Mid Term Exam

Management Control Systems

Fall 2012
ADM4345
Name:

ID#:

Section: Professor Conheadys

Professor Edens

INSTRUCTIONS:

Write your name and student ID number above and on the exam booklet provided.
Turn off all cell phones.
This examination comprises 5 numbered pages. This examination is not to be removed from the
examination room. You may not separate the pages.
This exam will be marked out of 100 marks (for convenience) and is 2 hours long. You should
budget approximately 1.2 minutes per mark. The exam is worth 20% of the overall course mark.
Please do not ask the invigilator or the professor any questions, as they will not be answered.
State reasonable assumptions, if you feel they are necessary.
Language (non-electronic) dictionaries are allowed with the proctors permission.
You must sign the Statement of Academic integrity below.

Statement of Academic Integrity

The Telfer School of Management does not condone academic fraud, an act by a student that
may result in a false academic evaluation of that student or of another student. Without
limiting the generality of this definition, academic fraud occurs when a student commits any
of the following offences: plagiarism or cheating of any kind, use of books, notes,
mathematical tables, dictionaries or other study aid unless an explicit written note to the
contrary appears on the exam, to have in his/her possession cameras, radios (or radios with
head sets), tape recorders, pagers, cell phones, or any other communication device which has
not been previously authorized in writing.
Statement to be signed by the student:
I have read the text on academic integrity and I pledge not to have committed or attempted to
commit academic fraud in this examination.
Signed:______________________________________
Note: an examination copy or booklet without the above signed statement will not be graded
and will receive an exam grade of zero.

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Required: You are a management consultant asked to assess the management control features at
Kavanaugh Associates, Incorporated. Your answer should include relevant application of Porters
Five Forces and Simons Levers of Control. Address your report to Mr. Richard Kavanaugh, Sr. The
presentation, grammer, syntax, and legibility of your report will be assessed out of fifteen marks
while its content will be assessed out of eighty five marks.

Kavanaugh Associates Incorporated (an organization chart is provided on page 5/5)

Mr. Richard (Rick) Kavanaugh, Sr. started Kanata Realty, Inc., a real estate firm about 40 years ago.
His personality and honesty made this undertaking a success. When his eldest son, John Kavanaugh,
graduated with an engineering degree, Kavanaugh, Sr. incorporated F & S Construction Company
and put John in charge. Forty percent of the stock was given to John, and 60 percent was deposited
with Kavanaugh Associates Incorporated which Kavanaugh Sr. controlled 100 percent. Having
intimate knowledge of the housing market, Kavanaugh Sr. suggested, and John agreed, that the
construction company should concentrate on custom designed and built houses in the price range of
$400,000 to $500,000.

John Kavanaughs technical knowledge and imagination made the

construction company a success. Competition was not nearly as tough in this specialized market as
in general real estate.

Kavanaugh Sr.s second son Court received a degree in architecture but upon graduation was not
ready to enter employment. Upon the suggestion of several friends and the family, Court Kavanaugh
continued with his education and pursued an M.B.A. degree. During this study, and because of a
special project he was assigned, he became interested in the development of living complexes around
shopping centres. In this project, both the living complex and the shopping centre were designed
with a continental motif. Further research convinced him that this project would not only be feasible,
but also very profitable. He discussed his idea and all the information he had gathered with his
father, who agreed that this kind of design seemed to be the upcoming style.

Upon Courts

graduation, the Kanata Rental Company was incorporated with the same stock arrangement as with
the F & S Construction Company.

Court bought land and proceeded with the design and building of a shopping centre and several
apartment buildings around this shopping centre. This undertaking was an instant success, too. The
shopping centre has an extraordinary 100 percent lease commitment and some prospects on a waiting
list. The apartments have an 85 percent occupancy rate. This complex has been and still is the in
thing in this community. Mostly young upper middle class people are living there.

Up until several years ago, Court had to maintain a large maintenance crew whose task was to keep
up both the shopping centre and the apartment buildings. However, when the youngest of the
children, Richard Kavanaugh, Jr., graduated, this function was separated from his brothers company,
and the Kanata Remodelling Company was incorporated. The Remodelling Company has two
divisions: Contracting and Building Supplies. The Contracting Division does the remodelling and the
Building Supplies division operates a wholesale building supply warehouse. All Building Supplies
sales to the divisions of Kavanaugh are at market price, and virtually all its sales are to other
Kavanaugh divisions. Stock arrangements were the same as for the other companies. Rick, Jr. was
put in charge of this company. Both Construction and Building Supplies divisions operate in very
competitive markets; but the advantages of selling to other companies within the Kavanaugh group
are significant.
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Over the years, the various family members have retired from active participation in the day-to-day
activities of the companies. Each still sets overall policies and objectives for the entities, but leaves
the daily operations to the general managers. Each general manager shares in the profit of his
company. Although there still is very close cooperation among these companies, they have grown to
be rather independent of each other. If one inside company wants any service from the other, these
services are priced the same as to outsiders. Managers of each feel they are competitive and offer the
best services for the lowest cost. For instance, the Kanata Remodelling Company does all the
maintenance for the Kanata Rental Company. However, to keep this contract, Kanata Remodelling
must be competitive with other maintenance companies.

These arrangements have generally been successful although occasional complaints have been raised.
Recently, however, the complaints have become more vocal. To some degree they were due to poor
general economic conditions. Last year was a depression year and, although the Kavanaugh group
fared better than the average real estate company, the general managers experienced a considerable
cut in their profit participation, and are now very conscious of any dealing which would reduce their
profits.

During the last year, the Kavanaugh family came up with another innovation in the real estate
business - the house trade-in. F & S Construction Company will construct a house for a buyer with
the understanding that his old residence be taken in as a trade, providing it is located in Kanata. In
many instances, this practice would avoid down payments for the buyer, as well as the
inconveniences of selling the house.

The value of the trade-in is established by Kanata Realty Inc. and Kanata Remodelling Company.
Kanata Remodelling Company will determine what should be done to the house and give an estimate
for necessary repair work. Kanata Realty Inc. will make suggestions as to certain remodelling needs
which make a house more valuable and saleable. Kanata Remodelling Company will also give firm
estimates on these suggestions. Kanata Realty Inc. will then give F & S Construction Company a
realistic market value of the renovated house.

This value of the renovated house, less the renovation costs, is used internally by F & S Construction
Company to determine its profit on a sale and trade-in. Externally, F & S Construction Company
will quote the buyer the renovated house value as the trade-in value, but also will increase its normal
price for the buyers new house by the costs of remodelling the trade-in. The reason for this
valuation is that the buyer may see the asking price for his old house in a sales advertisement and
may feel cheated if the price is more than he received. Very likely, he may not be aware of the total
renovation costs.

F & S Construction Company retains title to the trade-in house until it is sold. It is responsible for
any house repairs and remodelling, and for any interest, taxes, insurance, or other costs.

Kanata

Realty Inc. will list and sell the house, collecting a 6 percent commission. This plan has been
successful and has made the name of Kavanaugh a household word in the real estate business
throughout the province. However, the plan is not without drawbacks. The following transaction is
an example, and your advice is solicited.
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The F & S Construction Company sold a newly constructed house to Mr. Baxter as follows:
Price of new house
Trade-In allowance, old house
Cash (from mortgage)

$400,000
200,000
$200,000

Value Received:
Cash

$200,000

Trade-in

160,000

Total

$360,000

Cost of Building New House

Profit

320,000
$ 40,000

The trade-in value was established as follows: the fair market value of the old house, if fixed-up, was
determined as $200,000 by Kanata Realty Inc. The renovation needs were jointly determined by the
manager of Kanata Realty Inc. and by the manager of Kanata Remodelling Company. These needs
were costed by the manager of Kanata Remodelling Company as $40,000.

Two days after the deal was closed, a heavy rain occurred, and it was discovered that the roof must
be replaced and the basement water-sealed. The prices quoted by Kanata Remodelling Company for
these repairs were established at $16,000 and $8,000. These prices are with both labour and supplies
at market price. This is in addition to the fix-up costs.

The managers of the Kanata Realty Company and F & S Construction Company think that these
repairs should be priced at $12,000 only, since Kanata Remodelling Company has a 50 percent
variable cost factor. Kanata Remodelling Companys manager says that under no condition will he
make the repairs for a price other than that quoted. He claims to have enough outside business to
keep him occupied during the present high season. He might consider doing it for a somewhat lesser
price during the off-season, which will begin in several months. But this delay would mean not
selling the house for at least a full year. Also, predictions for next years prices for houses are
impossible to make.

To complicate matters further, the manager of Kanata Rental Company stated that he would like to
acquire the old house since it is located within the general territorial boundaries which he would
eventually like to incorporate. Furthermore, some of the people in the continental complex would
prefer houses to apartments, if they were available. He is unwilling to pay more than $200,000.
Considering real estate taxes, maintenance, and allocated management expenses he has estimated the
net present value of the house acquisition to be about $20,000, implying an internal rate of return of
about 15% - well above the companys cost of capital of 8%. Management expenses are fixed in
total and would not change with the acquisition of this house. From experience and research, he has
found that delays in occupancy, extra work like credit checks and minor repairs to satisfy the new
tenant usually mean there is little net income in the first year or two of a new house rental.

Managers bonuses are based on their own company profits only and targets for the divisions are
agreed to at the start of the year. Common costs from the holding company are allocated based on
sales dollars.
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Organization Chart

Kavanaugh Associates Incorporated

Kanata Realty
Inc.

F&S
Construction
Company

Kanata Remodelling
Company
Contracting
Division

Kanata Rental
Company

Building and
Supplies
Division

End of Exam

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