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May 27, 2002 Issue

Constructing Long-Term Incentive Plans with the Balanced Scorecard Model

A well-planned incentive compensation program contributes to organizational competitiveness by encouraging superior performance and, ultimately, improving organizational earnings and cash flow. This is true regardless of the organization's profit status.

Long-term financial viability is the most critical success factor facing organizations in all economic segments. Previous issues of Astronology explored using the balanced scorecard concept in performance management and internal job analysis. This issue explores using the balanced scorecard when designing effective long-term incentives.

Long-term incentives often suggest executive and management incentive programs involving stock options and equity. Alternative long-term incentive measures, however, can be applied to all forms of compensation.

The cornerstone of any effective employee incentive compensation program is determining the expected results. This is the first application of the balanced scorecard to be explored.

Financial Success

Many organizations use short-term financial success measures as the basis of short-term employee rewards. Many programs have quarterly or annual measurement periods tied to a net income target. This approach assumes employees focus better on short-term targets and immediate reinforcement of positive behaviors is possible.

Self-funded "goal-sharing" programs where the financial aspect of the scorecard funds the entire incentive program are another approach. However, there are numerous cases where these programs fail due to shortsighted measures. The financial measures were not appropriately linked to a longer-term organizational strategy. Risk-taking decisions, such as investing in new equipment, adding staff, etc., are avoided due to fear of not meeting the short-term goal.

In a long-term incentive program, a portion of each year's incentive is tied to financial targets set for a two to three year period. All organizations should set strategic initiatives of at least two years. While these initiatives are subject to change, the strategic targets should focus on sustaining or enhancing the organization's future viability.

Future employee incentive programs should combine the best of both long- and short-term financial targets.

Let's use a simple target such as gross operating margin - the percent of total operating revenue divided by total operating expenses. Organizations include this measure in their financial reporting, often down to the department or operating unit level. Gross operating margin percentages are forecasted initially on an annual basis. Quarterly or monthly sub-measures track the seasonal impact of new service / product introductions. In two to three year strategic plans, required margin levels to meet the strategic initiatives also are forecasted.

Many employee incentive programs provide up to 20% of pay reward opportunities. To fund the goal-sharing incentive program, calculate the total dollar value of the maximum incentive award. Then, calculate the level of gross operating margin required to fund the incentive.

To develop a long-term incentive program from this model, spread the maximum incentive target over the life of the strategic plan. In a two-year plan, the maximum payout each year is 10%. The equivalent margin required to fund at the 20% level is required in each of the program years. For example:

Calculate the maximum incentive to be paid out = 20% of eligible employee W-2 pay for Year 1.
Calculate the required gross operating margin to fund the incentive at the maximum level in Year 1 to maintain a budget neutral program.
Calculate appropriate goal sharing amounts, up to either 1/2 (in a two year program) or 1/3 (in a three year program) of the maximum payout based on actual gross operating margin results.
Increase the second year's incentive gross operating margin requirement by the same factor used in Year 1.

Customer, Quality, Growth, and Human Resource Scorecard Targets

The process above can be applied to all other balanced scorecard measures. Each target required for incentive payout set at the beginning of the program is applied to strategic initiatives in subsequent years. If the entire incentive program requires a 5% increase in customer satisfaction, then the target for all years of the program should be a 5% increase in satisfaction. If risks must be taken that will not allow for this in the first years of the program, there is still opportunity for payouts in subsequent years.

Stock Options and Management Long Term Incentives

There are many pros and cons to offering stock options to employees. The pros are a direct alignment of employee contributions to the interest of the shareholders; a program that is the truest form of long-term incentive since the ultimate value of the award is determined over many years; and a better understanding of what impacts the success of the organization.

However, there are cons as well, including no clear line of sight between employee contributions and award determination; difficulty in differentiating employee performance and contribution from organizational success; lack of stimulus during economic downturns; and perception of the program as a game of chance.

Some organizations do not apply balanced scorecard measures to their stock option allocations. When share allocation is determined at the employee level, the balanced scorecard performance review is used to determine the percentage of shares actually allocated. For example:

None of the units and / or individual's scorecard measures are met = 0% stock allocation
20% of the scorecard measures met = 25% stock allocation
40% of the scorecard measures met = 75% stock allocation
80% of the scorecard measures met = 100% stock allocation
100% of the scorecard measures met = 125% stock allocation

This methodology introduces the concept of long-term incentives to employees. This ensures the organization and its employees do not lose sight of the need to sustain successful achievement of objectives beyond the short-term. These programs also allow for risk taking when planning future services and products necessary to move the organization to the next level.

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ISSN Number 1549-0467