The annual bonus for senior managers at Wanstead Engineering was first agreed in 1998. Since then the company has seen no need to make any changes to the way in which the bonus is calculated. Both shareholders and managers agree the bonus is important, as it is a major factor in motivating and rewarding managers to maximize the agreed corporate objectives. The bonus scheme has also helped the company to retain senior managers. Shareholders want to see a steady improvement in the share price for a given level of risk and the directors are responsible for designing the remuneration systems.


Details of bonus calculation

The original forecast presented by managers was prepared on the assumption that no funds were available for investment in new products. Investments that have already been approved are considered essential to maintain current production capacity.

Original forecast – no funds available for investment in new products

Year 2001 2002 2003
*Profit £6 million £5 million £4 million
Capital employed (at beginning of year) £77 million £79 million £81 million


*Profit is calculated before tax and interest

The bonus is calculated by multiplying the ROI percentage by £1,000 if the capital employed is below £80 million and by £1,100 if the capital employed is greater than £80 million.

The group ignores tax and depreciation when calculating bonuses and the capital employed is the opening balance at the start of each and excludes cash balances which are held in a group account







Example: Capital employed = £50,000,000
ROI = 7.143%
Bonus = 7.143 X £1,000 = £7,143

Investment in new products


After receiving the forecast above senior managers were asked to identify three investments in new products. The company has been asked to only consider projects with cash inflows in 2002 and 2003. Although the senior managers were asked to identify 3 projects only 1 would be accepted.

Cost of capital is 10%

Project 1
Year 2001 2002 2003
Cash flow -£5 million £4.5 million £1.5 million
Net present value £330,579



Project 2
Year 2001 2002 2003
Cash flow -£2 million £0.1 million £3 million
Net present value £570,248



Project 3
Year 2001 2002 2003
Cash flow -£0.5 million Nil £1 million
Net present value £326,446



Questions

Question 1

Discuss why the bonus scheme could result in poor decisions and cause conflict between shareholders and senior managers.

Question 2

What changes would you like to see to the way in which bonus is calculated? Discuss why strategy is important when identifying financial objectives for a business unit.

GDHHsd

Question 1: Discuss why the bonus scheme could result in poor decisions and cause conflict between shareholders and senior managers.

The bonus scheme at Wanstead Engineering is based on the calculation of the ROI (Return on Investment) percentage. This means that the bonus amount is directly tied to the profitability of the company, as measured by the ROI. While this can be a motivating factor for managers to maximize corporate objectives, it can also lead to poor decision-making and conflicts.

One potential issue with this bonus scheme is that it does not take into account factors such as tax and depreciation. By ignoring these factors, the bonus calculation may incentivize managers to focus solely on maximizing profitability without considering the overall financial health of the company. This could lead to decisions that prioritize short-term gains over long-term sustainability.

Furthermore, the bonus scheme only considers the capital employed at the beginning of each year and excludes cash balances from the calculation. This means that managers are not incentivized to make efficient use of existing cash resources and may prefer to hold excess cash rather than investing it in projects that could generate higher returns.

As a result, conflicts may arise between shareholders and senior managers. Shareholders, who are focused on the steady improvement of the share price and want to see a good return on their investment, may feel that the bonus scheme does not align with their objectives. They may argue that managers should be incentivized to make strategic investments and consider factors such as risk, cost of capital, and long-term growth prospects.

Question 2: What changes would you like to see to the way in which bonus is calculated? Discuss why strategy is important when identifying financial objectives for a business unit.

To improve the bonus scheme at Wanstead Engineering, several changes could be considered:

1. Consideration of Tax and Depreciation: The bonus calculation should take into account factors such as tax expenses and depreciation. This would provide a more accurate reflection of the company's financial health and ensure that managers are incentivized to make decisions that align with long-term sustainability and profitability.

2. Inclusion of Cash Balances: Including cash balances in the bonus calculation would encourage managers to make efficient use of existing cash resources. They would be motivated to invest excess cash in projects that can generate higher returns, rather than holding onto it idly.

3. Incorporation of Risk Factors: The bonus scheme should consider risk factors associated with different projects and investments. Rather than solely focusing on ROI, the scheme could incorporate measures such as the cost of capital to assess the risk-adjusted return on investment. This would incentivize managers to consider the level of risk associated with different projects and make decisions that balance potential returns with acceptable levels of risk.

4. Alignment with Strategic Goals: Strategy is important when identifying financial objectives for a business unit. The bonus scheme should be designed to align with the company's overall strategy and long-term goals. This would ensure that managers are incentivized to make decisions that contribute to the strategic direction of the company and promote sustainable growth.

By incorporating these changes, the bonus scheme can be improved to align the interests of shareholders and senior managers, while also encouraging decision-making that takes into account the overall financial health and long-term objectives of the company.