Accounting on Proposal of a New Incentive System Order Instructions: This case has been selected to give you experience in using cost accounting as the basis of a compensation system.

You will have to evaluate an existing system, a proposed system, and comment on the strengths and weakness of each. Using this information, you will be required to propose what you think is the best system for Industrial Electronics.

•Make sure you support your opinion by a specific example
•Use the numbers in the case to support all of your claims.

Accounting on Proposal of a New Incentive System Sample Answer

The case begins with a description an incentive system that is ineffective. Hence, a newly proposed incentive system that is quite different was used to replace the old and ineffective system, but still not without problems.

QUESTION 1

The initial thing needed to be calculated is the percentage of salary awarded in terms of bonus for the five respective division of the company in order to find the economic profit objective. The formula for calculating this is:

The 12% used in the calculation is taken as the assumed rate of Industrial Electronics’ weighted average cost of capital. The results for these calculations are shown in table 1 below alongside the assets and profit differences between the actual results and the budgeted amount.

Table 1

This was then followed by the calculation of Actual Economic Profit using a similar formula as shown for the economic profit object with exception of the obvious difference where actual numbers are used rather than the budgeted numbers. This means the difference is obtained from actual numbers as well as the economic profit objective. The bonus is then calculated using this difference. Therefore, since for every $100,000 of economic profit achieved that is above economic profit objective, an additional of 5% salary is given to the division; the equation for these calculations are carried out using this formula:

Where x stands for hundred thousands of dollars in terms of profits that a division gets above the economic profit objective, and the results for these calculations are shown in Table 2 below. However, Division B bonus percentage was dropped to 150% from the obtained 230% because that was the maximum increase which could be given. The average bonus for the five divisions is 73%.

Table 2

QUESTION 2

This question requires an evaluation of the current (old) incentive or bonus system which provided bonuses to managers on basis of s share of the overall profits of the company after taxes that exceeds 12% of the net worth indicated in the books. However, this bonus system has its advantages (pros) and disadvantages (cons) as discussed below:

Advantages (pros) of the current system

1. The system is wealth sharing, for example, when the company is doing well, the success is shared among all managers, and vice versa. This means that when the company is able to offer larger payouts attributed to higher profits margins it will do so.
2. Teamwork is encouraged in this system since everyone is awarded a bonus on an equal measure of the company’s performance meaning everyone will strive for improved performance (Otley, 2004).
3. The performance targets are usually timeless and fixed meaning that no politics involved in negotiating during the performance targets setting process.
4. The system is straightforward and easy to understand.

Disadvantages (cons) of the current system    

1. It is not possible to largely control corporate performance with exception for the top level managers meaning bonus awards for division managers are affected very little even when their performance is poor or outstanding.
2. There is no reflection of the timeless goal of 12 per cent on the changes in the situation or the economic situation.
3. Profit after taxes on which the bonuses are based on does not reflect value creation well.
4. In this system the use of assets financed by debt, there is no charge imposed meaning that the debt and the asset net to zero on the worth recorded on the books.
5. The bonus cutoffs, both at the top (150%) and bottom (12%) are potentially bad because; (a) in the current situation of below minimum corporate performance some dissenting voices have been raised by some managers who performed well meaning this can demotivate them, and (b) there is no link between individual performance and bonuses awarded, especially at the middle and bottom level (Otley, 2004).

QUESTION 3

This question requires an evaluation of the newly proposed incentive or bonus system. The proposed bonus or incentive system seems to be likely better compared to the currently existing one in overall. However, its evaluation would help to given us insights of how actual it is through the results of its evaluation.

Advantages or benefits of the proposed new system

1. There is more control of performance measures whereby managers of divisions will be responsible for the results obtained by their divisions; group managers for the group results; and corporate managers for the results obtained by the corporation as a whole.
2. The awarding of bonuses is done on basis of a residual income, or an economic profit as a performance measure meaning there will be a charge for managers who tie up company assets in their business.
3. The form of financing used in the acquisition of the assets would not be influential to the performance measure.
4. There would be tailor-made performance targets in order to suit each business unit meaning that they would be more equitable and encourage greater commitment from all the managers (Maciariello & Kirby, 1994).

Disadvantages of the proposed new system

1. The accounting-based performance measures are short-term oriented and can significantly cost high technology businesses where research and development, as well as innovation, are critical success factors (Otley, 2004).
2. The performance measures are uniform, just providing summary results indicators and have no link to the company’s strategy and do not give an operating guideline for the managers on how the results will be accomplished.
3. The assigning of cash is arbitrarily done to the operating units.
4. Fixed assets charge leads to increasing returns with time making managers to be unwilling to replace more depreciated and worn out or older assets subsequently affecting operational efficiency (Chenhall, 2003).
5. The costs of capital do not differ across operating units or change over time in accordance with changes in interest rates.
6. It is difficult to set budget targets equitably in uncertain business conditions such as IE operates in.
7. The system has a loophole in which it can allow gamesmanship (e.g., creation of budget slack, window dressing).

QUESTION 4

This question requires a recommendation for a better system to award bonuses. This needs to address the new system’s weaknesses while retaining the advantages by evaluating the costs as well as the benefits of the suggestions. This is attributed to the fact that there is perfect solution here but a suggestion with better benefits or stronger support may be more appropriate.  Considering that IE operates in uncertain business environments and it is a high technology business, the proposed accounting-based bonus system is not appropriate because it is short-term oriented since it will discourage innovation, research and development which can not be accounted in the system’s performance measures (Vera & Kuntz, 2014). Moreover, the charge on fixed asset will also have the same effect because it may take long to develop a single new product. Thus, an appropriate bonus system show not put a lot of emphasis on financial measures but also should put considerable emphasis on essential non-financial measures such as product quality, customer satisfaction, which are the best predictors of long-term performance (Anthony & Govindarajan, 2007). As a result, an effective bonus system would be the one which strikes a balance between financial measures and non-financial metrics in order to ensure that it is an all-round system which appreciates positive contributions by everyone without necessarily focusing all emphasis on financial metrics (Horngren, Sundem & Stratton, 2005).

Accounting on Proposal of a New Incentive System References

Anthony, R. & Govindarajan, V. (2007). Management Control Systems. Boston, MA: McGraw-Hill.

Anthony, R. & Young, D. (1999). Management control in nonprofit organizations. Boston, MA: McGraw-Hill.

Chenhall, R. (2003). Management control system design within its organizational context: Findings from contingency-based research and directions for the future. Accounting, Organizations and Society, 28(2-3), 127-168.

Horngren, C., Sundem, G., & Stratton, W. (2005). Introduction to Management Accounting. Hoboken, NJ: Pearson.

Maciariello, J. & Kirby, C. (1994). Management Control Systems – Using Adaptive Systems to Attain Control. Hoboken, NJ: Prentice Hall.

Otley, D. (2004). Management control in contemporary organizations: towards a wider framework. Management Accounting Research, 5(2), 289-299.

Vera, A. & Kuntz, L. (2014). Finance-oriented vs. operations-oriented management control in public hospitals. Journal of Hospital Administration, 3(6), 190-204.