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MANAGEMENT COMPENSATION

Management Control SystemsChapter 12

September 2014

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Research Findings onOrganizational Incentives

People are influenced by both positive and negative incentives.

A Positive Incentive = REWARD, is an outcome that increases satisfaction of individual needs.

A Negative Incentive = PUNISHMENT, is an outcome that decreases satisfaction of individual needs.

September 2014

Iwan Pudjanegara, SE., MM. 3

Research Findings onOrganizational Incentives

Research on incentives tends to support :1) Individuals tend to be more strongly

motivated by the potential of earning rewards than by the fear of punishment (MCS should be reward oriented).

2) A personal reward is relative or situational. Monetery compensation is an important means of satisfying needs.

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Research Findings onOrganizational Incentives

3) If senior management signals by its actions that it regards the MCS as important, operating managers will also regard it as important.

4) Individuals are highly motivated when they receive reports, or feedback about their performance.

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Research Findings onOrganizational Incentives

5) Incentives become less effective as the period between an action and feedback on it increases.

6) Motivation is weakest when the person believes an incentive is either unatainable or too easily attainable. Motivation is strong when it takes some effort to attain the objective.

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Research Findings onOrganizational Incentives

7) 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. Objectives, goals, or standards are likely to provide strong incentives only if the manager perceives them as fair.

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Characteristics ofIncentives Compensation Plans

A manager’s total compensation package consists of 3 components :1. Salary2. Benefits3. Incentive compensation

The 3 components are interdependent, but “the incentive compensation” is related specifically to MC function.

September 2014

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Characteristics ofIncentives Compensation Plans

Managers typically receive higher compensation in large companies than in small firms, and companies in the same industry tend to compete with each other on compensation.

Incentive compensation plans must be approved by the BOD and the shareholders.

September 2014

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Characteristics ofIncentives Compensation Plans

2 types of Incentive Compensation Plans:1) Short-term Incentive Plans2) Long-term Incentive Plans

Short-term incentives plans are based on performance in the current year.

Long-term incentives plans are based on longer-term accomplishment and are related to the price of company’s CS.

September 2014

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Short-Term Incentive Plans

The Total Bonus Pool

Carryovers

Deferred Compensation

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Short-Term Incentive Plans(The Total Bonus Pool)

Total Bonus Pool : the total amount of bonus that can be paid to a qualified group of employees in a given year.

This formula usually is related to the overall company profitability in the current year.

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Short-Term Incentive Plans(The Total Bonus Pool)

Several methods to establish The Bonus Pool :The bonus equal to a set percentage

of the profits.•Many companies don’t like using this

method because it means paying a bonus even when profitability is low.

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Short-Term Incentive Plans(The Total Bonus Pool)

Pay bonuses only after a specified return has been earned on capital.• To base the bonus on a percentage of

earnings per share after a predetermined level of earnings per share has been attained.

However, this method does not take into account in investment from reinvested earnings.

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Short-Term Incentive Plans(The Total Bonus Pool)

• The bonus is equal to a percent of the profits before taxes and interest on long-term debt, minus a capital charge on the total of shareholder equity plus long-term debt.

The reason why companies using this method because managerial performance should be based on employing corporate net assets profitably & financial policy.

September 2014

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Short-Term Incentive Plans(The Total Bonus Pool)

• To define capital as equal to shareholder equity.

A difficulty with both this and the preceding methods is that a loss year reduces shareholder equtiy and thereby increases the amount of bonus to be paid in profitable years.

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Short-Term Incentive Plans(The Total Bonus Pool)

Base the bonus on increases in profitability over the preceding year.

Base bonuses on their profitability relative to that of their industry.

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Short-Term Incentive Plans(Carryovers)

An annual carryover of a part of the amount determined by the bonus formula.

Advantages :It is more flexibleIt can reduce the magnitude of the swings

that occur when the bonus payment is based strictly on formula amount calculated each yr.

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Long-Term Incentive Plans

Stock OptionsPhantom SharesStock Appreciation RightsPerformance SharesPerformance Units(find out their definition!!! Page 518-520)

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Incentives for BU Managers(Types of Incentives)

1. Financial Rewardsa) Salary Increaseb) Bonusesc) Benefitsd) Perquisites (automobiles, vacation

trips, club memberships, etc.)

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Incentives for BU Managers(Types of Incentives)

2. Psychological & Social Rewardsa) Promotion Possibilitiesb) Increased Responsibilitiesc) Increased Autonomyd) Better Geographical Locatione) Recognition (=pengakuan,

penghargaan)September 2014

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Incentives for BU Managers(Size of Bonus & Based on)

Size of Bonus Relative to Salary1) Upper Cutoffs2) Lower Cutoffs

Bonus Based on1) Business Unit Profits2) Company Profits3) Combination of the Two

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Incentives for BU Managers(Performance Criteria)

1. Financial Criteriaa) Contribution Marginb) Direct BU Profitc) Controllable BU Profitd) Income Before Taxes (IBT)e) Net Income (NI)f) Return on Investment (ROI)g) Economic Value Added (EVA)

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Incentives for BU Managers(Performance Criteria)

2. Time Perioda) Annual Financial Performanceb) Multiyear Financial Performance

3. Nonfinancial Criteriaa) Sales Growthb) Market Sharec) Customer Satisfactiond) Quality

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Incentives for BU Managers(Performance Criteria)

e) New Product Developmentf) Personnel Developmentg) Public Responsibility

4. Relative Weights Assigned to Financial & Nonfinancial Criteria

5. Benchmarks for Comparisona) Profit Budget b) Past Performancec) Competitor’s Performance

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Incentives for BU Managers(Bonus Determination & Form)

Bonus Determination Approach1) Formula-Based2) Subjective3) Combination of the Two

Form of Bonus Payment1) Cash 2) Stock3) Stock Options 4) Phantom Shares5) Performance Shares

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Agency TheoryConcepts

Divergent Objectives of Principals and AgentsNonobservability of Agents’Actions

Control MechanismsMonitoringIncentive ContractingCEO Compensation and SOPBU Managers & Accounting-Based Incentive

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Case 12-2 Crown Point Cabinetry

Team Presentation!!!

September 2014