The company was organized by product line.

Its 16 relatively autonomous divisions were managed as

profit centers. The division managers reported to one of four Business Group managers who, in turn,
reported to the company’s CEO.

Thirty managers, including all line managers at the level of division manager and above plus

key corporate staff managers, were eligible for an annual management bonus award. (Many lowerlevel

employees were included in a separate “management-by-objectives” incentive plan.) The

management bonuses were based on companywide performance. Each year, a bonus pool equal to

10% of the corporation’s profit after taxes in excess of 12% of the company’s book net worth was set

aside for assignment as bonuses to managers. This amount was divided by the total salary of all the

executives eligible for a bonus. This yielded an “award per dollar of salary.” The maximum bonus

paid was 150% of salary. Historically IE’s managers had been earning bonuses that ranged from of 30–
120% of salary, with the average approximately 50%. But because of the recession in the years 2000 and
2001, the bonus pool was zero.

Complaints about the management bonus system had been growing. Most of them stemmed largely

from division managers whose divisions were performing well, even while the corporation as a

whole was not performing well. These managers believed that the current bonus system was unfair
because it failed to properly recognize their contributions.

The quote cited at the beginning of the case was representative of these complaints.

In response, top management, with the assistance of personnel in the corporate Human Resources and

Finance departments, proposed a new management bonus plan with the following features:

1. Bonuses would be determined by the performance of the entity for which each manager was
responsible. That is, division manager bonuses would be based 100% on division performance;
group manager bonuses would be based 100% on group performance; and corporate manager
bonuses would be based 100% on corporate performance.
2. For bonus award purposes, actual performance would be compared with targets negotiated
during IE’s annual budgeting process. IE’s philosophy was to try to set budget targets at “threshold”
levels that were likely to be achieved if the management teams performed effectively. Corporate
managers knew that IE was a “high tech” company that operated in many business areas in which
there was significant operating uncertainty. It was often difficult to forecast the future accurately.
They thought that the relatively highly achievable budget targets provided the operating
managers with some insurance against an operating environment that might turn out to be more
harsh than that seen at the time of budget preparation.
3. Each division would be given an “economic profit” objective equal to budgeted operating profit
minus budgeted operating assets multiplied by 12%, which was assumed to be approximately
 IE’s weighted average cost of capital. For example, a division with an operating profit budget of
$100,000 and budgeted operating assets of $500,000 would be given an economic profit objective
of $100,000 − 60,000 = $40,000.
4. The actual investment base was calculated as follows:
Cash Assumed to be 10% of cost of sales
Receivables and Inventories Average actual month-end balances
Fixed assets Average actual end-of-month net book values
5. If an entity’s actual economic profits were exactly equal to its objective, the manager would earn
a bonus equal to 50% of salary. The bonus would increase linearly at a rate of five percentage
points for each $100,000 above the objective and be reduced linearly at a rate of five percentage
points for each $100,000 below the objective. The maximum bonus would be 150% of salary. The
minimum bonus would be zero.