Chapter 17 Strategic Cost Management

CHAPTER 17:EXECUTIVE PERFORMANCEMEASURES AND
COMPENSATION
Expected Learning Outcomes:
After studying this chapter, you should be able to…
1. Enumerate the objectives of management compensation.
2. Understand cash and noncash compensation.
3. Explain the 3 aspects of a bonus plan: the base for determining compensation, the
compensation pool from which the bonus is funded, and the bonus payment options.
Recruiting, motivating, rewarding and retaining effective managers are critical to the success of
all firms. An important integral part of the determination of a strategic competitive advantage of
a firm is an effective management compensation plan.
Objective of Management Compensation
The firm’s key objective is to develop management compensation plans that support its strategic
objectives, as set forth by management and the owners. The objectives of management
compensation are therefore consistent with the 3 objectives of management control:
1. To motivate managers to exert a high level of effort to achieve the goals set by top
management.
2. To provide the incentive for managers, acting autonomously, to make decisions consistent
with the goals set by top management.
3. To determine fairly the rewards earned by managers for their effort and skill and the
effectiveness of their decision making.
Executive Performance Measures and Compensation
Studies show that division manager’s compensation arrangements include a mix of salary,
bonuses and long-term compensation tied to earnings and stock price of the company such as
stock options and noncash compensation. The goal of such compensation arrangements is to
balance division and company wide incentives, as well as short-term and long-term incentives.
One survey of companies reported the average annual incentive component of compensation as
follows:
1. Average annual cash and stock compensation based on long-run performance equal to 57% of
current salary, and
2. Bonuses based on short-run performance equal to 40% of current salary.
These percentages vary widely over the sample; some firms use stronger performance incentives
than others.

Cash Compensation
Cash compensation includes salaries and bonuses. A company may reward good managerial
performance by granting periodic raises. Salary raises, once affected, are however usually
permanent while bonuses give a company more flexibility. Many companies use a combination
of salary and bonuses to fluctuate with reported income. Of course, income-based compensation
can encourage dysfunctional behavior such as the manager may engage in unethical practices
like
(1) Postponing needed maintenance, or
(2) Postponing revenue recognition at the end of the year in which maximum bonus has already
been achieved to the next year.
Noncash Compensation
Noncash Compensation is also important. Some managers may trade off increases in salary for
improvement in title, office location and trappings, use of expense accounts or use of corporate
country club facilities and so forth. Autonomy in the conduct of their daily business can also
make the manager efficient and an important perquisite (a type of fringe benefits over and above
salary).
Stock options which give executives the right to buy company stock at a specified price (usually
lower than market price) within a specified period, are often used to motivate executives to
improve the company’s long-run performance to increase the stock price.
Designers of executives or manager’s compensation plans emphasize 3 factors:
(1) achievement of organization goals,
(2) ease of administering the plans, and
(3) ensuring that affected executives perceive the plan.
Bonus Plans
As stated earlier, bonus compensation is the fastest growing element of total compensation and
often the largest part. A wide variety of bonus pay plans can be categorized according to 3 key
aspects:
 The base of the compensation that is, how the bonus pay is determined. The 3 most
common bases are (1) stock price, (2) cost, revenue, profit, or investment unit-based
performance, and (3) the balanced scorecard.
 Compensation pools, that is, the source from which the bonus pay is funded. The 2 most
common compensation pools are earnings in the manager’s own unit and a firmwide pool
based on the firm’s total earnings.
 Payment options, that is, how the bonus is to be awarded. The 2 common options are
cash and stock (typically ordinary shares). The cash or stock can either be awarded

currently or deferred to future years. Stock can either be awarded directly or granted in
the form of stock options.
Bases for Bonus Compensation
The choice of a base comes from a consideration of the compensation objectives, as outlined in
Figure 17-1.
Figure 17-1: Advantages and Disadvantages of Different Bonus Compensation Bases
Relative to Compensation Objectives.
MOTIVATION RIGHT DECISION FAIRNESS
Stock price (+/-) Depends on
whether stock and
stock options are
included in base pay
and bonus
(+) aligns
management
compensation with
shareholder interests.
(+) Consistent with
shareholders’
interests.
(-) Lack of
controllability.
Strategic performance
measures (cost,
revenue, profit, and
investment units)
(+) Strongly
motivating if
noncontrollable
factors are excluded
(+) Generally a good
measure of economic
performance
(-) Typically has only
a short-term focus
(-) If bonus is very
high, creates an
incentive for
inaccurate reporting
(+) Intuitive, clear,
and easily understood
(-) Measurement
issues: differences in
accounting
conventions, cost
allocation methods,
financing methods,
and so on.
Balanced scorecard
(critical success
factors)
(+) Strongly
motivating if
noncontrollable
factors are excluded
(+) aligns
management
compensation with
shareholder interests
(+) Consistent with
management’s
strategy
(-) Can be subject to
inaccurate reporting
of nonfinancial factors
(+) If carefully
defined and measured,
critical success factors
are likely to be
perceived as fair
(-) Potential
measurement issues as
above
Key: (+) means the base has a positive effect on the objective.
(-) means the base has a negative effect on the objective.
Bonus Compensation Pools
A unit- based pool is a basis for determining a bonus according to the performance of the
manager’s unit.

A firmwide pool is a basis for determining the bonus available to all managers through an
amount set aside for this purpose .
Figure 17-2: Advantages and Disadvantages of Different Bonus Pools Relative to
Compensation Objectives
Unit based (+) Strong motivation
for an effective
manager- the upside
potential
(-) Unmotivating for
manager for
economically weaker
units
(-) Provides the
incentive for
individual mangers
not to cooperate with
and support other
units when needed for
the good of the firm.
(-) Does not separate
the performance of
the unit from the
manager’s
performance.
Firmwide (+) Helps to attract
and refrain good
managers throughout
the firm, even in
economically weaker
units
(-) Not as strongly
motivating as the unit-
based pool
(+) Effort for the good
of the overall firm is
rewarded-motivates
teamwork and sharing
of assets among units
(+) Separates the
performance of the
manager from that of
the unit
(+) Can appear to be
fairer to shareholders
and others who are
concerned that
executive pay is too
high
Bonus Payment Options
The 4 most common payment options are:
Current bonus (cash and/or stock) based on current (usually annual) performance, the most
common bonus form.
Deferred bonus (cash and/or stock) earned currently but not paid for two or more years.
Deferred plans are used to avoid or delay taxes or to affect the manager’s future total income
stream in some desired way. This type of plan can also be used to retain key managers because
the deferred compensation is paid only if the manager stays with the firm.
Stock Options confer the right to purchase stock at some future date at a predetermined price.
They are used to motivate managers to increase stock price for the benefit of the shareholders.
When exercised, stock options also have the positive effect of increasing the executive’s
ownership in the firm, thereby further increasing the executive’s alignment with shareholder
interests. For this reason, many firms require executives to own a significant amount of stock in
the company.
Performance shares grant stock for achieving certain performance goals over two years or more.

The advantages and disadvantages of the 4 plans are shown in Figure 17-3.
Figure 17-3 Advantages and Disadvantages of Bonus Payment Options Relative to
Compensation Objectives
Current bonus (+) Strong motivation
for current
performance; stronger
motivation than for
deferred plans
(-) Short-term focus
(-) Risk-averse
manager avoids risky
but potentially
beneficial projects
(+/-) Depends on the
clarity of the bonus
arrangement and the
consistency with
which it is applied
Deferred bonus (+) Strong motivation
for current
performance, but not
as strong as for the
current bonus plan
since the reward is
delayed
Same as for current
bonus
Same as for current
bonus
Stock options (+) Unlimited upside
potential is highly
motivating
(-) Delay and
uncertainty in reward
reduces motivation
(+) Incentive to
consider long-term
issues
(+) Provides better
risk incentives than
for current or deferred
bonus plans
(+) Consistent with
(-) Uncontrollable
factors affect stock
price
Also same as for
current bonus
Performance shares Same as for stock
options
(+) Incentives to
consider long-term
factors that affect
stock price
(+) Consistent with
the firm’s strategy,
when critical success
factors are used
(+) Consistent with
when earnings per
share is used
(+/-) Depends on the
clarity of the bonus
arrangements and the
consistency with
which it is applied
Performance Measures at the Individual Activity Level
When evaluating performance at the individual activity level 2 issues are involved:
First: Designing performance measures of activities that require multiple tasks, and

Second: Designing performance measures for activities done in teams.
Performing Tasks
It is a common business practice that employers want their employees to allocate their time and
effort intelligently among the various tasks or aspects of their jobs. For example, marketing
representative sell products, provide customer support and gather market information. Production
works are responsible for both the quantity and quality of their output.
The performance measurement should measure the different aspects of an employee’s job and to
balance incentives so that all aspects are properly emphasized.
Team-based Compensation Arrangements
Pooling of talents of employees with multiple skills, knowledge, experiences and judgements can
resolve many businesses problems, be they manufacturing, marketing and design-related. A team
accomplishes better securities than individual employees acting alone. Business establishments
reward individuals or a team on the basis of team performance such as achieving regional sales
target by the regional team. Such team-based incentives encourage individuals to help one
another as they strive toward a common goal. To encourage development of team skills, some
companies use a checklist of team skills, such as communication and willingness to help. The
desirability of team-based compensation depends, to a great extent, on the culture and
management style of a particular organization. Some criticisms on team-based compensation are
(1) Incentives for individual employees to excel are diminished, harming overall performance,
and
(2) Some team members who are not productive contributors to the team’s success nevertheless
share in the team’s rewards thereby dampening the interest and morale of the good performers.
Team-based incentive compensation encourages employees to work together to achieve common
goals. Individual-based incentive compensation rewards employees for their own performance,
consistent with responsibility accounting.
A mix of both types of incentives encourages employees to maximize their own performance
while working together in the best interest of the company as a whole.
Environmental and Ethical Responsibilities
As companies try to achieve the performance goals of their organizations, managers should be
aware constantly of their environment and ethical responsibilities. Illegal practices (such as
bribery and corruption) and environmental pollutions (such as water and air pollution) carry
heavy fines and are prison offense under the laws of many countries. Business ethics present
difficulties in a single-country context, but they pose more problems in a global context.
Ethical behavior on the part of managers is paramount. They should not be tainted by “creative
accounting” resulting to overstatement of assets, understatement of liabilities, fictitious revenues
and understatement of costs. Additionally, management should promptly and severely reprimand
unethical conduct irrespective of the benefits that might accrue to the company from such action.

A strong underlying system is important for enforcing contracts and provides the basis for
confidence in ethical dealings. Other ethical problems with bribes and differing business laws
exist. US companies that contract with overseas firms may find themselves the target of
unfavorable publicity on use of child labor. The stories of bribery of Middle Eastern officials are
legendary. In some countries, these bribes are a necessary part of doing business. Insider trading
is not against the law in Europe and it is definitely illegal in the U.S.
Socially responsible companies set very strict environmental goals and measure and report their
performance against them. For example, a company makes environmental performance a line
item on every employee’s salary appraisal report. Another company appraises employees on
their part in reducing solid waste, outing emissions and discharges and implementing
environmental problems.
REVIEW QUESTIONS AND PROBLEMS
Questions
1. What is incentive compensation? What type of organization is best suited to incentive
compensation plans?
2. What are the 4 guidelines for effective incentive compensation systems? Briefly discuss each.
3. There are 4 broad approaches to distributing the proceeds of a bonus pool in a profit-sharing
plan:
1. Each person’s share is based on her salary.
2. Each person receives an equal share.
3. Each person’s share is based on his position in the organization (larger payments to people at
higher levels).
4. Each person’s share is based on individual performance.
Required:
a. For each of these alternatives, give 2 reasons to support that alternative.
b. For each of these alternatives, give 2 reasons against that alternative.
4. Describe each of the following:
a. cash bonus
b.profit sharing
c.gain sharing
d. stock option plan
When should an organization use of them?

Problems
Problem 1
PK Corporation has a profit-sharing plan that is worded as follows:
The company will make available a profit-sharing pool that will be the maximum of the
following 2 items:
1. 20% of profits in excess of the largest profit level which is 18% of assets, or,
2. Php 2,000,000.
The individual employee will receive a share of the profit sharing pool that is equal to the ratio of
that employee’s salary to the total salary paid to all employees. The company earned Php
20,000,000 in 20X4 and had net assets of Php 60,000,000. Total salaries for 20X4 were Php
12,000,000.
Required:
a. What would be the amount available for distribution from the profit-sharing pool?
b. What would Jo Marcelo’s profit share be assuming she earned Php 50,000 during 20X4?
Problem 2
FAC Corporation has a profit-sharing plan that is worded as follows:
The company will make available a profit-sharing pool that will be the maximum of the
following 2 items:
1. 25% of profits in excess of the largest profit level which is 18% of assets, or,
2. Php 3,200,000.
The individual employee will receive a share of the profit sharing pool that is equal to the ratio of
that employee’s salary to the total salary paid to all employees. The company earned Php
30,000,000 in 20X4 and had net assets of Php 72,000,000. Total salaries for 20X4 were Php
10,000,000.
Required:
a. What would be the amount available for distribution from the profit-sharing pool?
b. What would Francis Argante’s profit share be assuming he earned Php 40,000 during 20X4?
Multiple Choice
1. All of the following are true except
a. Cash bonuses, meals, and trips are example of expense reward.
b. Pay for performance systems base rewards on achieving or exceeding some measured

performance.
c. An intrinsic reward is base on performance and is any reward that one person provides to
another person to recognize a job well done.
d. In an effective compensation system, each employee should be paid a basic wage that reflect a
market assessment for his skill and experience.
2. Which of the following statement is false?
a. Incentive compensation systems, work best in organizations in which employees have no skill
or have not been empowered.
b. Profit sharing is a group incentive compensation plan focused on rewarfing short term
performances.
c. A stock option is right to purchase a unit of organization’s stock at a specified price for a set
time limit.
d. An important element of control is motivating the employees to pursue the organization’s
interest as they undertake their daily jobs.
3. Which of the following is NOTa true statement?
a. An important element of control is motivating employees to pursue the organization’s interest.
b. An important element of motivation is compensation.
c. Hygiene factors relate to the job context and define the environment of individual's work.
d. Compensation is not useful in motivating employees.
4. __________ is based on performance and is any reward that one person provides to another in
recognition of a job well done.
a. Valence
b. Intrinsic rewards
c. Extrinsic rewards
d. Hygiene factors
5. Which of the following is an intrinsic reward?
a. cash bonuses
b. job satisfaction
c. trips
d. meals
6. Which of the following is an extrinsic reward?
a. stock bonuses
b. recognition in organization 's newsletter
c. recognition on a plaque
d. All of the above

7. Which of the following is not an attribute of effective performance measurement systems?
a. The person must understand the job.
b. The job's performance measures should reflect the organization's key success factors.
c. The performance measurement system should set clear standards or targets for performance.
d. The pay for performance systems base rewards on only net income.
8. __________ systems base rewards or achieving or exceeding some measured performance.
a. Pay for performance
b. Base salary agreement
c. Intrinsic reward
d. Marketing
9. Which of the following is NOTan attribute of effective performance measurement system?
a. The performance measurement system should be accurate.
b. The reward system should focus on individual or group rewards depending on the nature of
the job.
c. The performance measurement system should set clear standards or targets for performance.
d. Incentive compensation are rewards system that pay only an hourly wage for hours worked.
10. Under the independent wage policy guideline for effective incentive compensation systems,
wage and incentive compensation systems, wage and incentive compensation policy for senior
management shoulder be developed by:
a. senior management
b. a board of director's compensation committee
c. employees
d. middle management
11. Which of he following is true about the independent wage policy for effective incentive
systems?
a. Senior management should have its own wage and incentive compensation.
b. The compensation committee should operate independently of senior management's direction.
c. A board of director's compensation committee should design the incentive compensation plan
for senior management.
d. All of the above are true.
12. Which of the following is true about the participation guideline for effective incentive
compensation systems?
a. Many experts believe that only the senior management should participate in an incentive
compensation plan.
b. Many experts believe that all employees should participate in an incentive compensation plan.
c. Incentive plans do not need to be documented clearly.
d. Many experts feel that the incentive compensation should be about 200% of the employees
basic wage for senior levels of the organization.

13. Which of the following guidelines is being described by statement below?
A board of director's compensation committee should design the incentive compensation plan for
senior management without direct influence from the senior management.
a. fairness
b. participation
c. basic wage level
d. independent wage policy
14. __________ is a group incentive compensation plan focused on rewarding short-term
performance.
a. A cash bonus
b. Profit sharing
c. Gain sharing
d. A stock options
15. __________ is (are) also called lump-sum rewards, pay for performance and merit pay.
a. A cash bonuses
b. Profit sharing
c. Gain sharing
d. Stock options
16. __________ is the right to purchase a unit of the organization's stock at a specified price.
a. A cash bonus
b. Profit sharing
c. Gain sharing
d. A stock options
17. Which of the following would not be advantage for distributing the proceeds of bonus pool in
profit sharing plan based on each person's salary?
a. easy to administer
b. likely to be considered fair
c. always reflects contributions made
d. easy to calculate
18. Which of the following would not be an advantage for distributing the proceeds of bonus
pool in profit sharing plan based on an equal share?
a. easy to administer
b. may have a little motivational effect
c. likely to be considered fair
d. reflects how people often divide rewards

19. Single performance measure can often
a. increase an employee's overall performance by focusing his or her attention on only one aspect
of their work.
b. create employee myopia by focusing their attention on only one aspect of their work.
c. lead to a greater job satisfaction for employees.
d. increase the level of teamwork in an organization.
20. Reward system designers consider all of the following when designing an incentive system
except
a. the level of uncertainty about goal achievement.
b. the personalities of employees.
c. the risk attitudes of employees.
d. the work ethic of employees.
21. Participation in decision making involves
a. filling out budget requests that are passed on to a superior.
b. telling a superior where you would like the budget set
c. a joint decision making process in which all parties agree to the levels at which the budget
should be set.
d. electing a spokesperson to tell a superior where you would like a budget set.
22. Empowering employees mean
a. they are free to strike at anytime.
b. they can hold secret meetings on company time.
c. they get a greater share of the raised pool than they did before.
d. they are given the ability to suggest and make changes to their work environment.
23. Participation in decision making may lead to the following benefits except
a. increased job satisfaction.
b. increased tensions between coworkers.
c. improved morale.
d. greater commitment to the decision.
24. Which of the following is NOTan attribute of effective performance measurement systems?
a. The person must understand the job.
b. The reward system should focus on individual or group rewards depending on nature of the
job.
c. The performance measurement system should be accurate.
d. The performance measurement system should set clear standards or targets for performance.

Chapter 17 Strategic Cost Management

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