FINANCE QUESTIONS

Finance Questions



Finance Questions

Question 1

Annual Incentive Plan:

At Duckworth industries, the senior managers (about 40 people) were part of the annual incentive compensation plan. This compensation plan was targeted toward division mangers and considered accounting variables such as cash flows, sales, inventory turnover, account receivables, gross margins, and other special projects in determining the bonuses of these managers. One major flaw of the plan was that it did not provide any incentive for managers to maximize those variables (e.g. profitability) that were not factored into the determination of manager bonus levels. Thus, a manager might be inclined to maximize sales growth and ignore profitability, as he had no incentive to maximize profitability. Another flaw with the existing system was that because it considered several accounting variables, it allowed managers to "cook the books" in order to achieve target margins. Additionally, the manager may provide excessive discounts in order to increase inventory turnover, while he may concomitantly increase cost of goods sold and other related expenses to reduce overall profitability. Another flaw of the plan was its failure to consider measurable parameters of product quality. Although the plan provided incentives to increase the numbers of units being sold, it did not take into account those units that were returned due to product defects. Again, such a scenario, in which a significant portion of managers' sales volume consists of defective units, will damage the company's credibility, market reputation, and ultimately hurt the company's profitability.

In 1990, the Duckworth shareholders finally realized the shortcomings of the existing incentive plan and made some fundamental changes to appropriately compensate the division mangers. Although the new plan incorporated parameters such as sales growth and profitability, this plan was still not perfectly aligned with corporate goals. The new plan still allowed division mangers to modify the accounting figures such that profitability was shown to increase annually. Additionally, this new plan stipulated that the accounting figures must improve annually; thus, there existed no incentive for managers to work any harder than was necessary to achieve a slight improvement over the previous year's figures. By intentionally limiting the growth of the important accounting numbers, managers could control the target numbers that were required for them to achieve bonuses.

Long Term Incentive plan

The long-term incentive plan initially covered only two executives and consisted of a phantom stock that made only one payment at the end of a five-year term. The performance factor that was used to determine the level of compensation was based on accounting numbers including the ROE and the annual growth in the net book value. Because this plan made only one payment at the end of the fifth year, it provided little incentive for managers to work diligently during the off years. Additionally, this plan promoted an attitude of neglect for those mangers that were performing poorly during the first half of a year; such managers could simply adopt a lackadaisical work ethic for the second half of such a year because he/she could start over the following ...