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Management Control Systems XII
management Control systems
44
Accounting
Graduate
05/05/2011

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Term
Research findings on organizational incentives
Definition
  • individuals tend to be more motivated by the potential of earning rewards than by fear of punishment.
  • personal rewards are relative or situational. (Money is only good to a certain point)
  • if senior management signals by action that the MCS is important, operating managers will regard it as important.
  • Incentives are less effective as the period between action and feedback increases.
  • motivation is weakest when the person believes an incentive is unattainable or too easily attainable.
Term
Manager's total compensation package consists of
Definition
  • salary
  • benefits (retirement and health care, but also perks)
  • incentive compensation
Term
Incentive plans can be divided into:
Definition
  • short-term
  • long-term
Term
Short term plans focus on:
Definition
performance in the current year
Term
Long-term plans focus
Definition
long-term on company stock
Term
Several Ways to establish a bonus pool
Definition
  • simplest is to make bonus equal to set percentage of profits
  • base bonus on percentage of earnings / share after a predetermined level of earnings / share has been attained.
  • define capital as shareholder equity plus long-term liabilities.
  • few copmanies base bonus on increase in profitability of preceding year
  • base bonus on profitability relative to that of their industry.
Term
Carryovers
Definition
  • instead of paying the total amount in the bonus pool, the plan may provide for an annual carryover of a part of the amount determined by the bonus formula
  • doesn't relate to the year the bonus was issued
  • also relates more to economy than performance
Term
Two advantages to Carryovers
Definition
  • more flexible; payment is not determined automatically by a formula and BOD can exercise judgment
  • reduce magnitude of swings that occur when bonus payment is based strictly on the fomula amount calculated each year.
Term
Deferred Compensation
Definition
  • although the amount of bonus is calculated annually, payments to recipients my be spread out over period of years, (usually 5).
  • under the system, executives receive 1/5 of their bonus in the year it was earned.  Remaining 4/5 is paid out equally over the next four years.
Term
Deferred compensation offers following advantages
Definition
  • managers can estimate their cash income the following year
  • deferred payments smooth the managers receipt of cash
  • managers who retire will continue to receive payments for a number of years
  • deferred time frame encourages decision makers to think long-term
Term
Deferred compensation has following disadvantages
Definition
  • deferred amount may or may not vest (won't receive deferred bonus if they leave company) "golden handcuffs"
Term
Long-term incentive plans
Definition
  • basic premise is that growth in the value of the company's common stock reflects the company's long-run performance
  • several types of plans and popularity is affected by changes in income tax law, changes in accounting treatment, state of stock market and various other factors
Term
Types of long-term incentive plans
Definition
  • stock options
  • phantom shares
  • stock appreciation rights
  • performance shares
  • performance units
Term
Stock Options
Definition
  • right ot buy number of shares of stock at or after a given date (exercise date) at ap rice agreed upon at the time of grant (usually current market price or 95% of market price)
Term
Phantom Shares
Definition
  • phantom stock plan awards managers a number of shares for bookkeeping purposes only
  • at the end of a specified period (five years) executive is entitled to award equal to the appreciation in the market value of the stock since the date of award
Term
Stock Appreciation Rights
Definition
  • right to receive cash payments based on an increase in the stock's value from the time of the award until a specified future date.
  • this and phantom shares are deferred cash bonuses in which bonus amount is function of the market price of the company's stock.
Term
Performance Shares
Definition
  • award a specified number of shares of stock to a manager when specific long-term goals to a manager when specific long-term goals have been met.
  • advantage is that ward is based on performance that executive can control paritally
  • limitation of basing bonuses on accounting measures of performance.
Term
Performance Units
Definition
  • cash bonus is paid when specific long-term targets are attained (get money instead of shares)
  • combines aspects of stock appreciation rights and performance shares.
Term
CEO compensation
Definition
  • disucssed by BOD after CEO has presented recommendations for subordinates compensation
  • committee applies same % to CEO's compensation but committee may signal a different appraisal by deciding on a higher or lower %.
  • sign of how board regards CEO performance.
Term
Proposals to ensure BOD acts in interest of shareholders
Definition
  • prevent directors from selling stock for duration of their term to encourage them to ask "tough questions" of CEO's without fear of adversely impacting short-term stock price
  • set mandatory limits on tenure of directors to avoid entrenchment with management
  • hold annual performance reviews of directors
  • avoid having CEO of corporation as chairman of board.
Term
Argument to support stock expense:
Definition
  • about 75% of CEO and top managment compensation represent stock options and should be expensed the same way as other 25% (cash bonus)
  • treating stock options as expense would result in more accurate earnings picture restorin investor confidence
  • under current rules, companies feel that stock options are free and over rewards CEO's.
  • treating options as expense would prevent top management from playing accounting game to pump up stock options.
  • double standards at present because companies are allowed to expense difference between issue price and exercsie price.
Term
Arguments against stock expense
Definition
  • stock options don't involve outlay of cash, so expensing them would penalize earnings
  • valuing stock options is far from easy, involves assumptions and estimates.
  • treating options as an expense will dampen earnings and reduce stock prices.
  • cash strapped startups use options to attract human talent.
  • stock options are disclosed in the footnotes to the balance sheets.
Term
Types of Incentives for Business Unit Managers
Definition
  • financial (salary increases, bonuses, benefits and perks - autombiles, vacatons, club memberships, etc)
  • psychological and social (promotion possiblities, increased responsibilities, more autonomy, better geographical location, recognition - trophy, participation in executive program)
Term
Size of Bonus relative to salary: two schools of thought
Definition
  • fixed pay system
  • performance based system
Term
Fixed pay system
Definition
  • recruit good people, pay them well, and then expect good performance
  • emphasize salary, not incentive bonus
Term
Performance based pay
Definition
  • recruit good people, expect them to perform well, and pay them if performance is actually good
  • emphasize incentive bonus, not salary
Term
Cutoff levels
Definition
  • bonus plan may have upper and lower cutoff level
Term
Upper cutoff level
Definition
level of performance at which a maximum bonus is reached
Term
Lower cutoff
Definition
level below which no bonus awards will be made
Term
upper and lower cutoff may produce undesirable side effects:
Definition
  • when business unit managers recognize that either max bonus will be achieved or they won't meet minimum bonus, they might work against corporate goals.
Term
Bonus Basis
Definition
  • buisness unit manager's incentive bonus could be based solely on total corporate profits or on business unit profits or some mix of the two
Term
Argument for linking bonus to unit performance
Definition
managers decisions and acitons more directly immpact performance of unit rather than other business units.
Term
Limitation of linking bonus to unit performance
Definition
  • could impair interunit cooperation because in a single industry firm, where business units are highly interdependent the manager's bonus is tied to corporate performance  because ooperation between units is critical
  • conglomerate situation, it would be counterproductive because units are autonomous and there would be free rider problems where one manager will relax and still get a bonus based on the performance of others
Term
Performance criteria is difficult because
Definition
it's hard to decide what criteria should be used to determine the bonus
Term
Financial performance criteria
Definition
  • in a profit center, financial criteria could include contribution margin, direct business unit profit, controllable business unit profit, income before taxes and net income.
  • in an investment center, decisions need to be made in definition of profit, definition of investment, and choice between ROI and EVA.
Term
Two kinds of Adjustments for uncontrollable factors
Definition
  • removes expenses that result from decisions made by executives above the business unit level
  • other one eliminates the effects of losses caused by "acts of nature" (fires, earthquakes, floods) and accidents not caused by manager's negligence
Term
Benefits of short-term financial targets
Definition
  • good idea to link bonus to achieving annual financial target (after making allowances for uncontrollable events)
  • induces managers to search for different ways to perform exisitng operations and initiate new activities to meet financial targets
Term
Limitations of Short-Term financial targets
Definition

relying only on financial criteria could cause severeal dysfunctional effects:

 

  • encourages short-term actions that aren't in a company's long-term interest (under maintenance of equipment)
  • managers might not undertake promising long-term investments that hurt short-term financial results
  • managers may be motivated to manipulate data to meet current period targets.
Term
mechanism to overcoe short-term bias
Definition
  • supplement financial criteria with additional incentive mechanisms can overcome short-term orientation of annual financial goals
Term
weaknesses of mechanisms to overcome short-term bias
Definition
  • managers have difficulty seeing the connection between efforts and rewards in a multi-year scheme, which lessens motivational effect of such awards
  • if a manager retires or is transferred during the multiyear period, implementing a plan becomes more complex.
  • likely that factors beyond the manager's control will influence the achievement of long-range targets.
Term
benchmarks for performance comparison
Definition
  • appraised by comparing actual results to profit budget, past performance, or competitors performance
  • business unit manager participates in development of budget and budget is challenging but attainable is also important
Term
Bonus Determination Approach
Definition
award can be determined by using a strict formula, such as % of business unit operating profit, or by purely subjective assessment by a manager's superior, or by some combination of the two
Term
One drawback of bonus determination approach
Definition
objective formulas are likely to induce managers to pay less attention to performance of their business units laong dimensions that are important but difficult to quantify
Term
Some subjectivity in determining bonuses is desirable in most units, esp. when manager's personal control over performance is low.  This happens when:
Definition
  • when business unit manager inherits problems created by a predecessor
  • when busienss unit is highly interdependent with other units and therefore its performance is influenced by decisions and actions of outside individuals
  • when strategy requires much greater attention to the longer-term concerns (as in case of business unit in a rapidly evolving industry)
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