Better Compensation Strategies For Todays Competitive Commerce

Increasing the value of an organization is a long term, step by step activity that must be managed in order to assure the best possible outcomes for the shareowners. In managing for organizational value increase, the focus is on the C-level executives and their actions, specifically on how to motivate them to make decisions that are good for the organization's future and that will increase the intrinsic future value of the company. As the article authors assert, what gets measured gets managed, and therefore the performance measurement of high level executives is important in supervising the good being of any organization. The problem is that the ways of measuring performance and the reward schemes have lagged behind the fast movements and changes of the business environment, this being a major issue which can cause real troubles for organizations in keeping up with the competitors. A poorly rewarded manager could hurt the organization by making decisions targeted at conforming to a dysfunctional performance incentive scheme, and from this many issues - such as misallocation of funds - can arise, which can lead to the sub-optimization of the enterprise future value.

The question is how to motivate a party to act on behalf of another, this being a known dilemma, that of the principal-agent problem. In motivating the employee, the principal (the employer) is hiring the agent (the employee) to pursue its (principal's) interests. Economists have thought and came up with a number of mechanisms that would align the interests of the employee with those of the employer: commissions, profit sharing, efficiency wages, and fear of firing or other methods to make people act with having in mind the interests of the employer. Basically, motivating the employee to act on behalf of the employer is the basic idea behind every employment contract, in which exist a compensation mechanism (the carrot) and various supervisory or control mechanisms (the stick). However, the reason why there are so many types of mechanisms trying to align the interests of the employee with those of the employer is simply that there is no bullet proof mechanism that works in all circumstances and for all organizations. Even more, these mechanisms are difficult to be made successful in practice, giving the large number of factors influencing both parties involved in any contract: differences between societies, the numerous organizational changes and the differences between organizational cultures, the differences between individuals and the different intrinsic or extrinsic motivators of each individual, plus the various personality types and many other factors. Therefore, organizations are continuously trying to create better incentives and reward schemes adapted to their organizations, which would achieve maximum performance with minimum effort.

The same agency problem is found in most employer / employee relationships, including when shareholders hire top level executives. The problem here is that the old compensation techniques are, as mentioned by the authors, are not associated with aligning the interests of professional managers with those of owners. Apparently, the size of the company is the only determinant of executive pay today, even though the reward schemes should be targeting more than just one objective. The reward scheme should focus on value creation, making sure that the decisions are increasing the value of the organization. Then, the reward scheme should limit the retention risk, which is higher during poor performing periods, and organizations should try to retain valuable employees, as their sum represents the total organizational value, and they are more valuable at the higher levels of the organization (such as top managerial level). Third, the reward scheme should focus on achieving its objectives at a reasonable cost. However, in practice, it seems that the rewarding schemes are not truly aligning the interests of employers with those of the owners, as many organizations are focusing on one aspect while losing sight of the other (equally important) aspects of the problem. One could say that motivating to achieve a desired behavior is not a simple one-dimensional issue, but a very complex, more like a multi-dimensional issue, with multiple facets and aspects that are all equally important.

Achieving motivation

The study of incentives stands at the basis of all economic activity, because the humans are purposeful beings. Finding out what motivates and enables particular behaviors is important in any organization at any level: finding what is the expectation that would encourage people to act in a certain way, and what are the factors that motivate a particular course of action are usual questions for both economists and business people. These questions are partly unanswered, but the best approach is for organizations to try and tweak the existing theories to their specific environment and culture, until the best possible solution and the strongest incentive scheme is found.

According to the different ways in which people can be motivated, there are many forms of incentives. If at the lower levels of the organization the motivation can be easier to manage, as low level employees do not make too many decisions and retention is less important, therefore the single most important issue being achieving the desired result at a reasonable cost. Most issues here are solved by salary, job security, fear of firing and other basic ways to motivate. At this level, promotions and other rewards (tournament strategies) are working, and the organization can benchmark employees one against the other, without worrying too much about the potential negative outcomes of such strategies, keeping everything under control. As opposed to that, at the top levels of the organization all the aspects related to decision-making, retention and cost are important, and they have to be balanced so that the outcome is as good as possible. Because of so many factors being important, finding the right incentive scheme is more complicated at the upper middle management and beyond. For example, using tournament strategies at higher levels of the organization can cause real problems, because these motivational strategies can reduce collaboration dramatically, even to the point in which employees can sabotage each other to "win" the reward. Also, these strategies, as they promote riskier behaviors, can lead to very poor decisions and a risky focus on the shorter term, while discounting the future of the organization; talking about this issue, the Enron case comes to mind. Therefore, the organizations must be very careful with the type of deferred compensation they adopt in the case of top level executives, in order to avoid the potential perverse effects of poor incentives.

The motivational theories that stand at the basis of organizational reward mechanisms start from the Maslow hierarchy of needs and Herzberg's two-factor theory (intrinsic/extrinsic), the hygiene factors theory, continuing with the drive and the drive-reduction theories and the incentive theory, the audience effect or the cognitive dissonance theory. There are many theories in behavioral psychology, and some are in contradiction with others, like the case of the incentive theory (based on positive reinforcement) and the drive theory (based on negative reinforcement). The vast number of possible outcomes of a reward strategy is pointing towards the need of case-by-case adaptation, which makes things difficult for organizations. And, if in the case of lower level employees the effects of these are less important, in the case of top level employees the potential negative effects are so potentially harmful for the organization that this issue must be taken into consideration carefully.

Measuring managerial performance

In order to motivate managers, there needs to exist an explanation for exactly what organizations expect from them - what is the best measurement of managerial performance, so that we can reward the appropriate actions leading the organization towards performance? This question leads us back to the value creation discussion, and it is obvious now that traditional accounting measurement practices are flawed, being prone to subjectivism, interpretations and being too easily manipulated. However, the traditional performance measurements are still leaned towards accounting measures, namely on profit and profit margins or rates of return percentages, and while it makes some sense to analyze the data resulted from the organizational activity, this can be done in many ways, some of which are providing a better understanding and offer a glimpse into the future performance of the organization (such as EVA rather than just monitoring profit margins or rates of return).

The better measurement techniques should consider risk, and this is one reason why the Economic Value Added (EVA) is superior to the traditional measures. The fact that EVA acknowledges and takes into consideration the cost of the capital (WACC), ignored by the traditional accounting, and the fact that EVA shows the increase in wealth for the organization after all the capital owners have been paid are important features of a better tool. In addition, EVA can be used at every level of the organization, for the entire organization or at project level, and a certain level of efficiency can be specified and targeted, which makes from EVA a perfect tool for managers in evaluating future performance of an organization.

Measurement is important - and how could it not be - if we don't measure, how can we understand what to improve, how and where to re-allocate resources or people, how we stand in comparison to other organizations (the competition), and ultimately, how can we know if the organization is efficient and cost effective? This, together with the common wisdom that says to eliminate unmeasured work or that frequent measurement enables timely corrective actions, gives an understanding of why measuring most organizational activities is important. However, multiple issues are limiting the usefulness of measurement, such as the heavy reliance on statistical tools and averages that discounts outliers, and the heavy reliance on rigid analysis and too little attention given to growth based and time based analysis such as the value added measures.

TABLE 1.The main purposes of Measuring Performance

Evaluate

Article name: Better Compensation Strategies For Todays Competitive Commerce essay, research paper, dissertation