INTRODUCTION

Baier Building Products is a small privately held wholesaler that provides commodity

building products to independent retail lumberyards. Organized as a corporation, the

company is strictly a regional wholesaler, selling products manufactured at lumber

mills to independent lumberyards. Over the years the company has built a strong reputation

for quality and customer service in Connecticut, Rhode Island, Massachusetts, and sections

of New York. However, very few new independent lumberyards are opening, and established

yards rarely expand into new locations. Independent yards are consolidating or closing in

response to the emergence of large national chains. Accordingly, Baier has established

several important strategic objectives, including improving market penetration and estab-

lishing good working relationships with existing customers.

Teddy Baier, the companys controller, took a copy of the firms financials (Table 1)

and started comparing the current years performance to the previous years results. Teddy,

the son of one of the owners, was concerned about data suggesting problems with Baiers

sales compensation scheme. Not only did the compensation scheme encourage opportunistic

behavior that produced large bonuses unrelated to effort, but the compensation scheme also

included incentives that might be discouraging cooperation among employees.

In the preceding 12 months, commodity building products markets experienced steep

price increases, resulting in record profits for the company. But Teddy doubted that the

performance level could be sustained because much of the profit increase was a function

of market forces rather than the direct result of sales force efforts. In addition to traditional

market forces such as the number of housing starts, uncertainty created by international

trade disputes had historically caused price fluctuations. The past few decades had witnessed

several periods of significant price volatility, during which replacement costs and selling

prices varied dramatically both weekly and daily. At other times market prices experienced

extended flat or drifting periods.

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TABLE 1

Baier Building Products

Income Statement Summary

Out-of-Warehouse Direct Total

Panel A: 2004 Actual Out-of-Warehouse versus Direct Sales

Sales $4,976,940 $8,785,710 $13,762,650

Cost of Sales 4,280,168 8,082,854 12,363,022

Gross Margin 696,772 702,856 1,399,628

Commissions 27,871 28,114 55,985

Operating Costs 455,781

Pre-tax Income $887,862

Panel B: 2003 Actual Out-of-Warehouse versus Direct Sales

Sales $4,053,810 $3,183,078 $7,236,888

Cost of Sales 3,687,759 3,090,094 6,777,853

Gross Margin 366,051 92,984 459,035

Commissions 14,642 4,708 19,350

Operating Costs 402,691

Pre-tax Income $36,994

Although Baier follows a corporate strategy that emphasizes growth in unit volume as

well as in sales dollars and margin, tracking unit volume is challenging due to differences

in the units of measure for various products, including square feet, board feet, or pieces.

Furthermore, market price volatility and difficulties of volume measurement make it hard

to correlate sales and margin performance to actual unit volume growth. Consequently,

Teddy is concerned that the company is paying out substantially more in sales commissions

this year compared to previous years without increasing unit volume. Given higher market

prices this year compared to last and incentives built into the companys compensation

system, Teddy wonders if employees are earning higher commissions without increasing

volume. He would also like to realign commission plan incentives with current business

objectives. During past periods of price volatility, Baier owners took a much more active

role in daily operations, keeping the business on track in terms of unit volume growth and

other corporate strategies. Teddy worries that owners might be delegating authority to em-

ployees who do not share the same objectives.

INDUSTRY OVERVIEW

The wholesale commodity building products business entails two sales channels: direct

and out-of-warehouse. Direct sales are so named because product is sent directly from the

mill (point of manufacture) to the lumberyard, thereby eliminating the need for the whole-

saler to operate warehouse facilities. Under direct sales contracts, very large orders (e.g.,

full truckloads or railcars) are shipped from the mill to customers with delivery times of

between three and eight weeks. Because the price is firmly set at the time of sale and

purchases represent large dollar commitments made many weeks in advance of receiving

the material, lumberyards use direct sales brokers to guide purchasing decisions. In partic-

ular, lumberyards value the services of brokers who can advise them about changes in the

building products market, because such advice allows yards to carefully plan for large

purchases with extended delivery times. Mills also value brokers who have developed good

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relationships with regional lumberyards. The direct sales business does not require a large

investment in fixed assets because the direct wholesaler serves as a broker and never takes

physical possession of product.

Out-of-warehouse transactions require wholesalers to purchase large quantities from

mills for shipment to wholesaler warehouse facilities. The wholesalers store the material

and prepare it for quick delivery in smaller quantities to local lumberyards. Unlike direct

sales transactions, out-of-warehouse transactions require wholesalers such as Baier Building

Products to invest in warehouse facilities and maintain adequate inventory stock levels.

Since out-of-warehouse sales incur costs tied to inbound and outbound shipping, storage,

and handling, end prices are higher than those charged for direct sales products. However,

lumberyards are willing to pay higher prices for out-of-warehouse sales because quick

delivery of small order quantities allows them to operate with fewer inventories than would

otherwise be required.

Potential synergies emerge when direct and out-of-warehouse sales are combined. Both

sales channels require strong market knowledge and the building of good relationships with

mills and lumberyards. Wholesalers with readily available product in their warehouses have

a competitive edge over wholesalers that have only direct sales capabilities. In the event of

unexpected delays in order shipments, wholesalers with warehouse inventories can make

some product available to direct sales customers. All other factors being equal, direct sales

customers are more likely to do business with wholesalers that have warehouse facilities

than with companies that only have direct sales capabilities. In fact, direct sales customers

are sometimes willing to pay slightly more per transaction to wholesalers with warehouse

facilities to reduce the risk of delayed deliveries.

COMPANY BACKGROUND

Dave and Ernie started the business in 1980, working out of their homes while bro-

kering direct sales of building products. In those early years, the direct sales business was

ideal because minimal investment was required. By the mid-1980s, the business was grow-

ing and showing consistent profitability; although revenue per unit was low, so was cost.

The company did not incur storage, handling, or outbound transportation costs because, as

brokers of direct sales, they did not take physical possession of product. A good part of

the companys competitive edge came from the strong industry knowledge of the founding

owners, Dave and Ernie Baierbrothers with an encyclopedic knowledge of building prod-

ucts that they used to gauge, predict, and capitalize on market changes. They never invested

heavily in information systems or instituted sophisticated performance incentives because

they relied on their industry knowledge and experience to guide their decisions.

Although brokering direct sales was profitable, Dave and Ernie wanted to expand. By

concentrating on only direct sales, they felt they were missing the synergies associated with

servicing both direct and out-of-warehouse customers. Expanding into the out-of-warehouse

business would allow them to capitalize on their specialized knowledge of building products

in a market with higher contribution margins. The availability of warehouse facilities would

also give them a competitive edge with direct sales customers. The brothers had learned

that direct sales customers often prefer dealing with wholesalers with warehouse facilities

because of reduced late delivery risks. When investigating the out-of-warehouse business,

Dave and Ernie found that revenue per unit is higher than that for direct sales, but so are

costs. Even considering the greater costs, they noted that margin percentages for out-of-

warehouse sales were historically higher than for direct salesa reflection of the value

lumberyards place on the convenience of out-of-warehouse sales.

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In 1987 the brothers decided to use inheritance money to buy a warehouse and to move

into the out-of-warehouse business. Revenues grew steadily, and the brothers found that a

60/40 split between warehouse/direct sales was ideal. The objective of maintaining a 60/

40 split was based on conventional wisdom and analyses showing that whenever direct

sales exceeded warehouse transactions, company income suffered. Dave and Ernie also

determined that too much focus on direct sales often meant insufficient warehouse inventory

to support higher margin out-of-warehouse sales. Having sufficient inventory levels was

critical to serving the companys out-of-warehouse customers.

In 1992 they hired Herman as their first salesman to support the out-of-warehouse

business and paid him a fixed salary plus commissions. Throughout this period Ernie served

as president, and Dave worked as the trader of commodity building products; in his role,

Dave was actively involved in brokering direct sales and purchasing inventory for the out-

of-warehouse business. As the business grew, Dave began keeping a watchful eye on the

relationship between volume and margins by reviewing the daily sales report, which detailed

product line, quantity, margin, and type (out-of-warehouse versus direct) for each transac-

tion scheduled to ship the next day. He also started to regularly examine an inventory

report, which showed inventory levels by product line and orders to be placed with mills.

Daves specialized knowledge as a trader made him very effective at knowing when and

how much inventory to secure. He was also very careful to balance the need to maintain

adequate inventory for out-of-warehouse customers with the demands of the direct sales

business.

Teddy, Daves son, joined the business as controller in 1999. One year later, Ernie

retired, and Dave took over as president. Dave found that he could not handle both the

presidents job and his responsibilities as a trader, so he hired Scott to take over his trading

duties. Dave believed that Scott, who had worked as a trader for another building products

firm, had the requisite skill set to be an effective trader. Since joining the firm, Scott has

built solid relationships with both lumberyards and mills. The last major personnel addition

occurred in 2001, when Molly was hired to support out-of-warehouse sales.

The companys current customer base consists exclusively of regional lumberyards.

Based on their unique market niches, some of these lumberyards are primarily out-of-

warehouse customers, while others are predominately direct sales customers. Regardless of

sales channel type, customers expect their wholesalers to have strong product and market

knowledge and be willing to share that knowledge with lumberyard staff. Customers also

expect complete and timely deliveries, attractive pricing, accurate invoicing, fair return

policies, and adequate levels of quality product.

CURRENT COMPENSATION PLAN AND KEY PERSONNEL

Given the importance of product knowledge, one strategic objective for the Baier Com-

pany is to develop and maintain product line expertise among its current staff. Therefore,

Dave has assigned certain products to individual members of the sales team, so the company

may develop product line experts who can assist other salespersons by supplying infor-

mation about specific products.

As shown in the Figure 1 organization chart, Teddy, Scott, Herman, and Molly report

to Dave. Specifically, Herman and Molly are responsible for out-of-warehouse sales, and

Scott is the companys trader. To encourage Herman and Molly to maintain and expand

their product knowledge, Dave has designated both of them as product line experts and

assigned them to specific customers and products. As out-of-warehouse salespeople,

Herman and Molly have compensation packages that consist of a base salary plus two

commission payments: one based on a fixed percentage of gross margin dollars of all sales

Baier Building Products, Inc.: Performance Incentives and Variance Analysis 285

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FIGURE 1

Baier Building Products

Organization Chart

Dave

Owner

and

President

Teddy

Controller

Accounting and

Financial Analysis

Scott

Trader

Direct Sales Broker

Purchases product for

warehouse.

Herman

Out-of-Warehouse Sales

Product Line Expert

Molly

Out-of-Warehouse Sales

Product Line Expert

to their assigned customers, and one based on a fixed percentage of gross margin dollars

generated in their product lines, regardless of who actually made the sale.

Herman is loyal to Dave, but he is resistant to change and very sensitive to any attempt

to alter his compensation plan. Although Herman is extremely knowledgeable and well

liked by all of his customers, he would consider leaving the company if a more lucrative

opportunity became available, or if he believed he was being unfairly affected by a change

in the compensation plan. Meanwhile, Molly has five years of experience in the business,

three with Baier. While she consistently demonstrates good business judgment and is liked

by her customers, she lacks Hermans depth of knowledge and experience.

When Scott assumed Daves trader duties, he became accountable for two related re-

sponsibilities: brokering direct sales and purchasing commodity inventory for the out-of-

warehouse business. Because of the companys small size and difficulty in finding qualified

individuals, Dave never seriously considered hiring two people and splitting these duties.

He felt fortunate that he was able to convince one knowledgeable person to come work for

Baier, since good traders are hard to find. The activities of a commodity building products

trader are in many ways analogous to those of a Wall Street trader. The traders position

requires both specialized knowledge and the ability to handle high levels of stress. Before

Scott was hired, Herman (who has the requisite knowledge) tried the trader position, but

he asked to go back to his old job after less than a month.

As the trader, Scott is not assigned any customers and is paid a commission on gross

margin dollars generated by direct sales. When demand is high and product is hard to

acquire, the current compensation plan gives Scott an incentive to focus most of his efforts

on direct sales and spend less time purchasing product for out-of-warehouse sales. Con-

sequently, Herman and Molly complain that they often do not have enough warehouse

inventory to sell to their customers. They point out that their customers are Baiers bread

and butter (60 percent of sales), and need to be accommodated, or they will patronize

competitors. Not only do Herman and Molly resent their lost commissions when there is

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TABLE 2

Baier Building Products

2004 Sales in 2003 Prices

Out-of-Warehouse Direct Total

2004 Sales Restateda $4,037,319 $6,801,279 $10,838,598

2003 Sales $4,053,810 $3,183,078 $7,236,888

Real Growth (% increase) None 114% 50%

Commission Payments Growthb 90% 497% 189%

a 2004 sales were indexed to 2003 dollars by referencing key commodity price levels reported in the 2005

Yearbook of Forest Product Market Prices and Statistics (2006) published by Random Lengths Publications. b Commission growth computed using the following formula:

2004 commission payments 2003 commission payments

2003 commission payments

not enough product in the warehouse, but they also have to work harder to preserve their

relationships with the customers involved.

Dave was surprised when he heard about the problem; he never anticipated having to

deal with such an issue when he left the traders position and hired Scott. When Dave was

more actively involved in the sales function, this type of problem never occurred. Dave

started to entertain different solutions, including hiring another individual to make out-of-

warehouse business purchases, monitoring Scotts transactions more closely, and changing

the compensation system. After reviewing the financials with Teddy, Dave concluded that

they could not afford to hire another person with Scotts skill set, even if someone could

be found. Instead, Dave decided that he would resume inspecting and approving the two

reports that he used to examine on a regular basis before he took over the company pres-

idencythe daily sales and inventory. Daves decision to resume monitoring these reports

gives him the information he needs to exert final control over the daily sales and inventory

purchase transactions. Although Dave and Teddy were confident that this additional mon-

itoring would be helpful, they concluded that the company also needed to change the

compensation system.

Another problem with the current compensation system is that it does not provide

adequate incentives to make sure that the paperwork for each sale is done correctly. This

problem is especially relevant, since a company objective is to become an error-free sup-

plier, a characteristic highly valued by the companys customers. Currently, incorrect pa-

perwork has resulted in a variety of problems, such as shipping the wrong product and/or

quantities. Presently, the system allows the company to trace paperwork problems to specific

customers and products, but not to specific employees. Moreover, the current system pro-

vides information at the end of each month on reasons for credit memos and adjustments

(e.g., errors in shipping, pricing, or quantity).

After completing his review of the financials, Teddy decided to restate 2004 sales

dollars in terms of 2003 prices. He used several years of historical data published in an

industry newsletter to establish 2003 price levels on key commodity products before in-

dexing equivalent 2004 data. The restated information revealed that out-of-warehouse com-

mission payments nearly doubled from 2003 to 2004 in spite of flat year-to-year sales

(Table 2). The relationship between sales growth and commission payments was even more

Baier Building Products, Inc.: Performance Incentives and Variance Analysis 287

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TABLE 4

Compensation Plan Criteria

1. Employees should be paid a competitive salary and have a commission plan without a cap.

2. Under normal circumstances, base salary is expected to account for 2/3 of total compensation

(wages plus commissions/bonuses).

3. Large commissions and/or bonuses are acceptable as long as they are tied to incremental

contributions to company strategic objectives and effort.

4. Opportunistic and/or self-serving behavior by individual employees should be discouraged by

the plan. The compensation plan needs to encourage good working relationships among

employees, a key strategic objective for the company.

5. The resulting compensation scheme should be: Tied to the companys strategic goals Easy to understand by the participants Verifiable by the participants without resorting to overly complex computations Limited to a maximum of 12 measures

6. Efforts should be made to balance the need for adequate inventory for out-of-warehouse customers

with the needs of the direct sales business.

TABLE 3

2 4 8-Foot Studs

Actual versus Budget

Out-of-Warehouse Direct Total

Panel A: 2004 Budget for 2 4 8-Foot Studs, Out-of-Warehouse versus Direct Sales

Units (in 1,000 board feet) 6,000 4,000 10,000

Sales $1,836,000 $1,000,000 $2,836,000

Total Contribution Margina $165,240 $30,000 $195,240

Commissions $6,610 $1,200 $7,810

Contribution Margin Per Unita $27.54 $7.50

Panel B: Actual for 2 4 8-Foot Studs, Out-of-Warehouse versus Direct Sales

Units (in 1,000 board feet) 2,283 4,371 6,654

Sales $995,388 $1,757,142 $2,752,530

Total Contribution Margina $139,354 $140,571 $279,925

Commissions $5,574 $5,623 $11,197

Contribution Margin Per Unita $61.04 $32.16

a Total Contribution Margin and Contribution Margin Per Unit are shown before deducting commissions.

extreme for direct sales. Teddy then collected budget versus actual information for 2 4

8-foot studsa product line that saw some of the largest price increases and that was

budgeted to account for 20 percent of the 2004 sales volume. Teddy had heard that out-of-

warehouse volume for this product line was substantially lower than expected, and he

wanted to see the exact dollar amount. The information shown in Table 3 supported his

suspicions: actual out-of-warehouse sales volume for the product line was less than half

the budgeted volume. However, total commission payments were higher than budget due

to price increases and the shift to direct sales.

Teddy knew that changes were needed. He took the list of criteria that his father and

uncle created (Table 4) and began working on a new compensation scheme. He had recently

288 Lamberton

Issues in Accounting Education, May 2008

read about the balanced scorecard (BSC) and wanted to implement some of the same

concepts. However, being familiar with the constraints of a small business, Teddy knew

that any new compensation plan must not be too cumbersome to implement.

Assume the role of Teddy the controller. Before designing a new compensation plan, you wanted to better understand sales performance for the two sales channels, direct and out-of-warehouse.

1. Perform a sales performance analysis by computing all the appropriate variances using the information collected for the 2x4 8-foot studs.

2. What other information (if any) would you like to have in order to perform your analysis in even more detail?

3. What insights does the analysis of sales performance provide to Dave? How does this analysis provide any insight that would be helpful in designing a new compensation scheme?