Chapter 9

Slide 9.
Chapter 9: Incentive Systems
Merchant, Management Control Systems PowerPoints on the Web, 3rd edition, Pearson Education Limited 2012
Slide 9.2
Financial results controls
Three core elements:

Financial responsibility centers
The apportioning of accountability for financial results within the organization
Formal management processes

Planning and budgeting to define performance expectations and standards for evaluating performance
Motivational contracts
To define the links between results and various organizational incentives
Slide 9.3
Positive and negative incentives
Positive incentives
Things employees value
rewards punishments
Negative incentives
Things employees like to avoid
Individuals are believed to be more strongly motivated by the potential of earning rewards than by the fear of punishment
Slide 9.4
Forms of rewards and punishments
Rewards
Monetary
Salary increases Bonuses Benefits Perquisites Club memberships Vacation trips
Promotion Autonomy Recognition Participation in decisions Office assignments Preferred parking places Titles
Punishments
Monetary
No raise No bonus No perquisites
Non-monetary

Non-monetary
Interference in job from superiors Loss of job Assignment to unimportant tasks No promotion Humiliation
Slide 9.5
The compensation package

Salary Benefits
Pension and health benefits Perquisites of various types
Incentive compensation
Short-term incentive plans
Based on the performance in the current year or less
Long-term incentive plans

Based on the performance measured over periods greater than 1 year and often related to the companys stock price
Slide 9.6
Short-term incentive plans
Based on performance in the current year or less For example, piece-rate payments, commissions, bonuses
Calculation (by formula) of short-term incentives
For example, 2% of sales; 10% of net profits For example, 60% of target bonus at 80% of target; 100% of target bonus at 100% of target (where target bonus = 30% of salary)
Slide 9.7
Long-term incentive plans
Based on the performance measured over periods greater than 1 year

Usually restricted to higher management levels
Accounting performance (e.g., EPS, ROE, ROA)

over a period of 35 years
Market-based performance
Stock
options
Restricted
Stock
stock
appreciation rights
Slide 9.8
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 often-competing results areas
Slide 9.9
Purpose of incentives (continued)
Attraction/retention
Paying employees only guaranteed salaries tends to attract risk-averse employees
Paying performance-dependent compensation tends to attract employees who are more risk tolerant, more aggressive, more confident in their abilities
Restricted stock, for example, often are geared towards employee retention
golden handcuffs
Slide 9.10
Purpose of incentives (continued)

Non-control
purposes
Provide a competitive compensation package Make compensation variable with firm performance Tax considerations
Slide 9.11
Key incentive design elements

Size of awards (fixed vs. variable pay) Level and type of measurement
Performance at the individual, entity or company level

Financial vs. non-financial performance; single or multiple measures or performance criteria
Shape of the performance-reward function Use of subjectivity
Slide 9.12
Proportion variable pay
Employees are risk averse ...

Performance-dependent rewards impose risk on the employees as performance is never fully controllable Across firms, differences in the proportion of atrisk pay are greater than differences in base pay Levels of at-risk pay generally decrease at lower organization levels
Slide 9.13
Shape of reward function
Commonly, the link between rewards and results is linear, but over a restricted performance range only
MAX
Rewards ($)
ZERO
Results (profit)
LOW
80% of budget target
HIGH
Slide 9.14
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 smooth over time To avoid the fact that managers will be unduly motivated to take actions to maximize bonus payouts To avoid undeserved bonuses due to windfall gains To alleviate the possibility of a faulty compensation plan design
Slide 9.15
Group rewards
Team-based rewards are often used to implement personnel / cultural controls

Group members monitor and sanction each others behaviors
They rarely provide a direct incentive effect

Stock-based plans, for instance, provide direct incentives only for a small number of managers at the very top of the firm Hence, for lower-level employees, compensation is made more volatile, although motivation may not be (greatly) affected
Slide 9.16
Bonus determination approach
Formulaically
The performance-reward link is explicit Alleviates bias or favoritism in assessing and rewarding performance but Possibly less focus on performance dimensions that are more difficult to quantify (e.g., R&D)
Subjectively
Allows performance to be evaluated more completely considering any of a number of hard-to-quantify, but important, performance areas Lack of explicitness increases the employee's risk (due to possible bias)
Slide 9.17
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?
Rewards should be timely

The discount rate employees apply to delayed rewards is said to be greater than the time value of money
Slide 9.18
Criteria for evaluating reward systems (continued)
Rewards should be durable

Rewards have greater value if positive feelings generated through the reward are long-lasting, that is, if employees remember them
Rewards should be reversible

To make rewards variable with performance and to create a lasting incentive effect (pay-for-performance vs. pay-for-pulse) Promotions, for instance, are difficult to reverse
Rewards should be cost efficient

To stimulate the desired motivation at minimal cost

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Slide 9.

Chapter 9: Incentive Systems

Financial results controls

Three core elements:

Formal management processes

Positive and negative incentives

Things employees like to avoid

Forms of rewards and punishments

The compensation package

Long-term incentive plans

Short-term incentive plans

Long-term incentive plans

Based on the performance measured over periods greater than 1 year

Accounting performance (e.g., EPS, ROE, ROA)

Directing effort: helping employees understand what is expected of them

Purpose of incentives (continued)

Purpose of incentives (continued)

Key incentive design elements

Performance at the individual, entity or company level

Shape of the performance-reward function Use of subjectivity

Proportion variable pay

Employees are risk averse ...

Shape of reward function

80% of budget target

100% of budget target

150% of budget target

Team-based rewards are often used to implement personnel / cultural controls

They rarely provide a direct incentive effect

Bonus determination approach

Criteria for evaluating reward systems

Rewards should be valued

Rewards should be large enough to have impact

Rewards should be understandable

Rewards should be timely

Criteria for evaluating reward systems (continued)

Rewards should be durable

Rewards should be reversible

Rewards should be cost efficient

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