Fixing a Hole

Prof. Robert Bloomfield, Cornell University

This case is based on a real-life situation;

names have been changed to protect identities.

Digging a Hole

Nancy Quine, Senior Vice President of Geriatric Products at Global Consumer Goods (GCG) came to work in early December to hear some bad news. Jesse Chalmers, a new sales manager, had made a major miscalculation. GCG allows sales managers to arrange their own promotion agreements with customers. Jesse chose to provide a “store coupon” arrangement with a major drug store (MDS) chain: customers who spent at least $4 on a GCG product on Black Friday (the Friday after Thanksgiving) or later that weekend would receive a $2 instant coupon to use on any product sold by MDS.

The promotion was a pyrrhic success. Assume a customer bought a product with a retail cost of $5. For a typical product, GCG would receive about $3. The net revenue brought in by the sale was recorded at $1: the $3 revenue from the store less the $2 coupon. (Store coupons are almost never used to buy another GCG product). However, this is only the beginning of the problem. Producing and shipping a product typically cost GCG about two-thirds of wholesale gross revenue amount, in this case 2/3 x $3 = $2. So GCG recorded a loss of $1 for each unit sold ($1 net revenue - $2 production and shipping cost). The promotion was so “successful” that GCG lost almost $10,000,000 in a single weekend.

Filling the Hole

As Senior Vice President, Nancy Quine was responsible for ensuring that Geriatric Products hit the profit targets assigned to it each quarter by headquarters. This $10M hole was an unpleasant surprise, especially since it was uncovered with only a few weeks left in the quarter. Nancy immediately set to work finding ways to boost the division’s profit by $10M. Here’s how she did it:

  1. Renegotiating transfer prices. Like many decentralized firms, GCG was split into numerous divisions. The Geriatric division produced few of the ingredients for the products it sold. Instead, it bought some materials from the outside (particularly packaging), but bought key ingredients for contents of the bottles (referred to as “product”) from other divisions. Also like many decentralized firms, transfer prices for these inter-divisional purchases were negotiated by divisional executives. Nancy’s first step was to call her negotiating partner who provided a key product ingredient and negotiate a lower price, retroactive to the beginning of the quarter. Nancy was confident that her negotiating partner would agree to the arrangement, since she had done the same for them two years ago in similar circumstances.
  2. Deferring selling expenses. GCG had been gearing up for a big launch of a new product. Such launches are typically preceded by several weeks of promotion on TV, print, radio and web outlets. Nancy called the marketing group and told them that they had $4 million less to work with in December. She would leave it to them to decide how to implement the cuts: they could delay promotion, focus on a more limited geography (e.g., only in the Northeast) or shift their mix to cheaper channels (e.g., less TV, more web advertising).
  3. Purchasing low-cost materials. The Geriatric division encouraged cost cutting by maintaining a suggestion box that all employees could use to propose measures that might improve efficiency. A committee including representatives from accounting, engineering, production and marketing, evaluated the proposals. One recommendation, never acted on, had received a strong evaluation: purchasing “unified” container lids that used a single piece of plastic instead of a cap-and-hinge construction. Nancy ordered $10M worth of the new lids. The original design would have cost $13 million. The standard cost accounting system assumed that the number of container lids purchased would have cost $13.5 million. Nancy doesn’t expect any of the container lids to be used before the end of the year.
  4. Planning a New Year’s Eve promotion. Because New Year’s Day fell on a Monday, Nancy saw an opportunity to bring in some extra profit before year end. She arranged another promotion with MDS for December 30th and 31st. Similar to the original promotion that caused the problems in the first place, MDS customers who purchased a CGS product received a coupon. However, the product had to cost at least $20 to get a $5 coupon, and the coupon applied only to another CGS good purchased costing $10 or more at the same time. This promotion was expected to generate substantial sales of products for incontinence and diabetes, both of which had relatively high price tags.

Questions

  • How exactly would each tactic result in profits to offset at least part of the $10M hole Nancy was trying to dig her way out of? Be sure to use your accounting knowledge, and specify what types of accounts will be affected and how these will show up on the division’s income statement and balance sheet. (For the New Year’s Eve promotion, how much profit will GCG expect from each coupon user?)
    • Renegotiating transfer prices is strictly an accounting maneuver—it does not alter the fundamental cash flows or value of the business as a whole, but does increase Geriatrics’ profits at the expense of other units. This maneuver will not affect cash at any unit, but will affect how they split up CGS and/or SG&A expenses.
    • Deferring selling expenses will increase this period’s income by reducing an immediate out-of-pocket expense. However, this comes at the cost of long-term profit: presumably the division is deviating from their otherwise-optimal business strategy of continuing with their planned marketing campaigns. The maneuver will increase cash and income, and reduce SG&A expenses.
    • Purchasing low-cost goods that remain in inventory might seem to have no income effect (just altering inventory in the balance sheet). But because the firm uses a standard costing system, the favorable purchase-price variance is immediately recognized in income as a downward adjustment to cost of goods sold. What is the long-term effect? That depends on the impact of the lower-cost caps on consumer satisfaction and future demand.
    • The New-Year’s Eve promotion will pull sales from next year into this year. It probably doesn’t maximize overall profit (combined over both years), because otherwise they probably would have scheduled the promotion without the budget shortfall. Will the gross profit for the promotion sales be positive? Unlike the promotion that created the hole, this one requires an additional purchase of CGS products. Assuming that people buy the minimum-price product ($10), the revenue on the second item is $6.67 before the discount, and the cost (at 2/3 of revenue) is $4.44. This means the second item creates a loss of about $0.56 with the $5 coupon; adding in the shipping cost of $2 implies a loss of $2.56, but that is far outweighed by the profit that will be generated by the regular-price item.
  • How should the GCG respond to each of Nancy’s tactics when they evaluate her performance as part of their annual compensation and promotion review? Taking each tactic separately, do you think Nancy acted ethically? Use the following scales for your responses:

Performance Evaluation Scale. The tactic is:

  1. To be strongly rewarded
  2. To be rewarded
  3. To be punished
  4. To be strongly punished
  5. A firing offense

Ethicality Scale. The tactic is:

  1. Clearly ethical
  2. Probably ethical
  3. Probably not ethical
  4. Clearly unethical
  5. Illegal

Answers to these last questions are controversial, but here are some observations:

  • None of the techniques appear to violate GAAP or other professional standards. In particular, none alter whether or when events are recorded (generally viewed as the least ethical form of earnings management); the first item is best viewed as accrual earnings management, in that it adjusts estimates. The other three are operational decisions. Interestingly, while these are the types of decisions that truly reduce the value of the firm (because they involve deviating from optimal business strategies), they are generally viewed as the most ethical.
  • My preferred model of assessing the ethicality of earnings management is to determine whether the accounting representation is “a lie”, and if it is, to use Sissela Bok’s “principle of veracity” to determine whether the lie is ethical.
    • A reporting or management is a lie if the resulting performance measure is intentionally false and deceptive regarding the underlying construct the measure purports to capture. In my view (which not everyone will agree with), the practice is deceptive only if people are not anticipating it to be used. The only one I see that seems potentially deceptive is the retroactive alteration of transfer prices and allocations. Even for internal transactions, I believe most people will believe that past transaction prices are fixed and won’t be changed, and would be deceived by the practice.
    • If a practice is viewed as a lie, Bok argues that it is ethical if reasonable outside observers would agree that the lie was an appropriate way to behave. Appropriateness in turn is evaluated by the direct harm or benefit upon the audience for the lie (those who will rely on it), and on the externalized effect of the lie on the “practice of veracity.” Even if the operational decisions are viewed as lies, it doesn’t seem obvious that there is harm to either the audience (the people evaluating Geriatrics) or the practice of veracity (whether it will increase the extent of lying) unless the practices are more egregious than usually expected. That doesn’t appear to be the case in most businesses. In contrast, I believe the retroactive adjustment of transaction prices is likely to make performance evaluation difficult, and to reduce the level of trust in allocations. This harm seems serious enough that I would probably penalize this practice, or at least implement policies to clarify that retroactive adjustments are unacceptable behavior.