Managers play a crucial role in divisional and company wide profitability and most firms therefore put considerable thought into how to reward them. Most managers get short term and long term incentives in addition to salary. For firms offering short term incentive plans, virtually all – 96% — provide those incentives in cash. For those offering long term incentives about 48% offer them as stock options. The latter are intended to motivate and reward management for long term corporate growth, prosperity and share holders value. For mature companies’ executives base salary short term incentives long term incentives and benefits might be 60%, 15%, 15% and 10% respectively. For growth companies, the corresponding figures might be 40%, 45% 25% and 10%. About 69% of companies in one survey had short term incentives although nearly a third of those said they didn’t consider them effective in boosting employee performance. We’ll look at short and long term, incentives.
Short term Incentives: The Annual Bonus
Annual bonus: Plans that are designed to motivate short term performance of managers and are tied to company profitability. ‘
As noted, most firms have annual bonus plans aimed at motivating managers’ and executives’ short term performance. Short term bonuses can easily result in plus or minus adjustments of 25% or more to total pay. There are three basic issues to consider when awarding short term incentives eligibility fund size and individual awards.
Most firms include both top and lower level managers, and mainly decide who’s eligible in several ways. Most base eligibility on a combination of factors, including job level / title Base salary and discretionary considerations (such as key jobs having a measurable impact on profits). Some simply base eligibility on job level or job title. A few base eligibility on salary level alone.
The percentage size of the bonus is usually greater for top level executives. Thus, an executive earning $150,000 in salary may be able to earn another 80% of his or her salary a as bonus while a manager in the same firm earning $80,000 can earn only another 30%. Similarly, a supervisor might be able to earn up to 15% of his or her base salary in bonuses. A typical breakdown might be executive 45% of base salary, managers 25% and supervisory personnel 12%.
The employer must also decide the total amount of bonus money to make available – fund size. Some use a nondeductible formula. They use a straight percentage (usually of the company’s net income) to create the short term incentive fund. Others use a deductible formula on the assumption that the fund should to accumulate only after the firm has met specified level of earnings. Some firms don’t use a formula at all, but make that decision on a totally discretionary basis.
There are no hard and fast rules about the proportion of profits to pay out. One alternative is to reserve a minimal amount of the profits say, 100% for safeguarding stockholders investments and then to establish a fund for bonuses equal to, say 20% of the corporate operating profit before taxes in excess of this safeguard amount. So here, if the operating profits were $200,000 (after putting away 105, to safeguard stockholders) then the management bonus fund might be 20% of $200,000 or $40,000. Other illustrative formulas might include:
1) Twelve percent of net earnings after deducting 6% of net capital.
2) Ten percent of the amount by which net income exceeds 5% of stockholders’ equity.
The third task is deciding the actual individual awards. Typically a target bonus (as well as maximum bonus, perhaps double the target bonus) is set for each eligible position. The actual award then reflects the person’s performance. The firm computes performance ratings for each manager, computes preliminary total bonus estimates and compares the total amount of money required with the bonus fund available. If necessary it then adjusts the individual bonus estimates. The basic rule should be: Outstanding managers should receive at least their target bonuses and marginal ones should receive to best below average awards. Give the money you save from the performance to the outstanding ones.
One question is whether managers will receive bonuses based on individual performance corporate performance or both. Firms usually tie top level executive bonuses mostly to overall corporate results (or divisional results if the executive heads a major division). This makes sense because to a large extent the company’s results are their own. But as one moves farther down the chain of command corporate profits become a less accurate gauge of a manager’s contribution. For, say supervisors or the heads of functional departments it often makes more sense to tie the bonus more closely to individual performance.