Page 387 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 7. Short-Term Incentives 373

Divisional Funds. From one main corporate fund, divisional funds may be generated by
either quantitative formula or qualitative judgment. Unless, in fact, the division is a wholly
integrated operation, it is unlikely that the same formula used for the corporate fund can be
applied at the divisional level. Even if it could, the number of participating executives (and
their level of pay) often does not relate in a consistent fashion to the profit level, thus
making a common formula ineffective. More commonly, reference is made to the degree of
success in attaining divisional goals.

Assessing Divisional Performance. Self-standing division formulas are much more likely to
be present in nonrelated, multi-industry companies when the corporation’s role is essentially
one of providing capital. In such a situation, it is not unrealistic to have separate bonus plans
for each unit based on percentage of profits above a stated return on investment. As the invest-
ment in the unit increases, so does the income needed in order to generate a bonus fund.
The basis for judging divisional performance under a corporate fund can range from use
of a single factor (such as return on investment for a profit-making unit) to a number of finan-
cial and nonfinancial factors. In addition, bookkeeping calculations can be made to adjust
financial performance. For example, divisional profits may be reduced by a corporate charge
for use of capital. This is similar to the economic profit approach described earlier. This could
be a simple charge on all capital or a higher charge beyond a certain amount. In the first
instances, if the company charges 7.5 percent, a division with $100 million of assets would
have profits reduced by $7.5 million; in the second approach the same division would be
assessed $7.3 million if the charge were 7 percent on the first $90 million and 10 percent of
anything above. Both require determining a minimum percentage to ensure divisions recog-
nize the cost of capital and don’t simply rush to increase profit without regard to capital costs.
The second formula requires determining the desired capital base to ensure the division is not
undercapitalized, the formula can be changed to charge only above a specified amount (e.g.,
$90 million). This determination should be made on a division-by-division basis. For those
who find this too cumbersome, an interim step such as a charge on excess inventories can have
a similar effect, although more narrowly defined (in this case keep inventories down).

Performance Factors. While the use of only one factor to determine performance is
certainly simpler, it provides no reinforcement of other performance factors. Regardless of
the number of factors, ideally, performance should be quantifiable in accordance with a
previously agreed-to measuring basis and the various scores connected to specific levels of
performance. In addition, the unit being rated should have access to the data throughout the
year, not simply at year-end.
Any payment in relation to profit budget (the amount of profit management hopes to
make for a stated period) places an emphasis on accurate forecasts. If top management
imposes such a relationship, it is outside the unit’s control; if the unit develops it, it encour-
ages conservative estimates. In addition, a unit may increase its own profitability (and
bonus fund) by taking actions not in the best interest of the company (or even the unit in
the long run).
We can argue that forecasts and performance can always be adjusted for factors outside
the unit’s control. Conceptually this is logical; unfortunately, it is often difficult to quantify,
much less identify, uncontrollable factors.
Not to take into account extraordinary circumstances (e.g., to say, “Let the chips fall
where they may”) is to either overreward mediocre performance or underreward outstanding