Cases from Management Accounting Practice

Volume 14

Edited by

Paul E. Juras, Ph.D.Paul A. Dierks, Ph.D.

Wake Forest University

The American Accounting Association (Management Accounting Section)

Institute of Management Accountants (Committee on Academic Relations)

Published by

Institute of Management Accountants10 Paragon Drive, Montvale, NJ 07645-1760

Claire Barth, editor and compositor Mandel & Wagreich, Inc., cover

Copyright 1998 by Institute of Management Accountants. All rights reserved.

IMA publication number 99339

ISBN 0-86641-275-1

Table of Contents

Case 1The Aristocrat Furniture Company Case: Performance Measurement

and Business Valuation ............................................................................................................. 1

Case 2Ciba Specialty Chemicals: Unlocking Significant Shareholder Value ........................................ 15

Case 3Letsgo Travel Trailers: A Case for Incorporating the New Model of the Organization

into the Teaching of Budgeting ............................................................................................... 33

Case 4Using EVA at OutSource, Inc. ......................................................................................................... 39

Case 5 (A)RVF Systems Inc. .............................................................................................................................. 45

Case 5 (B)RVF Systems Inc. .............................................................................................................................. 65

Case 6Evaluating Product Line Performance: The Case of Wellesley Paint ......................................... 73

Addendum to Volume 12, Cases from Management Accounting PracticeDestin Rides Again ........................................................................................................................... 79

Cases from Management Accounting Practice

Volume 14

1Case 1The Aristocrat Furniture Company Case

Performance Measurement and Business Valuation

Frank C. Evans, CBA, CPA, ABV, American Business AppraisersJohn H. Evans III, Katz Graduate School of Business,

University of Pittsburgh

We thank David M. Bishop, president of American Business Appraisers, Inc., and the participants in the 14thIMA Management Accounting Symposium, especially Paul Juras, for helpful comments and suggestions. Wealso thank Margaret Horne and Nicole Thibodeau-Morin for excellent research assistance.

Family and Business Background

Marsten Richardson, president of the Aristocrat Furniture Company, pondered the conditionof his familys business with mixed emotions. Just completing the end of the second genera-tion of ownership, the Richardson family had taken a business started by Marstens father,Randolph, and expanded it during the last 60 years into a much larger enterprise, serving theeastern half of the United States. In Marstens personal opinion, Aristocrats performance todate had been very good. For him, performance was measured in terms of the firms historicalrecord of healthy annual profits and the very significant current market value of the business,plus what it had contributed to his familys wealth and security (see Exhibits 1-1 and 1-2 forincome statement and balance sheet data for Aristocrat for the last five years, where H1 is thefirst historical year, i.e., five years ago; H2 is the second historical year, four years ago; etc.).

However, Marsten was aware that Aristocrats performance was measured very differ-ently by the firms director of operations, Philip Dhurt. Philip relied on a series of nonfinan-cial performance measures, which pointed to a variety of operational weaknesses and raiseddoubts about whether Aristocrat was really performing so well. In addition, Marsten wasalso concerned about the increasing competition that Aristocrat faced in all markets, as wellas by his lack of a clear blueprint for management succession within the firm. Finally, he wasconfronting the realization that he might be unable to pass on the business to the next genera-tion of Richardsons, as his father had done.

First, there was the competition, particularly Global Corporation, headquartered in Dela-ware. Marsten and his father had carefully followed their attorneys advice and had patentedseveral processes they had developed that provided higher quality and lower costs in theproduction of their line of high-quality sofas and chairs. They had also registered their trade-mark and brand names to protect the reputation and customer base that the company hadbuilt throughout its history.

Global, with its huge volume and market share, had continually encroached on Aristocratsprocesses and designs in a way that Marsten and his father felt were outright theft. They hadfought Global in court over this situation for the last eight years, but the cost and attentionrequired to maintain this battle were becoming prohibitive.

Copyright 1998 Institute of Management Accountants, Montvale, NJ

2Global is a fully integrated manufacturer and distributor of a broad line of dining room,bedroom, and hotel furniture and related products. They have always coveted Aristocratsname, products, and reputation because Global has been unable to develop or acquire suit-able products, including sofas, love seats, couches, and chairs, to compete in the high-endhome furniture market.

Marsten is also concerned about Phoenix Furniture Corporation, for whom he has muchmore respect. Headquartered in Arizona and about three times the size of Aristocrat, Phoenixproduces an excellent line of high-quality products primarily for the office furniture market.Like Aristocrat, they have developed proprietary processes and brand names and have at-tempted to protect them. Marsten Richardson understands, however, that Phoenix wants toexpand its product line to include the chairs and couches that are the mainstay of Aristocratsproduct line. Phoenix intends to diversify gradually into the home furniture market and ex-pand geographically to the New England and mid-Atlantic states.

Like Aristocrat, Phoenix is a closely held business, a majority of which is owned by theWhite family. Marsten first met the Phoenix CEO, Harry White, at a trade show more than 30years ago, and they have kept in touch ever since. One philosophical difference that alwaysseparated the two is organized labor. While Aristocrat has employed primarily union laborfor the last 30 years, Harry White strongly opposes unions and has never dealt with one eventhough Phoenix has four locations. Harry has avoided union organizing by having a veryopen policy on employee relations and strong employee benefits and a profit-sharing plan.

While organized labor has never held a dominant position in the furniture industry,particularly in the South and West, employees of many firms in the North and East are repre-sented by unions. Organized labors overall decline in the United States during the latter partof the 20th century also occurred in the furniture manufacturing industry. The number ofemployees represented by unions in that industry has declined from a high of 22% in 1968 toabout half of that at present. Global has both union and nonunion shops. And while the totalcost for an hour of labor does not vary substantially from Aristocrat to Global or Phoenix,Marsten believes that both Aristocrat and Phoenix have enjoyed lower labor costs as a per-centage of sales because of their more efficient production techniques.

Even with a successful history and a loyal customer base, Marsten viewed Aristocratssubstantial interest-bearing debt as a significant burden for the firm. In addition to the con-tinuing litigation with Global over patent and design infringement, he has seen Aristocratsprofit margins gradually erode over the last 10 years as competitors have slowly developedcompeting production technologies and improvements in product design.

Aristocrat is threatened even more with a changing market structure and merchandisingtechniques. They have always sold through major distributors and a network of specialtydealers who handled their high-quality product lines. New merchandising techniques, how-ever, have cut into the market share of both of these distribution channels, rendering each adeclining force in sales. Mass merchandisers, home centers, direct mail distributors, and cata-log wholesalers are all growing distribution channels that are becoming increasingly pricecompetitive.

Some of the major players in the market are particularly effective at advertising andcreating the image that they are the high-quality or low-price leaders when this is not alwaysthe case. Aristocrat lacks both the market share and size and the distribution channels toadequately present their messagehigh product quality, strong customer service and war-ranties, and competitive prices. Aristocrat also faces the continuing disadvantage of Globalsability to obtain quantity discounts in their purchase of specialty items such as fabrics, hard-

3ware components, and laminates. In addition, Globals status as a fully integrated manufac-turer brings them cost savings in raw material commodities such as wood products.

Given this series of competitive threats facing Aristocrat, Marsten felt it was essential totrack Aristocrats progress in meeting the competition. To do so, he had always relied on acombination of overall firm profitability and Aristocrats market share data in key markets.Specifically, he followed Aristocrats annual market share in its three largest local marketsbased on trade association data. More recently, Philip Dhurt, director of operations, had con-vinced Marsten to add a series of nonfinancial performance measures in the operations area tohis key set of indicators. Philip explained that these cycle time measures would reflect assetefficiency, and that as asset efficiency improved, so would Aristocrats financial performance.

Besides the issue of competitive threats, Marsten has also recently been forced to recog-nize management succession concerns within Aristocrat. While his oldest of four children,Dudley, is very bright, he has always lacked the ambition and discipline required to excel inan executive position.

His second oldest, Penelope, possesses excellent technical skills and entrepreneurial spiritbut had personal and philosophical differences with her father. After six years in the familybusiness, she sold her 8% interest back to the company as treasury stock and left five yearsago to start her own company, which manufactures a line of specialty furniture productsaimed at the restaurant and tavern market. Her firm, known as Pene Company, though small,is now turning a profit and has shown more than 20% sales growth for the last two years.

Marstens third child, Blakely, is both loyal and ambitious but has demonstrated poorjudgment in both personal and business matters. Two years ago he went through a particu-larly acrimonious divorce in which the value of his stock in the company was agreed to be-tween the parties as a trade-off; i.e., Blakely got the shares in the family company and hisspouse received other assets of the marriage. Blakely and Dudley both carry the title andsalary of vice president at Aristocrat, but neither contributes significantly to the companyssuccess.

The fourth child, Bisby, has been mentally handicapped since birth, and his shares areheld in trust for him. The trustee is his sister, Penelope.

At 63, Marsten recognizes his need to develop and implement a succession plan forAristocrat as soon as possible. He was recently diagnosed with prostate cancer, but his doctorassured him that, with proper care and attention, his life was not threatened. His lifestyle,however, was expected to change, and the companys present lack of executive-level manage-ment was more apparent then ever before. In light of both the competitive and successionconcerns, Marsten recently decided to have a valuation of the business performed for strate-gic planning purposes. The valuation was to assess the fair market value of 100% of the vot-ing and non-voting common stock of Aristocrat.

Marsten was curious about how an option that he was consideringto sell a tract of landcarried on the companys books at $500,000 but recently appraised at $4 millionmight affectthe valuation of Aristocrat. The land originally had been been acquired as a site for futuredevelopment, but its market value had grown so rapidly that this opportunity cost renderedit uneconomical for its original purpose. The company is presently renting it to a retailer andrecording the rent as other income on the income statement; in 19H5 the rent was $120,000.Through continuing improvements in design and manufacturing processing, the companyhad developed adequate capacity in their existing facility for the foreseeable future.

Ownership of the company at the end of 19H5 (H is for historical and 19H5 is the mostrecent historical year) was as follows:

4* Marsten Richardsons older brother and only sibling who, along with Marsten, first acquired shares in theirfathers initial capitalization of the company.

Shareholder

Voting Stock Non-Voting Stock

Total SharesNumber % Number %

Marsten Richardson 100,000 100.00% 410,000 50.0 510,000

Dudley Richardson 0.00 0.00 80,000 9.56 80,000

Blakely Richardson 0.00 0.00 80,000 9.56 80,000

Bisby Richardson 0.00 0.00 80,000 9.56 80,000

Smedley Richardson, IV* 0.00 0.00 170,000 20.73 170,000

Total shares issued and outstanding 100,000 100.00% 820,000 100.00% 920,000

Treasury stock 0.00 80,000 80,000

Total shares issued 100,000 900,000 1,000,000

Marstens wife, Emily, is a very capable associate who has worked with him in the busi-ness for many years without drawing a salary. She is in charge of sales and marketing and haspersonal contacts with several key accounts that are critical to the company. Although Emilyis in good health, she is distraught over Marstens health problems and wants to start imme-diately to enjoy the fruits of their many years of hard labor.

The company was recently approached by Inverness Investments, a mutual fund with aportfolio of blue chip companies. Inverness occasionally buys a controlling interest in high-growth specialty companies. The management of Inverness have no investment experiencein the home furniture industry but were impressed with the information they could gatherabout Aristocrat. They contacted Marsten three months ago through an intermediary to ex-plore a sale of the company to their mutual fund.

Because of his concerns about succession, Marsten had resisted his initial reaction, whichwas to decline Inverness expression of interest. Instead, he instructed his attorneys to pre-pare appropriate nondisclosure agreements and to proceed with an initial exchange of infor-mation.

As Marsten pondered his options, including a potential sale of the company, he wascontinually tempted to maintain his ownership. He had always worked long hours and wasuncertain if he could be happy in retirement. Marsten and Emily already owned a vacationhome in the South where Emily now wanted to extend their annual vacation from one to sixmonths. Marsten knew he would grow bored. He was also intrigued by Penelopes successwith her new company. He suspected that if they could just learn to get along, she would bean excellent CEO for Aristocrat.

Further, he continued to enjoy the challenges associated with important operational deci-sions facing the firm. In fact, he was giving considerable thought to two proposals brought tohim by Philip Dhurt, a trusted and long-time member of Aristocrats top management team.Philip was known to have an excellent knowledge of the latest operating trends in the busi-ness, plus a knack for exploiting opportunities in imaginative ways.

5Proposal to Invest in Technology

Philips first proposal stemmed from his belief that Aristocrat could not maintain its industryposition, let alone grow, unless they invested heavily in improved manufacturing and distri-bution technology. Philip was particularly concerned with the recent innovations introducedby Global Corporation in both production and distribution. In a meeting with Marsten, Philipexplained the results of a study he had done comparing certain operational features of Globaland Aristocrat. The analysis included the following comparative data.

Comparison of Global and Aristocrat ($mil)

Global Aristocrat

Annual sales 1,970.8 72.0Fixed assets (net) 616.7 22.5Inventory 425.2 13.3Total assets 1,255.0 52.3Net income 146.0 4.7

Order cycle 1.7 days 9.1 daysProduction cycle 3.1 days 14.8 daysDelivery cycle 5.8 days 25.2 daysTotal cycle 10.6 days 49.1 days

Philips study found, first, that Global uses a computerized order system that allowstheir stores to communicate immediately with the factory concerning products in short sup-ply. This system is represented by Globals much lower order cycle time than Aristocrats (1.7days versus 9.1 days for Aristocrat). This short order cycle time in turn has contributed totheir program to reduce inventory.

Second, Global uses an innovative production technology in their factories that allowsthem to minimize the time necessary to convert from production of one product to another.This is reflected in Globals advantage of a much lower production cycle time (3.1 days versus14.8 days for Aristocrat). Reducing production setup time in this way again contributes toGlobals inventory reduction program. It enables them to match production closely to de-mand, thereby avoiding the need to carry extensive inventory in their warehouse facilities.

Third, Globals automated technology links their factories to their warehouses and thewarehouses to the retail facilities that carry their products. The advantage conferred by thistechnology is reflected in Globals shorter distribution cycle time (5.8 days versus 25.2 daysfor Aristocrat), with the result that Global has less invested in inventory that is in transitbetween factory and warehouse and warehouse and retail facilities.

Philip emphasized to Marsten that Globals technological superiority in production anddistribution was enabling Global to achieve a corresponding advantage in generating returnsfrom operational assets. To counter this advantage, Philips proposal called for introducing athree-day special program that guaranteed delivery to the retailer or wholesaler withinthree days of receipt of an order. Philip designed this program based on similar initiatives inthe office furniture business segment that he learned about in trade association conventionsand publications. His research indicated that for office furniture, the standard lead time hadfallen from 20 weeks in the late 1970s to 26 weeks in the mid-1990s. Standard lead time is thesum of order placement time, manufacturing time, and delivery time. Some furniture manu-facturers, however, offered premium service in as short a period as two days. For example,

6Steelcases 48-hour special delivery program promises delivery of some 250 products in popularcolors and finishes to a specified location within two working days.

Philip believed that a corresponding three-day special program for Aristocrats sofas andchairs would offer several important advantages. First, it would appeal to retailers who couldnow tailor their inventory more effectively to the latest trends in customer demand whilesimultaneously reducing the retailers total inventory and related carrying costs. Second, andmore important, the three-day special would form part of a flexible manufacturing strategyfor Aristocrat in which they would reduce their own overall standard lead time from 42 daysto 14 days. The 14-day overall average would include programs such as the three-day specialwith very short standard lead times, as well as other products with longer lead times, butnone would exceed 24 days. Philip saw the great benefit to Aristocrat of the three-fold reduc-tion from 42 to 14 days as being the corresponding increase that it would produce in Aristocratseffective production capacity. He believed that even if not all of this increase in capacity wouldbecome effective in the first few years, Aristocrats effective production capacity would con-servatively be doubled. In turn, Aristocrats healthy profit margins would enable the firm todouble its net income, thereby earning enough to cover the cost of the investment in flexiblemanufacturing technology within a relatively short time.

More specifically, Philip estimated an investment of $10 million would be required forthe flexible manufacturing equipment and related support. In turn, if doubling productioncapacity produced a proportional increase in revenue, the result would be additional revenueof $70 million. He believed that at Aristocrats current profit margin, the addition to the bot-tom line would mean that the investment would pay for itself within two or three years.

Philip had studied the innovations made in the office furniture segment of the industrycarefully. His conclusion was that the key to competing effectively in the future rested witheffective use of technology in production and distribution. Technology promised to enableAristocrat to do more with the resources it had, and in Philips mind, this was the key. Heemphasized to his staff that every dollar of Aristocrats assets must double its production insales to meet his targets over the next five years. In turn, these targets were externally gener-ated benchmarks. They were based on where he saw the industry going over the next severalyears.

To help focus production department personnel on the needed improvements in assetefficiency, Philip had devised a series of nonfinancial performance measures. These measurestracked Aristocrats progress in generating more sales from its assets. Specifically, Philip be-gan by dividing standard lead time into three components: order time, manufacturing time,and delivery time. Next, each of these major components was further divided into five to 10major subcomponents. These nonfinancial performance measures were calculated daily andposted prominently in the central operations area of the unit responsible for the measure.Aristocrat employees took the measures very seriously and devoted considerable time andattention to improving them because a growing portion of their pay and bonus was deter-mined by an incentive compensation system tied to these performance measures.

After listening to Philips first proposal, Marsten was excited at how the projected boostin profitability would help secure Aristocrats long-term industry position. At the same time,experience had taught him that Philips enthusiasm for operational superiority could some-times cloud his financial judgment.

In addition, Marsten had several questions to raise with Philip in their next meeting.First, given what he estimated as a five-fold advantage in total cycle time enjoyed by Global,why didnt Global have an even greater superiority relative to Aristocrat in generating sales

7from their assets? Second, Marsten wondered about how well the efficiency focus of the newproduction and distribution technology would coordinate with Aristocrats current marketniche at the top end of the furniture market. Likewise, would these changes be compatiblewith Aristocrats unionized labor force, which was suspicious of change and not as techni-cally sophisticated as that of other competitors such as Phoenix or Global? For example, Marstenhad seen demonstrations of automated production and distribution in one of Phoenixs pro-duction hubs, and he was struck by how small in number the labor force was and by howindividual production employees appeared very comfortable with a computerized productionand scheduling system. In contrast, Aristocrats production philosophy historically had beenbuilt around a tradition of skilled woodworking with important reliance even today on handcraftsmanship. Finally, would this investment in new technology make Aristocrat more attrac-tive to a buyer if Marsten decided to sell the firm at some point after making the investment?

Proposal to Sell the Custom Cabinetry Division

While Philips first proposal generated excitement and curiosity from Marsten, his secondproposal received a much less favorable reaction. Philip proposed that Marsten should sell offAristocrats Custom Cabinetry Division (CD), the original line of business around which thefirm was founded. Philips proposal emphasized that CDs financial results had lagged be-hind those of the rest of the firm for at least five years, and its production facility was theoldest in the firm. Further, Philip argued that while Aristocrats reputation for quality hadoriginally been established by CD, that had been some 40 years earlier. Today, Aristocratsreputation stemmed more from the excellence of its products over a wide range of productsand markets, with CD holding no particularly preeminent position.

Philips second proposal made Marsten uncomfortable for a number of reasons. Mostfundamentally, he felt allegiance to his fathers original development of CD. It seemed thatselling CD would cut the firm off from its roots and tradition of excellence in its products.Anticipating that even considering such a move would be quite controversial and would raisestrong emotions, Marsten and Philip had agreed not to share the idea widely, even among topmanagement. However, Marsten felt that fairness required that he discuss the matter with hisson Blakely, who currently was associated with CD.

As Marsten expected, Blakely reacted strongly and negatively to the proposal. He ques-tioned Philips loyalty to the firm, emphasizing that not being a family member, Philip mightbe much less reluctant to move to a competitor, perhaps even to the organization that ac-quired CD. At the same time, Marsten was pleased that Blakelys reaction was not limited toan emotional response. He insisted to Marsten that within a few days he could provide acareful analysis of why selling CD would be a financial mistake. In fact, two days later hecalled Marsten and arranged to present the results of his study.

Marsten was further impressed when Blakely arrived at the meeting with copies of afinancial analysis spreadsheet detailing his calculations. Perhaps he had underestimatedBlakelys potential.

Blakely began, Dad, Ive prepared an analysis of what losing CD would mean to Aristo-crat. To show the effect of losing CD, Ive compared our actual results for the last five yearswith what we would have achieved without CD. As you can see, the effect would have beendisastrous. Instead of being the fourth-largest firm in the home furniture industry, with a 12%market share, we would have been eighth, with only a 7% market share. Analysts, our cus-tomers, our competitors, and our bankers would see us as a shrinking firm, diminished inimportance and relegated to the second or third tier in the industry. Not only that, but our

8earnings per share would have been an average of 40% less, producing a proportional drop inour stock price.

As the discussion moved into specific details, Marsten was further impressed at Blakelysability to provide a careful, objective reconstruction of what losing CD would have done tothe firm. For example, Blakely described how the age of CDs production facility actuallyworked to Aristocrats advantage. Much of the plant and equipment was already fully depre-ciated, and the remainder was close to it, with the result that Aristocrat enjoyed a significantcost advantage via the lower overhead that resulted. Marsten himself had recognized that CDwas still profitable, although at a diminished level, but he had apparently underestimatedhow much CD contributed to the firms overall financial health.

When Marsten met again with Philip the next day to review Blakelys case for keepingCD, the primary result was confusion, at least for Marsten. Philip rejected Blakelys entireanalysis, saying that it couldnt be more incorrect. In place of Blakelys careful spreadsheetsthat Marsten could follow easily, Philip proposed what he called an EVA perspective. Basedon the EVA perspective, Philip concluded that operating CD was destroying value for Aristo-crat, despite being profitable. The EVA concept was new to Marsten, and he felt himself begin-ning to agree with Blakelys suggestion that Philip might have some ulterior motive for tryingto persuade Marsten to part with what was obviously a very big part of Aristocrats success.Philip attempted to explain that EVA stood for economic value added and that it measuredhow much value a company created or destroyed in a given year. To do so, it charged the firma certain cost of capital for all employed capital. Either value was created by generating re-turns beyond the cost of capital, or value was destroyed if the firms returns failed to cover thecost of capital. Marsten had difficulty appreciating what EVA added to the usual accountingmeasure of a firms profit.

Offers to Purchase Aristocrat

Marsten also had to consider Globals recent preliminary offer to him. In a conversation overdinner with Myrtle Street, president of Globals dining room furniture division, Marsten learnedthat Global was concerned about Marstens lawsuits over patent infringement. Myrtle admit-ted that Global had not succeeded in matching Aristocrats quality or reputation. She ex-plained that Aristocrats product line would fit perfectly into Globals existing product lines,would expand their presence in the high end of the sofa and chair market, and would comple-ment Globals overall acquisition strategy that had begun several years before. She explainedthat for these reasons, subject to due diligence, she had been authorized to offer $27 millioncash plus assumption of all interest-bearing debt for a 100% ownership interest in Aristocrat.After the sale, Global would assume management of Aristocrat, and Marsten and Emily couldretire immediately.

Marsten was more comfortable with the discussions that he had recently engaged inwith Phoenix CEO Harry White. Their businesses and philosophies were similar in manyrespects, despite their differences on organized labor. Harry tentatively made an offer of $20million in Phoenix stock, plus assumption of interest-bearing debt, to acquire the familys100% interest in Aristocrat. This agreement would require Marsten to work 10 months peryear for three years at a salary of $600,000, with an option to phase out over the followingthree years at a pro rata salary. In these discussions, Marsten could never secure from Harrya promise that he would not eventually move the company to break the union.

Marsten did not believe that Phoenix could achieve many of the integration benefits,synergies, and economies that were available to Global. Phoenixs primary focus had always

9been office furniture, so the merged companies would have two distinct customer bases. Fur-thermore, their product lines and production processes were different enough that they didnot expect to be able to consolidate operations quickly. Like Aristocrat, Phoenix was strug-gling with the changing merchandising trends in the industry. Even with the acquisition ofAristocrat, they would lack the buying power of Global, and short-term marketing or distri-bution synergies appeared to be limited. Also because Phoenix ran like Aristocrat, they had athin management structure and, at least in the short term, would have to rely on Marstensand Emilys expertise and contacts.

General Economic and Specific Industry Conditions

As of the end of 19H5, the economy was moving into the fourth year of an economic expan-sion. Long-term interest rates had been moderate and stable at 8.0% during 19H5, but contin-ued growth and expansion were beginning to place pressure on both short- and long-termrates. Fueling this situation in particular was an anticipation of wage inflation as low unem-ployment created labor shortages in several key markets. Productivity growth had beenstrong and helped to fuel the expansion of the economy over the last several years. Busi-ness greed had been the topic of much debate during last years presidential election, andthe winning candidate had promised to raise taxes on both high-income individuals andcorporations.

Aristocrats sales followed the residential real estate markets in particular, in which threeconsecutive years of higher than long-term average growth had occurred. The general con-sensus among economists at the end of 19H5 was that a downturn was to be anticipated. To alesser extent, Aristocrats sales followed consumer durable spending in general. This sector,too, had been strong for several years, and most forecasts suggested that a softening in de-mand should occur in this market in 19F1 (F is for forecasted).

The home and office furniture industries had seen a pattern of consolidation amongmanufacturers over the last five years. For at least 10 years, the industry had experiencedexcess capacity, which had put continual downward pressure on prices. This situation con-tributed to weak profits throughout the industry and had gradually driven out the marginalperformers. As of the end of 19H5, the trend of consolidation had not ended and overallprofits remained weak.

Profits had benefited from continued technological improvements and general imple-mentation of just-in-time inventory processing. Larger players in the industry were also tak-ing advantage of the emerging distribution channels that tended to be unavailable to thesmaller competitors.

Brand names such as Aristocrat continued to command strong customer loyalty, particu-larly among the higher-quality product lines. Several of the medium and lower-quality prod-ucts were being converted to a commodity status through the new merchandising and distri-bution patterns, which tended to drive down prices on these products and reward the higher-volume, more efficient manufacturers and retailers.

Guidelines for Business Valuation

The typical business valuation process requires adjustments as part of the process of deter-mining the entitys economic performance or benefit stream. Risk drivers and growth factorsare key variables that determine the rate of return in the valuation computation. Details of theadjustments, risk drivers, and growth factors for Aristocrat are provided next.

10

Adjustment Issues

Marstens compensation. Marsten Richardsons compensation package exceeds market rate.A human resources experts research indicated that the total cost of market-rate compensa-tion paid to an arms-length CEO of a furniture manufacturer the size of Aristocrat over thepast five years would have provided the following savings, inclusive of payroll-related bur-dens: 19H1 and 19H2, $500,000; 19H3, $400,000; 19H4 and 19H5, $480,000.

Blakelys and Dudleys VP compensation. The compensation paid to these two related par-ties is more than market, given their level of competence. A likely buyer would have themreport to its executive staff with the expectation that either they would upgrade their perfor-mance or be replaced. These positions are necessary, and the market cost of the positions willbe similar to what these two insiders are paid.

Litigation expenses (nonrecurring). The company has been spending considerable amountsover the past several years in efforts to stop what it considers to be patent infringements byGlobal Furniture, Inc. Marsten has indicated a decision was made at the end of last year tostop this litigation to avoid the ongoing costs. This situation may be revisited in the eventAristocrat is not sold. Over the past five years these expenses have been as follows: 19H2,$56,000; 19H4, $224,000; and 19H5, $610,000; in the other two years there were none.

Facilities. The building and land are leased on an arms-length basis at a market rate. Thecurrent lease term has two years to go, and there are four five-year options. All options havestipulated terms and conditions, which are reasonable in light of market conditions.

Land (nonoperating). The $4 million-valued nonoperating land has been rented out for thefollowing rents: 19H5, $120,000; 19H4 and 19H3, $110,000; 19H2, $95,000; and 19H1, $75,000.

Risk Drivers and Rates of Return

Sales concentration. Approximately 20% of sales are to one customer, a regional retailfurniture chain. The chain is successful and solvent. There is no known reason to believe theywill cease doing business with the company; however, the customer is not contractually com-mitted to continue to buy from Aristocrat. (Emilys relationship with this customer is verystrong.)

Industry and competition considerations. The industry is concerned about increased foreigncompetition resulting from the North American Free Trade Agreement and possible similaragreements that would include other developing countries with lower labor costs, lower woodand fabric costs, and fewer environmental/regulatory costs. (To some degree a merger wouldincrease the acquirers ability to meet this challenge as a result of the economies of scale.)

Financial condition. The companys debt is roughly equal to one-third of sales.Rates of return. The following rates of return are as of the appraisal date:

20-year U.S. treasury bond yield (risk-free rate): 7.00% Equity risk premium (long-term common stock return in excess of long-term risk-freerate): 6.50% Small company risk premium: 6.1%

The above rates, which total 19.6%, reflect the average market return, adjusted for size.That is, in the long term, small, publicly traded stock has generated a return of 19.6% onaverage. In addition, factors specific to the subject company that make it more risky must beconsidered. If the subject company appears to have greater risk than the typical small, pub-licly traded company, the discount rate should be increased accordingly. Assume that an ad-ditional specific risk adjustment factor for Aristocrat is 7.0%.

11

Taxes

Assume that Aristocrats combined federal and state corporate tax rate is 40%.

Growth Factors

Marsten Richardson expects that Aristocrat, if it continues without being sold, can achievea 4% growth rate, roughly equal to inflation. Given the industrys excess capacity, this expec-tation is consistent with the industry forecasts for the near to intermediate term. It is reason-ably consistent with Aristocrats performance over the past five years, during which it hasachieved a slightly higher growth rate. This growth rate may become harder to maintaingiven the competitive challenges previously detailed and the fact that Marsten is getting tiredand has health concerns. Aristocrats lack of a management succession plan adds to doubtsabout the companys growth potential.

Case Requirements

Performance Measurement and Business Decisions

1. Evaluate Philips proposal for Aristocrat to invest heavily in technology. In your analy-sis, you can assume that the operational improvements that Philip envisions are technicallyfeasible. That is, the proposed investments will be able to generate the improvements in theoperational measures that Philip emphasizes. However, is this necessarily sufficient to makethe investment worthwhile? Pay particular attention to what Aristocrat is likely to be able toachieve from these operational improvements. Are they likely to be able to turn the improve-ments in nonfinancial performance measures into correspondingly positive financial results?

2. Evaluate Philips proposal to sell the Custom Cabinetry Division. What do you thinkof Blakelys arguments that such a sale would have crippling effects not only on the firmsprofitability but also on its prestige? What is the argument that Philip is apparently making,based on an EVA perspective, to suggest that Blakelys conclusions are fundamentally flawed?

Business Valuation

3. Surveys in the middle and latter part of the 1990s have indicated that business valua-tion is considered among the most important and fastest growing areas of public accountingpractice. Increasingly, the profession recognizes the need for management and owners ofclosely held companies to monitor shareholder value and manage the company to maximizethis value. This should be done whether the company is preparing for a sale or simply toenhance value on an ongoing basis.

Before management can evaluate acquisition offers made by potential buyers, they mustfirst clearly understand the shareholders present position. That is, management must firstdetermine the companys fair market value on a stand-alone basis before it can properly evaluateits investment value to one or more strategic buyers. This case presents computation of fairmarket value as the beginning of this process.

The income approach to business valuation is based on the theory that the value of acompany can be determined by computing the present value of the future returns of thatbusiness discounted at a rate of return that reflects the riskiness of the business. While thistheory is both simple and convincing, its application is far more complex. The appraiser mustfirst derive the rate of return, which begins with the estimate of a discount rate, usually for thenext periods net cash flow for equity. This rate can then be applied in a multiperiod discount-ing method. Alternatively, a single period capitalization method can be employed, which

12

involves converting a discount rate to a cap (capitalization) rate. The benefit or return streamemployed can be other than net cash flow. When a different return stream is used, as illus-trated in this case, which uses net income to invested capital, the rate of return must be ad-justed accordingly. The appraiser most often determines either the value of the equity of thebusiness or the value of the invested capital, which is commonly defined as the interest-bearing debt and equity. In the merger and acquisition setting, buyers and sellers are usuallyinterested in determining the value of the entire enterprise because this is the investmentusually sold. This quantity is referred to as invested capital. Because invested capital in-cludes both interest-bearing debt and equity, the corresponding return measure is the firmsweighted average cost of capital.

This portion of the case is intended to illustrate the valuation process.Estimate the value of a 100% controlling interest in Aristocrat on a stand-alone basis, i.e.,

its fair market value without consideration of any possible synergies. Likewise, for this part of thecase, use only the original historical financial statement data, i.e., do not consider the outcome of theproposals made by Philip Dhurt. Using the single period capitalization method and net incometo invested capital, first develop your estimate of the value of the invested capital of Aristo-crat and then convert this estimate to a value for equity.

4. After having developed your answer to the previous question, answer the followingdiscussion questions:

Why was an asset method not used? Could the market approach have been used? Why was net income to invested capital, instead of net income to equity, selected for this

assignment? Why was the single period capitalization method and not a multiyear discounting method

selected for computation of this stand-alone value? Why was the build-up method used to determine the discount rate for equity as op-

posed to use of the modified capital asset pricing model (CAPM)? How should Aristocrats real estate, which has a cost basis on the companys books of

$500,000 and an appraised value of $4 million, be handled in the valuation of the com-pany? This real estate has not been used in Aristocrats operations and is not expected tobe needed in the foreseeable future.

General Management

5. Discuss how the management succession issues facing Aristocrat are likely to influ-ence, first, Marstens response to the two specific proposals addressed in questions 1 and 2above and, second, the value of Aristocrat, which is the focus of questions 3 and 4 above. Howshould Marsten handle the succession issue?

6. Should Marstens decision with respect to the two proposals in questions 1 and 2depend on his decisions with respect to whether to sell the company? If so, in what ways?

13

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15

Case 2Ciba Specialty Chemicals: Unlocking Significant Shareholder Value

This case was prepared by Professor Leif Sjblom as a basis for class discussion rather than to illustrateeither effective or ineffective handling of a business situation.

The spin-off of Ciba Specialty Chemicals is already energizing the organization, encourag-ing entrepreneurial behavior and increasing our competitiveness. We believe that we arecreating optimal conditions for sustained success.

Dr. Rolf A. Meyer, Chairman

On March 6, 1996, Ciba-Geigy and Sandoz announced a surprise merger that created the worldssecond-largest life sciences conglomerate, Novartis. With SFr36 billion in sales and SFr100 billion($83 billion) in market value, this was the worlds biggest merger. To many employees of Cibasindustrial sector, the announcement came as a shock. Ciba-Geigy had underperformed the Swissstock market for several years. But since the company was considered conservative, nobody ex-pected a move as drastic as a merger with archrival Sandoz.

In the months after the merger, initial disbelief gradually gave way to cautious optimism. Inthe largest corporate spin-off ever, Cibas industrial sector would become an independent com-pany, with annual sales of SFr6.7 billion. The new company would focus on the specialty chemi-cals market, its core business; Novartis would be a pure life sciences company. For Ciba Spe-cialty Chemicals people, the prospects of an independent company were a source of anxiety andmotivation.

In 1997, with Ciba SC completely on its own, chairman Dr. Rolf Meyer and CEO Dr. HermannVodicka faced both opportunities and challenges. After the spin-off from Novartis, Ciba SC wasleft with a strong product portfolio and an excellent market position but, historically, a mediocrefinancial performance. Ciba SCs 7.5% operating profit margin fell way short of the 15% industrybenchmark, and only two of the five divisions earned their cost of capital. The SFr8 billion marketvalue of the new company (right after the spin-off) could be justified only by a major restructur-ing, cost cutting, and aggressive growth to regain market share lost through past inappropriatestrategies. Completely new structures had to be put in place, and the company needed to positionitself in the market. Still, on the up side, Ciba employees were energetic, proud, and motivated.

The Specialty Chemicals Industry

Specialty chemicals are complex chemicals of medium to high value. They typically are soldin small quantities to industrial buyers. Many are patent protected, although that share is de-creasing. Usually, they are key intermediate components of a wide variety of consumer and in-dustrial products. Specialty chemicals give specific properties and enhance the performance ofthousands of products such as detergents (whiteners), toothpaste, colors in fashion items, paint,and almost every item made of plastic. Thus, although most consumers are not aware of it, spe-cialty chemicals are part of our everyday life. Because of this, pricing and volume are driven byend-user applications rather than by the general economic environment.

Copyright 1997 by IMDInternational Institute for Management Development, Lausanne, Switzerland.All rights reserved. Not to be used or reproduced without written permission directly from IMD.

16

Ciba Specialty Chemicals is organized into five divisions. Two of them are turnaround busi-nesses. Each division is a global market leader in its chosen field. However, although the divi-sions have superior products and very high market shares, their financial performance has beenweaker than that of their competitors. (See Exhibit 2-1 for details of the strategy and competitiveposition of the divisions.)

The divisions were:

Additives. This was the most successful of Ciba's divisions, bringing in about 50% of thecontribution. The key challenge was to defend its margins and its strong market position.

Pigments. With the exception of 1996, this division also performed very well. Performance Polymers. After a problem year in 1991, restructuring had improved the situa-

tion. The turnaround was almost achieved, and the division was now a strong performerwhose main challenge was to maintain growth and further improve performance.

Consumer Care and Textile Dyes. After difficult years in 199395, the turnaround of thesedivisions was well underway.

The Old Ciba and the New Ciba

The Ciba SC management team remembered old Ciba fondly. Though it could be argued thatthe company acted conservatively and resisted radical moves, it had been very successful. It hadhad a very strong culturepeople joined the company, became part of the culture, and stayeduntil retirement. The challenge was clear: Preserve Cibas good aspects, avoid the old limitations.

The major problem with old Ciba had stemmed from its diversification. The companysbusiness portfolio had gotten so big and broad that it lacked focus. And decision making wasslow. The specialty chemicals business was practically a Cinderella storylong neglected, it hadnot been allowed to reach its potential. Chemicals had been only one small piece of a large busi-ness portfolio dominated by Pharmaceuticals. The Pharma division, with its history of high prof-its, had always received more capital and management attention than the highly competitivespecialty chemicals business, with its history of lower margins and several turnarounds. Clearly,the primary role of the industrial sector had been to provide cash to fuel further Pharma growth.This left little capital or management attention to develop the chemicals business.

Since Cibas core business was Pharma, all the systems, objectives, and performance evalu-ations had been inherited and revamped, rather than tailored to the needs of the chemicals busi-ness. Lines of responsibility were fuzzy. Decision making was slow, since most of the businessunits lacked a direct channel of communication to top management and large central units wereresponsible for key business processes. Working capital and fixed assets were at typical Pharmalevels but way above the levels appropriate for industrial products. The company was neitherperformance oriented nor fast to react. At the same time, the industry was becoming more andmore competitive.

One senior executive described the situation this way:

You could do things if you wanted to make things happen, but the fact is that very few did.And there were no direct and visible consequences of lack of performance. Mediocrity wastolerated for far too long, and this diluted peoples interest in excelling. A lot more energywas available, and people were ready to give a lot more, but we had no systems in place toencourage it.

Mr. Franz Gerny, head of Human Resources, saw these challenges for the people:

We want to keep the good aspects of old Ciba. However, in certain areas we must be tougher.People who dont deliver and who dont get results do not belong in the new company.

17

In the past, we didnt walk the talk. We didnt react quick enough, when younger peoplewhere looking for more challenge. Now we need to learn to fight hardernot to find ex-cuses for not reaching an objective.

The Shareholder Value Strategy

For several years, Ciba-Geigys position in the pharmaceuticals industry had been sliding. Thecompany had underperformed the stock market and its peers. A strategic review, based on theshareholder value concept (see Figure 2-1),1 had already been initiated by Chairman Rolf Meyerseveral years before the merger. The review had shown that several of Cibas businesses seemedto be undervalued by the market. To close the perception gap and provide a fair and full valu-ation, the company had aligned itself more closely with shareholders needs and increased disclo-sure; this included switching to international accounting standards.

Figure 2-1. McKinsey Framework for Shareholder Value Creation

Currentmarket value

Company valueas is

Potential valuewith internal

improvements

Potential valuewith internaland external

improvements

Optimalrestructured

value

Strategic andoperatingopportunities

Perceptiongap

Disposalsandacquisitions

Financialengineering

Source: Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, 2nded., New York: John Wiley & Sons, Inc., 1996.

This was not enough, however, to sway the investors. Ciba still underperformed the market.And shareholders still perceived the business portfolio as too broad and the company as unfo-cused. The market clearly preferred focused businesses, and Sandoz had been rewarded for itsdecision to spin off Clariant, their specialty chemicals business, in 1995. Before the merger withSandoz, the estimated shareholder value benefits from breaking up the business portfolio andmanaging the units as separate, focused businesses were estimated at several billion Swiss francs.The decision to spin off the specialty chemicals business had already been made before the merger.(See Exhibit 2-2 for stock market reactions to the merger.)

1 A company is creating shareholder value if its after-tax operating return is higher than its cost of capital. A numberof investment banks estimated Cibas WACC (weighted average cost of capital) to be approximately 7% (see Ex-hibit 2-1 for examples).

18

After the merger and subsequent spin-off, Ciba Specialty Chemicals was expected to createadditional shareholder value by streamlining operations and by gaining focus due to managing ahomogeneous business. Geographic expansion and new product development would bring thenewly focused business faster and more profitable growth. Now, after the divorce, Ciba was inthe unique position of being able to start with a clean slate, in effect, to create from scratch theoptimal structures and conditions for success.

Organizing for Shareholder ValueOld Ciba had both strong divisions and strong corporate headquarters, but the final wordalways rested at HQ. It was a grown structure that had evolved before shareholder valuethinking. Some people advised us to copy the old structure and reorganize afterward.That would have been the easy way out, but it would have been a mistake.

The basic principle is simple: We want to simplify the structures to create more focus. First,a job should always get done at the right place, where it makes the most sense. Second, weshould avoid the trap that we centralize too much, and the divisions lose their ability to runthe business. Third, we need to use synergiesbut only where they really exist.

Dr. Michael Jacobi, CFO

Like old Ciba, the new organization had five divisions. The old organization had been func-tional, with partly centralized R&D and purchasing and shared manufacturing, but now the divi-sions were fully accountable for strategy, R&D, marketing, and the whole supply chain, includ-ing purchasing. Moving Ciba away from their old product management focus, the new structurecreated fully integrated, segmented business units (see Figure 2-2 and Exhibit 2-3).

Figure 2-2. Organization of Ciba Specialty Chemicals

Additives Pigments PerformancePolymers

ConsumerCare

TextileDyes

16 Geographic RegionsShared services

Research Board

Customer Value Board(Key account management)

Manufacturing council

Supply chain council

Source: Ciba company document.

The business support functions also went through a major change, based on an efficientshared services concept. The country organizations, with 72 country heads, were replaced by16 regional presidents. Group services would be provided from 14 regional business supportcenters. Costly duplications in finance, IT, HR, and administration were avoided. In IT, for ex-ample, 25 people now performed a broader array of tasks than 170 people had before. Commonaccounting and the introduction of shared computer systems supported the structure.

The objective of the new organization was simple: a clear distribution of tasks, driven byefficiency, while maintaining the local know-how. Dr. Jacobi commented:

19

We want to avoid unproductive discussions about who does what and who pays. The oldplanning and reporting process was very complex. We spent lots of energy fighting internalcost allocations. For example, one-third of our mainframe capacity was used for calculatinginternal charges. On the other hand, there was also too much duplication in execution. Ournew structure is based on very standardized systems, clear interfaces, but, most impor-tantly, on a clear definition of responsibilities and execution tasks.

We simplified the structure because we just could not afford the old structurethis type ofchange was long overdue, and the reaction was very positive. But we had the right people,and we were able to make the most of the situation.

Corporate Functions and Cross-Divisional Coordination

The common view was that the new organization would centralize only what made sense,i.e., treasury and accounting, backbone IT services, legal services, investor relations, and commu-nications. The central organization would be less powerful than in Ciba-Geigy, and the level ofservice would match what the business could afford.

In the view of Ciba management, centralization was bad, but a coordination of central com-petencies made sense. To achieve the benefits of a more centralized organizational structure, withoutjeopardizing divisional accountability, cross-divisional coordination and synergies would be cap-tured by a Research Board, a Manufacturing Council, a Supply Chain Council, and a CustomerValue Board.

For the Research Board, the underlying principle was that the divisions closest to the cus-tomer would develop the products, but the company would own the technologies and competen-cies. The Research Board would ensure that skills, know-how, and experience were available andshared and would assess research projects and the global project portfolio and provide due long-term R&D perspective.

The Manufacturing Council would coordinate a site strategy, capacity utilization, and capi-tal expenditure. The Supply Chain Council would identify and exploit synergy between divi-sionsfor example, by sharing development work and best practice, providing competence cen-ters, and sharing transport or warehousing. The Customer Value Board would be concerned withkey account management systems, the optimal deployment and motivation of the sales force,customer satisfaction benchmarking, and best practice marketing tools and database marketing.

Considerable cross-divisional coordination was also needed in marketing, particularly inkey account management. The role of the regional organization was to integrate the activities ofthe divisions in a certain market. Brendan Cummins, regional president in China, put it this way:

In China, in the old Ciba-Geigy, we used to have nine divisions constructing or managing11 joint ventures. Because we were operating in divisional silos, we lost many opportuni-ties. We need much stronger coordination and experience sharing, particularly in develop-ing countries. We are one company, and we want to present only one face to governmentand our stakeholders.

Positioning the New Company

Despite the high emphasis on divisional autonomy, Ciba wanted to harness the benefits of aunified corporate image: one company, one vision, one identity. This corporate identity wouldcreate recognition in world markets, support business processes, raise the profile and enhancethe perceived value of Ciba, and distinguish it clearly from the old company.

Like many of the other changes taking place at the time, the new Ciba Specialty Chemicalsvisiondeliver value, perform to win, and shape the futurewas created by a very small team inrecord time. The companys new slogan, value beyond chemistry, reinforced the idea that from

20

now on, future business drivers would be excellent products plus all the things that contributedto customer value (see Exhibit 2-4).

During its long history, the Ciba brand name had established a very strong position in themarket. As one customer remarked, I perceive Ciba to mean high quality and outstanding ser-vice. Another said, Ciba is a label, and we trust this label because we know what the Cibaquality is worth. Thats very important. The strength of the bond Ciba had established with itsmain customers showed that the Ciba brand had considerable brand value that would translateinto shareholder value. So the Ciba name was kept. But to differentiate Ciba from other compa-nies and to express the strengths and values of the new company, a new visual identity wasconceiveda butterfly (see Exhibit 2-5).

Cibas positioning was very well received among customers, investors, and employees.Brendan Cummins said:

For the first time, we have a name, a vision, and clear systems aligned to support the busi-ness strategy. The new mission is focused, punchy, and conveys a specific message. It willbe THE driving force of the culture of the new company.

It was a tremendous boost to morale when we found out that we could retain the name ofCiba. Most employees felt that Ciba stood for something. This was especially the case inChina, where we had a strong brand name and more than 100 years of tradition. And thebutterfly met with unexpected positive response from the customers. Everyone is visuallyimpacted by the new symbol. For our employees, it is indicative of the new cultureit islight and quick.

Financial Incentives

To link management with shareholder interest, Ciba came up with an innovative compensa-tion package. The base salary was set at or below the average market level. In certain cases, thisresulted in a lower fixed salary for some managers. A short-term incentive plan for the top 700people moved the total compensation to the upper 25 industry percentile if certain shareholder-oriented targets such as sales growth and operating profits were met. The executive committeeand board members had to join a leveraged executive asset program (LEAP). They had to make acommitment to invest one years salary in Ciba stock and hold on to it for at least five years. Stockoptions provided upside leverage if the share price increased, but any downside risk was as-sumed by the individual. The share plan was offered on a voluntary basis, and with a smalleramount, to an additional top 250 executives, of whom 99% subscribed to the plan. In addition, tomotivate the workforce, each of the 20,000 people working for the company received one freevirtual share.

Additives: The Flagship Division

In 1996, the Additives division was Cibas flagship, contributing almost 50% of the profits.Only 35 years old, it was Cibas youngest division. With a dominant market position, the keychallenge was to retain market share and profitability.

Division head Dr. Reinhard Neubeck commented:

Traditionally we have had very good productsall patent protectedthat have sold them-selves. We had almost a monopoly until the early 1980s. We produced products, not focus-ing too much on marketing and PR. The customers perceived us as arrogant. Today, this hasall changed. We still have excellent, innovative products, but only 30% of our products arepatent protected. Consequently we are now much more proactive and more aggressive inthe market.

21

The future drivers of value were expected to come from end-user applications developedclosely with customers. Technical customer services and consultative selling were going to becritical to understanding the end users needs. The globalization of the customers was going torequire focused account teams, wide geographic reach, and a wide range of products. With prod-uct life cycles getting increasingly shorter, time to market was now critical. Ciba SC needed tomove from a tradition of sequential product innovation to a concurrent, but financially morerisky, product development process.

Consumer Care and Textile Dyes: The Turnaround Divisions

The two turnaround divisions, Consumer Care and Textile Dyes, were expected to gener-ate increased profits and shareholder value. In Consumer Care, the appointment of Dr. MartinRiediker had already heralded the turnaround:

This is simply an old business with a new focus. The old Chemicals division was the left-over of all the other divisionsall the pieces that nobody else wanted. What does it mean tobe a chemicals division in a chemicals company? The first step was to choose a name thatdescribes the futurenot what we are today. Now people realize that there is a differentfuture for our division.

Consumer Care was reorganized into business segments with responsibility for product andproduction-related strategies and assets, including R&D, production, marketing, supply chainmanagement, and four business areas responsible for sales. This reorganization provided newfocus and a new identity by breaking out of traditional markets and segments.

All we did was to open up space and provide a window of opportunity by moving thenecessary resources to the point where people are accountable. The energy was alreadythere, and we just had to release it.

The restructuring of the mature and very fragmented Textile Dyes business had alreadystarted with the appointment of Dr. Jean-Luc Schwitzgubel as division head in 1995. The basicproblems were an obsolete, reactive business structure that wasnt driving the business forward,too many products, underutilized capacities, and a lack of momentum due to market share losses.

Most management practice is based on cost control. It is true that we cannot be in businessif we dont have the right cost structure. However, we lost SFr300 million in sales between199395, and there is no way we could reduce cost that fast. Instead, we need to focus ongrowth and new business development. Everything is driven by revenue.

The old Ciba, with its pharma mentality, had always followed a premium pricing strategy.But although Textile Dyes products and technical service were excellent, customers were nolonger willing to pay a premium. Costs were too high, and asset utilization was too low. A certaintechnical arrogance had ensued from the companys being in a leading market position so long.In addition to the necessary cost cutting, the new organization unleashed the sales people andcreated a clear focus on selected core segments. Prices were reduced to reflect a competitive,value-based pricing strategy, and a major product development program was initiated. As a re-sult, 60 new products had been introduced in the last 12 months, while unattractive product lineshad been eliminated.

The Future

On June 10, 1997, Ciba SCs stock price reached SFr140. The share price reflected shareholdersexpectations of significantly higher future profits (see Exhibit 2-6). To live up to these expecta-tions, Ciba had to grapple with a number of challenges.

22

First, above-average growth would not be achieved with a traditional product managementapproach. Ciba wanted to enter the market segments where research mattered, which meantbecoming much more focused on innovation. To be on the leading edge, one must either be fasterthan competitors or develop more patents. According to CEO Dr. Hermann Vodicka, a key chal-lenge was to manage the product portfolio effectively in a constantly changing environment.

Second, the industry was expected to undergo major changes. As a supplier to many compa-nies that ultimately created and marketed branded consumer products, Ciba SCs business wasaffected by consumer trends. Consumers expected increasingly higher quality at lower prices. Atthe same time, the global retailers were becoming increasingly powerful. Cibas major clients, theconsumer goods producers, were putting increasing pressure on their suppliers to deliver value.As an alternative to a protection approach (i.e., patents), Ciba could respond by co-branding.Ciba already had limited branding experience with its Araldite products. Several other products,such as the UV protection fabric finish, had very high potential for being branded. However,retailers generally disliked too many labels, and Ciba had neither the experience nor the adver-tising budgets to support a major brand.

The third challenge was that the battle was likely to move into emerging markets, such asAsia, that had an altogether different cost structure and philosophy. Ciba had already movedsome activities, such as formulation, to these markets.2 However, with the customer base becom-ing ever more global, both opportunities and risks were looming.

Ciba Specialty Chemicals intended to address these challenges within the shareholder valueframework. The balance sheet was strong, and the spirit was high. Meanwhile, the stock pricekept rising, and expectations in the capital markets kept going up.

2 Formulation is the step after the chemical synthesis where customer-specific products are created.

23

Exhibit 2-1. Cibas Position in the Chemicals Industry

A. Top Ten Chemical Companies in 1996

1996 Sales in US$ billions

0

5

10

15

20

25

30

35

40D

u P

ont

Hoe

chst

BA

SF

Bay

er

Dow

Rh

ne-

Pou

lenc

Impe

rial

Che

m.

Mits

ubis

hiC

hem

ical

s

Akz

o N

obel

Nor

sk H

ydro

B. Top Fifteen Specialty Chemicals Companies in 1996

1996 Sales in USD billions

0.00

1.00

2.00

3.00

4.00

5.00

6.00

Cla

riant

-H

oech

st

Cib

a S

C

BA

SF

Akz

o N

obel

Bay

er

Dai

nipp

on

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m H

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Sol

utia

(Mon

sant

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W.R

. Gra

ce

Eas

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Che

mic

als

Dow

Cor

ning

Gre

at L

akes

Her

cule

s

Mor

ton

DS

M

Source: The Fortune Global 5 Hundred Ranked Within Industries, Fortune, August 4, 1997, p. F-16.

Chart includes specialty chemicals sales only. Clariant and Hoechst merged their operationsin 1997.

Source: Kerri A. Walsh and Andrew Wood, Specialties New Lineup, Chemical Week, April 30, 1997, pp. 3748.

24

Exhi

bit

2-1

(con

tinue

d)

Sou

rce:

IM

D a

nal

ysis

of

Cib

a p

rosp

ectu

s.

25

Exhibit 2-2. Stock Market Reaction to Ciba-Sandoz Merger

A. Stock Market Reaction to Merger

500

700

900

1100

1300

1500

1700

1900

2100

1/95

4/95

7/95

10/9

5

1/96

4/96

7/96

10/9

6

1/97

4/97

Ciba bearer

Sandoz bearer

Novartis bearer

Index

mergerannounced

B. Shareholder Value Created by Spin-Off of Ciba Specialty Chemicals

1400

1500

1600

1700

1800

1900

2000

2100

2200

3.1.

97

31.1

.97

28.2

.97

1.4.

97

30.4

.97

26.5

.97

CSC+Novartis

Novartis

Index

Start ofpremarketing

Price rangeannounced

First day ofrights trading

Shareholdervalue

Source: Public Information (Swiss Stock Exchange).

26

Exhibit 2-3. The New Organization

Divisions: strategy marketing production R&D purchasing supply chain management communication

Regions: sales communication representation information technology finance legal structures safety environment

Corporate: global portfolio strategy acquisitions treasury communication safety environment legal services

Old structure

divisions

geographic countries

corporate services

large risk of duplication

strong independent divisions

strong corporate checking

grown structure

clear focus on product management

slowness

New structure

divisions

geographic regions

limited corporate services

only what makes sense

One company

One team

One chance

green field approach

clear focus on our needs

speed

27

Exhibit 2-4. Mission Statement

Deliver Value: We deliver value for customers, employees, and shareholders. Value is createdthrough innovation, productive relationships with customers, and speed and simplicity in every-thing we do. We achieve this in balance with our responsibilities to society and the environment.

Perform to Win: We appreciate and recognise competence and performance. As empowered in-dividuals and teams in a networked company we focus on results. The perceptions and actions ofour stakeholders are crucial for our success. We want to win by being their partner of choice.

Shape the Future: We shape the future of our company and industry. We take the initiative andmake things happen, always embracing change as a source for new opportunities.

Innovative,entrepreneurial and

action-oriented

Committed tocustomers and

operationalexcellence

Respect the

environment

Delivervalue beyond chemistry

tomaximize valuation

Embrace change as asource of newopportunities

Excel in competenceand performance

Create and supportan inspiring team work

environment

The leading globalspecialty chemicals

company

Our Direction:

We have a strong global operational basis with target-oriented initiatives in place and a high levelof customer orientation.

We have a worldwide network of excellent, motivated people and management whose compen-sation is linked to target achievement.

We will continuously measure progress against the best in class and improve our business.

While we are determined to reduce our asset base and cost structures, we will outgrow our mar-kets with innovative products geared to create value for our customers.

All divisions have committed to outperform their competitors.

Source: Ciba company documents.

28

The Power of Transformation

We have chosen the butterfly as our new symbol because it is avivid and universal symbol which immediately differentiates CibaSpecialty Chemicals from all other companies. It expresses ourunique strengths, character, values and products on many levels. Itoffers endless possibilities for interpretation to reflect our evolutionover the years ahead.

The butterfly is widely regarded as a symbol of transforma-tion. As such, it is a particularly appropriate symbol for a companythat has just emerged in new formand which will continue to trans-form itself to meet changing needs.

Despite its apparent fragility, the butterfly lives in most partsof the world and travels vast distances across continents. It is lightbut strong at the same time. The universality of the symbol repre-sents Ciba Specialty Chemicals presence around the world.

The five colors symbolize the five divisions of Ciba SpecialtyChemicals all acting together towards one goal, one vision with onecorporate culture. By adopting a colorful image, we will communi-

Exhibit 2-5. The Power of Transformation

29

Exhi

bit 2

-6.

A.

His

tori

cal F

inan

cial

Sou

rce:

C

iba

com

pan

y d

ocu

men

ts.

30

Exhibit 2-6 (continued)B. Divisional Financial Performance

Source: Ciba company document.

DIVISIONAL DATA 1991 1992 1993 1994 1995 1996First half,

1997Sales: Additives 1,980 2,066 2,097 2,222 2,067 2,065 1,184 Consumer Care 1,269 1,297 1,295 1,216 1,081 1,108 590 Perf. polymers 1,301 1,303 1,245 1,238 1,239 1,322 797 Pigments 945 1,046 1,074 1,091 1,026 1,073 657 Textile Dyes 1,421 1,423 1,419 1,316 1,083 1,173 729 Total 6,916 7,135 7,130 7,083 6,496 6,741 3,957

Op. profits (EBIT) Additives 376 453 438 346 194 Consumer Care 155 110 28 50 63 Perf. polymers 54 74 135 75 91 Pigments 158 188 186 122 107 Textile Dyes 103 3 (36) 40 73 Corporate (358) (265) (252) (132) (51)Total 488 563 499 501 477

Net oper. assets Additives 2,274 2,141 2,072 ND 2,345 Consumer Care 1,377 1,286 1,197 ND 1,139 Perf. polymers 1,265 1,215 1,147 ND 1,460 Pigments 1,189 1,182 1,227 ND 1,518 Textile Dyes 1,918 1,736 1,570 ND 1,619 Shared op. assets 805 772 874 ND 744 Total op. assets 8,828 8,332 8,087 ND 8,825 Non-operating assets 1,244 1,283 1,284 ND 1,393 Total assets 10,072 9,615 9,371 ND 10,218

Depreciation (amortization) Additives 115 110 108 118 60 Consumer Care 73 78 87 71 32 Perf. polymers 89 53 61 52 27 Pigments 65 53 55 60 26 Textile Dyes 95 91 80 71 35 Non-divisional 59 28 7 12 53 Total 496 413 398 384 233

Capital expenditure Additives 169 124 126 144 47 Consumer Care 75 72 69 62 22 Perf. polymers 67 69 60 95 37 Pigments 87 74 111 166 67 Textile Dyes 120 78 68 71 31 Non-divisional 38 51 28 21 16 Total 556 468 462 559 220

Personnel Additives 4,254 4,366 4,379 ND ND Consumer Care 3,813 3,997 3,886 ND ND Perf. polymers 2,811 2,893 2,933 ND ND Pigments 2,838 2,896