Industrial Electronics, Inc. Acctg Case
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The first point about the current bonus system is one that can be viewed as either a pro or a con Ð- the fact that the bonuses are based on a company-wide performance. On the positive side, a bonus structure based on overall company performance displays a unitary goal as the main objective. This means that either everyone in the company enjoys the fruits of success or nobody does. Negatively, this also means that if a specific division has a great year, but the overall company doesnt perform that well, the people involved with the excelling division arent rewarded financially for all of their hard work.
The current bonus system also only allows for bonuses to be distributed if there are profits more than 10% (after taxes) in excess of 12% of the companys net book worth. If profits are low, then no bonuses are distributed. This was the case in years 2000 and 2001 when IE was adversely affected by the economy recession Ð- there was no money in the bonus pool at all.
The amount calculated above was then divided by all the executives that were eligible for a bonus in that given year. Another problem within this system is that all managers eligible are equally distributed the total amount set aside for a bonus. This means that a manager that sets records for sales and efficiency is awarded the same bonus amount as a manager that barely surpasses performance goals. This does not seem fair.
A good thing is that there is the potential to earn more than 100% of salary as a bonus. Most employees would consider this a very healthy bonus, even though the average sits around 50% of salary.
The first thing that must be calculated to find the percentage of salary awarded as bonus for the five divisions is to calculate the economic profit objective. This is calculated a: Budgeted Operating Profit Ð- (Budgeted Operating Assets * 12%). The 12% is the assumed rate of IEs weighted average cost of capital. This is listed in Table 1 along with the profit and assets differences between the actual results and the budgeted.
Actual Economic Profit will then be calculated using the same formula as indicated in the paragraph above, except with the obvious difference in using actual numbers instead of the budgeted numbers. The difference is then taken from the actual numbers and the economic profit objective. This difference is whats used to calculate the bonus. For every $100,000 of economic profit above the economic profit objective, the division is to earn an additional 5% of salary. The equation for this would be: .5 + (x * .05) where x is hundred thousands of dollars of profits above the economic profit objective. This step is shown in Table 2. The bonus percentage for Division B is dropped to 150% since that is the maximum. The average bonus across the five divisions is 73%.
Table 1
Division
Profit Difference
Assets Difference
Economic Profit Objective
$150
($1,000)
$40
$3,500
($1,000)
$40
$250
($200)
($70)
$400
$200
($1,180)
($500)
($200)
$360
Table 2
Division
Economic Profit Objective
Actual Economic Profit
Difference
Bonus
$310
$270
$3,660
$3,620
230% -> 150%
($70)
$204
$274
($1,180)
($804)
$376
$360
($116)
$476
avg % bonus
The proposed bonus system seems to be better than the currently established bonus system overall. However, it does have its flaws. One major flaw in the proposed bonus system is that it is rooted in the budgeted profits, assets, and economic profit objective. Basically, managers in the company have their bonuses based on forecasts of what their division should earn in profits and use in total assets. While statistic forecasting is a thorough process, it is still an estimate and is usually never dead-on accurate. Therefore, since the economic profit objective is based purely on budgeted numbers, and is then used with actual economic profit to determine the difference, if the forecasted numbers are wrong (or something like an unforeseeable occurrence like a natural