Discuss why the bonus scheme could result in poor decisions

Cost & Management Accounting

 

Discuss why the bonus scheme could result in poor decisions

 

Case 3 – Wanstead Engineering

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.

SECTION II – SOLVE ANY 4 QUESTIONS OUT OF 6.

 

  1. “Management accounting is a mid-way between financial and cost accounting.” Elucidate.

  1. What is the major revenue recognition criterion?

  1. What is a trading account? What are its major constituents? What is its major outcome?

  1. The cash flow statement is as useful to shareholders and lenders as to management. Explain.

  1. (a) “All future costs are relevant.” Do you agree? Why?

(b) “Fixed costs are really variable. The more you produce the less they become.”                                  

                    Do you agree? Explain.

  1. In connection with inventory ordering and control, certain terms are basic. Explain the meaning of each of the following:

    1. Economic order quantity

    2. Re-order point

    3. Lead time

    4. Safety stock

 

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Discuss why the bonus scheme could result in poor decisions

 

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