Thursday, August 20, 2020

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.


9 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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  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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