P
rofessors Kenneth A. Merchant and Wim A. Van der Stede wrote this teaching note as an aid to instructors using the Houston
F
earless 76, Inc. case.
Marshall School of Business
University of Southern California
Houston Fearless 76, Inc.
Teaching Note
Purpose of Case
This case describes a sales incentive system based on a traditional commission payout and a
proposal for change. The proposal raises a number of issues regarding performance
Suggested Assignment Questions
1. Why are Houston Fearless 76, Inc. (HF76) managers unhappy with the companys existing
sales incentive plan? Are weaknesses in this plan a major cause of the companys
performance problems?
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
107
Case Analysis
What does HF76 want from its salespeople?
Before getting into a discussion of the old and new sales incentive plans, it is useful to have the
students clarify the companys markets and to identify the behaviors that HF76 managers would
ideally like from their salespeople. HF76 is organized into four business units: HF International,
Extek, Mekel, and Pollution Control Systems.
a. HF International (photo processing)
Mature market
b. Extek (micrographics)
Mature market
c. Mekel (scanners)
More high tech, more growth potential
d. Pollution control systems
Only one sale to date
What does HF76 want its salespeople to do?
Provide good service to existing customers. This is particularly important in the mature
markets.
What should be the goals of the sales incentive system?
Motivation (stimulate effort)
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108
What are the key elements of the existing sales incentive plan?
What are the problems currently being faced?
Dealers and sales reps do not share customer lists.
Salespeople are not developing new customers. Most of them merely respond to inquiries.
Sales people are spread all over the country. The VP-Sales is in Atlanta. The organization is
hard to control/monitor.
The sales people have not received performance evaluations recently, or raises.
What are the key elements of the proposed incentive plan?
See Figure TN-1.
It is useful to clarify the shape of the performance/reward function. The slope of the payout
function in the existing system was 24% of sales. The slope of the function in the proposed
These slopes can be illustrated with a hypothetical example. Here is one that can be used:
Assume a high margin sale = 30% GM
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109
Under the old plan
Commission on the one sale = $2,000
Under the new plan
At 70% of plan ($1.12M in sales): Company GM = $336,000
Salesman commission = 0
Evaluation
Students should be asked to evaluate the plan and to provide recommendations for
improvement. There are a lot of issues that can be discussed. Students will raise most of the
obvious measurement and calibration issues. A good student report on this case is appended to
this teaching note.
Here are some other questions that can be posed if they do not come up naturally:
How should HF76 provide incentives to sell products that are sold at a negative gross
margin? HF76 had a number of these products, which managers wanted to keep selling for
customer access and service reasons. This is a difficult issue that HF76 managers had not
solved. Any number of approaches could have been used, such as guaranteeing the sales
force a minimum gross margin percentage on each sale.
Other, perhaps more peripheral, questions that can be posed, time allowing:
Should anything have been done with the incentives for the sales assistants?
This aspect of the plan does not seem to have any motivational value. On the other hand, it
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
110
Should HF76s managers have been satisfied with measuring and providing rewards for
profits on sales down only to the gross margin line, rather than down to a bottom-line
product profit figure?
The sales people do not control much below the gross margin line (only their selling
What the Company Did
The company presented the proposed plan to the sales force and met with unanimous and strong
objections. The top managers decided that the change was too radical, so they backed off on
their plan to make the change. Instead they modified their old plan. They left the old
commission plan in place, but they added three extra rewards. One was an extra bonus of 5% of
salary if total year-end sales were within plus or minus 10% of the sales forecast. The second
Pedagogy
This case contains a lot of issues that can be discussed. Thus the instructor will have to provide
some structure to the discussion to ensure coverage of the issues deemed most important. The
discussion above presents one possible structure. If that structure is used, the class timing could
be approximately as follows:
2. The existing incentive plan 5 ”
4. The proposed incentive plan 15 ”
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Figure TN-1
Key Features of the Existing and Proposed Sales Incentive Plans
Existing Plan Proposed Plan
Who is included in the plan? Salespeople Salespeople
Form of payment? Cash Cash
Frequency of payment? Monthly Annual award, but monthly
advances at 80% rate
Measures and weighting? Sales (100%)
Product gross margins (83%)
P
rofessors Kenneth
A
. Merchant and Wim A. Van der Stede wrote this teaching note as an aid to instructors using the Houston
F
earless 76, Inc. case.
Marshall School of Business
University of Southern California
A201-02
Houston Fearless 76, Inc. (A): Aftermath
On November 25, 2000, James Lee proposed the new plan in the annual sales meeting. All
salespeople voted against the plan, particularly the idea of replacing the sales-based commission
plan with a profit-based bonus plan. Here are some quotes from salespeople:
I understand that firms need to generate profitable sales and cash inflow. However, why
should we salespeople be held accountable for profitability? If the product is
unprofitable, that was caused by top managements pricing decision, or their decision to
keep the product offering.
..
Historically, HF76 has not had a good cost accounting system that could track
accurately the costs incurred to make a specific product. How can I trust that the profit
number is correct for the products I have sold?
..
We all understand that, from an operations perspective, more accurate forecasts are
always preferred. But given the nature of capital products, accurate forecasts are
difficult even if you work with customers closely. You know sales are going to happen
However, the new compensation plan provided extra rewards, on top of the existing
commission structure, in the following ways. First, salespeople could earn 5% of their salary if
total year-end sales were within plus or minus 10% of sales forecast. Second, salespeople would
earn an extra 3% of salary if they achieved each of the goals in a set of MBO targets negotiated
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About the new plan, James Lee explained:
This is the first step in moving our sales force to even think about other objectives beyond
sales. HF76 has always had the culture to make sales, even if it meant selling at a loss. This
However, James also realized that his attempt to revamp the sales incentive system based on his
original idea was largely unsuccessful. He reflected:
The fate of the new plan is not totally unexpected, although it is disappointing. I noticed that
the sales personnel were against the new plan from the very beginning of our meeting.
There are some good reasons for their opposition. For example, moving toward a profit-
based incentive system would require a relatively accurate cost system, and we do not have
J
ames Lee, an Executive MBA graduate, and Professor Larry Greiner wrote this case as a basis for class discussion rather than to
illustrate either effective or ineffective handling of an administrative situation.
Marshall School of Business
University of Southern California
A202-01
Houston Fearless 76, Inc. (B)
In January, 2002, M.S. Lee, President/CEO of Houston Fearless76, Inc. (HF76), expressed some
optimism about the changes that had occurred in the company:
We used to have overly optimistic sales forecasts, but now I feel they are more realistic.
accomplished.
On August 13, 2001, HF76 and Fuji Photo Film USA, Inc. (Fujifilm) announced that HF76
obtained an exclusive distribution agreement for Fujifilms micrographics products for the US
and Canadian markets. Ken Kopald, then Vice-President and General Manager of Fujifilm
USAs document products division also announced that he will be leaving Fujifilm after 29
lists from Fujifilm and HF76.
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115
Ken Kopald built from scratch his sales and service organization at Fujifilm USA, which grew
The plan is relatively simple but communicates much more than just a base salary and
flat rate commission. Also, our former Fujifilm sales staff was already used to a similar
plan at Fujifilm. And, we can shape direction by boosting commissions for the more
profitable products such as scanners and duplicators. We also weighted the
Company Performance
As of late January, financial statements for 2001 were not available from the Accounting
Department. Sales performance for recent years and projections through 2003 are provided in
Exhibit 1.
Growth Challenges
The number of sales transactions has increased tenfold and several departments have
experienced growing pains. Before ASI, HF76 would process 510 orders per day for spare
parts or custom-built equipment. Now, HF76 is receiving 4070 orders per day for film and
photochemicals our customers typically want the next day. M.S. Lee remarked, We have
changed from a manufacturing company to a distribution company overnight. Several other
areas need to change, too.
A New Organization
A new organization (Exhibit 2) was being contemplated by M.S. Lee. We have all this good
Exhibit 1
Houston Fearless 76, Inc.
Sales History
2000 2001 2002 2003
(Actual) % (Estimated) % (Forecast) % (Forecast) %
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
Exhibit 2
Proposed Reorganization – 2002
Houston Fearless 76, Inc.
M.S. Lee
Chairman/CEO
HF76
Corp HR/Security S. McLaren
CFO
J. Lee
VP Operations – ASI
VP Marketing –
ASI
Regional Field
Sales – ASI
Tech Support –
ASI
P
rofessors Kenneth A. Merchant and Wim A. Van der Stede prepared this teaching note addendum as an aid to instructors using the
H
ouston Fearless 76, Inc. case.
Marshall School of Business
University of Southern California
Houston Fearless 76, Inc.
Teaching Note
Addendum: Student Exam Assignment and Report
Below is one relatively representative example of a student analysis of the Houston Fearless 76,
Exam Rules
1. Next weeks midterm exam will be take-home. It will consist of a case similar to the cases
2. The exam can be done individually or in groups of up to three people. Groups will have to
monitor and manage themselves. All members of the group will receive the same grade on
3. Case reports (individual or one per group of three students maximum) must be e-mailed to
4. I will not answer any questions regarding the exam to avoid (perceptions of) unfair
5. Please make a comprehensive analysis to support your answers to the assignment questions,
6. If you cannot comply with the exam deadline or any other exam rule spelled out above, you
need to contact me as soon as possible, but certainly before I post the exam. I will maintain
a tough stance toward exceptions, such as a request for an extension of the exam deadline,
for the following reasons:
a) This is a take-home, open-book, open-note, open-everything exam.
b) You have two days (48 hours) to complete the exam.
Assignment Questions
Case Background
The Houston Fearless 76, Inc. (HF76) case study discusses a proposal for change in a sales
incentive program. The new program is interesting for a number of reasons, including a
proposed shift toward rewarding the generation of profits (actually gross margins), rather than
just sales, and a truth-inducing forecast incentive feature.
Case Questions
[Q1 = 30 points / Q2 = 30 points / Q3 = 30 points / Q4 = 10 points]
1. Evaluate the old incentive plan as well as the new incentive plan being contemplated. Are
there any significant impediments to the successful implementation of the new incentive
plan? Which?
2. Should HF76s managers have been satisfied with measuring and rewarding profits on sales
down only to the gross margin line, rather than down to a bottom-line product profit
figure? (More generally, discuss the issues associated with incentives placed on sales, gross
3. What modifications would you make to the proposed new plan, if any? Formulate specific
4. Would you make any changes to the system providing bonuses to sales assistants? Which?
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120
Student Report
Current Situation
Houston Fearless 76 (HF76) manufactures and sells products for several different markets, in-
cluding photo processing, micrographics and motion picture processing, scanner products, and
most recently, pollution control systems. The company has products in varying stages of the life
cycle. M.S. Lee intends to increase sales and profitability in each market through strategies
based on its corresponding life-cycle stage.
HF76 is currently experiencing several problems. Sales of its products have slowed. Although
this trend is in part due to market conditions, M.S. Lee believes the company is not doing
enough to develop new markets, to expand [its] existing markets, or to develop synergies among
[its] markets. In addition, the companys managers believe that HF76s performance is
lacking behind that of its major competitors on all dimensions. HF76 is also encountering
production-planning problems, which are linked to problems in forecast accuracy. Production
M.S. Lee believes that many of the companys troubles are related to the present sales force in-
centive system. This system provides a base salary of $40,000 to $60,000 and a commission as a
percentage of sales on products shipped within a salespersons assigned territory. The
Proposed Incentive Plan
HF76s new incentive plan is an attempt to re-align the sales forces goals to address problems
that HF76 is encountering. M.S. Lee had previously communicated to the sales force which
products were the most profitable; however, this communication has had no impact on
behavior. The new system is designed to translate that message into financial terms. In an effort
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The proposed system presents several problems. The change from commissions based on sales
to commissions based on gross margins has several inconsistencies. First, the percentage of
gross margin paid ranges from 1012% on high margin sales to 3035% on low margin sales.
This range in percentage paid seems to negate the effect it is supposed to create. In order to
induce salespeople to sell higher margin products, the rate paid on those margins should be
constant. On the other hand, if the plan is structured in this way out of fairness, in that different
The system also does not solve the forecasting problem. The 70% floor now encourages
sandbagging as opposed to optimistic forecasting. The increase in commission rate paid beyond
100% has the same effect. It seems that while there is some disincentive over the sale of the
marginal unit that pushes a salesman over the 110% threshold, that disincentive is more than
compensated for by the increase in commission rate paid for sales in that range. The plan will
induce salespersons to provide artificially low forecasts, and their subsequent compensation will
be well beyond what was intended. Absent a more effective forecasting approach, this new
compensation system will not be effective in alleviating the forecasting problems of the past.
There are also problems with MBO targets. The advantages to these targets are that they can be
tailor-made by M.S. Lee to address specific concerns that he has about his sales force. The
major impediment is the lack of communicability of the MBO targets. Salespeople often
prefer clearly defined compensation plans; incentives such as the percentage of sales are easy to
understand.
Sales vs. Gross Margins vs. Net Profits
The new compensation plan pays commissions on gross margins instead of net profits or sales.
This results in salespeople being measured by sales and also production cost. Many organization
measure salespeople performance as revenue centers and measure performance based on sales.
Sales personnel are responsible for making the sales and not for production. However, HF76 is
different since it is selling low volume and expensive capital equipment. Production is often
tailored to a specific sale that a salesperson makes. Therefore, it is important for salespeople to
consider production issues when making a sale.
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122
margin measures require a good communication flow between sales and production so that
production schedules will be efficient. However, it is important that production managers are
held accountable for production costs (i.e., by making them cost center managers). The
Recommendations
On the basis of the above discussion of the HF76 proposed compensation plan, we recommend
that changes be made to the plan in order to improve its effectiveness. The following paragraphs
discuss the changes that should help the compensation plan align the objectives of the company
with the actions of the employees. However, we recognize that these changes do not provide a
panacea to solving all compensation plan problems.
As mentioned, the proposed new plan does not jive with managements objective to increase
sales of high margin products. These margin percentages should be adjusted as previously
described. This does not, however, solve the issue of how to deal with low or negative margin
products. These products are important not for the profits they generate today but the potential
We have also determined that the 5% bonus is not significant enough to be effective in
encouraging accurate sales forecasting. However, we do not recommend an increase in such a
bonus as we disagree with it in principle. Since management wants accurate sales forecast but
does not want to deter sales growth, the forecast-accuracy bonus should be eliminated. We do
not recommend a direct penalty (loss of bonus) for sales beyond a target measure. Such a
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
123
sandbagging, it does not reward them. Also, even though the decrease in payout percentage
beyond the 100% mark may encourage myopic behavior, such as sales postponement, it will do
so to a lesser degree than would a flat cap on commissions. This structure is our best
compromise for balancing goals that are sometimes in conflict.
We also recommend that management become more involved in the forecasting process. In
general, forecasting (which provides the basis for budgeting) should remain a bottom-up
process. The salespeople should be required to fully explain and document their forecasts. They
Sales Assistants
The final aspect of the new compensation plan that needs to be modified is the bonuses for sales
assistants. Sales assistants provide administrative support for the sales people. Although they
provide value to the company, sales assistants are not directly responsible for sales, gross
margins, or even corporate performance. There is no link between the bonus and the
performance of sales assistants. The case provides an example of a sales assistant, Eva Colton,
who received a bonus. She neither expected nor understood why she received the bonus. This
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124
Exhibit 1
Recommended Compensation Structure