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Module VII

Management Compensation

Objectives
Why organizational incentives required? To discuss characteristics of incentive compensation plans. Compensation plans for Corporate Officers and Business Unit managers.

Why Incentives?
The key to motivate people is to give rewards to achieve the organizational goals and objectives. The rewards can be positive and negative as well. The positive incentive is an outcome that increases the satisfaction while the negative reward can be a punishment. Individuals tend to be more strongly motivated by the potential of earning rewards than by the fear component. Monetary compensation is an important for satisfying needs. But, beyond a certain satisfaction level, the nonmonetary rewards are very important. Individuals are highly motivated when they receive reports, feedback about their performance. The motivation can be weakest when either the targets are too tough or too easy.

Characteristics of Incentive Compensation Plan


A managers compensation package consists of three components: 1) salary, 2) benefits and 3) incentive compensation. The benefits are the retirement, health care, perquisites and many other. All the above three components are very important and interrelated but the third is related specifically with the management control functions. The decisions of incentive compensation plans are taken by board of directors and then approved in the annual meetings which requires share holders permission. Incentive compensation plan can be divided into two broad categories i.e. short term and long term incentive plan. Short term plans are based on the performance of the current year while the long term plans tie compensation with the longer term accomplishments.

Short term incentive plans


1. The total bonus pool: the total amount of bonus paid to a qualified group of employees in a given year is called the bonus pool. In a short-term incentive plan share holders vote on the formula to be used for bonus calculation. This formula usually is related to the overall company profitability in the current year. There are several ways to establish the bonus pool, the one is to calculate a pre decided percentages on profit. But, that means the bonus is paid even in case of less profits. So, the another method is to base the bonus on a percentage of earning per share after a pre determined level of earning per share. Few companies base the bonus on increases in profitability over the preceding year.

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2. Carryovers: - In this method the part of the bonus is kept as the carryovers and that amount can be used in the poor profit year. - Here the bonus is not based on any formula calculation rather there is a committee which takes this decision so it is easy of the board of directors also. - The problem with this method is that bonuses relate less directly to current performance. 3. Deferred Compensation: - although the amount of bonus is calculated annually, payments are spread out in number of years, usually five.

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- Under this system executives receive only one fifth of the bonus and rest four fifth will be paid equally in next four years. - The benefit of this method is that it creates the continuous income and even after the manager retires he will be getting the income. - And the another advantage is the differed time frame encourages decision makers to think in long term. - The disadvantage is it makes the payments in other years and so, in that year when the performance is very good they may paid less.

Long Term Incentive Plans


A basic premise of many long-term incentive plan is that growth in the value of the companys common stock reflects the companys long term performance. Stock Options: a stock options is a right to buy a number of shares of stock at or after a given a date in the future at a price agreed upon at a time the option is granted. The manager gains if he sells the stock later when the prices are increasing. However, many stocks options are for restricted stock, means, managers are not permitted to sell this stock for a specified period after it was acquired.

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2. Phantom Shares: - A phantom stock plan award managers a number of shares but for bookkeeping purpose only for a particular time period. - After that time duration the manager will be given the amount equal to the appreciation in the market value of the stock since the date of award. - This award may be in cash, in stock, or in both. Unlike the stock option, the phantom stock dont have transaction costs. - This involves a risk of a decrease in the market prices as well as interest costs are not involve in the phantom stock.

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3. Stock Appreciation Rights:

- A stock appreciation right is a right to receive cash payments based on the increase in the stocks value from the time of the award until a specified future date. 4. Performance Shares: - A performance share plan awards a specified number of shares of stock to a manager when specific long-term goals have been met. - Usually the goals are to achieve a percentage growth or return on investment. - This plan suffers from the limitation of performance base bonus, under some situations actins of executives to improve the earning per share might not contribute to the economic value of the firm.

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5. Performance Units: - In a performance unit plan, a cash bonus is paid when specific long-term targets are attained. - It is specially useful to those companies which have very less or no publicly traded stock. - The long-term targets must be carefully established in order to succeed. CEO Compensation - the CEOs compensation is usually discussed by the board of directors after the CEO has presented compensation for subordinates. - CEOs general attitudes, the actions to achieve the long term goals are taken into consideration.

Incentives for Business Unit Managers


A. Types of Incentives
1. 2. Financial Rewards: Salary Increase Bonus Benefits Perquisites Recognition Psychological and Social rewards: Promotion Possibilities Increased responsibilities Increase autonomy Better geographical location

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B. Size of Bonus relative to salary C. Bonus based on: Business Units Profits Company Profits Combination of two D. Performance Criteria: 1. Financial Criteria Contribution Margin. Direct Business Unit profit Income before taxes Net Income Return on Investment Economic Value Added

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2. Time Period Annual Financial Performance Multiyear Financial Performance 3. Non-financial Criteria Sales Growth Market Share Customer Satisfaction Quality New Product Development Personnel Development Public Responsibility 4. Relative weights assigned to financial and non-financial criteria 5. Benchmarks of comparison Profit Budget Past Performance Competitor's Performance

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E. Bonus Determination Approach: Formula Based Subjective Combination of both F. Form of Bonus Payment Cash Stock Stock Options Phantom Shares Performance Shares