20-1 The key objective of the firm is to develop management compensation plans that

support the firms strategic objectives:

1. To motivate managers to exert a high level of effort to achieve the firms goal.
2. To provide the right incentive for managers, acting autonomously, to make
decisions that are consistent with the firms goals.
3. To fairly determine the rewards earned by the manager for their effort and skill,
and for the effectiveness of their decision making.

20-2 Management compensation includes one or more of the following: salary, bonus,
and benefits or perquisites (perks).
Salary is a fixed payment, while a bonus is based upon the achievement of
performance goals for the period. Perks include special services and benefits for
the employee, such as travel, membership in a fitness club, life insurance, medical
benefits, tickets to entertainment events, and other extras paid for by the firm.

20-3 Risk aversion is the tendency to prefer decisions with assured outcomes over
those with uncertain outcomes. It is a relatively common decision-making
characteristic of managers. A risk-averse manager is biased against decisions
that have an uncertain outcome, even if the expected outcome is favorable. The
risk-averse manager prefers choices with certain outcomes to choices with more
favorable outcomes which are not certain. The effect is that certain decisions that
would be preferred by top management might be rejected by the manager because
of the managers risk aversion. Compensation plans can be adapted to deal with
risk aversion by, for example, making sure that a significant part of total
compensation is salary, which is not subject to risk. Other means include
rewarding the manager for achievement of critical success factors, such as an
investment in a promising new research area, in addition to the financial measures
which compensation is typically based upon (such as earnings or earnings per
share).
20-4 Management compensation plans designed to motivate managers can have
undesired unethical effects. The presence of very strong motivation due to a
compensation plan, without compensating accounting controls designed to detect
and prevent fraud, can lead to unethical behavior. The best method to reduce the
potential for unethical behavior is explained in chapter 1: adopting and adhering to
the Institute of Management Accountants Code of Ethics.

20-7 The three bases for incentive bonus plans are stock price, a strategic performance
measurement systems (cost, revenue, profit, or investment center), and the
balanced scorecard. See Exhibit below:
 Advantages and Disadvantages of Bonus Compensation Bases

Bonus Base Motivation Right Decision Fairness

Stock Price (+/-) depends on (+) consistent with (-) lack of
whether stock and shareholders controllability
stock options are interests
included in base pay
and/or bonus
(+) aligns
management
compensation with
short-term
shareholder interests
Strategic (+) strongly motivating (+) generally a good (+) intuitive, clear,
Performance if non-controllable measure of and easily
Measures (cost, factors are excluded economic understood
revenue, profit, performance (-) measurement
and investment (-) typically has only issues: differences
center) a short term focus in accounting
(-) if bonus is very conventions, cost
high, can cause allocation methods,
inaccurate reporting financing methods,
etc.
Balanced (+) strongly (+) consistent with (+) if carefully
Scorecard: motivating if non- managements defined and
Critical Success controllable factors strategy measured, CSFs
Factors are excluded (-) may be subject to are likely to be
(+) aligns inaccurate reporting, perceived as fair
management interest as for responsibility (-) potential
with long-term accounting measurement
shareholder interests measures issues, as for
responsibility
accounting

Key: (+) means the base has a positive effect on the objective;
(-) means the base has a negative effect on the objective.
20-8 The six financial ratios used in the evaluation of liquidity are:
The first and second ratios are the accounts receivable and inventory
turnover ratios which measure the firms ability to manage two important elements
of current assets - accounts receivable and inventory. The lower the balance in
these accounts relative to sales, the less cash will be tied up in these accounts,
and therefore the more cash the firm will have to pay its current obligations. The
greater these ratios, the better, and the higher the evaluation of the firms liquidity.
A third measure is the current ratio, current assets divided by current
liabilities, which measure the firms short-term ability to pay operating expenses.
The fourth measure, the quick ratio, is a very short-term measure of liquidity,
since the relatively less liquid inventory is not included.
The fifth measure, the cash flow ratio (cash flow from operations to current
liabilities)
The sixth measure, free cash flow ratio (net free cash flow divided by current
liabilities) measures the effect of the firms free cash flow on liquidity.

20-9 The two types of bonus pools are unit-based and firm-wide. The unit-based is
determined from earnings in the unit only, while the firm-wide pool is determined
from the earnings of the aggregate firm. See below:
Advantages and Disadvantages of Different Bonus Pools

Motivation Right Decision Fairness

Unit-Based (+) strong motivation (-) provides the (-) does not
for an effective incentive for separate the
manager the upside individual managers performance of the
potential not to cooperate unit from the
(-) unmotivating for with and support managers
manager of other units, when performance
economically weaker needed for the
units good of the firm
Firm-Wide (+) to attract (+) effort for the (+) separates the
and retain good good of the overall performance of the
managers throughout firm is rewarded - manager from that
the firm, even in motivates teamwork of the unit
economically weaker and sharing of (+) can ap pear to
units assets, etc, among be more fair to
(-) not as strong a units shareholders and
motivation for the others who are
individual manager as concerned that
the unit-based pool executive pay is too
high

Key: (+) means the pool has a positive effect on the objective;
(-) means the pool has a negative effect on the objective.
20-28 Performance Evaluation and Risk Aversion (20 min)

1. A flat salary with a bonus based on number of processed

applications would be best. The flat salary reduces Lewis risk level
because it insulates her from the uncertainty of a fluctuating
environment; the salary portion of her compensation is risk free. This
allows her to devote herself to the job without worrying that a sudden
crush (or absence) of applications will cause her to have a poor
performance report.

2. Emphasis will be placed on volume with less attention given to the

quality of the processing. Jill should be giving attention to both the
quantity and accuracy of the work done.

3. Some possible measures include:

1. A measure based on the number of complaints or due to errors
in the applications.
2. Surveys of applicants that inquire about the correctness of the
data.
3. Random checks of completed applications for correctness.
20-29 Performance Evaluation and Risk Aversion (20 min)

1. Compensation for Amy should be the ROI-based bonus since she is

risk neutral. Amy would accept some risk to increase profit for
Heartwood and thereby increase her compensation.

2. ROI is not a good evaluation standard for Amy because she has no
role in investing decisions. Return on sales would perhaps be a better
measure. This would emphasize sales margins as opposed to return
on investment. Also, controllable contribution could be used as a base
for performance measurement.

3. a. Yes, this is a fair performance evaluation method. Since Stiles

Furniture is in a similar environment with the same capabilities as
NightTime, then Stiles will be affected by the same business and
competitive environment as NightTime.
The fact that Stiles uses a significantly different manufacturing
strategy is irrelevant because the two companies have the same
capabilities. If Stiles is more successful with an alternative strategy,
then Amy should be held responsible for not altering her strategy as
well.
b. The advantage to residual income is that it will motivate Amy
to invest in all projects which earn over a threshold return. If Amys
division is earning a high ROI, and management is concerned that Amy
will pass over projects which have ROIs that are high but not as high
as Amy is currently earning, then residual income is the answer.
A disadvantage of residual income is that it will provide an unfair
advantage (or disadvantage) to Amy if NightTime is large (or small)
relative to Stiles.
20-30 Bonus Compensation (10 min)

Bens return is 1,898,000/22,500,000 = 8.4% which is greater than

companys return of 16,500,000/287,500,000 = 5.7%, so Ben qualifies for
the bonus. Bens total compensation is calculated as follows:
$200,000 + (.1 x 16,500,000 / (24+1)) = $266,000

Note that stock price and customer service information is provided but not
used in the calculation of compensation, as the firms compensation is
based only on salary and a bonus awarded if the unit manager exceeds a
return on assets target. Also note that, while the unit managers get a
bonus based on achieving a unit-based performance target, the bonus pool
is based on the performance of the whole company.

20-31 Bonus Compensation Base and Pool (20 min)

This question is intended primarily for class discussion, and there are a
variety of possible responses. A suggested approach follows.

1. Alternative bonus compensation bases include the SBU responsibility

center measures (cost center, profit center, revenue center, and
investment center) as well as a potential wide variety of nonfinancial
measures such as quality, customer satisfaction, and sustainability
metrics. A balanced scorecard or a multiple-measure approach is
also possible, using for example, a weighting of two or more
measures.
2. The use of revenues will probably have an upward bias on bonuses,
at least at financial service companies in recent years. The reason is
that revenue has grown faster than profits for these firms in recent
years. The Wall Street Journal estimates that bonuses in 2013
would have been 6% to 29% lower at selected financial firms if based
on earnings instead of revenues.
The use of revenues will motivate managers to look for ways to
increase sales, even though they may not be profitable, since profit is
not the base for the compensation. Shareholders are likely to be
pleased with increases in growth but more likely to be pleased with
increases in profits; so, in this case the compensation plan is not well-
20-31(continued -1)
 aligned with that of shareholder interests. A compensation base that
is most likely to be aligned with shareholder interests would probably
be multi-dimensioned, including profits, sales growth, and other
measures of financial and operating performance.

3. The use of a firm-wide bonus pool likely makes sense in the financial
services industry, since the firms have highly integrated operations.
Firms in other industries, such as consumer products, might find a
unit-based, or product-group-based approach more appropriate,
since the performance of product groups can be more readily
segmented.

4. The revenue-based method is not fair if you are considering the

shareholder point of view. The reason is noted in part 2 above;
shareholders are likely to place a higher value on earnings and cash
flow as opposed to revenue growth only. Considering the fairness of
the method in a broad sense, beyond the interests of shareholders,
opinions are likely to vary. An important point in this regard is that
the bonus payments to the financial service firms studied in The Wall
Street Journal averaged approximately 50% of total revenues.

20-43 Compensation; Benefits; Ethics (20 min)

1. The multiple levels of perquisites is a common practice and one that

is well understood and accepted. However, firms are obliged in ethics,
equity and fairness to all employees and to the shareholders to make
decision regarding perquisites on a reasonable basis. The amount of
perquisites should be associated with the responsibilities of the
manager, and should not be considered an entitlement of any given
level of employment. For example, an executive who must work
regularly with visitors from outside the firm should have the level of
perquisites, including a nice office that will allow the executive to greet
and make these visitors comfortable. Managers should also be
mindful, however, that an excess of perks will make many of these
visitors uncomfortable, and can cause an unfavorable image of the
firm.
Moreover, it is becoming more common for top level managers
to forego the excesses of many managers of the past, and they have
been rewarded by appreciation of shareholders and improved loyalty
and commitment of their employees.

2. Some of the instances described in the problem are probably within

the firms guidelines as acceptable use of perks. Often the firm will pay
for the spouse of an executive to accompany him or her on a trip where
the presence of the spouse is appropriate and in keeping with the
executive role on that trip. Other instances may involve ethical issues
which arise when perks are involved. Each should be judged in the
context of the management accountants position in the firm, the
significance of the amount of money involved, and the accountants
professional responsibilities as set forth in the Ethical Standards of the
American Institute of CPAs and the Institute of Management
Accountants.
The firms policies about perks should be clear and fair and
somewhat detailed, so that issues such as these are not handled after
the fact, but rather each manager knows the policies about perks, and
can avoid potentially unethical actions such as those described in the
problem.
20-44 Incentive Pay in the Hotel Industry (20 min)

1. The compensation would be as follows:

Compensation Plan
Salary $ 60,000
+ per room night $ 0.2055
+ per percentage point saved in expense $ 1,800
+ for each cent increase in room rate $ 30.00
+ for each percentage point saved in energy $ 600.00

Room nights Percent saved Rate Increase Energy Use

a. 30,000 5% $ 3.00 8
b. 25,000 3% $ 1.15 5
c. 28,000 0% $ 1.00 2

The compensation would be as follows:

a. $ 88,965 = $60,000 + $.2055(30,000) +$1,800(5) +$30(300) + $600(8)
b. $ 76,988 = $60,000 + $.2055(25,000) +$1,800(3) +$30(115) + $600(5)
c. $ 69,954 = $60,000 + $.2055(28,000) +$1,800(0) +$30(100) + $600(2)

2. The compensation plan appears to be an effective one, as it includes

all the key factors of success which the partners are interested in.
However, a key success factor for hotels, as for any service firm, is to
provide effective customer service, and none of the quantitative
measures includes customer service or satisfaction (though the
occupancy goal is said to include service quality, it is not quantitatively
included in compensation). Thus, the compensation plan should be
reviewed with the purpose of making sure that it includes customer
service in some significant manner.
Also, the compensation plan fails to specify appropriate ranges
for each of the three criteria, to rule out the possibility that a manager
will try to maximize earnings on one of the three and neglect the other
two. For example, a manager could earn a high bonus by setting room
rates very high, even though occupancy will probably fall.
The weights used in the compensation formula reflect the
partners goals for the investment. From a sustainability standpoint,
the compensation plan is strong; the reduction in energy usage, which
is reflected in two places in the compensation, both directly as a
measure of energy savings, and secondly as a part of savings for the
expense budget.
20-45 Incentive Pay Formula Development (30 min)

1.
There are two goals, a goal for number of customers and a price goal:

Customer goal:
300/day target customers x 365 days = 109,500 customers
weight x $12,800 = $6,400
$6,400/109,500 = $ .058 per customer served

Price goal:
$6.88 target price
weight x $12,800 = $6,400
$6,400/688 = $9.30 per penny of average price per customer

Thus the compensation plan is:

$68,000 + $.058 for each customer served plus $9.30 per penny
of average price per customer

Note that there are alternative ways to develop the compensation

plan. For example, the restaurant manager can develop a reward
system which pays no bonus unless the average price exceeds $6.88,
or some pre-determined price level. And similarly, the customer goals
might be awarded only if the manager exceeds a given level of
customers.
Also, the compensation plan suffers from the same limitations as
described in 20-44 above; namely, there needs to be a range or cap
set on each criteria so that the manager does not attempt to earn a
high bonus by maximizing one of the criteria and ignoring the other.

2. If 280 customers are served per day at $6.75 average price per
person, the total compensation to the manager would be:
$68,000 + $.058(280 x 365) + $9.30(675) = $80,205
20-46 Compensation Pools; Residual Income; Review of Chapter 19
(40 min)

1.
Return
Revenue Income Assets Asset Return on on

Consumer Electronics Turnover Sales Assets

2014 $ 155,780 $ 16,750 $ 84,550 1.842 10.75% 19.81%

2015 125,480 9,500 90,450 1.387 7.57% 10.50%

2016 90,950 5,700 92,450 0.984 6.27% 6.17%

Office Supplies

2014 48,750 2,100 22,500 2.167 4.31% 9.33%

2015 45,660 2,340 21,900 2.085 5.12% 10.68%

2016 52,800 3,250 18,000 2.933 6.16% 18.06%

Computers

2014 100,500 2,350 21,450 4.685 2.34% 10.96%

2015 95,400 1,650 22,550 4.231 1.73% 7.32%

2016 114,350 2,575 24,100 4.745 2.25% 10.68%

WBI Total

2014 305,030 21,200 128,500 2.374 0.070 16.50%

2015 266,540 13,490 134,900 1.976 0.051 10.00%

2016 258,100 11,525 134,550 1.918 0.045 8.57%

The calculations above show that 2016 had mixed results for MBI, as
income fell for one of the divisions and sales and profits increased for
two of the divisions. Overall, sales and income were both down. Note
that the Office Supplies unit was able to reduce its assets in 2015 and
2016 so that, while its income was only slightly higher in
20-46 (continued -1)
2016 its return on assets increased in both these years, and quite
significantly in 2016; the Consumer Electronics division, with falling
sales and income, while assets increased, saw its asset turnover,
return on sales and return on asset ratios fall sharply during the three
years. Note however, that the Consumer Electronics division, the
largest division, had the highest return on assets in 2011 and produced
80% of MBIs total income in that year. It is the downward trend in this
division that is troubling.
The Computer division, another large division, had a bad year in
2015 but recovered nicely in 2016. Overall, WBI saw a steady decline
in return on assets over the three years, due primarily to the problems
in the Consumer Electronics division.

2. [Operating Income - (.06 x Invested Assets)] x .10 = Bonus Amount

The total bonuses for each division and in total are determined as
follows: (actual amounts; not in 000s)
Total Bonus Consumer Electronics Office Supplies Computers Total
2014 $ 1,167,700 $ 75,000 $ 106,300 1,349,000
2015 407,300 102,600 29,700 539,600
2016 15,300 217,000 112,900 345,200

And given the number of executives:

Number of Executives Consumer Electronics Office Supplies Computers Total
2014 300 40 120 460
2015 350 40 140 530
2016 375 37 185 597

The Firm-wide bonuses for executives are as follows

Bonus per
Firm-wide Bonus Bonus Executive
2014 $ 1,349,000 $ 2,933
2015 539,600 1,018
2016 345,200 578

As for the sales and income in 2016, the bonus amounts for
executives fell sharply in 2016, and declined over the three-year
period.
20-46 (continued -2)
3.
When bonuses are determined on a division-based method, the
results are as follows:

Division-based Bonus per Executive Consumer Electronics Office Supplies Computers

2014 $ 3,892 $ 1,875 $ 886
2015 1,164 2,565 212
2016 41 5,865 610

Bonuses per executive were largest for consumer electronics in 2014

because this division, the largest, generated the largest amount of
residual income in 2014; per-executive pay is highest in Consumer
Electronics despite the fact that it has the largest number of
executives. Bonuses increased in Office Supplies because of the
increase in returns in that division and because there are a small
number of executives there (it is the smallest division), the per-
executive bonuses were the largest of any division in 2015 and 2016.
Bonuses in the Computer division followed the returns in this division,
down in 2015 and up again in 2016; overall the bonuses are smaller
in this division because of the relatively large, and increasing number
of executives in this division.

4.
Comparing the results for the three divisions in parts 2 and 3, it is
clear that the Consumer Electronics division managers would benefit
from the division-based plan based in 2014 and 2015, while the
Office Supplies division would benefit in 2015 and 2016 and those is
the Computers division benefit in 2016.

The contrast between the firm-wide and division-based bonus plans

is significant. The motivation of the firm-wide plan is to achieve an
environment where executives from the different divisions work
together for the overall firms goals. Since these divisions have a
degree of product similarity, it is likely that this is an important
motivation for MBI. To make the firm-wide plan work for all divisions,
particularly the Office Supplies division, MBI top management should
work to make the opportunities for cross-division profit clear.
20-46 (continued -3)

Pros: The company-wide bonus plan promotes the sharing of

corporate-wide assets. The bonus plan also helps to keep talented
managers that are running divisions that are not able to perform up to
expectations.
Cons: The company-wide bonus plan includes many factors not
under the control of each divisional manager. The bonus plan also
penalizes executives of profitable divisions that do not receive the total
benefit because of non-profitable divisions.
20-47 Compensation; Strategy (25 min)

For companies with substantial growth opportunities or long

product life cycles, bonus plans based on short-term decisions may not
adequately reflect long-term consequences of managerial decisions.
DBI could consider a stock option plan that initially sets the
exercise price of the option at the current share price, but then
periodically increases the exercise price by a growth rate consistent
with the companys cost of capital. Then the bonus plan would have
implemented long-term financial considerations before allowing stock
options to be paid off.
DBI may want to consider granting stock options where the
exercise price is adjusted with the appreciation of an industry index.
This will allow DBI to reward executives for an increase in the value of
their stock relative to that of companies facing similar risks.
DBI could also establish a bonus account system (deferred
bonus system). Under this system the executives do not receive the
full amount of the bonus earned in a particular year. A portion of the
bonus is placed in an account and is only paid out to the executives in
future periods if they meet specified performance criteria in the future.
This would minimize the chance that executives would increase current
performance measures at the expense of damaging future
performance.

Developing effective compensation plans is more difficult for

multinational companies such as DBI because foreign currency
fluctuations, customs and tariffs, differences in taxation, and political
changes will all have an effect on the managers performance
evaluation. The multinational firm strives to identify all the factors that
are controllable by the local manager and include these in the
performance evaluation and compensation plan. For example,
frequently managers of foreign SBUs are able to protect their unit
from unfavorable currency fluctuations by carefully chosen
purchasing, sales, and financing practices.
20-48 Executive Compensation; Teams; Strategy; Ethics (30
min)

1. Universal should use the new measures to improve product

quality and customer satisfaction.
a. At least three customer value-added measures for Universal Air
Inc. include the following:
Availability of products to meet customer needs on a timely
basis.
Price compared to the features and other benefits received
(value)
The number of product returns that can be an indication of
quality and reliability.

b. At least three process-efficiency measures for Universal include

the following:
New product development time and introduction time to market.
Order fulfillment cycle time.
Modifications, rework, and other non-value-added time and
activities.

2. At least three types of employee behavior that Universal Air Inc.

can expect by having middle management participate in the
development of the second set of new performance measures include
the following:
Increased job satisfaction and morale, as well as a feeling of
being valued
Better teamwork and cooperation, as measured for example by
employee and supervisor survey
A greater understanding of the company goals that should lead
to commitment and ownership of the goals.

3. To ensure that the cross-functional teams are effective, the

executive management at Universal Air Inc. needs to provide:
the necessary resources, including people and money
strong top management commitment to the process, clear
communication of this commitment and overall objectives to the

20-48 (continued -1)

functional managers and team members, and support for the

implementation of team-suggested changes.

incentive plans that reward performance for team participation

as well as organizational responsibilities. Better measurements
may include the "balanced scorecard" concept.

4. Referring to the specific standards (competence, confidentiality,

integrity, and credibility) in the Institute of Management Accountants
Statement on Ethical Professional Practice, John Brogan's behavior
is unethical for the following reasons:

Competence
Brogan is undermining the preparation of complete and clear
reports.

Confidentiality
Brogan is disclosing confidential information to someone
outside of the company (Sara Wiley).
Brogan appears to be using confidential information for
unethical advantage (i.e. brother-in-law's personal objectives).

Integrity
By curtailing the reporting of customer complaints, Brogan has failed
to:
avoid a conflict of interest,
refrain from actively or passively subverting the organization's
objectives.
communicate favorable and unfavorable information.

Credibility
Brogan did not:
communicate information fairly and objectively disclose fully
all relevant information.