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Chap 12

Chap 12

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Published by: Sachin Mishra on May 19, 2013
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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

bonus can be earned by a manager under both the plans . 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.Characteristics of Incentive Plans • A manager‟s total compensation package consists of three components: salary.

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 .

bonus is equal to percent of profit before taxes and interest on long-term debt.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. 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 .

capital can be equal to shareholder equity  in this option. obtaining comparable data may be difficult . 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.Characteristics of Incentive Plans  in another option.

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. plan may provide for carryover annually of part of amount  this method is more flexible.Characteristics of Incentive Plans • Carryovers:  instead of total amount in bonus pool. 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 .

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 • Long Term Incentive Plans:  growth in the value of company‟s common stock reflects company‟s 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.

whenever they decide to sell the stock however.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. 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. involves uncertainty in both directions about the ultimate amount paid . 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 stock‟s value from time of award until a future date this & previous plan.

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 • CEO‟s 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 .

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  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.

especially in Silicon Valley.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. this could damage innovative spirit in this sector  they are disclosed in foot-notes to the balance sheet . so fewer options will be issued  cash-trapped start-ups. use options to attract human talent.

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

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 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.

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. 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 . manager‟s bonus is tied primarily to corporate performance  in a conglomerate.

net income etc. criteria like contribution margin.Incentives for Business Unit Managers • Performance Criteria:  financial criteria: for a profit center. definition of profit. direct business unit 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 .are used for an investment center.

g. equipment undermaintenance .Incentives for Business Unit Managers Another adjustment eliminates effects of losses caused by “acts of nature” and accidents not caused by manager‟s 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.

multi-year performance can be base for manager‟s bonus . for e.g.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.

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

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

Incentives for Business Unit Managers • Bonus Determination Approach:  a bonus award can be determined by using a formula like % of business unit‟s 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 unit‟s performance are less valid measures of manager‟s 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. CEO is principal and business unit managers are agents  incentive contracts can reduce divergent preferences or objectives between principal and agents . shareholders are principals and CEO is their agent  at a lower level.

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 • 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 agent‟s preference for leisure over work is called work aversion.

while owners are risk neutral • Nonobservability of Agents‟ Actions:  as principal has inadequate information about agent‟s performance. he can never be certain how agent‟s 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  agents are assumed to be risk averse.

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 agent‟s actions. limiting actions that increase agent‟s welfare at expense of principal‟s interest .

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 agency theory attempts to explain that monitoring is more effective if agent‟s task is well defined and information or “signal” used is accurate  Incentive Contracting: principal should define performance measure to further interest of the agent.

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 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.

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 agent‟s 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 firm‟s stock price .

Agency Theory if bonus is based strictly on net income. agent‟s compensation will decrease while a contract based on business unit net income may have lower agency costs than straight salary. 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 . these costs do not go down to zero • A Critique:  this theory has been invented in 1960s. however.

Agency Theory  managers in nonprofit and Governmental organisations. who cannot receive incentive compensation. 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 can‟t be quantified and model oversimplifies real world relationship between superiors and subordinates  theory ignores other factors affecting above relationship . inherently lack motivation for goal congruence.

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