Question

PROBLEM 1-7.

You Get What you Measure! [LO 3]

Each year the president of Smart-Toys Manufacturing selects a single performance measure and offers significant financial bonuses to all key employees if the company achieves a 10 percent improvement on the measure in comparison to the prior year. She recently said, “This focuses my managers on a single, specific target and gets them all working together to achieve a major objective that will increase shareholder value.” Sarabeth Robbins is a new member of the company’s board of directors, and she has begun to question the president’s approach to rewarding performance. In particular, she is concerned that placing too much emphasis on a single performance measure may lead managers to take actions that increase performance in terms of the measure but decrease the value of the firm.

Required:

a. What negative consequence might occur if the performance measure is sales to new customer’s ÷ total sales in the current year versus the prior year? (Note: To receive a bonus, managers would need to increase this ratio compared with the prior year.)

b. What negative consequence might occur if the performance measure is cost of goods sold ÷ sales in the current year versus the prior year? (Note: To receive a bonus, managers would need to decrease this ratio compared with the prior year.)

c. What negative consequence might occur if the performance measure is selling and administrative expenses ÷ sales in the current year versus the prior year? (Note: To receive a bonus, managers would need to decrease this ratio compared with the prior year.)

Answer 1

a.	The mangers in this would only be focused on increasing the new customers and increasing the sales, so they would not focus on the profit earned on the sales. So, this could decrease the profit of the firm.
b.	The cost of goods sold has two portion fixed cost and variable production cost. The fixed production cost such as building and equpiment are uneffected by production level, however the variable cost such as wages paid differ with the production level. So, in order to reduce the cost of goods sold the production might get down, so the fixed cost burden would go up and the profit of the firm will come down.
c.	This is similar to option(b) where the fixed cost burden for selling and administrative cost would become more and the profitablity of the firm might go down