Armco Inc. : Midwestern Steel Division* Note: This case is unchanged from the Twelfth Edition. Approach The Armco case was designed to illustrate a performance measurement system with measures cascading from strategic priorities down to the lowest organization levels. The system is not tightly linked with incentive compensation, although that is being discussed. Still, the focus on measured results promises to change managerial behaviors significantly.
The case is particularly interesting because it describes a major change from an old measurement system which was primarily designed for standard financial reporting purposes and was not perceived, at least by top management, to be effective for management control purposes. The new performance measurement system eliminated most of the allocations of indirect costs and helped managers understand the critical success factors in their areas. In this case, then, students can understand two performance measurement systems and the companys reasons for changing from one to the other.They can evaluate the new system and decide whether the division managers have made optimal choices in designing their new system, and they can make a judgment as to whether the system should be used to increase the proportion of total compensation linked to performance. Most of the students will conclude the new system is a substantive change for the better. But then they will get a dose of reality as they see the problems Armco is having getting managers to adapt to the new system. Suggested Assignment Questions 1. What was wrong with the Midwestern Steel Divisions old system? As part of your analysis, study Exhibit 3 carefully and figure out what the columns tell you, individually and in total.
) 2. If the old system was so bad, why did the operating managers seem to like it? This teaching note was prepared by Professor Kenneth A. Merchant. Copyright 1998 Kenneth A.
Merchant. * 25-7 Chapter 25 – Reporting and Evaluation 3. 4.
Evaluate the new system and the way in which it was being implemented. What changes would you recommend, if any? Why? 5. What should Rob Cushman do about the two items described in the Remaining Issues section of the case?Case Analysis and Pedagogy 4. What factors most determine the success or failure of the Midwestern Steel Division? In particular, how important is cost control? Carbon wire rod is a commodity product, so cost control is critical for this line of business. There is some product differentiation in grinding media.
Customers can measure how long the steel balls last, and they value long-lasting balls. Armco believes it has a superior manufacturing technology that causes its balls to last longer. Further manufacturing technology innovations would provide additional profits to the division.Cost control is also important for grinding media, as Armco is the high cost producer in this market. Plant throughput (productivity) is one key to cost control. Armco can sell all the product it makes. (The plant has been operating at capacity for three years straight.
) Among the cost control challenges in the plant are the fact that the plant has old equipment, generally poor preventative maintenance practices (40% of the 700 hourly workers in the plant were maintenance workers), and less than optimum worker productivity. The people left in the plan are the most senior.They would not be hurt that much by a shutdown. They have pensions. Cost control is not that important to them. It would cost the company about $200 million to shut down the plant (environmental clean-up, pensions, etc. ).
Students might ask why Armco does not put more people or more equipment in the melt shop so it wouldnt be a bottleneck. The answer is that they would have to add a furnace, making an investment of approximately $100 million. This would add capacity which is not needed in the industry. 5. How were managers controlling performance with the old system?What were the strengths and weaknesses of the old system? 25-8 Chapter 25 – Reporting and Evaluation 6.
Strengths 1. Managers express need for detail so they can track month-to-month trends. 2. Has value in identifying problem areas. 3. Measured performance was based on managers ability to control cost above. System gave managers information consistent with objective they were given.
Weaknesses 1. Too much detail. Some numbers didnt change. Some very small. 2. System designed for inventory costing purposes. Have to allocate costs. For performance measurement purposes, not sure if the allocations mean anything.
. Source of some of the data is unclear.4.
Reports were delivered 15 days after month-end. This is too late. 5. System too focused on cost reductions, to the exclusion of other critical success factors. 6.
Managers performances judged on things over which they had no control. Many costs were caused by people who did not report to the managers (e. g. , capital spending, salaries, maintenance). Easy to blame poor performance on uncontrollables. 7. System not encouraging managers to work together.
Much local data. Contributes to suboptimization. 8. Not graphic. 9. Accounting accruals distort the costs.Example annual August maintenance shutdown accruals start in January.
It is important to walk students through Exhibit 3. Pick some representative columns and have students talk about what they mean or dont mean. Among the useful examples to discuss are nonmetallics, salaries, electricity, lubricants, and loco cranes.
Students should see the types of costs that make up total cost above. Which are the big items? Which items are variable and which are fixed? (The important ones are fixed. Costs per net ton are driven by tons produced. ) Point out the distorting effect of the August maintenance shutdown.S-orders represent extraordinary maintenance. It is accrued for. It is fixed in the short-run (a month), but it can vary over the year.
7. Why did the operating managers seem to like the old system? Familiarity Reports were related to budget Managers cant be held accountable because they always had an excuse for poor performance. (Nenni: The traditional way we ran our operating review meetings was that the would find managers some items that didnt make sense. Then they would discredit the report and the accountants. We never got to the items the managers can and should control.
Gives managers a false sense that they can control costs. Gives a global picture. (The managers would have liked to have the information every week. ) 25-9 Chapter 25 – Reporting and Evaluation Gives managers a sense that they are responsible for a large number (e.
g. , melt shop manager responsible for $50 million per year) After the students have had their crack at the analysis, if it hasnt come up, the instructor might usefully point their attention to Bob Nennis quote about the problem with non-value-added chores under the new system and the difference between value-added and non-value-added work. Nonvalue-added work includes everything customers are not willing to pay for. ) One prominent example of the non-value-added work associated with the old system (which is Bob Nennis focus) is the administrative burden required to keep it going. The old system took five accountants to operate.
The new system required only three, even in start-up mode; most of the accountants time was spent designing new reports. To what extent does Bob Nenni consider accounting to be value-added work? 8. What were the key features of the new system and what improvements did it promise?Hit the key design choices and discuss them; for example: Strategic (not just financial) focus. 10 key measures. Priorities must come from the general manager and his direct reports. Priorities must cascade from above so that everybody is working on the right things. Everybody agrees with the top four priorities safety, productivity, quality, and up-time. Safety is the #1 priority because managers do not want people to get hurt.
It is not #1 because it is the largest cost. Elimination of cost above measure New system does not do a trend analysis (e. g. , performance vs. a year ago or vs. ast rolling 12 months). What is key is whether manager did in January what he said he would do (vs.
agreed-to benchmark).Focuses attention on important categories and provides more detail on those Focuses on controllables. For example, melt shop manager controls KWH/T, not electricity dollars/T. Purchasing negotiates the price. Focuses more on productivity than costs. Standardardizes everything.
Everything is not driven by tons. Apparent reduction in the manufacturing managers financial responsibility. (The new system reported only what the employees reporting to each manager spent.
Those are the dollars that can be controlled. ) 9. What are the weaknesses of the new system? Its not a cost system. Company still needs a cost system.
The company still does not have a handle on what costs are controllable, what are fixed and variable, etc. 25-10 Chapter 25 – Reporting and Evaluation Should show consumption, not purchases. (There is still a problem with the source of the data. ) The performance standards are not benchmarked with the best in the industry. (Firms in the steel industry do not share much operating performance information. Seasonal factors are ignored. Uncontrollables still not handled well.
For example, what happens if the plant shuts down for a few hours? Should this be segregated from the managers performance reports? The system is not complete. Three measures maintenance, on-time delivery, and inspection are not yet implemented. Should the system focus on exception reporting, rather than provide all the detail? 10. The implementation process. Division managers decided to discontinue the old system immediately? What are the advantages and disadvantages of that decision?Managers would never adapt to new system if old system was still running. After the switch to the new system, they were frequently in Rob Cushmans office begging for their old reports. (Actually the old system is still being run, for inventory valuation and product costing purposes. But the operating managers have not been told that the old system is still running.
) The risk of the immediate switch-over is that uninformed decisions will be made: Managers dont have their old information, and they dont yet understand the new information. But the new system seemed to work.The periods after the switch-over to the new system were the best in the history of the plant. Department managers had no input into the design of the new system? Was that wise? Ideally it should be the operating managers, not the accountants, who identify what is critical to their areas. But the operating managers were consulted, and they said only, We want the old system. Only three managers in the division wanted the new system general manager, the the director of finance, and the manager of cost accounting. The other 997 people in the plant were indifferent to overtly combative.
What can be done to get operating managers to take the lead? Training? Hiring? Should accountants have a role in measuring quality, on-time delivery, etc.? vWhy did Bob Nenni deote so much energy to the performance measurement system instead of working on, for example, an activity-based costing system, which Armco does not yet have? He thought the performance measurement system, with its link to strategic priorities, was much more important than an accurate costing system. 11.
Remaining issues: When should something be considered uncontrollable? 5-11 Chapter 25 – Reporting and Evaluation Under the new system at Armco, the handling of uncontrollables is at the discretion of the individual superior. The lines between controllables and uncontrollables are tough to define. The company has a culture of making excuses. Should larger bonuses be linked to the new system measures? The answer to this question is complex. Among other things, it depends on the trust people have in the measures and the companys compensation strategy (e.
g. , compensation competitiveness, amount of risk they want managers to bear). 2. What has happened since the case was written? Many things have happened since the case was written.There was significant management turnover.
First, the manufacturing cost manager (Scott Molaro) resigned. He got frustrated by the operating managers resistance to change. Then there was significant turnover among the operating managers. The works manager (Charlie Bradshaw) was asked to retire. The maintenance manager (Ed Graves) was fired.
The rolling/finishing manager (Paul Phillips) retired. In April 1992, Armco Inc. acquired Cyclops Industries, Inc. another specialty steel manufacturer. The combined company needed capital, so they spun off the Midwestern Steel Division.
It is now a privately held, freestanding business. As of March 1993, the new performance measurement system was still operating. The three missing measures were still not implemented. Rob Cushman was not sure the on-time delivery measures would be worth the cost of developing them. Managers were not sure how best to develop the maintenance measures.
And they had not gotten around to developing the inspection measures.