Cost Analysis, Profit Planning, and Control

1. Cost Analysis, Profit Planning, and Control MBA 603 Chapter 12 - Management Compensation

2. Research Findings • People are influenced by positive (reward) and negative (punishment) incentives. • Research finds the following: • Individuals tend to be more motivated by potential earning rewards than punishment fear. • Monetary reward is a means of personal satisfaction up to a certain level then compensation begins to become less critical. • If senior management acts like compensation systems are important so will all levels of management.

3. Research Findings - Continued • Individuals are highly motivated when they receive reports and feedback about their performance. • Incentives become less effective as the period between action and feedback increases. • Motivation is weakest when a person believes the incentives are too hard or too easy to attain. • Incentives based on budgets as an objective is strongest when managers work with their superiors to create their operating budgets.

4. Characteristics of Incentive Compensation Plans • Manager’s total compensation package consists of : • Salary • Benefits (insurance, retirement plan, perks) • Incentive Compensation • The three components are interdependent while, the third is related to the management control function.

5. Characteristics of Incentive Compensation Plans • A study of over 14,000 managers found: • Bonuses were 20% of base pay. • Organizations with higher ratios of bonuses have higher performance levels. • Corporate bylaws and securities regulations require incentive plans to be approved by shareholders. • Outside consultants are used sometimes with the blessing of the board.

6. Characteristics of Incentive Compensation Plans - Continued • Short-term plans are based on current years goals. • Long-term plans are based on longer, strategic performance and are related to the price of the firm’s common stock.

7. Short-Term Incentive Plans • The Total Bonus Pool: the amount of bonus that can be paid to employees in a given year. • The size of the pool must be part of a compensation package that is competitive. • There are several ways to create a pool: • Simplest method - bonus as a % of profits. • Drawbacks - Payout on low profits • Does not take into account assets employed

8. Short-Term Incentive Plans - Continued • Bonuses based on a specified return on capital employed. Several ways to do this are: • % of earnings per share after a predetermined level of earnings per share has been reached. ( retained earnings must be accounted for in the formula). • Bonus is equal to % of EBTI minus the capital charge on total shareholder equity plus long-term debt. • Another form is to make defined capital equal to shareholder equity.

9. Short-Term Incentive Plans - Continued • One bad point to the aforementioned plans is a loss reduces shareholder equity and increases bonuses paid in profitable years - this leads to the “big bath”. • Some companies base bonuses on industry data - however, it is hard to get data and very subjective.

10. Short-Term Incentive Plans - Continued • Carryovers result when the board decides to retain money in the bonus pool based on a specific formula. • The compensation committee decides each year based on a formulas, etc. how much to add to the carryover. • The advantages to this system are: • It is more flexible and the board can exercise their judgement at various times. • The magnitude of the swings in the formula is dampened.

11. Short-Term Incentive Plans - Continued • Deferred Compensation refers to a system that pays bonuses out over several years based on a formula. • The advantages of this system are: • Managers can estimate their cash income for the coming year. • Payments smooth the manager’s receipt of cash - usually a tax advantage. • A retiring manager can receive additional income when he or she leaves the firm. • Deferred time frame encourages everyone to think long-term.

12. Long-Term Incentive Plans • Basic premise - growth in the value of the company’s common stock reflects long-run performance excellence. • Plans will evolve based on changes in the economy, taxes, and changes in accounting rules. • Stock Options are the right buy a number of shares at a specified date at a specific price.

13. Long-Term Incentive Plans - Continued • Managers are directed toward both short term performance (the award) and long-term objectives (the vesting schedule). • Managers gain when they sell the stock above it subscription price. • Some types are restricted in that they can not be sold for a specified time limit. • The accounting for these plans is not being considered for change - they will be expensed as granted.

14. Long-Term Incentive Plans - Continued • Phantom Shares are plans that award managers a number of shares for bookkeeping purposes only. They are used mainly in privately held companies. • After a number of years (5) the executive receives the appreciation value of the stock. • There are no transaction costs with this type of stock.

15. Long-Term Incentive Plans - Continued • Performance Shares are a specific award for a number of shares of stock to a manager when specific long-term goals are achieved. • An example would be a certain percentage growth in “EPS” over a 3 tot 5 year period. • Advantage of the former two plans is the award is based on performance an executive can control. • Disadvantage is that the plans are based on accounting measures.

16. Long-Term Incentive Plans - Continued • Performance Units are a specific award for a number of shares of stock to a manager when specific long-term goals are achieved. • The cash payment includes the stock appreciation and performance shares. • It is employed when there is little or no stock publicly traded.

17. Incentives for Corporate Officers • Earning management bonuses are based on subjective performance goals for many corporate executives. • The CEO usually bases awards on assessments of each person’s performance. • Many assessment systems are based on MBO which are agreed to at the beginning of the fiscal year.

18. CEO Compensation • CEO compensation is discussed by the board after the CEO has discussed the subordinate payment schedules. • The compensation committee will recommend the amount for the CEO based on his or her performance. • If it is higher than normal it is a positive sign to the CEO, the converse of this is true.

19. CEO Compensation - Continued • An off shoot of the corporate scandals tied to CEO performance and accounting manipulations is the push to reform corporate governance such as: • Prevent directors from selling stock for the duration of their term which will force them to ask tough questions to CEO’s. • Establish mandatory limits to the service length of Directors so they cannot become entrenched with current management.

20. CEO Compensation - Continued • Hold annual performance review of directors. • Ensure that the CEO of the company cannot also be the chairman of the board. • Also, as mentioned earlier, the drive to expense stock options has caught on to control the manipulation of accounting results. • Companies such as Coca-Cola and the Washington Post have started to expense stock options along with many other large firms.

21. CEO Compensation - Continued • Some key factors in support of expensing Stock Options: • 75% of executive compensation are options so the other 25% is expensed - why not options? • Expensed options would provide a more accurate financial picture for investors. (Intel would have earned 4 cents a share or 80% less in 2001) • The current rules give the impression that options are free and therefore, over reward the CEO

22. CEO Compensation - Continued • Top management could not play games with results to pump up short term stock prices to maximize their cash options. • A double standard exists - companies can expense the difference between issue price and exercise price of the options for tax purposes but cannot do the same for financial reporting. (MicroSoft’s taxable income was reduced $2 billion by expensing options in 2000 but net income was not reported in that manner.)

23. CEO Compensation - Continued • Arguments against expensing Stock Options: • Options do not involve an outlay of cash and would unduly penalize earnings. • Valuing options is not an exact science, therefore, they could be subject to manipulation. • Expensing options will lower earnings and dampen stock prices and undermine the objective of agency principal theory, Fewer will be issued.

24. CEO Compensation - Continued • Cash strapped start-ups such as high tech firms in Silicon Valley use options to attract human capital. They lower operating costs and allow firms to attract the most competent engineers. • Options are already accounted for in the footnotes in financial statements. • Options did not bring down Enron and World Com alone - there are many factors.

25. Incentives for Business Unit Managers • Some incentives are financial, others are psychological and social. • Financial incentives revolve are salary increases, bonuses, benefits, and perqs. • Please Review Exhibit 12.1 - page 574.

26. Size of Bonus Relative to Salary • There are two schools of thought regarding how to mix fixed ( salary and fringe benefits) and variable (bonus) rewards to management compensation. • Fixed Pay System : Recruit good people, pay them well, and expect outstanding performance. Salaries are emphasized not bonuses. • Performance Based Pay: Recruit good people, expect them to perform, and pay them well if performance is actually good. Bonuses are emphasized not salaries.

27. Size of Bonus Relative to Salary - Continued • Recently, performance based systems seem to be gaining in importance. (See Exhibit 12.2) • A recent survey of 2800 major companies reveals in 1999, 63% offered variable pay up from 15% in 1990. • The main reason is emphasizing incentive compensation tends to motivate managers to exert maximum effort and avoid complacency, conservatism.

28. Size of Bonus Relative to Salary - Continued • Cutoff Levels create interesting problems for senior management. • Many systems have upper and lower limits which create control problems and opportunities for manipulating accounting results. • Managers can and will change numbers with respect to either the upper or lower limits to maximize their own payout from year to year.

29. Size of Bonus Relative to Salary - Continued • One way to combat this is to carry over the excess or deficiency into the following year, bonus payments would be based on the amount earned during the current year plus or minus any deficiency from the previous fiscal year. • Some techniques for “income smoothing” are manipulating bad debt reserves, warranty reserves, contingency reserves, etc.

30. Bonus Basis • Business unit manager’s incentive bonus could be based on total corporate profits or just the business unit profits, or a mix of both. • One Argument - linking bonus to unit performance is that a manager’s decisions and actions directly impact the performance of their own unit than that of other business units.

31. Bonus Basis - Continued • In a single industry firm with highly interdependent BU’s bonuses are tied to corporate performance because cooperation between units is very critical. • In conglomerates, BU’s are autonomous, therefore, it would be not productive to base managers’ bonuses on company profits, which would weaken the link between performance and rewards.

32. Bonus Basis - Continued • Free-Rider problems would be created by the previous situation. Some managers might relax and still get bonuses based on the efforts of other hard working managers. • In diversified firms it might be good to base part of BU managers’ bonuses on unit profits and part on company profits.

33. Performance Criteria • Financial Criteria could include contribution margin, BU profit, controllable BU profit, income before taxes, and net income. • In investment centers, decisions need to be made in three areas: • Definition of Profit • Definition of Investment • Choice between Return on Investment and EVA

34. Performance Criteria - Continued • Adjustments for Uncontrollable Factors fall into two categories: • Remove expenses that result from decisions made by executives above the business unit level. • Eliminate the losses caused by natural disasters like floods hurricanes, etc.

35. Benefits & Shortcomings of Short-Term Financial Targets • Relying only on financial criteria can create: • Short-term actions that are not in the company’s long-term interests (equipment maintenance). • Managers might forgo long-term investments to maximize short-term results. • Managers might manipulate accounting information to meet current period targets.

36. Mechanisms to Overcome Short-Term Biases • A company can supplement financial criteria with additional incentive mechanisms may overcome short-term goals ( Bonus spread on multiyear performance). • There are some disadvantages: • Managers have trouble seeing the link between efforts and rewards. • If managers retire or transfer accounting id very difficult.

37. Mechanisms to Overcome Short-Term Biases • There are factors beyond managers’ control that will achieve long-range targets. • Another method to correct the inefficiencies of financial criteria is to develop a scorecard. • It good model may contain: • Sales Growth • Market Share • Customer Satisfaction

38. Bench Marks for Comparison • A business unit manager’s performance can be appraised by comparing actual results to the budget. • The following considerations need to be used when using the budget as the basis: • BU manager must be a part of the plan’s development. • The budget is attainable and challenging.

39. Bonus Determination Approach • Wards can be based on s strict formula - % of BU profits, by purely subjective assessment by ones superior, or by a combination of the two. • Relying on objective formulas has it benefits: • Little ambiguity about performance standards. • Superiors cannot exercise biases in assessing subordinates.

40. Bonus Determination Approach - Continued • A major disadvantage is that objective formulas are likely to induce managers to pay less attention to the performance of their business unit along dimensions that are critical but hard to quantify. • Sometimes numerical indicators are not a good tools to measure performance such as: • BU manager inherits predecessor’s problems. • BU is interdependent with outsiders. • Strategy causes a heavy emphases on long-term.

41. Agency Theory • Agency theory controls how incentives and contracts can be written to motivate individuals to attain goal congruence for legal entities. • The Key Concepts of Agency Theory revolve around principals and agents that have divergent preferences and objectives. • Incentive contracts are tools to reduce these problem areas.

42. Some Problems With Agency • Principals own the company and hire agents to execute its charter as a business entity. • Agents are concerned about work aversion - principals not working hard or enjoying leisure time or deliberately withholding effort called shirking. • Since managers cannot diversify risk awaythey are risk adverse.