The Notewon Corporation is a highly diversified company that grants its divisional executives a significant amount of authority in operating the divisions. Each division is responsible for its own sales, pricing, production, costs of operations, and the management of accounts receivable, inventories, accounts payable, and use of existing facilities. Cash is managed by corporate headquarters; all cash in excess of normal operating needs of the divisions is transferred periodically to corporate headquarters for redistribution or investment. The divisional executives are responsible for presenting requests to corporate management for investment projects. The proposals are analyzed and documented at corporate headquarters. The final decision to commit funds to acquire equipment, to expand existing facilities, or for other investment purposes rests with corporate management. The corporation evaluates the performance of division executives by the return on investment (ROI) measure. The asset base is composed of fixed assets employed plus working capital exclusive of cash. The ROI performance of a divisional executive is the most important appraisal factor for salary changes. In addition, the annual performance bonus is based on the ROI results with increases in ROI having a significant impact on the amount of the bonus. The Notewon Corporation adopted the ROI performance measure and related compensation structure about 10 years ago. The corporation did so to increase the awareness of divisional management of the importance of the profit/asset relationship and to provide additional incentive to the divisional executives to seek investment opportunities. The corporation seems to have benefited from the program. The ROI for the corporation as a whole increased during the first years of the program. Although ROI has continued to grow in each division, the corporate ROI has declined in recent years. The corporation has accumulated a large amount of cash and short term marketable securities in the past three years. Corporate management is concerned about the increase in the short term marketable securities. A recent article in a financial publication suggested that the use of ROI was overemphasized by some companies with results similar to those experienced by Notewon.
a. Describe the specific actions division managers might have taken to cause the ROI to grow in each division but decline for the corporation. Illustrate your explanations with appropriate examples.
b. Explain, using the concepts of goal congruence and motivation of divisional executives, how Notewon Corporation’s overemphasis on the ROI measure might result in the recent decline in the corporation’s return on investment and the increase in cash and short term marketable securities.
c. Discuss how divisional statements of cash flows might provide some additional useful information to divisional executives and corporate management.
d. What changes could be made in Notewon Corporation’s compensation policy to avoid the current problems? Explain your answer. (CMA adapted)