CHAPTER 23

CONTROL: THE MANAGEMENT CONTROL PROCESS

Changes from Eleventh Edition
All changes to Chapter 23 were minor.
Approach
The management control cycle deserves emphasis. The hardest part to understand is strategic planning,
because it tends to be less precise and systematic than budgeting. Yet, strategic planning is a key step in
strategy implementation, since it involves the transformation of broad strategies into specific product
plans.
Most students find the material on behavioral aspects interesting and important. Some, however, regard
any statements about human behavior as manipulative, and hence, unethical. They have the impression
that managers spend their time exploiting workers and view behavioral principles as assisting in this
exploitation. A counter to this impression, if it should arise, is that it is important that managers
understand how people behave, not for the purpose of exploiting them but, rather so that they can reduce
frustrations and provide an atmosphere that will permit employees to release their full potential. The
example of computer costs is a way of showing that the purpose is not to exploit, but rather to motivate
people to act in a way that helps the organization without, in any way, harming the individual.
Cases
Tru-Fit Parts, Inc. deals with problems caused by not giving enough thought to the behavioral
implications of measurement systems.
Industrial Electronics, Inc. raises a number of issues, including performance measurement, performance
standards, functions linking performance with incentive awards, and the behavioral responses by
managers and employees to incentives. It also makes a nice exam case when the examination time is
limited.
Las Ferreteras De Mxico, S.A. de C.V. illustrates some of the problems managers commonly face when
they use the return on investment (ROI) measure of performance.
Boise Cascade Corporation asks students to understand the cost-based billing scheme of a data
processing department of a large corporation and to consider whether prices should be set to encourage
certain types of user behaviors (e.g., do their processing at night, make greater use of personal
computers).
Berkshire Industries PLC illustrates the advantages of and the problems faced in building a performance
measurement and incentive system around an economic profit measure.

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Problems
Problem 23-1: Sandalwood Company
a.

Divisions $ (000s)
Total
N
E
W
S
Sales.................................................................................................................................................................................
$3,800
$1,520
$570
$1,140
$570
Less: Avoidable costs.......................................................................................................................................................
2,675
835
234
1,392
214
Divisional contribution.....................................................................................................................................................
1,125
685
336
(252)
356
Corporate headquarters cost.............................................................................................................................................
975
390
146
293
146
$ 150
$ 295
$190
$ (545)
$210

Division
N
E
W
S

Sales
Revenue
$1,520
570
1,140
570
$3,800

% of
Sales
40%
15
30
15
100%

(1)
Allocated
Costs
$390
146
293
146
$975

(2)
Total
Costs
$1,225
380
1,685
360
$3,650

(2) - (1)
Avoidable
Costs
$ 835
234
1,392
214
$2,675

Unless its profitability can be improved in some way, the Weston Division should be closed because it
does not appear to be able to cover its own costs nor contribute to the total overall profitability. The
Southboro Division does not cover its share of Corporate Headquarters cost, but it does cover its own
costs and makes a contribution to overall profitability.
b. Business may be seasonally influenced by geographic location. However, the long-run future outlook
should be the guideline. In the long-run, all costs are considered variable and all divisions are
expected to bear a fair burden of corporate administration costs. Even though the Southboro Division
is making a contribution, some adjustments must be made in the long-run. One other consideration
may be the influence of one divisions output on anothers profit. For example, some of Edgewood
Divisions sales may be a direct result of some sales of the Southboro Division.
Lastly, other variables include human factors and hardships endured by employees. All of these
factors must be accounted for in the decision to close certain divisions.
Problem 23-2: Tarrell Company
a. The Tarrell Company sales compensation plan provides financial motivation to the sales force to
make profitable sales. First, sales commissions are contingent upon the collection of accounts
receivable. Thus, salespersons are discouraged from selling to high credit-risk customers simply to
generate sales volume (a double-edged condition; see part b). The sales commission is based upon
product profitability. This motivates members of the sales force to direct their efforts toward the most
profitable products in the line. Third, salespersons are not penalized if price concessions are
considered necessary and desirable to attract certain customers. Finally, the substantial year-end
bonus provides a strong economic stimulus to sales persons to meet their annual sales quota.
b. The Tarrell Companys sales compensation plan has several major deficiencies. Most notably, the flat
15 percent bonus for meeting or exceeding the annual sales quota does not stimulate a salesperson to
exceed the quota by more than a slight safety margin. Salespersons are further discouraged from
making sales far in excess of the quota due to the method of setting sales quotas. By setting the
annual quota at 50 percent of prior years sales, a salesperson increases his or her quota for the

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following year by making sales well in excess of the current years quota. If a salesperson has
achieved his or her quota near the end of the year, he or she would be motivated to hold back sales
until the following year. Second, the commission/collection policy could discourage the sales force
from contacting prospective customers who would be classified as slow, but collectable. Third, the
standard gross margin is not necessarily a good measure of product profitability. Product contribution
margin would be a better measure of product profitability. The standard gross margin does not reflect
cost-volume-profit relationships. Nor does it consider directly traceable marketing costs. Finally, the
reward system is apparently limited to monetary rewards. The system does not provide for higher
order rewards such as peer or superior recognition.
Problem 23-3: Alexander Company
a. Standards are often classified into three types ideal (tight), attainable (reasonable), or easy (loose).
Standards that are too loose or too tight will generally have a negative impact on worker motivation.
If standards are too loose, workers will tend to set their goals at this low rate, thus reducing
productivity below what is obtainable. If the standard is too tight, workers will realize that it is
impossible to attain the standard. They will become frustrated and will not attempt to meet the
standard. An attainable or reasonable standard that can be achieved under normal working conditions
is likely to contribute to the workers motivation to achieve the designated level of activity.
The plant management can participate in the setting of standards, or top management can impose
standards. Workers and plant management will tend to react negatively in the long-run to imposed
standards because they will feel threatened. If they participate in setting the standard, they can
identify with the standard procedure and the standard could become one of their personal goals.
In the case of Alexander, it appears that the standard was imposed on the plant. In addition,
management used an ideal standard to measure performance. Both of these actions appear to have had
a negative impact on output over the first six months.
b. Alexander made a poor decision to use dual standards. When the workers learn of the dual standard,
the companys entire measurement system will become suspect and credibility will be lost. Company
morale could suffer because the workers would not know for sure how the company evaluates their
performance. As a result, total disregard for the present and any future cost control system is likely to
develop.
Problem 23-4: Concord Publications
a. (1) The academic and administrative units will experience important operational changes. They will
now have the decision-making power to select the publications to be issued, the quality and
character of publication, and the quantity of the publication. Concomitant with this increased
decision power will be the responsibility for the financial consequences of their acts through the
inclusion of publication costs in their budget and charge-back from CP for services used. Now
academic and administrative units will be motivated by a desire to get the most value from their
publications relative to the budgeted amount for publications. These units should experience
higher morale as a result of these changes.
(2) Concord Publications will lose the decision-making power over the choice of publications to be
issued and the quality and quantity of the publications. CP essentially has become a production
shop, rather than a complete publication service, and as a result, financial responsibility is
diminished to only cost control. The management and professional staff of CP will likely have
lower morale due to its change from a professional publication shop to a production shop, and
they may be less motivated to produce fine publications because they no longer have a significant
amount of influence on the publication decision.

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(3) The operational change for the college will be the shift in publication responsibility from CP to
the other units. The budget system will need to be revised to include responsibility for publication
costs in the academic and administrative unit budgets. Also, a method to calculate and record the
charge-backs must be developed. The academic and administrative units may be more careful in
their selection of publications because they will be charged with the costs. CP may be less
concerned about cost control because the costs are allocated, and there could be a reduction in the
quality of publications. More conflicts between CP and the other units are likely to arise due to
the lessened power of CP combined with the inevitable disputes over the proper charges.
b. The president used a unilateral approach to introduce organizational change. This approach relies very
heavily on the presidents hierarchical position in the college. The definition and solution to the
problem were specified by the president and directed downward. In addition, the presidents
memorandum tends to be impersonal, formal, and task-oriented. This approach assumes that people
are highly rational and best motivated by authoritative directions.

Cases
Case 23-1: Tru-Fit Parts, Inc.*
Note: This case is unchanged from the Eleventh Edition.
Approach
This case, based on my contacts with an actual NYSE company, enables students to gain insights in two
areas of control system design. First, it illustrates (in the transfer pricing area) that some problems are not
completely soluble, and that a system with only a few problems may be better than an evident alternative.
Second, the case illustrates how a myopic view of control systems can create problems; in two instances
the company considered a specific behavioral aspect of a measurement scheme but neglected to recognize
the possibility of undesirable side effects of its approach.
I have used this case also as a 90-minute exam, with this assignment
Assume you are a consultant to Tru-Fit Parts, Inc. The information given in the case was collected by
you during a visit to the company. You are to analyze that information and then link your analysis to
specific recommendations. For exam purposes, assume you are presenting your analysis and
recommendations to me, rather than to an officer of Tru-Fit; this means you can tell me things you
would choose not to tell the company, but you are still in the role of a consultant.
By my standards, the below-average students overreact to the transfer pricing problem and fail to see the
plant manager bonus system adjustments role in AM-Manufacturing relations. Almost all students
understand the reason that inventories are excessive for most of the year.
In class, I let students deal with the three issues in whatever order they wish. Their discussion will tend to
lead to the summary comments Ive put at the end of this note.
Comments on Questions
Transfer price disputes. Case figures on sales indicate that AM Marketings purchases from the
manufacturing divisions total $200 million annually, compared with $440 million sales of those divisions
outside the company. The combination of this $200 million internal sales amount and the nature of TruFits products causes students to realize that there must be thousands of parts for which transfer prices
must be established. The procedure for pricing parts with OEM equivalents was as objective and fair as
*

This teaching note was prepared by professor James S. Reece. Copyright by James S. Reece.

2007 McGraw-Hill/Irwin

Chapter 23

feasible, in my view, and caused virtually no disputes.

For parts with no Tru-Fit OEM equivalents, I feel that a few disputes which usually were resolved by
the two divisions involved and which only occasionally were arbitrated is the best the company could
hope for, given the lack of objective data for setting these prices. (This is not to say the company didnt
try to identify other suppliers prices for these parts; but those prices, being from manufacturer to
distributor rather than at later channels in the distribution chain, were not that easy to learn since AM
Marketing didnt buy and distribute other manufacturers parts.) Thus, in my judgment, no change is
called for here. (This was also Tru-Fits CFOs feeling, but he welcomed an outsiders ratifying it. As a
result of our conversation, one segment of a management training program we developed for the company
dealt with the notion that there is no such thing as a perfect, dispute-free transfer pricing system.)
AM-Manufacturing relations. This causes students the most difficulty of the three stated problems. Many
students will argue that changing company policy and letting AM Marketing buy on the outside will solve
the problem. This proposal overlooks the fact that the present bonus scheme adjustment would not cause
the manufacturing profit centers to be penalized if AM Marketing shifted some purchases to outside
suppliers, just as they are not penalized now if they favor OEM customers over AM when the plants are
operating at or near capacity. (The proposal also does not recognize how strongly and validly held such
policies aimed at protecting company image can be.) It seems, then, that the plant manager bonus
adjustment for sales volume variances associated with AM, while meeting its intended objective of
equitability, is causing an undesirable side effect. Given that top management wants to increase the AM
portion of total outside sales, this is a serious problem. (A sharp student will note the reason for wanting
to increase AM sales: at present AM sales are $360 million, with a cost of goods sold i.e., purchases
from the other divisions at OEM market prices of $200 million, giving a gross margin for AM of 44
percent!)
One proposal to deal with this problem is to make the plants expense centers. To me, this begs the issue,
because someone in the manufacturing division will still have to decide how to allocate capacity at times
when combined OEM and AM demands exceed that capacity. With the OEM marketing tradition in two
of the three divisions, it is not evident that AM Marketing would get any more favored treatment if the
division top management made these capacity allocation decisions.
Another option is to do away with the bonus system adjustment, so that AM Marketings purchases affect
the manufacturing divisions in the same way that OEM customers purchases do. This should at least
make the divisions indifferent as between selling to AM or OEM, whereas now they are motivated to
favor OEM. This is the approach I favor, except it doesnt go far enough. Since AM sales are so
profitable, top management probably wants AM Marketing to be a more favored customer. This could be
achieved by a small across-the-board premium added to all transfer prices, or by having a multitiered
bonus plan that enables plant managers to share a part of AM profits (i.e., base part of the bonus on plant
profit and part on total company profit). I prefer the latter over an inflation of now-realistic transfer
prices.
Inventory levels. Top management was concerned that productivity-improving capital expenditures,
whose savings might not materialize during the first few months, would not be aggressively proposed by
the divisions unless the short-run negative impact such projects would have on ROI was somehow
cushioned. That was the rationale behind freezing the investment base at the January 1 level. This is an
example of the fixed-asset fixation in some managers minds when it comes to designing investment
center measurement schemes; rather, investment center schemes have the most impact on controllable
current assets in this case, inventories. Quite obviously the near Christmas draw-down of inventories
had little (if anything) to do with vacations, but rather was to reduce the denominator of the ROI fraction
at year-end so as to increase accounting ROI. In effect, the plants were profit centers, not investment
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centers; and controllable current assets will tend to increase relative to sales (i.e., collection period and
inventory turnover will decline) with a profit center measurement approach, since increased current assets
will provide some additional sales at the margin, and there is no charge levied on these assets.
The company could achieve its intended motivational goal if it were to freeze just the fixed assets portion
of the investment base, and base ROI calculations on the average of quarterly or monthly current asset
measurements. A better approach, I feel, is to make it clear to managers that ROI targets will be adjusted
downward if an otherwise attractive capital budgeting request is approved but it will have a short-run
negative impact on ROI.
Other issues. Generally, discussion of the three stated problems will raise some question about the
appropriateness of Tru-Fits organization structure. In particular, consolidation of the three separate OEM
sales groups is likely to be proposed, and perhaps even consolidation of all manufacturing activities under
a single manager. In this regard, to me the two key facts in the case are: (1) each divisions OEM
marketers tended to work with different people in a given customers organization; and (2) two of the
three divisions had been independent companies before being acquired by Tru-Fit. Note that OEM sales
personnel are not sellers in the usual sense of the word. They are more like adjuncts to the OEM
companies own design departments; working with different people in the OEM companies thus means
working with different engineering and design departments, not just different purchasing agents. Since
there is no evidence in the case that there is any need for interplay between Tru-Fit manufacturing
divisions, but there probably is a need for sales-production interplay within a division, I would leave the
structure as it is and capitalize on the perceived autonomy of these three divisions.
Also, some students usually are critical of the discretionary adjustment in the bonus scheme. (Such
students also tend to prefer my grading them using an equation that weights their written work, with no
discretion on their classroom contributions.) Certainly, this discretion can make it possible for a superior
to play favorites. However, the companys intent was to reduce the emphasis on short-term measured
accounting results, and to take into account longer-term perspectives, community activities, development
of subordinates, and the like. It might well be preferable to do this with a more formal MBO system; but
absent such a system, I think that having the discretionary aspect of the bonus is better than having a 100percent accounting formula-based bonus.
Also, there may be criticism that the higher a person was in the hierarchy, the more standard bonus points
he or she had. If one assumes that salary is related to the organizational hierarchy, the effect of this was to
equalize potential bonus as a percentage of salary. When this is clearly understood by students, some of
the criticism is eliminated, though it is still a valid issue whether the CEO of an organization should
more-or-less automatically receive the largest bonus.
Finally, with coverage in the business press the past few years about EPS-based bonus pools, there may
well be discussion of tying the annual bonus pool size by formula to annual EPS Certainly, this would
seem to lead to a short-run results emphasis. From top managements perspective, it is difficult to justify
to shareholders not having the bonus pool tied to each years results. Many companies are struggling with
this issue today, with stock options often seen as providing a better short-run versus long-run balance. It is
interesting to note that in many large Japanese companies, the accepted culture is that if earnings fall in a
given year, everyones bonus is lowered (or even eliminated); and everyone takes a salary cut if its a
really bad year. Thats certainly a short-run approach, yet other aspects of the Japanese business and
economic culture reinforce an overall longer-term perspective.
Summary Comments. In using this case as an exam, the student responses caused me to provide the
following comments as overall feedback:

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1. Before you suggest a solution to a problem, be sure that you have thought about what is causing the
problem. Many so-called business problems are really dilemmas, where one may be pleased with
minor improvement because a true solution is not possible. (Some students propose residual income
to deal with the excess inventories; but that doesnt help if the investment base remains frozen as of
January 1.)
2. If you are confident a change is needed, anticipate the difficulties in selling it, especially if your
proposal is likely to be viewed as radical or academic (e.g., residual income, two-step or shadowprice transfer prices, etc.).
3. If management believes there is a problem, you must address that belief, even though you feel the
problem is either minor or insoluble (e.g., the transfer pricing disputes); but addressing it does not
mean proposing change for changes sake.
Case 23-2: Industrial Electronics, Inc.*
Note: This case is changed from that appearing in the Eleventh Edition. The numbers have been modified
to provide greater differentiation among the divisions.
Purpose of Case
This case, which is really a short vignette, was written primarily for exam purposes in situations where
the examination time is short. But the case can also be used as the basis for a class discussion.
The case raises a number of issues, including performance measurement, performance standards,
functions linking performance with incentive awards, and the behavioral responses by managers and
employees to incentives.
Suggested Assignment Questions
Here are the questions used in the exam setting (importance weightings assigned to each question are
shown in parentheses):
(20%) 1. Calculate the bonus award (as a percent of base salary) that would be given to the manager of
each of the following five divisions under the proposed new bonus system. These divisions
are representative of the range of divisions within IE.
($000)

Division
A
B
C
D
E

Budgeted
Operating Profit

Budgeted
Operating Assets

Actual
Operating Profit

$1,000
1,000
50
(700)
600

$8,000
8,000
1,000
4,000
2,000

$1,150
4,500
300
(300)
100

Professor Kenneth A. Merchant wrote this teaching note. Copyright Kenneth A. Merchant.

Actual
Operating Assets
$7,000
7,000
800
4,200
1,800

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(20%) 2. Evaluate (i.e., discuss the pros and cons of) the current bonus system.
(30%) 3. Evaluate the proposed bonus system.
(30%) 4. Propose a bonus system that you believe is optimal for IE. Why do you think your proposed
system is optimal? Explain.
Discussion
The case starts by describing an ineffective incentive system. The old system was replaced by a new
system that is quite different, but still not without problems.
Question 1
Question one forces the students to apply the description of the new system to a hypothetical situation.
The purpose is to help them understand a key detail in the new system. Most students have no problem
solving question one. The bonus awards (as a percent of base salary) in Divisions A through E,
respectively, are 63.5%, 150% (the formula says 231%, but the maximum is 150%), 63.7%, 68.8%, and
26.2%.
Question 2
Question two asks for an evaluation of the current (old) bonus system. This system provided managers
with bonuses based on a share of overall corporate profit after taxes in excess of 12% of book net worth.
Advantages of the current system
1. It is a wealth sharing system. If the company does well, all managers do well, and vice versa. The
company has to make larger payouts when it is best able to do so.
2. The system might encourage teamwork because everyone is rewarded on the same measure of
group performance.
3. The performance targets are fixed and timeless. Thus there are no politics in the negotiation of
performance targets.
4. The system is easily understandable.
Disadvantages of the current system
1. Except for the highest level of managers, corporate performance is largely uncontrollable.
Division managers bonus awards are little affected if their division has an outstanding or a poor
year.
2. The timeless goal (12%) does not reflect the economic situation or changes in the situation.
3. Profit after tax is not a good reflection of value creation.
4. There is no charge for the use of assets that are financed by debt. The asset and the debt net to
zero in the effect on book net worth.
5. The bonus cutoffs, both at the bottom (corporate performance below 12%) and the top (maximum
bonus of 150% of salary), are potentially bad.
a. The current situation, in which corporate performance is below the minimum
performance level, has discouraged some of the managers. This discouragement could
lead to demotivation and turnover.

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b. There are performance regions where there is no link between performance and bonus
awards. This can adversely affect motivation. The cutoffs also provide motivations for
gamesmanship (i.e., moving income and assets between performance periods).
Question 3
Question three asks for an evaluation of the proposed new system.
Advantages of the proposed new system
1. The measures are more controllable. Division managers will be held accountable for division
results; group managers for group results; and corporate managers for corporate results.
2. The awards are based on an economic profit, or residual income, performance measure. Managers
would be charged for tying up assets in their business.
3. The type of financing used to acquire the assets would not affect the measure.
4. The performance targets would be tailored to each business unit. Presumably they would be more
realistic and more equitable and would engender greater commitment from each of the managers.
Disadvantages of the proposed new system
1.

The performance measures, which are accounting-based, are short-term oriented. This could
be particularly costly in a high technology business where innovation is a critical success factor.
Short-term accounting measures discourage research and development-related investments.

2.

The measures are just uniform, summary results indicators. They are not at all linked with
strategy, and they provide no operating guidance for managers as to how to accomplish the
results.

3.

Cash is arbitrarily assigned to the operating units. Why?

4.

Charging for fixed assets based on net book values causes well known problems. Among
other things, returns go up just with the passage of time and, hence, NBV-related measures
motivate managers not to replace older, more depreciated assets.

5.

There seems to be no adjustments made based on whether the company leases or owns fixed
assets.

6.

The costs of capital does not vary across operating units, and it seems not to change over
time, such as with interest rate changes.

7.

There is a scalability problem that may be perceived by some managers to be unfair. That is,
the bonus earned on, say, each $100k of economic profit is different across divisions.

8.

Budget targets are difficult to set equitably in uncertain environments such as IE operates in.

9.

The system provides room for gamesmanship (e.g., window dressing, creation of budget
slack).

10.

Under the new system, bonuses will probably be paid even when an operating unit is not
making target. Is this desirable, particularly when the targets are set to be highly achievable?

11.

Organizational interdependency seems to be small, but to the extent that divisions have to
cooperate, there is a chance here of suboptimization. The division-level performance measures
reward solely division performance.

12.

Is the new plan too complex? Will the affected managers understand it?

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Question 4
Question four asks for student recommendations. In answering question four, students must try to address
as many of the weaknesses of the new system as they can while retaining the advantages. They must also
consider the costs of their suggestions, as well as the benefits. There is no perfect solution here. The
purpose of the exercise is to expose students to some issues firms commonly face and to get them
thinking about various alternatives, and their costs and benefits.
Pedagogy
This is a short case. However, because it contains descriptions of two incentive plans and raises so many
issues, the discussion of it can easily consume an entire class period of 75 minutes or even more.
Following the ordering of the student assignment questions provides a logical way to develop the
material. However, completing the discussion of the old system (question two) might usefully be
completed before starting the discussion of the new system (questions one and three).
Case 23-3: Las Ferreteras De Mxico, S.A. de C.V.*
Note: This case is unchanged from the Eleventh Edition.
Purpose of Case
This case was written to illustrate some of the basic problems with the return on investment (ROI)
measure of performance. The problems arise in both the numerator (profit) and denominator (investment)
of the ROI measures. The case provides sufficient detail to allow students to discuss both how to measure
the basic elements of profits and investments and the behavioral implications of the use of these
measures. Students should also consider alternatives to the use of ROI measures.
The case also allows for discussion of some other issues that managers face in the design and
implementation of incentive systems. These include decisions about what employees to include in the
plan, what target bonus to set for each type of employee included, whether to use a bonus pool feature,
how to design the function linking performance measures and incentive awards, and how to set fair
performance standards for all employees.
Suggested Assignment Questions
1. Evaluate the proposed bonus plan that Mr. Gonzalez is considering.
2. How, if at all, would you modify the proposed plan?
Case Analysis
Background
It is useful to start the discussion by clarifying some key facts. Ferreteras is a publicly held company. Its
managers aspire to have the company be a Mexican equivalent of Home Depot or Lowes.
Ferreteras is not a small business. It operates 82 stores, organized into nine geographical regions. With
most student groups, it is probably useful to clarify the key recurring decisions in the business, and then
to identify who in the organizational hierarchy makes these decisions. Table TN-1 presents such a list:
*

Professors Kenneth A. Merchant and Wim A. Van der Stede wrote this teaching note. Copyright 2003 by Kenneth A. Merchant
and Wim A. Van der Stede.

10

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Table TN-1
Key Recurring Decisions
Person(s) responsible
for making the decision

Key recurring decisions

Order right items in the right quantities

Staffing with right numbers of good people

Pricing

Granting credit

S (with corporate check on large decisions)

Selling

S, R (large contractors only)

Store location and design

Advertising

Control expenses

Key:
S = store
R = region
C = corporate
This table makes it obvious how important the store manager role is in the company. The store managers
have considerable autonomy, so they play a key role in affecting the success of each store location.
Old Incentive Plan
Before this new proposal, performance-dependent incentives were not an important part of the Ferreteras
management system. Bonuses were small (2-5%) of base salary, and they were based on the companys
overall profits, so they were not controllable to any significant extent by any except the companys very
top managers. Mr. Gonzalez also provided some subjective bonuses for exemplary performance.
These weak incentives seem to have caused some employees to become lazy and to be not focused on the
aspects of performance important to the companys success. These problems are indicated in the quote
that opens the case.
New Incentive Plan
A consulting firm designed the new incentive plan. A number of issues might be discussed. One is the
decision to exclude all employees except the store, regional, and corporate managers. Clearly the lowerlevel employees create value for the company, but the consulting firm decided to exclude them with the
reasoning that Ferreteras could not measure effectively the performances of these individuals. If
prompted, some students will undoubtedly be able to suggest things that could have been done. For
example, sales people could have been rewarded for bringing profits from new sales or for increasing
sales from existing customers. Yard workers could have been rewarded for receiving positive customer
feedback.

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Another issue is the division of the bonus pool. Corporate managers are to be given, on average, 3%
(15%5 people) of the bonus pool. Regional managers get 1.67% each. Store managers get 0.85% each. In
comparison, the corporate bonus awards seem too high, particularly given that the top two managers, the
CEO and COO, are excluded from this plan.
A third issue is the function linking the measures with the bonus awards. There is a lower-level cutoff of
5%; no manager of a store earning an ROI of less than 5% earns any bonus. There is also an upper cutoff
at 11%. In 2002, then, six store managers earned no bonuses, and 15 managers earned the maximum.
Students should be asked to consider the behavioral implications of these cutoffs. The managers below
the 5% cutoff and above the 11% cutoff will be motivated to incur all the worthwhile expenses they can in
the current period and deferring all the revenues possible to the subsequent period because these shifts
will have no effect on their bonus. Thus, a gameplaying environment is created.
A fourth issue is controllability. The performance standards are the same for all the stores, but their
performance prospects are almost assuredly not equal. Some stores have better locations, and some
probably have more efficient layouts. Ideally, performance standards should vary by individual location.
This could be done through a formal budget negotiation process or more mechanically, such as by
adjusting the goals for differences in local construction activity.
A related problem: are the six managers earning no bonuses really the worst managers? Maybe they are
good managers who were transferred to poor performing stores and have not yet had a chance to turn
around that performance? There is no provision for making allowances for this contingency. That may
make it difficult for the company to induce good managers to move to poor-performing outlets.
Ferreteras may want to distinguish the evaluation of the store location from the evaluation of the
manager.
Finally, the logic of basing bonuses on a proportion of corporate profits can be questioned. The bonus
pool feature does limit the companys exposure. This is a wealth-sharing feature of the plan. If the
corporation does not do well, then payouts to employees are reduced. But corporate performance is
essentially uncontrollable, even by managers at the store and regional levels, so this bonus pool feature
just subjects these employees to uncontrollable risk. The yards do not seem to be greatly interdependent,
so there is no need to have a group reward to motivate teamwork.
The focus of the discussion, though, should be on the technical aspects of the ROI calculation and the
behavioral impacts of making ROI the central measurement in a bonus plan. The text reading provides a
summary of some of the advantages and disadvantages of using ROI as a criterion for evaluating and
rewarding managerial performance. Instructors can remind students of this list if that is deemed desirable.
The Calculation of Profit
The accounting treatment of revenues seems unfair in part. Stores are not given credit for sales orders
written by personnel at regional or corporate levels, yet the store has to provide the good for that sale.
Thus the stores incur the stocking and handling costs. Customer service on these sales may also suffer
because the stores are not dealing with their own customers.
The stores are charged with all their local expenses, direct charges from regional and corporate
headquarters, and allocations of all indirect costs. Some of even the local expenses may not be
controllable by the store manager. The rental and depreciation amounts may result from decisions made
by managers in the corporate office. The same arguments apply to the advertising material, catalogs, and
other materials. Will managers have the opportunity to reject such material if they feel they can
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accomplish their objectives with less expensive advertising that doesnt conform to corporate policy or
corporate image? Will that be allowed? Some of the direct charges may have a behavioral impact. For
example, will charges for credit checks discourage their use? The case does not provide much information
about the allocations of indirect expenses, but these raise some questions. Do the allocation bases have
any economic meaning? And why are the allocations of actual expenses, not standard. This allocation
method makes the yards bear the cost of any corporate budget overruns.
The Calculation of Investment
The calculation of investment similarly raises a number of measurement issues. Including month-end cash
balances as investment will encourage managers to get rid of their cash at the end of the month. End-ofperiod gameplaying like this is commonly referred to as window dressing. What purpose is served by
holding managers accountable for cash balances and what behavioral effects are produced should be of
concern.
Likewise, including month-end inventory at cost creates an opportunity for mangers to manipu late their
inventories in such a way that their investment is reduced. The effect of such reductions, however, will
inevitably be on the level of service they can provide to customers. Ferreteras system does not enable the
calculation of a cost of stock-outs.
Month-end receivables also provide opportunities for discretionary action by yard managers in allowing
credit, or by different managers adopting different policies and, hence, encouraging consumers and
customers to deal with one yard as opposed to another simply because of their credit policies.
Most students will quickly recognize the arguments against including investment in automobiles, trucks,
equipment, furniture and fixtures at their depreciated (net book value) cost. To illustrate the point,
instructors can draw a figure showing that ROI of any entity being evaluated in terms of the return on the
net book value of assets will increase over time, just with the passing of time. Use of net book value can
have some perverse behavioral effects. It can cause managers to delay replacing assets and to operate with
older, less efficient or less attractive, equipment and facilities. In the event extra equipment is available,
yard managers might have a tendency to dispose of the newer rather than the older equipment because of
the effect it will have on the investment base. Using net book value also causes problems in comparing
performance across yards because the yards assets are of different ages. A related issueleases at
Ferreteras are not capitalized.
Implementation Issues
While little information is given about the process by which the plan has been developed, students can
infer that the managers who will be greatly affected by the plan seem to have had little or no input into the
design. At the end of the case, Mr. Gonzalez is lamenting that he will have to be the one to announce the
implementation of the plan. This lack of participation can be costly both because the expertise of the
people at the operating levels was not tapped and because participation itself reduces resistance to
implementation.
Pedagogy
This teaching note has been written in roughly the order in which we suggest discussing the issues. At the
start of class, it is desirable to clarify both what is important for Ferreteras and who in the organization is
responsible for the various key decisions.
Before evaluating the new plan, it is useful to clarify the key elements of the plan. We like to have the
students describe the plan along many of the common plan dimensions, including the form of the awards
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(here cash), performance measures, degree of discretion allowed in making the awards, the shape of the
results/reward function, the size and frequency of the awards, the degree of uniformity of awards
throughout the organization, and the source of the funding (bonus pool).
Then students can be asked to evaluate the new plan and to suggest possible improvements. Instructors
should focus on the behavioral impacts of the plan and other plan alternatives. It is the induced behavior
of the employees in the company that will produce value, or not.
Case 23-4: Boise Cascade Corporation*
Note: This case is unchanged from the Eleventh Edition.
Approach
This case was written to illustrate a cost accounting/billing system in the difficult accounting environment
of corporate data processing.1 The case raises an interesting twist because managers at Boise Cascade
were considering not using actual (or average) costs for charging out usage of personal computers (PCs).
They were leaning toward undercharging for PC usage in hopes of creating a desired behavioral
response greater PC usage.
Suggested Assignment Questions
Suggested assignment questions are contained in the case. If the instructor does not want to raise issues
related to responsibility centers at this point, a topic discussed in Chapter 22, question 1 can be omitted.
Case Analysis
Question 1: Is Boise Cascades CDPS a profit center?
This is not an easy question. On the surface, CDPS appears to be a profit center since it generates
revenues and a profit. However, the best answer to question 1 is that CDPS is really a cost center, for a
number of reasons:
1. Unlike most profit centers, CDPSs goal was not to maximize profit. Its goal-was to report exactly
22% PROTC. This goal is essentially a break-even goal. It forces CDPS to earn an average rate of
return on the assets it used so that the organization does not dilute corporate return on equity. CDPS
managers were embarrassed when their organization earned a 40.6% PROTC in 1991. This
performance meant they had overcharged Boise Cascades product organizations for the services
they used.
2. CDPS does not generate any outside revenue. This is not a necessary condition for being a profit
center, but it can be almost a sufficient condition. If CDPS had many outside customers, Boise
Cascade would have little choice but to make CDPS a profit center.
3. Most important, CDPS managers do not make any trade-offs between revenues and costs. Their prices
are not market based (although some market comparisons are made for control purposes); their prices
are really just a way to pass on the costs. They are set to represent cost plus a margin to provide a
*

This teaching note was prepared by Professor Kenneth A. Merchant. Copyright 1998 by Kenneth A. Merchant.

Much has been written about this topic, and instructors can assign supplementary readings to delve into this area more deeply.
One possibility is R.L. Nolan, Controlling the Costs of Data Services, Harvard Business Review (July-August 1977), pp. 114124. See also, D. Kilpatrick, Why Not Farm Out Your Computing? Fortune (September 23, 1991), pp. 103-112.

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return on the assets employed.

Question 2: Evaluate the CDPS billing system. Do Dwight Kirschts criticisms have any merit?
Before they can critique the billing system, students must understand the system. Walking through the
system is a good way to start the class. Figure TN-I shows a schematic of the billing system.
Figure TN-1
Schematic of CDPS billing system (similar to cost accounting system)

CDPS managers picked the 15 most important cost drivers (billing categories). It is clearly not a complete
list. For example, in addition to the list of 15, they could have chosen to charge for inches of paper used
and hours of talk with a support person.
Meters were set up to measure how much of each resource (billing category) was being consumed by a
particular job. CDPS managers put prices on the consumption of each resource at various times a day,
with the goal to generate exactly 22% PROTC.
The alternative to this two-stage system is a one-stage system that would allocate costs directly from
CDPS to users. This could be done based on a (necessary rough) estimate of percent usage or from lineitems to jobs, perhaps on the basis of use of labor (e.g., programmer hours) or equipment (e.g., CPU,
printer) hours.
Here are some questions that can be posed to force students to think more deeply about the system:

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1. What if a user wants a tape mounted for an hour. (This is a billing category no longer in use.) There
would be no charge for this service. The costs would be spread to all other users.
2. Where are the PC support costs? They are not separately identified. They are located in a number of
cost line-items
3. What does Boise Cascade know about whether the costs are fixed or variable? There is nothing in the
formal system that makes this distinction, but CDPS managers intuitively understand the distinction.
They know that most of the hardware costs are fixed, and many of their charges reflect user
opportunity costs more than CDPS costs. For example, the cost of running a job during peak daytime
hours is no greater than that caused by running it at night except for the fact that the peak usage slows
the entire system. In addition, they recognize that hardware must be acquired to serve peak needs.
One more peak-time job could cause the acquisition of an entire new computer or printer, so prices
are set to discourage peak-time usage.
In order to critique the billing system, students should first consider the goals for the system. These are
described in the case:
1. establish and account for the costs of providing the services;
2. provide an incentive for users to thoughtfully manage their use of the resources;
3. aid CDPS in managing computer capacity;
4. facilitate financial justification for capital and expense requests.
Is this a good set of goals? Dwight Kirscht might make the following additions:
1. The charges should be reproducible. If you submit the same job at the same time of day, you should
get the same charges.
2. The charges should be externally benchmarked. They should be competitive and apply pressure for
CDPS management to manage well.
Is the billing system meeting its goals? Clearly CDPS has maintained a system that accounts for costs,
and this cost information seems to be used for managing CDPS. However, Dwight Kirscht claims that the
internal computer algorithms, which were built in 1972, are obsolete. The case does not provide enough
information to get into this issue, but some classes will have a student expert who will want to expand
on this point.
There is evidence in the case that the charges cause users to understand at least some of the costs of the
resources they are using. This understanding affects their behavior (e.g., scaling back resource-intensive
applications). But to the extent that some users do not understand some of their charges, Dwight Kirschts
criticism is valid in this area.
It is clear that the charges are not reproducible. This is another of Dwight Kirschts criticisms. The
charges are based on units of production, not units of output. A job submitted at a busy time will be
charged more, perhaps substantially more, than a job submitted at a slack time. And the charges are not
formally externally benchmarked. CDPS had a sense that their charges were reasonable only because
outside service bureaus had not submitted bids for some or all of the business.
Dwight Kirscht suggests that CDPS should not charge for use of its services at all. Is this a good idea? A
company might not want to charge for computer services if any of the following conditions exist?

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1. The costs of computer services are immaterial, or the costs of billing is greater than the benefits. (But
at Boise Cascade, CDPSs annual expenses are $8.3 million, versus $75.3 million net income. This is
clearly not immaterial.)
2. Computer services does not add directly to the value of the corporations products. It may just involve
staff functions, such as payroll and bookkeeping. In such cases, it is not particularly important for
users to see the cost details. They have no decision-making authority in these areas. (But CDPS
provides many value-added services.)
3. Computer services costs do not make a difference to managers in the measurement/evaluation/
incentive system. If managers dont pay attention to the cost information, there is no reason to show
them that information. (But that is not the case at Boise Cascade.)
4. Managers do not understand computers and the costs they entail. (If this is the case, should these
people be managers?)
5. The company wants to encourage EDP use, regardless of cost. (This may be the case with PCs at
Boise Cascade. It is not the case with the centralized computer resources.)
Question 3: Evaluate the new system for charging for the use of personal computers.
Where were the PC support costs before the change? They were buried in other line-items and charged to
other users.
Which of the following PCs being used within Boise Cascade should be charged by CDPS?

PC used for inputting jobs to the mainframe?

A 10-year-old PC rim by an experienced user who requires no user support?

An Apple Macintosh computer (which is not well supported by CDPS)?

A home PC on which a manager sometimes works?

A laptop computer a manager sometimes uses in the office and sometimes at home?

CDPSs decision was finally to charge for support of all PCs (both IBM- and Apple compatible) in the
Boise offices with non-dial access to CDPS computers. They excluded laptops, portables, and home
computers that are exclusively used in dial access mode.
If the cost of PC support was $122 per month, why did CDPS managers decide to charge just $100? It
was a round number that was easy to explain and to sell. Further, with the growth in PCs, it would soon
be accurate:
$60,930610 PCs = $100/month.

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Case 23-5: Berkshire Industries PLC*

Note: This case is unchanged from the Eleventh Edition.
Purpose of Case
The Berkshire Industries PLC case was written to illustrate the use of economic profit in a performance
measurement system. Consulting firms have developed various measures of economic profit; EVA,
developed by Stern Stewart & Co. is probably the best known. All of these economic profit measures are
modified versions of the concept that accountants have traditionally called residual income. In this case,
students are asked to evaluate an economic profit measure that involves two common measurement
adjustments, capitalization and amortization of advertising expenses and the elimination of goodwill
amortization.
The case also raises some related results control system issues. The system proposed in the case includes
automatic ratcheting of performance targets, a results/reward function without thresholds and caps, and a
bonus bank that smoothes out the bonus awards. Each of these system elements can be evaluated.
Students must also consider some implementation issues.
Suggested Assignment Questions
1. Were Berkshires motivations for a new incentive system reasonable? If so, what were their main
options for a new system? Was an economic profit-focused system a reasonable choice?
2. Use the data pertaining to the Snack Food Division, as shown in Exhibit TN-1, to calculate:
a. The economic profit for the division for 2000 and 2001
b. The economic profit target for the division for 2001
c. The division managers bonus payout (% of salary) for 2000 and 2001. (Assume that the
slope of the payoff line for 2000 was arbitrarily set by Berkshire management to equal
1.0.)
3. Assume the base salary of the manager of the Snack Foods Division was 120,000 in both 2000
and 2001. How much cash would the manager receive from his bonus payouts in 2000 and 2001?
4. Evaluate the Berkshire Industries new incentive plan. What changes would you recommend, if
any?
5. Should Mr. Embleton make special adjustments of the economic profit figures or the bonus
payouts for personnel in the Spirits Division in 2000 and 2001? Why or why not?
Instructors should use question 2 only if they want to get into the details of the economic profit
calculation. Beware: While the concept is straightforward, students who are not comfortable with
accounting have considerable difficulty with the calculations.

Professors Kenneth A. Merchant and Wim A. Van der Stede wrote this teaching note. Copyright by Kenneth A. Merchant and
Wim A. Van der Stede.

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Case Analysis
The companys motivation for a new incentive system arises from two concerns. First, the board was
concerned that Berkshire managers interests were not aligned with those of shareowners. The board
members were particularly concerned that EPS was not a good measure since growth in EPS did not
translate into stock price appreciation.
Second, the board wanted to introduce more objectivity into the performance evaluation and reward
system. Some board members believed that too much subjectivity in the reward system results in a weak
correlation between bonus awards and actual operating performance. Furthermore, the subjective part of
the bonus system caused managers to spend more time negotiating their bonus rather than worrying about
generating profit.
In general, the benefits of an economic profit-type system include the following:

It introduces balance sheet accountability to managers, some of whom are accustomed to

thinking only about income figures.

It aligns managers actions with shareowner values by encouraging managers to invest

only in projects that generate a return greater than the cost of capital.

An economic profit system is not the only alternative for holding managers accountable for capital usage.
Other bottom-line, summary performance measures, such as ROI, RONA, ROE, ROC, can be used for
that purpose. So can any of several combination-of-measures systems, such as those focused on key
performance indicators, management-by-objectives (MBO) systems, and Balanced Scorecards. These
latter systems can hold managers accountable for capital-related measures, such as asset turnover,
inventory turnover, and days receivables.
Economic profit measures are intuitively appealing because they are consistent with finance theory. They
signal to managers that they should make all investments promising returns greater than the companys
cost of capital.
However, there is evidence in the case, and also in some academic research studies, that economic profit
measures are not highly correlated with stock price changes and, hence, shareholder value. The
correlation between economic profit measures and shareholder returns is probably higher in good
economic times, when most performance indicatorsshareholder returns and economic profits, as well as
accounting returns, profits and salesare all generally trending upward. It is lower when the economic
cycle is changing.
The problem is that shareholder value is based on market estimates of the future, while economic profit,
like accounting profit, is a backward-looking measure. Economic profit measures do not provide the
measurement panacea that their label implies.
The second and third assignment questions, which will be time consuming for the students, are clearly
optional. They are designed to force students to get into the detail of the economic profit and bonus
calculations. Without the numerical example, many students will gloss over the details of the calculations,
assuming that they understand how the system works. But, there are a lot of complexities to comprehend.

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The completed table is shown in Exhibit TN-2. To do these calculations, students must prepare the
advertising expenditure amortization schedule, as shown in Exhibit TN-3. The economic profit
calculation is shown in Exhibit TN-4.
The answer to assignment question #3 is shown in Exhibit TN-5.
The fourth question asks students for an evaluation of the new system. Each of the elements of the system
can be evaluated separately. Each element has its advantages and disadvantages. Students should
understand that there is no perfect system.
Are economic profit measures congruent with changes in shareholder value? There is indication in the
case that it is not. But it may not be any worse than the various accounting measures, and it is better than
just accounting profit, which does not have an asset focus in it.
The automatic ratcheting of performance targets has the advantage of taking politics and gamesmanship
out of the target negotiation processes. But a ratcheting system does not use any knowledge about
changing business conditions and prospects. The problem in the Spirits Division illustrates this problem.
Is the 75% ratcheting parameter appropriately responsive to improving or declining performance?
The elimination of payout thresholds and caps is generally a good idea. The lower and upper payout
constraints create ranges where there is no link between performance and rewards. Thus they can
undercut motivation and stimulate gamesmanship in those performance ranges. But companies that use
such constraints argue that they should not have to pay bonuses for performance that is not above minimal
levels. And they worry that extremely high payouts are likely to be more due to uncontrollable luck
and/or poor bonus plan calibration than they are to extraordinarily good management performance.
The bonus bank idea is good in that it smoothes out the bonus payouts. This can be helpful to managers
faced with paying a largely fixed set of personal expenses (e.g., mortgage). The bonus bank also provides
an employee retention benefit. If managers leave the company, they forfeit all the remaining balances in
their bonus bank. But the bonus bank makes the payouts less responsive to changes in performance. This
can be seen in Exhibit TN-5. Thus it can dilute the motivational messages that the incentive system is
trying to provide to the managers.
A general criticism that students can make of the system, too, is that it is relatively complex. Can
managers understand all the elements of the system, which is quite different from what they were
accustomed to? If they do not understand all the details, does it really matter? Is all the complexity
necessary?
The fifth question asks whether Mr. Embleton should make some kind of special allowance for the Spirits
Division of Berkshire Industries in 2000 and 2001. This is a controllability issue. The poor economic
conditions seem to be out of the control of the managers of the Spirits Division. If budgets were prepared
for this division, the budgets could reflect the poor conditions. Use of a ratcheting system for setting
performance targets does not take economic conditions into consideration. Should Mr. Embleton have
empathy for the Spirits managers? One purpose of implementing the economic profit system was to
reduce the amount of discretion in the assignment of bonuses. On the other hand, if the division will truly
suffer significant employee turnover because of the loss of bonuses, perhaps some intervention is called
for.
Pedagogy

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The teaching of this case will depend significantly on how much the instructor wants to get into the
calculation of economic profit and the bonus awards. If the instructor wishes to have the students develop
all the numerical answers to the assignment questions as posed, a reasonable timing for a 75-minute class
is as follows:
The company and its need for change
The economic profit and bonus calculations
Evaluate the system and possible alternatives
The issue in the Spirits Division

10 minutes
30
25
10
75 minutes

Exhibit TN-1
Operating Data from Berkshire Industries Snack Foods Division (000)
1996

1997

1998

1999

2000

2001

137,051

162,401

184,898

194,321

(26,410)

(31,007)

(41,568)

(39,191)

(15,000)

(30,000)

(30,000)

Net operating profit before taxes

110,641

116,394

113,330

125,130

Income tax payments

(41,293)

(51,501)

(54,131)

(60,327)

69,348

64,893

59,199

64,803

593,040

630,268

580,920

568,113

15,000

45,000

75,000

28,0001

50%1

50%1

From the income statement:

Net operating profit before the
following items:
Consumer advertising expense
Goodwill amortization

(20,661) (23,730)
0

Net operating profit after taxes

(NOPAT)
From the balance sheet:
Net operating assets (book):
Accumulated amortization of goodwill

Economic profit
Economic profit performance target
Division managers bonus:
Target bonus
Bonus payout (% salary)
Note:
1

Established by management.

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1) Cumulative advertising expense through the end of 1997 is 181,410.

2) Cumulative advertising amortized through the end of the 1997 is 167,507.
Exhibit TN-2: Berkshire Industries Snack Foods DivisionCompleted Table (000)
1996

1997

1998

1999

2000

137,051

162,401

184,898

194,321

(26,410)

(31,007)

(41,568)

(39,191)

(15,000)

(30,000)

(30,000)

Net operating profit before taxes

110,641

116,394

113,330

125,130

Income tax payments

(41,293)

(51,501)

(54,131)

(60,327)

69,348

64,893

59,199

64,803

593,040

630,268

580,920

568,113

15,000

45,000

75,000

Net operating profit before the

following items:
Consumer advertising expense

(20,661) (23,730)

Goodwill amortization

Net operating profit after taxes

(NOPAT)
Net operating assets (book):
Accumulated amortization of goodwill

2001

Economic profit

32,256

29,309

Economic profit performance target

28,000

31,1922

Division managers bonus:

Target bonus
Bonus payout (% salary)

50%

50%

43.9%4

65.2%

Exhibit TN-3: Consumer Advertising Amortization Schedule for Snack Foods Division (000)
Consumer advertising expense
Amortization (3-year period):
1996 expend.
1997 expend.
1998 expend.
1999 expend.
2000 expend.
2001 expend.
Amortization of advertising expenditures
under economic profit

2
3
4

1998

1999

2000

2001

26,410

31,007

41,568

39,191

6,887
7,910
8,803

23,600

7,910
8,803
10,336

27,049

8,803
10,336
13,856

10,336
13,856
13,064

32,995

37,256

Cumulative advertising expense since

company was founded

207,820

238,827 280,395

319,586

Less cumulative advertising amortized

through end of 1998 if economic profit had
been used

191,107

218,156 251,151

288,407

28,000 + (32,256-28,000) * 0.75

0.50 + [(32,256 28,000) 28,000] * 1 = 0.652 (i.e., 65.2%)
0.50 + [(29,309 31,192) 31,192] * 1 = 0.439 (i.e., 43.9%)

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Net capitalization of advertising for

economic profit calculation of capital

16,713

23

20,671

29,244

31,179

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Exhibit TN-4
Economic Profit Calculation for Snack Foods Division (000)
2000

2001

Net operating income

before taxes

113,330

125,130

Add back: Consumer

advertising expense

41,568

39,191

(32,995)

(37,256)

30,000

30,000

Adjusted net operating

profit before taxes

151,903

157,065

Current years income tax

payments (from Exhibit
TN-1)

(54,131)

(60,327)

97,772

96,738

580,920

568,113

Add: Capitalized
advertising expenditures

29,244

31,179

Add: Accumulated
goodwill amortization

45,000

75,000

Adjusted Capital

655,164

674,292

Capital charge (10%)

65,516

67,429

Economic profit

32,256

29,309

NOPAT:

Subtract: Amortization of
advertising expenditures
under economic profit
Add back: goodwill
amortization

Adjusted NOPAT
Capital:
Net operating assets
(book)

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Exhibit TN-5
Bonus Bank Balance Calculation for Manager of Snack Foods Division (000)
2000

2001

13,6805

Excess bonus earned

18,2406

(7,320)7

Balance in bonus bank

18,240

6,360

4,560

1,590

60,000

60,000

61,590

Beginning balance in bonus bank

Excess bonus paid to manager

Target bonus
Bonus paid to manager

5
6
7
8

64,560

18,240 4,560
15.2% x 120,000
-6.1% x 120,000
60,000 + 25% * 18,240

25