Question

Operating income is a good summary measure of short-term financial performance. By itself, however, it does not indicate whether operating income in the short run was earned by taking action that would lead to long-run competitive advantage. For example, a manager might increase short-term operating income by producing more product while ignoring quality or the amount of rework. However, the company would like to see an increase in operating income without sacrificing quality. This problem illustrates one compensation method that might be used to motivate managers to act in the best interest of the company. Valley Corporation specializes in the manufacture of office furniture. Historically, Jack McCraw, president of Valley, paid managers a bonus based completely on operating income. In 2016, the Spectrum division manager earned a bonus of $27,060 and the Ranger division earned a bonus of $22,400. In 2017, Jack decided to revise the bonus plan to encourage division managers to focus on areas that were important to customers and that added value without increasing cost. In addition to operating income, the revised plan included incentives for reduced rework costs, reduced sales returns, and on-time deliveries. Bonuses are now calculated and awarded annually on the following basis: A base bonus of 2% of operating income, adjusted for three factors • Rework costs o The bonus is reduced for excess rework costs over and above 2% of operating income. • On-time deliveries o The bonus is increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if 96% to 98% of deliveries are on time. o The bonus is not adjusted if on-time deliveries are below 96%. • Sales returns o The bonus is increased by $3,000 if sales returns are less than or equal to 1.5% of sales. o The bonus is decreased by 50% of any excess of sales returns over 1.5% of sales. Results for Valley’s Spectrum division and Ranger division for 2017 and 2018, the first two years under the new bonus plan, are provided in the table below. Note: If a bonus results in a negative amount for a particular year, the manager simply receives no bonus. The negative amount is not carried forward to the next year.

ACCT 4233/5233 Valley Corporation Spectrum Division Ranger Divisiorn 2017 2018 2017 2018 $4,200,000$4,400,000$2,850,000 $2,900,000 $462,000$440,000$342,000 $406,000 Revenues Operating income On-time delive 95.4% 97.3% 98.2% 94.6% Rework costs $11,500 $84,000 $11,000 $70,000 $8,000 $6,000 $44,750 Sales returns $42,500 For each division, create two tables like the example below and calculate the bonu:s earned by each manager for 2017 and 2018. Be sure to show your work! Example: Spectrum Division 20xx Operating income Less: Deduction for excess rework Add: Increase for on-time deliveries Add/Less: Adjustment for sales returns Total bonus for the year 2. What effect did the change in bonus plan have on each manager's behavior over the course of the two years? Specifically, did the bonuses achieve the company's goals (increase operating income while reducing on-time deliveries, rework costs, and sales returns)? Explain your answer in detail. List at least two other adjustments to the bonus structure that might improve the new plan and explain how they would encourage goal congruence

Answer 1

spectrum division

	2017	calculation for 2017	2018	calculation for 2018
Operating Income	9240	[462000*2%]	8800	[440000*2%]
Less Deduction for excess work	-2260	[462000*2% -11500]	-2200	[440000*2%-11000]
Add increase for on time deliveries	0	below 96%	2000	between 96% - 98%
Add/Less Adjustment for sales return	-10500	2% sales return [4200000*1.5% -84000]*50%	-2000	[4400000*1.5% -70000]*50%
Total Bonus for the year	0	negative so rounded off to Zero	6600	[8800-2200+2000-2000]

RANGER Division

	2017	calc	2018	calc
Operating Income	6840	[342000*2%]	8120	[406000*2%]
Less Deduction for excess work	0	[342000*2% -6000]	0	[406000*2%-8000]
Add increase for on time deliveries	5000	above 98%	0	below 96%
Add/Less Adjustment for sales return	-1000	2% sales return [2850000*1.5% -44750]*50%	3000	[below 1.5% of sales]
Total Bonus for the year	10840		11120

2.

Spectrum Division

The Manager of Spectrum Division are not going to like the new bonus Plan. The new bonus plan resulted in Zero bonus in 2017 and only 6600$ bonus in 2018 as compared to 27060$ received in 2016.

We can see that the new plan is working for sales return reduction. Sales return in 2018 is reduced to 1.59% of sales as compared to 2017when sales return is 2% of sales. However goal of reducing sales return below 1.50% has yet to be achieved.Rework cost has been even in both the years with not much improvement.

Operating Income have reduced in 2018 so the plan is not working in increasing operating profit.However on time deliveries has increased in 2018 as compared to 2017.

New plan has not been working overall for managers as well as the performance.

Ranger Division.

The managers of ranger division are going to be unhappy with the new plan. As the bonus has reduced from 22400$ to 10840$ in 2017.However bonus in 2018 has been increased when compared to 2017.

Operating profit has increased in 2018.Also sales return has been reduced to great extent in 2018.

However on time deliveries has been reduced.

New plan seems to be working for Ranger division.If the performance of 2018 has been improved at same pace in coming years the bonus in new plan may exceed the old plan bonuses.