Purpose of Case

This case can be used to motivate discussions of a number of topics, including

financial responsibility centers, performance measurement, transfer pricing,

and incentives. The setting is an automobile dealership, a business about

which all students have some interest and understanding. And the setting is

real, so students can benefit from secondary learning about the industry and

business.

Because the incentives provided in this company, and the US automobile

dealership sector in general, are quite substantive, a significant portion of the

case discussion can be usefully devoted to examining and critiquing this

company’s performance measurement and incentive systems. But Puente Hills

Toyota has some features that, individually and in combination, make it

different from most other companies described in cases that focus on

incentive systems. This company is privately held; it makes use of some

nonfinancial performance measures; it provides incentives to personnel well

below the management level; and its managers are well aware that people are

“playing games” with some of the measures.

The Puente Hills Toyota case can also be used in conjunction with the Kooistra

Autogroep case study, which is also included in this textbook. Kooistra

Autogroep and Puente Hills Toyota are both automobile retailers with highly
similar organization and industry characteristics. But that is where the

similarities end. Kooistra Autogroep is based in the Netherlands where

incentive pay is much less prevalent. Even though there is some evidence that

even in the Netherlands companies begin to increasingly provide incentive

pay, its advent is nonetheless controversial and not yet well accepted.

Therefore, comparing and contrasting both cases (in one class or, alternatively,

two separate classes) can lead to useful discussions about cross-cultural

differences in the provision of incentives and in perceptions about the

effectiveness of incentives.

This note was prepared by Professors Kenneth A. Merchant (University of

Southern California) and Wim A. Van der Stede (London School of Economics)

for the sole purpose of aiding classroom instructors in the use of the Puente

Hills Toyota case. It provides analysis and questions that are intended to

present alternative approaches to deepening students' comprehension of

business issues and energizing classroom discussion.

Copyright 2007 by Kenneth A. Merchant and Wim A. Van der Stede. All rights

reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted in any form or by any means without permission.

Suggested Assignment Questions

1. Evaluate the performance measurement and incentive systems used at

Puente Hills Toyota. What changes would you recommend, if any?

2. At Puente Hills Toyota, most employees’ variable incentive pay increases

linearly with performance, however performance is defined; that is, the higher

the performance, the larger the bonuses that are paid. In most large

companies, however, particularly at managerial levels, no bonuses are paid

until a minimum level of performance, such as a budget goal, is exceeded.

What are the advantages and disadvantages of using a reward/performance

function like Puente Hill Toyota’s?

3. (When used in conjunction with Kooistra Autogroep.) When comparing the

use of incentives in the Puente Hills Toyota and Kooistra Autogroep cases, do

you believe that incentive pay is truly effort-inducing; that is, drive employees

to perform at their best? If you believe incentive pay is not, in whole or part,

effective in making employees work harder, then what other potentially useful

purposes does variable incentive pay provide for organizations relying on it, if

any?

Case Analysis

Responsibility Centers

The case illustrates clearly that financial responsibility centers exist in great

variety. While textbooks describe the possible generic responsibility centers as

cost centers, revenue centers, profit centers, and investment centers, this case

shows some of the variance that can exist within these generic categories. The

general sales manager is held accountable for net profit. Obviously, the

dealership also keeps track of balance sheet items, but the dealership general

manager’s incentives do not seem to consider them. So is the general

manager an investment center manager?

Similarly, the departments are profit centers, but not all costs are allocated to

them. They are more like “gross profit centers.” The salespeople are held

accountable for gross profit on the deals they initiate, so each salesperson is

also a “little profit center.” The service advisors are paid on commission, so

each advisor is a revenue center. The service technicians, though, are paid for

work accomplished.

It is useful to discuss why some seemingly uncontrollable indirect costs are

allocated to departments (see Exhibit 3). These allocations are mandated by

Toyota, so that they can compare dealership departments on a common basis

that treats each department more or less as a stand-alone business. Allocating

the costs also gives the department managers information as to what services

are being provided for them and it gives them some power to complain if the

size of the allocations becomes too high.

This issue can lead into a discussion of the differences between authority and

accountability. Managers are generally held accountable for results in areas

where they have authority. But the general sales manager’s bonuses are based

on performance measured in terms of profit after overhead allocations (line 59

in Exhibit 3). This is an example of a situation where this manager is held

accountable for areas over which he has less than full authority. Conversely,

the service manager’s bonuses are based on the department’s gross profit

performance, which is before allocations.

Merchant & Van der Stede, Management Control Systems, 3rd edition,

Instructor’s Manual

Transfer Pricing

Transfer pricing of service jobs done for internal customers (particularly the

Used Car department) is done at market prices. The alternative would be to

give the internal customer a discount, or perhaps even to transfer at cost.

What would happen under that alternative? It would shift profits from Service

to Used Car. It would also provide little incentive for Service to do internal

work. Puente Hills Toyota transfers at market prices because they want to

measure each department as a stand-alone business and they want to have

the Used Car department get as much priority in the Service area as any other

customer.

Performance Measurement
The measurement focus in this business is on profit measures. Do profit

measures provide a good indication of value creation in the car retailing

business? The answer here is probably yes. This is primarily a short-term

business. Dealerships are not making many investments that involve large lags

between time of investment and payoff (such as R&D), and they are not

creating many intangible assets. The one exception is customer goodwill, so it

is not surprising that Toyota mandates that considerable effort also be

devoted to the measurement of customer satisfaction (CSI).

It is apparent in the case, however, that some of the measures can be gamed.

Puente Hills Toyota managers worry about the gaming in the service area, and

they seem to have adequate controls over these behaviors. The CSI measure is

also gamed. But here the managers seem to “condone” the gaming because it

makes the dealership look better to Toyota. Does the dealership need an un-

gamed CSI measure for its own management purposes? How will they get

accurate information about customer service problems if and when they exist?

Incentive Plans

Useful class time can also be devoted to a discussion of the structure of the

incentive plans. Depending on the focus of the class and the class time

available, the instructor can have the students complete an incentive plan

matrix. On a whiteboard, list any or all of the key incentive plan elements. With

adequate time, instructors can address the following:

Eligibility (i.e., who is included in the plan?) Form of payment

Frequency of payment

Measure(s) and their importance weighting Performance standards

Shape of reward/performance function Size of reward (expected, maximum)

Funding (e.g., is there a company bonus pool constraint?) Uniformity (are

people in the same role treated the same?)

In an array of columns, list the roles for which the instructor wants to clarify

the incentive system. In this case, these might include the general manager,

general sales manager, service manager, salespeople, service advisors, or

service technicians.

Among other things, this analysis will show that: The payments are all in cash.

The payments are timely (monthly).

The bonuses are paid by formula; there is no bonus pool constraint.

There are no performance standards except in the service technician area

where standards are set by Toyota. Internally set budgets are used to calibrate

the payoff function, but goal- setting does not seem important in this

business.

The service manager reward/performance function is kinked upward to

encourage beating the budget.

The rewards are quite lucrative.

The first assignment question asks students for an evaluation of the

performance measurement and incentive system, which requires them to

identify good and bad points about it. In addition to the points raised above,

students might mention the following:

1. There are no deferred compensation elements that might provide retention

and tax benefits. 2. This is an incentive system that would require the company

to pay sizable bonuses even if

the company is losing money.

3. There is no bonus for teamwork. How much teamwork is necessary? The

case mentions one area that could be improved—service referrals to sales.

4. Is the company paying too much? Answering this question would require

knowledge of industry benchmarking. Some of these data are provided in the

case Appendices. Puente Hills Toyota’s practices seem in line with other

dealerships.

5. The bonuses are all formula-based. Would it be useful to allow some

subjectivity in case unforeseen events unfold or to reward otherwise hard-to-

measure aspects of inherently multitask jobs?

Generally, however, this measurement and incentive system probably must be

considered as effective. Much of this system is dictated by Toyota, and this is

an industry and company that has refined its systems over the years. And

within the Toyota family, Puente Hills Toyota is a top performer.

The second assignment question asks students to evaluate the features

of linear incentive pay increases with performance, as opposed to incentive

schemes with a floor where no bonuses are paid until a minimum level

(“hurdle”) of performance, such as a budget target, is exceeded. “Kinks” in the

function that relates incentives to performance (such as a floor (but also a cap)

on

Merchant & Van der Stede, Management Control Systems, 3rd edition,

Instructor’s Manual

performance) create temptations for “gameplaying.”3   Therefore, compared to kinked or

hurdle-  type incentive schemes, linear or commission-type incentive schemes

remove these temptations.  A potential disadvantage of linear incentive

schemes, however, is that they also remove the motivational effects of

performance targets. In other words, the company pays bonuses from the first

dollar of profits earned (or sales booked) even though overall performance

during the period may be poor or mediocre at best (i.e., profits or revenues

fail to meet target).

Whether the benefits of removing gaming outweigh the loss of motivation

due to removing targets depends on the situation. Employees can be strongly

motivated by linear incentives schemes in situations where efforts, results, and

incentives are tightly linked, as is likely for sales jobs (where the efforts of a

salesperson can be directly linked with the sale) or production jobs (where the

efforts of a shopfloor worker can be directly linked with the quantity and

quality of output). In these situations, therefore, commissions (as they are

typically called in a sales  setting) or piece rates (as they are typically called in a

production setting), strongly motivate  employees to work hard to sell/produce

every unit, whether the first or the last, regardless of  where, or if, a target is set.

In summary, given the nature of the sales environment in automobile retailers,

Puente Hills probably can be said to reap the benefits of linear incentives

through reducing the scope for gaming while still providing strong motivation

to perform at any point in time during the performance period.

We address the third assignment question in the Teaching Note for the

Kooistra Autogroep case study.

Pedagogy

As with most case classes, instructors must make a decision as to how

structured to make the discussion. However, we recommend following roughly

the same structure, as presented in this teaching note, to allow sufficient

discussion time spent on all critical elements of any financial results control

system, including responsibility centers (and transfer pricing), performance

measurement, and incentives. To serve as an integration case, which this case

provides an opportunity for, some structure is required as otherwise students

tend to focus too quickly on the incentive system that undoubtedly tends to

capture most of their attention when reading the case.

3 For a more detailed discussion, as well as examples of the various “games” that managers play under kinked incentive schemes, see

Jensen M. (November 2001). “Corporate budgeting is broken—let’s fix it”.

Harvard Business Review, 95–101.

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

note as an aid to instructors using the Houston Fearless 76, Inc. case.

Copyright 2003 by Kenneth A. Merchant and Wim A. Van der Stede. All rights

reserved. No part of this publication may be reproduced, stored in a retrieval

system, or transmitted in any form or by any means without permission.