Chapter 4 – The Big Pay Problem for Companies

Employment costs are the biggest cost for almost every company. Studies have shown that most companies have 70% of their costs in labor costs. Moreover, as mentioned above, most people feel that this huge business cost is spent under a failing system.

A healthy pay system helps employees focus on what creates value. “Helping employees focus on what creates value” is perhaps the most important part of management.

However, business schools do not teach this concept to MBAs. If you look at a major business school today (I looked at Stanford, my alma mater), only around 2-3% of courses touch on the “nuts and bolts” of incenting the workforce. Almost no student will take a full course on the topic of optimizing compensation. A student is more likely to take a course named “Mindfulness and Compassion” instead of the boring “Human Resource Management”. Indeed, while Stanford offers a course on “Incentives and Productivity”, it is only for research PhDs (no MBA show up, and only a few PhDs attend).

Contrary to what MBAs are taught, managing your people well is more important than any other topic.

Perhaps the most important thing a manager can do is to motivate employees to create value. However, the business press is oddly full of discussions of every other business issue. The business press ignores how companies treat their biggest cost and most important management issue. Labor costs are the biggest cost area, yet schools ignore this cost area.

The odd are that your boss singularly focuses on a sexy business school topic like strategy, supply chains, just-in-time inventory management, etc. While these are important topics, few bosses focus enough on properly motivating people and getting the best bang for their labor dollar.

Statistical studies show “employee motivation” is more important than most of what MBAs are taught. How you pay employees is more important than strategic factors.

A seminal study by Hansen and Wernerfelt looked at what drove firm profitability (they looked at 5-year average return on assets). The study looked at both strategic factors and focus on employee motivation. They sought to explain the differences between firms’ profitability.

The study found that strategic factors (industry profits, relative market share, and firm size) explained only 14% of the difference in profits between firms. Emphasis on goal accomplishment and on human resources explained a whopping 32% of the difference in profits between firms. The study showed that even in the same industry, better approaches to managing people leads to better profits.

The amounts at stake are huge. Banks that emphasize results-driven performance appraisal and profit sharing are 23% more profitable than average.

Incentives matter a lot, as shown in another big, well-controlled study by Gerhart and Milkovich. They used data on 16,000 managers from the top six levels at roughly 200 organizations and followed them for up to 5 years. They controlled for many factors including human capital, job type, etc. The study found that giving people larger bonuses increased profitability. Every 10% increase in the bonus-to-base ratio increased firm profits by 11%.

The study also found that including more employees in long-term incentives was terrific. Every 10% increase in employee eligibility for long-term incentives increased firm profits by 3%.

Both are great!

• Increasing employee bonus ranges

       +

• Increasing the number of people getting bonuses…

     Bigger company profits!

We now illustrate how this works. Compare two managers, Fred and Sally, who work for two different companies in the same industry. We call the two companies Average Inc. and EWYK Industries. Both managers have base pay of $150,000, but EWYK Industries gives a higher annual incentive bonus to Sally and includes her in a long-term plan.

In the example that follows, EWYK Industries should have a profit margin that is much higher than the margin of Average, Inc. Margins go from 6% to 8.76%, and increase of +46%.

Here is how this works.

Fred, who works for Average Inc., has had average annual bonuses of $30,000 per year. With a salary of $150,000, his bonus-to-base ratio is 20% ($30,000/$150,000). For senior executives only, Average Inc. also has a long-term incentive bonus plan that covers only 10% of employees and pays out every three years. Fred is not a member of the 10% that get a long-term incentive (his bonuses are only annual).

Sally, who works for EWYK Industries, has had average annual bonuses of $60,000 per year. With a salary of $150,000, her bonus-to-base ratio is 40% ($60,000/$150,000). EWYK Industries also has a separate, long-term incentive plan as well that covers 90% of staff. Sally gets an extra bonus of $50,000 if she stays around and the firm makes hits long-term targets three years from now.

EWYK Industries has a higher annual bonus to base ratio (40% versus 20%) and a higher percentage of employees in a long-term incentive plan (90% versus 10%). According the study, EWYK Industries should have a much higher profits. How much? We start by comparing the two companies and the two managers.

Remember, the two managers have the same base salary.

However, Sally (at EWYK Industries) has a higher bonus (40% of salary) versus the 20% at Average, Inc. In addition, Sally gets a long-term bonus while Fred is out of luck since only the 10% most senior managers of Average, Inc. get long-term bonuses if they stick around and the firm does well.

The following graphic summarizes the main differences between the companies and the two managers. .

Company                               Average                       EWYK

                                                  Inc.                         Industries

Manager Name                       Fred                           Sally

Base Pay                                $150,000                   $150,000

Annual Bonus                      $30,000                     $60,000

Long-term Bonus                $0                               $50,000 (paid every 3 years)

Ann. Bonus to Base Ratio    20%                          40%  <—-  20% Difference

Percentage Employees in

Long-term Bonus Plan          10%                         90%  <—- 80% Difference

Company Margins                   6%                            8.76 <—-EWYK Margins 146%                                                                                                         

                                                                                                        of Average, Inc.

                                                                                                       (see Appendix for calculation details)

According to the study, EWYK Industries should have a profit margin that is 146% (8.76/6.0 or +46%) higher than industry norms—almost a half increase in profitability. Note that this is after paying higher bonuses and total compensation than the average company. The effect of better incentive compensation results in both covering the incremental costs and generating incremental profits on top. The study did not find any negative effects from paying more to people. The authors did the study right, and adjusted for factors like employee education, age, tenure, job level, and levels supervised.

“We have a surprisingly effective way of motivating employees…” [Note new caption]

Companies that pay for value creation create more value.

We now show some evidence. Two Harvard Business School professors named Michael Jensen and Kevin Murphy studied how companies paid their CEOs. They tried to find out if how they paid management effected company performance.

The professors looked at the 1000 largest public companies and looked to see how much CEO pay varied with the company’s stock price. They also looked at how well the companies did by measuring how much the stock price went up. In effect, they measured how much value the CEO was creating for shareholders.

They ranked the 1000 companies by how much CEO pay went up or down if the stock price went up if the stock price went up one dollar. The top company on the list had CEO pay go up or down 89 cents for each dollar of share price swing. The bottom company had CEO pay go up or down only 0.004 cents for each dollar of share price swing. The top companies are Eat-What-You-Kill companies. The bottom companies are “Pay-No-Matter-What” companies

After ranking the companies by how they paid their CEOs, the professors looked to see if the companies have had the highest performance. As you might have guessed, the companies that pay for value creation did the best.

The top pay sensitivity to value companies (the top 5%) includes many of the best and most successful companies of the era. It includes Nike, Berkshire Hathaway, Schwab, Oracle, and many others.

On the chart that follows, you can see that the top 200 companies (the companies that most incentivized their CEOs for share price increases) had a 1-year shareholder return of 33%. This means that their share price change and dividends gave the shareholders a 33% return. Average companies (number 401-600) had less shareholder returns, 27%. The bottom companies (801-1000) had relatively miserable 10% returns to shareholders.

Similar trends exist when you look a 5-year or 10-year returns. There always seems to be at least a 5% annual difference in returns between an “Eat-What-You-Kill Company” and a “Fixed Pay Company”.

This difference may not seem a lot at first, but even a 5% average difference each year soon compounds to a lot of money (35% over 5 years).

This makes sense. If you pay CEOs or employees based on customer satisfaction scores, then you might expect that customers would be happier next year. If you pay CEOs and employees based on the value they create for shareholders, then you might expect that the company would create more value for shareholders in the next year.

If you pay for value created, shareholders will be much better off.

Company share price will be 35% higher than competition after 5 years.

Paying for value creation seems a no-brainer.

However, a skeptical reader might say raise a couple of issues with the above analysis. First, the skeptic might say, “Hold on, all the sexy high-return businesses might be on the left side of the graphic above. They tend to pay people by value creation and non-sexy businesses do not.”

Second, the skeptic might also ask, “While you have shown that business that pay for value creation deliver more value for shareholders, are the pay-for-performance companies successful on other measures? Are the companies growing revenues and profits faster as well, or are they just milking the business for stock returns for shareholders? Is paying for value creation a good long-term strategy for a business and its employees?

These are good questions.

To answer this question we examined a standard, low-growth, and non-sexy industry (the electric utility business) and looked at how shareholder returns, revenues, and profits varied by how much the company paid for value creation. We compared companies who paid executives for value and compared them to average companies.

The graphic below shows that Eat-What-You-Kill electric utilities grew revenues 3% faster, grew profits 4% faster, and grew shareholder returns 5% faster.

So, even in a standard, low-growth industry, paying for value created works.

However, even more important is that superior value creation drives superior results on most other measures of success. This is because companies that focus on value creation have better-motivated employees, more-loyal key talent, happier customers, growing revenues, funds to invest for future, and other symptoms of success. The cause of success is the creation of value. Paying for the creation of value leads to both the creation of value and other indications of success.

Eat-What-You-Kill companies succeed at measures other than shareholder returns. Eat-What-You-Kill companies grow and prosper.

Many companies miss the Eat-What-You-Kill Compensation, the first step on this logic chain. They tell their employees, “Go out and create value for senior management and shareholders. Increase growth and increase margins because I said so. Work hard to make me money even though I don’t share it with you.”

Because shareholders are naturally interested in companies that focus on creating value for shareholders, many companies espouse a concern for “Shareholder Value”. Look for how many times companies mention the words “Shareholder Value” in the annual reports of underperforming companies. However, look how the same companies pay senior executives excessive amounts whether the company increases shareholder value or not.

The true test of whether a company is a “Shareholder Value Company” is whether it pays for performance. The ultimate measure of performance for executives is, of course, shareholder value. As an employee or investor, you can rank companies objectively on executive pay sensitivity to value. This ranking gives a good leading indicator of competitive success.

The question remains, why do companies that use performance-based compensation outperform others?

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