Page 58 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

44 The Complete Guide to Executive Compensation

If there is other business income (e.g., alliances and comarketing ventures), it probably has a
separate line directly under net sales. This is followed by the cost of goods sold, or cost of sales
($37,459,700), namely, what it cost to make or buy the product (e.g., cost of materials used
and other manufacturing expenses such as pay and overhead). The reduction of sales by cost
of goods sold leaves gross margin ($64,086,700). This is a useful measurement for manufac-
turing and retailing pay plans. The next category of expenses is operating expense. In this cat-
egory are found research and development ($17,366,500), sales and marketing ($16,954,700),
and general and administrative expenses ($5,398,400). The latter includes compensation and
benefit costs (except for those directly involved in the cost of goods sold), including all exec-
utive compensation costs. If a company uses its own employees to construct a fixed asset (e.g.,
a building), the compensation and benefits costs will be added to the value of the asset and
depreciated over time. Incentive plans to be paid out after year-end have the estimated pay-
ment accrued quarterly over the year with the final amount “trued up” when payment is
made. To be eligible to charge the expense during the year, even though paid after the year,
the payment must generally be within 75 days of the close of the year. Multiyear plans with
payment only after the end of the multiyear period similarly have their estimated payout
accrued over the year, with the estimated amount calculated quarterly. Again, the final
quarter before payment will have the accrual trued up to match the actual expense.
Netting operating expenses from gross margin results in EBITDA (earnings before inter-
est, taxes, depreciation, and amortization). In this example, the amount is $24,367,100. Some
choose to use this amount for SBU incentive plans as it includes expenses within the control
of the unit. However, it is not usually appropriate at the company-wide level, as senior cor-
porate management should be held accountable for capital expenditures and acquisition
expenses. The category also includes depreciation ($1,387,600) for the period on equipment,
building, and property, as well as amortization of goodwill ($2,624,800), and patents and fran-
chise fees, if any. When all operating expenses have been removed, operating income
($20,354,700) remains, sometimes referred to as EBIT (earnings before interest and taxes).
Those who believe CEOs and other key corporate executives should neither be rewarded nor
penalized for changes in tax rates (which are out of their control) will use EBIT in their
incentive plan calculations; however, doing so also gives them a “free ride” on interest
charges.
Next, one includes interest expense ($3,845,700) and other income (e.g., gains or losses on
investment sales, fixed assets, and affiliate earnings—a loss of $1,764,900 in this example).
This results in income before provision for income taxes and extraordinary items, often
referred to as pretax income—$18,273,900 in the example—which is probably better for
CEOs and other top corporate executives than EBIT. Reducing this amount by the provision
for income taxes for the year ($6,714,800) results in income before extraordinary items
($11,559,100). Extraordinary items net of tax are sometimes referred to as “acts of God,” per-
haps an uninsured loss from an act of nature (e.g. avalanche, earthquake, fire, or flood).
Subtracting this amount of $418,500 leaves income from continuing operations ($11,140,600),
a figure usually of high interest to financial analysts and investors. Subtracting the effect
of discontinued operations net of tax ($1,481,800) leaves net income ($9,658,800). This is also
called net earnings, net profit, or the bottom line. Many argue that this figure should be used for
incentive calculations at the corporate level as it includes all the costs.

Cash Flow Statement. Income is not synonymous with cash, and therefore, a cash flow state-
ment showing the source and amount of cash receipts and payments is a useful supplement to