Faulkenheim GmbH is a manufacturer of tool and die machinery. Faulkenheim is a vertically integrated company that is organised into two divisions. The Frankfurt Steel Division manufactures alloy steel plates. The Tool and Die Machinery Division uses the alloy steel plates to make machines. Faulkenheim operates each of its divisions as an investment centre. Faulkenheim monitors its divisions on the basis of return on investment (ROI) with investment defined as average operating assets employed. Faulkenheim uses ROI to determine management bonuses. All investments in operating assets are expected to earn a minimum return of 11% before income taxes. For many years, Frankfurt’s ROI has ranged from 11.8% to 14.7%. During the fiscal year ending 31 December 2007, Frankfurt contemplated a capital acquisition with an estimated ROI of 11.5%; division management, however, decided against the investment because it believed that the investment would decrease Frankfurt’s overall ROI. Frankfurt’s 2007 operating income statement follows. The division’s operating assets employed were €15750000 at 31 December 2007, a 5% increase over the previous year-end balance.
1. Calculate the return on investment in average operating assets employed (ROI) for 2007 for the Frankfurt Steel Division.
2. Calculate Frankfurt Steel Division’s residual income on the basis of average operating assets employed.
3. Would the management of Frankfurt Steel Division have been more likely to accept the investment opportunity it had in 2007 if residual income were used as a performance measure instead of ROI? Explain.
4. Frank Weissmann, the chairman of Faulkenheim GmbH is considering one of four alternative ways to compensate division managers.
a. Pay each division manager only a flat salary and no bonus.
b. Make all of each division manager’s compensation depend on division residual income.
c. Make all of each division manager’s compensation depend on company-wide (Faulkenheim GmbH) residual income rather than divisional residual income.
d. Use benchmarking and compensate each division manager on the basis of his or her own division’s residual income minus the residual profit of the other division. Assume the two divisions have comparable levels of investment and required rates of return. Assume that division managers do not like bearing risk. Evaluate each of the four alternatives Weissmann is considering, in the context of the structure and businesses of Faulkenheim GmbH. Indicate the positive and negative features of each proposal.
5. What compensation arrangement would you recommend? Explain your answer briefly.