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EVA as the basis for incentive pay

Stock Loses Some Sway on Pay

October 30, 2012

Emily Chasan

Senior Editor Wall Street Journal

Fewer companies are tying their incentive-pay programs directly to their stock price, focusing instead on operating profits and cash-flow measures they say help employees better see their impact on company performance.

Just 16% of the 351 companies surveyed this month by PricewaterhouseCoopers LLP and the National Association of Stock Plan Professionals are using their stock price as a yardstick for short-term employee bonuses and incentives this year, down from 29% in 2009. Such incentives typically are aimed at middle and upper managers.

By contrast, the incentive benchmark used by most companies in the global survey is economic profit, a nonstandard measure reflecting a company’s operating earnings and cost of capital. Companies say the measurement, also called residual earnings or “economic value added,” more closely links employees’ incentives to spending and budget decisions they make.

PepsiCo Inc. began using economic-value measurements at its operating units earlier this year to focus managers on the cash-flow targets it wanted. It then bases bonuses on cash flow.

The change allows the beverage maker’s employees to make decisions about spending and profit “trade-offs themselves,” rather than simply being handed a budget to follow, says Hugh Johnston, PepsiCo’s chief financial officer. “It’s something they can wrap their arms around and say, ‘Now I understand how I can impact PepsiCo’s stock price.’ ”

Before the financial crisis, more companies linked bonuses to their sales, revenue, stock price or earnings per share. But, in the past few years, as those variables have been increasingly affected by pressures outside employees’ control, many companies have changed to performance benchmarks that employees can influence.

“As you start having downturns or mixed economic activity, managers need employees to focus on the fundamentals of their company’s operation,” says John Bremen, managing director at consulting firm Towers Watson & Co. “They need them to focus on generating revenues and cash, reducing costs, or generating profit in a particular division or region, so they’ll change the incentive plans accordingly.”

In the PwC survey, 27% of respondents said they were using some economic-profit measure this year to calculate incentives, up from 19% in 2011. In doing so, they are joining companies like Boeing Co., Ball Corp., Clorox Co. and Coca-Cola Co., which have for years tied short-term employee bonuses to economic-profit growth.

Economic profit, a company’s after-tax profit from operations, minus a charge for its cost of capital, lets employees see the kind of return investors would expect the company to get on profitable projects, says Bennett Stewart, CEO at economic-profit consulting firm EVA Dimensions.

“Whatever compensation scheme you have, that’s exactly what your employees are going to respond to,” says Daniel Rinkenberger, CFO of Kaiser Aluminum Corp., which has used economic profit to decide short-term incentives for key employees since 2006. “It’s driving them to do things our shareholders want, like not having excess assets in the pool. It drives people to be more efficient in how they have inventory deployed.”

PepsiCo’s new focus on economic profit will lower its capital spending to about 4.5% of sales this year, down from an historical average of about 5.5%, says Mr. Johnston, because employees are making better decisions. The company also has been able to cut the sums of money it has tied up in accounts receivable and inventory, boosting cash flow.

But while many companies, particularly manufacturers and consumer-goods makers, have adopted such measures, they might not be as effective in motivating employees at high-growth tech companies or other firms whose long-run success may depend on big investments that don’t immediately generate cash.

Manufacturer Crane Co. had used an economic value-added measure for incentive programs since 1998, but moved away from it last year in favor of specific sales, cash-flow and operating-profit targets that the company says help it invest more in growth projects that drain cash now and might take a few years to deliver returns. Crane’s new targets let employees see the value of longer-term investments so “when we go cut expenses, even in the downturn, we don’t cut growth,” said Crane Chief Executive Eric Fast, at an analyst conference in August.

Many companies that use the more complicated operating metrics have to spend time explaining them to employees. Mr. Johnston says PepsiCo spent a few hours this year on presentations to managers to explain its measurements, but it was time well spent. “It’s having exactly the effect we hoped it would this year,” he adds.


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