Effectiveness of Fred Riley's bonus plan used by Acme
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Acme Company manufactures a variety of industrial products which are sold throughout the country. Fred Riley has been manager the Eastern Branch of Acme Company for the past three years. Starting in year 2, he was able to qualify for a $50,000 annual bonus for meeting a target growth rate of 10% of gross sales. Income statements for Eastern for the three year period are given below. Amounts are in the $ thousands.
Year 1 Year 2 Year 3
Gross sales 20,300 22,400 24,800
Returns and allowances 150 320 480
Net sales 20,150 22,080 24,320
COGS 13,100 15,020 17,170
Gross margin 7,050 7,060 7,150
Operating expense:
Manager salary/bonus 100 150 150
Other branch overhead 840 870 910
Selling expense 840 1,020 1,190
Advertising 530 750 910
General and admin 4,060 4,480 4,960
Total 6370 7270 8120
Branch Income 680 -210 -970
All advertising is local to the branch, and is controlled by the manager. Selling expense is all such expenses other than advertising, such as sales staff compensation and travel. General and administrative expense represents corporate overhead which is allocated at the rate of 20% of gross sales.
Required:
1) Comment on the effectiveness of the bonus plan used by Acme.
2) Because Eastern Branch is showing increasing losses, a senior vice president has suggested that the branch be closed. Comment.
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Solution Summary
In a 387 word solution, the bonus plan is explained by the fact that it makes no sense at all. Under the terms, there are four reasons stated about how the bonus calculations can easily be manipulated. Following that are five proposed 'fixes' to save the branch from closure.
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Comment on the effectiveness of the bonus plan used by Acme.
The bonus plan makes no sense at all. Even in good times, profits are more important than sales. Gross margin is a much better basis for the calculation of a bonus. Even better is a plan whereby the manager is judged on all costs that are controllable by him. In this case, all costs are controllable except the corporate overhead allocation at 20% of sales.
The existing plan also allows for manipulation of resources to enhance the bonus, with no regard to profits. The problems are ...
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