Margaret Magee and Maxcor Manufacturing: Why might Ms. Magee feel uneasy about Maxcor's computation of 2005 operating profits?

(See attached file for full problem description)

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Margaret Magee has served both as an outside director to Maxcor Manufacturing since 1995 and as a member of the company's compensation committee since 2002. Margaret has been reviewing Maxcor's 2005 preliminary earnings statement in preparation for the February 2006 board and compensation committee meetings. She is uneasy about the company's definition and computation of "Operating profits" for 2005, particularly since management bonuses at Maxcor are based on achieving specific operating profit goals.

Maxcor Manufacturing- consolidated results of operations:
Years ended December 31
($ in millions) 2005 2004
Sales $98.4 $111.2
Operating costs (81.5) (92.2)
Cost of goods sold
Selling, general, and administrative expense (12.5) (12.9)
Operating profit 4.4 6.1

Research and development expenses (see notes) (5.7) (2.4)
Provision for plant closings (see notes) (2.6) -0-
Interest expense (2.9) (2.6)
Other income 0.7 1.2

Profit (loss) before taxes (6.1) 2.3
Provision (credit) for income taxes 2.1 (0.8)
Profit (loss) of consolidated companies (4.0) 1.5
Equity in profit of affiliated companies 0.2 0.3
Profit (loss) $(3.8) $1.8

The preliminary financial statements also contained the following footnotes:

Research and engineering expenses: Research and engineering expenses include both "research and development expense" for new product development and charges originally made to "cost of goods sold" for ongoing products improvements. The amounts (in millions) for 2005 and 2004 were.

2005 2004
Research and development expense $5.7 $2.4
Cost of goods sold 2.9 6.3
Research and engineering expenses $8.6 $8.7

Plant closing cost. In 2005, the company recorded provisions for plant closing and staff consolidation costs totaling $2.62 million. Included in this total are charges related to the probable closing of the company's York, Pennsylvania facility ($1.75 million), the consolidation of the North American operations of the Building Construction Products Division ($0.63 million), and charges to reflect lower estimates of the market value of previously closed U.S. facilities ($0.24 million). These costs include the estimated cost of employee severance benefits, the estimated net losses on disposal of land, buildings, machinery and equipment, and other costs incidental to the closing and planned consolidation.

Maxcor Manufacturing is an established, privately held manufacturer that operates in two principle business segments: building construction products, which involve the design, manufacturing, and marketing of construction and material- handling machinery; and engines for various off-highway applications. Before 2005 the company had experienced 15 years of steadily increasing sales and operating profits.

The company was founded in 1938 by Hugh Maxwell, a former ford motor company engineer. Neither Mr. Maxwell nor any members of his family are currently officers of the company. Maxcor's common stock is held by the Maxwell family trust (35%), the Maxwell employee stock ownership plan (ESOPs) trust (50%), a venture capital firm (13%), and current management (2%). Margaret Magee also serves as an outside trustee for the Maxwell ESOP Trust.

Maxcor's senior management participates in an incentive bonus plan that was first adopted in 1996. The bonus formula for 2005 was approved by the compensation committee at its February 2004 meeting. According to the plan, each senior manager's 2005 bonus is to be determined as follows:

Bonus as percentage 2005 operating profits
Of 2005 salary ($ in millions)
0% below $4.0
100 at least $4.0
200 at least $6.0
300 at least $8.0

The compensation committee can award a lesser amount than the indicated by the plan formula if circumstances warrant such action. No bonus reductions have occurred since the plan was adopted in 1996.

Required:
Why might Ms. Magee feel uneasy about Maxcor's computation of 2005 operating profits? Should Magee approve the 100% bonus payment for 2005 as specified by the plan formula? What changes (if any) would you recommend be made to the bonus formula for next year?
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