Wanstead Engineering

Case 9
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 year 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.

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 calculates the bonus based on the Return on Investment (ROI) percentage. The ROI is calculated by dividing the profit by the capital employed at the beginning of the year. However, this bonus scheme does not take into account tax, interest, or depreciation, which can affect the actual profitability of the company.

This can result in poor decisions by senior managers who might focus solely on maximizing the ROI without considering the overall financial health of the company. They might prioritize short-term gains and ignore long-term investments that could benefit the company in the future. This can lead to conflict with shareholders who are concerned about the long-term sustainability and growth of the company.

Additionally, the bonus scheme only considers the capital employed at the beginning of the year and excludes cash balances. This can incentivize senior managers to keep cash reserves low, as it would increase their bonus. However, this might not be in the best interest of the company, as having sufficient cash reserves is important for managing unexpected expenses or taking advantage of growth opportunities.

Overall, the bonus scheme's focus on ROI without considering other financial factors and the exclusion of cash balances can result in poor decision-making and conflict between shareholders and senior managers.

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

To improve the bonus scheme at Wanstead Engineering, it would be beneficial to consider the following changes:

1. Include a more comprehensive profitability measure: Instead of solely relying on ROI, the bonus scheme should consider a more holistic measure that takes into account all relevant financial factors, including tax, interest, and depreciation. This will provide a more accurate representation of the company's profitability and prevent managers from making short-sighted decisions.

2. Incorporate long-term performance metrics: Instead of basing the bonus solely on annual profit, it would be helpful to include long-term performance metrics such as revenue growth, market share, and customer satisfaction. This will encourage senior managers to focus on the long-term success of the company and avoid sacrificing long-term goals for short-term gains.

3. Consider a balanced scorecard approach: A balanced scorecard approach can provide a comprehensive view of a company's performance by considering financial, customer, internal process, and learning and growth perspectives. By incorporating multiple measures and objectives into the bonus calculation, senior managers will be encouraged to consider the overall health and sustainability of the business.

Strategy is important when identifying financial objectives for a business unit because it aligns the objectives with the long-term goals of the company. A well-defined strategy helps prioritize financial objectives that are consistent with the company's vision and mission. It ensures that financial decisions are in line with the overall direction of the company and contribute to its success.

Furthermore, strategy provides a framework for decision-making by considering external factors such as market conditions, competitors, and industry trends. It helps in identifying growth opportunities, managing risks, and allocating resources effectively. Without a clear strategy, financial objectives may be disconnected from the broader goals of the company, leading to sub-optimal decision-making and a lack of alignment between shareholders and senior managers.

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 solely on the return on investment (ROI) percentage and does not take into consideration factors such as tax, depreciation, or cash flows. This could lead to poor decisions as managers may focus solely on maximizing ROI without considering the overall financial health of the company. They may be inclined to make short-term decisions that boost ROI, such as cutting costs or deferring investments, which may not be in the best long-term interests of the company.

This misalignment of incentives between shareholders and managers can cause conflict. Shareholders, who are focused on the overall financial performance and steady improvement in share price, may demand a more comprehensive evaluation of the company's financial health. They may argue that the bonus scheme should take into account factors like cash flows, profitability after taxes, and the impact of investments on future growth. On the other hand, senior managers may resist changes to the bonus scheme as it may reduce their potential bonus payouts.

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. First, the calculation of the bonus could be revised to include factors such as tax, depreciation, and cash flows. This would provide a more comprehensive picture of the company's financial performance and ensure that managers are incentivized to make decisions that are aligned with the long-term interests of the company.

Additionally, the bonus scheme could be modified to include a component that rewards managers for achieving strategic objectives. Strategy is important when identifying financial objectives for a business unit because it provides a framework for aligning financial goals with the overall direction of the company. By incorporating strategic objectives into the bonus scheme, managers would be incentivized to make decisions that support the long-term growth and success of the company, rather than just focusing on short-term financial metrics.

Furthermore, the bonus scheme could take into consideration the impact of investments in new products or projects. Currently, the bonus calculation ignores the potential benefits of investments, which may discourage managers from proposing and pursuing new initiatives. By incorporating the net present value (NPV) of these investments into the bonus calculation, managers would be motivated to identify and pursue projects that generate positive NPV and contribute to the long-term growth and profitability of the company.

In summary, the changes to the bonus scheme should include a more comprehensive evaluation of financial performance, the inclusion of strategic objectives, and the consideration of the impact of investments. By aligning the bonus scheme with these factors, it would incentivize managers to make decisions that are in the best interest of the company's long-term success.