Does the Bonus Plan Reward the Right Thing?
Response to the following problem:
Roaring Springs Booksellers is an Internet book company. Customers choose their purchases from an online catalog and make their orders online. Roaring Springs then assembles the books from its warehouse inventory, packs the order, and ships it to the customer within three working days. The rapid turnaround time on orders requires Roaring Springs to have a large warehouse staff; wage expense averages almost 20% of sales.
Each member of Roaring Springs's top management team receives an annual bonus equal to 1% of his or her salary for every 0.1% that Roaring Springs's return on sales exceeds 5.0%. For example, if return on sales is 5.3%, each top manager would receive a bonus of 3% of salary. Historically, return on sales for Roaring Springs has ranged between 4.5% and 5.5%.
The management of Roaring Springs has come up with a plan to dramatically increase return on sales, perhaps to as high as 6.5% to 7.0%. The plan is to acquire a sophisticated, computerized packing machine that can receive customer order information, mechanically assemble the books for each order, box the order, print an address label, and route the box to the correct loading dock for pickup by the delivery service. Acquisition of this machine will allow Roaring Springs to lay off 100 warehouse employees, resulting in a significant savings in wage expense. Top management intends to acquire the machine by using new investment capital from stockholders and thus avoid an increase in interest expense. Because the depreciation expense on the new machine will be much less than the savings in reduced wage expense, return on sales will increase
All the top managers of Roaring Springs are excited about the new plan because it could increase their bonuses to as much as 20% of salary. As assistant to the chief financial officer of Roaring Springs, you have been asked to prepare a briefing for the board of directors explaining exactly how this new packing machine will increase return on sales. As part of your preparation, you decide to examine the impact of the machine acquisition on the other two components of the DuPont framework-efficiency and leverage. You find that even with the projected increase in return on sales, the decrease in asset turnover and in the assets-to-equity ratio will cause total return on equity to decline from its current level of 18% to around 14%.
Your presentation is scheduled for the next board of directors meeting in two weeks. What should you do?