Management Control Systems Chapter 10: Performance-Dependent Rewards Merchant and Van der Stede: Management Control Systems © Pearson Education Limited 2003

Financial results controls ... Three core elements: Financial responsibility centers The apportioning of accountability for financial results within the organization. Formal management processes Planning & budgeting to define performance expectations and standards for evaluating performance. Motivational contracts To define the links between results and various organizational incentives.

Control benefits of incentives ... Informational Rewards attract the employees’ attention and inform them of the relative importance of often-competing results areas. Motivational Employees typically put forth more (less) effort on activities that are (not) rewarded. Non-control purposes Provide a competitive compensation package; Make compensation variable with firm performance; Tax considerations.

Positive and negative incentives ... Positive incentives “rewards” Things employees value. Negative incentives “punishments” Things employees like to avoid. Individuals tend to be more strongly motivated by the potential of earning rewards than by the fear of punishment.

Forms of rewards and punishments ... Monetary: Salary increases; Bonuses; Benefits; Perquisites: Club memberships; Vacation trips; etc. Non-monetary: Promotion; Autonomy; Recognition; Participation in decisions; Office assignments; Preferred parking places; Titles, etc. Punishments Monetary Zero salary increase; Zero bonus; Zero perquisites. Non-monetary: Interference in job from superiors; Loss of job; Assignment to unimportant tasks; No promotion; Humiliation, etc.

The compensation package ... Salary Benefits Pension and health benefits; Perquisites of various types. Incentive compensation Short-term incentive plans Based on the performance in the current year or less. Long-term incentive plans Based on the performance measured over periods greater than 1 year and often related to the company’s stock price.

Short-term incentive plans ... Based on performance in the current year or less. e.g., bonuses, commissions, piece-rate payments. Calculation (by formula) of short-term incentives. e.g., 2% of sales; 10% of net profits. e.g., 20% of (performance - Target) Sometimes deferred payments, i.e., spread over period of several years (golden handcuff).

Long-term incentive plans ... Based on the performance measured over periods greater than one year. Usually restricted to relatively high management levels. Accounting performance (e.g., EPS, ROE, ROA) over a period of 3 to 5 years. Market-based performance e.g. stock options

Group rewards ... Team-based rewards are often used to implement personnel / cultural controls. Group members monitor and sanction each others’ behaviors. They rarely provide a direct incentive effect. Stock-based plans, for instance, provide direct incentives only for a small number of managers at the very top of the organization. Hence, for lower-level employees, compensation is made more volatile, but their motivation is not (greatly) affected.

Size of bonus ... Mostly, the link between rewards and results is linear, but over a restricted performance range only. MAX Rewards ($) Results (profit) ZERO LOW 80%of budget target 100%of budget target 150%of budget target HIGH

Cutoffs ... Lower cutoff Upper cutoff To avoid paying bonuses for performance which is considered “mediocre” or worse. Upper cutoff To maintain vertical compensation equity; To keep total compensation somewhat consistent over time so that managers are able to sustain their lifestyle; To avoid that managers will be unduly motivated to take actions to increase profits at the expense of the long term; To avoid “undeserved“ bonuses due to a windfall gain; Fear of a faulty compensation plan design.

Proportion variable salary ... Employees are risk averse ... Performance-dependent rewards impose risk on the employees as performance is never fully controllable. Across firms, differences in the proportion of bonus payments are greater than differences in base pay. The bonus proportions of compensation generally decrease at lower organization levels.

Bonus determination approach ... Strict formula Rewards can be specified with precision; There is little uncertainty or ambiguity about performance standards; Superiors cannot exercise any bias or favoritism in assessing the performance of subordinates; but Less attention for performance dimensions which are more difficult to quantify (e.g., R&D). Subjective assessment Especially desirable when the manager’s personal control over the business unit’s performance is low. Lack of explicitness increases the employee's risk.

Criteria for evaluating reward systems … (I) Rewards should be valued Rewards that have no value do not provide motivation; Reward tastes vary across individuals and are situational. Rewards should be large enough to have impact Reward “visibility” can affect impact. Rewards should be understandable What is the reason for earning the reward? What is the value of the reward? Rewards should be timely The discount rate employees apply to delayed rewards seems to be far greater than the time value of money.

Criteria for evaluating reward systems … (II) Rewards should be durable Rewards have greater value if the good feelings generated by the granting of a reward are long-lasting, i.e., if employees remember them. Rewards should be reversible To be able to correct mistakes of performance evaluations; Promotions, for instance, are difficult to reverse. Rewards should be cost efficient To stimulate the desired motivation at minimal cost.

Cases Amgen, Inc. (p. 321 ff.) HCC Industries (p. 348 ff.) What are Amgen’s key success factors? What are some of the critical contingencies the firm has to plan for? What rolle does the strategic planning process play at Amgen? How useful is it? What changes, if any, would you recommend to make this process more effective? HCC Industries (p. 348 ff.) Evaluate the decision to use ‘minimum perfromance standard’ targets instead of ‘stretch’ targets Should HCC managers have expected that the MPS-targetsetting philosophy would be equally effective in all four operating divisions? What, if anything, could have been done to improve the implementation of the new philosophy?