Case 425

Introduction

The main principle of an incentive compensation plan is to motivate managers to act in the best interests of the organization and its shareholders. The basic idea of behind such plans is to pay for performance. Incentive compensation plans possess two important elements: measures of performance and methods of compensation. The following is an analysis about weather the proposed incentive compensation plan for Purity Steel Corporation's Warehouse Sales Division is the correct method of rewarding the branch managers. This is brought to attention when a branch manager wonders whether his new warehouse should be leased to alleviate the impact on return on investment (ROI).

Background

The Warehouse Sales Division (WSD) is an autonomous unit of the Purity Steel Corporation, an incorporated steel producer. The unit operates 21 field warehouses throughout the United States. In 1995 sales totalled approximately $225 million, half of the products sold were purchased from Purity Steel's Mill Products Division, using a market-based transfer price. Harold Higgins, a former member of the Mill Products Division, was appointed general manager of the Warehouse Sales Division. Higgins was responsible for the entire division's operations and growth. Sales volumes and rate of return on investment would be two components to help measure growth and overall performance. The Warehouse Sales Division is an investment centre, which operated as a centralized unit before Higgins' arrival. Following his arrival, Higgins decided to decentralize the management of his division by making each branch manager was held accountable for the division's profits and invested capital at each of the different locations. An incentive compensation plan was one of the key features of his decentralization policy, which was to become effective in January 1995.

Higgins introduced the new compensation plan to branch managers in December 1994. He stated that the objective was to develop a fair way to compensate those managers who are working hard and doing an excellent job adding to the growth and success of the division. Implementing the new plan only needed the balance sheets prepared by each warehouse, this was easy to obtain because the warehouses had been preparing their monthly operating statements for years. The balance sheet possessed two major asset categories, inventories and fixed assets, which were easy to classify. Purity's central accounting department directly collected accounts receivables. However, as stated in the case an investment receivables, equal to thirty-five days' sales was charged to each warehouse. In addition to the assets, a small cash fund was deposited in a local bank. No current or long-term liabilities were recorded at the divisional level.

Affects of the New Compensation Plan

Some concerns by some managers about the new incentive plans with relation to their year-end compensation. One concern, in particular was brought to the attention of divisional management, which was from Larry Hoffman, manager of the Denver branch. Hoffman was unsure of what decision to make about whether he should lease the new warehouse being built or own it. The individual branch managers for this investment centre have authority to make decisions that affect both profit and investments, which in turn affect the compensation level received. Hoffman has forecasted that his sales volume will triple over the next eight years. As summarized in the request for expenditure statement, the project will pay out in about 7.3 years. In the prior year Hoffman received one of the biggest bonuses paid because of his high ROI, however after calculating a projection of his bonus for 1997, his ROI will drop from 17.3% to 7.2%, if he moves into the new facility at the end of the 1995. If Hoffman decides to lease the new building he will lease it for 20 years wit ha renewal option at $250,000 a year. As shown in exhibit 1, Hoffman would benefit more, with regards to compensation, if he owned the new facility. Improving a division's ROI can be obtained by increasing either one or both of the ROI components, sales margin and capital turnover. Improving ROI is a difficult process and will need further consideration.

Current Compensation Plan

A successful incentive compensation plan should recognize the desired behaviour 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 shouldn't exceed 50% of the manager's regular salary; keep in mind that salary adjustments to salaries can always be made.

1. Objectives (Exhibit 1):

o To operate the Division and its branches at a profit

o To utilize efficiently the assets of the Division

o To grow

As an investment centre, the WSD is mostly concerned with the profits generated by each of its branches. As an improvement to branch mangers' 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

Base salary:

o Determined mostly on dollar sales volume of the district in the prior year.

o Increase in sales or profitability considered

o Established by General Manager, WSD and ranges will be reviewed periodically to keep the Division competitive with similar companies.

Growth Incentive:

o Is calculated as $1750 for every $500,000 of increased sales during the year.

o An advantage of a formula-based plan is that