CHAPTER 17

EXECUTIVE PERFORMANCE MEASURES

AND COMPENSATION

Recruiting, motivating, rewarding and retaining effective managers are critical to

the success of all firms. An important and integral part of the determination of a

strategie competitive advantage of a firm is an effective management

compensation plan.

Objectives of Management Compensation

The firm's key objective is to develop management compensation plans that

support its strategic objectives, as set forth by management and the owners. The

objectives of management compensation are therefore consistent with the three

objectives of management control:

1. To motivate managers to exert a high level of effort to achieve the goals

set by top management.

2. To provide the incentive for managers, acting autonomously, to make

decisions consistent with the goals set by top management.

3. To determine fairly the rewards earned by managers for their effort and

skill and the effectiveness of their decision making.

Executive Performance Measures and Compensation

Studies show that division manager's compensation arrangements include a mix

of salary, bonuses and long-term compensation tied to earnings and stock price of

the company such as stock options and noncash compensation. The goal of such

compensation arrangements is to balance division and company wide incentives,

as well as short-term and long-term incentives.

One survey of companies reported the average annual incentive component of

(1) Average annual cash and stock compensation based on long-run

performance equal to 57% of current salary, and

(2) Bonuses based on short-run performance equal to 40% of current salary.

Executive Performance Measures and Compensation 585

These percentages vary widely over the sample, some firms use stronger

prorformance incentives than others.

Cash Compensation

Cash compensation includes salaries and bonuses. A company may reward good

managerial performance by granting periodic raises. Salary raises, once affected,

are however usually permanent while bonuses give a company more flexibility.

Many companies use a combination of salary and bonus to reward performance by

keeping salaries fairly level and allowing bonuses to fluctuate with reported

income. Of course, income-based compensation can encourage dysfunctional

behavior such as the manager may engage in unethical practices like

(1) Postponing needed maintenance, or

(2) Postponing revenue recognition at the end of the year in which maximum

bonus has already been achieved to the next year.

Noneesh Compensation

Noncash compensation is also important. Some managers may trade off increases

in salary for improvement in title, office location and trappings, use of expense

accounts or use of corporate country club facilities and so forth. Autonomy in the

conduct of their daily business can also make the manager efficient and an

important perquisite (a type of fringe benefit over and above salary).

Stock options which give executives the right to buy company stock at a specified
price (usually lower than market price) within a specified period, are often used to

motivate executives to improve the company's long-run performance to increase

the stock price.

Designers of executive or manager's compensation plans emphasize three factors:

(1) achievement of organization goals,

(2) ease of administering the plans, and

(3) ensuring that affected executives perceive the plan.

586 Chapter 17

Bonus Plans

As stated earlier, bonus compensation is the fastest growing element of total

compensation and often the largest part. A wide variety of bonus pay plans can be

categorized according to the three key aspects:

The base of the compensation, that is, how the bonus pay is determined.

The three most common bases are (1) stock price, (2) cost, revenue, profit

or investment unit-based performance, and (3) the balanced Scorecard.

Compensation pools, that is, the source from which the bonus pay is

funded. The two most common compensation pools are earnings in the

manager's own unit and a firmwide pool based on the firm's total earnings

Payment options, that is, how the bonus is to be awarded. The two

common options are cash and stock (typically ordinary shares). The cash

or stock can either be awarded currently or deferred to future years. Stock

can either be awarded directly or granted in the form of stock options.

Bases for Bonus Compensation

as outlined in Figure 17-1.

Figure 17-1: Advantages and Disadvantages of Different Bonus

Compensation Bases Relative to Compensation Objectives

Motivation

Right Decision

Fairness

Stock price

(+) Consistent with

shareholders' interests.

(-) Lack of

controllability:

(+/-) Depends on

whether stock and

stock options are

included in base pay

and bonus

(+) aligns management

compensation with

shareholder interests

(+) Strongly motivating

if noncontrollable

factors are excluded

Strategic

performance
measures

(cost, revenus,

profit, and

investment

units)

(+) Generally a good

measure of economic

performance

(-) Typically has only a

short-term focus

(+) Intuitive, clear, and

easily understood

(-) Measurement

issues: differences in

accounting

conventions, cost

allocation methods

Balanand

secard

critical

SUS$

Executive Performance Measures and Compensation 587

(-) If bonus is very high, financing methods, and

creates an incentive for so on

inaccurate reporting
(+) Strongly motivating (*) Consistent with () if carefully defined

If noncontrollable

management's strategy and measured, critical

factors are excluded (-) Can be subject to success factors are

(+) aligns management Inaccurate reporting of likely to be perceived

compensation with nonfinancial factors

shareholder interests

Potential

measurement issues,

as above

as fair

factors)

Key: (*) means the base has a positive effect on the objective

(-) means the base has a negative effect on the objective.

Bonus Compensation Pools

A unir-based pool is a basis for determining a bonus according to the performance

of the manager's unit.

A firmwide pool is a basis for determining the bonus available to all managers

through an amount set aside for this purpose.

Figure 17-2 summarizes the advantages and disadvantages of each approach to

bonus pools.

Figure 17-2: Advantages and Disadvantages of Different

Bonus Pools Relative to Compensation Objectives

Fairness

Motivation
Unit based

Right Decision

(-) Provides the

incentive for individual

managers not to

cooperate with and

support other units

when needed for the

good of the firm.

(-) Does not separate

the performance of the

unit from the manager's

performance

(+) Strong motivation

for an effective

manager - the upside

potential

(4) Unmotivating for

manager for

economically weaker

units

588 Chapter 17

Firmwide

(+) Helps to attract and

retain good managers

even in economically

weaker units

(-) Not as strongly

motivating as the unit-

based pool

(+) Effort for the good

of the overall firm is

rewarded -motivates

teamwork and sharing

of assets among units

(+) Separates the

performance of the

manager from that of

the unit

(+) Can appear to be

fairer to shareholders

and others who are

concerned that

executive pay is too

high

Key: (+) means the pool has a positive effect on the objective.

(-) means the pool has a negative effect on the objective.

Bonus Payment Options

The four most common payment options are:

the most common bonus form.

Deferred bonus (cash and/or stock) earned currently but not paid for two or more

years. Deferred plans are used to avoid or delay taxes or to affect the manager's

future total income stream in some desired way. This type of plan can also be used

to retain key managers because the deferred compensation is paid only if the

manager stays with the firm.

Stock options confer the right to purchase stock at some future date at a

predetermined price. They are used to motivate managers to increase stock price

for the benefit of the shareholders. When exercised, stock options also have the

positive effect of increasing the executive's ownership in the firm, thereby further

increasing the executive's alignment with shareholder interests. For this reason,

many firms require executives to own a significant amount of stock in the

company.

Performance shares grant stock for achieving certain performance goals over two

years or more.

The advantages and disadvantages of the four plans are shown in Figure 17-3.

Executive Performance Measures and Compensation

589

Figure 17-3: Advantages and Disadvantages of Bonus Payment

Options Relative to Compensation Objectives

Motivation

Right Decision

Fairness

Current bonus
(+) Strong motivation

for current

performance; stronger

motivation than for

deferred plans

(-) Short-term focus

(-) Risk-averse

manager avoids risky

but potentially

beneficial projects

Same as for current

bonus

(+/-) Depends on the

clarity of the bonus

arrangement and the

consistency with which

it is applied

Same as for current

bonus

Deferred bonus (+) Strong motivation

for current

performance, but not as

strong as for the

current bonus plan

since the reward is

Stock options (+) Unlimited upside

potential is highly

motivating

(-) Delay and

uncertainty in reward

reduces motivation

(+) Incentive to

consider longer-term

issues

(+) Provides better risk

incentives than for

current or deferred

bonus plans

(+) Consistent with

shareholder interests

-) Uncontrollable

factors affect stock

price

Also, same as for

current bonus

Performance

shares

Same as for stock

options
(+ -) Depends on the

clarity of the bonus

arrangements and the

consistency with which

it is applied

(+) Incentive to

consider long-term

factors that affect stock

price

(+) Consistent with the

firm's strategy, when

critical success factors

are used

(+) Consistent with

shareholder interests

when earnings per

share is used

Key: (+) means the payment option has a positive effect.

(-) means the payment option has a negative effect.

590

Chapter 17

Performance Measures at the Individual Activity Level

When evaluating performance at the individual activity level two issues are

involved:

First: Designing performance measures of activities that require

Second: Designing performance measures for activities done in teams.

Performing Tasks

It is a common business practice that employers want their employees to allocate

their time and effort intelligently among the various tasks or aspects of their jobs.

For example, marketing representative sell products, provide customer support and

gather market information. Production works are responsible for both the quantity

and quality of their output.

The performance measurement should measure the different aspects of an

employee's job and to balance incentives so that all aspects are properly

emphasized.

Team-based Compensation Arrangements

Pooling of talents of employees with multiple skills, knowledge, experiences and

judgments can resolve many businesses problems, be they manufacturing,

marketing and design-related. A team accomplishes better securities than

individual employees acting alone. Business establishments reward individuals or

a team on the basis of team performance such as achieving regional sales target by

the regional team. Such team-based incentives encourage individuals to help one

another as they strive toward a common goal. To encourage development of team

skills, some companies use a checklist of team skills, such as communication and

willingness to help. The desirability of team-based compensation depends, to a

great extent, on the culture and management style of a particular organization.

Some criticisms on team-based compensation are

(1) Incentives for individual employees to excel are diminished, harming

overall performance, and

success nevertheless share in the team's rewards thereby dampening the

interest and morale of the good performers.

Executive Performance Measures and Compensation 591

Team-based incentive compensation encourages employees to work together to

achieve common goals.

Individual-based incentive compensation rewards

employees for their own performance, consistent with responsibility accounting

A mix of both types of incentives encourages employees to maximize their own

performance while working together in the best interest of the company as a whole.

Environmental and Ethical Responsibilities

As companies try to achieve the performance goals of their organizations,

managers should be aware constantly of their environmental and ethical

responsibilities. Illegal practices (such as bribery and corruption) and

environmental pollutions (such as water and air pollution) carry heavy fines and

are prison offense under the laws of many countries. Business ethics pi-sent

difficulties in a single-country context, but they pose more problems in a global

context.

Ethical behavior on the part of managers is paramount. They should not be tainted

by "creative accounting resulting to overstatement of assets, understatement of

liabilities, fictitious revenues and understatement of costs.

Additionally, management should promptly and severely reprimand unethical

conduct irrespective of the benefits that might accrue to the company from such

action.

A strong underlying system is important for enforcing contracts and provides the
basis for confidence in ethical dealings. Other ethical problems with bribes and

differing business laws exist. US companies that contract with overseas firms may

find themselves the target of unfavorable publicity on use of child labor. The

stories of bribery of Middle Eastern officials are legendary. In some countries,

these bribes are a necessary part of doing business. Insider trading is not against

the law in Europe and it is definitely illegal in the US.

Socially responsible companies set very strict environmental goals and measure

and report their performance against them. For example, a company makes

environmental performance a line item on every employee's salary appraisal

report. Another company appraises employees on their part in reducing solid

Waste, outing emissions and discharges and implementing environmental

problems.