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Copy of Berkshire Industries Case Study

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jenny hua

on 4 April 2013

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Transcript of Copy of Berkshire Industries Case Study

Berkshire Industries PLC Synopsis We had to do something different. The company was doing great according to all the performance indicators we monitored, and our managers were earning nice bonuses, but the share owners weren't benefiting.

- William Embleton, Managing Director, Berkshire Industries PLC Conclusion is here is important is important too is important Founded in 1852 as brewery serving local pubs.
Over years has grown internally and by acquisition.
By 2002, medium-sized, publicly held corporation focused on beverages and snack foods industry. Annual turnover of about £500 million
Employed nearly 3,500 people in six countries.
Four operating divisions: Beer, spirits, soft drinks, and snack foods.
Decentralized: Managing directors had considerable autonomy Since going public, primary performance emphasis on EPS.
In 1999, explored idea of new performance measurement and incentive system based on “economic profit” measure of performance.
Concern that managers' interests not aligned with those of shareholders.
Subjectivity of current performance evaluation and reward system.
New incentive plan that uses both ROI
and stock option plans best alternative:
Provides congruency among shareholder and management objectives, enforces desired behaviors of firm value creation.
Management understandability and goal congruence far outweigh any flaws
of ROI.
3 consulting firms submitted proposals for new measurement and incentive system.
Selected New York consulting firm Corey, Langfeldt and Associated (CLA). CLA's Proposal Based on “economic profit” measure of performance:
Economic profit = Adjusted Net Operating Profit after Taxes (NOPAT) – [Capital x Cost of Capital].

Two adjustments to NOPAT to make economic profit measure more accurately reflect relationship between costs and benefits:
1] Consumer advertising expenses:
Capitalize and amortize.
Add current year’s expense back to operating profits.
Add capitalized amount to net operating assets.

2] Goodwill:
No longer amortize.
Add cumulative amortized goodwill back to net operating assets.
Add amortized amount back to operating earnings.

CLA claimed their economic profit measure provided right signals to management all the time:
Measure increase (decreases) when shareholder value created (reduced).

No stock-based incentive plan:
- Stock prices volatile in short term.
- Lower-level managers can only have possibly modest effect on share prices.

Incorporated Berkshire's “continuous improvement“ philosophy:
Performance targets increased each year based on percentage of previous year's actual performance.
Elimination of payout thresholds and caps.
Creation of “bonus bank” to improve manager retention and reduce manager risk by smoothing out the bonus awards. 1] Oversold on many levels:
Asserts that economic profit measure “highly correlated” with shareholder returns.
Grossly underplays complications of EVA formula

2] Adjustments to EVA:
Too few
In violation of iGAAP:
- Advertising and promotional costs expensed as incurred.
- Internally developed intangibles not recognized as an asset.

3] Automatic ratcheting of performance targets ignores:
Measurement items which may need to be added or omitted
External circumstances for which one cannot plan.

4] Explicit elimination of payout thresholds and caps, unlimited amount of bonus seem excessive.

5] Possibility of 100% base salary for managing director obvious attempt to sell the proposal.

6] Use of a “bonus pool” wasteful and coercive. The Problems:
Set 1 (CLA's Proposal) The Problems:
Set 2 (Implementation of Proposal) 1] Creation of considerable management confusion:
Managers not understanding how economic profit measure is computed continuing to manage based on old earnings-based management reports.

2] Discouragement and demotivation:
Due to automatic ratcheting of performance targets and disregard for unplanned, external circumstances.
As result of recession, bonus awards for Spirits Division managers significantly below target levels.
Spirits managers had sizable negative balances in bonus bank accounts.

3] Widely shared perception of basic failure of economic profit measure:
While economic profit had improved, shareholders had not benefitted as stock price actually declined.
Alternative Solutions 1] Continue to use the EVA model, but greatly modify CLA's system:
Add more adjustments to the model.
Enable allowances for external circumstances to be taken into account when evaluating performance.
Eliminate use of bonus bank, instead investing the money.
Better explain (honestly) the EVA model (how each component is calculated, the implications/effects of various items, etc.)

2] Implement a new return-on-investment (ROI) and stock option measure for performance. Selected Solution Implement new ROI and stock option measure for performance.
ROI for division managers
Stock options for senior management.
Type of stock option plan should be specific:
- Restrictions.
- Vesting period.
- Amount of stocks to issue.

Implementation of independent compensation committee. Rationale Unlike EPS and “economic profit,” ROI accounts for each division’s investment.
Berkshire can compare ROI to each division’s cost of capital.

Implementation of independent compensation committee:
Manage uncontrollable factors facing division manager’s incentive plan.
Evaluate division performance in order to provide an unbiased bonus.
Act as cap to bonus plan.

Stock options encompass close correlation between change in share price and shareholder value.

Long-term focus will:
Encourage feeling of ownership among senior management.
Motivate over long-term.
Reduce management myopia created by ROI. Positive
Aspects Much simpler performance
measurement tool.
Simplicity can lead to cost-effective
incentive plan.
Managers can now control their own
success and are likely to be highly
entrepreneurial and motivated.
Flexibility can help senior
management make more
informed decisions. Negative Aspects Can create management myopia and suboptimization.
Preaction reviews of capital budgeting and strategic planning can help align division and corporate interests.
Long-term focus will reduce management myopia.

Risk of misleading performance signals.
Investment variable for ROI should be measured in terms to help lessen misleading signals.
Profit variable should include expenses such as advertising to reduce potential game-playing.

Stock-based incentives ineffective tool for motivating division managers.
Will be used with senior management, who influences share price more than division managers

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