. Return on sales.
2. Return on investment.
3. Asset turnover.
4. Net income.

23. On the graph below, lines A-B-C and D-E-F illustrates residual income (measured on the vertical axis in dollars) at various interest rates. Point G is the firm's cost of capital. Line ABC represents the residual income of Division X at various interest rates. Line DEF represents the residual income of Division Y at various interest rates.

Based on the graph above, for Division X versus Division Y, is the residual income and ROI for Division X greater than or less than that of Division Y?.

24. A company's rate of return on investment (ROI) is equal to the

1. Percentage of profit on sales divided by the capital employed turnover rate.
2. Percentage of profit on sales multiplied by the capital employed turnover rate.
3. Investment capital divided by the capital employed turnover rate.
4. Investment capital multiplied by the capital employed turnover rate.

25. Return on investment can be increased by

1. Increasing operating assets.
2. Decreasing operating assets.
3. Decreasing revenues.
4. Both b. and c.

26. The following information pertains to Bala Co. for the year ended December 31, 2012:

Sales	$600,000
Net income	100,000
Capital investment	400,000

Which of the following equations should be used to compute Bala's return on investment?

1. (4/6) × (6/1) = ROI
2. (6/4) × (1/6) = ROI
3. (4/6) × (1/6) = ROI
4. (6/4) × (6/1) = ROI

27. Select Co. had the following 2012 financial statement relationships:

Asset turnover	5
Profit margin on sales	0.02

What was Select's 2012 percentage return on assets?

1. 0.1%
2. 0.4%
3. 2.5%
4. 10.0%

28. The following selected data pertain to the Darwin Division of Beagle Co. for 2012:

Sales	$400,000
Net income	40,000
Capital turnover	4
Imputed interest rate	10%

What was Darwin's 2012 residual income?

1. $0
2. $ 4,000
3. $10,000
4. $30,000

29. Division A is considering a project that will earn a rate of return which is greater than the imputed interest charge for invested capital, but less than the division's historical return on invested capital. Division B is considering a project that will earn a rate of return that is greater than the division's historical return on invested capital, but less than the imputed interest charge for invested capital. If the objective is to maximize residual income, should these divisions accept or reject their projects?

30. Which combination of changes in asset turnover and income as a percentage of sales will maximize the return on investment?

*31. Residual income is often preferred over return on investment (ROI) as a performance evaluation because

1. Residual income is a measure over time while ROI represents the results for a single time period.
2. Residual income concentrates on maximizing absolute dollars of income rather than a percentage return as with ROI.
3. The imputed interest rate used in calculating residual income is more easily derived than the target rate that is compared to the calculated ROI.
4. Average investment is employed with residual income while year-end investment is employed with ROI.

Value-Based Management: EVA

32. What is a major disadvantage of using economic value added (EVA) alone as a performance measure?

1. It fails to focus on creating shareholder value.
2. It promotes the acceptance of unprofitable projects.
3. It fails to reflect all of the ways that value may be created.
4. It discourages cost cutting.

Items 33 and 34 are based on the following information:

The following are selected data for Walkin Corporation for the year ended 20X1:

Net operating profit before taxes	$31,250,000
Inventory	5,000,000
Long-term debt	40,000,000
Depreciation expense	9,000,000
Change in net working capital	5,000,000
Capital expenditures	8,000,000
Invested capital (net assets)	80,000,000
Weighted average cost of capital	10%
Tax rate	20%

33. Which of the following measures economic value added for Walkin Corporation for the year?

1. $3,000,000
2. $7,000,000
3. $15,000,000
4. $17,000,000

34. Which of the following measures the amount of free cash flow for Walkin Corporation for the year?

1. $7,000,000
2. $8,000,000
3. $21,000,000
4. $25,000,000

35. The following information is available for the wholesale products division of Watco:

Net operating profit before interest and taxes	$30,000,000
Depreciation expense	10,000,000
Change in net working capital	5,000,000
Capital expenditures	4,000,000
Invested capital (total assets − current liabilities)	50,000,000
Weighted-average cost of capital	10%
Tax rate	40%

What is the amount of economic value added (EVA) for the division?

1. $30,000,000
2. $13,000,000
3. $25,000,000
4. $ 5,000,000

Items 36 and 37 are based on the following information:

The following information is available for Armstrong Enterprises for 2012:

Net operating profit (income) after taxes	$36,000,000
Depreciation expense	15,000,000
Change in net working capital	10,000,000
Capital expenditures	12,000,000
Invested capital (total assets − current liabilities)	100,000,000
Weighted-average cost of capital	10%

36. What is the amount of the economic value added (EVA)?

1. $20,000,000
2. $26,000,000
3. $15,000,000
4. $36,000,000

37. What is the free cash flow for 2012?

1. $36,000,000
2. $30,000,000
3. $29,000,000
4. $26,000,000

Traditional Financial Statement Analysis

38. Which of the following is not a measure of asset utilization?

1. Inventory turnover.
2. Average accounts receivable collection period.
3. Fixed asset turnover.
4. Debt to total assets.

39. What financial analysis technique would imply benchmarking with other firms?

1. Horizontal analysis.
2. Vertical analysis.
3. Cross-sectional analysis.
4. Ratio analysis.

Items 40 and 41 are based on the following information:

The Dawson Corporation projects the following for the year 2012:

Earnings before interest and taxes	$35 million
Interest expense	5 million
Preferred stock dividends	4 million
Common stock dividend payout ratio	30%
Common shares outstanding	2 million
Effective corporate income tax rate	40%

^**40. The expected common stock dividend per share for Dawson Corporation for 2012 is

1. $2.34
2. $2.70
3. $3.90
4. $2.10

^**41. If Dawson Corporation's common stock is expected to trade at a price/earnings ratio of eight, the market price per share (to the nearest dollar) would be

1. $125
2. $56
3. $72
4. $68

Items 42 through 46 are based on the following information:

The data presented below show actual figures for selected accounts of McKeon Company for the fiscal year ended December 31, 2012. McKeon's controller is in the process of reviewing the 2012 results. McKeon Company monitors yield or return ratios using the average financial position of the company. (Round all calculations to three decimal places if necessary.)

2012 Operations

Sales*	$350,000
Cost of goods sold	160,000
Interest expense	3,000
Income taxes (40% rate)	48,000
Dividends declared and paid in 2012	60,000
Administrative expense	67,000

* All sales are credit sales.

**42. McKeon Company's debt-to-total-asset ratio at 12/31/12 is

1. 0.352
2. 0.315
3. 0.264
4. 0.237

^**43. The 2012 accounts receivable turnover for McKeon company is

1. 1.882
2. 3.500
3. 5.000
4. 4.118

^**44. Using a 365-day year, McKeon's inventory turnover is

1. 2.133
2. 2.281
3. 1.995
4. 4.615

^**45. McKeon Company's total asset turnover for 2012 is

1. 0.805
2. 0.761
3. 0.722
4. 0.348

^**46. The 2012 return on assets for McKeon Company is

1. 0.261
2. 0.148
3. 0.157
4. 0.166

Items 47 through 53 are based on the following information:

Depoole Company is a manufacturer of industrial products and employs a calendar year for financial reporting purposes. These questions present several of Depoole's transactions during the year. Assume that total quick assets exceeded total current liabilities both before and after each transaction described. Further assume that Depoole has positive profits during the year and a credit balance throughout the year in its retained earnings account.

^**47. Payment of a trade account payable of $64,500 would

1. Increase the current ratio but the quick ratio would not be affected.
2. Increase the quick ratio but the current ratio would not be affected.
3. Increase both the current and quick ratios.
4. Decrease both the current and quick ratios.

^**48. The purchase of raw materials for $85,000 on open account would

1. Increase the current ratio.
2. Decrease the current ratio.
3. Increase net working capital.
4. Decrease net working capital.

^**49. The collection of a current accounts receivable of $29,000 would

1. Increase the current ratio.
2. Decrease the current ratio and the quick ratio.
3. Increase the quick ratio.
4. Not affect the current or quick ratios.

^**50. Obsolete inventory of $125,000 was written off during the year. This transaction

1. Decreased the quick ratio.
2. Increased the quick ratio.
3. Increased net working capital.
4. Decreased the current ratio.

^**51. The issuance of new shares in a five-for-one split of common stock

1. Decreases the book value per share of common stock.
2. Increases the book value per share of common stock.
3. Increases total shareholders' equity.
4. Decreases total shareholders' equity.

^**52. The issuance of serial bonds in exchange for an office building, with the first installment of the bonds due late this year,

1. Decreases net working capital.
2. Decreases the current ratio.
3. Decreases the quick ratio.
4. Affects all of the answers as indicated.

^**53. The early liquidation of a long-term note with cash affects the

1. Current ratio to a greater degree than the quick ratio.
2. Quick ratio to a greater degree than the current ratio.
3. Current and quick ratio to the same degree.
4. Current ratio but not the quick ratio.

Benchmarking and Best Practices

54. Southwest Airlines benchmarked the process of turning around an airplane with the pit stop process for formula racecars. This is an example of

1. Internal benchmarking.
2. Generic benchmarking.
3. Competitor benchmarking.
4. Functional benchmarking.

55. Which measures would be useful in evaluating the performance of a manufacturing system?

1. Throughput time.
2. Total setup time for machines/Total production time.
3. Number of rework units/Total number of units completed.
   1. I and II only.
   2. II and III only.
   3. I and III only.
   4. I, II, and III.

Quality Control Principles

56. A tool which indicates how frequently each type of defect occurs is a

1. Control chart.
2. Pareto diagram.
3. Cause-and-effect diagram.
4. Fishbone diagram.

57. A tool which identifies potential causes for failures or defects is

1. Control chart.
2. Pareto diagram.
3. Cause-and-effect diagram.
4. Strategy map.

58. Which of the statements best describes the concept of six-sigma quality?

1. 10 defects per million.
2. 3.4 defects per million.
3. 6.0 defects per million.
4. 100 defects per million.

59. Which of the following quality tools is another term for continuous improvement?

1. Theory of constraints.
2. Kaizen.
3. Six-sigma.
4. Lean manufacturing.

Cost of Quality

60. In considering cost of quality methodology, quality circles are associated with

1. Prevention.
2. Appraisal.
3. Internal failure.
4. External failure.

61. In the cost of quality, which of the following is an example of an “internal failure”?

1. Cost of inspecting products on the production line by quality inspectors.
2. Labor cost of product designers whose task is to design components that will not break under extreme temperature conditions.
3. Cost of reworking defective parts detected by the quality assurance group.
4. Cost of parts returned by customers.

62. In the cost of quality, which of the following is an example of a “prevention cost”?

1. Cost of inspecting products on the production line by quality inspectors.
2. Labor cost of product designers whose task is to design components that will not break under extreme temperature conditions.
3. Cost of reworking defective parts detected by the quality assurance group.
4. Cost of parts returned by customers.

63. Delta Manufacturing Co. has had a problem with its product quality. The company has had a large amount of costs related to product recalls. In considering cost of quality methodology, if the company wants to reduce these costs, the most likely place to incur costs would be for

1. Prevention.
2. Appraisal.
3. Internal failure.
4. External failure.

64. In the cost of quality, costs incurred in detecting individual units of product that do not conform to specifications are

1. Prevention costs.
2. Appraisal costs.
3. Internal failure costs.
4. External failure costs.

Business Process Management

65. In an attempt to improve operations, companies often go through analyses and redesign of the way processes are performed. Which of the following is not considered to be an aspect of a business process that may be focused on to achieve improvement?

1. Technology.
2. Human performance.
3. The interaction between technology and human performance.
4. Strategic goals.

66. Management of organizations that engage in business process management view business processes as

1. Requirements for good control over the organization.
2. Systems that provide information for good management.
3. Strategic assets that must be understood, managed and improved.
4. Mechanisms that keep employees from shirking.

67. At which phase in the business process management life-cycle does management simulate performance of the process in a test environment?

1. Design.
2. Modeling.
3. Execution.
4. Optimization.

68. In the theory of constraints, an operation or resource where the work performed approaches or exceeds the available time is referred to as

1. A bottleneck.
2. A time driver.
3. Customer-response time.
4. Manufacturing lead time.

^**69. Antlers, Inc. produces a single product that sells for $150 per unit. The product is processed through the Cutting and Finishing departments. Additional data for these departments are as follows:

The current production rate is the budgeted rate for the entire year. Direct labor employees earn $20 per hour and the company has a “no layoff” policy in effect. What is the amount of the throughput contribution per unit as computed using the theory of constraints?

1. $90.00
2. $76.67
3. $46.67
4. $26.67

^**70. Three of the basic measurements used by the Theory of Constraints (TOC) are

1. Gross margin (or gross profit), return on assets, and total sales.
2. Number of constraints (or subordinates), number of nonconstraints, and operating leverage.
3. Throughput (or throughput contribution), inventory (or investments), and operational expense.
4. Fixed manufacturing overhead per unit, fixed general overhead per unit, and unit gross margin (or gross profit).

71. Which statement best describes the objective of the theory of constraints?

Project Management

72. Which of the following involves comparing measures of actual progress of a project to planned progress?

1. Project planning.
2. Project scheduling.
3. Project control.
4. Project closure.

73. Which of the following is a detailed listing of the man-hour, equipment, and materials requirements for a project?

1. Statement of work.
2. Work breakdown structure.
3. Project specifications.
4. Milestone schedule.

74. Which of the following is used to describe the practice of adding resources to shorten selected activity time on the critical path of a project?

1. Making adjustments.
2. Project crashing.
3. Slack time.
4. Reengineering.

75. When a project can be completed in a number of completely different ways that might involve branching after performing activities, the best schedule and control technique would be

1. Program Evaluation and Review Technique.
2. Gant chart.
3. Critical Path Method.
4. Graphical Evaluation and Review Technique.

76. A technique that is often used in project management to identify tasks where attention should be focused because they are the most critical is referred to as

1. ABC Analysis.
2. Milestone analysis.
3. Work breakdown analysis.
4. Tasking.

Multiple-Choice Answers and Explanations

Answers

Explanations

1. (b) The requirement is to identify the purpose of a balanced scorecard. Answer (b) is correct because the balanced scorecard uses financial and nonfinancial measures to measure performance. Answer (a) is incorrect because strategic planning is designed to develop strategy. Answer (c) is incorrect because developing cause-and-effect linkages is an important part of developing a balanced scorecard. Answer (d) is incorrect because setting priorities is a part of strategic planning.

2. (a) The requirement is to identify the item that is not one of the four perspectives of the balanced scorecard. Answer (a) is correct because investment in resources is not a perspective of the balanced scorecard. The balanced scorecard deals with performance measurement. Answer (b) is incorrect because customer perspective is used in the balanced scorecard. Answer (c) is incorrect because learning and growth perspective is used in the balanced scorecard. Answer (d) is incorrect because financial perspective is used in the balanced scorecard.

3. (a) The requirement is to identify the measure that is related to internal business processes. Answer (a) is correct because cycle time is the time it takes to manufacture a product and, therefore, is an important part of the business processes perspective. Answers (b) and (c) are incorrect because they are part of the learning and growth perspective. Answer (d) is incorrect because it is part of the customer perspective.

4. (d) The requirement is to define the balanced scorecard. Answer (d) is correct because the balanced scorecard is a strategic performance measurement and management framework. Answer (b) is incorrect because it is the definition of a strategy map. Answer (c) is incorrect because it is the definition of a list of strategic initiatives.

5. (b) The requirement is to identify the focus of value-based management. Answer (b) is correct because value-based management focuses on financial measures to measure performance. The balanced scorecard uses both financial and nonfinancial measures to measure performance.

6. (a) The requirement is to identify what illustrates cause-and-effect relationships. Answer (a) is correct because a strategy map displays cause-and-effect relationships within the balanced scorecard framework. Answer (b) is incorrect because the value chain is the sequence of business processes that add value to a good or service.

7. (d) The requirement is to identify the item that is not a component of the balanced scorecard. Answer (d) is correct because an assessment of human resources is not a component of a balanced scorecard. Answer (a) is incorrect because a statement of strategic objectives is a component of a balanced scorecard. Answer (b) is incorrect because targets for performance are part of a balanced scorecard. Answer (c) is incorrect because strategy initiatives are part of a balanced scorecard.

8. (c) The requirement is to identify the description of the value chain. Answer (c) is correct because the value chain is the sequence of business processes in which usefulness is added to the product or service. Answer (a) is incorrect because cause-and-effect linkages are used to develop the balanced scorecard. Answer (b) is incorrect because the baseline level of performance is the current level of performance. Answer (d) is incorrect because there is no chain of financial and nonfinancial measures.

9. (c) The requirement is to identify which item is not a characteristic of the balanced scorecard. Answer (c) is correct because customer performance is one of the four primary components of the balanced scorecard framework; therefore, it is not excluded. Answers (a), (b), and (d) are incorrect because they are all characteristics of the balanced scorecard.

10. (d) The requirement is to identify where in the balanced scorecard framework surveys of employee satisfaction should appear. Answer (d) is correct because surveys of employee satisfaction would appear in the learning and growth perspective which includes various employee measures including employee turnover. Answer (a) is incorrect because the financial perspective includes measures such as profitability and return on investment. Answer (b) is incorrect because the customer perspective includes measures like customer satisfaction. Answer (c) is incorrect because the internal business processes perspective includes measures related to cost, quality, and time.

11. (c) The requirement is to identify the efficiency measure. Answer (c) is correct because an efficiency measure relates output to a measure of input. Answer (a) is incorrect because it does not relate output to input. Answer (b) is incorrect because it is an effectiveness measure. Answer (d) is incorrect because it does not relate output to input.

12. (a) The requirement is to identify the definition of a strategy objective. Answer (a) is correct because it is the definition of a strategy objective in the balanced scorecard framework. Answer (b) is incorrect because it describes a strategic initiative. Answer (c) is incorrect because it is the definition of a strategy map. Answer (d) is incorrect because it is the definition of a target.

13. (d) The requirement is to identify the definition of a target. Answer (d) is correct because it is the definition of a target in the balanced scorecard framework. Answer (a) is incorrect because it is the definition of a strategic objective. Answer (b) is incorrect because it is the definition of strategy initiatives. Answer (c) is incorrect because it is the definition of a strategy map.

14. (b) The requirement is to calculate the return on sales for the division. Answer (b) is correct because return on sales is calculated as net income/sales which is equal to 4% ($2,000,000/$50,000,000).

15. (c) The requirement is to calculate the asset turnover ratio for the division. Answer (c) is correct because the asset turnover ratio is calculated by dividing sales by the average investment amount. Therefore, it is equal to 2.5 ($50,000,000/$20,000,000).

16. (a) The requirement is to calculate ROI for the division. Answer (a) is correct because ROI is calculated by dividing net income by the amount of the average investment. Therefore, ROI is equal to 10% ($2,000,000/$20,000,000).

17. (d) The requirement is to calculate RI for the division. Answer (d) is correct because RI is equal to net income minus interest on the investment. Therefore, RI is equal to $400,000 [$2,000,000 − ($20,000,000 × 8%)].

18. (c) The requirement is to calculate the interest rate spread for the division. Answer (c) is correct because the interest rate spread is the difference between the return on investment and the required rate of return (cost of capital). In this case, the spread is equal to 2% [($2,000,000/$20,000,000) − 8%].

19. (a) The requirement is to calculate the return on investment. Answer (a) is correct because the return on investment would be computed by dividing net income by average invested capital ($300,000/$500,000 = 60%).

20. (c) The requirement is to calculate the residual income. Answer (c) is correct because the residual income would be computed as follows: Net income ($300,000) minus the interest on invested capital $90,000 (18% × $500,000) is equal to $210,000.

21. (b) The requirement is to identify the graphical representation of ROI. Answer (b) is correct because point B is equal to ROI. Answer (a) is incorrect because return on sales (net income/sales) is not represented on this graph. Answer (c) is incorrect because asset turnover (sales/total assets) is not represented on this graph. Answer (d) is incorrect because operating income is located at point A.

22. (d) The requirement is to identify the graphical representation of net income. Answer (d) is correct because point A is equal to net income. Answer (a) is incorrect because return on sales (net income/sales) is not represented on this graph. Answer (b) is incorrect because ROI is represented at point B. Answer (c) is incorrect because asset turnover (sales/total assets) is not represented on the graph.

23. (b) The requirement is to identify the graphical representation of the relationship between residual income and ROI. Division X's residual income is located at point A and Division Y's residual income is located at point D. Division X has a larger residual income. Division X's ROI is located at point B and Division Y's ROI is located at point E. Thus Division Y's ROI is greater than Division X's ROI.

24. (b) The requirement is to identify the formula for ROI. Answer (b) is correct because it describes the DuPont ROI analysis: ROI = Return on sales multiplied by the capital employed turnover rate (which can be measured as total asset turnover).

25. (b) The requirement is to identify how ROI might be increased. One way of measuring ROI is return on assets (ROA). The formula is net income/total assets. Answer (b) is correct since if operating assets decrease (the denominator in ROI), then ROI would decrease. Answer (a) is incorrect because increasing operating assets would cause ROI to decrease. Answer (c) is incorrect because decreasing revenue would cause net income (the numerator) to decrease. A reduction in operating income would cause ROA to decrease.

26. (b) Return on investment (ROI) may be calculated using the following equation:

Thus, the equation that should be used to compute Bala's return on investment is (6/4) × (1/6) = ROI.

27. (d) Return on assets, also referred to as return on investment (ROI), is calculated as follows:

28. (d) Residual income equals the net income of a division minus imputed interest on the division's assets. In this question, we are given Darwin's operating income and imputed interest rate, but Darwin's assets must be derived using sales and capital turnover, as shown below.

Since Darwin's invested capital is $100,000, its operating income is $40,000, and interest is imputed at 10%, residual income is calculated as follows:

29. (d) Residual income is income minus an imputed interest charge for invested capital. Residual income will be maximized as long as the division earns a rate of return that exceeds the imputed charge. Division A's project will earn a rate of return greater than the imputed interest charge, so this project should be accepted. Division B's project will earn a rate of return less than the imputed interest charge, so this project should not be accepted.

30. (b) The DuPont formula is used to calculate return on investment.

The combination of changes which will maximize return on investment are to increase both asset turnover and income as a percentage of sales, since multiplying two larger numbers will result in a larger product.

31. (b) The requirement is to identify why residual income is preferred over return on investment as a performance evaluation technique. Answer (b) is correct because the focus on return on investment can cause high-performing divisions not to invest in projects that are in the best interest of the overall organization. Answer (a) is incorrect because both techniques can measure results for a single period. Answer (c) is incorrect because the imputed interest rate and the target rate should be the same. Answer (d) is incorrect because the investment level should be computed on the same basis.

32. (c) The requirement is to identify the major disadvantage of using EVA alone. Answer (c) is correct because many times value creation activities do not immediately increase return, and EVA (in the short run) does not reflect the value of these activities. Answer (a) is incorrect because a major advantage of EVA is its focus on creating shareholder value. Answer (b) is incorrect because EVA does not promote the acceptance of unprofitable projects. Answer (d) is incorrect because EVA encourages cost cutting activities.

33. (d) The requirement is to calculate EVA. Answer (d) is correct because EVA is equal to Operating profit after taxes − Cost of invested capital. Net operating profit after taxes is equal to Net operating profit before taxes multiplied by one minus the tax rate, or $25,000,000 [$31,250,000 × (1 − .20)]. Accordingly, EVA is equal to $17,000,000 [$25,000,000 − ($80,000,000 × 10%)].

34. (c) The requirement is to calculate free cash flow. Answer (c) is correct because free cash flow is equal to Net operating profit after taxes + Depreciation expense − Change in net working capital − Capital expenditures. Therefore, free cash flow is equal to $21,000,000 ($25,000,000 + $9,000,000 − $5,000,000 − $8,000,000).

35. (b) The requirement is to calculate EVA for the division. Answer (b) is correct because EVA is calculated as net operating profit after taxes (NOPAT) minus the capital charge on invested capital. In this case, NOPAT is equal to net operating profit before interest and taxes ($30,000,000) minus taxes ($30,000,000 × 40%), which is equal to $18,000,000. EVA is then equal to $13,000,000 [$18,000,000 − ($50,000,000 × 10%)].

36. (b) The requirement is to calculate economic value added. The formula for EVA is Net operating profit after taxes − Cost of invested capital. EVA would be computed as follows:

37. (c) The requirement is to calculate free cash flow. Free cash flow would be computed as follows:

38. (d) The requirement is to identify the ratio that does not measure asset utilization. Answer (d) is correct because the debt to total assets ratio is a debt utilization (financial leverage) ratio. Answers (a), (b), and (c) are incorrect because they are asset utilization ratios.

39. (c) The requirement is to identify the nature of benchmarking with other firms. Answer (c) is correct because cross-sectional analysis involves comparing results and ratios to those of other firms in the same industry. Answer (a) is incorrect because horizontal analysis involves comparisons of results and ratios for the same firm over time. Answer (b) is incorrect because vertical analysis involves comparisons of relationships in a firm's financial statements for a single year. Answer (d) is incorrect because ratio analysis does not imply any particular comparison.

40. (d) The requirement is to calculate the expected dividend per share. Earnings after interest is equal to $30 million ($35 million − $5 million). Net earnings after taxes is equal to $18 million [$30 million × 1 − Tax rate (40%)]. The net earnings after dividends to preferred shareholders is equal to $14 million ($18 million − $4 million), and the dividend for common stockholders is equal to $4,200,000 ($14 million × 30%). The dividend per share is equal to $4,200,000/$2 million shares = $2.10. Therefore, the correct answer is (d).

41. (b) The requirement is to calculate the market price from the earnings per share and price/earnings ratio. Net earnings is equal to $18 million ($35 million − $5 million) × (1 − 40%). Net earnings available to common stockholders is equal to $14 million ($18 million − $4 million). Earnings per share is equal to $14 million/2 million shares, or $7.00. Therefore, the estimated market price would be $7.00 × 8 = $56, or answer (b).

42. (b) The requirement is to calculate the debt-to-total-asset ratio. Answer (b) is correct. The debt-to-total-asset ratio is calculated by dividing total debt by total assets. Therefore, the debt-to-total-asset ratio is equal to 0.315 ($78,000 current liabilities + $75,000 long-term debt) ÷ ($210,000 current assets + $275,000 noncurrent assets). Answers (a), (c), and (d) are incorrect because the computations are not correct.

43. (d) The requirement is to calculate accounts receivable turnover. Answer (d) is correct. Accounts receivable turnover is calculated by dividing total credit sales by the average balance of accounts receivable. The average balance of accounts receivable is $85,000 [($100,000 + $70,000) ÷ 2]. Therefore, accounts receivable turnover is equal to 4.118 ($350,000 credit sales ÷ $85,000 average accounts receivable).

44. (a) The requirement is to calculate inventory turnover. Answer (d) is correct. Inventory turnover is calculated by dividing cost of goods sold by average inventory. Average inventory is equal to $75,000 [($70,000 + $80,0000) ÷ 2]. Therefore, inventory turnover is equal to 2.133 ($160,000 ÷ $75,000).

45. (b) The requirement is to calculate total asset turnover. Answer (b) is correct. Total asset turnover is calculated by dividing sales by average total assets. Average total assets is equal to $460,000 = [($210,000 + $275,000) + ($180,000 + $255,000)] ÷ 2. Therefore, total asset turnover is equal to 0.761 ($350,000 ÷ $460,000).

46. (c) The requirement is to calculate return on total assets. Answer (c) is correct. Return on assets is calculated by dividing net income by average total assets. As determined in the previous question, average total assets is equal to $460,000. Net income is equal to $72,000 ($350,000 sales − $160,000 cost of goods sold − $3,000 interest expense − $48,000 income taxes − $67,000 administrative expense). Therefore, return on assets is equal to 0.157 ($72,000 ÷ $460,000), or 15.7%.

47. (c) The requirement is to determine the effect of payment of an account payable. Answer (c) is correct. The quick ratio is equal to quick assets divided by current liabilities and the current ratio is equal to current assets divided by current liabilities. Since we are told that quick assets exceed current liabilities, both ratios are greater than one. With a ratio greater than one if you reduce the numerator and denominator by an equal amount, the ratio will increase.

48. (b) The requirement is to determine the effect of a purchase of raw materials on account. The correct answer is (b). Since we know that the current ratio is greater than one, an increase in the numerator and the denominator by an equal amount will decrease the ratio. Answers (c) and (d) are incorrect because working capital will not change.

49. (d) The requirement is to determine the effect of the collection of accounts receivable. Answer (d) is correct. Collection of accounts receivable has no effect on the quick or current ratio because both cash and accounts receivable are part of the numerator of both ratios.

50. (d) The requirement is to determine the effect of writing off inventory. Answer (d) is correct because a write-off of inventory will decrease the current ratio. Answers (a) and (b) are incorrect because inventory is not used in computing the quick ratio. Answer (c) is incorrect because working capital will be decreased.

51. (a) The requirement is to determine the effect of a five-for-one stock split. Answer (a) is correct because a stock split increases the number of shares outstanding and, therefore, reduces the book value per share. Answers (c) and (d) are incorrect because the transaction does not affect total stockholders' equity.

52. (d) The requirement is to determine the effect of issuing serial bonds in exchange for an office building. Answer (d) is correct because the first installment is a current liability which affects the quick ratio, the current ratio, and working capital.

53. (b) The requirement is to determine the effect of liquidating a long-term note with cash. Answer (b) is correct. Cash is included in the numerator of both the quick and current ratios. However, a reduction in cash affects the quick ratio more than the current ratio because it is smaller.

54. (b) The requirement is to identify the definition of benchmarking outside of the firm's industry. Answer (b) is correct because generic benchmarking involves benchmarking to the best practices regardless of the industry. Answer (a) is incorrect because internal benchmarking involves benchmarking within the firm. Answer (c) is incorrect because competitor benchmarking involves benchmarking against direct competitors. Answer (d) is incorrect because functional benchmarking involves benchmarking within the same broad industry.

55. (d) Answer (d) in correct because of these nonfinancial measures would be useful in evaluating the performance of a manufacturing system. Throughput (cycle) time measures the total amount of production time required per unit. This measure is important to assess the timeliness of the production process, which is required for on-time delivery of goods. The proportion of total production time consumed by setup activities reflects one aspect of production efficiency. Setup time represents money spent on a non-value-adding activity, and thus should be minimized as much as possible. The proportion of total units completed which require rework is a useful measure of product quality. An excessive rate of rework alerts management that it needs to examine its quality control procedures.

56. (b) The requirement is to identify which tool is used to identify frequency of defects. Answer (b) is correct because a Pareto chart ranks the causes of process variations by the degree of impact on quality. Answer (a) is incorrect because a control chart is a statistical plot that helps to detect deviations before they generate defects. Answer (c) is incorrect because a cause-and-effect diagram is used to identify the potential causes of defects. Answer (d) is incorrect because a fishbone diagram is an alternative name for cause-and-effect diagrams.

57. (c) The requirement is to select which tool identifies causes of failures or defects. Answer (c) is correct because cause-and-effect diagrams identify causes of failures/defects and can be used to identify the reasons why a process goes out of control. Answer (a) is incorrect because a control chart is a statistical plot that helps to detect deviations before they generate defects. Answer (b) is incorrect because a Pareto diagram indicates how frequently a type of defect may occur. Answer (d) is incorrect because a strategy map is a statement of what the strategy must achieve and what is critical to its success.

58. (b) The requirement is to identify the concept of six-sigma quality. Answer (b) is correct because six-sigma is a statistical measure expressing how close a product comes to its quality goal. Six-sigma is 99.999997% perfect with 3.4 defects per million parts.

59. (b) The requirement is to identify the terms used to identify continuous improvement. Answer (b), Kaizen, is correct because it is the Japanese art of continuous improvement. It underlies the total quality management and JIT business techniques. Answer (a) is incorrect because the theory of constraints is a method to maximize operating income when faced with some bottleneck operations. Answer (c) is incorrect because six-sigma is a statistical measure expressing how close a product comes to its quality goal. Six-sigma is 3.4 defects per million parts. Answer (d) is incorrect because lean manufacturing is an operational strategy focused on achieving the shortest possible cycle time by eliminating waste.

60. (a) The requirement is to identify the nature of quality circles. Answer (a) is correct because quality circles are designed to develop ways to prevent defects. Answer (b) is incorrect because appraisal costs are related to inspecting and testing to ensure product acceptability. Answer (c) is incorrect because internal failure involves the costs of finding defective units before they are shipped to customers. Answer (d) is incorrect because external failure is the cost of defects that reach the customer.

61. (c) The requirement is to identify the item which reflects the internal failure component. An internal failure cost is a cost incurred when substandard products are produced but discovered before shipment to the customer. Reworking defective parts is an example of an internal failure. Answer (a) is incorrect because it is an example of an appraisal cost. Answer (b) is incorrect because it is an example of a prevention cost. Answer (d) is incorrect because it is an example of an external failure cost.

62. (b) The requirement is to identify the item which reflects the prevention cost component. A prevention cost is a cost incurred to prevent defects. These costs include the cost to identify the cause of the defect, take corrective action to eliminate the cause, train people, and redesign the product or the production process. Answer (b) is correct because it is an example of a quality activity designed to do the job right the first time. Answer (a) is incorrect because it is an example of an appraisal cost. Answer (c) is incorrect because it is an example of an internal failure cost. Answer (d) is incorrect because it is an example of an external failure cost.

63. (a) The requirement is to identify where to incur costs to prevent product recalls. Answer (a) is correct because spending funds to prevent defects is generally most cost effective.

64. (b) The requirement is to identify how costs incurred to detect nonconforming units are classified. Answer (b) is correct because appraisal costs are costs associated with quality control and include testing and inspection. Answer (a) is incorrect because prevention costs involve any quality activity designed to do the job right the first time. Answer (c) is incorrect because internal failures occur when substandard products are produced but discovered before shipment to the customer. Answer (d) is incorrect because external failure costs are incurred for products that do not meet requirements of the customer and have been shipped to the customer.

65. (d) The requirement is to identify the aspect of business process improvement that is not generally a focus. Answer (d) is correct because examination of strategic goals is part of strategic planning, not part of business process management. Answers (a), (b) and (c) are incorrect because they all represent ways to improve business processes.

66. (c) The requirement is to identify how business process managers view business processes. Answer (c) is correct because business process managers view processes as strategic assets that can create value and competitive advantage. Answers (a), (b) and (d) are incorrect because they all describe very limited views of business processes.

67. (b) The requirement is to identify the phase that involves simulation of performance of the process in a test environment. Answer (b) is correct because this describes the modeling phase. Answer (a) is incorrect because the design phase involves design of the new process. Answer (c) is incorrect because the execution phase involves implementing the process. Answer (d) is incorrect because optimization involves identifying additional improvements in the process after it is implemented.

68. (a) The requirement is to identify a component of the theory of constraints. Answer (a) is correct because a bottleneck is any resource or operation where the capacity is less than the demand placed upon it. Answers (b), (c), and (d) are incorrect because they are not components of the theory of constraints.

69. (a) The requirement is to compute throughput contribution per unit. Answer (a) is correct because through put contribution per unit is equal to revenue minus direct materials. Thus, throughput contribution per unit is equal to $150 (revenue per unit) − $45 (Cutting direct materials) − $15 (Finishing direct materials) = $90. Answers (b), (c), and (d) are incorrect because they represent incorrect computations of throughput contribution per unit.

70. (c) The requirement is to identify the three basic measurements used by the Theory of Constraints. Answer (c) is correct because the Theory of Constraints focuses on throughput contribution, investment (or inventory), and operational expense (operating costs). Answers (a), (b), and (d) are incorrect because they represent other types of performance measures.

71. (a) The requirement is to describe the objectives of the theory of constraints (TOC). The objective of TOC is to increase throughput contribution while decreasing investment and operating costs. Throughput contribution is revenues minus the direct materials cost of goods sold. Investment is the sum of materials cost in direct materials; work in process and finished goods inventories; research and development costs; and the costs of equipment and buildings. Operating costs include salaries and wages, rental expense, utilities, and depreciation.

72. (c) The requirement is to identify the stage that involves comparing measures of actual progress to planned progress. Answer (c) is correct because this describes an aspect of project control. Answers (a), (b), and (d) are incorrect because they represent other stages of the project management lifecycle.

73. (c) The requirement is to identify which of the items is a detailed listing of the man-hour, equipment, and materials requirements for a project. Answer (c) is correct because this is a description of the project specifications. Answer (a) is incorrect because the statement of work is a narrative description of the work to be performed. Answer (b) is incorrect because the work breakdown structure breaks the project into manageable, independent, and measureable elements that can be budgeted and assigned. Answer (d) is incorrect because the milestone schedule sets forth the start date, the end date, and other major milestones involved in completing the project.

74. (b) The requirement is to identify the term used to describe the practice of adding resources to shorten selected activity time on the critical path of a project. Answer (b) is correct because this describes project crashing. Answers (a), (c), and (d) are incorrect because they are not terms used to describe this process.

75. (d) The requirement is to identify the scheduling and control technique that would be most appropriate when a project can be completed in a number of completely different ways. Answer (d) is correct because the Graphical Evaluation and Review Technique is appropriate for these types of projects. Answers (a), (b), and (c) are incorrect because these scheduling and control techniques do not perform as well under these circumstances.

76. (a) The requirement is to identify the technique used to identify critical tasks. Answer (a) is correct because ABC Analysis involves categorizing tasks into groups from those that are urgent and important to those that are neither urgent nor important. Answers (b), (c), and (d) are incorrect because they are not terms used to describe a technique to identify critical tasks.

Written Communication Tasks

Written Communication Task 1

The management of Hewitt Company is considering adopting a balanced scorecard to measure performance. Karen Wells, the chief financial officer for the company, has asked you to prepare a memorandum describing a balanced scorecard and the advantages of adopting such a system.

To:	Ms. Karen Wells, CFO
	Hewitt Company
From:	CPA Candidate

Written Communication Task 2

The management of Taylor Corporation is attempting to adopt new performance measures. Henry Warren, the chief executive officer, has asked you to prepare a memorandum describing how management should choose between alternative measures.

To:	Mr. Henry Warren, CEO
	Taylor Corporation
From:	CPA Candidate

Written Communication Task 3

Assume that you are a consultant providing services for Webster Corp. Webster is performing a significant project-based implementation of a new enterprise resource system. The company is concerned about the difficulties in performing the project. Compose a memorandum to management describing the risks involved in executing a project that is cross-functional in nature.

To:	Webster Corp. President
Re:	ERP project management
From:	CPA Candidate

Written Communication Task Solutions

Written Communication Task 1

To:	Ms. Karen Wells, CFO
	Hewitt Company
From:	CPA Candidate

I understand that you are considering implementing a balanced scorecard performance measurement system at Hewitt Company. This memorandum explains the nature and benefits of such a system.

The balanced scorecard is a performance measurement system that includes both financial and nonfinancial measures. It includes measures in the four perspectives of financial, customer, internal business processes, and learning and growth. By measuring performance with multiple measures across these four perspectives, a balanced scorecard is more strategic than other systems that rely primarily on financial measures. It aids in communicating the company's strategy to all members of the organization and helps insure that they work to achieve the organization's strategic goals.

I suggest that you continue with your plan to implement a balanced scorecard system because I believe that it is superior to other single-dimensional systems.

If you have any questions, please contact me.

Written Communication Task 2

To:	Mr. Henry Warren, CEO
	Taylor Corporation
From:	CPA Candidate

This memorandum is designed to assist you in deciding how to select among different performance measures for Taylor Corporation.

Selecting among different performance measures requires an understanding how the measures will be used. Possible uses include for compensation, resource allocation, and business unit performance. Different measures are more appropriate for different purposes.

It is important that all performance measures reflect the strategy of the company. Measures that are strategic communicate the goals of the organization and motivate management to pursue those goals. Performance measures must also represent economic reality. They should provide a clear and accurate measure of relative performance. Finally, if the measures are used to evaluate and compensate managers, they should be sensitive to factors that are in the manager's control and not sensitive to factors beyond the manager's control. The measures should be clearly controllable by the manager being evaluated.

As you can see, selection of appropriate performance measures is a complex process. If you would like to discuss your selection of measures in more detail, please contact me.

Written Communication Task 3

To:	Webster Corp. President
Re:	ERP project management
From:	CPA Candidate

You have requested that we provide information about the issues involved in executing a project to implement an enterprise resource management system. In particular, you are concerned that the cross-functional nature of the project will be difficult to manage.

You should understand that the cross-functional nature of this project creates additional risk of failure that must be controlled. The most important requirement for success of a cross-functional project is full support by top management. The team must have this support to get adequate cooperation from the various functional managers of the organization. This also means that the relationships between the project manager and various functional managers must be clearly defined to avoid conflict. Finally, senior management must support the project manager's decisions, recognizing that these decisions must be made quickly and with limited information to ensure that the project remains on schedule. If senior management recognizes and resolves these issues, the risk of failure will be significantly reduced.

If you have any additional questions about the issues regarding completing the project, please contact me.