Acc 640 - Purity Steel and Ford Motor

Jerry Shi, Kasumi Takeuchi, Peter Ciaverilla

ACC 640

Purity Steel and Ford Motor

1. What actions should Higgins take in response to Larry Hoffman’s concerns?

As Hoffman says himself, he does not have enough financial knowledge to decide the best investment plan for the company, and he depends on the company’s compensation plan for his investment decisions. Through the compensation plan calculation, he knows higher ROI is better, therefore he is concerned that maybe he should lease instead of own the new warehouse, especially after hearing Jack Dorenbush in Omaha is getting a lot better ROI in his district from leasing. However, while leasing will let him have higher ROI than owning the new warehouse, the company’s compensation plan incentivizes him to go with owning the warehouse. Hoffman believes that the incentive compensation plan doesn’t automatically adjust for the difference between owning and leasing.

Hoffman had an ROI of 17.3% and an incentive compensation of $30,392 in 2012. If Hoffman moves into the new warehouse that he specified on his RFE, he is projected to have:

• 7.19% ROI and $20,992 incentive compensation if the warehouse is owned.

• 7.33% ROI and $18,931 incentive compensation if the warehouse is leased.

Having a floor and ceiling on the ROI amounts could result in branch managers not performing at their optimal levels. ROI is a short-term measure and significantly influences managers to make decisions only considering short-term advantages or disadvantages. Since the compensation measures a period of one year, managers may be more likely to decide on crucial investment purchases or disposal on a short-term basis.

The floor and ceiling are intended to reward high-performing managers while not paying out too much. ROI’s advantages are that it’s easily controlled and understood. But ROI’s disadvantages are that, in addition to being short-term, it’s easy to manipulate, especially by not making investments that would be beneficial long-term. An alternative could be the balanced scorecard, as discussed in Borealis.

Related to ROI, the sliding scale arrangement is an issue because it doesn’t automatically adjust for the difference between owning and leasing. The differences are:

• The values of buildings (net of depreciation) (starting at $2,568,960 in 2014) and land ($300,000) for owning.

• The annual lease payments of $243,200 for leasing.

• The difference in depreciation ($92,765 for owning vs. $49,225 for leasing).

The current scale incorrectly “punishes” a