Wa0013.

Chapter
12
Management
Compensation
Every organization has goals. An important role of management control systems is to motivate
organizational members to attain those goals. This chapter focuses on incentive mechanisms
and compensation systems and their function in influencing the behavior of employees, as they
seek goal congruence. Managers typically put forth a great deal of effort on activities that are
rewarded and less on activities that are not rewarded. There are many examples of compensa-
tion systems that do not reward behavior leading to organizational goals or that reward be-
havior countering these goals. In this chapter, we discuss the design of incentive compensation
plans for general managers in order to avoid the “folly of rewarding A while hoping for B.”
We first discuss research findings on organizational incentives. We then describe the nature
of incentive compensation plans and distinguish between short-term and long-term plans.
Next, we describe how the compensation of individual managers is decided at both the corpo-
rate and business-unit levels. Finally, we describe agency theory—an approach for deciding on
the best type of incentive compensation plan.
Research Findings on Organizational Incentives

The key to motivating people to behave in a manner that furthers an organization’s goals lies
in the way the organization’s incentives relate to the individuals’ goals. People are influenced
by both positive and negative incentives. A positive incentive, or “reward,” is an outcome that
increases satisfaction of individual needs. Conversely, a negative incentive, or “punishment,” is
an outcome that decreases satisfaction of those needs. Reward incentives are inducements to
satisfy their needs that individuals cannot obtain without joining the organization. Organiza-
tions reward participants who perform in agreed-upon ways. Research on incentives tends to
support the following:
• Individuals tend to be more strongly motivated by the potential of earning rewards
than by the fear of punishment, which suggests that management control systems
should be reward oriented.
513
514 Part Two The Management Control Process
• A personal reward is relative or situational. Monetary compensation is an important

means of satisfying needs. Beyond a certain satisfaction level, however, the amount of
compensation is not necessarily as important as nonmonetary rewards.
• If senior management signals by its actions that it regards the management control
system as important, operating managers will also regard it as important. If senior
management pays little attention to the system, operating managers will follow suit.
• Individuals are highly motivated when they receive reports, or feedback, about their
performance. Without such feedback, people are unlikely to feel a sense of achievement
or self-realization or to figure out how they can change their behavior to meet their
objectives.
• Incentives become less effective as the period between an action and feedback on it in-
creases. At lower levels in the organization, the optimal frequency may be only hours;
for senior management, it may be months.
• Motivation is weakest when the person believes an incentive is either unattainable or
too easily attainable. Motivation is strong when it takes some effort to attain the ob-
jective and when the individual regards this attainment as important in relation to his
or her needs.
• The incentive that a budget or other statement of objective provides is strongest when
managers work with their superiors to arrive at the budgeted amounts. Objectives,
goals, or standards are likely to provide strong incentives only if the manager perceives
them as fair and is committed to attaining them. The commitment is strongest when it
is a matter of public record—that is, when the manager has explicitly agreed that the
budgeted amounts are attainable.
Characteristics of Incentive Compensation Plans

A manager’s total compensation package consists of three components: (1) salary, (2) benefits
(principally retirement and health care, but also perquisites of various types), and (3) incentive
compensation. Managers typically receive higher compensation in large companies than in
small firms, and companies in the same industry tend to compete with each other on compen-
sation. Otherwise, few other generalizations can be made about the level of management com-
pensation.
The three components are interdependent, but the third is related specifically to the man-
agement control function; this chapter, therefore, discusses primarily the incentive compensa-
tion component.
A study of the pay and bonuses received by 14,000 managers over the period 1981–85 (70,284
observations from 219 organizations) found that, on average, bonuses were 20 percent of base
pay, but that there were substantial differences among organizations, even those in the same in-
dustry. There were greater differences in the proportion of bonus payments than in base pay.
Organizations with higher ratios of bonuses tended to have better subsequent financial perfor-
mance than other organizations.1
1
Barry Gerhart and George T. Milkovich, “Organizational Differences in Managerial Compensation and Financial
Performance,” Academy of Management Journal, December 1990, pp. 663–91.
Chapter 12 Management Compensation 515
Most corporate bylaws and securities regulations require incentive compensation plans
and revisions of existing plans to be approved by the shareholders. (By contrast, shareholders
do not approve salaries, nor does the annual proxy statement give information about com-
pensation, except for each of the five highest paid officers and the total for all officers and di-
rectors.) It follows that the plan must be approved by the board of directors before it is voted
on at the annual meeting. Before submitting a plan to the board, senior management works
to ensure it is the best one for the organization, often hiring outside consultants to assist in
this effort. The compensation committee of the board of directors usually participates exten-
sively in discussions of the proposed plan.
Incentive compensation plans can be divided into short-term and long-term plans. Short-
term incentive plans are based on performance in the current year. Long-term plans tie com-
pensation to longer-term accomplishments and are related to the price of the company’s com-
mon stock. A manager may earn a bonus under both plans. The bonus in a short-term plan
usually is paid in cash, and the bonus in a long-term plan usually is an option to buy the com-
pany’s common stock.
Short-Term Incentive Plans

The Total Bonus Pool
The total amount of bonus that can be paid to a qualified group of employees in a given year is
called the “bonus pool.” In a short-term incentive plan, shareholders vote on the formula that
will be used to arrive at it. This formula usually is related to the overall company profitability
in the current year. In deciding on the size of this pool, the overriding issue is to make sure the
total compensation paid to executives is competitive.
There are several ways to establish the bonus pool.
The simplest method is to make the bonus equal to a set percentage of the profits. For ex-
ample, if profits of $50 million represent an average profitable year, and if a $1 million bonus
fund is required to make the executive compensation package competitive, the bonus formula
then could be set up to pay 2 percent of net income in bonuses.
Many companies don’t like using this method because it means paying a bonus even when
profitability is low. Moreover, it fails to reflect additional investments; thus, profits and, conse-
quently, bonuses can increase simply as a result of new investments, even though the com-
pany’s performance may be static or even deteriorating. Many firms therefore use formulas
that pay bonuses only after a specified return has been earned on capital. There are several
ways to do this.
One method is to base the bonus on a percentage of earnings per share after a predeter-
mined level of earnings per share has been attained. Using our earlier example, assume the
following situation:
1. Estimated level of satisfactory profitability: $50 million.
2. Desired amount of bonus at the above level of profitability: $1 million.
3. Number of shares outstanding: 10 million.
4. Minimum earnings per share before bonus payments: $2.50.
5. Bonus formula: 4 percent of profits after subtracting $2.50 per share.
This method, however, does not take into account increases in investment from reinvested
earnings. The solution is to increase the minimum earnings per share each year by a percent-
age of the annual increase in retained earnings. In the example above, assume that the esti-
mated profits for the year are $50 million before bonuses and that dividends are $30 million.
The plan might stipulate that a 6 percent return must be earned on additional investments be-
fore any additional bonuses are paid. The $2.50 minimum earnings per share thus would be
adjusted for the coming year in the following manner:
Increase in retained earnings:
$50,000,000 (profit) ⫺ $500,000 (bonus after taxes)
⫺ $30,000,000 (dividends) ⫽ $19,500,000
Increase in required earnings before bonus:
Total ⫽ $19,500,000 * 0.06 ⫽ $1,170,000
Per share ⫽ $1,170,000 ⫼ 10,000,000 ⫽ $0.117
Adjusted minimum earnings per share:
$2.50 ⫹ $0.12 ⫽ $2.62
No reductions in the required earnings per share are normally made when the company expe-
riences a loss; however, the required earnings would not be increased until retained earnings
exceeded the preloss level.
Another method of relating profits to capital employed is to define capital as shareholder eq-
uity plus long-term liabilities. The bonus is equal to a percent of the profits before taxes and in-
terest on long-term debt, minus a capital charge on the total of shareholder equity plus long-
term debt. (This is similar to the economic value added concept discussed in Chapter 7.)
Companies using this method reason that managerial performance should be based on em-
ploying corporate net assets profitably, and because financial policy—not operating man-
agers—determines the proportion of long-term debt to total capital, this proportion should not
influence the judgment about operating performance.
Yet another option is to define capital as equal to shareholder equity. A difficulty with both
this and the preceding method is that a loss year reduces shareholder equity and thereby in-
creases the amount of bonus to be paid in profitable years. This might tempt management to
take a “big bath” in a year with otherwise low profits to make earning future bonuses easier.
A few companies base the bonus on increases in profitability over the preceding year. This not
only rewards a mediocre year that follows a poor one but also fails to reward a good year that
follows an excellent one. This problem can be partially corrected by basing the bonus on an im-
provement in the current year that is above a moving average of the profits in a number of past
years.
Some companies base bonuses on their profitability relative to that of their industry. Ob-
taining comparable industry data may be difficult, however, because few companies have the
same product mix or employ identical accounting systems. This method also could result in a
high bonus in a mediocre year, because one or more competitors had a poor year.
In calculating both the profit and the capital components of these formulas, adjustments may
be made in the reported amount of net income and in the reported amount of shareholder equity.
Certain types of extraordinary gains and losses, and gains and losses from discontinued opera-
tions, may be excluded. Additionally, goodwill that results from acquiring other companies may
be excluded even though it is included in the published financial statements.
Carryovers
Instead of paying the total amount in the bonus pool, the plan may provide for an annual car-
ryover of a part of the amount determined by the bonus formula. Each year a committee of the
board of directors decides how much to add to the carryover, or how much of the accumulated
carryover to use if the bonuses would otherwise be too low. This method offers two advantages:
(1) It is more flexible; payment is not determined automatically by a formula and the board of
directors can exercise their judgment. (2) It can reduce the magnitude of the swings that occur
when the bonus payment is based strictly on the formula amount calculated each year. Thus,
in an exceptionally good year, the committee may decide to pay out only a portion of the bonus.
Conversely, in a relatively poor year, the committee may decide to pay out more than the
amount justified by the current year’s performance by drawing from the carryover amount.
The disadvantage of this method is that bonuses relate less directly to current performance.
Deferred Compensation
Although the amount of the bonus is calculated annually, payments to recipients may be
spread out over a period of years, usually five. Under this system, executives receive only one-
fifth of their bonus in the year in which it was earned. The remaining four-fifths are paid out
equally over the next four years. Thus, after the manager has been working under the plan for
five years, the bonus consists of one-fifth of the bonus for the current year plus one-fifth of each
of the bonuses for the preceding four years. In some companies, the deferred period is three
years. This deferred payment method offers the following advantages:
• Managers can estimate, with reasonable accuracy, their cash income for the coming
year.
• Deferred payments smooth the manager’s receipt of cash, because the effects of cycli-
cal swings in profits are averaged in the cash payments.
• A manager who retires will continue to receive payments for a number of years; this
not only augments retirement income but also usually provides a tax advantage, be-
cause income tax rates after retirement may be lower than rates during working life.
• The deferred time frame encourages decision makers to think long term.
A disadvantage of deferred bonus plans is that they do not make the deferred amount avail-
able to the executive in the year earned. Because bonus payments in a year are not related to
performance in that year, they may act as less of an incentive.
When bonus payments are deferred, the deferred amount may or may not vest. In some in-
stances, a manager will not receive the deferred bonus if he or she leaves the company before
it is paid. This arrangement is called a golden handcuff because it acts as a disincentive for
managers to leave an organization.
Long-Term Incentive Plans

A basic premise of many long-term incentive plans is that growth in the value of the company’s
common stock reflects the company’s long-run performance. There are several types of such
plans. Their popularity is affected by changes in the income tax law, changes in accounting
treatment, the state of the stock market, and various other factors. Consequently, different
plans are popular at different times.
Stock Options
A stock option is a right to buy a number of shares of stock at, or after, a given date in the fu-
ture (the exercise date), at a price agreed upon at the time the option is granted (usually the
current market price or 95 percent of the current market price). The major motivational bene-
fit of stock option plans is that they direct managers’ energies toward the long-term, as well as
the short-term, performance of the company.
Examples. Wendy’s was having trouble with high turnover—300 percent per year among
crew members. After introducing a stock option plan for crew managers, Wendy’s reduced
turnover in this group, which in turn reduced turnover among assistant managers from 60
percent to 38 percent. This contributed to a reduction in turnover among crew members to
about 150 percent per year.2
Howard Schultz, CEO of Starbucks, believed that the behavior of the company toward its
employees was reflected in the way employees interacted with the customers, which in turn
would determine the success of Starbucks. The company provided stock options to every em-
ployee, and as a result Starbucks had the lowest turnover of any food and beverage com-
pany.3
To align the interests of managers with those of shareholders, IBM announced a new
stock option plan for its top 5,000 executives in 2004. Under this scheme, if IBM’s stock in-
creased by 20 percent, shareholders would no doubt get the entire 20 percent premium but
executives would get a 10 percent premium.4
The manager gains if he or she later sells the stock at a price that exceeds the price paid for
it. Unlike some of the alternatives mentioned below, the outright purchase of stock under a
stock option plan gives managers equity that they can retain, even if they leave the company,
and a gain that they can obtain whenever they decide to sell the stock. However, many stock
options are for restricted stock. Managers are not permitted to sell this stock for a specified
period after it was acquired.
Example. Historically, stock options have been a popular form of rewarding employees at
both startups and established companies, particularly in the technology sector. Microsoft,
Cisco, Amazon.com, and eBay are just some of the companies that use stock options for com-
pensation. There are several reasons for this. First, stock options and their upside potential
tend to attract highly talented employees to these companies, and technology companies de-
pend on the high caliber of their human capital to succeed. Second, employees will volunteer
innovative ideas only if they can profit from them. Third, companies can pay employees
lower salaries and bonuses because of the stock option program. Fourth, so far, the value of
2
Kerry Cappell, “Options for Everyone,” BusinessWeek, July 22, 1996, pp. 80–84.
3
Howard Schultz (CEO, Starbucks), Entrepreneur, November 2003.
4
BusinessWeek, March 8, 2004.
stock options does not reduce the bottom line. Finally, stock options are intended to encour-
age employees to focus on the long term.
In 2002, in the wake of several accounting scandals, there was a growing call for stock
options to be accounted for as an expense. This would give investors a more complete and
accurate picture of a company’s financial
performance. Supporters of expensing options included Warren Buffett, Alan Greenspan,
and the Financial Accounting Standards Board (FASB). The collapse of companies such as
Tyco, Global Crossing, World Com, and Enron Corporation, where employee compensation
was heavily tied to options and resulted in manipulation of the financials to improve the
short-term stock price, has led to calls for reform.5
Phantom Shares
A phantom stock plan awards managers a number of shares for bookkeeping purposes only. At
the end of a specified period (say, five years) the executive is entitled to receive an award equal
to the appreciation in the market value of the stock since the date of award. This award may
be in cash, in shares of stock, or in both. Unlike a stock option, a phantom stock plan has no
transaction costs. Some stock option plans require the manager to hold the stock for a certain
period after it was purchased. This involves a risk of a decrease in the market price as well as
interest costs associated with holding the stock. This risk and these costs are not involved in a
phantom stock plan.
Stock Appreciation Rights

A stock appreciation right is a right to receive cash payments based on the increase in the
stock’s value from the time of the award until a specified future date. Stock appreciation rights
and phantom shares are types of deferred cash bonuses in which the bonus amount is a func-
tion of the market price of the company’s stock. Both plans have the advantages of a stock op-
tion plan. Compared to a cash bonus paid currently, they involve uncertainty—in both
directions—about the ultimate amount paid.
Example. Avis Inc., the rental car company that “tries harder,” agreed to be purchased by
hotel franchiser HFS Inc. for $763 million, including $85 million in phantom stock and stock
appreciation rights for Avis Inc.’s management.6
Performance Shares
A performance share plan awards a specified number of shares of stock to a manager when spe-
cific long-term goals have been met. Usually, the goals are to achieve a certain percentage
growth in earnings per share over a three- to five-year period; therefore, they are not influ-
enced by the price of the stock. The advantage of this plan over the stock option and phantom
stock plans is that the award is based on performance that the executive can control, at least
partially. Also, the award does not depend on an increase in stock prices, although the increase
in earnings is likely to result in an increase in stock prices. This plan suffers from the limita-
tion of basing the bonus on accounting measures of performance. Under some conditions, ac-
5
Alan Levinsohn, “Stock-Option Accounting Battle Heats Up after Seven-Year Détente,” Strategic Finance, June 2002,
p. 63.
6
Aaron Bernstein, “Should Avis Try Harder—For Its Employees?” BusinessWeek, August 12, 1996, pp. 68–69.
tions that corporate executives take to improve earnings per share might not contribute to the
economic worth of the firm.
Performance Units
In a performance unit plan, a cash bonus is paid when specific long-term targets are attained.
This plan thus combines aspects of stock appreciation rights and performance shares. It is es-
pecially useful in companies with little or no publicly traded stock. Long-term targets must be
carefully established for this plan to succeed.
Example. In 2004, in addition to his salary and bonus, Jeff Immelt, the CEO of General
Electric, was awarded $250,000 performance unit shares (PSUs) that were tied to cash flow
performance metrics. For the PSUs to vest (five-year vesting period), Jeff Immelt would
have to increase operating cash flows by 10 percent a year.7
Incentives for Corporate Officers

In the preceding section, we described how the total bonus pool is calculated. In this section
and the next, we describe how the total is divided among the corporate officers and among the
business unit managers, respectively.
Each corporate officer, except the chief executive officer, is responsible in part for the com-
pany’s overall performance. These corporate officers are motivated by, and entitled to, a bonus
for good performance. However, the part of performance that each of them generated cannot be
measured. For example, how can one measure the contribution to profits made by the chief fi-
nancial officer or the human resources vice president or the chief counsel?
To stimulate motivation, the chief executive officer (who recommends awards to the compen-
sation committee of the board of directors) usually bases awards on an assessment of each per-
son’s performance. These assessments are necessarily subjective. Some companies use a man-
agement by objectives system (MBO) in which specific objectives are agreed upon at the
beginning of the year and their attainment is assessed by the chief executive officer.
CEO Compensation
The chief executive officer’s compensation usually is discussed by the board of directors com-
pensation committee after the CEO has presented recommendations for subordinates’ com-
pensation. The CEO’s general attitude toward the appropriate percentage of incentive com-
pensation in a given year is fairly obvious from this presentation. In ordinary circumstances,
the committee may simply apply the same percentage to the CEO’s compensation. However,
the committee may signal a different appraisal of the CEO’s performance by deciding on a
higher or lower percentage. This, perhaps more than any other expression of the board’s opin-
ion, is a critical sign of how the board regards the CEO’s performance. It should be accompa-
nied by a frank explanation of the reasons for the decision.
7
www.CFO.com.
Are chief executive officers paid too much? This issue has become very hotly debated as the
business world has been rocked by a series of scandals over the last two years, starting with
the bursting of the Internet bubble, and moving on to problems in the telecom industry—all of
which have greatly affected several other leading companies. One offshoot of these scandals
has been a major push to substantially reform corporate governance in order to restore in-
vestor confidence. Several proposals have been made to ensure that the board of directors acts
in the interest of shareholders and does not work at the mercy of CEOs:8 (1) Prevent directors
from selling their stock for the duration of their term to encourage them to ask the “tough”
questions of CEOs without fear of adversely impacting short-term stock prices. (2) Set manda-
tory limits on the tenure of directors to avoid their becoming too entrenched with management.
(3) Hold an annual performance review of directors. (4) Avoid having the CEO of the corpora-
tion act as the chairman of the board.
Examples. Since 2000, there have been several cases of poorly designed compensation
packages. See, for example, the well-publicized excessive amounts given to Richard Grasso
(New York Stock Exchange), Dennis Kozlowski (Tyco), and Carly Fiorina (Hewlett-Packard)
after their employment contracts were terminated. To prevent these incidents, shareholders
now demand more transparency with regard to executive compensation contracts.9
Another area that has received considerable momentum is to force companies to account for
stock options as an expense.10 Under current rules, companies do not have to count the cost of
stock options as an expense It is argued that the collapse of companies such as WorldCom and
Enron had something to do with stock option overload; executives resorted to questionable ac-
counting and indulged in uneconomical acquisitions to boost short-term earnings and stock
price, so as to cash their stock options.
Companies such as Coca-Cola and the Washington Post have started to expense options on a
voluntary basis. The following arguments are given in support of expensing stock options in the
year they are awarded to top management. First, about 75 percent of CEO and top manage-
ment compensation represent stock options. They should be expensed, the same way the other
25 percent (salary, cash bonus) is expensed. Second, treating stock options as an expense would
result in a more accurate earnings picture, thereby restoring investor confidence. For example,
Intel would have earned just 4 cents a share for 2001, 80 percent less than the reported figure,
if options were expensed. Third, under current accounting rules, companies feel that stock op-
tions are free, and hence they overreward CEOs with options. But options dilute shares and
have real costs. Fourth, treating options as an expense would prevent top management from
playing accounting games to pump up short-run stock prices in order to cash their options. Fi-
nally, there are double standards at present because companies are allowed to expense the
difference between issue price and exercise price of options for income tax purposes but a sim-
ilar requirement does not exist for financial reporting. For instance, Microsoft’s taxable income
was reduced by $2 billion as a result of expensing options in 2000, but its net income reported
to stockholders did not contain this expense.
8
“How to Fix Corporate Governance,” BusinessWeek, May 6, 2002, pp. 69–78.
9
New York Times, April 3, 2005.
10
“To Expense or Not to Expense,” BusinessWeek, July 29, 2002, pp. 44–48.
The following arguments are advanced against expensing stock options. First, unlike salary,
stock options do not involve outlay of cash. Hence, expensing them would unduly penalize earn-
ings. Second, valuing stock options is far from easy. It involves assumptions and estimates.
Thus, the resulting number could be subject to manipulations. Third, treating options as an ex-
pense will dampen earnings and reduce stock price. To prevent this, companies will issue fewer
options. This goes against the concept of employee ownership and results in a loss of the atten-
dant motivational benefits. Fourth, cash-strapped startups, especially in Silicon Valley, use op-
tions to attract human talent. To the extent expensing options would discourage companies
from issuing stock options, it could seriously damage the innovative spirit in the technology sec-
tor. Finally, stock options are disclosed in footnotes to the balance sheet. In any case, stock op-
tion accounting is not what brought down Enron and WorldCom.
Example. Given the backlash against stock options, companies are experimenting with
other schemes. The CEO of Cardinal Health was required to hold shares of the company
equaling five times his annual salary. In the case of Coca-Cola, its CEO would lose all his
shares if he was not with the company for five years.11
Incentives for Business Unit Managers

A wide array of options exists in developing an incentive compensation package for business
unit managers (see Exhibit 12.1).
Types of Incentives
Some incentives are financial, others are psychological and social. Financial incentives include
salary increases, bonuses, benefits, and perquisites (automobiles, vacation trips, club member-
ships, and so on). Psychological and social incentives include promotion possibilities, increased
responsibilities, more autonomy, a better geographical location, and recognition (trophy,
participation in executive development programs, and the like). In this part of the chapter, we
discuss the financial incentives for business unit managers, while recognizing that managers’
motivation is influenced by both financial and nonfinancial incentives.
Examples. In addition to commissions based on the sales revenue generated
by the sales force they supervised, directors (i.e., supervisors) of Mary Kay
Cosmetics received a dozen pink roses, a plaque, and a custom-designed suit at an award
ceremony. If they maintained a certain level of performance, they were given the use of a
pink Buick or Cadillac for two years.
In the business process outsourcing (BPO) industry in India, the employee turnover typi-
cally is about 75 percent, due to heavy demand for IT professionals. IBM’s BPO arm in
India, Daksh, had managed to lower the employee turnover in backoffice operations to
20 percent through an innovative scheme. When an employee got a salary increase, bonus,
or promotion, the employee’s parents were brought to the company to celebrate the occasion,
thereby cultivating deeper loyalty to Daksh.12
11
New York Times, April 3, 2005.
12
BusinessWeek, August 8, 2005.
EXHIBIT 12.1 Incentive Compensation Design Options for Business Unit Managers
A. Types of Incentives 2. Time Period

1. Financial Rewards a. Annual financial performance
a. Salary increase b. Multiyear financial performance
b. Bonuses 3. Nonfinancial Criteria
c. Benefits a. Sales growth
d. Perquisites b. Market share
2. Psychological and Social Rewards c. Customer satisfaction
a. Promotion possibilities d. Quality
b. Increased responsibilities e. New product development
c. Increased autonomy f. Personnel development
d. Better geographical location g. Public responsibility
e. Recognition 4. Relative Weights Assigned to Financial and
Nonfinancial Criteria
B. Size of Bonus Relative to Salary
5. Benchmarks for Comparison
1. Upper Cutoffs
a. Profit budget
2. Lower Cutoffs
b. Past performance
C. Bonus Based on c. Competitor’s performance
1. Business Unit Profits
E. Bonus Determination Approach
2. Company Profits
1. Formula-Based
3. Combination of the Two
2. Subjective
D. Performance Criteria 3. Combination of the Two
1. Financial Criteria
F. Form of Bonus Payment
a. Contribution margin
1. Cash
b. Direct business unit profit
2. Stock
c. Controllable business unit profit
3. Stock Options
d. Income before taxes
4. Phantom Shares
e. Net income
5. Performance Shares
f. Return on investment
g. Economic value added
Size of Bonus Relative to Salary

There are two schools of thought about how to mix fixed (salary and fringe benefits) and vari-
able (incentive bonus) rewards in managers’ total compensation. One school states that we re-
cruit good people, pay them well, and then expect good performance (see Exhibit 12.2). Compa-
nies subscribing to this school emphasize salary, not incentive bonus. This is called a fixed pay
system. Compensation is not linked to performance and therefore is not at risk. This raises
the question, What happens if the person does not perform well? A fixed pay system, however,
has merit under certain circumstances, as the following example illustrates:
Example. The Charles Schwab Corporation pioneered the discount brokerage concept. Un-
like traditional brokerage houses, Schwab brokers earned fixed salaries, not sales commis-
sions. Brokers who work under the commission system are motivated to maximize transac-
tions in order to earn more commissions. Thus, commissioned sales personnel do not
necessarily act in their customers’ best interests. Schwab’s brokers, working for salary
rather than commission, tended to be less pushy and acted in customers’ long-term best in-
terests. Customer service was one of the reasons behind Schwab’s superior performance vis-
à-vis its industry.
Fixed Pay
Recruit good people

EXHIBIT 12.2
Two
Philosophies Pay them well
on Incentive
Compensation
Expect good performance
Performance-Based Pay
Recruit good people
Expect good performance
Pay them well if performance is actually good
Another school states that we recruit good people, expect them to perform well, and pay
them well if performance is actually good (Exhibit 12.2). Companies subscribing to this philos-
ophy practice performance-based pay; they emphasize incentive bonus, not salary.
In general, performance-based pay systems have been gaining favor among companies. An
American Compensation Association Survey of 2,800 major companies revealed the percentage
of companies offering variable pay was 63 percent in 1999, up from less than 15 percent in
1990.13
The fundamental difference between the two philosophies arises from the fact that com-
pensation comes first and performance comes later under fixed pay. Conversely, performance
comes first and compensation comes later under performance-based pay. The two philosophies
have different motivational implications for managers. Because salary is an assured income,
emphasizing salary may encourage conservatism and complacency. Emphasizing incentive
bonus, on the other hand, tends to motivate managers to put forth maximum effort. For this
reason, many companies employ incentive bonuses for business unit managers.
Example. From 1993 to 1999, Yoichi Morishita, president of Matsushita, embarked on a
strategic overhaul of the company. He shifted the firm’s focus from low-margin consumer
electronics business to high-tech products, such as digital cellular phones, digital TVs, and
digital video discs, and into new industries, such as software engineering and network-com-
munications technology. Japanese companies (including Matsushita) traditionally awarded
bonus almost entirely on seniority. Breaking with tradition, Matsushita switched to a com-
pensation system based on performance rather than seniority, plus stock options for key ex-
13
“Workers Thinking, Investing Like Entrepreneurs,” The Valley News, January 9, 2000, p. E1.
ecutives. Performance-based pay was seen as critical to implementing Matsushita’s strate-

gic shift since 1993. Many of the best ideas in the emerging digital technologies come from
young engineers who would not be adequately rewarded for their ideas in the traditional se-
niority-based system.14
Cutoff Levels
A bonus plan may have upper and lower cutoff levels. An upper cutoff is the level of perfor-
mance at which a maximum bonus is reached. A lower cutoff is the level below which no bonus
awards will be made. Both cutoffs may produce undesirable side effects. When business unit
managers recognize that either the maximum bonus has been attained or that there will be no
bonus at all, the bonus system may work against corporate goals. Instead of attempting to op-
timize profits in the current period, managers may be motivated to decrease profitability in one
year (by overspending on discretionary expenses, such as advertising or research and develop-
ment) to create an opportunity for a high bonus the following year. Although this would affect
only the timing of expenses, such action usually is undesirable.
One way to mitigate such dysfunctional actions is to carry over the excess or deficiency into
the following year—that is, the bonus available for distribution in a given year would be the
amount of bonus earned during the year plus an excess, or minus any deficiency, from the pre-
vious year.
Bonus Basis
A business unit manager’s incentive bonus could be based solely on total corporate profits or on
business unit profits or some mix of the two. One argument for linking bonus to unit perfor-
mance is that the manager’s decisions and actions more directly impact the performance of his
or her own unit than that of other business units. However, such an approach could severely
impair interunit cooperation.
Example. Quantum Corporation created a team called “Lethal” to design, make, and de-
liver a 2.5-inch disk drive (the company made 3.5-inch disk drives at that time) in 14
months. (In the past, the company had taken 24 months for such new products.) Lethal was
a cross-functional team consisting of members from engineering, manufacturing, marketing,
finance, and human resources. Instead of setting up performance measures for each func-
tion, Lethal set up team-based performance measures which helped the team introduce its
new product on time.15
In a single industry firm whose business units are highly interdependent, the manager’s
bonus is tied primarily to corporate performance because cooperation between units is critical.
In a conglomerate, on the other hand, the business units usually are autonomous. In such a con-
text, it would be counterproductive to base business unit managers’ bonuses primarily on com-
pany profits; this would weaken the link between performance and rewards. Such a system cre-
ates free-rider problems. Some managers might relax and still get a bonus based on the efforts
of other, more diligent managers. Alternatively, in a poor profit year for the company, a unit that
turns in an outstanding performance will not be rewarded adequately. In a conglomerate, there-
14
“Putting the Bounce Back into Matsushita,” The Economist, May 22, 1999, pp. 67–68.
15
Christopher Meyer, “How the Right Measures Help the Team Excel,” Harvard Business Review, May–June 1994,
pp. 98–99.
fore, it is desirable to reward business unit managers primarily based on business unit perfor-
mance and so foster the entrepreneurial spirit.
For related diversified firms, it might be desirable to base part of business unit managers’
bonuses on unit profits and part on company profits to provide the right mixture of incen-
tives—namely, to optimize unit results while, at the same time, cooperating with other units to
optimize company performance.
Example. Motorola is a related diversified firm with business units such as pagers, cellular
telephones, and two-way radios. These businesses share a common wireless radio-frequency
design technology. To encourage business units to cooperate, the compensation of business
unit general managers was based on companywide performance.16
In 2000, as Motorola was working to recover from several years of poor performance, co-
operation within the firm was reemphasized, and managers were compensated based on
how well they promote collaboration.
Performance Criteria
A difficult problem in the incentive bonus plan for business unit managers is to decide which
criteria shall be used to determine the bonus.
Financial Criteria
If the business unit is a profit center, choosing financial criteria could include contribution
margin, direct business unit profit, controllable business unit profit, income before taxes, and
net income. If the unit is an investment center, decisions need to be made in three areas: (1) de-
finition of profit, (2) definition of investment, and (3) choice between return on investment and
EVA. We discussed the considerations involved in choosing performance criteria for profit cen-
ters and investment centers in Chapters 5 and 7, respectively. If the responsibility center is a
revenue center, the financial criteria would be sales volume or sales dollars.
Example. Avon, a global cosmetics company, had about 445,000 sales representatives in the
United States who called on customers to make sales and who were rewarded on the basis
of sales volume. This reward system for its sales force will be even more critical as Avon en-
ters developing countries such as India. In developing countries, retailing outlets are not so-
phisticated, so direct sales to the end-use customer becomes very important. Also, women in
most developing countries want to work a flexible, part-time schedule as a way to
supplement family income.17
Adjustments for Uncontrollable Factors

In addition to selecting the financial criteria, companies must determine what adjustments
they will make for uncontrollable factors. Typically, they adjust to two kinds of influences. One
adjustment removes expenses that result from decisions made by executives above the busi-
ness unit level.
Example. A major consumer products company reported, “A few years ago we decided to
close a factory in Germany that was working at 30 percent of capacity. The expenses were
16
“Motorola,” BusinessWeek, May 4, 1998, p. 142.
17
“Scents and Sensibility,” The Economist, July 13, 1996, pp. 57–58.
deducted at the corporate level. It was not the decision of the manager in Germany, so we
couldn’t penalize him.”18
Another adjustment eliminates the effects of losses caused by “acts of nature” (fires, earth-
quakes, floods) and accidents not caused by the manager’s negligence.
Example. The following comment by an executive in a distribution company, who was
asked if he would make an adjustment if a fire occurred in a warehouse, is typical: “I would
start with the assumption that this couldn’t be foreseen. Then I would look at the causes.
Was the fire caused by a breach of security or a lackadaisical attitude toward safety? If the
fire was outside the manager’s control, I would make the adjustment.”19
Benefits and Shortcomings of Short-Term Financial Targets

It is a good idea to link business unit managers’ bonus to achieving annual financial targets
(after making allowances for uncontrollable events). It induces managers to search for differ-
ent ways to perform existing operations and initiate new activities to meet the financial tar-
gets.
However, relying only on financial criteria could cause several dysfunctional effects.20 First,
it could encourage short-term actions that are not in the company’s long-term interests (e.g.,
undermaintenance of equipment). Second, managers might not undertake promising long-
term investments that hurt short-term financial results. Third, managers may be motivated to
manipulate data to meet current period targets.
Example. Sunrise Medical Inc., a medical products company, decentralized its operations and
linked division managers’ bonuses to their own divisions’ bottom lines. If a division did not
make suitable profits, its general manager did not receive a bonus, even if the company as a
whole was profitable. On January 4, 1996, Sunrise’s directors disclosed that one of its divi-
sions, Sunrise Bio Clinic, had falsified its accounting records to show higher-than-actual prof-
its. Some argued that the bonus system was partly to blame for Bio Clinic’s falsified
accounts.21
Mechanisms to Overcome Short-Term Bias

Supplementing financial criteria with additional incentive mechanisms may overcome the
short-term orientation of annual financial goals. For example, a firm might base part of its
managers’ bonus on multiyear performance (i.e., performance over a three- to five-year period).
Although this has the obvious advantage of extending the time horizon of managers, there are
certain weaknesses. First, managers have difficulty seeing the connection between their efforts
and rewards in a multiyear award scheme, which lessens the motivational effect of such
awards. Second, if a manager retires or is transferred during the multiyear period, imple-
menting such a plan becomes more complex. Third, it is more likely that factors beyond the
manager’s control will influence the achievement of long-range targets.
18
Kenneth A. Merchant, Rewarding Results: Motivating Profit Center Managers (Boston: Harvard Business School Press,
1989), p. 121.
19
Ibid., pp. 125–26.
20
J. J. Curran, “Companies That Rob the Future,” Fortune, July 4, 1988, pp. 84–89; “More than Ever, It’s Management for
the Short Term,” BusinessWeek, November 24, 1986, pp. 92–93.
21
Tom Petruno, “Bonuses Can Have a Darker Side,” The Valley News, February 4, 1996, p. E3.
Example. In investment banking and brokerage houses, it is not uncommon to give

bonuses to traders based on profits on each deal they make. This creates incentives for the
traders to take big risks in the hope of big paychecks. However, it could potentially lead to
serious financial problems for the organization. The collapse of Barings, an investment bank
in the United Kingdom, is a case in point. To mitigate this problem, Salomon Brothers al-
tered its bonus scheme. Employees at Salomon were entitled to a bonus on a deal only if the
company achieved predetermined return on equity. Further, a portion of the bonus was de-
cided based on multiyear performance to be sure that Salomon’s future profits were not sac-
rificed by short-term actions.22
Another method to correct for the inherent inadequacies of financial criteria is to develop a
scorecard that includes one or more nonfinancial criteria, such as sales growth, market share,
customer satisfaction, product quality, new product development, personnel development, and
public responsibility. Each of these factors will affect long-run profits. Senior management can
create the desired long-term versus short-term profit orientation on the part of business unit
managers and allow for factors that are not reflected in the financial measure by selectively
choosing financial and nonfinancial criteria and appropriate weights among these criteria.
Examples. When John Martin, CEO of PepsiCo’s fast-food restaurant chain Taco Bell, em-
barked on his transformation program in 1988, he shifted decision making from the com-
pany’s headquarters to restaurant managers and increased each manager’s responsibility
from 5 to 20 restaurants. This empowerment was supported by a fundamental change in the
reward system. A bonus scheme, linked to customer service levels, profit targets, and sales,
significantly increased both managerial and hourly compensation. If Taco Bell managers
performed, they earned more than three times the fast-food industry average. This, coupled
with bonuses based on length of service, reduced the appeal of hopping from one fast-food
chain to the next in search of higher pay, a practice thought to be endemic among fast-food
restaurant managers. As a result, Taco Bell reduced restaurant manager turnover by more
than 50 percent and hourly employee turnover to 30 percent. These changes in the roles and
rewards of restaurant managers contributed significantly to Taco Bell’s dramatic improve-
ment since 1988. Between 1988 and 1993, the company opened more than 2,000 new restau-
rants, increased worldwide sales from $1.5 billion to nearly $4 billion, and more than tripled
net income to over $250 million. Over the same period, there was a sharp improvement in
customer satisfaction—measured by value-for-money perceptions—while that of competitors
declined.23
PA Consulting, a management and technology consulting firm based in Britain, was orga-
nized by business units. The company tied the bonus of consul-tants to the profits from their
own units. This system had the potential to create an uncooperative environment. To pre-
vent that, employees’ bonuses were also based on the clients they brought in and those they
served, and on subjective reviews by peers, subordinates, superiors, and clients. If a consul-
tant referred a client to another unit, he or she received a bonus. Similarly, a consultant who
felt that a client could be served better by taking the help of staff from another unit was mo-
tivated to do so since it led to better reviews by clients and colleagues.24
22
“Pay and Performance: Bonus Points,” The Economist, April 15, 1995, pp. 71–72.
23
“Renewal at Taco Bell,” Transformation, Gemini Consulting 6, Spring 1995, p. 8.
24
“Pay Purview,” The Economist, August 29, 1998, pp. 59–60.
Another mechanism to correct for the short-term bias is to base part of the business unit man-
agers’ bonus on long-term incentive plans, such as stock options, phantom shares, and perfor-
mance shares. These plans focus business unit managers on (1) companywide performance and
(2) long-term performance. Advantages and limitations of these plans were discussed earlier.
Example. Interpublic, which runs four advertising agencies (McCann-Erickson, Lintas,
Dailey & Associates, and the Lowe Group), designed incentive systems for its business units
to make sure they focused on profitability and growth. The compensation for managers was
based on long-term performance: four years’ performance but awarded every two years. This
helped keep managers from jumping ship, an ever-present agency business threat. Employ-
ees were rewarded with stock and bonuses for exceeding their numbers and for qualitative
results, such as setting up succession plans and servicing clients.25
Benchmarks for Comparison

A business unit manager’s performance can be appraised by comparing actual results to the
profit budget, past performance, or competitors’ performance. The typical practice is to evalu-
ate a business unit manager against the profit budget. As discussed in Chapter 9, the follow-
ing considerations are important when using the profit budget as a motivational tool: (1) The
business unit manager participates in the development of the profit budget, and (2) the budget
is challenging but attainable.
Bonus Determination Approach

A bonus award for a business unit manager can be determined by using a strict formula, such
as a percentage of the business unit’s operating profit, or by a purely subjective assessment by
the manager’s superior, or by some combination of the two.
Example. In 1992 employees of FormPac did not receive bonuses, even though they worked
hard, because the company was not making profits. The employees did not know why they
had not received bonuses because the bonuses were strictly based on the discretion of an un-
communicative CEO. This demotivated employees and generated distrust. To regain credi-
bility in the bonus system, FormPac’s CEO, William Duff, published the monthly and year-
to-date sales and profit figures on a display board and linked employees’ bonuses to
published sales growth and profit figures. By 1996 FormPac’s employees seemed to have
more faith in the bonus system.26
Relying exclusively on objective formulas has some clear merits: Reward systems can be
specified with precision, there is little uncertainty or ambiguity about performance standards,
and superiors cannot exercise any bias or favoritism in assessing the performance of subordi-
nate managers. However, one major drawback is that objective formulas are likely to induce
managers to pay less attention to the performance of their business units along dimensions
that are important but difficult to quantify (e.g., research and development, human resource
management). Some subjectivity in determining bonuses, therefore, is desirable in most units,
especially when a manager’s personal control over a unit’s performance is low. In such situa-
25
“Sibling Rivalry,” Forbes, February 15, 1993, pp. 119–20.
26
Donna Fenn, “Bonuses That Make Sense,” Inc., March 1996, p. 95.
tions, numerical indicators of the unit’s performance are less valid measures of the manager’s
performance. This type of situation is likely to happen under the following circumstances:
• When the business unit manager inherits problems created by a predecessor.
• When the business unit is highly interdependent with other units and, therefore, its
performance is influenced by the decisions and actions of outside individuals.
• When the strategy requires much greater attention to longer-term concerns (as is the
case in a business unit aggressively building market share or business units in rapidly
evolving industries).
Example. Lucent Technologies used subjective performance reviews and loose controls over
new ventures in fields ranging from digital radio and Internet telephony to electroplating and
public safety—new ventures where innovation was critical.27
Agency Theory
Agency theory explores how contracts and incentives can be written to motivate individuals to
achieve goal congruence. It attempts to describe the major factors that should be considered in
designing incentive contracts. An incentive contract, as used in agency theory, is the same as
the incentive compensation arrangements discussed in this chapter. Agency theory attempts to
state these relationships in mathematical models. This introduction describes the general
ideas of agency theory without giving actual models.
Concepts
An agency relationship exists whenever one party (the principal) hires another party (the
agent) to perform some service and, in so doing, delegates decision-making authority to the
agent. In a corporation, shareholders are principals and the chief executive officer is their
agent. The shareholders hire the CEO and expect that he or she will act in their interest. At a
lower level, the CEO is the principal and the business unit managers are the agents. The chal-
lenge becomes how to motivate agents so that they will be as productive as they would be if
they were the owners.
One of the key elements of agency theory is that principals and agents have divergent pref-
erences or objectives. Incentive contracts can reduce these divergent preferences.
Divergent Objectives of Principals and Agents

Agency theory assumes that all individuals act in their own self-interest. Agents are assumed
to receive satisfaction not only from financial compensation but also from the perquisites
involved in an agency relationship, such as generous amounts of leisure time, attractive work-
ing conditions, country club memberships, and flexible working hours. For example, some
agents may prefer leisure to hard work or effort. Leisure is assumed to be the opposite of effort.
27
“A Survey of Innovation in Industry,” The Economist, February 20, 1999, pp. 5–28.
Managers’ efforts increase the value of the firm, while leisure does not. An agent’s preference
for leisure over effort is called work aversion. Deliberately withholding effort is called shirking.
Principals (i.e., shareholders), on the other hand, are assumed to be interested only in the fi-
nancial returns that accrue from their investment in the firm.
Agents and principals also diverge with respect to risk preferences. Agency theory assumes
that managers prefer more wealth to less, but that marginal utility, or satisfaction, decreases
as more wealth is accumulated. Agents typically have much of their wealth tied up in the for-
tunes of the firm. This wealth consists of both their financial wealth and their human capital.
Human capital—the manager’s value as perceived by the market—is influenced by the firm’s
performance. Because of the decreasing utility for wealth and the large amount of agent capi-
tal that depends on the company, agents are assumed to be risk averse: They value increases
from a risky investment at less than the expected (actuarial) value of the investment.
On the other hand, company stock is held by many owners, who reduce their risk by diver-
sifying their wealth and owning shares in many companies. Therefore, owners are interested
in the expected value of their investment and are risk neutral. Managers cannot as easily di-
versify away this risk, which is why they are risk averse.
Nonobservability of Agents’ Actions

Divergent preferences associated with compensation and perquisites arise whenever the prin-
cipal cannot easily monitor the agent’s actions. Shareholders are not in a position to monitor
the CEO’s activities daily to ensure that he or she is working in their best interest. Likewise,
the CEO is not in a position to monitor daily the activities of business unit managers.
Because the principal has inadequate information about the agent’s performance, the prin-
cipal can never be certain how the agent’s effort contributed to actual company results. This sit-
uation is referred to as information asymmetry. These asymmetries can take on several forms.
Without monitoring, only the agent knows whether he or she is working in the principal’s best
interest. Moreover, the agent may know more about the task than the principal. This additional
information that an agent may have is called private information.
The divergence of preferences between the principal and agent, and the agent’s private in-
formation, may lead the agent to misrepresent information to the principal. This misrepresen-
tation is of such a general nature that the name moral hazard has been given to the situation
in which an agent being controlled is motivated to misrepresent private information by the na-
ture of the control system.
Control Mechanisms
Agency theorists state that there are two major ways of dealing with the problems of diver-
gent objectives and information asymmetry: monitoring and incentives.
Monitoring
The principal can design control systems that monitor the agent’s actions, limiting actions that
increase the agent’s welfare at the expense of principal’s interest. An example of a monitoring
system is the audited financial statement. Financial reports are generated about company per-
formance, audited by a third party, and then sent to the owners.
Agency theory has attempted to explain why different agency relationships involve different
levels of monitoring. For example, monitoring is more effective if the agent’s task is well de-
fined and the information, or “signal,” used in monitoring is accurate. If the task is not well de-
fined or easily monitored, then incentive contracting becomes more appealing as a control de-
vice. Monitoring and incentives are not mutually exclusive alternatives. In most firms, the
CEO has an incentive contract along with audited financial statements that act as a monitor-
ing device.
Incentive Contracting
A principal may attempt to limit divergent preferences by establishing appropriate incentive
contracts. The more an agent’s reward depends on a performance measure, the more incentive
there is for the agent to improve the measure. Therefore, the principal should define the perfor-
mance measure so that it furthers his or her interest. The ability to accomplish this is referred
to as goal congruence. When the contract given to the agent motivates the agent to work in the
principal’s best interest, the contract is considered goal congruent.
A compensation scheme that does not incorporate an incentive contract poses a serious
agency problem. For example, if CEOs were paid a straight salary, they might not be motivated
to work as diligently as when compensation consisted of a salary plus bonus. The latter case
motivates CEOs to work harder to increase profits, increasing their compensation and, at the
same time, benefiting the principal. Therefore, contracts are written that align the interests
between the two parties by incorporating an incentive feature—that is, the principal writes a
contract permitting management to share in the wealth when firm value is increased.
Example. To protect against its CEO’s possible risk aversion, CBS included a protection
clause in CEO Les Moonves’s contract that would pay him $5 million in the event CBS was
sold to another company. A few months after Moonves arrived at CBS, Westinghouse pur-
chased CBS and the clause was activated.28
Principals face the challenge of identifying signals that are correlated with both agent effort
and firm value. The agent’s effort, along with outside factors (e.g., the general economy, natural
disasters), combine to determine performance. The more closely an outcome measure reflects
the manager’s effort, the more valuable the measure is in an incentive contract. If the perfor-
mance measure is not closely correlated with the agent’s effort, there is little incentive for the
agent to increase his or her effort.
None of the incentive arrangements can ensure complete goal congruence. This is because of
the difference in risk preferences between the two parties, the asymmetry of information, and
the costs of monitoring. These differences cause additional costs. Even an efficient system of in-
centive alignments will still result in some divergence of preferences; this is called the residual
loss. The addition of the incentive compensation costs, the monitoring costs, and the residual
loss are formally titled agency costs.
28
Marc Gunther, “Turnaround Time for CBS,” Fortune, August 19, 1996, pp. 65–68.
CEO Compensation and Stock Ownership Plans

A company that pays its CEO a bonus in the form of stock options offers an example of the
agency costs inherent in incentive compensation. One cost is the risk-preference differences be-
tween the owners and the CEO. The agent, already risk averse, incurs additional risks when his
or her pay is based on stock price performance. To compensate the CEO for taking on this risk,
the contract will have to increase the amount of expected pay. In addition, to minimize the pos-
sible downside potential, the agent may not take on high-risk/ high-return projects that the
principal may find desirable.
A second problem with a stock ownership bonus plan is the lack of direct causal relationship
between the agent’s effort and the change in stock price. Stock prices are affected by factors
outside the agent’s control (e.g., general economic conditions, government intervention). If
these factors cause the stock price to rise, then the agent receives increased pay at the owners’
expense without any increased effort. On the other hand, the stock price may decrease even if
the agent works hard.
In spite of these two problems, the stock ownership incentive contract is preferred to a con-
tract that does not have an incentive feature. As pointed out earlier, a flat salary has larger
agency costs associated with it.
Business Unit Managers and Accounting-Based Incentives

The relationship between a business unit manager’s effort and the stock price is more remote
than that between the CEO’s effort and the stock price. It is difficult to isolate the contributions
that individual business units make to increases in the firm’s stock price. For this reason, a com-
pany might base the business unit manager’s bonus on business unit net income. However, this
incentive contract still has agency costs similar to those discussed in the CEO stock ownership
plan. For example, market demand for a product may fall because of a new substitute product,
but the manager may still perform well within the new smaller market. If the bonus is based
strictly on net income, however, the agent’s compensation will decrease. In addition, the agent
may inflate net income through accounting manipulations that do not affect firm value. One in-
stance of this is the sale of fixed assets that have a market value in excess of book value. While
a contract based on business unit net income may have lower agency costs than straight salary,
these costs do not go to zero.
A Critique
Agency theory was invented in the 1960s and since then has been written about extensively in
academic journals. But the theory has had no discernible practical influence on the manage-
ment control process. There has been no real-world payoff. By “payoff” we mean that a man-
ager used the results of agency theory to make a better compensation decision. Many man-
agers are not even aware of agency theory.
Agency theory implies that managers in nonprofit and governmental organizations, who
cannot receive incentive compensation, inherently lack the motivation necessary for goal
congruence; many people do not accept this implication.
Some who have studied agency theory aver that the models are no more than statements of
obvious facts expressed in mathematical symbols. Others state that the elements in the models
can’t be quantified (what is the “cost of information asymmetry”?), and that the model vastly
oversimplifies the real-world relationship between superiors and subordinates. The models
incorporate only a few elements. They disregard other factors that affect this relationship, such
as the personalities of the participants, agents who are not risk averse, nonfinancial motives,
the principal’s trust in the agent, the agent’s ability on the present assignment and potential
for future assignments, and so on.
We describe the theory in the hope that students will find it useful in thinking about how in-
centive compensation influences the motivation of managers, but we caution about using it to
solve actual compensation problems.
Summary
The incentive compensation system is a key management control device. Incentive compen-
sation plans can be divided roughly into two types: those that relate compensation to profits
currently earned by the company, called “short-term incentive plans”; and those that relate
compensation to longer-term performance, called “long-term incentive plans.” Several factors
should be considered when allocating the total bonus pool to corporate executives and busi-
ness unit managers. An incentive system that explicitly incorporates the following has a
much better chance of success:
• The needs, values, and beliefs of the general managers who are rewarded.
• The culture of the organization.
• External factors, such as industry characteristics, competitors’ compensation prac-
tices, managerial labor markets, and tax and legal issues.
• The organization’s strategies.
Suggested Additional Readings

Banker, Rajiv, D. Gordon Potter, and Dhinu Srinivasan. “An Empirical Investigation of an In-
centive Plan That Includes Nonfinancial Performance Measures.” The Accounting Review,
January 2000, pp. 65–92.
Betcher, John G. How to Design & 1Implement a Results-Oriented Variable Pay System. New
York: AMACOM, 1996.
Chingos, Peter T., and Peat Marwick, eds. Paying for Performance: A Guide to Compensation
Management. New York: John Wiley & Sons, 1997.
Crystal, Graef S. In Search of Excess: The Overcompensation of the American Executive. New
York: W. W. Norton, 1992.
Finkelstein, Sydney, and Donald C. Hambrick. Strategic Leadership: Top Executives and Their
Effects on Organizations. St. Paul, MN: West, 1996.
Fisher, Joseph, and Vijay Govindarajan. “Profit Center Manager Compensation: Impact of
Market, Political, and Human Capital Factors.” Strategic Management Journal, March 1992,
pp. 25–27.
Hall, Brian J. “What You Need to Know about Stock Options,” Harvard Business Review,
March–April 2000, pp. 121–31.
Henderson, Andrew D., and James W. Fredrickson. “Information-Processing Demands as a
Determinant of CEO Compensation.” Academy of Management Journal 39, no. 3 (June 1996),
pp. 575–606.
Henderson, Richard I., and Richard J. Henderson. Compensation Management in a Knowl-

edge-Based World. Upper Saddle River, NJ: Prentice Hall, 1996.
Hills, Frederick S., et al. Compensation Decision Making. Harcourt Brace
Jovanovich College and School Division, 1997.
Lederer, Jack L., and Carl R. Weinberg. “Are CEOs Paid Too Much?” Chief
Executive, May 1996, pp. 26–31.
Martocchio, Joseph J. Strategic Compensation: A Human Resource Management Approach.
Upper Saddle River, NJ: Prentice Hall, 1997.
Milkovich, George T., and Jerry M. Newman. Compensation. 3rd ed. Homewood, IL:
BPI/Irwin, 1990.
———. Compensation. New York: McGraw-Hill College Division, 1999.
Rodrick, Scott S., ed. Incentive Compensation and Employee Ownership.
Oakland, CA: National Center for Employee Ownership, 1999.
Sprinkle, Geoffrey B. “The Effect of Incentive Contracts on Learning and
Performance.” The Accounting Review, July 2000, pp. 299–326.
Zehnder, Egon. “A Simpler Way to Pay.” Harvard Business Review, April 2001, pp. 53–62.
Case 12-1
Lincoln Electric Company (A)
People are our most valuable asset. They must feel secure, important, challenged, in control of
their destiny, confident in their leadership, be responsive to common goals, believe they are
being treated fairly, have easy access to authority and open lines of communication in all possi-
ble directions. Perhaps the most important task Lincoln employees face today is that of estab-
lishing an example for others in the Lincoln organization in other parts of the world. We need
to maximize the benefits of cooperation and teamwork, fusing high technology with human tal-
ent, so that we here in the USA and all of our subsidiary and joint venture operations will be in
a position to realize our full potential.
—George Willis, CEO, The Lincoln Electric Company
The Lincoln Electric Company was the world’s largest manufacturer of arc-welding products
and a leading producer of industrial electric motors. The firm employed 2400 workers in two
US factories near Cleveland and an equal number in eleven factories located in other coun-
tries. This did not include the field sales force of more than 200. The company’s US market
share (for arc-welding products) was estimated at more than 40 percent.
The Lincoln incentive management plan had been well known for many years. Many college
management texts referred to the Lincoln plan as a model for achieving higher worker pro-
ductivity. Certainly, the firm was successful according to the usual measures.
When James F. Lincoln died in 1965, there had been some concern, even among employees,
that the management system would fall into disarray, that profits would decline, and that year-
end bonuses might be discontinued. Quite the contrary, 24 years after Lincoln’s death, the com-
pany appeared to be as strong as ever. Each year, except the recession years 1982 and 1983,
saw high profits and bonuses. Employee morale and productivity remained very good. Em-
ployee turnover was almost nonexistent except for retirements. Lincoln’s market share was
stable. The historically high stock dividends continued.
A Historical Sketch
In 1895, after being “frozen out” of the depression-ravaged Elliott-Lincoln Company, a maker of
Lincoln-designed electric motors, John C. Lincoln took out his second patent and began to man-
ufacture his improved motor. He opened his new business, unincorporated, with $200 he had
earned redesigning a motor for young Herbert Henry Dow, who later founded the Dow Chemi-
cal Company.
Started during an economic depression and cursed by a major fire after only one year in
business, the company grew, but hardly prospered, through its first quarter-century. In 1906,
John C. Lincoln incorporated the business and moved from his one-room, fourth-floor factory
to a new three-story building he erected in east Cleveland. He expanded his work force to 30
This case was prepared by Arthur D. Sharplin, McNeese State University. Copyright © by
Arthur D. Sharplin.
and sales grew to over $50,000 a year. John preferred being an engineer and inventor rather
than a manager, though, and it was to be left to another Lincoln to manage the company
through its years of success.
In 1907, after a bout with typhoid fever forced him to leave Ohio State University in his se-
nior year, James F. Lincoln, John’s younger brother, joined the fledgling company. In 1914 he
became active head of the firm, with the titles General Manager and Vice President. John re-
mained President of the company for some years but became more involved in other business
ventures and in his work as an inventor.
One of James Lincoln’s early actions was to ask the employees to elect representatives to a
committee (called the “Advisory Board”) which would advise him on company operations. The
Advisory Board met with the Chief Executive Officer every two weeks. This was only the first
of a series of innovative personnel policies which, over the years, distinguished Lincoln Elec-
tric from its contemporaries.
The first year the Advisory Board was in existence, working hours were reduced from 55 per
week, then standard, to 50 hours a week. In 1915, the company gave each employee a paid-up
life insurance policy. A welding school, which continues today, was begun in 1917. In 1918, an
employee bonus plan was attempted. It was not continued, but the idea was to resurface later.
The Lincoln Electric Employees’ Association was formed in 1919 to provide health benefits
and social activities. Over the years, it assumed several additional functions. In 1923, a piece-
work pay system was in effect, employees got two weeks paid vacation each year, and wages
were adjusted for changes in the Consumer Price Index. Approximately 30 percent of the com-
mon stock was set aside for key employees in 1914. A stock purchase plan for all employees was
begun in 1925.
The Board of Directors voted to start a suggestion system in 1929. Cash awards, a part of the
early program, were discontinued in the mid-1980s. Suggestions were rewarded by additional
“points,” which affected year-end bonuses.
The legendary Lincoln bonus plan was proposed by the Advisory Board and accepted on a
trial basis in 1934. The first annual bonus amounted to about 25 percent of wages. There was
a bonus every year after that. The bonus plan became a cornerstone of the Lincoln manage-
ment system, and recent bonuses approximated annual wages.
By 1944, Lincoln employees enjoyed a pension plan, a policy of promotion from within, and
continuous employment. Base pay rates were determined by formal job evaluation, and a merit
rating system was in effect.
In the prologue of James F. Lincoln’s last book, Charles G. Herbruck wrote regarding the
foregoing personnel innovations:
They were not to buy good behavior. They were not efforts to increase
profits. They were not antidotes to labor difficulties. They did not constitute a “do-gooder”
program. They were expressions of mutual respect for each person’s importance to the job to
be done. All of them reflect the leadership of James Lincoln, under whom they were nur-
tured and propagated.
During World War II, Lincoln prospered as never before. By the start of the war, the company
was the world’s largest manufacturer of arc-welding products. Sales of about $4 million in
1934 grew to $24 million by 1941. Productivity per employee more than doubled during the
same period. The Navy’s Price Review Board challenged the high profits. The Internal Rev-
enue Service questioned the tax deductibility of employee bonuses, arguing they were not
“ordinary and necessary” costs of doing business, but the forceful and articulate James Lin-
coln was able to overcome the objections.
Certainly after 1935 and probably for several years before that, Lincoln productivity was
well above the average for similar companies. The company claimed levels of productivity more
than twice those for other manufacturers from 1945 onward. Information available from out-
side sources tended to support these claims.
Company Philosophy
James F. Lincoln was the son of a Congregational minister, and Christian principles were at
the center of his business philosophy. The confidence that he had in the efficacy of Christ’s
teachings was illustrated by the following remark taken from one of his books:
The Christian ethic should control our acts. If it did control our acts, the savings in cost of
distribution would be tremendous. Advertising would be a contact of the expert consultant
with the customer, in order to give the customer the best product available when all of the
customer’s needs are considered. Competition then would be in improving the quality of
products and increasing efficiency in producing and distributing them; not in deception, as
is now too customary. Pricing would reflect efficiency of production; it would not be a selling
dodge that the customer may well be sorry he accepted. It would be proper for all concerned
and rewarding for the ability used in producing the product.
There was no indication that Lincoln attempted to evangelize his employees or customers—
or the general public, for that matter. Neither the Chairman of the Board and Chief Executive,
George Willis, nor the President, Donald F. Hastings, mentioned the Christian gospel in
speeches and interviews. The company motto, “The actual is limited, the possible is immense,”
was prominently displayed, but there was no display of religious slogans and no company
chapel.
Attitude toward the Customer

James Lincoln considered the customer’s needs the raison d’être for every company. “When any
company has achieved success so that it is attractive as an investment,” he wrote, “all money
usually needed for expansion is supplied by the customer in retained earnings. It is obvious
that the customer’s interests, not the stockholder’s, should come first.” In 1947 he said, “Care
should be taken . . . not to rivet attention on profit. Between ‘How much do I get?’ and ‘How do
I make this better, cheaper, more useful?’ the difference is fundamental and decisive.” Willis,
too, ranked the customer as management’s most important constituency. This was reflected in
Lincoln’s policy to “at all times price on the basis of cost and at all times keep pressure on our
cost.” Lincoln’s goal, often stated, was “to build a better and better product at a lower and lower
price.” “It is obvious,” James Lincoln said, “that the customer’s interests should be the first goal
of industry.”
Attitude toward Stockholders

Stockholders were given last priority at Lincoln. This was a continuation of James Lincoln’s phi-
losophy: “The last group to be considered is the stockholders who own stock because they think it
will be more profitable than investing money in any other way.” Concerning division of the largess
produced by incentive management, he wrote, “The absentee stockholder also will get his share,
even if undeserved, out of the greatly increased profit that the efficiency produces.”
Attitude toward Unionism

There was never a serious effort to organize Lincoln employees. While James Lincoln criticized the
labor movement for “selfishly attempting to better its position at the expense of the people it must
serve,” he still had kind words for union members. He excused abuses of union power as “the nat-
ural reactions of human beings to the abuses to which management has subjected them.” Lin-
coln’s idea of the correct relationship between workers and managers was shown by this com-
ment: “Labor and management are properly not warring camps; they are parts of one organization
in which they must and should cooperate fully and happily.”
Beliefs and Assumptions about Employees

If fulfilling customer needs was the desired goal of business, then employee performance and
productivity were the means by which this goal could best be achieved. It was the Lincoln at-
titude toward employees, reflected in the following comments by James Lincoln, which was
credited by many with creating the success the company experienced:
The greatest fear of the worker, which is the same as the greatest fear of the industrialist in
operating a company, is the lack of income. . . . The industrial manager is very conscious of
his company’s need for uninterrupted income. He is completely oblivious, evidently, of the
fact that the worker has the same need.
[The worker] is just as eager as any manager is to be part of a team that is properly orga-
nized and working for the advancement of our economy. . . . He has no desire to make profits
for those who do not hold up their end in production, as is true of absentee stockholders and
inactive people in the company.
If money is to be used as an incentive, the program must provide that what is paid to the
worker is what he has earned. The earnings of each must be in accordance with accomplish-
ment.
Status is of great importance in all human relationships. The greatest incentive that
money has, usually, is that it is a symbol of success. . . . The resulting status is the real in-
centive. . . . Money alone can be an incentive to the miser only.
There must be complete honesty and understanding between the hourly worker and man-
agement if high efficiency is to be obtained.
Lincoln’s Business
Arc welding had been the standard joining method in shipbuilding for decades. It was the pre-
dominant way of connecting steel in the construction industry. Most industrial plants had
their own welding shops for maintenance and construction. Manufacturers of tractors and all
kinds of heavy equipment used arc welding extensively in the manufacturing process. Many
hobbyists had their own welding machines and used them for making metal items such as
patio furniture and barbecue pits. The popularity of welded sculpture as an art form was
growing.
While advances in welding technology were frequent, arc-welding products, in the main,
hardly changed. Lincoln’s Innershield process was a notable exception. This process, described
later, lowered welding cost and improved quality and speed in many applications. The most
widely used Lincoln electrode, the Fleetweld 5P, was virtually the same from the 1930s to 1989.
For at least four decades, the most popular engine-driven welder in the world, the Lincoln SA-
200, had been a gray-colored assembly, including a four-cylinder Continental “Red Seal” engine
and a 200-ampere direct-current generator with two current-control knobs. A 1989 model SA-
200 even weighed almost the same as the 1950 model, and it certainly was little changed in ap-
pearance.
The company’s share of the US arc-welding products market appeared to have been about
40 percent for many years. The welding products market had grown somewhat faster than the
level of industry in general. The market was highly price-competitive, with variations in prices
of standard items normally amounting to only 1 or 2 percent. Lincoln’s products were sold di-
rectly by its engineering-oriented sales force and indirectly through its distributor organiza-
tion. Advertising expenditures amounted to less than 0.75 percent of sales. Research and de-
velopment expenditures typically ranged from $10 million to $12 million, considerably more
than competitors spent.
The other major welding process, flame welding, had not been competitive with arc welding
since the 1930s. However, plasma arc welding, a relatively new process which used a conduct-
ing stream of superheated gas (plasma) to confine the welding current to a small area, had
made some inroads, especially in metal tubing manufacturing, in recent years. Major advances
in technology which would produce an alternative superior to arc welding within the next
decade or so appeared unlikely. Also, it seemed likely that changes in the machines and tech-
niques used in arc welding would be evolutionary rather than revolutionary.
Products
The company was primarily engaged in the manufacture and sale of arc-welding products—elec-
tric welding machines and metal electrodes. Lincoln also produced electric motors ranging
from 0.5 to 200 horsepower. Motors constituted about 8 to 10 percent of total sales. Several mil-
lion dollars had recently been invested in automated equipment that would double Lincoln’s
manufacturing capacity for 0.5- to 20-horsepower electric motors.
The electric welding machines, some consisting of a transformer or motor and generator
arrangement powered by commercial electricity and others consisting of an internal com-
bustion engine and generator, were designed to produce 30 to 1500 amperes of electrical
power. This electrical current was used to melt a consumable metal electrode, with the
molten metal being transferred in superhot spray to the metal joint being welded. Very high
temperatures and hot sparks were produced, and operators usually had to wear special eye
and face protection and leather gloves, often along with leather aprons and sleeves.
Lincoln and its competitors marketed a wide range of general-purpose and specialty elec-
trodes for welding mild steel, aluminum, cast iron, and stainless and special steels. Most of
these electrodes were designed to meet the standards of the American Welding Society, a trade
association. They were thus essentially the same as to size and composition from one manu-
facturer to another. Every electrode manufacturer had a limited number of unique products,
but these typically constituted only a small percentage of total sales.
Welding electrodes were of two basic types:
1. Coated “stick” electrodes, usually 14 inches long and smaller than a pencil in diameter,
were held in a special insulated holder by the operator, who had to manipulate the elec-
trode in order to maintain a proper arc width and pattern of deposition of the metal
being transferred. Stick electrodes were packaged in 6- to 50-pound boxes.
2. Coiled wire, ranging in diameter from 0.035 to 0.219 inch, was designed to be fed con-
tinuously to the welding arc through a “gun” held by the operator or positioned by au-
tomatic positioning equipment. The wire was packaged in coils, reels, and drums
weighing from 14 to 1000 pounds and could be solid or flux-cored.
Manufacturing Processes
The main plant was in Euclid, Ohio, a suburb on Cleveland’s east side. There were no ware-
houses. Materials flowed from the 1Ⲑ2-mile-long dock on the north side of the plant through the
production lines to a very limited storage and loading area on the south side. Materials used
on each workstation were stored as close as possible to the workstation. The administrative
offices, near the center of the factory, were entirely functional. A corridor below the main level
provided access to the factory floor from the main entrance near the center of the plant. For-
tune magazine declared the Euclid facility one of America’s 10 best-managed factories,1 and
compared it with a General Electric plant also on the list:
Stepping into GE’s spanking new dishwasher plant, an awed supplier said, is like stepping
“into the Hyatt Regency.” By comparison, stepping into Lincoln Electric’s 33-year-old, cav-
ernous, dimly lit factory is like stumbling into a dingy big-city YMCA. It’s only when one
starts looking at how these factories do things that similarities become apparent. They have
found ways to merge design with manufacturing, build in quality, make wise choices about
automation, get close to customers, and handle their work forces.
A new Lincoln plant, in Mentor, Ohio, housed some of the electrode production operations,
which had been moved from the main plant.
Electrode manufacturing was highly capital-intensive. Metal rods purchased from steel pro-
ducers were drawn down to smaller diameters, cut to length, coated with pressed-powder “flux”
for stick electrodes or plated with copper (for conductivity), and put into coils or spools for wire.
Lincoln’s Innershield wire was hollow and filled with a material similar to that used to coat
stick electrodes. As mentioned earlier, this represented a major innovation in welding technol-
ogy when it was introduced. The company was highly secretive about its electrode production
processes, and outsiders were not given access to the details of those processes.
1
Gene Bylinsky, “America’s Best-Managed Factories,” Fortune, May 28, 1984, p. 16.
Lincoln welding machines and electric motors were made on a series of assembly lines.
Gasoline and diesel engines were purchased partially assembled, but practically all other com-
ponents were made from basic industrial products (e.g., steel bars and sheets and bar copper
conductor wire).
Individual components, such as gasoline tanks for engine-driven welders and steel shafts for
motors and generators, were made by numerous small “factories within a factory.” The shaft for
a certain generator, for example, was made from raw steel bar by one operator who used five
large machines, all running continuously. A saw cut the bar to length, a digital lathe machined
different sections to varying diameters, a special milling machine cut a slot for the keyway, and
so forth, until a finished shaft was produced. The operator moved the shafts from machine to
machine and made necessary adjustments.
Another operator punched, shaped, and painted sheet-metal cowling parts. One assembled
steel laminations onto a rotor shaft, then wound, insulated, and tested the rotors. Finished
components were moved by crane operators to the nearby assembly lines.
Worker Performance and Attitudes

Exceptional worker performance at Lincoln was a matter of record. The typical Lincoln em-
ployee earned about twice as much as other factory workers in the Cleveland area. Yet the com-
pany’s labor cost per sales dollar in 1989, 26 cents, was well below the industry average.
Worker turnover was practically nonexistent except for retirements and departures by new
employees.
Sales per Lincoln factory employee exceeded $150,000. An observer at the factory quickly
saw why this figure was so high. Each worker was proceeding busily and thoughtfully about the
task at hand. There was no idle chatter. Most workers took no coffee breaks. Many operated sev-
eral machines and made a substantial component unaided. The supervisors were busy with
planning and record-keeping duties and hardly glanced at the people they “supervised.” The
manufacturing procedures appeared to be efficient—no unnecessary steps, no wasted motions,
no wasted materials. Finished components moved smoothly to subsequent workstations.
The Appendix to this case gives summaries of interviews with employees.
Organizational Structure
Lincoln never allowed development of a formal organization chart. The objective of this policy
was to ensure maximum flexibility. An open-door policy was practiced throughout the company,
and personnel were encouraged to take problems to the persons most capable of resolving
them. Once, Harvard Business School researchers prepared an organization chart reflecting
the implied relationships at Lincoln. The chart became available within the company, and
management felt that the chart had a disruptive effect. Therefore, no organization chart ap-
pears in this case.
Perhaps because of the quality and enthusiasm of the Lincoln workforce, routine supervi-
sion was almost nonexistent. A typical production foreman, for example, supervised as many
as 100 workers, a span of control which did not allow more than infrequent worker–supervisor
interaction.
Position titles and traditional flows of authority did imply something of an organizational
structure, however. For example, the Vice President, Sales, and the Vice President, Electrode
Division, reported to the President, as did various staff assistants such as the Personnel Di-
rector and the Director of Purchasing. Using such implied relationships, it was determined
that production workers had two or, at most, three levels of supervision between themselves
and the President.
Personnel Policies
As mentioned earlier, Lincoln’s remarkable personnel practices were credited by many with
the company’s success.
Recruitment and Selection

Every job opening was advertised internally on company bulletin boards, and any employee
could apply for any job so advertised. External hiring was permitted only for entry-level posi-
tions. Selection for these jobs was done on the basis of personal interviews; there was no apti-
tude or psychological testing. Not even a high school diploma was required—except for engi-
neering and sales positions, which were filled by graduate engineers. A committee consisting of
vice presidents and supervisors interviewed candidates initially cleared by the Personnel De-
partment. Final selection was made by the supervisor who had a job opening. Out of over 3500
applicants interviewed by the Personnel Department during one period, fewer than 300 were
hired.
Job Security
In 1958 Lincoln formalized its guaranteed continuous employment policy, which had already
been in effect for many years. There had been no layoffs since World War II. Since 1958, every
worker with over two years’ longevity had been guaranteed at least 30 hours per week, 49
weeks per year.
The policy was never so severely tested as during the 1981–1983 recession. As a manufac-
turer of capital goods, Lincoln had business that was highly cyclical. In previous recessions the
company had been able to avoid major sales declines. However, sales plummeted 32 percent in
1982 and another 16 percent the next year. Few companies could withstand such a revenue col-
lapse and remain profitable. Yet, not only did Lincoln earn profits, but no employee was laid off
and year-end incentive bonuses continued. To weather the storm, management cut most of the
nonsalaried workers back to 30 hours a week for varying periods of time. Many employees were
reassigned, and the total workforce was slightly reduced through normal attrition and re-
stricted hiring. Many employees grumbled at their unexpected misfortune, probably to the sur-
prise and dismay of some Lincoln managers. However, sales and profits—and employee
bonuses—soon rebounded, and all was well again.
Performance Evaluations
Each supervisor formally evaluated subordinates twice a year using the cards shown in Exhibit
1. The employee performance criteria—“quality,” “dependability,” “ideas and cooperation,” and
“output”—were considered to be independent of each other. Marks on the cards were converted
EXHIBIT 1
Merit
in the office and engineering.

with other department heads
department in the shop and
head and the inspection
jointly by your department
This rating has been done
Increasing Quality
Rating
Cards This card rates the QUALITY of work you do.
It also reflects your success in eliminating errors and in reducing scrap
Quality
and waste.
Increasing Dependability
by your department head.

This rating has been done
This card rates how well your supervisors have been able to depend on you to do
Dependability
those things that have been expected of you without supervision.
It also reflects your ability to supervise yourself, including your work safety
performance, your orderliness, care of equipment, and the effective use you make
of your skills.
engineering.
heads in the office and
shop and with other department
Time study department in the
by your department head and the
This rating has been done jointly
Increasing Ideas & Cooperation
Ideas & Cooperation

This card rates your Cooperation, Ideas, and Initiative.
New ideas and new methods are important to your company in our
continuing effort to reduce costs, increase output, improve quality and
work safety, and improve our relationship with our customers. This card
credits you for your ideas and initiative used to help in this direction.
It also rates your cooperation—how you work with others as a team.
Such factors as your attitude toward supervision, coworkers, and the
company, your efforts to share knowledge with others, and your
cooperation in installing new methods smoothly are considered here.
Increasing Output Days Absent

and engineering.
department heads in the office
the shop and with other
production control department in
by your department head and the
This rating has been done jointly
This card rates HOW MUCH PRODUCTIVE WORK you actually turn
out. It also reflects your willingness not to hold back and recognizes
Output
your attendance record.

to numerical scores which were forced to average 100 for each evaluating supervisor. Individ-
ual merit rating scores normally ranged from 80 to 110. Any score over 110 required a special
letter to top management. These scores (over 110) were not considered in computing the re-
quired 100-point average for each evaluating supervisor. Suggestions for improvements often
resulted in recommendations for exceptionally high performance scores. Supervisors discussed
individual performance marks with the employees concerned. Each warranty claim was traced
to the individual employee whose work caused the defect. When that happened, the employee’s
performance score might be reduced, or the worker might be required to repay the cost of ser-
vicing the warranty claim by working without pay.
Compensation
Basic wage levels for jobs at Lincoln were determined by a wage survey of similar jobs in the
Cleveland area. These rates were adjusted quarterly in accordance with changes in the Cleve-
land area wage index. Insofar as possible, base wage rates were translated into piece rates.
Practically all production workers and many others—for example, some forklift operators—
were paid by piece rate. Once established, piece rates were never changed unless a substantive
change in the way a job was done resulted from a source other than the worker doing the job.
In December of each year, a portion of annual profits was distributed to employees as
bonuses. Incentive bonuses since 1934 had averaged about 90 percent of annual wages and
somewhat more than aftertax profits. The average bonus for 1988 was $21,258. Even for the re-
cession years 1982 and 1983, bonuses averaged $13,998 and $8,557, respectively. Individual
bonuses were proportional to merit rating scores. For example, assume the amount set aside
for bonuses was 80 percent of total wages paid to eligible employees. A person whose perfor-
mance score was 95 would receive a bonus of 76 percent (0.80 * 0.95) of annual wages.
Vacations
The company was shut down for two weeks in August and two weeks during the Christmas
season. Vacations were taken during these periods. For employees with over 25 years of ser-
vice, a fifth week of vacation could be taken at a time acceptable to superiors.
Work Assignment
Management had authority to transfer workers and to switch between overtime and short time
as required. Supervisors had undisputed authority to assign specific parts to individual work-
ers, who might have their own preferences due to variations in piece rates. During the
1982–1983 recession, fifty factory workers volunteered to join sales teams and fanned out
across the country to sell a new welder designed for automobile body shops and small machine
shops. The result—$10 million in sales and a hot new product.
Employee Participation in Decision Making

Thinking of participative management usually evokes a vision of a relaxed, nonauthoritarian
atmosphere. This was not the case at Lincoln. Formal authority was quite strong. “We’re very
authoritarian around here,” said Willis. James F. Lincoln placed a good deal of stress on pro-
tecting management’s authority. “Management in all successful departments of industry must
have complete power,” he said. “Management is the coach who must be obeyed. The workers,
however, are the players who alone can win the game.” Despite this attitude, there were sev-
eral ways in which employees participated in management at Lincoln.
Richard Sabo, Assistant to the Chief Executive Officer, related job
enlargement/enrichment to participation. He said, “The most important participative tech-
nique that we use is giving more responsibility to employees. We give a high school gradu-
ate more responsibility than other companies give their foremen.” Management put limits
on the degree of participation which was allowed, however. In Sabo’s words:
When you use “participation,” put quotes around it. Because we believe that each person
should participate only in those decisions he is most knowledgeable about. I don’t think pro-
duction employees should control the decisions of the chairman. They don’t know as much as
he does about the decisions he is involved in.
The Advisory Board, elected by the workers, met with the Chairman and the President every
two weeks to discuss ways of improving operations. As noted earlier, this board had been in ex-
istence since 1914 and had contributed to many innovations. The incentive bonuses, for exam-
ple, were first recommended by this committee. Every employee had access to Advisory Board
members, and answers to all Advisory Board suggestions were promised by the following meet-
ing. Both Willis and Hastings were quick to point out, though, that the Advisory Board only
recommended actions. “They do not have direct authority,” Willis said, “and when they bring up
something that management thinks is not to the benefit of the company, it will be rejected.”
Under the early suggestion program, employees were awarded one-half of the first year’s
savings attributable to their suggestions. Later, however, the value of suggestions was reflected
in performance evaluation scores, which determined individual incentive bonus amounts.
Training and Education

Production workers were given a short period of on-the-job training and then placed on a piece-
work pay system. Lincoln did not pay for off-site education, unless very specific company needs
were identified. The idea behind this policy, according to Sabo, was that not everyone could
take advantage of such a program, and it was unfair to expend company funds for an advan-
tage to which there was unequal access. Recruits for sales jobs, already college graduates, were
given on-the-job training in the plant, followed by a period of work and training at one of the
regional sales offices.
Fringe Benefits and Executive Perquisites

A medical plan and a company-paid retirement program had been in effect for many years. A
plant cafeteria, operated on a break-even basis, served meals at about 60 percent of usual
costs. The Employee Association, to which the company did not contribute, provided disability
insurance and social and athletic activities. The employee stock ownership program resulted in
employee ownership of about 50 percent of the common stock. Under this program, each em-
ployee with more than two years of service could purchase stock in the corporation. The price
of the shares was established at book value. Stock purchased through this plan could be held
by employees only.
Dividends and voting rights were the same as for stock which was owned outside the plan.
Approximately 75 percent of the employees owned Lincoln stock.
As to executive perquisites, there were none. Executives had crowded, austere offices; no
executive washrooms or lunchrooms; and no reserved parking spaces. Even the top execu-
tives paid for their own meals and ate in the employee cafeteria. On one recent day, Willis
arrived at work late because of a breakfast speaking engagement and had to park far away
from the factory entrance.
Financial Policies
James F. Lincoln felt strongly that financing for company growth should come from within the
company—through initial cash investment by the founders, through retention of earnings, and
through stock purchases by those who worked in the business. He saw the following advan-
tages to this approach:
1. Ownership of stock by employees strengthened team spirit. “If they are mutually anx-
ious to make it succeed, the future of the company is bright.”
2. Ownership of stock provided individual incentive because employees felt that they
would benefit from company profitability.
3. “Ownership is educational.” Owner-employees “will know how profits are made and
lost; how success is won and lost. . . . There are few socialists in the list of stockholders
of the nation’s industries.”
4. “Capital available from within controls expansion.” Unwarranted expansion would not
occur, Lincoln believed, under his financing plan.
5. “The greatest advantage would be the development of the individual worker. Under the
incentive of ownership, he would become a greater man.”
6. “Stock ownership is one of the steps that can be taken that will make the worker feel
that there is less of a gulf between him and the boss. . . . Stock ownership will help the
worker to recognize his [or her] responsibility in the game and the importance of vic-
tory.”
Until 1980, Lincoln Electric borrowed no money. The company’s liabilities consisted mainly of
accounts payable and short-term accruals.
The unusual pricing policy at Lincoln was succinctly stated by Willis: “At all times price on
the basis of cost, and all times keep pressure on our cost.” This policy resulted in the price for
the most popular welding electrode going from 16 cents a pound in 1929 to 4.7 cents in 1938.
More recently, the SA-200 welder, Lincoln’s largest-selling portable machine, had decreased in
price from 1958 through 1965. According to Dr. C. Jackson Grayson of the American Productiv-
ity Center in Houston, Texas, Lincoln’s prices had increased only one-fifth as fast as the Con-
sumer Price Index from 1934 to about 1970. This resulted in a welding products market in
which Lincoln became the undisputed price leader for the products it manufactured. Not even
EXHIBIT 2 Lincoln Electric’s Financial History

1974 1979 1980 1981 1982 1983 1987 1988 1989
Sales (in millions
of dollars) $233 $385 $401 $469 $329 $277 $377 $478 $582
Return on equity* 25% 19% 16% 19% 9% 9% 15% 16% 12%
Debt to equity ratio† 0% 0% 0% 0% 0% 0% 2% 7% 11%
Segment data:
Arc-welding products (% of total sales) 91% 91% 91% 91%
Other products (% of total sales) 9% 9% 9% 9%
* Profit after tax

Return on equity ⫽
Stockholders’ equity
†
Long-tterm debt
Debt to equity ratio ⫽
Long-term debt ⫹ Stockholders’ equity
the major Japanese manufacturers, such as Nippon Steel for welding electrodes and Osaka
Transformer for welding machines, were able to penetrate this market.
Substantial cash balances were accumulated each year preparatory to paying the year-end
bonuses. The bonuses totaled $54 million for 1988. The money was invested in short-term US
government securities and certificates of deposit (CDs) until needed. The company’s financial
history is shown in Exhibit 2.
How Well Did Lincoln Serve Its Stakeholders?

Lincoln Electric differed from most other companies in the importance it assigned to each of
the groups it served. Willis identified these groups, in the order of priority ascribed to them, as
(1) customers, (2) employees, and (3) stockholders.
Certainly the firm’s customers had fared well over the years. Lincoln prices for welding
machines and welding electrodes were acknowledged to be the lowest in the marketplace.
Quality was consistently high. The cost of field failures for Lincoln products had recently
been determined to be a remarkable 0.04 percent of revenues. The “Fleetweld” electrodes
and SA-200 welders had been the standard in the pipeline and refinery construction indus-
try, where price was hardly a criterion, for decades. A Lincoln distributor in Monroe,
Louisiana, said that he had sold several hundred of the popular AC-225 welders, which were
warranted for one year, but never handled a warranty claim.
Perhaps best-served of all management constituencies were the employees. Not the least of
their benefits, of course, were the year-end bonuses, which effectively doubled an already aver-
age compensation level. The foregoing description of the personnel program and the comments
in the Appendix further illustrate the desirability of a Lincoln job.
While stockholders were relegated to an inferior status by James F. Lincoln, they did very
well indeed. Recent dividends had exceeded $11 a share, and earnings per share approached
$30. In January 1980, the price of restricted stock, committed to employees, had been $117 a
share. By 1989, the stated value at which the company would repurchase the stock if tendered
was $201. A check with the New York office of Merrill Lynch, Pierce, Fenner and Smith at that
time revealed an estimated price on Lincoln stock of $270 a share, with none being offered for
sale. Technically, this price applied only to the unrestricted stock owned by the Lincoln family,
a few other major holders, and employees who purchased it on the open market. Risk associ-
ated with Lincoln stock, a major determinant of stock value, was minimal because of the small
amount of debt in the capital structure, because of an extremely stable earnings record, and be-
cause of Lincoln’s practice of purchasing the restricted stock whenever employees offered it for
sale.
A Concluding Comment
It was easy to believe that the reason for Lincoln’s success was the excellent attitude of the em-
ployees and their willingness to work harder, faster, and more intelligently than other indus-
trial workers. However, Sabo suggested that appropriate recognition be given to Lincoln execu-
tives, whom he credited with carrying out the following policies:
1. Management limited research, development, and manufacturing to a standard product
line designed to meet the major needs of the welding industry.
2. New products had to be reviewed by manufacturing and all producing costs verified be-
fore the products were approved by management.
3. Purchasing was challenged not only to procure materials at the lowest cost but also to
work closely with engineering and manufacturing to ensure that the latest innovations
were implemented.
4. Manufacturing supervision and all personnel were held accountable for reduction of
scrap, energy conservation, and maintenance of product quality.
5. Production control, material handling, and methods engineering were closely super-
vised by top management.
6. Management made cost reduction a way of life at Lincoln, and definite programs were
established in many areas, including traffic and shipping, where tremendous savings
could result.
7. Management established a sales department that was technically trained to reduce
customer welding costs. This sales approach and other real customer services elimi-
nated nonessential frills and resulted in long-term benefits to all concerned.
8. Management encouraged education, technical publishing, and long-range programs
that resulted in industry growth, thereby assuring market potential for the Lincoln
Electric Company.
Sabo wrote, “It is in a very real sense a personal and group experience in faith—a belief that
together we can achieve results which alone would not be possible. It is not a perfect system,
and it is not easy. It requires tremendous dedication and hard work. However, it does work, and
the results are worth the effort.”
Appendix
Employee Interviews
Typical questions and answers from employee interviews are presented below. The employees’
names have been changed to protect their privacy.
Interview 1
Ed Sanderson, a 23-year-old high school graduate who had been with Lincoln four years and
who was a machine operator in the Electrode Division at the time of the interview.
Q: How did you happen to get this job?
A: My wife was pregnant, and I was making three bucks an hour and one day I came here
and applied. That was it. I kept calling to let them know I was still interested.
Q: Roughly what were your earnings last year including your bonus?
A: $45,000.
Q: What have you done with your money since you have been here?
A: Well, we’ve lived pretty well, and we bought a condominium.
Q: Have you paid for the condominium?
A: No, but I could.
Q: Have you bought your Lincoln stock this year?
A: No, I haven’t bought any Lincoln stock yet.
Q: Do you get the feeling that the executives here are pretty well thought of?
A: I think they are. To get where they are today, they had to really work.
Q: Wouldn’t that be true anywhere?
A: I think more so here because seniority really doesn’t mean anything. If you work with a
guy who has 20 years here, and you have 2 months and you’re doing a better job, you will get
advanced before he will.
Q: Are you paid on a piece-rate basis?
A: My gang does. There are nine of us who make the bare electrode, and the whole group gets
paid based on how many electrodes we make.
Q: Do you think you work harder than workers in other factories in the Cleveland area?
A: Yes, I would say I probably work harder.
Q: Do you think it hurts anybody?
A: No, a little hard work never hurts anybody.
Q: If you could choose, do you think you would be as happy earning a little less money and
being able to slow down a little?
A: No, it doesn’t bother me. If it bothered me, I wouldn’t do it.
Q: Why do you think Lincoln employees produce more than workers in other plants?
A: That’s the way the company is set up. The more you put out, the more you’re going to
make.
Q: Do you think it’s the piece rate and bonus together?
A: I don’t think people would work here if they didn’t know that they would be rewarded at
the end of the year.
Q: Do you think Lincoln employees will ever join a union?
A: No.
Q: What are the major advantages of working for Lincoln?
A: Money.
Q: Are there any other advantages?
A: Yes, we don’t have a union shop. I don’t think I could work in a union shop.
Q: Do you think you are a career man with Lincoln at this time?
A: Yes.
Interview 2
Roger Lewis, a 23-year-old Purdue graduate in mechanical engineering who had been in the
Lincoln sales program for 15 months and who was working in the Cleveland sales office at the
time of the interview.
Q: How did you get your job at Lincoln?
A: I saw that Lincoln was interviewing on campus at Purdue, and I went by. I later came to
Cleveland for a plant tour and was offered a job.
Q: Do you know any of the senior executives? Would they know you by name?
A: Yes, I know all of them—Mr. Hastings, Mr. Willis, Mr. Sabo.
Q: Do you think Lincoln salespeople work harder than those in other
companies?
A: Yes. I don’t think there are many salespeople for other companies who are putting in 50- to
60-hour weeks. Everybody here works harder. You can go out in the plant, or you can go up-
stairs, and there’s nobody sitting around.
Q: Do you see any real disadvantage to working at Lincoln?
A: I don’t know if it’s a disadvantage, but Lincoln is a spartan company, a very thrifty com-
pany. I like that. The sales offices are functional, not fancy.
Q: Why do you think Lincoln employees have such high productivity?
A: Piecework has a lot to do with it. Lincoln is smaller than many plants, too; you can stand in
one place and see the materials come in one side and the product go out the other. You feel a part
of the company. The chance to get ahead is important, too. They have a strict policy of promoting
from within, so you know you have a chance. I think in a lot of other places you may not get as
fair a shake as you do here. The sales offices are on a smaller scale, too. I like that. I tell someone
that we have two people in the Baltimore office, and they say, “You’ve got to be kidding.” It’s
smaller and more personal. Pay is the most important thing. I have heard that this is the high-
est-paying factory in the world.
Interview 3
Joe Trahan, a 58-year-old high school graduate who had been with Lincoln 39 years and who
was employed as a working supervisor in the tool room at the time of the interview.
Q: Roughly what was your pay last year?
A: Over $56,000; salary, bonus, stock dividends.
Q: How much was your bonus?

A: About $26,000.
Q: Have you ever gotten a special award of any kind?
A: Not really.
Q: What have you done with your money?
A: My house is paid for—and my two cars. I also have some bonds and the Lincoln stock.
Q: What do you think of the executives at Lincoln?
A: They’re really top-notch.
Q: What is the major disadvantage of working at Lincoln Electric?
A: I don’t know of any disadvantage at all.
Q: Do you think you produce more than most people in similar jobs with other companies?
A: I do believe that.
Q: Why is that? Why do you believe that?
A: We are on the incentive system. Everything we do, we try to improve to make a better prod-
uct with a minimum of outlay. We try to improve the bonus.
Q: Would you be just as happy making a little less money and not working quite so hard?
A: I don’t think so.
Q: Do you think Lincoln employees would ever join a union?
A: I don’t think they would ever consider it.
Q: What is the most important advantage of working at Lincoln?
A: Compensation.
Q: Tell me something about Mr. James Lincoln, who died in 1965.
A: You are talking about Jimmy, Sr. He always strolled through the shop in his shirt sleeves.
Big fellow. Always looked distinguished. Gray hair. Friendly sort of guy. I was a member of
the Advisory Board one year. He was there each time.
Q: Did he strike you as really caring?
A: I think he always cared for people.
Q: Did you get any sensation of a religious nature from him?
A: No, not really.
Q: And religion is not part of the program now?
A: No.
Q: Do you think Mr. Lincoln was a very intelligent man, or was he just a nice guy?
A: I would say he was pretty well educated. A great talker—always right off the top of his
head. He knew what he was talking about all the time.
Q: When were bonuses for beneficial suggestions done away with?
A: About 18 years ago.
Q: Did that hurt very much?
A: I don’t think so, because suggestions are still rewarded through the merit rating system.
Q: Is there anything you would like to add?
A: It’s a good place to work. The union kind of ties other places down. At other places, electri-
cians only do electrical work, carpenters only do carpenter work. At Lincoln Electric we all
pitch in and do whatever needs to be done.
Q: So a major advantage is not having a union?
A: That’s right.
Questions
1. How would you characterize Lincoln Electric’s strategy? In this context, what is the na-
ture of Lincoln’s business and upon what bases does this company compete?
2. What are the most important elements of Lincoln’s overall approach to organization
and control that help explain why this company is so successful? How well do Lincoln’s
organization and control mechanisms fit the company’s strategic requirements?
3. What is the corporate culture like at Lincoln Electric? What type of employees would
be happy working at Lincoln Electric?
4. What is the applicability of Lincoln’s approach to organization and control to other
companies? Why don’t more companies operate like Lincoln?
5. What could cause Lincoln’s strategy implementation approach to break down? What
are the threats to Lincoln’s continued success?
6. Would you like to work in an environment like that at Lincoln Electric?
Case 12-2
Crown Point Cabinetry
Introduction
It was 2002 and Brian Stowell, CEO of Crown Point Cabinetry, was reflecting on the incredible
change he had seen in his nine years of leadership at the small manufacturing company. Located
in rural Claremont, New Hampshire, Crown Point supplied high-end custom kitchen cabinets to
customers throughout the United States. The company was a respected and desirable employer
in its small community, boasting an inspired and motivated workforce. It had earned the trust
of thousands of customers nationwide. But it wasn’t always that way.
Industry
The U.S. cabinet industry was highly fragmented, with more than 5,000 manufacturers sup-
plying stock, semi-custom, and custom cabinets1 through multiple distribution channels. In
1998 the largest manufacturer held 15 percent of the market, while the second largest held
just 7 percent. Over half the manufacturers employed fewer than 10 people.
Demand for cabinets followed residential construction industry trends. Distributors and
dealers each represented about 30 percent of manufacturers’ cabinet purchases, while home
centers and builders shared the remainder evenly. Less than 1 percent of cabinets were pur-
chased direct from manufacturers. As big-box home improvement retailers emerged in the ’90s,
the trend toward stock cabinets strengthened while the custom share of the market weakened,
from 26 percent in 1989 to less than 15 percent by 1999.2
Crown Point, at 85 employees, was a relatively large manufacturer, although some cabinet-
making firms employed upwards of 1,000 people. Crown Point made custom cabinets and, with an
average sale in 2001 running over $25,000 for a kitchen cabinet set, competed in the high end of
the cabinet-making market.
History
Norm Stowell founded the business in 1979, producing the first cabinets in his garage. Em-
bracing principles of quality and service, by 1992 Norm had grown the business to more than
100 employees, which included all seven of his children. While revenues were growing sub-
This case was written by David Vanderschee (T’02) under the supervision of Professor Vijay Govindarajan and Julie Lang
(T’93) of the Tuck School of Business at Dartmouth College. © Trustees of Dartmouth College.
1
Stock cabinets, typically sold by large home-center retailers, are pre-designed, often unassembled cabinets that come in
specific widths and heights, with minimal optional features. Custom cabinets are “one off,” designed specifically for a
particular customer, with no restrictions on features or sizes. Semi-custom are a hybrid of the two, with standard widths
and heights and variable features and design options.
2
Figures are quoted for unit sales. Dollar market share for custom cabinets has declined from 31 percent in 1990 to 26 per-
cent in 1999.
stantially, the bottom line was suffering. Brian Stowell, one of the Stowell offspring involved in
the company, managed sales in 1992 but took a special interest in running the business. With
the agreement of his siblings and his father, Brain assumed the lead executive role in 1993.
Crown Point’s Products and Production Process

Crown Point manufactured cabinets in its 33,000 square foot facility (about half the size of a
soccer field). The facility was small by light-manufacturing plant standards, as evidenced by
cramped work-in-process and finished inventory. Each kitchen cabinet, available in a variety
of styles, woods, and finishes, was custom designed to exacting customer specifications. The
design was transferred to the production floor where raw material (mainly maple, oak, pine,
and other woods) was cut to make cabinet frames, doors, and boxes. Work was separated by
task on the floor. Each piece was hand sanded and finished with stains or specialty paints.
The final product was assembled, blanket wrapped, and shipped via furniture truck. Order
to delivery generally took 14 to 20 weeks, with lead time (time to get the sale into production)
consuming most of that period. The actual manufacturing time typically was 10 days. Al-
though investments had been made in new cutting and finishing equipment, the dedication
to handcrafting every part of each cabinet made the workers’ interaction with the wood an
ongoing critical part of making a Crown Point cabinet.
A Change in Philosophy
Crown Point’s environment was similar to that at many small manufacturing shops. Growing
sales, a dedicated management group, and a satisfied dealer network had not translated into
healthy financial performance. Some employees were loyal, but a large number of jobs opened up
four or more times each year, yielding an average annual employee turnover of 300 percent.
Many individuals described management/employee relations as “horrible.” One employee recol-
lects “the managers used to have a real attitude, like they were on a power trip. They would stand
over our shoulders trying to make sure everything was right. And when it wasn’t, they were sure
to tell you about it.”
Absenteeism was rampant. Management’s reaction to this problem, and to many other prob-
lems, was to wield a heavy hand. Administrators enacted a policy of denying holiday pay for
anyone who called in sick before or after a holiday weekend. It seemed to have little effect.
The most significant problem, however, was poor in-process quality control.3 As Brian recol-
lects, “While our finished quality was great, we were building a cabinet three or four times be-
fore it got out of the shop.” Early in 1993 Brian decided to experiment with a different ap-
proach.
3
In-process quality control is defined as the monitoring and control of quality during the production cycle. Finished qual-
ity refers to the quality of the finished product.
A New Attitude
Standing atop a table on the shop floor, Brian called a meeting of the company to lay out his vi-
sion.
“Starting today,” he said, “things are going to change. Right now we are wasting tremendous
money on rework and wasted materials. I don’t want that money going out the door; I would
rather give it to you. People are leaving here with no retirement benefits. It breaks my heart to
see this happening. I want to be able to afford to give people these things. From now on, if you
don’t care about first-time quality, there won’t be a job for you. If you do care, you’ll always have
a job here.”
He continued on a second theme: “Today this place isn’t a particularly desirable place to
work. My vision is that one day people will say to you, ‘You work at Crown Point? Wow, I’d love
to get in there.’”
Employees were skeptical but Brian asked them to trust him. As a goodwill gesture, he de-
cided the company would provide donuts and coffee every morning for breakfast, although it
couldn’t really afford the expense. The announcement of change introduced a period of re-
structuring and painful transition. Management critically evaluated employees based on their
quality of workmanship and cut the payroll from 76 to 53 people by 1994. During that period,
unit and dollar sales increased.
Team-Based Management
Unlike most of the management team at Crown Point, Brian Stowell’s wife, Becky, had experi-
ence in other business settings. As a family member and shareholder, she was privy to many of
the struggles Crown Point faced. Foremost among these struggles were the restructuring deci-
sions management was making. Deciding which employees were the source of quality problems
was challenging and politically charged. Twelve months after Brian’s speech, Becky offered a
simple yet radical solution: get rid of the management layers and let employees decide who
among their peers was worth keeping. She advocated a team-based management approach
that empowered employees with personnel and management decision-making responsibility.
The philosophy was adopted, and eight production line managers were placed in work teams
alongside the employees they formerly supervised. Some managers quit rather than be
“demoted.” Others adapted effortlessly. Still others tried but were unable to work under the
new system.
The production departments were converted into teams consisting of up to 12 people. Meet-
ings were held daily to facilitate communication, air grievances, suggest work improvements,
and schedule production. A pattern quickly developed wherein two or three individuals would
dominate discussion while the rest remained silent. To combat this problem, all employees
were offered communication training and teams were broken into smaller groups.
By 1994 teams had designed co-worker review sheets, or “scorecards.” These were used to
evaluate team member performance and recommend salary increases up to a maximum per-
centage set by management. The scorecard, which has remained unchanged since its inception,
was intentionally subjective in nature. Varying levels of scorecard detail were offered by em-
ployees but one thing seemed constant: many employees received repeated criticism, but very
few were denied the maximum salary increase. The result was that almost all employees re-
ceived the same (maximum) percentage increase.
Since their inception, teams have been vested with the power to hire and fire teammates.
The head of human resources first interviews candidates for a team opening. Recommended
candidates are then interviewed by the team. Over 75 percent of candidates that HR passes
have been rejected subsequently by the team.
Gainsharing
In 1997 Crown Point instituted an incentive system designed to reduce labor costs. Labor typ-
ically constitutes 25 percent of costs for a cabinet manufacturer. Brian and Becky4 proposed
sharing labor cost savings with employees through a program termed gainsharing. The system
worked as follows:
1. Brian multiplied sales figures for each month by a set percentage, based on a reason-
able estimate of what the company could afford to pay for labor. This figure was used
to determine a maximum bonus pool.
2. From this figure, actual labor costs for regular hours, overtime labor costs, and a holi-
days/vacation budget were subtracted.
3. The remaining funds were distributed evenly each month as a percentage among em-
ployees, based on wages earned.
4. Each month was started anew regardless of the previous month’s performance. Every
Monday afternoon, a meeting was held to go over, among other things, the results to
date for gainsharing bonuses. Over 95 percent of the time since their inception, gain-
sharing bonuses have been paid out, averaging 11–20 percent of annual compensation
from 1997 to 2001.
An undesired result of the gainsharing system was animosity toward individuals who
worked overtime. Since gainsharing was based on total company performance and payout was
tied to wages earned, individuals who worked overtime received a disproportionate share of
the gainsharing bonus. Attrition seemed to take care of the problem as individuals who needed
to work overtime (due to consistently unfinished work) were eventually counseled out by other
members of their team.
Backorder Penalty/Reward System

Crown Point prided itself on on-time and complete delivery. Orders that left the shop incom-
plete were identified as “backorders.” A backorder required further shipment of missing parts
and field installation of those parts. As gainsharing bonuses were paid, the number of backo-
rders seemed to increase. Brian repeatedly pointed out the long-term impact backorders had
on the business. He explained that because the business was so dependent on satisfied cus-
tomers and word-of-mouth advertising, it was critical that every order be received complete
and on time. The speeches didn’t seem to help.
4
Becky Stowell, Brian’s wife, became a full-time employee in 1994 and vice president of Crown Point in 2001.
Beginning in 1998, a $250 penalty was applied to the gainsharing pool for every backorder
experienced. No impact was noticed, so the penalty was increased to $500. Again there was no
measurable impact. Finally, in 1999 the penalty was increased to $1,000 and a lunch was
promised for every employee for every week in which no backorders occurred. The frequency of
backorders declined noticeably. Workers cheered when a week passed without a backorder, and
lunches were soon being served nearly every Thursday. Not everyone was happy, though, par-
ticularly front office personnel who had the added task of arranging lunch for 85 people every
week. And some people wondered whether the $500 weekly lunch bill was justifiable.
Wage Increases
Gainsharing bonuses approached 20 percent in the first year of implementation. The follow-
ing year, 1998, Brian and Becky decided to raise wages. They rationalized that employees
were better able to secure loans and plan/pay for items when they could count on a secure
salary. Wages were raised again 14 months later—in 2000—and again in 2001. These wage
increases had the effect of keeping gainsharing bonuses contained at less than 25 percent on
an annual basis. Employees, predictably, were delighted at the increases although some
feared the increased labor rates would ultimately result in job losses. Brian assured them
that the extra money was a direct result of continued labor savings due to increased produc-
tivity and that job security was still a priority.
Safety
A safety program was instituted under Norm Stowell’s stewardship. In 1994 a safety team was
established under the direction of Becky Stowell and Jeff Stowell, Brian’s brother. The team
wrote rules and guidelines for work, and employees were empowered to remove others from the
shop floor for safety violations. The safety team determined penalties, including dismissal, for
violators. Everyone was subject to the same rules; even the founder and president was “retrained”
on safety standards. Serving on the safety team became a necessary but sometimes unenviable
part of working at Crown Point as team members sometimes agonized over decisions to fire
friends who violated safety rules.
Crown Point has long been a part of a self-funded, self-managed workers compensation trust
made up of a select groups of small manufacturers. The group administers workers compensa-
tion insurance with the state of New Hampshire. Inclusion in the group requires an impecca-
ble safety record and commitment to safe work practices. As a tribute to Crown Point’s safety
record, the company today enjoys the lowest experience mods5 within this group. As late as
1992, Crown Point’s experience mod was 40 percent above state average. By 2001 it had
dropped to 32 percent below state average.
5
An “experience mod” is a number indicating the multiple at which a firm is above or below the state average for workers
compensation insurance. Experience mods are based on both frequency and severity of worker injury claims. The state
average firm has an experience mod of 1.
Community Citizenship
Crown Point considers community citizenship an important part of doing business. In 2001
Crown Point won the Claremont Chamber of Commerce’s first annual Company of the Year
award. This award was based on quality and quantity of nominations received from community
citizens. Many of the nominations for Crown Point received by the chamber reportedly were
from Crown Point employees.
In 2002 a committee of Crown Point employees was formed to collect funds from employees,
matched by the company, for distribution to community initiatives. The company receives nu-
merous requests to receive awards or recognition for community sponsorships. Employees on
the citizenship committee take turns accepting these awards on behalf of the company.
Communication
Largely as a result of the team-based structure, communication in the company has flourished.
Brian introduced an open-door policy, toured the shop regularly, came to know all employees by
name, and participated in many of the daily production team meetings. (Production teams met
three times a day to review production and quality progress.) Employees have used their free-
dom to approach Brian with their concerns. The weekly shop-wide meetings are used to com-
municate financial performance, safety information, and general company announcements.
Some of Brian’s community business colleagues marvel at the openness of information shared,
much of which they consider proprietary, noting they would “never let [their] employees know
how much money [they’re] making or spending on labor.”
Crown point has not been plagued by many of the disputes common among family-owned
businesses. Communication among family members has always been good. Brian notes that
even though many of the changes he instituted were not supported by his father, Norm chose
to take a hands-off approach and gave Brian and Becky the freedom to succeed or fail.
Other
Crown Point has added numerous other benefits for employees since 1993. A 401K retirement
plan was implemented in 1996. Initially, the company paid the plan’s administrative costs but
did not match employee donations. By 2001 it was matching contributions to 50 percent of em-
ployee donations, up to a maximum of 10 percent of a worker’s salary. Ninety-five percent of
employees participate in the retirement plan—about 20 percent greater than average for plans
of its type. Annual company picnics, a box suite at a nearby urban sports arena, a company-
sponsored downhill skiing program, a soft ice cream maker and popcorn popper in the lunch-
room, and continued and expanded daily breakfasts are examples of the some of the
perquisites reserved exclusively for employees.
Sales and Marketing

Until 1993 Crown Point, like most other custom cabinet manufacturers, used an extensive
dealer network (76 in total) to sell its cabinets. Direct sales accounted for less than 25 percent
of sales in 1994, rose to 50 percent in 1998, and reached 95 percent in 2001. The reason for the
transition was simple. Brian felt the 30 percent margin captured by dealers could be better
used internally to fund an in-house design/sales team and increased advertising. The design
team received calls from potential customers, solicited business from design professionals and
contractors, prepared quotations, and closed sales. The team grew from 1 to 13 people and was
compensated one-third base pay and two-thirds commission. Crown Point’s marketing budget
grew more than fourfold from 1994 to 2001, with much of the increased expenditure allocated
to trade journal advertising. A 2002 show of the nationally syndicated home improvement tele-
vision program Bob Vila’s Home Again highlighted Crown Point’s factory and quality work-
manship as part of a Vermont home renovation project, bringing invaluable attention to the
company.
Results
It would appear that the goals Brian laid out in his 1993 speech have been achieved. In-process
quality has improved dramatically, allowing for significant productivity gains and materials
savings. The attitude at the plant is telling. One of the employees echoed the feeling of many
there: “I do quality work because that’s what the customer wants,” he said. “The Stowell fam-
ily has done so much for me, I want to do more for them.” A local Claremont resident confided
that many in the town wish they could work at Crown Point because, as he noted, “they treat
their help real well.” Another employee stated, “People are impressed when they find out I
work for Crown Point.”
The financial results have been solid. Sales more than tripled between 1993 and 2001. Gross
margin as a percent of sales increased 6 percent and is over 15 percent better than the U.S. av-
erage for cabinetwork plants. Net margin moved from breakeven to over 10 percent. And all
this occurred while base wage rates (including gainsharing) increased 2.5 fold.
Even more remarkable, employee turnover has been reduced to near zero, absenteeism is
negligible, and management employee relations are at an all-time high. As praise poured in
from customers, the community, and the employees, Brian wondered what it was that turned
it all around. Could something have been done differently? Were there other ways to get these
results? Could the Crown Point experience be transferred to other business settings? Finally,
noting that increasing competition from local cabinetmakers was a threat to the business, he
wondered how Crown Point could extract further productivity gains from an already inspired
workforce.
Questions
1. What is the strategy of Crown Point Cabinetry?
2. What is responsible for the company’s turnaround?
3. Is the Crown Point experience transferable to other business settings?
Case 12-3
Worthington Industries
In 1999 Worthington Industries enjoyed sales revenues of $1.8 billion in steel processing and
metals-related businesses. The company, headquartered in Columbus, Ohio, operated 53 plants
in 11 countries and boasted 7,500 employees. John H. McConnell founded the company in
1955. His son John P. McConnell became chairman and CEO in 1996. The financial perfor-
mance of the company for the past five years is given in Exhibit 1. The company consistently
outperformed its industry. Fortune magazine selected Worthington as one of the “100 Best
Places to Work” in 1998 and 1999.
The company was organized into three business units: Worthington Steel, Worthington
Cylinders, and Dietrich Industries.
Worthington Steel
The Worthington Steel Company, founded in 1955, essentially invented the steel processing in-
dustry as it exists today. An established leader with more than 1,000 customers, Worthington
Steel served a broad range of markets, including automotive, lawn and garden, construction,
hardware, furniture and office equipment, electrical controls, leisure and recreation, appli-
ances, and farm implements. The company offered the widest range of services in the industry,
from slitting and blanking to hydrogen annealing, hot-dipped galvanizing, and nickel plating.
Worthington earned its leadership position as a custom processor of flat-rolled steel by pro-
viding superior quality and service. It provided value-added services that bridged the capabil-
ities of major steel producers and the specialized expectations of steel end-users.
Worthington Cylinders
Worthington Cylinders offered the most complete line of pressure cylinder vessels in its indus-
try:
• LPG (liquefied petroleum gas) cylinders were used to hold fuel for everything from gas
barbecue grills and camping equipment to residential heating systems and industrial
EXHIBIT 1 Financial Performance: 1995–99 (Dollars in Millions)

1995 1996 1997 1998 1999
Net sales $1,126 $1,127 $1,428 $1,624 $1,763
Gross margin $ 183 $ 178 $ 207 $ 253 $ 294
Gross margin as percentage of net sales 16% 16% 15% 16% 17%
Operating income $ 115 $ 99 $ 111 $ 136 $ 146
Operating income as percentage of
stockholders’ equity 19% 15% 16% 18% 21%
This case was prepared by Vijay Govindarajan and Joseph A. Maciariello.

forklift trucks. Outside North America, LPG cylinders were used to hold fuel for com-
mercial and residential cooking needs, such as gas burners and stoves.
• Refrigerant cylinders were used to service commercial and residential air-conditioning
and refrigeration systems as well as automotive air-conditioning systems.
• Industrial and specialty high-pressure, acetylene, and composite cylinders were used
to hold gases for various applications, such as cutting and welding metals, breathing
(medical, diving, firefighting), semiconductor production and beverage delivery, and
compressed natural gas.
Dietrich Industries
America’s largest manufacturer of steel framing materials, Dietrich Industries was an impor-
tant segment of the Worthington Industries family of value-added, metals-related businesses.
Acquired in 1996, the Pittsburgh-based subsidiary produced steel studs, floor joists, roof
trusses, and other metal accessories for wholesale distributors and commercial and residential
building contractors.
Dietrich unveiled an interactive CD to make it easier than ever to choose steel framing. This
design tool allowed developers, architects, contractors, and builders to develop building speci-
fications by accessing the industry’s broadest line of metal framing products. It could be used
by a novice to finish a basement or by an expert designing a major office building.
Administrative Systems1
The administrative systems of Worthington are considered under the following sections: val-
ues, organization structure, human resource policies, and reward systems.
Values
John H. McConnell developed the company’s values and, over the years, they remained con-
stant (see Box 1). At their core was the golden rule: to treat others the way one wanted to be
treated. While the values clearly stated that the firm’s first duty was to shareholders, they also
underwrote a culture in which customers, suppliers, and especially employees were treasured
assets. In fact, all employees were encouraged to become shareholders by participating in the
profit-sharing plan.
Worthington expected employees to work hard and help it succeed, but it treated them
well, believing people would be fair and honest if they were treated fairly and honestly. Em-
ployees were praised for good work and urged to develop their skills. The company offered a
tuition reimbursement program to help them continue their education. Managers kept their
office doors open to signal their accessibility. They encouraged open communication and
tried to keep company discussions free of politics. These and other measures enabled Wor-
thington to enjoy a high level of trust between its workers and managers.
1
This section is based on work by Joseph A. Maciariello in Lasting Value (New York: John Wiley & Sons, 2000), chap. 11.
Box 1
Worthington Industries’ Philosophy
Earnings: The first corporate goal for Worthington Industries is to earn money for
its shareholders and increase the value of their investment. We believe that the best measurement of the
accomplishment of our goal is consistent growth in earnings
per share.
Our Golden Rule: We treat our customers, employees, investors, and suppliers, as
we would like to be treated.
People: We are dedicated to the belief that people are our most important asset.
We believe people respond to recognition, opportunity to grow, and fair compensation. We believe that
compensation should be directly related to job performance and therefore use incentives, profit sharing
or otherwise, in every
possible situation. From employees we expect an honest day’s work for an honest
day’s pay. We believe in the philosophy of continued employment for all Worthington people. In filling
job openings, every effort is expended to find candidates within Worthington, its divisions or subsidiaries.
When employees are requested to relocate from one operation to another, it is accomplished without
financial loss to the individual.
Customer: Without the customer and his need for our products and services we have nothing. We will
exert every effort to see that the customer’s quality and service requirements are met. Once a
commitment is made to a customer, every effort is made to fulfill that obligation.
Suppliers: We cannot operate profitably without those who supply the quality raw materials we need
for our products. From a pricing standpoint, we ask only that suppliers be competitive in the
marketplace and treat us as they do their other customers. We are loyal to suppliers who meet our
quality and service requirements through all market situations.
Organization: We believe in a divisionalized organizational structure with responsibility for
performance resting with the head of each operation. All managers are given the operating latitude and
authority to accomplish their responsibilities within our corporate goals and objectives. In keeping with
this philosophy, we do not create corporate procedures. If procedures are necessary within a particular
company operation, that manager creates them. We believe in a small corporate staff and support group
to service the needs of our shareholders and operating units as requested.
Communication: We communicate through every possible channel with our customers, employees,
shareholders and operating units as requested.
Citizenship: Worthington Industries practices good citizenship at all levels. We conduct our business in
a professional and ethical manner when dealing with customers, neighbors, and the general public
worldwide. We encourage all our
people to actively participate in community affairs. We support worthwhile
community causes.
Source: Joseph A. Maciariello, Lasting Value (New York: John Wiley & Sons, 2000), p. 182.
This climate of mutual respect ultimately benefited Worthington’s customers. Employees

knew their work was valued and took pride in doing their jobs well. The profit-sharing plan
acted as an additional incentive for them to help the company succeed. As a result, Wor-
thington was very customer focused. Workers produced high-quality products and gave at-
tentive service. Worthington’s salespeople worked not just to meet, but to exceed, customers’
needs.
The company treated its suppliers equally well and prized their loyalty as well as that of its
customers.
Organization Structure
Worthington considered its organization structure to be flat. Its profit-sharing plan, for ex-
ample, recognized only four basic levels: production, administrative, professional, and execu-
tive. This and the fact that the company favored smaller plants—fewer than 150 employees—
made it easier for employees to communicate with each other. It also helped them to identify
with, and commit to, Worthington.
Plant managers enjoyed considerable autonomy, operating their facilities as individual
profit centers. Some functions, such as purchasing, were centralized because it was more eco-
nomical for the company to do so. Similarly, human resource services were shared because this
allowed Worthington to provide the same services companywide—a move that especially ben-
efited new acquisitions. Otherwise, Worthington essentially was decentralized.
Human Resource Policies

At Worthington, managers weren’t the only key decision-makers. Production workers on the
employee councils also participated in various managerial decisions. Workers were appointed
to the councils at most plants. They met at least once a month to talk about critical issues, such
as plant safety, and conveyed this information to their fellow employees every quarter.
One of their primary responsibilities was to decide whether new employees should become
permanent. New workers were required to complete a 90-day probationary period before they
were eligible for permanent status. During this time, council members discussed the individual’s
job performance with his or her co-workers. If the comments were favorable, the council ap-
proved a permanent hire by majority vote. Once approved, the new employee drew a salary,
rather than an hourly wage, and became eligible for the profit-sharing plan. Managers could
make recommendations or, if circumstances warranted it, fire the employee. But, generally, they
acknowledged that workers on the production floor were better positioned to evaluate how well
other employees performed.
Relationships between councils and managers were cordial. Managers appreciated the
unique perspective that production workers brought to problems. They enjoyed working with
them as team members. Employees, in turn, responded with trust and openness.
Workers who wanted to move up the ladder had plenty of opportunity at Worthington. The
company filled 95 percent of its job openings with internal candidates. Getting promoted de-
pended largely upon merit. Promotion-minded employees were encouraged to further their
personal and professional development by taking courses and assuming other jobs throughout
the company. People with common sense, who could lead and work well with people, were con-
sidered management material; these skills outweighed product knowledge. The company of-
fered numerous success stories, among them that of Donald Malenick. He started out on the
production floor and retired, in 1999, as president of the company.
Reward Systems
Employees were rewarded for good performance through competitive salaries and Worthing-
ton’s profit-sharing plan. Salaries were in the top quartile for comparable jobs in each plant’s
location.
Profit sharing, distributed quarterly, was equally generous. Employees were vested in the plan
according to their status as production workers, administrators, professionals, or executives. As
an individual rose through the ranks, shares made up a greater portion of his or her compensa-
tion. Executives’ shares, for example, were calculated according to a set formula and made up as
much as 60 percent of their total compensation. By comparison, profit shares made up 20 to 25
percent of production workers’ total compensation. The size of the pool they shared with admin-
istrators and professionals hinged on both the company’s performance and that of individual
plants. Employees recognized that the better Worthington and its plants did, the more money
they made.
This point was reinforced by Worthington’s sales force training program. It was designed to
increase profitability through increased customer satisfaction. Every salesperson spent six
months working in a plant that made the products they sold, filling orders alongside produc-
tion workers, learning plant capability, and gaining expertise in technical areas. They also ac-
quired a greater understanding of order profitability. At Worthington, if an order was not
profitable, it was not taken. Employees understood that neither they nor the company could af-
ford it.
Question
Evaluate the management systems at Worthington Industries from the standpoint of how they
help the company to outperform its competitors.
Case 12-4
Wayside Inns, Inc.
It was May 11, 1992, and Kevin Gray was conducting a routine quarterly inspection of the
Memphis Airport Wayside Inn. The property was one of those that fell under his jurisdiction
as regional general manager for Wayside Inns, Inc. During his inspection tour Gray was
called aside by the Inn’s manager, Layne Rembert, who indicated some concern about a pro-
posed expansion of his motel.
“I’m a little worried, Kevin, about that plan to bring 40 more rooms on stream by the end of
the next fiscal year.”
“Why all the concern, Layne? You’re turning away a significant number of customers and, by
all indications, the market will be growing considerably.”
“Well, I’ve just spoken with Ed Keider. He’s certain that the 80-room expansion at the cen-
tral Toledo property has lowered his return on investment. I’d really like to chat with you
about what effects the planned expansion will have on my incentive compensation and how
my income for the year would be affected.”
The Company
Wayside Inns, Inc., located in Kansas City, Missouri, was formed in 1980 as the successor cor-
poration to United Motel Enterprises, a company that operated several franchised motels
under licensing agreements from two national motel chains. Because of the complicated and
restrictive contract covenants, United was unable to expand the scope of either of their two
motel operations through geographical dispersion.
The successor corporation was formed to own, operate, and license a chain of motels under
the name Wayside Inns, as well as to continue to operate the present franchises held by United.
Management felt that the strategy of developing their own motel chain would afford them
greater flexibility and would allow them to more easily attain the long-term growth strategies.
Another major reason for the move was that the new corporate strategy would allow manage-
ment to pursue the implementation of a comprehensive marketing plan which they had been
slowly developing over the last seven years.
The company’s fundamental strategy was to cater to those business travelers who were gen-
erally not interested in elaborate settings. There were no common areas such as lobbies, con-
vention rooms, bars, or restaurants. The chain emphasized instead clean rooms, dependable
service, and rates that generally were 15 to 20 percent lower than other national motel chains.
A free-standing restaurant was always located on the motel’s property—in some cases it was
operated by Wayside. In general, however, concessionary leases were granted to regional
restaurant chains.
This case was prepared by Charles T. Sharpless, research assistant, under the supervision of Professor M. Edgar Barrett.
Copyright © by M. Edgar Barrett.
Wayside’s management made it a point to locate their properties near interstate highways
or major arteries convenient to commercial districts, airports, and industrial or shopping fa-
cilities. In a given city, one would often find Wayside Inns at various strategic locations. This
strategy was founded on the belief that it was preferable to have a total of 600 rooms in five
or six locations within one city rather than have one large hotel with 600 rooms. The strategy
resulted in the clustering of hotels in those cities that could support the market. Once several
hotels had been built in a particular city, management would seek new properties in regions
commercially linked to that city.
Wayside was well aware that their aggressive strategy was successful only to the extent that
unit managers followed corporate policies to the letter. In order to ensure an aggressive spirit
among the unit managers a multifaceted compensation plan was developed. The plan was com-
posed of four elements, but was basically tied to profitability. A base salary was calculated
which was loosely tied to years of service, dollar volume of sales, and adherence to corporate
goals. An incentive bonus was calculated on sales volume increases. An additional incentive
bonus was calculated using the Inn’s return on investment. Fringe benefits were the final ele-
ment and were a significant factor in the package. (See Exhibit 1.) Generally, base salaries
ranged from $16,000 to $21,000 and total compensation was in the neighborhood of $24,000 to
$30,000. The unit manager always lived on the premises and his wife usually played a role in
managing the Inn. As a result, the average couple were in their late 40s or beyond. Many did
not have previous motel experience.
The firm had grown substantially since its inception, and the prospects for future growth
were favorable. The company’s expansion strategy had evolved into a three-tiered attack. Most
importantly, management actively pursued the construction of new motels seeking an ever-
widening geographical distribution. Second, 76- and 116-room properties were expanded if
analysis demonstrated that they were operating near or at full capacity. Third, old properties
that became a financial burden or did not contribute the required rate of return were sold.
Wayside Inns were usually constructed in one of three sizes—76 rooms, 116 rooms, or 156
rooms.
Wayside Inns was a public corporation listed on the American Stock Exchange. It had
1,542,850 shares outstanding, with an average float of 400,000 shares. The common stock price
had appreciated considerably, and analysts felt that investor interest was due to a number of
factors but was primarily linked to their innovative marketing strategy. Wayside’s average oc-
cupancy rate on established properties was 10 to 20 percent higher than competitive motels.
Their specifically targeted market segment (the business traveler) was generally unaffected by
seasonal or environmental factors. Additional company strengths, considered significant by
service industry analysts, were an aggressive management, reduction of construction costs
and completion times due to standardization, and efficient quality control of present proper-
ties.
The Memphis Airport Wayside Inn

The Wayside Inn at Memphis Airport was one of the mid-sized units in the chain—one of the
original 116-room properties. It was located at the intersection of Brooks Road and Airways
Road, approximately five miles from the center of the city. The motel had opened on Febru-
EXHIBIT 1 Unit Managers’ Compensation Package

Base Salary
Base salary ranges are calculated on the basis of years of service and relative sales volume for a particular
inn. Salaries are subject to annual review, and the amount of adjustment will largely depend upon the
recommendation of the regional general manager. Every attempt will be made to keep salary levels
consistent with competitive chains.
Sales Volume Incentive

Every unit manager, having earned a profit before taxes, will receive a bonus equal to 1 percent of any
revenue increase over the previous year’s level. In the event of a revenue decrease, there will be no
bonus and the following year’s bonus will be calculated using the revenue of the year preceding the
decline as a base figure.
Return on Investment Bonus

Investment will be defined as current assets, fixed assets, other assets, and any deferred expenses. Return
is defined as profit before interest expense and taxes.
The formula for the bonus calculation will be:
ROI * PF ⫽ ROI bonus
where:
EBIT
ROI ⫽ and PF ⫽ Performance factor
Investment
The performance factor is used to differentiate between the larger and smaller investments and to
offset the inherent complexities of managing the larger properties.
Size of Investment ($) Value of Performa

Factor ($)*
0– 600,000 . . . . . . . . . . . . . . . . $15,000
600,000–1,200,000 . . . . . . . . . . . . . . . . $25,000
1,200,000–1,800,000 . . . . . . . . . . . . . . . . $36,000
1,800,000–2,500,000 . . . . . . . . . . . . . . . . $45,000
2,500,000–up . . . . . . . . . . . . . . . . . . . . . . $50,000
*The regional general manager has the discretion to reduce or increase the
value of the performance factor for a particular property upon central head-
quarters’ approval.
Fringe Benefits
Each unit manager shall receive an apartment (two bedrooms, full kitchen, and den) on the premises, a
company car for sales calls, laundry service, and local phone service at no expense.
ary 9, 1984, and had developed a very good following in the succeeding years. While the oc-
cupancy rate had averaged near 43 percent for the first year, it had increased steadily over
the years. By 1991, it operated at near full capacity for five nights a week. The Inn depended
on salesmen and commercial travelers for approximately 80 percent of its revenue.
The property had been originally purchased in 1982 for $225,675. Construction costs for
the motel had amounted to approximately $923,020, and furnishings, hardware, software, and
office equipment had been purchased for $265,500.
Wayside Inns had contributed an initial equity capitalization of $75,000. The parent had
also loaned $275,000 to the subsidiary which was secured by promissory notes. A national
insurance company granted a mortgage of $950,000 on the land and physical plant. Finally,
$405,000 had been received from Memphis Interstate Bank to finance equipment and sup-
ply purchases and to provide the necessary working capital. (See Exhibits 2 and 3 for oper-
ating data and Exhibits 4 and 5 for financial statements.)
There were approximately 10 competitive motels, which were franchises of the major na-
tional chains, within a two-mile radius of the Memphis Airport Inn. There also existed a num-
ber of independent motels within the area. However, they were generally of the budget type
and did not offer the quality on which Wayside based their reputation. Recent surveys con-
ducted by the Memphis Chamber of Commerce indicated that average occupancy rates hov-
ered near 72 percent and that the average room sold for $29.00. Expansion plans by the major
chains were expected to account for an additional 800 rooms across the whole city in the fol-
lowing 18 months.
The Proposed Expansion

Wayside’s Project Development staff had arrived at a projected schedule of costs that would be
associated with the completion of a 40-room expansion. Cost adjustments would be necessary
depending on the particular city and conditions. However, variances were not expected to be
significant.
EXHIBIT 2 Selected Operating Statistics (for the Periods January 1 to December 31)
1991 1990 1989 1988 1987
Occupancy Report
Room nights available . . . . . . . . . . . . . 41,975 41,975 41,975 41,975 41,975
Occupied room nights . . . . . . . . . . . . . 36,634 35,595 33,454 32,613 31,522
Occupancy rate (%). . . . . . . . . . . . . . . 87.3 84.8 79.7 77.7 75.1
Room revenue ($) . . . . . . . . . . . . . . . . 998,277 857,839 680,789 577,250 510,656
Average room rate ($) . . . . . . . . . . . . . 27.25 24.10 20.35 17.70 16.20
Weekly Occupancy (%)
Monday . . . . . . . . . . . . . . . . . . . . . . . . 99 89 95 94 92
Tuesday . . . . . . . . . . . . . . . . . . . . . . . . 99 99 94 92 91
Wednesday . . . . . . . . . . . . . . . . . . . . . 99 98 96 94 89
Thursday . . . . . . . . . . . . . . . . . . . . . . . 99 97 92 87 86
Friday. . . . . . . . . . . . . . . . . . . . . . . . . . 91 87 72 70 65
Saturday . . . . . . . . . . . . . . . . . . . . . . . 61 55 51 50 48
Sunday . . . . . . . . . . . . . . . . . . . . . . . . 63 59 58 57 55
Turnaway Tally*
Monday . . . . . . . . . . . . . . . . . . . . . . . . 26.1 22.8 15.1 10.1 11.5
Tuesday . . . . . . . . . . . . . . . . . . . . . . . . 27.7 21.0 19.3 16.0 12.1
Wednesday . . . . . . . . . . . . . . . . . . . . . 38.2 33.2 26.9 19.5 13.3
Thursday . . . . . . . . . . . . . . . . . . . . . . . 43.9 36.3 31.4 20.4 16.6
Friday. . . . . . . . . . . . . . . . . . . . . . . . . . 22.6 15.8 10.9 5.2 2.4
Saturday . . . . . . . . . . . . . . . . . . . . . . . 9.6 5.7 2.8 0.2 0.6
Sunday . . . . . . . . . . . . . . . . . . . . . . . . 8.5 6.4 3.0 1.3 0.5
*A turnaway is considered a customer who either calls the motel, requests a room in person, or calls central reservation service and is told
there are no vacancies. See Exhibit 3 for further data.
EXHIBIT 3 Daily “Turnaway” Statistics for 1991

Week Sun. Mon. Tues. Wed. Thurs. Fri. Sat.
1 ....... 0 25 26 36 45 0 0
2 ....... 0 23 21 24 25 0 0
3 ....... 0 10 11 17 23 3 0
4 ....... 0 20 21 16 46 5 0
5 ....... 0 16 17 25 38 0 0
6 ....... 0 20 15 38 43 7 0
7 ....... 0 25 32 45 25 0 0
8 ....... 0 10 12 42 46 10 0
9 ....... 0 21 14 40 71 12 0
10 . . . . . . . 0 23 28 39 23 15 0
11 . . . . . . . 0 19 25 41 45 16 0
12 . . . . . . . 0 25 30 43 39 20 0
13 . . . . . . . 0 46 42 24 45 21 0
14 . . . . . . . 0 28 25 58 40 30 0
15 . . . . . . . 0 35 14 61 63 32 0
16 . . . . . . . 0 24 22 25 45 43 4
17 . . . . . . . 0 13 46 26 49 15 11
18 . . . . . . . 0 25 29 13 45 12 2
19 . . . . . . . 0 43 40 61 71 10 15
20 . . . . . . . 0 22 55 62 68 45 23
21 . . . . . . . 20 42 36 67 55 46 36
22 . . . . . . . 22 39 35 50 47 39 33
23 . . . . . . . 23 22 33 38 35 38 32
24 . . . . . . . 24 28 25 25 41 17 0
25 . . . . . . . 10 29 24 15 41 25 10
26 . . . . . . . 0 24 20 39 35 18 6
27 . . . . . . . 0 30 18 25 24 42 38
28 . . . . . . . 25 29 15 35 35 45 27
29 . . . . . . . 29 26 66 41 82 11 12
30 . . . . . . . 15 25 50 62 65 18 9
31 . . . . . . . 13 42 43 47 48 16 5
32 . . . . . . . 17 31 25 35 50 17 15
33 . . . . . . . 18 32 16 28 32 18 12
34 . . . . . . . 12 15 22 23 28 20 14
35 . . . . . . . 10 14 25 27 26 21 23
36 . . . . . . . 6 17 24 61 67 15 12
37 . . . . . . . 19 56 27 43 40 15 16
38 . . . . . . . 18 55 71 39 42 20 18
39 . . . . . . . 14 16 35 46 41 23 17
40 . . . . . . . 5 12 20 48 47 27 6
41 . . . . . . . 16 23 15 45 53 29 5
42 . . . . . . . 7 25 18 42 43 31 4
43 . . . . . . . 0 18 20 41 39 43 4
44 . . . . . . . 0 19 21 48 53 46 11
45 . . . . . . . 0 29 23 19 47 47 4
46 . . . . . . . 0 31 24 25 29 41 16
47 . . . . . . . 0 20 26 31 33 52 12
48 . . . . . . . 10 22 16 49 52 26 10
49 . . . . . . . 15 24 18 40 38 20 8
50 . . . . . . . 16 21 19 31 41 10 4
51 . . . . . . . 43 37 45 47 37 15 2
52 . . . . . . . 35 31 40 38 42 6 20
Total . . . . . . 442 1,357 1,440 1,986 2,283 1,175 498
EXHIBIT 4 Memphis Airport Wayside Inn

INCOME STATEMENT
For the Years Ended December 31
1990 1991
Revenues:
Room revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $857,839 $ 998,277
Restaurant rental . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29,148 32,304
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,798 19,148
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 902,785 $1,049,729
Operating costs and expenses:
Room . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194,620 229,520
Selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 204,767 217,020
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,118 58,320
Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41,610 45,473
Maintenance and repairs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46,672 48,498
Management and reservations fees . . . . . . . . . . . . . . . . . . . . . . . . . . 46,372 53,394
Operating income: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 320,626 397,504
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159,617 168,610
Profit before taxes: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 161,009 228,894
Federal taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,746 83,406
Net earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $105,263 $ 145,488
Engineering and legal fees were expected to be somewhere in the neighborhood of $18,000.
Environmental Impact Studies to comply with federal regulations and the local building per-
mits were estimated to cost $12,000. Construction costs for the expansion and adjoining park-
ing facility were expected to be near $1,050,000. Such an expansion was expected to generate
additional annual, nondirect operating costs of $46,000 (largely for personnel, utilities, and
maintenance). Direct room expenses were expected to remain at an average of 23 percent of
room revenue. Management and reservation fees paid to the parent were based on a formula
of 5 percent of room revenue plus $30 per room per year.
Performance Evaluation
After dinner that evening, Kevin Gray decided to review his file on Layne Rembert’s com-
pensation package and on his related performance evaluation. He checked his records to de-
termine what Rembert’s total compensation had been for 1991. He then performed a rough cal-
culation of what it would be for 1992 if the additional 40 rooms were to have been available
during all of this time period (see Exhibit 6).
Over the past few years, Gray had also developed a 20-point performance evaluation re-
port which he used to base his decisions on salary increases (see Exhibit 7). This system was
derived from one he had witnessed when he had been previously employed by a national
food service organization. While the report had been developed primarily for his own use in
helping to determine who should receive merit increases in salary, Gray placed a great deal
EXHIBIT 5 Memphis Airport Wayside Inn

BALANCE SHEET
1990 1991
Assets
Current assets:
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 19,050 $ 18,800
Trade receivables . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86,825 101,620
Merchandise. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22,817 25,312
Prepaid expenses:
Insurance . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,622 4,110
Mortgage interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,524 8,022
Linens . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,320 2,480
Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144,158 160,344
Fixed assets:
Land. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225,675 225,675
Building, equipment, furniture, and fixtures . . . . . . . . . . . . . . . . . . 1,327,740 1,370,515
Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . (268,375) (326,695)
Total fixed assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,285,040 1,269,495
Other assets:
Franchise . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 10,500
Supplies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28,540 28,450
Total other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,540 38,950
Total assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,469,738 $1,468,789
Liabilities
Current liabilities:
Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 68,671 $ 53,066
Taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,240 27,212
Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59,915 52,611
Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 151,826 132,889
Long-term liabilities:
Mortgage payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 684,000 646,000
Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 302,500 248,000
Notes payable to parent . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 140,000 105,000
Total long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,126,500 999,000
Net worth:
Capital stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75,000 75,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116,412 261,900
Total net worth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191,412 336,900
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,469,738 $1,468,789
of weight on his report. In fact, he was entertaining the notion of recommending that it be
instituted companywide. He made no bones about letting unit managers know that he
looked for other things than pure return on investment. He felt that there were a number of
variables that could seriously affect profitability over which the unit manager had no con-
trol. In addition, he believed an efficient operation was to a large extent contingent on cus-
tomer satisfaction.
EXHIBIT 6 Effect of Proposed Expansion on Rembert’s Income

Total Compensation for 1991 Projected Compensation after Expansion
Base salary . . . . . . . . . . . . . . . . . . . . . . . . . . $18,500 Base salary . . . . . . . . . . . . . . . . . . . . . . . . . . $18,500
Sales volume incentive Sales volume incentive
(1,049,729 ⫺ 902,785) * .01 (1,485,859 ⫺ 1,049,729) * .01
146,944 * .01 ⫽ . . . . . . . . . . . . . . . . . . . 1,469 436,130 * .01 ⫽ . . . . . . . . . . . . . . . . . . . 4,361
Return on investment bonus Return on investment bonus
397,504 624,235
* 36,000 * 45,000
1,468,789 2,573,789
.2706 * 36,000 ⫽ . . . . . . . . . . . . . . . . . . . . 9,743 .2425 * 45,000 ⫽ . . . . . . . . . . . . . . . . . . . . 10,914
Total compensation . . . . . . . . . . . . . . . . . . . $29,712 Total compensation . . . . . . . . . . . . . . . . . . . $33,775
Projected income statement (as calculated by Gray):

Revenue:
Room revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,420,238
Restaurant rental . . . . . . . . . . . . . . . . . . . . . . . . . . 40,571
Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,050
Total revenues . . . . . . . . . . . . . . . . . . . . . . . . . . 1,485,859
Operating costs and expenses:
Room . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326,700
Operating expenses . . . . . . . . . . . . . . . . . . . . . . . 376,832
Depreciation and amortization . . . . . . . . . . . . . . . 82,400
Management and reservation fees . . . . . . . . . . . . 75,692
Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 624,235
Remarks: Room revenue projected as 47,184 occupied room nights at an average price of $30.10. This figure is attributed slightly to annual
growth but largely to turnaways accommodated.
Investment is figured loosely and may vary in actuality, but variance will not significantly affect ROI.
Questions
1. Is the proposed investment likely to be a good one for Wayside Inns, Inc.?
2. Is Layne Rembert’s concern justified?
3. Is the current compensation package for inn managers an appropriate one? If not,
what would be?
4. Should the performance measurement system for a regional general manager be fo-
cused upon the same factors that are used by Kevin Gray and Wayside Inns to evaluate
and compensate an inn manager? (An RGM has responsibility for a geographical area
containing anywhere from 10 to 15 motels.)
EXHIBIT 7 Performance Evaluation Report

Ranking
(1) (2) (3) (4)
Poor Average Good Superior
Motel environment
Exterior appearance _____ _____ _____ _____ * .2 ⫽ _____
Interior appearance _____ _____ _____ _____ * .5 ⫽ _____
Maintenance work _____ _____ _____ _____ * .3 ⫽ _____
Room spot check _____ _____ _____ _____ * .5 ⫽ _____
Personnel attitude _____ _____ _____ _____ * .3 ⫽ _____
Managerial factors
Accurate reports _____ _____ _____ _____ * .3 ⫽ _____
Reservation control _____ _____ _____ _____ * .2 ⫽ _____
Accounts receivable _____ _____ _____ _____ * .2 ⫽ _____
Payroll _____ _____ _____ _____ * .3 ⫽ _____
Controllable costs _____ _____ _____ _____ * .5 ⫽ _____
Occupancy rate _____ _____ _____ _____ * .5 ⫽ _____
Other factors
Cooperation with RGM _____ _____ _____ _____ * .3 ⫽ _____
Sales calls _____ _____ _____ _____ * .3 ⫽ _____
Personnel turnover _____ _____ _____ _____ * .3 ⫽ _____
Complaints _____ _____ _____ _____ * .3 ⫽ _____
Total _____ _____ _____ _____ _____
Ranking
20.0–17.8 Excellent
17.7–15.0 Good
14.9–11.0 Must improve
10.0–5.0 Very poor

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Chapter

Research Findings on Organizational Incentives

• A personal reward is relative or situational. Monetary compensation is an important

Characteristics of Incentive Compensation Plans

Short-Term Incentive Plans

Long-Term Incentive Plans

Stock Appreciation Rights

Incentives for Corporate Ofﬁcers

Incentives for Business Unit Managers

A. Types of Incentives 2. Time Period

Size of Bonus Relative to Salary

Recruit good people

Expect good performance

Recruit good people

Expect good performance

Pay them well if performance is actually good

ecutives. Performance-based pay was seen as critical to implementing Matsushita’s strate-

Adjustments for Uncontrollable Factors

Beneﬁts and Shortcomings of Short-Term Financial Targets

Mechanisms to Overcome Short-Term Bias

Example. In investment banking and brokerage houses, it is not uncommon to give

Benchmarks for Comparison

Bonus Determination Approach

Divergent Objectives of Principals and Agents

Nonobservability of Agents’ Actions

CEO Compensation and Stock Ownership Plans

Business Unit Managers and Accounting-Based Incentives

Suggested Additional Readings

Henderson, Richard I., and Richard J. Henderson. Compensation Management in a Knowl-

Attitude toward the Customer

Attitude toward Stockholders

Attitude toward Unionism

Beliefs and Assumptions about Employees

Worker Performance and Attitudes

Recruitment and Selection

in the office and engineering.

by your department head.

Ideas & Cooperation

Increasing Output Days Absent

your attendance record.

Employee Participation in Decision Making

Training and Education

Fringe Beneﬁts and Executive Perquisites

EXHIBIT 2 Lincoln Electric’s Financial History

* Profit after tax

How Well Did Lincoln Serve Its Stakeholders?

Q: How much was your bonus?

Crown Point’s Products and Production Process

Backorder Penalty/Reward System

Sales and Marketing

EXHIBIT 1 Financial Performance: 1995–99 (Dollars in Millions)

This case was prepared by Vijay Govindarajan and Joseph A. Maciariello.

This climate of mutual respect ultimately beneﬁted Worthington’s customers. Employees

Human Resource Policies

The Memphis Airport Wayside Inn

EXHIBIT 1 Unit Managers’ Compensation Package

Sales Volume Incentive

Return on Investment Bonus

Size of Investment ($) Value of Performa