The company was organized by product line.

Its 16 relatively autonomous

divisions were managed as profit centers. The division managers reported to one
of four Business Group managers who, in turn, reported to the companys CEO.
Thirty managers, including all line managers at the level of division manager and
above plus key corporate staff managers, were eligible for an annual
management bonus award. (Many lowerlevel employees were included in a
separate management-by-objectives incentive plan.) The management
bonuses were based on companywide performance. Each year, a bonus pool
equal to
10% of the corporations profit after taxes in excess of 12% of the companys
book net worth was set
aside for assignment as bonuses to managers. This amount was divided by the
total salary of all the executives eligible for a bonus. This yielded an award per
dollar of salary. The maximum bonus paid was 150% of salary.
Historically IEs managers had been earning bonuses that ranged from of 30
120% of salary, with the average approximately 50%. But because of the
recession in the years 2000 and 2001, the bonus pool was zero.
Complaints about the management bonus system had been growing. Most of
them stemmed largely from division managers whose divisions were performing
well, even while the corporation as a whole was not performing well. These
managers believed that the current bonus system was unfair because it failed to
properly recognize their contributions. The quote cited at the beginning of the
case was representative of these complaints.
In response, top management, with the assistance of personnel in the corporate
Human Resources and Finance departments, proposed a new management
bonus plan with the following features:
1. Bonuses would be determined by the performance of the entity for which
each manager was responsible. That is, division manager bonuses would
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be based 100% on division performance; group man ager bonuses would
be based 100% on group performance; and corporate manager bonuses
would be based 100% on corporate performance.

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2. For bonus award purposes, actual performance would be compared with
targets negotiated during IEs annual budgeting process. IEs philosophy
was to try to set budget targets at threshold levels that were likely to
be achieved if the management teams performed efectively. Corporate
managers knew that IE was a high tech company that operated in many
business areas in which there was significant operating uncertainty. It was
often difcult to forecast the future accurately. They thought that the
relatively highly achievable budget targets provided the operating
managers with some insurance against an operating environment that
might turn out to be more harsh than that seen at the time of budget
preparation.
3. Each division would be given an economic proft objective equal to
budgeted operating
profit minus budgeted operating assets multiplied by 12%, which was
assumed to be approximately IEs weighted average cost of capital. For
example, a division with an operating profit budget of $100,000 and
budgeted operating assets of $500,000 would be given an economic profit
objective of $100,000 60,000 = $40,000.
4. The actual investment base was calculated as follows: Cash Assumed to
be 10% of cost of sales
Receivables and Average actual month-end balances inventories Fixed
assets Average actual end-of-month net book values.
5. If an entitys actual economic profits were exactly equal to its objective,
the manager would earn a bonus equal to 50% of salary. The bonus would
increase linearly at a rate of fve percentage points for each $100,000
above the objective and be reduced linearly at a rate of fve percentage
points for each $100,000 below the objective. The maximum bonus would
be
150% of salary. The minimum bonus
would be zero.

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