Page 220 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 11: Management Compensation

investments put in, which in turn gives additional profits although the performance of the Notes
company may remain static or even deteriorating.
2. To base bonus on a percentage of earnings per share, over and above a predetermined
level of earnings per share. This method does not consider increases in investment from
reinvested earnings. This problem can be tackled by increasing the minimum earnings
per share year by a percentage of the annual increase in retained earnings.
3. To relate profits to capital employed i.e., shareholders’ equity plus long-term liabilities.
Bonus is equal to a percent of the profits before taxes and interest on long-term debt minus
a capital charge on the total of shareholders’ equity plus long-term debt. This is similar to
Economic Value added concept or Residual Income method. The difficulty with this method
is that a loss year reduces shareholders’ equity and thereby increases the amount of bonus
to be paid in subsequent profitable years.
4. To define capital as equal to shareholders’ equity. This has the same disadvantage as in the
earlier method.

5. Base bonus or increase in profitability over the previous year. This method rewards a
mediocre year that follows a poor one but also fails to reward a good year if it happens to
follow an excellent one. This problem can be partially corrected by basing the bonus on an
improvement in the current year that is above moving average of profits in the number of
past years.
6. Base bonus on company profitability relative to industry profitability. Obtaining
comparable industry data may be difficult because few companies have the same product
mix or employee identical accounting systems. This method also could result in a high
bonus in a mediocre year because one of the competitors had a poor year.

Notes In calculating both the profit and capital components of the above bases, adjustments
may be made in the reported net income because of extraordinary gains and losses on
account of discontinued operations.

Similarly, goodwill resulting from acquisition is to be excluded though included in the published
financial statements.
Instead of paying the total amount in the bonus pool, the plan may provide annual carry over of
a part of the amount and the extent of accumulated carryover to use in the current year if the
bonus otherwise be too low in the current year. These are decided by the committee of the board
of directors. His method of Carryover offers more flexibility since payment is not determined
by a formula and the board of directors can exercise its judgement. Again, it reduces the magnitude
of swings that occur when bonus payments is strictly based on the formula. The disadvantage of
this method is that bonus is less related to current performance.

Though the amount of bonus is calculated annually, payments to recipients may be spread over
a period of years 5 or 3. Under this system, executives receive only one-fifth or one -third of their
bonus in the year in which it was earned. Balance portion is paid equally over the next four years
or two years as the case may be.
This deferred payment method offers a number of advantages:

1. Managers can estimate, with reasonable accuracy, their cash income for the current year.
2. Deferred payments smoothen the managers’ receipt of cash because the effects of cyclical
swings in profits are averaged in the cash payments.

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