MEASURING AND REWARDING THE PERFORMANCE OF MANAGERS

While some companies consider the performance of the division to be equivalent to the performance of the manager, there is a compelling reason to separate the two. Often, the performance of the division is subject to factors beyond the manager's control. It is particularly important, then, to take a responsibility accounting approach and evaluate managers on the basis of factors under their control. A serious concern is the creation of a compensation plan that is closely tied to the performance of the division.

Incentive Pay for Managers Encouraging Goal Congruence

Managerial evaluation and incentive pay would be of little concern if all managers were equally likely to perform up to the best of their abilities, and if those abilities were known in advance. In the case of a small company, owned and managed by the same person, there is no problem. The owner puts in as much effort as she or he wishes and receives all of the income as a reward for performance. In most companies, however, the owner hires managers to operate the company on a day-to-day basis and delegates decision-making authority to them. The stockholders of a company hire the CEO through the board of directors, and division managers are hired by the CEO to operate their divisions on behalf of the owners. Then, the owners must ensure that the managers are providing good service.

Why wouldn't managers provide good service? There are three reasons: (1) they may be unable to perform the job, (2) they may prefer not to work hard, and (3) they may prefer to spend company resources on perquisites. The first reason requires owners to discover information about the manager before hiring him or her. Recall that one reason for decentralization was to provide training for future managers. The training process provides signals about the managerial ability of division managers. The second and third reasons require the owner to monitor the manager or to arrange an incentive scheme that will more closely ally the manager 's goals with those of the owner. Some managers may not want to do hard or routine work. Some may be risk-averse and not take actions which expose them, and the company, to risky situations. Thus, it is necessary to compensate them for undertaking risk and hard work. Closely related to the desire of some managers to shirk responsibility is the tendency of managers to overuse perquisites. Perquisites are a type of fringe bene fit received over and above salary. Some examples are a nice office, use of a company car or jet, expense accounts, and company-paid country club memberships. While some perquisites are legitimate uses of company resources, they can be abused. A well-structured incentive pay plan can help to encourage goal congruence between managers and owners.

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. Raises are one way for a company to reward good managerial performance. 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.

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.

Pro fit-sharing plans make employees partial owners in the sense that they receive a share of the pro fits. 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 pro fits 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.

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 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 Can field, 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 20x0 and could be exercised after two years. If, by August 20x2, Palgate stock has risen to $23 per share, Lois can purchase all 100,000 shares for $2,000,000 (100,000 $20 option price) and immediately sell them for $2,300,000 (100,000 $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 pro fit 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 pro fits. That is, any pro fit 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 encourages managerial efforts in that direction. Single measures of performance, however, which are often the basis of bonuses, are subject to gaming behavior in that managers may increase short-term measures at the expense of long-term measures. For example, a manager may keep net income high by 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.

Both cash bonuses and stock options can encourage a short-term orientation. To encourage a longer-term orientation, some companies require top executives to purchase and hold a certain amount of company stock to retain employment.

Another issue to be considered in structuring management compensation plans is that owners and managers may be affected differently by risk. Managers with much of their own capitalboth financial and humaninvested in the company may be less apt to take risks. Owners, because of their ability to diversify away some of the risk, may prefer a more risk-taking attitude. As a result, managers must be somewhat insulated from catastrophic downside risk in order to encourage them to make entrepreneurial decisions.

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.12

Measuring Performance in the Multinational Firm

It is important for the MNC to separate the evaluation of the manager of a division from the evaluation of the division. The manager's evaluation should not include factors over which he exercises no control, such as currency fluctuations, income taxes, and so on. It is particularly difficult to compare the performance of a manager of a division (or subsidiary) in one country with the performance of a manager of a division in another country. Even divisions that appear to be similar in terms of production may face very different economic, social, or political forces. Instead, managers should be evaluated on the basis of revenues and costs incurred. Once a manager is evaluated, then the subsidiary financial statements can be restated to the home currency and uncontrollable costs can be allocated.

International environmental conditions may be very different from, and more complex than, domestic conditions. Environmental variables facing local managers of divisions include economic, legal, political, social, and educational factors.

Some important economic variables are inflation, foreign currency exchange rates, income taxes, and transfer prices. For example, MNCs have invested heavily in developing countries. The result is that those countries have built considerable manufacturing capacity and are now competing aggressively around the world, leading to lower prices and deflation on a global basis. As a result, MNCs, used to dealing with the inflationary environment of the 1970s and 1980s, will have to shift gears to deal with deflation. In this case, cost control is essential.

Legal and political factors are important. For example, a country may not allow cash out flows or may forbid the import of certain items. U.S. agricultural laws do not allow rooted plants to enter the country. This posed a problem for U.S. florists who needed poinsettias for the Christmas season but did not have the greenhouse capacity to grow them throughout the rest of the year. Mexico provides an ideal growing environment for the plants. However, potted plants cannot enter the United States. Plant science advances solved the importation problem. The plants are imported as cuttings that have been quick cooled, bagged, and shipped in dry ice. They clear Customs in this form, arriving at their destination within the 72-hour window.14 The result is a thriving poinsettia-growing industry in Mexico and many more of the colorful plants available for U.S. consumers. Educational, infrastructure, and cultural variables affect how the multinational firm is treated by the subsidiary 's country. Many clothing distributors in the United States depend on factories in developing countries to do the manufacturing. However, first those companies had to develop the area, putting in roads and communication equipment and providing training for workers.

Comparison of Divisional ROI The existence of differing environmental factors makes interdivisional comparison of ROI potentially misleading. For example, the lack of consistency in internal reporting may obscure interdivisional comparison. A minimum wage law in one country may restrict the manager's ability to affect labor costs. Another country may prevent the export of cash. Still others may have a well-educated workforce but poor infrastructure (transportation and communication facilities). Therefore, the corporation must be aware of and control these differing environmental factors when assessing managerial performance.

The accountant in the MNC must be aware of more than business and finance. Political and legal systems have important implications for the company. Sometimes, the political system changes quickly, throwing the company into crisis mode. Other times, the situation evolves more slowly.

On occasion, the political structure may mean that standard U.S.-based methods of control may not "work" in foreign countries. For example, under the communist regime in the former USSR, manufacturers received a budget, actual results were compared with the budget, and variances were computed. Variance analysis, however, did not have the same meaning that it has in the United States. If a company faced a variance, the solution was to send the plant 's senior political operative to Central Planning Headquarters with a case of champagne or cognac. The hoped-for result was a change in the budget so that it matched actual results and the variance disappeared. The business objective was not efficiency or effectiveness, but a compliance with the central plan. While the Central Planning Headquarters no longer exists, this culture of altering the plan to match the actual results does continue to exist.

Multiple Measures of Performance Rigid evaluation of the performance of foreign divisions of the MNC ignores the overarching strategic importance of developing a global presence. The interconnectedness of the global company weakens the independence or stand-alone nature of any one segment. As a result, residual income and ROI are less important measures of managerial performance for divisions of the MNC. MNCs must use additional measures of performance that relate more closely to the long-run health of the company. In addition to ROI and residual income, top management looks at such factors as market potential and market share.

Additionally, the use of ROI and RI in the evaluation of managerial performance in divisions of an MNC is subject to problems beyond those faced by a decentralized company that operates in only one country. It is particularly important, then, to take a responsibility accounting approach and evaluate managers on the basis of factors under their control. For example, the manager of the Moscow McDonald's cannot simply purchase food; it is not available for purchase locally, and imports from Denmark and Finland are very expensive. As a result, some food is grown locally. Similar difficulties are faced by companies in Eastern Europe. Multiple measures of performance, keyed to local operating conditions, can spotlight managers' responses to different and difficult operating conditions.

Discuss in the light of:

1) Need for Incentive rewards

2) Types and Methods of rewards

3) Your opinion in favor and/or against such rewards:

After reading from your book, you should also read and presentsome outside your book information, your own experience in terms of financialbenefit and/or burden on the organization and over all culture. You should also list references.