Industry Analysis Quality Metal Service Center is a service center that purchases metal from a mill to sell to their customers. The company was established 100 years ago as a local metals distributor. Now it has become a national distributor of metals and has seen sales of $750 million. The current metal industry is a mature, highly competitive and fragmented industry. However, a number of key trends in the industry have allowed metal service centers to grow.
One of these trends was the retrenchment of Steel Mill’s in which they decided to increase productivity by cutting back on product lines that used low-volume specialty products. This trend helped metal service centers thrive through the production of specialty products. Customers have few options, and must go to metal service centers if they want specialty products. The second trend of the metal industry is the high cost of ownership and maintenance of inventory. The high cost of inventory and maintenance created a high barrier to entry for metal service centers.
Most metal service centers decided to use the “just-in-time” inventory management system to try to reduce their inventory costs. This resulted in smaller order quantities and more frequent deliveries. This gave metal service centers the advantage over the mills because customers were able to maintain low inventories which led to lower costs. Quality and productivity had become the major issues with metal users. Many programs were created in attempt to improve the quality and productivity of their processes which would result in an overall increase in profitability.
Metal users found that having fewer suppliers led to higher quality and they were able to benefit from the long term relationship with the suppliers. 1 Quality Metal Service Center Strategy Quality Metal’s strategy provided a guide to achieve their goals and objectives. Edward Brown, the president and chief executive officer, created three objectives for Quality Metal to follow. The first objective was to focus their sales efforts on targeted markets of specialty metal users. This was done by eliminating the commodity market from their product lines.
This allowed them to redeploy their assets into highertechnology metals which offered much higher returns and had less competition. Their second objective was to identify the industries and geographic markets where the higher-technology metals were consumed. They were now committed to providing to customers who were high-technology metal users. To be able to accurately identify the areas and industries that use the products, they developed a data base system that allowed them to project potential sales on a location by location basis.
They were also able to project demand on a nationwide basis which allowed them to determine where it would be most beneficial to open a new service location. The last objective was to develop techniques and marketing programs that would increase market share. They were able to do this by offering the customers programs that assisted them in implementing a just-in-time inventory management control system. They also offered their customers various processing services that were much less expensive for Quality to perform than for their customers.
They used their assets to increase market share and to provide better customer service. Organization Structure The organizational structure of Quality Metal Service Center consisted of four regions each with about 6 districts each. Each district had a district manager who 2 managed a warehouse manager, sales manager, credit manager, purchasing manager, and administration manager. The finance, marketing, operations, and human resources were managed at the corporate level. Each manager was able to make decisions regarding their departments.
The warehouse manager was responsible for transportation, loading and unloading, storage, and preproduction processing. The sales manager was responsible for managing the inside and outside sales staff. The sales manager was manager did not have the authority to determine price or discount terms. The price, discount terms, and freight adjustments were decided on the district level. The credit manager was responsible for assessing risk of new credit accounts and managing customer collections.
The purchasing manager was responsible for choosing suppliers and negotiating credit terms but was not responsible for making payments to suppliers. Responsibility Allocation and Performance Measurement According to a survey conducted by Fortune, out of 1,000 companies, 78% used investment centers in their management control systems. Of the US companies that used investment centers, 64% evaluated their investment centers using ROI. In the case of Quality Metals, each of its 23 districts was designated an investment center.
The district managers were evaluated based on attaining a predetermined return on asset (ROA) level. The ROA levels were agreed on at the beginning of the each year by district managers and the corporate office. District managers were given bonuses based on their ability to exceed 90% of the targeted ROA set at the beginning of the year. Therefore, the determination of the asset base is very important in the management control system and to district managers. The asset base used would determine the motivations each district 3 anager has use deployed assets efficiently and when or if new equipment should be acquired. Quality Metal used 5 categories in determining its asset base. The first category used in Quality’s asset base included property, plant, and equipment. More specifically, category 1 designated land, warehouse buildings, and equipment each district manager used in the asset base at gross value. Companies can choose to include fixed assets such as PPE at book value (cost minus depreciation), or gross value. The decision can affect the motivations of a manager.
Including PPE at book value misstates a business unit’s profitability. If book value is used, the decision to acquire new equipment may be incorrectly interpreted by managers. For example, a new piece of equipment may have a positive net present value (NPV) over the life of the asset, but the acquisition would increase the asset base in the first year, and the initial cash flows would not increase ROA proportionally to a business unit’s target ROA. In other words, even if the acquisition is beneficial to the company overall, the ROA would be too low for the manager to accept the decision.
Including PPE at gross value does remedy the problem. However, PPE at gross value always understates the true ROA of a business unit. Similarly, PPE carried at gross value may also motivate managers to get rid of equipment that may still be useful because the gross value is higher, and disposing of PPE with high gross value can significantly lower a business unit’s asset base. Most companies include fixed assets at net value and trust managers to account for the known margin of error. The second category included in Quality
Metal’s asset base is leased buildings and equipment, except leased trucks, at the capitalized value. Financial leases are similar to debt, and are reported on the balance sheet. There is some debate in including leased 4 equipment because the assets are being paid for by the company, and therefore should be fully utilized. However in most companies, including Quality Metals, the decision to lease is made at the corporate level. Therefore holding the district managers responsible for a decision that they cannot control seems unfair.
Nonetheless, the leased assets have been assigned to the district manager for use, and should be included in the asset base to be fully utilized efficiently. The third category in the asset base is inventory. Inventory is added in units, based on the average units during the period, at replacement costs. Replacement costs were based on current mill price schedules. Companies usually include inventory in the asset base because business unit managers can some control over the level of inventories on hand. In the case of Quality Metals, inventory management is very important to the overall company strategy.
Quality Metal targets niche markets that use highly specialized metal products. The risk of obsolescence is very high is inventory sits or gets too high. In addition, Quality Metals relied on low lead times and quick deliveries to customers who relied heavily on timely service. Therefore, including inventories in the asset base was very important for Quality Metals. The decision to include inventories at replacement costs also was a strategic decision. Companies can decide what value to include inventories at in the asset base.
Inventories can be included at market price, standard cost, average cost, or replacement cost. The costs assigned to inventory can influence a business unit manager’s decisions. If the lower of the costs are assigned, managers may not be as motivated to reduce the finished goods inventory levels. However, if the higher costs are assigned to inventories, managers may be motivated to lower inventory levels, thereby reducing their asset base 5 as well at a more significantly level. At Quality Metals, replacement cost is used to probably get a more accurate measure of ROA.
The replacement cost of inventories represents the theoretical costs of assets being used by a business unit at a given moment. It could be interpreted as the current amount of assets being deployed in inventories in a business unit. The replacement costs in this case also represent current prices from mills. The replacement cost probably also encourages managers to keep inventories efficiently moving. The fourth category is accounts receivable. Accounts receivable is similar to inventories in that they can be controlled by the business unit.
Quality Metals has a credit manager within the district that controls the credit terms and enforces collections. The amount of time the receivables is left open effects the cash flow of the company, and managers should be motivated to keep receivables within 30 days. Quality Metals includes accounts receivables in the asset base by using the average of the period. Cash was not included in the asset base because the amounts for trivial. The fifth category is not a real category, but rather a decision not to include a current liability as a deduction against the asset base.
Quality Metal does not generally deduct accounts payable from the asset base. However an adjustment was made to the asset base via a contra asset account, if negotiated pay terms exceed the company standard of 30 days. In general, accounts payable can be thought of a zero interest source of capital for a company. Payment terms can be negotiated to receive inventory up front, and payment be made later. So if a district manager could negotiate favorable terms, then Quality Metal would deduct those payables from the asset base.
However, delaying payments unduly may result in a reduction in the company’s credit rating overall. 6 Therefore, it is very important the terms are accepted by both parties, and district managers are not just delaying payments Performance Evaluation and Incentives For district managers, their performance evaluation and incentives were dependent on meeting and exceeding 90% of their ROA target. Basically, the formula used to determine the size of the bonus was based on the manager’s base salary and the amount in excess of the 90% targeted ROA.
The maximum amount of bonus managers could take was equal to 75% of their base salary. A critical factor in calculating the incentive profits is the computation of district profits. For calculating district profits, we believe that income taxes should not be charged on the calculation of profits. Although, income taxes can actually make a large difference in the profits, managers should not be evaluated based on these types of charges. Managers cannot actually control the income taxes that are charged for on their district and they cannot avoid paying those charges either.
Their performance and their ability to make profits for their district are not related to the amount of income taxes they will have to pay. As far as corporate overheads, they should not be allocated to districts. Allocating corporate overheads to districts would affect the profits of the district as well as the incentive profits of the district managers. The managers are not responsible for the corporate overheads and do not have any authority on controlling them or using them efficiently. As a result their performance and evaluation should not be affected by corporate expenses and decisions. 7
Finally, district profits can be computed either on the basis of historical cost or replacement cost. Using historical cost and including depreciable assets in their net book value, business profitability can be misstated and as a result managers will not be motivated to make correct investment decisions on the benefit of the entity. Moreover, historical cost can vary depending on the amount of money that the company paid as well as the timing of the purchase. As a result, the assets of the company might be understated and the managers might make investment decisions that are not profitable for the firm.
Using replacement cost managers can have a better idea of the assets employed by the company and their current valuation. Managers can be evaluated on the current prices of the assets employed and they can be motivated to use the assets and make investment decisions based on relevant values of assets and not on historical cost. Meeting with the Columbus District Manager Ken Richards is one of Quality Metal’s most successful district managers. His district has been continuously successful in recent years, consistently earning well above 30 percent return on assets. In March 992, he was approached with a proposal to purchase a new piece of processing equipment. This new piece of equipment would cost $600,000 which would yield a positive net present value of $286,000 and with a payback period of 4. 5 years. Since this purchase is over $10,000 Ken has to bring it to corporate in order for it to be approved. He needs to analyze the purchase and decide whether the purchase will affect his yearly bonus positively or negatively. The proposal to acquire the new processing equipment is an attractive one for Quality Metal because it yields a net positive present value from the purchase.
Ken Richards most likely will not bring the proposal to corporate for approval because his 8 bonus would decrease significantly compared to if he does not acquire the new equipment. Incentive Compensation System The Return on Assets (ROA) percentage shows how profitable a company’s assets are at generating revenue. ROA gives an idea of how effectively management is using assets to generate earnings. The problem with using ROA as a performance measurement for managers is that managers will make decisions based on their bonuses rather than in the best interest of the company.
Using ROA as a performance measure for district manager’s performance can be improved incorporating more motivation to improve the company as a hold rather than just the individual district. It could incorporate company-wide performance into the performance measure in order to motivate managers to make decisions that will benefit the company as a whole. The current system does not motivate managers to make investment decisions that align with the benefit of the company. We can actually see that in the case of the purchase of the processing equipment. If the district manager does not accept the proposal then his incentive bonus will be 11. % of the base salary, whereas if he accepts it his incentive bonus will decrease to 4. 28% of the base salary. Based on the current method of incentive bonus, Mr. Richards does not have any incentive to accept to buy the new equipment since it will decrease his bonus. However, the net present value of the new equipment is positive which means that the equipment would actually add value to firm. We can see that the incentive profits are affected by either a purchase or a disposal of an asset. In this case, the district managers purchase new equipment which 9 akes the adjusted profits fall below the actual profits and as a result the incentive profits are less than before the purchase. Moreover, in some cases district managers can sell assets that might have been useful for the company in order to reduce the actual assets less than the targeted assets and thus credit the difference multiplied by the ROA to the actual profits. As a result, the adjusted profits could be higher than before and cause the incentive profits to increase. These examples illustrate that the incentive system used by the company does not align with the aggressive growth strategy of the firm.
The district managers do not have any incentives to take advantage of growth opportunities and provide above-average return on assets. In our analysis, we examined EVA as a performance and incentive measure tool. Using EVA, the financial decisions of a business unit will be consistent with the decisions and the interests of the company. However, the use of EVA is not appropriate for new investments. The EVA will be depressed in the first years because of the high net book value of the asset. As a result, the true benefit of the investment will not be reflected.
In order to deal with the issue of accounting for fixed assets, we recommend three alternatives. First of all, fixed assets could be excluded from the investment base and evaluated separately. Second, the decision for acquisition of a new fixed asset could be made on the corporate level, so that we can avoid the conflict with the district manager’s incentive bonus. Finally, companies could use the annuity depreciation method to calculate the correct economic value added and return on investment. However, this method is in reality rarely used since it is not practical and is based largely on estimates.
