Thor-Equip AS specialises in the manufacture of medical equipment, a field that has become increasingly competitive. Approximately two years ago, Knut Solbær, president of Thor-Equip, decided to revise the bonus plan (based, at the time, entirely on operating profit) to encourage divisional managers to focus on areas that were important to customers and that added value without increasing cost. In addition to a profitability incentive, the revised plan also includes incentives for reduced rework costs, reduced sales returns and on-time deliveries. Bonuses are calculated and awarded semi-annually on the following basis. A base bonus is calculated at 2% of operating profit. The bonus amount is then adjusted by the following amounts:
a. (i) Reduced by excess of rework costs over 2% of operating profit.
(ii) No adjustment if rework costs are less than or equal to 2% of operating profit.
b. Increased by €5000 if over 98% of deliveries are on time, by €2000 if 96-98% of deliveries are on time and by €0 if on-time deliveries are below 96%.
c. (i) Increased by €3000 if sales returns are less than or equal to 1.5% of sales.
(ii) Decreased by 50% of excess of sales returns over 1.5% of sales.
Results for Thor-Equip’s Kari and Siri Divisions for the year 2007, the first year under the new bonus plan, follow. In the previous year, 2006, under the old bonus plan, the Kari Division manager earned a bonus of €27060 and the Siri Division manager a bonus of €22440.
1. Why did Knut need to introduce these new performance measures? That is, why does he need to use these performance measures over and above the operating profit numbers for the period?
2. Calculate the bonus earned by each manager for each six-month period and for the year
3. What effect did the change in the bonus plan have on each manager’s behaviour? Did the new bonus plan achieve what he desired? What changes, if any, would you make to the new bonus plan?