George Lawrence was beside himself. As the CEO of Wolfboro Engineering, Inc., he knew that the company’s growth and continued successful financial performance depended on high quality investments that would lead to improved market share. Yet, this year’s capital budgeting cycle was almost complete, and he had received almost no proposals for new investments from one of his division general mangers. If this situation continued, the long term viability of the company was in serious jeopardy.
Wolfboro Engineering had been started some 15 years ago by Mr. Lawrence. Mr. Lawrence, a graduate of a well-known engineering school, had spent the first ten years of his career as an electrical engineer with a large utility company. Seeing the opportunities for advancement limited, he had struck out on his own. For the first five years after he founded Wolfboro Engineering, he had worked almost exclusively on his own, doing engineering consulting and design. Then, about ten years ago, on the advice of a friend, he began experimenting with the design and manufacture of computer hardware. From that time on, the company had not stopped growing.
Some five years ago, the company became too large for Mr. Lawrence to manage on his own, and he decentralized into three semi-autonomous divisions: office products, home computing, and aeronautics. Currently, each division was an investment center, and each division general manager (DGM) was treated as an independent entrepreneur. The three DGMs were expected to seek out new opportunities in their markets, respond to them, and operate profitably.
Initially, the divisions had been created as profit centers, and they had done reasonably well, although not as well as Mr. Lawrence had anticipated. As a result, about a year and a half ago, Mr. Lawrence, a firm believer in incentives, had decided to change the profit center arrangement. Under the new arrangement, instead of being paid on the basis of profits, each DGM was paid on the basis of the return on assets (ROA) of his or her division.
Each DGM had been given a very small base salary, but for every percentage point above a predetermined ROA, he or she received $35,000. At the time, Mr. Lawrence felt certain that the change would give the DGMs an incentive to increase ROA, and indeed ROA had gone up, even for the aeronautics and home computing divisions, where there was intense competition for market share and hence rather low ROA percentages. Overall, however, the company had about a 9 percent ROA and a 15 percent return on equity, which Mr. Lawrence thought was quite respectable, especially given the market opportunities and growth possibilities that still existed. Wolfboro’s most recent financial statements are contained in Exhibit 1. The bonus calculation figures for the same year are contained in Exhibit 2.
“It doesn’t make sense,” he complained to his accountant. “By investing in more assets and earning more profits, my DGMs can increase their bonuses. So why aren’t I seeing more investment proposals from Karen. She sent in only one proposal, and that was to invest in a . . .
- Which division do you think Karen runs? Why?
- Why do you think she sent in a proposal to improve inventory turnover?
- Why didn’t she sent in more investment proposals? Under what circumstances might she do so?
- What should Mr. Lawrence do?