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Unformatted text preview: 6. Incentive Compensation Systems
1. 2. 3. 4. 5. 6. 7. Outline Philosophies on incentive compensation Purpose of incentives Forms of rewards/punishments Key elements of incentives Bonus determination approach Criteria for evaluating reward systems The truth inducing incentive model Bus 424 sixth lecture presentation 1 Financial results controls 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 results and various organizational incentives Bus 424 sixth lecture presentation 2 Two philosophies on incentive compensation Fixed Pay Recruit good people Pay them well Expect good performance Bus 424 sixth lecture presentation 3 Two philosophies on incentive compensation Performance-Based Pay Recruit good people Expect good performance Pay them well if performance is actually good Bus 424 sixth lecture presentation 4 Purpose of incentives 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 oftencompeting results areas. Bus 424 sixth lecture presentation 5 Purpose of incentives Attraction/retention – Paying employees only guaranteed salaries tends to attract riskaverse employees. – Paying performancedependent 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”. Bus 424 sixth lecture presentation 6 Purpose of incentives (Continued) Noncontrol purposes Provide a competitive compensation package Make compensation variable with firm performance Tax considerations Bus 424 sixth lecture presentation 7 Positive and negative incentives Positive incentives “rewards” Things employees value Negative incentives Things employees like to avoid “punishments” Individuals tend to be more strongly motivated by the potential of earning rewards than by the fear of punishment. Bus 424 sixth lecture presentation 8 Forms of rewards and punishments
» Zero salary increase » Zero bonus » Zero perquisites Rewards – Monetary Salary increases Bonuses Benefits Perquisites – Club memberships – Vacation trips – Nonmonetary Promotion Autonomy Recognition Participation in decisions Office assignments Preferred parking places Titles
9 – Non-monetary
» Interference in job from superiors » Loss of job » Assignment to unimportant tasks » No promotion » Humiliation Bus 424 sixth lecture presentation The compensation package Salary Benefits – Pension and health benefits – Perquisites of various types Incentive compensation – Shortterm incentive plans Based on the performance in the current year or less – Longterm incentive plans Based on the performance measured over periods greater than one year and often related to the company’s stock price. Bus 424 sixth lecture presentation 10 Shortterm incentive plans Based on performance in the current year or less e.g., bonuses, commissions, piecerate payments Calculation (by formula) of shortterm incentives e.g., 2% of sales; 10% of net profits e.g., 20% of overtarget performance e.g., 60% of “target bonus” at 80% of target; 100% of “target bonus” at 100% of target; (where target bonus = 30% of salary). Bus 424 sixth lecture presentation 11 Longterm incentive plans 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 Marketbased performance – Stock options – Stock appreciation rights – etc. Bus 424 sixth lecture presentation 12 Key incentive design elements
x Level of measurement (performance at the individual, entity, or company level) Size of awards (i.e. leverage vis-à-vis 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)
(See Chapters 10-11) x x x x Bus 424 sixth lecture presentation 13 Group rewards Teambased rewards are often used to implement personnel/cultural controls. – Group members monitor and sanction each others’ behaviors. They rarely provide a direct incentive effect. – Stockbased plans, for instance, provide direct incentives only for a small number of managers at the very top of the organization. – Hence, for lowerlevel employees, compensation is made more volatile, but their motivation is not (greatly) affected. Bus 424 sixth lecture presentation 14 Proportion variable pay Employees are risk averse Performancedependent 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. Bus 424 sixth lecture presentation 15 Shape of reward function Mostly, the link between rewards and results is linear, over a restricted performance range only
MAX but Rewards ($) ZERO LOW Results (profit) 80% of budget target 100% of budget target 150% of budget target
HIGH Bus 424 sixth lecture presentation 16 Cutoffs Lower cutoff – To avoid paying bonuses for performance which is considered “mediocre” or worse. 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. Bus 424 sixth lecture presentation 17 Bonus determination approach 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). 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. Bus 424 sixth lecture presentation 18 Criteria for evaluating reward systems Rewards should be valued Rewards that have no value do not provide motivation. Reward tastes vary across individuals and are situational. Rewards should be large enough to have impact Reward “visibility” can affect impact. Rewards should be understandable What is the reason for earning the reward? What is the value of the reward? Rewards should be timely The discount rate employees apply to delayed rewards seems to be far greater than the time value of money. Bus 424 sixth lecture presentation 19 Criteria for evaluating reward systems (Continued) Rewards should be durable Rewards have greater value if the good feelings generated by the granting of a reward are longlasting, i.e., if employees remember them. Rewards should be reversible To be able to correct mistakes of performance evaluations; Promotions, for instance, are difficult to reverse. Rewards should be cost efficient To stimulate the desired motivation at minimal cost. Bus 424 sixth lecture presentation 20 •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 output targets so low that the budget is easily achieved. Bus 424 sixth lecture presentation 21 B = B0 + b Yh + a (Y Yh) if Y >= Yh or B = B0 + b Yh c (Yh Y) if Y < Yh where, B = Actual bonus paid B0 = Basic bonus Yh = Budgeted output Bus 424 sixth lecture presentation 22 Example: B0 =70; a=0.2 b=0.3 c=0.5 for Y >= Yh B= 70 + 0.3Yh + 0.2 (Y-Yh) or B= 70 + 0.3Yh - 0.5 (Yh -Y) for Y < Yh Bus 424 sixth lecture presentation 23 Actual output 50 50 60 70 80 90 100 Budgeted output 70 80 90 100 60 Bus 424 sixth lecture presentation 24 ...
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This note was uploaded on 05/23/2010 for the course BUS 424 taught by Professor Joe during the Spring '10 term at Skidmore.
- Spring '10