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Three days of predictions, insights, and advice from leaders in finance, sales, HR, supply chain and more
Register now here
By John Stretch, MD at Stretch Business Training
Management incentive schemes are used to implement strategy, retain the best people, and improve financial performance. A well-designed scheme will induce managers to behave as though they were shareholders of the business.
The Enron and WorldCom debacles some years ago, and Wells Fargo in 2016, demonstrated that poorly designed and uncontrolled schemes can promote unethical behaviour. Incentive schemes need transparency and strong corporate governance.
A study in the United States correlated the bonuses paid to 14,000 managers over a period of 5 years, with their organisation’s financial performance. This study showed that organisations with high bonus payouts performed much better financially than those who did not pay high bonuses.
This attracted the attention of finance people. Where previously the incentive schemes were designed and administered by the Human Resource function, incentives came to be seen as a financial tool to drive better performance, leading to higher ROE and higher share prices.
In the previous century, many firms used simple profit-based schemes based either on a straight percentage of profits, or on beating the budget. These schemes are easily understood, familiar to senior management, and measurable through a firm’s accounting system.
In the 1980s and 1990s many companies used these budget-beating schemes. In recent years, they have become less popular, as budget targets have been invalidated due to factors outside managers’ control including commodity price fluctuations, interest rate changes, and global economic instability.
Many managing directors have benefited enormously from share option schemes. These schemes fail when global markets crash. It does not require too much insight to realise that management actions and share prices are often unrelated.
Today some firms have chosen to rather focus internally using appraisal-based schemes based on peer assessment. In spite of accusations of nepotism, some very successful private companies still favour subjective awards based on judgement by each person’s superior officer.
Return based schemes are popular in many listed companies. Originally, these schemes rewarded a return on assets greater than a target percentage. Today most schemes require a firm to exceed an objective, externally determined cost of capital target. This method incorporates a growth target into the equation. You take real dollars, not percentages, to the bank.
Twenty-five years ago Coca-Cola CEO Roberto Gouizetta described his company’s business "We raise capital to make concentrate, and sell it at an operating profit. Then we pay the cost of that capital. Shareholders pocket the difference." Source: Fortune Magazine, 1993.
Two subjective decisions must be made after the residual income number has been finalised:
The article was first published in Unit 4 Prevero Blog
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