Revenue Recognition - IBM

Revenue Recognition - IBM Once there were giants … the Standard Oil Trust, the mighty Railroads who owned the West, U.S Steel, "what's good for the country" General Motors and "Ma Bell". ITT in its heydays had its own state Department and then of course there was mighty "Big Blue", IBM. Time, the Sherman Anti-trust law, foreign competition and management failure have treated them harshly. Until the mid-nineteen eighties IBM was the dominating force in the computer industry. It was feared that eventually IBM would be the only computer company in the world. The Justice Department conducted an almost decade long investigation to determine if IBM should be broken up under the Sherman Antitrust laws. However, unnoticed by the Department of Justice or IBM, competition arose from an unexpected quarter, the garages of Silicon Valley. There computer "nerds" were developing small desktop computers that eventually would challenge the hegemony of "Big Blue". While IBM did not completely ignore what was happening in its backyard, neither did it take the PC revolution seriously. IBM, where everyone wore a white shirt and dark tie, would not be intimidated by ex- Hippies in T-shirts. IBM bet that mainframe computers would continue to rule the business world. By the mid-nineteen eighties it became obvious that IBM was losing the bet and belatedly it too entered the PC field. Until then IBM had been a cash generating machine, its main problem seemed to be how to minimize its reported earnings. In 1984 the company boasted a 26.5% return on equity, but by 1989 the return on equity had plunged to 9.8% and in the early 1990's it had disappeared in losses. The price of IBM stock hit a high of $175 per share in 1987, by 1993 it had dropped to $52. Something had to change. Computer Sales Traditionally, IBM's computer business consisted of the manufacture and sale or lease of main-frame computers. The computers were installed and "operationalized" and maintained by IBM employees. IBM is known for "standing behind its product", but overall, mainframe customers had few alternatives, due to IBM' domination of the field. When IBM belatedly entered the PC market, it faced a very different environment. Not only was there significantly more competition, but also rapid technological change. IBM instituted a number of policies to make sales or leases of its computers more attractive: Stretched out payment plans, a "try and buy" policy with no initial payment, free upgrades and a "price protection plan" under which, if prices fell, the customer would only have to pay the new, lower price. Shipping and Delivery IBM uses a delivery system that is somewhat similar to the Airlines "Spoke and Hub" system. Upon completion computers are shipped to central distribution warehouses and from there they are delivered to customers. It used to take up to 45 days until computers would reach the ultimate customer, but this has been cut to 30 days. One Stop shopping For internal and external reporting purposes the company separately accounts for and discloses revenues and costs for hardware products, software products and services. Historically, customers had purchased each of these categories separately. Today the technology industry has become “Network Centric”. Customers demand more than delivery and installation of products. The demand for products has been changed into a demand for “Solutions”. To remain competitive, IBM began offering “Business Solutions” in addition to individually selling products, as had traditionally been the case. Company sales consultants were instructed to aggressively market the “Total Business Solution” and provide customers with a combined price quote that includes hardware, software and networking products and services. Sales consultants receive a small base salary, however, the majority of their income consists of commissions based on revenue recognized. Revenue Recognition Revenue is recognized when the product is shipped. While IBM makes provisions for returns and adjustments, nevertheless, it was criticized by a number of accountants and even one of its own auditors for using "aggressive revenue recognition" methods. Thornton O'glove, a San Francisco based auditing expert, charged that in 1984 these and other aggressive accounting methods were responsible for 26% of IBM's profit increase or 45 cents a share. According to him, in 1985 earnings fell 10 cents a share, but without the accounting changes the decline would have been 86 cents a share. IBM disputed these charges and claims that it makes appropriate provisions. TYPICAL CONTRACT. Following are the major terms of a typical contract: • • • • • • • IBM agrees to provide X Company 1,000 PC’s Each PC will be preloaded with “vendor” software The 1,000 PC’s will be integrated into a Local Access Network (LAN) The LAN will provide access to the X Company’s mainframe The billing software will be customized to interface with marketing The fee for the project is $1,000,000 The project is to be completed in 12 months. Costs for this contract are expected as follows: • • • • $350,000 $100,000 $200,000 $ 50,000 Cost of PC’s, based on 40% margin (list price) Cost of the software, based on 40% margin (list price) Cost of labor related to integration of network Cost of labor to customize the billing software.