MANAGEMENT COMPENSATION

Research Findings on Organizational

Incentives
Individuals tend to be more strongly
motivated by the potential of earning rewards
than by the fear of punishment.
A personal reward is relative or situational.
Individuals are highly motivated when they
received reports, or feedback, about their
performance.
Incentives beome less effective as the period
between an action and feedback on it increases.
Motivation is weakest when the person believes
an incentive is either unattainable or too easily
attainable.
The incentive that a budget or other statement of
objective provides is strongest when managers
work with their superiors to arrive at the
budgeted amounts.
Characteristics of Incentive
Compensation Plans


Incentives for Business Unit Managers
A wide array of options exists in developing an
incentive compensation package for business
unit managers
Types of Incentives
There are two types of Incentives:
Financial Rewards
Psychological and Social Rewards


In this chapter, we discuss the financial incentives
for business managers, while recognizing that
managers motivation is influenced by both
financial and nonfinancial incentives.
Size of Bonus Relative to Salary
Upper Cutoffs
Is the level of performance at which a maximum
bonus is reached.
Lower Cutoffs
Is the level below which no bonus awards will be
made.

Bonus Basis
A business unit managers incentive bonus could
be based on:
Total Corporate Profits, or
Business Unit Profits, or
Combination of the Two.

Performance Criteria
A difficult problem in the incentive bonus plan
for business unit managers is to decide which
criteria shall be used to determine the bonus.
Financial Criteria
Adjustment for Uncontrollable
Benefits and Shortcomings of Short-Term Financial
Targets
Mechanism to Overcome Short-Term Bias
Benchmarks for Comparison
Performance Criteria
Financial Criteria
If the Business Unit is a profit center, choosing
financial criteria could include Contribution
Margin, Direct Business Unit Profit, Controllable
Business Unit Profit, Income Taxes, and Net
Income.
If the Unit is an Investment Center, the decisions
need to be made in three areas: Definition of
Profit, Definition of Investment, and choice
between ROI and EVA.
Performance Criteria
Adjustments for Uncontrollable Factors
Typically, there are two kinds of influences
Remove expenses that result from decisions made by
executives above the business unit level.
Another adjustment eliminates the effects of losses
caused by acts of nature and accidents not caused by
the managers negligence.
Performance Criteria
Benefits and Shortcomings of Short-Term
Financial Targets
it is a good idea to link business unit managers
bonus to achieving annual financial targets (after
making allowances for uncontrollable events).
Performance Criteria
Mechanisms to Overcome Short-Term Bias
Supplementing financial criteria with additional
incentive mechanisms may overcome the short-
term orientation of annual financial goals.

Performance Criteria
Benchmarks for Comparison
A business unit managers performance can be
apraised by comparing actual results to the profit
budget, past performance, or competitors
performance.
Bonus Determination Approach
A bonus award for a business unit manaher
can be determined by formula-based, or by
subjective, or by combination of the two.
Form of Bonus Payment
Cash
Stock
Stock Options
Phantom Shares
Performance Shares
Agency Theory
Agency theory explores how contracts and
incentives can be written to motivate
individuals to achieve goal congruence.
It attempts to describe the major factors that
should be considered in designing incentive
contracts.
Concepts
An agency relationship exists whenever one
party (the principal) hires another party (the
agent) to perform some service and, in so
doing.
One of the key elements of agency theory is that
principals and agents have divergent
preferences or objectives. Incentive contracts
can reduce these divergent preferences.
Divergent Objectives of Principals and
Agents
For example, some agents may prefer leisure to
hard work or effort.
Leisure is assumed to be the opposite of effort.
Managers efforts increase the value of the
firm, while leisure does not. An agents
preference for leisure over effort is called
work aversion.
Agents and principals alse diverge with respect
to risk preferences.

Nonobservability of Agents Actions
Divergent preferences associated with compensation and
perquisites arise whenever the principal cannot easily
monitor the agents actions.
The divergence of preferences between the principal and
agent, and the agents private information, may lead
the agent to misrepresent information to the principal.
The misrepretation is of such a general nature that the
name moral hazard has been given to the situation in
which an agent being controlled is motivated to
misrepresent private information by natuure of the
control system.
Control Mechanism
Monitoring
Incentive Contracting
CEO Compensation and Stock Ownership
Plans
Business Unit Managers and Accounting-
Based Incentives
A Critique
Agency theory was inverted in the 1960s and
since then has been written about extensively
in academic journals. But the theory has had
no discrenible practical influence on the
management control process.