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Management Compensation Essay

1296 words - 6 pages

For organisations to achieve their goals, it is important that management control systems motivate managers and influence their behaviour to align their goals with the goals of the organisation (goal congruence). This can be achieved by reward and incentive systems because managers will tend to focus on the activities that are rewarded. Research have shown that people will be more motivated by the potential of earning rewards than by the fear of punishment.

A managers total compensation package consists of salaries, benefits and an incentive compensation. Incentive compensation plans are divided into short-term and long-term plans.

Under a short-term plan, managers are usually paid in ...view middle of the document...

But a disadvantage is basing the bonus on accounting measures of performance.

For business unit managers, incentives can be financial, psychological or social. Some organisations have a fixed pay system, which pays a high salary and at the same time expect the manager to perform well. This system emphasizes on salaries rather than incentives, which can lead to managers feeling conservative by holding back change and innovation. Also, if the manager does not perform well, this can be problematic for the organisation. Another, more preferred system is to expect the managers to perform well, and paying them according to the level of performance. This system emphasizes more on incentive bonuses instead of salaries.

Top-level managers often have difficulty deciding on which criteria to determine incentive bonus plans for business unit managers. If the business unit is a profit centre, the financial criteria could include contribution margin, direct business unit profit or net income. If the business unit is an investment centre, decisions need to be made in three areas such as definition of profit, definition of investment and the choice between return on investment and EVA.

The Agency theory explores how rewards and incentives can be used to motivate individuals to achieve goal congruence. The concept of Agency theory is that one party (the principal) hires another party (the agent) to perform services and delegate decision-making authority to other agents. The challenge for businesses is to motivate the agents to attain organisational goals. However, principals and agents may have conflicting preferences or objectives, these problems can be dealt with by monitoring and incentive contracting. Under monitoring, the principal can design control systems that monitor the actions of the agent, for example, the use of audited financial statements. However, monitoring is only efficient if the agent’s task is well defined and the information used in monitoring is accurate.
With incentive contracting, a principal establishes appropriate incentive contracts, which rewards agents depending on a performance measure, resulting in the manager consistently improving the measure.

There are arguments that bonuses based solely on financial measures such as profits causes managers to focus on short-term results by sacrificing long-run performance. In order to move away from this, organisations should implement compensation plans that enhances financial measures with non-financial measures to assess performance that have not been taken into account in short-term results. However, when dealing with multiple performance measures, it can be difficult to determine the weights to place on various measures when determining bonuses. One option is to use a formula that explicitly weighs each measure. Another is to introduce subjectivity into the bonus award process, however it is argued that subjectivity can decrease motivation.

By using a balanced scorecard...

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