Berkshire Industries PLC

The Company

Founded in 1852 as a brewery serving local pubs.

2002- Medium sized publicly held corporation focused on beverages and snack foods industry.

Listed on London Stock ExchangeHeadquarters-Manchester ,England.

Operating divisions – 1)Beer 2)Spirits 3)Soft drinks 4)Snack FoodsOperated in a decentralized fashion

Measurement and Incentive Systems

Primary performance emphasis at Berkshire was on Earnings Per Share(EPS).

Long term EPS growth target was 8%,target was modified each year based on anticipated market conditions and pending acquisitions.

Annual planning process was a bottom up process which first involved operating divisions proposing their EPS targets for the year and their means of achieving them.

Division’s draft plan were consolidated and compared with Berkshire’s corporate EPS growth target.

“Planning Gap” was eliminated by discussions among corporate and divisions managers.

Mainly by increasing some or all divisions target.

Profit Reserve:-To meet analysts expectation 10% of planned earnings were kept as profit reserve.

The reserve was established to ensure if some of its divisions were not able to meet the target the corporation would still achieve the target.

If the company achieved the target without using profit reserve, reserve was used to spend on discretionary projects.

In 2000 and 2001 reserve was used to meet the Corporate EPS target.

Senior management of Berkshire comprising of 40 people participated in annual incentive compensation plan.

Performance was evaluated based on the achievement of earning targets in the entity to which the manager was assigned

Target bonus ranged from 20% to 90%of base salary.

Motivation for new Incentive Plan

Motivation of new plan stemmed from two concerns

1) Managers interests were not aligned with those of shareowners.

They were Concerned that EPS was not a good measure of performance, as management mantra was to maximize the shareowner value.

2) Bonus awards loosely correlated with realized operating performances.

Managers were given bonuses even when the entity did not perform well.

Politicking-The managers tried to convince their evaluators that they had performed well, even though their results were disappointing

New System

William Embelton was given the responsibility to implement the new system.

Enbelton asked three consulting firms to submit proposals.

Corey Langfeldt and Assosciates (CLA) was selected.

CLA approach was based on firm’s proprietary “economic profit” measure of performance.

Economic profit=Adjusted net operating profit after taxes(NOPAT)-[Capital * Cost of Capital]

NOPAT excluded all non operating non cash charges such as depreciation, asset write offs, and reserves.

Cost of Capital was determined annually for each business unit based on long term GOVT obligation and risk premium on an assumed capital structure and risk factor(beta value) for comparable firms.

Berkshire’s business units were all seen as relatively stable industries all were given the same cost of capital rate 10%.

CLA indentified over 100 adjustments to improve the relationship between economic profits and share price

Only two adjustments were purposed to keep the model simple.

1) Company’s consumer advertising expenses should be capitalized and amortized on a straight line basis over 3 years. The current year’s expense was added back to operating profits and the capitalized amount was added to net operating assets.

2) Goodwill that had arisen from the company’s acquisition should not be amortized.

Cummulative goodwilll that had been amortized to date should be added back to net operating assets and all goodwill amortization expense should be added back to operating expenses.

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CLA

CLA claimed that motivating managers to maximize their entity’s economic profit would induce them to invest in their entities futures.They would make all investments promising retuns greater than company’s cost of capital

CLA consultants recommended against the implementation of stock based incentive programs.

Pointed out that stock prices are affected by many external factors and are highly volatile in short term and are not a effective tool of management.

CLA system involved automatic ratcheting of performance targets.

Managers were compensated directly for improving their entity’s economic profits.

In the first year the performance targets were set based on a projection of the units economic growth rate, if the growth rate was good the target was set by multiplying .75 of the amount by which actual performance exceeded(fell short of)the unit’s prior years performance.

Explicit elimination of payout thresholds and caps. Managers were assigned a target bonus, a fixed percentage of base pay that would be earned if their units achieved their performance targets.

Targets were increased slightly over from previous bonuses, so that to encourage managers to accept the change.

Target bonuses ranged from 20% of base salary to functional managers within a division to 100% for Berkshire’s Managing Director.

Bonus Bank :- Bonus bank was intended to reduce manager risk by smoothing out the bonus awards, to reduce managers short term gaming behaviors and to improve manager retention.

If a unit’s economic profit exceeded the performance target, the excess bonus was credited to the bonus bank.

Managers were paid their target bonus plus one fourth of the amount in the bonus bank.

If targets feel short a negative entry was made in the bonus bank.

Problems and Concerns

New system had created considerable management confusion, which persisted even after all the operating managers had attended a series of training sessions.

Many managers seemed not to understand how the economic profit measure was computed and some them continued to manage their entities based on old system.

Discouragement and demotivation in the Spirits Division.

In 2000 and 2001 due to recession the economic profits in Spirit Divisions were poor.

With consumer demand down, competitors cut prices significantly and Spirits had to match their reductions.

This all had a disastrous effect on margins. Spirits failed to achieve both its 2000 performance target and its ratcheted down 2001 target by wide margins.

Consequences were bonus awards for Spirits managers were significantly below target levels and all Spirits managers had sizable negative balances in their bonus bank account.

Widely shared perception of a basic failure of the economic profit measure itself.

Overall Berkshire’s performance as measured in terms of economic profit seemed excellent, but stock prices had declined.

Evaluation of Incentive plan

Pro’sMaximum bonus that can be earned is

unlimitedEncourages team work as they have common

profit goalPolictiking can be reducedBonus bank followed the mangers if they

changed their divisions

ConsDiscouragement and demotivation because

profit bank is based on historic performance.Considerable confusion among the managers

regarding incentive systemInnovation was reducedIncentive system did not take current market

scenario in consideration

ChangesVariable pay based incentivesIncentive system not based on past years

dataCurrent market scenario should be taken into

consideration for incentivesInnovation should be rewarded

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