(Pay and incentives) Peach Chemical Corporation is a multinational firm that markets a variety of chemicals for industrial uses. One of the many autonomous divisions is the North America Petro-Chemical Division (NAPCD). The man¬ ager of NAPCD, Karyn Kravitz, was recently overheard discussing a vexing problem with her controller, William Michaels. The topic of discussion was whether the division should replace its existing chemical-handling equipment with newer technology that is safer, more efficient, and cheaper to operate.

According to an analysis by Mr. Michaels, the cost savings over the life of the new technology would pay for the initial cost of the technology several times over. However, Ms. Kravitz remained reluctant to invest. Her most fundamental concern involved the disposition of the old processing equipment. Because the existing equipment has been in use for only 2 years, it has a very high book value relative to its current market value. To illustrate, Ms. Kravitz noted that if the new technology is not purchased, the division will earn a net income of $4,000,000 for the year. However, if the new technology is purchased, the old equipment will have to be sold, and Ms. Kravitz noted that the division can probably sell the equipment for $E2 million. This equipment has an original cost of $8 million and $1.5 million in depreciation has been recorded. 1 hus a book loss of $5.3 million ($6.5m — $1.2m) would be recorded on the sale.

1022 PART VII Performance Evaluation Ms. Kravitz’ boss, Jim Heitz, is the president of the Western Chemical Group, and his compensation is based almost exclusively on the amount of ROI generated by his group, which includes NAPCD.

After thoroughly analyzing the facts, Ms. Kravitz concluded, “The people in the Western Chemical Group will swallow their dentures if we book a $5.3 million loss.”

a. Why is Ms. Kravitz concerned about the book loss on disposal of the old technology in her division?

b. What are the weaknesses in the performance pay plan in place for Western Chemical Group that are apparently causing Ms. Kravitz to avoid an invest¬ ment that meets all of the normal criteria to be an acceptable investment (ignoring the ROI effect)?