Discussion Question 5 –Incentive compensation system
XYZ Electronics Bhd produced a wide range of electronic equipment, including
signal sources, test equipment, communications systems, and various piece parts and
subassemblies such as motors, generators, and probes. Total annual sales were in
excess of RM50 million.
The company’s objective was to maximize shareholder value. In most of its business
areas, XYZ had to be innovative to stay ahead of the competition. However, price
competition was also significant, so the company also had to maintain tight control
over costs.
The company was organized by products line. Its 10 relatively autonomous divisions
were managed as profit centers. The division managers reported to one of four
Business Group managers, who, in turn, reported to the company’s CEO.
Twenty managers, including all managers at the division level and above, were
eligible for an annual management bonus award. (Many lower-level employees were
included in a separate “management-by-objectives” incentive plan.) Divisional
performance from medium level and above. The management bonuses were based on
company-wide performance (group performance base). Each year, a bonus pool equal
to 10 percent of the company’s profit after taxes in excess of 12 percent of the
company’s book net worth (profit after tax – 12%) (similar to EVA formula) was set
aside for assignment as bonuses to managers. This amount was divided by the total
salary of all the executives eligible for the bonus. This yield an “award per dollar of
salary.” The maximum bonus paid was 150 percent of salary.
Historically, XYZ’s managers had been earning bonuses that ranged from 30 to 120
percent of salary, with the average approximately 50 percent. But because of the
recession/sluggish economy or market recently, the bonus pool was zero.
Complaints about the management bonus system had been growing. Most of them
stemmed largely from division managers whose divisions were performing well, even
while the company as a whole was not performing well. These managers believed that
the current bonus system was unfair because it failed to properly recognize their
contributions. The quote cited above was representative of these complaints.
In response, top management, with the assistance of personnel in the corporate
Human Resources and Finance departments, proposed a new management bonus plan
with the following features:
a. Bonuses would be determined by the performance of the entity for which each
manager was responsible. That is, division manager bonuses would be based
100 percent on division performance; group manager bonuses would be based
100 percent on group performance; and corporate manager bonuses would be
based 100 percent on corporate performance.
b. For bonus award purposes, actual performance would be compared with
targets negotiated during XYZ’s annual budgeting process. XYZ’s philosophy
was to try to set budget targets so that they were 80-90 percent achievable by
effectively performing management teams. Corporate managers knew that
XYZ was a high-tech company that operated in many business areas in which
it was difficult to forecast the future accurately. They thought that the
relatively high achievable budget targets provided the operating managers with
some insurance against an operating environment that might turn out to be
more harsh than that seen at the time of budget preparation.
c. Each division would be given an “economic profit” objective equal to
budgeted operating profit minus budgeted operating assets (value at net book
value: historical asset value – acc dep) multiplies by 12 percent, which was
assumed to be approximately XYZ’s weighted average cost of capital. For
example, a division with an operating budget of RM100,000 and budgeted
operating assets of RM500,000 (this amount must be low, 500,000 x 12%=
60,000) would be given an economic profit objective of RM100,000 –
RM60,000 = RM40,000. [based on Residual Income]
d. The actual investment base was calculated as follows:
Cash : Assumed to be 10 percent of cost of sales
Receivables and inventories : Average actual month-end balances
Fixed assets : Average actual end-of-month net book values
e. If an entity’s actual economic profits were exactly equal to its objective, the
manager would earn a bonus equal to 50 percent of salary. The bonus would
increase linearly at a rate of five percentage points for each RM100,000 above
the objective and be reduced linearly by five percentage points for each
RM100,000 below the objective. The maximum bonus would be 150 percent
of salary. The minimum bonus would be zero.
Divisio Budgete Budgete Economi Actual Actual Actual
n d d c profit Operatin Operatin economi
Operatin Operatin g Profit g Assets c profit
g Profit g Assets (RM’000 (RM’000
(RM’000 (RM’000 ) )
) )
A 1,000 8,000 40 1,150 7,000 310
B 1,000 8,000 40 4,500 7,000 3660
C 50 1,000 (70) 300 800 204
D (700) 4,000 (1180) (300) 4,200 (804)
E 600 2,000 360 100 1,800 (116)
Required:
a. Discuss the pros and cons of the current bonus system.
Related to financial performance base
Pros Cons
Using Group Encourage teamwork for As company incentive is
Performance base all division’s managers, based on companywide. It
(company-wide they will work to achieve is not fair to those high
performance) goal congruence. Each of perform division’s
the manager won’t just manager. It will
Advantage for company- focus on individual discourage and
wide performance could
performance. demotivated them to work
be disadvantage for
with extra effort, as those
individual performance
did not perform well still
receive the bonus.
If they perform well, it
does not reflect to their
bonus, not motivating
because not access
individual performance
Profit reward As company is a profit
center division, only focus
on short term performance
If company manager
incentive
Cost control (not fully
answer)??
Encourages Cost
Control: The bonus
system encourages
managers to maintain tight
control over costs. This
emphasis on cost control
is essential, especially in
an industry with significant
price competition. It
promotes efficiency and
financial discipline
throughout the
organization.
Maximum cutoff point From company From high performing
(150%) perspective, the maximum manager perspective, it is
cutoff point can limit demotivating as manager
excessive payout for may not happy with the
bonus. By doing this, it upper limit of bonus
can reduce the agency (150% of salary)
cost of the company.
They are not satisfied, they
think that they achieved
high above the target, so
they deserve higher
bonus which align with
their performance. The
maximum cutoff point of
150% will demotivated
them to put in all their
efforts to increase
profitability.
Minimum cutoff point The minimum cutoff point
(0%) of 0% will demotivated
the managers. Manager
will get zero bonus if they
not performing good. It is
seeming as penalization
to the manager even the
bad result is due to
economic circumstances.
It doesn’t measure true
effort of employee
Explicit Fixed formula The formula for Limited flexibility
(not for high manager) calculating the bonuses is The current bonus system
[in this case is division based on company-wide provides a fixed bonus
manager, a middle performance which are the pool based on a specific
manager] bonus pool, and the formula tied to
maximum bonus limit of profitability. This lack of
150 percent of salary. It flexibility restricts the
provides an ability to adapt to
understandable and changing circumstances
transparent formula for that affect profitability,
determining the rewards. such as economic
There is no politics downturns or market
involved and it is easy to fluctuations.
follow. This clarity can
help prevent favoritism or In situations where the
biases in the allocation of bonus pool becomes zero,
bonuses. as in the case of a
recession, it can
Manager can always demotivate managers who
calculate their bonus rely on bonuses as a part
related to the performance of their compensation.
as it has a fixed formula to
calculate. The fixed Even if there is good
formula offers objective economic condition, it also
and doesn’t involve any bring disadvantage
subjectivity. because it does not reflect
the true effort of
manager in improving the
profitability.
Profitability as Focusing too much on
performance measure profitability means that
will lead to game managers are focusing on
manship by manager short termism.
Implication for managers:
Managers tend to cut
Can also use for ques certain cost just to look
(b) good for the current
year, but in the long-run, it
will affect the company.
Manager will manipulate
profit and play around
with the figures to show
good profit in current
year. For example, they
move income from future
to current year or move
cost from current year to
future. They just want to
see good result in the
current year and don’t care
about the future.
To show good profit,
COGS must below and
ending inventory must be
high. (sale must be high to
give high profit) [COGS =
begin inv + purchase –
ending inv]
Managers will keep high
inventory to show good
profit (not good behavior
to manipulate)
b. Evaluate the proposed bonus system. [from (a) – (e)]
Pros Cons
Profit base divisional Change from group Don’t have team work,
and corporate performance to cannot achieve goal
performance (A) (divisional) performance congruence
This approach aligns the Divisional will compete
incentives of managers between each other, will
with the performance of lead to suboptimal
their respective divisions,
decisions They will
groups, or the company
as a whole. It can make decisions that
motivate managers to benefit for their division
focus on achieving their only and not in the best
targets and contribute interest on the company
extra effort to overall as a whole.
organisational success.
Suboptimization can still
If they perform well, it happen (similar to current
will reflect to their bonus bonus system)
because access individual
performance.
(disadvantage in existing
change to advantage here)
Set budget target at 80 – The proposed system Discourage the manager
90% (B) mentions that budget that performance well
targets are set to be 80- (high performing) as it
90 percent achievable by is easy to achieve.
effectively performing Manager don’t need to
management teams. This put extra effort to achieve
approach recognizes the the target.
challenges of accurately
forecasting the future in a Difficult to evaluate
high-tech industry. By whether manager achieve
setting relatively high target due to Budget
achievable targets, it slack: Low performing
allows managers to strive manager will put
for excellence while Revenue low target and
considering the cost at high target
uncertainties of the
business environment.
Motivate the manager
that did not perform well
(low performing)
Formula: Residual Net book value= historical It is not good to
income (C) cost – accumulated dep company as the company
may keep many old assets
Investment base (D) Using net book values in that don’t have
fixed assets, the operating
capital charge will be low, productivity
- May be good to
manager and motivate
manager to keep the
asset …
To get high bonus,
manager need show high
economic profit. Hence,
the value of operating
asset must be low to get
high economic profit.
In proposed system,
operating asset is based
on net book values
Manager will want to keep
the old asset even though
the asset is not
productive, as it will
have very low book value
(if replace, the met book
value will become higher,
no depreciation at all will
increase the operating
asset, deduction will be
higher and economic profit
will be lower – not a good
decision made by
managers)
Recommendation: Can
change to current cost to
encourage manager to
replace the old asset with
new asset (to avoid
keeping old asset that are
not productive)
Profitability as Focusing too much on
performance measure profitability means that
will lead to game managers are focusing on
manship by manager short termism.
Implication for managers:
Managers tend to cut
Can also use for ques certain cost just to look
(b) good for the current
year, but in the long-run,
it will affect the
company.
Manager will manipulate
profit and play around
with the figures to show
good profit in current
year. For example, they
move income from future
to current year or move
cost from current year to
future. They just want to
see good result in the
current year and don’t
care about the future.
To show good profit,
COGS must below and
ending inventory must be
high. (sale must be high
to give high profit)
[COGS = begin inv +
purchase – ending inv]
Managers will keep high
inventory to show good
profit (not good behavior
to manipulate)
Divisional performance --- Because ignore group
performance
Using same scale for all Not motivating because
division (E) have limit on the bonus
[maximum and minimum
cutoff limit] (same as
current bonus system)
The scale is not fair
because each division
having different target but
the scale applied is same
for all division. (can show
figures)
Table is used for
calculate the bonus for
each division
c. Propose specific recommendations to the management of XYZ Electronics
Bhd. to improve its bonus system
- Using non-financial measures (ie. Stock option) instead of just focus on
financial (profit)
- Suggest looking long term instead of short term to avoid manipulation
- Do not set a max limit to determine the bonus range.
- Balanced Scorecard approach (BSC)
BSC considers multiple dimensions of performance which can provide a
more holistic assessment of an individual or team’s contributions to the
company’ overall success. This prevents a narrow focus on financial
performance only but encourages company to focus on customer
satisfaction, internal process efficiency and employee development.
Besides, BSC shifts the focus from short-term financial gains to long-term
sustainable growth and improvement in various areas, leading to an
enhanced organizational performance over time.
No right and wrong ans
