Sunday, September 20, 2009

Short Term Incentives

Most firms have annual bonus plans aimed at motivating the short-term performance of managers and executives. Short term bonuses can easily result in plus or minus adjustments of 25% or more to total pay. There are three basic issues to consider when awarding short term incentives: eligibility, fund size, and individual awards.

Eligibility: Most firms opt for broad eligibility – they include both top and lower-level managers and mainly decide who’s eligible in one of two ways. Based on one survey about 25% of companies decide eligibility based on job level or job title. About 54% decide eligibility based on a combination of factors, including job level/title, base salary level, and discretionary considerations such as identifying key jobs that have a measurable impact on profitability. Base salary level alone is the sole determinant in less then 3% of the companies polled.

The size of the bonus is usually greater for top-level executives. Thus, executive earning $150,000 in salary may be able to earn another 80% of his or her salary as a bonus, while a manager in the same firm earning $80,000 can earn only another 30%. Similarly, a supervisor might be able to earn up to 15% of his or her base salary in bonuses. Average bonuses range from a low of 10% to a high of 80% or more. A typical company might establish a plan whereby executives could earn 45% of base salary, managers 25%, and supervisory personnel 12%.

Fund Size: the firm must also decide the total amount of bonus money to make available fund size. Some use a nondeductible formula. They use a straight percentage usually of the company’s net income to create the short term incentive fund. Others use a deductible formula, on the assumption that the fund should start to accumulate only after the firm has met a specified level of earnings. Some firms don’t use a formula at all, but make that decision on a totally discretionary basis.

There are no hard-and-fast rules about proportion of profits to pay out. One alternative is to reserve a minimal amount of the profits, say, 10% for safeguarding stockholders’ investments and then to establish a fund for bonuses equal to, say 20% of the corporate operating profit before taxes in excess of this base amount. Thus, if the operating profits were $200,000 them the management bonus fund might be 20% of $180,000 or $36,000. Other illustrative formulas used for determining the executive bonus fund are as follows:

1. Ten percent of net income after deducting 5% of average capital invested in business.
2. Twelve and half percent of the amount by which net income exceeds 6% of stockholders’ equity.
3. Twelve percent of net earnings after deducting 6% of net capital.

Individual Awards: The third task is deciding the actual individual awards. Typically, a target bonus as well as maximum amount, perhaps double the target bonus is set for each eligible position, and the actual award reflects the person’s performance. The firm computes performance ratings for each manager, computes preliminary total bonus estimates, and compares the total amount of money required with the bonus fund available. If necessary, it then adjusts the individual bonus estimates.

One question is whether managers will receive bonuses based on individual performance, corporate performance, or both. The basic rule should be: outstanding managers should receive at least their target bonuses, and marginal ones should receive at best below-average awards. Firms usually tie top-level executive bonuses to overall corporate results or divisional results if the executive heads a major division. But as one moves farther down the chain of command, corporate profit become a less accurate gauge of a manager’s contribution. Supervisors or the heads of functional departments, it often makes more sense to tie the bonus to individual performance.

Many firms tie short term bonuses to both organizational and individual performance. Perhaps the simplest way is the split-award method, which breaks the bonus into two parts. Here the manager actually gets two separate bonuses, one based on his or her individual effort and one based on the organization’s overall performance. Thus, a manager might be eligible for an individual performance bonus of up to $10,000, but receive only $2,000 at the end of the year, based on his or her individual performance evaluation. But the person might also receive a second bonus of $3,000 based on the firm’s profits for the year. Give the money you save from the poor performers to the outstanding ones.

One drawback to this approach is that it may give marginal performers too much – for instance, someone could get a company-based bonus, even if his or her open performance is mediocre. One way to get around this is to use the multiplier method. In other words, make the bonus a product of both individual and corporate performance. A manager whose own performance is poor does not even receive the company-based bonus.

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