ABRAMS COMAPANY CASE 5-4 ABRAMS COMPANY

Que. 1: Evaluate each of the concerns expressed by top management, and if necessary, make recommendation appropriate to the circumtences described in the case
The Abrams case is about using profitability measures to evaluate profit centers. The case also reflects a long academic debate in the US-literature about ROI problems. In EU companies it is more common to evaluate PCs with Income measures like RI and EVA. This case covers the tree main problems in controlling profit centers:

1. The ROI behavior 2. Transfer pricing disputes 3. Operational trouble shouting

It is very difficult to find a relevant and fair capital base for the ROI measure. Abrams use

book value for fixed assets which inflate the ROI measure as the assets age.
The age and mix of assets also differs among divisions which give unfair measures. It is also easy for the divisions to manipulate the capital base at the end of the year. ROI based bonus

may rob the future, who want to invest in assets if that reduce the bonus.
I recommend this company to use RI or EVA instead of ROI and to control the investments separately using NPV and capital turnover measures. The bonus should be based on the budgeted income level, the RI target. The problem with the inventory level can not be controlled with ROI management. If the company change to RI/EVA it will be possible to to negotiate relevant inventory levels in the budget process. High inventory levels can also be managed with differentiated capital charges

Prepared by: Milan Padariya, 63-MBA(Pharma)

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that will create high interest costs. The best way to control operational tasks is to us non financial measures such as inventory turnover. Use non financial measures to control the inventory levels. If it is an strategic issue you can connect this measure to the bonus system.

Que. 2: What is overall evaluation of Abrams management control system? Describe any strength or weakness that you identified but did not include in answering the previous question. What changes, if any, would you recommend to top management?

In general, Abrams Company adopts the lowest cost, differentiation, market focus and ROI strategies to accomplish the organizations goal. Furthermore, In order to implement the strategies the firm establishes its own management control systems.

Evaluation of Abrams Management Control System:

The current measurement system of the company is ROI. The ROI target is set based on budget profit divided by actual beginning of the year net assets. Actual ROI is calculating by actual profit divided by actual beginning of the year net asset. The advantage of the Abrams Company ROI system is it does not consider the investment added during the year, because the investments provide little effort to the year, but more benefit to the future. However, the ROI measurement system has some weakness, such as defer asset replacement, short-term focus at the expense of long-term.

The incentive compensation plan of Abrams Company is bonus plan, and it calculate accurately based on an equation, and it seems equal for all members. In addition, some adjustments also are made associate with the performance of the managers. The performance is measured by compare of actual profit and budget profit. However, all the measurement is
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associate with data, sometimes the performance will be influence by variance elements, such as, economic environment, the demand level, material price, cost of labor, and government policy, so the measurement need to improve in some areas. The dollar amount of corporate bonus pool was established by a fixed formula linked to company earning per share. This incentive compensation plan can be considered as a reward system. Using this method the company can increase or maintain motivation.

STRENGTH :
-The company has a clear management structure. -The company has employed a bonus plan for employees. -The AM Marketing division will input products form the other three divisions, and sell it to domestic and foreign market, it helps the company save cost when it input internal.

WEAKNESS:
The Abrams Company has three totally independent divisions, and the three divisions are lack of connection. They purchase their materials separately, and they carried excessive inventories most of the year. Also, inside sales sometimes need a negotiation on price, the may lead to low productivity.

SUGGESTIONS TO PERFORMANCE MEASUREMENT SYSTEM:

1) ROI: can be used combination with other performance measures to avoid the limitations of ROI. The company can establish a non-financial performance measurement system such as

the balanced scorecard .With a good performance measurement system, the incentive
compensation plan will be improved.

(2) EVA ( Economic value added): can be used instead of ROI Suggestions to transfer pricing A transfer price fixed by the top management in compliance with the AM division and the other divisions involved which could be revised when it is out of date. This fixed price
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could be adjusted due to inflation. There should be an internal policy on it. Therefore, top management should implement a cost-based transfer prices because when competitive prices are not available, transfer prices may be set on the basis of cost plus a profit markup.

RECOMMENDATION:
The non-financial performance measurement system should be established. The

balanced scorecard is a good choice for company measure performance. With a good
performance measurement system, the incentive compensation plan will be

improved.

Prepared by: Milan Padariya, 63-MBA(Pharma)

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