Assignment

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, General Products Division, Industrial Electronics, Inc.

Industrial Electronics, Inc. (IE) 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 $8 billion.
The company's objective was to maximize shareholder value. In most of its business areas, IE 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 product line. Its 16 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-five managers, including all managers at the level of division manager and above, were eligible for an annual management bonus award. (Many lower-level employees were included in a separate "management-by-objectives" incentive plan.) The management bonuses were based on company-wide performance. Each year, a bonus pool equal to 10 percent of the corporation's profit after taxes in excess of 12 percent of the company's book net worth was set aside for assignment as bonuses to managers. This amount was divided by the total salary of all the executives eligible for a bonus. This yielded an "award per dollar of salary." The maximum bonus paid was 150 percent of salary.

Historically IE's managers had been earning bonuses that ranged from of 30-120 percent of salary, with the average approximately 50 percent. But because of the recession, in the years 2000 and 2001, 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 corporation 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:

• 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.

• For bonus award purposes, actual performance would be compared with targets negotiated during IE's annual budgeting process. IE'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 IE 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 highly 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.

• Each division would be given an "economic profit" objective equal to budgeted operating profit minus budgeted operating assets multiplied by 12 percent, which was assumed to be approximately IE's weighted average cost of capital. For example, a division with an operating profit budget of $100,000 and budgeted operating assets of $500,000 would be given an economic profit objective of $100,000 - 60,000 = $40,000.

• The actual investment base was calculated as follows:

• 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 $100,000 above the objective and be reduced linearly by five percentage points for each $100,000 below the objective. The maximum bonus would be 150 percent of salary. The minimum bonus would be zero

Questions

1. Evaluate (i.e., discuss the pros and cons of) the current bonus system.

2. Calculate the bonus award (percent of base salary) that would be given to the manager of each of the following four divisions under the proposed new bonus system. These divisions are representative of the range of divisions within IE.

3. Evaluate the proposed bonus system.

4. Propose a bonus system that you believe is optimal for IE. Why do you think your proposed system is optimal? Explain.