This blog is about compensation incentive
Care should be taken to assure that short-term objectives, upon which the program is based, are consistent with the long-term objectives of the enterprise. If new products are essential to future success, but negatively impact current year's earnings and cash flow, some provision should be made in the plan to deal with this situation, e.g., basing a portion of the bonus upon new product development.
To provide for achievements that may not be quantifiable both short- and long-range goals, some portion of the unit's bonus (usually 20% to 30%) should be discretionary, based upon senior management's evaluation. For example, achieving operating income goals could be 70% of the bonus pool with 30% being discretionary, or operating income could be 40% with cash flow and discretionary each comprising 30%.
A carefully constructed bonus program will list some of the key areas that will be considered in making the judgment of how the discretionary portion is earned. For example, this list might include the successful introduction of a new product, penetration of a new market, reduction of employee turnover, sale of obsolete or slow moving inventory, etc.
If, in retrospect, the bonus targets are considered inequitable by senior management, the discretionary portion allows them some flexibility to make corrections without having to abrogate the targets.
Extraordinary Performance
In many programs, a provision is made for rewarding extraordinary performance if the top of the target range is exceeded. Extraordinary performance should be subject to critical scrutiny, as it is frequently not real. Sometimes the nature of the company also dictates the need for caution. An example occurred at a division manufacturing computerized production test equipment designed to specification for durable goods manufacturers. Each project carried a multi-million dollar price tag. Because the span between the start of production and the delivery of product often exceeded a year, the division used "percentage-of- completion" accounting. With a base salary of $150,000 and bonus percentage of 40%, the division president's bogey was $60,000. The division reported pre-tax profit far in excess of its bonus target, and the division president was awarded a bonus of $120,000. During the following year the division lost money because actual costs to complete jobs shipped during the year significantly exceeded estimated costs used in computing the previous year's income. The engineering estimates of percentage complete proved to be very optimistic in the "record" year, which resulted in excessive bonuses to the division president and some other executives, including the V.P. Finance and the V.P. Engineering. Management changes followed in the aftermath of this lack of integrity in the financial reports.
How Actual Individual Bonus Awards Are Determined
As quickly as feasible after year end, the actual results are compared to the bonus targets, and the bonus percentage earned by each operating unit and the corporate office is determined. The percentage earned is multiplied by the unit's bonus pool to determine the dollar amount of bonus earned by the unit. The manager of the operating unit is then informed of two facts by the individual to whom he or she reports:
* Total bonus dollars earned by the unit.
* The bonus dollars earned by the manager (including a discretionary portion based on the manager's performance).
The unit manager then recommends the distribution of the portion of the discretionary bonus available to the operating unit, based on the performance of the employees in the unit. These recommendations are given to the chief executive officer (CEO), who submits his or her recommendations for corporate and operating unit bonuses to the compensation committee of the board of directors. The compensation committee reviews these recommendations and decides on the appropriate bonus for the CEO.
Proper Administration to Maximize Effectiveness
CPAs in industry frequently take the lead role in administering bonus programs. They are heavily involved in the review, analysis, and critique of strategic plans and budgets and comparison of actual results to plans and budgets. This leads to their involvement in developing realistic bonus targets and calculating bonus payments earned, which are the crucial elements in administering a program. Specific aspects which deserve careful attention are discussed below.
Bonus Targets Should be Designed to Motivate Maximum Efforts. If targets are too high, they may be viewed as unattainable and become discouraging. If they are too low they may be viewed as "in the bag," and encourage a euphoric and possibly indolent attitude. The objective should be to set targets at what will be viewed as "an attainable stretch." Analysis of profit plans is crucial to managements' judgment of what constitutes an attainable stretch. Some managers cannot resist the temptation to build cushions into their plans, to increase the likelihood that they will attain or exceed their planned income. At the other extreme are managers who are overly optimistic about their unit's capabilities: they project net income they believe will impress top management but could be perceived by their key employees as unattainable. Such an unrealistic target could discourage rather than motivate the operating unit employees.
Targets Must be Clearly Understood. It is critical that bonus participants participate in the setting of bonus targets. Their views and suggestions should be given serious consideration. When their suggestions are rejected or modified, the reasons should be clearly communicated. Misunderstandings concerning the bonus targets create unproductive time spent in discussions and demoralized employees who believe that they are being treated unfairly. Problems are most likely to arise in a new program or in connection with a newly acquired company. In a new acquisition, the inclusion of allocated corporate office costs in the unit's income statement is frequently a sensitive issue.
Corporate allocations should be dealt with at the outset, and agreed upon, or they will surely cause ill will later. Most companies include allocated corporate office costs, including interest expense, in the budgeted and actual income statement, and thereby reduce net income. The primary argument in favor of allocating corporate overhead is that if it was not done, operating units would ignore these costs in pricing decisions. It would then be possible for all the units to have net income while the overall company sustains a loss.
Periodically Communicate the Outlook for bonuses. To maximize the motivational value of the program, the financial staff of each operating unit should periodically communicate the current outlook for annual bonuses to bonus participants. This is accomplished by comparing a forecast of the bonus criteria with the bonus targets. Using the forecasted percentage of bonus earned for the unit, each participant can forecast his or her bonus. A review of the key actions necessary to accomplish or exceed the forecast should be included in this periodic bonus update. This can be a very strong motivational tool, because the bonus participants have an identifiable personal stake in the accomplishment of these actions. Many companies include a bonus update in their regularly scheduled operating review.
Resolve Bonus Problems Early. One way to accomplish this is to periodically update the outlook for bonuses for each operating unit. Strong lines of communication are beneficial to both operating units and corporate staff. One of the benefits of a bonus update is early identification of problems which require action on the part of senior management. Anyone who has lived through a year-end closing knows this is not the best time to resolve sensitive problems. By identifying problems in the bonus program as the year unfolds, it is possible to take prompt action, minimizing damage. If the bonus criteria have not been clearly stated, they should be modified with the participation of unit and senior management.
If the operating units and corporate staff have been monitoring the program during the year, the calculation of bonuses should go smoothly. The type of problems most frequently encountered are assertions by the operating unit that there are circumstances which were unforeseen at the time targets were set. They believe that in the interest of fairness, the situation warrants special consideration in determining the bonuses, e.g., war, recession, earthquake etc. Another could be an act of top management, such as a strike the unit was told to take, or a law suit they were instructed to settle even though they were confident they would win. Making changes in a bonus program can be a dangerous practice and should be considered only in exceptional circumstances. Too much flexibility in adjusting targets may destroy the motivational value of the program.
In many cases, determining the impact of unforseen events can be an impossible task. For example, consider the effect of a strike on earnings. It requires an estimate of the sales lost due to the strike. Sales may be higher before the strike due to customer anticipation and higher after the strike due to customers needing to replenish depleted inventory. Some customers may have been lost to competitors. The futility of calculating the earnings impact becomes apparent.
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