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Executive Bonuses

Performance and Bonuses

IntroductionThere is a feeling that there is something going wrong with capitalism. Since 2000, the wages of median employees have hardly raised while at the same time the pay at the top grew many times and that especially financiers are overpaid. When at the height of the 2008 financial crisis the financial industry required a bailout of more than $1 trillion from US taxpayers, it became known that bonus payments of Wall Street banks were totalling $18 billion, the president Barack Obama gave expression to this feeling by publicly naming this shameful. A year later, the 2009 G-20 meeting in London called for more regulation of financial markets and stated a firm opposition to further financial stimulus packages. When in 2010 the European sovereign debt service became a severe threat for the EU and as it again turned out that financial institutions had played a role by having lent recklessly to governments and private borrowers thus causing overspending and property bubbles, part of the blame for the crisis was put on these institutions. The public wondered why their directors had to be paid millions of euros worth of bonuses when their institutions had to be saved with public money. Then when in early 2012 it became known that the board of the Royal Bank of Scotland, a bank that is 82% state owned after a government's bail-out, agreed to pay its main executive a bonus worth £963,000, it caused such a public outcry that within days he decided to turn it down.Bonuses have come under fire; it is believed that they lured top bankers and managers into socially wasteful investments and are regarded as the main drivers of greed and irresponsibly short-sighted behaviour. An often stated justification is they are high because elsewhere they are even higher. But even when the bonus payments have come under intense criticism, they are also considered important instruments for motivating managers and employees.Bonuses are useful as complements to compensation packages when awarding good performance in terms of the underlying goals and as a variable compensation component based on performance, both of which will motivate executives.However, they are only useful when the owners, typically the shareholders, clearly specify the underlying goals. The problem is that these bonus systems are often poorly designed. They often only loosely or ineffectively align the financial interests of managers with those of owners.The StructureThis page presents an example on how to structure a bonus decision in a transparent way based on performance. It shows the three goals that need to be achieved which are: "Shareholder" the firm's performance has been good for its shareholders, "Profit" firm's profit is sufficient and "Liquidity" Firm's liquidity is sound.

Each of the three goals has specific objectives expressed as ratios. To indicate what is expected of an executive, the board can attach a weight of importance to each of the three goals, show what it wants him to have achieved with the firm in a certain period by determining maximal and minimal values for each of the ratios and giving each an importance in the form of a weight. At the end of the period the actual achievements will determine the size of the bonus.This decision structure is modelled in an MS Excel workbook. The contents of the excel workbook sheets is shown in the PDF file here on the left. Its last pages show examples on how the changing in weights and differences in scoring have an effect on the size of the bonus awarded. To open this PDF file, click on the button at the left. A click on the "Movie ON" buton shows in a movie the Exel sheets and the effects of weighting. The Excel file also can be obtained. A click on the button opens a secured "PayPal" site where after having paid €15 for the file with Paypal or a credit card, it will be possible in a "Click2Pay" site to download the file.

In ConclusionThis example shows that, with a commonly known piece of software present on most people's computer, it is possible to make the justification for rewarding a bonus simple to explain and to be easily understood.It shows that the bonus can be based on firm’s policy as expressed in its goals and on firm’s actual performance. On the one hand, it puts the board in a position to specify what it considers reasonable to expect from an executive and on the other hand, it provides a transparent justification and explanation towards their shareholders and the general public of why the executive was worth the bonus.

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