6.

Incentive Compensation Systems

Outline
1. Philosophies on incentive compensation
2. Purpose of incentives
3. Forms of rewards/punishments
4. Key elements of incentives
5. Bonus determination approach
6. Criteria for evaluating reward systems
7. The truth inducing incentive model

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 Financial results controls
n Three core elements:
– Financial responsibility centers
§ The apportioning of accountability for financial results
within the organization

– Formal management processes

§ Planning & budgeting to define performance expectations
and standards for evaluating performance

– Motivational contracts
§ To define the links between financial results and various
organizational incentives

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Two philosophies on incentive compensation

Fixed Pay

Recruit good people

Pay them well

Expect good performance

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Two philosophies on incentive compensation

Performance-Based Pay

Recruit good people

Expect good performance

Pay them well if performance

is actually good

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 Purpose of incentives
n Motivation
– Motivation has two elements:
§ Inducing effort: getting employees to work hard

– Employees typically put forth more (less) effort on

activities that are (not) rewarded.

§ Directing effort: helping employees understand

what is expected of them
– Rewards attract the employees’ attention and inform
them of the relative importance of often-competing
results areas.

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 Purpose of incentives
n Attraction/retention

– Paying employees only guaranteed salaries tends to attract

risk-averse employees.

– Paying performance-dependent compensation tends to attract

employees who are more risk tolerant, more aggressive,
more confident in their abilities.

– e.g., stock option plans often are geared towards employee

retention; they provide a form of “golden handcuffs”.

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Purpose of incentives (Continued)
n Non-control purposes
§ Provide a competitive compensation
package

§ Make compensation variable with

firm performance

§ Tax considerations

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 Positive and negative
incentives
n Positive incentives “rewards”
§ Things employees value

n Negative incentives “punishments”

§ Things employees like to avoid

n Individuals tend to be more strongly motivated

by the potential of earning rewards than by the
fear of punishment.

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Forms of rewards and punishments
! Punishments: n Rewards:
– Monetary: – Monetary:
§ Salary increases
» Zero salary increase § Bonuses
» Zero bonus § Benefits
» Zero perquisites § Perquisites
– Non-monetary: – Club memberships
– Vacation trips
» Interference in job
from superiors – Non-monetary:
§ Promotion
» Loss of job
§ Autonomy
» Assignment to
§ Recognition
unimportant tasks
§ Participation in decisions
» No promotion
§ Office assignments
» Humiliation § Preferred parking places
§ Titles

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 The compensation package
n Salary

n Benefits
– Pension and health benefits
– Perquisites of various types

n Incentive compensation
– Short-term incentive plans
§ Based on the performance in the current year or less
– Long-term incentive plans
§ Based on the performance measured over periods greater
than one year and often related to the company’s stock price.

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 Short-term incentive plans
n Based on performance in the current year or less
§ e.g., bonuses, commissions, piece-rate payments

n Calculation (by formula) of short-term incentives

§ e.g., 2% of sales; 10% of net profits
§ e.g., 20% of over-target performance
§ e.g., 50% of “target bonus” at 80% of target;
100% of “target bonus” at 100% of target;
(where target bonus = 30% of salary).

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 Formula-based short-term incentives

Bonus
100% bonus at 100% target

30,000

20,000
50% bonus at 80% target
10,000

50 80 100 150
Percentage of budget Achievement

Annual Salary: $100,000; Target Bonus 30%: $30,000

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 Long-term incentive plans
n Based on the performance measured over periods
greater than one year.

§ Usually restricted to relatively high management levels

§ Accounting performance (e.g. EPS, ROE, ROA)
over a period of three to five years

§ Market-based performance
– Stock options
– Stock appreciation rights

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Key incentive design elements
! Level of measurement (performance at the
individual, entity, or company level)

! Proportion of awards (i.e. leverage vs. fixed pay)

! Shape of the performance-reward function

! Use of “subjectivity”

! Type and number of measures (financial vs.

nonfinancial; bottom-line vs. basket of measures)

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 Group rewards
n Team-based rewards are often used to
implement personnel/cultural controls.
– Group members monitor and sanction each others’ behaviors.

n They rarely provide a direct incentive effect.

– Stock-based plans, for instance, provide direct incentives only for a
small number of managers at the very top of the organization.

– Hence, for lower-level employees, compensation is made more

volatile, but their motivation is not (greatly) affected.

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 Proportion of variable pay
n Employees are risk averse

§ Performance-dependent rewards impose risk on the

employees as performance is never fully controllable.

§ Across firms, differences in the proportion of bonus

payments are greater than differences in base pay.

§ The bonus proportions of compensation generally

decrease at lower organization levels.

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 Shape of reward function
n Mostly, the link between rewards and results is linear, but
over a restricted performance range only

MAX
Rewards ($)

ZERO
LOW 80% of 100% of 150% of HIGH
budget budget budget
target target target
Results (profit)
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 Cutoffs
n Lower cutoff
– To avoid paying bonuses for performance which is considered
“mediocre” or worse.

n Upper cutoff
– To maintain vertical compensation equity.
– To keep total compensation somewhat consistent over
time so that managers are able to sustain their lifestyle.
– To avoid that managers will be unduly motivated to take actions to
increase profits at the expense of the long term.
– To avoid “undeserved“ bonuses due to a windfall gain.
– Fear of a faulty compensation plan design.

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Bonus determination approach
n Strict formula
§ Rewards can be specified with precision.
§ There is little uncertainty or ambiguity about
performance standards.
§ Superiors cannot exercise any bias or favoritism
in assessing the performance of subordinates.
but
§ Less attention for performance dimensions
which are more difficult to quantify (e.g. R&D).

n Subjective assessment
§ Especially desirable when the manager’s personal
control over the business unit’s performance is low.
§ Lack of explicitness increases the employee's risk.

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Criteria for evaluating reward systems
n Rewards should be valued
§ Rewards that have no value do not provide motivation.
§ Reward tastes vary across individuals and are situational.

n Rewards should be large enough to have impact

§ Reward “visibility” can affect impact.

n Rewards should be understandable

§ What is the reason for earning the reward?
§ What is the value of the reward?

n Rewards should be timely

§ The discount rate employees apply to delayed rewards
seems to be far greater than the time value of money.

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 Criteria for evaluating reward
systems (Continued)
n Rewards should be durable
§ Rewards have greater value if the good feelings generated
by the granting of a reward are long-lasting, i.e., if employees
remember them.

n Rewards should be reversible

§ To be able to correct mistakes of performance evaluations;
§ Promotions, for instance, are difficult to reverse.

n Rewards should be cost efficient

§ To stimulate the desired motivation at minimal cost.

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•The Truth Inducing Incentive Model*
•To motivate people to “reveal” their private information
truthfully in the process of target setting
•To work hard to meet or exceed the budget
•To provide penalties for managers who set over
optimistic budgets.

* Chow, Cooper and Waller, (1988), Participative budgeting: Effects of a truth-inducing pay scheme and information
asymmetry on slack and performance, The Accounting Review, Vol. 63, No. 1, pp. 111-122.

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1. B = B0 + b Yh + a (Y - Yh) if Y >= Yh
or
2. B = B0 + b Yh - c (Yh - Y) if Y < Yh
where,
B = Actual bonus paid
B0 = Basic bonus
Yh = Budgeted output
Y = Actual output
0 < a < b < c = Incentive parameters

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Example:
B0 =70; a=0.2 b=0.4 c=0.5
B= 70 + 0.4Yh + 0.2 (Y-Yh) for Y >= Yh
or
B= 70 + 0.4Yh - 0.5 (Yh -Y) for Y < Yh

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Actual output Budgeted output
50 60 70 80 90 100
50
60
70
80
90
100
n Budgeted output = 60; Actual output: 50; 60; 70.

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n Groupexercise of the truth inducing
model:
– What is the total bonus based on the
following information:
§ Budgeted profit: $100,000;
§ Fixed salary: $15,000.
§ Incentive parameters: a=0.04; b=0.05; c=0.08.
§ A) Actual profit: $125,000.
§ B) What if the actual profit: $75,000

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n Groupdiscussions of the truth inducing
model:
– Two periods model: Concerns?
– What if the objective is to penalize any
deviation from the budget.
§ Original model:
1. B = B0 + b Yh + a (Y - Yh) if Y >= Yh
or
2. B = B0 + b Yh - c (Yh - Y) if Y < Yh

- How to change the original model to a slack inducing

model

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