Question

CASE 6: COMPENSATION PLAN (CO Riverside Mining and Manufacturing is a vertically integrated company that mines, processes, and finishes various non-precious metals and minerals. Riverside has de centralized both on a geographical and on an operational basis. For example, Explo- ration and Development, which includes all mining operations, has been designated a strategic business unit (SBU). There are multiple divisions within this SBU, such as North American Exploration and Development, South American Exploration and Development, and other divisions. Similarly, Refining, which has often been lo- cated near the mines, is another strategic business unit and is divisionalized by geo- graphical region. Riverside has a clearly stated management control system that includes long- standing policies on transfer pricing, performance evaluation, and management compensation. Transfers are made at full cost plus a markup to approximate net re- alizable value. Riverside's primary operating divisions (such as mining) are required to fill internal orders before servicing outside orders. Each division has full respon- sibility over setting prices and sales targets as well as monitoring costs. Also, divi- sional managers have decision-making authority over fixed investments (capital equipment) up to $0.5 million as long as the investments can be internally financed. For any investment exceeding 50.5 million, final approval must be given by the SBU and head office. For performance evaluation purposes, Riverside uses two basic measures to evaluate managers. First, it uses budgeted income, and second, return on investment (ROI). Divisional managers develop their budgets in line with goals set centrally for the organization. All budgets must be approved by the SBU and central executive before final acceptance. Net income includes headquarters' allocations based on a percentage of divisional sales. ROI is calculated as net income divided by total as- sets. As with the budget target, the ROI target has to be approved. Although the weighted average cost of capital for the company is 12%, cach division negotiates its target ROI according to past performance and perceived risks and uncertainty in the environment. Progress toward the budgeted income and ROI targets are evaluated on a quarterly basis. Riverside's bonus compensation scheme was extended to its divisional man- agers last year. The bonus consists of a "50/50 cash plus deferred payment scheme that is measured each quarter. For example, if a division manager exceeds budgeted income and ROI targets for the division, then the manager is awarded a bonus, 50% of which is paid immediately in cash and 50% of which is invested in "phantom shares" that can be redeemed three years hence, given continued good performance. The total value of the bonuses range from 10 to 100% of regular salary, depending on how well managers did and their level in the organization. Actual amounts of bonuses earned in any given year depend on the centrally calculated bonus pool, which is defined as a percentage of overall company income. Some of the divisional managers have been unhappy with the bonus compensa- tion scheme. They felt they were at a disadvantage because of their lack of control over their prices (due to the nature of the external market), and their inability to achieve the growth in the ROI required by central headquarters. The division man- agers believed that a shift to residual income would help, but Riverside CEO rejected this, feeling that residual income would not allow comparison of divisional results. The results of three of these divisions are shown in Exhibit 6-1. As well, the managers of the Primary Operating Divisions wanted the restric- tions on the internal versus external sales lifted so that they could achieve better results than they were currently experiencing. REQUIRED 1. a. Calculate the residual income figure for each of the three divisions. b. In point form, list the advantages and disadvantages that residual income might have over the use of ROI at Riverside. 2. Evaluate the manage ment control system currently in place at Riverside, outlining its strengths and weaknesses, and make recommendations for any changes you feel are necessary Copyright © 2010 Pearson Education Canada

Case Study answering format should have executive summary, Introduction & Background, Alternatives, Recommendations and Implementation. Thank you

Answer 1

1.

a) Residual income calculation:

	Division A	Division B	Division C
Actual net income	$148.00	$1,968.00	$1,020.00
Imputed interest on
actual total assets	133.08a	1,057.32b	834.60c
Residual Income	$ 14.92	$ 910.68	$ 185.40

a12% x $1,109

b12% x $8,811

c12% x $6,955

b) Advantages of residual income:

Residual income motivates managers to concentrate on maximizing an absolute dollar figure rather than a ratio.

The absolute dollar figure is less open to manipulation than is a ratio (Note: The income and asset values can still be manipulated but the dollar figure is less sensitive to subtle "tinkering.")

The residual income figure may be perceived to be fairer than ROI since the company cost of capital is used for all divisions.

Disadvantages:

Residual income does not allow for comparisons across divisions.

Residual income is not normally used as a performance indicator by external analysts, whereas ROI is.

2.

The strengths of the Riverside Mining and Manufacturing management control system are as follows:

1) The company has decentralized, and this places authority and responsibility for decisions with the local managers, who have the most knowledge of and control over supply and demand for the products and services of their operations. This should enhance decision making in the firm and should provide a good training ground for managers.

2) The company has clearly-stated and well-established policies for transfer pricing, budgeting, performance evaluations, and reward systems. Thus, the management control climate is unambiguous, and managers are clearly aware of the "rules" and the goals of their operations.

3) The managers are given a degree of autonomy over sales, budgeting, and investment decisions. This "hands-off" policy should encourage a degree of entrepreneurial behaviour among the managers that in its positive aspect should lead to higher company profits.

4) Transfer prices are set so as to approximate net realizable value. This is a market price equivalent which, in a competitive market such as that in which Riverside operates, is probably appropriate. The requirement to transfer internally first ensures a ready supply to meet internal objectives.

5) Central headquarters maintains final approval over budgeting, pricing, and investment (greater than $0.5 million) decisions, thus providing a kind of "watchdog" role to ensure overall coordination of company goals and strategies.

6) The company uses two performance measures to evaluate managers—net income and ROI—rather than a single measure. This allows the company and the manager to adopt a dual perspective rather than single-mindedly pursuing one or the other of the performance indicators. Both measures are simple to determine and to understand, are observable, and can be audited by independent outsiders. Both provide comprehensive indications of divisional performance.

7) The incentive scheme in place at Riverside combines both short-term and long-term rewards. The immediate cash rewards are attractive to managers and motivate them to perform well in the current period. The 50% deferred bonus in "phantom shares" should motivate them to look at the longer-run performance of their division and of the company as well, since their bonus will depend on increasing share price as well as divisional performance. The amount of bonus paid (10% to 100%) is sufficient to be motivational, and the bonus payout is clearly linked to a defined bonus pool based on company net income. The longer-run incentive may tie managers to the company (the "golden handcuff" effect).

Riverside's management control system also has a number of weaknesses that may detract from its effectiveness.

1) Decentralization may cause agency problems. Local managers have a greater amount of information and more detailed information about the state of their divisions than does central headquarters; that is, there is information asymmetry between a division and central headquarters. This may lead managers to withhold information so as to enhance their performance results (information impactedness). On the assumption that managers are risk averse, they may also be motivated to take actions in their own best interests, which may not be in the best interest of the company. These agency problems may result in additional costs to the company to monitor divisional results both through internal and external audits.

2) The agency problems are also linked to potential dysfunctional decision making by division managers. Specifically with regards to the use of ROI as a performance measure, managers may be averse to investing in new fixed capital unless it is equal to or exceeds their current ROI, even if the investment is greater than the 12% cost of capital for the company. Net income, the other performance measure at Riverside, is equally prone to such manipulation. Managers may be motivated to shift revenues and expenses between periods so as to maximize income in one period while perhaps taking a "big bath" in another.

3) The transfer pricing policy has definite drawbacks. First, the enforced internal transfers hamper the divisional autonomy of both transferor and transferee. The transferring department does not have the freedom to develop its own markets and the receiving department becomes dependent on the primary divisions for its supply. As well, the use of full cost, which appears to be full actual cost, allows the transferring department to transfer inefficiencies. There is some modification here, however, in that, if transfer price is genuinely an approximation of NRV, there is at least some connection to market prices, and this should provide some objective basis for pricing.

4) The budgeting system and reporting system where divisions provide their own information can have problems, as noted above. One major drawback is the potential to include slack in the budget so as to make it attainable. Again, this would require upper management to scrutinize budgets and results closely to counteract the possible slack.

5) The incentive system may induce short-run behaviour in the cash portion, and the "phantom shares" may not be motivational since the divisional managers may not feel that they have any control over share price.

6) The allocation of head office costs on an ability to bear basis may also be dysfunctional, since the manager has no control over the direct incurrence of these costs and can reduce them only by reducing divisional sales. For those central services that can be monitored, it may be better to allocate on a usage basis and, perhaps, even create a charge-out system. This would make central services accountable for its expenses, and divisional managers would have greater control over consumption of these services.

7) Confining performance measures only to financial indicators does not give a full picture of the effectiveness of divisions.

Some of the recommended changes that emerge from this discussion of the strengths and weaknesses of the management control system at Riverside are the following:

1) Base transfer prices on standard costs or budgeted costs to approximate NRV so that inefficiencies are not transferred.

2) Expand the performance measures to include key success factors so as to assess divisional performance more effectively.

3) Ensure that internal audits and external audits are undertaken to monitor the full communication of divisional results and plans and to minimize manipulation.

4) Develop a cost allocation system based on usage of central services.

5) Base incentive rewards on the expanded performance system.

6) Residual income may replace ROI, but since it is still subject to many of the same problems, it may not be an improvement.