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The Power of Ideas
Tying Compensation to Performance
Accounting professor Sunil Dutta revives merits of value-based
management
Ken Lay made $19 million in salary and bonus and $217
million from selling Enron stock. Sandy Weill of Citigroup
made $54 million in 2003. Dick Grasso of the New York
Stock Exchange was awarded $139 million in special pay.
Those are just the marquee names found in any newspaper
report on executive compensation. The average annual
pay of the top 25 CEOs in the S&P 500 was $32.7
million last year, according to Business Week.
Were these executives worth many times more than what
the average US worker makes? Did their performance merit
such excess?
Shareholders have not been shy in asking those questions,
demanding that manager pay be tied to performance. In
the aftermath of corporate scandals such as Enron, some
companies are looking more closely at their compensation
policies and writing new incentive plans that focus
on value creation.
All this has provided rich fodder for Berkeley accounting
associate professor Sunil Dutta, who studies value-based
management and compensation. In a paper written with
Stanford business professor Stefan Reichelstein(who
moved from the Haas School to Stanford in 2001) he argues
that one measure companies should use, in addition to
judging the bottom line, is residual income. Simply
defined, residual income is net income minus the cost
of capital -- that is, the shareholders' investment.
"When companies compile accounting profits they
forget about important costs such as the cost of capital,"
he said.
Residual income as a measure of company performance
is not new – it's been around since the
1950s, Dutta said. But the concept has recently come
back into vogue in the wake of accounting scandals and
some companies are adopting it. Compensation consultant
Stern Stewart & Co. argues that what it calls "economic
value added" is the financial performance measure
that comes closest to capturing the true profit of an
enterprise. In other words, economic value added or
residual income is the true profit or the amount by
which earnings exceed or fall short of the minimum rate
of return that shareholders could get by investing in
comparable securities.
Dutta said that while net income or revenue growth
as measures of performance are good for external purposes,
they don't always make sense internally, especially
when designing incentive plans: "You want to incentivize
your managers to do the thing that makes sense from
a shareholder point of view."
But any notion of residual income is only as good as
the accounting rules used in computing the numbers.
In their paper Dutta and Reichelstein describe how residual
income as a measure of performance can be used with
managers who make capital investment decisions. "Residual
income metrics do well if you use the proper depreciation
metrics and we identify what those are," Dutta
said. The paper provides theoretical guidance regarding
the appropriate capital charge rate and the choice of
depreciation schedule for the purpose of performance
management. "We find that the principal can optimally
delegate the investment decision to the better informed
manager and reward the manager in proportion to the
achieved residual income," the paper concludes.
Dutta said the concept of residual income as performance
measure is transferable to other decisions a manager
makes, such as sales. He and Reichelstein are pursuing
research into those areas – to bolster the growing
body of evidence that value-based management can increase
the value of the company as well as its image among
shareholders.
Sunil Dutta is the Joan and Egon von Kaschnitz Distinguished
Associate Professor of Accounting and International
Business and the co-chair of the Haas School Accounting
Group.
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