Executive incentive compensation in construction
by Nino D. Pedrelli
Gilbane Building Co., Providence, RI
Incentive compensation in general is a topic of wide range importance as nearly two-thirds of all listed companies have one form or another.(l) It is a subject of major significance to construction in particular since in a survey performed four years ago, construction led all other industries polled in the offering of bonuses to top officers .(2)
The purpose of this paper is not to praise or criticize certain executive incentive plans, but to shed light upon some of the current formal systems now in use. Detailed information concerning any company’s incentive compensation plan is usually very sensitive. This is borne out by the relatively low questionnaire response rate in this study. However, it is this very sensitivity which makes the practical applications of the study presented here so powerful. For companies which already have formal incentive plans, this paper will provide a very helpful tool in evaluating the strengths and weaknesses of their systems.
In giving an insight into the various types of plans now in use, the information provided will also be directly applicable to companies which intend to institute formal plans.
Incentive plans of the executive type include only those employees who have substantial responsibility within their company. In the companies surveyed, eligibility extended from the chief executive officer down to project managers of major projects (this level was not included in all of the plans sampled).
The purpose of an executive incentive compensation system is to help insure the attainment of stated corporate, short-term objectives. It is intended to motivate managers to attain these goals by the way it evaluates performance and by the procedures used in rewarding the partial or full achievement of these goals.
Depending upon the nature of the organization, incentive plans can be either formal or informal. As policies and procedures tend to become more formalized in organizations of increasing size and diversity, so do incentive plans. Proceeding from this premise, the survey sample population was limited to the construction industry’s top fifty companies (according to 1978 contract volume) as rated by Engineering News-Record. Also, due to the sensitivity of the subject matter, the survey concentrated on publicly held companies since it was felt that they would be more candid than private firms.
A total of 48 personal letters and questionnaires were mailed to 30 companies. Two surveys were sent to each of the public companies, one to a high ranking operations manager and one to the top financial officer. In the case of private companies, only the top financial officer received a questionnaire. Of the 30 sampled, seven responded to the survey. Of the respondents, six were publicly held companies. While preparing this article, follow-up interviews were held with respondents, where possible.
In order to preserve the anonymity of the respondents, they will here be referred to as Companies A, B, C, D and X, Y, Z. The first group characterized themselves as being decentralized into profit centers while Companies X, Y and Z are centralized. Company organizational form is a major dividing line concerning incentive plans. This is due to the differing types of objectives against which divisional performance in centralized and decentralized organizations are evaluated. The section covering sub-unit targets will delve into this point further. Other descriptive characteristics of the respondents are listed in Table 1.
This paper is essentially divided into two major sections. The first deals with the various performance targets and measures that are utilized in executive incentive plans. The second portion will discuss the procedure of how the various plans translate performance measurements and evaluations into actual bonus awards. This will entail presenting bonus calculation formulas and/or procedures in use. In order to better follow the presentation, the reader is heartily suggested to refer to Table 2 which summarizes and condenses the results.
Objectives and Measures
Typically, an employee’s bonus amount will depend upon his evaluation in any or all of the following three categories: corporate, sub-unit (department or division) and individual performance. The various goals utilized in each of these categories will be examined separately. Individual performance measures will not be dealt with to any great degree.
Incentive plans are tied to the achievement of pre-specified corporate targets in six of the seven responding companies. Company A, the lone dissenter, utilizes only sub-unit and individual evaluations as the basis for their incentive plan.
In all cases the corporate goals are profit targets of different types. Three of the companies utilize after-tax profit figures (B, D & X) while Company Y employs a gross profit before-tax target. Company Z arrives at a before-tax figure by increasing the Net Income (essentially an after-tax figure) by the tax amount which was originally subtracted. As a further precaution, extraordinary items of gain or loss can be eliminated in whole or in part at the discretion of the Incentive Awards Committee. The corporate target itself, however, is expressed as a specific return on equity.
General literature in the field indicates that the most common standard against which company performance is evaluated is the earnings per share (EPS). At the start of the evaluation period a desired EPS is stated and is then compared against the actual EPS achieved. This is essentially the same as using the return on equity.
The use of before-tax as opposed to after-tax figures hinges around the concern that through financial accounting methods, tax amounts may be unduly manipulated and thereby distort profit figures. Since the majority of companies employ after-tax targets, this concern is obviously not widespread. These companies most likely depend upon less formal procedures to prevent the “massaging” of profit amounts.
Only two of the respondents did not utilize divisional or departmental targets which were tied into the incentive structure (B & Y). As might be expected, decentralized companies relied more on objective measures (e.g., sales volume, profit, etc.) while centralized organizations employed ratings of a more subjective nature (i.e., judgmental evaluations made by upper echelon executives.)
It should be noted here that the various targets being presented are only those which serve as in integral part of the incentive plan. Surely in such sophisticated organizations as these, additional measures are utilized to monitor sub-unit performance.
The greater dependence upon subjective evaluation in centralized companies, one may assume, is due to the relative difficulty of attaching accurate, objective performance standards to the types of sub-units present in these organizations (e.g., Engineering, Estimating, Purchasing, etc.). A decentralized profit center, on the other hand, more easily lends itself to being evaluated against objective goals.
This pattern is also evidenced in companies in other industries. Textron, the highly diversified conglomerate, is one case in point. Its divisions are quite independent. In fact, many are in different industries, and, as such, performance is strictly judged against a pre-specified return on investment. Although fixed formula methods have the disadvantage of being insensitive, they do facilitate interdivision comparisons and provide unquestionably clear objectives. Itek Corporation on the other hand has a relatively low degree of divisional autonomy and independence. Each division manager goes over his accomplishments with respect to previously stated objectives along with his forecast for the coming year, with a management committee. In this way he is able to defend his situation rather than be coldly evaluated against an absolute standard .(3)
Some companies refrain from setting divisional incentives at all. At J. C. Penney, incentive pay is geared to the relative difficulty of a recipient’s job. At the beginning of each year, top management decides which executives face the toughest immediate challenge and derive potential bonuses accordingly.(4)
The decentralized divisions of a construction company may be organized to be quite independent. However, since presumably they all function in the same industry, one would expect a certain degree of restriction placed on divisional independence. This restriction should be reflected in the bonus plan.
Profit targets play a role in evaluating performance in three of the four decentralized companies (Company B does not tie division performance into its incentive system at all). Company A derives an after-tax profit figure for each of its divisions by applying a theoretical tax rate against sub-unit earnings. This figure is then compared against profit bogies which have been previously established for the division. Company C employs a more sophisticated version of the profit target concept by tying the figure to a specified field profit margin. In this way, division overhead as well as profit is evaluated and therefore controlled. Company D utilizes both objective and subjective measures and subdivides performance into four categories: (1) Financial (e.g., actual profit vs. budget, expense and income budgets’ performance, profit per employee). (2) Operations management. (3) Human resources management (e.g., manpower development), and (4) Personal categories. Financial performance is given the greatest importance in the evaluation process.
Reviewing the objective sub-unit targets, it is interesting to note the dependence on profit as a goal without regard to market share or industry economic conditions. Therefore, it seems as though companies are heavily dependent upon their forecasting abilities in order to set fair targets for their executives.
As for the centralized organizations which utilize sub-unit goals (X&Y), both declined to elaborate as to the types of targets they employ. They did state, however, that sub-unit, performance is subjectively evaluated against these goals.
As mentioned previously, individual performance measurements were not dealt with in any great depth. Only two of the respondents mentioned having formal, numerical performance ratings for employees. In Company D, employee performance is given a rating on a scale of 1 to 10. In Company Z on the other hand, the measurements used are as follows: 0=Marginal; 1=Competent; 2=Commendable; 3=Distinguished. Performance is graded to the nearer half-point based on previously established standards. The remaining respondents employ more informal processes in evaluating individual performance. This usually takes the form of giving superiors certain limited discretionary powers in adjusting bonus sizes. The formal process of how these awards are originally determined is the topic of the next section.
To recapitulate then, three companies based their executive incentive plans on company and individual performance (B, X & Y). One utilized sub-unit and individual performance (A), and three employed corporate, sub-unit and individual evaluations (C, D & Z). It is interesting to note here the difference in incentive schemes utilized by Companies A and B. Although both are decentralized, the former evaluates sub-unit and individual performance while the latter rewards corporate and individual accomplishments. In Company A, one would expect sub-units to be more independent of each other and less of a “company” feeling among employees than in Company B. On the other hand, by not incorporating sub-unit evaluations into the incentive structure, Company B may not be stimulating optimum sub-unit performance. This also holds true for Companies X and Y.
As mentioned in the introduction, the basic requirement for eligibility in these executive incentive plans is that participants have substantial responsibility in an executive or managerial capacity. Although the question of how many participants should be included in a plan is enitrely discretionary, a rough rule of thumb has been suggested. An incentive compensation plan begins to lose its credibility and motivating power when more than one percent of a company’s total employment is included in the plan (in companies with less than 25,000 employees).(5) Examination revealed that none of the respondents to this survey violated this “rule.”
Six of the seven companies were willing to provide information as to how individual bonus awards are determined. Company A volunteered that it was determined according to a fixed plan but declined to elucidate.
Upon analysis of the various distribution procedures, awards seemed to be set through one of two methods: deductive and inductive. Through the deductive method, dependent upon the achievement of the corporate (sub-unit in one case) target, a bonus pool is conceived. The size of this pool is set as some specified percentage of profit, and varies directly with the degree to which the target is achieved. The pool is then divided among the participants according to a formal procedure.
The achievement of the corporate goals in companies employing the inductive method acts more as a “trigger” to signal that participants may receive bonuses. Awards are then set up on an individual basis and no bonus pool, as such, exists. It is not surprising to note that the companies which utilized this inductive procedure also paid the lowest bonus levels in comparison to other respondents.
Companies X and Y utilize this inductive approach to bonus awards. At Company X, if the company meets at least the minimum profit objective as determined by the Chief Financial Officer, participants automatically become eligible for 50 percent of the “standard” bonus entitlement. Awards are then subjectively set as a percentage of base salary and participants are categorized into three groups based on job classification. The groups and allowable percentages are as follows: Group I (Vice Presidents) 5-20 percent, Group II (Projects Manager, Engineering Manager) 5-12 percent, Group III (Department Managers) 3-8 percent. The “standard” entitlement is the mid-range percentage in each group. The achievement of the profit objective then “triggers” the “standard” entitlement. The awards may then be increased in size up to the allowed percentage of salary. Again, no pool is utilized. It should be noted that bonus sizes at Company X are a much smaller percentage of base salary than at companies that utilized the deductive procedure.
Although all four of the remaining respondents (B, C, D & Z) employ deductive methods to establish bonus pools, fundamental differences in the distribution procedures are evident.
At Company B, the following formula is utilized to determine the pool:
Award Fund = 6% (Minimum NPAT) + 22% (Actual
NPAT – Min NPAT)
NPAT = After tax earnings
Min NPAT = 105% of previous year’s NPAT
The formula is designed with the intent that the target fund be 8 percent of the current year’s NPAT and the current NPAT be 120 percent of the previous year. In this manner, the incentive system is also tied to a planned company earnings growth rate. Distribution of the pool is then set as a percentage of salary. Participants are categorized into eight groups each having its own award percentage. These groups include the President with 45 percent, down to “Key Employees” (home office department heads) with 20 percent.
Two pools are utilized at Company C. One is sub-unit performance based and the other is based on corporate achievement. Since both the company and its divisions are evaluated against profit targets, roughly the same method is employed to set the sizes of the pools. In order for the company or its divisions to have a pool established, at least 70 percent of the profit objective must be achieved. Above this cutoff there are three categories of qualifications:
70% – 90% 2% of profit forms the bonus pool
90% – 100% 5% of profit forms the bonus pool
100% + 5% of profit plus 5% of excess forms
the bonus pool
The two pools do differ in their distribution methods, however. The division pool is divided among participants according to relative salary levels with the division manager having the discretion to redistribute up to 25 percent of the pool. This power is provided in order to more equitably reward individual performance. Participants in this pool include the division manager, chief estimator, and a handful of project managers. Participants in the corporate pool are all assigned “points” or payout ratios. These ratios determine the degree of participation in the pool and are based on an employee’s impact on company performance (the president has the highest ratio). Staff officers as well as line managers take part in this pool.
Companies D and Z seem to have the most formal and cohesive incentive plans in that not only are corporate, sub-unit and individual performance considerations a part of bonus determination but the distribution process is expressed in terms of numerical ratings and formulas.
In Company D there are basically four factors which determine the size of an employee’s award. The first is corporate performance. There is a single pool in the parent corporation and like other plans presented, its size is related to Net Income and varies with the success of the company. Secondly, the sub-units are evaluated against specific objectives and are each assigned ratings based on their performance. These ratings are used to “weigh” the relative participation in the corporate pool, by employees of different sub-units. In other words, all individual ratings being equal, employees in an outstanding sub-unit will have larger bonuses than those in a mediocre performing sub-unit.
Within the sub-units lie the two remaining determining factors. These consist of an employee’s bonus grade and individual performance rating. Bonus grades are determined by a participant’s position and are based on the leverage the job has on profit. In this company, line managers are given higher bonus grades than staff officers. Individual performance ratings which are set on a scale of 1 to 10 are given less weight than bonus grades in influencing individual awards.
To summarize, within each sub-unit, relative individual bonus sizes are determined by bonus grade and individual performance. The sub-unit ratings then serve to differentiate relative individual award sizes within the entire company.
Company Z has the most formal and theoretically sophisticated distribution procedure. Roughly the same four types of determining factors are present, however, they are employed through a different procedure. There are three major steps involved in this process. First, the performance of the company, the sub-units and the participants are each rated. The measurements are made as follows: 0=Marginal; l=Competent; 2=Commendable; 3= Distinguished. Grading is made to the nearer half-point and is based on established standards similar to management by objectives’ goals.
The second step in the procedure is to determine for each participant how much “weight” should be given to each of the three grades in deriving the award. To accomplish this, a total of six “weighting” points are assigned to each participant. These points are then allocated to the three grades based on the type of position of the employee. For example, the President’s weighting points may be distributed: 5(Corporate grade) – 0(Sub-unit grade) – 1 (Individual grade); a line manager’s: 2 – 3 – 1, and a staff officer’s: 3 – 0 – 3.
The final step consists of deriving an actual award through three mathematical computations. Each of the three “grading” points are multiplied by their respective weighting points. The three resulting products are then summed. As a part of the next operation, each participant receives a certain number of “accountability” points which are based upon impact on company profit. The purpose of these points is to establish relative levels of importance of employees within the company. The previously mentioned sum is then multiplied by the individual’s accountability points and the resulting product represents a participant’s “award” points. In the last computation, each individual’s award points are multiplied by a constant (derived from the bonus pool to represent the dollar value of one award point) and this finally yields the employee’s bonus amount. Company Z makes this involved process manageable by utilizing a computer program to arrive at the individual awards. A sample award derivation is demonstrated in Appendix I.
To summarize this section, then, two respondents did not utilize bonus “pools” as such as a basis for awards. These two companies were both centralized organizations and determined bonuses inductively by considering company and individual performance and then setting an amount. The remaining respondents did employ pools whose size was determined by a pre-specified percentage of corporate profits exceeding a certain level.
In this latter group, two types of bonus award distribution methods emerged. Three pools allocated awards predominantly on the basis of percentage of salary. Three other pools employed variations of a “point” system which determined each participant’s “stake” in the pool. In its most sophisticated form this system, through a very formal procedure, took corporate, sub-unit and individual performance into weighted account in determining an award.
An area of study which is not central to the thrust of this paper and which will be dealt with only briefly here is the concept of using the form of the award itself as an incentive. The basis for this idea lies in the assumption that executives have different income needs and tax statuses. Therefore, straight cash as an incentive will vary in “perceived” value, with different executives. According to this premise, then, incentive plans will have greater motivating power if executives are allowed to have a limited choice as to what forms their awards may take. This is described in one article as the “compensation cafeteria” approach.(6)
In this study, two of the respondents pay awards only in cash (C & X), while three others (B, D & Z) utilize a combination of payment forms. These consist of: current cash, deferred cash, current stock and deferred stock.
Company B pays two-thirds of a participant’s award as current cash and defers the remaining third as stock or cash payable after completing ten years of service. Apart from the cafeteria concept, this seems to have been designed to entice longer tenure from important employees. Company D allows their executives to split their awards between current and deferred cash. Participants at Company Z are allowed to choose from the four selections the portion and form they wish the award to take. The company, however, also reserves the right not to be bound by the executives’ preference when determining award forms.
Therefore, from the results of this study, it seems as though the compensation cafeteria concept has not yet inserted itself into the construction industry.
The fairness of implementing corporate and sub-unit objectives of an absolute nature is heavily dependent upon a construction company’s forecasting abilities. This approach evaluates performance against a forecast target without regard to performance achieved relative to other companies (sub-units) in the same industry (market). A division manager who salvages respectability in a declining market may be insufficiently rewarded while a division in a rising market may be able to coast along to meet its objective. This type of situation is increasingly plausible considering present volatile and uncertain conditions in the construction industry. The unjust punishing or rewarding of participants will erode the effectiveness of an incentive plan since goal acceptance is the foundation necessary for any system to truly succeed.
In other words, companies should utilize objectives which also evaluate how a total profit figure is attained. Specified profit margins tied to profit targets achieve this to a certain degree. Companies should also attempt to introduce objectives tied to market and industry fluctuations. Evaluating performance with respect to a target expressed in “real” terms (i.e., discounting changing external conditions) will motivate the same level of performance as was intended when the goal was first specified. Where practicable, expressing a sub-unit’s profit target in conjunction with its market share may accomplish this.
The other major specific conclusion concerns the two common methods which emerged for bonus calculations and distribution. The approach of distributing bonuses based on salary level or as a specified percentage of salary is reasonably fair to participants and is relatively easy to administer. However, the aforementioned point method, by directly integrating corporate, sub-unit and individual performance evaluations into the bonus calculation process more accurately (albeit theoretically) relates short term performance to bonus amount. This so-called point procedure is obviously the more theoretically involved of the two approaches and is indicative of an incentive plan of a higher level of sophistication.
Along these lines, a general conclusion which may be tentatively (due the small sample size) drawn is that only a small minority of the nation’s largest construction firms employ executive incentive plans which are at a very high level of sophistication. A sophisticated bonus plan may employ subjective evaluations and need not be composed solely of strict objective standards. The important point is that they are incorporated into the plan in a formal manner. Of the seven respondents, only one, Company Z, has a formal plan which may be described as being close to the state-of-the-art in the field of incentive compensation. Characteristics of this plan which distinguish it as such include: 1. Formal performance evaluation ratings; 2. Integration of corporate, sub-unit and individual factors; 3. Formal numerical process to derive bonus amounts; 4. Selection of award forms.
The bonus plans of the remaining respondents are by no means primitive and seem to be reasonably effective. They are, however, in lower and varying stages of evolution. This evolutionary process begins when a formal plan is first introduced and entails its subsequent fine tuning and/or revamping over time as the needs of the organization change and grow. Although all of the plans presented here are well past the initial stage, a fair amount of fine tuning has yet to be done.
This study was performed in the spring of 1979 while the author was a graduate student in the Program of Construction Management and Engineering at Stanford University. The costs involved were graciously borne by the Stanford Construction Institute. Special thanks are extended to Prof. Boyd C. Paulson, Jr., to Prof. Henry Irwig and to the survey respondents themselves.
Table 1. — Company Characteristics
Table 2 — Results Summary
Bonus determination for a Division Manager:
Profits in excess of 10 percent return on equity this year are equal to $1,000,000. Therefore the bonus pool will be:
8% ($1,000,000) = $80,000.
The company has had only a relatively successful year, however, both the Division Manager and his sub-unit have done very well.
Corporate grade = 2.0
Sub-unit grade = 3.0
Individual grade = 2.5
Based upon his position as a line manager, his weighting points shall be distributed as follows: 2-3-1.
His division is not a major one, therefore his “accountability” points shall be equal to 0.6. (The Presdent’s points are equal to 1.0).
Therefore the computations are as follows:
1. 2(2.0)+ 3(3.0)+ 1 (2.5)= 15.5 points
2. 15.5 × 0.6 = 9.90“award”points.
3. Sum of the “award ” points for all the participants equals the total points in the incentive plan, using the term Z for this purpose.
4. $80,000 ÷ Z points = K (Dollars per one award point).
5. 9.90 award points × K = Bonus award for the Division Manager.
Appendix II – References
1. Patton, A., “Why Incentive Plans Fail,” Harvard Business Review, May-June, 1972, p. 58.
2. “Top Management Pay Relies Heavily on Bonuses,” Engineering News-Record, Oct. 16, 1975, p. 16.
3. Salter, M., ‘Tailor Incentive Compensation to Strategy,” Harvard Business Review, March-April, 1973, pp. 94-96.
4. Chung, K., “Incentive Theory and Research,” Personnel Administration, Jan.-Feb., 1972, p. 51.
5. Patton, A., op. cit., p. 65.
6. Hettenhouse, G., “Compensation Cafeteria for Top Executives,” Harvard Business Review, Sept.-Oct., 1971, p. 115.
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