Managerial Rewards
Managerial rewards frequently include incentives tied to performance. The objective is to encourage goal congruence, so that managers will act in the best interests of the firm. Arranging managerial compensation to encourage managers to adopt the same goals as the overall firm is an important issue. Managerial rewards include salary increases, bonuses based on reported income, stock options, and noncash compensation.
Cash Compensation
Cash compensation includes salaries and bonuses. One way a company may reward good managerial performance is by granting periodic raises. However, once the raise takes effect, it is usually permanent. Bonuses give a company more flexibility. Many companies use a combination of salary and bonus to reward performance by keeping salaries fairly level and allowing bonuses to fluctuate with reported income. Managers may find their bonuses tied to divisional net income or to targeted increases in net income. For example, a division manager may receive an annual salary of $75,000 and a yearly bonus of 5 percent of the increase in reported net income. If net income does not rise, the manager’s bonus is zero. This incentive pay scheme makes increasing net income, an objective of the owner, important to the manager as well.
Managerial rewards frequently include incentives tied to performance. The objective is to encourage goal congruence, so that managers will act in the best interests of the firm. Arranging managerial compensation to encourage managers to adopt the same goals as the overall firm is an important issue. Managerial rewards include salary increases, bonuses based on reported income, stock options, and noncash compensation.
Cash Compensation
Cash compensation includes salaries and bonuses. One way a company may reward good managerial performance is by granting periodic raises. However, once the raise takes effect, it is usually permanent. Bonuses give a company more flexibility. Many companies use a combination of salary and bonus to reward performance by keeping salaries fairly level and allowing bonuses to fluctuate with reported income. Managers may find their bonuses tied to divisional net income or to targeted increases in net income. For example, a division manager may receive an annual salary of $75,000 and a yearly bonus of 5 percent of the increase in reported net income. If net income does not rise, the manager’s bonus is zero. This incentive pay scheme makes increasing net income, an objective of the owner, important to the manager as well.
Of course, income-based compensation can encourage dysfunctional behavior. The manager may engage in unethical practices, such as postponing needed maintenance. If the bonus is capped at a certain amount (say the bonus is equal to 1 percent of net income but cannot exceed $50,000), managers may postpone revenue recognition from the end of the year in which the maximum bonus has already been achieved to the next year. Those who structure the reward systems need to understand both the positive incentives built into the system as well as the potential for negative behavior. Profit-sharing plans make employees partial owners in the sense that they receive a share of the profits. They are not owners in the sense of decision making or downside risk sharing. This is a form of risk sharing, in particular, sharing of upside risk. Typically, employees are paid a flat rate, and then, any profits to be shared are over and above wages. The objective is to provide an incentive for employees to work harder and smarter.
Stock-Based Compensation
Stock is a share in the company, and theoretically, it should increase in value as the company does well and decrease in value as the company does poorly. Thus, the issue of stock to managers makes them part owners of the company and should encourage goal congruence. Many companies encourage employees to purchase shares of stock, or they grant shares as a bonus. A disadvantage of stock as compensation is that share price can fall for reasons beyond the control of managers. For example, Wal-Mart stock rose and fell in value in the early 1990s. When the stock price fell, managers worried about employee morale. To keep morale high, the company created a cash bonus pool to be distributed for meeting sales and income targets.
Companies frequently offer stock options to managers. A stock option is the right to buy a certain number of shares of the company’s stock, at a particular price and after a set length of time. The objective of awarding stock options is to encourage managers to focus on the longer term. The price of the option shares is usually set approximately at market price at the time of issue. Then, if the stock price rises in the future, the manager may exercise the option, thus purchasing stock at a below-market price and realizing an immediate gain.
For example, Lois Canfield, head of the Toiletries Division of Palgate, Inc., was granted an option to purchase 100,000 shares of Palgate stock at the current market price of $20 per share. The option was granted in August 2005 and could be exercised after two years. If, by August 2007, Palgate stock has risen to $23 per share, Lois can purchase all 100,000 shares for $2,000,000 (100,000 x $20 option price) and immediately sell them for $2,300,000 (100,000 x $23). She will realize a profit of $300,000. Of course, if Palgate stock drops below $20, Lois will not exercise the option. Typically, however, stock prices rise along with the market, and Lois can safely bet on a future profit as long as Palgate does not perform worse than the market
Companies are becoming more aware of the impact on options of the overall movement of the stock market. If the market moves strongly higher, there is the potential for windfall profits. That is, any profit realized from selling stock based on low cost options may be more closely related to the overall rise in the stock market and less related to outstanding performance by top management. In addition, top executives with a number of options may focus on the short-term movements of the stock price rather than on the long-term indicators of company performance. In essence, they may trade long-term returns for short-term returns. Typically, there are constraints on the exercise of the options. For example, the stock purchased with options may not be sold for a certain period of time. A disadvantage of stock options is that the price of the stock is based on many factors and is not completely within the manager’s control.
Issues to Consider in Structuring Income-Based Compensation
Stock-Based Compensation
Stock is a share in the company, and theoretically, it should increase in value as the company does well and decrease in value as the company does poorly. Thus, the issue of stock to managers makes them part owners of the company and should encourage goal congruence. Many companies encourage employees to purchase shares of stock, or they grant shares as a bonus. A disadvantage of stock as compensation is that share price can fall for reasons beyond the control of managers. For example, Wal-Mart stock rose and fell in value in the early 1990s. When the stock price fell, managers worried about employee morale. To keep morale high, the company created a cash bonus pool to be distributed for meeting sales and income targets.
Companies frequently offer stock options to managers. A stock option is the right to buy a certain number of shares of the company’s stock, at a particular price and after a set length of time. The objective of awarding stock options is to encourage managers to focus on the longer term. The price of the option shares is usually set approximately at market price at the time of issue. Then, if the stock price rises in the future, the manager may exercise the option, thus purchasing stock at a below-market price and realizing an immediate gain.
For example, Lois Canfield, head of the Toiletries Division of Palgate, Inc., was granted an option to purchase 100,000 shares of Palgate stock at the current market price of $20 per share. The option was granted in August 2005 and could be exercised after two years. If, by August 2007, Palgate stock has risen to $23 per share, Lois can purchase all 100,000 shares for $2,000,000 (100,000 x $20 option price) and immediately sell them for $2,300,000 (100,000 x $23). She will realize a profit of $300,000. Of course, if Palgate stock drops below $20, Lois will not exercise the option. Typically, however, stock prices rise along with the market, and Lois can safely bet on a future profit as long as Palgate does not perform worse than the market
Companies are becoming more aware of the impact on options of the overall movement of the stock market. If the market moves strongly higher, there is the potential for windfall profits. That is, any profit realized from selling stock based on low cost options may be more closely related to the overall rise in the stock market and less related to outstanding performance by top management. In addition, top executives with a number of options may focus on the short-term movements of the stock price rather than on the long-term indicators of company performance. In essence, they may trade long-term returns for short-term returns. Typically, there are constraints on the exercise of the options. For example, the stock purchased with options may not be sold for a certain period of time. A disadvantage of stock options is that the price of the stock is based on many factors and is not completely within the manager’s control.
Issues to Consider in Structuring Income-Based Compensation
The underlying objective of a company that uses income-based compensation is goal congruence between owner and manager. To the extent that the owners of the company want net income and stock price to rise, basing management compensation on such increases helps to encourage managerial efforts in that direction. However, single measures of performance, which are often the basis of bonuses, are frequently subject to gaming behavior. That is, managers may increase short-term measures at the expense of long-term measures. For example, a manager may keep net income highby refusing to invest in more modern and efficient equipment. Depreciation expense remains low, but so do productivity and quality. Clearly, the manager has an incentive to understand the computation of the accounting numbers used in performance evaluation. An accounting change from FIFO to LIFO or in the method of depreciation, for example, will change net income even though sales and costs remain unchanged. Frequently, we see that a new CEO of a troubled corporation will take a number of losses (e.g., inventory write-downs) all at once. This is referred to as the “big bath” and usually results in very low (or negative) net income in that year. Then, the books are cleared for a good increase in net income, and a correspondingly large bonus, for the next year.
Noncash Compensation
Noncash compensation is an important part of the management reward structure. Autonomy in the conduct of their daily business is an important type of noncash compensation. At Hewlett-Packard, cross-functional teams “own” their business and have the authority to reinvest earnings to react quickly to changing markets. Perquisites are also important. We often see managers who trade off increased salary for improvements in title, office location and trappings, use of expense accounts, and so on. Perquisites can be well used to make the manager more efficient. For example, a busy manager may be able to effectively employ several assistants and may find that use of a corporate jet allows him or her to more efficiently schedule travel in overseeing far-flung divisions. However, perquisites may be abused as well. For instance, one wonders how the shareholders of Tyco benefitted from their 50 percent share of the $2 million party that former Tyco chief Dennis Kozlowski threw for his wife’s birthday, or from Kozlowski’s $6,000 shower curtain
Noncash Compensation
Noncash compensation is an important part of the management reward structure. Autonomy in the conduct of their daily business is an important type of noncash compensation. At Hewlett-Packard, cross-functional teams “own” their business and have the authority to reinvest earnings to react quickly to changing markets. Perquisites are also important. We often see managers who trade off increased salary for improvements in title, office location and trappings, use of expense accounts, and so on. Perquisites can be well used to make the manager more efficient. For example, a busy manager may be able to effectively employ several assistants and may find that use of a corporate jet allows him or her to more efficiently schedule travel in overseeing far-flung divisions. However, perquisites may be abused as well. For instance, one wonders how the shareholders of Tyco benefitted from their 50 percent share of the $2 million party that former Tyco chief Dennis Kozlowski threw for his wife’s birthday, or from Kozlowski’s $6,000 shower curtain
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