Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
frequently are evaluated, and receive a large part of their compensation, based on sales. Such compensation systems are used to: (1) motivate sales
More generally, just about everyone’s performance is routinely evaluated and rewarded (or punished) by someone else. Just as companies evaluate
and reward their employees, parents evaluate and reward their children, individuals evaluate and reward their friends, partners, and spouses, and
teachers evaluate and reward their students. In all settings, the performance evaluation and reward system is geared toward motivating effort,
directing attention, obtaining private information, and/or attracting a certain type of person. For example, an instructor uses examinations to both
Question 2:
2.a. Using formulas 1-3 from the case text, the machinist’s compensation for the week is (notice that Oa > Os; i.e., 180 > 133.33 (40/0.3))
2.b. If 185 deck kits are fabricated, then the machinist’s compensation for the week is:
Notice that compared to question 2.a (when 180 deck kits were fabricated), the machinist’s compensation is higher. When standards are held
constant, fabricating more deck kits (by either exerting greater effort or implementing process improvements) leads to greater compensation.
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(productivity) and the probability of an audit, the machinist’s expected two-week compensation (again using formulas 1-3 in the case text)
for the three scenarios presented in Table 2 is calculated below:
Choice Wp (period 1)1
Wp (period 2)
Expected2
Total
Expected Pay
C$982.35 $923.41 $1,905.76
1: Wp1 (A, B, C) = (# deck kits completed) × 0.30 × (20 × 0.885)
2: E[Wp2] (A, B, C) = (# deck kits completed) × 0.30 × (20 × 0.885) × (1 – paudit)
+ (# deck kits completed) × (revised standard) × (20 × 0.885) × paudit
Choice B maximizes the machinist’s expected two-week compensation. Notice that even though output is highest under choice C, the
machinist’s second-period (and beyond) compensation is expected to be lower than choices A and B because of the likely increase in the
standard – i.e., John Deere is likely to ratchet-up the employee’s standard and extract some of the first-period compensation. John Deere, on
the other hand, clearly prefers choice C because production per labor hour is highest and cost per unit of production is lowest.
This problem illustrates the inherent tradeoff faced by employees evaluated under the standard-hour plan. Specifically, when deciding
whether to increase their productivity levels, employees must trade-off the benefits of higher current period compensation with the potential
2.c. Using equation (1) from the case text, the machinist’s production wages for 100/180 deck kits are:
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Using equation (2) from the case text, the machinist’s non-production wages for 100/180 deck kits are:
* In 2.a., the machinist produced a 180 deck kits in 40 hours. Assuming constant productivity, 180 40 = 100 y. Solving (and rounding
down), y 22 production hours.
** Based on assumptions in 2.a.
Using equation (3) from the case text, the machinist’s total wages for 100/180 deck kits are:
Thus, the machinist’s weekly compensation decreases by $64.80 ($955.80 – $891.00) if s/he ramps production down to 100 deck kits.
Notice that the machinist has a monetary incentive to over-produce, thereby generating excess inventory (in this case deck kits). This is
costly to John Deere on several fronts: (1) increased inventory holding costs – in this case an extra $80 per week; (2) potential for spoilage,
damage, costly rework, and/or obsolescence due to holding inventory; (3) muted incentives for employees to engage in any activity other
than production such as training new employees or helping co-workers.
2.d. Employee A – compensation under John Deere’s contract and the competitor’s contract:
Employee B – compensation under John Deere’s contract and the competitor’s contract:
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2.e. As illustrated in questions 2.a and 2.b, the standard-hour plan can motivate employees to work hard. In the absence of standard adjustments,
employee compensation strictly increases as production increases. Unfortunately, substantial increases in productivity can also trigger audits
and standard increases – thus, employees may withhold effort in certain situations (as shown in question 2.b). As illustrated in question 2.d,
the standard-hour plan also can attract employees with high levels of skill and motivation.
As illustrated in question 2.c, the standard-hour plan does not always direct employees to activities that provide John Deere the most value.
All in all, the goals of John Deere and its manufacturing employees are not perfectly aligned under the standard-hour plan.
Question 3:
Organizations can reap many benefits by moving from an individual-based to a team-based performance-evaluation and reward system.
First, team-based compensation schemes allow performance measures to be collected at a more aggregate level. The use of aggregate
information is especially advantageous when it is costly to collect information at the individual level. This can generate tremendous cost
production activities across work-shifts and job classifications. Such meetings did not take place under the individual-based standard-hour
plan.
A third advantage to organizations is that team-based plans can encourage members of the group to monitor each other’s performance. Since
each individual’s compensation is tied to the collective efforts of the group, there are incentives to ensure that every team member is
contributing at a high level.
influence might be used to enforce norms that are not in the best interest of firm owners. For example, team members can encourage other
members to work at low levels of effort to guarantee that team standards remain at desired levels.
Another cost to organizations of team-based plans is that they can provide incentives to employees to free-ride off the effort of others.
Because individuals only receive a portion of the benefit for each unit of effort (1 the number of team members), individuals under team
based performance-evaluation and reward systems frequently have an incentive to shirk and rely on other members to accomplish the team’s
collaboration and effort-sharing).
Another benefit to employees is that team-based plans allow risks inherent in manufacturing environments to be shared across all team
members. That is, under a group-based plan, lost compensation attributable to a “bad” event that is outside the control of the team (such as a
machine breakdown) is equally shared by all. Under an individual-based compensation plan, however, a single employee often bears a
substantial proportion of the compensation risk associated with a “bad” event.
Finally, group-based plans can raise equity concerns among team-members. Specifically, under a group-based plan, the compensation of
highly skilled and/or hard working employees could be reduced by lower skilled and/or effort-averse employees (and vice-versa). That is,
group-based plans may under-compensate hard-working and/or highly skilled employees and over-compensate lesser skilled, or more effort-
averse, employees. Such equity issues could lead to employees being less satisfied with team-based, rather than individual-based,
compensation.
Question 4:
4.a. Using equation (4) in the case text, the adjustment factor, A, for the team is calculated as follows:
Team input hours = 30 employees × 40 hours per employee = 1,200 hours
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Team standard output hours = 180 units × 6.5 hours per unit = 1,170 hours
is, the machinist could feel s/he is working just as hard under CIPP as under the standard-hour plan. However, since pay is linked to the
productivity of others, his/her compensation might actually decrease under CIPP.
4.b. The Machinist’s Weekly Compensation—185 Mowers Produced
Using equation (4) from the case text, the adjustment factor, A, for the team is calculated as follows:
Team input hours = 30 employees × 40 hours per employee = 1,200 hours
Team standard output hours = 185 units × 6.5 hours per unit = 1,202.5 hours
benchmarks are held constant, producing more mowers (by either working harder or implementing process improvements) leads to higher
compensation. Thus, similar to the standard-hour plan, CIPP should motivate employees to increase their productivity.
The Machinist’s Compensation over the next two Bi-annual Periods – 180 Mowers Produced
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Bi-annual Period 1 Compensation
Using equation (4), the adjustment factor, A, for the team is calculated as follows (note: the adjustment factor is identical to that previously
calculated):
Team input hours = 30 employees × 40 hours per employee = 1,200 hours
Team standard output hours = 185 units × 6.5 hours per unit = 1,202.5 hours
Thus, the machinist’s compensation for bi-annual period 1 (before the bonus) would be:
Wbi-annual period 1 = $960.80 × 26 weeks per bi-annual period = $24,980.80
Since the team exceeded the standard by over 6.49 percent (the adjustment was over 120 percent), the machinist will receive a bonus
calculated as follows:
Bonus = 26 weeks × 40 hours × $20 × 0.05 = $1,040.00
Bi-annual Period 2 Compensation
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Team input hours = 30 employees × 40 hours per employee = 1,200 hours
Team standard output hours = 185 units × 6.5 hours per unit = 1,202.5 hours
Thus, the machinist’s compensation for bi-annual period 2 would be:
Wbi-annual period 2 = $920.80 × 26 weeks per bi-annual period = $23,940.80
Total Compensation Over the Two Bi-annual Periods
More generally, when deciding whether to implement an innovation, teams evaluated and rewarded under CIPP continue to face a tradeoff
between the benefits of higher current period compensation and the cost of being evaluated and rewarded under a higher benchmark in the
future. As illustrated in question 2.b, this is very similar to the tradeoff faced by employees under the standard-hour plan. However, there are
two fundamental differences between the tradeoff faced by employees under the standard-hour plan and the tradeoff faced by employees
under CIPP.
First, under CIPP, employees know exactly how increases in production efficiency affect their future standards. Under the standard-hour
plan, on the other hand, standard increases were somewhat arbitrary.
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Second, CIPP provides an additional incentive for teams (a one time bonus) to increase their production efficiency. As illustrated in this
question, the bonus attempts to mitigate the tradeoff faced by manufacturing teams when deciding whether to make their production
processes more efficient.
The Labor Savings to John Deere
The reduction in the machinist’s bi-annual compensation would be $1,040 ($24,980.80 before the benchmark increase – $23,940.80 after the
benchmark increase). Thus, John Deere rewards a one-time bonus to the machinist of $1,040 to generate permanent bi-annual cost savings
4.c. By spending non-production hours training the two newly hired employees, the machinist could increase the productivity of these two
group-members. Further, increasing the productivity of these two group members would ultimately enhance the efficiency of the F725 Front
Mower team. Since the machinist’s compensation depends upon the efficiency of his or her team, the machinist would have financial
incentives to spend non-production hours training the two newly hired employees.
4.d. CIPP continues to reward high skills and high effort levels since performance and pay, ceteris paribus, strictly increase as these variables
increase. Under CIPP, however, compensation levels not only depend on individual performance but also depend on the performance of
other team members. This dependence on other team members can alter the incentives of both high-skilled and low-skilled employees to
4.e. Overall, CIPP appears to make improvements over the standard-hour plan in motivating effort, extracting production information, and
appropriately directing the attentions of its manufacturing employees. To achieve these gains, John Deere likely trades-off its ability to
attract the most highly skilled employees. In the remainder of this section, we discuss some of these improvements and tradeoffs of CIPP
when compared to the standard-hour plan as well as present actual performance results from the plan. Finally, we discuss improvements that
John Deere management would like to make to CIPP in the upcoming contract negotiations.
Motivating and Extracting Roles
Because employees know ex ante exactly when and how their standards will increase (i.e. they no longer have to fear audits and arbitrary
standard adjustments) and receive bonuses when these standards do increase, CIPP can more effectively both motivate effort and extract
(thus, we combined the discussion of the motivating and extracting roles).
Thus, for the first three years after the implementation of CIPP, production teams were willing to tradeoff the benefit of higher current
period compensation and one-time bonuses for the costs of higher future benchmarks. However, following this initial three year period of
production efficiency gains, the steady increase in team benchmarks leveled off. Figure 1 demonstrates that the average team benchmark
only increased from 0.92 in period six (year three) to 0.93 by the end of period eight (year four). At this level, manufacturing teams were no
longer willing to trade-off the benefit of the one time 5 to 10 percent bonus for the costs of higher future standards.
Instead, manufacturing teams began to produce just shy of the 120 percent adjustment level. Figure 2 presents the distribution of actual bi-
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