Economic profit replaces stocks as executive compensation

Wall St. is finally listening to what economists have been saying for years, that economic profit is a better way to motivate employees.  Not only does it make visible the hidden cost of capital by including a charge for the capital being used, but it also can measure the performance of individual business units.

With better performance evaluation metrics it is easier to align the incentives of employees with the profitability goals of an organization.  In particular, it "tells" employees that using capital has a cost, which makes it less likely that they commit the "hidden cost fallacy."

"Whatever compensation scheme you have, that's exactly what your employees are going to respond to," says Daniel Rinkenberger, CFO of Kaiser Aluminum Corp., KALU +0.47% which has used economic profit to decide short-term incentives for key employees since 2006. "It's driving them to do things our shareholders want, like not having excess assets in the pool. It drives people to be more efficient in how they have inventory deployed."

PepsiCo's new focus on economic profit will lower its capital spending to about 4.5% of sales this year, down from an historical average of about 5.5%, says Mr. Johnston, because employees are making better decisions. The company also has been able to cut the sums of money it has tied up in accounts receivable and inventory, boosting cash flow.

This story ties into several of the themes in the book:

• Chapter 1:  How to give employees enough informaiton to make good decisions, and the incentive to do so.
• Chapter 3:  How to avoid the hidden cost fallacy.
• Chapter 21 and 22:  How to align the incentives of employees and divisions with the profitability goals of a company.