Compensation Pay for Performance

Key Topics – Pay for Performance Types of incentive plans Types of incentive plans Merit pay and motivation Merit pay and motivation Sales incentive programs Sales incentive programs Corporate-wide gainsharing and profit sharing plans Corporate-wide gainsharing and profit sharing plans

Variable Pay Variable Pay Variable Pay Tying pay to some measure of individual, group, or organizational performance. Tying pay to some measure of individual, group, or organizational performance.

Sales Incentives Straight Commission Sales Incentive Plans Straight Salary Salary and Commission Combinations

Incentive Plans for Salespersons Straight Salary Plan Straight Salary Plan Compensation plan that permits salespeople to be paid for performing various duties that are not reflected immediately in their sales volume. Compensation plan that permits salespeople to be paid for performing various duties that are not reflected immediately in their sales volume. Advantages: Advantages: Encourages building customer relationships. Encourages building customer relationships. Provides compensation during periods of poor sales. Provides compensation during periods of poor sales. Disadvantage: Disadvantage: May not provide sufficient motivation for maximizing sales volume. May not provide sufficient motivation for maximizing sales volume.

Incentive Plans for Salespersons Straight Commission Plan Straight Commission Plan Compensation plan based upon a percentage of sales. Compensation plan based upon a percentage of sales. Draw is a cash advance that must be paid back as commissions are earned. Draw is a cash advance that must be paid back as commissions are earned. Disadvantages: Disadvantages: Emphasis is on sales volume rather than on profits. Emphasis is on sales volume rather than on profits. Customer service after the sale is neglected. Customer service after the sale is neglected. Earnings tend to fluctuate widely between good and poor periods of business. Earnings tend to fluctuate widely between good and poor periods of business. Temptation to grant price concessions to get sales. Temptation to grant price concessions to get sales.

Incentive Plans for Salespersons Combined Salary and Commission Plan Combined Salary and Commission Plan A compensation plan that includes a straight salary and a commission component (“leverage”). A compensation plan that includes a straight salary and a commission component (“leverage”). Advantages: Advantages: Combines the advantages of straight salary and straight commission forms of compensation. Combines the advantages of straight salary and straight commission forms of compensation. Offers greater design flexibility Offers greater design flexibility Can be used to develop the most favorable ratio of selling expense to sales. Can be used to develop the most favorable ratio of selling expense to sales. Motivates sales force to achieve specific company marketing objectives in addition to sales volume. Motivates sales force to achieve specific company marketing objectives in addition to sales volume.

Incentives for Professional Employees Profit sharing and stock ownership Double-track wage systems Managerial and Executive Incentives Bonuses and merit increases Performance incentive bonuses Executive perquisites (perks)

Executive Compensation The Executive Pay Package The Executive Pay Package Base salary Base salary Short-term incentives or bonuses Short-term incentives or bonuses Long-term incentives or stock plans Long-term incentives or stock plans Benefits Benefits Perquisites (perks) Perquisites (perks)

Executive Compensation Justifications Justifications Large financial incentives reward superior performance. Large financial incentives reward superior performance. Business competition is pressure-filled and demanding. Business competition is pressure-filled and demanding. Good executive talent is in great demand. Good executive talent is in great demand. Effective executives create shareholder value. Effective executives create shareholder value.

Types of Long-Term Incentive Plans Stock optionsRights granted to executives to purchase shares of their organization’s stock at an established price for a fixed period of time. Stock price is usually set at market value at the time the option is granted. Stock appreciation rights (SARs) Cash or stock award determined by increase in stock price during any time chosen by the executive in the option period; does not require executive financing. Stock purchaseOpportunities for executives to purchase shares of their organization’s stock valued at full market or a discount price, often with the organization providing financial assistance. Phantom stockGrant of units equal in value to the fair market value or book value of a share of stock; on a specified date the executive will be paid the appreciation in the value of the units up to that time. Restricted stockGrant of stock or stock units at a reduced price with the condition that the stock not be transferred or sold (by risk of forfeiture) before a specified employment date. Performance unitsGrants analogous to annual bonuses except that the measurement period exceeds one year. The value of the grant can be expressed as a flat dollar amount or converted to a number of “units” of equivalent aggregate value. Performance shares Grants of actual stock or phantom stock units. Value is contingent on both predetermined performance objectives over a specified period of time and the stock market.

Executive Compensation: Ethics and Accountability Incentive payments are excessive compared with return to stockholders. Incentive payments are excessive compared with return to stockholders. Time periods for judging and rewarding performance are too short. Time periods for judging and rewarding performance are too short. Quarterly earnings growth is emphasized at the expense of research and development. Quarterly earnings growth is emphasized at the expense of research and development. Emphasis is placed upon equaling or exceeding executive salary survey averages. Emphasis is placed upon equaling or exceeding executive salary survey averages. Benefits do not relate closely to individual performance. Benefits do not relate closely to individual performance.

Executive Compensation Reform Current Reform Measures Current Reform Measures The Internal Revenue Service (IRS) is looking for tax- code violations in executive pay packages and will make executive pay a part of corporate audits. The Internal Revenue Service (IRS) is looking for tax- code violations in executive pay packages and will make executive pay a part of corporate audits. The Securities and Exchange Commission issued pay disclosure rules which require companies listed on the New York Stock Exchange and NASDAQ to disclose the true size of their top executive pay packages. The Securities and Exchange Commission issued pay disclosure rules which require companies listed on the New York Stock Exchange and NASDAQ to disclose the true size of their top executive pay packages. The Financial Accounting Standards Board (FASB) now requires that stock options be recognized as an expense on income statements. The Financial Accounting Standards Board (FASB) now requires that stock options be recognized as an expense on income statements.

Executive Compensation Reform (cont’d) Other Reform Measures: Other Reform Measures: The adoption of performance formulas that peg executive compensation to organizational benchmarks other than stock price The adoption of performance formulas that peg executive compensation to organizational benchmarks other than stock price Shareholder resolutions that allow shareholders the right to vote on executive pay packages Shareholder resolutions that allow shareholders the right to vote on executive pay packages Greater accountability by compensation committees to justify large executive pay awards or severance or retirement packages Greater accountability by compensation committees to justify large executive pay awards or severance or retirement packages

Group Incentive Plans Team Incentive Plans Team Incentive Plans Compensation plans where all team members receive an incentive bonus payment when production or service standards are met or exceeded. Compensation plans where all team members receive an incentive bonus payment when production or service standards are met or exceeded. Establishing Team Incentive Payments Establishing Team Incentive Payments Set performance measures upon which incentive payments are based Set performance measures upon which incentive payments are based Determine the size of the incentive bonus. Determine the size of the incentive bonus. Create a payout formula and fully explain to employees how payouts will be distributed. Create a payout formula and fully explain to employees how payouts will be distributed.

Team Incentive Plans (cont’d) Advantages Advantages Team incentives support group planning and problem solving, thereby building a team culture. Team incentives support group planning and problem solving, thereby building a team culture. The contributions of individual employees depend on group cooperation. The contributions of individual employees depend on group cooperation. Team incentives can broaden the scope of the contribution that employees are motivated to make. Team incentives can broaden the scope of the contribution that employees are motivated to make. Team bonuses tend to reduce employee jealousies and complaints over “tight” or “loose” individual standards. Team bonuses tend to reduce employee jealousies and complaints over “tight” or “loose” individual standards. Team incentives encourage cross-training and the acquiring of new interpersonal competencies. Team incentives encourage cross-training and the acquiring of new interpersonal competencies.

Team Incentive Plans (cont’d) Disadvantages Disadvantages Individual team members may perceive that “their” efforts contribute little to team success or to the attainment of the incentive bonus. Individual team members may perceive that “their” efforts contribute little to team success or to the attainment of the incentive bonus. Intergroup social problems—pressure to limit performance and the “free-ride” effect may arise. Intergroup social problems—pressure to limit performance and the “free-ride” effect may arise. Complex payout formulas can be difficult for team members to understand. Complex payout formulas can be difficult for team members to understand.

Group Incentive Plans (cont’d) Gainsharing Plans Gainsharing Plans Programs under which both employees and the organization share the financial gains according to a predetermined formula that reflects improved productivity and profitability. Programs under which both employees and the organization share the financial gains according to a predetermined formula that reflects improved productivity and profitability.

Scanlon Plan Rewards come from employee participation in improving productivity and reducing costs. Rucker Plan (SOP) Shared rewards come from the difference between labor costs and sales value of production. Improshare Gainsharing based on increases in productivity of the standard hour output of work teams. Gainsharing Incentive Plans Earnings-at-risk Encourages employees to achieve higher output and quality standards by placing a portion of their base salary at risk of loss.

Scanlon Plan Suggestion Process

Enterprise Incentive Plans Profit Sharing Profit Sharing Any procedure by which an employer pays, or makes available to all regular employees, in addition to their base pay, current or deferred sums based upon the profits of the enterprise. Any procedure by which an employer pays, or makes available to all regular employees, in addition to their base pay, current or deferred sums based upon the profits of the enterprise. Challenges: Challenges: Agreement over the percentages of shared of profits and the forms of distribution (cash or deferred) of profits between company and employees Agreement over the percentages of shared of profits and the forms of distribution (cash or deferred) of profits between company and employees Annual variations and possibility of no payout due to financial condition of company Annual variations and possibility of no payout due to financial condition of company Maintaining motivational connection of profit-sharing to performance of employees Maintaining motivational connection of profit-sharing to performance of employees

Enterprise Incentive Plans (cont’d) Stock Options Stock Options Granting employees the right to purchase a specific number of shares of the company’s stock at a guaranteed price (the option price) during a designated time period. Granting employees the right to purchase a specific number of shares of the company’s stock at a guaranteed price (the option price) during a designated time period. The value of an option is subject to stock market conditions at the time that option is exercised. The value of an option is subject to stock market conditions at the time that option is exercised.

Enterprise Incentive Plans (cont’d) Employee Stock Ownership Plans (ESOPs) Employee Stock Ownership Plans (ESOPs) Stock plans in which an organization contributes shares of its stock to an established trust for the purpose of stock purchases by its employees. Stock plans in which an organization contributes shares of its stock to an established trust for the purpose of stock purchases by its employees. The employer establishes an ESOP trust that qualifies as a tax-exempt employee trust under Section 401(a) of the Internal Revenue Code The employer establishes an ESOP trust that qualifies as a tax-exempt employee trust under Section 401(a) of the Internal Revenue Code Stock bonus plans are funded by direct employer contributions of its stock or cash to purchase its stock. Stock bonus plans are funded by direct employer contributions of its stock or cash to purchase its stock. Leveraged plans are funded by employer borrowing to purchase its stock for the ESOP. Leveraged plans are funded by employer borrowing to purchase its stock for the ESOP.

Employee Stock Ownership Plans Rewards and Risks of ESOPS Advantages Disadvantages Liquidity and value Pride of ownership Deferred taxes Single funding basis Not insured Retirement benefits

Pay-for-performance: many challenges Pay-for-performance: many challenges Meeting the challenges requires planning Meeting the challenges requires planning Should be part of larger compensation system Should be part of larger compensation system Should fit with overall strategic plan of org. Should fit with overall strategic plan of org. Pay-for-performance at four levels: Pay-for-performance at four levels: Individual, group, plant, organization wide Individual, group, plant, organization wide If P-f-P plan becomes entrenched If P-f-P plan becomes entrenched Employees will expect them regularly Employees will expect them regularly P-f-P for executives and salespeople requires additional thought P-f-P for executives and salespeople requires additional thought Summary and Conclusions