Executive Compensation as a Strategy

Few HR practices can have as profound or obvious an impact on strategic success as the company’s long-term incentives. Whether expanding through joint ventures abroad, consolidating operations, or following some other strategy, few firms can fully implement strategies in just one or two years. As a result, the long term signals you send your managers and executives regarding what you will (or won’t) reward can have a big effect on whether your strategy succeeds. A strategy to boost sale by expanding abroad might suggest linking long term rewards to increased sales abroad. A cost reduction strategy might require linking them to improved profit margins.

Companies also provide various incentives to persuade executives to remain with the firm. For example, golden parachutes are payments companies make in connection with a change in ownership or control of a company. For example, a company’s golden parachute clause might state that, should there be a change in ownership of the firm, the executive would receive a one-time payment of $2 million. Under recently issued IRS regulations, companies cannot deduct “excess” golden parachute payments made to executives, and the executive must pay a 20% excise tax on the golden parachute payments. Other firms, perhaps more dubiously guarantee large loans to directors and officers, for instance, to buy company stock. Thus, directors and officers of Conseco Inc. owed the company more than $500 million for such loans when shares of the company stock dropped precipitously.

Employers designing long term incentives thus ignore their firm’s strategy at their peril. Compensation experts suggest first defining the strategic context for the executive compensation plan, and then rating the compensation package itself what is basically an HR Scorecard-type process:

1. Define the strategic context for the executive compensation program, including the internal and external issues that face the company, and the firm’s business objectives. For example, ask: What are our organization’s long term goals, and how can the compensation structure them? What defines the organizational work culture – its basic values regarding what people should and should not do and how will the compensation program mold that culture? What competitive challenges do we face?
2. Based on your strategic aims, shape each component of the executive compensation package (base salary, short term incentives, long term incentives, and benefits and perquisites), and then group the components into a balanced plan that makes sense in terms of motivating executive behavior to achieve these aims. Each component should help to focus the manager’s attention on the behaviors required to achieve the company’s strategic goals.
3. Create a stock option plan that gives the executive compensation package the special character it needs to meet the unique needs of the executives and the company and its strategy.
4. Check the executive compensation plan for compliance with all legal and regulatory requirements and for tax effectiveness.
5. Install a process for reviewing and evaluating the executive compensation plan whenever a major business change occurs.

Preferably, translate goals and aims into measurable terms. First, try to identify the main financial factors that drive the company’s business. In many companies, a careful analysis of historical financials shows that well over 90% of economic value change is driven by a few simple items that can be separated out. For example, you may find that about 10 or 15 financial items – pricing, discounts, raw material costs, and net sales, for instance are the controllable factors that drive the improvements in the value of the company and the value of the shareholders’ investment. Then, link executives’ incentives to these items, to motivate the required behaviors.

One popular strategy today is to improve supply chain efficiencies. For example, Dell Computer encourages its customers to monitor their order status online, since doing so reduces the need for Dell employees to answer order status question. Airlines encourage fliers to book their travel online, since this means less need for reservations clerks and fewer commissions to travel agents.

The problem is, companies often spend millions on technology for supply chain efficiencies, only to find they fail because employees resist the changes. Many firms are therefore using incentives to support these change programs. For example, one incentive program at Sun Microsystems focuses on customer satisfactions metrics. Employees receive incentives based on achieving supply chain related improvements in activities like on-time delivery and customer returns K*Tec electronics established a similar incentive system. Each of the firm’s program management teams has a dedicated customer. K*Tec teams are rewarded based on how well they manage supply-chain related activities such as inventory turnover and capital invested. The programs are mostly for mid-to-upper level managers.

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