4 Reasons Net Profit is a Poor Incentive Compensation Metric

 

The subject of incentive compensation systems comes up regularly in meetings of Chief Executive Boards International. One surprisingly consistent theme among business owners is, "I want everyone's attention to be on the bottom line." Of course they do -- that's where their attention is focused.
 
So they attempt to construct incentives using Net Profit as a metric and then work out some math around that number. If they implement such a plan, they figure out several years later that it's costing them real money (perhaps 5%-10% of their net profit) and buying them nothing in terms of employee behavior. Why? Several reasons:

1. It's not meaningful on an individual basis -- Since everyone is included, there's not enough money to go around. People see bonuses of $100 here and there and it's lost in the roundoff error of their withholding.
    
2. It's not fair -- The slackers get rewarded just the same as those who hit grand slams. As Andy Capp once said in the comic strip, "It's doing less than average that keeps average within reach."   In general, broad-brush (everybody wins) incentive comp schemes are just a way to make yourself feel like you're sharing your wealth.  They do nothing to drive behavior.
    
3. They can't connect the dots -- The overriding reason this doesn't work is that the average employee just can't connect the results of his day-to-day actions with a term (Net Profit) he doesn't understand in the first place. Wish as you might, all the education in the world won't fix this problem. They're not owners. The deal they signed up for was to exchange hours of their lives for dollars.
    
4. They can't control it -- There are a dozen factors outside their job description that drive Net Profit. In their minds, there's no material connection between their job and the goal.

These are a few of the fundamental "litmus tests" of Incentive Compensation design, and a broadly-inclusive Net Profit-based plan flunks several all of them. See: 8 Questions to Ask if Your Incentive Comp Plan Isn't Working

Still, you say, "I really like Net Profit as an incentive metric." Assuming you really want a Net Profit based incentive plan and you want it to actually drive behavior, you may be able to make that work by applying some simple rules:

1. Limit the plan to only your key managers -- the 4 or 5 players who report directly to you and have leadership influence on their employees. That way, you're talking about enough money to matter to them. Hopefully, these are people who can connect the dots between their actions and Net Profit and you can focus your education efforts to that effect solely on them.
    
2. Make the plan sensitive enough to pay out real money -- Don't pay from "first dollar" of net profit. Start the payouts above an annually-defined threshold, and NOTHING if that target isn't met. See: The #1 Incentive Compensation Plan Design Mistake
    
3. Tilt the plan in favor of the house -- 4:1 would be 20% of Net Profit above the threshold (pay $20, keep $80). That way, no matter how much you're paying out, you're feeling good about it.
    
4. Make it achievable -- The Net Profit payout threshold has to be below your net profit target, so the plan pays something at your business plan's target Net Profit (or "Par")
    
5. Make the plan "rich" enough that it'll turn their heads. Properly constructed, these key managers should be able to earn bonuses of a least 10% of their salaries -- perhaps as much as 50% in a banner year. A plan constructed this way would probably pay a % of base salary, proportional to how much Net Profit beats the annual threshold.

As with any incentive plan, your mileage may vary. If you have an incentive plan based on Net Profit that drives employee behavior, please click "Comments" below and share that with others. Or share with us your plan design that's working, regardless of its basis.

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Terry Weaver


CEO
Chief Executive Boards International
http://www.chiefexecutiveboards.com/
TerryWeaver@ChiefExecutiveBoards.com


 

Got Cash? Want Some Decent Interest?

 

Cash is a great thing to have, and many Chief Executive Boards International members are sitting on a lot of cash (thankfully). Universally, they're unhappy with their current returns. Now, we don't generally write on investment ideas, but a lot of members share this problem, so here's an idea for your consideration. 

Despite the currently-lousy rates on Certificates of Deposit (CDs) in general, there's one pretty good deal out there. Ally Bank is offering a 5-year CD at a rate of 2.54% -- about 5 times the yield of 2-year Treasuries. "Interesting," you'd say, "but I don't want to tie up cash for that long, even at that rate, because I'm expecting rates to rise." That's the best part. The early-withdrawal penalty is only 2 months' interest, Meaning that your "last 12 months" rate, if you pull the money out sooner, is still 2.3%. These long-term rates are a bit obscure on the Ally website. Here's a link that should help: http://www.ally.com/bank/high-yield-cd/#tabs=rates.

Note also that CDs are FDIC insured, up to a max of $250,000 per depositor, per financial institution. This could come in handy, considering that Ally is also engangled in the GMAC-originated mortgage foreclosure scandal.  That's not likely to change their financial position, however, since the stalled foreclosures have already been written off and that cash was gone years ago.  You  may wish to shop http://www.bankrate.com/ for other options.  Besides rate, the withdrawal penalty is the major consideration. 

So, what's the best strategy to make this work for you? First, get the money out of your company and into your own hands. Take some chips off the table. If it makes sense, you can always loan some money back to the company, right? And if something really bad happens that sinks the company, you've got that cash out of harm's way, on your side of the corporate veil.

Then shop for a high-yield CD (there are others out there) with a minimal early withdrawal penalty. That way, if you're convinced rates are going to rise (they have to, actually), you'll have a lot of options at higher yields -- Treasury Bonds, Corporate Bonds, CDs, etc., without much cost for changing horses.  Suggestion: Break it up into multiple CDs, so you can withdraw only part of the money if you need to.

Wait -- patience is rewarded in fixed-income investing. 

Some time in the future, when rates have risen to satisfactory levels, reinvest your CD money in something with a better return. Who knows, if you continue to accumulate cash, maybe you'll decide on some equity or real estate investments, as well. No matter what, your money has been safe and earning a premium interest rate in the meantime.

This is a classic "dry powder" strategy.   You're earning more than the inflation rate and also flexible -- when a better investment option surfaces, you're poised to strike.  
 

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Terry Weaver


CEO
Chief Executive Boards International
http://www.chiefexecutiveboards.com/
TerryWeaver@ChiefExecutiveBoards.com


 

Newton Was Right -- Yet Again

 

Since commerce began, CEOs and owners of businesses have struggled to get their workforce to understand the financial side of the business -- why we need profit, why we can't distribute all of it, where the money goes, etc. In fact, some owners have trouble themselves when they get past the income statement. A P&L is pretty straightforward. In fact, I talked with a person whose business failed this past year, and he said, "I understood my P&L pretty well. What I didn't understand was my Balance Sheet -- I think that's what did me in". PS: He's right about that.  

I recently needed to explain the relationships between the P&L and the balance sheet to a group of senior and middle managers, and was looking for a metaphor that might "stick" better than just walking through the numbers. Here's what I came up with, and I'm hoping it might be useful to you in explaining the same thing some day.

There's an amazingly direct relationship between aviation and business. Flying an airplane is a whole lot like running a business, if you understand the correlations. What are some of those?

• Direction = Strategy -- We're making good time. Are we going to end up where we want to be?
   
• Airspeed = Revenue (sales) -- What keeps an airplane flying is air rushing over the wings, providing lift. In fact, lift is directly proportional to airspeed. There's also a critical airspeed at which the airplane stops flying -- the stall speed.
   
• Altitude = Available Cash -- The game-over point in flying? Premature contact with the ground, otherwise known as a crash. Altitude = 0. Same in business -- game-over occurs when cash = 0. You only get to run out of money once. You can come close to running out of money lots of times.
   
• Rate of Climb = Profit (or more accurately, cash flow) -- If you're losing altitude, recovery requires either of two things -- more airspeed (sales) or reduced weight in the airplane. Lift stays the same and you gain altitude. How do you reduce weight in the airplane? 

Throw the luggage overboard (jettison expenses). They have stores where you're going, and you can buy more clothes. 

If you're carrying mail, throw that overboard (eliminate non-essential activities). Those people will get over it -- they'll just send those letters again. 

Pick a non-essential passenger and throw him overboard. Not pleasant, but could mean the survival of the rest of the party. You can figure out that part of the metaphor.

There are a couple of other ways to solve an airspeed problem, such as more thrust. More energy applied to the business. Or more energy applied directly to Revenue generation. You could also reduce drag -- eliminate mistakes, outsource non-core activities, increase productivity or automate.
 
The most useful part of this metaphor, I believe, centers around the most critical tradeoff in flying. That's the tradeoff of altitude for airspeed. When airspeed slows, lift is reduced, rate of climb becomes negative, or if you try to maintain altitude, you'll stall. So, you point the nose down and let gravity help you maintain airspeed above stall speed. Business equivalent? You settle for less profit, or even a loss to maintain airspeed. This will work for awhile. How long? Until you run out of altitude (cash). When altitude = 0, game over.


The important lesson, well known by old pilots, is this:

If you're losing both airspeed and altitude, you've got to come up with ideas -- usually pretty quickly. The best recent aviation example of ideas overcoming loss of airspeed and altitude is the "Miracle on the Hudson" -- the story of Flight 1549.  In that story, Captain Sullenberger maintained critical airspeed, sacrificed altitude, and came up with an amazing number of ideas, just in time to become a hero.   


If you have metaphors or word pictures you've used to help your workforce understand the business, please click on "Comments" below and share them with others.


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Terry Weaver


CEO
Chief Executive Boards International
http://www.chiefexecutiveboards.com/
TerryWeaver@ChiefExecutiveBoards.com

"You never want to run out of airspeed, altitude and ideas all at the same time"

Double Dip? Not Likely -- Brace Yourself for Growth

 

A "double-dip" recession is not only unlikely, it's the oppoosite of what's probable -- several quarters of continuing, though not exciting economic growth.  Something we try to do at Chief Executive Boards International is provide perspective across the many business sectors represented by our members.  I recently heard a most interesting and provocative perspective on the US economy presented by Bob Doll, Vice Chairman & Chief Equity Strategist for Fundamental Equities for BlackRock.  Here are some of the things Bob had to say that suggest those waiting to invest in either their businesses or equities may want to reconsider:   

• Business owners, almost universally, say things are "less bad" than they were 6 months ago (consistent with our members' input) 
   
• You would think employment was down in 2010 - actually, according to the Bureau of Labor Statistics (BLS), private-sector employment has risen by 763,000 (temporary census workers are not part of that data)
   
• We've had 5 consecutive quarters of GDP growth since 2Q 2009
   
• The media talks of a "Jobless Recovery".  Actually, all recoveries start out jobless.  At about 2.5% GDP growth, companies start re-hiring (we're not there yet)
   
• Part of our protracted slow growth is consumers de-levering -- paying down debt.  This results in about a 1% GDP drag -- overall a good thing, but slows the pace of recovery
   
• Growth is likely to continue and slowly accelerate, unless the economy is hit by a 2x4 -- such as a sharp decrease in money supply, raising interest rates quickly.  There's little indication of that intent on the part of the Fed. 
   
• The US Stock market is less US-dependent than you think -- 40% of US S&P 500 revenue is from International operations
   
• Only 15% of US S&P 500 revenue is from US Consumers
   
• We had one month of "less bad" news from the financial media (September) - stocks ran up 10%, indicating that people have been very defensively positioned (waiting to return to stocks)

 So, overall, Bob Doll is in the same camp with Brian Wesbury, author of It's Not as Bad as You Think.  While the media continues to be negative about the economy might be a good time to make your move if you agree Bob and Brian. 


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Terry Weaver


CEO
Chief Executive Boards International
http://www.chiefexecutiveboards.com/
TerryWeaver@ChiefExecutiveBoards.com