Operating income is a good summary measure of short-term financial performance. By itself, however, it does not indicate whether operating income in the short run was earned by taking action that would lead to long-run competitive advantage. For example, a manager might increase short-term operating income by producing more product while ignoring quality or the amount of rework. However, the company would like to see an increase in operating income without sacrificing quality. This problem illustrates one compensation method that might be used to motivate managers to act in the best interest of the company.

Valley Corporation specializes in the manufacture of office furniture. Historically, Jack McCraw, president of Valley, paid managers a bonus based completely on operating income. In 2016, the Spectrum division manager earned a bonus of $27,060 and the Ranger division earned a bonus of $22,400.

In 2017, Jack decided to revise the bonus plan to encourage division managers to focus on areas that were important to customers and that added value without increasing cost. In addition to operating income, the revised plan included incentives for reduced rework costs, reduced sales returns, and on-time deliveries. Bonuses are now calculated and awarded annually on the following basis:

A base bonus of 2% of operating income, adjusted for three factors Rework costs o The bonus is reduced for excess rework costs over and above 2% of operating income.

On-time deliveries o The bonus is increased by $5,000 if more than 98% of deliveries are on time, and by $2,000 if 96% to 98% of deliveries are on time. o The bonus is not adjusted if on-time deliveries are below 96%. Sales returns o The bonus is increased by $3,000 if sales returns are less than or equal to 1.5% of sales. o The bonus is decreased by 50% of any excess of sales returns over 1.5% of sales.

Results for Valleys Spectrum division and Ranger division for 2017 and 2018, the first two years under the new bonus plan, are provided in the table below.

Note: If a bonus results in a negative amount for a particular year, the manager simply receives no bonus. The negative amount is not carried forward to the next year.

For each division, create two tables like the example below and calculate the bonus earned by each manager for 2017 and 2018. Be sure to show your work! What effect did the change in bonus plan have on each manager's behavior over the course of the two years? Specifically, did the bonuses achieve the company's goals (increase operating income while reducing on-time deliveries, rework costs, and sales returns)? Explain your answer in detail. List at least two other adjustments to the bonus structure that might improve the new plan and explain how they would encourage goal congruence