Northrend Forest Products
Question 12:
Northrend Forest Products uses an incentive-based compensation plan for its upper management personnel. a. Do you see any obvious conceptual problems with the company’s compensation program? b. How would you expect the compensation plan to influence managers’ reaction to Betty’s recommendation? Would these reactions be good or bad from the standpoint of maximizing the price of NFP’s stock? c. What other options could NFP consider to reduce the division impact on compensation?
Answer:
a. There are some obvious flaws that can be easily recognized from the company’s current incentive-based compensation plan: * The first problem with the compensation plan is that it seems to be unfair for the division managers. To senior executive managers of NFP, incentive compensation is based on the performance of the entire corporation and it is fine. But to division managers, using those three factors (ROE, sales growth and earnings growth) at division level is unfair as those ratios varies across industries and might be out of the managers control. For example, the industry of Plastic goods and Real estate usually provide higher growth rate than other industry; therefore, even managers in Wood and Timber products division do their jobs equal or better than their Plastic and Real estate counterparts, their compensation still might be lower than them. As a result, the factors might not reflect the division managers’ real performance. * The second problem of the compensation plan is that the compensation only takes into account how profitable of each division regardless of risk. As only focus on profit, this current compensation plan encourage division managers to take risk as the higher the risk of the project, the higher the profit the project offers. The entire corporation might suffer if all the risky projects perform negatively. * Finally, the factors used to evaluate compensation are averaged over the last three years. This method of
Northrend Forest Products uses an incentive-based compensation plan for its upper management personnel. a. Do you see any obvious conceptual problems with the company’s compensation program? b. How would you expect the compensation plan to influence managers’ reaction to Betty’s recommendation? Would these reactions be good or bad from the standpoint of maximizing the price of NFP’s stock? c. What other options could NFP consider to reduce the division impact on compensation?
Answer:
a. There are some obvious flaws that can be easily recognized from the company’s current incentive-based compensation plan: * The first problem with the compensation plan is that it seems to be unfair for the division managers. To senior executive managers of NFP, incentive compensation is based on the performance of the entire corporation and it is fine. But to division managers, using those three factors (ROE, sales growth and earnings growth) at division level is unfair as those ratios varies across industries and might be out of the managers control. For example, the industry of Plastic goods and Real estate usually provide higher growth rate than other industry; therefore, even managers in Wood and Timber products division do their jobs equal or better than their Plastic and Real estate counterparts, their compensation still might be lower than them. As a result, the factors might not reflect the division managers’ real performance. * The second problem of the compensation plan is that the compensation only takes into account how profitable of each division regardless of risk. As only focus on profit, this current compensation plan encourage division managers to take risk as the higher the risk of the project, the higher the profit the project offers. The entire corporation might suffer if all the risky projects perform negatively. * Finally, the factors used to evaluate compensation are averaged over the last three years. This method of