Fifth edition Alnoor Bhimani Charles T. Horngren Srikant M. Datar Madhav V. Rajan Farah Ahamed
Consider each of the four proposals that Frank Weissmann is considering a
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| 4 Consider each of the four proposals that Frank Weissmann is considering a Pay division managers a flat salary independent of division RI Paying division managers a flat salary has the advantage that it will not subject division managers to any uncontrollable risk. But, this arrangement also suffers from the disadvantage that it will not provide division managers with any incentives to undertake extra physical and mental effort. b Compensate managers only on the basis of division RI The benefit of this arrangement is that managers would be motivated to put in extra effort to increase RI because managers rewards would increase with increases in RI. But compensating managers largely on the basis of RI subjects the managers to excessive risk, because each division’s RI depends not only on the manager’s effort but also on the random factors over which the manager has no control. A manager may put in a great deal of effort, but the division’s RI Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5 th Edition, Instructor’s Manual © Pearson Education Limited 2012 maybe low because of adverse factors (high interest rates, recession, which the manager cannot control. To compensate managers for taking on uncontrollable risk, Weissmann must pay them additional amounts within the structure of the RI-based arrangement. Thus, using only performance-based incentives will cost Weissmann more money, on average, than paying a flat salary. The key question is whether the benefits of motivating additional effort justify the higher costs of performance- based rewards. Finally, rewarding a manager on the basis of division RI will induce managers to maximise the division’s RI, even if taking such actions are not in the best interests of the company as a whole. This is an important consideration, because the two divisions are vertically integrated with the output of the Frankfurt Steel Division used by the Tool and Die Machinery Division. For example, to maximise the Steel Division’s RI, the manager of the Steel Division may prefer to produce premium alloy steel plates demanded by outside customers, which generate a higher return for the division but hurt the interests of the Machinery Division and Faulkenheim GmbH as a whole. c Compensate managers largely on the basis of company-wide RI Rewarding managers on the basis of company-wide RI will motivate managers to take actions that are in the best interests of the company rather than actions that maximise a division’s RI. This issue is particularly relevant because the two divisions are vertically integrated and hence highly interdependent. A negative feature of this arrangement is that each division manager’s compensation will now depend not only on the performance of that division manager but also on the performance of the other division manager. For example, the compensation of the manager of the Frankfurt Steel Division will depend on the Machinery Division manager’s performance, even though the manager of the Steel Division may have little influence over the performance of the Machinery Division. Hence, evaluating division managers on the basis of company-wide RI will impose extra risk on them and increase the cost of compensating them. d Compensate each division manager using the other division’s RI as a benchmark The benefit of benchmarking or relative performance evaluation is to cancel out the effects of common non-controllable factors that affect a performance measure. Taking out the effects of these factors provides better information about management performance. However, for benchmarking and relative performance evaluation to be effective, it is critical that similar non-controllable factors affect each division. It is not clear that the same non-controllable factors that affect the performance of the Steel Division (industry-wide steel capacity, for example) also affect the performance of the Tool and Die Machinery Division. If the non-controllable factors are not the same, then comparing the RI of one division with the RI of the other division will not provide any useful relative performance evaluation information, but will only add noise to division performance measures and hence, impose extra risk on the division managers. Faulkenheim would then have to compensate the managers forbearing this extra risk. Bhimani, Horngren, Datar and Rajan, Management and Cost Accounting, 5 th Edition, Instructor’s Manual © Pearson Education Limited 2012 A second factor for Weissmann to consider is the impact that benchmarking and relative performance evaluation will have on the incentives for the division managers of the Steel and Machinery divisions to cooperate with one another. Benchmarking one division against another means that a division manager will look good by improving his or her own performance or by making the performance of the other division manager look bad. 5 I would propose a compensation arrangement that builds on the various elements described in requirement 4. I would include (i) a salary component to reduce the risk the division manager is subjected to (ii) a bonus based on division residual income to provide managers with incentives (the motivation for having some salary and some performance-based bonus in compensation arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager (iii) a small bonus based on company-wide residual income to encourage cooperation and coordination among managers given the integrated and interdependent nature of the two divisions and (iv) a bonus based on the performance of each division manager relative to other steel and tool and die machinery companies. For reasons outlined in requirement 4, I would not use one division’s performance as a benchmark for the other division in this situation. |