Week 8: Performance Measurement

and Reward Systems

Topic objectives

• Explain the key attributes when designing a reward system

• Differentiate between intrinsic and extrinsic rewards in
performance based incentives
• Explain the advantages and limitations of different forms of
rewards i.e. cash and equity
• Explain the different types of performance measures and
targets used to motivate and reward performance

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Topic objectives cont.

• Outline the key components of reward systems to help monitor

and control performance across different hierarchies
– Corporate
– Strategic
– Business Unit
– Responsibility Centre
– Managerial
– Individual
• Calculate bonus system distribution in an annual shared bonus
pool system

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Designing Incentives and reward systems design

1. Who should incentives apply to

– senior executives, divisional and unit managers, line managers, others?
2. What performance measures will be used
o i.e. single financial measure or some combination of measures (objective v subjective)
3. Should performance be measured at the individual, divisional, unit,
corporate level or some combination thereof
– if a combination of performance is used, what weightings?
– i.e. senior executives weighted more on corporate than individual performance?
4. How to align incentivised performance with corporate goals
o links to strategy? reflect managerial control and responsibility?
o What about relative performance evaluation (ranked employee performance)?

5. Distinction between short-term and longer-term incentives

– what proportion of total rewards should relate to short-term versus long-term?

6. What targets will be set?

Performance-based incentives
• What are performance-based incentives?
– Additional rewards or payments over and above base salary
– Attached to goal achievement
– Expected to motivate performance
– Hold the manager accountable for the resources they are responsible for
• Performance measures can take a number of forms:
– Financial/non-financial
– Short-term/long-term
– Internal/external
– Flexible/inflexible
– Subjective/objective
• Choice between these forms depends on:
– Strategy
– Ability to determine input / output relations
– Span of control of employee

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Span of accountability: design and measures

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Which manager has the broader span of control?
How can you tell?
Performance Weighting Manager A Manager B

Corporate 10% 50%

Business Unit 30% 40%

Individual 60% 10%

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Performance-based incentives
• Incentives can take the following forms:
– Intrinsic
o Self-motivation, job satisfaction etc
o People believe goals are legitimate and are committed to achieving them
– Extrinsic
o Formal incentives which include cash, gifts, shares, share options etc.

• Ideal systems should consider the desired ‘risk appetite’

– The amount of risk the organisation is willing to bear
– The level of capital senior managers place ‘at risk’

• Strategic intent of reward system design

– Must understand the strategic intent of an incentive system design
– Are controls required to stabilise management activity or to enable
innovation?
– MAS design for directional or motivational purposes?

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Performance measures & incentives

• Ideally, performance measures should be:

– Objective
o Independently measured and verified
o But….are tasks that require conceptual, creative thinking able to
be objectively measured?
– Complete
o Capture all relevant attributes of achievement
o But ….are relevant attributes always known ex ante

– Responsive
o Reflect actions that managers can directly influence
o Incentive payments rise and fall depending on performance
o But …how ‘responsive’ are CEO performance measures really?

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Performance measurement and targets

• Are measures directional? i.e. activities to be performed

• Are targets motivational? i.e. operate as a carrot or a stick?

Factor to be measured Possible performance target

Direct materials cost Budgeted/standard direct materials cost

Customer satisfaction Average customer satisfaction rating of 5

Defect rates No more than 1/1000 defects

Assignment completion Satisfactory completion

Market share 10% increase from previous period

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Directional influences of reward systems

Performance measures and targets

• Communicate the aspects of performance that are most
important
– i.e. Key Success Factors

• Focus attention towards specific tasks/activities

• Limit attention to specific tasks/activities

– Remember the use of responsibility accounting and responsibility
centres

• Provide feedback for modifying future performance

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Directional influence of reward systems

Attaching rewards to performance measures

• Provides a signal about the relative importance of each

performance measure and its underlying behaviours

• Therefore rewards provide further information to encourage

individuals to;
– Communicate aspects of performance that are most important

– Focus attention towards specific tasks/activities

– Limit attention to specific tasks/activities

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Motivational influence of reward systems

• Performance measures can motivate managers to perform

well when targets for performance are attached to these
measures

• Role of Performance Targets

– To encourage individuals to set work goals

• Performance tends to be higher when work goals are set,

compared to when individuals have no set goals
– As long as goals are perceived as;
o Clearly understood

o Challenging but achievable

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Motivational influence of reward systems

• The Carrot. Attaching rewards to performance measures

may motivate individuals to work towards achieving
performance targets

– Rewards add value to performance target achievement

• But … The Stick. attaching rewards to performance may
create expectations of future rewards
– If these expectations are not continuously met, motivation
may decline
– Rewards may have a negative impact on motivation over
time

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Corporate financial performance-based incentives

Source: Productivity Commission Report 2009, p190

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Compensation for different management levels

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Controllable financial measures – ideal?

Responsibility Traditional Performance

Centre* Measurement
Profit Centre/Manager Controllable Profit

Engineered Cost centre/Manager

Controllable Costs
Discretionary Cost Controllable Costs to a limited
centre/Manager extent
Revenue Centre Controllable Revenues
Controllable Investment
Investment centre/Manager
(measured using ROI or RI**

* Responsibility Centres were discussed in Topic 2

** Residual Income (RI) and ROI measures were discussed in Topic 3
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What about adjusting accountability to include
uncontrollable factors?

Being able to influence other and engage the support of others will foster innovation
Entrepreneurial Activities: Silo Management

Entrepreneurs are individuals who pursue opportunities (either on their own

or inside organisations) without regard to the resources they control
By holding managers accountable for more than they control, a company
can encourage entrepreneurial behaviour
Balance and tradeoffs: breaking down silos
Calculating Bonuses: Check List

1. Bonus Pool Size

– How large/small? – i.e. a % of corporate earnings
2. Allocation formula
– Level of work unit performance
o Individual; Plant; Group; Corporate
o May depend on span of control and interdependencies
o Extent of interdependencies can be used to determine weightings
– Level of Achievement
o 90%; 100%; 110% - sliding scale???
o How much bonus should be received for different levels of
performance achievement?

3. The type and mix of incentives

Example: Waltons Home Builders incentive plan

Waltons Home Builders’ corporate head office is located in Melbourne.

They have State Managers overseeing 43 Local offices around Australia.
A cash-based incentive plan is attached to improvements in ROI.

Calculations
Bonus pool size : $400 000 + 10% of corporate profits in excess of $22 million
Bonus pool divided: Local Managers (65%); State Managers (15%); Corporate
(20%)
The bonus pool will be divided among the Local Managers on the basis of the
number of bonus units awarded:
5% annual ROI = one bonus unit;
> 5% = one bonus unit per 1% increase (to a maximum of 6 bonus units)
The monetary value of a bonus unit is found by dividing the total dollar amount in the
local office pool by the total number of bonus units earned by all local managers.
 Waltons Home Builders incentive plan cont.

Waltons earned a profit before tax of $22.5million.

REQUIRED
a) Calculate the size of the bonus pool for Local Office Managers
b) Calculate the bonus each Local Office Manager would receive
Size of the bonus pool =
ROI No. of Bonus Bonus Bonus size
Achieved offices Units Units Total
4% 3
5% 10
6% 12
8% 14
12% 4

Total bonus units =

Each bonus unit =
Waltons Home Builders incentive plan cont.

Summary:
• Bonus pool total: $400,000 plus 10% x 500,000
• Total pool shared among: head office (20%); state
managers (15%); and, 43 local managers (65%)
• For local managers: 65% of the total bonus pool is on
100% individual ‘local’ work unit performance
– i.e. 100% Local; 0% State; 0% Waltons overall performance
• Type and mix of incentives - bonus is entirely cash
– no long-term equity or other incentives
• Measure to achieve performance bonus: ROI
• Discuss the issues you find with this case
Changing behaviour with reward systems

• James Anderson is a very experienced manager of a sales

department, which is treated as a profit centre
• James’ performance is evaluated based solely on his ability to
enhance quarterly department profit
• James receives a substantial quarterly bonus based on whether
he meets his profit target each quarter
• His profit target for this quarter is $400,000
• Actual profit was $410,000 – James received his bonus!!
Required:
• Comment on James performance?
• What reward system would you recommend to senior
management to encourage goal congruent behaviour?
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