hilton et al 06_001

hilton et al 06_001 - Third Edition 200(k). Strategies for...

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Unformatted text preview: Third Edition 200(k). Strategies for Business Decisions man 53v ’ 86:." Ronald W. Hilton Cornell University Michael W. Maher University of California, Davis Frank H. Selto University of Colorado at Boulder lllchraw—Hill rwin Boston Burr Ridge, IL Dubuque,lA Madison,Wl New York San Francisco St. Louis Bangkok Bogota Caracas Kuala Lumpur Lisbon London Madrid Mexico City Milan Montreal New Delhi Santiago Seoul Singapore Sydney Taipei Toronto Chapter 20 Strategy, Balanced Scorecards. and Incentive Systems 835 Portion of Valley Commercial Bank's Balanced Scorecard -_'..Buéine'ss3_and: " ;':'-’pr'0duciti°n [proteases .' :i . , perfetmance. . '} :1 pagans-ea g ._ defective-loan " .anplicatisns. Customer retention Customer satisfaction e" '0 t’iuNK COMMER‘IJA' Alfred Sloan, famous chief executive officer of General Motors, instituted one of the first incentive systems. A strong advocate of using incentives, he started a bonus plan u“ in 1918 at General Motors to better motivate division managers to act in the best interests of the company and its shareholders. This bonus plan stressed payfor per- formance based on the achievement of desired levels of performance. Pay for per- formance bases at least some portion of a manager’s income on measure(s) of orga- nizational performance rather than a guaranteed amount. Although modern incentive systems can be complex, all are similar to Sloan’s original because they stress pay for performance. Thus, two key principles of an incentive system are: Lt’r 5 Understand the key principles of performance- based incentive systems. 1. Measurement of performance. 2. Compensation based on measured performance. Today, virtually all large companies, many small ones, and an increasing number of nonprofit organizations use incentive plans for executives, managers, and, to a lesser degree, employees at all levels. You could easily find yourself eligible for incentive compensation soon after completing your studies. For example, employ- ment with a business assurance or consulting firm might offer you mostly salary with a long-term opportunity of a partnership and profit sharing. A high—technology com— pany, on the other hand, might offer a relatiVely low initial salary with an early opportunity for stock ownership. Similarly, once you are with an organization, you must decide how to attract and retain good employees with different incentives. The structure of incentive systems can matter greatly to employees and employers. These plans can have a substantial impact on annual pay. For example, CEOs of major US firms are paid millions of dollars per year on average, and often much of this pay is based on incentives related to performance. The components of CEO pay vary across firms and are changing because of the financial bubble that burst in 2000 and, in the United States, because of the Sarbanes-Oxley Act of 2002, which was a reaction to CEO misdeeds and compensation—related, financial disclosure failures that accompanied the bubble.3 Exhibit 20~8 illustrates representative variety in CBO compensation for a recent, postbubble year. It is interesting to speculate how the different incentiVe systems might affect CEO behavior. For example, would Tecumseh Products’ all-salary system motivate its CEO differently than Medtronic’s mostly unrealized long—term compensation sys- tem? We will discuss these issues later, but, apart from the money, is the “real world” v' winner-=3;-.x-=z»r;:r.r'n-,-;";.:-..-,__- "r.,.l_.,.-,. - . . - mam-m mum - - mar-Wm: 3See a summary at www.aicpa.org/infolsarbanes/index.asp. r— 836 Part V Evaluating and Managing Performance Examptes of Recent CEO Compensation ($000) I mes-it Precincts $ 475.00 $ 0 $ 0 $ 0 $ 47500 i 1,000.00 6,250.00 0 0 7,250.00 i 1. 1.06300 1.00240 0 12,465.80 14,531.20 - 109.60 152.60 0 32,814.10 33,076.30 1,025.00 1,368.70 1,575.90 37.07520 41.04480 “ 71-3 750.00 6.650.00 37.53960 65,674.70 1i0.614.30 | i ‘ Longrterm compensation typically consists of stock grants. stuck appreciation rights. and stock-option grants. Unrealized compensation usur l ally is from stock appreciation rights and stock option grants that had not been exercised. These terms are explained Eater in the chapter. Data , i were obtained from the Wall Street Journal/Mercer 2003 CEO Compensation Survey. May 2004. which is available online at i i hip:lMinews‘.comldocumentlexecrmy ceocom_p_04p_df. I 1.. different from school? If you are currently a student, you already work within a performance-based incentive system; grades in courses can be based on multiple measures of performance. You can easily imagine how differences in the rewards or incentives might alter your motivation and behavior. Do you study as hard for a .J course that you take pass-fail as for one you take for a grade? Do you concentrate on the same parts of the course if the grade is based on a comprehensive paper versus problem-oriented exams? Variations in incentives and rewards affect student behav- ior as they do CEOs and other employees who work for rewards. The key to design— ing incentive systems is to understand as well as possible which behaviors are desired and how incentives and rewards are likely to influence behaviors. In nearly every case, you get what you measure and reward—even if it is not what you intended. Moira-tended {Zonaenuerices of incentive Systems A classic article titled “On the Folly of Rewarding A While Hoping for B” speaks to fundamental problems with many incentive systems.4 The title of the article reveals that designers of incentive plans can be surprised to find that these systems motivate unintended behavior or create disincentives to desired behavior. Here is an example that affects most of us: Most US states regulate the rates that energy-producing com— panies can charge. The stated objectives of the regulation are to offer the utility a fair profit while protecting consumers. Traditionally, rates have been based on the costs incurred to produce energy. However, at the same time most utilities operate with “fuel-adjustment clauses” that allow them to separately recover all costs of fuel used to produce power. These clauses create disincentives to invest in improvements that reduce fuel costs because the investments increase the utility‘s costs but only con- sumers would realize the cost savings from lower fuel consumption. Rate regulation and fuel adjustment clauses clearly tell utilities that investments to reduce fuel con- sumption are a waste of money, an unintended consequence of the regulatory system. Early on, Valley Commercial Bank had a problem of rewarding A when top man- agement really wanted B. As a small service-oriented bank, VCB realized the impor— tance of customer relations and relied on satisfying its customers to keep them coming back for more loans and services. The original incentive system, however, emphasized short-term profits and cost minimization, which gave branch managers the incentive to reduce staff. This narrow focus resulted in fewer employees spending less time with customers and lower customer satisfaction. As a result, the bank began to lose some of its key customers because of its incentive system, which it soon revised. 4 S. Kerr, “On the Folly of Rewarding A While Hoping for B." Chapter 20 Strategy, Balanced Scorecards. and Incentive Systems fiesired Eei‘iaviormwit"s iii?" to: fiegin The starting point of designing an effective incentive system is knowing the behavior that the organization wants to motivate. Managers cannot motivate people to “do the right thing” if no one knows what the right thing is. An effective incentive system should motivate employees to achieve the organization’s goals and objectives and reward them if they do. Reality intrudes Unfortunately, translating goals into effective incentive systems is not always as easy as it might seem because sometimes the desired outcome is not easily observed. Here is a seemingly easy question: What is the “right thing” for a profit—seeking corpora— tion? The standard answer in a market economy is a long-term competitive return for stockholders. In reality, translating even this standard statement into an incentive plan can be a challenge. What’s so hard about creating an incentive system that promotes a “long—term competitive return for stockholders”? For one thing, the “long-term” might be 5 or 10 years from now. A company may wait that long to reward or penalize managers, but what if it needs to reward good managers now or risk losing them to competitors? What is the “competitive” benchmark? What is the proper measure of “return”? Are “stockholders” the only stakeholders in the company (that is, those who have an interest in its actions)? We now turn to the important issue of tying desired behavior t6 desired performance in the chapter. Role forTheories of incentives and Behavior A company could develop incentive plans by trial and error, trying alternatives until a plan appears to generate the desired behavior. Although it might succeed eventually, using trial and error is not the most efficient way to proceed. Fortunately, a number of theories are well grounded in observations of individuals and organizations and can provide reliable advice. Not surprisingly, because incentives are so important, researchers have studied the psychology and economics of incentives for many years. Relying on the guidance from this research is an efficient way to begin to design an incentive plan. The most commonly used theories of incentives are expectancy the— ory, goal-setting theory, and agency theory. See the appendix to this chapter for an overview of these important theories that we synthesize here. Our interpretation of these theories and observations of successful practice generate the following guide- lines for designing effective incentive plans. Theory and Practice Guideline Most individuals are motivated by self-interest .... .. Performance-based rewards must be greater than alternative rewards from nonperformance. Organizations get the behavior they reward ........ .. Performance measures and related rewards must reflect organizational goals. Effort follows rewards ........................................... .. Employees must believe that their efforts influence performance and wilt be rewarded. Difficult but attainable goals motivate best .......... .. impossible goals are demotivators and so are easy goals. Make goals difficult but not impossible. Fairness is a basis for sustained motivation .......... .. Rewards must be linked to desired performance in a fair and consistent manner. Manipulation undermines fairness and effort ........ .. Performance measures must be observable and verifiable. Different rewards can motivate effort .................... .. Rewards must meet market conditions, and rewards must be available. Incentive systems involve trade—offs .................... .. Minimizing the overall costs of aligning goals and monitoring behavior is a goal of incentive system design. 837 838 Part V Evaluating and Managing Performance Features of Performance-Based Incentive Systems a} Evaiuate the advan~ tages and disadvantages of alternative features of incentive systems, Performance-Based Incentive System Choices Incentive systems can include many alternative features. We now turn to a number of specific choices that designers of incentive systems must make. Identifying the required trade»offs between effective rewards, goal alignment, monitoring, and cost necessitates choosing among many alternative incentive-system configurations and reviewing systems in place to be sure they are still effective.S Exhibit 20—9 displays the many choices that accumulate to create the elements of an effective performance-based incentive system. Designers of incentive systems should consider all of these choices because ignoring any of them can lead to a less— effective system. All of the elements in Exhibit 20—9 speak to this question: Given the goai(s) of the organization, which alternative incentivefl) will motivate the desired behavior most effectively? The answer to that question must be placed in context: The situation faced by each company determines the answer. There are no universally right or wrong answers, but there are better or worse answers in a particular situation. Furthermore, many equally effective combinations of incentive plan elements might exist in similar situations. Our aim is to provide an overview of the choices, not to suggest the correct choices for any situation. We discuss each of the boxed alterna- tives in Exhibit 20—9 in turn. Absoiute or Reiative ii’erfoi-mance One may evaluate performance against absolute objectives or relative to others“ per- formance. Absolute performance evaluation compares individual performance to set objectives or expectations. For example, in classes that use absolute performance evaluation, the instructor grades on an absolute scale, and how well others perform does not affect your grade. For example, panel A of Exhibit 20—10 illustrates a grade distribution that uses absolute cutoffs (100 percent < A < 90 percent; 90 percent E B < 80 percent, etc). Relative performance evaluation compares an individual’s per- formance to that of others. In classes that use relative performance evaluation, the instructor grades on the curve; that is, your grade depends on how you perform rela- tive to everyone else. For example, panel B of Exhibit 20—10 reflects a grade distribu- tion relative to an instructor’s desired curve of 12.5 percent As, 50 percent 133, 25 perv cent Cs, and 12.5 percent BS and F3. Both approaches can be effective, but the situation determines the effectiveness. For example, grading on an absolute basis, when exams are extremely difficult, can reduce one‘s belief that studying can lead to 5 Personal and corporate income tax regulations also can have major effects on the design of incentive systems. These issues are beyond the scope of this text. PerformanCe ‘ ' -Basedr.§-._'I;j .'_Management 1 ' " Incentive ' - “System: _. I} Chapter 20 Strnlcgy. Balanced Scorecards. and incentive Systems Panel A: Absolute Grades a high grade. Thus, studying effort might be less in this situation than if the instructor graded on a relative basis, where final grades reflect relative performance On difficult exams. Like other companies that use a relative performance evaluation, VCB bench- marks branch-bank performance with that of other banks in the same industry.6 Thus, a branch that generated 3 percent revenue growth in a market where the average rev- enue growth was 4.5 percent might receive a lower evaluation than a VCB branch that earned 3 percent in a market with 2 percent average revenue growth. Just as grading on the curve shields students from the risk of an extremely difficult test, rela- tive performance evaluation shields a manager from the risk of managing a division in a market that performs poorly. Relative performance evaluation also motivates high performance if the manager’s division is in a market that performs well. A disadvantage of relative performance evaluation is that it does not provide incentives for managers to move out of poorly performing markets into those that perform well. Why would successful managers in a poor market move to a more competitive market where relative performance evaluation makes the likelihood of rewards low? Furthermore, if good managers decide to move, they might have to work much harder for the same relative performance. At VCB, top management believes that relative performance evaluation of some aspects of performance is effective. Using relative performance evaluation, tOp man- agement assesses each branch bank’s revenue growth performance relative to each other and to similar banks in the same market. The bank rewards the managers of branches with the highest relative revenue growth. This controls for unforeseen changes in business conditions that might affect all banks“ revenue growth. Consider the relative evaluations in Exhibit 20—1 1. Using a set of comparative banks, VCB branches F, E, and B achieved below—average revenue growth, but VCB branches G, 6For a field study of companies using relative performance evaluation. see M. Maher, “The Use of Relative Performance Evaluation in Organizations.” _ Absolute versus Relative Grading B40 Relative Revenue Growth Valley COMMERCIAL BANK Part V Evaluating and Managing Performance Relative Revenue Growth 8.00% 7.00%) 6.00% 5.00% 4.00% D, A, and C had above-average revenue growth. Thus, under the same conditions that all faced, branches G, D, A, and C outperformed the average. Using relative performance evaluation allows VCB to avoid the diffiCult task of setting appropriate revenue growth objectives necessary for absolute performance evaluation. Unless the objectives are sufficiently difficult and accurately reflect future business conditions, the absolute objectives might be ineffective motivators. If they are set too high or business conditions deteriorate, managers perceive little chance of earning rewards. Conversely, if objectives are set too low or the business climate improves, managers can easily earn their rewards. in the first case, VCB misses opportunities for growth because managers do not try, and in the second case, it pays too much for less than best efforts. hormuiamfiaserfi er fiuhg‘iective iii‘et-fermance Some companies base rewards on a performance evaluation formula, which com— putes rewards earned for specific achievements. For example, VCB rewards revenue growth by paying branch managers a bonus based on the following explicit formula: For each percentage point by which revenue growth exceeds the market average, say 5 percent, the manager receives a bonus of 4 percent of his or her base salary. Thus, a manager knows, for example, that if her branch’s revenue growth was 8 percent for a particular year (that is, three percentage points above the 5 percent threshold percent) and her base salary is $100,000 per year, her bonus is $12,000 (three percentage points times 4 percent per point times $100,000). A manager who did not meet the market average revenue growth rate receives no bonus. This bonus is in addition to the manager’s base salary. VCB included this incentiVe as part of its formula but rejected a formula-only approach to performance evaluation for branch managers as too restrictive to its culture and business climate. One consid- eration was that using only a formula penalizes managers assigned to problem branches, which VCB management believed is demoralizing and leads to unwanted loss of talented managers. Another factor that limited VCB’s enthusiasm for using only an incentive formula was concern about setting the right formula parametbeS Chapter 20 Strategy. Balanced Scorecards. and Incentive Systems (e.g., average market growth and bonus percentage). Different parameters generate different incentives and might lead to different actions. Having diverse sources of compensation minimizes the risk of incentive-formula mistakes and allows for some experimentation with different formula parameters. Formula~based evaluations importantly require measures that are accurate, reli- able, and verifiable. InaCCurate, unreliable, or manipulated measures can create the opportunity for conflict over measured performance and incentives to cheat. Conflict and cheating might encourage eventual measurement improvements but can seri- ously impair the organization’s performance while the inadequate measures are in place. Sometimes taking actions that improve the evaluation numbers but that are detrimental to the organization in the long run is possible (cg, branch managers can add riskier customers to increase recorded revenues without adjusting for expected future losses). Organizations also can measure some areas of formula-based nonfi- nancial performance as reliably as financial performance, but most organizations his~ torically have had more ability and need to measure and verify financial performance because of financial and tax reporting requirements. Companies also may use subjective performance evaluation by using non— quantified criteria. The advantage of subjective evaluation is that it considers factors that-“a formula does not explicitly capture. For example, suppose that the sales growth of one of VCB’s branches was below target because it serves a declining market. The bank wants to maintain a presence there, however, because the market area will be thefocus of economic redevelopment activities by local and federal governments. Matching the future benefits and opportunity costs of this management decision in an explicit formula can be difficult. Subjective performance evaluation also can elimi- nate opportunities for “gaming” formulaTbased evaluations. Subjective evaluation can counter the tendency to manipulate the numbers in the formula. Recent financial reporting scandals have shown that these gaming motivations can be strong. The advantage of a formula-based plan is that managers know precisely what is expected of them and what reward they will receive relative to expectations. The Sub— jective approach is a less certain form of incentive plan and can be susceptible to favoritism, political maneuvering, and even a “good-old-boys” approach to incentive compensation. Incentive compensation might become a function more of how well superiors like managers than of performance, thus reducing the link between effort and reward. Employees often are comfortable with a subjective approach when they believe in upper management’s ability, are willing to take some risks, and trust upper management. Otherwise, employees tend to prefer a formula approach. An increasing number of organizations use elements of both subjective and formula-based incentives. For example, VCB rewards branch managers based on a formula that includes revenue growth, net interest margin, and return on net assets as well as subjective evaluation based on industry norms, a manager’s level of responsi- bility, and the judged value of a manager’s contributions. Financial or Nonfinancial Ferformance Financial performance reflects the achievement of financial goals, such as cost con— trol, revenue growth, earnings, and residual income. Chapter 18 of this text provides extensive discussion of these performance measures, which we do not repeat here. Organizations that ostensibly measure performance with only financial or only nonfi— nancial performance measures could be found. Some profit-seeking firms apparently base rewards only on “bottom~1ine” financial performance. Some nonprofit organiza- tions overtly reward only on the basis of meeting nonfinancial goals. However, nearly every organization really uses both financial and nonfinancial measures of per- formance. For example, in the most bottom-line-oriented corporation, an executive who exceeds financial goals will not last long after being convicted of a serious crime. Furthermore, the most altruistic, nonfinancial, nonprofit organization cannot tolerate an executive who repeatedly fails to operate within the organization’s financial means or diverts the organization’s funds for personal use. Financial and nonfinancial 84E 842 Part V Evaluating and Managing Perfonnnnce performance measurement is not an either-or issue but involves identifying which mea— sures and what balance to use. We next briefly review financial performance measures. Financial performance:Accounting measures or stock price? Financial performance measures commonly include levels or growth of the following:7 Revenues. Costs. Cash flow. Operating income (before or after extraordinary items, taxes). Return on investment (total assets, net assets, or equity). Residual income or EVA . Stock price. All of these measures except stock price are explicitly based on accounting earnings- related numbers. The last three items are most commonly used to evaluate business unit performance. VCB uses a mix of financial performance measures in its perform— ance evaluations. Executives are evaluated on residual income, and branch managers are evaluated on net interest margin, return on assets, and revenue growth. VCB does not evaluate or provide incentives based on the bank’s stock price because the bank feels that (1) the stock price normally is not directly controllable by managers and (2) basing incentives on stock price might cause undesirable consequences if managers tried to manipulate the stock price. VCB believes that stock price performance will follow financial performance. Nonfinancial performance: operational, organizational, social and environmental factors. Evidence indicates that the use of nonfinancial measures of performance in incentive plans is increasing. Of course, organizations have used nonfinancial measures for managing operations for many years, but including them in incentive plans is an important development.8 Perhaps the greatest advantages of adding nonfinancial measures to the incentive system are ( 1) focus on the leading indicators of profit and (2) recognition of the time lags between nonfinancial and financial performance. Incentives based on nonfinan— cial performance direct employees’ attention to leading activities more effectively than do indirect incentives based on lagging financial performance alone. Although employees might know that poor quality can surface later as lower profits, for exam- ple, the time lag and lack of direct effect can lower the belief that their quality-related actions affect performance. Value Commercial Bank evaluates nonfinancial perform- ance for compensation, although it does so subjectively. As with all aspects of incentive plans, however, nonfinancial performance mea- sures have costs as well as benefits. Costs of including nonfinancial measures in incentive plans include these: Increased cost of performance measurement and supporting information systems. Increased cost of reporting and verifying the validity of performance measures. Difficulty in determining the proper balance between financial and nonfinancial measures. Danger of “information overload” from too many measures causing lack of focus on overall performance. Increased opportunities for disputes over the validity of performance measures. Increased opportunities for manipulating formula-based incentive plans that include multiple measures. 7 Typically, growth is computed as follows, using annual revenue as an example: Revenue growth = (This year’s revenue — Last year’s revenue) + Last year’s revenue. 3 See the beginning of this chapter and Chapter 7 for examples of commonly used measures. Chapter 20 Strategy. Balanced Scorecards, and Incentive Systems Use of Nonfinancial Measures of Performance Professors lttner and Larcker of the ion School of Business have reviewed the findings of many surveys, cases, and field studies investigating firms' uses of nonfinancial measures of per- formance for both management activities and incentive compensation They report that as many as 36 percent of firms explicitly include nonfinancial measures in executive incentive plans. On average, 37 percent of the total evaluation was based on these nonfinancial measures. Firms that use nonfinancial measures in their incentive plans tend to be more innovative, to have adopted TQM, to have long product—development cycles, to have been more subject to regulation, and to have had “noisier” financial performance. Thus, factors, such as innovativeness and adoption of TQM, apparently affect the use of nonfinancial measures of performance in incentive plans. Nonfinancial measures of performance used most commonly in incentive plans include customer satisfaction, productivity, employee performance, communityi'environmental performance, and innor vation. But lttner and Larcker point out that very little objective research reflects whether using these measures in incentive plans results in better long—term financial performance. At this point, firms might be reluctant to disclose that they have found successful packages of measures; alternatively, they might include these measures based on the logic of linkages among leading and lagging indi— cators of performance rather than hard evidence. Source: 0. ittner and D. Larcker, "innovations in Performance Measurement: Trends and Research Implications.” See also H. Banker, G. Potter, and D. Sri'nivasan. "An Empirical Investigation of an Incentive Plan That includes Nonfinancial Performance Measures." If adding nonfinancial measures adds problems, why not use financial perform— ance observed over a period of time long enough to capture the effects of nonfinan- cial 'pei‘f01'mance?9 One answer might be that nonfinancial measures can add value in excess of their costs. Another might be that although competition for managerial tale ent requires frequent evaluation and payment of compensation, financial perform— ance cannot be matched to efforts in a timely manner. These answers might explain why many organizations have added nonfinancial performance measures to their incentive systems. For example, McDonald’s evaluates and compensates many managers on nonfinancial performance, such as customer and employee satisfaction, social responsibility, and adoption of technology. The measures to use and the ways to include them in performance~based incentive plans are some of the greatest chal- lenges of incentive system design, and more research is needed in this area. Narrow or Broad Responsibility of Performance An organization can define performance narrowly or broadly. Should a manager’s rewards depend on the performance of that individual, of the manager’s division, or of the company as a whole? For example, should VCB evaluate its branch managers based their performance on a set of personal goals, the performance of the manager’s branch bank, or the performance of the bank as a whole? Basing compensation on only the performance of the company as a whole gives managers incentives to coop- erate, share information, and consider the impact of their actions on the entire organi- zation. This is especially important in large companies whose managers might not see much relationship between their actions and the company’s performance. Incentives work best, however, when individuals see a strong link between their actions and performance results (see the appendix to this chapter). Moving from incentives based on individual performance to companywide performance lessens an individual’s influence on the performance measure. Many companies reward division managers for both business-unit and companywide performance, seeking a balance that is appropriate for their situations. VCB rewards executives based on overall bank performance. The bank strives to create incentives for cooperation among branch managers by linking some of their rewards to the bank’s overall eco- nomic performance. 9A. Rappaport articulates this question in his book Creating Shareholder Value. Management in Practice 20.3 844 Part V Evaluating and Managing Performance fimirrbsolEEncel-Vcfl “ *2.’ ‘ 3.. ' ‘ [5511 are Edlt \jaw loser! Fm rods Re a: A but Bonuses Based on Bank |"' 012' "'-‘ 'é"éirroa.'toife>u;(oia-sotzriMarionon ‘ ' i A f and BranCh FmanClai _ Financial Permanence Elonus Parameters Performance ._2_..I Bonustarat ; -15 Bonusweiht mflm i .LlVCErasidualincurna _ . . . i .5. I ' ' '- 1 ' 1-" - bronchi: '7 El'fancllfl " .- W ‘Branehc i .5 ‘Manaersala . 3 Return an imaslment a e fifllfiavanus mwth _g_ iBranch manaar bonus 1Q} VCB residual income. $BSE'IF $654-$552>D.$E$4-58$2D 2171‘ Flalum on investment. IF ?-$C$2>U ?-$C$2 ’IUEID ‘5053‘86 12 Revenue growth. lFlBB~$D52>EI.(EB-$D$\23'1OODYSDE'EIS if!“ Total bonus 1 . Consider the partial bonuses based on individual branch and overall bank finan- cial performance shown in Exhibit 20—12. Note that each branch manager receives a $1,600 bonus based on VCB’s overall residual income performance (row 10) corn- puted as follows:10 fiesidual income Quadrant: or Beferr’ed Rewards Employees prefer rewards sooner than later, but the organization often could benefit from waiting. Rewards for performance can be given now based on current perform— ance or later on sustained performance. Current compensation rewards can be in the form of cash or stock that can be cashed immediately or soon after the award. For example, a manager might be rewarded quickly with a cash bonus if the residual income increases 10 percent by the end of the year or later on a deferred basis if the residual income increases by an average of 10 percent per year over the next three years. Thus, the company defers any rewards for the first and second years’ perform— ance until after the third year. An alternative is to grant the rewards now but restrict their payment until a future date. These deferred rewards can be cash or stock as well as stock options. We defer coverage of stock and option rewards to the next section. Current rewards. Current rewards have the obvious advantage of being closely linked to current performance. Because uncertainty related to current rewards is low, current rewards should provide strong motivation to improve current performance. The disad- vantage of current rewards is that they can induce employees to manipulate the per- formance measures without concern for future performance or with the expectation of “cashing out” and leaving the organization before undesirable consequences occur. Deferred rewards. Advantages of deferred rewards based on sustained performanCe are that (1) good managers might have incentives to stay with the company (cg, “golden handcuffs") and (2) managers have incentives to focus attention on long term performance. Many commentators argue that managers, particularly in the United States, are too short—term oriented. They take actions now that look good in the short term but are detrimental in the long term. A good example is the failure of some companies to invest in new technology. This “myopic” view of performance keeps earnings high in the short term by avoiding write-offs or high depreciation expenses but can be detrimental in the long term. Switching to deferred rewards “3 Note that the use of the “IF” function ensures a bonus only if residual income {134) exceeds the target (B2). Other formulas compute bonuses based on branch performance in excess of targets in similar ways. n Chapter 20 Strategy. Balanced Scorecards. and Incentive Systems based on sustained financial performance can capture the lagged effects of good or poor nonfinancial performance and create incentives to make needed inipt‘Ovements. A disadvantage of a deferred reward is that managers might view it as coming too far in the future to be motivational. Giving a manager a reward in stock to be paid five years from now is less attractive than giving a payment at the end of the current year. VCB uses a combination of current and deferred awards for top managers but primarily pays current awards for lower—level managers and their subordinates. When making deferred awards to executives, the bank defers the award for three years. This time period appears to be sufficiently long (1) to capture lagged effects of actions and (2) to motivate the managers to think about the future but (3) is not so far in the future that incentive effects of the managers themselves are lost. Salary, Bonus, or Search Rewards Most management incentive plans include multiple forms of reward, including salary, bonus, stock, stock appreciation rights, and stock options. Organizations design the reward package to address the motivational issues raised earlier in the chapter, within stockholder and taxation guidelines, and many have found that a combination of rewards is more effective than a single form of reward. Most large orgahizations have compensation committees that design the mix of rewards to reflect the company’s compensation philosophy. Some organizations stress salary; others stress performance-based compensation to provide more motivation. For example, VCB states the following: One of the essential elements of the Bank’s compensation poiicy is to align the interests of the CEO, executive officers, and key employees with the interests of stockholders. . . .The total com- pensation package is designed to provide a significant percentage of executive compensation from programs such as the bonus plan and stock-based long-term incentive programs, which link execu- tive rewards to long-term shareholder rewards. Salary. Nearly all management employees work in exchange for some salary that is more or less guaranteed. Occasionally, an executive works without salary, but this usually is in exchange for stock or other deferred rewards or as a charitable contribu— tion to a nonprofit organization. The typical salary issues are (1) the level of salary and (2) the proportion of compensation that is salary versus performanceubased reward. Salary levels often are benchmarked with the organization’s industry and the level of responsibility within the organization. At extremes, a manager receives 100 percent of his compensation from salary, or another manager receives 100 percent of her compensation based on performance. What difference does the proportion of salary make? At 100 percent of compensation, a salary insulates an employee from most risks, so one might think that the employee will be inclined to make risky decisions. In real- ity, however, such compensation is more likely to attract employees who are not inclined to take risks. Furthermore, fixed compensation can turn away employees who recognize that their compensation has no upside potential regardless of their effort or ability to manage. Because most stockholders can diversify their invest- ments, they prefer that managers take some risks, but they must compensate them for doing so. One way to motivate risk taking is to shift some compensation from salary and make it depend on performance that is affected by managers’ risky decisions. Making all compensation based on performance might not be desirable, however, because, as mentioned earlier, this places all of the risk on managers. The organization might attract only extreme risk takers or those who demand a large stake in the organization in exchange for the risk they must bear. Most organizations find a balance between guaranteed salary and performance-based compensation that attracts, retains, and motivates employees to make good decisions. 845 846 Tying managers’ incentive compensation to the company‘s stock performance has the obvious benefit of aligning managers’ incentives with those of shareholders. Part V Evaluating and Managing Performance Cash bonuses. Cash bonus awards have the advantage of being liquid and highly attractive because the reward is immediate and unconstrained. Companies usually make cash bonus awards based on the achievement of performance objectives. Often these bonuses have a floor or lower threshold of performance (e.g., a minimum return on investment) before the employee earns any bonus. Many cash bonus incentives also have a ceiling or an upper threshold beyond which no more bonuses can be earned. Much interesting research has focused on the motivational properties of these awards and the incentives they generate to manipulate financial measures of performance. ” Stock awards. Stock awards. in contrast to cash bonuses. might not be redeemable for cash until some time in the future. Some companies have an unwritten rule that man- agers cannot sell company stock until they leave the firm or retire. Stock awards that cannot be immediately sold, while perhaps not as attran tive as an equivalent amount of cash, can align the inter- ests of managers with those of shareholders better than cash awards can. For this reason, top-executive compensation often is composed more heavily of stock than of cash bonus or salary. (See Exhibit 20—8.) Stock appreciation rights. Stock appreciation rights (SARs) confer bonuses to employees based on increases in stock prices for a predetermined number of shares. For example, suppose you have been granted 10 SARs and the stock price increased $25. Your bonus would be equal to 10 X $25 2 $250. This incentive combines the immediacy of a cash bonus with the long-term benefit to owners of increases in stock prices. Stock options. Stock options give an individual the right to purchase a certain num- ber of shares at a specified price over a specified time period and provide strong incentives for managers to increase stock value over the long run.12 A stock option has a lower monetary value than a share of stock, so a company might create more incentive to increase share prices by awarding stock options than simply awarding the same value and fewer shares of stock. Managers who receive large awards of stock options have much to gain from increases in share prices. This does not mean that managers lose nothing if the stock price declines, however, because the value of the options decline and managers suffer the opportunity cost of not increasing stock value (or earning an alternative cash bonus). Awards of stock options, therefore, have the motivational impact of stock grants but at a lower cost to the company. Despite the benefits of stock options, their use has declined in the years after the financial bubble burst in 2000. In addition, sufficient concern now exists that stock-option awards give matt- agers too much incentive to manipulate stock prices in the short run rather than build the company for the long term. A number of top US executives have tried recently to illegally manipulate stock prices but have found that getting caught means losing their reputation, wealth, and, in some cases, freedom. Perhaps when a climate of trust has been earned and then returns, firms will again base more compensation on stock ” A classic article is by Paul Healy, “The Effect of Bonus Schemes on Accounting procedures and Accrual Decisions." 'ZA readable article on stock options is “What You Need to Know About Stock Options“ by B. Hall. Chapter 20 Strategy. Balanced Scorecards, and incentive Systems options. Until then, we should expect more stock awards and bonuses based on accounting and operating performance. VCB rewards its branch managers with cash bonuses for meeting revenue growth, net interest margin, and return on net asset objectives. Executives also earn stock based on meeting overall residual income objectives. The proportions of execu— tive compensation value have averaged 40 percent salary, 30 percent cash bonus, and 30 percent stock. At present, VCB does not extend significant long-term compensa- tion to 10wer-level managers. Most of their compensation is salary and bonus based. Ethical Aspects of Incentives and Compensation Few people object to the concept and practice of pay for performance. Most peeple, however, object when pay is inconsistent with performance. For decades compensation experts have observed that executive pay often rises even in companies whose operating or stock price performance has dropped. Add extensive downsizing to this mismatch of pay and performance, and many see high executive pay as unethical and unfair to both stockholders and employees whosr: returns and pay have decreased. The mismatch of executive pay and firm performance has been widely observed in diverse organizations such as energy firms, telecorrununications, charities, investment funds, and health care. How can a mismatch between pay and performance persist? In some cases, the mismatch is the result of poorly designed incentive systems that generate high rewards even when stockholders lose money. ‘3 In other cases, critics blame rampant CEO greed and lack of oversight by stockholders’ representatives on boards of direc- tors. 1“ Others like Graef Crystal cite lack of required disclosures and widespread cor~ porate structures that leave compensation decisions in the hands of the CEOs them— selves, who cannot be trusted to report performance fairly or be objective critics of their own performance and value to the firm.15 If managers really cannot be trusted, one might predict that many stockholders believe the worst and either do not purchase stock or discount the value of the stock for the amount of excessive pay. In fact, stockholders’ fear of untamed executive behavior might explain why so many pulled their billions of dollars (or what was left) out of the stock market following the bubble burst in 2000. Concern for the integrity of the stock market and the well-being of the entire economy partly explains the ori- gin of the Sarbanes-Oxley Act of 2002, which among other things places the respon~ sibility for reported performance squarely on CEOs. The intent is that they can never again say, “I’m just the CEO. I don’t understand the complexity of accounting.” In fairness, many organizations have restructured their incentive systems to bet- ter match pay and performance. For example, in a recent year, McDonald’s did not reach its operating goals, and executives received no bonus compensation. Some firms restructured their systems voluntarily, but many others did so in response to increased disclosures required by 1992 SEC regulations and more recently the Sarbanes-Oxley Act of 2002.16 It is likely that these regulatory actions will more closely align executive pay and performance, but in the end it is difficult to mandate integrity or ethical behavior. The least costly economic system would be based on trust and integrity; however, that ideal state is contrary to human nature. The costs of aligning incentives and monitoring behaw ior are high, but the opportunity cost of allowing unethical behavior is higher. Unethical behavior will be a continuing problem, but the return of investors to the stock market might be a sign of increasing trust in improved pay for performance incentive systems. l3For example, see N. Mathiason, “Failing Fund Men Pile on the Pounds." '4 V. Galloro and L, Benko, “Are They Worth It?“ '5 G. Crystal, “Why CEO Compensation Is so High”; M. Jensm‘t and K. Murphy, “CEO Incentives—It‘s Not How Much You Pay, but How." ’5 See K. Lo, “Economic Consequences of Regulated Changes in Disclosure: The Case of Executive Compensation." Interestingly, Lo found that managers of firms whose stockholders had the most to gain from improved incentive systems were most likely in 1991 to lobby against increased disclosures of their pay. LG ‘1“ Discuss ethical issues of incentive Systems. 847 84B You’re the Decision Maker 20.2. Part V Evaluating and Managing Performance incentive -t in "we stir {litigateiterations A. Nonprofit organizations range from small, informal organizations such as Sports clubs, student organizations, and parent groups supporting sports and music activities to large, well-established organizations such as the U ‘ the 11:: Cross. most universities, and government departments and agencies, such as the 13ostai Service, the Department of 'unspo: ion and the Ens-"arc: ' Agenc'r, By definition, a nonprofit organization has something other than earning a profit as its primary goal. Thus, effective nonprofit incentive systems primarily should create incentives for managers to perform well on nonfinancial dimensions.” Although nonprofits do not try to maximize profits, they must provide services in a cost-effective manner. Nonprofits compete for scarce funds and nonmonetary sup- port and must be able to show donors and supporters that their contributions are being used effectively. Smart Money magazine, for example, annually analyzes the efficiency of charitable organizations. Thus, a nonprofit’s concern for creating value at lowest cost can be similar to that of a profit-seeking firm. Nonprofit organizations also must demonstrate proper accountability for the use of funds and manage their operations and revenues to ensure that they break even. Despite differences between for-profit and nonprofit organizations, nonprofits increasingly use features of executive incentive plans developed in the private sector. These organizations also compete for top management talent and must align execu— tives’ interests with those of the organizations. Many nonprofit organizations award performance bonuses up to 10 percent of salary. Some nonprofit hospitals offer per— formance bonuses based on cost savings, health care improvements, and other fac- tors. Many organizations, however, decline to develop incentives to retain manage- ment talent only to find that they must pay much more to replace talent lost to the private sector or more aggressive nonprofits. Incentive plans also can create difficulties for nonprofits. For example, Harrisburg Hospital in Pennsylvania lost its nonprofit, tax—exempt status in part because the state’s courts ruled that its executive compensation plan, which gave cash bonuses for return on equity and revenue performance, clearly was designed to promote the hospital’s bottom line. The court observed that, although incentive plans were not contrary to the notion of a nonprofit organization, this incentive plan aligned managers” interests more with earning profits than providing charitable health care services. The incentive plan was convincing evidence that the hospital had a strong profit motive.18 Designing Incentive Systems You are a consultant advising Valley Commercial Bank about its incentive systems for lower—level managers and employees. Your interviews with branch and department managers inform you that they are satisfied with the new balanced scorecard performance measurement system (see Exhibit 20—6) but believe that they are not rewarded for performing well. Nonmanagement employees likewise enjoy their jobs but do not believe that they have real incentives to‘ work harder or better. At the end of each year, most branch and department managers and employees receive annual salary increases between 4 percent and 6 percent. Branch managers also earn bonuses up to 10 percent of their salary for meeting sales growth and return on asset objectives. Promotions appear to be based on seniority; the longer a person is in a job, the better the per- son‘s chances for promotion. Do the interview responses signal a potential problem? if so, what do you think that VCB sh0u|d do? (Solution begins on page 857.) ‘7 For a comprehensive treatment of management control in nonprofit organizations, see R. N. Anthony and D- W. Young, Management Control in Nonprofit Organizations. ‘3 Harrisburg Hospital v. Dauphin County Board of AssessmenrAppeais Chapter 2!} Strategy. Balanced Scorecards, and incentive Systems iatti'rn'rmry of s2.rrr'i"in':er"cinl tr. unit s L:‘ Incentive system designers should consider each element of Exhibit 20—9 to ensure that the plan addresses all alternative choices. To sum, VCB seeks to attract, moti- vate, and retain competent employees and to align their interests with shareholders” long-term interests. The bank’s incentive system has the following features: Absolute or relative performance. VCB uses both forms of performance: Residual income and environmental performance are compared to absolute objectives; evaluations of revenue growth, net interest margin, and return on assets are based on relative performance of similar business units. Formula—based or subjective performance. VCB also uses both formula and sub- jective evaluations. Residual income, net interest margin, and return-on~asset incentives for branch managers are formula based, but the bank subjectively evaluates other areas of performance that are measured less reliably (e.g., the value of employee suggestions). Financial 0r nonfinancial performance. As mentioned, VCB uses only financial performance measures in its formula-based incentive plans. The bank under~ stands the value of its nonfinancial performance for long-term success, but qual- ityg-of measurement is an issue. If the bank could reliably measure key nonfinan- cial performance from its balanced scorecard, it would formally include some of them in its formula—based incentives. Until then, VCB will continue to evaluate nonfinancial performance subjectively. Top candidates for inclusion in the incen— tive formula include employee satisfaction, productivity, and customer satisfac— tion because they are based on reliable instruments and can be audited. Narrow or broad responsibility of performance. VCB evaluates its executives on bankwide performance but its branch managers primarily on branch perfor— mance, with a relatively small emphasis on bankwide performance. Current or deferred rewards. VCB executives receive both current and deferred rewards; lower~ievel managers receive mostly current rewards. Salary or bonus rewards. All VCB employees receive a salary, but executives receive most of their compensation from bonus or stock rewards. Currently, lower-level managers receive most compensation from salaries, and lower-level employees receive all compensation from salaries. Although VCB has put much effort into designing its incentive plans, every plan can be improved. The bank’s board of directors annually reviews it in light of recent developments and changes in competitive pressures and recommends improvement. Current recommendations include refining some nonfinancial performance measures for inclusion in the bank‘s incentive formulas. The bank’s president and CEO also serves on the boards of directors of several charitable, nonprofit organizations and has been urging their boards to adopt features of the incentive plans of VCB and other successful companies. galaneed Scorecard—Eased incentives If the performance measures in Exhibit 20—6 are important to VCB’s success, employees should take actions to improve each of them and they should be in the scorecard. The issue is whether employees will do that without explicit incentives attached to each measure. Perhaps, if employees believe the story that a balanced scorecard tells, as discussed earlier, they will manage their activities to improve the measures with or without explicit incentives. Without explicit incentives, an organization must be sure that employees under- stand how performance on these measures affects the financial results and that rewards and penalties will result from successful financial performance. Removing rewards one or more levels of activity away from an individual’s actions can reduce the rewards’ effectiveness, however. As a result, the success story told by a balanced scorecard’s 849 850 Part V Evaluating and Managing Performance measures must be repeated again and again until it is part of the organization’s cul- ture. in some organizations this can be as effectiVe as creating explicit incentives. However, organizational culture is difficult to change, so an organization might find it difficult to revise the story of success if needed. Extending a balanced scorecard to an evaluation and incentive system involves two additional steps: Weighting the performance measures. Tying explicit incentives to measures (individually or in total). Performance on each measure in the system should have rewards. It does seem likely that no one person or management level should be evaluated on all of the measures, however. That can lead to information overload and unreasonable expectations for the influence one person can have on overall performance. A more reasonable approach is to assign responsibility and incentives for the various measures to persons who can best affect or control outcomes. Some organizations also assign overall scorecard incentives to managers at higher levels to reinforce the goal to ensure that subordi— nates are working to improve the measures they directly control. The nature of the incentive system (measures and rewards) will differ according to the organization. Effective incentive systems usually require reliable, objective, and Verifiable per- formance measures and clear guidance for evaluating trade’offs. Because the primary purpose of a balanced scorecard is to communicate and implement strategy, many organizations have not resolved these incentive issues. Partly as a result, some com- panies experienced significant internal conflict when they began to use a balanced scorecard as an incentive device. In a few cases, these companies have dispensed with a balanced scorecard altogether, but in others the conflict has led to compro- mises and improvements in performance measures and internal auditing procedures. Because VCB’s balanced scorecard had no major surprises and most employees can see the rationale behind each scorecard area and its measures, almost no debate about the scorecard itself occurred. Employees at all levels understand that the score card is a balanced set of measures that reflects the bank’s strategy to grow and pros- per. Bank employees report that they understand why and how their efforts can improve the bank’s financial performance. This was a major improvement in the communication of the bank’s strategy and led employees to focus on improving the measures that they can influence. Although none of the performance measures was perfect, top management believed that using them for performance evaluation reinforces the desired behavior and generates superior profitability. However, many employees express concern about the use of the scorecard as a fomula-based evaluation and incentive system because they believe that some measures are too subjective or capable of manipular tion. They wonder how they should act when faced with trade-offs between measures that might conflict (e.g., reducing costs or improving customer satisfaction) and whether they will be penalized for making trade-offs. Because VCB’s employees trust top management and are comfortable with some subjective evaluations, the bank has been able to coordinate its formula-based and subjective evaluations (as dis- cussed earlier) with the use of a balanced scorecard for communication, motivation, and evaluation. As in nearly all organizations, VCB’s balanced scorecard and incen- tive system continue to evolve and improve. Chapter Summary Leading indicators of performance are early measures of outcomes of activities that allow organizations to predict problems, identify opportunities, and prevent mistakes. Leading indicators predict organizer tional outcomes such as customer satisfaction and future sales. Employees use leading indicators to manage activities and processes to ensure favorable final outcomes. Employees act to make improve- ments based on signals from leading indicators rather than wait to see whether final outcomes are favor) able or unfavorable before making improvements or corrections. Organizations use performance measures of (I) organizational learning and growth, (2) businesS and production processes. and (3) customers as leading indicators of (4) financial performance. Chapter 20 Strategy, Balanced Scorecards. and Incentive Systems A balanced scorecard is a model of cause-and—effect relations among leading and lagging indica- tors of performance. It is useful for measuring and communicating the effects of activities on organiza- tional performance. A balanced scorecard shows the cause and effect among these four areas of perfor— mance. One can think logically of performing well on learning and growth as leading to improved business processes and improved cusromer satisfaction and loyalty, which leads to improved financial performance. Various linkages exist among the four areas, but the point is that performing well on the three leading (usually nonfinanciai) areas should lead to improved financial performance and that finan— cial performance lags nonfinancial performance. If it is possible to quantify these cause-and-effect rela— tionships. a balanced scorecard can be a valuable financial planning model. The two key elements of an incentive system are the #186251”?ij of performance and the medium 3‘ J ofcompeumtion. Managers make many choices regarding incentive systems, These choices regarding performance evaluation include whether to rely on measures of current or future performance. whether to use division or companywide performance measures, whether to base performance on accounting results or stock performance, and whether to use absolute or relative performance evaluation. Furthermore, these choices include whether to base rewards on a subjective evaluation or a fixed for- mula and whether to reward good performance with cash, stock, or prizes. The objective of designing incentive plans is to select a package of performance measures and rewards that will attract, motivate, and retain good employees and align their interests with those of the organization. to ChapterTwenty Theories of Incentives and Behavior BSI We discuss two views of incentives and human behavior that address key parts of to 5 Understand three incentive systems, expectancy and agency theories of motivation and incentives. These are not opposing views, but they stress different aspects of motivation and behavior. Together, they provide a relatively complete picture of the nature of incen- tives that motivate behavior. ExpectancyTheory of Motivation and incentives Expectancy theory explains that people are motivated by monetary or nonmonetary incentives to act in ways that they expect to provide them the rewards that they desire and to prevent the penalties that they wish to avoid. ‘9 This theory’s roots are in orga- nizational psychology. To motivate people to behave in a particular way, incentive plans must do two things: 1. Provide desirable rewards or undesirable penalties. 2. Provide a high probability that behaving as the organization desires will lead to those rewards or penalties. That is, the incentive plan provides expectancy that desired behavior leads to desired rewards. For example, the goal of a course of study is to disseminate or acquire knowledge. The incentive system to motivate achievement of that goal is a system of grades awarded for examination performance. It is fair to assume that high grades are desirable, so the reward itself is in place. What if the instructor’s exams— the measures of performance—are so unrelated to the material being studied that there is a low probability that studying will improve exam scores? Expectancy theory predicts that students will not be motivated to study by this incentive system because they believe that studying has a low probability of improving test scores. Thus, nei- ther the instructor nor the students will achieve the goal of learningfiacquiring knowledge through study—because the incentive plan does not provide sufficient expectancy that rewards will be related to studying. '9 T. B. Green, Performance and Motivation Strategies for Today '3 Workforce: A Guide to Expectancy Theory Applications. theories of motivation and incentives. 852 Part V Evaluating and Managing Performance Expectancy Theory. Incentives and Motivation A: Employee effort is high when reward is linked to performance and performance is linked to effort r—F— High expectancy of reward motivates effort HIGH exectanc HIGH exectanc that effort will result in that performance will result in reward performance Reward based on performance High expectancy of ‘ performance motivates effort I B: Studying effort is low when exam performance is not linked to studying — — n — — — — m — — Expectancy of reward has no effect on effort -— — — — — -— — — — — | 111 X - (D O H. N 5 O '- 'hstasaarnanee::sa .. result in reward Low expectancy of performance motivates low effort C: Customer service effort is low when reward is not linked to customer service performance - -- -- r 7 Low expectancy of reward motivates low effort resfult in " ' " Expectancy of performance _ __ has no effect on effort ' _ Expectancy success and failure. Exhibit 20_l3 reflects the basic elements of expectancy theory. Panel A shows the ideal incentive system: Effort is high when employees have a high expectancy that their efforts affect performance and that the performance will be rewarded appropriately. The feedback arrows in panel A reflect that both of the high expectancies reinforce the motivation to exert effort. Panel B, however, shows a breakdown in the incentive system. This is the situation describing students exerting low study effort if they have a low expectancy that studying will affect exam performance. The promise of a high grade based on high performance has no effect because the link in the expectancy chain between studying and exam performance has broken. Some incentive systems’ expectancy chains are broken at the link between performance and reward; still others are broken at both links. comtsdAL'BANK Expectancy theory and VCB’s old incentives. Panel C of Exhibit 20—13 applies expectancy theory to customer service activities at VCB before improving the incen- tive system. Top management wants to improve customer relations and for several years has gathered measures of customer satisfaction using customer—satisfaction questionnaires about the bank’s services. (You might have completed these in assess- ing restaurant or hotel quality and service and in evaluating your instructors.) At one time the bank provided no rewards to employees for efforts that build customer satis- faction. As shown in panel C of Exhibit 20—13, expectancy theory explains why VCB’s employees were not motivated to build customer satisfaction: They were not rewarded for it. (This does not consider personal rewards that might have come from Chapter 20 Strategy, Balanced Scorecards, and incentive Systems employees’ interactions with the customers.) Consequently, VCB probably did not have as many satisfied customers as it might have had with a better incentive plan. Recently, to promote customer satisfaction, the bank began to reward employees if customers are satisfied with the services they receive. This makes the incentive sys- tem more like panel A of Exhibit 20-—13. Because VCB management and employees believe that good service is likely to build customer satisfaction and customer satisfac- tion predictably leads to rewards, this incentive system promotes the desired behavior. Extrinsic and intrinsic rewards. Extrinsic rewards come from outside the individual from teachers, parents, organizations, or partners and include grades, money, praise, and prizes. Intrinsic rewards, on the other hand, come from within the individual, such as the satisfaction from studying hard, the feeling of well-being from physical exercise, the pleasure from helping someone in need, or the satisfaction of doing a good job. Getting an A on an exam is an extrinsic reward; satisfaction with your per- formance is an intrinsic reward. Although VCB originally did not reward its employees for building customer satisfaction, the employees might have received an intrinsic reward, such as internal satisfaction from providing good service. They also might have been rewarded with thanks and affection from loyal customers, which are also extrinsic rewards, but not from the bank. By adding extrinsic rewards to the incentive plan, VCB reinforced existing rewards and increased the likelihood that employees would work to improve customer satisfaction by increasing the expectancy of rewards from desired behavior. “People receive many intrinsic and extrinsic rewards. Teachers and caregivers, such as nurses, often work for wages less than their ability and effort can command because they receive intrinsic rewards from the work. In addition, many people vol« unteer their services not only because of the intrinsic rewards but also for the extrin- sic rewards—praise and gratitude——they receive. These are factors to consider in designing incentive systems. Some jobs inherently have more rewards than others do, and what people consider to be rewards differs. Some are motivated mostly by money; others are more motivated by public praise. One size does not fit all. Creating incentives tailored to each individual is diffi— cult for most organizations. However, improving everyone’s opportunities for intrin— sic rewards from desired behavior by making work interesting might be possible. Ensuring that extrinsic rewards are distributed fairly and based on the terms of the incentive plan is also important. To augment rewards from the job, many organiza- tions encourage employees to seek intrinsic (satisfaction) and extrinsic (“volunteer of the month”) rewards by donating their time to charitable work; some companies even allow employees to take some time from their jobs for charitable work. An effective incentive plan considers opportunities for both intrinsic and extrin— sic rewards and penalties and allows opportunities for variations, particularly of intrinsic rewards. Effective motivation usually requires a balance between extrinsic and intrinsic rewards, but the balance point varies with the organization and the peo— ple it attracts and retains. Goal-setting theory. Related to incentives is goal-setting theory, which is perhaps the most thoroughly tested incentive theory.20 Goal-setting theory has established the following conclusions: Impossible goals all but eliminate motivation because people realize that the desired performance and rewards cannot be achieved, regardless of effort. ' Easy goals reduce motivation to the minimum necessary to achieve them. Easy goals create lost opportunities to create more value at lower cost. Difficult but attainable goals consistently create the most motivation, effort, and lead to the highest level of performance compared to either impossible or easy goals. 1" E. A Locke. and G. P. Latham. 1990. A Theory afGaal Setting and Task Performance. 853 354 Part V Evaluating and Managing Perl'ornmncc AgencyTheot-y of incentives and Rehavior Agency theory is an economic concept of incentives and behavior based 0n the rela— tionship between a principal (cg, employer) who offers an incentive plan (or con— tract) and an agent (e. g., employee) who accepts the contract to work on behalf of the principal. In agency theory, incentive plans serve four purposes: they (1) improve organizational success by (2) motivating the employee to work, (3) by aligning the employee’s goals with the employer’s goals, and (4) allocating decision authority. A corporation such as VCB, for example, exhibits multiple principalmagent relation- ships, which include the following: Principals Contract Agents VCB shareholders Rewards e9 Oversight of management VCB board of directors VCB board of directors Rewards <—> Strategic management of VCB VCB top management VCB top management Rewards <—> Operational management of branch VCB branch managers banks VCB branch managers Rewards <—) Performance of branch-bank VCB branch employees activities VCB employees are agents of branch managers, who are agents of top managers at bank headquarters, who are agents of the board of directors and shareholders who own the company. Note that most employees have both a principal role and an agent role. What binds them together is an enforceable incentive plan or contract; princi~ pals offer rewards in exchange for making specific decisions. The focus of expectancy theory and agency theory differs, but they complement each other. Expectancy theory focuses on the characteristics of the incentive plans that motivate people whereas agency theory focuses on the contracting behavior between principal and agent. In a sense, they are two sides of the same coin. Applied to organizational settings, expectancy theory seeks to understand the types of per- formance measures and rewards that motivate employees. Agency theory, on the other hand, assumes that both principals and agents want to maximize their rewards at minimum cost, but they need each other. The principal provides the work and the rewards, which the agent does not, but the agent has the ability to do the work, which the principal does not. However, each has an opportunity cost in most cases: The agent can work elsewhere, and the princi- pal can put her money in the bank and earn interest. The principal wants to maximize her profits, which includes minimizing incentive costs, and the agent wants to mini— mize his effort to earn a market wage. The incentive plan needed to bring them together at least meets both parties‘ opportunity costs, aligns both parties’ goals, and clearly describes the decisions to be made. Improper incentives can cause misbehavior. Agency theory is complicated by the reality that once employed, employees do not necessarily behave in the ways that their employers desire. Furthermore, because any measure of performance is imper- fect, neither party can regard the incentive system as entirely fair. Employers might suspect undetected manipulation of performance measures, and employees might resent the risk imposed on them by imperfect measures. The employer could respond with other constraints on or monitoring of behavior at work. Employees might believe that working at a more leisurely pace, surfing the Web instead of working on company projects, or loafing with their friends at work are fair. Some employees even have incentives to steal more than time from the company. Furthermore, some employees might not have the skills or knowledge that they professed when they were hired or that they should maintain to stay employable at their current pay. All of these result in costs—lost opportunities to create value—for the employer and the employee. The incentive system not only must motivate employees to work but also must be designed so that employees’ rewards are fair and contingent on the organiza— tion’s meeting its goals. Minimizing agency costs with incentives and monitoring. The principal seeks to mini- mize total agency costs, which are the sum of opportunity costs of misbehavior and out- Chapter 20 Strategy. Balanced Scorecards. and incentive Systems 855 of-pocket costs for incentives Total Agency Costs 2 f. and monitoring performance. cues-ts of ii'icentivee + T I A c B“ “I” . Pi' The plan attract and motivate qualified High 1 Costs employees to behave accord— -' ing to the organization’s goals, but doing this costs money for paying employees and for monitoring to ensure that performance measures are valid. These payments reduce the value left for prin- cipals, so they seek to mini- mize them. A company might Low spend so much money on Costs f“ Costs of " Misbehavior I Best Incentive Plan incentives and reporting Low High (e.g., bonuses, accounting Levels oflncentives and reports, internal audits) that Monimring no employee will ever do something that is not in shareholders’ interests——and no qualified employee will sub- mit to these working conditions. However, such actions are unlikely to be economi— cal given the high costs of the incentives and reporting compared to the opportunity costs- of misbehavior. As Exhibit 20—14 shows, the best incentive plan trades off the costs of administering alternative incentive plans against the costs of misbehavior. The best incentive plan is not the one that drives the costs of misbehavior to zero (far right), nor is it the one that spends the least on incentives and reporting (far left). The best plan is located between these extremes, reflected by a “level” of incentives and monitoring on the X—axis. In theory, this is the mix of incentives and monitoring mechanisms that mini- mizes total agency costs. Agency theOiy shows that the “perfect” incentive system is too expensive and that some level of employee misbehavior is desirable; the overall best system is a result of evaluating trade~offs. Changes to reduce agency costs. All organizations experience some agency costs. According to agency theory, organizations change their incentive plans when they perceive an opportunity to reduce total agency costs. For example, VCB’S board of directors realized that the bank’s incentive system motivated managers to minimize current spending and cut staff rather than to build customer satisfaction. Bank man— agers were “playing by the rules,” but the incentive plan directed them to act in a way that was not in the long-term interests of the bank’s shareholders. One agency cost identified was a loss of profits because the bank was losing dissatisfied customers. Note that this also hurt employees because the bank was less profitable. As described in the body of the chapter, VCB changed the incentive System to include rewards for improved customer satisfaction because the bank believed the cost of the new incen— tive system was less than the lost profit from losing dissatisfied customers. Key Te rms For each term’s definition, refer to the indicated page or turn to the glossary at the end of the text. absolute performance customer value, 828 lagging indicator, 821 relative performance evaluation, 838 employee capabilities, 824 leading indicator, 820 evaluation, 838 agency COStSs* 854 expectancy theory,* 351 pay for performance, 835 “am aPpm‘fiati‘lfl rights agency “1901‘ W“ 354 extrinsic rewardsfi‘ 853 performance evaluation (SARSL 846 ' balanced scorecard, 820 Incentive SystemS 320 formula, 840 StOCk Options: 846 customer retention or intrinsic rewardsf 353 subjective performance loyalty, 828 evaluation, 841 *Term appears in the Appendix. ...
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hilton et al 06_001 - Third Edition 200(k). Strategies for...

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