Even Semester (2012-2013)

Universitas Bina Nusantara

Binus International

Student Information

Name : Felicia Juliani Putri (1401088406)

Michelle (1401089453)

Raissa Hadisaputra (1401088513)

Course Code : AC403 Course Name : Management Control System

Class : 05PAB Name of Lecturer : Dr. Ancella Hermawan

Title of Assignment : Armco, Inc.: Midwestern Steel Division

Type of Assignment : Group Assignment

Submission Pattern : Hard Copy

Due Date : March 6th

, 2013 Submission Date : March 6th

, 2013

The assignment should meet the below requirements.

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the softcopy submission. 3. The above information is complete and legible.

4. Compiled pages are firmly attached.

5. Assignment has been copied (soft copy and hard copy) for each student ahead of the submission.

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Declaration of Originality

By signing this assignment, we understand, accept and consent to BiNus International terms and policy on plagiarism. We hereby declare that this work represents my own effort, and that all text and code have been written by me and has not

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Signatures of Students: 1. Felicia Juliani Putri

2. Michelle

3. Raissa Hadisaputra

Assignment Cover Letter (Group Assignment)

Background

Early in 1991, management of Kansas City Works of Armco began to implement new

performance measurement for Midwestern Steel Division. Bob Nenni, Director of Finance for

the division explained that managers spent more time explaining why changes in costs were

caused by problems with the accounting system in the old system. After they fixed the problem,

new performance measurement is found. It is designed to give better management focus on

things that are most important for them to worry about. Furthermore, it also helps them to warn

any potential problems incurred and improve commitment to achieve objectives.

In the summer of 1991, the new system was still being implemented. However, Bob believed that

the new system would be successful and he hoped that its use would spread throughout Armco.

Background of Armco and the Kansas City Works

Armco, Inc. was a producer of stainless, electrical and carbon steels and steel products. It also

produced coated, high strength and low-carbon flat rolled steels and oil field machinery and

equipment as the result of joint venture. In 1990, Armco was successful in becoming the 6th

largest steel manufacturer in United States with over $1.7 billion in net sales and $77 million

operating profits.

Midwestern Steel Division could generate $550 million of sales in 1990. Kansas City Works was

the largest entity, accounting for approximately $250 million in sales. Like that of most of the

firms in US steel industry, business at the Kansas City Works had declined significantly in the

last decade. Armco, Inc. experienced decrease in sales and operating profits. Moreover, the

employment was down from 5,000 employees in 1980 to 1,000 in 1990. It recorded significant

losses in 1980s, but it had been marginally profitable since 1988.

Kansas City Works produced two primary products: grinding media and carbon wire rod.

Grinding media were steel balls used for crushing ore in mining operations, whereas carbon wire

rod was used to make shopping carts, bed springs, coat hangers, and other products. In 1990, the

Kansas City Works sold 500,000 tons of rods and 200,000 tons of grinding media. Armco was

recognized as the leading supplier of its grinding media products in United States. It was proved

by being the most durable, and it received fewer complaints than its competitors. Conversely, its

carbon wire rods, as a commodity product, were not a profitable product since the production

still used old technology. The usage of the old technology caused it did not become cost

competitive. However, the rods generated volume and helped cover some of the fixed costs of

the plant.

The Works was not a low-cost manufacturer caused by several reasons, such as the higher of

union labor costs and inefficient plant infrastructure. The cost of union labor was higher than

some of its nonunion competitors. In addition, inefficient plant infrastructure was caused by the

usage of many employees about five times higher. As the result of its cost disadvantage, the

Work’s managers were intended to substitute the weakness by differentiating the offered

products. It developed the new higher-value products and success in selling approximately 10%

of new higher value products each year.

According to Rob Cushman, division president’s evaluation, all salaried employees in Works had

chances to get incentives ranging 5-30% of annual salary as awards based on performance

measurement. The incentives were affected by individual’s organization level and subjective

measurement. There were three measurements that applicable for these awards. For instance Rob

Cushman explained the criteria to evaluate the performance of Charlie Bradshaw, Works

Manager, as being based on one third on plant safety, one third on hard production numbers, and

one third on his evaluation of Charlie’s leadership.

Critical Success Factors in the Works

A. The melt shop

The shop’s goal was to run three shifts a day, seven days a week, 50 weeks a year, excluding

eight hours a week used for preventive maintenance. The rest 2 weeks of the year were used

for the extensive preventive maintenance and installation of new equipment. Theoretically

speaking, the shop would produce 110 heats/week. However, the best average result was 99

heats/week.

The performance of this melt shop affected the performance of the Kansas City as a whole.

It was because the output from the meat shop’s production would determine the output of

the plant as a whole. Moreover, the meat shop costs accounted for nearly 40% of total steel

conversion costs incurred in the plant. The largest expenditures in the melt shop were for

production material, labor, and energy. Energy itself accounted for 10% melt shop costs. In

1988 Armco made an $8 million investment in a new ladle arc furnace that significantly

changed the melting furnace technology used in the plant, and costs were declining as the

managers learned how best to use the new technology.

In addition, the quality of raw steel produced was a significant component in determining

whether the quality met the specific requirements. It was affected by the grades of scrap

steel and nonmetallic materials being used. Some production processes were standardized,

with the addition of some nonmetallic done either by automated equipment or by production

employees following standardized recipes.

B. Rolling and Finishing

The significant costs incurred in this phase were for labor, energy, maintenance, and yield

losses. This areas were heavily capital intensive. Based on the customers’ actual testing on

grinding operations, Armco’s ball were more than competitive; they lasted up to 15% longer

than did its closest competitor’s balls.

C. Maintenance

The goal of maintenance was to maximize equipment uptime while controlling maintenance

expenditures. The maintenance activities were divided into three groups. There was an

assignment of electrical and mechanical maintenance employees to each manufacturing cost

center. A third group operated a centralized maintenance shop. The cost in the maintenance

was mostly for maintaining workers.

The Old Performance Measurement System

The manufacturing areas of Kansas City Works were divided into five responsibility areas:

melting, casting, the 19” mill, the rod mill department, and the grinding media department. Each

responsibility center was comprised of one or more cost centers. Before the changes were made

in 1991, the performances of these cost center managers and superiors were evaluated in terms of

cost control and safety. The key cost performance measure, which was called “Cost Above”,

included the cost added per ton of steel at each production stage and for the entire plant. The

costs were reported to manufacturing managers on an Operating Statistics Report that was

produced on approximately the 15th

day following each month end.

The Operating Statistic Reports provided a five-year history, monthly, and year-to-date actual,

and monthly and year-to-date objectives and variances form objective for each of the factors that

determined total Cost Above for each cost center. The reports used the same accounting

information that was used in the financial reporting and inventory valuation purposes, so the

figures included allocations of indirect manufacturing costs.

The New Performance Measurement System

A. The goals of the new system

As the director of finance, Bob Nenni had been working on a performance measurement

system since 1989. However, he had been unable to design and implement the new system

while keeping the old system going due to staff constrains. Therefore, on November 1, 1990,

Rob Cushman was appointed as Midwestern Steel Division and sponsored the

implementation of a new performance measurement system. Moreover, he allowed Bob to

discontinue the usage of Operating Statistics Report in January 1991 in order to implement

the new system.

The new system was designed both to provide the middle and lower-level managers with a

greater understanding of how their actions related to the implementation of the division’s

business strategies and as an improved method for managers at all levels to assess the extent

to which the desired results were being achieved. Then, the vision and goal were compared

with the actual results.

Bob and Rob thought that the implementation of new system promised two major

improvements. First, the new system was designed for managers to focus on few key

objectives that largely determined the Kansas City Works’ success and not get involved in

the detail until problems incurred. Second, the new system was designed to provide an

improved basis for evaluating operating managers and manufacturing supervisors. It

included a balanced set of performance measures, including quality, schedule achievement,

and safety, in addition to costs. In addition, the cost reports would improve because it only

included the cost which deemed controllable by each individual operating manager.

B. The design of the new system

There were 10 key performance measures were defined as the new system design for Kansas

City Works, including:

1. Heats per week, which was only relevant to the melt shop. This measurement was a critical

measure since the melt shop was a bottleneck operation.

2. Tons per man hour, which was a productivity measure

3. Disabling injury index, which was a safety measure

4. Total quality index, which was the product of three measures: physical yield, percentage of

product meeting specification, and percentage on-time shipment

5. Spending, which was the accumulation of all expenses incurred by the people reporting

directly to a manager

6. Maintenance performance, had not yet been clearly defined by the middle of 1991, but

maintenance labor cost and material cost were being measured

7. Cash flow, was measured monthly for the plant

8. Product mix, was the percentage of high carbon products sold compared to low carbon

9. Inventory days on hand, was tracked monthly

10. Sales price minus cost of net metal, a measure of value added which was tracked monthly

In the new system, Cost Above measure was eliminated. Production managers were no

longer cost center managers. The cost detail in the new system was reduced. Moreover, the

cost considered in the new system was only the expenditure by the employees in the

organizations.

C. The implementation process

The new system focused on first on heats per week, tons per man hour, physical yield, and

spending as the entire task could not be accomplished immediately. The operating managers’

initial reaction to the sample reports was dissatisfaction. The early reports did not provide

the line-item expense detail to which they had become accustomed. Several managers

complained because of incompleteness of the reports.

In late April, the accounting group started to provide spending numbers for the entire cost

center. This change allowed managers to compare their budgeted spending targets which had

been prepared using old performance philosophy. Starting in 1992, they promised that the

reports would reflect only the new performance philosophy.

In June 1991, Bob Nenni was convinced that company was on the right track even though

some managers were uncomfortable with the new system. And he knew that the delays in

implementation process had frustrated both information users and his accounting staff.

Accounting division felt that they spend only 20% spending of their time in accounting on

the non-value-added chores of inventory valuation for financial reporting purposes.

Remaining Issues

In 1990, there were two issues related to incentives and performance measurement. First, the

issue was about how to evaluate managers’ performances for uncontrollable factors. For instance,

early in 1991, the melt shop suffered two transformer failures because of fluctuations in the line

voltages provided by local utility, Kansas City Power and Light. The failures had happened

every year, but melt shop managers had recently upgraded some electrical switches to try to

eliminate the problem. However, the failures occurred again and it was impossible to have an

average of 101 heats per week. It could be concluded that this issue led to unaccomplished goal

planned for 1991.

Second, the issue was about whether to increase proportion of total compensation that was linked

to individual performance evaluations or not. In other words, how much the total compensation

should be provided in fixed salary, how much should be paid only to those who were good at

getting things done and done well.

Analysis

The strength of old performance measurement system:

1. Based on critical success factors in the Works, action control did exist in determining whether

the finished products met the required specifications. In fact, there was a standardized

production process for the company to alleviate the lack of direction. The melt shop

determined the grades of scrap steel and nonmetallic materials used in the process since the

quality of finished products was affected significantly by those components. Moreover, some

nonmetallic done either by automated equipment or by production employees. Although it

was done by production employees, standardized recipes were provided to maintain the

quality of finished product. It proved that the company had a strength action control in the

melt shop’s production process.

2. In addition, the shop’s goal was really clear that to run three shifts a day, seven days a week,

and 50 weeks a year, excluding eight hours a week used for preventive maintenance. The

maintenance was maintained properly in order to maximize equipment uptime while

controlling maintenance expenditures. The existence of regular maintenance would prevent

the Works to spend money if there were trouble in the equipment. The potential cost occurred

because of problems in equipment was high because the problems in the melt shop, as the

“bottleneck” operation, would affect the entire manufacturing process.

3. All salaries employees in the Works were eligible for cash incentive awards based on

performance evaluation made by supervisors and Rob Cushman, division president. This is an

indication of applying result controls. The incentive award potentials ranged from

approximately 5-30% of annual salary depending on the individual’s organization level. The

incentives would influence the employee’s performance. It would provide a positive

motivational impact to develop them in achieving the goal. The implementation of result

control in terms of cash incentives would be greatly interesting for some people.

The weakness of old performance measurement system:

1. Managers did not know how performance of the company as a whole. They only focused on

achieving their own objectives. Therefore, the problem may occur due to different objectives

between low, middle and top managers.

2. The operating statistic report provided too much information. Moreover, it was inconvenient

to be read. The melting operation managers, Gary Downmey, also mentioned that the some

items in report were quite small in dollar amounts.

3. The report was produced on 15th day following each month end. It took longer time for

managers in correcting the previous actions, which produced an unsatisfactory result.

The strength of the implementation of new performance measurement system:

1. The new systems were designed in order to provide the most important information as the

result on focusing on certain significant data. The new system caused them to focus on five or

six things that cause 80% of costs instead of 40. The managers were focused on their

objectives rather than the performance of the overall performance that might cause the

objectives of top management and those in the middle and lower managers are not the same.

Therefore, the new system was created in order to increase the competitiveness and to avoid

unnecessary expenses.

2. The setting of performance targets was a significant element of result control system. The new

system defined the performance targets, for instance for the melt shop, the company provided

the target heats per week. Those targets would affect the behavior of the employees in two

ways. First, they would stimulate the employee to improve their performances by providing

conscious goals to strive for. It was because most people preferred to be given a specific

target to shoot for to direct them and measure their own performance. Second, they can

compare how they performed based on comparison of actual and budgeted result. The failure

in achieving the targets warned the managers to change their actions and think other ways or

strategy in order to achieve the targets.

3. One of conditions that are present in determining the effectiveness the result controls is the

employees whose behaviors are being controlled have significant influence on the results for

which they are being held accountable. The new measurement performance evaluation

systems involve the controllable factors which enable managers to compare between the

actual and budgeted targets. As provided in Exhibit 6 about the new system pilot performance

report, the report provided not only the actual and planned amount, but also the variance.

In the implementation of new performance measurement system, several problems still occurred.

1. Lack of communication between the creator of new system, such as Rob Cushman, Charlie

Bradshaw, Bob Nenni, Gil Smith, and others, to managers, the users of new key performance

measures. In fact, in early April 1991, Charlie Bradshaw complained to Bob Nenni that he

received nothing of use from other departments since the old reports had been discontinued.

There was a possibility that the lack of communication led to misinterpretation the

implementation of the new systems. Moreover, other operating managers stated that

eventually the operating mangers understood the old reports which made them aware to

change it. The statement proved that there were lack of understanding of the purpose in

creating reports and unable to acknowledge the importance of specific information in the

reports. Those problems caused the employees perform poorly and the likelihood of the

desired behaviors occurring is relatively small. As they were lack of direction, they did not

understand clearly what the organization wants form them.

2. Lack of motivation which occurred because of the lack of direction. As stated in the case, the

implementation process had frustrated the employees. In addition, the operating managers’

was disappointed with the sample reports which did not provide the line-item expense detail

to which they had become accustomed. The lack of direction would lead to unwillingness to

change and move from their comfort zone. It caused the lack of employees’ motivation to

develop themselves in order to improve their performance.

3. Unclear key performance measures. One of the 10-key performance measures was

maintenance performance. It was stated that the maintenance performance measures had not

yet been clearly defined. This issue would lead the measurement not congruent with the

organization’s objectives and encourage the employees to do the wrong things.

4. Occurrence of uncontrollable factors. In 1991, there was an issue related to the evaluation of

managers’ performances. The situation was the evaluation involved uncontrollable factors,

which was transformer failure. The failure was caused by the unstable line voltage provided

by local utility, Kansas City Power and Light. As the result, the average heats per week were

above 101 as had been stated in the goal of new system. Therefore, the difficulties would

occur in the implementation of new performance evaluation systems as the result of the

uncontrollable factors. The occurrence of uncontrollable factor created a dilemma for Rob

Cushman, division president, whether to consider this issue affecting the evaluations of his

operating managers. This was a significant issue since the performance in melt shop, which

was measured by heats per week, would affect the performance of Kansas City Works as a

whole.

5. There was a consideration related to increase proportion of total compensation that was linked

to individual performance evaluations. How much of total compensation should be provided

in fixed salary along with how much should be paid only to those who were good at getting

things done and done well? There were no specific criteria determined yet in calculating the

percentage increase.

Recommendations

1. In order to solve the miscommunication between employees, there should be a regular meeting

for several months. For instance, the company conducts a regular meeting with managers

every Monday in order to announce what is the expected performance dimensions.

Furthermore, the progress of implementation is also discussed during the meeting. Any

problems and limitations are delivered to get the solution. Therefore, the developer of new

system will help to avoid the lack of direction during the implementation.

In addition, the activities and evaluation of activities should be supervised properly. Rob

Cushman has to make sure that the new systems were implemented according to the

expectations or company’s objectives. Besides providing reward for those who can achieve

their targets, the company can give any punishment to motivate the employees in

implementing new system rather than staying with the old standard.

2. In order to support the implementation of the new system, Bob Nenni as the director may

discontinue the Operating Statistics Report System (old system). As stated in the case, Bob

Nenni believed that if the managers kept using the old data, they would not considered what

improvements could be made from the new one. Furthermore, lack of direction because of the

new system implementation can be solved by conducting a weekly training in a month for all

of the employees so that the employees could understand what the purpose of this new system

implementation is, how this new system actually works, so they might be willing to move

from their comfort zone.

3. Key performance measures should be measureable by numbers or a countable amount. In this

case, it is stated that one of the ten key performance measures which was maintenance

performance had not yet been clearly defined. Maintenance performance actually can be

measured by, for instance, the numbers of the system down in a month. By measuring the

maintenance performance, it can indicate whether the company’s maintenance performance

had been running well or not; and whether the maintenance activities had been adequate or

not. If the measurement performance does not perform good result, company can decide

whether to intensify the maintenance activities or to find out the problems which cause the

system down more often.

4. Company may consider purchasing new equipment with more advanced technology. Armco’s

rod mill used relatively old technology, which was not cost competitive. Even though the

sales volume of rod mill was high, but the sales helped to cover some of fixed costs of the

plant. Therefore, although it is costly to buy new technology machine, however it will give

benefit in long run. This advantage can also be seen in the melt shop, the cost declined

because company invested $8 million for new melting furnace technology used in the plant.

5. Certain percentage multiplied total salary of employee may be applied in determining the

compensation given. If the desired results are achieved in several months, company may

increase the compensation in order to motivate employees. Salary range, job position, and

performance evaluation are factors in selecting the amount percentage used. For instance,

company may give higher compensation to higher level of manager or salary.