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Marshall School of Business
University of Southern California
Berkshire Industries PLC
Teaching Note
Purpose of Case
The Berkshire Industries PLC case was written to illustrate the use of economic profit in a
performance measurement system. Consulting firms have developed various measures of
economic profit; EVA, developed by Stern Stewart & Co. is probably the best known. All of
Suggested Assignment Questions
1. Were the Berkshires motivations for a new incentive system reasonable? If so, what were
their main options for a new system? Was an economic profit-focused system a reasonable
choice?
2. Use the data pertaining to the Snack Food Division, as shown in Exhibit TN-1, to calculate:
a. The economic profit for the division for 2000 and 2001
291
3. Assume the base salary of the manager of the Snack Foods Division was £120,000 in both
2000 and 2001. How much cash would the manager receive from his bonus payouts in 2000
and 2001?
Case Analysis
The companys motivation for a new incentive system arises from two concerns. First, the board
was concerned that Berkshire managers interests were not aligned with those of shareowners.
The board members were particularly concerned that EPS was not a good measure since growth
in EPS did not translate into stock price appreciation.
Second, the board wanted to introduce more objectivity into the performance evaluation and
reward system. Some board members believed that too much subjectivity in the reward system
results in a weak correlation between bonus awards and actual operating performance. Further
more, the subjective part of the bonus system caused managers to spend more time negotiating
their bonus rather than worrying about generating profit.
In general, the benefits of an economic profit-type system include the following:
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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The second and third assignment questions, which will be time consuming for the students, are
clearly optional. They are designed to force students to get into the detail of the economic profit
and bonus calculations. Without the numerical example, many students will gloss over the
details of the calculations, assuming that they understand how the system works. But, there are a
lot of complexities to comprehend.
The automatic ratcheting of performance targets has the advantage of taking politics and
gamesmanship out of the target negotiation processes. But a ratcheting system does not use any
knowledge about changing business conditions and prospects. The problem in the Spirits
Division illustrates this problem. Is the 75% ratcheting parameter appropriately responsive to
improving or declining performance?
The elimination of payout thresholds and caps is generally a good idea. The lower and upper
payout constraints create ranges where there is no link between performance and rewards. Thus
they can undercut motivation and stimulate gamesmanship in those performance ranges. But
companies that use such constraints argue that they should not have to pay bonuses for
A general criticism that students can make of the system, too, is that it is relatively complex.
Can managers understand all the elements of the system, which is quite different from what they
were accustomed to? If they do not understand all the details, does it really matter? Is all the
complexity necessary?
The fifth question asks whether Mr. Embleton should make some kind of special allowance for
the Spirits Division of Berkshire Industries in 2000 and 2001. This is a controllability issue. The
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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Pedagogy
The teaching of this case will depend significantly on how much the instructor wants to get into
the calculation of economic profit and the bonus awards. If the instructor wishes to have the
students develop all the numerical answers to the assignment questions as posed, a reasonable
timing for a 75-minute class is as follows:
The company and its need for change 10 minutes
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
294
Exhibit TN-1
Operating Data from Berkshire Industries Snack Foods Division (£000)
1996 1997 1998 1999 2000 2001
From the income statement:
Net operating profit before the
following items:
137,051 162,401 184,898 194,321
Consumer advertising expense (20,661) (23,730) (26,410) (31,007) (41,568) (39,191)
From the balance sheet:
Net operating assets (book): 593,040 630,268 580,920 568,113
Additional Information:
1. Cumulative advertising expense through the end of 1997 is £181,410.
32 Established by management.
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
295
Exhibit TN-2
Berkshire Industries Snack Foods DivisionCompleted Table (£000)
1996 1997 1998 1999 2000 2001
Net operating profit before the
following items:
137,051 162,401 184,898 194,321
Net operating assets (book): 593,040 630,268 580,920 568,113
Accumulated amortization of goodwill 0 0 0 15,000 45,000 75,000
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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Exhibit TN-3
Consumer Advertising Amortization Schedule for Snack Foods Division (£000)
1998 1999 2000 2001
Consumer advertising expense 26,410 31,007 41,568 39,191
Amortization (3-year period):
Amortization of advertising expenditures
under economic profit
23,600 27,049 32,995 37,256
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
297
Exhibit TN-4
Economic Profit Calculation for Snack Foods Division (£000)
2000 2001
NOPAT:
Net operating income before taxes 113,330 125,130
Capital:
Net operating assets (book) 580,920 568,113
Add: Capitalized advertising expenditures 29,244 31,179
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
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Exhibit TN-5
Bonus Bank Balance Calculation for Manager of Snack Foods Division (£000)
2000 2001
Beginning balance in bonus bank 0 13,68036
