CHAPTER 9

Incentive Systems

One of the primary principles of effective management is that rewards should be the third thing you work
on. Measurements should come second, and both rewards and measurements should be subordinated to
performance definition; i.e., clear and unambiguous articulation of what needs to be done.
Steven Kerr, Chief Learning Office, Goldman Sachs1

The third major element of financial results control systems deals with the provision of organi-
zational rewards; that is, the design of incentive systems. As per the opening quote above,
incentives follow performance defi nition. Performance defi nition, described by Kerr as the
“clear and unambiguous articulation of what needs to be done,” includes both defining desired
performance and assigning responsibility for achieving the desired results. Defi ning desired
performance and setting adequately challenging performance targets in the desired perfor-
mance areas are among the main purposes of planning and budgeting systems, which we dis-
cussed in Chapter 8. Designing responsibility centers, which we discussed in Chapter 7,
determines the accountability for the desired result areas. Incentive systems, which we discuss
in this chapter, tie rewards (and/or punishments) to the performance evaluations. Incentive
systems are important because they reinforce the defi nitions of the desired result areas and
motivate employees to achieve and exceed the performance targets. Section IV of this text
focuses exclusively on the important topic of performance measurements, which drive the per-
formance evaluations and associated incentives in most organizations.
Copyright © 2017. Pearson Education Limited. All rights reserved.

Hereafter, we use the term incentives to refer primarily to things that employees value –
(positive) rewards. That said, organizations can, and do, also provide some negative rewards,
or punishments or penalties.2 In an organizational context, however, punishments commonly
manifest themselves through an absence of positive rewards, such as not being paid a bonus or
being passed over for a promotion. Naming and shaming is another type of unpleasant experi-
ence (hence, punishment) that employees would rather avoid. For example, at Black & Decker’s
semiannual meeting of division heads, managers who had met their budget targets sat on the
left side of the room, whereas those who had failed to meet their targets were asked to sit on
the right in order to explain to the others why they had not met their targets. Mr. Archibald,
the executive chairman, explained proudly: “They hate being over on the right. We think this
kind of peer competition is motivational.” In a similar fashion, China’s Haier, the large con-
sumer appliances company, uses naming and shaming by prominently displaying photographs
of managers throughout the company with a red smiley face for good performance and a yel-
low frowning one for those doing poorly.3
Table 9.1 lists some of the types of rewards that organizations use. Note that many of these
rewards are non-monetary. Although it is widely accepted that individuals universally value
money, it is equally correct to suggest that monetary rewards are not the only thing that people

353
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

Table 9.1 Examples of positive and negative rewards

Positive rewards Negative rewards (punishments)

Autonomy Interference in job from superiors

Power Loss of job

Opportunities to participate in important decision-making processes Zero salary increase

Salary increases Assignment to unimportant tasks

Bonuses Chastisement (public or private)

Stock options No promotion

Restricted stock Demotion

Praise Public humiliation

Recognition

Promotions

Titles

Job assignments

Office assignments

Reserved parking places

Country club memberships

Job security

Merchandise prizes

Vacation trips

Participation in executive development programs

Time off
Copyright © 2017. Pearson Education Limited. All rights reserved.

Source: K. A. Merchant, Modern Management Control Systems: Text and Cases (Upper Saddle River, NJ: Prentice Hall, 1998), p. 427

value.4 When properly chosen, non-monetary rewards will be greatly appreciated by employ-
ees, and in many cases, they place a smaller financial burden on the firm. For example,
While raises or bonuses are not unimportant, especially in [an] uncertain financial climate,
[survey evidence suggests] that workers across a spectrum of ages – from Baby Boomers
who have worked hard to reach the peaks of their career, to Generation X’ers struggling to
satisfy professional ambitions and personal fulfillment, to Millennials who view work/life
balance as their right – are looking for a remix of conventional rewards. Many of these don’t
cost a dime but pay off in increased engagement, loyalty, and willingness to go the extra
mile. For example, when surveyed about the possibility of working remotely, 83% of Millen-
nials and 75% of Boomers say that the freedom to choose when and where they work
motivates them to give 110%.5

Therefore, organizations typically do not rely on just a single form of rewards. In many for-
profit firms, various monetary incentives in the form of cash or stock usually go up and down
with performance. But a manager’s autonomy, authority, recognition, and status often do, too.
Corporate managers can (threaten to) reduce the decision autonomy of entity managers by

354
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Purposes of incentives

refusing to fund investments in entities where performance is poor. In entities where perfor-
mance is excellent, they can grant managers additional power and increase their recognition
within the firm by publicizing the results. Employees who climb the corporate ladder also often
are given various perks (discretionary rewards), such as the opportunity to travel first class, to
pick a larger office, to be given first choice for vacation scheduling, to have a preferred parking
spot, and so on.
This chapter first describes the purposes of incentives. It then focuses mainly on monetary
incentives to discuss various important incentive system decisions that organizations need to
consider, such as about the extent to which the incentives are determined formulaically, the
shape of the incentive-performance function, and the form and size of incentive pay. The chap-
ter concludes by providing a set of criteria for evaluating incentive systems.

Purposes of incentives

Performance-dependent rewards, or incentives, provide the impetus for the alignment of

employees’ natural self-interests with the organization’s objectives. They provide three types of
management control benefits. The first is informational. The rewards attract employees’ atten-
tion and inform or remind them of the relative importance of often-competing results areas,
such as cost, quality, customer service, asset management, and growth. Merely telling employ-
ees that customer service, for example, is important might have some effect on their behaviors.
But including customer service measures in annual bonus plans is more likely to convince them
to emphasize customer service. In other words, the rewards signal which performance areas
are important and help employees decide how to direct their efforts. For this reason, the infor-
mational aspect of incentives is sometimes also referred to as the effort-directing purpose.
A pertinent example is the global financial services company, Barclays. Reeling from missel-
ling practices by branch personnel of insurance, loans, and bank accounts, which it believed
their commission payments had encouraged, the company decided that “Barclays staff will no
longer be paid any commission for selling financial policies,” but that “from now on, any bonuses
will be dependent entirely on giving customers good quality service” because “the key to
Barclays long-term success is the level of service we provide, not how many products we sell.”6
Also in banks, brands have been shown to be shaped less by advertising and marketing than by
Copyright © 2017. Pearson Education Limited. All rights reserved.

their customers’ experiences. “In such cases, customers get the message only if employees do,”
which is why some banks, like HSBC, link the pay of some of their employees to indicators of
brand health.7
The informational purpose of incentives is equally pertinently illustrated by the case when
Bob Dudley, the UK oil group’s new chief executive at BP, vowed to improve BP’s safety culture
upon taking the helm following the company’s deep-sea oil well disaster in the Gulf of Mexico.
To make his point, Mr. Dudley announced that the company had decided that bonuses for the
fourth quarter of 2010 would be based solely on how employees perform in terms of safety and
risk management. BP would honor the existing performance contracts for the first three quar-
ters of the year, but the fourth quarter’s performance would be measured “solely according to
each business’s progress in reducing operational risks and achieving excellent safety and com-
pliance standards,” he said. In so doing, Mr. Dudley signaled in no uncertain terms that the
company was “absolutely clear that safety, compliance and operational risk management [was
to be] BP’s number one priority, well ahead of all other priorities.”8
The second control benefit is motivational. Some employees need incentives to exert the
extra effort required to perform tasks well; that is, to work hard, do a good job, and succeed.9 In
other words, this purpose of incentives is sometimes also called the effort-inducing purpose.

355
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

Sometimes even hard-working employees need incentives to overcome their natural aversion to
some difficult or tedious actions that are in their organization’s best interest, such as working
cooperatively with other divisions to resolve customer complaints, making cold sales calls to get
more business, preparing paperwork, or training employees. The crucial point here, however, is
that the incentive systems are designed to encourage the desired behaviors, and not to crowd
them out.10
The third control benefit is attraction and retention of personnel. Performance-dependent
rewards are an important part of many employees’ total compensation package. Some rewards
are promised because the organization wants to improve employee recruitment (selection) and
retention, either by offering a package that is comparable or superior to the packages offered by
their competitors or in the relevant labor market, or by linking payments to an employee’s con-
tinued employment. Some firms also overtly offer compensation packages with below-average
base salaries but with performance-dependent compensation elements (variable pay) that pro-
vide the opportunity to earn above-average total compensation if excellent performance is
forthcoming. These packages tend to appeal to employees who are entrepreneurial, rather than
risk averse, and those who are confident about their abilities to achieve. These efforts to use
compensation packages to attract and retain the most suitable employees often form a key ele-
ment of firms’ personnel control strategy, as discussed in Chapter 3.
Finally, incentive systems also serve several non-control purposes. Incentive systems that are
performance-dependent make compensation more variable with firm performance. This
decreases cash outlays when performance is poor and, thus, smooths earnings, because com-
pensation expense is lower when profits are lower. This purpose is clearly articulated in a recent
survey of practice, and inevitably put into the context of the aforementioned attraction and
retention purpose:
“Organizations are under immense pressure to keep costs in line to remain competitive,
and as a result, we are seeing more than 90 percent of companies shifting more of their
spending to variable pay because this type of strategy enables them to recognize and
reward performance without growing their fixed cost,” said Ken Abosch [at compensation
consultant] Aon Hewitt. “Pay is a top engagement driver for employees, and as the market
continues to improve, organizations will need to differentiate through variable pay pro-
grams to attract and retain top talent.”11
Copyright © 2017. Pearson Education Limited. All rights reserved.

Incentive system design choices can also affect a firm’s tax payments. Some forms of compensa-
tion are not deductible for tax purposes, and some deductions are limited. For example,
Section 162(m) of the US Internal Revenue Code limits the deductibility of compensation in excess
of $1 million paid to an employee unless the compensation qualifies as “performance-based.” The
intent of this law was to discourage high guaranteed payments to executives in situations where
shareholders were not benefiting (presumably because the fixed pay is not performance-based).12
Government regulations also affect compensation arrangements in organizations, thus driv-
ing another important concern of incentive system design – compliance. For example, concerns
for compliance were heightened following the financial crisis of 2008, especially in banks,
where lawmakers and regulators, although with significant variations across countries, man-
dated or tinkered with caps on bonuses and deferred bonuses as well as restrictions on how
bonuses are paid out (such as, for example, in deferred shares instead of cash).13 Firms respond
to these restrictions by finding ways to maintain competitive compensation packages. The fol-
lowing quote illustrates this: “Banks are now rushing to find ways to maintain overall levels of
compensation. With bonuses limited to a small multiple of salaries and banks unwilling to
greatly increase their fixed costs, many firms – including Goldman – are hoping to bridge the
gap by introducing role-based allowances” (italics added).14 The idea behind these role-based
allowances is that they would not qualify as bonuses as defined by the regulator (such as by

356
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Monetary incentives

being based on seniority or “role” instead of on performance) and thus would not count toward
the bonus cap, while having some characteristics of bonuses such as being adjustable upward or
downward each year. One could therefore maintain that the regulation has led to a new form of
compensation – so-called allowances – that fall somewhere between fixed pay and bonuses,15
and which, for this reason, will be closely scrutinized by the regulators.16
While this chapter focuses on the management control benefits of incentives, it must be rec-
ognized that the control and non-control purposes of incentive systems can, and must, some-
times be traded off against each other. Consequently, observing organizations’ incentive
practices does not necessarily provide definitive clues as to which incentives they find to be
most effective for control purposes.

Monetary incentives

Money is an important form of reward that is often linked to performance, particularly at

management levels in organizations. Monetary incentives certainly are not the only form of
reward, and they may not even always be the best one, but their use is common. There are
three primary ways through which monetary incentives can be provided: performance-based
salary increases, short-term incentive plans, and long-term incentive plans. Note that the
term “performance-based” is key to distinguishing incentives from entitlements. When we
use incentives hereafter, we presume them to be performance- or merit-based, instead of
amounts being awarded as cost-of-living adjustments or on the basis of seniority, custom (e.g.
a holiday “bonus” depending on salary band rather than performance), or collective bargain-
ing agreements.
That is not to say that there is agreement about the extent to which pay should be perfor-
mance-based. Indeed, views on this vary widely. For example, a survey in the United Kingdom
revealed that, in the private sector, 54% of the responding employees believe that their salary
should reflect their own performance, 36% think it should reflect inflation, and 32% feel it
should reflect their experience. In the public sector, however, the percentages are 36% perfor-
mance, 55% inflation, and 33% experience. These variations support the aforementioned
selection purpose of incentives – that is, different incentive incentives systems will attract, or can be
designed to attract, different types of individuals to different types of organizations. Indeed, the
Copyright © 2017. Pearson Education Limited. All rights reserved.

survey also suggested that while “public sector workers agreed that private sector workers should
be paid based on how well they perform, they are more reluctant to see their own pay linked to
individual performance (36%), that of their team (11%) or that of their organization (5%).”17

Salary increases
Organizations give, or at least consider, salary increases to their employees typically each year.
These salary increases are minimally cost-of-living adjustments. But they can also be seen as an
incentive when at least some portion of the raise is merit-based. Salary increases are typically a
small proportion of an employee’s salary, but they have considerable value because they are not
just a one-time or lump-sum payment; instead, they provide a permanent increment because
employees’ salaries are rarely reduced (although, in years of austerity, further increases may be
put on hold).
Salary increases can be seen as an incentive when they are expected to be “earned” through
performance or the acquisition of skills that promise improved performance in future periods.
Even the Vatican has apparently introduced an “element of incentive” into its salary system, as
it takes into account issues such as “dedication, professionalism, productivity and correctitude”
when awarding pay raises.18

357
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

Short-term incentives
Many organizations in the private sector, but also increasingly those in the public sector, in a
growing number of countries, use short-term incentives, which include bonuses, commissions,
and piece-rate payments. Incentives have become so widespread that some have claimed that
they are “overused” and that they “emerge as the first answer to almost every problem” in the
sense of:

Is the medical system inefficient? Set up a managed care system that provides financial
incentives to doctors, insurers, patients, and hospitals. Bad customer service? Provide
financial incentives for better customer service. Airplanes not flying on time? Pay employ-
ees if the planes fly on time, and so on.19

The primary rationale for variable pay is to differentiate pay; that is, to provide rewards in
accordance with an employee’s contributions to the organization, hence the notion of pay-for-
performance or variable pay. Such pay is meant to provide the motivation for employees to go the
“extra” proverbial mile for the “extra” compensation. But such compensation is also risk-sharing
because the employee (employer) receives (pays) the incentive compensation only when the
performance on which it is based has been realized; hence, the notion of at-risk pay from the
employee’s side. For the employer, however, this feature makes compensation expense more
variable with performance, where compensation expense is higher (lower) when performance
is better (worse), and thus, when the firm can best (least) afford the higher (lower) pay.
Short-term incentives typically provide cash payments (although other forms of payment
such as in the form of equity are also possible) based on performance measured over periods of
one year or less. The awards are often called annual incentive pay or bonuses. The awards can be
based on the performance of a single individual, or on that of a group of which an individual is
a member, such as a work team, a profit center, or even the firm as a whole. Probably the most
commonly used performance metrics in annual bonus plans are financial; or to put differently,
there are very few bonus plans that would not have at least some financial performance metric
included.20 For example, a division manager’s bonus could be calculated as a percentage of the
division’s profits up to a maximum (e.g. not to exceed, or capped at, half the manager’s annual
salary). But there are innumerable ways to set bonus formulas, the key parameters of which we
discuss in more detail in a later section.
Copyright © 2017. Pearson Education Limited. All rights reserved.

In addition to financial measures of performance, the incentive plan can also include bonus
payments contingent on achievements in nonfinancial performance areas. For example, 30% of
an entity manager’s bonus could be based on meeting targets for customer satisfaction and a
further 10% based on meeting targets for environmental performance. In some cases, nonfinan-
cial performance is the dominant portion. At Lloyd’s and Royal Bank of Scotland, for example,
individual sales performance represents only a small fraction (less than 5%) of the bonus of
retail banking personnel; the rest is based on customer service and satisfaction levels.21
When the bonus formula in annual incentive plans includes multiple performance dimen-
sions, bonuses can be earned, sometimes controversially, due to on-target performance in one
or some areas despite poor performance in other areas, and while the firm is making losses or
jobs are being cut, say. This happened, to the outrage of shareholders, when the boss of oil firm
BP, Bob Dudley, earned a 20% increase in his 2015 compensation while overseeing the firm’s
biggest-ever operating loss for that year. Ironically, shareholders had, in the prior year, voted in
favor of the pay policy that resulted in Mr. Dudley’s pay packet for 2015, which was designed to
measure his effectiveness in hitting a series of targets such as scaling back capital spending,
reducing costs, and maintaining safety.22 Companies that are concerned about this eventuality
can make bonus payments contingent on minimum performance thresholds in all of the bonus
formula components and, thus, use one performance measure as condition or a modifier for the

358
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Monetary incentives

other. Again, the combinations of possibilities add up to a virtually infinite number of conceiv-
able bonus formulas.
To add further to the variety of bonus plans, some short-term incentive awards are assigned
in two steps. First a bonus pool is funded, often based on corporate performance and often con-
ditional on meeting minimum corporate performance thresholds. In the second step, the pool is
then assigned to individuals, usually through a rating system that provides higher awards to
better performers.23
All of the major compensation consulting firms provide data on reward practices collected
from a large number of firms across industries in a large number of countries around the world.
These surveys are not always easy to compare (due to different sample composition in terms of
type and size of companies as well as industry and country coverage, plus different survey
instruments and incentive system categorizations and valuations taken at different times).
Overall, however, these surveys suggest that short-term incentive pay is ubiquitous at manage-
ment levels with nontrivial payouts relative to base salary for on-target performance, and with
a trend of variable pay spreading around the world. However, in addition to a wide variation
across countries, industries, and firm sizes and types, the surveys exhibit a wide spread in vari-
able pay across organizational roles and levels. Although it is virtually impossible to draw a line
through these findings, perhaps one careful generalization is that both bonus eligibility and
magnitude tend to increase with organization level; that is, as employees move up the organiza-
tional ladder, they are more likely to be eligible for a bonus and to receive a proportionally big-
ger bonus, when earned, out of total compensation.
Despite this generalization, variation remains the norm. For example, even though bonuses
are typically strongly geared in the financial sector – where, according to data from the Euro-
pean Banking Association, the average bonus for bankers earning more than ₠1 million can be
well over three times fixed pay24 – some banks, perhaps rare exceptions, do not believe in
bonuses. Par Boman, chief executive at Sweden’s Handelsbanken, argues that bonuses create a
mismatch between short-term incentives and long-term performance:

I do not believe you can combine long-term commitment with short-term incentives or you
will have a mismatch. That doesn’t mean I’m against bonuses in principle, but in our com-
pany, we cannot see that they will help us develop the bank in the long-term. It doesn’t
make sense to pay bonuses in good times and then in bad times tell employees they have
to work harder for 30 percent less money.25
Copyright © 2017. Pearson Education Limited. All rights reserved.

Perhaps the key message is that short-term incentive (STI) and long-term incentive (LTI)
plans, to which we turn next, should complement each other. In the words of Peter Schloth,
Principal with Mercer, a major compensation consulting firm:

Properly designed LTI programs should motivate to develop strategies and policies to
achieve long-term growth and increase the value of the organization. Effective STI pro-
grams should motivate to execute on strategies and policies, and make good operating
decisions to maximize performance over the course of a year.26

Long-term incentives
Long-term incentive awards are based on performance measured over periods greater than
one year. Their principal objective is to reward employees for their role in creating long-term
value. In addition to motivating employees to contribute to the organization’s long-term suc-
cess, long-term incentive awards also aim to attract and retain key talent by making total
expected compensation more attractive; by encouraging employee ownership (through
equity-based features of the plan);27 and by tying incentive payouts to service period require-
ments (to address retention concerns). Long-term incentive awards often are restricted to

359
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

relatively high levels of management based on the argument that executive decision-making
at these levels most directly impacts the long-term success of the organization, although some
would object to this argument and call instead for a distributed responsibility for long-term
success to everyone in the organization. We will come back to this point when we discuss
group rewards.
Long-term incentive plans (LTIPs) come in multiple forms; as with short-term incentive
plans, one must be careful to generalize selected features of these plans. There is variation in
the period that LTIPs cover (although three to four years is quite common); in the performance
metric(s) the plans include; and in the targets that are expected to be achieved over the period.
Some LTIPs measure performance in accounting terms, such as earnings per share (EPS), say.
The target for these metrics can be cumulative over the LTIP period (such as by requiring EPS to
be within a given range each year of the performance period in addition to meeting the target at
the end of the period), or instead be stipulated as an end-of-period target (where the plan
requires only that the EPS target is achieved at the conclusion of the performance period regard-
less of the actual fluctuations in EPS during the period). Some firms implement consecutive
(end-to-end) LTIPs, meaning that a new cycle begins only at the completion of the previous one.
Others opt for overlapping performance cycles, where a new plan begins each year; hence, mul-
tiple plans are running simultaneously, making it easier to tweak the long-term targets, or even
the chosen metrics, each year. Overlapping LTIPs also facilitate enrolling newly eligible employ-
ees and new hires each year.28
Equity-based plans are another common way to provide long-term incentives. These plans
provide rewards based on changes in the value of the firm’s stock. Equity-based plans, too, come
in many forms, including the following:

Stock option plans

Stock option plans give employees the right to purchase a set number of shares of company
stock at a set price (i.e. the exercise or strike price) during a specified period of time (i.e. after
the options vest but before they expire). Although stock option terms vary across firms, most
options are granted at the money (i.e. the exercise price is equal to the stock price on the day of
grant) with a three- to five-year vesting rate (i.e. one-third, one-fourth, or one-fifth of the
options granted, respectively, vest at the end of each of the first three, four, or five years), and a
10-year maturity (i.e. the options expire 10 years after they are granted). When the stock price
Copyright © 2017. Pearson Education Limited. All rights reserved.

is above the option exercise price – that is, when the stock options are in the money – the
employee can exercise the vested options and either hold the shares or sell them with a gain.
However, when the strike price of vested options is higher than the stock price, the options are
said to be underwater. Rather than having motivational effects, underwater options often are a
source of morale and retention problems, particularly if the firm’s stock price malaise is deemed
to persist.
While employees might desire stock options because of the size of the potential gains, stock
options also have several attractive features for the granting firms. From an incentive perspec-
tive, employees benefit only when the stock price goes up, so stock options motivate employees
to work effectively, one would presume, to increase their company’s stock price. This improves
incentive alignment, as employees benefit only when shareholders benefit; that is, when the
stock price goes up and, presumably, value has been created. Moreover, the potential for share
ownership associated with stock options also affects alignment by tying some of the employee’s
wealth to the company’s future. Finally, vesting schedules coupled with service-based restric-
tions that cause employees to forfeit unvested options when they leave the firm are believed to
enhance employees’ long-term focus on the business as well as retention. Thus, stock options
get employees to think more like owners while enhancing retention of talent. Stock options also
allow the firm to provide incentive compensation without cash outlay, which makes stock

360
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Monetary incentives

options particularly attractive for cash-constrained firms such as those during start-up but also
turnaround, either not yet generating profits or facing losses (and retention concerns).29 In fact,
stock options create a positive cash flow for the firm when employees exercise options (due to
the purchase of shares, but also due to a tax-deductible compensation expense in the amount of
the difference between the exercise price of the options and the market price of the stock).
Moreover, until 2005, most stock option grants did not require the firm to take a charge against
earnings. This flaw in the accounting rules provided powerful incentives for firms to grant
options rather than to use other forms of compensation that require expensing. As of 2006,
however, the most commonly applied accounting rules around the world, including Interna-
tional Financial Reporting Standards (IFRS) and US Generally Accepted Accounting Principles
(GAAP), require that the fair value of the stock options at the grant date be estimated using an
option pricing model. A detailed discussion of such non-control implications of stock options,
however, is outside the scope of this text.
Despite these features, stock options also have several disadvantages. Stock option grants
represent a potential future issuance of shares, which creates dilution and may put a downward
pressure on stock prices (which firms try to counter by committing to share repurchases with
the proceeds from the exercise of stock options). Stock options also sometimes motivate manag-
ers to undertake riskier business strategies because the managers are rewarded for gains but
not penalized for losses. Their risk-taking behavior can increase stock price volatility. Stock
options also have been criticized for generating windfall compensation due to market-wide
stock price improvements rather than strong firm performance. In reverse, however, stock
options also can fall underwater due to bearish stock market conditions rather than poor firm
performance and cause morale and retention problems. Also when the firm is performing
poorly and the stock price is subdued, stock options are worth little and, thus, are likely to erode
the motivation to perform – ironically, just at a time when it is important for the executives and
employees to be motivated the most. Moreover, given the relatively high liquidity of stock
options (due to short vesting periods) and, often, the vast amounts of stock options held, execu-
tives may be encouraged to take actions that boost stock price in the short term but harm share-
holders in the long run after the options have been cashed in. Considering these issues, the
premise that stock options contribute to the creation of shareholder value has been actively
debated and researched.30
Before they became so contested, however, stock options were by far the most prevalent form
Copyright © 2017. Pearson Education Limited. All rights reserved.

of stock-based incentives during the 1990s, particularly in the United States and especially in
certain industries (e.g. hi-tech). Although stock options remained in play, the years 2003 and
2004 began to show declining grant rates, rising exercise rates, and declining eligibility as
firms were increasingly considering alternatives to standard option plans, particularly below
the executive/management level.31 The decline in stock options’ popularity around that time,
particularly in the United States, coincided with the change in accounting rules that required
stock option expensing. But other reasons could help explain stock options’ decline, such as the
bear stock market in the United States that drove many stock options underwater, as well as
investor activism against the ostensibly excessive pay that stock options helped provide during
the boom. Investors also scorned the dilution effects of the large amounts of stock options that
were being granted.
Differences in stock option use have existed, and continue to persist, across countries, how-
ever. Firms in Britain and France, for example, make use of stock options, whereas firms else-
where in Europe have a preference for full-value share awards (see below). That said, use of
stock options, never so widespread in Europe as in America, appears to be declining in most
countries.32 With the decline in stock option usage, however, other forms of equity-based
compensation have become more prominent, including restricted shares and, especially,
performance awards.33

361
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

Restricted stock plans

Employees eligible for restricted stock do not have to spend cash to acquire the stock, as the
shares of stock are given to them; but selling those shares is restricted for a specified period of
time (five years, say) and contingent upon employment at that time. In other words, the
employee has full ownership rights over the shares, including voting and dividend rights; but
the shares are subject to sale restrictions and/or risk of forfeiture until the vesting event occurs,
that is, until completion of the service period.
Restricted stock obviously provides a reward for increases in stock price, although the stock
itself also has value when the stock price is flat or even declines (unlike stock options that only
provide a reward when the stock price exceeds the exercise price). Because full-value stock
awards like restricted stock have less risk than stock options, the firm can issue fewer shares as
it would when using stock options instead, thus causing less dilution. On the other hand,
restricted stock has been derided as a giveaway or pay-for-pulse (rather than pay-for-
performance). This is because the stock has some value (even if the stock price declines), and the
restrictions on selling the stock disappear merely with the passage of time and continued
employment during that time; that is, with the completion of the service period. For this reason,
restricted stock is said to better serve retention purposes and benefits stemming from owner-
ship, rather than motivation per se.

Performance stock or option plans

To mitigate the “giveaway” feature of restricted stock and bolster the pay-for-performance
rationale, some firms have resorted to performance awards by making their stock grants contin-
gent on the achievement of stock or non-stock goals over a specified period. In this way, perfor-
mance stock shares are restricted stock shares that vest upon the achievement of specific
performance targets and not merely the completion of a service period. Until the specific per-
formance target has been achieved, the shares are subject to sale restrictions and/or forfeiture
contingent on continued employment. Once vested, the performance shares usually are no
longer subject to restriction.
Similarly, performance options are alternative stock option plans that make vesting or
exercise of the options contingent on improvements in stock performance or the achievement
of certain stock or non-stock targets. Performance options can come in different forms. Pre-
Copyright © 2017. Pearson Education Limited. All rights reserved.

mium options have exercise prices greater than the stock price on the grant date. Indexed
options have exercise prices contingent on performance relative to a peer group of firms.
Performance-vested options link the vesting of the options to the achievement of performance
targets, such as return on equity, earnings per share, or other financial or operating measures
(e.g. sales growth).
Examples can be varied, such as for performance stock option plans that contain both pre-
mium pricing and performance vesting. Regardless of the variations, the key idea behind these
alternative stock option plans is to provide stronger incentives to maximize shareholder value
by raising the bar for stock price improvements before the options become exercisable (as is the
case with premium and indexed options) or by raising the bar on the conditions to vest and,
thus, earn the stock (as is the case with performance-vested options). However, as is true for all
incentive plans that require the setting of performance targets, triggers, or thresholds, doing so
effectively is a key challenge. When the performance conditions are set too leniently, the per-
formance stock or option plans will be seen as merely providing giveaways. But when they are
set too tough, they can have other undesired consequences, such as excessive risk taking, dis-
couragement, and/or turnover.
There are many other possible long-term incentive instruments, but most are variants of
stock option, restricted stock, or performance stock/option plans. For example, both restricted

362
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Monetary incentives

stock and performance stock plans involve granting stock. But sometimes firms provide awards
in units instead of actual shares. For example, at the Coca-Cola Company:

Performance Share Units (PSUs) provide an opportunity for employees to receive common
stock if the specified performance measure [i.e. compound annual growth in economic
profit] is met for a predefined performance period [i.e. over three-year periods – 2012–14,
2013–15, 2014–16, 2015–17, etc.]. PSUs generally are subject to an additional holding
period. PSUs generally vest 100% after four years (three-year performance period followed
by a one-year holding period).

However,

The PSUs for the 2013–2015 performance period will have zero payout because the pre-
established economic profit growth target was not met. As with the two prior PSU pro-
grams, no compensation will be realized for this portion of long-term incentive compensation.
[For the 2014–16 period, the Company’s 2016 proxy statement states that] Through
December 31, 2015, payout is projected above the target level. Company performance over
the remaining year of the performance period [2016] will determine the number of shares
earned, if any. Results will be certified in February 2017.
[And, for the 2015–17 period, the Company’s 2016 proxy statement states that] Through
December 31, 2015, payout is projected near the target level. Company performance over
the remaining two years of the performance period [2016 and 2017] will determine the num-
ber of shares earned, if any. Results will be certified in February 2018.34

Performance share units are thus granted in units instead of actual shares, where each unit
awarded usually represents the value of one share of stock. But PSUs only entitle the employee
to stock upon vesting, and as the example illustrates, when the vesting is performance-based –
and thus when these are so-called performance shares – they may not always result in an award.
(Moreover, as recipients of PSUs, employees usually have no ownership rights until vesting,
since no shares are actually issued until that point.)
Another variation of equity-based long-term incentives are Stock Appreciation Rights (SARs).
SARs are similar to options in that the eligible employees benefit from appreciation in the com-
pany’s stock price. They are different in that the employees do not have to spend cash to acquire
the stock. Instead, without acquiring the stock, employees just receive the amount of any
Copyright © 2017. Pearson Education Limited. All rights reserved.

increase in stock price over the specified period. But like stock options, the employee typically
can exercise the SAR at any point after vesting but before expiry. When the SAR is exercised,
the firm pays the employee cash (cash SARs), stock (stock SARs), or a combination of both, in an
amount equal to the stock’s appreciation since the date of grant.
As with short-term incentive plans, the variety of long-term incentive plans is infinite, which
should caution against making any seemingly simple generalizations or patently effective pre-
scriptions. That said, evidence suggests that equity-based incentives have grown historically to
a recent plateau, as follows:

The percentage of pay tied to the stock market for CEOs of US companies was negligible
in the early 1980s, rose to about one-quarter in the early 1990s, peaked at roughly one-half
in the early 2000s, and remains near 40% today.35

Another discernable trend perhaps is the decrease in the use of stock options and the increase
in performance-based plans. Consistent with this, the aforementioned 2016 proxy statement of
Coca-Cola explicitly states that they “adjusted the mix if equity compensation to use fewer stock
options and more performance share units” in line with their compensation practice or princi-
ple where “the vast majority of pay is to be performance-based and not guaranteed.” David
Hofrichter, principal and business development leader of Hewitt’s Executive Compensation

363
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

Consulting practice, echoes this by opining that, indeed, “Compensation Committees now want
something for [their LTIP grants]; [which] they are expressing […] through performance plans
that target key metrics and support the strategy of the organization.”36

Incentive system design

In the following sections, we discuss three related incentive system design choices: the extent to
which the rewards are determined formulaically, the shape of the incentive-performance func-
tion, and the size of incentive pay.

Incentive formula
The types of rewards provided and the bases on which they are awarded are commonly com-
municated to the incentive plan participant by means of an incentive formula and described in
an incentive contract that might be written in great detail. However, the rewards sometimes
can also be assigned subjectively instead of completely formulaically. Subjectivity almost inevi-
tably plays some role for decisions about promotions and job assignments. But subjectivity can
also be part of annual bonus assignments in the following ways: (1) all or part of the bonus is
based on subjective judgments about performance; (2) the weights on some or all quantitative
measures are determined subjectively; or (3) a subjective performance threshold or override is
used, in which case a subjective determination as to whether or not to pay a bonus is made.
Subjectivity can be used for a number of reasons. It may be difficult to describe the bases for
the rewards and/or their weightings from a large set of evaluation criteria prior to the perfor-
mance period. Keeping the contract flexible can mitigate motivating employees in directions that
turn out to be no longer appropriate as conditions change. When the contract is left flexible,
employees are encouraged to keep doing their best and not give up in the face of an impossible
performance target or, in reverse, coast once the target is achieved. And, keeping the bases for
rewards vague can reduce employees’ propensities to manipulate the performance measures.37
The use of subjectivity in contracting, however, can affect employee risk. It can decrease risk
if it allows adjustments for the effects of factors that are outside the employee’s control (which
we discuss in greater detail in Chapter 12). But the use of subjectivity can also increase employee
risk. First, with implicit contracts, employees bear the risk that their evaluators might evaluate
Copyright © 2017. Pearson Education Limited. All rights reserved.

them on different bases from what they were assuming when they made their decisions; that is,
subjective evaluations are prone to hindsight bias. Second, if employees do not trust their evalu-
ators to make informed and unbiased performance assessments, subjectivity can result in
employee frustration, demotivation, and friction. Finally, when evaluations are subjective,
employees may attempt to inappropriately influence their evaluators for better evaluations.
These problems, however, are reduced if the employee and the evaluator develop a working
relationship with greater mutual trust, which has been shown to be critical for the effective
implementation of completely or partially subjective performance evaluations.38

Shape of the incentive function

When the reward promises are formulaic, the link between rewards and the bases on which
they are awarded is often determined by a rewards-results or pay-performance function. This
was illustrated in a budget setting in Chapter 8 (Figure 8.3), showing that bonuses are typically
promised only over a restricted performance range; that is, the function has lower and upper
reward cutoffs, and it is linear in shape (although sometimes with kinks) between the cutoffs.39
At profit center levels, most firms set a lower cutoff or threshold in their short-term incentive
contracts. Below some significant fraction (e.g. 80%) of targeted annual performance (which is

364
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Criteria for evaluating incentive systems

typically the budget), managers do not earn incentive pay for performance. Organizations set a
lower cutoff because they do not want to pay any bonuses for performance they consider medio-
cre or worse. The fraction of the target set as the lower limit varies, among other things, with
the predictability of the target; that is, it tends to be a lower fraction when predictability is
lower. An upper cutoff or cap on incentive payments also is commonly used; it means that no
extra incentive pay is provided for any additional performance above the cutoff. The caps are
typically set at a percentage of the annual performance target, such as 150% of budget. Upper
cutoffs can be considered for a number of reasons, including the following:

1. A concern that the high incentive payments might not be deserved because of windfall gains
(unforeseen good luck);
2. A concern that employees will be unduly motivated to take actions to increase current period
performance at the expense of the long term; in other words, produce results that are unsus-
tainable (which was the stated reason for the cap on bonuses for banks in the European Union,
a rule that limits bonuses of high-earning bankers to the same level as their salaries or twice
the amount with shareholder approval, to “curb the high bonus multiples that European law-
makers say contributed to excessive risk taking in the run-up to the financial crisis”);40
3. A desire not to pay hierarchically subordinate employees more than hierarchically higher
employees or managers, thus maintaining vertical compensation equity;
4. A desire to keep total compensation somewhat consistent over time so that employees are
able to sustain their lifestyle and, thus, to mitigate “feast-or-famine” volatility in pay year
over year; and,
5. A concern about a possibly faulty plan design, the risk of which is greatest when the plan is new.

Size of incentive pay

Because employees almost invariably value money, a significant proportion of variable pay
should motivate them to achieve the performance goals. Further, compensation packages that
offer significant performance-contingent pay (at-risk pay or pay-for-performance) are likely to
attract employees who are confident about their abilities to produce superior results and/or are
more willing to accept risk. In that sense, the type of compensation package offered serves an
employee selection role.
Copyright © 2017. Pearson Education Limited. All rights reserved.

However, the most important consideration regarding the high use of variable pay is that if
performance is not totally controllable by the employees, then the incentive system inevitably
imposes risk on them (hence the term at-risk pay). Employees, therefore, will want to be com-
pensated for bearing that risk; that is, their compensation in expectation must be higher than
what it would be when offered a fixed salary. If the organization fails to provide the risk pre-
mium, which is an additional compensation expense, it will find itself unable to compete for
talent in the labor markets.

Criteria for evaluating incentive systems

Each incentive plan – being one of many possible variations, as we have seen – should be care-
fully evaluated on all of its features individually and collectively; that is, as a package. This
should be done regularly as circumstances change, as seems to be “best practice” in many firms,
as suggested by Andrew MacLeod, head of pay research at Aon Hewitt:

Rather than debating the philosophical point of whether or not bonus plans work, compa-
nies seem to be more focused on assessing whether they are working in reality and

365
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

improving their design to make them more likely to succeed. Ninety-four percent of our
study’s respondents now have a review process in place, with a big increase in the use of
cost/benefit analysis.41

Setting aside infinite variations in specific incentive plan designs, the following criteria can
be used as overall principles when evaluating an incentive system.
First, the rewards should be valued. Rewards that have no value will not provide motivation.
However, reward tastes probably vary across individuals. As compared with top executives,
lower-level managers are likely more interested in protecting their autonomy and in improving
their prospects for promotion in addition to the size of their short-term income (after their base
salaries are assured). Employees later in their careers are probably more concerned about job
security. And so on. Overall, studies suggest that the reasons people join and stay with an
organization are broader than compensation alone, including the satisfaction that comes from
the work they do and the role they have, the long-term opportunities for development and
advancement, and the feelings of belonging to an admirable organization that shares their val-
ues.42 Reward tastes also vary across countries due to many factors, including culture, stage of
economic development, and differences in tax and regulation, although evidence suggests that
these differences are diminishing and that the world is getting flatter when it comes to incentive
pay.43 Nonetheless, some differences at various levels will remain, and if organizations can tai-
lor their reward packages to their employees’ preferences, then they could possibly provide the
control benefits of incentives more effectively. Such tailoring is costly, however, and firms often
opt to administer a single organization-wide incentive system (or, at most, just a few systems).
Second, the rewards should be large enough to have impact. If rewards that are valued are
provided in trivial amounts, the effect can be counterproductive. Employees can be insulted
and react with such emotions as contempt and anger.44 Reward visibility may affect impact. If
rewards are visible to others, the motivational effect is enhanced by a sense of pride and recog-
nition.
Third, rewards should be understandable. Employees should understand both the reasons for
and the value of the rewards. Organizations can incur considerable expense in providing poten-
tially valuable rewards, but if employees do not understand them well, the expense will not
generate the desired motivational effects.
Fourth, rewards should be timely. Delay in providing the rewards after the performance is
said to dilute their motivational effects. Prompt rewards also increase the extent of any learning
Copyright © 2017. Pearson Education Limited. All rights reserved.

that takes place from receiving the reward and connecting it to the performance for which it
was given.
Fifth, the effects of the rewards should be durable. Rewards have greater value if the good
feelings generated by the granting of a reward are long lasting; that is, if employees remember
them.
Sixth, rewards should be reversible. Performance evaluators often make mistakes, and some
reward decisions are more difficult to correct than others. Promotions, for example, are difficult
to reverse.
Finally, rewards should be cost efficient; that is, all else equal, incentives should achieve the
desired motivation at minimal cost. As the quote earlier in this section suggests, however, many
organizations now seem to have a review process in place, with a big increase in the use of cost-
benefit analysis.

Monetary incentives and the evaluation criteria

How well do the monetary rewards that many organizations provide satisfy the reward evalua-
tion criteria? Monetary rewards can have potent impacts on employees’ behaviors because vir-
tually everyone values money. Money can be used to purchase goods and services that can

366
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Criteria for evaluating incentive systems

satisfy each employee’s most pressing desires. A vice president in a human resources consulting
firm expressed this advantage in colorful terms, “You can’t pay orthodonture bills with crystal
from Waterford.”45 Put differently, “working for cookies is not an option.”46 Money also has
important symbolic values. It reflects achievement and success, it accords people prestige, and
it sometimes even serves as a proxy for some people’s estimation of their self-worth.
However, the observation that employees almost without exception value money does not
necessarily imply that higher incentives will lead to higher performance. Indeed, studies sug-
gest that there may be an inverse U-shaped relationship between effort levels and incentive
intensity, indicating that ever higher incentives may actually result in a decline in performance
or produce unintended consequences. Those consequences stem from dysfunctional behaviors
and “gaming” of the performance metrics to increase “measured” performance and personal
wealth at the expense of long-term value creation or “real” performance improvements47 (vari-
ous examples of which we discussed in the earlier chapters). This is anecdotally expressed in
the following quote from John Cryan, chief executive at UBS, a global bank:

Mr Cryan not only noted that overall levels of compensation in his industry remain too high.
He also pondered whether bonuses really spur his banking colleagues to the elevated lev-
els of productive effort such inducements are supposed to extract. In his own case,
Mr Cryan said the answer was no. “I will not work any harder or any less hard in any year, in
any day because someone is going to pay me any more or less,” he observed.48

This echoes the view of Jeroen van der Veer, the former boss at Shell, an oil major:

If I had been paid 50 per cent more, I would not have done [my job] better. If I had been paid
50 per cent less, then I would not have done it worse.49

Of course, these gentlemen were very well paid, which may affect their marginal utility for
money and thus how “much” they value it. That said, various monetary rewards sometimes also
fail the impact criterion. Merit raises, for example, are typically quite small for most employees,
so total raises look small in times of low inflation. But even bonuses may suffer from impact or,
worse, lead to demotivation when expected but not earned:

The impact of a cash bonus is often short-lived. Staff quickly start to think of it as a perma-
nent part of their compensation. The following year they quite naturally become upset if
their bonus turns out to be lower.50
Copyright © 2017. Pearson Education Limited. All rights reserved.

Moreover, the performance evaluations on which the merit raises are based typically are
infrequent, kept confidential, or communicated to employees in quite vague terms, thus leaving
them ambiguous (thereby affecting understandability) and possibly failing to provide a sense of
recognition. Indeed, the annual performance reviews on the basis of which merit raises are
typically determined have recently been increasingly debated in terms of their effectiveness to
properly motivate employees.51 To quote from a Harvard Business Review article:

In a survey Deloitte conducted recently, more than half the executives questioned (58%)
believe that their current performance management approach drives neither employee
engagement nor high performance. [What is more, tallying] the number of hours the organi-
zations were spending on performance management – they found that completing the forms,
holding the meetings, and creating the ratings consumed close to 2 million hours a year.52

Another common issue arises when firms that fall on hard times “flatten” pay, inadvertently
or not. Because it is difficult to cut an employee’s pay, poor performers are merely given no
raises or bonuses, and the penalty to these employees is low. But lowering the payments to the
top performers is where it hurts, often leading to perceptions of inequity, demotivation, and
increased turnover, unhelpfully, among the most valuable employees.

367
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-06 07:40:07.
 Chapter 9 • Incentive Systems

On the other hand, some forms of monetary incentives, such as stock options, have been said to
have “too much” impact. Stock options have often been granted in large numbers to, particularly,
higher-level employees or executives. Due to the large number of stock options typically granted and
held by top executives, and exacerbated by relatively short vesting periods, the executives may be
encouraged to take actions that affect stock price in the short term but harm shareholders in the long
run. For example, an action that can slightly affect stock price downward at the time of a stock option
grant, or boost stock price at the time of a stock option exercise, can make a huge difference for the
stock options to be subsequently “in the money” or yield a greater payout at exercising, respectively,
when applied to a very large number of stock options. In other words, pay can be significantly impacted
by short-term movements in stock prices, thus encouraging executives to take measures to affect stock
price rather than to maximize shareholder value in the long term (by which time they may have left
the firm). In that sense, and due to the potential short-term impact that stock price may have on the
potential value and payout from stock options, these instruments are, in fact, working against their
intended purpose – that is, to have the executives focused on the long term rather than to take actions
that affect short term. This illustrates that, indeed, impact is a powerful criterion for incentives to
have; but equally, when impact directs behaviors in ill-aligned ways, it can be detrimental.53
Because incentive contracts sometimes are quite complex (as are many long-term incentive
plans, such as performance stock plans) or even ambiguous (when they include the use of sub-
jectivity), and because performance-related feedback is infrequent, incomplete, and/or biased,
employees often fail to understand the reasons why they are given the rewards (or the size of
their rewards). When the rewards fail the understandability criterion, they are less likely to
produce the desired effects. Stock options are often said to be ill-understood by employees,
especially at lower organizational levels. Regarding performance rating issues, such as com-
pleteness and/or biases, particularly in annual performance reviews, a Deloitte report cites
work in psychology that found that only one-fifth of the variance in employee performance rat-
ings reflects the employee’s actual performance; the larger part reflects other factors, particu-
larly rater perceptions (three-fifths of the variance) and other noise:

Assessing someone’s skills produces inconsistent data. Objective as I may try to be in

evaluating you on, say, strategic thinking, it turns out that how much strategic thinking I do,
or how valuable I think strategic thinking is, or how tough a rater I am significantly affects
my assessment of your strategic thinking.54
Copyright © 2017. Pearson Education Limited. All rights reserved.

Monetary rewards vary in their timeliness. Piece-rates used in some production settings are
possibly the timeliest. Sales commissions are perhaps a close second. The most common period
for performance reviews, however, such as for salary increases and bonuses, is annual. Long-term
incentive awards – those based on multiyear performance – are less timely. It has been suggested
that the mental discount rate employees apply to delayed rewards is greater than the time value of
money. Or, as Peter Boreham, a director at Hay Group, put it: “Once you go beyond three years [as
is commonly the case with long-term incentive plans], the mental discount that executives put on
rewards gets very large; any longer and it becomes a lottery ticket.”55 One survey study estimates
that incentive pay is discounted compared to fixed pay by about 10% for cash bonuses and 50% or
more for deferred bonuses and long-term incentives.56 Hence, extending the time horizon of
incentives, which has been increasingly called for to enhance a focus on the long term, is not cost-
less given the rather large mental discount that people attach to delayed payouts.
Following the 2008 financial crisis, a common trend in the calls for change was to defer
bonus payments because “deferring bonus payments helps companies to control short-termism,”
said Vicki Elliot, a worldwide partner at Mercer. “It means that a portion of the bonus is payable
to employees in installments based on subsequent company and/or business unit performance.
This claw-back approach sends the message that the bonus isn’t finally determined until com-
pany or business unit performance is sustained.”57 In other words, deferring some of the bonus

368
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Criteria for evaluating incentive systems

payments should prevent employees from pocketing bonuses when they misleadingly appear to
be doing well and keeping the money when their firm subsequently suffers or even collapses.
“There has been too much focus on payments that are very short-term focused, people who pick
up the tab for short-term profits, without having to bear the costs of long-term impairments,”
said Stephen Green, chairman of HSBC, a global bank.58
Another way to possibly mitigate the short-term focus of some incentive systems while cir-
cumventing the cost of the “mental discount” that comes with deferred payments is to consider
risk-adjusted measures as the basis for bonus determination. However, the vast majority of
banks (and likely nonfinancial firms as well) admitted that they lack “reliable methods to meas-
ure the risks they are running” and had to “work out how to phase compensation to make sure
it reflects the risks being taken over a long period.” 59 Some banks have considered paying
bonuses in contingent bonds (rather than cash), which are “wiped out” if the bank’s capital ratio
[a key indicator for a bank’s survival] falls below a predefined threshold, which should curb
incentives to take excessive risk.60 But even though the employees own the bonds, they may
value them less than cash. As we will see in the next chapter, there are indeed no easy solutions
to overcome the ubiquitous myopia problem.61 And, this is not only a problem in banks, although
the crisis clearly has put a spotlight on their incentive systems. For example, several Chinese
cities and counties dropped gross domestic product (GDP) as a performance metric for govern-
ment officials in an effort to shift the focus to protecting the environment and reducing poverty:

The move, which follows a directive issued by top leaders, is among the first concrete
signs of China switching its blind pursuit of economic growth at all costs towards meas-
ures that encourage better quality of life. Analysts say that adherence to GDP as a perfor-
mance metric – thus linking it to local officials’ promotion – has contributed to
environmental degradation and urban sprawl as officials encouraged heavy industry and
bulldozed agricultural land to build housing developments.62

This latter example is one of promotion-based incentives, which are durable. Most monetary
rewards, in contrast, particularly small ones, are not. In many cases, salary increases are “lost
in the paycheck” – they are quickly spent and forgotten (see also earlier quotes above). One
survey found that 29% of employees who earned bonuses used them to pay bills; 18% “admitted
they couldn’t remember where the money went.” The report concluded that, for most employ-
ees, “[cash] bonuses have no lasting value.”63 Durability can perhaps be improved if the award
Copyright © 2017. Pearson Education Limited. All rights reserved.

is given but restricted for a period of time, such as with an award of restricted stock (or contin-
gent bonds, as in another example above), because the employee can see the reward, and can
value it, but cannot spend it. This benefit of durability would also apply to the deferred bonus
schemes that firms ponder, thus involving a tradeoff against the possible cost due to mental
discounting. In contrast, some non-monetary rewards, such as a promotion or a recognition
that goes on one’s CV, are quite durable (although they tend to be less or not reversible).
Indeed, monetary rewards also vary in their reversibility. Bonus awards are reversible because
they are typically contingent on performance in a single period. Salary increases, on the other
hand, provide an almost guaranteed increment because pay cuts are rare. But some question
whether even bonuses are truly reversible. Employees come to expect them, and if there is no
payout, they will be frustrated, especially if it happens because the company is not doing well.
Recall the quote here from Handelsbanken, arguing that “it doesn’t make sense to pay bonuses in
good times and then in bad times tell [employees] they have to work harder for 30 percent less
money.”64 Or, as Tidjane Thiam, chief executive of Credit Suisse, a global bank, muses:

Remuneration is a “battle ground.” [And although he] is not against bonuses for his invest-
ment bankers, if pay goes up and down with performance, but, “it’s the ‘and down’ that
they don’t accept.”65

369
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Finally, monetary rewards tend to be expensive. The value provided to the employees is a
direct cost to the firm. Some other forms of rewards, such as titles, recognition, interesting job
assignments, or prized parking spots are much less expensive, yet they can have value to
employees.
Although monetary rewards do not satisfy all the evaluation criteria equally well, the crite-
ria are not all equally important, either. As such, monetary rewards possibly are quite effective
in satisfying the most important criteria. In particular, money is highly valued, so monetary
awards attract most employees’ attention. That is not to say that monetary rewards are not
sometimes overused or that they could not be better designed.66 As we have shown, such design
considerations inevitably will involve tradeoffs among the various criteria.

Group rewards

Team or group rewards certainly have advantages; they were discussed in Chapter 3 as one the
methods by which personnel/cultural controls can be implemented. But they also have some
significant disadvantages. Group rewards often do not provide direct and strong incentive effects.
They provide a direct incentive only if the individuals to whom the rewards are promised per-
ceive that they can influence the performance on which the rewards are based to a considerable
extent. Group rewards also create the potential for free riding. In larger teams, particularly, some
team members can slack off and suffer little adverse effects on the rewards earned.
As such, stock-based plans, one prominent form of group rewards, provide direct incentives
only for the small number of managers at the very top of publicly held firms who presumably
can influence their firm’s stock price in a meaningful way. When lower-level employees are
included in stock-based plans, their compensation is made more volatile and uncertain, but
their motivation is not proportionally affected.
Group rewards can produce a beneficial form of cultural control, however. Team members
may monitor and sanction each other’s behaviors and produce improved results. Comments
like, “Get to work; you’re hurting my profit sharing!” are evidence that cultural control – mutual
monitoring – is working. It is this benefit and the avoidance of some dysfunctional effects of
individual rewards that group rewards can provide.
Some firms have used group rewards very effectively over long periods of time. For example,
Copyright © 2017. Pearson Education Limited. All rights reserved.

all employees (or “partners,” as the company calls them) at John Lewis, a large UK retailer,
share in the company’s profit, which in some years amounts to several weeks up to two months’
worth of salary for each employee, depending on company performance. “Today’s results reflect
the collective hard work of our partners,” said Charlie Mayfield, John Lewis chairman. “While
not a universal panacea, [our collective performance-based bonus plan] clearly underpins the
partnership’s performance,” he added.67 Other firms have variations of group rewards through
share ownership. For example, Slater & Gordon, a stock-exchange-listed Australian law firm,
commented on its employee stock ownership plan as being designed to “encourage staff reten-
tion, improve performance, and align employee and shareholder incentives.”68

Conclusion

Incentives are an important part of the results-control arrangements used to direct employees’
behaviors. Rewards that can be linked to measures of performance or subjective performance
evaluations come in many forms. It is widely, but not universally, believed that monetary

370
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Notes

rewards are important for motivation. However, a wide range of other forms of rewards, such as
praise, titles, recognition, promotions, and so on, also can be potent motivators while being cost
efficient and having advantages in terms of satisfying the various other evaluation criteria that
we discussed.
Incentive contract design presents problems that are far larger than just the choice of rewards,
however. For example, tailoring rewards to employees’ individual preferences would seem to be
effective, but that benefit has to be weighed against the potential for employees’ perceptions of
inequities and the cost of contract administration. Similarly, it is well recognized that organiza-
tions’ total compensation package must be competitive to attract and retain talented employees.
If a portion of the compensation package, such as base salary, is not competitive, perhaps because
cash is in short supply during the start-up phase of a new venture, then the incentives-perfor-
mance function for the variable portion of pay may have to be adapted to compensate, or alterna-
tive forms of compensation such as stock options may have to be provided.
Perhaps the safest advice that can be proffered is that incentives should be sufficiently mean-
ingful to offset other motives employees have to act in ways that are contrary to the organiza-
tion’s best interests, but the rewards should not be greater than those necessary to provide the
needed motivation. An incentive system will not create value for the organization unless the
incremental value of the increased performance generated by the incentives exceeds the associ-
ated compensation and administration expense. Organizations also have to worry about imple-
menting an incentive system that encourages behaviors that do not lead to the desired outcomes.
Many incentive systems have unintended consequences that can actually destroy value, such as by
encouraging results that maximize incentive pay in the short term while jeopardizing the long-
run viability of the organization. If that is the case, it may be better to have no incentive system
than to have a bad one. The literature is littered with examples of incentives having unintended
consequences. This is, in a perverse sense, testimony that incentives work – that is, they encour-
age employees to produce results. But if poorly designed incentive systems encourage employees
to produce the wrong results or do the wrong things in the wrong way, then strong incentives
will only get the organization off track, and sometimes even ruin the firm, more quickly.

Notes
1 S. Kerr, “Executives Ask: How and Why Should Firms and 5 S. A. Hewlett, “Attract and Keep A-Players with Nonfinan-
Their Employees Set Goals,” Academy of Management cial Rewards,” Harvard Business Review (May 24, 2012),
Copyright © 2017. Pearson Education Limited. All rights reserved.

Executive, 18, no. 4 (November 2004), pp. 122–3. online at hbr.org/2012/05/attract-and-keep-a-players-wit.

2 For recent research on incentive schemes including pen- 6 “Barclays Abolishes Commission Bonuses for Branch
alties, see for example W. A. Van der Stede, A. Wu, and S. Staff,” BBC (October 10, 2012), online at www.bbc.co.uk/
Y. Wu, “The Reinforcement Effect of Bonuses and Penal- news/business-19902562.
ties,” Working Paper (2016); M. H. Christ, K. L. Sedatole, 7 “What Are Brands For?,” The Economist (August 30, 2014),
and K. L. Towry, “Sticks and Carrots: The Effect of Con- online at econ.st/VPofD5.
tract Frame on Effort in Incomplete Contracts,” The 8 “BP Links Bonuses to Safety Performance,” The Financial
Accounting Review, 87, no. 6 (November 2012), pp. 1913– Times (October 18, 2010), online at on.ft.com/1QueezM.
38; T. Hossain and J. A. List, “The Behavioralist Visits the 9 There is a large literature on this, but for a review of
Factory: Increasing Productivity Using Simple Framing research examining the effects of monetary incentives on
Manipulations,” Management Science, 58, no. 12 (2012), effort and performance, see S. E. Bonner and G. B. Sprinkle,
pp. 2151–67. “The Effects of Monetary Incentives on Effort and Task
3 “Cut-and-Build Archibald,” Forbes (September 23, 1996), Performance: Theories, Evidence, and a Framework for
p. 46; “Grow, Grow, Grow,” The Economist (April 17, Research,” Accounting, Organizations and Society, 27, no.
2010), Special Report, p. 13. 4/5 (May–July 2002), pp. 303–45. Another good review
4 For examples of recent research on non-monetary incen- or overview article with further references is T. Cham-
tives, see S. M. Lourenço, “Monetary Incentives, Feedback, orro-Premuzic, “Does Money Really Affect Motivation? A
and Recognition – Complements or Substitutes? Evidence Review of the Research,” Harvard Business Review (April
from a Field Experiment in a Retail Services Company,” The 10, 2013), online at hbr.org/2013/04/does-money-really-
Accounting Review, 91, no. 1 (January 2016), pp. 279–97. affect-motiv.

371
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

10 An interesting article in this regard, as its title aptly sug- 26 “Key Differences Exist between Long- and Short-term
gests, is U. Gneezy, S. Meier, and P. Rey-Biel, “When Executive Incentive Awards,” Mercer (March 10, 2015),
and Why Incentive (Don’t) Work to Modify Behavior,” online at www.mercer.com.
Journal of Economic Perspectives, 25, no. 4 (Fall 2011), 27 For an academic article on this topic, see U. Von Lilien-
pp. 191–210. feld-Toal and S. Ruenzi, “CEO Ownership, Stock Market
11 “U.S. Organizations Report Highest Compensation Spend Performance, and Managerial Discretion,” The Journal of
in 39 Years,” Aon Media Center (August 26, 2015), online Finance, 69, no. 3 (June 2014), pp. 1013–50.
at aon.mediaroom.com/news-releases?item=137290. 28 See, for example, “Key Differences Exist between Long-
12 See, for example, “IRS Releases Final Regulations Under and Short-Term Executive Incentive Awards,” Mercer
Section 162(m),” Harvard Law School Forum on Corporate (March 10, 2015), online at www.mercer.com.
Governance and Financial Regulation (April 9, 2015), 29 See, for example, M. Matejka, K. A. Merchant, and W. A.
online at corpgov.law.harvard.edu/2015/04/09/irs- Van der Stede, “Employment Horizon and the Choice of
releases-final-regulations-under-section-162m. Performance Measures: Empirical Evidence from Annual
13 See, for example, “Regulations and Lower Returns Put Bonus Plans of Loss-Making Entities,” Management Sci-
Pressure on Pay and Bonuses,” The Financial Times (April ence, 55, no. 6 (June 2009), pp. 890–905.
24, 2014), online at on.ft.com/QGRu8v; “SEC Proposes 30 See, for example, B. Hall and K. Murphy, “The Trouble
Rules on Executive Pay and Performance,” The New York with Stock Options,” Journal of Economic Perspectives, 17,
Times (April 29, 2015), online at nyti.ms/1OEoKcQ; no. 3 (Summer 2003), pp. 49–71; “Do Stock Options
“Bonus Reforms to Come under Glare of Financial Stabil- Improve Performance?,” CalBusiness (Spring–Summer
ity Board,” The Financial Times (November 8, 2015), 2010), pp. 8–9. See also D. Aboody, N. Johnson, and R.
online at on.ft.com/1WK47e6. Kasznik, “Employee Stock Options and Future Firm Per-
14 “Goldman Sachs Pioneers Plan to Deal with Bonus Cap,” formance: Evidence from Option Repricings,” Journal of
The Wall Street Journal (January 30, 2014), online at on. Accounting and Economics, 50, no. 1 (May 2010), pp.
wsj.com/1czchTr. 74–92; “US Chief Executives Hoard Good News for Stock
15 “City Bankers to Evade EU Bonus Cap with ‘Role-Based’ Sales,” The Financial Times (September 7, 2014), online at
Allowances,” The Financial Times (April 13, 2014), online on.ft.com/1oUm9Jb; A. Edmans, L. Goncalves-Pinto, Y.
at on.ft.com/Q4eMoO. Wang. and M. Groen-Xu, “Strategic News Releases in
16 “EU Bank Watchdog Signals Crackdown on Allowances,” Equity Vesting Months,” Working Paper (2016), online at
The Financial Times (June 13, 2014), online at on.ft. papers.ssrn.com/sol3/papers.cfm?abstract_id=2489152.
com/1on9CDS. 31 See, for example, Watson Wyatt Worldwide, Stock Incentives:
17 “Majority of Public Sector Employees Have Reservations Moving toward a Portfolio Approach (2005) and Deloitte &
about Performance-Related Pay, Reveals CIPD,” HR Mag- Touche USA LLP, 2005 Stock Compensation Survey (2005).
azine (January 16, 2013), online at www.hrmagazine. 32 “Pay Attention,” The Economist (June 12, 2008), pp. 77–8.
co.uk. 33 “Last Gasp for Stock Options?,” The Wall Street Journal –
18 “Vatican Unveils Merit-Based Pay,” BBC (November 22, CFO Journal (August 26, 2013), online at http://blogs.
2007), online at www.bbc.co.uk. wsj.com/cfo/2013/08/26/last-gasp-for-stock-options.
19 J. Pfeffer and R. Sutton, Hard Facts (Boston, MA: Harvard See also “Five Trends in Stock Compensation,” HR Times
Copyright © 2017. Pearson Education Limited. All rights reserved.

Business School Press, 2006), p. 129. (March 20, 2014), online at hrtimesblog,com.
20 See, for example, “Aon Hewitt: Bonus Schemes in Europe 34 The Coca-Cola Company, online at www.coca-colacom-
Back on Track” (September 23, 2014), online at www. pany.com/content/dam/journey/us/en/private/fileassets/
consultancy.uk. pdf/investors/annual-meeting/TCCC-2016-Proxy-State-
21 “Lloyds Says Customer Service Key to Future,” The Finan- ment.pdf.
cial Times (December 12, 2013), online at http://on.ft. 35 M. J. Mauboussin and D. Callahan, “A Long Look at Short-
com/1kDQavb. Termism: Questioning the Premise,” Journal of Applied
22 “Pay Dirt,” The Economist (April 23, 2016), online at econ. Corporate Finance, 27, no. 3 (Summer 2015), pp. 70–82.
st/26gMsSS. 36 “Hewitt Study Shows Long-Term Incentives in Executive
23 For an academic treatment of “bonus pools,” see M. Eder- Compensation Packages Are Back – but with a Catch,” Aon
hof, M. V. Rajan, and S. Reichelstein, “Discretion in Mana- Hewitt (August 5, 2010), online at www.hewittassociates.
gerial Bonus Pools,” Foundations and Trends in Accounting, com.
5, no. 4 (2011), pp. 243–316; and W. A. Van der Stede, 37 For an overview, see J. Bol, “Subjectivity in Compensation
“Review of ‘Discretion in Managerial Bonus Pools,’” The Contracting,” Journal of Accounting Literature, 28 (2009),
Accounting Review, 88, no. 1 (January 2013), pp. 351–4. pp. 1–24.
24 “Goldman Sachs Pioneers Plan to Deal with Bonus Cap,” 38 For a detailed discussion and further references to this lit-
The Wall Street Journal (January 30, 2014), online at on. erature, see M. Gibbs, K. A. Merchant, W. A. Van der
wsj.com/1czchTr. Stede, and M. E. Vargus, “Determinants and Effects
25 “Bank Chief Champions Case for Fixed Pay,” The Financial of Subjectivity in Incentives,” The Accounting Review, 79,
Times (February 18, 2010), online at on.ft.com/1rse0F3. no. 2 (April 2004), pp. 409–36.

372
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Notes

39 See also K. J. Murphy, “Performance Standards in Incen- 2015), online at hbr.org/2015/04/reinventing-perfor-

tive Contracts,” Journal of Accounting and Economics, 30, mance-management.
no. 3 (December 2000), pp. 245–78; X. Zhou and P. Swan, 53 See, for example, J. Efendi, A. Srivastava, and E. Swan-
“Performance Thresholds in Managerial Incentive Con- son, “Why Do Corporate Managers Misstate Financial
tracts,” Journal of Business, 76, no. 4 (October 2003), Statements? The Role of Option Compensation and Other
pp. 665–96. Factors,” Journal of Financial Economics, 85, no. 3
40 “Regulations and Lower Returns Put Pressure on Pay and (September 2007), pp. 667–708; “CEOs Strategically
Bonuses,” The Financial Times (April 24, 2014), online at Time News Releases for Their Own Benefit,” LSE Business
on.ft.com/1JFJxum. Review (March 22, 2016), online at blogs.lse.ac.uk/busi-
41 “Bonuses Are Back, but with Tighter Rules and Better Tar- nessreview/2016/03/22/ceos-strategically-time-news-
gets,” Aon Media Center (September 17, 2014), online at releases-for-their-own-benefit.
aon.mediaroom.com/news-releases?item=137052. 54 M. Buckingham and A. Goodall, “Reinventing Perfor-
42 “Companies Using Employee Engagement to Attract, mance Management,” Har vard Bu siness Review
Retain Top Talent,” Industry Week (July 2, 2010), online at (April 2015), online at hbr.org/2015/04/reinventing-
www.industryweek.com; D. Scott and T. McMullen, The performance-management.
Impact of Rewards Programs on Employee Engagement, 55 “Hard to Get,” CFO Europe (April 2009), pp. 38–41.
Hay Group & World-at-Work (June 2010). 56 “Making Executive Pay Work: The Psychology of Incen-
43 K. Abosch, J. Schermerhorn, and L. Wisper, “Broad-Based tives,” PwC Report (2012), online at www.pwc.co.uk.
Variable Pay Goes Global,” Workspan (May 2008), 57 “Financial Organizations Shuffling Compensation Pro-
pp. 56–62. grams,” World-at-Work (January 14, 2010), online at
44 “Forty-One Percent of Employees Say They Would Be www.worldatwork.org. See also “UBS Extends Deferred
Insulted by a Low Bonus,” World-at-Work (November 3, Bonus Plan,” Bloomberg (January 23, 2015), online at
2010), online at www.worldatwork.org. bloom.bg/1Bjucbk; “Moody’s Urges Slower Bank Bonus
45 “Bonus Question: Cash Rewards or Gifts? Experts Are Payouts,” The Financial Times (December 9, 2014), online
Divided,” The Los Angeles Times (May 30, 1999), p. C5. at on.ft.com/131jzOy.
46 “Bonuses Are Bad for Bankers and Even Worse for Banks,” 58 “HSBC Chief Backs Bank Pay Reform,” BBC (September
The Financial Times (January 25, 2016), online at on. 13, 2008), online at www.bbc.co.uk.
ft.com/1WJF8Ju. 59 “Banks, Aware of Discord on Pay, Work to Adjust, a Survey
47 See, for example, K. Pokorny, “Pay – But Do Not Pay Too Finds,” The Wall Street Journal Europe (March 30, 2009),
Much: An Experimental Study on the Impact of Incen- p. 3.
tives,” Journal of Economic Behavior and Organizations, 60 “UBS Extends Deferred Bonus Plan,” op. cit.
66, no. 2 (May 2008), pp. 251–64; D. Ariely, U. Gneezy, G. 61 R. Gopalan, T. Milbourn, F. Song, and A. V. Thakor, “Dura-
Loewenstein, and N. Mazar, “Large Stakes and Big Mis- tion of Executive Compensation,” The Journal of Finance,
takes,” Review of Economic Studies, 76, no. 2 (April 2009), 69, no. 6 (December 2014), pp. 2777–2817.
pp. 451–69; see also W. A. Van der Stede, “The Pitfalls of 62 “Small Chinese Cities Steer Away from GDP as Measure of
Pay-for-Performance,” Finance & Management (December Success,” The Financial Times (August 13, 2014), online at
2007), pp. 10–13. on.ft.com/1rpzRqj.
Copyright © 2017. Pearson Education Limited. All rights reserved.

48 “Bonuses and the Illusion of Banking Performance,” The 63 “Bonus Question: Cash Rewards or Gifts? Experts Are
Financial Times (November 25, 2015), online at on.ft. Divided,” op. cit.
com/1LAeYRs. 64 “Bank Chief Champions Case for Fixed Pay,” Financial
49 “Bonuses Are Bad for Bankers and Even Worse for Banks,” Times (February 18, 2010), online at on.ft.com/1rse0F3.
op. cit. 65 “Bonuses Are Bad for Bankers and Even Worse for Banks,”
50 Ibid. op. cit.
51 See, for example, “Meritocracy without the Numbers,” 66 See also W. A. Van der Stede, “Designing Effective Reward
Strategy + Business (September 22, 2015), online at strat. Systems,” Finance & Management (October 2009),
bz/SbPkwJU; “Why GE Had to Kill Its Annual Perfor- pp. 6–9.
mance Reviews after More than Three Decades,” Quartz, 67 “John Lewis Staff Get £151m Bonus,” BBC (March 11,
online at qz.com/428813; “The Measure of a Man: 2010), online (www.bbc.co.uk); see also “TSB Freezes
Reports of the Death of Performance Reviews Are Exag- CEO Pay, Pledges Free Employee Shares in IPO,” Bloomb-
gerated,” The Economist (February 20, 2016), online at erg (June 5, 2014), online at bloom.bg/1GCxXK0.
econ.st/1U9VifD. 68 “Slater & Gordon Offers One Million Shares to Employ-
52 M. Buckingham and A. Goodall, “Reinventing Perfor- ees,” The Law Society Gazette (July 11, 2014), online
mance Management,” Harvard Business Review (April (www.lawgazette.co.uk).

373
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

CASE STUDY
Harwood Medical Instruments PLC

Harwood Medical Instruments PLC (HMI), based just “more balanced” scorecard. In November 2009, just
outside of Birmingham, England, manufactured spe- before introducing a new bonus plan, Mr. Guthrie
cialty medical instruments and sold them in market explained to his chief financial officer that he was will-
niches that were becoming increasingly competitive and ing to pay out higher bonuses than had been paid histori-
price sensitive because of pressures to reduce healthcare cally if improved performance warranted doing so.
costs. HMI was organized into nine divisions each run by The new plan provided a base bonus for division
a general manager. Over the years, HMI had grown both general managers of 1% of division operating profits
organically and by acquisition. Six of the divisions had for the half-year period. This base bonus was adjusted
been acquired by HMI within the past decade. as follows:
All of HMI’s divisions sold medical products to hos-
● Increased by £5,000 if over 99% of deliveries were on
pitals, laboratories, and/or doctors, so the need for
time; by £2,000 if 95–99% of deliveries were on time;
product quality and reliability was high. The divisions
or by zero if less than 95% of deliveries were on time.
varied significantly, however, in terms of the degree to
which their success depended on, for example, devel- ● Increased by £5,000 if sales returns were less than
opment of new products, efficiency of production, and/ or equal to 1% of sales, or decreased by 50% of the
or customer service. excess of sales returns over 1% of sales.
Bonuses for division general managers were paid ● Increased by £1,000 for every patent application
semi-annually. Up to the year 2009, these bonuses were filed with the UK Intellectual Property Office.
calculated as 1% of division operating profits. ● Reduced by the excess of scrap and rework costs
HMI’s managing director, Andy Guthrie, had con- over 1% of operating profit.
cerns, though, that the operating profit measure was too
● Reduced by £5,000 if average customer satisfaction
narrowly focused. He had been reading articles about
ratings were below 90%.
performance measurement and decided to implement a
Copyright © 2017. Pearson Education Limited. All rights reserved.

Exhibit 1 Harwood Medical Instruments PLC

Operating results for the Surgical Instruments and Ultrasound Diagnostic Equipment Divisions, 2010 (£ in 000s)

Surgical Instruments Division Ultrasound Diagnostic Equipment Division

1st half of 2010 2nd half of 2010 1st half of 2010 2nd half of 2010

Sales £42,000 £44,000 £28,600 £29,000

Operating profit £4,620 £4,400 £3,420 £4,060

On-time deliveries 95.4% 97.3% 98.2% 94.6%

Sales returns £450 £420 £291 £289

Patent applications filed 0 1 4 8

Scrap and rework costs £51.1 £45.0 £39.7 £28.2

Customer satisfaction (average) 78% 89% 81% 91%

374
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Superconductor Technologies, Inc.

If the bonus calculation resulted in a negative needed, but controlling costs was critical. The Ultrasound
amount for a particular period, the manager received Diagnostic Equipment Division (Ultrasound), which was
no bonus. Negative amounts were not carried forward acquired in 2007, sold and serviced ultrasound probes,
to the next period. transducers, and diagnostic imaging systems. The ultra-
Exhibit 1 shows results for two representative HMI sound market promised excellent growth and profits if
divisions for the year 2010, the first year under the new the division could keep its sophisticated products on the
bonus plan. The Surgical Instruments Division (SID), one cutting edge technologically and control both product
of HMI’s original businesses, sold a variety of surgical development and production costs effectively.
instruments, including scissors, scalpels, retractors, and In 2009, the total annual bonuses for the year earned
clamps. The markets for these products were mature, so by the managers of SID and Ultrasound were approxi-
growth was relatively slow. Not much innovation was mately £85,000 and £74,000, respectively.

This case was prepared by Professor Kenneth A. Merchant.

Copyright © by Kenneth A. Merchant.

CASE STUDY
Superconductor Technologies, Inc.

In October 2003, Martin (Marty) McDermut, Senior large numbers of options that they had been granted.
Copyright © 2017. Pearson Education Limited. All rights reserved.

VP, CFO, and Secretary of Superconductor Technolo- He sighed:

gies, Inc. (STI), was reflecting on some issues related
These things have tremendous motivational effects,
to his company’s compensation and incentive sys-
but they can really get you in trouble if you don’t
tems. He had multiple concerns. Marty knew that
think the issues all the way through.
STI’s most important asset was its people, and he
was worried about employee retention. STI’s stock
price was stuck far below its historical highs, so most
of the options that had been granted to employees
Company history and strategy
were “underwater.” Without the prospects of sig- Superconductor Technologies, Inc. was founded in
nificant rewards, some of the company’s key people Santa Barbara, California, in 1987 by Nobel Prize
might be “ready to bolt.” He wondered, “What can winner Dr. J. Robert Schrieffer, who teamed up with
we do so that these things that we have put in place three venture capitalists to form a company to capi-
don’t vanish?” talize on a scientifi c breakthrough known as high-
Marty also worried that some of the incentive sys- temperature superconductivity (HTS) technology. In
tem elements might motivate some behaviors that were the mid-1990s, STI managers decided to focus their
not in the shareholders’ best interest. One specific con- application of HTS technology on the wireless com-
cern of this type was that top management would be munications industry. In 1997, STI began the trans-
too motivated to try to sell the company to cash in the formation to an operating company with the launch

375
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

of its first commercial product, the SuperFilter ®. M. STI was considered to be a consensus-driven com-
Peter Thomas, a wireless-industry veteran, was hired pany. As Marty McDermut phrased it, “People buy into
as CEO. our major decisions before we go ahead.” Plans were
By 2003, STI was the global leader in developing, developed on a bottom-up basis. Performance was
manufacturing, and marketing HTS products for wire- reviewed monthly, and the forecasts for the remainder
less communication networks. STI’s products incorpo- of the year were updated quarterly.
rated patented technologies that extended network STI went public in March 1993 (NASDAQ: SCON),
coverage, increased capacity utilization, and improved with 1.5 million shares offered at $10 per share. In an
both the uplink and downlink radio frequency signals, eight-week period in early 2000, STI’s stock price shot
thus lowering the incidence of dropped and blocked up above $100, but it came down as quickly as it had
calls. They also enabled higher wireless transmission risen. Most of the time since then, the stock had been
data rates while reducing operators’ capital and trading below $5 per share (see Exhibit 3).
operating costs. Over 3,000 STI systems had been Still, STI’s future looked bright. In 2003, approxi-
installed worldwide, making STI the clear leader in the mately 150,000 wireless communications base stations
HTS wireless network optimization technology mar- were deployed in the United States alone, providing
ketplace. STI’s successes stemmed largely from its tech- service to nearly 140 million people.1 The number of
nological developments, including patented thin-film US subscribers to mobile services had been growing at
technologies and unique software design and simula- 14% per year, and the average monthly minutes of use
tion tools. It planned to exploit its management, engi- per person was growing at an annual rate of 26%. The
neering, and manufacturing expertise to maintain and combined effect of more subscribers and more minutes
expand its market leadership in radio frequency of use resulted in an exponential increase in total wire-
enhancement solutions. less communications traffic. That growth was expected
In 2003, STI, which had nearly 300 employees, to continue, and the greater wireless traffic had also led
was organized into two main operating entities. One to a rise in radio frequency interference, resulting in
was located in Sunnyvale, California, at the former more dropped and blocked calls and origination fail-
site of Conductus, a company acquired in December ures, outcomes that negatively affect customer satisfac-
2002. People at the Sunnyvale location were primar- tion. Consequently, the wireless operators had
ily involved in research, some of which was funded continuing needs to find new, cost-effective ways to
by the federal government on a cost-plus basis. The increase network traffic while improving network per-
other operating entity was located in Santa Barbara, formance. STI’s products, which could be employed at a
California. Personnel at the Santa Barbara location fraction of the cost of building more base stations, were
were responsible for the company’s commercial designed to be part of the solution to the industry’s
Copyright © 2017. Pearson Education Limited. All rights reserved.

applications. delivery problems.

STI management looked at the year 2002 as a
“watershed year,” even though STI reported a net loss Elements of management
of $19.5 million that year (see financial statements in compensation
Exhibits 1 and2). The reason was the increased market
acceptance of STI’s products, which was expected to The compensation package for STI’s top 30 people,
fuel further revenue growth and bring the company those down to the director level (one level below vice
closer to profitability. In its entire 17-year history, STI president), was comprised of three elements:
had never made a profit. In 2002, STI also completed a 1. Base salary. STI set its salaries at competitive lev-
multimillion-dollar expansion of its production facili- els. For most employees, including top executives,
ties in Santa Barbara to ramp up production and fur- annual salary increases were in the range of 0–5%.
ther improve product quality.
2. Cash bonuses. All top STI executives were included
Since 2001, STI revenues had grown quite rapidly.
in a bonus plan that provided cash awards based on
In 2003, revenues were expected to be nearly $50 mil-
lion, up from $22 million in 2002. In both 2002 and
2003, STI was named one of the “Technology Fast 50” 1
The global numbers were nearly one million base stations serving
companies in the Los Angeles area. more than one billion customers.

376
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Superconductor Technologies, Inc.

Table 1 Key elements of corporate “Performance some executives had performed better than others.
Scorecard” They decided that these differences should be recog-
nized by basing some of the bonus awards on indi-
Cash Number of employees vidual performance. They decided to base the
Sales Warranty expenses bonuses 75% on corporate performance and 25% on
individual performance.
Profits Inventory
Each executive’s individual performance was eval-
Timing of sales Yield uated in terms of achievements in 4–9 perfor-
Receivables (days outstanding) Gross margins mance areas tailored to the individual’s areas of
responsibility. Examples of achievements that
On-time delivery performance Product reliability were considered in the evaluations of specific indi-
viduals included:
● Successfully accomplish a project milestone;
the achievement of a weighted combination of cor-
porate and individual objectives. The targeted bonus ● Reduce costs of products manufactured;
awards varied by organization level, from 25% to ● Establish a needed line of credit;
40% of base salary. ● Maintain receivables at a level equal to or less than
Up through 2002, all bonuses were based exclu- 28 days outstanding;
sively on corporate performance. The compensation ● Make significant new hires/retain valued em-
committee of the board of directors reached a judg- ployees;
ment about corporate performance by comparing
● Maintain safe workplace (no lost-time accidents).
results measured in terms of the elements of a “per-
formance scorecard” (see Table 1) with expectations. The evaluations of individual performance were
The performance evaluation judgments did not linked to bonus awards as follows:
automatically weight all the measurement elements
equally in importance. Ken Barry, VP-Human % of target
Resources and Environmental Health & Safety, sus- Evaluation bonus earned
pected that sales (revenue growth) was by far the
Exceeded objectives 37.5
most important criterion considered by the compen-
sation committee. He postulated that the judgments Met objectives 25
about bonuses might come about as follows:
Partially missed objectives 12.5
Copyright © 2017. Pearson Education Limited. All rights reserved.

Let’s see … they met the revenue target; … they Substantively missed objectives 0
didn’t earn as much profit as we’d expected; … but,
they didn’t have any major operational problems
When the compensation committee was not sure of
internally or externally, … and they signed a big
its evaluations, they generally asked for more infor-
deal … so, taken together, that probably warrants a
mation or for an explanation from the “team leader,”
bonus equal to potential for the year …
CEO Peter Thomas, before making the final call.
Ken concluded that what it really came down to in 3. Stock options. Annually, almost all STI employees
normal years was for the compensation committee were given stock options. The purpose of the options
to decide whether to award a bonus at 80%, 100%, was to promote the success, and enhance the value,
or 120% of the target bonus. Because the Board met of the company by linking the personal interests of
with the key executives about four times a year, Ken participating employees to those of the company’s
believed that they had sufficient knowledge to make stockholders and by providing such employees with
these bonus decisions, although the evaluations an incentive for outstanding performance. The
were undeniably subjective. details of the stock option plan had been modified
Before 2002, everyone received the same, undiffer- somewhat over the years, but all the options granted
entiated bonus potential percentage. In 2002, how- were 10-year options, and they vested over either
ever, the compensation committee concluded that four or five years.

377
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

The number of options granted varied depending on that would be difficult until and if the company started
organization level, tenure, and individual perfor- earning profits.
mance. Lower-level employees were given only a few, The 2003 Equity Incentive Plan provided 10-year
perhaps only 200, options per year. Top management options to be awarded on January 1, 2004, with “cliff vest-
received thousands of options annually. Exhibits 3 and ing” after five years.3 However, this plan also included a
4 provide detail on the option grants given to STI’s top unique feature, a promise of accelerated vesting – 50% on
five executives. January 1, 2004, and 50% on January 1, 2005 – if the
Ken Barry estimated that in a normal year, about company was profitable in the fourth quarter of 2003 and
10% of the workforce (30 employees, say) did not if the profits were judged to be sustainable.4
receive stock options, for one of three reasons, each of In January 2003, the executives whose salaries had
which explained the treatment of about 10 of the been cut had their salaries reinstated to prior levels.
excluded employees. The first reason was because some They were not given back pay, however.
employees did not meet performance expectations.
Ken added, “By not meeting performance expectations
I mean that we usually let these employees go within
Issues for the future
the next year.” Second, some employees were not given Both Marty McDermut and Ken Barry raised issues
the annual allotment of options for equity reasons. about the incentive packages that STI should use in the
Some of them, for example, had recently received extra future. If accounting rules regarding stock options
options because they had been promoted. And third, were changed to require the immediate recording of
extra options were not provided to employees hired the value of the options as an expense, as seemed likely
during the last quarter of the year.2 to happen, should that cause the company either to dis-
continue the granting of options or to restrict their use,
perhaps only for top executives? Should the company
Implementation of the instead substitute restricted stock, or some combina-
compensation plans tion of restricted stock and options? Marty did not
In 2001, STI failed to achieve its revenue plan by a nar- think that the solution would be just to provide higher
row margin. All STI executives were given 80% of their bonus payments because those payments would cause
target bonus. “a big hit to the P&L.”
The year 2002 was not a good one. STI did not come Particularly if the use of options was to be restricted,
close to achieving its aggressive revenue plan. The STI Ken Barry thought that the company would need more
plan was set at $32 million, and the actual revenues for deferred compensation options, mechanisms that
2002 were $22 million. In July 2002, management
Copyright © 2017. Pearson Education Limited. All rights reserved.

3
implemented a salary cut of 10% for the top 10 execu- That is, all the options would vest on January 1, 2009.
4
tives. At the end of the year, no bonuses were paid, and Without the cliff vesting feature, the accelerated vesting in this plan
would have had a significant accounting implication. The original
virtually all the options that had been granted previ- fixed price options did not require the recording of any compensa-
ously were underwater. tion expense because the options were granted at the market price
In March 2003, STI’s board approved a 2003 Equity at the time of grant (Accounting Principles Board Statement 25,
Accounting for Stock Issued to Employees, October 1972). However,
Incentive Plan that reserved six million shares for issu- without the cliff vesting provision, a change in terms, in this case
ance to key employees, directors, and consultants of the acceleration of vesting, if it happened, would require STI to
the company. Two million of these shares were record compensation expense in accordance with the “variable
method” (FASB Interpretation 44, Accounting for Certain Transac-
reserved for the top 20 executives. This plan replaced tions Involving Stock Compensation: An Interpretation of APB Opinion
other stock option plans created in 1992, 1998, and No. 25, March 31, 2000). Under variable accounting, compensation
1999. It was designed both to help ensure that STI did expense is recognized based on the excess of the underlying stock’s
market price over the exercise price on the exercise date. Then, prior
not lose its key employees and to drive employees to to the exercise date, compensation expense is estimated each period.
focus on having the company become profitable. It varies with the movement in the price of the company’s stock in
Becoming profitable was important because manage- comparison to the exercise price. Therefore, if a company changes
the terms of its stock option grants, it is subject to the uncertainty
ment wanted to raise more money, but they were told of how much compensation expense it will have to record, not only
during the vesting period of the option, but until the option is actu-
ally exercised by the employee. If the company’s stock performs well,
2 the company will probably have to take a hit to earnings.
All employees were given stock options when they were first hired.

378
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Superconductor Technologies, Inc.

would allow the company to spread the employees’ for long-term success? Ken also was not sure whether
compensation over 5, 10, or even 15 years. Deferred the assignments of the rewards should be less subjec-
compensation approaches had tax benefits for the tive after the firm became profitable.
employees, and they allowed the company to save cash Ken had also started thinking about issues that the
during its most rapid growth period. company would face when it expanded internationally.
Related was a concern about the appropriate short- STI had no foreign employees as yet, but Ken knew that
term/long-term balance of the incentive package. incentive approaches varied markedly around the world.
Should STI link the much desired annual profit objec- He wanted to be prepared to give recommendations to
tive more strongly with incentives, or should the com- management when and if the international expansion
pany continue to be patient in its positioning of the firm took place.

Exhibit 1 Superconductor Technologies, Inc.: Income statement data for years ending December 31 ($ millions)

2002 2001 2000 1999 1998

Net sales or revenues 22.40 12.39 9.96 7.12 7.98

Cost of goods sold 17.36 8.49 13.92 5.54 10.79

Depreciation, depletion, and amortization 1.93 2.14 1.79 1.31 0.94

Gross income 3.11 1.77 –5.75 0.27 –3.74

Selling, general, & admin expenses 18.90 18.90 15.09 10.88 5.44

Other operating expenses 0.00 0.00 0.00 0.00 0.00

Other expenses – total 38.18 29.52 30.80 17.72 17.16

Operating income –15.79 –17.13 –20.85 –10.60 –9.18

Extraordinary charge – pretax 3.80 0.98 0.13 0.00 0.00

Nonoperating interest income 0.22 1.05 0.81 0.02 0.08

Earnings before interest and taxes (EBIT) –19.37 –17.06 –20.17 –10.58 –9.10
Copyright © 2017. Pearson Education Limited. All rights reserved.

Interest expense on debt 0.15 0.15 0.48 0.30 0.06

Pretax income –19.51 –17.20 –20.66 –10.88 –9.16

Income taxes 0.00 0.00 0.00 0.00 0.00

Net income before extra items/preferred div –19.51 –17.20 –20.66 –10.88 –9.16

Extra items & gain(loss) sale of assets 0.00 0.00 –10.61 0.00 0.00

Net income before preferred dividends –19.51 –17.20 –31.27 –10.88 –9.16

Preferred dividend requirements 1.76 2.60 2.20 1.36 0.27

Net income available to common –21.27 –19.80 –22.86 –12.24 –9.43

379
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Exhibit 2 Superconductor Technologies, Inc.: Balance sheet data for years ending December 31 ($ millions)

Assets 2002 2001 2000 1999 1998

Cash and ST investments 18.19 15.21 31.82 0.07 0.31

Receivables (net) 3.41 1.45 3.69 1.59 1.94
Total inventories 6.35 5.73 3.78 2.75 2.72
Raw materials 1.84 1.39 1.09 0.43 0.82
Work in progress 3.14 2.95 1.96 1.69 1.67
Finished goods 2.01 1.40 0.72 0.63 0.24
Progress payments & other −0.65 0.00 0.00 0.00 0.00
Prepaid expenses 0.00 0.00 0.00 0.00 0.00
Other current assets 0.56 0.60 0.50 0.45 0.17
Current assets – total 28.50 22.98 39.79 4.85 5.14
Long-term receivables 0.82 0.00 0.00 0.00 0.00
Property, plant & equipment – net 11.09 5.22 4.99 4.10 5.11
Property, plant & equipment – gross 23.74 16.24 14.34 12.15 12.10
Accumulated depreciation 12.65 11.03 9.35 8.05 6.99
Other assets 25.74 1.96 1.98 2.14 2.25
Deferred charges 0.00 0.00 0.00 0.00 0.00
Tangible other assets 0.49 0.28 0.11 0.21 0.18
Intangible other assets 25.25 1.68 1.88 1.93 2.07
Total assets 66.15 30.16 46.76 11.09 12.51

Liabilities & shareholders equity

Accounts payable 5.89 2.70 2.00 1.80 2.40
ST debt & current portion of LT debt 1.55 0.28 0.24 2.16 0.81
Accrued payroll 1.05 0.84 0.90 0.67 0.58
Income taxes payable 0.00 0.00 0.00 0.00 0.00
Dividends payable 0.00 0.00 0.00 0.00 0.00
Other current liabilities 3.50 0.41 0.46 0.24 0.00
Current liabilities – total 12.00 4.23 3.60 4.87 3.79
Long-term debt 0.57 0.27 0.51 0.75 0.93
Other liabilities 3.23 2.00 4.24 0.00 0.00
Total liabilities 15.80 6.50 8.35 5.62 4.72
Copyright © 2017. Pearson Education Limited. All rights reserved.

Preferred stock 0.00 37.53 0.00 20.34 8.98

Common equity 50.34 −13.87 38.41 −14.87 −1.20
Common stock 0.06 0.02 0.02 0.01 0.01
Capital surplus 154.74 73.34 110.65 32.21 35.01
Other appropriated reserves 0.00 −2.28 −4.52 0.00 0.00
Retained earnings −104.46 −84.95 −67.75 −47.09 −36.22
Total liabilities & shareholders equity 66.15 30.16 46.76 11.09 12.51
Common shares outstanding (thousands) 59,823.55 18,579.16 17,823.16 7,739.22 7,722.59

380
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Superconductor Technologies, Inc.

Exhibit 3 Superconductor Technologies, Inc.: Stock performance Copyright 2003 Yahoo! Inc.
http://finance.yahoo.com/
Copyright © 2017. Pearson Education Limited. All rights reserved.

381
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Exhibit 4 Superconductor Technologies, Inc.: Executive officer compensation

The following table sets forth all compensation received for services rendered to the Company in all capacities during the
fiscal years ended December 31, 2002, 2001, and 2000 by the Company’s Chief Executive Officer and the four executive
officers other than the Chief Executive Officer whose total salary and bonus for fiscal year 2002 exceeded $100,000.

Annual compensation Long-term compensation

Securities All other

Bonus Other underlying compensation
Name and principal position Year Salary ($) ($) ($)1 options (#) ($)2

M. Peter Thomas 2002 303,854 – – 125,000 1,980

President and Chief 2001 300,014 72,000 – 75,000 2,323
Executive Officer 2000 285,394 70,000 – 250,000 1,290

E. Ray Cotten 2002 194,997 – – 57,750 6,180

Senior Vice President, 2001 209,467 30,172 – 7,300 7,250
Business Development 2000 195,582 28,080 – 20,000 3,810

Robert B. Hammond 2002 208,394 – – 57,750 690

Senior Vice President and 2001 205,945 29,628 – 3,650 809
Chief Technical Officer 2000 194,613 27,675 – 40,000 690

Robert L. Johnson4 2002 186,267 – – 66,000 690

President, STI Wireless 2001 182,163 26,244 – 38,350 809
Systems, North America 2000 116,4624 20,048 – 100,000 504

Martin S. McDermut5 2002 194,961 – – 43,750 690

Senior Vice President, 2001 193,895 23,310 – 43,750 809
Chief Financial Officer and Secretary 2000 167,2125 24,975 43,3743 100,000 398

Charles E. Shalvoy6 2002 277,052 – – – –

President and CEO 2001 264,992 56,644 – 153,000 –7
of Conductus 2000 250,185 66,250 – 200,000 –

1
 xcludes certain perquisites and other amounts that, for any executive officer, in the aggregate did not exceed the lesser of $50,000 or 10% of the total
E
annual salary and bonus for such executive officer.
2
Term life insurance premiums.
3
One-time relocation expenses.
Copyright © 2017. Pearson Education Limited. All rights reserved.

4
Mr. Johnson joined the Company in April 2000.
5
Mr. McDermut joined the Company in February 2000.
6
Mr. Shalvoy joined the Company in December 2002. All compensation paid by Conductus prior to acquisition of Conductus by the Company. Mr. Shalvoy
is the President of the Conductus subsidiary and an Executive Vice President of Superconductor Technologies, Inc.
7
Because Conductus provided group term life insurance for its employees and named executive officers on an aggregate basis, Conductus is unable to
determine the amount of term life insurance premiums paid by Conductus for Mr. Shalvoy during the 2002, 2001, and 2000 fiscal years.

Source: STI Proxy Statement, May 23, 2003

382
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Superconductor Technologies, Inc.

Exhibit 5 Superconductor Technologies, Inc.: Option grants to executives in 2002

The following table sets forth certain information regarding stock options granted during the fiscal year ended December 31, 2002,
to each of the executive officers named in the table under “Executive Officer Compensation – Summary Compensation Table.”

Potential realizable value at

assumed annual rates of stock
Individual grants price appreciation for option term3

Number of % of Total
securities Options
underlying granted to Exercise
options employees price Expiration
Name granted1 in fiscal year2 ($/share) date 5% ($) 10% ($)

M. Peter Thomas 125,000 15% 5.60 2/4/2012 385,930 950,563

E. Ray Cotten 57,750 7% 5.60 2/4/2012 178,300 439,160

Robert B. Hammond 57,750 7% 5.23 1/23/2012 178,300 439,160

Robert L. Johnson 66,000 8% 5.23 1/23/2012 190,307 468,736

Martin S. McDermut 43,750 5% 5.23 1/23/2012 126,151 310,715

4
Charles E. Shalvoy – – – – – –

1
 xcept as set forth herein, each option vests over a four-year period at the rate of 1/4th of the shares subject to the option at the end of the first 12
E
months and 1/36 the of the remaining shares subject to the option at the end of each monthly period thereafter so long as such optionee’s employment
with the Company has not terminated.
2
Total number of shares subject to options granted to employees in fiscal 2002 was 851,975, which number includes options granted to employee
directors, but excludes options granted to nonemployee directors and consultants.
3
The Potential Realizable Value is calculated based on the fair market value on the date of grant, which is equal to the exercise price of options granted in
fiscal 2002, assuming that the stock appreciates in value from the date of grant until the end of the option term at the compounded annual rate specified
(5% and 10%). Potential Realizable Value is net of the option exercise price. The assumed rates of appreciation are specified in rules of the SEC and do
not represent the Company’s estimate or projection of future stock price. Actual gains, if any, resulting from stock option exercises and common stock
holdings are dependent on the future performance of the common stock and overall stock market conditions, as well as the option holders’ continued
employment through the exercise/vesting period. There can be no assurance that the amounts reflected in this table will be achieved.
4
Mr. Shalvoy joined the Company in December 2002 and did not receive any options from the Company in 2002, although he did receive options from
Conductus in 2002 prior to the acquisition.

Source: STI Proxy Statement, May 23, 2003.

Copyright © 2017. Pearson Education Limited. All rights reserved.

This case was prepared by Professors Kenneth A. Merchant and Wim A. Van der Stede.
Copyright © by Kenneth A. Merchant and Wim A. Van der Stede.

383
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

CASE STUDY
Raven Capital, LLC

In late December 2009, portfolio managers at hedge Hedge funds differ from other managed funds in a
fund Raven Capital, LLC had just fi nished delivering few key areas. Hedge fund investors are typically
annual performance reviews and year-end bonuses to required to have high income, high net worth, and
their staff s. They spent considerable time and effort demonstrated investment knowledge. Because hedge
trying both to allocate bonuses fairly and to keep funds manage money for a limited range of sophisti-
employees happy. But those two goals were sometimes cated, accredited investors, they operate with fewer
in conflict. Every year some employees were surprised regulations than other funds. They are less restricted in
by the amount of their bonuses. Some of the surprises their use of leverage and are distinguished from mutual
were positive, but inevitably some were negative. funds by a greater flexibility in investment strategies.
CFO Julie Behrens reflected on Raven’s performance Hedge fund management companies are typically
evaluation and incentive compensation plan: organized as limited partnerships. The manager acts as
the general partner, and the investors act as the limited
Hedge funds like ours have access to lots of data.
partners.
We have many performance measures and indices
Most hedge fund companies use the same business
that we can use for benchmarking purposes. But
model. They derive revenue from two sources: man-
interestingly, our incentive plan is not purely quan-
agement fees and incentive fees. Management fees,
titative. We consider the performance metrics, but
typically 1–2% of assets under management (AUM),
none of them gives us a complete picture of an
are earned regardless of performance. Incentive fees,
employee’s contribution to the company. The man-
collected annually, are performance-based, typically
agement team makes our evaluation system work
totaling 20% of a fund’s return above a “high water
with painstaking qualitative adjustments. Still, I
mark,” the highest level of value the fund ever had for
wonder if we should make at least a portion of our
each investor. If a fund loses money, its managers are
incentive plan more formulaic.
not penalized, but they cannot collect further incentive
Copyright © 2017. Pearson Education Limited. All rights reserved.

fees until the fund surpasses its high water mark; i.e.
Industry background until the losses are recovered. The high water marks
Hedge fund managers pursue absolute returns on their are different for each investor, depending on the point
underlying investments. The investments can be any at which they invested their monies. (See Exhibit 1 for a
combination of financial vehicles, including stocks, simple high water mark example.) Hedge funds typi-
bonds, commodities, currencies, and derivatives. cally use the management fees to cover their operating
Sometimes hedge fund managers hold cash, sell short, expenses. Incentive fees are normally distributed to
and/or buy or sell options or futures. staff as bonuses.
The word “hedge” means to manage risk. Risks come The year 2008 was an extremely challenging year for
in many forms, such as inflation risk, market risk, inter- the hedge fund industry. The S&P 500 index dropped
est rate risk, currency risk, sector risk, and regional risk. 37%, the credit markets tightened, and investors around
Hedge fund managers are experts in designing hedging the world fled to safe investments. AUM at hedge funds
positions for most perceivable risks, making a true fell sharply due to trading losses and redemptions, as
hedge fund less risky than a traditional long-only invest- investors rushed to liquidate their assets. A record num-
ment fund, at least in theory. But each hedge fund is ber of hedge funds closed in 2008. By 2009, the S&P
unique. Different hedge funds use different mixes of 500 rose 24%, regaining some of the prior year’s losses.
investment vehicles, and their strategies vary signifi- According to several indexes that track hedge fund per-
cantly from conservative to highly speculative. formance, hedge funds that survived 2008 were up 18%

384
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Raven Capital, LLC

or more in 2009, making it the best year for hedge fund Organization
performance since 2003. However, almost half of all
Raven’s 17 employees were organized into two groups,
hedge funds were still below their high water marks at
Investment Management and Business Operations. Max
the end of 2009.
Stoneman was the general manager and CIO of Raven.
Together with Jeffrey Lomnitz, Max also managed the
Raven Capital, LLC Investment Management Group. Max and Jeffrey acted
as Raven’s portfolio managers (PMs), managing 100%
Investment strategy of the firm’s assets. They supervised the analysts and
Raven Capital, LLC was founded in 1999 by Maxwell traders who comprised the balance of Investment Man-
(Max) Stoneman. Total AUM in 2009 were slightly less agement. Julie Behrens managed Business Operations.
than $1 billion. Raven’s funds bought and sold long and (See Exhibit 3 for an organization chart.)
short positions in domestic equities. Raven managers The analysts were industry specialists who closely
focused their investments in industries – financial, studied and monitored the publicly traded companies in
energy, technology, consumer products, and health- their industry. They studied financial statements, inter-
care – in which they had years of expertise and many viewed management, and ran models, working to iden-
management contacts. Their heaviest investment tify inflection points in companies’ business models.
weights were in the financial and energy industries. Analysts frequently championed stocks for inclusion in
Almost half of Raven’s AUM came from “funds of Raven funds, and made entry and exit price recommen-
funds” – funds that invested in portfolios of different dations. They were also responsible for monitoring
hedge funds. Another 33% came from pension and stocks once investments had been made in them.
retirement funds, and 18% came from high net worth As PMs, Jeffrey and Max were responsible for “pull-
individuals. Only 1.5% came from foundations and ing the trigger” on stock picks. They considered ana-
endowments. (See Exhibit 2 for a chart of capital lysts’ inputs, and decided which stocks to buy at what
sources by investor type.) price, and how to size the positions. The analysts per-
As a traditional hedge fund, Raven made investment ceived the PM’s investment styles as being somewhat
decisions based on fundamentals, not short-term different. One was described as wanting to be a “home
momentum, arbitrage opportunities, or expectations of run hitter.” The other was said to take “smaller cuts at
superior predictions of macroeconomic trends. Analyt- the ball because he did not like volatility.”
ical horse power was considered key to Raven’s success. The traders were responsible for executing buy and
Raven managers sought superior returns based on a sell orders at the portfolio managers’ target prices. Hit-
thorough understanding of strategic, financial, and ting target prices could be difficult, especially for illiq-
uid stocks or to buy and sell orders large enough to
Copyright © 2017. Pearson Education Limited. All rights reserved.

competitive dynamics of companies and industries, as

well as selective entry and exit points. Specifically for move the stock price. Traders made use of relationships
long positions, Raven targeted both growth companies and negotiations with executing brokers to obtain
and solid companies that were currently out of favor. favorable pricing.
Raven also took short positions in companies that they Raven was a relatively small firm. Most of its employ-
perceived had fundamental problems, aggressive ees lived in the same neighborhood, and knew each
accounting and overstated earnings, and/or stock other socially as well as professionally. Employee ten-
prices that reflected unrealistic earnings expectations. ure at Raven was higher than the hedge fund industry
Raven’s approach was disciplined. Managers were average.
cognizant of macroeconomic trends, but macro trends
Performance
did not materially alter the overall strategies, long/
short exposures, or industry focus. As portfolio man- For over a decade, the Raven Capital team had deliv-
ager Jeffrey Lomintz put it, “We do what we say we’re ered superior risk adjusted returns for the investors
going to do within the bands that are prescribed who entrusted their monies to the company. For exam-
because we want to have product integrity.” Raven ple, Raven’s Flagship Fund (the Fund), the firm’s oldest,
funds had tight net exposure targets (long exposure had an annualized return since inception of 14.8%, as
plus the absolute value of short exposure). Net expo- compared to a 7.3% annualized return for the S&P 500
sure for their long/short funds was typically 40%–55%. firms in that period. In approximately 70% of the

385
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

months when the market was down, the Fund’s values The bonus allocation decisions were made subjec-
either increased or were down less than the market tively by the management team, Max and Jeffrey (the
declined. (See Exhibit 4 for the Fund’s monthly fund two PMs) and Julie (CFO). They considered many
risk report.) quantitative measures but applied considerable judg-
But 2008 was a year for the record books on the ment in deciding what quantitative factors to consider
downside. Though Raven funds beat the overall mar- and how to weight the multiple indicators in impor-
ket, they lost significant absolute value. The Fund tance. Jeffrey explained, “Most importantly we need a
dropped 27% (the S&P dropped 37%). While techni- process that is fair and repeatable.”
cally the job of a hedge fund was to participate when The bonuses were awarded based on a combination
the market went up, and lose less when the market of company, team, and individual performance. For
went down, many clients had an expectation that the evaluating analysts, the primary quantitative evalua-
fund would never lose money, let alone a significant tion measure was an analyst performance report (see
amount of money. Exhibit 5) that was updated monthly and closely
Raven’s liquidity terms were much more liberal than tracked by all members of the Raven team. The perfor-
those of many hedge funds. Raven funds did not have mance of every stock that an analyst “touched” was
lock-ups or gates.1 For example, if a fund had a gate of coded, and the monthly profits or losses from those
15%, and investors requested withdrawals totaling stocks were tracked in the report.
25% of the fund’s assets, fund managers could legally Though the management team knew that at least
refuse all withdrawals exceeding 15%. Investors des- some analysts would prefer to be awarded bonuses
perate for cash sold their assets that were liquid regard- based entirely on quantitative measures, they recog-
less of performance, and the funds entrusted with nized several difficulties with a strictly formulaic
Raven were liquid. That liquidity policy contributed approach. First, analysts could only choose stocks within
significantly to the decline of Raven’s AUM in 2008 as their industry of expertise, so their performance could
investors needed to get cash fast. be helped or hindered by industry performance. Though
By the end of 2009, both the markets and Raven theoretically their performance could be measured
funds turned a corner. The Fund was up 36% and had against an industry benchmark, managers believed that
exceeded its high water mark. But despite the invest- in practice it was very difficult to find a robust index.
ment gains, the firm’s AUM had not returned to any- Second, exposure to short or long positions could
thing near their historical levels. By the end of 2009, have a significant effect on performance as well. It may
Raven’s AUM were only 41% of what they had been at well have been in an analyst’s best interest to take only
the beginning of 2008. long positions in a rising market, but Raven strategy
often required somebody to “take shorts for the team.”
Copyright © 2017. Pearson Education Limited. All rights reserved.

Analyst compensation Finally, analysts could “touch” stocks in several

ways that were not reflected in the stock performance
Raven analysts earned a minimum base salary of report. For example, if an analyst made a stock recom-
$180,000 plus an annual bonus granted at the discre- mendation, but the PM chose not to buy a position, the
tion of management. Bonuses fluctuated significantly stock was not tracked on the report. Several analysts
but generally ranged from approximately $150,000 kept track of those stocks on their own, to receive credit
upward to several million dollars. for good picks even if they did not become part of a
Raven’s incentive fees earned became the annual fund. Equally, if an analyst made a “save” by recom-
bonus pool. The bonus pool was split two-thirds to mending getting out of a position, it was not directly
Investment Management and one-third to Business reflected in the report, either. Analysts could clearly
Operations, as was traditional in the industry. Within also make bad calls that the PM chose not to imple-
Investment Management, the PMs typically took a ment. Jeffrey explained, “I could follow an analyst’s
standard percentage of the pool, and the balance was recommendation to buy a stock at $10 and ignore his
allocated to the other employees. recommendation to sell at $15. If I ultimately sell at
$18, who gets the credit? The analyst had a good idea
1
but he told me to sell the stock earlier, and I didn’t, so
Lock-ups restricted withdrawals of the original investment in a hedge
fund for a period of time. Gates limited the percentage of a fund’s we made even more money. That’s one area where the
assets that could be withdrawn during any redemption period. performance evaluations get murky.”

386
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Raven Capital, LLC

Ultimately, company performance drove bonuses, approach, most typically awarding a pre-negotiated
since the company couldn’t pay out more than it earned percentage of fund returns as an annual bonus. Win-
in incentive fees. Max explained, ston reflected, “The great thing about that is you know
exactly what you make.”
There are years where everyone is overpaid. If the
firm has a great year and you have horrible perfor-
mance, you’ll be overpaid. But in years like this year, Concerns
everyone is underpaid. You may have done well, but
Each year seemed to present unique evaluation chal-
fees were lower because we had to get up to our high
lenges. Julie listed some of the questions that had to be
water marks again. There were not as many dollars
addressed:
to go around. But my memory is not that short.
What is the firm making? How are the funds doing?
Management used a “mental carry forward” to com-
How should we evaluate employee contribution?
pensate people they felt had been overpaid or under-
Should we pay for tenure? How much of the bonus
paid in prior years. Managers also adjusted bonuses
pool should go to those working in administration?
based on qualitative factors. For example, they consid-
ered whether analysts wasted time with poor recom- Reflecting on the 2009 year-end performance
mendations. Jeffrey explained, “Some analysts use a reviews, the Raven management team had some con-
dart board approach. If you throw enough darts, you’ll cerns. They feared that bonus expectations had
eventually hit the board, but it puts the burden on the become unmanageable. They valued their analysts
PMs to sort through all those ideas.” and wanted to keep them happy. High water marks
From the analysts’ perspective, Raven’s evaluation had made this year unusually difficult for Raven and
method, while not perfectly visible, was generally seen for hedge funds in general. But because fund returns
as fair. The analysts were not oblivious to the economics were high, some analysts felt entitled to bonuses simi-
of the business. They were aware of how much the com- lar to the record amounts earned in 2007. And, as Max
pany earned each year, and had a general idea of what and Jeffrey both noted, “Most employees overrate
they deserved as a bonus. While they sometimes believed their performances and overvalue their worth.” In the
their bonus award was not completely fair compared past, it was not uncommon for analysts who were
with other analysts, the differences were generally not unhappy with their compensation to jump to compa-
huge. As analyst Winston Hill put it, “we’re not under- nies with more assets or to start hedge funds of their
paid by 50%.” Winston explained further: own, but that possibility had become far less likely
given the state of the industry.
I don’t know the mad science behind how Max
Max and Jeffrey were also concerned that they were
comes up with some of his performance metrics.
Copyright © 2017. Pearson Education Limited. All rights reserved.

not accomplishing much in the way of evaluating and

I’m sure he runs the numbers a number of different
improving performance through the review process.
ways. There is an art to this as well as a science …
During their reviews, analysts paid careful attention to
Everyone thinks that Max and Jeffrey are fair peo-
the bonus award, but were unable to focus on anything
ple. This model would not work if there wasn’t a
else. One possibility that Julie had suggested was to
trust factor.
move performance reviews to September, to separate
Having such a subjective process was not the indus- performance discussions from the awarding of
try norm. Many other hedge funds did use a formulaic bonuses, which would still be done in December.

387
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Exhibit 1 Hypothetical high water mark example

Pool at beginning Pool at end Incentive fee earned at

of period % return $ return of period rate of 20% of fund returns

Year 1 $800,000 125% 1$200,000 $1,000,000 $40,000*

Year 2 $1,000,000 220% 2$200,000 $800,000 $0

Year 3 $800,000 110% 2$80,000 $880,000 $0

Year 4 $880,000 125% 1$220,000 $1,100,000 $20,000**

*($1,000,000 − $800,000) × 0.2 = $40,000

**($1,100,000 – $1,000,000) × 0.2 = $20,000

Exhibit 2 Raven assets under management by investor type (as of 7/1/2009)

Copyright © 2017. Pearson Education Limited. All rights reserved.

388
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Raven Capital, LLC

Exhibit 3 Organizational chart

Copyright © 2017. Pearson Education Limited. All rights reserved.

389
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Exhibit 4 The fund risk report

Statistical Highlights

Firm AUM $732M

Fund AUM $128M

Returns Since Inception Fund S&P 500

Cumulative 687.50% 182.70%
Annualized 15.11% 7.34%

General Summary MV Delta Adj.

Equity ($) $131,557,936 –
LMV ($) $119,262,214 $131,035,077
SMV ($) ($61,414,565) ($73,739,807)
Gross Exposure $180,676,779 $204,774,884
Net Exposure $57,847,649 $57,295,270
LMV (% Equity) 90.65% 99.60%
SMV (% Equity) (46.68%) (56.05%)
Gross Exposure (% Equity) 137.34% 155.65%
Net Exposure (% Equity) 43.97% 43.55%
1 day VaR 95% $1,392,438 –
1 day VaR 99% $2,111,171 –

Position Info. Long Short

Top 25 positions 74.88% (30.21%)
# of Positions 53 63
Days Liquidity (Fund) 0.70 0.12
Turnover 15.58% 35.68%

Risk Metrics Fund S&P 500

Standard Dev. 3.87% 4.60%
Standard Dev. Ann. 13.42% 15.94%
Sharpe Ratio 0.85 0.55
Downside Dev. 2.53% 3.49%
Sortino Ratio 1.30 0.30
Copyright © 2017. Pearson Education Limited. All rights reserved.

Benchmark Comps Fund S&P 500

R2 54.44 1.00
Beta 0.62 1.00
Alpha (Since Inception) 574.63% –
Correlation 0.74 1.00

(Continued)

390
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Raven Capital, LLC

Exhibit 4 Continued

Definition of risk metrics

Alpha The Y-intercept of the security characteristics line. The specific benchmark used in
the Monthly Fund Risk Reports is the S&P 500 with dividends reinvested.

Annualized standard deviation (Monthly standard deviation) × (square root of 12).

Beta With ra denoting the rate of return of asset A and rp denoting the rate of return of
referencing benchmark, beta can be expressed as beta(a) = covariance (ra,rp)/
variance (rp).

Correlation coefficient Correlation coefficient pX,Y between two random variables X and Y, with standard
deviations sigma (X) and sigma (Y) is defined as pX,Y = covariance (X,Y)/(sigmaX
sigmaY).

Downside deviation The standard deviation of the returns that are less than the minimum acceptable
return (MAR).

Hard to borrow This is defined by our broker as MV of short equities for which we receive less than
our cold rate.

Liquidity The day’s liquidity for each position is calculated by dividing the shares held by 30%
of the average 20-day trading volume. The day’s liquidity for the firm or fund is based
on the weighted average of firm or fund holdings.

R2 R-squared, coefficient of determination, in linear regression, which is employed here,

R-squared is simply the square of the correlation coefficient.

Sortino Ratio Investment return-risk free (ROR)/downside deviation. The downside deviation is
relative to a user-specified minimum acceptable return (MAR), which in the case of
the fund risk report is 0.

Standard deviation The square root of variance.

Copyright © 2017. Pearson Education Limited. All rights reserved.

391
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Chapter 9 • Incentive Systems

Exhibit 5 Analyst performance report

Long portfolio
Month to month profit/loss in $ millions (profit and loss defined as realized plus changes in unrealized)

Analyst Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2009

MS 22.6 −1.3 29.3 21.7 8.1 −13.4 −11 7.7 32.6 30.5 −31.4 −8 87.4

BS 5.4 0.5 7.1 1.8 13.3 −5.6 −6.2 7.3 5.3 10.7 2.5 −1.2 40.8

JL 9.8 −1.5 13.8 11.7 16.1 7.8 −17 24 22.1 16.6 −30.4 1.6 74.6

NK 3.7 −0.5 −4.3 2.8 0.7 4.2 −9.8 3.1 4.6 9.7 −0.2 −3.0 11.07

WH 8 2.1 −1 8.3 12.1 −10.7 −2 −1.2 −1.1 −0.6 −1.6 −1.4 11.02

CF 0.2 −0.1 −0.1 0.1 −0.01 −0.2 −0.1 −0.1 0.1 −0.03 0.1 −0.31

CIM −1.4 −0.4 2.3 2.5 3.4 0.5 0.7 −0.8 0.02 1.2 −0.6 −0.01 7.4

IPOS 0.27 0.2 0.4 0.5 0.3 −0.01 0.05 0.09 1.73

GOLD −1.2 −0.8 −0.1 −0.4 −0.3 0.5 −0.5 −2.8

TOTAL 46.8 −0.7 46.4 49.1 53.2 −17.3 −44.7 40.7 64.1 71.4 −61.2 −12.3 235.4

Short portfolio
Month to month profit/loss in $ millions (profit and loss defined as realized plus changes in unrealized)

Analyst Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2009

MS 13.8 6.9 29.9 4.5 5.8 −9.7 19.8 13.8 36.2 50.2 4.8 9.8 185.8

BS 0.9 −0.8 −0.3 −5.9 4.9 −0.9 7.8 9.6 6.9 15.3 11.1 0.1 48.8

JL 2.6 9.6 16.9 4 11.4 14.5 −15.2 27.4 13.9 4.7 −14 12.8 88.7

NS 3.3 1.5 −2.4 −0.4 −1.7 3.1 −8.6 0.7 3.2 6.4 8.8 −5.6 8.3

WH 3.8 5 −2 −2.4 2.1 −11.9 1.7 −0.3 −1.1 −0.6 −1.6 −1.4 −8.7
Copyright © 2017. Pearson Education Limited. All rights reserved.

CF 0.2 −0.1 −0.1 0.1 −0.01 −0.2 −0.1 −0.1 0.1 −0.03 0.1 −0.3

CIM −1.3 −0.3 2 2.1 2.9 0.9 0.8 −0.8 −0.2 1.2 −0.1 −0.2 7.1

IPOS 0.3 0.2 0.4 0.5 0.3 −0.01 0.1 0.1 1.7

GOLD/SPYS −4.7 4.4 −4.5 −7.5 −7 1.6 7.7 −3.7 −3.6 −0.01 5.6 0.7 −11.3

TOTAL 18.3 26.6 39.5 −5.2 18.5 −1.6 14.2 47.4 56.8 80 17.8 16.9 329

(Continued)

392
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 Raven Capital, LLC

Exhibit 5 Continued

Total portfolio
Month to month profit/loss in $ millions (profit and loss defined as realized plus changes in unrealized)

Analyst Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 2009

MS −8.8 8.3 0.6 −17.2 −2.3 3.8 30.8 6.1 3.5 19.7 36.2 17.8 98.5

BS −4.4 −1.3 −7.3 −7.7 −8.4 4.7 14 2.3 1.5 4.7 8.6 1.3 8.0

JL −7.2 11.1 3 −7.7 −4.7 6.8 1.8 3.4 −8.2 −11.9 16.5 11.2 14.1

NK −0.3 2 1.9 −3.2 −2.4 −1.1 1.2 −2.5 −1.4 −3.4 9 −2.6 −2.8

WH −4.2 2.9 −1 −10.6 −10 −1.3 3.6 0.8 −19.7

CF

CIM 0.03 0.1 −0.3 −0.4 −0.5 0.4 0.2 0.03 −0.2 0 0.5 −0.2 −0.3

NC

SPYS −3.5 4.4 −3.8 −7.5 −6.6 1.9 7.2 −3.2 −3.6 −0.01 5.6 0.7 −8.5

TOTAL −28.4 27.3 −6.9 −54.3 −34.7 15.6 58.9 6.7 −7.3 8.6 79 29 93.6

Allocated capital % of allocated % return on

Analyst 2009 profit % of 2009 profit ($ millions) capital allocated capital

MS 234.59 71.3% 800 33% 29.3%

JL 88.71 27.0% 800 33% 11.1%

NS 8.31 2.5% 300 12% 2.8%

WH −8.66 −2.6% 300 12% −2.9%

CF −0.31 −0.1% 2 0% −15.3%

CIM 7.09 2.2% 30 1% 23.6%

Copyright © 2017. Pearson Education Limited. All rights reserved.

IPOS 1.73 0.5% 0%

GOLD/SPYS −11.26 −3.4% 190 8% −5.9%

TOTAL 329.03 100% 2422 100% 13.6%

This case was Prepared by Professor Kenneth A. Merchant and research assistant Michelle Spaulding.
Copyright © by Kenneth A. Merchant.

393
Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.
 This page intentionally left blank
Copyright © 2017. Pearson Education Limited. All rights reserved.

Merchant, K., & Van, D. S. W. (2017). Management control systems 4th edition : Performance measurement, evaluation and incentives. Retrieved from http://ebookcentral.proquest.com
Created from bilibrary on 2019-03-07 02:24:55.