Assume the operations manager at the company you own prefers to put in low effor
ID: 1168351 • Letter: A
Question
Assume the operations manager at the company you own prefers to put in low effort rather than high effort. In order the manager to exert high effort, his expected financial gain must be at least $60,000 higher than if he puts in low effort. You are evaluating three possible compensation packages:
A flat salary of $300,000
A payment equal to 5% of the expected profits from the profit center
A flat payment of $200,000 plus 5% of any profits over $10 million.
a. Discuss the effects of each of the compensation packages on company profits and the behavior of the manager. What assumptions are needed in order to compare the expected values and risks associated with each option?
b. How would a risk averse versus a risk neutral manager view the different compensation packages?
Explanation / Answer
a.
A flat salary of $300,000
It will put operation manager to make only the amount of effort that will only meet the basic target as well as his / her job will be preserved also. It will happen because high efforts are not going to offer any additional pay offs.
A payment equal to 5% of the expected profits from the profit center
It will make operation manager to be insecure ad demotivated as such compensation plan does not guarantee anything. It is his /her effort that will generate profit and out of that profit, 5% amount will be paid to the operation manager. It means that, in the event of nonprofit making scenario, operation manager will not be paid anything even if he / she has worked for the full month.
A flat payment of $200,000 plus 5% of any profits over $10 million
It offers the best possible compensation plan to the manager as it is a mix of fixed and variable compensation. It will motivate the manager and offers a challenge to achieve what he/she can through the best of effort. Operation manager will also realize that his efforts are being monetarily rewarded.
Assumptions needed are as following:
b.
Risk averse manager will go with that package that is risk free. It means that the flat salary of $300,000 will be the first choice. A plan that consists of only variable salary will be least preferred by the risk averse manager.
Risk neutral manager will neither be risk taker nor be risk averse. He will go with the best expected payoff. In the given options, risk neutral manager will go with the salary package of $200,000 plus 5% of any profits over $10 million. This package is a mix of fixed payment and a challenge to achieve more with the best effort what can be put in by the manager.
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