Blue Line Management and OByrnes Pp4p Compensation - Report Example

Student’s Name Instructor’s name Class Date Describe Blue Line Management and O’Byrne’s PP4P compensation plan and the relationship Blue Line Management The blue line involves management of value of a company by indicating the intrinsic level of free cash flows discounted at the opportunity cost of capital. The blue line indicates how the intrinsic value of a company may fluctuate over time due to changes in the expected cash flows of a business or the opportunity cost of capital. This means the blue line and value of a company increases when it invests in a project with positive NPV. In this way, the goal of a value driven company is to raise its blue line as much as possible. Any decision made by a manager destroys or enhances the value of a company irrespective of whether there is knowledge of it or not. Blue line management does not focus on the price of the shares of a company, but instead considers the intrinsic value generated for the stakeholders. According to Kaiser and Young (2009), managers have to consider the value that their organizations create for all stakeholders instead of focusing on share prices. Managers who focus on management of share prices have been shown to do this at the detriment of value. They argue that in order to enhance the prices of a company’s shares, managers need to work on increasing value in order to grow the blue line to the neighborhood of the value they want. If a manger spends time and other resources in enhancing the red line, it is almost certain that the blue line will suffer. Blue line management, on the other hand, involves strategies geared towards enhancing the value of the company and the share price is left to the capital markets for determination. In this way, the capital market is considered to be efficient in determining the share value. A key issue with the situation is that the mangers rarely consider the market to be efficient because according to Kaiser and Young (2009), they are paid to think that way. When managers are given stock or option grants that can be liquidated in the short term, it is not surprising to expect them to manage share prices. In a company where the earnings per share growth or total shareholder returns are prominent features in the balanced scorecard of senior managers, the business is likely to be organized around red line as opposed to blue line management. Red line management is evident through strategies such as buying back of one’s own shares to increase earnings per share. Accounting numbers may also be manipulated to reduce earnings volatility. Revenue management through buyback of shares is motivated by the belief that the share price of a company is based on a fixed multiple of earnings. In this case, any action increasing EPS even with no impact on value generation or revenues will cause the share price to rise. This aspect is based on the expected increase in future cash flows, and when it does not materialize, the share price falls. In blue line management, indicators should not be used to punish employees who do not achieve set targets. They should also not be used to reward those who achieve such targets because it would promote the focus on red line management. A blue line approach to the use of KPIs focuses on their relevance as learning tools. In blue line management, using indicators as compensation or incentive tools reduces their relevance in creating value. Value generation requires experimentation where having the right answers is irrelevant to asking the necessary questions. KPIs should be treated as hypotheses and failing to achieve them should not be punishable because it would adversely affect learning. In this way, managers should rely on blue line aspects to determine value and how people are compensated. O’Byrne’s Perfect pay for Performance plan The sensitivity of pay to performance has two distinct dimensions; the alignment of pay and performance and the pay leverage. According to O’Byrne (2), the two measures do not provide a complete measure of pay for performance. Significant issue in these dimensions of payment is that the system is inefficient if pay for poor performance is above the market rates. As a result, it is associated with three dimensions of alignment, leverage, and the pay premium based on industry average. The PP4P is designed to enhance how compensation is based on performance and the value that the employee delivers to the company. The plan achieves perfect alignment, a leverage of 1.0 and zero relative cost and then modifying it in a series of changes to reduce alignment to reduce leverage and alignment to median levels. The main features of the PP4P plan include the grant value of the annual performance share grant being equated to market total compensation adjusted for relative performance since the start of the five-year measurement period. The second aspect is that each performance share grant vests at the end of the fifth year with a vesting multiple equal to 1/(1 + the industry return since the date of grant). There are four distinct factors that may determine why actual pay differs from the PP4P (O’Byrne 7). These factors include paying market compensation that is not based on past performance, stock compensation independent of industry performance, paying cash compensation, and inconsistent leverage across years. The article by O’Byrne presents a pay for performance model that is different from the conventional one applied by the ISS. The model differs from the conventional approach in several ways such as the use of grant date pay as opposed to the mark to market pay. The peer group of companies considered for the industry assessment is narrowly related and pay leverage is determined through the difference between the pay percentile and performance percentile. A further analysis of the plan as it is applied in the case of ISS shows that it is related to three measures of cost, a cost proxy, and third measure that is not aligned with any dimension of pay for performance. The PP4P plan ensures that the management of an organization is compensated perfectly based on performance of the company in terms of the value created for the shareholders. The approach is efficient in addressing the relevance of value for the shareholders and providing a sure way of providing the required compensation based on the industry averages and relative performance of the company. Pay leverage and the average cost to the company are managed efficiently in a way that reduces the total disparity based on industry differences. The approach ensures that the managers are paid for the value that they create and not the share prices or other measures such as punitive performance indicators. The relationship The relationship between PP4P and Blue Line Management is that they are both interested in determining the overall value that is created be employees to the shareholders. Instead of focusing on prices or other measure that do not necessarily indicate value, Blue line management involves a focus that is solely targeted on value created to the shareholders. The analysis shows that the managers are unlikely to enhance value if they focus on the share price because they may engage in revenue management or other strategies for influencing the bottom line. The PP4P approach ensures that the value of a company over a period of five years forms the basis for determining the level of compensation that should be provided. The manager is compensated in a way that ensures that value growth or generation becomes the most important aspect. The PP4P plan can be applied as an aspect of Blue Line Management because it eliminates the use of performance indicators as a determinant of the pay structures and levels. The compensation given to an employee using the PP4P plan improves the focus on value creation as opposed to the price of shares or other forms of equity. The focus on actual value generated in the organization as a determinant of the compensation made is significant in ensuring that managers work towards generating value for their shareholders (O’Byrne 10). As indicated in Kaiser and Young, managers who focus solely on red lime aspects of their organizations such as share prices are likely to produce reductions in the intrinsic value of the company. This aspect has to be considered in developing compensation plans because focusing on EPS and share price related measures would produce adverse outcomes for the shareholders. In order to make sure that the application of PP4P enhances Blue Line Management, the payment structures are effective in developing a strategy that incorporates value in the compensation provided. Blue Line Management involves a focus on value in determining the strategies that should be applied in order to grow an organization. Blue line management approaches can be applied in product development, compensation, and strategy development. They are efficient in producing overall value that is beneficial to the shareholders as well as the customers. In the case of PP4P, value and performance are considered as the most significant correlates (O’Byrne 9). The expected value for an enterprise is directly influenced by the value generated to the shareholders. The issue of shareholder value is critical in blue line management and it determines the best way that managers should be organized and compensated in order to address the needs and expectations of shareholders. PP4P can be used to enhance the blue line management approach by providing an efficient way of ensuring that managers are pushed to perform according to the set standards and compensated based on the value they produce. In conclusion, blue line management presents an efficient way of managing the value that shareholders get from an organization. It allows them to focus on the intrinsic value of the company as opposed to the price or other related indicators. It is clear that focusing on red line aspects of management is critically inefficient as a way of achieving the expected value generation. Managers who focus on growing the EPS or increasing the price of their shares are likely to lower the overall value of their organization. This is because the revenue management approaches indicate expectations of value growth. If the value growth is not achieved, the market responds negatively in the future by declining the overall price hence producing reductions in the value of the organization. The main issue with blue line management is that it focuses on intrinsic value of a company arising from the developments that are beneficial to the shareholders and other stakeholders. The issue of PP4P in executive compensation works well with blue line management because the pay structures are based on the market rates. The Blue line management involves the use of indicators as a platform for growth as opposed to being used to punish employees who do not achieve set targets or reward others. KPIs should also not be used to reward employees who achieve such targets because it would promote the focus on red line management. In blue line management, using indicators as compensation or incentive tools reduces their relevance in creating value. Value generation requires experimentation where having the right answers is irrelevant to asking the necessary questions. The PP4P approach involves allowing the managers to enhance the value of their companies and knowing that they will be compensated based on the generated value. By ensuring aspects such as pay leverage and correlation to the market value of the organization, the managers will be motivated to grow the value of their organizations through legitimate channels. The focus on value ensures that price related measures are not utilized to assess the value of an employee to an organization. References Kaiser, K. and Young, S. D. (2014), Managing for Value 2.0. Journal of Applied Corporate Finance, 26: 8–19. doi: 10.1111/jacf.12049 O'Byrne, S. F. (2014), Three Versions of Perfect Pay for Performance (Or The Rebirth of Partnership Concepts in Executive Pay). Journal of Applied Corporate Finance, 26: 29–38. doi: 10.1111/jacf.12051 Read More