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Category: Business
Autor: anton 12 April 2011
Words: 2027 | Pages: 9
Introduction

The main principle of an incentive compensation plan is to motivate managers to act in the best interests of the organization and its shareholders. The basic idea of behind such plans is to pay for performance. Incentive compensation plans possess two important elements: measures of performance and methods of compensation. The following is an analysis about weather the proposed incentive compensation plan for Purity Steel Corporation’s Warehouse Sales Division is the correct method of rewarding the branch managers. This is brought to attention when a branch manager wonders whether his new warehouse should be leased to alleviate the impact on return on investment (ROI).

Background

The Warehouse Sales Division (WSD) is an autonomous unit of the Purity Steel Corporation, an incorporated steel producer. The unit operates 21 field warehouses throughout the United States. In 1995 sales totalled approximately $225 million, half of the products sold were purchased from Purity Steel’s Mill Products Division, using a market-based transfer price. Harold Higgins, a former member of the Mill Products Division, was appointed general manager of the Warehouse Sales Division. Higgins was responsible for the entire division’s operations and growth. Sales volumes and rate of return on investment would be two components to help measure growth and overall performance.

The Warehouse Sales Division is an investment centre, which operated as a centralized unit before Higgins’ arrival. Following his arrival, Higgins decided to decentralize the management of his division by making each branch manager was held accountable for the division’s profits and invested capital at each of the different locations. An incentive compensation plan was one of the key features of his decentralization policy, which was to become effective in January 1995.

Higgins introduced the new compensation plan to branch managers in December 1994.

Page 2 Purity steel Essay

He stated that the objective was to develop a fair way to compensate those managers who are working hard and doing an excellent job adding to the growth and success of the division. Implementing the new plan only needed the balance sheets prepared by each warehouse, this was easy to obtain because the warehouses had been preparing their monthly operating statements for years. The balance sheet possessed two major asset categories, inventories and fixed assets, which were easy to classify. Purity’s central accounting department directly collected accounts receivables. However, as stated in the case an investment receivables, equal to thirty-five days’ sales was charged to each warehouse. In addition to the assets, a small cash fund was deposited in a local bank. No current or long-term liabilities were recorded at the divisional level.

Affects of the New Compensation Plan

Some concerns by some managers about the new incentive plans with relation to their year-end compensation. One concern, in particular was brought to the attention of divisional management, which was from Larry Hoffman, manager of the Denver branch. Hoffman was unsure of what decision to make about whether he should lease the new warehouse being built or own it. The individual branch managers for this investment centre have authority to make decisions that affect both profit and investments, which in turn affect the compensation level received. Hoffman has forecasted that his sales volume will triple over the next eight years.

As summarized in the request for expenditure statement, the project will pay out in about 7.3 years. In the prior year Hoffman received one of the biggest bonuses paid because of his high ROI, however after calculating a projection of his bonus for 1997, his ROI will drop from 17.3% to 7.2%, if he moves into the new facility at the end of the 1995. If Hoffman decides to lease the new building he will lease it for 20 years wit ha renewal option at $250,000 a year. As shown in exhibit 1, Hoffman would benefit more, with regards to compensation, if he owned the new facility. Improving a division’s ROI can be obtained by increasing either one or both of the ROI components, sales margin and capital turnover. Improving ROI is a difficult process and will need further consideration.

Current Compensation Plan

A successful incentive compensation plan should recognize the desired behaviour that the company wants to stimulate within the managers. The current compensation plan clearly communicates the objectives that WSD management hopes to achieve. It consists of a combination of a basic salary and extrinsic rewards. Return-on-investment is the primary source of measure for the plan.

ROI was capped at 20% and 5% was established at the floor. He also predicted that 1/3 of the managers would be below the 5% eligibility level or ROI for a bonus, while the rest of the 2/3 would receive a bonus in variations. Higgins also felt that the bonuses shouldn’t exceed 50% of the manager’s regular salary; keep in mind that salary adjustments to salaries can always be made.

1.Objectives (Exhibit 1):

oTo operate the Division and its branches at a profit

oTo utilize efficiently the assets of the Division

oTo grow

As an investment centre, the WSD is mostly concerned with the profits
generated by each of its branches. As an improvement to branch mangers’ compensation, Higgins and his co-worker made a few adjustments to the basic management salary structure. However, to incorporate the objective of growth and improvements in profits an extrinsic reward was introduced. As a performance measure, ROI was introduced because it takes account both branch income and the capital invested in the particular branch.

2.Components

Base salary:

oDetermined mostly on dollar sales volume of the district in the prior year.

oIncrease in sales or profitability considered

oEstablished by General Manager, WSD and ranges will be reviewed periodically to keep the Division competitive with similar companies.

Growth Incentive:

oIs calculated as $1750 for every $500,000 of increased sales during the year.

oAn advantage of a formula-based plan is that managers know exactly what the will receive.

Return-on-Investment Incentive:

oMeasures how effectively each branch used its invested capital to earn a profit.

oManagers paid in direct proportion to their effective use of assets placed at their disposal

oEmphasis: to increase the return at any level of investment, high or low

3.Limitations on ROI

oNo incentive paid to managers below 5% before federal taxes

oNo additional incentive will be paid above %20

oNo payments will be made in excess of $50,000

4.Calculation on ROI incentive

oExact incentive amounts cannot be determined if illustrated using a graph. However rough estimates can be determined (Exhibit 2)

oExact amounts can be determined by following these steps:

1.Subtract 500,000 from the last 6 digits of investment if they are above $500,000

Example: investment: 8,763,750

ROI: 7.3%

=(763,750-500,000)= 263,750

2.Divide the number in step 1 by 500,000

Example: 263,750/500,00= 0.5275%

3.In the 1% column in Exhibit 2, take the difference between the next highest investment and the lowest investment.

Example: high investment: 8,500,000 $2150

Low investment 8,000,000 $ 2100 Difference : $50

4.Multiply the result from step 3 by result in step 2 and add the 1% column figure for the next lowest investment. Example: $50 x 0.5275= $26.37+2100= 2126.37

5.Multiply the result from step 4 by actual ROI

Example: 2126.37 x 7.3= $15522.54 bonus payment

Problems with current compensation plan:

Some major problems that came to my attention were that capping the ROI amounts could result in branch mangers not performing at their optimal levels. ROI is a short-term measure and is significantly influences managers to make decisions only considering short- term advantages or disadvantages. Agency costs also seems to be a problem, this occurs when managers pursue their own interests instead of the Divisional manager’s. Since the compensation measures a period of one year, managers may be more likely to decide on crucial investment purchases or disposal on a short-term basis.

ROI

Measuring return-on-investment is one of the widely used performance measures in an investment centre. The ROI calculation illustrates the relationships between the profits and the capital used to create that amount of profit in a division. The formula of ROI is: ROI= Income / Invested Capital

It can also be rewritten as ROI= (income/ invested capital) = (income/ sales revenue) x (sales revenue/ Invested capital), which is sales margin multiplied by capital turnover.

Advantages:

oGood Economic measure

oPerformance and standards easily understood

oHighly motivational

oHigh levels of controllability

Disadvantages:

oShort-term Focus

oCreates incentive for inaccurate financial statements

oSelf interest of managers dominates decisions

oEasy to manipulate

Alternatives to ROI

Residual Income (RI)

RI measures the average return on every dollar invested. Residual income for an investment centre is defined as:

Investment centre Profit – (invested capital X imputed interest rated). The imputed interest rate is the cost of acquiring the investment capital; in most companies the imputed interest rate depends on the risk of the investment which funds will be used. Therefore, divisions that have different levels of risk will be assigned different imputed rates. RI is a measured in dollar amounts.

Advantages:

oPromotes goal congruency

oEasy to calculate

oNot as manipulative

Disadvantages:

oDistorts comparisons between divisions or branches of different sizes

oDoes not provide a perfect measure of performance.

Economic Value Added (EVA)

Similar to the RI, EVA is measured in solar terms, however it is different in two ways. Firstly, the investment centre’s current liabilities are subtracted from its total assets and weighted –average cost of capital (WACC) is used in the calculation. The division’s income is adjusted from accounting to economic income.

EVA= Division’s after=tax operating profit- [(total assets – current liabilities) X WACC]. EVA indicates how much shareholder wealth is being created. WACC is the average of the after-tax cost f debt capital and the cost of equity capital weighted by the relative proportions of the firm’s capital provided by debt and equity.

Advantages:

oAligns manager’s interest with the shareholder’s

oAvoids some problems with ROI exclusively

oUnder ROI managers may sell off assets that are earning more than division’s cost of capital, yet are lower than the division’s current ROI

Disadvantages:

oProblems with adjusting accruals/valuating assets

oIs not appropriate for firms with high proportions of intangible assets

oBackwards looking only, does not focus on future competitivenessAssumes management will continue to invest in high return projects.

Issues with financial measures

oBranch units may not be comparable

oPerformance measures may lead to conflict between branches and managers

oThis year versus prior years may not be the best way to measure

oManagers may feel encouraged to maximize accounting profit at the expense of long-term value

oNon-financial measures should also be implemented

Recommendation

oTo address Hoffman’s concern of missing out on compensation because he is expanding his warehouse and adding more capital I recommend that the current compensation be tweaked to adjust for such issues. Higgins should apply the expectancy view to try to help the mangers not reaching the above 5% of ROI goal. By outlining the clear goals of the division and stating what is expected from branch mangers will help branch mangers understand what kid of behaviour is rewarded.

Rewarding should not be limited to only extrinsic reward such as bonuses, but also incorporate intrinsic such as satisfaction of doing a good job. Preparing a balance scorecard can facilitate the creating of performance measures and creating goal congruency. Exhibit 3 is a chart illustrating 3 common questions that should be asked when choosing the perfect measure. Also there are four levers of control that help balance the tensions between:

oProfit, growth and control

oIntended and emergent strategies

oUnlimited opportunities and limited management attention

oSelf-interest and desire to contribute

Exhibit 4 is a summary of the four levers

Higgins can also measure performance as a comparison to yearly budgets. In addition, he could reward mangers that exceed the projected profits or is below the expected costs. To push mangers to make decisions with long-term outcomes in mine, Higgins could pay out the earned incentives over a period of 5 years, so branch mangers aren’t only worried about short-term outcomes, which in the long- run are unprofitable to the division. As discussed above, EVA is the best measure of an incentive compensation plan, it incorporates other factors the branch and the branch manager may be dealing with.

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