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.
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