Chapter 12 Management Compensation

Research Findings on Organizational Incentives

Ppl are more strongly motivated by reward than by fear of punishment (MCS should be reward-oriented A personal reward: relative or situational; $$ compensation is most important to a certain level; non-$ rewards important beyond that level Senior managements signal (through actions) towards MCS influences managers view of MCS Feedback => motivate Longer period between action & feedback = Less effective incentives ; lower level => shorter period Unattainable & too easily attainable incentive = lowest motivation Budget & objective incentive strongest when created together w upper mgmt. (perceived fairness )

Characteristics of Incentive Compensation Plans

3 components of compensation plan (interdependent): 1. Salary 2. Benefits (retirement, health care) 3. Incentive compensation * (short & long-term) Short-term Incentive Plans (3) 1. Total bonus pool - Total amount of bonus paid to qualified group of employees in given year - Formula determined by SHs vote; diff methods: o % x profit ( because have to pay bonus even when profit is low) o % x EPS after a pre-detd EPS has been attained (e.g.) min EPS before bonus: $2.50 bonus formula: 4% after subtracting $2.50 EPS ( because does not take into account increase in investment from reinvested earnings) o % x EPS after a pre-detd EPS (adjusted higher) (Pg. 516) (e.g.) assume 6% required ROR before bonus paid (A) Increase in RE = profit bonus dividends (B) Increase in reqd earnings b4 bonus = (A) x 6% / #shares Adjusted Min EPS = $2.50 + (B) o % x EBIT capital charge of L&SE performance based on employing net asset profitably could use capital charge of SE only loss year reduces SE and increase bonus; big bath o % increase in profitability

reward a mediocre yr following a poor prev yr; does not reward a good year following a better year o % industry (hard to determine) 2. Carryovers - Bonus carryover Advantages: 1. More flexible; payment not determined automatically by formula; BOD can exercise their judgment 2. Can reduce magnitude of the swings that occur when bonus is strictly based on formula (lower volatility) - Disadvantages: relate less directly to current performance 3. Deferred Compensation - Payments of bonus may be spread out over period of years - Advantages: o Cash income in coming year can be estimated w/ reasonable accuracy o Smooth cash receipt o Retired manager continue receiving $ after retirement; tax advantage o Deferred time frame encourage long-term oriented decision - Disadvantages: o Deferred amt not available in the year earned o Bonus not related to performance of current year (less incentive) o Deferred bonus may not vest (N/A if leaves company) golden handcuff: disincentive for mger to leave company Long-term Incentive Plans (5) 1. Stock Options - Right to buy shares @ future date @ specified price - Gives manager equity they can retain (even if they leave company) - Restricted stock mgmt. not permitted to sell for a specified period - Advantages o encourage focus on long-term performance o upside potential attract highly talented employees o motivate innovative ideas o lower salary & bonuses o SO value does not reduce bottom line - Disadvantage: risk of decrease in price, interest costs w/ holding stock 2. Phantom Shares (deferred cash bonus) Awards shares for bookkeeping purposes only @ end of period: award = appreciation in MV of stock since date of award in cash or share; no transaction cost; no risk & interest cost from stock option

3. Stock Appreciation Rights (deferred cash bonus) - Right to receive cash payments based on increase in stock value from time of award until a specified future date

4. 5. -

Same advantage as stock option Performance Shares Awards a specified # of shares to manager when specific long-term goals met E.g. % growth in EPS in 3-5 years; not influenced by price of stock Advantage: Award based on performance that the exec can control Disadvantage: limitation of basing bonus on EPS; higher EPS might not mean higher economic worth Performance Units Cash bonus paid when long-term goals are met Combines aspects of stock appreciation & performance shares Useful in non-public traded companies

Incentives for Corporate Officers

CEO compensation - Detd after CEO presents recommendations for subordinates compensation - Align BOD & SH interest: o Prevent directors from selling their stock for duration of their term to encourage them to ask touch question of CEO without fear of adverse impact on ST stock price o Set mandatory limits on the tenure of directors to avoid their becoming too entrenched with mgmt o Hold annual performance review of directors o Avoid having CEO act as the chairman of board o Account for stock options as an expense *** Support expensing SO: 75% CEO & top mgmt. compensation represent SO therefore should be expensed like the other 25% salary More accurate earnings picture = higher investor confidence Firms feel that SOs are free, hence they overreward CEOs with options; but options dilute shares and have real costs Double standards (expense diff btwn issue & X price for tax purposes, but not for financial reporting purposes) Against expensing SO: Do not involve outlay of cash; should not reduce earnings Hard to value; involves assumptions & est (low reliability, sub to manipulation) Lower earnings, reduce stock price Cash-strapped startups use options to attract human talent; expensing discourages using SOs Disclosed in footnotes to B.S.

Incentives for BU Managers

1. Types of Incentives i. Financial: 1) salary, 2) bonus, 3) benefits, 4) perquisites ii. Psychological & Social: 1) promotion possibilities; 2) increased responsibilities; 3) increased autonomy; 4) better geo location; 5) recognition 2. Size of Bonus Relative to Salary - Fixed pay: compensation not linked to performance (conservatism) - Performance-based: pay well if performance is good (max. effort) - Cutoff Levels o Upper cutoff lvl of performance @ which a max bonus is reached o Lower cutoff lvl below which no bonus is awarded mgmt. may decreased/delay rev recognition (smoothing) can mitigate this w/ carryover 3. Bonus Basis i. BU profits (conglomerate; autonomous BUs) ii. Company profits (single industry firm/integrated, interdependent) iii. Combination of both (related diversified firms) 4. Performance Criteria i. Financial - Profit center: CM; BU profit; controllable profit; IBT; NI - Investment center: def of profit; def of investment; choice btwn ROI & EVA - Revenue center: sales volume; sales dollars - *Adj for uncontrollable factors: o Remove expense from higher lvl exec o Eliminate losses caused by acts of nature ii. Time period - Annual financial performance o Motivate mgmt. to meet target o Encourage ST actions not LT interest o Give up LT investment for ST result o Manipulate data to meet current target - Multiyear financial performance o Extend time horizon of mgers o Lack of link between effort and reward o Retirement complicates things o LT targets beyond mgmt. control iii. Non-financial - Balanced scorecard (sales growth; market share; customer satisfaction; product quality; new product development; personnel development; public responsibility) iv. Relative weights assigned to financial & non-financial - (see ST & LT Incentive Plans above)

Benchmarks for comparison 1. BU mger participates in dev of profit budget 2. Budge is challenging but attainable 5. Bonus Determination Approach 1. Formula based - Advantage: Precise; not biased - Disadvantage: less attention to performance of unquantifiable activities (R&D; HRM); sub to est. - When mgmt. control lvl is low, # indicator is less valid for mgers performance measurement: o When BU mger inherits problem created by predecessor o BU highly interdependent with other BU; decision influenced by outside individuals o Strategy requires greater attention to LT concerns 2. Subjective 3. Combination of both 6. Form of Bonus Payment (Cash; Stock; SO; Phatm shr; perf shr)

v.

Agency Theory
Explores how contracts and incentive can be written to motivate individuals to achieve goal congruence Agency relationship exist when principal hires agent (e.g. SH hires CEO) Goal: reduce divergent preferences; (work hard vs. shirk; 401 =_=) Agents: risk & effort adverse Owner: risk neutral Non-observability of agents action: info asymmetry; private information; moral hazard

Control Mechanism 1. Monitoring a. Audited FS b. Effective if agents task is well defined; accurate information 2. Incentive a. Incentive Contracting (link compensation & performance) - Residual loss: resulting divergence of preference - Agency cost: incentive cost, monitoring cost & residual loss - E.g. CEO stock option plan
o o Higher risk = higher incentive compensation = higher cost Lack of direct causal relationship btwn effort & shr price

b. BU manager & accounting based incentives - This is more remote than CEO effort & stock price - Can be based on BU net income - Lower agency cost