Calculating the bonus that each managing director would earn in the two years

Topic: Management accounting problem (case study).

Task details:

Youngblood International has its head office in Brisbane and operates throughout Australia, New Zealand and parts of Asia. There are three main divisions:

• Brewing division – this is the oldest division, and it operates major breweries in Perth and Brisbane.

• Newspaper division – owns leading tabloid newspapers in several cities.

• Cable television division – operates cable television services in Asia and Australia. This is a high-risk, growing market.

Each division is headed by a managing director, who has been given a high level of decision-making authority. Each managing director effectively runs his or her division as a stand-alone business within the general policy guidelines provided by the board of directors in the head office. Each managing director agrees to achieve a series of targets: return on investment (ROI), market share and sales growth. These targets are developed each year as part of the annual budget-setting process. Intense lobbying takes place between each managing director and the board of directors to determine the most suitable targets.

Each managing director receives an annual cash bonus based on achieving the target divisional ROI. The company defines ROI as operating profit, before interest and taxes, divided by divisional assets (measured at original cost less accumulated depreciation). Senior managers are each eligible for a cash bonus of $60 000 if they reach their divisional ROI target. If performance is above target, share options are awarded at the rate of 10 000 shares for every additional point over target. Thus, if the ROI target is 13% and the division achieves 15%, the manager would be awarded 20 000 share options. These options are at the prevailing market price on the last day of the financial year, and must be taken up within two years of the award. During the past year, the market price of the company’s shares increased from $4 to $6. If the ROI target is not reached, there are no bonuses or share options, and the managing director has to provide convincing reasons for the poor performance. As a consequence of the performance measurement and reward system, the managing directors are highly motivated to achieve, and exceed, their ROI targets.

Jenice Cookson has just been appointed as a new management accountant in the head office, charged with redesigning the performance measurement system. As her first task, she has obtained the financial data for last year and the latest forecast for the current year, for each division, in thousands of dollars, as follows:

Leonard Smith, the managing director of the brewing division, is concerned that his market share, and hence his ROI, is likely to suffer next year, as his main competitor has recently purchased new brewing technology.

While his own brewing equipment is only ten years old, it is unable to produce the new varieties of beer that customers are demanding, and maintenance and operating costs are increasing.

Smith is considering a proposal to invest $10 million in new equipment. This will probably increase next year’s operating profit for his division by $1 million. Smith has analysed the future cash flows of this proposal, and the new acquisition will easily satisfy the minimum required rate of return of 10% for all new investments that is set for the Youngblood group. Without this acquisition, Smith expects his divisional ROI to drop to 14% next year.

Required:

1. Calculate the ROI for each division for last year and the current year, as well as the two components of ROI: profit margin and return on assets. Comment on the relative performance of the three divisions.

2. Calculate the bonus that each managing director would earn in the two years.

3. Explain why Leonard Smith is reluctant to invest in the new brewing equipment. Provide calculations to back up your answer.

4. Jenice Cookson is considering expanding the divisional targets to include a range of non-financial measures. She is interested in developing a scorecard for each division. For each of the three divisions:

a) Formulate objectives for each of the four perspectives: financial, customer, internal business process and learning and growth.

b) Construct a strategy map to demonstrate the relationship between objectives for each perspective.

c) Suggest lag and lead indicators for these perspectives.