Page 226 - DMGT514_MANAGEMENT_CONTROL_SYSTEMS

Unit 11: Management Compensation

3. Benefits and shortcomings of short-term financial targets: Linking business unit manager’s Notes
bonus with annual financial targets after adjusting uncontrollable factors may induce
managers to search for ways and means to improve the financial targets, which may lead
to the following:
(i) The short-term actions which are not in long-term interests of the company (e.g.
under the maintenance of equipment) may be encouraged.
(ii) Managers may not for new investments which will benefit long-term at the expense
of short-term financial results.
(iii) Managers may be motivated to manipulate its accounting records to show higher
than actual profits.

4. Mechanism to overcome short-term bias: If financial criteria are supplemented with
additional incentive mechanism shortcomings of short-term financial targets can be
avoided. The following are the possibilities:
(i) To base part of the manager’s bonus on multi-year performance i.e., performance
over a three to five-year period, which has the advantage of extending the time
horizon of the managers. The approach has certain weaknesses. First, the efforts and
rewards in a multi-year award scheme lessen the motivational effect. Second, a
manager may retire or be transferred during the multi-year period resulting in lots
of complexity. Third, there is mere likelihood that factors beyond the control of the
manager will influence the achievements of long-range targets.
(ii) To develop a balanced scorecard including one or more non-financial criteria such
as sales growth, market share, customer satisfaction, product quality, new product
development, personnel development and public responsibility. Each of these factors
will affect long-run profits.
(iii) To base part of the business unit managers’ bonus on long-term incentive plans such
as stock options, phantom shares and performance shares. These plans focus the
business unit managers on company-wide performance and on long-term
performances. Advantages and limitations of these plans have been discussed in
earlier sections.
5. Benchmarks for comparison: The performance of a business unit manager can be appraised
by comparing actual results with the profit target, with past performance or with
competitor’s performance. Normal practice is to evaluate the business unit manager against
the profit budget and from the motivational point of view, the business unit manager
should participate in the development of profit budget and the budget is challenging and
attainable.
Bonus determination approach: A bonus award for a business unit manager can be determined
on the basis of either a strict formula such as: percentage of business units operating profit or a
purely subjective assessment by the manager’s superior or by some combination of the two.
Exclusive reliance and objective formula i.e., output control, has some merits; reward system
can be specified with precision with performance standards, and the superiors cannot exercise
any bias or favouritism in assessing the performance of subordinate managers. The major
limitation is that they cannot induce managers to look into other dimensions that are important
but difficult to quantify such as: R&D and human resources management, other than performance
criteria. Hence, some subjectivity in determining bonuses, therefore, is desirable in most units.

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