Case Study, Finance and Accounting
Assignment Questions

Question 1 (15 points)
Here is a portion of the output from one possible model of profits from the Store24 (A) case. Use the output for Questions a through c below.

Coefficients    Standard Error    t Stat    P-value
Intercept     (24,181.49)           62,263.64           (0.39)           0.70
MTenure        1,732.55                312.21            5.55            0.00
Mtenure^2             (4.83)                   1.44           (3.35)           0.00
CTenure        2,460.36                974.71            2.52            0.01
Ctenure^2           (16.90)                 10.38           (1.63)           0.11
Pop              3.48                    1.40            2.49            0.02
Comp     (25,455.64)             5,136.14           (4.96)           0.00
Visibility      19,761.67              8,750.21            2.26            0.03
PedCount      39,140.91              8,486.86            4.61            0.00
Res      62,707.99            38,571.38            1.63            0.11
Hours24      56,375.90            18,193.91            3.10            0.00

a) According to this model, how much would store profit be expected to increase if manager tenure increased by one year (all else equal)? (Remember that tenure is measured in months in the data.)

b) Does the regression output indicate that each year managers and crew become less valuable? Why or why not?

c) Population has a very small coefficient compared to the other independent variables. Does this mean that it has a trivial effect on profit compared to the other variables?  Explain.

Question 2 (15 points)
Einstein, Inc. produces a variety of basic metal products.  The products are near-commodities, with prices determined by a competitive market, and there is little customer loyalty.  Market prices tend to be volatile from month to month.  Einstein has invested in highly flexible production processes, so that it can quickly shift its product mix to make whichever products yield the most profit, given current market prices and Einstein’s production costs.  (These costs tend to be lower than competitors’ costs for some products but not for others).
Suppose that Einstein has a well-designed ABC system. Cost-data collection is highly automated, and managers at Einstein can easily access current activity-based cost estimates for any product.
Current selling price and full ABC cost per unit for five products are as follows:
1           2           3           4            5
Sales Revenue        $500        $350        $480        $530        $435
ABC production cost      320          380          390             405          380
ABC gross profit      180          (30)            90          125            55

For simplicity, assume that these represent all the products that Einstein can currently make.  Production costs include materials, labor (all production-related personnel, including engineers and production managers), variable overhead (electricity, supplies, etc.), and lease and depreciation costs for machinery and facility space. Costs in each of these categories are substantial. (Thus, for example, Einstein is not in the position that some companies are, of having almost no depreciation expenses.)

Is the firm using its accounting information appropriately to make product-mix decisions in each of the three scenarios below?  If not, what would you suggest that they do differently?  (If you think additional cost information is needed to make good decisions, explain what this information is and why it is necessary.)

a)    Suppose the economy is slow, and the firm has idle capacity at all production processes.  (Remember that idle capacity costs are not included in the production costs shown above but are expensed as they occur.)  Einstein decides not to produce product 2 until its market price rises again, because product 2 currently generates a negative ABC profit.

b)    Suppose the economy heats up, and the firm has more orders than it can handle.  Adding capacity is not feasible in the short term.  Einstein decides to produce as much of its most profitable products, 1 and 4, as it can sell, and as much of product 3 as it can fit into its production schedule after demand for products 1 and 4 is satisfied.

c)    Suppose that the economic situation is as in (b): the firm has more orders than it can handle, and adding capacity is not feasible in the short term. Einstein decides that under these circumstances, ABC profits are not the right basis for making decisions. Instead, Einstein focuses on a measure they call margin 1, which equals revenues minus materials and labor, on the assumption that overhead allocations are not very relevant for their current short-term product-mix decisions. The firm therefore aims to make more of the products that provide higher margin 1 per unit.
Question 3 (15 points)
Consider the firms in the cases we studied that do not use activity-based costing, or time-driven activity-based costing. Identify one firm that you think would have been better able to solve the problem that was the focus of the case if it had a type of activity-based costing system.  Also, identify one firm for which you think activity-based costing would not have made a major contribution to solving the problem that was the focus of the case.  Explain your choices.
Question 4 (20 points)
DN Holdings, a department store chain, is trying to upgrade its customer service in order to compete with a rival chain which has recently moved into its territory and has a very strong customer-service reputation.  DN management knows that customer service is currently high in some of its stores but low in others. On average, its current reputation for service is less than outstanding.  In order to build support for better customer service throughout the chain, DN management decides to analyze existing data to show how much more profitable its own high-service stores are than its low-service stores.
DN has created a customer-service indicator which is composed of a combination of ratings from mystery shoppers and surveys of customers by an independent organization.  The scale for this indicator ranges from 1 to 50, with higher numbers indicating higher quality. DN also has data on a number of factors that are likely to influence store profits. These include store size, rural versus urban location, manager performance rating (1 €“ 5 scale, where 5 is high), per capita income in the surrounding region (low to high ranges, summarized on a 1 €“ 5 scale, where 5 is high), non-managerial employee skill index (a measurement the Human Resources department has created, which ranges from 1 to 20; high numbers are better) and age of the store.  (Age is generally a negative factor.  No stores are so new that they are still building up to a stable sales level, and some are old enough that they are no longer very attractive, or some portion of their customer base has moved away from them.)
Based on regression analysis, what can you tell DN about customer service?  For example: How big an effect on profit does it have? Does it have a bigger effect on profits in some portions of the customer-service range than others?  Is this effect similar at all types of stores?  What influences the level of customer-service quality (so far as we can tell from the information available)?
Question 5 (20 points)
Many people in many organizations do not think about their day-to-day work in primarily financial terms but rather in terms of nonfinancial measures: the number of on-time flights (Logan Airport), the yield of the manufacturing process (% of output units that are nondefective: Analog Devices), or the number of patients per day at a clinic and the success of medical personnel in diagnosing and treating these patients (Cambridge Hospital). An important task of financial management is to translate business processes into financial terms, in order to support decisions that insure the continuing financial viability of the organization.
Choose a case from the course (not one of the cases that you chose for question 3).  For this case, summarize:

a)    What important nonfinancial information is being financialized in this case, and why is this particular information important to the organization at the time of the case?

b)    How can financialization support better decision making in this case? That is, what decisions can be made with the financial information that could not be made as well based on nonfinancial information only?  (Be specific and concrete here: find an example in the case that you can use to illustrate your argument.)

c)    Estimates are only estimates, and as such they usually contain error. Identify one likely source of important error in the financialization you described in part (a), and explain why it is important (that is, how might it lead to suboptimal decisions).

d)    Identify a (realistic) way in which the error you identified in (c) could be reduced in the short to medium term; or else explain that, in the state of the organization’s processes and information technology, the error is likely to be unavoidable (and thus managers should be aware of the information risk it creates).

Question 6 (15 points)
To estimate customer lifetime value, CBR Bank uses a probability transition matrix for two bank products: car loans (CL) and credit cards (CC).  The number in each cell is the probability that a customer who had the product in that row in one year will have product indicated in the column in the next year.
CL only    CC only    Both        Neither
CL only    0.2        0.1        0.5        0.2
CC only    0.1        0.5        0.2        0.2
Both        0.1        0.1        0.7        0.1
Neither        ~0.0        ~0.0        ~0.0        ~1.0

The expected profit for the bank from car loans is ($100) per year, and for credit cards it is $1,000 per year.

What does the probably matrix tell us about CBR’s expectations since, after all, they developed this matrix for a specific purpose? For a customer who has only the car loan in the current year (year 1), what is the expected profit generated for the bank by this customer next year (year 2)? What would the expected profits be in year 3? What is the present value of the expected profits during each of the three years, and in total, using an 8% discount rate (contrary to what we did in class, discount the first year)? What advantages are there in using this approach to calculate customer lifetime value and what reservations would you have with using it exclusively?