The key issue in the case is that the incentive compensation system does not motivate district managers to make decisions which are consistent with the strategy of Quality Metal Service Center (QMSC) because it is tied to the district’s target ROA. Acquiring the new processing equipment reduces the incentive bonus of the Columbus District Manager, Mr. Ken Richards, from 11.1% to 4.28% of his base salary. This happens because the asset base increases with the new equipment and will exceed the target for 1992. This may motivate him to not proceed with the purchase even if the proposal of the Sales Manager, Ms. Elizabeth Barret, shows that the acquisition results to a positive NPV and thus, should be sent to the home office for approval.
To solve the issue, QMSC should use EVA instead of ROA as the measure of district and manager performance. Since EVA is the best proxy for shareholder value at the business unit level, improving EVA will also improve the company’s overall performance. The managers’ district objectives will then be congruent with the company’s overall objectives. This will induce Mr. Richards to employ additional assets which will promote the growth of both the Columbus district and QMSC, such as the one in Ms. Barret’s proposal. The purchase of the new processing equipment is also in line with the company’s objective to develop techniques and marketing program that would increase market share in identified industries and geographic markets of specialty metal users. Having the equipment will allow QMSC to provide the demand for processed metals in the Columbus District with a short lead time, addressing the concern of potential customers.
Another aspect of the issue that needs to be looked into is the decision on what assets should be included in the investment base and what expenses should be charged from profits. QMSC includes land, warehouse buildings, and equipment at gross book value in its investment base. This results to an EVA that signals a decrease in profitability during the early years of the assets when in fact, profits increased. It will be better for the company to use annuity depreciation so that the profitability calculations will show the correct EVA. Leased buildings and equipment are also part of the asset base. This motivates managers to lease rather own assets whenever the interest charge that is built into the rental cost is less than the capital charge that is applied to the investment base.
Thus, the head office must think carefully before approving the leases of the districts as the managers might just be using it to window dress their performance. QMSC also includes inventory and accounts receivables, without subtracting standard accounts payable, using average values for the period. This is a good practice because these are representative of the assets used during the period and thus, conceptually a satisfactory measure of the amount that should be related to profits. On the other hand, QMSC’s computation for district profits is a fair approach because it only considers expenses that can be controlled by the district managers.