In January, Gloria Kan, CEO of Kan Enterprises, sat in her corner office overlooking Hong Kong harbour, puzzling over the group's most recent acquisition, Maple Products ("MP"). This business, which operates out of Leeds, UK, should have resulted in a good return for the Kan group, but something did not seem quite right.

Kan Enterprises is a conglomerate with subsidiaries and joint ventures in more than 60 countries; its operations include construction, manufacturing, and telecommunications. The primary business of MP is to sell air conditioning pumps, which it does throughout Europe. MP also sells accessories to repair and maintain the pumps, but around 90% of turnover and profits are from the pumps themselves. MP purchases kits for making the air conditioning pumps, mainly from East Asia, and assembles them at its factory in Leeds. Kan Enterprises purchased MP 15 months ago and agreed on budgets with the managing director shortly after that. Gloria Kan had expected the business to generate annual profits of between 10 and 12 million GBP.

Management Incentives

Bonuses for the directors of MP were set at the start of the budget year based on return on assets (ROA), as shown in Table 1. ROA is calculated as the profit for the year divided by the average of the opening and closing asset base (total assets less current liabilities), as recorded in the management accounts.

Maple Products owns its premises in Leeds outright and the land and buildings were revalued three years ago; the revalued amount is recorded in the management accounts (net of depreciation). The plant and machinery in Leeds is old but serviceable and currently has a very low net book value. Due to frequent shipping delays, MP holds high levels of raw materials inventory; trade receivable levels are also high because MP sells to major wholesalers who negotiate long periods of credit. All these factors contribute to the asset base used in the calculation of ROA. ROA is the standard measure used by Kan Enterprises for all its divisions. The median ROA in the air conditioning sector is 14%. The top quartile reports a ROA of 17% or more.

Bonus Ratchet

The agreement Kan Enterprises established with the team at MP was that when the ROA exceeds 15%, the Maple Products directors receive a bonus equal to 10% of salary. There is also an incentive ratchet, with a bonus of 15% of salary if ROA exceeds 18.5%, or a bonus of 20% of salary if ROA exceeds 22%.

The base bonus (10% of salary) results in directors' total remuneration being around the median for the sector. A bonus of 15% of salary puts the directors just below the top quartile for the sector, while a bonus of 20% of salary puts the directors just below the top decile for the sector.

Detail of Budgeted Profit for the Year

Gloria Kan inspected the detailed original budget for Maple Products (Table 2), prepared the previous January.

The managing director of MP has overall responsibility for achieving the profit for the year; this director is also responsible for MP investment decisions.

EMEA Regional Report

The team in charge of businesses in the EMEA (Europe, the Middle East, and Africa) region also prepared business notes, which include details on Maple Products. Some events had occurred after the original budget was drawn up and were not reflected in the figures in Table 2. The EMEA report noted that a new sales office had been set up in April for Maple Products using unoccupied space at Kan Enterprises' headquarters in Hong Kong, to take advantage of Kan Enterprises' contacts in the Asia-Pacific region. The estimate for sales in the Asia-Pacific region at the time of this development was in the order of 300,000 units from April to December (this would have resulted in 4,200,000 total units sold for the year). However, the sales office had been enormously successful, resulting in 600,000 units sold in the Asia-Pacific region, and therefore worldwide sales of 4,500,000 units for the year.

Part A Discussion Questions

Complete these tasks before moving on.

1. Taking on the role of a director in Maple Products, how might the incentive scheme affect your behavior as a director throughout the year? Would you have been largely in favor or against the expansion into the Asia-Pacific region?