Question & Answer

Differentiate between a lag indicator and a lead indicator.  Provide two examples of each.           

       (LO1)

Explain the differences between financial and non-financial performance measures and give two examples of each.

            (LO1)

 Remuneration plan    (LO2, 4, 5)

Matahari Ltd manufactures and installs renewable energy systems. It has four divisions in Australia: Wind, Thermal Solar, Photo Voltaic (PV) and Installation. The company was listed on the Australian Stock Exchange in 2013.

The CEO, William Smith, believes that divisional managers should be given a high degree of autonomy and held accountable for the performance of their divisions. He believes that if the divisions prosper then the company and its shareholders will prosper.

Before the beginning of each financial year, William reviews performance and then sets a return-on-investment (ROI) target for each division for the coming year. ROI is defined as the operating profit as a percentage of the book-value of the assets employed. Targets are set in consultation with the respective divisional manager with due regard to the prevailing market conditions. William makes sure that the ROI target is challenging but achievable. Over the past 10 years, the ROI targets have tended to increase slightly each year. Key personnel within each division are awarded a performance bonus, if and only if, the ROI of that division exceeds the target.

For the past 7 years, Matahari has been using a bonus and incentive scheme to motivate and reward key personnel. The scheme is based on the distribution of a bonus pool. The size of the bonus pool is 10% of Matahari’s residual income for the year and is capped at $1.5 million per year. The bonus pool is distributed to divisions on the basis of  the ROI achieved by each division. If a division does not reach its target, it does not receive a bonus. If a division achieves its target, it receives a bonus score equal to the division’s actual ROI less the division's target ROI, up to a maximum of 5.00 points. The bonus pool is then distributed according to each division’s score relative to the total bonus score. The bonus awarded to a division is then distributed to key personnel as determined by the divisional manager.

William is disappointed that Chloe Lee, the manager of the PV Division, has not taken the opportunity to increase her division’s production capacity. The shareholders are supportive and would be happy to finance the expansion. William recalls that divisional managers have been reluctant to submit investment proposals on several occasions in the past.

William has also found himself starting to think more about the suitability of the bonus system and underlying performance measures. A member of William’s business network has suggested that Matahari would benefit from the adoption of a balanced scorecard. William gets nervous when people start talking about non-financial measures; he thinks his focus on a small number of key financial measures has worked well to date and aligns with shareholder interests. 

          Required

(a)   For the year ended 30 June 2019, Matahari’s residual income was $13 939 000. The target and actual ROI’s for each division are given in the Table below. Calculate the bonus awarded to each division by completing the Table below.

(b) State two key strengths of the existing bonus plan.

(c) Identify one key weakness of the existing bonus plan and suggest a change that would alleviate the weakness.

Incentives and risk management

Part B

Once the Western Australian operation has settled and sales are going well, Bernard considers further expansion opportunities. Given the mature life cycle status of the brewery industry, declining consumption, strong competition from leading producers and competition from substitute products, Bernard wants to expand his business in other value-adding ways. He calls on his management team for ideas. One potential idea worth pursuing comes from Damien Poulsen, a long-term employee.

Damien Poulsen has been Bernard’s one and only production manager in charge of Mountain Mist’s spring water. Bernard has great respect for Damien’s work ethic and long-standing commitment to Mountain Mist. Damien is also a qualified microbiologist and employs a team of experts to extract and process the Mountain Mist spring water for the brewing department. A large portion of the Spring Water department’s (SWD) activities relates to the quality control (QC) function for Mountain Mist Brewery. Their main requirement is to ensure the spring water continually meets Mountain Mist’s strict specifications. The mix of sulphates, calcium, phosphorous and magnesium must be correct as excessive amounts of any ingredient can result in poor tasting ales. It can also lead to residue forming on the ale containers.

As the spring water from Mountain Mist’s Macedon Ranges spring provides beautifully tasting spring water (free of excessive mineral content) and more than enough spring water for the beer manufacture, Damien Poulsen suggested to Bernard that they expand production into bottled water sales. He points out that spring water is the fastest growing beverage type in Australia and Mountain Mist would be foolish not to take advantage of the opportunity to participate in this market. Australians spent more than $500 million on bottled water last year, a 1.6 per cent increase on the previous year. The current key competitors in the bottled water market include Coca-Cola Amatil Limited (42.0 per cent), P&N Beverages Australia Pty Ltd (22.0 per cent) and others (36.0 per cent). These key competitors own prominent brands including Mount Franklin, Peats Ridge and Cool Ridge. Damien suggest to Bernard that a niche marketing opportunity exists and that they should compete with the higher-priced sparkling and still water brands, which include European imports such as San Pellegrino and Perrier.

Damien is also aware of exploiting the growing market sensitivities towards increased water consumption. For instance, climate change has increased demand for bottled water (because of the extended hot summers). However, the demand remains high throughout the cooler seasons of the year for other sports and health-related reasons. The factors that significantly contribute to increasing demand for bottled water include general health awareness and greater knowledge of the benefits of adequate water consumption, concerns about the microbiological condition and taste of tap water in some regions, and that fact that many consumers are beginning to acknowledge bottled water as a healthy alternative to high-sugar soft drinks.

In Damien’s proposal, he outlines the cost structure required for the bottled spring water proposal. He builds his figures from the 2009 industry data. He bases his figures on the average retail price for 1-litre of bottled water ($2.53). Damien outlines the purchases that are most significant to this industry. They include containers, labels and other packaging materials. He explains how the costs for water extraction, such as pumping equipment, have been included in the depreciation cost (but mentions that these costs are currently paid for in full by the brewery). Water costs are relatively minor. That is, they pay the Macedon Ranges Shire Council fees for ground water extraction; however, the fees are insignificant.

In the proposal, Damien also mentions that he could draw on existing labour for the production processes, but will need a small number of additional staff to handle the clerical, sales and marketing functions. The total labour costs are equivalent to 14.7 per cent of revenue. In this machine-intensive industry, approximately 53 per cent of total labour is required for managerial, clerical, sales, marketing and other functions. The remaining 47 per cent of total labour is involved in the bottled water production.

Damien includes asset acquisitions and associated depreciation costs in his proposal. To begin, he includes full depreciation costs on existing equipment required for the filtration, UV sterilisation and zonation processes that remove undesirable compounds and organic elements from the spring water. Damien also includes the purchase of new assets such as computers and automated bottle production lines in his depreciation costs. In addition, he includes the purchase and depreciation on two trucks required to transport the bottled water to distributors from the Mountain Mist source. In Damien’s list of acquisitions required, he makes mention of new legislative requirements associated with environmental emissions. With this impending legislation, Damien allocates funds to the newly implemented carbon pollution reduction scheme (CPRS) that will measure, monitor and report on the Mountain Mist carbon emissions. To meet the legislative requirements, Damien needs to allocate a percentage of staff resources (15 per cent of one full-time employee’s wages) and equipment to correctly measure their carbon emissions. He notes that this additional cost will be incurred regardless of the decision to invest in the bottled spring water project.

Damien also includes accounting, auditing, repair, maintenance, market research and advertising as components of ‘other’ costs. Marketing is a significant cost to the bottled water industry given the need to differentiate a largely homogeneous product. He explains that, in Europe, for water to be designated ‘natural’ it must be bottled at the spring. This could be an important marketing feature for Mountain Mist bottled spring water, even though Australia does not have such a labelling requirement. He mentions how competitor water that has been transported in holding tanks to bottlers can risk contamination. As such, water that is not bottled on site may require chlorination which in turn affects the taste. Mountain Mist water, as it is bottled onsite, can truly offer the ‘natural’ European equivalent marketing feature. Damien explains how they would pitch this style of marketing in the up-market hospitality channel representing pubs, restaurants, cafes, cinemas and arenas. They will also focus on marketing to supermarkets and convenience stores as sales through these major outlets comprise 67 per cent of total bottled water sales, but, in this setting, they will not compete on price. He points out that while price is important (that is, they will compete with house brands and generics), the image, particularly from the large brands, remains the most important factor in establishing market share.

The niche market could bear additional costs for perceived additional quality and

image created by the brewery arm.

The main thrust of Damien’s argument is for Mountain Mist to exploit its economies of scope by expanding its beverage offerings. He explains that while materials and packaging are the main cost pressures, he hopes to achieve up to 60 per cent gross profit margin on the Mountain Mist private-label bottle water sales. He argues that he can reduce many of the costs. For example, input costs will be reduced as Mountain Mist has the spring water onsite. Rent is not applicable as Mountain Mist owns the Macedon Ranges facilities. In addition, wages, much of the depreciation and other costs can be allocated to the brewing division as it is currently paying for them anyway.

As Bernard evaluates Damien’s $30 million bottled water proposal, he also considers the key success factors in the bottled water manufacturing industry.

·           Control of distribution arrangements — arrangement of distribution ensures timely delivery, low costs and maximised product reach.

·           Economies of scope — economies of scope refers to the efficiencies in distribution, marketing and administration when a firm produces a wide range of beverage brands.

·           Having a good reputation — first movers have an advantage in this industry in that they can establish strong reputations, which new competitors need to spend heavily on marketing to match.

·           Market research and understanding — market research into consumer profiles, attitudes and preferences are important for informing both brand promotion and bottle and label design.

·           Marketing of differentiated products — product innovation and differentiation (including packaging) contributes significantly to selling the industry’s products.

·           Economies of scale — scale economies are very important to a low value product since high volumes must be produced and sold to achieve reasonable profits.

·           Establishment of brand names — strong brand names contribute to the appeal of bottled water as an accessory, as well as building a product’s reputation of quality. This allows bottlers to both win market share within particular consumer segments, and to charge premium prices.

·           Attractive product presentation — the design of the bottle is of importance in winning market share and justifying higher pricing in this competitive industry.

·           Effective product promotion — use of in-store merchandising can have a strong influence on consumer choice.

This all sounds quite interesting to Bernard, but he does wonder at the affect of the carbon pollution reduction scheme and the more recent negative publicity bottled water is receiving. This negative publicity surrounds the view that bottled water is not environmentally friendly as it produces significant greenhouse gas emissions and plastic bottles commonly end up in landfill.

Bernard wonders at the viability of Damien’s $30 million proposal.

Required

(a)          Advise Bernard on the types of strategic risks you might associate with Mountain Mist. In your discussion, include the risks associated with the expansion of Mountain Mist’s brewing to Western Australia and into the spring water market. You may also wish to discuss the beverage industry in general.

(b)          What do you consider the level of risk exposure for Mountain Mist? Justify using the risk profile discussion in this chapter.

(c)           What suggestions do you have for Bernard to overcome these risks?

(LO2, 3, 4 and 6)

  Incentives and risk management

Part A

In the early 1980s, Bernard Hancock built a small brewery on his 150-acre property in the Macedon Ranges. The brewery, named Mountain Mist Brewery, was designed with ales in mind and Bernard introduced a number of cutting edge and innovative technologies to make the well-known, popular pale ale Misty Hop and others such as Hazy Heidi, Mountain Maid and Sunny Sherpa. The brewery’s highest selling pale ale (Misty Hop) is widely recognised as a high quality boutique beer and is sold, along with the brewery’s other ales, to clubs and restaurants around Australia. All Mountain Mist Brewery ales are distributed in kegs (large containers) and 12-bottle cartons through its Victorian and national wholesalers. The brewery has continued to expand capacity on its site to meet growing consumer demands.

Bernard’s vision for Mountain Mist Brewery is to:

·           grow profitably with incremental investment into selected markets to become one of the top six breweries in Australia

·           continuously improve perceived consumer quality by improving taste, freshness, package integrity and package appearance

·           enhance distributor service with better lead times, accurate order fills and lower product damage

·           continuously lower company costs per litre of beer so Mountain Mist can maintain resources for long-term productivity and success

·           continuously improve business performance through engaging and developing employees.

Given recent sound performance, Bernard is pleased he had made the decision to expand Mountain Mist’s production interstate. This decision was made in line with Bernard’s key objective to be one of the top six national competitors. Mountain Mist currently holds seventh position. With its nearest competitor, Little Creatures, expanding into the eastern market from its Western Australian base, Bernard wants to ensure Mountain Mist will not only maintain market share but grow in size to take Little Creatures’ sixth position. Bernard wants to improve Mountain Mist’s brand presence in the western region, as well as reduce the transportation costs of moving beer across Australia. A local presence in Western Australia would also help reduce reliance on national retail distribution channels. A production site has been selected. A production manager from the Macedon Ranges site has been given the role of overseeing the operational set-up and staying on to manage the new operation. Others, such as microbiologists from the Mountain Mist laboratory, have also been offered the opportunity to move interstate. Thus, Bernard is moving some expertise from the Macedon Ranges and employing more staff at both sites to meet the new staffing requirements. As well as wanting a smooth manufacturing set-up, Bernard argues that it is vital for the Mountain Mist beer to be 100 per cent comparable between manufacturing sites. For Bernard, there are many issues still to contend with in relation to sourcing raw materials.

Bernard also needs to employ a manager to oversee the sales side of the Western Australia venture. He has offered the role of Western Australia Sales Manager to Matt Jerome. Matt is in his late 20s and had been working for Mountain Mist for about four years in the administration area as an accounts clerk. He has recently spent time on the administrative side of the new Western Australian operations. Bernard is pleased with Matt’s work and knows he is keen to move from administration and account keeping into managing sales at the new facility. While he has not had any previous sales experience, Bernard is keen to offer Matt this personal development opportunity.

Matt’s salary comprised a base salary and an incentive based on sales performance. While Mountain Mist had the corporate balanced scorecard (described earlier), they did not link scorecard results to their sales managers’ incentive plans. Bernard was concerned that the balanced scorecard measures would not drive the innovation and risk he required of his sales team. For example, Bernard wanted his sales team to continue to have the flexibility to make last minute changes if their customers required. He thought if they were influenced by rigid balanced scorecard performance measures, they might, in fact, be demotivated. He was also worried that they would work to the measure rather than profit maximisation through meeting customers’ unique, changeable and often immediate needs. Thus, Matt was able to earn a bonus based on the sales generated in the Western Australian region. Matt was also given the autonomy to hire his own sales and administration staff to help manage this new sales division. In addition, Bernard left Matt responsible for overseeing both sales and bookkeeping roles. After all, Matt had excelled at his administrative role in the past.

Bernard has contemplated varying remuneration options for Matt. Although Matt will have assets under his control, Bernard decides to reward Matt based on the following incentive structure:

·           base salary — $120 000 per annum

·           individual bonus — based on the Western Australian division’s EBIT (capped at $50 000 per annum)

·           corporate bonus — based on Mountain Mist’s corporate performance (2 per

·           cent share of ‘above budget’ corporate profit pool)

·           other — 50 per cent of private health insurance cost, relocation expenses for Matt’s family.

Matt has moved his family from the Macedon Ranges to Western Australia and begun to promote Mountain Mist Brewery. The aim is to have manufacturing operations and sales in place for summer 2010–11.

Required

(a) Discuss the benefits and limitations of Matt’s incentive scheme proposed by Bernard.

(b) It is mentioned in the case that Matt has assets under his control. What performance measurement alternatives could Bernard have used? How might they improve (or otherwise) on the scheme proposed by Bernard?

(LO2, 3, 4 and 6)

            Risk classification

Regal Foods is a multi-divisional company operating in a range of locations around the globe. Its product-based divisions are: Ice Cream and Associated Dairy Products, Confectionery, Nutrition, and Prepared Food. Regal has total sales in excess of $10 billion. The CEO, Ruby Day, recently undertook a company review, which identified the following strategies and objectives:

• optimising product performance through strong research and development, product innovation and market share growth

• enhancing financial performance through financial discipline and targeted capital expenditure.

Divisional managers have traditionally been allowed significant autonomy in line with the decentralised divisional structure. CFO Paul Falkenberg has recently introduced relative performance evaluation (RPE) at the divisional level to promote competitiveness, with the objective of growing the company.

Ice Cream and Associated Dairy Products Division

The Ice Cream and Associated Dairy Products Division focuses on such products as ice cream, yoghurt, milk and cheeses. The current divisional manager is Alette Rennie, who has been in the position for the past three years. In that time, Alette has achieved average annual divisional revenue growth of 6 per cent. However, there are concerns about some of the exposures the division has. For example in a recent email to the CFO and CEO, Alette expressed concerns about some of the division’s exposures to the agricultural industry, the increasing global competition in dairy products, and the lack of bargaining power of the company in the local milk price wars.

Nutrition Division

The Nutrition Division focuses on health-related products. Historically, the Nutrition Division has been an excellent contributor to group performance, with annual growth rates of up to 12 per cent for the period 2006 to 2012, and revenues exceeding $2 billion. However, divisional manager Bruce Buncle has found it increasingly difficult to maintain growth. An increasingly crowded market for health and nutritional products seems to be the main driver of these difficulties. As a consequence, debt levels of the division seem to be rising. However, Buncle is conscious that he needs to develop new products and markets in line with company objectives.

Buncle and his management team have been considering a range of investment opportunities and have decided on a major investment in the bottled water industry. While the industry has its challenges (for example, environmental opposition to the use of plastic bottles, tightening environmental regulations and the expectation of reduced carbon emissions), Buncle and his management team see a lot of potential with such a strategic move. However, where significant capital expenditure is required, Buncle finds the company investment decision-making processes frustrating.

The management team within the Nutrition Division has identified a new spring water source in a regional area. The local authorities are in favour of the springs being used to supply the Nutrition Division with spring water for a new water bottling plant to be built in the region. In fact, the local authorities are willing to forgo local taxes and provide subsidies to Regal to ensure the plant is built. The region has experienced relatively high levels of unemployment in recent years and the new plant will generate some 100 local new jobs. While there is some local opposition to the new facility on environmental grounds, Buncle considers these to be manageable. While he knows the project’s financial benefit is mainly after the third year, he knows that the investment is a good strategic move for his division.

Required

Using the risk classification framework (strategic, operational, legal and regulatory, and financial) identify the key risks to which Regal and its divisions are exposed.

(LO6)

            Assessing a remuneration plan

Hailey’s Hair Products has two criteria upon which its reward system is based: (1) rewarding executives for performance and (2) adding to shareholder value. At present, the remuneration package for executives consists of a base salary, annual bonus and stock options. The base salary is considered critical to attract the ‘best’ people to positions with the bonus and stock options encouraging performance that leads to increases in the share price.

Base salaries are set at competitive levels to attract and retain the ‘best’ people. The bonus is payable if executives meet the annual performance targets set by the board at the beginning of the year. The stock options are not able to be exercised until five years after being granted. A recent initiative has meant that executives are able to substitute the bonus payment for stock options (but still with the five year restriction).

The board’s remuneration committee is made up entirely of independent directors and makes use of outside advisors to ensure that recommendations are fair to all shareholders.

Required

Evaluate the remuneration plan for executives.

(LO2, 3 and 4)

Behavioural issues associated with reward systems

Fitness Forever International sells personal exercise equipment both within Australia and internationally. One division of Fitness Forever produces a product called Absaway, which is a specialised piece of equipment that focuses on exercising the abdominal region. The Absaway is manufactured with both internally sourced and purchased-in components.

The divisional performance report shows that the division made sales of 20 000 units at a price of $100 each. The variable costs were $60 per unit. Fixed costs were $200 000.

Fitness Forever calculates mangers’ bonuses based on profit. The manager of the Absaway division wants to maximize his bonus. To ensure that the divisional margin is reported at its highest possible level, the manager has been producing more units of the Absaway than required based on sales forecasts. Producing more units has the effect of increasing the ending inventory, which, in the income statement, reduces the cost of goods sold (also called cost of sales). This, in turn increases the divisional margin. The extra production of Absaway units has to be stored, thus increasing the need for warehouse space.

Required

(a) Comment on the strategy of the manager to produce more units of product than are needed in order boost divisional profits. Is it in the best interest of Fitness Forever?

(b) You have been asked to comment on the current reward system at the next board meeting and make recommendations about any changes you think are necessary. What will you say?

(LO3, 4 and 5)

            Evaluating a reward system

You are on the board of a computer software company that has three distinct divisions: home networks, small business systems and ERP systems. In a bid to encourage higher performance, it has been proposed that the company would benefit from creating a reward system with a profit-sharing component for divisional managers. At present, divisional managers are paid a fixed salary.

The proposal is for the company to pool 5 per cent of the company’s profits each month and pay this amount at the end of the year based on divisional managers’ performance against targets. The targets will be set in the preliminary performance review at the beginning of the year. Targets will cover both divisional and company-wide performance. It is thought that this approach will encourage a commitment to the organisation and encourage individuals to strive for better results. There will be a vote for the current proposal at the next board meeting.

Required

(a) Discuss the advantages and disadvantages of the proposal.

(b) Outline an alternative reward system.

(LO2 and 4)

Reward plan structure

Whistlestop Adventure has grown from a one-man operation into a large, soon to be listed, adventure clothing and equipment company. For much of its four-year history, Whistlestop has used one company-wide incentive plan that all employees and managers participated in. The plan is based on equal sharing of a bonus pool determined on the basis of 10 per cent of all profits earned over $2 million. As the company has grown, the benchmark profit figure has changed, but otherwise the plan has remained substantially the same. The company founder explained that the plan was structured this way to encourage an organisational and team view, an objective that has permeated the company’s activities since its beginning.

With the impending stock exchange listing, the newly constituted remuneration committee has been working on the development of new incentive plan for executives and managers. The brief from the board includes the requirement to ‘develop an incentive plan in line with company’s strategy of revenue growth through high-quality products and customer service, and align the interests of the new executive team with shareholders’.

Required

(a) If you were a member of the remuneration committee of Whistlestop how would you suggest the incentive plan be structured to meet the requirements set by the board?

(b) What are the dangers for Whistlestop in moving away from the current incentive plan to a new one? How could these dangers be overcome?

(LO2 and 4)

            Risk management

The Dancing Goat is the name Logan Jones chose for his café. The origins of the name came from a 1600s fable of a young goat herder watching his goats dance after they ate red coffee beans. Logan wanted his customers to have the same pleasant ‘dancing’ experience when they drank his specialty coffee blends. In his Sopital Lane café in Melbourne, Logan has a central roasting room in which he roasts fresh coffee beans from around the world. He offers 12 blends of coffee and delights customers with the atmosphere of his classy, European-style café with couches and low tables. The Dancing Goat has become very successful and Logan began to expand his operations to several locations around Melbourne. He roasts the coffee at the main Sopital Lane café and transports it daily to the other cafés. Logan now has 10 cafés located around Melbourne. They offer a deliberately small, but high-quality gourmet menu. Logan is well liked by his staff and they all understand his requirement for friendly service, a pleasant atmosphere and excellent coffee. Every new staff member learns to make coffee to Logan’s strict specifications and wears The Dancing Goat uniform with pride. Logan is particularly pleased when returning customers at each of the cafés praise his friendly, well-trained staff. Nevertheless, after several years of successful operations, the profitability of the Dancing Goat has begun to decline. Logan has decided to revisit The Dancing Goat’s ‘branding’ strategy. He recently read the following article relating to the Starbucks decision to ‘unbrand’.

The idea is that the [Starbucks] chain will turn some of its premises into individually branded neighbourhood coffee shops, to find out whether it will do better by adopting a facade that’s more like an old-fashioned neighbourhood coffee shop. In its home-town of Seattle, an outlet called 15th Avenue Coffee and Tea will be the test-bed for this new non-brand, selling beer and wine as well as high end brew.

Logan is particularly interested in Starbuck’s test-bed 15th Avenue Coffee and Tea store, which courted coffee connoisseurs with the same elaborate coffee brewing machines that Logan decided to purchase for The Dancing Goat cafés.

Although Logan is a little dubious about the potential success of the Starbucks’ approach in his operations, he is aware that several café managers are dissatisfied and keen to make significant changes. Logan ponders. Why not let one of the cafés loose for a couple of years to trial a similar unbranding approach? Logan could set simple performance targets based on profitable growth and pay uncapped incentives. He will allow the manager to determine what would best suit the local clientele without too much interference from Logan. After all, Logan knows the manager of the trial café he has selected is not scared to take risks. Logan will be satisfied as long as the profitability of this café remains at an acceptable level.

Required

Given your understanding of risk management, briefly provide advice to Logan on:

(a) The risk profile and level of risk exposure for The Dancing Goat of the new approach.

(b) How Logan might reduce this level of risk exposure.

(LO6)

Developing a reward system

Synergy Ltd’s incentive plan is based on a shared bonus pool. Return on investment (ROI) is used as the main performance metric and is calculated as:

Operating profit before tax ÷ Assets at gross book value

Receipt of the incentive is dependent on the achievement of annual ROI targets. These targets were set in consultation with division managers. Moreover, the senior management team is rewarded on the basis of organisational ROI. The amount of bonus received by managers is determined as follows. The bonus pool is determined as:

$100 000 + 10% of increases in annual combined ROI

The bonus pool is shared 15 per cent to senior management (shared equally among 10 managers on the basis of organisational ROI), 50 per cent to divisional managers (shared among three managers according to divisional ROI) and 35 per cent to managers within the divisions (shared among 12 mangers according to divisional ROI). The bonus payment is in the form of cash. While some members of the management team have expressed concerns about the use of ROI as the key performance metric, the CEO is intent on keeping things simple and believes that ROI is a good summary measure on which to base senior management and divisional manager rewards.

One of the senior managers, Sonia Lee, has become persistent in her objections to the current bonus scheme. She feels the scheme needs to reflect shareholder interests with suitable measures at each level of the company that reflect managers’ span of control and the right mix of incentives.

Required

You have been asked to advise the board of Synergy Ltd on a possible new incentive plan that addresses the concerns of Sonia Lee. Prepare a report outlining the detail of your incentive plan. Make sure you explain how your plan addresses Sonia’s concerns.

            (LO2 and 4)

            Executive remuneration: two-strikes policy

Investigate which companies have experienced either one-strike or two-strikes on their remuneration reports in the last year or two. Summarise your results and collect the specifics of one example.

(LO4 and 5)

Shared bonus pool

Sarah Tesar is the lead partner of a medium-sized accounting firm. The eight partners share in an annual bonus pool. The characteristics of the bonus pool system include:

• The bonus pool size each year is calculated as 40 per cent of annual profit.

• The bonus pool is allocated on the basis of bonus units awarded according to the partners’ performance against target fees generated from new clients. This is meant to reinforce the firm’s strategy of growth through new client acquisition. If the fees target is met, one bonus unit is awarded; if the fees target is exceeded by 10 per cent, two bonus units are awarded; if the fees target is exceeded by 20 per cent, four bonus units are awarded; and if the fees target is exceeded by more than 20 per cent, six bonus units are awarded.

This year the annual profit was $2.2 million and the partner performance according to their fees from new client target was as follows: three partners achieved 10 per cent above target; three other partners achieved 20 per cent above target; and two partners exceeded the target by more than 20 per cent.

Required

(a) Calculate:

(i) the value of the bonus pool to be shared

(ii) the value of one bonus unit

(iii) the value of the bonus each manager would receive for the year.

One of the partners, Russell Morris, has sought a meeting with Sarah to discuss the shared bonus pool system. He wrote in an email to Sarah ‘I spend a lot of my time providing our in-house training programs . . . I can’t be out chasing new clients at the same time! Why do we only have one measure for the bonus system?’

(b) How important is the selection of the bonus allocation formula and the measure(s) to be used?

(c) In the light of Russell’s email, would you advise Sarah to make any changes to the current system? Explain.

(LO4)

Risk classification framework

Harley–Davidson, Inc. has found itself having to confront a number of risk-related issues. These have mainly related to:

(a) the need to increase the number of recalls due to faults

(b) surging costs of making the repairs to faulty motorbikes

(c) increasing pressure on market share.

Required

Classify each of the three events above according to the risk classification framework (strategic, operational, legal and regulatory, and financial).

(LO6)

Shared bonus pools

Becky Tan is the CFO at Frosters Systems, a diversified company with eight different business units (divisions). Becky has been asked by the CEO to develop a shared bonus pool system.

Required

What key decisions will Becky have to make to set up the shared bonus system?

(LO4)

Actions to mitigate risk

Ben, an employee of Joseph’s, appears to be extremely enthusiastic about his back-office accounting role. He has been with Joseph’s company for about four years and has performed well in his position. Ben is very keen to progress in the company and Joseph has recently decided to offer him a posting at a small international operation in Asia. While the role is to remain in the back office, the position will not require efforts on a full-time basis. Instead, Joseph decides to provide Ben with an opportunity to manage the currently vacant front-office trading role. While the operation is small and Ben has limited trading skills, Joseph is sure Ben will be able to manage both roles and hopefully learn about, and at the same time develop, the trading arm of this international operation. Joseph decides to award Ben an uncapped bonus on profits earned for the group on top of his negotiated annual base salary.

Required

Prepare a report advising Joseph on the risk management ramifications of his decisions. What actions should Joseph take to mitigate any perceived risk?

(LO6)

Remuneration disclosure

The ASX Corporate Governance Principles and Recommendations set out rules to deal with enhanced management performance and effectiveness and requires disclosure of the process for performance evaluation of the board, its committees and individual directors and key executives. However, the outcomes of individual evaluations are not required to be disclosed.

Required

Why do you think such a recommendation is included in the guidelines?

(LO5)

    Assessing reward systems

You are a remuneration consultant employed by a listed company to assess the CEO’s reward plan. The board is concerned that the CEO is overpaid in absolute terms and also when compared to other CEOs of major corporations.

Required

How might you determine whether or not the reward plan is appropriate?

(LO2, 3 and 5)

            Reward systems for different levels of employees

Freshwater is an entity that processes and distributes bottled water throughout Australia and New Zealand. You have been employed as a remuneration consultant to develop a new reward system for the entity.

Required

Explain how you would develop an incentive plan for the CEO, the divisional manager of the process division, and the sales manager who arranges customer sales. How are the reward systems similar? How are the reward systems different?

(LO2 and 4)

    Developing a reward system and reward targets

You are a remuneration consultant. The board of a large multi-national bank has asked you to draft a proposal for a new reward system for senior executives. Currently all senior executives are paid a fixed salary. Your investigations at the entity reveal its mission is to be ‘the number one provider of quality banking services in the southern hemisphere’. You note that the entity has planned for 10 per cent profit growth over the next five years with a corresponding growth in share price. The entity has identified customer satisfaction, product quality and product innovation as the key indicators of success.

The directors are concerned as company profits have been declining. They consider a revised remuneration scheme may motivate senior executives to grow profits and the share price.

Required

Prepare a report to the board outlining a new remuneration plan for the executives of the entity.

            (LO2, 3 and 4)

Risk profiling

You are required to offer advice to a small but growing community bank. Describe the steps you would take to prepare a risk profile for this organisation.

(LO6)             

Assessing rewards based on accounting profit

Stevan is the divisional manager with the Liberty Property Development Group. His performance report shows a positive divisional margin but a loss for the year. Stevan has complained to the CEO about the common costs that have been charged to his division, and questions the method of charging. If they were not charged or were allocated in a different way, he would have a favourable profit figure and would be awarded his bonus.

Required

Should Stevan’s bonus be awarded based on the profit or loss figure? Why?

(LO2 and 4)

            Behaviour effect of share options

Assume you are a senior manager at a publicly listed company. Under the company’s longer-term incentive plan you have recently received a parcel of share options. These share options can only be exercised (converted to shares) after three years.

Required

How might this incentive affect your behaviour and decision making?

            (LO3)

            Relative performance evaluation

Relative performance evaluation at the company level often results in using a market index like the ASX100 as the peer group.

Required

Outline the potential advantages and disadvantages of this practice.

            (LO2, 3 and 5)