Assume the operations manager at the company you own prefers to put in low effor

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

Ans: Case 1 when salary is flat $300000: in this case no profit shall be effected since salary is fixed that means it does'nt matter if profit is high or low.

Case 2 if payment is equal to 5% of the expected profits from the profit centre then it means salary is totally depend on profit therefore if higher is the profit then higher will be the salary and vice versa.

case 3 when salary is partially fixed and partially depend on profit therefore salary upto $200000 will not effected by profit or profit shall not be effected by salary however salary is also depend on profit so in case of profit is more then $10 million then salary is 5% of excess profit so profit shall be reduce accordingly.

Risk averse means a situation where investor prefer lower returns with known risk instead of higher returns with unknown risks on the other hand risk neutral is a situation where investor completly ignores risk in making investment decisions.

Therefore in case of risk averse the management shall prefer the first case that means flat salary of $300000 and in case of risk neutral the management may prefer either case 2 or case 3 because the management shall ignore the risk therefore management can take higher or lower risk.

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