Management Compensation Schemes - Assignment Example

Management Compensation Schemes Executive Summary This report aims at understanding and analyzing various aspects of management compensation schemes. It initiates with the explanation of various constituents of the compensation schemes and the rationale for their inclusion. Later, it moves on to the importance of each of the compensation ingredient and also applies the agency cost theory to this discussion, thereby, analyzing the costs and attributing them to the agency theory. The report then moves towards analyzing the importance of accounting numbers to the management compensation and the way numbers can illustrate reality or otherwise. Finally, the report sums up the discussion and ends towards analyzing the importance and impact of the present financial crisis on the compensation schemes. 1. Introduction Globally, executives and the management have always been criticized of higher pay structure, causing damage to the financial numbers of the organization. The payroll structuring in human resource department define how individuals in an organization at various levels are to be paid and adjusted. Along the similar lines, management compensation packages and schemes are defined as the mechanisms following which the salaries of management individuals are based, in accordance with Henderson (1985), as agreed by Colt (1998) and Chingos (2002). These are composition of various constituents that will be defined and discussed in the later chapters of this report. However, it is essential to identify the level of management and the need of compensating it well. Management is the care taker of the organization; it looks after the various affairs of the business, in various models, and has the bird eye view of the proceedings. Their job not just includes looking after the employees and staff but also to correct what is going wrong, take preemptive measures, having a proactive approach, keeping an auditor’s eye, guiding the strategic path of the organization, guiding the business and its functions, keeping a check on the proceedings and so on. The gurus in an organization, with assistance of human resource management and department, have well been able to define the job description and structured the details about various jobs in an organization, but the scope and description of a management job remains undefined, and it has become really difficult for human resource department to organize a list of things-to-do or things-to-be-done by the management. Therefore, only the bird’s eye view of the role and responsibility is what defines how management should act, and subsequently, each managerial level individual defines their own set of job description and responsibilities to do. Following the same argument, it can well be derived that life for a management individual is not an easy task and thus the compensation schemes should be defined in an appropriate manner considering these issues, as agreed up on by Lochner (2007). 2. Composition of Management Compensation Package This section has been devoted to analyze the composition of the management compensation package, and moreover to link this composition and its various elements to the job responsibilities of the management. Compensation packages are generally designed to provide managers with an incentivized ground for maximizing the share holders’ wealth i.e. linking pay to performance. However, the performance is not only depends on how much efforts the manager puts in but also depends on events that lie beyond the control of a manager. In accordance with Handlogten (2001), some typical components of the management compensation packages are as follows along with their brief description: Base salary: the basic salary that is disbursed to the person in any case irrespective of the performance of the individual or the company. Annual bonus tied to accounting performance: this part of the salary is the one that is linked to the overall performance of the company. Stock options: this is an incentive program whereby based on the performance of the firm, the management has the right to get stocks of the firm as an option. Restricted stock: this is a deviation of the stock option whereby the management being the owner of the shares cannot sell the shares, as a restriction. Fringe benefits: the benefits other than the salary, such as company maintained car, various allowances, etc. Severance payments: this implies add on such as paid leaves, sick leaves, medical allowance, retirement benefits, etc. The summation of all the monetary inflows define the taxable income; all other benefits such as company car, children education plan, traveling allowance, etc. are not liable to taxes. The compensation patterns vary from industry to industry, based on size of the firm and also across the various countries. 2.1 Rationale for Salary Components A salary component is always present when defining the salary structure. This is because of various reasons. Firstly, the presence of a salary component gives a basis to the human resource department for promotion, incentives and bonuses since the salary component acts as the basic amount, increments and other factors can be decided on percentage basis. Secondly, it allows the ease of standardization amongst individuals at various levels. It also facilitates in developing categories or levels within the organization or the hierarchical pay roll as the human resource department calls it. Other than this, having basic salary also ensures that the accounting or the human resource personnel involved in developing packages can develop proportionality between the salary to develop allowances, thus leading to the complete packages developed then on. Subsequently, a salary component has to be present on a general note. When referring to the executives and the management individuals in an organization, for whom a proportion of the salary amount is tied to the over-all performance and numbers that the organization produces, a salary component is essential for ensuring that they have some confirm source of income coming. For instance, if the compensation is purely performance based then a year of under-performance would imply no money for the executive person. Alongside, the general benefits as stated above are also reaped in this case. For example when deciding annual bonuses, it is three or four times the salary amount, and other tying up of increments, bonuses, etc. is also possible for the executive management. On a general note, executives are highly cautious about their salary component since this is their measure for risk aversion. 2.2 Rationale for Non-Salary Components Management compensation often includes non salary components as well, and many examples of these are presented previously. There are two prime forms of non salary components; firstly are the general ones like the fringe benefits, and secondly, is the one that is tied to the financial performance of the firm. In both cases, these may be in proportion to the salary or otherwise. The example of the former would include education package, company maintained vehicle, and other allowances. The example of the later would include performance based incentives such as stock options, and other bonuses. The later are of higher significances because salary component is aimed for the managers to keep the firm well running but the non salary components are add on motivation for them to keep running the firm in an effective manner. Therefore, their significance cannot be ignored, and thus, these are generally included in salary packages. 2.3 Package Component vs. Type of Agency Cost Agency cost is a concept whereby ideally two entities are involved in an agency relationship, where one party acts as an agent, for the other party which is a principal, and the principal must pay a cost for the agent to continue on acting on behalf of the principal; this cost is known as agency cost. In accordance with Dodd (2005), this cost arises mainly due to conflict of interest between the agent and the principal, and as theory explains, agent is the management and principal are the shareholders. The interest of shareholders is that the management should run the organization in a manner that ensures maximization of the shareholder’s wealth, while the interest of the management is for the company to grow for maximizing their personal power and wealth, and this may not be in true interest of the shareholders. The fact of the matter remains that the agency costs cannot be ignored within a setup, particularly when the principals are not in full charge of the proceedings. This cost is best spent by means of giving material and moral incentives to the agents for appropriate execution of their responsibilities, and thereby an alignment of interest of principals and agents is achieved, and the conflict of interest is removed. Classical examples of material incentives are performance bonuses and stock options. This explanation leads to the conclusion, as also stated by Henderson (1994), that the package components described in the previous section can further be classified into material or moral incentives. Therefore, following are the division of the components, previous identified, in the two categories, whereby the classification is based on the consideration that material incentives are for the performance beyond the job responsibility to gain effectiveness, while the moral incentives are the generic salary ingredients in an organization: 2.3.1 Material Incentives With due consideration, following are considered as material incentives: Annual bonus tied to accounting performance Stock options Restricted stocks Subsequently, these elements cover the agency cost associated with the agent (the management) running the show and putting in for that extra mile for the principal (the shareholders) to ensure maximization of shareholder wealth. 2.3.2 Moral Incentives With due consideration, following are considered as material incentives: Base salary Fringe benefits Severance payments Subsequently, these elements cover the agency cost associated with the agent (the management) running the show for the principal (the shareholders). 3. Inclusion of Performance Targets Henderson (1993) states that there can be various performance targets, which can be associated as a part of the salary packages. However, these targets cannot be based on smaller values like sales or turn over or even generic performance measures, but these targets would be in the bigger picture. The performance target for the management would be about: Increasing the market share Increasing the customer base About new product launches About the level of success associated with the launched products About how well the organization has managed expenses Achieving a desired growth rates Meeting targets set during or at the end of the previous terms Schuster (1984) states that, the most important aspect here is that all these variables shall be on comparative basis to the previous period performance to analyze the changes, improvements and differences. These and many such performance targets can be included as a part of the salary packages. 3.1 Role of Accounting Numbers Bragg (2007) states that accounting numbers play an important role with regards to these targets as these are the fundamental variables used and manipulated to give the desired outcome. History is full of cases whereby the accounting numbers were manipulated to an extent that the targets seemed to be well achieved, in fact over-achieved, and the management got their share of the incentives. But in the long run, when the curtains were raised, it was realized what damage had already taken place. Accounts department, if records and represents the data in the right, lawful and meaningful manner, it can illustrate the clear picture on where, what and how, and the picture of performance can easily be drawn. Bragg (2007) further states that the accounts department of any firm, whether public or private limited, has a big time responsibility on its shoulders as it should ensure transparency of the flow of numbers, wherever they may be applicable. Let it be transparency of sales figures or the same phenomenon applied on any other numbers; accounts department has the art for artificial make-over on the numbers or the window dressing of the financial statements, the fact remains that all is in the hands of the accounts department. The accounts department must act independently, without any external pressure from any individual in the firm, and the sole controlling body for the accounts department should be the concerned auditors, within or external to the organization. Accounts is one of those departments of the organization that have a centralized view of what is happening around in any department of the organization knowing the truest picture of the organizational standing. Without the involvement of the accounts department, it may seem impossible for individuals in an organization to be involved in a successful fraudulent activity. The classical fraud cases, whereby, manipulation of numbers has been witnessed, have showed clear indication of various aspects that led to the issue and one of them was the involvement of the accounts department. Subsequently, the numbers released by the accounting department would lead to the actual decision on whether or not the management’s performance has been up to the task or otherwise. Therefore, it can be concluded that the accounting numbers are the prime source for analyzing the management performance over a term for ensuring that their targets have been achieved. 3.2 Accounting Incentives to Management There are numerous accounting incentives that these targets provide to the management. Firstly, they are a source of motivation for the management to outperform their previous performance. Secondly, it allows them to keep a track of their performance in terms of the associated rewards that are expected at the end of the term or period. Other than these two major incentives, there are a lot more; factors such as controls, benchmarking, measurement of performance, ad hoc performance analysis, analytics on how to gain momentum, and so on can be derived from the same. Beyond these advantages, generally, incentives are exempted from taxes as they are counted beyond the net income and added after tax deductions; therefore, the individual remains in the same tax bracket, while realizing higher amount of money. This is specially the advantage in case of stock related bonuses; stocks given to the executives or the management are not accounted for, neither accountable towards taxation and subsequently, the realized gains are higher than the ones that are present in numbers since the bonus is not accounted for towards taxation purposes. This has been the biggest advantage for executive management individuals who were earning low on base salaries and higher on bonuses; with the recent recession in place, the salary cuts did not matter them a lot since their base salary was readily very less. On the contrary, those getting higher base amounts had a lot to suffer due to salary cuts. 4. Conclusion As it is visible from the discussion in this report, management compensation schemes are composed of two primary segments i.e. the first segment whereby they get paid for the normal job, and the second segment whereby they get paid for the performance beyond the normal level that is achieved. It is similar to a sales person job, as stated by Colt (1998), whereby a fixed salary is attached with a variable that is the commission on each unit of sales and on milestones. History and researches reveal, as stated by Minow (2008), that management of various companies have performed in a variety of manners to get the incentives from the firm itself; some took the easy way of manipulating numbers and evidences can be seen on the cases of Enron, Wordcall for example, while some took the difficult route of actually working hard and taking the organization to its peak, and such names are generally highlighted in annual reports only – not in success stories – in accordance with Swensen (2005). The present financial crisis have had a significant impact on the management compensation schemes whereby both, the management with higher base salary and the one with lower base salary have suffered because the former suffered salary cut while the later got cut on their respective incentives since targets were not met. Though the former did get cut in incentives and the later did get cut in base salaries but that was not very significant. The revival of the world from the present crisis can lead to a better future for the executive management of organizations, the world over. 5. References Benjamin Graham, David Le Fevre Dodd (2005) Security analysis: principles and technique. 3rd Edition McGraw-Hill Professional David F Swensen (2005) Unconventional Success: A Fundamental Approach to Personal Investment. Simon & Schuster Donald L. Caruth, Gail D. Handlogten (2001) Managing compensation (and understanding it too): a handbook for the perplexed. Greenwood Publishing Group Henderson (1994) Compensation Management 6th Edition Pearson Education Canada James F. Reda, Stewart Reifler, Laura G. Thatcher, Philip R. Lochner, Jr. (2007) The Compensation Committee Handbook. 3rd Edition. John Wiley and Sons Jay R. Schuster (1984) Management compensation in high technology companies: assuring corporate excellence Lexington Books Peter T. Chingos (2002) Paying for performance: a guide to compensation management. 2nd Edition. John Wiley and Sons Richard I. Henderson (1993) Compensation Management: Rewarding Performance. 6th Edition Prentice Hall Richard I. Henderson (1985) Compensation management: rewarding performance 4th Edition. Reston Pub. Co. Robert A. G. Monks, Nell Minow (2008) Corporate Governance. 4th Edition. John Wiley and Sons, 2008 Steven M. Bragg (2007) Accounting Best Practices. 5th Edition. John Wiley and Sons Stockton B. Colt (1998) The sales compensation handbook. 2nd Edition. AMACOM Div American Mgmt Assn Read More