Chapter 23 Contrc,l: The Management Cont,.
ol process 727
addition to the support services charge, staffpC users billing change. Each had pC-LAN systems. Rex Dorman
would still be billed the same depreciation expense, knew he would receive some complaints from these
but now a22percentPRoTc markup would be added. departments who originally based their decisions to
This markup would add approximately one-third to the use PCs on a cost comparison with mainframe use
PC purchase price. before the billing change. Rex said ,.We know that
CDPS managers noted that this solution for charging some people will complain, but pCs have been subsi_
for PC costs would require mainfiame users to continue dized up to this point and they [pC users] need to start
subsidizing PC support costs for a few years. But even carrying a portion of their costs.,,
so, this change accounted for l0 percent ofthe 24 per-
cent reduction in billing rates planned for 1992.
Questions
The effect on users ofthis change was varied. The
Timber and Wood Division would benefit from the l. Is Boise Cascade's CDpS a profit center?
change. It was an operating group and, therefore,
2. Evaluate the CDPS billing system. Do Dwight
owned all of its PCs. In addition, it used a lot of main-
Kirscht's criticisms have any merit?
frame CPU time, and did most of its interfacing
with the mainframe computer through dumb termi- 3. Evaluate the new system for charging for the use of
nals. The Legal, Corporate Communications, and personal computers?
Planning departments would be hurt most by the
Case 23-5
Berkshire Industries PLC*
We had to do something different. The company was had grown, both internally and by acquisition. In2002,
doing great according to all the performance indicators Berkshire was a medium-sized, publicty held corpora-
we monitored and our managers were earning nice tion focused on the beverages and snack foods indus-
bonuses, but the shareowners weren't benefiting. try. It had annual turnover of about f500 million and it
Embleton employed nearly 3,500 people in six countries. Berk-
-William shire was listed on the London Stock Exchange. The
William Embleton, managing director of Berkshire In- company headquarters were still located in Manches-
dustries PLC, explained why his company had imple- ter, England, where the company was founded.
mented a new incentive system based on an..economic Berkshire had four operating divisions: beer, spir-
profit" measure of performance starting in the year its, soft drinks, and snack foods. The managing direc-
2000. In 2002, however, Berkshire managers were of
tors each of these divisions had considerable
questioning whether their new system had had its de- autonomy because Berkshire operated in a decentral-
sired effects. The new economic profit measure did not ized'fashion. The small headquarters staffwas primar-
seem to be any better in reflecting shareowner returns ily responsible for coordinating the finance, human re-
than did the old measure-accounting earnings-on sources, and various administrative functions (e.g.,
which Berkshire managers had previously focused. And legal, information systems).
the new system was causing some management confu-
sion and a perceived unfairness issue. Mr. Embleton MEASUREMENT AND INCENTIVE SYSTEMS
had to decide whether to modify the new system, and if Since the company had gone public, the primary
so how, or to replace it with something else.
performance emphasis at Berkshire had been on cor-
THE COMPANY porate earnings per share (EPS). The company,s long-
term EPS growth target was 8 percent, but the target
Berkshire Industries PLC (Berkshire) was founded in
was modified each year based on anticipated market
1852 as a brewery serving local pubs. Over the years it
conditions and pending acquisitions, ifany.
* Copyright O by Kenneth The company's annual planning process was a
A. Merchant and Wim A. Van der
Stede, University of Southern California. bottom-up process, which flrst involved the operating
728 Part 2 ManagementAccounting
divisions proposing their earnings targets for the year EPS was not a good msasure of perfoimance in the
and their means of achieving them. The division.s draft
new era where the management mafttra had becorm ET
plhns were consolidated and compared with Berkshire's
"maximization of shareowner yalue.,, Thsy nslsd thd
coryorate EPS growth target. Typically the difference while Berkshire's EpS had been improvin! sreadily, a
between the divisions'plans and the corporate target was
an average annual growth rate of9 percent in the last
material. This "planninggap', was eliminatedin a series of
decade, the company's shareowners had nct benefited
discussions among corpffate and division managers, The company's share price had increased only slightly
typicatly by increases in some or all divisions, targets- over that period oftime.
Because top management considered it so impor_
Second the board wanted to force more objectiriq, ;
tant to meet analysts: EpS expectations, they also es_ into the performance er,aluation and reward systeJ. i
tablished a corporate "profit reserve', of approximately Some board members believed that too many subjectirc Aa
10 peroent of planned earnings. This reserve was es_ bonus awards were being made, giving managers l9!
tablished to ensure that the corporation would achieve t9!
bonuses even in yoars where theiratity did not perform
its targets even ifone, or perhaps even two, ofits divi_ well. One effbct of allowing subjective judgments was 2rr
sions failed to achieve their targets. If, later in the year,
that bonus awards were only loosely correlated with the M
management determined that the company would Adr
realized operating performances. Another effect was a
achieve its targets, they would release this reserye to
the Investments Committee for spending on discre_
lot of misspent time, as manage$ engaged in..politick_ __I
ing." They tried to comrince their evaluators that thq,
tionary projects, most of whieh had relatively long_ Cur
had performed well, wen though the results were disap
term payoffs. But in 2000 and 2001. none of this re_ (o
pointing. The board members in fayorof changethought l"t
serve was released to the Investments Committee. All that a new incentive system should place sharp limits on
of it was turned in to meet the corporate EpS targets.
Senior mlnagers at Berkshire, a group of about
the use of subjectivity in granting bonus awards, if not q
eliminate it entirely.
40 people, parlicipated in an aanual incentive compen-
sation plan. Performance was evaluated based on
rFl
achievernent ofearnings targets in the entity to which THE NEW SY5TEM
the malager was assigned: a division in the case of di_ In rosponse to &e board's rsquest, William Embleton
visionlevel personnel or the entire corporation in the asked three consulting firms to submit proposals for an relatir,r
case ofcorporate-level personnel. The taryet bonuses engagement to design a Rew measurement and incen_ cost-ol
ranged from 20 percent to 90 percent of base salary, tive system. After a series of meetings, the Berkshire Ine
depending on the manager,s level of seniority. The management team and board selected the large Neu a speci
plan allowed for subjective overrides of bonus awards Yorh-headquartered flrrn of Corey, Langfeldt and make d
if superiors, or the compensation commiftee of the Associaies (CLA). The consulting engagement was matchr
board of directors in the case of top management, fblt staffed by CLA associaies based in Londoa. lationstr
that performance shortfalls were caused by factors The CLA approach was based on the firm,s propri_ The CL
beyond the manager's control. etary "economic profit" measure of performance. The 100 adji
CLA formula for economic profit was: tions. B
posed a
THE MOTIVATION FOR A NEW Economic profit
keep ttre
INCENTIVE PLAN Adjusted net operating profit after taxes
companj
In 1999, Berkshire's board of directors asked William [Capital X Cosr of capital] capitaliz
Embleton to explore the desirability of a new perfor_ Net operating proflt after taxes (NOpAT) excluded all thtee y'ea
maoce measurement and incentive system based on an non-operating non-cash charges, such as depreciation, to operat
"economic profit" measure of performance, a concept added to
amortization, asset write-offs and write-downs, and
that had received many popular reviews in the man_ reserves, Cost of eapital was determined annually for example-
agement press. each business unii trased on the yield on long_term Secon
The board's motivation for a new plan stemmed govrnment obligations plus a risk premium calcu_ goodwill
from two concerns. First, they were concerned that lated based on an assunied capital structure and risk tions shor
managers' interests were not aligned with those of factor (p value) for comparable peer firms. Since rln the
shareornners. They were particularly concerned that Ur*
Berkshire's business units were all seen' as being in amortizatio
also preserl
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73O Part2 ManagementAccounting
systems, they explained, were usually hopelessly com- A third element of the system was the explicit elim_
plex. The systems typically incorporated measures ination of payout thresholds and caps. Managers were
that were not directly linked with shareowner value. assigned a target bonus, a fixed percentage of base
They included performance concepts that were vague pay, that would be earned if their units just achieved
(for example, personnel development) and supported their performance targets. These targets were increased
by weak measures. And they rarely made the trade-offs slightly from the bonus levels that were earned under
among the multiple measures clear. The overall effects Berkshire's old system to encourage managers' accep-
were diffi..rsion of management attention and loss of tance of change. The target bonuses ranged fiom
understandability and accountability. 20 percent of base salary for functional managers
The CLA consultants also recommended against within a division to 100 percent for Berkshire's man-
the implementation of a stock-based incentive pro- aging director. Ifthe units exceeded their performance
gram. They pointed out that stock prices are affected targets, managers would earn larger bonuses. The
by many external factors and are highly volatile in the slope of the line determining the payoffs for each level
short-term. They further explained that stock-based in- of economic profit was based on each unit's historical
centives are not an effective tool for motivating divi- growth rate. This slope was intended to remain the
sion- and lower-level managers who can have, at best, same from year to yeaq although it was subject to
a modest impact on share prices. board review. The maximum bonus that could be
The measurement-focus of the CLA presentation earned was unlimited (see Exhibit 2).
was highly convincing to some of the board members. The fourth element ofthe system was a "bonus bank"
One remarked: that was intended to reduce manager {isk by smoothing
out the bonus awards, to reduce managers' short-term
This is what we need, one simple measure that
goes up when shareowner value is created and that gaming behaviors, and to improve manager retention. If
goes down when value is destroyed. If we get our a unit's economic profit performance exceeded the per-
managers focused on this measure, they will be formance target, the "excess" bonus earned (calculated
working in the best interest of our shareowners. as the slope of the payoff function times the amount by
With earnings, we just don't know what we're which the actual economic proflt exceeds the target) was
getting. credited to the bonus bank. Managers were then paid
their target bonus plus one-fourth of the amount in the
A second of the CLA system involved the
"I"*.nt of performance targets. In the bonus bank. If economic proflt fell below the target
automatic ratcheting
amount, a negative entry (obtained as the slope of the
CLA system, managers were compensated directly payoff function times the amount by which the actual
for improving their entity's economic profits. In the
economic profit fell short of the target) was made to the
first year, the performance targets were set based on a
bonus bank. Ifmanagers changed divisions, their bonus
projection of the unit's historical economic profit
bank amounts would follow them. Managers who left
growth rate, if that growth rate was deemed to be
Berkshire voluntarily forfeited the amounts in their
good performance, multiplied by 75 percent. There-
bonus bank accounts.
after, performance targets were set automatically
based on improvements from the actual performance
PROBLEMS AND CONCERNS
of the prior year. Each business unit's performance
target was ratcheted up (down) by 75 percent of the While Berkshire's board members' and managers'
amount by which actual pelformance exceeded (fell hopes were high after the company's introduction of the
short of) the unit's prior year's performance. The new economic profit system in 2000. early experiences
CLA consultants explained that this method of set- with the system were disappointing. The new system
ting targets avoided the need to renegotiate perfor- had caused several problems and concerns. The board
mance targets each year and, hence, the politics and and the top management team were considering
gameplaying that was almost inevitably associated whether the system needed fixing. Some even ques-
with these negotiations. It also incorporated the de- tioned whether the new system should be continued.
sired management philosophy of continuous im- One problem was that the new system had created
provement. considerable management confusion, which persisted
I
I
ExHlBlr 2
Chapter
Link between Economic profit performance and Bonus Awards
Bonus
23
.Control:
The Management Conttol process 73.1
Award
(% ofsalary)
( v.^r1 Targer
| + 0.75 x (Year I
I Actual - Year I
I
t
Target)
Year 1 Year 1 Economic Profit
Thrget Actual
even after all the operating managers had attended a se- had sizable negative balances in their bonus bank
ries of training sessions. Corporate managers thought accounts.
that the operating managers would quickly learn how Ian Dent, Spirits'managing directog asked William
the economic profit measure worked, since their Embleton for some special adjustments. He requested
bonuses now depended on it. But a number of the man- that the Spirits division performance targets be ad-
agers seemed not to understand how the economic profit justed retroactively to reflect the economic conditions
measure was computed, and some of them continued to that were actually faced. He did not think it was fair for
manage their entities based on their old earnings-based his managers to suffer the negative effects of factors
management reports. over which they had no control. He explained that his
A second problem was discouragement and demo- team had worked very hard in the trying conditionsthey
tivation in the Spirits Division (Spirits). In both 2000 had faced and they had made the hard decisions that
and 2001 , economic profits in Spirits were poor. In the were called for, including cutbacks in discretionary
recessionary times, consumers were drinking less expenses and layoffs. He also requested that the eco-
spirits. With consumer demand down, some of the nomic profit system not be applied to his division
Spirits Division's competitors cut prices significantly because it was not responsive to changing market con-
and Spirits had to match their reductions. This had a ditions. Ian was worried that his division would suffer
disastrous effect on margins. Spirits failed to achieve some significant management losses because of his
both its 2000 performance target and its ratcheted- managers' negative bonus bank balances.
down 2001 target, by wide margins. As a conse- A third problem was a widely shared perception of a
quence, bonus.awards for Spirits managers were sig- basic failure of the economic profit measure itself. Over-
nificantly below target levels, and all Spirits managers all, Berkshire's performance, as measured in terms of
732 Part2 ManagementAccounting
EXHIBIT 3 Berkshire Industries'Earnings, Economic Profit, and Stock Price,
1997*2002
I (millions) Stock
price
(r)
30
20
i0
economic profit, seemed excellent. Economic profit
had improved since 2000, but the company's stock
Questions
price had actually declined over this period (see Exhibit
1. Evaluate Berkshire's measurement and incentive
3). The CL.d consultants had sold the new system
system. Would you continue using the system? If
based on a promise of a high correlation between the
not, why not? If so, what changes would you sug-
company's economic profit numberc and returns to
gest, and why?
shareowners, but to date, at least, the economic profits
did not seem to be moving in parallel with the stock 2. What, if anything, should Mr. Embleton do to alle-
price. The shareowners had not beneflted. viate the problem in the Spirits division?
