Summit Equipment specializes in the manufacture of medical equipment, a field that has become increasingly competitive. Approximately two years ago, Ben Harrington, president of Summit, decided to revise the bonus plan (based, at the time, entirely on operating income) to encourage division 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 includes incentives for reduced rework costs, reduced sales returns, and ontime deliveries. Bonuses are calculated and awarded semi-annually on the following basis. A base bonus is calculated at 2% of operating income; this amount is then adjusted as follows:
a. i. Reduced by excess of rework costs over and above 2% of operating income.
ii. No adjustment if rework costs are less than or equal to 2% of operating income.
b. i. Increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if 96% to 98% of deliveries are on time.
ii. No adjustment if on-time deliveries are below 96%.
c. i. Increased by $3,000 if sales returns are less than or equal to 15% of sales.
ii. Decreased by 50% of excess of sales returns over 1.5% of sales.
Note:If the calculation of the bonus results in a negative amount for a particular period, the manager simply receives no bonus, and the negative amount is not carried forward to the next period.Results for Summitâs Charter Division and Mesa Division for 2015, the first year under the new bonus plan, follow. In 2014, under the old bonus plan, the Charter Division manager earned a bonus of $27,060 and the Mesa Division manager a bonus of $22,440.
Required: 1. Why did Harrington need to introduce these new performance measures? That is, why does Harrington need to use these performance measures in addition to the operating-income numbers for the period? 2. Calculate the bonus earned by each manager for each six-month period and for 2015. 3. What effect did the change in the bonus plan have on each managerâs behaviour? Did the new bonus plan achieve what Harrington desired? What changes, if any, would you make to the new bonus plan?
Charter Division Mesa Division January 1, 2015 July 1, 2015 January 1, 2015 July 1, 2015 to to to to June 30, 2015 Dec. 31, 2015 June 30, 2015 Dec. 31, 2015 Revenue $4,200,000 $4,400,000 $2,850,000 $2,900,000 Operating income $ 462,000 $ 440,000 $ 342,000 $ 406,000 On-time delivery 95.4% 97.3% 98.2% 94.6% $ 11,500 $ 84,000 $ 1,000 $ 70,000 Rework costs $ 6,000 $ 8,000 Sales returns $ 44,750 $ 42,500