kasian lee <kasianlee@gmail.

com>
To:rowena.bautista2008@yahoo.com
Jun 20 at 5:02 PM
Ate rd, i found an answer for the case in the net... I hope this helps...

Although its not good to find answers in the net but i opted to copy it
still for better reference and further understanding. As i beliebe that
this answer if better as what i can create. Hahaha...

Thanks...

Case 23-3: Las Ferreterías de México, S.A. de C.V.*

Note: This case is unchanged from the Twelfth Edition.

Purpose of Case

This case was written to illustrate some of the basic problems with the return on investment (ROI)
measure of performance. The problems arise in both the numerator (profit) and denominator (investment)
of the ROI measures. The case provides sufficient detail to allow students to discuss both how to measure
the basic elements of profits and investments and the behavioral implications of the use of these
measures. Students should also consider alternatives to the use of ROI measures.

The case also allows for discussion of some other issues that managers face in the design and
implementation of incentive systems. These include decisions about what employees to include in the
plan, what target bonus to set for each type of employee included, whether to use a bonus pool feature,
how to design the function linking performance measures and incentive awards, and how to set fair
performance standards for all employees.

Suggested Assignment Questions

1. Evaluate the proposed bonus plan that Mr. Gonzalez is considering.

2. How, if at all, would you modify the proposed plan?

Case Analysis

Background

It is useful to start the discussion by clarifying some key facts. Ferreterías is a publicly held company. Its
managers aspire to have the company be a Mexican equivalent of Home Depot or Lowe’s.
Ferreterías is not a small business. It operates 82 stores, organized into nine geographical regions. With
most student groups, it is probably useful to clarify the key recurring decisions in the business, and then
to identify who in the organizational hierarchy makes these decisions. Table TN-1 presents such a list:

Table TN-1
 Key Recurring Decisions

Person(s) responsible
Key recurring decisions for making the decision

Order right items in the right quantities

S
Staffing with right numbers of good
S
people
Pricing
S
Granting credit
S (with corporate check on large
decisions)
Selling
S, R (large contractors only)
Store location and design
C
Advertising
S
Control expenses S

Key:
S = store
R = region
C = corporate

This table makes it obvious how important the store manager role is in the company. The store managers
have considerable autonomy, so they play a key role in affecting the success of each store location.

Old Incentive Plan

Before this new proposal, performance-dependent incentives were not an important part of the Ferreterías
management system. Bonuses were small (2-5%) of base salary, and they were based on the company’s
overall profits, so they were not controllable to any significant extent by any except the company’s very
top managers. Mr. Gonzalez also provided some subjective bonuses for exemplary performance.

These weak incentives seem to have caused some employees to become lazy and to be not focused on the
aspects of performance important to the company’s success. These problems are indicated in the quote
that opens the case.

New Incentive Plan

A consulting firm designed the new incentive plan. A number of issues might be discussed. One is the
decision to exclude all employees except the store, regional, and corporate managers. Clearly the lower-
level employees create value for the company, but the consulting firm decided to exclude them with the
reasoning that Ferreterías could not measure effectively the performances of these individuals. If
prompted, some students will undoubtedly be able to suggest things that could have been done. For
example, sales people could have been rewarded for bringing profits from new sales or for increasing
sales from existing customers. Yard workers could have been rewarded for receiving positive customer
feedback.
Another issue is the division of the bonus pool. Corporate managers are to be given, on average, 3%
(15%5 people) of the bonus pool. Regional managers get 1.67% each. Store managers get 0.85% each. In
comparison, the corporate bonus awards seem too high, particularly given that the top two managers, the
CEO and COO, are excluded from this plan.

A third issue is the function linking the measures with the bonus awards. There is a lower-level cutoff of
5%; no manager of a store earning an ROI of less than 5% earns any bonus. There is also an upper cutoff
at 11%. In 2002, then, six store managers earned no bonuses, and 15 managers earned the maximum.
Students should be asked to consider the behavioral implications of these cutoffs. The managers below
the 5% cutoff and above the 11% cutoff will be motivated to incur all the worthwhile expenses they can
in the current period and deferring all the revenues possible to the subsequent period because these shifts
will have no effect on their bonus. Thus, a gameplaying environment is created.

A fourth issue is controllability. The performance standards are the same for all the stores, but their
performance prospects are almost assuredly not equal. Some stores have better locations, and some
probably have more efficient layouts. Ideally, performance standards should vary by individual location.
This could be done through a formal budget negotiation process or more mechanically, such as by
adjusting the goals for differences in local construction activity.

A related problem: are the six managers earning no bonuses really the worst managers? Maybe they are
good managers who were transferred to poor performing stores and have not yet had a chance to turn
around that performance? There is no provision for making allowances for this contingency. That may
make it difficult for the company to induce good managers to move to poor-performing outlets.
Ferreterías may want to distinguish the evaluation of the store location from the evaluation of the
manager.

Finally, the logic of basing bonuses on a proportion of corporate profits can be questioned. The bonus
pool feature does limit the company’s exposure. This is a wealth-sharing feature of the plan. If the
corporation does not do well, then payouts to employees are reduced. But corporate performance is
essentially uncontrollable, even by managers at the store and regional levels, so this bonus pool feature
just subjects these employees to uncontrollable risk. The yards do not seem to be greatly interdependent,
so there is no need to have a “group reward” to motivate teamwork.

The focus of the discussion, though, should be on the technical aspects of the ROI calculation and the
behavioral impacts of making ROI the central measurement in a bonus plan. The text reading provides a
summary of some of the advantages and disadvantages of using ROI as a criterion for evaluating and
rewarding managerial performance. Instructors can remind students of this list if that is deemed desirable.
The Calculation of Profit

The accounting treatment of revenues seems unfair in part. Stores are not given credit for sales orders
written by personnel at regional or corporate levels, yet the store has to provide the good for that sale.
Thus the stores incur the stocking and handling costs. Customer service on these sales may also suffer
because the stores are not dealing with their own customers.

The stores are charged with all their local expenses, direct charges from regional and corporate
headquarters, and allocations of all indirect costs. Some of even the local expenses may not be
controllable by the store manager. The rental and depreciation amounts may result from decisions made
by managers in the corporate office. The same arguments apply to the advertising material, catalogs, and
other materials. Will managers have the opportunity to reject such material if they feel they can
accomplish their objectives with less expensive advertising that doesn’t conform to corporate policy or
corporate image? Will that be allowed? Some of the direct charges may have a behavioral impact. For
example, will charges for credit checks discourage their use? The case does not provide much information
about the allocations of indirect expenses, but these raise some questions. Do the allocation bases have
any economic meaning? And why are the allocations of actual expenses, not standard. This allocation
method makes the yards bear the cost of any corporate budget overruns.

The Calculation of Investment

The calculation of investment similarly raises a number of measurement issues. Including month-end cash
balances as investment will encourage managers to get rid of their cash at the end of the month. End-of-
period gameplaying like this is commonly referred to as window dressing. What purpose is served by
holding managers accountable for cash balances and what behavioral effects are produced should be of
concern.

Likewise, including month-end inventory at cost creates an opportunity for mangers to manipulate their
inventories in such a way that their investment is reduced. The effect of such reductions, however, will
inevitably be on the level of service they can provide to customers. Ferreterías’ system does not enable
the calculation of a cost of stock-outs.

Month-end receivables also provide opportunities for discretionary action by yard managers in allowing
credit, or by different managers adopting different policies and, hence, encouraging consumers and
customers to deal with one yard as opposed to another simply because of their credit policies.

Most students will quickly recognize the arguments against including investment in automobiles, trucks,
equipment, furniture and fixtures at their depreciated (net book value) cost. To illustrate the point,
instructors can draw a figure showing that ROI of any entity being evaluated in terms of the return on the
net book value of assets will increase over time, just with the passing of time. Use of net book value can
have some perverse behavioral effects. It can cause managers to delay replacing assets and to operate with
older, less efficient or less attractive, equipment and facilities. In the event extra equipment is available,
yard managers might have a tendency to dispose of the newer rather than the older equipment because of
the effect it will have on the investment base. Using net book value also causes problems in comparing
performance across yards because the yards’ assets are of different ages. A related issue—leases at
Ferreterías are not capitalized.

Implementation Issues

While little information is given about the process by which the plan has been developed, students can
infer that the managers who will be greatly affected by the plan seem to have had little or no input into the
design. At the end of the case, Mr. Gonzalez is lamenting that he will have to be the one to announce the
implementation of the plan. This lack of participation can be costly both because the expertise of the
people at the operating levels was not tapped and because participation itself reduces resistance to
implementation.

Pedagogy
 This teaching note has been written in roughly the order in which we suggest discussing the issues. At the
start of class, it is desirable to clarify both what is important for Ferreterías and who in the organization is
responsible for the various key decisions.

Before evaluating the new plan, it is useful to clarify the key elements of the plan. We like to have the
students describe the plan along many of the common plan dimensions, including the form of the awards
(here cash), performance measures, degree of discretion allowed in making the awards, the shape of the
results/reward function, the size and frequency of the awards, the degree of uniformity of awards
throughout the organization, and the source of the funding (bonus pool).

Then students can be asked to evaluate the new plan and to suggest possible improvements. Instructors
should focus on the behavioral impacts of the plan and other plan alternatives. It is the induced behavior
of the employees in the company that will produce value, or not.

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