Short-term Performance Incentives for Executives Performance Incentives for Executives & Managers Incentive Timing Reward Bonus < 12 months Cash Long-term Incentive 2-5 years Stock or Cash Short-term Performance Bonus: Basis: individual or team of managers Contingency: Meeting or exceeding Performance metrics (choice: before or after the fact). MBAO 6600 - Executive Compensation

MBAO 6600 - Executive Compensation Short-term Performance Incentives for Executives (Halloran, M., ACA Journal, 1998) Designing Short-term Performance Incentives: Things to Consider: 1. What is strategically important during the measurement period? 2. How important is the bonus vis a vis salary and LTIs? 3. What factors can the CEO or SBU managers influence? 4. What can be measured? MBAO 6600 - Executive Compensation

Short-term Performance Measures Financial Measures - tied to accounting and/or market performance goals. 1. Earnings measures: EPS - very popular measure of financial performance; does not reflect cash flow. Operating Income, Net Income - measure of total profits in a time period. Can be manipulated by making optimal accounting choices. Cash flow - total cash generated from business, takes appreciation, amortization into account. MBAO 6600 - Executive Compensation

Short-term Performance Measures (Halloran, ACA Journal 1998) 2. Returns to Financial Investments ROE - return on equity. Reflects efficient use of stockholders investments. Uses book value of equity. ROCE - return on capital employed. Means return on total capital regardless of source of financing - can be equity or debt. Used in capital intensive industries. ROS - return on sales. Captures efficiency of the selling/producing process. Does not consider investment in business. MBAO 6600 - Executive Compensation

Short-term Performance Measures (Halloran, ACA Journal 1998) 3. Value-based Financial Measures - accesses the income of a business relative to capital invested. Takes into consideration business risk. More closely aligned to market values than other financial metrics. Avoids book values that financial returns measures use reflecting initial purchase of assets. EVA - economic value added. Formula: Net Operating Income After Taxes - investment in assets X weighted average cost of capital. MBAO 6600 - Executive Compensation

Short-term Performance Measures Non-Financial Performance Measures - related to value chain, non-financial strategic objectives 1. Value Chain Activities - customer service, product development, productivity, etc. Customer service - customer satisfaction, cycle time Product development - new products, patents, revenues from new products Productivity - quality (six sigma), cycle time, unit output costs (labor productivity, utilization of raw materials, overhead, etc.) MBAO 6600 - Executive Compensation

MBAO 6600 - Executive Compensation Applying the Performance Measures with the Balanced Scorecard Approach (Kaplan & Norton, HBR, 1992) Balanced Scorecard - approach to evaluate performance of executives using a blend of financial and non-financial measures. It tries to align the performance objectives and rewards of executives with both strategic goals and shareholder goals. 1. Balanced scorecards are more likely to be used for short-term goals. 2. Different weights are given to different objectives. MBAO 6600 - Executive Compensation

MBAO 6600 - Executive Compensation Applying the Performance Measures with the Balanced Scorecard Approach (Kaplan & Norton, HBR, 1992) Balanced Scorecard Performance Measures are Derived from Specific Strategic Goals 1. Financial Measures 2. Customer Measures 3. Internal Business Operational Measures 4. Innovation and Learning Measures Refer to example of Balanced Scorecard at ECI taken from Kaplan & Norton’s 1992 HBR article. MBAO 6600 - Executive Compensation