Deck 4: Organizational Architecture

Question 1

Christian Children's Fund
Christian Children's Fund, Inc. (CCF), established in 1938, is an international, nonsectarian, nonprofit organization dedicated to assisting children. With program offices around the world, it provides health and educational assistance to more than 4.6 million children and families through over 1,000 projects in 30 countries, including the United States. CCF's programs promote long-term development designed to help break the cycle of poverty by improved access to health care, safe water, immunizations, better nutrition, educational assistance, literacy courses, skills training, and other services specific to improving children's welfare.
Most of CCF's revenues come from individual donors who are linked with a specific child. About 75 percent of the sponsors are in the United States, and in 2003, CCF had total revenues of about $143 million. (See Exhibit 1.)
In 1995, CCF began developing an evaluation system, nicknamed AIMES (Annual Impact Monitoring and Evaluation System), to assess the performance of its programs and whether they are making a positive, measurable difference in children's lives. A working group of national directors, program managers, CCF finance and audit managers, and outside consultants developed a series of metrics that allowed CCF to be more accountable to its sponsors, as well as an evaluation tool to continually assess the impact of its programs on children. The working group wanted metrics that (1) captured critical success factors for CCF's projects; (2) focused on a program's impact, not its activities; (3) measured the program's impact on children; and (4) could be measured and tracked.
The following indicators were chosen:
Under 5-year-old mortality rate
Under 5-year-old moderate and severe malnutrition rate
Adult literacy
One-to-two-year-old immunizations
Tetanus vaccine-protected live births
Families that correctly know how to manage a case of diarrhea
Families that correctly know how to manage acute respiratory infection
Families that have access to safe water
Families that practice safe sanitation
Children enrolled in a formal or informal educational program
Each family in a community with a CCF program is given a family card that tracks each of the preceding 10 indicators for that family. In 1997, the first year of implementation, AIMES captured the health status of about 1.9 million children in approximately 850 projects in 18 countries. Annual visits by project staff or volunteers update each family's card. The family cards are aggregated at the community level, national level, and then in total for CCF, and provide a reporting system. CCF managers then track trends and compare performance at the community, national, and organizational levels.
It took CCF two years to develop these metrics, test them, and train the staff in all the national offices in how to use the system. AIMES does not prescribe the strategy each community should adopt but rather allows each community to design programs that promote the well-being of children in that community. Program directors can use the AIMES data as a tool to monitor and manage their programs. If child mortality is high, local program directors decide how best to reduce the rate. The 10 AIMES metrics have made project managers more focused and better able to concentrate resources in those areas that make a measurable difference in children's health. CCF uses the information to make program and resource allocation decisions at the community level. The family card has promoted better nutrition via appropriate feeding and child care practices because there is now more direct contact between CCF staff and volunteers and families.
Required:
Using this chapter's organizational architecture framework, discuss the strengths and weaknesses of CCF's AIMES project.
SOURCES: D. Henderson, B. Chase, and B. Woodson, "Performance Measures for NPOs," Journal of Accountancy (January 2002), pp. 63-68; and www.christianchildrensfund.org.

Answer 1

The AIMES system illustrates a key point: "What you measure is what you get." By adopting the ten metrics, CCF will focus the organization on these ten outcome measures. There are reasons for and against using the AIMES metrics. These are discussed below.
Strengths:
• The AIMES project forced CCF to think about what their mission is and how best to achieve that mission. In terms of Figure 1-3, it forced CCF to better link their strategy to at least one part of their organizational architecture (performance evaluation).
• Program directors use the AIMES data as a tool to monitor and manage their programs.
• The ten metrics make project managers more focused and better able to concentrate resources in areas that make a measurable difference in children's health.
• CCF uses the information to make program and resource allocation decisions.
• The family card has promoted better nutrition via appropriate feeding and child care practices because there is now more direct contact between CCF staff and volunteers and families.
• CCF is now more accountable to their donors.
Weaknesses:
• While the AIMES project better linked CCF's strategy to one piece of its organizational architecture, it did not address the other two legs of the stool (decision rights assignment and performance rewards). AIMES, by only attacking one leg of the stool might cause the three legs to become unbalanced.• Because the ten metrics are in fact used to assess program effectiveness and to allocate resources, this creates incentives for the community managers who oversee the collection of the data via the family cards to game the system. This gaming can be outright fraud by giving individual families better scores than they actually achieved. CCF, in describing the AIMES system does not mention the internal audit procedures used to insure the accuracy of the reported data. Some of the metrics such as "access to safe water," "practice of safe sanitation," "families know how to manage diarrhea or respiratory infection," inherently require the local staff to make subjective evaluations. Knowing that future funding or their performance is being judged based on these subjective evaluations creates incentives for CCF's data collectors to bias their subjective evaluations.
• CCF does not report the aggregate AIMES data on their web site or in their annual reports. Requests for these data were declined. Hence, CCF's claim that AIMES makes CCF more accountable to its donors is incorrect.
• The chapter's discussion of organizational architecture argues that performance measures and compensation schemes should be linked to the decision rights assigned to the managers. In CCF's case, program managers have decision rights to design programs that improve children's welfare. Certainly, the ten AIMES metrics capture many important aspects of children's welfare. But, an individual program manager's impact on any of these metrics is very small relative to factors a CCF manager cannot control. For example, suppose an earthquake or civil war occurs. Despite the local manager's best efforts, all ten indicators will likely fall. The CCF manager cannot control most of the external factors driving these ten metrics. This exposes the local manager to enormous risk. Decreases in metrics will cause the local manager (who has more knowledge of the local conditions) to argue that events outside of his/her control caused the decline. But these same managers are less likely to explain improvements in the metrics are not the result of their effort. Hence, CCF senior managers will spend a lot of time sorting out the real causes of changes in the metrics. (Chapter 5 on responsibility accounting expands on this discussion.)
FIGURE 1?3
Framework for organizational change and management accounting

Question 2

Empowerment
It is frequently argued that for empowerment to work, managers must "let go of control" and learn to live with decisions that are made by their subordinates. Evaluate this argument.

Answer 2

Organizational Architecture:
Organizational architecture refers to the whole structure of an organization. It contains the hierarchy of management levels, their roles and responsibilities and the infrastructure facilities of the organization.
It is the whole architecture of an organization which enables it to accomplish its goals and objectives and also enable to make a vision.
An organization with proper segregation of duties and powers can survive better. If the whole controlling and decision-making power passed on to the workers of the organization then this may lead the organization towards the huge problematic situation. So there should be proper power distribution between management and workers.
The managers of the organization should keep analytical decision-making powers with them and should provide production related powers to the workers as they are also playing a key role in the functioning of an organization.
The managers are the higher authorities of the organization and they should not blindly follow the decisions of their subordinates rather make decisions their own.

Question 3

Woodhaven Service
Background Woodhaven Service is a small, independent gas station located in the Woodhaven section of Queens. The station has three gasoline pumps and two service bays. The repair facility specializes in automotive maintenance (oil changes, tune-ups, etc.) and minor repairs (mufflers, shock absorbers, etc.). Woodhaven generally refers customers who require major work, such as transmission rebuilds and electronics, to shops that are better equipped to handle such repairs. Major repairs are done in-house only when both the customer and mechanic agree that this is the best course of action.
During the 20 years that he has owned Woodhaven Service, Harold Mateen's competence and fairness have built a loyal customer base of neighborhood residents. In fact, demand for his services has been more than he can reasonably meet, yet the repair end of his business is not especially profitable. Most of his competitors earn the lion's share of their profits through repairs, but Harold is making almost all of his money by selling gasoline. If he could make more money on repairs, Woodhaven would be the most successful service station in the area. Harold believes that Woodhaven's weakness in repair profitability is due to the inefficiency of his mechanics, who are paid the industry average of $500 per week. While Harold does not think he overpays them, he feels he is not getting his money's worth.
Harold's son, Andrew, is a student at the university, where he has learned the Socratic dictum, "To know the Good is to do the Good." Andrew provided his father with a classic text on employee morality, Dr. Weisbrotten's Work Hard and Follow the Righteous Way. Every morning for two months, Harold, Andrew, and the mechanics devoted one hour to studying this text. Despite many lively and fascinating discussions on the rights and responsibilities of the employee, productivity did not improve one bit. Harold figured he would just have to go out and hire harderworking mechanics.
The failure of the Weisbrotten method did not surprise Lisa, Harold's daughter. She knew that Andrew's methods were bunk. As anyone serious about business knows, the true science of productivity and management of human resources resides in Professor von Drekken's masterful Modifying Organizational Behavior through Employee Commitment. Yes, employee commitment was the answer to everything! Harold followed the scientific methods to the letter. Yet, despite giving out gold stars, blowing up balloons, and wearing a smiley face button, he found Lisa's approach no more successful than Andrew's.


Required:
a. This case presents some popular approaches to alleviating agency costs. Although certain aspects of each of these methods are consistent with the views presented in the text, none of these methods is likely to succeed. Discuss the similarities and differences between the ideas of the chapter and
(i) Dr. Weisbrotten's approach.
(ii) Harold Mateen's idea of hiring "harder-working" mechanics.
b. Discuss the expected general effect on agency costs at Woodhaven Service of the new incentive compensation plans. How might they help Woodhaven? Assuming that Harold wants his business to be successful for a long time to come, what major divergent behaviors would be expected under the new compensation proposals? How damaging would you expect these new behaviors to be to a business such as Woodhaven Service? Also, present
a defense of the following propositions:
(i) Harold's plan offers less incentive for divergent behavior than Honest Jack's.
(ii) Limiting a mechanic's pay by placing an upper bound of $750 per week on his or her earnings reduces the incentive for divergent behavior.
c. Suppose Harold owned a large auto repair franchise located in a department store in a popular suburban shopping mall. Suppose also that this department store is a heavily promoted, well-known national chain that is famous for its good values and easy credit. How should Harold's thinking on incentive compensation change? What if Harold did not own the franchise but was only the manager of a company-owned outlet?
d. In this problem, it is assumed that knowledge and decision rights are linked. The mechanic who services the car decides what services are warranted. Discuss the costs and benefits of this fact for Woodhaven Service and the independently owned chain-store repair shop.
e. Suppose that Woodhaven's problems are not due to agency costs. Briefly describe a likely problem that is apparent from the background description in this problem.

Answer 3

a.(i) Dr. Weisbrotten's approach is fundamentally contrary to the suggestions of the chapter. Basically, by introducing Weisbrotten, Harold seeks to alter the preferences of his employees. While it is possible to lower agency costs by convincing agents that working harder on the job is desirable in itself, the text is pessimistic about such a strategy. Normally self-interested people's preferences are not easily altered. However, the firm can reduce the agency problem, if not goal incongruence, by structuring agents' incentives that when agents maximize their incentive-based payoffs, the principal's utility (or wealth) is also maximized. In other words, the agent's and the principal's goals become congruent through the agent's incentive scheme, not by a change in the agent's preferences.
(ii) The idea of hiring harder-working mechanics appears to have some merit as a means of reducing agency costs in that it eliminates conflicting interests of agents and principals by limiting the set of agents to those who already have the same goals as the principal. However, there is something naive about this notion. Is there such a condition as "hardworkingness?" Is this condition common enough in the population that Harold can expect to find mechanics out of work who possess it? Furthermore, how would one go about testing for hardworkingness? Mechanics looking for work are not likely to be the most hard working.
b. Harold thinks that Woodhaven's lack of bottom-line success in repairs is due to his mechanics' lack of productivity. He also believes that incentive-based compensation for the mechanics will help this problem. Two kinds of plans are suggested, commission and flat rate. The commission plan is designed to boost profits by boosting revenues. Assuming that the price of each service is above the marginal cost of performing that service, offering mechanics a percentage of revenues should work to increase profits. The flat rate is designed to boost profits by cutting costs. Whereas revenues from labor charges are always derived from standard rather than actual times, paying mechanics by the hour makes the labor costs incurred depend upon the actual time they spend on the job. Given more demand than capacity, and given the likely propensity of workers to prefer leisure over toil, the mechanics may very well be spending too long on each job. If they were paid only for the "just right" amount of time, subsidized leisure would disappear, giving mechanics an incentive to lower labor costs.
However, nothing occurs in a vacuum, and changing compensation schemes could be expected to have other effects as well. Most importantly, both compensation plans induce behavior that is divergent from Harold's desires. If he paid mechanics a percentage of the sales they generate, many mechanics would likely generate revenue that should not be generated. Suddenly, Woodhaven would "specialize" in $2,000 engine rebuilds, whether the staff had the technical knowledge for this kind of repair or not. In a worst-case scenario, mechanics would simply cheat customers by selling expensive services that were not necessary and might not even be performed. If mechanics are paid a standard number of hours for a job, they will simply work faster. So fast, indeed, that a drop in quality is likely.
Since Woodhaven is a neighborhood shop, it is likely that many customers know one another. This would cause the rapid and easy transfer of information about any problems among Woodhaven's client base. Because of Woodhaven's small size and lack of recognition outside of the neighborhood, it would probably be difficult to continually replace alienated clientele. We may, therefore, conclude that the relative cost of cheating and/or lowering quality would be unusually high for Woodhaven Service. One would be inclined to reject any plan that would not tightly control acts that might alienate the present customers.
(i) Intuitively, one can see that Honest Jack's plan would generate more dysfunctional behavior than Harold's. By paying a minimum salary of $300, Harold's commission plan would likely reduce the quantity of unnecessary services performed. First, since it is easier to meet one's financial obligations with $300 than with nothing, the mechanics would feel less of a "need" to cheat the customers. Also, since an average volume of business would earn each mechanic the same amount of money under either plan, the marginal benefit from each additional sale would be less under Harold's commission plan than under Jack's.
(ii) Placing an upper bound upon potential weekly earnings would further diminish mechanics' incentive to cheat customers. It is likely that there would be diminishing marginal returns for cheating customers due to factors such as the increasing probability of getting caught, guilt feelings, or simply lack of capacity to perform further repairs. At some point, it would no longer be profitable for the mechanic to cheat. If this point occurs at a figure below the dollar figure that is set as the upper bound, then the quantity of dysfunctional behavior is the same with or without the upper bound. However, if the point at which cheating is no longer profitable is above the upper-bound dollar figure that is set, the upper bound will actually reduce the quantity of cheating. Since the upper bound, in all cases, either reduces cheating or does not change it, we would expect the upper bound to tend to lessen cheating.
c. This question is related to the celebrated 1992 case in which Sears auto repair departments were accused of overcharging customers for unnecessary work. For Woodhaven Service, the cost of cheating would be very high. Indeed, one would suspect that very little cheating would be profitable for Harold, a fact that would heavily influence any decision on incentive-based compensation. However, if Harold owned the mall franchise described above, the price of cheating would be much lower. Location, brand recognition, and other factors would all make cheating cheaper. Promotion would bring in new customers to replace alienated ones. Mall shoppers would likely give the shop a try and would be unlikely to discuss their auto service experience with a large proportion of the shop's potential market. It would appear that Harold at the mall would reap all the same benefits as Harold in the neighborhood, but without the costs of cheating. We would therefore think it far more likely that Harold would install one of the incentive compensation plans described above at the mall than at Woodhaven Service. It is difficult to assess how being manager at a company-owned store would affect Harold's outlook. We need more information on the compensation plan used for such managers. On the one hand, increasing sales would be less beneficial for an employee than an owner. Lower rewards would indicate less desire to use an incentive compensation plan. On the other hand, differences in the cost of cheating for the owner and the manager are unclear. Losing your franchise may be more expensive than losing your job, but losing your job is more expensive than a letter of reprimand from the parent company.
d. Another way to reduce the risk of dysfunctional behavior by mechanics is to strip them of their decision rights. Since the approval of a supervisor would be needed to perform some or all services, the mechanics would find their ability to cheat severely curtailed. However, this increased control comes with a cost. Skilled supervision would be required and knowledge would have to be transferred to the person who now has the decision rights. Indeed, the person with the decision rights would likely have to duplicate much of the mechanic's diagnostic work to confirm the mechanic's conclusions regarding service requirements.
In the case of Woodhaven Service, the cost of separating knowledge and decision rights should be low. Due to the small size of the facility, there is simply not that much to supervise. After 20 years, Harold should know enough about cars and repairs to be able to decide whether or not a major service is warranted and whether it would be best to do it in-house. However, in the mall shop, there is a lot more to watch and a lot less reason to care. Therefore, it would seem that the collocation of knowledge and decision rights makes more sense at the mall than at Woodhaven.
e. There are many approaches Woodhaven could take to better itself financially. One that leaps out: Raise prices. Demand is so strong that it outstrips supply, indicating that the price of regular service is too low. Furthermore, the profitability of gasoline operations suggests loyal customers who are willing to pay a premium for what is essentially a commodity item. Obviously, there is something at Woodhaven that the customers like and that Harold is not charging them for in the service end of his business.

Question 4

Pay for Performance
Communities are frequently concerned about whether or not police are vigilant in carrying out their responsibilities. Several communities have experimented with incentive compensation for police. In particular, some cities have paid members of the police force based on the number of arrests that they personally make. Discuss the likely effects of this compensation policy.

Question 5

Course Packets
Faculty members at a leading business school receive a budget to cover research expenditures, software and hardware purchases, travel expenses, photocopying for classroom use, and so forth. The budget is increased $250 for each class taught (independent of the number of students enrolled).
For example, a faculty member receives a base budget of $14,000 for this year and teaches three courses-hence, the faculty's total budget is $14,750. Finance professors teach much larger classes than any other functional area (e.g., accounting) and they tend to have larger course packets per student. Faculty can photocopy their course packets and have their budgets reduced by the photocopying charges. Or the faculty can distribute course materials via the school's network where students can download them and print them on their personal printers.
Required:
a. Which faculty members are more likely to put course packets and lecture notes on their Web pages, and which faculty are more likely to photocopy the material and distribute it to their students?
b. Is this partitioning of faculty members distributing materials electronically versus making paper copies efficient?

Question 6

Allied Van Lines
Why are drivers for long-haul (cross-country) moving companies (e.g., Allied Van Lines) often franchised, while moving companies that move households within the same city hire drivers as employees? Franchised drivers own their own trucks. They are not paid a fixed salary but rather receive the profits from each move after paying the franchiser a fee.

Question 7

Voluntary Financial Disclosure
Prior to the Securities Acts of 1933 and 1934, corporations with publicly traded stock were not required to issue financial statements, yet many voluntarily issued income statements and balance sheets. Discuss the advantages and disadvantages of such voluntary disclosures.

Question 8

University Physician Compensation
Physicians practicing in Eastern University's hospital have the following compensation agreement. Each doctor bills the patient (or Blue Cross Blue Shield) for his or her services. The doctor pays for all direct expenses incurred in the clinic, including nurses, medical malpractice insurance, secretaries, supplies, and equipment. Each doctor has a stated salary target (e.g., $100,000). For patient fees collected over the salary target, less expenses, the doctor retains 30 percent of the additional net fees. For example, if $150,000 is billed and collected from patients, and expenses of $40,000 are paid, then the doctor retains $3,000 of the excess net fees [30 percent of ($150,000 - $40,000 - $100,000)] and Eastern University receives $7,000. If $120,000 of fees are collected and $40,000 of expenses are incurred, the physician's net cash flow is $80,000 and Eastern University receives none of the fees.
Required:
Critically evaluate the existing compensation plan and recommend any changes.

Question 9

American InterConnect I
Employee satisfaction is a major performance measure used at American Inter Connect (AI), a large communications firm. All employees receive some bonus compensation. The lower-level employees receive a bonus that averages 20 percent of their base pay, whereas senior corporate officers receive bonus pay that averages 80 percent of their base salary. Bonus payments for all employees are linked to their immediate work group's performance on the following criteria: income, revenue growth, customer satisfaction, and employee satisfaction. Managers can have these criteria supplemented with additional specific measures, including hiring targets and some other specific objective for each manager, such as meeting a new product introduction deadline or a market share target. Employee satisfaction usually has a weight of between 15 and 20 percent in determining most employees' overall bonus. To measure employee satisfaction, all employees in the group complete a two-page survey each quarter. The survey asks a variety of questions regarding employee satisfaction. One question in particular asks employees to rate how satisfied they are with their job using a seven-point scale (where 7 is very satisfied and 1 is very dissatisfied). The average score on this question for all employees in the group is used to calculate the group's overall employee satisfaction score.
Required:
Describe what behaviors you would expect to observe at AI.

Question 10

Raises
A company recently raised the pay of employees by 20 percent. The productivity of the employees, however, remained the same. The CEO of the company was quoted as saying, "It just goes to show that money does not motivate people." Provide a critical evaluation of this statement.

Question 11

Vanderschmidt's
Jan Vanderschmidt was the founder of a successful chain of restaurants located throughout Europe. He died unexpectedly last week at the age of 55. Jan was sole owner of the company's common stock and was known for being very authoritarian. He made most of the company's personnel decisions himself. He also made most of the decisions on the menu selection, food suppliers, advertising programs, and so on. Employees throughout the firm are paid fixed salaries and have been heavily monitored by
Mr. Vanderschmidt. Jan's son, Joop, spent his youth driving BMWs around the Netherlands and Germany at high speeds. He spent little time working with his dad in the restaurant business. Nevertheless, Joop is highly intelligent and just received his MBA degree from a prestigious school. Joop has decided to follow his father as the chief operating officer of the restaurant chain. Explain how the organization's architecture might optimally change now that Joop has taken over.

Question 12

Sales Commissions
Sue Koehler manages a revenue center of a large national manufacturer that sells office furniture to local businesses in Detroit. She has decision rights over pricing. Her compensation is a fixed wage of $23,000 per year plus 2 percent of her office's total sales. Critically evaluate the organizational architecture of Koehler's revenue center.

Question 13

Formula 409
"I used to run the company that made Formula 409, the spray cleaner. From modest entrepreneurial beginnings, we'd gone national and shipped the hell out of P G, Colgate, Drackett, and every other giant that raised its head. From the beginning, I'd employed a simple incentive plan based on 'case sales': Every month, every salesman and executive received a bonus check based on how many cases of 409 he'd sold. Even bonuses for the support staff were based on monthly case sales. It was a happy time, with everyone making a lot of money, including me." "We abandoned our monthly case-sales bonus plan and installed an annual profit-sharing plan, based on personnel evaluations. It didn't take long for the new plan to produce results."
SOURCE: Wilson Harrell, "Inspire Action: What Really Motivates Your People to Excel?" Success, September 1995.
Required:
What do you think happened at this company after it started the annual profit-sharing plan?

Question 14

Pratt Whitney
A Wall Street Journal article (December 26, 1996) describes a series of changes at the Pratt Whitney plant in Maine that manufactures parts for jet engines. In 1993, it was about to be closed because of high operating costs and inefficiencies. A new plant manager overhauled operations. He broadened job descriptions so inspectors do 15 percent more work than they did five years ago. A "results-sharing" plan pays hourly employees if the plant exceeds targets such as cost cutting and on-time delivery. Now, everyone is looking to cut costs.
Hourly employees also helped design a new pay scheme that is linked to the amount of training, not seniority, that an employee has. This was after the plant manager drafted 22 factory-floor employees, gave them a conference room, and told them to draft a new pay plan linked to learning. Shop-floor wages vary between $9 and $19 per hour with the most money going to people running special cost studies or quality projects, tasks previously held by managers. This text emphasizes the importance of keeping all three legs of the stool in balance. Identify the changes Pratt Whitney made to all three legs of the stool at its Maine plant.

Question 15

Theory X-Theory Y
A textbook on organization theory says: Drawing upon the writings of Maslow, McGregor presented his Theory X-Theory Y dichotomy to describe two differing conceptions of human behavior. Theory X assumptions held that people are inherently lazy, they dislike work, and that they will avoid it whenever possible. Leaders who act on Theory X premises are prone to controlling their subordinates through coercion, punishment, and the use of financial rewards; the use of external controls is necessary, as most human beings are thought to be incapable of self-direction and assuming responsibility. In contrast, Theory Y is based on the assumption that work can be enjoyable and that people will work hard and assume responsibility if they are given the opportunity to achieve personal goals at the same time.16
Using the framework presented in the text, critically analyze Theory X-Theory Y.
16V. K. Narayanan and R. Nath, Organization Theory: A Strategic Approach (Burr Ridge, IL: Richard D.Irwin, 1993), p. 403.

Question 16

American InterConnect II
Employee bonuses at American InterConnect (AI), a large communications firm, depend on meeting a number of targets, one of which is a revenue target. Some bonus is awarded to the group if it meets or exceeds its target revenue for the year. The bonus is also tied to meeting targets for earnings, employee satisfaction, hiring goals, and other specific objectives tailored to the group or manager. AI has several product development groups within the firm. Each is assigned the task of developing new products for specific divisions within the firm. Product developers, primarily engineers and marketing people, are assigned to a new product development team to develop a specific new product. Afterward, they are assigned to new development teams for a different division or are reassigned back to their former departments. Sometimes they become product managers for the new product. Product development teams take roughly 18 months to develop and design the product. For example, Network Solutions is one group of products AI sells. The employees in the product development group for Network Solutions receive part of their bonus based on whether Network Solutions achieves its revenue target for that year. It typically takes AI three years from the time a product development team is formed until the product reaches the market. Once a new product idea is identified and researched, a prototype must be built and tested. Finally, it is introduced. Another 18 months is required for approval, manufacturing design, further testing, and marketing. These functions are performed after the product development team has been reassigned.
Required:
Analyze the incentives created by basing a portion of each current product developer's bonus on revenues for products now being sold.

Question 17

Tipping
One of the main tenets of economic analysis is that people act in their narrow self-interest. Why then do people leave tips in restaurants? If a study were to compare the size of tips earned by servers in restaurants on interstate highways with those in restaurants near residential neighborhoods, what would you expect to find? Why?

Question 18

White's Department Store
Employees at White's Department Store are observed engaging in the following behavior: (1) They hide items that are on sale from the customers and (2) they fail to expend appropriate effort in designing merchandise displays. They are also uncooperative with one another. What do you think might be causing this behavior, and what might you do to improve the situation?

Question 19

Coase Farm
Coase Farm grows soybeans near property owned by Taggart Railroad. Taggart can build zero, one, or two railroad tracks adjacent to Coase Farm, yielding a net present value of $0, $9 million, or $12 million.

Coase Farm can grow soybeans on zero, one, or two fields, yielding a net present value of $0, $15 million, or $18 million before any environmental damages inflicted by Taggart trains. Environmental damages inflicted by Taggart's trains are $4 million per field per track. Coase Farm's payoffs as a function of the number of fields it uses to grow soybeans and the number of tracks that Taggart builds are shown next.

It is prohibitively expensive for Taggart Railroad and Coase Farm to enter into a long-term contract regarding either party's use of its land.
Required:
a. Suppose Taggart Railroad cannot be held liable for the damages its tracks inflict on Coase Farm. Show that Taggart Railroad will build two tracks and Coase Farm will plant soybeans in one field.
b. Suppose Taggart Railroad can be held fully liable for the damages that its tracks inflict on Coase Farm. Show that Taggart Railroad will build one track and Coase Farm will plant soybeans in two fields.
c. Now suppose Taggart Railroad and Coase Farm merge. Show that the merged firm will build one track and plant soybeans in one field.
d. What are the implications of the merger for the organizational architecture of the newly merged firm in terms of decision rights, performance measurement, and employee compensation?
SOURCE: R. Sansing.

Question 20

Rothwell Inc.
Rothwell Inc. is the leader in computer-integrated manufacturing and factory automation products and services. The Rothwell product offering is segmented into 15 product categories, based on product function and primary manufacturing location.
Rothwell's sales division sells all 15 product categories and is composed of 25 district offices located throughout the United States. The company is highly decentralized, with district offices responsible for setting sales price, product mix, and other variables. District offices are rewarded based on sales. Some large customers have plants in more than one of Rothwell's sales districts. In cases where sales are made to these customers, the district offices participate jointly and sales credits are shared by each district involved. The sales division compensation plan designed by L. L. Rothwell, founder of the firm, was structured so that the staff would pursue sales in each of the 15 product categories.
The selling program has the following features:
• Each sales representative receives a commission based on a percentage of the sales revenue generated.
• Each district (approximately 160 sales reps) is assigned a quota for each product line, defined in terms of dollar sales.
• In addition to commission, sales reps are eligible for an annual bonus. The company calculates individual bonuses by multiplying the number of bonus points earned by the individual target bonus amount. Points are credited at the district level.
• In order for all sales reps in a district to qualify for a bonus, the district must achieve 50 percent of quota in all 15 product groups and 85 percent of quota in at least 13 groups.
• Bonus points are awarded for sales greater than 85 percent of quota.
• Five product groups have been identified as strategic to Rothwell. These "pride-level" products are weighted more heavily in bonus point calculations. Over the past three years, Rothwell generated exceptionally high sales-and awarded record bonuses. Profits, however, were lackluster. L. L. was befuddled!
Required:
a. Evaluate the compensation situation at Rothwell.
b. Identify the types of behavior the existing system promotes and explain how such behavior may be contributing to the firm's declining profitability. Suggest improvements.

Question 21

Gong-Fen
"It was in Deyang in 1969 that I came to know how China's peasants really lived. Each day started with the production team leader allocating jobs. All the peasants had to work, and they each earned a fixed number of 'work points' ( gong-fen ) for their day's work. The number of work points accumulated was an important element in the distribution at the end of the year. The peasants got food, fuel, and other daily necessities, plus a tiny sum of cash, from the production team. After the harvest, the
production team paid part of it over as tax to the state. Then the rest was divided up. First, a basic quantity was meted out equally to every male, and about a quarter less to every female. Children under three received a half portion." "The remainder of the crop was then distributed according to how many work points each person had earned. Twice a year, the peasants would all assemble to fix the daily work points for each person. No one missed these meetings. In the end, most young and middle-aged men would be allocated 10 points a day, and women 8. One or two whom the whole village acknowledged to be exceptionally strong got an extra point. 'Class enemies' like the former village landlord and his family got a couple of points less than the others, in spite of the fact that they worked no less hard and were usually given the toughest jobs." "Since there was little variation from individual to individual of the same gender in terms of daily points, the number of work points accumulated depended mainly on how many days one worked, rather than how one worked."
SOURCE: J. Chang, Wild Swans: Three Daughters of China, (New York: Anchor Books, 1991), pp. 414-15.
Required:
What predictable behavior do you expect the Chinese agricultural system will generate?

Question 22

International Computer Company
International Computer Company (ICC) has annual revenues of $2 billion primarily from selling and leasing large networked workstation systems to businesses and universities. The manufacturing division produces the hardware that is sold or leased by the marketing division. After the expiration of the lease, leased equipment is returned to ICC, where it is either disassembled for parts by the field service organization or sold by the international division. Internal studies have shown that equipment leased for four years is worth 36.5 percent of its original manufacturing cost as parts or sold overseas. About half of ICC's systems are leased and half are sold, but the fraction being leased by ICC is a falling proportion of total sales. The leasing department is evaluated on profits. Its annual profits are based on the present value of the lease payments from new leases signed during the year, less
1. The unit manufacturing cost of the equipment.
2. Direct selling, shipping, and installation costs.
3. The present value of the service agreement costs.
Each leased piece of equipment will be serviced over its life by ICC's field service organization.The leasing division arranges a service contract for each piece of leased equipment from the field service organization. The field service organization commits to servicing the leased equipment at a fixed annual cost, determined at the time the lease is signed. The leasing department then builds the service cost into the annual lease payment.
The leasing department negotiates the lease terms individually for each customer. In general, the leasing division sets the annual lease terms to recover all three cost components plus a 25 percent markup (before taxes). The 25 percent markup for setting the annual lease payment seemed to work well in the past and provided the firm with a reasonable return on its investment when ICC had dominance in the workstation market niche. However, in recent years, new entrants have forced the ICC leasing department to reduce its markup to as low as 10 percent to sign leases. At this small margin, senior management is considering getting out of the lease business and just selling the systems.
The following lease to Gene Science is being priced by the leasing department. A four-year lease of a small network of three workstations is being negotiated. The unit manufacturing cost of the network is $30,000. The service costs, which are payable to the field service department at the beginning of each year, are $2,000 (payable at installation), $3,000, $4,000, and $5,000 (payable at the beginning of each of the next three years, respectively). Selling, shipping, and installation costs are $7,000. The leasing department has an 8 percent cost of capital. To simplify the analysis, ignore all tax considerations.
Required:
a. Using a 25 percent markup on costs and an 8 percent discount rate, calculate the fixed annual lease payment for the four-year lease to Gene Science.
b. Comment on some likely reasons why a 25 percent markup on leased equipment is proving more difficult to sustain. Should ICC abandon the lease market? What are some alternative courses of action?

Question 23

International Computer Company
International Computer Company (ICC) has annual revenues of $2 billion primarily from selling and leasing large networked workstation systems to businesses and universities. The manufacturing division produces the hardware that is sold or leased by the marketing division. After the expiration of the lease, leased equipment is returned to ICC, where it is either disassembled for parts by the field service organization or sold by the international division. Internal studies have shown that equipment leased for four years is worth 36.5 percent of its original manufacturing cost as parts or sold overseas. About half of ICC's systems are leased and half are sold, but the fraction being leased by ICC is a falling proportion of total sales. The leasing department is evaluated on profits. Its annual profits are based on the present value of the lease payments from new leases signed during the year, less
1. The unit manufacturing cost of the equipment.
2. Direct selling, shipping, and installation costs.
3. The present value of the service agreement costs.
Each leased piece of equipment will be serviced over its life by ICC's field service organization. The leasing division arranges a service contract for each piece of leased equipment from the field service organization. The field service organization commits to servicing the leased equipment at a fixed annual cost, determined at the time the lease is signed. The leasing department then builds the service cost into the annual lease payment.
The leasing department negotiates the lease terms individually for each customer. In general, the leasing division sets the annual lease terms to recover all three cost components plus a 25 percent markup (before taxes). The 25 percent markup for setting the annual lease payment seemed to work well in the past and provided the firm with a reasonable return on its investment when ICC had dominance in the workstation market niche. However, in recent years, new entrants have forced the ICC leasing department to reduce its markup to as low as 10 percent to sign leases. At this small margin, senior management is considering getting out of the lease business and just selling the systems.
The following lease to Gene Science is being priced by the leasing department. A four-year lease of a small network of three workstations is being negotiated. The unit manufacturing cost of the network is $30,000. The service costs, which are payable to the field service department at the beginning of each year, are $2,000 (payable at installation), $3,000, $4,000, and $5,000 (payable at the beginning of each of the next three years, respectively). Selling, shipping, and installation costs are $7,000. The leasing department has an 8 percent cost of capital. To simplify the analysis, ignore all tax considerations.
Required:
a. Using a 25 percent markup on costs and an 8 percent discount rate, calculate the fixed annual lease payment for the four-year lease to Gene Science.
b. Comment on some likely reasons why a 25 percent markup on leased equipment is proving more difficult to sustain. Should ICC abandon the lease market? What are some alternative courses of action?