Reference no: EM132743633

Question - (ROI, RI, division manager's compensation, nonfinancial measures - CGA adapted)

General Appliance builds coffee makers and battery-powered small tools. For a long time, GA held a reputation for strong, durable, and reliable appliances. This reputation began to decline however when increased competition forced GA to cut costs, and this was handled poorly. For a moderate period following the cost cutting, as long as they were able to take advantage of their reputation, GA's sales remained relatively steady. This effect then all but disappeared. The loss of reputation, coupled with increased overseas competition, caused GA's sales to plummet sharply.

On January 1, 2018, GA began a massive effort directed toward rewarding for quality. In the two years that followed, sales failed to go up, but remained steady at around $10 million per year. A significant amount of money was spent on testing equipment, increasing inspection, setting up a statistical process control system, reworking or throwing out defective items, and on paying incentives. The results of the effort are presented in the following exhibit:

Quality costs as a % of sales for the years ended 2017 2018 2019

External Failure Cost 8.20 2.40 1.15

Internal Failure Costs 2.80 4.00 3.40

Appraisal Costs 2.00 3.20 3.39

Prevention Costs 1.20 2.60 2.79

Total Quality Costs 14.20 12.20 10.73

Also on January 1, 2018, GA got organized into 3 divisions: electronic circuits, coffee makers and battery-powered small tools. Electronic circuits were used by the other 2 divisions, and 100% of its production was transferred at full cost plus an 8% mark up (this is the standard practice in the electronic components industry) to coffee makers and battery-powered small tools. All rejections made by coffee makers and small tools were treated in the quality control system as internal failures, but most of the times they were not reported simply because electronic circuits replaced them immediately in the production lines.

Each division had a bonus pool with 50% based on quality performance and 50% based on financial performance. The 50% based on financial performance is equal to the 20% of the divisional residual income (the minimum required rate of return is the ROI of the worst performing division). The 50% based on quality performance is calculated as: (Internal Failures as % of sales - External Failures as % of sales) x GA's net profit.

Given the results of last year, the manager of the coffee maker division asked the top managers to review the current compensation system, because he was having the feeling that his division has been subsidizing those 'lazy' fellows of electronic circuits. He supported his claim with the following:

2019 Electronic circuits Coffee makers Battery-powered small tools

Net profit $500,000 $700,000 $660,000

Investment $2,500,000 $7,000,000 $6,000,000

External failures 0% of sales 1.2% of sales 2.4% of sales

Internal failures 5% of sales 2% of sales 3.2% of sales

Appraisal costs 0% of sales 5.2% of sales 3.1% of sales

Prevention Costs 1% of sales 7% of sales 4.2% of sales

Instructions - Calculate the bonus paid to each division. Explain to the upper management if the money is being spending effectively and if the claims of the divisional manager are correct.