Lecture 16

LESSON 16 Compensation Structure and Differentials Chapter 6: Introduction to Executive Compensation and Components of Remuneration: Learning Objective •

To understand the meaning and concept of Executive Compensation

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To know the unique features of Executive Remuneration

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To know the various components of Executive Remuneration

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To read articles on Executive Compensation

Executive Compensation: Introduction: For the higher management, salaries are influenced by the size of a company performance of the company, by the specific industry, and in party by the contribution of the incumbent to the process of decision-making. The more profitable the organization is the firm, the better is the compensation paid to the executives. The industries that are more highly constrained by governmental regulation (banks, life insurance, railroads, public utilities) pay relatively less than those that are more free to carry on their business (private firms). Executive remuneration has certain unique features, such as: (1) It cannot be compared to the wage and salary schemes meant for other employees in organizations; (2) Executives are denied the privilege of having unionized strength; (3) Secrecy is maintained in respect of executive remuneration; (4) Executive pay is not supposed to be based on individual performance measure but rather on unit or organizational performance. (5) Executive remuneration is subject to statutory ceilings in some respects Components of remuneration-

See –rewards management by Armstrong Introduction: Write Executive remuneration generally comprises four elements: (i)

Salary and allowance,

(ii)

Bonus,

(iii)

Incentives,

(iv)

Perquisites.

Description of each element: Salary is the first component of executive remuneration. Salary is supposed to be determined through evaluation and serves as the basis for other types of benefits. Bonus plays an important role in today's competitive executive payment programmes. There are almost as many bonus systems as there are companies using this form of executive remuneration. If bonus constitutes short-term benefit, stock options are long-term benefits offered to executives. Stock options are attractive to shareholders too. Perquisites contribute a major source of income for executives. Straight salaries, bonuses, stock purchase plans and profit-sharing are used to compensate major executives. Of these, the straight salary is the most common method. The salary is determined by mutual agreement between the individual and the employer. The sales effected, the cost of production, reduction in expenses and the profits made are also taken into account. Bonuses related to performance are also aid to executives at a certain percentage of the profits. The bonuses may average from 30 per cent- to 50 per cent of the basic salary. These bonuses operate most effectively in increasing motivation when the following conditions exist: The amount paid is closely related to the level of individual performance;

The amount paid after taxes represents a clearly noticeable rise above the base salary level. The amount paid is closely related to the level of company performance; The amount paid is tied into the base salary in such a way that the combined earnings are equitable both in relation to internal and external standards; The amount paid is reduced drastically whenever an individual experiences a real and continuing decrease in performance effectiveness; The amount paid is based on an easily understandable system of allocation, and the individual is provided with complete information on the relationship between bonus and performance. Moreover, executives are compensated for the various expenses incurred by them, for taxation takes away a major portion of their salary. Such payments are in the form of – (a) Medical care; (b) Counsel and accountants to assist in legal, tax and financial problems; (c) Facilities for entertaining customers and for dining out; (d) Company recreational area (swimming pool and gymnasium); (e) The cost of the education and training of executives, scholarships for their children, and allowances for business magazines and books; and (f) Free well-furnished accommodation, conveyance and servants. All these go under the head of perquisites. Based upon his research findings on managerial pay, Megginson offers the following generalisations: Satisfaction with pay is a function of comparison with another's pay, with downward comparisons' having the greatest impact. A manager's satisfaction with his income and its motivational effect appear to be directly related to anticipated pay raises. Those managers who expect large increases in future apparently are less satisfied with their existing level of income; those expecting little or no increases are more satisfied.

The choice of merit, as opposed to seniority, as the basis for determining salary rates tends to increase with education and position. The actual determinants of pay differentials seem to be job level supervisory experience and professional experience. Managerial incentive compensation has tended to become flexible. If the various compensation media are to be used to motivate managers, there must be a return to a greater flexibility. Tutorial Activity 1.1 An Article on Empowerment and Growth The EVA story at TCS By S.Mahalingam Tata Consultancy Services (TCS) employs over 15000 professionals, has offices in 23 countries and projects in 50 countries across the world, and revenues around $700 million. Among its clientele are number of Fortune 500 companies and it is in the league of 30 top IT consulting firms in the world. TCS today is an Indian enterprise with a global reach its hiring and people care practices are in line with the industry practices and the compensation model has been traditional. The company has now set its sights on becoming a truly global organisation. Its vision is to be among the top 10 IT consulting organisations in the world, a global employer of choice. It is looking towards institutionalising leading edge practices in hiring, training, and people care, with and innovative EVA - based compensation model. The target model will be one that offers a high growth, high performance internal environment to empowered, proactive, high-brand consultants operating in a dynamic external environment. One important factor in understanding the context of TCS growth is that the company veritably set up the industry in India and metamorphosed in phases from an industrybuilder to a lead-player in the industry it created. In the new market place it has defined for itself, it has to run alongside the new breed of competitors in the country on the one hand, and on the other, the established giants in the global league it is breaking into, as a logical culmination of its growth. In the initial phase, the mission within TCS, right from 1968 when the organisation came into being, appeared to the creation of the industry and the setting standards. The expansion of the market took place in the 70s and 80s when the company grappled with issues of fixing rates in different countries and the cost structure of the company was being formed internally. It was also part of a group which had its own tradition to follow in terms of creation of infrastructure, communication, training the work force, continuing

education and many such issues. Creating and identity of purpose and shared vision for the employees was critical as also the building of a number of assets. Given the expediencies of the trail-blazing phase in the 70s and the 80s, profit maximisation was not the only goal. The company, nevertheless, was profitable. In the 90s, with the globalisation of Indian software, there was a spurt of competitors with operational excellence as their capability. In this phase too, TCS continued to grow, but it had to grow higher than the competition, which was no longer small. It needed to go ahead and start looking at itself all over again. Evolution of EVA The current operating environment is characterised by players who are increasingly moving into globalisation and towards a more perfect market place. The industry is faced with stiff competition, consolidation, rapid technological advancement and obsolescence, high R&D costs and talent retention. As a strategy-focused organisation, TCS was looking at growth beyond competition, defining for themselves and expansion path that would sustain their leadership in a world shaped by continuously evolving market forces. They thus had to think above operational excellence into product innovation to evolve projections for multi-year growth framework. EVA seemed to provide the tool for this self-propelling growth model. The search lights now beamed on a different set of focus paths: How to grow at a rate higher than just the increase in numbers? How to sell competency and value rather than skills? How to manage commitment without over-committing? How to reduce wastage and increase efficiency to avoid the trappings of a very high cost organisation? The answer translated to measures at all levels. The total pre-occupation with customer's satisfaction had to be re-turned to introduce an element of profit orientation. This needed a system of efficient resource management, better control of outstanding, performance evaluation that would link reward to revenue generation. The company had to make sure the operational and tactical levels were aligned with the strategic, so that customer satisfaction was reflected through higher revenues, and sales officers were responsive to selling the more valuable services of TCS rather than just meeting targets. To take proactive steps to enhance value for themselves as well as their customers, in around 1996, the company organised its structure into a three dimensional model (Exhibit) defined along industry practices (which are verticals like engineering, transportation, telecom), service practices (assignment themes such as eBusiness, outsourcing, architecture and technology consulting), and geographies (which are regional groupings). The TCS business units now belongs to one cell or span across multiple cells in this cubic grid. Each is a revenue generating unit outside the grid, which do not have a direct

revenue earning capability. These include the corporate office support functions and R&D, which contribute in an indirect way towards the organisation's earnings. The EVA model In giving shape to the EVA model, an organisation needs to keep its focus towards the ultimate goal of aligning its people to the corporate mission, creating an entrepreneurial culture through an empowered work force, and building ownership with accountability. TCS worked out a EVA framework to align corporate value with the performance of the constituent business units and the individuals who comprised these. It translated to a compensation model, where the employee had a share in the corporate pie with add-ons from the profits of the Business Unit and the Individual Performance Factor. At the individual level, an employee needs to know the drivers to tweak to enhance the EVA of the company, of the business unit, and his own contribution towards all these. There are three basic drivers - revenue, cost, and capital charge. Revenue is driven by the r ate or license price put into the product, sales, billable hours, response time, and domain skills. On time delivery obviously has an impact on revenue because better delivery cycles improve the turnaround to the customers. Cost is managed through productivity, is affected by sales and marketing costs, recruitment and others. Receivables and training are the bulk of the capital charge. These are a representative list, and there are many others. The individual works towards the improvement of the benefit package, which essentially has three components - the Corporate EVA, the Business Unit EVA, and the Individual Performance Factor. Out of the total EVA payment a certain percentage goes to each employee on the basis of corporate EVA improvement. Secondly, if your business unit did better than another business unit, then automatically you got more than the other business unit. Again it is a team reward concept. The third one depends on the evaluation of individual performance. Strategic benefits With the introduction of EVA, yet another plank has fallen in to place in the systemic efforts towards optimisation. Activity Based Costing, implemented 1992 onwards, was a major factor facilitating the smooth transition to EVA. Balance Scorecard was another adaptation in the journey towards excellence. TCS also participated in the Tata Business Excellence Model, (TBEM), which is really an adaptation of the Malcolm Baldridge award, for the Tata companies. Initiatives such as the process map, a metrics definition, a number of data collection points are other enablers in data driven management. With the introduction of EVA, the company has to take a fresh look at the integrated system in a holistic perspective, and evolve ways and means of optimising it.

Implementation of EVA requires the integration of the planning and the tracking process. TCS sought to achieve this through a home grown tool called e-pilot, which essentially drills down from strategy to day-to-day activity. This facilitates the integrated planning approach, in defining the corporate EVA, linking it to the business unit/cell, and further to various components down the line, all the way to the drivers connected to each activity. With the drill-down of targets, the tracking becomes automated. Incentive scheme A comprehensive EVA - based Incentive Compensation Plan has been designed for the employees. Building the incentive scheme requires a detailed exercise in arriving at the target EVA. The TCS model was defined backed by a market analysis and a study of 24 competitors, largely outside India. The framework had specifications for target EVA, with carefully defined EVA intervals and provision for the positioning of zero EVA. The gradation continued through incentives corresponding target attainment, the double incentive. Implementation now covers the whole consulting organisation. TCS is also implementing the bonus bank at the individual level. This exercise begins with a target bonus being earmarked for allocation on corporate target realisation, with a built in multiplication factor for exceeding the targeted EVA. When the corporate target is exceeded, a 'potential bonus' is declared. This accrues to the bonus bank of the individual as two components: Component A, the result of the share in the corporate pie; Component B, a composite factor depending on the business unit and individual performance. The accruals are cumulated over the years and the pay out each year is decided as a portion of this cumulative balance, leaving a surplus in the bonus bank. This concept of bonus bank allows an unlimited multi-year decision horizon, replacing the traditional thresholds and caps. It demands sustainable performance improvements, and maintains the important cumulative relationship between pay and performance. The firsthand experience was a revelations, as we saw how we actually get paid out from the increases, demonstrating the dictum that EVA pays for itself. The reward is that the size of the pie could become different as its gets enlarged and the individual and the corporation appears to benefit considerably. It ensures the channelisation of information across levels and each entity can see how it fares against targets. It enhances the sense of participation through the realisation of the share in the larger pie, and provides the motivation to contribute to enlarge the pie. EVA really forces the organisation to adopt a proper business planning approach, gets a focus on strategies, and helps monitor the accountability of people. In a nutshell, it gives a barometer on how the organisation is being run and mandates critical stocktaking to evolve on a continuous improvement path.

Tutorial Activity 1.2 An Article on Human Capital by S. Mahalingam Originally published in Praxis (Business Line), May 2001. Pundits of today assert that it is the human capital that energises the creation of wealth We, the people of the modern ICE age, seem to have come full circle, to taking a look at ourselves. Management theories are veering round to a re-evaluation of that invaluable human factor and its critical contribution to the creation of wealth. In fact, they have gone one step further to stress that people are the wealth. Pundits of today assert that while the other forms of capital, including material, equipment, tools and technology, only represent inert potentialities, it is the human capital that converts this potential and energizes the creation of wealth. Let us take a peep into this fascinating attempt at pricing the priceless, or what was hitherto considered priceless simply because not many serious attempts were made at its valuation. What makes the challenge more interesting is that this form of capital is floating rather than fixed. No organization can own its human capital the way it owns its other assets. And, inevitably, there is a constant 'flight of capital'. Here we have all the trappings of perpetual dynamics when compared to static assets whose tenure can be safely projected. Today, there is nothing sacrosanct about employeremployee relationships and a professional parting of ways is an accepted way of life. For instance, the only loyalty the silicon generation exhibits is to the Silicon Valley itself, not to any individual organization within its bounds. The imperatives of attrition have to be accorded due recognition, and this is the other dimension an organization has to focus on. Employers have to understand the value that is lost when a key employee leaves. So, we will also examine the cause of attrition in the new knowledge-oriented organization and what can be done to motivate loyalty. Capital redefined An organization is made up of competencies which we can loosely call 'capital'. Its key components are 'customer capital', 'structural capital' and 'human capital'. Broadly a company's strength arises out of its customer base which purchases its products. This customer capital triggers a number of key decisions such as new product and service packages, new designs in anticipation of customer preferences and new locations from which a number of customers could be profitably served. We have heard of a company being acquired purely because of the strength of its customer base. Besides customers, the strength of an organization arises out of the efficiency of its operations. This is characterized by the manner in which its processes are

designed and operated. We can call this the structural capital. But the key strength comes out of its human capital. It is the expertise of its employees which ensures that customers are acquired and retained, and the processes work efficiently to satisfy the customer's needs. We can say that human capital is the basis for the creation of customer and structural cap-ital. The accounting system does not capture the values of these forms of capital. Indeed, even a management information system hardly captures the accretion or depletion of these critical components in the functioning of an organization. For a knowledge base on the knowledge worker In the information technology (IT) industry, we started examining the issues relating to the human capital of an organization. If people hold the key to prosperity anywhere, it is more so in the IT industry which employs knowledge workers. Here, human capital is not merely one component of capital; it is the critical component that forms the basis for other forms of capital: People with their expertise are the sole creators of value to the customer and people through their effort are the key to the optimization of its process efficiency. Perhaps the natural corollary to this is the high attrition rate in the IT industry. So IT organizations have a critical need to know the value they would forego when they are about to lose a person. This knowledge is important in taking appropriate action, in making counter-offers, in keeping up a constant preventive effort to fine-tune the compensation structure. All these should always be in line with the value being pro-vided by the employees. Bundle of competencies An employee has a bundle of competencies, each of which needs to be valued. In the computer software field, with which I am most familiar, we classified competencies under five major heads - domain, technology, project management, initiative and leadership. A software project attempts to computerize applications such as production scheduling in a manufacturing organization, trade settlement in a stock exchange or recoveries for an insurance company. An analyst developing the requirements for the system must have expertise in the specific business area such as manufacturing, securities trading or insurance. We call this business knowledge the domain expertise. A software designer must be knowledgeable about the technology that provides the platform for the system and makes it work. Similarly, project management is an essential area of expertise for a person leading a part or whole of a project, to ensure that resources are marshaled to yield effective results in the required time. Besides these, what makes a person valuable to the organization is the consummate acumen for enterprise and execution - the generation of ideas and the speed of implementation. These come under the umbrella of initiative.

Finally comes the quality of being an inspiration to others: Is a person a thought leader? The ability to apply a new technology in ways unanticipated is one example of displaying thought leadership. The depth dimension We have defined different categories in which the skill-level of a person can be classified. This will bring out the breadth of expertise. We need to also know the depth of experience. There are four levels of expertise that are termed exposed, experienced, expert and excellent. A person who has merely gone through a training programme is only exposed to the technology. If he has practiced that skill in one or more projects for an acceptable minimum period, he becomes experienced. An expert is one who is recognized by his peers to be knowledgeable, to whom they turn for resolution of complex problems. Excellence is attained and proclaimed when an outside committee of experts in the field recognizes a person's expertise. This level is usually reached when a person passes an examination or is invited to become a member of an exclusive club of experts. Now for the verdict... Therefore, a person's competency can be judged by looking at both the breadth and depth of his skills. The all-important question now is whether these skills are of value. For example, expertise in an old computer language, which has become obsolete, has little market value. However, before January 1, 2000, this rare skill was of great importance to people who still had running systems that used these obsolete languages. The value therefore is contingent upon the use to which the expertise is put. In the software field, as in most others, there is value to a skill so long as it is usable and there is effective demand for people possessing that skill. Is there a magic formula? Once we have determined that there is value, we need to establish its quantification. A skill has a value so long as it can fetch a return. One method is to look at possible returns over the next five years and thereafter discount the amount by an accepted percentage to arrive at the current value. This will require us to forecast the revenue that can be generated each year over the next five years for a person (for instance, a Java programmer). The attempt is to calculate the value of a competency at a point in time. Therefore, we do not bother about the additional value that may accrue to a person as he moves up the competency ladder A person has a set of competencies and a value is assigned to each of these competencies. The sum total of it is the value of an employee and the sum total of the value of all

employees is the human capital of the organization. This human capital, together with the customer and structural capital produces the revenue. To retain Ms High Value When an employee leaves, an organization loses that much of capital as determined by the valuation given above. The organization's response to this situation should be guided by the value being lost. Unfortunately, there may be no escalation when a valuable employee leaves. The senior management gets into the act only when a very experienced employee leaves, irrespective of whether he has a higher or lower value than a less experienced person. An organization needs to look for a system for the scientific computation of employee values, stored in a constantly updated data-base, with triggers for intimation to top management based on employee valuation. Management can then be made to sit up and take notice whenever high-value employees leave, irrespective of the years of service. In fact, compensation across the board can be structured to be in line with this valuation system. Why do employees leave an organization? Compensation is only one of the factors and, unfortunately, that is the only factor looked into. In my organization, we did a detailed survey on what would result in increased commitment to the organization, which intrinsically meant reduction in attrition. We realized that increase in job satisfaction as well as increase in opportunities at higher levels of value had a positive influence. These resulted in a person moving up the expertise ladder. There are supplementary factors too, such as improvement in the work environment and elimination of irritants largely brought about as a result of bureaucracy. What kind of effort is needed to enhance satisfaction levels as well as eliminate irritants? It again depends on the potential value created or lost. A major factor for a person's loyalty to an organization is the compensation structure. The value of a person can certainly be a guiding factor in arriving at the appropriate compensation level. Miles to go... Organizations are getting differentiated on the basis of the knowledge each possesses. In a world of constant technological changes, an organization prospers from the quality of its people. People who are relevant for today's work may not be able to meet the challenges of tomorrow. We need to get them to forget some aspects of today's competency and build the requirements of the future into them. Increasingly, the investment decisions of top management will not be restricted to the acquisition of brickand-mortar assets, but of building additional competencies in people. Human resources valuation has remained an academic exercise and largely ignored even in industries where the expertise of employees is the key differentiating factor. The

process of valuation is complex and challenging. But unless we adequately assess the value of human resources, we will not be able to respond to future needs.