SECTION II

Management Control Alternatives

and Their Effects

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CHAPTER 2
Results Controls

If asked to think about powerful ways to influence behavior in organizations, most people
would probably think first about pay-for-performance, which is no doubt an effective motivator.
For example, at Thor Industries, a large recreational vehicle manufacturer, CEO Wade Thomp-
son attributes much of the company’s success to its incentive compensation system. Among
other things, the company shares 15% of each division’s pretax profits with the division manag-
ers, because, Mr. Thompson explained, “I want every one of our company heads to feel like it is
their business, in their control. If they don’t perform, they don’t get paid very much. If they do,
there is no cap to what they can make.”1 Indeed, Vicky Wright, managing director at Hay Group,
a compensation consultancy firm, argues:

[Many] companies on the Most Admired list [a list of companies produced annually by
Fortune] have chief executives who understand what performance measurement is all
about. It’s about learning how to motivate people – how to link those performance meas-
ures to rewards.2

Pay-for-performance is a prominent example of a type of control that can be called results

control because it involves rewarding employees for generating good results. Identifying what
are good results, as we will see, is crucial. Indeed, following the financial crisis through to today,
pay-for-performance systems, especially in banks, have received a hard look, in part because,
rather than producing “good” results, they have been bashed for having bred “bonus cultures”
of greed and short-termism. Even the chief executives of such major banks as Barclays admitted
that their bonus systems were overly “geared,” created temptations for employees to “cut cor-
ners,” and may have backfired through “ethical lapses,” while the chief executive of Deutsche
Bank touched on the basic underlying motivational effect of bonuses by contemplating that
“[he] ha[d] no idea why [he] was offered a contract with a bonus in it because [he couldn’t
imagine he would] work any harder or any less hard in any year, in any day because someone is
going to pay [him] more or less.”3
Nonetheless, even in the aftermath of the financial crisis, investors, regulators, and politi-
cians did not indiscriminately call to do away with pay-for-performance; rather, their calls for
reform were typically directed at making compensation more closely tied to sound performance,
particularly long-term value creation.4
Setting aside possible idiosyncrasies of the financial sector, where one could argue that good
employees work hard every day in other organizations without monster bonuses, results con-
trols of the pay-for-performance variety are widely used, even increasingly so in the non-profit
sector. For example, the National Health and Hospitals Reform Commission in Australia argued
that the fee-for-service system of healthcare rebates often fails to promote the most effective

33
Chapter 2 • Results Controls

treatments because doctors get paid for each consultation or clinical activity regardless of
whether the patient recovers well or not. In considering how to reform this system, the Commis-
sion recommended to link the pay of doctors and nurses to measures of how well they treat their
patients or how quickly they are seen.5 Similar initiatives to create “accountable care organiza-
tions” by providing extra rewards for efficiency and quality performance have also been consid-
ered elsewhere, particularly in the United States.6 “The idea is to see whether shifting financial
incentives for hospitals can make people healthier and save the U.S. money before Medicare’s
hospital trust fund becomes depleted, which could happen by 2024.”7
Clearly, designers of results controls of the pay-for-performance variety have “good” results
(e.g. long-term value creation) – even perhaps lofty results (e.g. making people healthier and
saving a country’s healthcare system from ruin) – in mind when implementing them, brought
about through the motivational, results-driven effects such systems purportedly can have.
Anecdotal as well as research evidence, however, have repeatedly thrown the potency of these
systems into sharp relief by suggesting that either they have weak or no effects or, where they
do, they can produce the wrong results or have severe unintended consequences.
Even so, and despite, perhaps, a prevalent emphasis on pay-for-performance in many con-
texts, the rewards that can be linked to results go far beyond monetary compensation. Other
rewards that can be usefully tied to measured performance include job security, promotions,
autonomy, plum assignments, and recognition. (We discuss the vast array of rewards that can
be given more fully in Chapter 9.)
Furthermore, results controls create meritocracies. In meritocracies, the rewards are given to the
most talented and hardest-working employees, rather than to those with the longest tenure or the
right social connections. At Koch Industries, a conglomerate, results controls are seen as the “secret
sauce” with two main ingredients – meritocracy and operational efficiency. Charles Koch, its boss,
is proud to proclaim that “workers can earn more than their bosses [and] high-school-educated
farm boys from Kansas can rise faster than Ivy League MBAs” based on their performance.8
The combinations of rewards linked to results inform or remind employees as to what result
areas are important and motivate them to produce the results the organization rewards. Results
controls influence actions or decisions because they cause employees to be concerned about the
consequences of their actions or decisions. The organization does not dictate to employees what
actions or decisions they should take; instead, employees are empowered to take those actions or
decisions they believe will best produce the desired results. Results controls also encourage
employees to discover and develop their talents and to get placed into jobs in which they can
perform well.
For all these reasons, well-designed results control systems can help produce the results
desired. A review of studies on the use of incentives to motivate performance found an average
gain in performance of about 22% stemming from the use of incentive programs.9 Like all other
forms of controls, however, results controls do not operate in isolation10 and, equally, cannot be
used in every situation. They are effective only where the desired results can be clearly defined
and adequately measured by the organization, and where the measured results can be suffi-
ciently controlled by the employee.11 We discuss the conditions for the effective use of results
controls in greater depth in this chapter.

Prevalence of results controls

Results controls are commonly used for controlling the behaviors of employees at many organi-
zational levels. They are a necessary element in the employee empowerment approach to man-
agement, which became a major management trend starting in the 1990s.12 Results controls

34
 Prevalence of results controls

are particularly dominant as a means of controlling the behaviors of professional employees;

those with decision authority, like managers. Reengineering guru Michael Hammer even
defines a professional as “someone who is responsible for achieving a result rather than [for]
performing a task.”13
Results controls are consistent with, and even necessary for, the implementation of decen-
tralized forms of organization with largely autonomous entities or responsibility centers (which
we discuss in more detail in Chapter 7). For example, business pioneer Alfred Sloan observed
that he sought a way to exercise effective control over the whole corporation yet maintain a
philosophy of decentralization.14 At General Motors (and numerous other companies that fol-
lowed), the results controls under Sloan’s leadership were built on a return-on-investment
(ROI) performance measure (which we discuss in more detail in Chapter 10). By using this type
of control system, corporate management could review and judge the effectiveness of the vari-
ous organizational entities while leaving the actual execution of operations to those responsible
for the performance of the decentralized entities – the entity managers.
Many large corporations have gone through the process of instituting decentralized forms of
organization with a concurrent increased emphasis on results control. For example, DuPont
replaced a complex management hierarchy by splitting the company into 21 strategic business
units (SBUs), each of which operates as a free-standing unit. The SBU managers were given
greater responsibility and asked to be more entrepreneurial and more customer-focused. They
were also asked to bear more risk, because a large portion of SBU managers’ compensation was
based on SBU performance (sales and profitability). The managers noticed the change. One
SBU manager said, “When I joined DuPont [21 years ago], if you kept your nose clean and
worked hard, you could work as long as you wanted. [But today] job security depends on
results.”15 The change was perceived as being successful: A Business Week article noted that,
“The image of DuPont has morphed from giant sloth to gazelle.”16
In 2010, Sanofi-Aventis, a large pharmaceutical company, divided its vast resources into
decentralized disease-based units, each with its own departments for research and develop-
ment, regulatory affairs, marketing, and sales – a plan designed to identify promising drugs
more quickly and weed out failures before spending large amounts of money on unsuccessful
drugs. One industry expert noted that “the [model of] fully independent units, operating under
the parent company’s umbrella, [constitutes] a break from the traditional big pharma business
model, and represents companies’ interest in duplicating the flexibility and cost-efficiencies of
small biotech and biotech-like companies.”17 By establishing accountability for a fully inte-
grated entity’s results, where the entity manager closest to the business makes the tradeoffs and
takes responsibility over the entity’s budget, the company aims to instill a “performance cul-
ture” that encourages both operating discipline (efficiency) and greater responsiveness to local
business needs (flexibility).
In other words, decentralization attempts to replicate an “entrepreneurial model” within
typically large corporations, where entity managers are given decision authority but then held
responsible for the results that their decisions produce. Accountability for results was exactly
the driving motive behind a recent reorganization into “reporting segments” at Air Products
Chemicals Inc., a large industrial gases producer, which Seifi Ghasemi, Air Products’ chief exec-
utive, claimed would retain Air Products’ leadership position through “a decentralized, simpler,
and more efficient structure which creates true profit and loss (P&L) accountability at many
levels of the organization.”18
Similarly, when Nick Reilly became CEO in late 2009 of troubled Opel, the German car man-
ufacturer owned by General Motors, he announced that he wanted to encourage an entrepre-
neurial spirit at Opel by delegating most decisions to country heads and dismantling GM’s
bureaucratic style of centralized management that fostered a “debilitating culture of passing
the buck.” “It might seem obvious, but it isn’t the way GM was managed and there was definitely

35
Chapter 2 • Results Controls

some confusion about who was accountable,” he said. “From the top line of revenue to the bot-
tom line of profit, this is now the responsibility of the managing directors of the major entities,”
Reilly added.19
However, managers will act in an entrepreneurial manner necessary to thrive in competitive
environments not only if they are subjected to the same market forces and pressures that drive
independent entrepreneurs, but also if they are promised commensurate rewards for the risks
they bear from doing so. As such, Richard Chandler, founder of Sunrise Medical, a medical
products company, defended his company’s decentralized organization and lucrative incentives
by stating that “people want to be rewarded based on their own efforts. [Without divisional
accountability] you end up with a system like the U.S. Post Office. There’s no incentive [for
workers to excel].”20
Results controls need not be limited to management levels only; they can also be driven
down to lower levels in the organization, as many companies have done with good effects. Lin-
coln Electric, a worldwide leader in the production of welding products, serves as the poster
child of companies that use results controls down to the lowest organizational level. Lincoln
Electric provides wages based solely on piecework for most factory jobs and lucrative perfor-
mance-based bonuses that can more than double an employee’s pay.21 This incentive system
has created such high productivity that some of the industry giants (General Electric, Westing-
house) found it difficult to compete in Lincoln Electric’s line of business (arc welding) and exited
the market. A Business Week article observed that “in its reclusive, iconoclastic way, Lincoln
Electric remains one of the best-managed companies in the United States and is probably as
good as anything across the Pacific.”22 And even though Lincoln’s legendary Incentive Perfor-
mance System has essentially remained the same since it was installed in 1934, the company is
still acclaimed for its systems and performance today, such as in the book The Modern Firm.23
Whereas decentralization is an effective way to empower employees in a results-control con-
text, there can, and even should, be limits to empowerment in certain circumstances. One prob-
lem is infighting, as exemplified at Sears, a struggling US retailer. Edward Lampert, the investor
who had tried for eight years to turn around the company, “divided Sears into more than 30
units, each with their own presidents, chief marketing officers, boards of directors and profit-
and-loss statements, which former executives say has caused infighting.”24
Other issues stem from loss of economies of scale or increased costs and inefficiencies, or
even inconsistencies, and complexity. This is reflected in the situation that Alex Gorsky, a
21-year Johnson & Johnson veteran who was named CEO in April 2012, inherited:
The J&J that Gorsky inherited was superficially easy to understand: 40% of sales came
from drugs, another 40% from medical devices, and the rest from consumer products. Dig
deeper and it was unimaginably complex: 275 operating companies, 450 distribution cent-
ers, more than 120 manufacturing sites, 500 outside manufacturers, and 60 enterprise
resource-planning systems. It was more a flotilla of speedboats than a single ship. In the
past, that famous decentralization inspired entrepreneurial thinking. Lately, it caused qual-
ity-control problems that bedeviled the company.25

Gorsky said: “We have to be more decisive and disciplined, and more efficient. Otherwise, it
is too complex, and it costs too much.” Part of that was addressing decentralization: Gorsky
introduced a program to centralize procurement, which would enhance J&J’s buying power. He
also ordered up new quality and compliance controls to ensure consistent standards.26
Decentralization may also increase overlap, and curiously, it “may also create more oppor-
tunities for corruption by increasing the number of decision makers with the power to exploit
the decision-making process for personal gain.” 27 For example, when pursuing rapid growth
in China, French hypermarket Carrefour faced systemic corruption among its management
ranks at the local levels. Unlike the centralized approach to management that Wal-Mart

36
 Results controls and the control problems

employed in China, Carrefour empowered local managers to take charge of virtually all
aspects of running their stores, including product pricing and promotions, supplier selection,
and store design. Whereas this high degree of flexibility gave ample leeway for managers to
expand fast in the early stages of building the chain, it also encouraged widespread bribe-
taking at the local level and, over time, led to higher operating costs and reputation risk than
would a centralized system.28
But decentralization puts decision making closest to where the detailed knowledge and
understanding of the business resides, allowing greater responsiveness. “A decentralized struc-
ture provides better information over time, which helps decision-making and accountability,”
said Lambert of Sears,29 and echoed by Airbus chief Fabrice Bregier:

Now is the time to give a little bit more power to local teams in our countries, in our pro-
grams, in our plants [as] we need to take decisions faster. This is a weakness of Airbus. It
takes much too long to make decisions, I want to speed it up and simplify it.30

The chief executive at China’s Huawei, Ren Zhengfei, put it as follows:

The future model is to give the biggest say to our local teams who are closest to our cus-
tomers and empower them so they have flexibility in interaction with customers. The head-
quarters or corporate functions will change into a more supporting and service function.31

And at Samsonite, the luggage maker, chief executive Tim Parker said:

I think we were trying to run a very centralized business in a marketplace where our con-
sumers differed enormously. We had to decentralize our decision-making. So we created
an Asian business, a Europe business and an American business, and that allowed each
management team to concentrate on local customers.32

The multitude of examples above also illustrate that firms can decentralize by geographical
regions, business groups or segments, product lines, or a variety of other lines of delegation in
their organization structure. One critical point, however, is that decentralization or “delegation
of decision rights” to managers, and the design of incentive systems to motivate these managers
to generate the desired results, are two critical organizational design choices in a results-con-
trol context; they are part of what organizational theorists call the organizational architecture.
This literature maintains that organizational choices about decentralization and incentive sys-
tems should be made jointly, and that concentrating on one element to the exclusion of the other
will lead to poorly designed organizations.33

Results controls and the control problems

Results controls provide several preventive-type benefits. Well-defined results inform employ-
ees as to what is expected of them and encourage them to do what they can to produce the
desired results. In this way, the results controls alleviate a potential lack of direction. Results
controls also can be particularly effective in addressing motivational problems. Even without
direct supervision or interference from higher up, the results controls induce employees to
behave so as to maximize their chances of producing the results the organization desires. This
motivational effect arises particularly when incentives for producing the desired results also
further the employees’ own personal rewards. Finally, results controls also can mitigate per-
sonal limitations. Because results controls typically promise rewards for good performers, they
can help organizations to attract and retain employees who are confident about their abilities.

37
Chapter 2 • Results Controls

Results controls also encourage employees to develop their talents to position themselves to
earn the results-dependent rewards.34
The performance measures that are a part of the results controls also provide some non-
motivational, detection-type control benefits of a cybernetic (feedback) nature, as was men-
tioned in Chapter 1. The results measures help managers answer questions about how various
strategies, organizational entities, and/or employees are performing. If performance fails to
meet expectations, managers can consider changing the strategies, the processes, or the man-
agers.35 Investigating and intervening when performance deviates from expectations is the
essence of a management-by-exception approach to management, which large organizations
commonly use.

Elements of results controls

The implementation of results controls involves four steps: (1) defining the dimension(s) on
which results are desired; (2) measuring performance in the chosen dimensions; (3) setting
performance targets for employees to attain for each of the measures; and (4) providing rewards
for target attainment to encourage the behaviors that will lead to the desired results. While
these steps are easy to list, executing them effectively can be challenging.

Defining performance dimensions

Defining the right performance dimensions involves balancing an organizations’ responsi-
bilities to all of their stakeholders, including owners (equity holders), debtholders, employ-
ees, suppliers, customers, and the society at large. Should a firm’s sole aim be to maximize
shareholder returns, or should it also, or even primarily, be customer- or employee-focused?
Are these performance foci mutually exclusive, or are they rather mutually reinforcing?36
Where do performance dimensions such as innovation and sustainability belong? And so on.
As challenging as defining the desired performance dimensions may be, it is equally critical
to choose performance measures that are congruent or aligned with the chosen performance
dimensions because the goals that are set and the measurements that are made will shape
employees’ views of what is important. Phrased differently, what you measure is what you get.
For example, firms may define one of their desired performance dimensions to be shareholder
value creation, and yet measure performance in terms of accounting profits. This implies that
employees are likely to try to improve the measured performance (in this example, accounting
profits) regardless of whether or not it contributes to the desired performance (in this example,
shareholder value). We discuss this problem, and the difficulties related to this particular exam-
ple, further in Chapters 5, 10, and 11.
Similarly, firms may aim to pursue innovation, yet they end up measuring patents filed.
Anxious to promote innovation, many companies offer incentives to their employees to
develop patentable ideas, and such incentives are likely to produce results in the form of an
increase in the number of patents filed. But as Tony Chen, a patent attorney with Jones Day
in Shanghai, notes, “patents are easy to file, but gems [can be] hard to find in a mountain
of junk.” 37
Citibank’s chief executive, Michael Corbat, slightly rephrased this adage by proclaiming
that “you are what you measure.”38 He felt he needed to measure performance in five catego-
ries to try to alleviate the singular focus of managers on one measure, exactly because you get
what your measure. His plan was welcomed by an analyst who commented that “the most
important job of a CEO is to make sure that the right incentives are in place [because]
improper measures lead to improper behavior.” 39 We discuss the use of multiple measures of

38
 Elements of results controls

performance, such as by way of so-called scorecards, which Mr. Corbat advocated at Citibank,
in Chapter 11.
The problem of misalignment has also been at the heart of some of the work by Jean Tirole,
the 2014 Nobel Prize winner in economics. Tirole examines the undesirable consequences that
performance-dependent incentives in the measured areas can have, either by skewing how
employees approach their jobs, shifting effort away from less-easily measured (and hence unre-
warded) tasks such as long-term investments, employee development, and within-firm cooper-
ation; or by undermining work ethic by encouraging excessive risk-taking, inducing “managed”
performance or producing “fudged” performance metrics.40 The first part of this problem – the
skewing part – is known in the literature as the multitasking problem, and we discuss it in more
detail in Chapter 5.
Even though Bloomberg concluded that “there’s a role for Tirole to advise on how to struc-
ture compensation without inciting the kind of disastrous risk-chasing that sparked the finan-
cial crisis,”41 this important congruence problem also surfaces in many other sectors,
including the non-profit sector. For example, a study by the Home Office in the United King-
dom found that organized trafficking was a “thriving industry” that “makes a killing,” amass-
ing healthy profits with little risk of detection. The study suggested that one of the reasons for
this was the ill-defined performance targets that the police had to meet. Solving high volumes
of simple crimes such as petty thefts and home burglaries is easier and cheaper than the long-
drawn-out and expensive police work that is needed to crack down on trafficking rings. Even
though the goal was to reduce crime, the result may have been that hardened criminals were
let off.42
Hence, not only do firms need to decide what is desired, but they also must ensure that their
measurements of the desired performance dimensions are aligned with what is desired. If they
are not, the results controls are likely to encourage employees to produce undesired results. The
results controls can then be said to have unintended consequences.

Measuring performance
As per the above, then, measurement is a critical element of a results-control system. The object
of the measurement is typically the performance of an organizational entity or an employee
during a specific time period. Many objective financial measures, such as net income, earnings
per share, and return on assets, are in common use. So, too, are many objective nonfinancial
measures, such as market share, customer satisfaction, and the timely accomplishment of cer-
tain tasks. Some other measurements involve subjective judgments involving assessments of
qualities; for example, “being a team player” or “developing employees effectively.”
Performance measures typically vary across organizational levels. At higher organizational
levels, most of the key results are defined in either stock market terms (such as share price)
and/or financial or accounting terms (such as a return on equity). Lower-level managers, on
the other hand, are typically evaluated in terms of operational measures that are more control-
lable at the local level. The key result areas for a manager in charge of a manufacturing site, for
example, might be a combination of measures focused on production efficiency, inventory con-
trol, product quality, and delivery time. The variation in the use of financial and operational
performance measures between higher- and lower-level management creates a hinge in the
management hierarchy. That is, at some critical middle organizational level, often a profit
center level (see Chapter 7), managers must translate financial goals into operational goals.
These managers’ goals are defined primarily by financial measures, so their communications
with their superiors are primarily in financial terms. But because their subordinates’ measures
are primarily operational, their downward communications are primarily in operational
terms.

39
Chapter 2 • Results Controls

If managers identify more than one result measure for a given employee, they must attach
weightings to each measure so that the judgments about performance in each result area can be
aggregated into an overall evaluation. The weightings can be additive. For example, 60% of the
overall evaluation is based on return on assets and 40% is based on sales growth. The weight-
ings can also be multiplicative. For example, achievement of profit and revenue goals might be
multiplied by a score assessed on the basis of environmental responsibility. If the environmen-
tal responsibility score is less than 70%, say, the multiplier is zero, yielding no bonus. Sometimes,
organizations make the weightings of performance measures explicit to the employees, as in the
example just presented. Often, however, the weightings are partially or totally implicit, such as
when the performance evaluations are done subjectively. Leaving the weighting implicit blurs
the communication to employees about what results are important. Employees are left to infer
what results will most affect their overall evaluations. That said, evidence suggests that implicit
weights can generate improvements in performance and, thus, can be effective as an alterna-
tive, or at least complement, to the explicit weighting of performance measures in incentive
contracts.43

Setting performance targets

Performance targets are another important results-control element because they affect behav-
ior in two ways. First, they improve motivation by providing clear goals for employees to strive
for. Most people prefer to be given a specific target to shoot for, rather than merely being given
vague statements like “do your best” or “work at a reasonable pace.”44 Second, performance
targets allow employees to assess their performance. People do not respond to feedback unless
they are able to interpret it, and a key part of interpretation involves comparing actual perfor-
mance relative to target. The targets distinguish strong from poor performance. Failure to
achieve the target signals a need for improvement. (We discuss performance targets and target
setting processes in more detail in Chapter 8.)
The following example illustrates both points. Maria Giraldo, a nurse in the intensive care
unit at Long Island Jewish Medical Center, used to be evaluated on such criteria as leadership,
respectfulness, and how well she worked with others. A few years ago, her hospital imple-
mented a new computer-based performance system that broke down her job description into
quantifiable goals, such as to keep infection rates for her unit low and patient satisfaction
scores high, all relative to specific target levels. Ever since this new system was implemented,
at review time, the discussion does not linger on about how Ms. Giraldo had performed. Either
she hit the targets, or she did not. The clarity about measures and goals, and the reviews “by
the numbers” that they allow, changed Ms. Giraldo’s views about success and what she needs
to do to get ahead in her career – all for the better, she believed.45 (In Chapter 9, we discuss the
drawbacks of relying exclusively on objective, formulaic performance evaluations in more
detail.)

Providing rewards
Rewards or incentives are the final element of a results-control system. The rewards included in
incentive contracts can come in the form of anything employees value, such as salary increases,
bonuses, promotions,46 job security, job assignments, training opportunities, freedom, recogni-
tion, and power. Punishments are the opposite of rewards. They are things employees dislike,
such as demotions, supervisor disapproval, failure to earn rewards that colleagues earn, or, at
worst, dismissal.

40
 Elements of results controls

Organizations can elicit motivational effects from linking the prospect of rewards (or
punishment) to results that employees can influence. For example, organizations can use
any of a number of extrinsic rewards. They can grant additional monetary rewards, such as
in the form of cash or stock. They can use non-monetary rewards, such as by granting high-
performing employees public recognition and more decision authority. Alternatively, in
entities where performance is mediocre or poor, they can threaten to reduce the decision
authority and power that managers derive from managing their entities or decline to fund
proposed projects.
Results measures can provide a positive motivational impact even if no rewards are explic-
itly linked to results measures. People often derive their own internally generated intrinsic
rewards through a sense of accomplishment for achieving the desired results. For example,
when William J. Bratton became the New York City police commissioner, he gave his police
force one clear, simple goal: cut crime.47 (Previously the thinking had been that crime was due
to societal factors beyond the department’s control, so the police were measured largely by how
quickly they responded to emergency calls.) He also implemented a results-control system. He
decentralized the department by giving the 76 precinct commanders the authority to make
most of the key decisions in their police units, including the right to set personnel schedules,
and he started collecting and reporting crime data daily. Even though Commissioner Bratton
legally could not award good performers with pay raises or merit bonuses, the system was
deemed effective. In the subsequent two years, major felonies in New York fell first by 12% and
then a further 18%, respectively. This clearly could not have been attributable to pay-for-perfor-
mance in the strictest sense; it was instead due, at least in part, to providing officers with clear
goals and empowering them to go about fighting crime. Seeing the results of their initiatives
may have given police officers a sense of accomplishment and a greater intrinsic motivation to
perform well.
The motivational strength of any of the extrinsic or intrinsic rewards can be understood in
terms of several motivation theories that have been developed and studied for over 50 years,
such as expectancy theory. Expectancy theory postulates that individuals’ motivational force, or
effort, is a function of (1) their expectancies, or their belief that certain outcomes will result from
their behavior (e.g. a bonus for increased effort); and (2) their valences, or the strength of their
preference for those outcomes. The valence of a bonus, however, is not always restricted to its
monetary value; it also may have valence in securing other valued items, such as status and
prestige.48
Organizations should promise their employees the rewards that provide the most powerful
motivational effects in the most cost-effective way possible. But the motivational effects of the
various forms of reward can vary widely depending on an individual’s personal tastes and cir-
cumstances. Some people are greatly interested in immediate cash awards, whereas others are
more interested in increasing their retirement benefits, increasing their autonomy, or improv-
ing their promotion prospects. Reward tastes also vary across countries for a number of rea-
sons, including differences in cultures and income tax laws.49 However, if organizations can
tailor their reward packages to their employees’ individual preferences, they can provide mean-
ingful rewards in a cost-efficient manner. But tailoring rewards to individuals or small groups
within a large organization is not easy to accomplish and is sometimes even seen as possibly, or
even legally, inequitable. A tailored system will likely be complex and costly to administer.
When poorly implemented, it can easily lead to employee perceptions of unfairness and poten-
tially have the opposite effects of those intended: demotivation and poor employee morale. We
discuss the choice of different forms of incentives and incentive system design in more detail in
Chapter 9.

41
Chapter 2 • Results Controls

Conditions determining the effectiveness of results controls

Although they are an important form of control in many organizations, results controls cannot
always be used effectively. They work best only when all of the following conditions are present:

1. Organizations can determine what results are desired in the areas being controlled;
2. The employees whose behaviors are being controlled have significant influence on the
results for which they are being held accountable; and,
3. Organizations can measure the results effectively.

Knowledge of desired results

For results controls to work, organizations must know what results are desired in the areas they
wish to control, and they must communicate the desired results effectively to the employees
working in those areas. Results desirability means that more of the quality represented by the
results measure is preferred to less, everything else being equal.
As we alluded to earlier, even if one might agree that (one of) the primary objective(s) of for-
profit firms or corporates is to maximize shareholder value, this does not imply that the desired
results, even if the overall objective is understood, will be unequivocally known or have unam-
biguous meaning at all intermediate and lower levels in the organization. The disaggregation of
overall organizational objectives into specific expectations for all employees lower in the hier-
archy is often difficult. Different parts of the organization face different tradeoffs.
For example, purchasing managers create value by procuring good-quality, low-cost materi-
als on time. These three result areas (quality, cost, and schedule) can often be traded off against
each other, and the overall organizational objective to maximize profit provides little guidance
in making these tradeoffs. The importance of each of these results areas may vary over time and
among parts of the organization depending on differing needs and strategies. For example, a
company (or entity) short of cash may want to minimize the amount of inventory on hand,
which may make scheduling the dominant consideration. A company (or entity) with a cost
leadership strategy may want to emphasize the cost considerations. A company (or entity) pur-
suing a unique product quality image or differentiation strategy may emphasize meeting or
exceeding the specifications of the materials being purchased. Thus, to ensure proper purchas-
ing manager behaviors, the importance orderings or weightings of these three results areas
must be made clear and aligned with the strategy.
If the wrong results areas are chosen, or if the right areas are chosen but given the wrong
weightings, the combination of results measures will not be congruent with the organization’s
intended objectives. Using an incongruent set of results measures may then result in motivating
employees to take the wrong actions. In the above setting, for example, ill-guided cost consid-
erations may damage the company’s pursued product-quality reputation.

Ability to influence desired results (controllability)

A second condition that is necessary for results controls to be effective is that the employees
whose behaviors are being controlled must be able to affect the results in a material way in a
given time period. This controllability principle is one of the central tenets of responsibility
accounting (which we discuss in more detail in Chapters 7 and 12). Here are some representa-
tive expressions that have stood the test of time of this perennial principle:

It is almost a self-evident proposition that, in appraising the performance of divisional

management, no account should be taken of matters outside the division’s control.50

42
 Conditions determining the effectiveness of results controls

A manager is not normally held accountable for unfavorable outcomes or credited with
favorable ones if they are clearly due to causes not under his control.51

The main rationale behind the controllability principle is that results measures are useful
only to the extent that they provide information about the desirability of the actions or deci-
sions that were taken. If a results area is totally uncontrollable, the results measures reveal
nothing about what actions or decisions were taken. Partial controllability makes it difficult to
infer from the results measures whether or not good actions or decisions were taken.
In most organizational situations, of course, numerous uncontrollable or partially uncontrol-
lable factors inevitably affect the measures used to evaluate performance. These uncontrollable
influences hinder efforts to use results measures for control purposes. As a consequence, it
becomes difficult to determine whether the results achieved are due to the actions or decisions
taken or, rather, to uncontrollable factors or noise. Good actions and decisions will not necessar-
ily produce good results. Bad actions or decisions may similarly be obscured.
In situations where many significant, uncontrollable influences affect the available results
measures, results control is not effective. Managers cannot be relieved of their responsibility
to respond to some uncontrollable factors or be exempted from dealing with reasonable or
normal uncertainty in their environment; but if these factors, or the uncertainty, are difficult
to separate from the results measures, results controls do not provide good information for
either evaluating performance or motivating good behaviors. We discuss the methods that
organizations use to cope with uncontrollable factors in results-control systems in more detail
in Chapter 12.

Ability to measure controllable results effectively

Ability to measure the controllable results effectively is the final constraint limiting the feasi-
bility of results controls. Often the controllable results that the organization desires, and that
the employees involved can affect, cannot be measured effectively. In virtually all situations,
something can be measured; but often, however, the key results areas cannot be measured
effectively.
The key criterion that should be used to judge the effectiveness of results measures is the
ability to evoke the desired behaviors. If a measure evokes the right behaviors in a given situ-
ation – that is, if the measure can be said to be congruent with the desired results area – then
it is a good control measure. If it does not, it is a bad one, even if the measure accurately
reflects the quantity it purports to represent; that is, even if the measurement has little meas-
urement error.
To evoke the right behaviors, in addition to being congruent and controllable, results meas-
ures should be precise, objective, timely, and understandable. Even when a measure has all of the
above qualities, it should also be cost efficient; that is, the costs of developing and using the
measure should be considered.

Precision
Measurements inevitably contain error, some random, some systematic. Error makes the meas-
urement inaccurate. Measurement accuracy refers to the degree of closeness of measurements
of a quantity to its actual (true) value. Precision is the degree to which repeated measurements
under similar conditions show the same result; if they do, the measurements can be said to be
reliable. Using a bull’s-eye analogy, accuracy describes the closeness of arrows (measurement)
to the target (true value). When all arrows are grouped tightly together, the cluster of arrows
(measurement) is considered precise since they all struck close to the same spot, even if not nec-
essarily near the bull’s-eye.

43
Chapter 2 • Results Controls

Reducing systematic error (or bias) improves accuracy but does not change precision. How-
ever, it is not possible to achieve accuracy in measurement without precision; that is, when the
measures contain mostly random error or, thus, when they are unreliable. In other words, and
in the bull’s-eye analogy, if the arrows are not grouped close to one another, they cannot all be
close to the bull’s-eye. Therefore, lack of precision is an undesirable quality for a results meas-
ure to have. But even precise measures that are biased (i.e. that contain systematic error) may
not be of great use for control purposes. If the degree of the systematic error is not known; then
the measurement will be systematically biased by either showing greater or lesser values than
the actual value (see the next section on objectivity).
It is obvious that some aspects of performance (such as social responsibility, leadership acu-
men, and personnel development) are difficult, or even impossible, to measure precisely, either
because the measurements contain random error or are systematically biased (such as may be
the case when subjective performance evaluations are used). Precision, therefore, is important
because without it, the measure loses much of its information value. Imprecise measures
increase the risk of misevaluating performance. Employees will react negatively to the inequi-
ties that inevitably arise when equally good performances are rated differently.

Objectivity
An objective measure here means that it is not influenced by personal feelings, mental states,
emotions, tastes, or interpretations – hence, that it is unbiased. Measurement objectivity will be
inevitably suspect where either the choice of measurement rules or the actual measuring is
done by the persons whose performances are being evaluated. Low objectivity is likely, for
example, where performance is self-reported or where evaluatees are allowed considerable dis-
cretion in the choice of measurement methods. Indeed, and referring to the earlier definition
related to measurement precision, low objectivity is likely to introduce systematic error due to,
for example, selectivity, leniency, or lack of self-criticalness. If that is the case, the measure-
ment may be precise, but it will not be accurate. Good measures for control purposes therefore
should be both precise (reliable) and objective (unbiased).
There are two main ways to increase measurement objectivity. The first is to have the meas-
uring done by people independent of the processes that generate the results, such as by person-
nel in the controller’s department. The second is to have the measurements verified by
independent parties, such as auditors.

Timeliness
Timeliness refers to the lag between the employee’s performance and the measurement of
results (and the provision of rewards based on these results). Timeliness is an important meas-
urement quality for two reasons. The first is motivational. Employees need repeated perfor-
mance pressure to perform at their best. The pressure helps ensure that the employees do not
become complacent, inattentive, sloppy, or wasteful. Measures, and thus rewards, that are
delayed for significant periods of time lose most of their motivational impact. The sustained
pressure can also encourage creativity by increasing the likelihood that employees will be stim-
ulated to repeatedly search for new and better ways to improve results.
As The Financial Times noted about deferred bonuses in banks, “beloved by the regulators
because they allow the payout to be adjusted if conditions change, [they do, however,] reduce
the motivational value of bonuses – by the time the employees receive the money they may not
remember what was being rewarded,”52 making it also unlikely that the rewards will affect or
adjust the behaviors that led to those results.
A second advantage is that timeliness increases the value of interventions that might be nec-
essary. If significant problems exist but the performance measures are not timely, it might not
be possible to intervene to fix the problems before they cause (more) harm.

44
 Conditions determining the effectiveness of results controls

Understandability
Two aspects of understandability are important. First, the employees whose behaviors are being
controlled must understand what they are being held accountable for. This requires communi-
cation. Training, which is a form of communication, may also be necessary if, for example,
employees are to be held accountable for achieving goals expressed in new and different terms,
such as when an organization shifts its measurement focus from accounting income to, say,
economic value added (more on this in Chapter 11).
Second, employees must understand what they must do to influence the measure, at least in
broad terms. For example, purchasing managers who are held accountable for lowering the
costs of purchased materials will not be successful until they develop strategies for accomplish-
ing this goal, such as improving negotiations with vendors, increasing competition among ven-
dors, or working with engineering personnel to redesign certain parts. Similarly, employees
who are held accountable for customer satisfaction must understand what their customers
value and what they can do to affect it. The same holds for teachers in universities who often do
not understand what specific teaching skills or approaches result in better (or worse) teaching
evaluations by their students at the end of the term.
When employees understand what a measure represents, they are empowered to work out
what they can do to influence it. In fact, this is one of the advantages of results controls: good
control can be achieved without knowing exactly how employees will produce the results.

Cost efficiency
Finally, measures should be cost efficient. A measure might have all of the above qualities and
yet be too expensive to develop or use (e.g. when it involves third-party surveys of customers,
say, to collect the data), meaning that the costs exceed the benefits. When that is the case, the
firm may need to settle for an alternative, more cost-efficient measure. Advances in technology
and data analysis, such as related to “big data,” have made data that had hitherto been hard to
obtain or analyze more readily available. But data are not information, and these data do not
uniformly have good properties, where much of it is unstructured. For example, understanda-
bility in terms of the claimed relationships with specific actions and decisions often is particu-
larly problematic. And even objectivity can be an issue, perhaps surprisingly, because, as it has
been said, “torture the data long enough and they will confess to anything.”53
For example, California’s MemorialCare Health System is part of a movement by hospitals
around the United States to change how doctors practice by monitoring their progress toward
goals. What is different this time, some hospital executives argue, is that “new technology ena-
bles closer, faster tracking of individual doctors,” where MemorialCare is keeping detailed data
on how the doctors perform on many measures, including adolescent immunizations, mammo-
grams, and keeping down the blood-sugar levels of diabetes patients. The results are compiled,
number-crunched, and eventually used to help determine how much money doctors will earn,
where the new insurance payments also factor in quality goals. An assessment of this “doctor-
data” system indicates that it has helped reduce the average stay for adult patients, trimmed the
average cost per admitted adult patient, and led to improvements in indicators of quality,
including patient re-admissions, mortality, and complications. This has not been unconten-
tious, however. Cardiologist Venkat Warren said that he worried that “some bean-counter will
decide what performance is” and wondered whether doctors would be pushed to avoid older
and sicker patients who might drag down their numbers.54
Overall, many measures cannot be classified as either clearly good (effective) or poor (inef-
fective). Different tradeoffs among the measurement qualities create some advantages and dis-
advantages. For example, measures can often be made more congruent, controllable, precise
and objective if timeliness is compromised. Thus, in assessing the effectiveness of results

45
Chapter 2 • Results Controls

measures, many difficult judgments are often necessary. These judgments are discussed in
more detail throughout several chapters of this text.

Conclusion

This chapter described an important form of control, results control, which is used at many lev-
els in most organizations. Results controls are an indirect form of control because they do not
focus explicitly on the employees’ actions or decisions. However, this indirectness provides
some important advantages. Results controls can often be effective when it is not clear what
behaviors are most desirable. In addition, results controls can yield good control while allowing
the employees whose behaviors are being controlled high autonomy. Many people, particularly
those higher in the organizational hierarchy but also so-called knowledge workers, value high
autonomy and respond well to it, although they may not always respond well to the measures
used, particularly when these suffer from significant weaknesses in terms of the various meas-
urement properties we discussed.
Results controls are therefore clearly not effective in every situation. Failure to satisfy all
three effectiveness conditions – knowledge of the desired results, ability to affect the desired
results, and ability to measure controllable results effectively – will impair the results controls’
effectiveness, if not render them impotent. Worse, it could produce dysfunctional side effects,
various forms of which we discuss in later chapters.
That said, results controls usually are the major element of the management control system
(MCS) used in all but the smallest organizations. However, results controls often are supple-
mented by action and personnel/cultural controls, which we discuss in the next chapter.

Notes
1 “Lord of the Rigs,” Forbes (March 29, 2004), p. 68. a Manufacturing Firm,” European Accounting Review, 24,
2 “Measuring People Power,” Fortune (October 2, 2000), p. no. 2 (2015), pp. 241–76.
186. 11 As an example of several results-control issues that can
3 “Bank Bonuses: Bashing Ignores the Benefits for Inves- arise when these conditions are not met, see S. Kerr, “The
tors,” Financial Times (November 27, 2015), online at on. Best-Laid Incentive Plans,” Harvard Business Review, 81,
ft.com/1kXpBJ9. no. 1 (January 2003), pp. 27–40.
4 Ibid. See also “Geithner: Link Executive Pay to Perfor- 12 See, for example, K. H. Blanchard, J. P. Carlos, and W. A.
mance,” The Washington Times (June 10, 2009), online at Randolph, The Three Keys to Empowerment (San Fran-
washingtontimes.com. cisco, CA: Berrett-Koehler Publishers, 1999). Also see “C.
5 “Performance Pay Likely for Doctors,” The Australian Oswick, “Engaging with Employee Engagement in HRD
(May 6, 2009), online at www.theaustralian.com.au. Theory and Practice,” Human Resource Development
6 “Hospitals Prescribe Big Data to Track Doctors at Work,” Review (2015), pp. 1–9, particularly Figure 1, p. 2.
The Wall Street Journal (July 11, 2013), online at www. 13 M. Hammer, Beyond Reengineering: How the Process-Cen-
wsj.com. tered Organization is Changing Our Work and Our Lives
7 “Medicare’s $963 Million Experiment,” Business Week (New York: Harper Business, 1996).
(September 6, 2012), online at www.bloomberg.com. 14 A. P. Sloan, My Years with General Motors (New York: Dou-
8 “From Alpha to Omega,” The Economist (August 15, bleday, 1964).
2015), online at econ.st/1J5S3AE. 15 “For DuPont, Christmas in April,” Business Week (April
9 S. J. Condly, R. E. Clark, and H. D. Stolovitch, “The Effects 24, 1995), p. 130.
of Incentives on Workplace Performance: A Meta-Analytic 16 Ibid., p. 129.
Review of Research Studies,” Performance Improvement 17 “Sanofi Seeks Efficiencies with New Model,” The Boston
Quarterly, 16, no. 3 (2003), pp. 46–63. Globe (August 16, 2010), online at www.boston.com.
10 I. Friis, A. Hansen, and T Vamosi, “On the Effectiveness of 18 “Air Products Unveils Widespread Reorganization,” The
Incentive Pay: Exploring Complementarities and Substi- Wall Street Journal (September 18, 2014), online at on.
tution between Management Control System Elements in wsj.com/1w5yrGy.

46
 Notes

19 “In Break with Past, No More Passing the Buck at Opel,” 35 See, for example, D. Campbell, S. Datar, S. L. Kulp, and V.
Reuters (December 6, 2009), online at www.reuters.com. G. Narayanan, “Testing Strategy with Multiple Perfor-
20 R. H. Chandler, quoted in “Sunrise Scam Throws Light on mance Measures: Evidence from a Balanced Scorecard at
Incentive Pay Programs,” The Los Angeles Times (January Store 24,” Journal of Management Accounting Research,
15, 1996), p. D3. 27, no. 2 (Fall 2015), pp. 39–65.
21 The details of Lincoln Electric’s legendary Incentive Perfor- 36 “Shareholders vs. Stakeholders: A New Idolatry,” The
mance System are described in the case bearing the compa- Economist (April 24, 2010), pp. 65–6.
ny’s name at the end of Chapter 4. See also “Ohio Firm 37 “Patents, Yes; Ideas, Maybe,” The Economist (October 14,
Relies on Incentive-Pay System to Motivate Workers and 2010), pp. 78–9.
Maintain Products,” The Wall Street Journal (August 12, 38 “Citi’s CEO Is Keeping Score,” The Wall Street Journal
1983), p. 23; and “Lincoln Electric: Where People Are Never (March 4, 2013), online at www.wsj.com.
Let Go,” Time (June 18, 2001), p. 40. Today, the company’s 39 Ibid.
website states that “Every year since 1934, eligible employ- 40 See, for example, R. Benabou and J. Tirole, “Bonus Cul-
ees have received a profit sharing bonus in December. ture: Competitive Pay, Screening and Multitasking,”
Lincoln’s pay-for-performance culture, rewards employees Working Paper 18963 (Cambridge, MA: National Bureau
for their contributions to the success and profitability of the of Economic Research, 2013).
Company. The average bonus award over the last 10 years 41 “Banker Bonuses Get a Nobel Dis,” Bloomberg View (Octo-
is 40% of an employee’s year to date, base earnings” ber 13, 2014), online at bv.ms/1toxQQN.
(www.lincolnelectric.com/en-us/company/careers/Pages/ 42 “Making a Killing,” The Economist (July 16, 2009), p. 36.
lincoln-tradition.aspx; accessed December 2015). 43 D. Campbell, “Nonfinancial Performance Measures and
22 “This Is the Answer,” Business Week (July 5, 1982), pp. 50–2. Promotion-Based Incentives,” Journal of Accounting
23 J. Roberts, The Modern Firm: Organizational Design for Research, 46, no. 2 (2008), 297–332.
Performance and Growth (New York: Oxford University 44 G. P. Latham, “The Motivational Benefits of Goal-Setting,”
Press, 2004). Academy of Management Executive, 18, no. 4 (November
24 “Lampert Cuts Sears Below 50% to Meet Redemptions,” 2004), pp. 126–9.
Bloomberg (December 4, 2013), online at bloom. 45 “Performance Reviews by the Numbers,” The Wall Street
bg/1RodSO2. Journal (June 29, 2010), online at online.wsj.com.
25 “Embracing the J&J Credo,” Barron’s (December 14, 2013), 46 See, for example, D. Campbell, “Nonfinancial Perfor-
online at www.barrons.com. mance Measures and Promotion-Based Incentives,” Jour-
26 Ibid. nal of Accounting Research, 46, no. 2 (2008), 297–332.
27 “OECD Casts Doubt on Indonesia Growth View,” The Wall 47 “A Safer New York City,” Business Week (December 11,
Street Journal (September 27, 2012), online at on.wsj. 1995), p. 81.
com/1Oao9zG. 48 V. H. Vroom, Work and Motivation (New York: Wiley,
28 “Carrefour Contends with Bribes in China,” Forbes 1964).
(August 27, 2007), online at www.forbes.com. 49 E. P. Jansen, K. A. Merchant, and W. A. Van der Stede,
29 “Lampert Cuts Sears Below 50% to Meet Redemptions,” “National Differences in Incentive Compensation Prac-
op. cit. tices: The Differing Roles of Financial Performance Meas-
30 “Airbus Chief Bregier to Empower Local Sites in Company urement in the United States and the Netherlands,
Overhaul,” Bloomberg (September 10, 2012), online at Accounting, Organizations and Society, 34, no. 1 (January
www.bloomberg.com. 2009), pp. 58–84.
31 “Huawei’s Chief Breaks His Silence,” Business Week (May 50 D. Solomons, Divisional Performance: Measurement and
9, 2013), online at www.bloomberg.com. Control (Homewood, IL: Richard D. Irwin, 1965), p. 83.
32 “Samsonite Sees Rapid Growth in Asia,” The Wall Street 51 K. J. Arrow, “Control in Large Organizations,” in M. Schiff
Journal (December 29, 2013), online at on.wsj. and A. Y. Lewin (eds.), Behavioral Aspects of Accounting
com/1zDPRcr. (Englewood Cliffs, NJ: Prentice Hall, 1974), p. 284.
33 See, for example, J. Brickley, C. Smith, and J. Zimmer- 52 “Bank Bonuses: Bashing Ignores the Benefits for Inves-
man, Managerial Economics and Organizational Architec- tors,” op. cit.
ture (Boston, MA: McGraw-Hill Irwin, 2001). 53 “A Different Game: Information Is Transforming Tradi-
34 For the so-called “selection effect” benefits of (results) tional Businesses,” The Economist (February 25, 2010),
controls, see, for example, D. Campbell, “Employee Selec- online at http://econ.st/KA1qb8.
tion as a Control System,” Journal of Accounting Research, 54 “Hospitals Prescribe Big Data to Track Doctors at Work,”
50, no. 4 (September 2012), pp. 931–66. op. cit.

47
Chapter 2 • Results Controls

CASE STUDY
Office Solutions, Inc.

In December 2014, Bob Mairena, president of Office Both Bob and Cindy had an entrepreneurial spirit and
Solutions, Inc., an office supply distributor based in were looking for an opportunity to start their own busi-
Southern California, was considering making a signifi- ness. They saw an opportunity in the early 1980s. Per-
cant change in the compensation plan for his sales per- sonal computers were just coming into prominence,
sonnel. The company’s current compensation plan for creating a new need for computer supplies. Traditional
all sales personnel was based on sales commissions, office supply companies did not have the technical
plus the potential for an incentive of 2–4% for achieve- expertise to sell computer supplies effectively. Bob and
ment of some specific sales goals. Cindy prepared themselves by taking computer classes
However, Bob had come to believe that a commis- at night. By 1984, they had gained enough expertise to
sion-based compensation system was appropriate start a company called Data Extras, the predecessor to
only for the few individuals bringing in signifi cant Office Solutions.
amounts of new business, those whom he called For several years, Data Extras successfully pro-
“hunters.” Most of the company’s salespeople were vided supplies to companies with computers. Eventu-
not hunters; they were not generating significant ally, however, computer supplies became a commodity,
amounts of new business. They were more like account and the expertise and consulting services that Data
managers who, Bob thought, should be compensated Extras offered were no longer as valuable and the
with a lower-risk plan based on a relatively high pro- business was not scalable. Bob and Cindy made a stra-
portion of guaranteed salary, supplemented with a tegic decision to expand the business to carry a full
performance-dependent bonus. Because of lower job line of office supplies. In 1989, the Data Extras name
pressure and more stable compensation, the account was changed to Office Solutions to reflect the change
managers should be paid less than sales reps. Office in service scope.
Solutions could use the cost savings to funnel more Over the years, Office Solutions grew both organi-
money to the relatively few salespeople who were cally and by acquisition. In 2014, it was generating
generating growth opportunities for the company. approximately $36 million in annual revenue. The
But Bob was not yet totally sure how the new system company had 110 employees, including 40 salespeople
should be designed and what kind of transition would who sold four product lines: office supplies, office furni-
be required to get the salespeople comfortable with ture, facility supplies, and print services. ( Exhibit 1
the change. shows an organization chart.) Office Solutions used
23 company-owned trucks to deliver its products to
customers.
The company Offi ce Solutions used sophisticated management
Office Solutions, Inc., headquartered in Yorba Linda, techniques. Its distribution system was very efficient.
California, sold and distributed a full range of office The company carried only the most basic supplies in
supplies to customers in Southern California, from San its own warehouse. Most of the products sold were
Diego in the south to Santa Barbara in the north. The delivered to them on the following morning and
company was founded in 1984 by a husband-and-wife delivered to the customer with a 98.5% fi ll ratio. The
team, Bob and Cindy Mairena. company was also metrics-driven. A vital-factor
Prior to starting Office Solutions, Bob worked for spreadsheet, which tracked sales, sales leads, and
UPS and Cindy worked for an office supply company. multiple other measures, was produced regularly. An

48
 Office Solutions, Inc.

electronic ticker on the wall tracked call-service sta- Adding to the management challenges in the indus-
tistics in real time. try, sales of office supplies were shrinking. As customers
Office Solutions had many long-tenured employees moved toward digital information sharing, they needed
and a fun working atmosphere. For example, Bob was a fewer supplies such as paper, toner, files, and binders.
proponent of fitness. He encouraged employees to wear Some privately owned distributors posted small posi-
exercise gear at work, and most of them participated in tive, single-digit sales growth in 2013,1 but the big-box
a company exercise break twice a day. companies in the industry were reporting continuing
Office Solutions offered every employee, excluding sales declines. Sales at Office Depot fell 4% in 2013,
those included in any other incentive plan, a quarterly excluding effects of the merger with Office Max. Staples’
incentive of 1% of salary if the company made its sales declined 5% in 2013, and the company announced
quarterly profit numbers. This incentive was designed plans to close more than 225 of 2,000 stores.2
both to enhance unity of purpose and to share profits
and risks with the employees. The Office Solutions strategy
Office Solutions managers’ understanding of the com-
Industry environment petitive landscape allowed it to carve out a successful
Until the mid-1980s, the office supply industry was competitive niche. They categorized industry custom-
dominated by small, independently owned dealers, ers using a pyramid paradigm (see Figure 1). At the
some owned by the same families for generations. Then bottom of the pyramid were small customers, defined
three large big-box retailers – Staples, Office Max, and as businesses with 1–15 employees. These customers
Office Depot – as well as consolidators – such as Corpo- typically bought office supplies directly from retail out-
rate Express, USOP, and BT, who were more focused in lets or online.
the commercial contract space – entered the market. Figure 1 Customer pyramid
These office supply giants built nationwide distribution
networks and retail presence. They enjoyed economies Enterprise customers:
250+ employees
of scale, and they shaved margins. Among other things,
they offered “loss leaders,” selling some popular prod- Commercial customers:
ucts at or below cost to attract new customers. In 2013, 15–250 employees

Staples, the largest office supply retailer, had annual

Retail customers:
revenues of $23 billion. Office Depot and Office Max 1–15 employees
merged in November 2013 and had combined 2013 rev-
enue of $17 billion. The success of the big-box stores
drove thousands of independent dealers out of busi- At the top of the pyramid were enterprise custom-
ness. But in 2014, the office supply industry still ers, defined as businesses with 250+ employees. These
included the two remaining big-box companies, thou- businesses typically had multiple employees purchas-
sands of independent retailers, and, increasingly, ing office supplies, but prices and product choices were
online retailers such as Amazon that had moved into controlled with a contract between the company and
the office supply space. By early 2015, an additional the dealer that was negotiated at the corporate level.
merger between Staples and Office Depot had been Staples and Office Depot served most of the enterprise
negotiated and was awaiting FTC approval. customers. Pricing strategy was the key to winning
The independent dealers that survived consolida- enterprise business. Dealers in this market segment
tion and the onslaught of the retailers were strong deal- offered popular products at low prices to win contracts;
ers that were competitive. Independents still owned margins for some products could be as low as 5%.
about 35–45% of the market, and they were especially These dealers had to bid carefully and have an excel-
strong in the small and medium business space. Two lent understanding of product mix so that they could
major wholesalers served this market. They both pro- win contracts and still earn a reasonable profit.
vided depth and breadth of product offerings and pub-
lished the two major marketing catalogs that were 1
M. E. Biery (2014). Office Supply Stores Seeing Profit Margins Erased,
customized by the individual dealers to provide brand- Forbes.com, April 13.
ing consistency in their specific markets. 2
SEC filings.

49
Chapter 2 • Results Controls

Office Solutions’ primary market included those increase product penetration by introducing, mar-
companies in the middle of the pyramid, commercial keting, and selling additional products and services
customers with 15–250 employees. These businesses to existing customers.
typically worked with dealers and had a single decision 3. Acquisition: Sales reps were expected to open
maker responsible for all of the office supply purchases. doors for the acquisition of new customer accounts.
Commercial customers were the most likely to value After the door was opened, Office Solutions sup-
strong relationships and excellent customer service. ported the reps as needed with specialists in the
Office Solutions had recently started moving up the areas of furniture, printing, and janitorial sup-
customer pyramid, competing for enterprise-level con- plies. At the enterprise level, sales reps were
tracts. Bob recognized the mergers of the big-box sup- expected to identif y when current contracts
pliers as an opportunity. Enterprise customers usually expired and to register Office Solutions for the con-
considered three bids. With only two, or maybe only tract bid process. Once in the bid process, Office
one, big box distributors remaining, Bob reasoned that Solutions management became involved with the
Office Solutions could be a viable second or third option. contract negotiations (e.g. pricing) and responded
The role of the sales representatives was different at directly to customer queries without the input of
the enterprise level. They were responsible for initially the sales rep.
requesting participation in the RFP and for building
enough of a relationship to understand the expectations Sales personnel were also charged with maintaining
and priorities of the customer. The formal bid response the accuracy of the information in Office Solutions’
and margin management was wholly provided by cor- sales-related systems.
porate. Once the contract was established, the role of The reps were not responsible for pricing because
the representative became less important as customer they did not understand the business well enough to
service provided more direct and immediate contact consider all the relevant factors and all of the dynamics
and problem resolution. affecting pricing.
Bob also recognized the move towards e-commerce. The office supply market in Southern California was
He committed a growing share of company resources huge, estimated at $1.2 billion per year, so plenty of
towards the company website and online marketing. opportunities existed for Office Solutions sales person-
A major growth engine for Office Solutions was the nel. The sales people were free to develop new busi-
acquisition of other office supply dealers. Over the ness wherever they thought their potentials were
years, Office Solutions had acquired quite a few smaller highest; they were not assigned to sales territories.
companies. The purchase of an office supply company They could use Office Solutions’ customer-relation-
was, in essence, the purchase of the target’s salespeo- ship-management (CRM) system and identify poten-
ple and their customer relationships. Every effort was tial customers that were not already buying from
made to retain the target’s salespeople for at least a Office Solutions. The salespeople lived all over South-
year, at which point their customer relationships were ern California, and they tended to call on customers
transferred to Office Solutions. near where they lived.

The sales role The existing sales compensation

program
The role of the sales personnel at Office Solutions was
threefold: Sales personnel were included in a commission-plus-
bonus program.3 They earned a commission of 25% of
1. Retention: Sales reps were responsible for keeping the gross profit generated by sales to their customers. A
their current customers happy. Customer service commission-based compensation structure had the
responsibilities included consultative services, obvious benefit of making the sales compensation costs
ensuring that customer orders were handled cor-
rectly and on time, handling rush orders and other
special requests, and general relationship building. 3
In 2014, a few sales personnel were in different compensation
programs. They had joined Office Solutions as part of an acquisition,
2. Penetration: Sales reps were responsible for increas- and they remained on the compensation structure provided by their
ing sales to their existing customers. They could former employer.

50
 Office Solutions, Inc.

Table 1 Calculation of base bonus was vital for management to correct slumps before they
materialized into low sales numbers.
Achievement Bonus earned Managers and sales reps met together as a group
of gross profit goal (% gross profit) every month to discuss their performance against
100.00–104.99% 0.4% their official goals and the other measures on the
VFSS. The meetings could be unpleasant for those
105.00–109.99% 0.5
who did not meet their goals. Performance against
110.00–114.99% 0.6 goals was also discussed during annual performance
reviews.
115.00–119.99% 0.7
Finally, Office Solutions held annual sales meetings
> 120% 0.8 where the top sales reps were recognized. Bob found
that the recognitions were surprisingly motivating. He
variable. If sales declined, costs declined with them, explained:
thus reducing profit risk. I can think of some sales reps who were perfectly
Bonuses were paid only if the sales personnel met or content with their compensation, but became very
exceeded their gross profit goal. The goal was set by top unhappy when they were no longer recognized as
management based on a targeted growth rate. Sales one of the top sales reps at the sales meeting.
managers met with their sales reps to explain the goal
and to secure commitment to the goal. They spent time
breaking down the goal by month, category, and cus-
Concerns
tomer and discussing how it could realistically be Bob recognized some shortcomings in the current com-
achieved. pensation structure. First, it did not seem to provide
The base bonuses ranged in value from 0.4% to 0.8% adequate motivation to generate new business. Bob
of the gross profit earned by the sales rep’s accounts noted that while there were some exceptions,
according to the step function shown in Table 1. The
Most people don’t enjoy hunting. Hunting only hap-
sales reps could earn an additional bonus of 0.15% of
pens when you have to and that happens when you
gross profit for each of three smaller product categories
are building your book of business.
(furniture, facility supplies, printing) if they exceeded
a category revenue goal. These sales categories were Bob wanted the sales reps to generate more new busi-
smaller and more volatile than the office supply cate- ness. He had ambitious growth goals for the company.
gory, but they were also more profitable. But many, perhaps even most, of the sales personnel
Under this system, bonuses amounted to a rela- could seemingly earn enough money to satisfy their
tively small part of the overall compensation package, lifestyle needs just by retaining the customers that they
maxing out at less than 4.8% 4 of a sales rep’s total were already serving.
compensation. Second, the compensation structure was perhaps
too lucrative. Office Solutions was competing with the
Additional accountability big-box stores that had lower costs of sales. Bob wanted
to reduce his company’s overall cost of sales so that
Office Solutions tracked several measures in addition they were more in line with the competition.
to the official gross profit goal in a report called the Finally, the commission structure attempted to moti-
vital factor spreadsheet (VFSS). (Exhibit 2 shows an vate the reps with “carrots.” The reps acted too much
excerpt from a VFSS.) This report tracked sales leads like independent contractors. Bob thought that he
all the way from initial contact to a yes-or-no decision, needed a better way to express dissatisfaction with job
as reported by the sales reps. The sales reps did not like performance, and he needed objective criteria for ter-
reporting their leads in such detail, but the information minating underperforming employees. He explained:

In addition to setting the pay structure, you need to

4
manage the activity. You have to monitor what they
Maximum bonus is 1.25% of GP. Maximum total compensation is 25%
of GP (commission) + 1.25% of GP (bonus). Max percent of incentive are doing and motivate them to sell more. People
compensation in the form of bonus is 1.25%/26.25% =4.76%. slack off when they have met their own needs. For

51
Chapter 2 • Results Controls

example, one of our reps—I’ll call him Tom—seems William is a good example of someone who
perfectly happy earning $40,000 a year. I suspect should be an account manager. He has been with us
that he spends as much time as a tennis instructor for many years and is our #2 salesperson, responsi-
as he does as a sales rep. We reprimand Tom ble for $2.5 million in sales. He works 24/7. He is up
privately after every monthly sales meeting, but all the time checking backorder reports. The cus-
that seems to be of no consequence to him. tomers love him. He micro-manages their accounts
By age 50, most of the reps are cruising. They to make sure that nothing goes wrong. He does a
are not out generating new accounts. I need to great job of customer retention and selling more cat-
grow the business. Should I fire all of my estab- egories of products to his accounts. But he hasn’t
lished reps who are not willing to hunt? generated even two new accounts each year. I have
had a sales manager go with him to help him develop
new leads, but that is just not what he is good at.
A proposal for change
Bob’s instinct was to leave the compensation plan for
In determining what changes to make, Bob decided
those in the sales rep category just as it was. The com-
that he should divide the sales personnel into two
pensation mix for the account managers would change
groups – sales reps and account managers – and differ-
dramatically to a targeted 70% base salary and 30%
entiate their compensation programs. Those desig-
variable compensation, which included both commis-
nated as sales reps would be just those personnel who
sion and bonus. The expected total compensation of
were bringing in significant amounts of new business.
the account managers would be set to be slightly lower
The sales reps’ compensation structure would continue
than the current compensation levels, reflecting the
to be based almost exclusively on commission.
reduced compensation risk.
To illustrate the characteristics of a near-ideal sales
rep, Bob thought immediately of Marsha:
Transition
Marsha is in her late 40s. She will do about $3 mil-
lion in sales this year. She is a pure hunter, and she Through some early, casual discussions, Bob had got-
loves competing. She lost a $600,000 account last ten some indications that the transition to a new com-
year because her client was acquired, but she has pensation structure for the account managers would
replaced it already. Her weakness is that she deals not be easy. Bob raised the subject first with William,
with too much minutiae. When she is ready, I will someone who was important to the company but also
give her an assistant to do computer set-ups and the perfect candidate for the switch to account man-
the like. I want her focused on new business. ager. Bob offered William what he thought was a gener-
ous package: a base salary that was 90% of William’s
The non-hunter sales reps would be placed into the
current commission level, with the potential to earn an
account manager category. Many of these personnel
additional 10–15% as a bonus. (Exhibit 3 shows Wil-
were excellent at customer relations and retention of
liam’s compensation calculations.) But William
accounts, but, for whatever reason, they did not bring
resisted. He insisted that he wanted to continue as a
in significant amounts of new clients. Bob explained:
sales rep despite Bob’s warnings that there would be a
If a sales rep is only retaining existing customers, lot more pressure to win new accounts should he
his or her job description should be changed to an choose to remain in that role.
account manager with a pay structure that makes Bob suspected that the conversations would be
sense for those job responsibilities. Theoretically I even more difficult if the change in structure was
would love to have a company full of sales reps who combined with the reduction in expected compensa-
are aggressively pursuing new business, but I don’t tion, as Bob thought it should. For the reps who wished
want to use a sales rep compensation model to pay to stay on the commission structure, should he add a
someone who is actually functioning as an account negative consequence if they failed to acquire new
manager or really working as an outside customer accounts?
service representative. Bob knew that he still had some details to work out.

52
 Office Solutions, Inc.

Exhibit 1 Office Solutions Organization Chart, December 2014

CEO
Bob
Mairena

Director, SVP,
Manager, VP, Manager,
HR Operations
Marketing Sales Accounting
Michelle Marsh John Acampora

Manager,
Manager, Manager, Sales Sales Sales
Customer
Purchasing Distribution Manager Manager Manager
Service

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

Sales Rep Sales Rep Sales Rep

53
54
Exhibit 2 Excerpt from the VFSS

New Accounts Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Manager 1 8 9 14 13 7 6 8 16 6 10 4 8 109

Manager 2 10 4 12 9 4 5 3 9 9 6 2 7 80

Manager 3 9 7 10 12 20 10 9 8 6 17 6 5 119

Manager 4 1 1 7 1 3 2 2 4 0 4 1 4 30

Manager 5 3 1 0 2 1 3 0 0 1 2 2 0 15

Total 31 22 43 37 35 26 22 37 22 39 15 24 353

Cumulative Revenue for New Customers in 2013

Manager 1 13,448 21,730 23,271 18,861 52,671 26,750 28,146 59,864 67,255 67,957 45,639 47,417 473,008

Manager 2 9,559 9,278 13,053 18,043 20,620 22,450 21,629 27,317 32,833 41,019 31,279 32,591 279,672

Manager 3 3,949 3,542 13,771 17,779 29,084 40,260 43,052 42,337 82,297 84,185 54,250 70,911 485,418

Manager 4 - 19,583 37,788 18,107 1,125 16,267 5,159 5,779 8,290 1,747 64,215 106,122 284,182

Manager 5 - - - - - 847 8,479 301 1,266 5,874 7,974 17,879 42,620

Total 26,956 54,133 87,882 72,790 103,500 106,574 106,465 135,598 191,941 200,782 203,358 274,921 1,564,899

Total Goal 37,750 69,000 100,750 132,400 169,750 206,500 238,750 264,500 296,250 333,250 353,000 364,500 2,566,400

Variance (10,794) (14,867) (12,868) (59,610) (66,250) (99,926) (132,285) (128,902) (104,309) (132,468) (149,642) (89,579) (1,001,501)

Var % −28.6% −21.5% −12.8% −45.0% −39.0% −48.4% −55.4% −48.7% −35.2% −39.8% −42.4% −24.6% −39.0%

Bids: Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Manager 1 5 27 35 21 17 18 19 14 11 10 11 4 192

Manager 2 16 13 17 12 11 9 17 6 11 6 3 10 131

Manager 3 5 12 13 13 10 9 14 7 12 8 4 4 111

Other 2 4 5 4 5 4 4 6 5 2 2 2 45

Total 28 56 70 50 43 40 54 33 39 26 20 20 479
 Exhibit 2 Continued

Opportunities Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14 Total

Stage 1 - 430 484 507 544 545 541 520 577 552 566 576 394
Qualifying

Stage 2 - Initial 351 379 426 425 440 416 340 366 368 357 367 289
Meeting

Stage 3 163 167 193 216 219 200 174 166 164 155 157 134
- Developing
Proposal

Stage 4 118 114 113 114 121 108 146 149 157 169 162 127
- Presentation

Stage 5 51 70 98 58 57 51 45 47 51 53 56 50
- Commitment
to Buy

Total Current 1,113 1,214 1,337 1,357 1,382 1,316 1,225 1,305 1,292 1,300 1,318 994
Opportunities

Stage 6 - Won 255 272 284 293 304 318 319 348 387 418 436 321

Stage 7 - Lost 180 192 226 244 270 268 299 318 413 440 468 333

Total All 1,548 1,678 1,847 1,894 1,956 1,902 1,843 1,971 2,092 2,158 2,222 1,648
Opportunities

(Continued)

55
56

Exhibit 2 Continued

2013 Web
Analytics Jan-14 Feb-14 Mar-14 Apr-14 May-14 Jun-14 Jul-14 Aug-14 Sep-14 Oct-14 Nov-14 Dec-14

Sessions 20,812 17,825 18,806 18,780 18,182 34,969 37,566 35,964 37,869 39,959 31,827 28,523

Users 8,851 7,813 8,297 8,045 7,974 14,681 15,957 15,895 16,603 16,805 14,381 13,634

Pageviews 35,903 30,877 33,137 33,426 34,216 304,010 325,674 309,291 318,452 345,600 275,187 238,281

Pages/Visit 1.73 1.73 1.76 1.84 1.88 8.69 8.67 8.6 8.41 8.65 8.65 8.35

Visit Time 2:46 2:48 2:41 2:42 2:44 7:33 7:25 7:05 6:56 7:14 7:06 6:52

Bounce Rate 66.02% 66.55% 67.09% 66.57% 67.10% 42.62% 43.87% 44.11% 44.29% 43.22% 43.76% 45.86%

% New Visits 31.16% 30.63% 31.61% 30.11% 31.44% 35.92% 30.98% 31.52% 31.13% 29.45% 30.77% 31.69%

Session: A session is a period time where the user is actively engaged with your website.
User: Users have had at least one session within the selected date range. Includes both new and returning users.
Pageviews: The total number of pages viewed. Repeated views of a single page are counted.
 Office Solutions, Inc.

Exhibit 3 William’s Compensation Calculator

William’s 2014 performance

2014 Goal 2014 Actual Variance Variance %

Total Revenue $ 2,104,350 $ 2,254,393 $ 150,043 7.1%

Office Supply Rev. $ 1,411,512 $ 1,403,717 $ (7,795) −0.6%

Furniture Rev. $ 313,899 $505,495 $ 191,596 61.0%

Facility Supply Rev. $ 228,071 $239,152 $ 11,081 4.9%

Printing Rev. $ 150,868 $106,029 $ (44,839) −29.7%

Gross Profit $ 502,939 $538,799 $ 35,860 7.1%

Revenue from New Accounts $ 39,000 $1,200 $ (37,800) −96.9%

William’s 2014 compensation under commission structure

Percentage Gross Profit Base Compensation

Commission 25.00% $538,799 $134,700

Base Bonus .50% $538,799 $2,694

Furniture Bonus .15% $538,799 $808

Facility Bonus .15% $538,799 $808

Printing Bonus 0 0

Total Compensation $139,010

William’s compensation under new proposal

AS OFFERED TO WILLIAM

90% base/10% bonus If 70% base/30% bonus

Base Salary $121,230 $94,290

Bonus Potential $ 13,470 $40,410

Total Compensation $134,700 $134,700

This case was prepared by Professor Kenneth A. Merchant and Research Assistants Michelle Spaulding and Seung Hwan
(Peter) Oh.
Copyright © by Kenneth A. Merchant.

57
Chapter 2 • Results Controls

CASE STUDY
Puente Hills Toyota

In December 2003, Howard Hakes, vice president of It was important for the dealerships to keep two
Hitchcock Automotive Services, reflected on some of the important constituencies – manufacturers and custom-
challenges his team faced in managing his company’s ers – happy. The manufacturers allocated larger
stable of automobile dealerships. He illustrated his points numbers of their best-selling models to their better
by discussing the challenges faced at Puente Hills Toyota, performing dealers. The manufacturers evaluated
Hitchcock’s largest dealership, although all of the Hitch- their dealers in terms of their abilities to fulfi ll their
cock dealerships faced essentially the same problems. market potential: to meet sales targets the manufactur-
This is very much a people business. It’s people
ers set for each geographical trading area, known as
who give us our biggest successes as well as our
the primary market area. The dealerships also had to
biggest challenges. At our Toyota store, in sales, I
satisfy the manufacturers’ licensing and certification
would say that about 20% of our people are loyal
standards. The manufacturers regularly performed
to the company and really want to do a good job.
compliance audits to evaluate dealership practices in
The other 80% are just in this for the money . . . and
comparison with the established standards. However,
they can make more money here than anywhere
Howard Hakes believed that short of flagrant violations
else. Our compensation attracts some very tal-
of standards (e.g. selling competing brands under the
ented people. But some of these people are
same roof), fulfi lling market potentials was the pri-
sharks who try to get away with whatever they
mary factor affecting the dealers’ relationships with
can. Others have personal problems. They live
the manufacturers.
from paycheck to paycheck; that is their mentality.
Customer satisfaction was obviously important in
Still others are cancers whose bad habits can
obtaining repeat sales and, hence, future profits. Cus-
spread. We coach and counsel; we give written
tomer satisfaction surveys were given to every cus-
notices; and for most of the employees, once they
tomer who bought or leased a vehicle or had one
get the message that is the end of the problems.
serviced at a dealership. A copy of the survey given to
But for some others . . .
all Toyota customers who purchased or leased a vehicle
I think the key to management in this business is
is shown in Exhibit 1.1 The responses to these survey
all about managing attitude. How can we keep the
questions were mailed directly to the manufacturer
team moving in the same direction, to get every-
and aggregated into a customer satisfaction index (CSI),
body to be part of the team, and prevent the can-
to which considerable attention was paid by both the
cers from spreading?
manufacturer and dealership managers. Manufactur-
ers sometimes changed dealership vehicle allocations
when CSI ratings fell below acceptable levels in three
The company and industry consecutive years.
Hitchcock Automotive Services was a privately held cor-
poration comprised of seven automobile dealerships – Puente Hills Toyota
three Toyota dealerships and one each for Volkswagen,
Ford, Hyundai, and BMW – and a large body shop. All of Puente Hills Toyota (PHT) was a large Toyota dealer-
the entities were located in southern California. Four of ship. Annual sales were about $85 million, including
the dealerships, including Puente Hills Toyota, were sit-
1
uated adjacent to each other in City of Industry, Califor- Toyota also required the use of a service survey, which asked service
customers a comparable set of questions focused on satisfaction with
nia, about 25 miles east of Los Angeles. The others were (1) making the service appointment, (2) writing up the service order,
located in Anaheim, Hermosa Beach, and Northridge. (3) work quality, (4) work timeliness, (5) price, and (6) the facilities.

58
 Puente Hills Toyota

approximately $10 million from the body shop, which only marginally profitable. Used vehicles provided a
provided services to all of the Hitchcock dealerships in better profit source, as Howard Hakes explained:
City of Industry. PHT had a total of 145 employees, and
This is one of the last barter businesses left. For
annual profits totaled about $1.8 million.
some new vehicles, there is only an $800 difference
PHT had won many awards for excellent perfor-
between the window sticker price and dealer cost,
mance. For example, the dealership had been awarded
so there is not much margin and not much room for
Toyota’s President’s Award for overall excellence in
bargaining. In used vehicles, we have a little more
each of the prior 13 years.
profit opportunity. We can sometimes take a trade-
In 2003, PHT moved into a new, state-of-the-art, $13
in for $2,000, put $1,500 worth of work in it, and sell
million facility with 119,000 square feet of space. The
it for $6,000.
new building provided the latest in customer ameni-
ties, including a children’s play area, a movie theatre, The ser vice department was consistently PHT’s
efficient work layout areas, and room for growth. most profitable department, with margins typically
PHT’s organization structure was fairly typical in in the range of 15–20%. (See comparison statis­t ics
the industry. Reporting to the dealership general man- f rom an industr y consulting report show n in
ager were a general sales manager whose organization Appendix A.)
included both new and used vehicle sales, a service As required by Toyota, PHT managers kept separate
manager, a body shop manager, a parts manager, and records for new and used vehicle sales, as if they were sep-
a director of finance and insurance (F&I) (see arate departments, even though all PHT salespeople could
Exhibit 2). The one unique feature of the organization sell both new and used vehicles. The separation of new
was the combined new and used vehicle sales depart- and used vehicle profits required some allocations of
ment. Only about one in five auto dealerships, typi- expenses. With rare exceptions, all items of expense were
cally the smaller ones, had such a combined vehicle split 70% to new vehicles and 30% to used vehicles, an
sales department. More typically, the managers of the allocation formula that was typical in the industry. How-
new and used vehicle sales departments reported ard Hakes knew that this formula was somewhat arbitrary.
directly to the dealership general manager. But PHT For example, he knew that some forms of advertising, such
managers liked the flexibility of having their sales per- as half-hour television shows or “infomercials” on Spanish
sonnel sell whatever vehicle customers wanted, new or language television stations, were solely aimed at selling
used, and some customers wanted to look at both new used vehicles. But, he explained, “I’ll bet we aren’t off by
and used vehicles. more than 5% with the 70 –30 split. Maybe it’s 65 –35, one
Each of PHT’s departments was managed as a profit way or the other, but we won’t be further off than that.”2
center. Many indirect or overhead expenses, such as All interdepartmental transfers were done at market
dealership administrative salaries and dealership prices. Thus, for example, when PHT’s used vehicles were
advertising expenditures, were assigned or allocated to serviced in the PHT shop, the sales department paid full
the departments. Only some infrastructure-related retail price for parts and labor. This policy gave the used
expenditures (e.g. rent and equivalent) and some other vehicle manager some negotiating power in the service
expenditures over which the department managers area. Paying full retail price ensured that internal used
had little or no control (e.g. insurance, taxes, legal, and vehicle service jobs would not be given lower priority.
auditing) were not allocated to them. Valuations of used vehicle trade-ins sometimes cre-
Exhibit 3 shows one page of the financial statement ated disagreements. These valuations were important
report that PHT was required to submit monthly to primarily because the sales personnel earned commis-
Toyota Sales Corporation. The other pages in this report sions based on the profits of the “deals” they closed.
called for an extensive array of information, including Such disagreements were common in dealerships
the profitability of the other departments, balance sheet
data, unit sales by model, personnel counts by depart- 2
The industry consulting report showed that for FY 2002, the average
ment and category, and a variety of performance ratios overhead expenses (equivalent to line 57 in Exhibit 3) in the industry
(e.g. total bonuses as a percentage of sales, gross profit were $2.6 million for new vehicle departments, or 7.22% of sales
average per unit of each model sold). (equivalent to line 1 in Exhibit 3) or 94.48% of new vehicle depart-
ment profit (equivalent to line 33 in Exhibit 3). For used vehicle depart-
The profitability of PHT’s departments varied widely. ments, average overhead expenses in the industry amounted to $1.4
As in most dealerships, new vehicle sales at PHT were million, or 8.12% of sales or 85.78% of used vehicle department profit.

59
Chapter 2 • Results Controls

because new car salesmen were often motivated to over The bonuses, which were typically 250 –300% of the
pay the customer for trade-ins to secure the new car sales employees’ base salaries, provided a significant
sale. And at PHT, and indeed all dealerships, needed proportion of total compensation. The salaries were
repairs on trade-ins were sometimes not spotted at the paid semi-monthly, and commissions and bonuses
time of the sales deal. This could happen anytime, but were paid monthly.
at PHT it was most likely to happen on Sundays when Howard Hakes explained that one side benefit of
the service department was closed and no service having a combined new and used vehicle sales depart-
advisor could be called in for a second opinion on esti- ment was that, combined, the department was
mated trade-in repair costs. As Howard explained: generally profitable, whereas new vehicle sales depart-
ments alone often were not.3 Howard wondered how
On Mondays, we often have animated discussions managers provided “profit-based” incentives in sales
between sales and service about the repairs that the departments that were losing money.
service department claims are required on trade-ins. All of the sales managers’ bonus plan contracts also
But we stick to the market price rule! If the costs of included the following wording:
repair are higher than what the salesmen had antici-
Adjustments. “Any cancelled sales or subsequent
pated on Sunday, it eats into their deal profit. If they
changes to the account as a result of a returned
don’t agree with the service repair cost estimate,
product will be calculated into the commissionable
they are free to sell the trade-in “as-is” on the whole-
gross profit and will be used to calculate your com-
sale market. Sometimes they even get lucky when
missions earned for each month. Adjustments may
the repair problem isn’t spotted there either. That’s
also be made to correct errors, or for rewrites to
why some used vehicles come to be called “lemons.”
the deal; unwinds, null and voided deals; customer
receivables not collected (including, but not limited
Performance measures and incentives to down payments, drive-off fees, insurance
Compensation of line personnel at PHT was high, par- coverage, or penalties on trade-in), or policy
ticularly given the employees’ generally relatively adjustments.”
modest education levels. Even young salespeople, those
Other Factors. “Other factors such as the Customer
still in their early 20s, could earn $6,000–$7,000 per
Satisfaction Index (CSI)4 and Employee Satisfac-
month if they hustled and followed up effectively with
tion Index (ESI)5 score may be taken into account in
customers. Top sales personnel could earn $20,000 per
determining bonuses.”
month, or even more. Some service technicians earned
over $10,000 per month. Performance-based incen- How these nonfinancial performance indices were
tives were a significant part of the compensation of all taken into account for bonus determination was left
line personnel. vague. They could be used in a positive sense, to pro-
vide “discretionary” bonus awards, or they could be
A. Incentives in the sales department used to limit the formula bonuses. However, no one at
All personnel in the sales department were paid a rela- PHT could remember any situations where they had
tively modest base salary plus incentive pay. The sales- made a substantive difference in the bonuses awarded,
men and assistant sales managers earned commissions perhaps because at PHT, the indices had never fallen
on the deals they closed. The average commission rate below acceptable levels.
was 20% and 7% of deal gross profit for salesmen and For comparison purposes, Appendix B provides
assistant sales managers, respectively. The general sales
manager, used vehicle sales manager, and sales desk man- 3
The consulting report showed that about one in three new vehicle
agers’ bonuses were based on a proportion of depart- sales departments incurred a loss (see note (2) in Appendix A).
4
mental profit after overhead expenses but before taxes CSI was explained earlier in the case. The sales customer survey
form is shown in Exhibit 1.
(line 59 in Exhibit 3). The general sales manager and 5
ESI was calculated from the results of a survey designed by a
desk sales managers were paid 2.25% and 1.2–1.5% of consulting firm given annually to all PHT employees. Each employee
this amount for the total sales department, respectively. was asked to indicate the level of agreement, on a scale from 1
(strongly disagree) to 5 (strongly agree), with 26 statements, such
The used vehicle sales manager was paid 5% of this as “I feel my work is valued by the dealership” and “Overall the
amount for the used vehicle department only. managers are honest and fair in their treatment of employees.”

60
 Puente Hills Toyota

excerpts from a consulting report showing vehicle replace the defective electronic module, hook up a test
dealership department manager compensation data. In recorder, and test-drive the vehicle. The flag rate for
this appendix, Schedule 1 shows data about the amounts this job might be 48 minutes. A technician who wanted
and forms of monetary compensation given to depart- to cut corners might skip the test drive. Knowing that a
ment managers. Schedule 2 shows the measures used in supervisor would check the vehicle’s mileage-in and
allocating formula bonuses. Schedule 3 shows the inci- mileage-out, he would have to put the vehicle up on a
dence and size of discretionary (nonformula) bonuses. hoist and run it for, perhaps, three minutes to increase
the odometer mileage. But by cutting corners, he might
B. Incentives in the service department be able to complete the entire job in less than
15 minutes.
The service technicians were paid from $10 to $23 per
PHT managers had two types of controls over these
“flag hour” of work completed. The actual hourly rate
gaming behaviors. First, if the time spent on a job was
depended on each individual’s technical specialty and
very low, service managers asked the technician for an
their certifications (e.g. master technician). Flag hours
explanation of the anomaly. Second, management mon-
were standards set by the manufacturer for the
itored the number of “re-checks,” instances where the
accomplishment of specific tasks. The standards were
problem was “not fixed right the first time.” In the indus-
set so that an average qualified technician could
try, a 1% re-check rate was considered good. The re-
achieve them. However, it took technicians at PHT,
check rate usually could not go to zero because some of
who were generally very experienced, about 45 min-
the re-checks were not the technician’s fault. The cause
utes on average to do one flag hour of work. For some
might be simply that a needed part was unavailable.
technicians the disparity between flag and actual
Technicians who cut corners were “written up,” that
hours was much higher. Jesus Barragan, PHT’s service
is, given notice, and their ticket was deducted. “Bad
manager, said “Our top guy, who is a ‘natural,’ beats
habits can be corrected; bad mechanics can’t,” Jesus
the flag time by 600%.” The disparity also varied by
Barragan observed.
area.
Howard Hakes had some confidence that this gam-
The service advisors earned a base salary of approxi-
ing problem was under control because the service area
mately $2,000 per month. They also earned bonuses as
at PHT was averaging only about four re-checks per
follows:
month for approximately 700 completed service jobs. If
8% commission on customer-paid labor and parts; service technicians were cutting corners in a signifi-
6% commission on manufacturer-paid labor under cant way, he estimated that the re-check rate would be
warranty; significantly higher.
6% commission on labor and parts paid for internally The service technicians at PHT were very loyal to
at PHT. the company, because “we treat them as people, not
mechanics,” Jesus said. “We also train and pay them
The PHT service manager was paid a base salary of well.” Turnover was virtually zero.6 But the mechanics
$3,000 per month plus a bonus based on a percentage had to buy their own tools. Jesus Barragan noted that
of the service department gross profit (before overhead “one of our guys has bought well over $535,000 worth
expenses). The percentage was 3.75% if the gross profit of tools during his 36-year career with us, but then, he
figure was $195,000 or less in any given month; the makes $130,000 per year too.”
percentage rose to 4% if gross profit exceeded
$195,000. The $195,000 was the total annual budgeted
amount divided by 12. Management Issues
Howard Hakes knew that his PHT management team
had not solved all their problems. He lamented about the
C. Gameplaying temptations in the service
fact that, in general, sales personnel were not effective
area
at following up with customers. Follow-up means that
Because they were paid by the job, service technicians
had temptations to cut corners. For instance, for a 6
This is in stark contrast with turnover in the sales department, which
typical Electronic Engine Control (EEC) repair, the Howard described as “horrid” (about 60% per year, as opposed to
technician might be required to diagnose the problem, only about 5% in service).

61
Chapter 2 • Results Controls

the sales staff keeps in touch with potential customers inputs for the influential ratings of automobile reliabil-
with whom there has been an initial contact. Follow-up ity published by the firm J.D. Power & Associates and, as
includes outreaches (e.g. phone calls, thank you cards) mentioned above, the manufacturers used those ratings
to customers who visited the sales department but have to allocate their vehicles. As a consequence, in the quest
not yet decided to purchase a vehicle, as well as sales for “perfect” ratings, customers were regularly
approaches to customers who are driving an older vehi- “coached” on how to complete the questionnaire at the
cle that has recently been serviced at PHT. PHT had time they purchased a new vehicle. And, sometimes,
established regular processes for both types of follow- dealerships asked customers to drive to the dealership
up. For example, service advisors were encouraged to when they received the questionnaire from the manu-
explain to customers which service costs were likely to facturer. When they arrived, the customer would give
occur on their older vehicle in the coming years and to the questionnaire to a dealership employee and receive
invite the client to visit the sales department. However, a present, such as a full tank of gas. The employee would
these activities consumed time, and the service advisors complete the questionnaire and send it to the manufac-
regularly ignored them. Could incentives be provided to turer. Howard was not sure whether some of his “shark”
encourage follow-up and referral behaviors? salesmen also engaged in such practices, and if they did,
Howard also worried that the CSI measure, which what he should do about it.
could provide useful information, sometimes had ques- Despite these issues, Howard was confident that
tionable validity. Howard had heard that some dealer- PHT was one of the best-managed dealerships in the
ships regularly “gamed” the measures because they had country.
become so important. The CSI ratings were important

62
 Puente Hills Toyota

Exhibit 1 Puente Hills Toyota: Customer satisfaction survey

(Continued)

63
Chapter 2 • Results Controls

Exhibit 1 Continued

64
 Puente Hills Toyota

Exhibit 2 Puente Hills Toyota: Organization structure

65
Chapter 2 • Results Controls

Exhibit 3 Puente Hills Toyota: Sample page of financial reporting package

66
 Puente Hills Toyota

Exhibit 3 Continued

67
Chapter 2 • Results Controls

Appendix A Puente Hills Toyota: Excerpts from Consulting Report showing automobile dealership and
department data (FY 2002)1

1st Quartile Median 3rd Quartile Average St. Dev.

1. NEW VEHICLE DEPARTMENT

Sales ($000) 17,217 27,134 42,470 36,479 34,585

Net profit ($000)2 −49.7 197.2 706.7 530.0 1,195.7
Return on sales −0.002 0.008 0.021 0.009 0.020

2. USED VEHICLE DEPARTMENT

Sales ($000) 10,000 14,533 21,016 17,240 11,601

Net profit ($000)2 − 22.7 20.0 451.4 258.6 470.4
Return on sales − 0.003 0.014 0.026 0.013 0.025

3. SERVICE DEPARTMENT

Sales ($000) 1,560 2,257 3,594 32,846 1,926

Net profit ($000)2 54.8 180.8 346.3 246.6 324.1
Return on sales 0.028 0.081 0.130 0.072 0.093

4. TOTAL DEALERSHIP

Sales ($000) 34,326 49,933 73,502 62,236 47,286

Net profit ($000)2 43.4 100.2 1772.0 1,443.9 1,742.8
Return on sales 0.015 0.020 0.022 0.031 0.015

1
Data obtained from 256 dealerships. The sum of the sales and profits of the service and the new and used vehicle departments do not add up to
the dealership totals because sales and profits associated with body and parts are not included.
2
Note that 30.2% of the new vehicle departments, 27.8% of the used vehicle departments, 16.9% of the service departments, and 5.1% of the dealerships
incurred a loss.

68
 Puente Hills Toyota

Appendix B Puente Hills Toyota: Excerpts from Consulting Report showing department manager compensation
data (FY 2002)

Schedule 1: Department Manager Compensation: Total and Breakdown into Components – Base Salary, Formula
Bonuses, and Discretionary Bonuses (overall averages)

Base salary Formula bonus Discretionary bonus

NEW VEHICLE DEPARTMENT MANAGERS

(Average total compensation = $78,428)1

Average ($) $31,901 $44,829 $5,104
Percent receiving 79.23% 64.48% 23.50%
Average % of total compensation 44.89% 36.77% 4.26%

USED VEHICLE DEPARTMENT MANAGERS

(Average total compensation = $72,195)1

Average ($) $31,672 $40,376 $4,046
Percent receiving 85.04% 66.14% 27.56%
Average % of total compensation 47.12% 38.32% 5.03%

SERVICE DEPARTMENT MANAGERS

(Average total compensation = $61,422)1

Average ($) $33,278 $30,575 $2,302
Percent receiving 90.00% 68.00% 20.00%
Average % of total compensation 56.00% 34.26% 3.53%

ALL DEPARTMENT MANAGERS COMBINED

(Average total compensation = $70,189)1

Average ($) $32,379 $37,993 $3,739
Percent receiving 84.90% 66.27% 23.14%
Average % of total compensation 49.80% 36.17% 4.17%

1
Total Compensation consists of any or all of the following components: Base Salary, Formula Bonuses (maximum of three), Discretionary Bonus, and
Spiffs.
Definitions:
*Formula Bonuses are based on quantitative performance measures (e.g. department profit). Some contracts have up to three formula bonuses, although
the majority of the managers (60%) receive one formula bonus only. Across departments, the first formula bonus is on average 85% of the total formula
bonus. Also, the first formula bonus is on average more than seven times larger than the second formula bonus.
*Discretionary Bonuses are based on the supervisor’s subjective judgments of the managers’ performances.
*Spiffs are miscellaneous rewards (not reported above), which are difficult to characterize in a standard way. Common examples are the use of
promotional vehicles and certain incentives provided by the vehicle manufacturers (e.g. vacation trips). Although receipt of spiffs is common (about 63%
of the managers receive them), their economic significance is relatively low (about $4,593 for those who receive spiffs, compared at $15,000 to $20,000
for those who receive a discretionary bonus).

(Continued)

69
Chapter 2 • Results Controls

Appendix B (Continued)
Schedule 2: Dealership Performance Measure Used in Department Manager Formula Bonuses (as a percentage of all
formula contracts)

Formula bonus #1 #2 #3

Dealership Gross profit 1.8 1.7 0.0

Net profit 27.0 10.9 20.0
Gross profit 6.4 6.9 0.0

New vehicle sales Net profit 5.8 1.7 2.9

Inventory 0.0 1.1 0.0
Unit sales 0.0 6.3 2.9
Gross profit 5.9 4.6 14.3

Used vehicle sales Net profit 2.2 5.2 8.6

Inventory 0.2 2.9 14.3
Unit sales 0.5 7.5 2.9
Gross profit 14.5 4.6 2.9

New = used Net profit 8.6 6.9 11.4

Inventory 0.0 0.0 5.7
Unit sales 0.3 8.6 2.9
Gross profit 2.7 1.1 0.0

Parts Net profit 1.9 2.3 0.0

Revenue 0.2 0.0 0.0
Gross profit 9.4 4.0 0.0

Service Net profit 8.6 6.9 5.7

Revenue 0.8 0.0 0.0

Body, parts, & service Gross profit 2.6 5.7 2.9

Net profit 0.6 10.9 2.9
% Gross profit 43.3 28.7 20.0
% Net profit 54.8 44.8 51.4

Schedule 3: Average Discretionary Bonus for Managers Who Receive a Discretionary Bonus (dollars and percentage
of total compensation)

Average discretionary bonus

Pct. receiving Dollars % tot. comp.

New vehicle department managers 23.5% $21,958 18.1%

Used vehicle department managers 27.6% $15,719 18.3%

Service department managers 20.0% $11,801 17.7%

All department managers 23.1% $16,664 18.0%

This case was prepared by Professors Kenneth A. Merchant and Wim A. Van der Stede of the University of Southern California
and Pieter Jansen of the University of Groningen (the Netherlands).
Copyright © by Kenneth A. Merchant, Wim A. Van der Stede, and Pieter Jansen.

70
 Kooistra Autogroep

CASE STUDY
Kooistra Autogroep

When he took over as CEO of the Kooistra Autogroep in dealership, one Suzuki dealership, one Saab dealer-
2002, Tom Kooistra made significant changes to his com- ship, one Alfa Romeo dealership, and one combined
pany’s management control system. Most significantly, Chevrolet, Cadillac, Corvette, and Hummer dealer-
he decentralized decision-making authority, developed ship. Opel (a brand of General Motors) had been the
a performance reporting system that included both market leader in the Netherlands since the 1970s,
financial and nonfinancial information, and introduced with a market share of almost 10% in 2006. Toyota
a pay-for-performance system for the company’s dealer- was the sixth-largest brand, with a 7% market share.
ship and department managers. Tom explained: Citroën had a market share of 4%, and Suzuki and
Chevrolet had market shares of about 2–3%. The
My father had been running this company like a
other brands sold by Kooistra – Saab, Alfa Romeo,
family, but we’ve become too big to operate like
Cadillac, Corvette, and Hummer – all had market
this. Besides, we need to be more competitive to
shares of less than 1%. For these smaller brands, the
survive. That’s why I am so keen on implementing
nearest competing dealership was typically located
the new pay-for-performance plan. With decentrali-
far away. In addition to the car dealerships, the Koois-
zation comes accountability for performance. If our
tra Autogroep also owned a body repair shop and a car
people are willing to accept that accountability,
lease company.
then I am quite willing to share with them a fair pro-
In the context of Dutch automobile retailers, Koois-
portion of the company’s success.
tra was large. Even in 2007, the typical Dutch car deal-
But while the company’s managers seemed to value ership sold and serviced cars of only one brand from a
the increased authority and performance-related infor- single location. Most dealerships were family-owned,
mation, their feelings regarding the pay-for-perfor- with about 20 employees on average.
mance system were mixed. In 2007, Tom was considering In the early 2000s, as a consequence of the weak
whether he should try to reinforce the system by telling economic conditions and increased competition, the
the managers that the system was here to stay and that financial performance of most Dutch car dealers dete-
they needed to learn how to make it work, or whether he riorated. This performance deterioration gave rise to
should revise, or possibly even abandon, the system. many changes in the industry. One important change
was industry consolidation. Many larger car dealer-
ships expanded through acquiring several formerly
The company family-owned dealerships. Kooistra Autogroep was
Kooistra Autogroep was a family-owned automobile among the fi rst to expand the number of brands sold,
retailing company founded in 1953. Over the years, standardize operating procedures, and exploit econo-
Kooistra grew from a small company that sold and ser- mies of scale.
viced cars of only one or two brands from a single location In 2002, Tom Kooistra’s father retired, and Tom
to a top-20 player in the Dutch car dealership market. took over as the company’s CEO. Tom chaired the
In early 2007, it owned and operated 13 dealership loca- company’s top-management team (see Exhibit 1).
tions selling 10 brands of automobiles and employed Also on the top-management team were Anna Lub-
approximately 325 people. bers, CFO, and eight managers. Five of the managers
The Kooistra dealerships were located in the city of were dealership managers, each responsible for sev-
Tilburg and in smaller surrounding towns in the eral dealership locations selling between one and
southern part of the Netherlands. Kooistra owned five five brands. Each dealership location employed a
Opel dealerships, three Toyota dealerships, one Citroën sales manager, a ser vice manager, a workshop

71
Chapter 2 • Results Controls

manager,1 and a parts manager. The other three top- Table 1 Average return on sales in the Dutch car
level managers were responsible for the body repair dealership sector (2001–2005)
shop, 2 the car lease company, and the group’s central
after-sales department. 3 These managers supervised 2001 2002 2003 2004 2005
receptionists, salesmen, technicians, and ware- Average 1.02% 1.35% 1.19% 1.05% 0.31%
housemen. Also in the company was a central corpo- Netherlands
rate staff responsible for finance and accounting,
Source: BOVAG Autodealers 2006. Reproduced with permission.
marketing, quality management, personnel and
organization, used car auctions,4 and fleet sales. 5
Although some of its dealerships had been perform- company’s management control system needed to
ing quite well, recent overall performance of the Koois- change. Tom’s father used to make most of the significant
tra Autogroep was subpar, but still in line with industry decisions across all the company’s operations. Tom,
averages. To ensure adequate resources necessary for however, believed that he needed to decentralize deci-
business continuity, a rule of thumb in the Dutch car sion-making. Tom thought that the dealership managers
dealership business was that the return on sales (net should have substantial authority for the critical deci-
profit over sales) should be at least 2%. However, due sions in their business, including the hiring, firing, and
primarily to generally poor economic conditions, the supervising of their dealership personnel; advertising
average returns of Dutch car dealerships had not been investments; sales promotions in their local markets;
near this level since the late 1990s (see Table 1). and price reductions that might be needed to move
excess inventory or to meet the competition.
The new management control system But Tom also believed that with decentralization
came results accountability. To make this accountabil-
As Kooistra Autogroep became a larger and more com- ity possible, Tom implemented three new systems when
plex organization, Tom Kooistra concluded that the he took over as the CEO in 2002: performance report-
ing, budgeting, and pay-for-performance. These new
1
Some of the dealerships were located in close proximity. For these
systems were to be implemented by fiscal year 2003.
dealerships, Kooistra Autogroep maintained one central work-
shop managed by the after-sales department (see Exhibit 1), which 1. Performance reporting
serviced several brands. The dealerships in the other locations had
their own workshop. The workshops essentially serviced both the The new performance reporting system included both
sales and service departments. For service jobs, customers went financial and nonfinancial information. It was used as
through the service department, which determined the work that
needed done as well as the (estimated) cost and time for completion
an instrument to communicate the company’s most
of the work. In addition, the workshop performed get-ready work for important objectives to the dealership and department
new cars sold by the sales department, installation of accessories managers; to provide these managers with the infor-
on new cars, and service and reconditioning work on used cars for
resale by the dealership.
mation they needed to do their jobs; and to provide
2
Like the service workshop, the body repair shop obtained busi- feedback to top management so that they could moni-
ness internally through the service department and from used car tor the lower-level managers’ performances. Tom
sales for reconditioning body work. The body repair shop, however,
also had its own reception for walk-in customers, as not all Dutch explained:
car dealerships provided car body repair work. Another significant
My father needed to inform the dealership manag-
source of business consisted of contracts with insurance companies
for repairs related to car accidents. ers and the department managers only about the
3
Because the centralized service workshop was quite large, the role of most important performance indicators because
after-sales manager was created to oversee several workshop super-
visors who, in turn, supervised the mechanics (see Exhibit 1). he made most of the operational decisions. I decen-
4
Customers who bought a car often expected the dealership to tralized an important part of his decision-making
purchase their old car. Like most dealerships, Kooistra Autogroep authority. But when I made the operating managers
classified these used cars into two categories. Cars that were in good
enough condition were offered for sale by the dealership to used car responsible for achieving the required perfor-
customers. Cars in poor condition, however, considering the reputa- mance, I also had to communicate much more
tion of the dealership, were auctioned off in batches by the auction detailed performance information to them.
sales department to other companies that specialized in selling these
(cheaper) cars outside of a brand name dealership network. One type of performance report, which was referred to
5
The fleet sales department was responsible for establishing and
maintaining relationships with, and selling cars to, companies that as the “Balanced Scorecard” within the Kooistra organ-
bought cars in large numbers. ization, was distributed to the managers on a weekly

72
 Kooistra Autogroep

basis. It reported year-to-date summary performance very hard look at them. In the end, however, I
on key metrics for each individual manager’s opera- believe that we find the proverbial happy medium
tions (e.g. a dealership) with an indication of progress for targets that we feel the manager should be will-
towards budget target accomplishment. Exhibit 2 ing to commit to.
shows this so-called Balanced Scorecard for the Toyota
dealership. In addition to the weekly balanced score- But not only did the budgeting discussions serve a
cards, the managers also received far more detailed training role, they also were a valuable communication
monthly reports, with sometimes up to hundreds of tool to focus discussions about the business, which
line items pertaining to their areas of operation. allowed Tom and Anna to solicit information from
The dealership and department managers apparently those who were closest to the day-to-day operations
used the performance reports actively. Tom explained: from which they themselves had become farther
removed.
Every Thursday at 2 o’clock, the dealership and Tom and Anna monitored performance through
department managers receive their Balanced weekly reviews of the Balanced Scorecards. When they
Scorecards by email. When I walk through the saw performance patterns that were of concern to them
company on Thursday afternoon and the reports because they were not consistent with the budget tar-
have not yet been emailed, department managers gets and/or the performance of other company entities,
ask me what’s up. The department managers are they had conversations with the managers. The entire
interested in their performance and, particularly, in top-management team also held monthly meetings to
comparing their performance vis-à-vis target. review performance issues and discuss other company-
wide business matters.
2. Budgeting The net profit budget targets were believed to be
achievable with considerable effort. As Exhibit 2 shows,
At the same time, Tom introduced a formal annual budg-
the Toyota dealership had almost achieved its 2006 net
eting process. Although various types of financial and
profit target even though there were still five weeks to
nonfinancial information were considered during the
go in the budget year. When asked, the Toyota dealer-
budgeting process, the main focus was on determining
ship manager estimated that at the time his budget was
net profit targets for the forthcoming year.
approved, his likelihood of achieving the net profit tar-
Net profit was defined as revenues minus controlla-
get was around 90%. He also pointed out that “Although
ble expenses, which in practice meant that most
I’ve made my budget in each of the past three years, it
corporate overhead allocations were “below the line”
was rather close. But not all of my department manag-
on which the operating managers focused. However,
ers met their budget each year. My workshop depart-
Tom felt that continued decentralization would eventu-
ment had some cost control issues and did not always
ally lead the company to improve its methods of allo-
achieve its net profit targets.” The Toyota dealership
cating shared service costs to obtain more inclusive net
was among the best-performing entities in the Kooistra
profit numbers and, thus, to allow even better account-
Autogroep.
ability at lower organizational levels.
Some of the other dealership managers, however,
The budgeting process was intended to be bottom-
complained that they had trouble meeting their budget
up. The responsible managers prepared their own
targets due to factors outside of their control. For exam-
budget proposals. The budget proposals were then
ple, the combined Chevrolet, Cadillac, Corvette, and
reviewed by Tom and the CFO, Anna Lubbers, followed
Hummer dealership complained that recent hikes in fuel
by what they both described as “rather tough, some-
prices had negatively impacted car sales beyond what
times vociferous, discussions” with each manager. Tom
could have been foreseen at budget time. He wasn’t sure,
and Anna decided the final budgets.
however, that Tom would be sympathetic if he failed to
The budget discussions served several useful pur-
meet his budget, which he likely would this year.
poses. Most managers were inexperienced with budg-
But Tom also could sometimes “help” the dealerships
eting and only few of them had had any formal business
make their target. Kooistra Autogroep had a sizable con-
education. Anna noted that,
tract with a big rental car company that specified the
For these and other reasons we can’t always trust number and type of cars (e.g. small cars, medium-sized
the initial budget proposals, so we have to have a family cars, vans), but not the brand, that the rental car

73
Chapter 2 • Results Controls

company purchased. Thus, when the Opel dealership dealership that had been acquired. These contracts
was close to making its target but needed “a little help,” could not easily be renegotiated. Considering these fac-
Tom could offer the Opel Astra model to the rental car tors, Kooistra’s top managers admitted that the sales
company. Alternatively, if the Toyota dealership needed bonus plan was limited in scope. It also was still subject
some help, he could propose the Toyota Corolla instead. to change. Anna Lubbers, CFO, explained that manage-
Tom noted that, because of this leverage, he faced con- ment was considering fine-tuning the sales bonus plan
siderable lobbying from the dealership managers to go by incorporating other performance criteria – perhaps
with their brand. He said, “I never hear any complaints gross, or even net, profit per car.
when good fortune comes their way. It’s only when they Tom’s new pay-for-performance system for managers
miss their targets that I hear them grumbling.” added a bonus element to the managers’ compensation
package. The bonuses were added on top of the manag-
ers’ salaries. Target bonuses for dealership managers
3. Pay-for-performance
were set between 10% and 20% of annual salary. Target
A third major change was the expansion of a pay-for- bonuses for department managers were set at 8% of
performance system for salespeople and the implemen- annual salary. For dealership and department manag-
tation of a pay-for-performance system for dealership ers, the bonuses were based on the extent to which the
and department managers. Some salespeople already managers met their annual net profit targets as set dur-
received a bonus. But now Tom introduced a pay-for- ing the budgeting process. Only managers who met their
performance bonus plan for the managers. net profit target earned their target bonus. No bonuses
Traditionally, compensation for nearly all personnel were paid for below- or above-target performance.
in the Netherlands was not performance-dependent. It Both Tom and Anna believed that the bonus plan
was based on a job rating, an assessment of the training specifically, and the idea of pay-for-performance more
and experience needed for executing a job, rather than generally, was putting the company on the right track.
on the individual performance of the employee. The job Tom explained:
ratings were linked to pre-established salary increases.
Hence, the relationship between levels of compensation I introduced bonuses primarily to make managers
and actual employee performance was usually weak. conscious of the fact that something had changed
To bypass the limits of salary increases for a certain […] that department managers were not only given
job grade, top-performing individuals often were more decision-making authority but that their
promoted to jobs with a higher job rating when those responsibilities to meet expected performance also
positions became available. For example, sometimes, had changed. I think the plan had that desired effect.
excellent car salespeople were promoted to sales man-
Management also had the authority to reduce any or
ager positions. These promotions sometimes happened
all bonus awards. However, in the first three years since
even when the dealership would have benefited more
implementation of the system, such discretion had
from the individual’s continued selling efforts than it
never been applied. Moreover, the criteria that might
would from their management skills.
justify a bonus reduction were not yet clear, as Tom
For years at Kooistra, salespeople had had monthly
explained:
sales targets, defined in terms of the number of (new
and used) cars sold. Some of the salespeople were eligi- Theoretically we might reduce bonuses because,
ble for bonus payouts. In 2007, these bonus-eligible for example, administrative procedures were not
salespeople earned €18.50 per car sold. In addition, followed or customer satisfaction ratings were too
when the salesperson met his or her monthly sales tar- low. But a bonus reduction would be a very subjec-
get, the bonus amount was doubled to €37.00 per car tive decision. We need to articulate the criteria for
for the month. On average, bonus payments were about such decisions more clearly. This is a priority for
25% of salary for salespeople who met their targets. the coming year.
However, not all salespeople were yet eligible for
bonuses. Of the 45 salespeople at Kooistra Autogroep,
only 25 were bonus-eligible because some of them had
Issues
negotiated a compensation package without a bonus Pay-for-performance was a relatively unknown phe-
contingency when they were hired, sometimes at a nomenon in Dutch companies. For example, one study

74
 Kooistra Autogroep

showed that in 2001, only 10% of the department man- Did the pay-for-performance system provide a sig-
agers in Dutch car dealerships received a formula nificant motivational boost? Edwin thought the answer
bonus, and only 7% received a “discretionary” (subjec- to this question was no:
tively assigned) bonus (see Exhibit 3). For sales manag-
Due to the economic situation, the last couple of
ers, these percentages were somewhat higher: 20% and
years were not good years. Consequently, my
7%, respectively (not tabulated in Exhibit 3).
dealership and some of my department managers
However, several studies had shown that Dutch
did not make their targets and did not receive their
companies (not just car dealerships) were increasingly
bonus. In my opinion, however, this has not affected
relying on pay-for-performance practices, which was
the motivation of any of us. We are all still working
commonly attributed to increased international com-
hard. On the other hand, even in good years the
petition. One study concluded that although only a
level of the bonuses is, I think, too low to motivate,
minority of Dutch companies applied some form of pay-
particularly for the department managers. In all
for-performance, the trend towards doing so was
truth, I wouldn’t mind if we abolished the bonuses
upward, with 33%, 36%, and 40% of a sample of Dutch
for department managers.
firms using some form of pay-for-performance in 1997,
1999, and 2001, respectively.6 On the other hand, Tom Kooistra and Anna Lubbers
Because such systems were rare in Dutch dealer- were convinced that the bonuses could, and did, affect
ships, perhaps not surprisingly, Kooistra Autogroep motivation. Tom explained:
faced considerable skepticism from its employees
when it first introduced its pay-for-performance sys- Our managers are certainly highly motivated. This
tem. A survey conducted by a consultant showed that was true in recent years even though, due to the
the vast majority of Kooistra employees preferred a poor economic situation, some of them were una-
salary raise over a bonus, even if the raise was signifi- ble to realize their performance targets. But I am
cantly lower than the expected bonus. To illustrate this convinced that they make considerable extra effort
point, Edwin V liering, a dealership manager, when they have a chance to meet their targets. For
recounted the following conversation he had had with example, they organize extra sales activities when
one of his salesmen: realization of the target is possible. I also know that
they feel good when they achieve their targets.
In terms of profit and sales volume, the last three–four
That is part of the motivation. But the money is
years were generally bad years for Dutch car dealer-
obviously important as well.
ships. At the beginning of 2006, one of my top sales-
men asked for a salary raise. I offered her a bonus Anna Lubbers agreed that the bonuses could provide
instead. In her situation the bonus would have resulted strong motivational effects, although she believed that
in more money than the raise she had asked for, even that depended strongly on the likelihood that the man-
in the poor last couple of years. Nevertheless, she agers can meet their targets:
was unhappy. She clearly valued the security of a
It is important to set realistic targets. Only bonuses
fixed income. I’d say that she is quite representative
that are based on realistic targets have a motivat-
of the vast majority of employees around here.
ing effect. Setting realistic targets is particularly
6
important in years of an economic slump, like in
For example, see S. Bekker, D. Fouarge, M. Kerkhofs, A. Román, M.
de Voogd-Hamelink, T. Wilthagen, and C. de Wolff, Trend-rapport: recent years. When the target is a pie in the sky, the
Vraag naar Arbeid 2002 (Tilburg, August 2003, ISBN 906566 0623). bonus will not work.

75
Chapter 2 • Results Controls

Exhibit 1 Kooistra Autogroep: Organization structure

76
 Kooistra Autogroep

Exhibit 2 Kooistra Autogroep: Sample summary performance report for a dealership (2006)

Eindhoven Toyota 2006 2006 2006 2005

1 Jan–17 Nov 2006 (47 wks) Target Actual Percent Actual

47/52 wks = 90%

Sales Department
New car units 250 229 92 221
Used cars units 225 231 103 225
New car revenues 5,900,000 5,467,522 93 5,298,521
Used car revenues 3,100,000 2,978,644 96 2,906,335
Sales revenues 9,000,000 8,446,166 94 8,204,856
New car net 125,000 112,135 90 107,154
Used car net 5,000 3,504 70 982
Sales net [1] 130,000 115,639 89 106,172
Sales net margin 1.44% 1.37% 1.29%
New car net /unit 500 490 485
Used car net /unit 22 15 −4
Used car warranty expenses 84,275 82,364 98 90,264
Warranty expense/used car 375 357 401
Manufacturer incentives 150,000 122,687 82 165,922

Service Workshop
Service revenues 860,000 815,367 95 845,648
Service net [2] 215,000 191,819 89 201,087
Service net margin 25.00% 23.53% 23.78%
Number of orders 1,650 1,621 98 1,648
Number of cars handled 1,050 1,002 95 1,010
Capacity (number of hours) a 8,800 8,745 99 8,800
Productive hours b 8,350 8,328 100 8,319
Invoiced hours c 7,400 7,149 97 7,380
Productivity b/a 95% 95% 95%
Invoiced hours percentage c/a 84% 82% 84%

Parts Department
Parts revenues 1,325,000 1,318,879 100 1,291,820
Parts net [3] 275,000 276,312 100 256,562
Parts net margin 20.75% 20.95% 19.86%
Parts rev./invoiced hrs workshop 179 184 175
Interest Expenses [4] 245,000 216,560 88 232,487
Total revenues 11,185,000 10,580,412 95 10,342,324
Total net [1] + [2] + [3] − [4] 375,000 367,210 98 331,334
Total net margin 3.35% 3.47% 3.20%
Inventory
New cars in stock 50 47 58
New cars average days in stock 45 40 51
New cars in stock >90 days 10 8 14
Number of backorders 50 62 49
Used cars in stock 60 55 60
Used cars average days in stock 50 45 60
New cars in stock >90 days 0 1 12
Used cars stock (euros) 475,000 424,954 287,469
Parts in stock (euros) 135,000 133,659 136,953

(Numbers are disguised.)

77
Chapter 2 • Results Controls

Exhibit 3 United States vs. Netherlands comparison of compensation plans used in car dealerships

US sample (1998) Netherlands sample (2001)

Base Formula Discretionary Base Formula Discretionary

salary bonus bonus Spiffs salary bonus bonus Spiffs

General Managers [N = 250] Avg. Tot. Comp. = $190,658 (n = 240) [N = 61] Avg. Tot. Comp. = €58,303 (n = 61)
Comp. package breakdown 56.8% 36.5% 3.9% 2.9% 96.9% 2.6% 0.4% 0.1%
Number receiving n = 238 n = 170 n = 49 n = 110 n = 61 n=9 n=3 n=1
Percent receiving 95.2% 68.0% 19.6% 44.0% 100% 14.8% 4.9% 1.6%
Average amount $82,262 $136,724 $36,449 $10,458 €56,029 €13,079 €6,000 €3,000
Avg. pct. of total comp. 58.2% 51.5% 18.9% 6.3% 96.9% 17.5% 8.1% 5.1%
Department Managers [N = 526] Avg. Tot. Comp. = $72,390 (n = 510) [N = 145] Avg. Tot. Comp. = €36,318 (n = 145)
Comp. package breakdown 49.8% 36.2% 4.2% 9.9% 98.7% 0.9% 0.2% 0.3%
Number receiving n = 433 n = 338 n = 118 n = 323 n = 145 n = 15 n = 10 n = 30
Percent receiving 82.3% 64.3% 22.4% 61.4% 100% 10.3% 6.9% 20.7%
Average amount $35,757 $53,751 $15,149 $4,585 €35,745 €3,992 €940 €457
Avg. pct. of total comp. 58.7% 54.6% 18.0% 15.6% 98.7% 8.6% 2.7% 1.2%

Capital “N” indicates the total number of managers in each sample; small “n” indicates those managers in each sample receiving the particular
compensation element. Averages are computed for those that receive the respective compensation element (n), as opposed to being computed on the
total sample (N). ToTal CompensaTion is the sum of Base salary, Formula Bonus, DisCreTionary Bonus, and spiFFs. spiFFs are miscellaneous rewards, such
as the use of promotional vehicles and certain incentives provided by the car manufacturers (e.g. vacation trips). All numbers are annualized.
Source: Jansen, E. P., K. A. Merchant, and W. A. Van der Stede (2009), “National Differences in Performance Dependent Compensation Practices: The
Differing Roles of Financial Performance Measurement in the United States and The Netherlands.” Accounting, Organizations and Society, 34(1): 58–84.

This case was prepared by Professors Pieter Jansen, Kenneth A. Merchant, and Wim A. Van der Stede.
Copyright © by Pieter Jansen, Kenneth A. Merchant, and Wim A. Van der Stede.

CASE STUDY
Houston Fearless 76, Inc.

In late 2000, M.S. Lee, president/CEO of Houston Fear- people and give them opportunities to be success-
less 76, Inc. (HF76), was considering making a major ful, but I also want the company to get to the next
change in the company’s sales incentive system: level of performance. Are our structures set up to
motivate them to do that?
We need revenue growth and consistent profitabil-
ity, and right now we don’t have them. I think our I think we have a range of problems. We’re clearly
primary problem relates to sales, which have not doing enough to develop new markets, to
slowed. Some of this is due to market conditions, expand our existing markets, or to develop syner-
but I also think that our sales effort and sales sup- gies among our markets. We have an obvious mis-
port can be improved. I want to take care of our match between our company objectives and our

78
 Houston Fearless 76, Inc.

sales force incentives because our commissions In 1976, M.S. Lee, a former Houston Fearless employee,
are based on sales, not product profitability. We use and two partners bought the Houston Fearless Photo Divi-
different compensation structures for different sion. They named their company Houston Fearless 76,
products, and I have heard some grumbling among Inc., both to take advantage of the excellent reputation
the sales people about equality. And our sales fore- the company had developed, especially in film-processing
casts are inconsistent. Forecast accountability is circles, and to commemorate the year of their acquisition.
not strong since there is no downside for salesper- Mr. Lee later acquired all of his partners’ shares.
sons for overstating forecasts. This sometimes HF76 prospered in the 1970s and 1980s. In the 1990s,
causes production planning problems. however, film-based product markets experienced a dra-
So we need to make some changes to improve matic decline. Many corporate customers, including
performance. We need better systems now more those in the banking, healthcare, and movie industries,
than ever because we are entering some new mar- were moving toward digital production and record-
kets that are more competitive than those to which retention technologies. Facing the declining market
we have been accustomed. demand, several of HF76’s competitors had exited the
film-product market. Mr. Lee believed, however, that
With these concerns in mind, Mr. Lee asked his son,
“the demise of film was greatly exaggerated.” He wanted
James (who joined HF76 in 1998 and later became
the company to continue serving its traditional film-
head of corporate development and operations, and
based market, particularly in good niche markets, as it
who was attending the University of Southern Califor-
repositioned itself in faster-growing markets.
nia Executive MBA Program), to critically evaluate
In the 1990s, Mr. Lee aggressively expanded in both the
HF76’s sales function and to revamp the sales incentive
traditional film market and growing digital market
plan. M.S. and James Lee planned to present a proposal
through a series of acquisitions. In 1990, HF76 acquired
for change at the annual sales meeting to be held in
Extek Microsystems, an innovator of film-duplicating tech-
mid-December 2000.
nology that served a customer base similar to that of HF76’s
in the micrographics marketplace. Extek’s operations were
Company history
integrated into HF76’s Compton facility. In 1997, HF76
Houston Fearless 76, Inc. was a privately held company acquired Houston International, Inc. which manufactured
headquartered in Compton, California. Annual company large-volume, specialized (e.g. long roll) film processors.
sales were approximately $15 million. The company had This division was renamed HF International, but its opera-
120 employees. HF76 was a worldwide leader in the tions were not moved from its Yuma, Arizona, location. In
design, manufacturing, marketing, and service of high- 1999, HF76 acquired 80% of Mekel Engineering, located in
quality micrographic products, photographic film and Brea, California, which produced scanners that converted
paper processors, photographic chemical handling microfilm and microfiche to digital format, lightweight
equipment, and photographic quality control accessories. film and video cameras, heads-up display units for fighter
HF76’s roots dated back to 1939 when H.W. Hou- aircraft, and traffic photo-citation analyzers.
ston, one of Howard Hughes’s movie-making business For over 30 years, HF76 also had a government divi-
partners, founded a company around the development sion, called HF North, that supported the US Air Force
of the first automatic roll film processor. Most of the through a variety of special projects that involved film
H.W. Houston Co.’s early customers were closely con- processers, power distribution systems, mobile shelters,
nected to the motion-picture industry. Later in the climate control units, and pollution control systems.
1940s, the company went public and expanded into a This division was located at Beale Air Force Base, near
manufacturing company that produced a wide range of Sacramento.
products, including film processors, hair-clips, turbine HF76 was also attempting to diversify its product line
blades, and radar. At one time it was one of the largest by capitalizing on potentially sizable commercial appli-
manufacturing companies in the Los Angeles area. In cations of the pollution control systems developed by HF
1950, the company merged with Fearless Camera Cor- North originally for the US Air Force. These innovative
poration of Culver City and became known as the pollution control systems separated practically all
Houston Fearless Corporation. Later, however, the kinds of water contaminants, from heavy metals to toxic
company faced many problems, and it was forced to file biohazardous waste. A production facility for these sys-
for bankruptcy and to liquidate its assets. tems had just been started in the Compton location.

79
Chapter 2 • Results Controls

The company in 2000 HF76 product gross margins averaged approximately

28%, but they varied significantly across product lines
After the 1999 Mekel acquisition, HF76 was organized and models. Relatively low profit margins (10–15%)
into four product divisions (see Exhibit 1). Each divi- were earned on processors and pollution control systems.
sion operated as a profit center. Corporate staff pro- Duplicator sales were relatively profitable (30–35% mar-
vided support and coordination of activities. The gins). However, HF76’s managers were selling some spe-
pollution control business was being developed at the cific models of their older product lines at minimal, or
corporate level under the purview of James Lee. even negative, gross margins. They did so because they
The HF76 culture was close-knit, family-like, and wanted to retain their customer base in order to earn
casual. M.S. Lee, the president/CEO, was a former local profits on forthcoming replacement part sales, the mar-
“entrepreneur of the year.” He was a strong central fig- gins on which were usually in excess of 40%.
ure, but he was also perceived as being highly caring, Industry performance benchmarks were difficult to
honest, and nurturing. Staff were given recognition establish accurately because HF76’s smaller competi-
and periodic awards (e.g. parties, logo merchandise). tors were all privately held and their larger competitors
M.S. Lee described the company’s strategy as follows: (e.g. Eastman Kodak, Bell & Howell) were so large that
We now have products at different market stages. they could bury their HF76-relevant financial results in
We have some emerging products, particularly pol- aggregated financial statements. However, HF76’s
lution control systems and traffic photo-citation managers believed that their company’s performance
analyzers. We have some potentially high growth was lagging behind that of its major competitors on all
markets for some of our scanner products. And we dimensions. For example, in 1999, HF76’s profit margin
have a lot of mature products, such as our proces- (as a percentage of sales) was only 0.04%, while the
sors and duplicators. industry benchmark, as given to HF76 management by
Each market requires a different strategy. For a management consulting firm, was 5.7%. HF76’s
example, for products in the emerging and growing inventory turnover was 2.6 compared to the industry
markets, we need our sales force to identify new benchmark of 4.9. The HF International division, which
customers and new markets. For products in the was operating at a loss, was creating concern.
mature markets, our sales force should capitalize
on our brand name and maintain as much volume Marketing and sales efforts
as possible in the niche market, probably through
targeting local government and accounting firms All of the HF76 products, with the exception of replace-
and through special trade-in programs to stimulate ment parts, sold for significant prices, so they were
the replacement of old machines. capital equipment for the buyers. For example, a typical
new photo processing machine, one of HF76’s low-end
The HF76 divisions each did their own manufactur- products, sold for approximately $60,000, and some of
ing. Most product lines had some standard products, the high-end products sold for several hundred thou-
or at least subassemblies. In these cases, HF76 would sand dollars. Thus, the sales process usually involved
build to inventory, based on demand forecasts. In the more than just taking an order. For many of the prod-
microfilm and motion-picture film processing markets, ucts, the sales cycle was lengthy, a year or more. In
customers typically waited about 30 days for delivery many cases, particularly for the more advanced prod-
of machines that required some customization. Largely ucts, the salespeople had to serve as consultants, help-
custom products were built after the order was booked, ing their customers to solve problems.
and the wait in such cases could be several months. Until the last few years, most of HF76’s sales were
HF76 suffered from the sales/operations frictions made through a network of dealers (sometimes referred
common to many companies. Operation managers to as “strategic partners”) and independent sales repre-
often complained that salespeople were not aware of sentatives. The dealers and reps provided HF76 with a
the required lead times and that some of their rush professional sales effort, local customer knowledge,
orders imposed significant overtime labor costs. Sales, and, in the case of the dealers, sales of complementary
on the other hand, complained that they sometimes products and a service capability, with little or no fixed
lost orders because their operations department could costs. However, most of the dealers and reps did no pro-
not meet the required delivery schedule. active marketing; they merely responded to inquiries.

80
 Houston Fearless 76, Inc.

Further, having the dealers and reps do the selling was dealers to be more aggressive. They were planning to
expensive because HF76 had to offer them significant require the dealers to do some significant selling in order
price concessions (typically 40% off list price) or high to remain on the dealer list. In return, they were going to
commission rates (typically 7–10%). One active inde- promise some exclusive territory protection.
pendent rep was also paid a fixed retainer fee. She was The scanner business (Mekel), which had more high-
somewhat like an employee, but with a lower salary tech products with higher growth potential, used all the
and no benefits, and a higher commission rate. She also sales channels. The company had two in-house salespeo-
had no obligation to serve HF76’s interests (e.g. market ple. Jim Mancini sold throughout the United States. Ryan
development) if she did not believe that those efforts Chase was responsible for Asia and Latin America. And
would lead to her own commissions. some sales were made through dealers and independent
To provide a more effective and more company- reps. One rep, Stephanie Eller, described earlier as being
focused selling effort and, secondarily, to cut costs, on retainer, generated almost one-sixth of Mekel’s total
HF76 managers were trying to build up the company’s scanner sales in 2000. HF76 managers estimated that its
own internal sales force. All of HF76’s competitors sold customer base for scanner products numbered about
all their products direct to customers. For internal 300–400, but it did not know the names of all its custom-
sales, HF76’s goal was to keep the sales costs (compen- ers because some distributors did not share their lists.
sation and expenses) to less than 10% of total sales, but One HF76 salesman, Mark Fogarty, was responsible
they did not always achieve that goal. for selling pollution control systems. Mark was a
The tasks required to sell the various HF76 products technical person with little sales experience. By late
varied significantly depending on a number of factors, 2000, HF76 had just gotten to the point that it could
including the product characteristics, the market build the pollution control systems in any volume, and
conditions, and the company’s customer relationships. only one system had been sold.
Despite some redundancy (e.g. some of HF76’s sales- One constant across all the divisions was that the
people for different equipment lines called on the same salespeople were not, by themselves, actively develop-
customers), HF76 managers did not think that they ing new customers. They generally relied on a list of
could organize the company’s sales effort entirely geo- regular customers to contact and on company advertis-
graphically. Selling the HF76 products required consid- ing to interest customers. They then responded to tele-
erable technical knowledge, for example, about optics, phone and email inquiries.
micrographics, and software. Little of that knowledge The in-house salespeople reported to Bob Smith (VP
was consistent across product lines. Marketing), although in reality they worked relatively
The photo processing business (HF International) independently. The salespeople were geographically
was mature. Most sales in this market involved replace- spread across the country. For example, Brett Hutchins
ment of existing equipment and replacement parts, so (Houston International) lived in Maryland; Matt Petilla
the potential customer base was quite well known. The (micrographics) lived in St. Louis; Bob Smith lived in
US photo processing market had 1,000–1,500 potential Atlanta. All of the salespeople traveled extensively to
customers, mostly those who did wholesale photo fin- meet with their customers. The salespeople had the
ishing (e.g. school portraits, weddings). One HF76 authority to discount up to 5% off list price. Larger dis-
salesperson, Brett Hutchins, covered the eastern half of counts had to be proposed to and approved by Mr. Lee.
the country. Sales in the western half were made Assistants at both corporate and division levels pro-
through independent sales reps. vided support to the sales force. Among other things,
The micrographics and motion-picture processing they made some follow-up telephone calls to customers,
markets (Extek) were also mature. Most of the microfilm maintained the databases, delivered the sales contracts
customers were local government entities. (Most corpo- to production, designed the company’s advertisements,
rations had moved to digital storage of documents.) The and set up the marketing shows. They also helped allevi-
vast majority of sales in this market were made through ate some of the salespeople’s weaknesses. For example,
a network of approximately 125 dealers, only some of one salesperson had no typing or computer skills. Thus,
which were active. HF76 had one salesman, Matt Petilla, he needed more support in preparing sales contracts.
working in the micrographics and motion-picture mar- Bob Smith managed the sales function primarily by
kets. Matt was also given the task of culling the dealer monitoring the weekly sales reports. He also periodi-
list to a smaller number. HF76 managers wanted their cally observed salespersons’ behaviors on sales trips

81
Chapter 2 • Results Controls

and trade shows. About the evaluation process, Bob but my big sale took me two years of effort. The
noted: “I can distinguish good performers from poor year before last I sold only two scanners . . . In my
ones through the ways they deal with clients. But forecasts, I wouldn’t mention the name of a com-
more directly, their performances are reflected auto- pany if the probability of the sale is less than 80%
matically in the reports of items shipped to their terri- or 90%. You often don’t get a solid answer from
tory.” Bob also noted that HF76 had not had formal international customers until the last minute.
performance evaluations in two years. He said, “We
can’t afford raises, so why bother evaluating people?”
The old sales incentive plan
HF76 had gradually been computerizing its sales track-
ing systems. Previously, all tracking had been manual. Up through 2000, all of the salespeople, except Mark
Fogarty,1 were paid a base salary plus commission.
The salespersons’ base salaries looked relatively low,
Sales forecasts typically $40,000–$60,000, but the total compensa-
The sales personnel were asked to provide an annual tion packages and their structure were industry com-
sales forecast at the beginning of each year. Then they petitive. Commissions were set at a defined percentage
were asked to update their forecasts on 30-, 60-, and of sales, measured as revenue from items shipped
90-day rolling bases. The forecasts were important for within the salesperson’s assigned territory. The com-
production planning purposes; for example, for deci- mission rate differed across salespeople on a negoti-
sions about which parts to buy and what subassemblies ated basis with specific attention paid to product
to produce to inventory. characteristics and market situation. Two salesmen,
However, according to Mr. Lee, the sales forecasts Brett Hutchins and Matt Petilla, earned a 4% commis-
were inconsistent: sion. Ryan Chase earned a 2% commission because he
was relatively new in his job. Bob Smith earned 1% on
Forecast accountability does not really exist in our all company sales within the United States, Canada,
current compensation structure. There is no mech- and Mexico. The actual commissions the salespeople
anism to prevent salespersons from overstating earned were typically in the range of 50% of base sal-
forecasts or sandbagging. Thus, the salespeople ary, but they could be substantially more.
tend to be optimistic, and efficient production plan- The sales assistants shared a small bonus pool if
ning sometimes becomes very difficult. HF76 met its overall sales goals. In 1999, each assistant
Bob Smith, on the other hand, thought that the sales was given approximately $1,000. One assistant, Eva
forecasts were reasonably accurate. He noted: Colton (Mekel), described her reaction to the bonus.
Last year our sales goals were too tough. We worked I had forgotten about the bonus. The $1,000 came
hard, but the market was soft. This year’s targets are as a total shock . . . If we make this year’s goal, and
more realistic, so I think we’ll do better. But we can’t right now we’re behind, it’ll be great. But there is
control all of the results. Things happen. For exam- not much I can do to help us get there.
ple, some sales get held up past the period end. This
year one of our big customers, Olin Mills, cut their
A new incentive plan being
budget at the last minute, and we did not get a large
contemplated
order that we expected. On the other hand, we
sometimes get a “bluebird” [a large order that was M.S. Lee wondered what could be done to improve the
not forecast]. We surely have to be out there working company’s marketing and sales efforts. He explained:
with our customers to know what is going to hap-
Some causes of our low profits and cash flows are
pen, but even so we can’t control everything.
obvious, such as a declining film-based product
Ryan Chase (Scanner Product Sales – Pacific Rim) market and our decision to invest strategically for
explained the forecasts from his perspective:
I don’t have an annual forecast because I’m rela-
1
tively new on the job. I have no basis for a forecast. Mark Fogarty had been assigned to the job of marketing and sales
of pollution control systems only recently, and he had not yet been
I guess if they forced me, I would forecast 10 scan-
included in the current incentive plan. However, he was lobbying for
ners per year. I got lucky last year with sales of 14, inclusion, and a decision on that had to be made soon.

82
 Houston Fearless 76, Inc.

future gains. However, I believe that we are not fully was sometimes in the company’s strategic interest to
exploiting market and profit opportunities for either make some of these sales. Should they report “phony”
our traditional products or our new products. In gross margins to the salespeople to motivate them to
particular, our sales force has not done what I want sell these low margin products? Or should they weight
them to do. I want them to open new markets, to the commission payouts according to the “strategic
sell in more profitable markets, and to give us more importance” of the sale? If the latter, how should strate-
lead time for better operational planning. gic importance be defined, and how should it be
explained to the salespeople?
After a series of discussions, M.S. and James Lee
The actual commission slopes would be set for each
concluded that they needed to make a major change in
individual so that at 100% of plan, each salesperson
the company’s sales incentive plan to attempt to alter
could expect to earn in commission slightly more under
behaviors in the desired ways. James observed:
the new plan than they would have earned under the
It was pretty clear that the old incentive plan was old plan. This feature was considered essential for
not working. The commissions were exclusively securing the salespersons’ easy acceptance of the
based on sales volume. While we tried to tell the change. However, the commission structure (see
sales force which products were most profitable, Exhibit 2) would be quite different. No commissions
they seemed to be willing to push sales at any cost would be paid for sales up to a minimum performance
or price. They also were paying little attention to standard, defined as 70% of the annual gross margin
other strategic goals, such as the opening of new forecast. This feature was intended to allow for greater
markets or accounts or improving the accuracy of payout leverage at high performance levels. Between
their forecasts. This is perhaps natural because 70% and 100% of the planned annual gross margin,
they were not evaluated on those factors. In addi- commissions would be paid at rates that were much
tion, the linkage between efforts and rewards was higher than would be the case if commissions were
unclear. Sales people received compensation for paid on all sales. That is, if commissions were paid on
items shipped within their territory regardless of all sales, the commission rate (as a percentage of gross
whether they were instrumental in making the sales margin) would be in the range of 10 –12% on high mar-
or not. So, overall, the old incentive plan created gin sales and 30–35% on low margin sales. Because of
distorted incentives. the leverage provided by the minimum performance
standard, the actual commission rate paid on gross
To overcome the problems in the old system, M.S. margins earned above the 70% threshold could be
and James were considering a quite different incentive raised to 30–100%. For sales above 100% of the annual
plan that they thought would translate HF76 missions gross margin plan, the slope on the commission curve
and strategies into sales actions. They planned to leave would be 25% higher than in the 70 –100% range, to
base salaries at current levels but were planning to encourage the higher performers to develop new mar-
implement a new incentive plan consisting of three ele- kets and customers effectively. No cap was placed on
ments: (1) a commission based on product gross mar- the maximum commissions that could be earned.
gins, but with no commissions paid until gross margins Salespeople were to be paid commissions on an annual
exceeded 70% of forecast; (2) a bonus based on fore- basis, but monthly cash advances would be paid at a
cast accuracy; and (3) a bonus based on achievement of rate of 80% of annual plan to allow the salespeople to
individual management-by-objectives targets. smooth out their cash flow.
The objective of basing commissions on product To encourage the salespeople to take their sales fore-
gross margins was to encourage salespeople to focus casts seriously, a second element of the plan promised
their effort where company profit potentials were an extra bonus based on the accuracy of the sales fore-
greatest. M.S. and James hoped that the salespeople’s casts. The salespeople would earn an extra 5% of base
knowledge of product gross margins, combined with salary if their total gross margins were within 10%
the incentive reinforcements, would affect their sales (plus or minus) of the annual gross margin forecasts.
behaviors beneficially. M.S. and James Lee hoped that this “truth-inducing”
One unsolved issue: M.S. and James had not yet feature of the plan would motivate the salespeople to
decided what commissions they should pay on negative reveal their best estimates of their market prospects
and low-gross-margin products. They thought that it rather than be optimistic, as had been typical in the

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Chapter 2 • Results Controls

past, or conservative, as might be expected with the Assessment was subjective and intended to lean in
new 70%-of-forecast minimum performance standard. favor of the employee. If top management deemed the
The third element of the contemplated new plan, the salesperson’s performance in all of the defined areas as
MBO targets, was designed to facilitate communica- satisfactory, the salesperson would be given an extra
tion and reinforcement of management desires and 5% of base salary.
expectations in any of a variety of areas. The target No changes were planned to the bonus system for
areas and specific targets would be negotiated between the sales assistants.
each individual and management. Typical MBO targets
might include items such as the following:
Concerns
● adding a significant number of new customers;
M.S. and James were preparing to present their pro-
● coordinating well with production; posal for the new sales incentive plan at the company’s
annual sales meeting, to be held on December 13,
● keeping annual travel expenses below travel
2000. However, both of them were concerned. They
expense forecasts;
knew that changes of this magnitude could be made
● strengthening ties with professional associations; only rarely, so it was important that this change be
made correctly. They were offering to pay their sales-
● improving communications through effective use of
men significantly more money. Would they be getting
email;
at least equivalent value in return? And even more
● learning and utilizing Microsoft Office and other importantly, was this plan what the company needed to
software. push itself to a higher level of performance?

Exhibit 1 Houston Fearless 76, Inc., corporate organization chart, 2000

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 Houston Fearless 76, Inc.

Exhibit 2 Comparison of old and new commission structure

This case was prepared by Professors Kenneth A. Merchant and Wim A. Van der Stede and Research Assistant Liu Zheng.
Copyright © by Kenneth A. Merchant and Wim A. Van der Stede.

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