Case 23-2: Industrial Electronics Inc. Issue: Evaluate the proposed bonus system. Background: “My division had another great year last year. We all worked hard, and the results were there. But again we got no reward for our hard work. It’s very frustrating.” Division Manager. KSF Innovation. Good cost control due to price competition. Internal Environment Industrial Electronics Inc. sells a wide range of electronic equipment. (Like EVERY other case!!!) $8 Billion in sales. High-tech industry makes it difficult to forecast, since it’s a volatile industry. Goal is to maximize shareholder value. External Environment Competes on new/innovative products and also price. We infer there is an economy-wide recession during the time period of this case. Current Management Control System Decentralized by product line, set up into 4 Business Groups. Responsibility centre – there are 16 autonomous divisions, that act as Profit Centres. 25 Managers (All levels including and above Division Manager) receive an annual bonus Lower level managers are included in a “Management by Objectives” incentive plan. (This is a system that offers incentives based on the achievement of a number of specific objectives, which may not all be financial, ie: # of new customers added, # of successful orders filled in a month…) Bonus Pool based on 10% * (( Net Income – (12% of Assets-Liabilities)) Pool/Total Salary of 25 Managers = Award per salary $. Max = 150% of salary. Before 2000, average bonus was 50% of salary…..in 2000 and 2001 bonus was $0. (Recession.) Problem: Both good and bad managers got no bonus in those years. Pros of Current Bonus System Managers only get bonuses when the Company profits, and can afford it – this “shares the wealth.” Encourages teamwork, due to having a common profit goal, but it seems these units are independent. Performance targets are fixed, timeless and without bias – reduces politics. Simple and easy to understand. Cons of Current Bonus System Rewards are not directly linked to individual effort/performance. Corporate performance is uncontrollable. (Volatile industry, recession.) Profit-related targets can motivate a short-term view, thus sacrificing the innovation KSF. “Net Worth (Assets – Liabilities) is a strange measure of assets used. Usually, we use total assets. If the Company is not doing well, no bonuses are paid, but what if individual divisions are doing very well – reduces their motivation to sustain that, given a recession year. Could reduce morale by this lack of motivation, and promote turnover. Proposed New System Bonus would now be based on individual performance – Division Manager rewarded on his Division’s performance, Group Manager rewarded on his Group’s performance, etc. Bonus compares to budgeted targets. We’re told these targets are 80% to 90% achievable if management did a reasonable job. Formula is (Budgeted Operating Profit – (12% of Operating Assets)), where 12% is taken to be the cost of capital. In other words, the target Operating Profit is reduced by a capital charge for the use of assets……which makes these units now INVESTMENT CENTRES. (our topic next week!) “Operating Assets” include Cash calculated at 10% of COGS (why??? This seems arbitrary and artificial…each unit wouldn’t have cash, or their own GL…cash would be held centrally) + AR and Inventory at their average month end balances, + Fixed Assets, at average month end balance. If managers meet targets exactly, they get a bonus of 50% of their salary. Managers get an additional/or reduced 5% bonus linearly for each increment over/under $100,000. As an example: 50% / 5% = 10*$100,000 = $1,000,000. If results are $1,000,000 below target, they get no bonus. That’s big difference between budget and actual before no bonus is given!!! The MAXIMUM bonus is 150%...150% / 5% = 30*$100,000 = $3,000,000 above targets. Pros of Proposed System Reward is linked to individual performance, which is good when there is no interdependence among units. The measure uses a total productivity #: Sales – expenses and asset use. The operating targets are separately estimated for each unit, which means a better reflection of their potential. This is equitable and also achievable, and a source of motivation and commitment for managers. Cons of Proposed System Using Operating Income is a short-term measure, as above, which could compromise innovation. We wonder why cash is included in operating assets – it seems arbitrary. Net Book Value as a measure of assets in this calc is a poor mechanism, given that over time, NBV decreases naturally (given depreciation) which makes the return greater…and this discourages asset replacement. 12% as a cost of capital for each unit isn’t realistic, as it would naturally differ from unit to unit given the difference in assets employed..also, if the 12% is constant, this doesn’t actually reflect TRUE cost of capital. Setting budgets in this industry is difficult given the volatility; is this task easier for some units than others? We are given no information on the Budgeting Process…If a manager created his own budget, and “padded” it (with extra expenses) then he can easily meet/exceed such a budget and get a bonus. This bonus system awards managers even if they don’t reach their targets..is that the right message to send? Simple enough to follow. Recommendations Remove cash from asset calculation Charge for fixed assets based on market value to encourage replacement, and updated technology. Use an appropriate cost of capital number based on actual levels of debt and equity financing. Ensure budgets are challenging but achievable. Just meeting target is maybe worthy of a bonus, but not meeting it AT ALL is not worthy of a bonus. May want to consider a component on overall profits.
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