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Expectancy theory reminds us that incemtives work best when

individuals see a strong link between their actions and performance

results. Moving from incentives based on individual performance to
bankwide performance lessens an individual's influence on the
performance measure. Thus, companywide incentives are expected to
be less effective motivators than are incentives based on individual
performance. For ex ample, Honeywell has hundreds of divisions. One
particular division's performance has very little impact on that of the
company as a whole. Thus, Honeywell and many other large
companies base much of a division's manager's compensation on the
performance of that manager's division.

Other considerations make broader performance measures desirable

First, narrowly focused incentives reduce the motivation for broad
cooperation and information sharing. This is true particularly if the
organization uses relative performance evaluation, causing managers to
compete among themselves for rewards. Onganizations are reluctant to
set up disincentives to cooperation and conversion of individual
knowledge into organizational knowledge because these are key
competitive factors.

Second, the development of a valid measure of financial performance

at narrow levels of responsibility is difficult. For example, although the
measurement of operating income for the bank might be casy, the
measurement of each branch's contribution can be more difficult and
the measurement of each individual manager's contrbution to bank
income could be impossible. income could be impossible The problem
is that drivers of both revenues and costs often are higher level
activities, which are not influenced by an individual or a business sub
unit Thus, any attempt to measure individual profit (or the profit of
micro-profi centers -a can be either too restncted to be informative or
mured arbitrary revenue and cost allocations Most companies reward
division managers for both business unit and company wide
performance seeking a balance is appropnate for situations tend to base
Companies that are decentralized and have numerous divisions with
diverse activitieson the performance of the division and less on that of
the company m for example is and diverse company that bases nearly
the a decentralized compensation of its business unit managers on the
performance of each manager temillar another large company, is
untegrated and much more centralized thanITT Caterpillar ties more of
the compensation its bu unit managers to companywide performance
stoves vCB rewards executives based on overall bank performance The
bank also to to create ntives for cooperation by linking some of branch
managers rewards the bank's overall economic performance Because
interactions among branches are minimal, VCB evaluates revenue
growth net asset margin.and retum on assets These provide incentives
to improve undividual branch performance and inject some
competition among branches The trick for VCB is to balance these
incentives so that mana will improve performance of their branches but
have a significant stake in the bank s overall bank finan Consider
thebonuses based on individual branch and overall receives a cial
performance partial that each branch manager com shown in Exhibit
21-6 Note 10 $1,600 bonus based on VCB s overall residual income
performance (row puted as follows:

Curret or Deffered Rewards


based on current performance or later on sustained performance.Current

compenstion rewards can be in the form of cash or stock that can be
cashed immediately or soon after the award.For example, a manager might
be rewarded quickly with a cash bonus if the stock price increases 10
percent by the end of the year or later on a deferred basis if the stock price
increases by an average of 10 percent per year over the next three
years.Thus, the company defers any rewards for the first and second years'
performance until after the third year.These deferred rewards can be cash
or stock as well as stock options.We defer coverage of stock options
rewards to the next section.Current rewards.Current rewards have the
obvious advantage of being closely linked to current performance.Because
uncertainty related to current reward's is low, the high expectancy
associated with current rewards should provide strong motivation to
improve current performance.The disadvantage of current rewards is that
they can induce employees to manipulate the perfomance measures
without concern for future performance or with the expectationof "cashing
out" and leaving the organization.Deferred rewards.Advantages of
deferred rewards based on sustained performance are that good managers
might have incentives to stay with the company (eg goldenhandcuffs') and
(2) managers have incentives to focus attention on long-term
performance.Many commentators argue that managers, particularly in
theUnited States, are too short-term oriented.They take actions now that
look good in the short term butare detrimental in the long term.A good
example is the failure of some com- panies to invest in new
technology.This view of performance keepscamin "myopic" high in the
short term by avoiding write-offs or high depreciation expenses but is
detnmental in the long term.Switching to deferred rewards based on
sustained financial performance can capture the lagged effects of good or
poor nonfinancial performance and avoid disincentives tomakecostly
improvements.A disadvantage of a defemed reward us that managers
might view it as coming too fa in the future to be motivational.Recall from
expectancy theory that the reward should be attractive to be
motivational.Giving a manager a reward in stock to bepaid five years from
now is less attractive than giving a payment at the end of the current year
vcB uses a combination of current and deferred awards for top managers
butpri marily pays current awards for lower-levelmanagers and their
subordinates.When Valle making defemed awardsto executives, the bank
defers the award for three five years.This time appears to be sufficiently
long (l) to capture lagged effects of actions and COMMEROAL (2) to
motivate the managers to think about the future but (3) is not sofar in the
future that incentive cffects or the managers themselves are lost.Salary,
Bonus, or Stock Rewards Most management incentive plans include
multiple forms of reward, including salary bonus, stock.and stock
options.Organizations design the reward package to address the
motivational issues raised earlier within stockholder and taxation
guidelines, and have found that a combination ofrewards ismore
effectivethan a single form of reward Most large organizations have
compensation committees that gn the mir of rewards to reflect the
company'scompensation philosophy.Some organizations stress
salary.others stress performance-based compensation to provide more
mouva tion, For example, VCB statesthe following One ofthe essential
elementi of the Bank's compensation policy is to align the interests of the
CEO.executive officers, and keyemployees with the interests of
stockholden... The total compensat......

Salary.early all manage- ment employees work in ex change for some

salary that is more or less guaranteed.Occasionally, an executive works
without salary, but this usually is in exchange for stock or other deferred
re- wards or is a charitable contri- bution to a nonprofit organi- zation.The
typical salary issues are (1) the level of salary and (2) the proportion of
compensation that is salary versus performance-based re- ward.Salary
levels often are benchmarked with the organi- zation's industry and the
level of responsibility within the organization.Most organiza- tions operate
within industry norms.At extremes, a man ager receives 100 percent of his
compensation from salary, or another manager receives 100 percent of her
compensa- tion based on performance.What difference does the pro-
portion of salary make?

At 100 percent of compensation, a salary insulates an employee from most

nsks so the employee might be inclined to make risky decisions.In reality,
however, such com pensation is more likely to attract employees who are
not inclined to take risk.Furthermore, set salaries can tum away employees
who recognize that their compensa- tion has no upside potential.regardless
of their effon or ability to manage Because most stockholders can diversify
their investments, they prefer that managers take some nsks.but they must
compensate managers for doing so.One way to motivate risk taking is to
shift some compensation from salary and make it depend on performance
that managers' risky decisions can improve, Making all compensation
based on performance might not be desirable, however, because, as
mentioned earlier, this places all ofthe risk on managers.The organization
might at tract only extreme risk takers or those who demand a large stake
in the organization in exchange for the risk they must bear Most
organizations find a balance between guar anteed salary and performance-
based compensation that attracts, retauns.and motivatcs employees to
make good bonuses.Cash bonus awards have the advantage
of being liquid and highly attractive because the reward is immediate and
unconstrained.Companies usually make cash bonus awards based on the
achievement of financial performance object- tives often these bonuses
have a noor or lower threshold of performance (eg a minimum retum on
investment before the employee earns any bonus. Many cash incentives
also have a cciling or anupper threshold beyond which no more bonuses
will be eamed Much interesting research" has focused on the motivational
properties of these plans and the incentives they generate to manipulate
financial measures of performance.

stock awards.Stock awards, in contrast to cash bonuses, might not be

redeemable for cash until some time in the future.Some companies have an
unwntten rule that tnanagers cannot sell company stock until they leave the
firms or retire.Stock awards that cannot be immediately sold, while
perhaps not as attractive as equivalent amount of cash, align the interests
of managers with those of shareholders better than cash awards do.For this
reason, top-executive compensation commonly is composed more heavily
of stock than of cash bonus or salary, Stock might not align managers in
terests, however, as well as stock options do stock options.Stock options,
which give an individual the right to purchase a number of shares at a
specified price o a specified time period, provide strong incentives for
managers to increase stock value over the long run.The use of stock option
rewards has increased dramatically over the past decade.A stock option
has a lower monetary value than a share of stock, so a company can crea
more incentive to increase share prices by awarding stock options simply
awarding the same value and fewer shares of stock.Managers who receive
large awards of stock options have much to gain from in in share
prices.This does not mean that managers lose nothing if the stock price
declines, however because the value of the options decline and managers
suffer the opportunity cost of not in creasing stock value (or earning an
alternative cash bonus Awards of stock op- tions, therefore,have the
motivational impact of stock grants but at a lower cost to the company.
The popular press portrays many executives who have worked for relativ
small salaries to be eager to cash in their stock options after years of work
and relative poverty." Nonetheless, currentestimates are that US executives
hold bil lions of dollars of unexercised stock options, even after the
Internet bubble b 2000-2001. These options continue to align their
incentives with those of stock holders. Although some concern exists that
stock-option awards give managers inentives to manipulate stock prices in
the short run rather than build the company for the long term, most of this
concern appears to be misguided. Although agency heory predicts that
managers will manipulate if the benefits of higher stock prices exceed the
costs of being caught, available evidence from the United States indi cates
a high correspondence between executive wealth aargely from stock
options) and company value.Designing stock option plans to properly
align pay with per can create is complicated, however, and the choice of
the wrong type of plan disincentives, VCB rewards its branch managers
with cash bonuses for meeting revenue growth, et interest margin, and
return asset objectives.Executives earn Vall tions that are exercisable over
a four-year period based on meeting overall residual in come
objectives.The proportions of executive compensation value have
averaged 30 COMMEROA does not extend percent present voB Most of
their significant performance-based compensation to lower level
managers.Most of their compensation is salary and bonus based.
Designing incentive compensation Plans You are a consultant advising
vasey Commercial Bank about componsation plans lower-level managers
and employees.Your intervews with branch and department managers
inform you that they are satisfied with the new balanced scorecard
portormance measurement system (see Ehbt 20-6) but believe that they are
not rewarded for performing wel Nonmanagement employees likewise
enjoy ther jobs but do not believe that theyhave realincent ves to work
harder or better Ar the end of each year most tranch and department
managers and employeos recenve annual salary increases between 4
percent and 6 percent.Branch managers also earn bonuses up to 10 pencont
of their salary for meeting sales growth and return on asset objoctves
Promotons appear to be based on seniority the longer a person is in ajob,
the better the penon's chances for promoton.a.Do the interview responses
signal a potential problem?so, what do you think that vc8 should
do?Solution begins on page 808)

Summary of Valley Commercial Bank's Incentive Plan Review Exhibit

21-3 (p 880), which is the framework of this chapter's discussion of
performance-based incentive plans As mentioned.plan designers should
consider ea clement of this diagram to ensure than the incentive plan
addresses all altemative choices.To sum, VCB seeks to attract mouv and
retain competent employe and to align their interests with shareholders
long-term interests The bank's incen ve plan has the following features
Absolute or relative performance VCB uses both forms of performance
Residual income and environmental performance are compared toabsolute
objectives, evaluations of revenue growth, net interest margin, and return
on assets are based on relative performance 2. Formula based or subjective
performance VCB also uses both fomnula and subjective evaluations
Residual income, net interest margin, and return-on.asset incentives for
branch managers are formula based, but the bank subjectively evaluates
other areas of performance that are important to its balanced scorecard (see
Exhibit 20-6 but are measured less reliably (eg value of employee
suggestions) 3. Financial or nonfinancial performance Asnentioned VCB
uses only financi measures of performance in its formula-based incentive
plans The bank understands the value of its nonfinancial performance for
long-term success, but quality of measurement is an issue If the bank could
reliably measure ke nonfinancial measures from its balanced scorecard(see
You re the Decision 2), it would formally include some of them in its
formula-based Maker incentives Until then, VCB will continue to evaluate
nonfinancial perfomnance subjectively Top candidates for inclusion in the
incentive formula include employee satisfaction, productivity, and
customersatisfaction because they are based on reliable instruments and
can be audited 4. Narrow or broad responsibilir of performance, VCB
evaluates its xecutives on bankwide performance but its branch managers
primarily on branch performance with a relatively small emphasis on
bankwide performance 5. Currenn or deferred rewards VCB executives
receive both current and deferred rewards, lower-level managers receive
mostly cument rewards.6. Salary or bonus rewards All VCB employees
rec a salary but executiv receive most of their compensation from bonus or
stock option rewards Currently lower-level managers receive most
compensation from salaries and ower-level employees receive all
compensation from salaries (see You re theDecision Maker 213

Although VCB has put much effort into designing its incentive plans,
every plan VCB has put much clrort can be improved The bank's board
directors annually reviews it in light developments and changes in
competitive pressures and recommends improvement Cument
recommendations include refining some nonfinancial performance
measures for inclusionthe bank's incentive formulas.The bank's president
and CEO also serves on the boards of directors of several charitable,
nonprofit organizations and has been urging their boards to adopt features
of the incentive plans of VcB and other suc cessful companies.Incentive
Plans in Nonprofit organizations Nonprofit organizations range from
small, informal organizations such as sports clubs, student organizations,
and parent groups supporting sports and music activiues to well-
established organizations such as the Uniled Way the Amercan Red
Cross,most universities, and govemment departmentsand agencies, such as
the US Postal service the Department of Transportation, and the En
ironmental Protection Agency.Many of these nonprofit organizations
apply the concepts in this chapter, with some modifica uons, for the same
that profit-seeking competent employees and to align their interests with
those of the organizations B definition, a nonprofit organization has
something other than eaming a profit asits pri many goal.Thus, effective
nonprofit incentive plans pnmanly should create incentiv for managers to
perform well on nonfinancial dimensions Key Nonfinancial Performance
This focus on nonfinancial performance largely is due to the absence of
prices or ob- jective values for the outputs of nonprofit organizations For
example, although mostagree that helping victims of natural disastersisa
valuable activity, there is not a ready Red Cross services.Indeed, the lack
of fonnal markets market value for American one of the major reasons for
the existence on nonprofit organizations;they fill needs not addressed by
markets.When markets do exist for govemment services, in particu- lar,
increasing pnvatuzation of government activities is occurring Because they
are not seeking to eam profits, nonprofit organizations d not man- age
themselves by the numbers to the same extent as profit companies
do.Whereas a company can evaluate a business unit manager's
performance by measures such as return on inves ment or economic value
added, these comparisons usually are not available or relevant for
nonprofit organizations Although many large charitable or ganizations
publicize financial performance measures such as the percentage of
revenues directly devoted to providing services, most nonprofits do not
and perhaps should not manage themselves primarily by financial n Some
nonprofit organizations operate more by culture or shared values than for
profits do.For example, the parents in a school support organization share
the value of providing support for their children's educational
activities.Likewise, the culture of re ligious organizations binds members
and provides a powerful force for acting to achieve commdn goals None of
this means hat al performance is unimportant al a nonprofit organization,
however Importance of Financial Performance Although nonprofits do not
try to maximize profits, theyhave strong needs to provide services in a
cost-effective manner Nonprofits a compete for scarce funds and

support and must be able to show donors and supporters that their
contributions are being able used effectively Smart Money magazine, for
example, annually analyzes the efficiency o ons.nonprofit's concem value
be similar to that of a profit-seeking firm.organizations must demonstrate
proper accountability for the use of funds and manage their operations and
revenues to en sure that they break even.For example, the US Postal
Service is under a mandate to break even financially and to manage itself
more like a for-profit enterprise.It controls billions of dollars of assets in
buildings, vehicles, and sorting equipment, so management adopted
economic value-added policies to help control its capital costs
Management evaluated its per- formance by applying a cost of capital to
the assets for each responsibility center usingis borrowing rate that
Congress mandated: one-eighth of a percent over the three- month
Treasury Bill rate.With stiff competition from the private sector, such as
United Parcel Service and Federal Express, the US Postal Service also
must concentrate on customer service.To see it and other government
agencies adopt a balanced scorecard with economic value added as one of
the financial measures will not be surprising Increasing the Use of Private-
Sector-Developed Incentive Plans In some voluntary and charitable
organizations, incentive compensation plans rely heavily on
intrinsicrewards Most employees generally earn a lower salary than they
do in the private sector.Furthermore, nonprofits do not offer opportunities
for large fi these voluntary and charitable nancial payoffs for excellent
performance.However, organizations attract people for whom the intrinsic
reward from doing good work compensates for the lost financial
compensation available in the private secto Government agencies also
attract people who obtain intrinsic rewards from the work and or people
who prefer the security and benefit packages that are oftenavailable in
government organizations Despite differences between for-profit and
nonprofit organizations, nonprofit organ izations increasingly use features
of executive incentive plans developed in the private sector.These
organizations also compete for top management talent and must align
exec- utive's interests with those of the organizations.Expectancy and
agency theories do not disappear in nonprofit organizations.The NonProfit
Times reported a recent salary sur which indicated that nonprofits are
faced with greater competition lfor executive talentj with the private sector
that's unparalleled to anything they've seen before.Furthermore, 20 percent
of responding organizations reported awarding performance of bonuses me
nonprofit hospitals offer performance bonuses up to 10 percent based on
cost savings, health care improvements, and other factors.Many
organizations however, decline to develop incentives to retain
management talent only to find that they must pay much more to replace
talent lost to the private sector or more aggressive non profits.Some
nonprofit organizations even have developed stock-option plans to
compete with for-profit firms.How can that be when nonprofits have no
shares to option?Clever compensation consultants have found tax
loopholes that allow nonprofit orga nizations to award options for mutual
fund or corporate shares.One Big-5 consultant stated."The tax-exempt
organization i going to have to compete with taxable corpo- Such plans are
controversial rations for talent, and this gives them more flexibility.
because nonprofits fear tuming off donors who expect their executives not
to be so are skeptieal that awarding optionsin stock concerned with
personal wealth and who are skeptical that awarding options in stock

of for-profit firms can align managers' goals with those of the

nonprofit.Still, stock op tions can be a way to attract and retain
management talent.Incentive plans also can create other difficulties for
nonprofits.For example, Harrisburg Hospital in Pennsylvania lost its
nonprofit, tax-exempt status in part becaase the state's courts ruled that its
executive compensation plan, which gave cash bonuses for return on
equity and revenue performance, clearly was designed to promote the
hospital's bottom line.The court observed that, although incentive plans
were not contrary to the notion of a nonprofit organization, this incentive
plan aligned managers' interests more with eaming profits than providing
charitable bealth care services.The incentive plan was convincing evidence
that the hospital had a strong profit motive.Despite controversy and
difficulties, we expect incentive plans to become more com- mon (but
perhaps more sensitive to the organization's mission) in nonprofit