Page 369 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 7. Short-Term Incentives 355

those wanting to reinforce importance of the company will add a company value (perhaps
10 percent), proportionately reducing group and subgroup.

Individual Performance
It has often been said that what gets measured gets attention. When measurements set the
level of pay, they get a lot of attention. Because of the short time frame (a year or less) and
the inclusion of an individual performance component, short-term incentives more than any
of the other four pay elements focus the individual on what has to be done. It is, therefore,
critical that the measurements be selected carefully and that they support the achievement of
the business plan. Furthermore, objectives should not only be attainable but also should be
limited in number. Too many objectives dilute focus.
As stated in Chapter 2, performance should not be judged by financial measurements
alone. While they may be easy to attain, financial measurements do little to illustrate how
value is created.

SETTING THE TARGET

In setting the goal, planners have several choices. One choice is to examine historical results,
namely, last year’s and maybe several years before it. This is called the look-back approach.
Another choice is to essentially build a goal from the bottom up, much like zero-base budget-
ing establishes a budget beginning with zero. This is called the look-forward approach. A third
choice is to use the data from a given peer group. This is called the look-around approach.
Historical (Look-Back) Approach

The historical approach often uses a fixed-percentage increase to establish the following
year’s target [e.g., a 15 percent increase over previous year’s earnings per share (EPS)]. This
has the benefit of simplicity but most assuredly will either be too generous or too conserva-
tive depending on the circumstances. Namely, it can be affected by acquisitions and divesti-
tures, as well as a change in accounting. Recalculating both periods on a comparable basis can
offset this impact; however, the results are artificial. Using the formula in Table 7-7, the
bonus calculation is shown in Table 7-8. In this example, the threshold payment is 5 percent
(for a 6 percent increase in both factors over the previous year). The target award is set at
25 percent for a 10 percent increase in both measurements, and the maximum award is
100 percent of salary for an increase of 20 percent or more in both measurements. Note that
the unadjusted financial results would result in no bonus. However, by recalculating for the
ongoing business, a payment is made.
The advantage to this approach is that it focuses on continuous improvement and avoids
gamesmanship of managers lowballing targets for high payouts. The disadvantage is that it is
not sensitive to outside factors. Note also that the increase in sales per share serves as a circuit
breaker limiting the payout on earnings per share. This is a common feature on a multiple-
performance-measurement plan, with the circuit breaker being the most important factor.

Business Plan (Look-Forward) Approach
The look-forward approach requires setting targets each year based on an assessment of
threats and opportunities to the company. This approach allows individuals to lowball or