Question

Discussion Case 6-1

Should We Implement an Earnings-Based Bonus Plan? Benjamin Vincent is the CFO of Annie Company. The company’s CEO has asked Benjamin to design an incentive scheme that will motivate employees to focus more on the company’s bottom-line results. Benjamin is considering a plan that will give each employee a bonus based on the company’s reported net income for the year. Each employee will receive an amount equal to the company’s earnings per share multiplied by either 10,000 times, 50,000 times, or 200,000 times, depending on the employee’s level in the company. Last year, Annie Company’s earnings per share was $1.32. Benjamin has asked you for your advice. In particular, he wants you to explain the disadvantages of having an earnings-based bonus system.

We Only Need Another $100,000!

Chris Titera is the CFO for Dallas Company. It is January 10, and Chris has just finished compiling the preliminary financial results for the most recent fiscal year, which ended on December 31. The preliminary results indicate that Dallas lost $100,000 during the year. Dallas is a large company (with assets in excess of $1 billion), so the $100,000 loss is essentially the same as zero. However, the board of directors thinks that it conveys a very negative image for Dallas Company to report a loss for the year, even if the loss amount is very small. As a result, it has instructed Chris to look at the numbers again and see if he can turn this loss into a profit. What things can Chris do, as the CFO, to turn this loss into a profit? What concerns should Chris have?

Answer 1

Disadvantages of Earning based Bonus System:

1) Employee Motivation: In general earning based bonus fails to drive the motivation of the employees who tend to be the liabilities (dead weight) rather than the assets in the team. When each employee get the same incentive (multiplier times the EPS), the performers and non-performers would be equally rewarded. This overall will fail to bring up the low performers given the fact they are making the same as the high performers in their team or those in the same level in the hierarchy.

2) External Factors: Employees who are diligent and high performers, might not be incentivized justifiably due to the  EPS of the company going down attributing to external factors, like Market Trends, Government Policies, Corporate Action, etc. In other words, in Earning based bonus system employees will miss out on opportunities due to factors beyond their control.

3) Entitlement vs Motivation: When employees get Earning based bonuses, they tend to see it as an entitlement similar to other company based perks. Thus eventually, this mode of incentive fails to motivate employees, because they tend to understand that their own contribution is in a "pin in a haystack", which hardly makes or breaks their potential to earn a certain amount of bonuses.

I think the next question is a separate question.

(It would be great if some additional information is provided, like the Income and Cash Flow Statements), however, I am mentioning some points with a general business perspective

1) Monetize Assets: Given the company has assets worth upward of billions of dollars, it can monetize on assets, Example: Leasing assets for a short period, selling off Non Performing assets

2) Employee Benefit: The firm can delay providing incentives, bonuses to a group of employees and provide them in arrears.

3) Leadership Incentive: The firm can certainly tie the incentives of the CXOs and leadership with the quarterly/annual loss in the short run to ensure the company can prevent posting net loss by an amount of $100,000. In the process, the Leadership can certainly take a cut in their incentives which will be beneficial for them in the long run, since posting loss (results in red), however, small may send the share prices of the firm down, which will eventually reduce the net worth of the leadership, because a significant amount of their annual compensation is provided in the form of company shares (ESOPS- Employee stock options)