Chapter 12, Problem 30E

Evaluating Management Control Systems—Ethical Considerations

Magnolia Manufacturing makes wing components for large aircraft. Kevin Choi is the production manager, responsible for manufacturing, and Michelle Michaels is the marketing manager. Both managers are paid a flat salary and are eligible for a bonus. The bonus is equal to 1 percent of their base salary for every 10 percent profit that exceeds a target. The maximum bonus is 5 percent of salary. Kevin’s base salary is $180,000 and Michelle’s is $240,000.

The target profit for this year is $6 million. Kevin has read about a new manufacturing technique that would increase annual profit by 20 percent. He is unsure whether to employ the new technique this year, wait, or not employ it at all. Using the new technique will not affect the target.

Required

1. a.      Suppose that profit without using the technique this year will be $6 million. By how much will Kevin’s bonus change if he decides to employ the new technique? By how much will Michelle’s bonus change if Kevin decides to employ the new technique?
2. b.      Suppose that profit without using the technique this year will be $8.5 million. By how much will Kevin’s bonus change if he decides to employ the new technique? By how much will Michelle’s bonus change if Kevin decides to employ the new technique?
3. c.       Suppose that profit without using the technique this year will be $4.8 million. By how much will Kevin’s bonus change if he decides to employ the new technique? By how much will Michelle’s bonus change if Kevin decides to employ the new technique?
4. d.      Is it ethical for Kevin to consider the impact of the new technique on his bonus when deciding whether or not to use it? Explain.
5. e.       Assess the management control system used at Magnolia Manufacturing and provide recommendations for changes, if any are required. Be sure to discuss:
6. • Decision authority
7. • Performance measures
8. • Compensation

To determine

Calculate K’s bonus when he decides to employ the new technology.

Answer to Problem 30E

K’s bonus increases by $3,600 and M’s bonus increases by $4,800.

Explanation of Solution

Contingent compensation:

Contingent compensation is the amount paid to the employees on the basis of their performance. Unlike fixed compensation, the contingent compensation is based on the performance of the employee in their respective job profile.

Calculate the change in K’s bonus and M’s bonus when he decides to employ the new technology:

The bonus is given when profit exceeds the target level of $6 million. Hence, initially, the bonus will be zero for K and M as the profit did not exceed the target level of $6 million.

Target profit increases by 20%. The bonus is equal to 1 percent of their base salary for every 10 % profit that exceeds a target. It will be 2% $(\frac{20\%}{10\%})$ of their base salary in the case of 20% increment in profit.

The increment in K’s bonus:

$\begin{array}{c}\text{Increment in K's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$180,000 }\times \text{ 2\%}\\ \text{= \$3,600}\end{array}$

Thus, K’s bonus increases by $3,600.

The increment in M’s bonus:

$\begin{array}{c}\text{Increment in M's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$240,000 }\times \text{ 2\%}\\ \text{= \$4,800}\end{array}$

Thus, M’s bonus increases by $4,800.

To determine

Calculate K’s bonus when he decides to employ the new technology. It is given that the profit for the year is $8.5 million.

Answer to Problem 30E

The bonus has changed by $1,800 for K and by $2,400 for M.

Explanation of Solution

Contingent compensation:

Contingent compensation is the amount paid to the employees on the basis of their performance. Unlike fixed compensation, the contingent compensation is based on the performance of the employee in their respective job profile.

Calculate the change in K’s bonus and M’s bonus when he decides to employ the new technology:

The bonus is given when profit exceeds the target level of $6 million. The current level of profit is $8.5 million.

Change in the bonus of K:

$\begin{array}{c}\text{Chnage in bonus = Current bonus - Previous bonus}\\ \text{= \$9,000 (1) - \$7,200 (4)}\\ \text{= \$1,800}\end{array}$

Change in the bonus of M:

$\begin{array}{c}\text{Chnage in bonus = Current bonus - Previous bonus}\\ \text{= \$12,000 (1) - \$9,600 (4)}\\ \text{= \$2,400}\end{array}$

Thus, the bonus has changed by $1,800 for K and by $2,400 for M.

Working note 1:

Calculate the bonus on the revised level of profit (10.2 million):

Bonus for K:

$\begin{array}{c}\text{K's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$180,000 }\times \text{ 5\% (2)}\\ \text{= \$9,000}\end{array}$

Bonus for M:

$\begin{array}{c}\text{M's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$240,000 }\times \text{ 5\% (2)}\\ \text{= \$12,000}\end{array}$

Working note 2:

Calculate the % of incentive:

Target profit increases by 20%. The bonus is equal to 1 percent of their base salary for every 10 % profit that exceeds a target. It will be 7% $(\frac{70\%}{10\%})$ of their base salary in the case of 20% increment in profit.

$\begin{array}{c}\%\text{ of increment =1 - }\frac{\text{Actual profit}}{\text{Tagret profit}}\\ \text{=1 - }\frac{\$10.2\text{ million (3)}}{\$6\text{ million}}\\ =\text{ 0}\text{.7 approximately}\end{array}$

Maximum bonus allowed is 5%. So the bonus will be calculated on the basis of 5% of salary.

Working note 3:

Calculate the change in profit:

$\begin{array}{c}\text{Revised profit = Actual Profit }\times \text{ (\% of increment)}\\ \text{= \$8,500,000 }\times \text{ 1}\text{.2}\\ \text{= 10,200,000}\end{array}$

Working note 4:

Calculate the bonus on the current level of profit (8.5 million):

Bonus for K:

$\begin{array}{c}\text{K's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$180,000 }\times \text{ 4\% (5)}\\ \text{= \$7,200}\end{array}$

Bonus for M:

$\begin{array}{c}\text{M's bonus = Base salary }\times \text{ (\% of incentive)}\\ \text{= \$240,000 }\times \text{ 4\% (5)}\\ \text{= \$9,600}\end{array}$

Working note 5:

Calculate the % of incentive:

Target profit increases by 20%. The bonus is equal to 1 percent of their base salary for every 10 % profit that exceeds a target. It will be 4% $(\frac{40\%}{10\%})$ of their base salary in the case of 20% increment in profit.

$\begin{array}{c}\%\text{ of increment =1 - }\frac{\text{Actual profit}}{\text{Tagret profit}}\\ \text{=1 - }\frac{\$8.5\text{ million}}{\$6\text{ million}}\\ =\text{ 0}\text{.4 approximately}\end{array}$

To determine

Calculate K’s bonus and M’s bonus when he decides to employ the new technology. It is given that the profit for the year is $4.8 million.

Answer to Problem 30E

There will be no change in the bonus as the bonus is zero in both the cases.

Explanation of Solution

Contingent compensation:

Contingent compensation is the amount paid to the employees on the basis of their performance. Unlike fixed compensation, the contingent compensation is based on the performance of the employee in their respective job profile.

Calculate the change in K’s bonus and M’s bonus when he decides to employ the new technology:

The bonus is given when profit exceeds the target level of $6 million. The current level of profit is $4.8 million. There will be no bonus on the current level of profit.

Revised level of profit:

$\begin{array}{c}\text{Revised profit = Actual Profit }\times \text{ (\% of increment)}\\ \text{= \$4,800,000 }\times \text{ 1}\text{.2}\\ \text{= 5,760,000}\end{array}$

Revised level of profit is $5,760,000. It is below the target level of profit of $6 million. So there will be no incentive for the revised level of profit too.

Thus, there will be no change in the bonus as the bonus is zero in both cases.

To determine

Explain whether it is ethical for K to consider the impact of technology change on his incentive.

Answer to Problem 30E

No, it is not ethical for K to consider the impact of technology change on his incentive.

Explanation of Solution

Dysfunction decision making:

Dysfunction decision making is a process where subordinates decide for its benefit without considering the adverse effect of the decision on the business organization.

Considering the impact of technology:

K should not decide employing the technology on a self interest basis. He should consider the importance of the implementation of technology for the benefit of the company. It is ethically wrong to consider self-interest over the organization’s interest.

Thus, it is not ethical for K to consider the impact of technology change on his incentive.

To determine

Provide recommendations for changes, if any are required.

Explanation of Solution

Recommendations to Company M:

Following are the recommendations to Company M:

• • K has control over the production of the goods in Company M. He may manipulate the production process for his bonus. So K’s activities should be evaluated on a regular basis.
• • The bonus level is restricted to 5%. It should be increased in order to make the employee more motivated.
• • M’s activity of selling should be evaluated on a regular basis as he may influence the sales to earn some bonus.

Thus, Company M should follow the above-explained recommendations to change the bonus plan.