Page 383 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 7. Short-Term Incentives 369

have a significant impact on the bonus fund. Will the impact of extraordinary items be
removed from formula values? If so, within the Financial Accounting Standards Board
(FASB) requirements, who will make the decision?
The formal plan (including the fund formula) should be as broad as possible to allow the
executive compensation committee to make specific determinations within the plan parameters.
The Plan’s Fund

Developing the Fund Formula. Once the basic objectives have been identified, determin-
ing the number of bonus participants and the size of the bonus fund will set formula values.
The approximate amount of bonus dollars needed in a good year depends on overall prof-
itability, requirements for capital expenditures, and the stability of profits. Certainly, formula
figures will be lower if profits are high or stable, or if capital requirements are low. As these
change negatively, formula percentages will need to rise to allow for an adequate fund.
To quickly estimate the needed amount, multiply the percentage of bonus candidates
times the percentage of their salaries to be paid in incentives to determine the percentage of
payroll. The latter multiplied by the payroll indicates approximate dollars. For example, if
20 percent of the monthly paid employees will be eligible, and the awards will average
10 percent of their salary, then the bonus fund will need approximately $4 million for a $200
million payroll. This is only an approximation, however, and it will err consistently on the low
side because the candidates are paid more than the total group average. This can be easily
adjusted if one knows the average salary of candidates versus the total payroll. Thus, if the
candidates average approximately $100,000 in salary versus $50,000 for all monthly paid (twice
the average), then the needed fund is $8 million (i.e., $4 million 2).
To build the formula, determine how much bonus should be generated under moderate,
successful, and very successful financial conditions. Often these are called threshold, target,
and maximum. By summing the desired bonus amounts for each candidate under the three
conditions, it is possible to determine how much total bonus is needed. Normally, this is
adjusted upward by another 10 to 20 percent (better to err on the high side than the low).
Once the amount needed has been calculated, trial and error with various formulas will find
the one that best meets the requirements.
Testing the Fund Formula. To set up a formula-driven fund, calculate a target bonus for
every one and sum the totals. As most formula plans are a percentage of something, one can
solve for the unknown X.
For example, a company may choose to use a certain percentage of net income for nor-
mal awards. If last year’s net income was $10,000,000 and the sum of normal bonuses is
$1,000,000, then the bonus fund percentage should be 10 percent.
Next, one needs to determine what is the minimum or threshold amount that would be
paid to individuals. Typically, this is 10 percent to 20 percent of the normal award. Thus, if the
normal award for a particular job is $50,000 and the threshold was set at 20 percent of the
normal award, the threshold amount would be $10,000. The threshold is the lowest payment
above zero and is often described in terms of probability of achievement. For example, some
might set the probability of achieving the threshold at 80 percent and therefore set the thresh-
old payout at 20 percent of the normal award. Others might set the probability of achievement
at 90 percent and therefore the threshold payout at 10 percent of the normal award.
The formula is then further tested to see if it is appropriate at individual threshold
performance. If the sum of threshold performance awards were $100,000, it would suggest