Name : Mutiara Izzati Diva

Student ID : 1910533027
Management Control System
Summary
Management Compensation

Introduction

The incentive compensation system is a key management control device. Since it is an

important mechanism that encourages and motivates managers to achieve organizational
objectives. Incentives tend to support:

1. Individuals get strongly motivated by the potential of earning rewards than the fear of
punishment.
2. A personal reward is relative or situational.
3. If senior management by its actions regards the management control system as import
ant, operating managers will also regard it likewise.
4. Individuals are highly motivated when they receive reports or feedback about their per
form
5. An incentive becomes less effective as the period between an action and the feedback
increases.
6. Motivation is the weakest when the person perceives an incentive as being either unatt
ainable or too easily attainable.
7. The incentives provided by the budget or other statements of objective are the stronge
st when managers participate actively along with their superiors in the process of arriv
ing at the budgeted amounts

Characteristics of Incentive Compensation Package

A manager’s total compensation package consists of three components:

1. Salary
2. Benefits and perquisites and
3. Incentive compensation

The three components are interdependent but the third is specially related to the managem
ent control function.
 Incentive compensation plans can be divided into:

 Short-term incentive plans, which are based on performance in the current year and
 Long-term incentive plans, which relate compensation to the longer-term accomplish
ments. The manager may earn a bonus under both plans. Short-term bonus is usually p
aid in cash whereas long-term bonus plan usually consists of an option to buy the com
pany’s equity shares at some price other than market value.

Short-term Incentive Plans

First of all, the total amount of bonus that can be paid to a qualified group of employees i
n a given year which is called the “bonus pool”, is decided based on overall profitability in th
e current year (in some companies, the current quarter) and also make the total compensation
paid to executives competitive.

Several methods of establishing bonus pool:

1. Bonus equal to a set percentage of profits.

2. To base bonus on a percentage of earnings per share, over and above a predetermined
level of earnings per share.
3. To relate profits to capital employed.
4. To define capital as equal to shareholder equity.
5. Base bonus or increase in profitability over the previous year.
6. Base bonus on company profitability relative to industry profitability.

Long-term Incentive Plans

The basic premise of long-term incentive plans is the growth in the value of company
shares; reflect company’s long-run performance. There are several types of such plans. The p
opularity of specific plan changes with factors like changes in income-tax law, changes in acc
ounting treatment and the state of the stock market.

1. Stock Options: A stock option is a right to buy a no. of shares at or after a given date i
n future (the exercise date) at a price agreed upon at the time the option is granted (us
ually the current market price of 95% of the current market price).
2. Phantom shares: This method awards managers a number of shares for bookkeeping p
urposes.
 3. Stock appreciation rights: A stock appreciation right is a right to receive cash payment
s based on the increase in the value of shares from the time of the award until a specifi
ed future date.
4. Performance shares: A performance share plan awards a specified number of shares to
a manager when specific long-term goals have been met i.e., percentage growth in ear
nings per share over a three to five year period and was not influenced by stock prices
due to reasons other than increase in company’s earnings
5. Performance units: In a performance unit plan, a cash bonus is paid on the attainment
of Notes specific long-term targets. This plan, thus, combines aspects of stock appreci
ation rights and performance shares. This plan is useful in companies with little or no
publicly traded stock.

Incentives for Business Unit Managers

A wide range of options exist in developing an incentive compensation package for b

usiness unit managers.

- Types of incentives:
❑ Financial rewards
a) Salary increase
b) Bonuses
c) Benefits
d) Perquisites
❑ Psychological and Social Rewards:
a) Promotion possibilities
b) Increased responsibilities
c) Increased autonomy
d) Better geographical location
e) Recognition
- Size of bonus relative to salary:
❑ Business unit profits
❑ Lower cut-offs
- Bonus based on:
❑ Business unit profits
 ❑ Company Profits
❑ Combination of the two
- Performance criteria:
❑ Financial criteria
a) Contribution margin
b) Direct business unit profit
c) Controllable business unit profit
d) Income before taxes
e) Net income after tax
f) Return on investment
g) Economic value added
❑Time period
a) Annual financial performance
b) Multi-year financial performance
❑ Non-financial criteria
a) Sales growth
b) Market share
c) Customer satisfaction
d) Quality
e) New product development
f) Personnel development Notes
g) Public responsibility
❑ Relative weights assigned to financial and non-financial criteria
❑ Benchmarks for comparison
a) Profit budget
b) Past performance
c) Competitors performance.
- Bonus determination approach:
❑ Formula based
❑ Subjective
❑ Combination of the two
- Form of bonus payment:
 ❑ Cash
❑ Stock
❑ Stock options
❑ Phantom shares
❑ Performance shares

Performance Criteria

To decide the criteria, as the basis for deciding bonus for business unit managers, the f
ollowing need to be considered:

1. Financial criteria: If the business unit is a profit center, the choice of financial criteria
include contribution margin, direct business unit profit, controllable business unit prof
it, income before taxes and net income after taxes.
2. Adjustments for uncontrollable factors: In addition to selecting the financial criteria, a
djustments need to be made for uncontrollable factors such as: expenses as a result of
decisions made by executives above the business unit level (to close a factory that was
working at 30 % of capacity) and to eliminate the effects of losses due to acts of natur
e (fire, earthquakes, floods) an accidents not arising due to negligence of the manager.
3. Benefits and shortcomings of short-term financial targets: Linking business unit mana
ger’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.
4. Mechanism to overcome short-term bias: If financial criteria are supplemented with a
dditional incentive mechanism shortcomings of short-term financial targets can be avo
ided.
5. Benchmarks for comparison: The performance of a business unit manager can be appr
aised by comparing actual results with the profit target, with past performance or with
competitor’s performance