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April 01, 2012
How Economics and Business Management Apply To Compensation

Recently, we spoke with Alfred J. Candrilli, a partner at Organizational Consulting Group (www.OrganizationalConsultingGroup.com) and Marwaan Karame of Economic Value Advisors (www.ev-advisors.com) and the subjects of economics and business management played a prominent role in our discussion. Actually, that was by design. Candrilli and Karame propose a unique approach to creating a compensation program, and it involves a heavy dose of both.

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“Traditional incentive compensation plans are a solution for mediocrity,” Karame asserts. He points out several flaws in the typical program, which sometimes involve a threshold and a cap. Using salespeople to illustrate the flaws inherent in this method, Karame says that the threshold and the cap each tend to encourage ‘sandbagging.’

“If someone has sold enough to reach their cap for the year,” he says, “they may tend to slow down, holding off sales until the following year when they can again work toward their bonus. If they have failed to meet their threshold, the same thing may happen. Assuming they don’t get fired, they may stop trying while they wait for the opportunity to renegotiate their incentive plan with a lower threshold.”

Both of these tactics work against the company’s – and the shareholders, in a publicly traded company – best interests. That’s where the economics discussion really begins. Karame explains that Value Based Management creates an atmosphere where every department and every employee can contribute to the success or failure of the company. But first, they need to understand the business as a whole.

The Rational-Actor Paradigm
“Value Based Management is a business philosophy that is focused on value creation,” Karame says. In order to understand how it works, one must understand a few basic economic concepts. One of them is the rational-actor paradigm. It says that people act in a way that maximizes value, recognize their own self-interest, and usually are rational based on these things.

“Some make the argument that people are not rational,” Karame says. “But generally speaking, given the right people, the right information, and the right incentives, they are. If any one of those three is missing, they may not appear to act rationally.”

Self-interest is often the root of human behavior, and that may or may not be a bad thing, Karame explains: “Self-interest drives employees to promote the interests of the company. Value Based Management is a way to extend that self-interest concept to the company. It is more than a measure of performance. Maximizing the long-term shareholder value means employees are giving their best every day. And it means directing resources toward the most productive or promising individuals, and making continued improvements. All of those require the right people, the right information and the right incentives.”

Value Based Management means emphasizing long-term value rather than short-term share price, Karame says. Enron is an example of a company that emphasized share price over value, and the result of that behavior has had a cascading effect ever since, in terms of legislation, transparency initiatives and consumer suspicion. Concentrating on share price can lead to wrong behaviors, as it did in that case. On the other hand, Value Based Management has a long-term, value focus, and tends to attract and retain employees who exhibit the qualities we all desire in employees – things like integrity, competence and diligence.

So how does one create shareholder value? What measures should be used, especially when different facets of the business (HR, operations, finance, sales) all seem to have competing agendas? “Economic value is the one true measure of value creation,” says Karame. “It provides focus, simplicity and line-of-sight.”

Creating Economic Value
“Economic Value is a financial performance measure of the true economic profit of an enterprise,” says Candrilli. “It simply states that value is only added if the operations of an organization return more than its cost of capital.”

To illustrate, think about a kid who has been investing in a publicly-traded lawn care business. His $500 investment has been returning 15% -- not bad. But, he believes he can make more by opening his own lawn care business. So he sells his shares (which costs him his 15% return) and borrows an additional $500 from his dad (at 5% interest). Applying some basic math shows that the weighted average cost of his total $1,000 investment in the business is 10%.

Economic Value is calculated simply with this formula: Net Operating Profit After Taxes, or NOPAT, minus capital charge.

In the case of our junior entrepreneur, sales are $2,500 and expenses are $2,000, leaving $500 in EBIT, or Earnings Before Interest and Taxes. The taxes are $200, for a NOPAT of $300.

The Capital charge is calculated using the capital amount and the cost of capital. In this case, the capital is $1,000 and the cost of that capital is 10%. Multiplied together, the capital charge is $100.

Economic Value, as defined by Candrilli and Karame, is the difference between the two ($300 - $100 = $200 EV). A very positive outcome for the new business venture.

By educating employees at all levels about Economic Value, they can easily see how their personal contribution to the company’s success will also contribute to their own success.

Karame says he worked with a VP of Finance at one company where all employees of the organization – from executives to the shop floor – were trained about Economic Value. The VP of Finance was skeptical that lower level employees would truly understand the concept. So as they walked through the work area, he stopped a forklift driver, and asked him how to calculate economic value. Without hesitation, the driver answered correctly, “NOPAT minus capital charge.”

Believing that perhaps the driver had been coached, the VP pushed further, asking “How does your job impact EV every day?” The forklift driver looked toward a pile of boxes in the corner of the warehouse. He said, “As that stack of boxes gets smaller, capital charge on inventory is reduced. Warehouse space can be consolidated to reduce overall invested capital, directly increasing EV.” Needless to say, the VP of finance now understands that employees at all levels of the organization can apply this information.

“In a traditional pay-for-performance compensation plan, the targets are often not tied to shareholder value,” Karame says. He and Candrilli believe that an effective compensation plan should apply a Value Based Management philosophy in order to align business interests with the creation of value. The ultimate measure of value creation, Candrilli says, is Economic Value, as exhibited by our lawn mowing entrepreneur.

Focus Comp Plan on Long Term
Karame says he is not necessarily concerned that executives in publicly traded companies are overpaid. As long as they are paid based the value they bring, he says, he doesn’t mind if they get very wealthy; “as long as the shareholders get insanely wealthy – for the long-term.”

To build a compensation plan that includes Economic Value, Karame suggests removing limits, from thresholds to caps. He says the program should encourage long-term thinking by using a multi-year target, perhaps three years. He prefers to structure the bonus with 100% paid out in the current year when a particular target is met, then a partial bonus above that level. The balance goes into a bonus reserve account to be paid out at a later time. “Bonus reserves help avoid short-term thinking and excessive risk-taking, and encourage longer-term thinking,” he says.

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