F 09420010120134021 PP T 08

Course : F0942 Management Control System
Year
: 2013-2014
Incentive Compensation Systems
Slide 9.3
Chapter 9:
Incentive Compensation Systems
Kenneth A. Merchant and Wim A. Van der Stede, Management Control Systems, 2nd Edition Pearson Education Limited 2007
Slide 9.4
Financial results controls
Three core elements:

Financial responsibility centers
The apportioning of accountability for financial results
within the organization
Formal management processes

Planning & budgeting to define performance expectations
and standards for evaluating performance
Motivational contracts
To define the links between results and various
organizational incentives
Slide 9.5
Positive and negative incentives
Positive incentives
rewards
Things employees value
Negative incentives
punishments
Things employees like to avoid
Individuals tend to be more strongly motivated

by the potential of earning rewards than by the
fear of punishment.
Slide 9.6
Forms of rewards and punishments
Punishments
Rewards
Monetary
Monetary
Zero salary increase
Zero bonus
Zero perquisites
Non-monetary
Interference in job
from superiors
Loss of job
Assignment to
unimportant tasks
No promotion
Humiliation
Salary increases
Bonuses
Benefits
Perquisites
Club memberships
Vacation trips
Non-monetary
Promotion
Autonomy
Recognition
Participation in decisions
Office assignments
Preferred parking places
Titles
Slide 9.7
The compensation package
Salary
Benefits
Pension and health benefits
Perquisites of various types
Incentive compensation
Short-term incentive plans
Based on the performance in the current year or less
Long-term incentive plans

Based on the performance measured over periods greater
than one year and often related to the companys stock price.
Slide 9.8
Short-term incentive plans
Based on performance in the current year or less

e.g., bonuses, commissions, piece-rate payments
Calculation (by formula) of short-term incentives
e.g., 2% of sales; 10% of net profits

e.g., 20% of over-target performance
e.g., 60% of target bonus at 80% of target;
100% of target bonus at 100% of target;
(where target bonus = 30% of salary).
Slide 9.9
Long-term incentive plans
Based on the performance measured over periods

greater than one year.
Usually restricted to relatively high management levels
Accounting performance (e.g. EPS, ROE, ROA)

over a period of three to five years
Market-based performance
Stock options
Stock appreciation rights
etc.
Slide 9.10
Purpose of incentives
Motivation
Motivation has two elements:
Inducing effort: getting employees to work hard
Employees typically put forth more (less) effort on

activities that are (not) rewarded.
Directing effort: helping employees understand

what is expected of them
Rewards attract the employees attention and inform

them of the relative importance of often-competing
results areas.
Slide 9.11
Purpose of incentives
Attraction/retention
Paying employees only guaranteed salaries tends to
attract risk-averse employees.
Paying performance-dependent compensation tends to
attract employees who are more risk tolerant, more
aggressive, more confident in their abilities.
e.g., stock option plans often are geared towards
employee retention; they provide a form of golden
handcuffs.
Slide 9.12
Purpose of incentives (Continued)
Non-control purposes
Provide a competitive compensation package
Make compensation variable with firm performance
Tax considerations
Slide 9.13
Key incentive design elements
Level of measurement (performance at the

individual, entity, or company level)
Size of awards (i.e. leverage vis--vis fixed pay)
Shape of the performance-reward function
Use of subjectivity
Type and number of measures (financial vs.

nonfinancial; bottom-line vs. basket of measures)
(See Chapters 10-11)
Slide 9.14
Group rewards
Team-based rewards are often used to

implement personnel/cultural controls.
Group members monitor and sanction each others
behaviors.
They rarely provide a direct incentive effect.

Stock-based plans, for instance, provide direct incentives
only for a small number of managers at the very top of the
organization.
Hence, for lower-level employees, compensation is made
more volatile, but their motivation is not (greatly) affected.
Slide 9.15
Proportion variable pay
Employees are risk averse

Performance-dependent rewards impose risk on
the employees as performance is never fully
controllable.
Across firms, differences in the proportion of bonus
payments are greater than differences in base pay.
The bonus proportions of compensation generally
decrease at lower organization levels.
Slide 9.16
Shape of reward function

Mostly, the link between rewards and results is linear,
but over a restricted performance range only
MAX
Rewards ($)
Results (profit)
ZERO
LOW
80% of
budget
target
100% of
budget
target
150% of
budget
target
HIGH
Slide 9.17
Cutoffs
Lower cutoff
To avoid paying bonuses for performance which is
considered mediocre or worse.
Upper cutoff
To maintain vertical compensation equity.
To keep total compensation somewhat consistent over
time so that managers are able to sustain their lifestyle.
To avoid that managers will be unduly motivated to take
actions to increase profits at the expense of the long term.
To avoid undeserved bonuses due to a windfall gain.
Fear of a faulty compensation plan design.
Slide 9.18
Bonus determination approach
Strict formula
Rewards can be specified with precision.
There is little uncertainty or ambiguity about
performance standards.
Superiors cannot exercise any bias or favoritism
in assessing the performance of subordinates.
but
Less attention for performance dimensions
which are more difficult to quantify (e.g. R&D).
Subjective assessment
Especially desirable when the managers personal
control over the business units performance is low.
Lack of explicitness increases the employee's risk.
Slide 9.19
Criteria for evaluating reward systems
Rewards should be valued

Rewards that have no value do not provide motivation.
Reward tastes vary across individuals and are situational.
Rewards should be large enough to have impact

Reward visibility can affect impact.
Rewards should be understandable

What is the reason for earning the reward?
What is the value of the reward?
Rewards should be timely

The discount rate employees apply to delayed rewards
seems to be far greater than the time value of money.
Slide 9.20
Criteria for evaluating reward systems (Continued)
Rewards should be durable

Rewards have greater value if the good feelings generated
by the granting of a reward are long-lasting, i.e., if employees
remember them.
Rewards should be reversible

To be able to correct mistakes of performance evaluations;
Promotions, for instance, are difficult to reverse.
Rewards should be cost efficient

To stimulate the desired motivation at minimal cost.

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Course : F0942 Management Control System

Incentive Compensation Systems

Financial results controls

Three core elements:

Formal management processes

Positive and negative incentives

Things employees value

Things employees like to avoid

Individuals tend to be more strongly motivated

Forms of rewards and punishments

The compensation package

Long-term incentive plans

Short-term incentive plans

Based on performance in the current year or less

Calculation (by formula) of short-term incentives

e.g., 2% of sales; 10% of net profits

Long-term incentive plans

Based on the performance measured over periods

Accounting performance (e.g. EPS, ROE, ROA)

Stock appreciation rights

Employees typically put forth more (less) effort on

Directing effort: helping employees understand

Rewards attract the employees attention and inform

Purpose of incentives (Continued)

Key incentive design elements

Level of measurement (performance at the

Size of awards (i.e. leverage vis--vis fixed pay)

Shape of the performance-reward function

Type and number of measures (financial vs.

Team-based rewards are often used to

They rarely provide a direct incentive effect.

Proportion variable pay

Employees are risk averse

Shape of reward function

Bonus determination approach

Criteria for evaluating reward systems

Rewards should be valued

Rewards should be large enough to have impact

Rewards should be understandable

Rewards should be timely

Criteria for evaluating reward systems (Continued)

Rewards should be durable

Rewards should be reversible

Rewards should be cost efficient

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