Business 231: Managerial Accounting & Analysis

HCC IndustriesWilliam Duncan, Seth Stephen

Abstract

HCC Industries is a manufacturer of hermetically sealed electronic connection devices and microelectronic packages. Until 1986, HCC operated with a stretch budgeting concept that was then altered to a minimal performance standard (MPS). We recognize a major problem in the difference between company and employee goals. In this report, we will analyze the decision to use MPS rather than the stretch budget concept, evaluate employee expectations, and offer recommendations to better amalgamate corporate and employee goals.

HCC IndustriesUntil 1986, HCC, a manufacturer of hermetically sealed electronic connection devices and microelectronic packages, operated under the stretch budgeting concept, which considered the “belief that aggressive targets would motivate the managers to perform at their highest possible levels” (Merchant, 329). This concept encouraged optimistic budgeting that in most cases, left divisional managers with low chances of achieving budget goals. HCC had shown slow growth through this budgeting planning and “the problem was that at 60% of budget, the managers were still in bonus territory, so they didn’t have to worry much about meeting budget. Their budgets were like a wish. They were too easily blown off” (Merchant, 332). Stretch targets encouraged optimistic budgeting that allowed more flexible management performance, and therefore encouraged managers to disregard budget goals yet still receive 80% bonus potential if profits before taxes met a threshold of 60% of their budget. As a result, divisions within HCC consistently missed targets and managers adopted lax attitudes towards performance- they could still receive a bonus despite a negative budget variance of 40%.

Before we enter a discussion about the transition to the minimum performance standard (MPS), we must recognize the emergence of the firm’s major problem. HCC’s stretch budgeting concept had potential to encourage managers to excel, but since the main goal of the managers was to earn bonuses, the concept never fulfilled its potential. The goal of HCC and the goals of its managers and employees differed in this sense. The reason why the stretch concept failed was this difference in goals.

When HCC transitioned into the minimum performance standard in 1986, the goal of corporate was to set budgets so that “the felt probability of achievement was 100%” (Merchant, 323). To encourage extra effort, “the managers were asked to set targets their reflected a performance level considered to be beyond normal capability” that included a 25-30% increase in an area rather than 5-10% (Merchant, 323). This change in budgeting concepts came with a change in incentive planning;

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“under the new plan, a division bonus pool was created based on 20% of the amount by which actual division PBT exceeded the MPS, plus 25% of the amount by which it exceeded the target” (Merchant, 333). The managers and employees expressed a concern that they would not reach the same budget potential under the new system. Under agency theory, employees are more concerned with short run performance related to their bonuses than long run company performance. Combined with the fact that three of the four division managers of HCC were engineers, who were “not very good at budgeting. They [were] engineers and generally do not have a lot of business training,” meaning they had minimal future vision and a lack of understanding of industry trends, both future and past (Merchant, 331). In an industry with such an emphasis on technology, an intense understanding of the industry is necessary. The nature of the industry requires engineers to stay on the cutting edge of R&D to maintain competitive advantage, but also a distinct ability to understand trends. Considering that no formal industry analysis takes place for HCC’s budgeting, causing the company to be too reliant on their customers’ estimations on booking. This makes HCC entirely too reliant on their customer’s performance and increases the impact of delinquency risk. The fact that most managers lacked the necessary financial background to construct accurate budgets, even though three of four preferred conservative budgets, presents a major problem in either budgeting system.

The MPS system was beneficial in the fact that it solidified the goals of HCC corporate. However, under the operation of the current divisional managers and employees who were still operating under agency theory, the managers found problems in that “if they made only half their targets, they may earn only 60% of the [bonus] pool” (Merchant, 333). Considering that all managers, with exception of newly acquired Hermetite’s manager, Alan Wong - who happened to be the only manager with previous MBA/CPA/Lawyer experience - preferred a conservative approach to budgeting, the MPS system should have worked. However, when managers are operating under agency theory with an un-transparent incentive system, even conservative managers can miss MPS budgets.

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One of the managers’ main complaints was the incentive system of the MPS system. The managers were required to set their budgets “so that the felt probability of achievement was 100%. In addition to the MPS, the managers were asked to set targets that reflected a performance level considered to be beyond normal capacity” (Merchant, 333). These performance targets were advised to involve a 25-30% increase in something, a mark that would only have a roughly 50% chance of achievement. Under the new incentive plan associated with the MPS, “a division bonus pool was created based on 20% of the amount by which actual division PBT exceeded the MPS, plus 25% of the amount by which it exceeded the target” (Merchant, 333). The main issue with this incentive plan continues to be the subjectivity of the plan; the details of the plan were left “vague because the importance of particular targets varies over time” (Merchant, 333). HCC’s COO, Al Berger “did not want to quantify the relationships” between the bonus pool and the seven performance areas (1. PBT, 2. Bookings, 3. Returns (as percentage of total dollars shipped), 5. Rework aging (number of jobs and percentage less than 30 days), 6. Efficiency (net sales/number of employees), 7. Delinquencies (dollar volume and percentage of delinquent orders outstanding). The mistake here is that there is little transparency between corporate and its employees.

To resolve this issue, we recommend that the COO sit with each divisional manager before each fiscal year to determine and weigh the importance of each performance area. By weighing the importance, HCC reduces subjectivity, which, in turn, reduces the need for a long approval process and allows for a quicker, more efficient bonus turnaround. It also combines the MPS system that corporate desires with the transparency that the managers want. By quantifiably weighing the importance of each performance goal, HCC can set standards that will keep it in business long term while adhering to the managers’ desires to earn bonuses. Because the managers will understand exactly which performance area is weighted how, they will understand which areas they need to perform well in to earn a sufficient bonus. In our recommended bonus incentive plan, the managers will earn their desired bonuses and HCC corporate will achieve their MPS goals.

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In the appendix, we have included a sample budget calculation for the year 1988 from here on out. Through reducing subjectivity and increasing transparency, the individual divisions will be able to know exactly what they need to accomplish to earn their bonus and corporate can help set budget goals that are beneficial and attainable.

Appendix

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