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To answer this question, First, I will show the definition of bonus, final profit and gross profit as follows: Bonus refers to a sum of money granted or given to an employee, in addition to regular pay, usually in appreciation for work done, length of service, accumulated favors, etc. Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses in a given period of time which is the final profit in the general understands. Gross profit is the total revenue subtracted by the cost of generating that revenue. Simply, we can use a mathematical equation to show what the difference is between final profit and gross profit. Net income is calculated in the below formula:
Net income = Gross profit – Total expenses – Taxes.
A．Why was Ellie, who is accountable for a responsibility centre, not satisfied with bonuses based on final profit for the centre?
A responsibility centre is an organizational unit that is headed by a manager who is responsible for its activities in term of relative financial results (Schoute 2008). Revenue, Cost, Profit and Investment, are the major four generally distinguished responsibility centers (Anthony & Govindarajan 2004). Suppose that Ellie is in charge of the revenue center which generate involves both input and output activities and her bonus is based on the final profit of her responsible center which she was not satisfied with and insist that the bonus should be based on gross profit, the reasons are two folds:
Figure 1 Optimal level of corporate decentralization
First of all, final profit is more fluctuate and less controllable within each responsibility centre than gross profit regarding the various cost. As shown in figure 1 above which contains a model that is designed to find out the optimal level of decentralization, for a responsibility centre there are two source of cost within the company: information asymmetry and externalities. The information asymmetry refers to the extent to which the knowledge is specific within different layers in the company and externalities are defined as the interdependencies between different business units (responsibility centre). Both the information and externalities could lead to the increase of the cost then minus the final profits. While such cost could not be reduced and controlled with Ellie’s authorization, her effort to increase the revenue will be offset by the increase of uncontrollable costs and overheads, it is understandable that Ellie would require a swift from final profit based bonus system to gross profit bonus system.
Secondly, the majority of her income will be based on bonuses. Even though bonus is a performance based compensation system in which Ellie should perform well to earn the bonus. But in term of economy recession during which the products do not sell well and though the various cost declines also the fixed cost will take away the majority of the profit, under such condition the gross profit bonus scheme would be more convenient to the Ellie whose income is largely accounting on the bonus. In a long term perspective, maybe a profit base bonus plan will create more bonus to Ellie provided that Ellie is a performing chief of her responsibility centre but in separate terms Ellie choose to base her bonus on a more stable basis, i.e. the gross profit may be due to her characteristic of high uncertainty avoidance level.
B. Why might it not be in the best interests of the owner-manager of the firm to base employee bonuses on the gross profit of the responsibility centre?
Gross profit is not the final income for a firm, which also includes a variety of expenses. For example: rent, utilities management fee, wages, bonuses, benefits, subsidies, communications, transportation, travel, business public relations, entertainment, inventory, fixed assets depreciation, office supplies and so on. Subtracting these expenses from gross profit is profit before tax. The result of that profit minus tax is the net profit. If the employee’s bonus is based on gross profit, then there is such a possibility that the company’s net profit is negative sometimes. For instance, a business’s gross profit, expenses and taxes respectively account for 22% of turnover ($10,000), 20% and 0.5%, which is showed as follow:
Gross profit 22% $2200
Expenses (not include bonus) 20% $2000
Taxes 0.5% $50
Profit (include bonus) $150
Thus,the profit (include bonus) of the business is $150. If the bonus of employees by10% of gross profit, that is
Then the bonuses employees received more than profits (include bonus). In other word, the net profit the company received from the business is negative. Of course, this is only a possibility. If the firm’s gross profit is high and expenses are low, a negative profit situation can be avoided. However, no matter whether the net profit is negative, bonuses based on gross profit will reduce the number of cash flow, which will affect the firm development particularly in term of market recession.
Another kind of worries that the owner-manager may have for the gross profit based bonus scheme happens in another extreme- market booming. Under the market booming conditions the company’s products may be selling quite fast due to the dramatic growth of the market needs, then two trends happen: one is that Ellie may not need to work hard to get a sound bonus; the other trend is that Ellie could invest all the possible costs to boost the increase the sales irrespective of whether the investment will be beneficial to the company’s profitability especially in a long term perspective. So to the owner-manager’s view, final profit generation is what the employees should focus on rather than the growth of total revenue only, and the possible neglect caused by the gross profit bonus system make the system not the best interests of the owner-manager.
C. What would be the most effective way of determining employee bonuses that should satisfy the requirements of both employees and the owner-manager?
While most of the empirical research into the executive bonuses has been devoted to establishing a link between executive incentives and company performance (Mejia & Wiseman 1997), there is still no a absolute perfect bonus scheme that could be applied in every company as many variables need to be taken into consideration such as corporate culture. In Ellie’s case, I will provide some suggestion on improving the executive bonus plan rather than offering a most effective method of bound deciding. Under the different requirement of Ellie and owner-manager, a multi-factor bonus scheme could be used by the company. The bonus of Ellie could be contributed by both final profit and gross profit and even other non-accounting factors such as employee satisfaction. Even this is a compromising plan that require both parties to sacrifice their best interests to some extent, but it would be more effective than solely base on either of gross profit or final profit. What’s more the proportion rate that these factors contribute could be changing according to the situations which has reserved room for operational adjustment.
After the discussion about the configuration of the bonus bases, another issue that need to be paid attention to is deciding the size of the bonus. The size of bonus can be influenced by a lot of factors such as industrial average level and corporate profitability. The size of bonus should be controlled in a manner that it could still motivate employees to perform. What’s more, bonus should be used appropriately with other motivation methods such as promotion. Take Ellie’s case as example, suppose that the size of bonus keeps growing, the bonus dollar has less valence to her after a certain point as she advanced to the next level of Maslow’s hierarchy of needs (1954).
A Calculate the break-even point in dollar of sales for the year ended 30 June 2010.
Variable cost per unit: $660,000/300,000=$2.2
Net sales per unit: $1,200,000/300,000=$4
Break-even point in dollars: $4*261,111.11=$1,044,444.44
B Calculate the break-even point for each of the option being considered by management
Fixed cost and variable cost on cost of sales: $895,000/2=$447,500
Fixed cost: $447,500+$105,000+$70,000=$622,500
Variable cost: $447,500+$36,000+$24,000=$507,500
Variable cost per unit: $507,500/300,000=$1.69
Break-even point in dollars: $4*269,480.51=$1,077,922.07
Unit sales: 300,000*(1-10%) =270,000
Variable cost per unit: $660,000/270,000=$2.44
Net sales per unit: $4*(1+15%) =$4.6
Break-even point in dollars: $4.6*217,592.59=$1,000,925.92
Fixed cost on selling expenses: $32,000+$1,200,000*5%=$92,000
Fixed cost: $295,000+$92,000+$70,000=$457,000
Variable cost per unit: $660,000/300,000=$2.2
Break-even point in dollars: $4*253,888.88=$1,015,555.55
C What action should be recommended to management? Explain why
For the option 1, in order to adjust the mixed and variable cost of sale to 50% and 50% variable, more resources such as new production equipments need to be directed into the increase of the fixed cost. And in the unclear market conditions where the sale for the next fiscal year is not promising the break-even point in unit dollar $1,077,922.07 which is even more than the this next’ digit of $1,044,444.44. Obviously, this option is not recommendable to the management in term of difficulties. For the rest two options, even though they both have similar break-even points in term of dollar (1,000,925.92 and 1,015,555.55), but in term of unit the option 2 (217,592.59) obviously owns advantages over the third option which require a sale of 253,888.88, and when this year’ sale has witnessed a severe drop, it is advisable that the management adopt the option 2.
If produce by Dee Vee Dee Ltd,
The total cost of a production level of 80,000=48.5*80,000=3,664,000
If purchase, the cost of purchase will include:
As mentioned in the question, half of the direct fixed overhead could be eliminated if the castings are purchased rather than self production, then the fixed factory overhead=16*80,000*0.5=640,000
Then the total cost if the casting are purchased=3,360,000+640,000=4,000,000
In term of total cost at a demand level of 80,000, option 2 incurred more cost than the first option (4,000,000 versus 3,664,000), and in term of total unit cost option 1 incurs $48.5 while the purchase option incurs $50, so it will be advisable that the company remains its production rather than purchase from the supplier at the unit demand of 80,000 if the current manufacturing capacity currently being used could not be reallocated for other usage that can further reduce the cost.
A．Rank the three machines using each of the following methods:
1. Net present value method
Net present value of Diamondo
= present value of net annual cash flows – Capital investment
= $250,000 4.8333 – $1,200,000
Net present value of Divine Diamonds
= present value of net annual cash flows – Capital investment
= $200,000 5.1972 – $1,000,000
Net present value of Rough Diamonds
=present value of net annual cash flows – Capital investment
= $200,000 4.3436 – $900,000
From the analysis of the above three, it shows that the Rocks Ltd will negative present value if the company chooses Rough Diamonds while it will have positive net present value if the company chooses Diamondo and Divine Diamonds machine. So the ranking of the three machines using net present value method will be:
Divine Diamonds> Diamondo > Rough Diamonds
2. Payback period
Payback period of Diamondo = Investment / Net cash flows
= 4.8 years
Payback period of Divine diamonds = Investment / Net cash flows
=$1,000,000 / $200,000
= 5 years
Payback period of Rough diamonds= Investment / Net cash flows
=$900,000 / $200,000
= 4.5 years
So the ranking of the three machines using payback period method will be:
Rough Diamonds > Diamondo > Divine Diamonds
3. Return on average investment
Annual rate of return = Expected annual net income÷Average investment
Average investment = Original investment + Value at End of useful life
On the basis of the above formulas, we can have the following conclusion.
Return on average investment of Diamondo
= $370,000 ÷ ($1,200,000 + 0)
Return on average investment of Divine diamonds
= $320,000 ÷ ($1,000,000+ 0)
Return on average investment of Rough diamonds
= $320,000 ÷ ($900,000+ 0)
On the basis of the above data we can have the rank of the Return on average investment:
Rough Diamonds > Divine Diamonds > Diamondo
B Comment on the ranking
Under the method of net present value method which focuses on the net present value in term of cash inflow increases. The ranking under this method is Divine Diamonds> Diamondo > Rough Diamonds which is the same as the ranking by estimated life of the three machines, in other words the net present value method focuses the aggregate cash inflows of an investment in today’s perspective, but it has not considered the efficiency of the investment. The payback period different from the net present value method focuses on how fast the cash inflow could payback the investment. The ranking using this method is Rough Diamonds > Diamondo > Divine Diamonds, the optimal choose by this method is Rough Diamonds which has the least initial cost and moderate annual cash inflow increase. The return on average investment consider the annual expected profit against the initial cost as important, it focuses on the return of the investment but neglects the present value compared to the net present value method. Of these three methods, the net present value method will provide the best result for the company as it is a standard method for evaluating the time value of money of these three machines which are long term investments.
The firm may prefer the payback period if the cash flow is critical to the company and that’s why the company is focusing on the payback period and hope that the investment could be paid back in term of cash inflow in the shortest period. And the company also might prefer the return on average investment while it is focusing on the profitability of the investments.
Anthony & Govindarajan 2004, Anthony, R. N. & Govindarajan, V. 2004, Management Control Systems, 11th edn, McGraw-Hill/Irwin, New York
Christie, A. A., Joye, M. P. & Watt, R. L. 2003, Decentralization of firm: Theory and evidence, Journal of corporate finance, 9 (1), pp.3-36
Maslow, A. 1954. Motivation and Personality. New York: Harper. pp. 236
Mejia, G. L. & Wiseman, R. 1997, Reframing executive compensation: An assessment and outlook, Journal of Management, 23:293-347
Schoute, M. 2008, Determinants of responsibility centre choices, JAMAR, Vol. 6. No.1, Vrije Universiteit Amsterdam