Management
Compensation
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Management Compensation
Every organization has
goal. An important role of
management control
systems is to motivate
organizational members
to attain those goals
Research Findings on
Organizational Incentives
Research on incentives tends to support the
following :
• Individuals tend to be more strongly motivated by the
potential of earning rewards that by fear of punishment.
• A personal reward is relative or situational
• Individuals are highly motivated when they receive
reports or feedback about their performance
• Incentives become less effective as the period between
an action and feedback on it increases.
• Motivation is weakest when the person believes an
incentive is either unattainable or too easily attainable
• The incentive that a budget or other statement of
objective provides is strongest when managers work
with their superiors to arrive at the budgeted amounts
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Characteristics of Incentive
Compensation Plans
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A manager’s total compensation package consists of
three components :
1. Salary
2. Benefits (principally retirement and health care)
3. Incentive compensation
• The three components are interdependent, but the third is
related specifically to the management compensation
• Incentive compensation plans can be divided into short
term and long term plans.
• Short term incentive plans are based on performance in
the current year.
• Long term plans tie compensation to longer term
accomplishments and are related to the price of the
company’s common stock.
Characteristics of Incentive
Compensation Plans
Short Term Incentive Plans
a. The Total Bonus Pool
• The total amount of bonus that can be paid
to qualified group of employees in a given
year is called the “bonus pool”
• There are several ways to establish the
bonus pool :
a. The bonus equal to a set percentage of the
profits
b. The bonus on a percentage of earnings per
share has been attained.
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Research Findings on
Organizational Incentives
Short Term Incentive Plans
b. Deferred Compensation
• Although the amount of the bonus is calculated
annually, payments to recipients may be spread out
over a period of years.
• This deferred payment method offers the following
advantages :
a. Managers can estimate their cash income for the
coming year.
b. Deferred payments smooth the manager’s receipt of
cash.
c. A manager who retires will continue to receive
payments for a number of years.
d. The deferred time frame encourages decision makers
to think long term.
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Research Findings on
Organizational Incentives
Short Term Incentive Plans
b. Deferred Compensation
• Although the amount of the bonus is calculated
annually, payments to recipients may be spread out
over a period of years.
• This deferred payment method offers the following
advantages :
a. Managers can estimate their cash income for the
coming year.
b. Deferred payments smooth the manager’s receipt of
cash.
c. A manager who retires will continue to receive
payments for a number of years.
d. The deferred time frame encourages decision makers
to think long term.
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Characteristics of Incentive
Compensation Plans
Long Term Incentive Plans
A basic premise of many long term
incentive plans is that growth in the value
of the company’s common stock reflects
the company’s long run performance.
a. Stock Options
• The major motivational benefit of stock
option plans is that they direct manager’s
energies toward the long term, as well as
the short term, performance of the
company.
• Managers are not permitted to sell this
stock for a specified period after it was
acquired.
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Characteristics of Incentive
Compensation Plans
Long Term Incentive Plans
b. Phantom Shares
• A phantom stock plan awards managers a number of
shares for bookkeeping purposes only.
• At the end of a specified period, the executive is
entitled to receive an award equal to the appreciation
in the market value of the stock since the date of award
c. Phantom Shares
• A stock appreciation right is a right to receive cash
payments based on the increase in the stock’s value
from the time of the award until a specified future date.
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Characteristics of Incentive
Compensation Plans
Long Term Incentive Plans
d. Performance Shares
• A performance share plan awards a specified
number of shares of stock to a manager
when specific long term goals have been
met.
e. Performance Units
• In a performance units plan, a cash bonus is
paid when specific long term targets are
attained.
• This plan thus combines aspects of stock
appreciation rights and performance shares.
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Incentives for Corporate Officers
• To stimulate motivation, the CEO
(Who recommends awards to the
compensation committee of the
board of director) usually bases
awards on an assessment of each
person’s performance.
CEO Compensation
• The CEO’s compensation usually is
discussed by the board of directors
compensation committee after the
CEO has presented
recommendations for subordinates’
compensation.
Incentives for Business Unit
Managers
Types of Incentives
a. Financial : salaries increases, bonuses, club
memberships, etc
b. Psychological and social : promotion possibilities,
increased responsibilities, etc.
Bonus Basis
• A business unit manager’s incentives bonus could
be based solely on total corporate profits or on
business unit profits or some mix of the two.
• One argument for linking bonus to unit
performance is that the manager’s decisions and
actions more directly impact the performance of
his or her own unit than that of other business
units.
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Incentives for Business Unit
Managers
Size of Bonus Relative to Salary
Two Philosophies on Incentive Compensation
1. Fixed Pay
Recruit Good People
Pay Them Well
Expect Good Performance
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Incentives for Business Unit
Managers
Size of Bonus Relative to Salary
Two Philosophies on Incentive Compensation
2. Performance Based Pay
Recruit Good People
Expect Good Performance
Pay Them Well if Performance is Actually
Good
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Incentives for Business Unit
Managers
Performance Criteria
The difficult problem is to decide which criteria shall be
used to determine the bonus
a. Financial Criteria
• If the unit is a profit center, financial criteria could
include contribution margin, net income etc.
• If the unit is an investment center, decisions need to be
made in three area : definition of profit, definition of
investment and choice between ROI and EVA
• If the unit a revenue center, the financial criteria would
be sales volume or sales dollar
b. Benchmarks for Comparison
• A business unit manager’s performance can be
appraised by comparing actual results to profit budget,
past performance or competitor’s performance.
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Agency Theory
Concepts
An agency relationships exists whenever one party (the
principal) hires another party (the agent) to perform
some service and, in so doing, delegates decision
making authority to the agent.
One of the key elements of agency theory is that principals
and agents have divergent preferences or objective.
a. Divergent Objectives of Principals and Agents
• Agency theory assumes that all individuals act in their
own self interest. Agents area assumed to receive
satisfaction not only from financial compensation but
also from the perquisites involved in agency
relationship, such as generous amount of leisure time
• Principal (shareholders), are assumed to be interested
only in the financial returns that accrue from their
investment in the firm.
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Agency Theory
Control Mechanisms
Agency theorists state that there are two major ways of
dealing with the problems of divergent objectives and
information asymmetry : monitoring and incentives.
a. Monitoring
• The principal can design control systems that monitor the
agent’s actions, limiting actions that increase the agent’s
welfare at the expense of principal’s interest. Example :
audited financial statement
b. Incentive Contracting
• A principal may attempt to limit divergent preferences by
establishing appropriate incentive contracts. The more an
agent’s reward depends on a performance measure, the
more incentive there is for the agent to improve the
measure.Therefore, the principal should define the
performance measure so that it furthers his or her
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Agency Theory
Control Mechanisms
Agency theorists state that there are two major ways of
dealing with the problems of divergent objectives and
information asymmetry : monitoring and incentives.
c. CEO compensation and Stock Ownership Plans
• A company that pays its CEO a bonus in the form of stock
options offers an example of the agency cost inherent in
incentive compensation.
d. Business Unit Managers and Accounting Based
Incentives
• It is difficult to isolate the contributions that individual
business units make to increases in the firm’s stock price.
For this reason, a company might base the business unit
manager’s bonus on business unit net income.
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Agency Theory
A Critique
• Agency theory implies that managers in
nonprofit and governmental organizations,
who cannot receive incentive compensation,
inherently lack the motivation necessary for
goal congruence, many people do not accept
this implication.
• Models are no more than statements of obvious
facts expressed in mathematical symbols.
• Others state that the elements in the models
can’t be quantified (what is the “cost of
information asymmetry” ?), and that the model
vastly oversimplifies the real world
relationship between superiors and
subordinates.
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Summary
 The incentive compensation system is a
key management control device.
 An incentive system that explicitly
incorporates the following has a much
better chance of success :
• The needs, values, and beliefs of the
general managers who are rewarded.
• The culture of organization
• External factors, such as industry
characteristics, competitor’s
compensation
• The organization’s strategies
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The End