ACC3602

Managerial Planning and Control

Semester II, AY 2014/15
Instructor:Dr.ZhuZinan
Email:bizzz@nus.edu.sg
Office:BIZ1#724

Lecture 6
Incentive Systems
RelevantChapters:

MerchantandVanderStede,ManagementControlSystems:
PerformanceMeasurement,Evaluation,andIncentives,Chapter
9
LearningObjectives:
1.
Purposesofincentives
2.
Monetaryincentives
3.
Incentivesystemdesign
4.
Criteriaforevaluatingincentivesystems

1. Purposes of incentives

Positiveincentives
rewards
Thingsemployeesvalue

Negativeincentives punishments
Thingsemployeesliketoavoid

Incentivescanbemonetaryornonmonetary.

1. Purposes of incentives

Motivation
Motivationhastwoelements
Inducingeffort:gettingemployeestoworkhard
Employeestypicallyputforthmore(less)effortonactivities
thatare(not)rewarded

Directingeffort:helpingemployeesunderstand
whatisexpectedfromthem
Rewardsattracttheemployeesattentionandinformthem
oftherelativeimportanceofoftencompetingresultsareas

1. Purposes of incentives

Attraction/retentionofpersonnel
Payingemployeesonlyguaranteedsalariestendsto
attractriskaverse employees
Payingperformancedependentcompensation
tendstoattractemployeeswhoaremorerisk
tolerant,moreaggressive,moreconfidentintheir
abilities
Restrictedstock,forexample,oftenaregeared
towardsemployeeretention

2. Monetary Incentives

Thecompensationpackage:

Salary
Benefits
E.g.,Pensionandhealthbenefits

Incentivecompensation
Shorttermincentiveplans
Basedontheperformancemeasuredoverperiodsofone
yearorless
Longtermincentiveplans
Basedontheperformancemeasuredoverperiodsgreater
than1yearandoftenrelatedtothecompanysstockprice

2. Monetary Incentives

Shorttermincentiveplans

Basedonperformancemeasuredoverperiodsof
oneyearorless
Forexample,pieceratepayments,commissions,
bonuses

Calculation(byformula)ofshorttermincentives
Forexample,2%ofsales;10%ofnetprofits
Forexample,60%oftargetbonusat80%oftarget;
100%oftargetbonusat100%oftarget
(wheretargetbonus=30%ofsalary)

2. Monetary Incentives

Longtermincentiveplans

Basedontheperformancemeasuredoverperiods
greaterthan1year

Usuallyrestrictedtohighermanagementlevels

Accountingperformance (e.g.,EPS,ROE,ROA)
overaperiodof35years

Marketbasedperformance

Stockoptions

Restrictedstock

Performancestock

2. Monetary Incentives

Stockoptionplans

Stockoptionplansgiveemployeestherighttopurchaseaset
numberofsharesofcompanystockatasetprice(i.e.,theexercise
orstrikeprice)duringaspecifiedperiodoftime(i.e.,afterthe
optionsvestbutbeforetheyexpire).
Mostoptionsaregrantedatthemoney(i.e.,theexercisepriceis
equaltothestockpriceonthedayofgrant)witha35yearvesting
rate(i.e.,1/3,1/4,or1/5oftheoptionsgranted,respectively,vestat
theendofeachofthefirstthree,four,orfiveyears),anda10year
maturity(i.e.,theoptionsexpire10yearsaftertheyaregranted).
Whenstockprice>optionexerciseprice(i.e.,optionsareinthe
money),theemployeecanexercisethevestedoptionsandeither
holdthesharesorsellthemwithagain.

2. Monetary Incentives

Restrictedstockplans

Employeeseligibleforrestrictedstockdonothavetospendcashto
acquirethestock,butsellingthestockthattheyaregivenis
restrictedforaspecifiedperiodoftime(typically35years)andis
contingentuponcontinuedemployment.
Restrictedstockprovidesarewardforincreasesinstockprice.
Restrictedstockhasbeenderidedasagiveawayorpayforpulse
(ratherthanpayforperformance)becausethestockhassome
value(evenifthestockpricedeclines)andtherestrictionson
sellingdisappearmerelywiththepassageoftimeandcontinued
employment.
Betterserveretentionpurposes
Restrictedstockvs.stockoption

2. Monetary Incentives

Performancestockplans

Toeliminatethegiveawayperceptionofrestrictedstockand
accentuatepayforperformance,somefirmshaveresortedto
performanceawards.
Performancestocks:maketheirgrantscontingentonthe
achievementofstockornonstockgoalsoveramultiyearperiod.
Forexample,yourcompanygrantsyou2,000performanceshares
thatwillresultin2,000sharesiftheearningspershare(EPS)of
yourcompanygrowby10%peryearorcumulativelyby30%after
threeyears.
E.g.,CocaColaCompany

3. Key incentive design elements

Sizeofincentivepay

Shapeoftheperformancerewardfunction

Incentiveformula(Useofsubjectivity)

Levelandtypeofmeasurement

Performanceattheindividual,entityorcompanylevel

Financialvs.nonfinancialperformance;singleormultiple
measuresorperformancecriteria

3. Key incentive design elements

Sizeofincentivepay(fixedvs.variablepay)

Becauseemployeesalmostinvariablyvaluemoney,a
significantproportionvariablepayshouldmotivatethemto
achievetheperformancegoals.
Compensationpackagesthatoffersignificantperformance
contingentpayarelikelytoattractemployeeswhoare
confidentabouttheirabilitiestoproducesuperiorresults
and/ormorewillingtoacceptrisk. employeeselection
Acrossfirms,differencesintheproportionofatriskpayare
greaterthandifferencesinbasepay
Levelsofatriskpaygenerallydecreaseatlower
organizationlevels

3. Key incentive design elements

Shapeofrewardfunction
Commonly,thelinkbetweenrewardsandresultsislinear,
butoverarestrictedperformancerangeonly
MAX

Rewards ($)

Results (profit)

ZERO
LOW

80% of
budget
target

100% of
budget
target

150% of
budget
target

HIGH

3. Key incentive design elements

Lowercutoff
Toavoidpayingbonusesforperformancewhichis
consideredmediocreorworse
Uppercutoff
Tomaintainverticalcompensationequity
Tokeeptotalcompensationsomewhatsmoothovertime
Toavoidthefactthatmanagerswillbeunduly
motivatedtotakeactionstomaximizebonuspayouts
Toavoidundeservedbonusesduetowindfallgains
Toalleviatethepossibilityofafaultycompensationplan
design

3. Key incentive design elements

Incentiveformula

Formulaically
Theperformancerewardlinkisexplicit
Alleviatesbiasorfavoritisminassessingandrewarding
performance
Possiblylessfocusonperformancedimensionsthatare
moredifficulttoquantify

Subjectively
Allowsperformancetobeevaluatedmorecompletely
consideringanyofanumberofhardtoquantify,but
important,performanceareas
Lackofexplicitnessincreasestheemployee'srisk(dueto
possiblebias)

4. Criteria for evaluating reward systems

Rewardsshouldbevalued
Rewardsthathavenovaluedonotprovidemotivation
Rewardtastesvaryacrossindividualsandare
situational
Rewardsshouldbelargeenoughtohaveimpact
Rewardvisibilitycanaffectimpact
Rewardsshouldbeunderstandable
Whatisthereasonforearningthereward?
Rewardsshouldbetimely
Delayinprovidingtherewardsaftertheperformanceis
saidtodilutetheirmotivationaleffects.

4. Criteria for evaluating reward systems

Rewardsshouldbedurable
Rewardshavegreatervalueifpositivefeelings
generatedthroughtherewardarelonglasting,thatis,
ifemployeesrememberthem
Rewardsshouldbereversible
Promotions,forinstance,aredifficulttoreverse
Rewardsshouldbecostefficient
Tostimulatethedesiredmotivationatminimalcost

4. Criteria for evaluating reward systems

Incentivesshouldbesufficientlymeaningfultooffsetother
motivesemployeeshavetoactinwaysthatarecontraryto
theorganizationsbestinterest,buttherewardsshouldnot
begreaterthanthosenecessarytoprovidetheneeded
motivation.
Anincentivesystemwillnotcreatevaluefortheorganization
unlesstheincrementalvalueoftheincreasedperformance
generatedbytheincentivesexceedstheassociated
compensationandadministrationexpense.
Itmaybebettertohavenoincentivesystemthantohavea
badone.

EndofLecture6