MANAGEMENT COMPENSATION

Research Findings on Organisational Incentives

Reward incentives are inducements to satisfy their needs that individuals cannot obtain without joining the organisation Research on incentives points out following: individuals tend to be more strongly motivated by potential of earning rewards than by fear of punishment a personal reward is relative or situational individuals are highly motivated, on receiving reports or feedback about their performance

Research Findings on Organisational Incentives

incentives become less effective as period between an action and its feedback increases motivation is weakest when person believes that incentive is either attainable/easily attainable if senior management signals about importance of management control system, operating managers will also regard it as important incentive provided by a budget or other statement of objective is strongest when managers work with their superiors to arrive at amounts

Characteristics of Incentive Plans

A managers total compensation package consists of three components: salary, benefits and incentive compensation incentive compensation is related to the management control function most corporate bylaws and securities regulation require such incentive plans and revisions of existing plans to be approved by shareholders Incentive compensation plans are divided into short-term and long-term plans, bonus can be earned by a manager under both the plans

Characteristics of Incentive Plans

Short Term Incentive Plans: total amount of bonus that can be paid to a qualified group of employees in a given year is called bonus pool simplest method for bonus pool is to make bonus equal to a set percentage of profits many companies may not like above method as bonus will be paid even in low profit periods and additional investments are not reflected one method is to base bonus on % of EPS after a predetermined level of EPS has been obtained

Characteristics of Incentive Plans

this above method does not take into account increases in investments from reinvested earnings another method of relating profits to capital employed is to define capital as shareholder equity plus long term liabilities in above method, bonus is equal to percent of profit before taxes and interest on long-term debt, minus a capital charge on total of shareholder equity plus long-term debt this method is used as managerial performance should be based on corporate net assets profitably

Characteristics of Incentive Plans

in another option, capital can be equal to shareholder equity in this option, difficulty is that a loss year reduces shareholder equity and increases bonus to be paid in profitable years a few companies base the bonus on increase in profitability over preceding year some companies base bonuses on their profits relative to that of their industry in above case, obtaining comparable data may be difficult

Characteristics of Incentive Plans

Carryovers: instead of total amount in bonus pool, plan may provide for carryover annually of part of amount this method is more flexible, since Board of Directors can exercise their judgement also, it can reduce magnitude of swings that occur when bonus payment is strictly on formula disadvantage in this method is that bonuses relate less directly to current performance generally, payments are not automatically determined by a formula

Characteristics of Incentive Plans

Deferred Compensation: payments to recipients may be spread out over a number of years in this method annually merit is that managers can estimate their cash income with reasonable accuracy deferred payments smooth cash receipts a retiring manager will continue to receive cash for a number of years this time frame encourages to think long term disadvantage is that deferred amount is not available to executive in the year earned

Characteristics of Incentive Plans

Long Term Incentive Plans: growth in the value of companys common stock reflects companys long run performance, is basic premise of such plans Stock Options: It is the right to buy a number of shares of stock at, or after, a given date in the future, at a price agreed upon at the time option is granted (usually current market price or 95% of current price) major benefit is that managers energies are directed towards performance of the company

Characteristics of Incentive Plans

outright purchase of stock under the plan gives managers equity that they can retain, even if they leave the company and a gain that they obtain, whenever they decide to sell the stock however, many stock options are for restricted stock Phantom Shares: manager is awarded a number of shares for bookkeeping purposes only this award may be in cash, shares of stock or both this plan has no transaction costs

Characteristics of Incentive Plans

at end of a specified period, executive is entitled to receive an award equal to appreciation in market value of stock since date of award risk of decrease in market price and interest costs associated with holding shares is not in this plan Stock Appreciation Rights: It is a right to receive cash payments based on increase in stocks value from time of award until a future date this & previous plan, involves uncertainty in both directions about the ultimate amount paid

Characteristics of Incentive Plans

Performance Shares and Units: A performance share plan awards a specified no. of shares based on specific long-term goals met advantage of this plan is that award is based on performance that executive can partially control like EPS, but limitation is that bonus is based on accounting measure A performance unit plan pays cash bonus based on specific long term targets met it is especially useful in companies with little or no publicly traded stock

Incentives for Corporate Officers

CEOs compensation is usually discussed by Board of Directors compensation committee based on his recommendations for subordinates compensation Are CEOs paid too much ? a hot debate Several proposals have been made to ensure that BODs act in interest of shareholders: prevent directors from selling their stock for duration of their term to encourage them to ask tough questions of CEOs without fear of adversely affecting short-term stock prices

Incentives for Corporate Officers

set mandatory limits on tenure of directors to avoid their becoming too entrenched with management hold an annual performance review of directors avoid having CEO of corporation as chairman of the board Following arguments are given to support expensing stock options in year for top managers: about 75% of CEO and top management compensation represents stock options under current rules, stock options are felt as free

Incentives for Corporate Officers

treating stock options as an expense would result in a more accurate earnings picture this would prevent top managers from playing accounting games to pump up short-run stock prices in order to cash their options finally, there are double standards at present since companies are allowed to expense difference between issue and exercise price of options for income tax purposes but it is not required for financial reporting options dilute shares and have real costs

Incentives for Corporate Officers

Following arguments are advanced against expensing stock options: stock options do not involve cash outlay valuing stock options is far from easy it will dampen earnings and reduce stock price, so fewer options will be issued cash-trapped start-ups, especially in Silicon Valley, use options to attract human talent, this could damage innovative spirit in this sector they are disclosed in foot-notes to the balance sheet

Incentives for Business Unit Managers

Types of incentives: financial rewards: Salary increase, bonuses, benefits & perquisites psychological and social rewards: Promotion possibilities, increased responsibility, increased autonomy, better geographical region and recognition size of bonus relative to salary: One school of thought states that we recruit good people, pay them well and then expect good performance fixed pay performance

Incentives for Business Unit Managers

Another school states that we recruit good people expect them to perform well and pay them well if performance is actually good performance based pay cut off levels: upper cutoff and lower cutoff levels will be specified, but both will have side effects managers may be motivated to decrease profits in one year to create high bonus for following year this issue can be solved by carrying excess or deficiency into the following year

Incentives for Business Unit Managers

Bonus basis: bonus could be based solely on total corporate profits or on business unit profits or on both in a single industry firm whose business units are highly interdependent, managers bonus is tied primarily to corporate performance in a conglomerate, it is desirable to reward managers primarily based on business unit performance to solve free rider problems for related diversified firms, mix of unit performance and company profits can be used

Incentives for Business Unit Managers

Performance Criteria: financial criteria: for a profit center, criteria like contribution margin, direct business unit profit, net income etc.are used for an investment center, definition of profit, definition of investment and choice between ROI and EVA has to be done adjustments for uncontrollable factors: One adjustment removes expenses resulting from decisions made by executives above unit level

Incentives for Business Unit Managers

Another adjustment eliminates effects of losses caused by acts of nature and accidents not caused by managers negligence benefits and shortcomings of short-term financial targets: it induces managers to search for different ways to perform existing operations and initiate new activities to meet financial targets It could encourage short-term actions not in longterm interests of the company e.g. equipment undermaintenance

Incentives for Business Unit Managers

managers might not undertake promising long term investments that hurt short-term financial results managers may be motivated to manipulate data to meet current period targets mechanisms to overcome short-term bias: advantage is that supplementing financial measures with additional incentive mechanisms may overcome short-term orientation of annual financial goals, for e.g. multi-year performance can be base for managers bonus

Incentives for Business Unit Managers

there are certain weaknesses in this mechanism: Firstly, managers have difficulty seeing connection between their efforts and rewards in a multilayer award scheme Secondly, if a manager retires or is transferred during multilayer period, implementing such a plan becomes too much complex Thirdly, it is more likely that factors beyond managers control will influence achievement of long-range targets

Incentives for Business Unit Managers

another method is to develop a scorecard having one or more nonfinancial criteria like sales growth, market share, product quality etc., which will affect long-run profits another mechanism to correct short-term bias is to base part of business unit managers bonus on long-term incentive plans, such as stock options, phantom shares etc. benchmarks for comparison: Typical practice is to evaluate a business unit manager against the profit budget

Incentives for Business Unit Managers

Bonus Determination Approach: a bonus award can be determined by using a formula like % of business units operating profit or by purely subjective assessment by superior or by some combination of the two only objective formula use has some merits: reward system can be specified with precision there is little uncertainty on performance standard superiors cannot show any bias demerit is that less attention will be given to the dimensions difficult to quantify like R & D

Incentives for Business Unit Managers

numerical indicators of units performance are less valid measures of managers performance in the following cases: unit manager inherits problems of predecessor unit is highly interdependent with other units and hence, its performance is influenced by decisions and actions of outside individuals strategy requires much greater attention to longterm concerns as in cases of units aggressively building market share

Agency Theory
This theory explains how contracts & incentives can be written to motivate individuals to achieve goal congruence Concepts: in a corporation, shareholders are principals and CEO is their agent at a lower level, CEO is principal and business unit managers are agents incentive contracts can reduce divergent preferences or objectives between principal and agents

Agency Theory
Divergent Objectives of Principals and Agents: this theory assumes that all individuals act in their own self-interest agents are assumed to receive satisfaction from financial compensation and perquisites an agents preference for leisure over work is called work aversion, deliberately withholding work is called shrinking principals are assumed to be interested only in financial returns that accrue from their investment in the firm

Agency Theory
agents are assumed to be risk averse, while owners are risk neutral Nonobservability of Agents Actions: as principal has inadequate information about agents performance, he can never be certain how agents effort contributed to actual results; this situation is termed as information asymmetry agent may know more about task than principal this additional information is private information shareholders are not able to monitor activities of CEO

Agency Theory
moral hazard is a situation, where an agent being controlled is motivated to misrepresent private information by nature of control system Control Mechanisms: there are two major ways of dealing with problem of divergent objectives and asymmetry: Monitoring: principal can design control systems to monitor agents actions, limiting actions that increase agents welfare at expense of principals interest

Agency Theory
agency theory attempts to explain that monitoring is more effective if agents task is well defined and information or signal used is accurate Incentive Contracting: principal should define performance measure to further interest of the agent; this ability to achieve is termed as goal congruence a compensation scheme not incorporating an incentive contract poses problem like CEO not motivated when paid a straight salary as compared to salary plus bonus

Agency Theory
principals face challenge of identifying signals that are correlated with both agent effort and firm value none of incentive arrangements can ensure complete goal congruence due to difference in risk preferences between two parties, asymmetry of information and costs of monitoring CEO compensation and Stock Ownership Plans A company paying bonus in form of stock options to CEO shows example of agency cost like risk preference differences inherent in compensation

Agency Theory
agent may not take on high risk/high return projects found desirable by the principal another problem with stock ownership bonus is lack of direct casual relationship between agents effort and change in stock price in spite of these two problems, stock ownership contract is preferred to a non-incentive contract Unit managers & accounting-based incentives: it is difficult to isolate contributions made by individual business units to changes in the firms stock price

Agency Theory
if bonus is based strictly on net income, however, agents compensation will decrease while a contract based on business unit net income may have lower agency costs than straight salary, these costs do not go down to zero A Critique: this theory has been invented in 1960s, but has had no discernible influence on management control process real-world payoffs have not been seen where managers have benefitted by using this theory

Agency Theory
managers in nonprofit and Governmental organisations, who cannot receive incentive compensation, inherently lack motivation for goal congruence, according to this theory some people believe that models are no more than statements of obvious facts expressed in mathematical symbols other people say that elements in model cant be quantified and model oversimplifies real world relationship between superiors and subordinates theory ignores other factors affecting above relationship