End of Chapter: Performance Measurement, Compensation, and Multinational Considerations

Problem for Self-Study

The baseball division of Home Run Sports manufactures and sells baseballs. Assume production equals sales. Budgeted data for February 2020 are as follows:

The table depicts budgeted data for Home Run Sports for February 2020. The details of the table are as follows:

1. Current assets: 400,000 dollars

2. Long-term assets: 600,000 dollars

3. Total assets: 1,000,000 dollars

4. Production output: 200,000 baseballs per month

5. Target return on investment, operating income divided by total assets: 30 percent

6. Fixed costs: 400,000 dollars per month

7. Variable cost: 4 dollars per baseball

Compute the minimum selling price per baseball necessary to achieve the target ROI of 30%.
Using the selling price from requirement 1, separate the target ROI into its two components using the DuPont method.
Compute the RI of the baseball division for February 2020, using the selling price from requirement 1. Home Run Sports uses a required rate of return of 12% on total division assets when computing division RI.
In addition to her salary, Amanda Kelly, the division manager, receives 3% of the monthly RI of the baseball division as a bonus. Compute Kelly’s bonus. Why do you think Kelly is rewarded using both salary and a performance-based bonus? Kelly does not like bearing risk.

Solution

$\begin{array}{rcl} Target operating income & = & 30 % of $ 1,000,000 of total assets \\ = & $ 300,000 \\ Let P & = & Selling price \\ Revenues - Variable costs - Fixed costs & = & Operating income \\ 200,000 P - (200,000 \times $ 4) - $ 400,000 & = & $ 300,000 \\ 200,000 P & = & $ 300,000 + $ 800,000 + $ 400,000 \\ = & $ 1,500,000 \\ P & = & $ 7.50 per base ball \end{array}$

Proof:

The table depicts the proof for the computation of the minimum selling price per baseball necessary to achieve the target return on investment of 30 percent. The details of the table are as follows:

Revenues, 200,000 baseballs times 7.50 dollars per baseball: 1,500,000 dollars
Variable costs, 200,000 baseballs times 4.00 dollars per baseball: 800,000 dollars
Contribution margin: 700,000 dollars
Fixed costs: 400,000 dollars
Operating income: 300,000 dollars

2. The DuPont method describes ROI as the product of two components: return on sales $(income \div revenues)$ and investment turnover $(revenues \div investment) .$

$\begin{matrix} \frac{Income}{Revenues} \times \frac{Revenues}{Investment} = \frac{Income}{Investment} \\ \frac{$ 300,000}{$ 1,500,000} \times \frac{$ 1,500,000}{$ 1,000,000} = \frac{$ 300,000}{$ 1,000,000} \\ 0.2 \times 1.5 = 0.30, or 30 % \end{matrix}$

$\begin{array}{lcl} R I & = & Operating income - Required return on investment \\ = & $ 300,000 - (0 . 12 \times $ 1,000,000) \\ = & $ 300,000 - $ 120,000 \\ = & $ 180,000 \end{array}$

4. $\begin{array}{lll} Kelly ’ s bonus & = & 3 % of R I \\ = & 0 .03 \times $ 180,000 = $ 5,400 \end{array}$

The baseball division’s RI is affected by many factors, such as general economic conditions, beyond Kelly’s control. These uncontrollable factors make the baseball division’s profitability uncertain and risky. Because Kelly does not like bearing risk, paying her a flat salary, regardless of RI, would shield her from this risk. But there is a moral-hazard problem with this compensation arrangement. Because Kelly’s effort is difficult to monitor, the absence of performance-based compensation will provide her with no incentive to undertake extra physical and mental effort beyond what is necessary to retain her job or to uphold her personal values.
Paying no salary and rewarding Kelly only on the basis of RI provides her with incentives to work hard but also subjects her to excessive risk because of uncontrollable factors that will affect RI and hence Kelly’s compensation. A compensation arrangement based only on RI would be costlier for Home Run Sports because it would have to compensate Kelly for taking on uncontrollable risk. A compensation arrangement that consists of both a salary and an RI-based performance bonus balances the benefits of incentives against the extra costs of imposing uncontrollable risk.