Purity Steel Corporation, 1995 “I’m no expert in high finance,” said Larry Hoffman, manager of the Denver branch for the Warehouse Sales Division of Purity Steel Corporation, to Harold Higgins, general manager of the division, “so it didn’t occur to me that I might be better off by leasing my new warehouse instead of owning it. But I was talking to Jack Dorenbush over in Omaha the other day and he said that he’s getting a lot better return on the investment in his district because he’s in a leased building.
I’m sure that the incentive compensation plan you put in last year is fair, but I didn’t know whether it adjusted automatically for the difference between owning and leasing and I just thought I’d raise the question. There’s still time to try to find someone to take over my construction contract and then lease the building to me when it’s finished if you think that’s what I ought to do. ” Purity Steel Corporation was an integrated steel producer with annual sales of about $4. 5 billion in 1995. The Warehouse Sales Division was an autonomous unit that operated 21 field warehouses throughout the United States. Total sales of the division were approximately $225 million in 1995, of which roughly half represented steel products (rod, bar, wire, tube, sheet, and plate) purchased from Purity’s Mill Products Division. The balance of the Warehouse Sales Division volume was copper, brass, and aluminum products purchased from large producers of those metals. The Warehouse Sales Division competed with other producer-affiliated and independent steel warehousing companies and purchased its steel requirements from the Mill Products Division at the same prices paid by outside purchasers.
Harold Higgins was appointed general manager of the Warehouse Sales Division in mid1994, after spending 12 years in the sales function with the Mill Products Division. Subject only to the approval of his annual profit plan and proposed capital expenditures by corporate headquarters, Higgins was given full authority for his division’s operations and was charged with the responsibility to “make the division grow, both in sales volume and in the rate of return on its investment. ” Prior to his arrival at division headquarters in St. Louis, the Warehouse Sales Division had been operated in a centralized manner; all purchase orders had been issued by division headquarters, and most other operating decisions at any particular warehouse had required prior divisional approval. Higgins decided to decentralize the management of his division by making each branch (warehouse) manager responsible for the division’s activities in his or her geographic area. In Higgins’s opinion, one of the key features of his decentralization policy was an incentive compensation plan announced in late 1994 to become effective January 1, 1995.
The description of the plan, as presented to the branch managers, is reproduced in Exhibits 1, 2, and 3. Monthly operating statements had been prepared for each warehouse for many years; implementing the new plan Do Doctoral Candidate Antonio Davila and Professor Robert Simons prepared this updated case based on an earlier version. The case material of the Harvard Graduate School of Business Administration is prepared as a basis for class discussion and not to illustrate either effective or ineffective handling of administrative problems.
Two major asset categories, inventories, and fixed assets (buildings and equipment), we’re easy to attribute to specific locations. Accounts receivable were collected directly at Purity’s central accounting department, but an investment in receivables equal to 35 days’ sales (the average for the Warehouse Sales Division) was charged to each warehouse. Finally, a small cash fund deposited in a local bank was recorded as an asset of each branch. No current or long-term liabilities were recognized in the balance sheets at the division or branch level. At the meeting in December 1994, when the new incentive compensation plan was presented to the branch managers, Higgins had said: tC op yo Howard Percy [division sales manager] and I have spent a lot of time during the last few months working out the details of this plan. Our objective was to devise a fair way to compensate those branch managers who do a superior job of improving the performance in their areas.
First, we reviewed our salary structure and made a few adjustments so that branch managers do not have to apologize to their families for the regular paycheck they bring home. Next, we worked out a simple growth incentive to recognize that one part of our job is simply to sell steel, although we didn’t restrict it to steel alone. But more importantly, we’ve got to improve the profit performance of this division. We established 5% as the return-on-investment floor representing minimum performance eligible for a bonus. As you know, we don’t even do that well for 1994, but our budget for next year anticipates 5% before taxes. Thus, in 1995 we expect about a third of the branches to be below 5%? and earn no ROI bonus? while the other two-thirds will be the ones who really carry the weight. This plan will pay a bonus to all managers who help the division increase its average rate of return. We also decided on a sliding scale arrangement for those above 5%, trying to recognize that the manager who makes a 5% return on a $10 million investment is doing as good a job as one who makes a 10% return on only a half-million dollars.
Finally, we put a $50,000 limit on the ROI bonus because we felt that the bonus shouldn’t exceed 50% of salary, but we can always make salary adjustments in those cases where the bonus plan doesn’t seem to adequately compensate a branch manager for his or her performance. No After the telephone call from Larry Hoffman in May 1996, quoted in the opening paragraph, Harold Higgins called Howard Percy into his office and told him the question that Hoffman had raised. “We knew that we probably had some bugs to iron out of this system,” Percy responded. Let me review the Denver situation and we’ll discuss it this afternoon. ” At a meeting later that day, Percy summarized the problem for Higgins: Do As you know, Larry Hoffman is planning a big expansion at Denver. He’s been limping along in an old multi-story building with an inadequate variety of inventory, and his sales actually declined last year. About a year ago he worked up an RFE [request for expenditure] for a new warehouse which we approved here and sent forward. It was approved at corporate headquarters last fall, the contract was let, and it’s to be completed by the end of this year.
I pulled out one page of the RFE which summarizes the financial story. Larry forecasts nearly a triple in his sales volume over the next eight years, and the project will pay out in about seven and a half years. Here is a summary of the incentive compensation calculations for Denver that I worked up after I talked to you this morning. Larry had a very high ROI last year and received one of the biggest bonuses we paid. Against that background, I next worked up a projection of what his bonus will be in 1997 assuming that he moves into his new facility at the end of the year. Our lease there is a so-called operating lease, which means that we pay the insurance, taxes, and maintenance just as if we owned it. The lease runs for 20 years with renewal options at reduced rates for two additional 10-year periods. Assuming that we could get a similar deal for Denver, and adjusting for the difference in the cost of the land and building at the two locations, our lease payments at Denver during the first 20 years would be just under $250,000 per year. Pushing that through the bonus formula for Denver’s projected 1997 operations shows an ROI of 7. %, but Larry’s bonus would be about 15% less than if he was in an owned building. op yo “On balance, therefore,” Percy concluded, “there’s not a very big difference in the bonus payment as between owning and leasing, but in either event, Larry will be taking a substantial cut in his incentive compensation. ” As the discussion continued, Larry Hoffman and Howard Percy revisited the formula for ROI: Net Income Return-on-investment = Investment in Operating Assets Net Income Sales x Sales Investment in Operating Assets = ( Return on Sales) x (Asset Turnover) No TC = Do
The Warehouse Sales Division has three major objectives:
A. To operate the Division and its branches at a profit.
B. To utilize efficiently the assets of the Division.
C. To grow.
This compensation plan is a combination of base salary and incentive earnings. Incentive earnings will be paid to those managers who contribute to the achievement of these objectives and in proportion to their individual performance. op yo
II. Compensation Plan Components
There are three components to this plan:
A. Base Salary Base salary ranges are determined for the most part on dollar sales volume of the district(s) in the prior year. The higher the sales volume, the higher range to which the manager becomes eligible. The profitability of dollar sales or increases in dollar sales is an important consideration. Actual salaries will be established by the General Manager, Warehouse Sales Division, and the salary ranges will be reviewed periodically in order to keep this Division competitive with companies similar to ours.
B. Growth Incentive If the district earns a net profit before the federal income tax for the calendar year, the manager will earn $1,750 for every $500,000 of increased sales over the prior year. Proportionate amounts will be paid for greater or lesser growth.
C. Return-on-Investment Incentive No In this feature of the plan, the incentive will be paid in relation to the size of the investment and the return-on-investment. The manager will be paid in direct proportion to his effective use of assets placed at his disposal. The main emphasis of this portion of the plan is on increasing the return at any level of investment, high or low.
Do III. Limitations on Return-on-Investment Incentive
A. No incentive will be paid to a manager whose branch earns less than 5% return-on-investment before federal taxes.
B. No increase in incentive payment will be made for performance in excess of 20% return-on-investment before federal taxes.
C. No payment will be made in excess of $50,000 regardless of performance.
However, a rough estimate can be made by:
A. Finding the approximate level of investment on the horizontal scale.
B. Drawing a line vertically from that point to the approximate return-on-investment percent.
C. Drawing a line horizontally from that point to the vertical scale which indicates the approximate incentive payment.
Annual return of funds $ 7. 3 years 4,072,150 5,534,549 96 (177) Less 35% tax Net income $ (220) (53) (273) Less depreciation Total return over 8 years (in dollars) Capital expenditures required (in dollars): Land Building Equipment Relocation expense
Forecast Additional Sales, Expenses, and After-Tax Profits Due to New Facility (dollars in thousands)
Gross profit dollars
Less expenses excluding depreciation
Assumptions used for 1997 projections at Denver: Old facility and equipment sold at the end of 1996, proceeds remitted to corporate headquarters. Depreciation on new facilities in 1997 is $43,540 (60 years, straight line) and $49,225 on equipment (various lives, straight line). Year-end investment in receivables and inventory will approximate 1995 relationship: receivables at 10% of annual sales, inventories at 25% of annual sales. Average total investment assumes that new fixed assets are acquired on December 31, 1996, and that other assets at that date are the same as at the end of 1995. Profit taken from RFE as $995,000 less $185,000 first-year decline, less $100,000 relocation expense. Additional mill profit of $65,000 does not reflect on divisional books and was used only at corporate headquarters for capital expenditures evaluation purposes.