MM6012 Compensation Management and Employee Performance

Case Analysis: 29 Purity Steel Corporation 2012

Arrange By:

Fajarina Ambarasari

29118048

Master of Business Administration

School of Business and Management

Institut Teknologi Bandung

Bandung

2019
Case : 29 Purity Steel Corporation 2012

Current Compensation Plan

A successful incentive compensation plan should recognize the desired behavior
that the company wants to stimulate within the managers. The current compensation
plan clearly communicates the objectives that WSD management hopes to achieve.
It consists of a combination of a basic salary and extrinsic rewards. Return-on-
investment is the primary source of measure for the plan. ROI was capped at 20%
and 5% was established at the floor. He also predicted that 1/3 of the managers
would be below the 5% eligibility level or ROI for a bonus, while the rest of the 2/3
would receive a bonus in variations. Higgins also felt that the bonuses should not
exceed 50% of the managers regular salary; keep in mind that salary adjustments to
salaries can always be made.
1. Objectives
• To operate the Division and its branches at a profit
• To utilize efficiently the assets of the division
• To grow
As an investment center, the WSD is mostly concerned with the profits
generated by each of its branches. As an improvement to branch managers
compensation, Higgins and his co-worker made a few adjustments to the
basic management salary structure. However, to incorporate the objective
of growth and improvements in profits an extrinsic reward was introduced.
As a performance measure, ROI was introduced because it takes account
both branch income and the capital invested in the particular branch.

2. Components
A. Base Salary
- Determined mostly on dollar sales volume of the district in the
prior year.
- Increase in dollar sales or profitability considered
 - Established by General Manager, WSD and ranges will be
reviewed periodically to keep the Division competitive with
similar companies.
B. Growth Incentive
- It is calculated as $1750 for every $500,000 of increased sales
during the year.
- An advantage of a formula-based plan is that managers know
exactly what they will receive
C. Return on Investment Incentive
- Measures how effectively each branch used its invested capital
to earn a profit.
- Managers paid in direct proportion to their effective use of
assets placed at their disposal.
- Emphasis: to increase the return at any level of investment, high
or low

3. Limitations on ROI
• No incentive paid to managers below 5% before federal taxes.
• No additional incentive will be paid above %20
• No payments will be made in excess of $50,000

4. Calculation on ROI incentive

A. Exact incentive amounts cannot be determined if illustrated using a
graph. However rough estimates can be determined (Exhibit 2)
B. Exact amounts can be determined by following these steps:
1) Subtract 500,000 from the last 6 digits of investment if they are
above $500,000
Example:
Investment: 8,763,750
ROI: 7.3%
= (763,750-500,000) = 263,7502.
 2) Divide the number in step 1 by 500,000
Example: 263,750/500,00= 0.5275%
3) In the 1% column in Exhibit 2, take the difference between the next
highest investment and the lowest investment.
Example:
High investment: 8,500,000 $2150
Low investment 8,000,000 $ 2100
Difference: $50
4) Multiply the result from step 3 by result in step 2 and add the 1%
column figure for the next lowest investment.
Example: $50 x 0.5275 = $26.37+2100=2126.375.
5) Multiply the result from step 4 by actual ROI
Example: 2126.37 x 7.3= $15522.54 bonus payment

Problems with current compensation plan:

- Limiting the amount of ROI can result in branch managers not performing at
optimal levels.
- ROI is a short-term measure and is significantly influences managers to make
decisions only considering short- term advantages or disadvantages.
- Agency costs become a problem when managers pursue their own interests,
not division managers.
- Since the compensation measures a period of one year, managers may be more
likely to decide on crucial investment purchases or disposal on a short-term
basis.

ROI
Measuring return-on-investment is one of the widely used performance measures
in an investment center. The ROI calculation illustrates the relationships between
the profits and the capital used to create that amount of profit in a division. The
formula of ROI is:
 𝐼𝑛𝑐𝑜𝑚𝑒
𝑅𝑂𝐼 =
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙
It can also be rewritten as:
𝐼𝑛𝑐𝑜𝑚𝑒 𝐼𝑛𝑐𝑜𝑚𝑒 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒
𝑅𝑂𝐼 = = ×
𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 𝑆𝑎𝑙𝑒𝑠 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

which is sales margin multiplied by capital turnover.

Advantages:
- Good Economic measure
- Performance and standards easily understood
- Highly motivational
- High levels of controllability
Disadvantages:
- Short-term Focus
- Creates incentive for inaccurate financial statements
- Self-interest of managers dominates decisions
- Easy to manipulate

Alternatives to ROI
Residual Income (RI)
RI measures the average return on every dollar invested. Residual income for an
investment center is defined as:
𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡 𝐶𝑒𝑛𝑡𝑒𝑟 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑖𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 × 𝑖𝑚𝑝𝑢𝑡𝑒𝑑 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒𝑑

The imputed interest rate is the cost of acquiring the investment capital; in most
companies the imputed interest rate depends on the risk of the investment which
funds will be used. Therefore, divisions that have different levels of risk will be
assigned different imputed rates. RI is a measured in dollar amounts.
Advantages:
- Promotes goal congruency
- Easy to calculate
- Not as manipulative
Disadvantages:
- Distorts comparisons between divisions or branches of different sizes
- Does not provide a perfect measure of performance.

Economic Value Added (EVA)

Similar to the RI, EVA is measured in solar terms, however it is different in two
ways. Firstly, the investment centers current liabilities are subtracted from its total
assets and weighted average cost of capital (WACC) is used in the calculation. The
divisions income is adjusted from accounting to economic income.

𝐸𝑉𝐴 = 𝑡𝑎𝑥 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑜𝑛𝑔 𝑝𝑟𝑜𝑓𝑖𝑡 − [(𝑡𝑜𝑡𝑎𝑙 𝑎𝑠𝑠𝑒𝑡𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑙𝑖𝑎𝑏𝑖𝑙𝑖𝑡𝑖𝑒𝑠) × 𝑊𝐴𝐶𝐶

EVA indicates how much shareholder wealth is being created. WACC is the
average of the after-tax cost f debt capital and the cost of equity capital weighted
by the relative proportions of the firm’s capital provided by debt and equity.
Advantages:
- Aligns managers interest with the shareholders
- Avoids some problems with ROI exclusively
- Under ROI managers may sell off assets that are earning more than divisions
cost of capital, yet are lower than the divisions current ROI
Disadvantages:
- Problems with adjusting accruals/valuating assets
- Is not appropriate for firms with high proportions of intangible assets
- Backwards looking only, does not focus on future competitiveness Assumes
management will continue to invest in high return projects.
Issues with financial measures:
- Branch units may not be comparable
- Performance measures may lead to conflict between branches and managers
- This year versus prior years may not be the best way to measure
- Managers may feel encouraged to maximize accounting profit at the expense
of long-term value
- Non-financial measures should also be implemented

Recommendation
To address Hoffmans concern of missing out on compensation because he is
expanding his warehouse and adding more capital, I recommend that the current
compensation be tweaked to adjust for such issues. Higgins should apply the
expectancy view to try to help the mangers not reaching the above 5% of ROI goal.
By outlining the clear goals of the division and stating what is expected from branch
managers will help branch managers understand what kind of behavior is rewarded.
Rewarding should not be limited to only extrinsic reward such as bonuses, but also
incorporate intrinsic such as satisfaction of doing a good job. Preparing a balance
scorecard can facilitate the creating of performance measures and creating goal
congruency. Exhibit 3 is a chart illustrating 3 common questions that should be
asked when choosing the perfect measure. Also, there are four levers of control that
help balance the tensions between:
- Profit, growth and control
- Intended and emergent strategies
- Unlimited opportunities and limited management attention
- Self-interest and desire to contribute

Exhibit 4 is a summary of the four levers Higgins can also measure performance as
a comparison to yearly budgets. In addition, he could reward mangers that exceed
the projected profits or is below the expected costs. To push mangers to make
decisions with long-term outcomes in mine, Higgins could pay out the earned
incentives over a period of 5years, so branch managers are not only worried about
short-term outcomes, which in the long- run are unprofitable to the division. As
discussed above, EVA is the best measure of an incentive compensation plan, it
incorporates other factors the branch and the branch manager may be dealing with.