CASE 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 perfor-
mance 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 rela-
tive to others.
Now that you are beginning to get questions from shareholders and analysts about how some of
these investments are performing, I realized that Cynthia and I had better brief you on what some of
the problems are that we have with division performance measurement.

tan Rogers, president of Western Chemical Corporation (WCC), was meeting with
S 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 pre-
pared 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 invest-
ment 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 dis-
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 mar-
keted chemicals and chemical programs for water and waste treatment. Additional products
and chemical services targeted manufacturing processes where the quality of a customers
product could be enhanced. The company was proud of its industry reputation for quality of

Professor William J. Bruns and Professor Roger Atherton of Northeastern University prepared this case as the basis for class
discussion rather than to illustrate either effective or ineffective handling of an administrative situation.
Copyright © 1995 by the President and Fellows of Harvard College. To order copies or request permission to reproduce materi-
als, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No
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means — electronic, mechanical, photocopying, recording, or otherwise — without the permission of Harvard Business School.

From Performance Measurement and Control Systems for Implementing Strategy: Text and Cases, First Edition.
Robert Simons. Copyright © 2000 by Pearson Education, Inc. Published by Pearson Prentice Hall. All rights reserved.
533
 CASE: WESTERN CHEMICAL CORPORATION

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 arrange-
ments. 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 had 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 considered 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 ba-
sic 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 ap-
parent 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, any-
where 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 in-
come for WCC. That is the actual income that we would report to the outside world.
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 cor-
porate income. This report makes it appear that we are operating at a loss of just under $1.2 mil-
lion, $532,000 of which is the share of our joint venture partner, and our share is the $646,000.

Stan Rogers In this business WCC has invested, in addition to its technical knowledge and tech-
described the nology, $5 million of its money. In addition, we do not guarantee the debt, which is
investment: 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,

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 CASE: WESTERN CHEMICAL CORPORATION

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 invest-
ment to WCC.
Sheldon Our actual return consists of the fees paid to WCC, or $867,000, and our share of
continued: 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 before 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
wholly-owned divisions.
One of the reasons that this report appears 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 appear that the
business was doing just fine.
Samantha Chu Your explanation implies that there must be some other measures of performance
spoke up: 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

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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
get 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 includ-
ing 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.
In addition we have recently started to 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 to fix it compared
to the region of manufacture measure which is pretty daunting.
Stan Rogers There is an incremental layer of complexity here in that this plant is starting to pro-
interjected: duce 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 they will not show up in the Region of Sale numbers.
We have not yet sorted this out, but my suspicion is that you 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 struc-
tures 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 Have you found a solution to the problem yet?
pause which
followed:
Rogers We understand it. We have not institutionalized a management reporting system
that
answered: 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.

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 CASE: WESTERN CHEMICAL CORPORATION

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 busi-
ness, 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 From a business standpoint we understand this we think. When we want to do a pre-
chimed in: sentation 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, repetitious report-
ing 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 priori-
ties. 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 We are really just beginning to use EVA as a tool to get people to understand the is-
continued: sues. 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 of 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 the division performance measurement prob-
lems, echoing some of the conclusions of Sheldon:

You know, I would say the same thing. There 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.

Questions
1. What is causing the problems in measuring division performance at Western Chemical Corpora-
tion?
2. Are there alternative methods for measuring division performance that would avoid the problems
that WCC management is having with the methods that they have been using?
3. Evaluate the approach to using economic value added (EVA) that WCC management is discussing
and using experimentally. What are the strengths and weaknesses of this approach?
4. How should the performance of divisions of WCC be measured?
5. What should Samantha Chu tell the analyst if he asks specifically about the investments in the
Czech Republic, Poland, and Malaysia?

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 CASE: WESTERN CHEMICAL CORPORATION

EXHIBIT 1 Financial Information by Geographic Area

Western Chemical Corporation (WCC) is engaged in the worldwide manufacture and sale of
highly specialized service chemical programs. This includes production and service related
to the sale and application of chemicals and technology used in water treatment, pollution
control, energy conservation, and other industrial processes as well as a super-absorbent
product for the disposable diaper market.
Within WCC, sales between geographic areas are made at prevailing market prices to
customers minus an amount intended to compensate the sister WCC company for providing
quality customer service.
Identifiable assets are those directly associated with operations of the geographic area.
Corporate assets consist mainly of cash and cash equivalents; marketable securities; invest-
ments in unconsolidated partnerships, affiliates, and leveraged leases; and capital assets used
for corporate purposes.

Geographic Area Data (in millions)

1994 1993 1992
Sales
North America $ 886.9 $ 915.1 $ 883.7
Europe 288.9 315.6 346.5
Latin America 72.2 66.4 60.7
Pacific 127.7 116.7 108.2
Sales between areas (30.1) (24.4) (24.6)
$1,345.6 $1,389.4 $1,374.5
Operating Earnings
North America $181.6 $216.9 $211.3
Europe (10.2) 41.8 48.9
Latin America 9.3 11.4 10.0
Pacific 14.3 14.4 14.4
Expenses not allocated to areas (20.3) (21.6) (24.3)
$174.7 $262.9 $260.3
Identifiable Assets
North America $ 485.2 $ 566.6 $ 562.2
Europe 245.2 227.4 225.5
Latin America 66.9 45.4 42.7
Pacific 147.9 126.3 124.7
Corporate 337.0 246.7 395.5
$1,282.2 $1,212.4 $1,350.6

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 CASE: WESTERN CHEMICAL CORPORATION

Exhibit 1 Continued
Amounts for North America sales in the tabulation above include exports to the fol-
lowing areas:

(IN MILLIONS) 1994 1993 1992

Latin America $21.9 $19.2 $16.0
All other 7.3 13.0 12.0

The decrease in operating earnings in 1994 was mainly attributable to the pretax provi-
sion of $68 million for consolidation expenses. Of that amount, approximately $34 million
was included in European operations.

EXHIBIT 2 Income from Czech Republic Joint Venture

($ in thousands)
9/95 YEAR-TO-DATE
Revenues $11,510
Cost of sales (9,541)
Selling, technical expenses, and administrative expenses (891)
Other income/Other charges (209)
Income before interest and taxes $ 869
Interest (1,120)
Fees (867)
Foreign exchange (60)
Income (loss) $ (1,178)
Minority interest 532
Taxes —
Net income (loss) $ (646)

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 CASE: WESTERN CHEMICAL CORPORATION

EXHIBIT 3 Income from Poland Plant ($ in thousands)

9/95 YEAR-TO-DATE
Revenues $32,536
Cost of sales (28,458)
Selling, technical expenses, and administrative expenses (2,529)
Other income/Other charges (121)
Income before interest and taxes $ 1,428
Interest —
Fees —
Foreign exchange 34
Income $1,462
Minority interest —
Taxes —
Net income $ 1,462

EXHIBIT 4 Income from Malaysia and Southeast Asia ($ in thousands)

Region of Manufacture Region of Sale

9/95 YEAR-TO-DATE 9/95 YEAR-TO-DATE

Revenues $12,020 $36,052
Cost of sales (12,392) (26,648)
Selling, technical expenses, and (3,775) (4,845)
administrative expenses
Other income/Other charges (685) (285)
Income before interest and taxes $ (4,832) $ 4,274
Taxes (40%) — (1,710)
Net income $ (4,832) $ 2,564
Capital charges (3,600)a (6,686)b
Economic value added $ (8,432) $ (4,122)
a
$30,000 @ 12% ⫽ $3,600
b
$110,000 @ 12% ⫻ [(36,052 ⫺ 12,020) / 102,800] ⫹ 30,000 @ 12% ⫽ $6,686

540