Western Chemical Corporation: Divisional PERFORMANCE MEASUREMENT*The fact is that we reall...

Western Chemical Corporation: Divisional PERFORMANCE MEASUREMENT*

The fact is that we really have not yet figured out the best way to measure and report on the performance of some of our foreign operations. Because of different ownership arrangements and the use of local financing, when we use conventional accounting principles and standards, we often get financial reports that seem to contradict what we believe to be the true results of operations. This creates problems within the company because people who are not familiar with particular operations see the reports and draw erroneous conclusions about how this one or that one is performing relative to others.

Now that you are beginning to get questions from shareholders and analysts about how some of these investments are performing, 1 realized that Cynthia and I had better brief you on what some of the problems are that we have with division perfoimance measurement.

Stan Rogers, president of Western Chemical Corporation (WCC), was meeting with Samantha Chu, recently appointed director of Investor Relations, and Cynthia Sheldon, who had recently been appointed vice president and controller. Chu had that morning received an inquiry from a well-known chemical industry analyst who had some fairly specific questions about some of the company’s investments in Europe and the Far East. When she questioned Sheldon, Cynthia suggested that they meet with Rogers to examine some of the issues that Rogers and Sheldon had been discussing, so that Chu could answer the analyst’s requests more accurately.

The information on the financial performance of WCC’s foreign operations was prepared by the same accountants who maintained the company’s accounts and who prepared its quarterly and annual reports. A single database for all accounting had been established some years earlier in the belief that it could serve all accounting needs of both managers and those external to the company. A common chart of accounts and accounting policies was used throughout the company and in all of its subsidiaries.

A variety of new alliances and ownership arrangements had been used in recent international ventures to speed entry to new international markets and to minimize investment and risk. Because of these, Rogers had become. convinced that some of the reports the accountants were preparing about some of the ventures could be quite misleading. It was for that reason that he and Sheldon were already discussing alternative ways to measure divisional performance, and that Sheldon thought Chu should be brought into their dir cussion before trying to answer the analyst’s queries.

The Company and International Ventures

In 1995, WCC was a 75-year-old, Fortune 300 chemical company. Its largest business marketed chemicals and chemical programs for water and waste treatment. Additional products and chemical services targeted manufacturing processes where the quality of a customer’s product could be enhanced. The company was proud of its industry reputation for quality of its solutions to customer problems and exceptional service to customers. WCC had 4,900 employees and operated more than 35 plants in 19 countries. Financial information by geographic area is shown in Exhibit 1.

WCC manufactured in many different countries using a variety of ownership arrangements. Some plants were wholly owned manufacturing sites, and others were operated as joint ventures with local affiliates. Three of these plants were useful illustrations as background for discussing the problems the company faced in measuring the performance of its international ventures. All had been constructed and had come on- stream in the 1991–1993 period.

A chemical plant on the outskirts of Prague in the Czech Republic was operated as a joint venture with a local partner. Total investment in the plant was between $35 and $40 million, including working capital. WCC retained a controlling interest in the joint venture and operated the plant. The company had invested about $5 million in the venture, and the balance of the investment had come from the venture partner and local borrowing.

A similar plant in Poland was 100% owned, and the total capital investment of $40 to $45 million including working capital had been funded by WCC. The venture itself hnd no external debt.

A third plant in Malaysia was also 100% owned. The plant was built to add capacity in the Pacific region, but the plant was consid ered part of the company’s production capacity serving the global market. WCC had invested approximately $35 million in this Malaysian plant.

Measuring the Performance of Three International Ventures

Cynthia Sheldon had prepared some exhibits using representative numbers, and she began by explaining the income statement for the venture in the Czech Republic to Samantha Chu.

The first case is Prague. It is pretty much a classic situation. What I have put together here is a basic income statement for the facility for the first three quarters of 1995 (Exhibit 2). What this helps to show is how the difference between the ownership structures in Prague and Poland lead to apparent differences in reported income.

This is a nine-month year-to-date income statement for the joint venture. Earnings before interest and taxes of $869,000 is what we would normally report internally for a wholly owned subsidiary, and that is what would be consolidated. As you proceed down the income statement, there is a charge for interest because we have the ability to leverage these joint ventures fairly highly, anywhere from 60% to 80%. This is interest on external debt—cash going out. We account for it this way because the venture has its own Board of Directors, even though we have management control and retain much of the ability to influence operations, which is not always the case. The fees of $867,000 are coming to WCC under a technical agreement that we have with the joint venture, as a percentage of revenues. In this case, we have put a minority interest line to get down to a net income for WCC. That is the actual income that we would report to the outside world.

EXHIBIT 1 Financial Information by Geographic Area

EXHIBIT 2 9/95 Year-to-Date Income from Czech Republic Joint Venture (in Thousands)

We are reporting externally a loss of $646,000 on this business, when in truth, relative to our other businesses which are reported before interest charges and before fees, it is contributing to our corporate income. This report makes it appear that we are operating at a loss of just under $1.2 million, $532,000 of which is the share of our joint venture partner, and our share is the $646,000.

Stan Rogers described the investment:

In this business WCC has invested, in addition to its technical knowledge and technology, $5 million of its money. In addition, we do not guarantee the debt, which is off balance sheet so far as WCC is concerned. One other way that we can look at these businesses is to look at cash flows to WCC, and cash return on investment to WCC. When we do that, because of the $867,000 in fees which are paid to WCC, there is some return. Although the return is small, it is reasonable at this stage of development of a new business. This business, because of the fees, has been in a loss position, but because of the fees it has shown a positive cash return on investment to WCC.

Sheldon continued:

Our actual return consists of the fees paid to WCC, or $867,000, and our share of the reported operating losses, for a net income of $221.000. That is the return on our approximately $5 million investment. If the subsidiary were wholly owned with a total investment of approximately $40 million, we would be looking at the $869,000 income befoie interest and taxes, to which we might decide to apply a tax, on the investment of $40 million. That is how we measure the performance of whollv owned divisions.

One of the reasons that this report appeals as it does was that, a few years ago, then current management decided to work from a single data base and to have one group prepare both the external financial reports and the management reports for internal use. It was a fine decision, except for the fact that the external reporters did not have the interest or ability to report what was actually going on in the affiliates.

Now, let’s look at the report for our subsidiary in Poland (Exhibit 3). This plant is 100% owned, so we do not report any interest or fees. The total capital investment was funded by the company and totaled about $40 or $45 million including working capital. There is no external debt or minority interest and no fees. The other charges include the amortization of interest that was capitalized during the construction of the plant. The cost of sales includes some profit from materials that are purchased from other plants, but the prices paid are reasonable if you compare them with competitors’ prices This is another interesting problem that we struggle with, since we are probably reporting $2 or $3 million in profits elsewhere because of these plant purchases. But consider how this would look if we were deducting interest on $30 million of debt, and fees of 8% of revenues as we do in the case of the Prague affiliate. We would then be showing a loss from the business of about $3 million. The accountants do not consider this, and their report makes it appeal’ that the business was doing just fine.

EXHIBIT 3 9/95 Year-to-Date Income from Poland Plan (in Thousands)

Saitiantha Chu spoke up:

Your explanation implies that there must be some other measures of performance that tell you how these plants are performing. What are those?

Sheldon:

We use budgets and the original business plans. We look at the performance against those expectations.

Rogers:

Also, although we do not monitor cash flows to the degree that we ought to, we have in our head the cash contribution compared to the amounts that we have invested. In the Czech Republic we can look ahead and see that in the future we will have a 35% to 45% cash on cash return. Poland is draining cash out of us at a remarkable rate, and we have not yet figured out a way to stop it. There are still a lot of unresolved business problems. Compared to the original business plan we have not been able to generate the revenues that were forecasted and the costs have been higher. We do not present cash flow reports to our managers, so these analyses all have to be done in our heads. The information we would need to bring this about formally is all available, but we just have not asked anyone to do it.

What we have are three new plants built at about the same time, each having very complex and different financial reporting issues that lead you to have completely different views of the business. Cynthia, show Samantha the report on the plant in Malaysia and what happens when we introduce an economic value added (EVA) approach. . . .

Sheldon:

The third plant was built to supply a high margin part of our business. That part of our business is truly a global business in that we can actually ship our product from any of several plants to anywhere in the world. When the decision to build a plant in Malaysia was made we were running out of capacity. We made a strategic decision that we wanted to be located in Malaysia, but this was to be part of our production facilities to serve the global market. We do not usually build a separate plant to supply only the high margin products. The volumes sold and shipped tend to be small, and adding the technostructure of technical service and laboratories to a plant makes the economics somewhat unfavorable unless there are several other units in the same plant producing higher volume products to help carry the costs of these necessary add-ons.

Looking at the column labeled “Region of Manufacture,” you can see the sales and profitability of the manufacturing facility in Malaysia [Exhibit 4], It sells $12 million worth of product, and you can see that with the costs being what they are, the plant is losing a lot of money. The capital charge that we show is an attempt to gel a measure of the economic value added by the plant. As was the case with Poland, this report does not include any interest on the total investment of almost $35 million, or any fees.

The EVA approach uses a 12% capital charge based on the assets employed such as working capital, including accounts payable, and fixed capital. Depreciation is included in cost of sales. I think the way we use EVA is very simple, exactly the way it is employed by other folks, but some get much more sophisticated about allocations, capitalized research and development, and the like We do not do that.

EXHIBIT 4 9/95 Year-to-Date Income from Malaysia and Soothe: ist Asia (in Thousands)

*$30,000 @ 12% =$3.600.

†($110,00 @%) x [(36.052 - 12,020)/102,800 @ 12%) = $6,686.

In addition we have recently started lo look not just at “region of manufacture” but also at “region of sale,” primarily to get an understanding of whether or not a market is attractive. The second column labeled “Region of Sale” is all product being sold in Southeast Asia even if it is being manufactured outside, so it includes the cost of manufacturing product, shipping it, and delivering it to customers in the region. On that basis the earnings before interest and taxes are about $4 million. If we wanted to get down to economic value added we would need to deduct taxes and a capital charge and the economic value added would still be negative but not so much so that we could not develop some reasonable strategies lo fix it compared to the region of manufacture measure which is pretty daunting.

Stan Rogers interjected:

There is an incremental layer of complexity here in that this plant is starting to produce for the rest of the world because we are running out of capacity and are using this plant as the swing plant. Those shipments will show up in the region of manufacture numbers, but Ihey will not show up in the region of sale numbers. We have not yet sorted this out, but my suspicion is that von cannot look at it this way and get an intriguing view—a solid view—of the business. We probably have to look at the whole system and analyze the incremental revenues and costs of the whole business.

The reason why I see this as another iteration of the same or complexity of the same problem, is that in Prague and Poland we had the different corporate structures that led to different accounting treatments of interest and fees, which gave us completely warped views on what was going on in the business. This presents the same challenge but adds the dimensions of region of manufacture and region of sale accounting and the need for total system analysis.

Samantha Chu broke the silence of the pause which followed: “Have you found a solution to the problem yet?” Rogers answered:

We understand it. We have not institutionalized a management reporting system that would lead someone who is intelligent but does not understand the background to understand what is really going on. We do not have a management reporting system in place that shows the relative performance of the three plants in a clear manner. On this basis the system does not work.

Some Possible Solutions to the Performance Measurement Problem

Cynthia Sheldon began a discussion of some possible solutions to the division performance measurement problem:

We are scratching away at a solution, perhaps using the concept of economic value added. We probably will also separate the people who are preparing the managerial reports from those who are concerned with external reporting, even though both groups will be working from the same databases. Until now, when we report to external public relations and to the Chairman about the performance of the business, we have used external reporting standards and bases. I have concluded that to get away from that we have to have a separate group engaged with the businesses.

Stan Rogers chimed in:

From a business standpoint we understand this, we think. When we want to do a presentation we will do a one time analysis, pulling the numbers together that we think best reflect the situation. But we do not have a disciplined, repetitive reporting system that produces an analysis of how these businesses are doing in any other way than the way the external reporting system does it. That is an issue of priorities. We just do not have the time or resources to fix the system now. It is not that we do not understand the problem, or that we could not do it. I think we understand the problem, and we understand the intellectual underpinnings of a solution.

I know that does not help you in responding to the analyst’s questions today, so you will just have to respond very carefully.

Cynthia Sheldon continued:

We are really just beginning to use EVA as a tool to get people to understand the issues. There is nothing wrong with using cash flow, return on net assets, and other familiar financial measures. There are always problems with any single financial measure, but right now in order to get people to focus it is easier to have one number and EVA is the most effective single number. We know that in order to make the business viable in our Southeast Asia region we have to go down a path of expanding the business. When you expand, EVA goes down, so if you focus on only that measure you risk saying that I do not want to do that. That is not the right answer. We are already seeing that kind ol problem. But at least EVA gets people to focus on the cost of the capital associated with the income that they earn, and it gets more of a sense of cash flow, but we do not rely solely on it.

Stan Rogers summed up his feelings on Ihe division performance measurement problems, echoing some of the conclusions of Sheldon:

You know, 1 would say the same thing. I here is not a planning department here that thinks about EVA and all that kind of stuff. We probably could use better numbers, but driving the business off any single number probably would not work.

Required

(4) How should the performance of divisions of WCC be measured?