This blog is about incentive bonus
Well-planned bonus programs can contribute to a company's competitiveness by encouraging superior performance and, ultimately, improving the organization's earnings and cash flow. Typically a major co mponent of executive compensation programs, an annual incentive bonus scheme can also help firms attract and retain highly talented personnel. However, there are several issues that should be considered in the design and implementation of such a program. One of these is the considerable amount of corporate funds that will have to be spent to provide incentives attractive enough to motivate executives to improve their performance. Another consideration is the potential damage an ineffective program may do to the organization. Management should keep in mind that a successful program is one that has an internal control structure and a sensible upfront design, offers fair and reasonable individual bonus rewards, and is well-managed.
An effective incentive bonus program can have a positive impact on an entity's growth. An ineffective one can have the opposite effect. Advice on how to achieve the former and avoid the latter.
Intensified global competition has highlighted the importance of effective incentive compensation programs for U.S. companies. An annual incentive bonus program is a popular and effective form of incentive compensation, and is usually a key element in any company's executive compensation program.
A bonus program provides suitable rewards to motivate superior performance from the key people who impact profitability of the company. An effective program should maximize current profitability and assist management in attracting and retaining the best managerial talent. Achieving such an ambitious goal is not easy and can involve pitfalls which must be understood and considered in the design of the program and in its' administration. Providing suitable rewards to motivate superior performance usually requires the expenditure of a significant amount of corporate funds. If the program is properly designed and administered, it should have a major positive impact on earnings and cash flow. An ineffective program may have the reverse effect and severely damage the company.
As a factor in recruiting and retaining the best executives the program must be externally competitive and internally equitable. The program must be viewed from the perspective of the total executive compensation package, the details of which are outside the scope of this discussion.
Significant monetary rewards are necessary if the bonus program is going to motivate management. Unfortunately, such rewards sometimes motivate behavior not envisioned by top management. Both financial management and the auditors should be aware of those areas that are susceptible to manipulation for increasing bonus pay-outs. The internal control structure of the company must be strong enough to support the bonus program needs and cope with the pressures created by the program. It must be sufficient to produce timely, reliable data on which bonus program decisions are made.
Timely financial results are needed because bonus programs are most effective if there is a short time between accomplishing the objectives and paying the bonuses. Obviously, if the data is not reliable, bonuses paid will be inappropriate for the actual accomplishments.
The motivational aspect of bonus programs puts much pressure on the system. While obtaining an understanding of the internal control structure, auditors should bear in mind that there may be a temptation to manipulate data used for bonus determination. Auditors should be familiar with the bonus program, and should take its provisions into consideration when assessing control risk and in determining the nature, timing and extent of substantive tests.
There are myriad examples of irresponsible acts by otherwise rational managers due in large part to temptations to influence the calculations. One example, which demonstrates why the auditors must understand and consider the bonus program, occurred at a mid-western division of a major corporation. A new division manager was appointed to turn around the troubled division. In his first year he increased income dramatically. Based on the bonus formula, he and the division executives were paid exceptional bonuses for far exceeding bonus targets. Senior management was so pleased that they promoted him to group vice president. He hired a new division manager whose first quarter sales were significantly below target. Losses replaced profits. The group vice president discharged the new manager and took over the division himself until he could find a replacement.
This situation occurred when both the internal and external auditors had decided to skip the year-end audit of this division. A subsequent audit disclosed that many unshipped orders were booked as sales during the fourth quarter. This explained the exceptionally high sales and earnings for the past year, and the inability of the new manager to ship a sufficient quantity of products during the first quarter of the new year. The group vice president and division controller were discharged. Situations like this negatively impact the corporation and the lives of many people.
There are many instances when the accounting is geared to the bonus rather than to GAAP, but most are much more subtle. Usually they involve under-accruing expenses, delays in recording accounts payable, and underestimating doubtful accounts receivable or slow moving and obsolete inventory. In all of these cases, management and their auditors should keep in mind the bonus calculation as a reason to increase reported income.
The basic design issues for an annual bonus plan are: Who is eligible? How are individual potential bonus awards determined? And how will a units' performance be measured in determining the total bonus payable to the unit's participants?
Eligibility
Only those employees whose performance can significantly impact the company's results should be eligible for incentive bonuses. This is easier to say than put into practice. Most companies use one of three approaches in determining which employees are eligible for bonuses: key position, salary level, or salary grade. The choice of approach usually depends on the size of the company. Smaller companies will probably be able to use the key position approach, for which potential bottom-line impact is the criterion for selection. The necessity of reviewing the list of eligibles annually for appropriate additions and deletions may make this approach impractical for larger companies. Salary-level or salary-grade selections are easier for larger companies to administer, with salary grade having the advantage of relating to a position rather than an individual's salary. When using the salary level approach, it is necessary to adjust the cutoff annually to avoid continual increases in bonus eligibles. The problem inherent in this approach is the strong pressure to raise peoples' salaries to or above the "magic" cutoff.
Whatever approach is used, there will be pressure to expand the eligible list. Bonus eligibility represents status as well as an opportunity to earn more money and is therefore coveted by many employees. There should be a rationale for determining eligibility and a determination of how the eligibles list will be expanded and over what period. If too many people are eligible for bonuses, the individual awards will be less meaningful. The impact of the program may be lost.
Bonus calculations for operating divisions are based upon financial data provided by the division's chief accounting officer, who, as a key employee, is usually a bonus participant. This conflict of interest may be resolved by making the position ineligible for bonus participation and increasing the salary to be competitive with the same position in companies which do not pay bonuses.
Individual Bonus Awards
To achieve the desired objectives of the program, potential awards must be significant enough to motivate the bonus participants and be tied to the achievement of the company's objectives.
If the bonus is only a small percentage of salary, it is unlikely to provide a stimulus to extraordinary effort. In many companies, the normal bonus opportunity for an executive with significant responsibility is 40% to 50% of salary, with an opportunity to earn double that amount for achieving truly outstanding results. Such amounts generate powerful motivation.
The key management personnel who will participate in the program are determined for each operating unit prior to the beginning of each year. Based on their responsibilities, they are assigned a bonus percentage. Each participant's annual salary is multiplied by the bonus percentage to determine his or her potential bonus. This potential bonus, which is commonly referred to as a participant's "bogy," is the expected bonus to be earned if two things happen: The unit must attain its specified bonus objectives, and the participant must perform well. The sum of all the participants' "bogies" is the amount the firm plans to allocate to the bonus scheme and is usually referred to as the "bonus pool" for the operating unit. The relative size of the individual "bogies" to salaries determines the degree to which the program will drive performance and focus attention on the organization's goals.
Measuring Performance
An operating unit's formula for earning a bonus is usually based upon the degree of success in attaining unit goals, which are stated in terms of performance criteria--operating income, cash flow, return on investment, etc. Where bonus programs involve more than one operating unit, i.e., divisions and/or subsidiaries, separate formulas normally are tailored to the circumstances of each unit. Corporate bonuses may be based on a formula using overall company criteria, or may be based upon a judgement by the compensation committee of the board of directors. In developing bonus programs, care must be taken to assure that attainment of unit goals will consolidate into attainment of corporate goals.
The selection of appropriate criteria is crucial to the success of any incentive program. The criteria must reinforce organizational goals and encourage behavior that leads to accomplishment of these goals. The key performance criteria for judging an operating unit are used as the bonus targets. Senior management's judgment of the relative importance of each criterion will determine the weight given to it in the bonus calculations. These quantifiable targets comprise the "contractual" segment of the bonus and relate to short range goals. If these target amounts are attained for the year, the bonus participants are rewarded.
Bonus target ranges for each criterion selected to achieve corporate goals are established. The bottom of the range is the point at which no bonus is earned, and the top is the point at which full bonus is earned. In between, a partial bonus is earned.
It is wise to use more than a single criterion of performance for earning a bonus. While using one criterion is simpler, there is no performance reinforcement for other important factors.
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