Page 225 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Management Control Systems

Notes Cut-off Levels

A bonus plan may be limited at either end. (1) The level of performance at which a maximum
bonus is reached (upper cut-off) and (2) lower cut-off, the level below which no bonus award
will be available. When business unit managers recognize that either the maximum bonus has
been attained or there will be no bonus at all, the motivational aspect of bonus system will be
contrary to corporate goals. Instead of optimizing profits in the current period, managers may
be motivated to decrease profitability in one year by overspending on discretionary expenses
such as: advertising, research and development, so as to create an opportunity for a higher
bonus in the next year. This situation can be corrected by carrying over the excess or deficiency
into the following year i.e., bonus available for distribution in a given year would be the
amount of bonus earned during that year plus any excess or minus any deficiency from the
previous year.
Bonus Basis

A business unit manager’s incentive bonus could be based solely on total corporate profits or
solely on business unit profits or on some mix of the two.
Note: In a single industry firm, where business units are highly interdependent, the manager’s
bonus is tied primarily to corporate performance, since inter-unit co-operation is critical.
In a conglomerate, on the other hand, the business units are usually autonomous. In such a
context, it would be counterproductive to base business unit manager’s bonuses primarily on
company profits since this would weaken the link between performance and rewards. Therefore,
it is desirable to reward such business unit managers primarily based on business unit
performance and so foster the entrepreneurial spirit.
For related diversified firms, it might be desirable to base part of the business unit managers’
bonus on business unit profits and part on company’s profit, to provide the right mixture of
incentives - namely: to optimize units’ results while, at the same time, co-operating with other
units to optimize company performance.

11.5 Performance Criteria

To decide the criteria, as the basis for deciding bonus for business unit managers, the following
need to be considered:
1. Financial criteria: If the business unit is a profit centre, the choice of financial criteria
include contribution margin, direct business unit profit, controllable business unit profit,
income before taxes and net income after taxes. If the unit is an investment centre, decisions
need to be made in three areas:

(i) Definition of profit
(ii) Definition of investment, and
(iii) Choice between return on investment and EVA

If the responsibility centre is a revenue centre, the financial criteria would be sales volume
or sales rupees.
2. Adjustments for uncontrollable factors: In addition to selecting the financial criteria,
adjustments need to be made for uncontrollable factors such as: expenses as a result of
decisions made by executives above the business unit level (to close a factory that was
working at 30 % of capacity) and to eliminate the effects of losses due to acts of nature (fire,
earthquakes, floods) and accidents not arising due to negligence of the manager.

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