Just Rewards

Linking incentive compensation to business unit performance can be a win-win option for managers and the organization. But crafting a workable plan requires customizable metrics and intensive monitoring.

Perhaps more than any other employee group, the managers and executives running a company’s business units need incentive compensation programs that reflect their unique responsibilities. Unfortunately, they often do not get them.

"There are two diametrically opposed trends that have gotten extremely popular — EVA [economic value added] and the Balanced Scorecard," said Rich Semler, principal and worldwide practice director of management, performance and rewards with management consulting firm Sibson & Co. LLC in Los Angeles. But neither performance measurement system is usually the best tool for designing middle-management incentives. Proponents of EVA say that everything managers do can be reduced to one metric: net operating profit after taxes (NOPAT) above the cost of capital. Balanced Scorecard advocates say just the opposite, recommending that companies emphasize a host of operational, financial and customer-driven performance measures. "In my experience, both of those are ultimately flawed," Semler said. A single measure provides middle managers with no guidance on what they have to do differently, while "the problem with the Balanced Scorecard is that it tells them to do everything differently," he said.

EVA and the Balanced Scorecard aside, management incentives often provide little direct connection between a manager’s responsibilities and how the plan compensates him or her. "A lot of people think that managers are bright people and know business economics, so that should be enough," said Ted Slaughter, a principal with William M. Mercer Inc. in Chicago. But it often is not enough.

Consider the situation faced by a Fortune 100 company. Trying to work itself out of an extended period of flat stock price, the company took a hard look at its management incentives, which it had long based completely on overall corporate results. The company "spread its compensation like peanut butter, with everybody getting the same size bonus," said Semler. As a result, some business units were so focused on growth, without attention to the use of capital, that they were actually destroying value. At the same time, other business units were creating value, and the company was not rewarding those managers for their efforts.

To address these problems, the company developed short- and long-term incentive programs for the managers in each business unit, with goals based on profit above the cost of capital. As a result, managers became very careful about their capital usage, divesting businesses that didn’t contribute to desired results and forgoing acquisitions that would not provide earnings above the cost of capital. "The businesses got very focused on making themselves successful, and it created a tremendous performance culture at the business unit level," said Semler. As a result, the company’s stock outperformed the S&P 500 for several years after the plan’s introduction.

Such performance improvements don’t come easy. Developing workable and relevant management incentives requires executives to make some important decisions about what level of corporate performance to reward and how to measure that performance.