Why Capital Efficiency Measures are Rarely Used in Incentive Plans, and How to Change That

8 Pages Posted: 4 Jul 2009

See all articles by Stephen F. O'Byrne

Stephen F. O'Byrne

Shareholder Value Advisors, Inc.

S. David Young

INSEAD - Accounting and Control Area

Abstract

The article concludes by recommending that although measures like EVA used in combination with negative bonus banks provide the right incentives, EVA capital charges should be phased in gradually to reflect the delayed productivity of capital. At the same time, corporate boards should consider providing bonus bank “relief” when market and industry factors have excessively large negative effects on the performance measures and bonus awards.In illustrating the problems encountered when using such performance measures, the article uses case studies of three long-time “EVA companies” - Briggs & Stratton, Herman Miller, and Manitowoc - to highlight the difficulty of using a “bonus bank” (or “clawback”) system to hold managers fully accountable for earning a minimum return on capital. After presenting empirical data that shows “delayed productivity” of invested capital, the authors suggest that conventional capital efficiency measures can discourage value-increasing growth.Despite the wide acceptance of DCF valuation and its corollary that value is created only by earning more than the cost of capital, very few companies use performance measures that focus on corporate efficiency in using capital - measures such as return on capital (ROC) or economic value added (EVA) - as the main basis for their top management incentive programs. In this article, the authors begin by documenting the surprisingly limited use of such measures in management incentive plans. Next they analyze three often cited problems - difficulty in retaining managers, discouragement of growth investment, and complexity - that could account for the limited use of such measures. Third and last, they suggest a number of adjustments to standard capital efficiency measures that are designed to address these problems and, in so doing, to give corporate directors more confidence in using measures like EVA to reward and hold managers accountable for value-adding performance.

In illustrating the problems encountered when using such performance measures, the article uses case studies of three long-time “EVA companies” - Briggs & Stratton, Herman Miller, and Manitowoc - to highlight the difficulty of using a “bonus bank” (or “clawback”) system to hold managers fully accountable for earning a minimum return on capital. After presenting empirical data that shows “delayed productivity” of invested capital, the authors suggest that conventional capital efficiency measures can discourage value-increasing growth.

The article concludes by recommending that although measures like EVA used in combination with negative bonus banks provide the right incentives, EVA capital charges should be phased in gradually to reflect the delayed productivity of capital. At the same time, corporate boards should consider providing bonus bank “relief” when market and industry factors have excessively large negative effects on the performance measures and bonus awards.

Suggested Citation

O'Byrne, Stephen F. and Young, S. David, Why Capital Efficiency Measures are Rarely Used in Incentive Plans, and How to Change That. Journal of Applied Corporate Finance, Vol. 21, Issue 2, pp. 87-92, Spring 2009. Available at SSRN: https://ssrn.com/abstract=1428132 or http://dx.doi.org/10.1111/j.1745-6622.2009.00229.x

Stephen F. O'Byrne (Contact Author)

Shareholder Value Advisors, Inc. ( email )

1865 Palmer Avenue, Suite 210
Larchmont, NY 10538
United States
914-833-5891 (Phone)
914-833-5892 (Fax)

HOME PAGE: http://www.valueadvisors.com/Contact.htm

S. David Young

INSEAD - Accounting and Control Area ( email )

Boulevard de Constance
CEDEP No. 11
F-7705 Fontainebleau Cedex, 77305
France
(33) (0)1 64 69 43 45 (Phone)
(33) (0)1 60 74 55 00/01 (Fax)

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