Tuesday, October 30, 2012

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 goals of a company.


7 comments:

  1. I think it'a also likely to result in less corruption. Stepping back from hard economics, and into behavioral econ, Dan Ariely explains how stealing stocks doesn't cause the same feeling of guilt as stealing money. And so using stocks as compensation actually contributes to the immoral behavior of executives:

    http://www.youtube.com/watch?v=nUdsTizSxSI

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  2. https://www.facebook.com/photo.php?fbid=761872830491982&set=a.404595876219681.103599.142474049098533&type=1&theater

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  3. Commissions and incentive pay schemes as forms of motivators to increase productivity may be effective for work requiring repetitive or routine tasks such as on an assembly line. But, in settings in which creative problem solving or heuristic work is the custom these rewards may be much less effective at accomplishing their intended goal. It seems that all too often the practice of commission pay is anchored more in tradition than on reason, as the most conventional approach for bringing about a greater level of effort, such as from a sales force. Since the effectiveness of any motivator varies with the particular task, perhaps a break with tradition is worth examining. Rather than “if, then” reward based solely on individual performance, an alternative compensation scheme that some firms employ, and reap benefits from, places focus on not only compensation through salary but, also through some percentage of compensation linked to the organizations overall top-line growth, profits, and earnings per share. In other words, compensation closely linked to economic profit.

    Source: https://hbr.org/2012/07/a-radical-prescription-for-sales

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  4. I don’t really like Stock Trading, it’s way too risky, so that’s why we need to be extremely careful in how we work. I only prefer Forex trading which is extremely profitable for me and brings massive rewards. I would say maximum credit goes to my broker OctaFX, it’s a solid company with lovely conditions which includes low spread of 0.2 pips, high leverage up to 1.500 plus smooth trading platform so that helps me trade even better to succeed.

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  5. Many organizations utilize recognition programs as part of an employee incentive plan. When an employee feels valued and appreciated for contributions that advance an organization's goals, he or she is much more likely to be engaged and feel a sense of personal satisfaction. Positive feedback and open lines of communication between management and staff also inspire employee motivation and can often increase productivity or have them work towards the organization's bottom line.

    Many businesses seek ways to reduce operational or employee benefit costs by implementing incentive plans. As an employee of a large integrated health system, one method that is utilized by my employer is an aggressive health and wellness program. This program promotes and encourages employees to make healthier lifestyle decisions, and offers financial incentives to those employees who demonstrate proven success in such areas. By promoting and maintaining a healthy workforce, employees sick time has been drastically reduced, as well as doctor and hospital visits. As the healthcare provider for its own workforce, such programs, when successful, can boost an organization's profitability and motivate employees to "do the right thing" for themselves.

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