Las Ferreterias de Mexico, S.A. de C.V.

We had been operating our company like a family, but maybe were too big to operate that way. I think some of our people have gotten lazy, and our performance has suffered. That is why I asked for the design of a new incentive compensation plan. We need to be more competitive to survive. I want our people to focus on what they can do to improve company performance, and if were successful, I am quite willing to share a good proportion of the procceds of our success. -Fernando Gonzalez Chairman and CEO Las Ferreterias de Mexico, S.A. de C.V.

THE COMPANY
Las Ferreterias de Mexico, S.A. de C.V. (Ferreterias) was the second largest retailer of lumber, building material, and home improvement products and materials and homeimprovemen product ans equipment in Mexico. Ferreterias operated 82 stores in Mexixo City and troughout most of the nortern regions of Mexico. Each of Ferreterias stores offered between 10,000 to 20,000 stock keeping units (SKUs) in a retail sales area, an outside lumberyard area, and in a garden center. The total store areas ranged from 10,000 to 35,000 square feet. Ferreterias was founded in 1902 in a suburb of Mexico City by Fernando Gonzalezs grandfather. Over the years, the company added more locations. It was listed on the Mexican Stock Exchange in 1983. In 2002. EXIBIT 1 LAS FFETERIAS DE MEXICO, S.A. D.V. Income Statement as of 12/31/2002 (Ps 000) Net sales 2,216,540 Costs of sales 1,582,670 Gross Margin 633,870 Selling, General and Administrative Expenses 377,580 Depreciation Expense 65,740 Interest Expenses 14,320 Total Expenses 457,640 Earnings before Taxes 176,230 Incesome Tax Provision 58, 240 Net Earning after Taxes 117,990 Ferreterias had saies of 2.210 million pesos and profits of almost 120 million pesos (see summary financial statements in Exhibits 1 and 2).

Starting in the late 1980s, Fernando Gonzalez launched a major company needed to emulate the methods of the large American homebuilding retailers, such as Home Depot and Lowes, in order to survive. Thus, improving market share and improving operation efficiencies becme Ferreterias` strategic priorities. The store managers enjoyed considerable autonomy. They were responsible for hiring, firing, and supervising their store`s personnel. While the store hnd the same architectural designs and some basic stock keeping requirements, the individual store managers were allowed to adapt their merchandise offerings, their inventory levels, and their advertising and promotional activities to their local markets, which were quite diverse. The store managers were given considcrable latitude to reduce princes to move excess inventory or to meet competition. They were responsible for making creditgranting decisions, although for large accounts they were expected to ask finance personnel at headquarters to perform a credit check. And some aggressive store managers tried to generate new business by calling on prospective customers themselves. The 82 store were organized into nine geographical regions. The regional managers, each of whom was a former store manager, provided oversight and advice. At the of the case, one Mexican peso worth approximately USS0.10. Their role was seen as an important part of the management structure because most of the store managers had little formal education. Only a few were college educated, and few of those had formal business education. Each region also contained a regional sales office with specialisis who worked with larger customers, though, were made through the store nearest to the job. The corporate staff of Ferreterias provided a range of centralized function, including purchasing, human resources, marketing, real estate, and investor relations. Inventory was shipped to the store from one of three regional warehouses. All Ferreterias employees were paid a base salary or hourly wage plus a bonus based on a share of the companys overall profits. These bonuses were small, usually in the range of 2 5 percent of base salary, depending on organization level. In addition, Fernando Gonzalez typically provided some discretionary bonus awards to employees whose performance in a given year was exemplary. Generally, though, these types of bonuses were not considered to be effective at motivating behavior, as was indicated in the comment by Mr. Gonzalez presented at the beginning of the case. A NEW INCENTIVE PLAN In July 2002, Mr. Gonzalez hired a consulting firm to design a new performance-based compensation plan. He asked his chief financial officer and head of human resources to assist the firm with its work. Mr. Gonzalez`s original intent was to include all company salesmen, buyers, and managers in the new incentive plan. After a series of interviews, however, the consulting firm reported that it would not be easy to measure the performances of either salesmen of buyers. While most customers were assigned to one particular salesperson, it was difficult to assess whether a sale came from the assignes salesperson`s offorts. Many customers had dealt with Ferreterias for years, and they placed their orders regardless of whether or not they received a call from a Ferreterias salesperson. Some of the large contractors had also established personal relationships with one or more corporate or regional staff, and oftentimes they called their friends for advice, rather than relying on the salesperson

formally assigned to them. Measuring the performances of the buyers was similarly problematic. The primary aspect of buyer performance that could be measured the prices paid for items purchased-was affected by many factors over which the buyer had little control. These included the order size and market conditions. Because of these measurement problems, the consultants concluded that the measures that could be tracked would not provide meaningful bases on which to assign bonus awards. They recommended that they work first on designing an incentive plan for managers, which included the individual store managers (82), regional managers (9). And corporate staff managers (5). (Neither Fernando Gonzalez nor his chief operating officer was to be included in this plan: the compensation committee of the company`s board of directors determmed their bonuses). The consultant`s suggestion for the management incentive plan included the following features: 1. Bonus pool. A total bonus pool would be created according to the following formula: 4 million pesos plus 8 percent of the corporate income before bonuses and taxes in excess of 120 million pesos. The total bonus pool would be divided into three classes as follows: Store managers 70% Regional managers 15% Corporate staff managers 15% 2. ROI measure of performance. The bonus pools would be assigned to managers based on their entity`s return on investment (ROI). Defined as bonuseligible revenues minus expenses divided by total store investments. The following gundelines were provided to facilitate the calculation of the ROI for bonus purposes. The revenues eligible for bonuses include all shipments from the store except those stemming from sales orders written by regional or headquarters personnel. The expenses include all direct store costs and all regional and headquarters costs. The costs of significant regional and headquarters activities traccable directly to a given store . Cost of preparing a customer credit report, cost of a building upgrade would be charged directly to that store. All other costs would be allocated to the stores. Activity-based allocations would be used where possible, such as in using the stores relative proportions of receipts into inventory to allocate purchasing expenses. All other expenses would be allocated based on a proportion of bonus-eligible store revenues. 3. Allocation .. For store managers who had been in that position for less than the full year and managers who transferred between stores during a year, bonus units would be assigned by the relevant regional manager(s) by applying the basic bonus unit award philosophy as closely as possible. The regional managers` bonus pool would be divided among the regional managers based on a proportion of the bonus units earned by the stores in their region divided by the total bonus units earned by all stores.

The allocation of the corporate staff bonus pool would be decided by Fernando Gonzalez based on the corporation`s annual ROI performance. 4. Form of the awards. Bonuses were to be paid in cash as soon as the financial statements were prepared and audited and the amounts could be calculated. CONCERNS BEFORE IMPLEMENTATION As Mr. Gonzalez looked over the consulting firm`s design, he had some concerns. First, it was obvious to him that the new plan would increase the company`s compensation expense. How much would that expense increase, and would the benefits of the plan be worth that expenditure? Second, he knew that he would have to be the one to announce the implementation of the plan. He had to anticipate what his managers` reactions would be. What were they mostly likely to complain about? Is this plan fair to all of the managers? And, finally, he still lamented the fact that personnel in the regional sales and corporate purchasing organizations were not included in this plan. If their individual performances could not be measured objectively, was there some other way he could motivate them and reward them for performing their roles, which were critical to the company`s success? Questions 1. Evaluate the proposed performance measurement and incentive plan 2. How, if at all, would you modify the proposed plan?