FI EP01 | Who Should Get the Bonus?

1. Applause

Tuesday, 8 a.m. The conference room on the factory's second floor.

The last item at the monthly performance meeting was utilization by plant. A bar chart appeared on the screen. The bar on the far left stood tallest.

96% utilization.

The division head called the plant manager's name. It was the same spot for the third month running. A brief round of applause passed through the room, and the quality manager beside him gave his shoulder a light pat. He bowed his head in acknowledgment. In fifteen years of running a factory, he had held to one principle. Keep the line running.

After the meeting, he went down the stairs and passed the aisle beside the warehouse. Pallets filled even the innermost sections. Unable to turn in the narrowed aisle, a forklift was backing up for the second time.

The plant manager did not slow his pace. Those pallets were proof that the factory had kept working. They were goods they would be selling next year anyway.

2. The Sixth Class

A week earlier, on the fourth floor of the graduate business school's research building.

When the department head, who ran the course, knocked on the professor's office door, a stack of questionnaires lay spread across his desk.

"It's your turn next week. There was something I wanted to mention beforehand." The department head began before he had even sat down. "This cohort has an average of twenty years' practical experience. They've already been through cost accounting and financial statements several times at their companies. They've all made time in busy schedules to be here. I'd like them to leave with something they can really use when they're back at work making their next decision."

The professor held up a questionnaire. He had collected them from participants in the first week. There had been one question: "What does your company use to evaluate the performance of plant managers and subsidiary heads?"

"I've read them all. They put it in different words, but the answers are much the same. Ultimately, they're being evaluated on accounting profit."

"Is that a problem? Isn't that what everyone does?"

"It's too early to say whether it's a problem." The professor set down the stack. "But someone who completed the course last term came to see me. The student told me that at the latest close, the company had reported its highest net profit since it was founded, yet was short of working capital and had to take out a bank loan. The student asked me: So, did we do well or badly?"

The department head said nothing.

"If I'd given an answer then, it would have remained my answer. This time, I want everyone to judge the same numbers for themselves. If their judgments differ, we'll follow their reasons together."

After the department head left, the professor drew a table on a blank slide. Financial data for two companies. He deliberately kept the numbers simple. He filled every other cell with identical figures and left just one different.

A week later, Tuesday at 2 p.m. The main lecture hall in the graduate business school's main building.

It was the sixth class of the management course his company had sent him to. The plant manager sat in the front row, still carrying the glow of that morning's meeting.

The tiered seating was almost full. This was a course for business practitioners. Production managers from manufacturing companies sat among finance managers, cost accountants, sales executives, and owners running their own businesses. Graduate students had opened their laptops in the back rows, and a few fellow professors from the department sat in the very last row. They had come to observe. Altogether, there were about a hundred people.

The professor placed the stack of questionnaires on the lectern.

"I've read all the questionnaires from the first week. I asked what your companies use to evaluate plant managers and subsidiary heads. The wording varied a little, but the answers converged on almost one thing. Net profit."

"So today, I won't give a lecture. We'll do here what you do at work: evaluate performance and decide on a bonus."

The professor brought up the first slide.

There are two CEOs. To make the difference clear, let us assume that their circumstances are identical in every respect except one. The same product, the same selling price, the same sales volume and revenue, the same factory and cost structure, the same production capacity. Everything is the same. Only one thing differs: production volume.

"We've held the other conditions equal for comparison. We want to see what difference production volume makes."

The next slide showed the two companies' financial data.

(Monetary units are omitted. The figures cover the same period, and neither company has beginning finished goods inventory. All sales proceeds have been collected, and all costs have been paid in cash. Assume there is no income or expense other than the items shown.)

The professor worked down the table from the top.

"The two companies belong to one group, but each is an independent company. Each makes its own products and sells them. Over the same period, Company A's CEO made 100 units and sold 100. Company B's CEO made 1,000 units and sold 100. The selling price is 50 for both, so revenue is also the same at 5,000."

"Variable cost per unit and fixed costs for the period are the same. In this case, the direct variable cost is materials. Making one unit takes 12 in materials and 8 in variable overhead, such as utility costs that rise with production volume. Make one unit, and you spend 20. Don't make it, and you don't spend that money. The fixed cost of running the factory is 1,000 per period, and fixed selling costs are 500. Those fixed costs are the same however many units you make."

The professor pointed again to the top row.

"We've kept the conditions and numbers simple. The only difference is the number of units produced."

He put down the remote.

"You are the chair of this group. You must give one of these two CEOs a bonus. Who gets it?"

The plant manager looked once at the table and nodded. His eyes rested on Company B's production volume.

3. A Show of Hands

The professor gave them five minutes.

The room fell quiet. A few people took out calculators and began tapping. Others copied the table into their notebooks. Most studied it for a while and decided without a calculator. One sales executive took a single look, then soon put down his pen. In the back rows, the graduate students turned their laptop screens toward one another, silently checking something. The plant manager did not hesitate.

Five minutes passed.

"Please raise your hand if you'd give Company A's CEO the bonus."

Hands went up. A teaching assistant counted row by row.

"Sixty."

"And Company B's CEO?"

The plant manager was the first to raise his hand. At first, hands rose here and there. A few more went up after seeing him in the front row.

"Forty."

The professor wrote the two numbers on the board.

60 and 40.

"Six to four. There's a difference, but it's surprisingly close."

He looked around at those who had voted for B.

"I didn't say that to suggest you're wrong. Today, we'll start with the reasons of those forty people. A hand doesn't go up without a reason."

4. The Forty Who Chose B

The microphone went first to the plant manager in the front row.

"Anyone who's run a factory will understand. Under the same conditions, B made 1,000 units while A made only 100. No company leaves spare people and machines sitting idle. On the shop floor, you don't let anyone sit around gathering dust."

A few people laughed. There was agreement in the laughter.

"And this is something they keep making. It's not a one-off sale. They'll sell it next time, and the time after that. B used the spare time to make ahead what they'd have to make anyway. I'd praise B. You said they had the same production capacity, so A is the one that looks odd for leaving the line idle."

The professor asked a question.

"Do you think all that excess production will sell?"

"I can't guarantee every bit of it will sell. But standard products do move eventually."

A production manager spoke next.

"I was thinking about cost. A factory's fixed costs are the same whether you make a lot or a little. So the more you make, the less fixed cost each unit carries. B made the same thing in the same factory for less. On the shop floor, we call that cost reduction."

A cost accountant picked up the argument.

"B should come out ahead in the net profit calculation too. Some of the fixed costs will sit in the remaining 900 units of inventory. That reduces the amount expensed this period. On the books, B should have made more net profit. Inventory is an asset, not a loss."

The professor nodded and looked toward the last row. A colleague who taught management accounting had his hand raised.

"If fixed costs are divided by the actual quantity produced and loaded onto the products, each unit at B carries one-tenth of the fixed cost of a unit at A. The product cost is lower, so B comes out ahead if we evaluate by net profit. I chose B on that basis too."

Low chuckles rose from a few places in the room. Those who had voted for B sat a little straighter. The plant manager turned toward the last row and nodded. Even a professor was on his side.

A graduate student at the back cautiously raised a hand.

"I chose B, but honestly, half of it was a gut feeling. The factory hadn't stopped, the cost seemed likely to be lower, and I thought everyone would feel B had done more work."

The professor wrote a few words beside the 40 on the board.

Equipment use. Cost. Net profit on the books. Inventory is an asset.

"The reasons for choosing B connect with one another." He pointed to each of B's arguments in turn. "The judgment is that B used its equipment, lowered its unit cost, and increased net profit."

He turned to the other side.

"All right. Those of you who chose A rather than B—what did you see?"

5. The Sixty Who Chose A

The sales executive in a middle row took the microphone.

"I chose A as soon as I saw the table. The two companies sold the same quantity and had the same revenue. But B produced 900 extra units."

He pointed to the units-sold row on the screen.

"The fact that they sold 100 gives us grounds to put demand at that level. Yet B made ten times as much. Of course, this is an extreme hypothetical case, but those extra 900 units don't have orders attached to them. Spend enough years in sales, and you know: making something in advance doesn't mean you can sell it whenever you want, at whatever price you want. As time passes, it can easily turn into stock you have to discount."

He paused to choose his words.

"And this probably won't be a one-off. If they do the same thing next period—make 1,000 and sell 100—another 900 will be added to the 900 already left over. If they keep producing without a matching rise in demand, inventory will keep building by the amount of that excess production. There's no guarantee even today's demand will last forever. Meanwhile, the stock will become obsolete, and more and more of it will have to be sold for less or simply sit there unsold, piling up. Never mind the warehouse costs; it looks very likely they'll run short of space too. Surely they aren't going to build another warehouse…?"

The plant manager answered at once.

"I said these were standard products. Their specifications don't change."

"Unchanging specifications don't mean an unchanging market. What happens next time if a competitor cuts its price?"

Their voices rose a little. The professor did not intervene.

This time, the owner of a small company raised a hand.

"I looked at the money before the books. To make those extra units, they had to buy that much more material. They used more electricity and more consumables too. Where did that money come from? Out of the company's bank account, I'd say. At a company like mine, when that sort of money gets tied up in a warehouse, you start worrying about payday."

The cost accountant objected.

"The money hasn't disappeared. It's turned into inventory. If it sells, the money comes back."

"If it sells."

The business owner said just those words and put down the microphone.

The plant manager started to say something, then stopped. For a moment, the warehouse aisle he had passed that morning came to mind. He pushed the thought away.

A finance manager added his voice from the A side.

"I'm for A too. Though if you ask me to give a precise reason, I'm not sure I can. I agree that B's net profit will be higher on the books. But if that net profit came from making 900 extra units, I'm not sure that means the business was better managed."

The room grew quiet again.

The professor went to the board and picked up the chalk.

"Both sides are looking at the same table, yet seeing different things. Why is that?" He looked toward the front row. "Plant manager, what was it about B that you saw as performance?"

"The factory kept running. They made more in the same factory."

The professor wrote: Production efficiency.

"And our cost accountant?"

"Net profit on the books. If we calculate it, B should have more left over."

Net profit on the books.

The professor turned to the middle row. "And as a business owner, what did you look at?"

"What they sold, what they had left, and the money that went out of the bank account."

The professor wrote the last phrase: Money actually earned.

Production efficiency. Net profit on the books. Money actually earned.

"If those three always pointed in the same direction, every hand in this room would have gone up for the same side." He set down the chalk. "But which of these does your company's chair look at when deciding bonuses?"

The same answer came from around the room.

"Net profit."

"That's what you wrote on the questionnaires too. Then let's calculate that net profit ourselves."

6. Calculating Net Profit

The professor put the original financial data back on the screen and cleared the right side of the board.

"Naturally, we'll calculate net profit using absorption costing under financial accounting standards. The net profit your companies calculate and submit to the relevant authorities each time. This method includes both variable and fixed manufacturing costs in product cost. In this case, we'll allocate the 1,000 in fixed manufacturing costs across the actual number of units produced. Let's ask our cost accountant: what does one unit cost?"

The cost accountant answered from his seat.

"We add the direct variable cost of 12 to the variable overhead of 8. Then we put on top the factory's fixed cost of 1,000 divided by the number made. At A, 1,000 divided by 100 units gives 10 per unit. At B, dividing by 1,000 units gives 1."

The professor wrote it down.

"That's how we get the unit cost the production manager mentioned. A is 30 and B is 21. The calculated cost of one product is 9 lower at B." The professor looked toward the back row. "Next, the cost of the products sold. The quantity sold is 100."

A graduate student raised a hand.

"For A, 100 times 30 is 3,000. For B, 100 times 21 is 2,100."

"Now, what remains when we subtract the cost of goods sold from revenue?"

"For A, 5,000 minus 3,000 leaves 2,000. For B, 5,000 minus 2,100 leaves 2,900," the student replied.

"Which cost have we not deducted yet?"

"The fixed selling costs of 500," the cost accountant answered. "We've already included fixed manufacturing costs in product cost, so we don't deduct them again. Both companies deduct the full 500 in fixed selling costs as a period expense on this period's income statement."

The professor transferred the answer to the board.

The professor kept the chalk in his hand.

"One thing remains. B made 1,000 units and sold 100. How do the remaining 900 appear on the books? Let's ask our finance manager."

The finance manager tapped his calculator.

"As inventory. Nine hundred units at a unit cost of 21 makes 18,900. A has nothing left, so it's zero."

The professor gathered the numbers from the board into a single table and put it on the screen.

"The net profit you spoke of earlier is the 1,500 and 2,400 in this table. Revenue is the same, but the calculated net profit is 900 higher at B."

Net profit 2,400.

A small sound came from B's side. Someone murmured, "As expected." The plant manager uncrossed his arms and leaned back in his chair. The cost accountant pointed to his own calculations in his notebook. In the last row, the professor's colleague pointed to the manufacturing-cost-per-unit row and whispered something to the colleague beside him.

Those who had voted for A were silent. The sales executive read the table again from the top. The finance manager lowered his head and took another look at the inventory value he had just calculated.

"You're the group chair. Looking only at these results, who gets the bonus?"

"B," the plant manager answered first, with several voices following.

"Is there anything wrong with this calculation?"

The cost accountant shook his head. "No. We've just done it together."

The mood in the room shifted toward B.

Then the small-business owner raised a hand again.

"May I ask one thing?"

The professor handed the business owner the microphone.

"The two companies sold the same quantity and received the same money. Yet B's net profit comes out 900 higher. Where did that 900 come from? B hasn't sold a single unit more."

The cost accountant took the microphone again.

"The difference comes from fixed manufacturing costs. All of A's 1,000 went into the cost of goods sold. B allocated 1 per unit to the 100 units sold, so only 100 in fixed manufacturing costs went into the cost of goods sold. The other 900 remains in the inventory value of the 900 unsold units. It hasn't been expensed this period."

The business owner pointed to the net profit row.

"Then I understand where it was recorded. But does that mean B earned 900 more? Is that a reason to give B the bonus?"

The cost accountant looked at the screen, microphone still in hand. The plant manager shifted a little forward in his chair. In the last row, the professor's colleague put down his pen and turned toward the business owner.

Leaving the table on the screen, the professor walked to the board. Of the three phrases, he underlined "Net profit on the books." Below it, he wrote a single question mark.

"That's a good question. It's also the most important question asked in this room today."

He turned to the class.

"The calculation we've just done is one of several ways of working with the same facts. Next time, we'll calculate the business performance in this case using two other methods. And we'll look at those companies' bank statements. Then we'll ask the question again."

The professor turned off the screen.

"You are the chair. Who would you give the bonus to?"

7. The Inventory Report

The lights came up. Even as people rose from their seats, they found it hard to look away from the question mark on the board.

Halfway through packing his bag, the plant manager took out his phone. He logged into the company's system and opened the factory's inventory report for the previous month. The finished goods quantity appeared on the screen. It was close to twice what it had been three months earlier.

The bar chart from that morning's meeting came back to him. The tallest bar. The applause. And the warehouse aisle he had passed on his way down the stairs, the pallets filling even the innermost sections.

The plant manager did not turn off the screen. He kept looking down at that number until the lecture hall was almost empty.