Equitile Software Consulting

Marian Fisher, the founder and CEO of Equitile Software Consulting, sat down at her desk in early August 2019 and opened a blank Word document. She met with the heads of Equitile's four operating units every August to complete a thorough review of the business and begin the budgeting process for the next year. The company had been growing steadily for several years, but her recent conversations with managers and staff made her uneasy. Even as one of the units appeared to be having a blockbuster year, she worried that two units were going to underperform. Before meeting with the unit heads, she wanted to consider whether the current performance evaluation and compensation practices gave managers the incentives to grow the business and improve profitability.

Fisher reviewed the condensed financial information for each unit, as shown in Exhibit 1. The four units were roughly the same size and operated mostly independently, with only minimal cross-unit cost allocations applied for shared corporate expenses. The Electronic Medical Record and the Healthcare Law Advisory consulting divisions were unusual in that they tended to share the same clientsonce a hospital or clinic became a customer for one division, the other division was likely to sell additional services to the same customer. The link between the units was so strong that an internal company analysis showed that every incremental dollar of revenue for one of the units resulted in an incremental $0.40 of revenue and $0.15 of EBITDA for the other.

All four divisions were quite profitable on an EBITDA basis in 2018, and top-line sales growth had been in the high single-digits or double-digits for most divisions for the last three years. The only exception was the Internal Control Systems group, which actually recorded negative revenue growth from 2016 to 2017, and it appeared that the Internal Control Systems would underperform again in 2019. Fisher received a note from the unit manager the previous week stating that he expects that sales will be only 14.1m, rather than the originally budgeted 14.6m. Similarly, EBITDA is now expected to be 3.2m, rather than the budgeted 3.6m. If nothing else, she was becoming frustrated by the volatility of the division's performance. Notes from the other unit managers suggested that the other units are all running approximately at budget.

The four unit managers have the same compensation structure. In addition to a base salary, each manager has the opportunity to earn two separate bonuses, one meant to encourage the manager to grow sales and the other meant to improve profitability. The sales bonus is equal to at least one-half of the manager's budgeted base salary, but is earned only if the manager's division achieves at least 105% of last year's sales. The bonus increases by 2.5% of the manager's base salary for every 1% improvement on last year's sales (over and above 105% of last year's sales), up to a maximum of 125% of last year's sales. So, as an example, if the manager's division achieves 115% of last year's sales (i.e., 15% growth), then the manager's bonus equals 75% of the manager's base salary. If the manager's division achieves more than 125% of last year's sales, the manager's bonus is capped at 100% of the manager's base salary. If the manager's division achieves less than 105% of last year's sales, then the manager gets no sales bonus.

The second bonus for profit is designed similarly, but rather than being based on performance versus last year, it is based on performance relative to budget. When the executive team budgets EBITDA for each unit every year, this budgeted amount is usually just set to be equal to the prior year's performance. Like the sales bonus, the profit bonus is equal to at least one-half of the manager's budgeted base salary, but is earned only if the manager's division achieves at least 100% of the unit's budgeted EBITDA. The bonus increases by 1% of the manager's base salary for every 1% improvement on budgeted EBITDA, up to a maximum of 130% of budgeted EBITDA. Exhibit 2 summarizes the compensation for the unit managers over the last three years.

Answer the following.

1. To understand the incentives motivated by the performance evaluation and compensation system, consider the following decisions currently facing unit managers:

1. The Internal Control Systems unit manager has just been approached by a long-time client for an urgent project. The client is willing to pay $600K if the project is completed before the end of 2019. Otherwise, the project can be deferred to next year, in which case the client is willing to pay $450K. The unit manager estimates the project would be accretive to EBITDA by $300K (in 2019) if the project is undertaken this year, and by $180K (in 2020) if the project is undertaken next year. Would you expect the unit manager to take the project in 2019 or defer it to 2020? What decision would Fisher prefer?
2. Fisher recently observed two phenomena when reviewing performance over the last few years: 1) all divisions have been managing personnel expenses particularly well and 2) capital budget requests have increased significantly. She is trying to understand what may be driving these changes when she learns about a decision facing the Utilities Project Management unit. The Utilities Project Management unit manager is evaluating whether to purchase and roll out a new cloud-based system that would improve the efficiency of the contracting process with major suppliers. The unit manager's staff estimate that the system would require an upfront investment of $1.2m at the end of 2019, which would be capitalized and then amortized over the next five years. The staff also estimate that the investment would allow the unit to save $270K in personnel expenses (SG&A) for each of the next five years. Assume the unit uses 8% as the annual discount rate for project evaluation purposes, and assume the $270K would be incurred at the end of each year. Would you expect the unit manager to take the project?
3. The Electronic Medical Record unit manager is considering whether to bid for a new consulting contract put out by an organization that runs mobile health clinics. Her recent conversations with the sourcing manager at the organization have led her to believe that she can win the contract if she bids $1.5m. Unfortunately, her latest estimates suggest that the total cost of the contract would be quite high, and the most likely scenario is that her unit would actually lose about $100K (in EBITDA) on it. Would you expect the unit manager to take the project?

2. Evaluate the effectiveness of the Equitile's compensation scheme for the unit managers. Specifically, discuss the incentives and behavior that arise from:

1. The use of sales and EBITDA as metrics of performance (e.g., do we want managers to account for other factors when making decisions and if so, what factors are relevant?).
2. How targets are set for sales and EBITDA for bonus purposes. That is, consider the use of various bases including prior year actuals and budget amounts that reflect unit managers' expectations of performance for a given year.
3. Using a floor and ceiling for bonuses.

3. With three of the unit managers over the age of 60, Fisher expects a series of retirements on the horizon, and she would have to recruit their replacements. She also realized that she set the compensation system up for managers in the middle of their careers. Would the current incentive system be effective for managers at the end of their careers as well as for the new unit heads who replace them?

Exhibit 2: Condensed Compensation Information for Managers:

(all amounts in thousands)	2016	2017	2018	2019
	Actual	Actual	Actual	Budgeted
Electronic Medical Record
Salary	260	272	278	302
Sales bonus	161	-	172
EBITDA bonus	143	140	161
Utilities Project Management
Salary	242	270	280	295
Sales bonus	143	158	186
EBITDA bonus	-	161	170
Healthcare Law Advisory
Salary	330	350	355	362
Sales bonus	244	-	-
EBITDA bonus	221	220	183
Internal Control Systems
Salary	198	204	240	260
Sales bonus	137	-	140
EBITDA bonus	149	-	159

Exhibit 1: Condensed Unit Financial Information:

(all amounts in millions)	2016	2017	2018	2019
	Actual	Actual	Actual	Budgeted
Electronic Medical Record
Sales	18.2	18.6	20.4	24.1
EBITDA	6.2	6.3	6.8	6.8
Pre-tax operating income	2.2	1.9	1.9	2.1
Utilities Project Management
Sales	16.7	18.1	20.2	25.1
EBITDA	4.2	4.6	5.1	5.1
Pre-tax operating income	0.1	0.1	0.2	0.4
Healthcare Law Advisory
Sales	19.7	19.8	20.6	22.2
EBITDA	5.5	6.2	6.3	6.3
Pre-tax operating income	2.7	2.7	3	2.9
Internal Control Systems
Sales	14.3	13.1	14.2	14.6
EBITDA	3.4	3.1	3.6	3.6
Pre-tax operating income	0.9	0.8	1	1