Berkshire Case Study

1. Were Berkshire’s motivations for a new incentive plan reasonable? If so, what were their main options for a new system? Was an economic profit-focused system a reasonable choice?

A good incentive plan whether using market measures or accounting measures should be congruent, controllable, precise, objective, timely and understandable.

In the early 2000s Berkshire’s management had some concerns about their current incentive plan which was based on EPS accounting measure. Two main concerns fueled management’s motivation for a new incentive system.

First of all, management was concerned about congruence. While the EPS had steadily increased and division managers enjoyed nice bonuses, shareholder value had not benefitted and share price increased slightly. This is a big concern because it means that EPS growth did not translate into stock appreciation. This implies that Berkshire’s management interest were not aligned with those of shareholders which contradicts with the new era of management of maximizing shareholder value.

Second, Berkshire wanted to introduce more objectivity to the current system. Under this plan, awards could be overridden by senior management which lead to politicking and a lot of misspent time as well as distractions since division managers instead of focusing on their work were spending time to find arguments to bring to their evaluator in order to justify their bonus entitlement.

While their current system was precise and understandable, there too many concerns regarding congruence and objectivity. Therefore, we can conclude that Berkshire’s motivation for a new incentive plan was reasonable.

Main options

Berkshire had 2 main options for their incentive plan:

• Introduce market measures
• Use a combination of measures

Market measures

Market measures are also cost effective and easy to understand but they have some limitations. Some measures available such as stock price which measures the share price or the growth index which includes companies that shows signs of above average growth. Market measures are not always feasible since they are only available to public companies. Also, market measures lacks controllability since only top management have the authority to make decisions.

Combination of measures

Another option is to use a combination of measures. For example using market measures together with accounting as a surrogate measure and introducing some non-financial indicators such as personnel development, customer satisfaction.

 Economic profit-focused system

The economic profit is introduced to replace the accounting profit, which is essentially the accounting profit with 2 adjustments, and by taking in the consideration the capital costs (or the opportunity cost). The formula being: