Homework Lance
P 4-1: Solution to Empowerment (10 minutes)
[Empowerment versus control]
In contrast to the argument, “for empowerment to work, managers should not let go of all control.” If a manager gives a worker both decision control and decision management rights over a decision, the agency problems will be substantial. Managers must maintain some level of decision control (for example, monitoring). Workers can still be empowered by being given greater decision management rights (initiation and implementation rights).
P 4-2: Solution to Pay for Performance (10 minutes)
[Dysfunctional behavior with pay for performance]
The number of arrests would go up. However, the plan would likely have several undesirable effects. First, it would encourage the police to make arrests even if the reasons for the arrest are questionable. Second, it would encourage police to work on crimes where arrests are easy to make, rather than working on more serious crimes where it is more difficult to make numerous arrests. Third, the plan would not encourage cooperation or teamwork (since the bonus is based on individual arrests).
P 4-3: Solution to Course Packets (10 minutes)
[Opportunistic behavior and associated costs]
a. Finance faculty and those teaching large classes and/or those with large course packets are more likely to distribute class material electronically and those with smaller classes and smaller course packets will photocopy the material.
b. This is inefficient to the extent that most students download and then print the material on their personal printers. It is cheaper for one high-speed copier to make all the copies rather than having each student making copies on a more expensive and slower printers. If most students just download the materials, but do print only a fraction of the material, then all the faculty should be be distributing the material electronically.
P 4-4: Solution to Allied Van Lines (15 minutes)
[Agency costs and monitoring]
Long-haul truckers are much more difficult to monitor because they spend considerable time on the road by themselves. The only observable behavior is whether they make timely deliveries. Truck failures and wasted time on the road can lead to untimely deliveries. If the company owns the truck, the truck driver can blame the company for poor maintenance. If the truck driver owns the truck, then the trucker is responsible for truck maintenance and failure.
Inner-city truckers are easier to observe, and the company can perform maintenance of trucks daily.
P 4-5: Solution to Voluntary Financial Disclosure (15 minutes)
[Monitoring role of external financial reports]
The advantage of issuing financial statements voluntarily is reducing the monitoring costs of potential investors. If investors have more information about a company, they will bear less risk and be more willing to invest in the company.
The disadvantage of issuing financial statements is revealing proprietary information that may be of benefit to competitors. Firms may be reluctant to issue financial statements if they are performing poorly. Investors, however, will infer they are doing poorly if only the successful companies are issuing financial statements to distinguish themselves from poorly performing companies.
P 4-6: Solution to University Physician Compensation (15 minutes)
[Revenue sharing and compensation schemes]
The major problem with the compensation scheme is that physicians only pay 30 percent of the net cost of expenses once revenues exceed the stated salary target. Thus, if the doctor values some expenditure at more than 30 percent of the cost, but its value to the practice is less than its cost, the doctor will still make the expenditure. For example, suppose the physician has revenues in excess of the salary target and expenses and is considering taking a trip to a medical conference in Hawaii. The cost of the conference is $5,000. The value of the conference to the doctor is $4,500. Clearly, the trip would not be taken if the doctor had to pay the full cost. But since she only bears 30 percent of the cost (or $1,500) but values the trip at $4,500 she will take the trip.
The current salary target formula is dysfunctional. The hospital has to be careful about schemes that reimburse physicians for expenses that can be pure perks. For example, a doctor can take a trip to Hawaii for which she receives private benefits and the hospital no benefits. However, differentiating between “acceptable” and “unacceptable” expenses requires a costly monitoring system. One alternative is to charge the doctors a fixed rental fee for using the clinic. Such fixed fees do not affect marginal decisions.
P 4-7: Solution to American InterConnect I (15 minutes)
[Dysfunctional behavior from performance evaluation]
This question describes an actual company’s procedure for measuring employee satisfaction. They wanted to include employee satisfaction as a performance criterion to get people to work towards creating a better workplace. However, all employees’ performance was measured by their own self-reported satisfaction surveys. It should come as no surprise that all employees usually said they were very satisfied with their job. The only time this does not occur is when the group does not expect to receive any bonus because overall targets are not met or when they are so mad at their managers that they decide to punish them by reporting very low employee satisfaction.
Another problem with this scheme is that it discourages managers from setting tight targets and providing frank feedback to employees. To improve employee satisfaction managers will propose higher than optimum pay increases for their direct reports. These incentives are mitigated to the extent other targets are also adversely affected, such as earnings. However, at the margin, managers will substitute some earnings for more employee satisfaction.
This question raises the more general issue of why pay for employee satisfaction?
P 4-8: Solution to Raises (15 minutes)
[Pay and incentives]
Economic theory predicts that simply raising the pay of workers by 20 percent will not alter their effort choices (ignoring some potential “income effects”). Increasing the level of pay does not change the marginal costs and benefits of exerting effort. This, however, does not mean that money does not motivate people. The question is what would happen if the increase in pay were tied to increased effort? If the workers would be willing to exert more effort for more pay, then money could be said to motivate the workers.
P 4-9: Solution to Vanderschmidt’s (15 minutes)
[Specific knowledge and organizational architecture]
Joop does not have the same level of specific knowledge to run the company as his father. Rather the specific knowledge is likely to be held by other people throughout the company. Given this distribution of knowledge, Joop will probably have to decentralize decision rights. Decentralizing decision rights will require associated changes in the performance-evaluation and reward systems (so that the three legs of the stool balance). Joop will probably want to increase the emphasis on performance-based pay to motivate the newly empowered workers to make decisions that are in the best interest of the company.
P 4-10: Solution to Sales Commissions (15 minutes)
[Disincentives of sales commissions]
Given that she has decision rights over pricing and is evaluated and paid on sales, she will set prices to maximize sales, not profits. In fact, she will set price where marginal revenue equals her marginal cost, which does not include the marginal cost of the furniture.
P 4-11: Solution to Formula 409 (15 minutes)
[Changing incentive systems]
“About half of my people left the company — and, I might add, they were the best half, my racehorses. They were replaced by recruits from large companies, and gradually, 409 became a little version of a big company — a bureaucratic mess where nobody thought much about case sales. I didn’t want to run a company like that, so I sold it for a bundle and went back to being an entrepreneur and having fun.” (Source: Wilson Harrell, “Inspire Action: What Really Motivates Your People to Excel?” Success, September 1995.)
P 4-12: Solution to Pratt & Whitney (15 minutes)
[Changing all three legs of the stool]
Broadening job descriptions changed decision rights assignments. Workers were assigned the task of redesigning the compensation package to base pay on training not seniority.
Performance measures were based on cost cutting and other targets. Also, performance measures tracked training.
Performance rewards were changed to pay based on meeting targets and training.
P 4-13: Solution to Theory X-Theory Y (20 minutes)
[Applying the framework]
There are certain aspects of both Theory X and Theory Y that are consistent with the basic assumptions underlying our framework. Other parts are inconsistent. We assume that workers are self-interested and tend to prefer leisure to work. On the other hand, there are also parts of each job that people enjoy. Nowhere have we assumed that people are incapable of self-direction and assuming responsibility. If this were literally true, why assume subordinates possess these traits but not their supervisors?
It is certainly the case that the more enjoyable work can be made, the less you have to pay people. Enjoyable jobs do not have to pay as much as unpleasant jobs to attract and retain individuals to these jobs. However, not all jobs can be made enjoyable (garbage collectors, or jobs that entail firing people).
Coercion, punishment, and rewards are useful controls but must be coupled with performance measures and decision rights. Theory Y is trying to motivate behavior by assigning “enjoyable” decision rights to people. This won’t work unless coupled with performance measures and rewards.
P 4-14: Solution to American InterConnect II (20 minutes)
[Dysfunctional behavior from performance evaluation]
This question describes an actual company’s procedure for awarding bonuses to new product development teams. Although AI is trying to provide incentives for product developers to increase firm revenues by developing new products the market wants, the system isn’t working. The people assigned to new product development now are not the same ones who helped design the products the market is currently buying. Thus, the existing system is just adding noise to the product developers’ bonuses. It is increasing the variance and hence the risk of their compensation. Employees resent this. Also, in assigning people to development teams, it will be more difficult to get people to serve on teams for groups that have current products that are not selling well in the market (not meeting their revenue target).
The problem arises because the accounting system cannot track current revenues back to product developers who helped design the product.
While revenue-based compensation plans are common in practice, they can induce dysfunctional incentives. In particular, if the employees receiving bonuses based on revenues have the decision rights to set prices, they will set prices that maximize total revenue which is not the same price that maximizes profits. The revenue-maximizing price occurs where the last unit sold generates no additional revenue. The profit maximizing price is where marginal revenue equals marginal cost.
P 4-15: Solution to Tipping (20 minutes)
[Knowledge and incentives]
When a customer comes into a restaurant in the U.S. they have an implicit contract with the waiter to tip for good service. A customer might honor this contract for two reasons. First, the person might value being fair and not want to shirk on the implicit agreement (economics allows for people to care about fairness). Second, the customer will realize that if he shirks on the tip the next time he comes back to the restaurant the waiter will shirk on service. Tips are likely to be higher at restaurants in residential neighborhoods because the second effect (the repeat-customer effect) is likely to be large. Many customers who will not return will frequent restaurants on interstate highways. These customers have large incentives to shirk on the tip unless they care significantly about fairness to the waiter.
P 4-16: Solution to White’s Department Store (20 minutes)
[Dysfunctional behavior with pay for performance]
This behavior is likely to be caused by the compensation plan. Presumably, the employees are paid sales commissions. In this case, they have incentives to hide sale items if they think they can convince customers to purchase more expensive products. They also have limited incentives to exert effort on activities other than personal selling. For example, individual salespeople have incentives to freeride on the efforts of others in designing displays to attract customers. The situation might be improved by changing the compensation scheme to emphasize elements other than personal sales.
P 4-17: Solution to Coase Farm (25 minutes)
[Markets versus firms]
a. Because Taggart cannot be held liable for its environmental damages, it chooses the number of tracks with the highest net present value (two, yielding an NPV of $12 million.). Coase anticipates Taggart’s choice and chooses to use one field, the highest value use of the farm when Taggart builds two tracks. This yields an NPV of $7 million.
b. Because Taggart must pay Coase for any damages, Coase should plant soybeans on two fields to yield an NPV of $18 million. Taggart responds by building one track, yielding an NPV of $1 million ($9 million for operating the track less $8 million environmental damages it pays to Coase.) Coase gets $10 million from operating the farm plus $8 million damages from Taggart.
c. The investments that the merged firm make is to build one track and grow soybeans on one field, yielding a combined NPV of $20 million ($9 million from the track and $11 million from the field.) This is higher than the combined payoffs of $19 million under either setting ‘a’ or setting ‘b’.
d. First, the decision rights regarding the number of tracks to build and the number of fields to use must be centralized in the hands of someone who is in charge of maximizing firm-wide value instead of allowing the railroad division manager to choose the number of tracks and the farm division manager to choose the number of fields. Second, the railroad should become a profit center because it no longer has decision rights over investment (number of tracks to build) and the farm should become a cost center because it no longer has decision rights over how much soybeans to plant. Finally, employee compensation in the railroad and farm divisions should be tied to profits and costs, respectively, consistent with their allocation of decision rights.
P 4-18: Solution to Rothwell Inc. (30 minutes)
[Compensation schemes and sales incentives]
a. The high sales/low profits situation experienced by Rothwell is partially explained by an incongruence in Corporate and District objectives created by its compensation plan. Given the structure of the bonus plan, districts increase their bonus by generating large revenues at the expense of firm profits. Particular weaknesses in Rothwell’s bonus plan are noted below:
• Quotas and bonus points are measured in terms of revenue within each product line. A district can earn bonus points while making minimal profits for the firm. Selling one unit at full price, for example, would earn the same bonus credit as selling two units at half price. But selling two units at half price is a lot easier than selling one unit at full price.
• The use of sales revenues for both bonus qualification and bonus calculation, together with the practice of sharing sales across districts, also promotes suboptimal behavior. Managers short of making quota in a product line can organize sales transfers with managers exceeding quota in that line. This can be done in such a way that both districts benefit. This sort of collusion would lead to high bonus payouts relative to overall sales volume and reduce firm profits.
• The existing compensation plan does not address cost of sales. Districts are rewarded equally for equal dollar sales, even if one sale cost the district substantially more.
b. An alternative compensation plan is as follows:
• Continue the balanced selling program by basing bonus qualification on meeting quota in each product line. Define quotas in terms of units sold, rather than sales revenue.
• Use contribution margin of products sold as the base of bonus point calculation. By combining bonus qualification on units sold and bonus points on contribution margin, districts would no longer be rewarded for chopping price to sell additional units (as in the two-for-one situation described above).
• Continue to weight Pride Level product lines more heavily in bonus point calculation so that sales efforts are commensurate with long-term firm strategy.
• Identify budget items that are discretionary at the district level (entertainment, travel, etc.). Measure performance against these budgets and award or deduct bonus points accordingly. Factoring discretionary expenditures and contribution margin into the bonus point calculation gives district managers incentive to reduce cost of sales.
In summary, the improvements outlined above suggest that organizing district sales offices as profit centers rather than as cost centers better aligns district performance measurement and rewards with corporate objectives. Establishing district sales offices as profit centers is further supported by the fact that districts possess most decision rights (on both the revenue and expense sides) and should be evaluated accordingly.
P 4-19: Solution to Gong-Fen (30 minutes)
[Free-rider problems]
The current system generates influence costs as well as creating incentives for families to have additional babies since each child gets half a portion. “Since a child just over three obviously could not eat an adult’s share, it was desirable to have more children. The system functioned as a positive disincentive to birth control.”
However, the most serious incentive issues are likely the free-rider problems:
“(The performance and compensation system) was a constant source of resentment among the villagers — in addition to being a massive discouragement to efficiency. Every day, the peasants would screw up their eyes to watch how the others were working in case they themselves were being taken advantage of. No one wanted to work harder than others who earned the same number of work points. Women felt bitter about men who sometimes did the same kind of job as they, but earned two points more. There were constant arguments.” (Source: J. Chang, Wild Swans: Three Daughters of China (Anchor Books: New York, 1991, p. 415)).
P 4-20: Solution to International Computer Company (35 minutes)
[Capital budgeting and dysfunctional incentives from errors in the design of the performance measurement system]
This problem illustrates that not properly assigning design rights in the firm can lead to value-decreasing actions. The leasing division is not assigned the property rights to the leased equipment when it is returned to the firm. The returned equipment is “free” to the service department and the international division. Since the leasing department does not receive any financial benefits when the equipment is returned, it must recover the entire cost of the equipment in the original lease terms, which causes it to set a higher annual lease payment than if it factored in the present value of the salvage value of the equipment.
a. The fixed annual lease payment (ignoring the salvage value of the network) is computed as:
Let L = the four fixed annual lease payments received at the beginning of each year.
Then, the following equation must hold:
The left-hand-side of this equation is the present value of the annual lease payments and the right-hand-side is the present value of 125 percent of the costs charged to the leasing division. Solving the above equation yields:
3.577L = $61,470
L = $17,185
Therefore, to recover 125 percent of its costs, the annual lease payment is $17,185.
b. Increased competition has put pressure on the leasing department’s profit margins and markups. Just because the markups are falling, some to as low as 10 percent, does not mean that ICC should stop leasing the equipment.
One problem that is causing the leasing department to lose business is that they are trying to recover 125 percent of all their costs, excluding the salvage value of the leased equipment when it comes off lease. Therefore, while the leasing division is showing a 25 percent profit margin, the firm as a whole is making more money on the lease and these additional profits are showing up as profits in the field service organization and the international division who get the returned equipment for free. The leasing department is in a sense subsidizing the other two departments.
If the leasing department sold the returned equipment to the field service organization or the international division, they could set a much lower lease price. In this case the annual lease price is:
3.577L = $61,470 – $11,000 ×.7350
L = $14,925
Now, the leasing division can lower the annual lease payment by $2,260 to $14,925 per year and still recover 125% of its costs.
Notice that if the lease payment is $14,925, the leasing division’s markup over costs is about 8 1/2% ignoring the salvage value on the equipment. That is, solving for the markup in the following equation:
M = = 1.086
The preceding calculations demonstrate that the leasing division can lower its markup to about 8 percent if they do not receive the salvage value of the returned equipment. The firm is still making a 25 percent markup including the value of the returned equipment.
Clearly, ICC should not abandon the lease market. Instead, they should change the way decision rights are partitioned and give the decision rights regarding the returned leased equipment to the leasing department to determine how this equipment is best used. Also, the performance evaluation of the leasing department should be changed to give this department the revenues from the used equipment.
P 4-21: Solution to Repro Corporation (40 minutes)
[Internal competition and incentives]
a. Since a large portion of the compensation of the two sale forces (Products and Service) is comprised of the commission bonus, the two sales forces will be placed in direct head-to-head competition for customers. Firms which opt to purchase equipment from Products are lost sales potential for Service, and firms which contract for an FM through the Service division are lost sales for the Products division. As a result, the two sales divisions within Repro will be competing with each other as well as with external competitors for business.
The internal competition from the Service division will be especially unacceptable to the Products division. Having been in business for an extended period of time, Products has been able to generate extensive contacts with potential customers. Since both Products and Service are part of the same corporation, two possible scenarios will result:
(i) Service will be given access to Products’ customer database which the Products’ sales force has worked hard to create.
(ii) Products will prevent Service from accessing its customer database.
Under the first scenario, Products’ sales force will raise the “fairness” issue and under the second scenario, the Service division will be forced to duplicate the efforts of the Products sales force in identifying potential customers.
Note: The preceding answer is written with the view that internal competition is “bad” (reduces firm value). Internal competition can be “good” if the reduction in agency costs is greater than the costs of duplicated effort.
b. Under the assumption that the two sales forces will remain independent, Repro must encourage the two divisions to work together in identifying potential customers. If Products’ sales force identifies a potential customer in the market for office equipment solutions, and that customer’s need can better be served by an FM solution (assuming that higher profits also can be gained by Repro under FM), then the Products’ sales force must be encouraged to communicate this business opportunity to Service’s sales force. On the other hand, in situations where the Service sales force identifies a new customer and decides that the customer’s need can be better satisfied by the purchase of hardware, they must in turn be encouraged to contact Products’ sales force.
An incentive system must exist to encourage mutual cooperation between the two divisions. The bonus scheme should be redesigned to include a “finder’s fee” for both sales forces. If a Products salesperson identifies a potential FM customer that leads to a successful transaction and vice versa for the Service salesperson, that salesperson should be awarded a bonus. This type of bonus scheme will help to ensure that the externality associated with head-to-head competition between the two divisions is internalized, thus discouraging dysfunctional head-to-head competition and encouraging cooperation. In addition, the management (upper and lower) will be encouraged by company headquarters to maintain close contacts in regions where both divisions are located. This is advantageous to the company as a whole and will encourage greater interaction between divisions, providing an opportunity to work out possible problems at the local level.
Note: To be fully effective, the finder’s fee must be set at a level such that the members of both sales forces are made indifferent between selling their own division’s product and contacting the other division’s sales force.
Additionally, regional field division managers will likely end up working together in headquarters as their careers advance. This field interaction will serve as a teaching and learning opportunity for the managers.
In essence, the introduction of the Service division without a corresponding change in the compensation system results in a suboptimal situation. The organization’s architecture is a “three-legged stool” comprised of performance evaluation systems, decision rights allocation systems, and reward/punishment systems. A change in any one of these legs of the system must be accompanied by a change in the other legs to maintain stability.
Instead of having two separate sales forces, one for Product and one for Service, an alternative arrangement would be to have a single sales force that sells both. This raises the question of to whom does this organization report? Who evaluates them and sets their compensation? Having a single sales force likely results in Products and Service being merged into a single division.
Case 4-1: Solution to Christian Children’s Fund (45 minutes)
[Gaming performance metrics and insuring the 3 legs of the stool are balanced]
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.)
Case 4–2: Solution to Woodhaven Service (50 minutes)
[Incentives]
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.
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