A: Managerial Reward Schemes

A: Managerial Reward Schemes

1. Remuneration linked to minimum profit levels

   • Merits
     • This scheme would be easy to set up and monitor.
   • Demerits
     • scheme may lead to managers taking decisions that would result in profits being earned in the shortterm at the expense of longterm profitability
     • The scheme might also tempt managers to use creative accounting to boost the profit figure.
     • It could also lead to managers underachieving, i.e. relaxing as soon as the minimum is achieved.

2. Remuneration linked to economic value added (EVA)

   • Demerits
     • A potential disadvantage is that calculating the bonus may be complex.
   • Merits
     • EVA is a measure of the increase in the value of shareholder wealth in the period.
     • designed to more closely align the interests of the employee and the shareholder

3. Remuneration linked to turnover growth

   • Merits
     • Growth of the business and higher production levels can lead to economies of scale which in turn can help the business compete more successfully on price.
   • Demerits
     • IMPACT on Profitability
       • However, turnover growth could be achieved at the expense of profitability,
         • E.g. by reducing selling prices or by selecting high revenue product lines which may not necessarily be the most profitable.
           • Maximising turnover is therefore unlikely to maximise shareholder wealth.

4. An executive share option scheme (ESOP)

   • This scheme has the advantage that it will encourage managers to maximise the value of the shares of the company, i.e. the wealth of the shareholders. When an executive is awarded share options, the theory is that it is in their interests for the share price to rise, so they will do whatever possible to improve the share price. Their interests will be best served by working towards a goal that is also in the interests of the shareholders.
     • Such schemes are normally set up over a relatively long period thereby encouraging managers to make decisions to invest in positive return projects which should result in an increase in the price of the company shares. However, efficient managers may be penalised at times when share prices in general are falling.
   • Demerits
     • When directors exercise their share options, they tend to sell the shares almost immediately to cash in on their profit. Unless they are awarded more share options, their interest in the share price therefore ends when the option exercise date has passed.
     • If the share price falls when options have been awarded, and the options go ‘underwater’ and have no value, they cannot act as an incentive.
     • If a company issues large quantities of share options, there could be some risk of excessive dilution of the equity interests of the existing shareholders. As a result, it has been suggested that companies should recognise the cost of share options to their shareholders, by making some form of charge for options in the statement of profit or loss.
     • Directors may distort reported profits (creative accounting) to protect the share price and the value of their share options.