Exam Number: F10137

Word Count: 1500

CRANFIELD SCHOOL OF MANAGEMENT

Full Time MBA Programme 2010/11

Term: 1

Part: 1

EOS

WAC

“Tea Toast & Tenacity”

This assessment/report is all my own work and conforms to the University’s

regulations on plagiarism 
An identical copy of this document has been submitted to the Turnitin system

 EOS WAC – F10137 2010

Contents
Executive Summary...............................................................................................................................2
Introduction............................................................................................................................................3
Issues with NewTech’s CEO’s Current Package....................................................................................3
Wide Benchmarking.........................................................................................................................3
Inefficient KPIs (Key Performance Index )...............................................................................3
Organisational Slack and X-inefficiency ..................................................................................4
Recommendations..................................................................................................................................5
Base Pay..........................................................................................................................................5
Variable Pay...................................................................................................................................5
Other Considerations....................................................................................................................6
Conclusion.............................................................................................................................................7
Appendix1..............................................................................................................................................8
Organisational Coherence.................................................................................................................8
Appendix2..............................................................................................................................................9
X-INEFFICIENCY.............................................................................................................................9
Appendix3............................................................................................................................................10
Incentives and Risks.........................................................................................................................10
A. The Game Between Principal and Agent......................................................................................10
B. Profit, Managerial Bonus and External Factors..........................................................................12
C. Risk Aversion...............................................................................................................................12
Appendix4............................................................................................................................................14
The Williamson Model......................................................................................................................14
Bibliography.........................................................................................................................................16

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 EOS WAC – F10137 2010

Executive Summary

NewTech is a profit making company; however, its profitability is decreasing over time while

sales revenue is going up. One major reason why the company is losing profit is the risk-

averse attitude of the CEO Mr. Michael J Mcmanus towards launching new products whose

patents have already been obtained. The probable reasons why instead of gaining profits from

commercialisation of ‘sleeping patents’ the CEO is currently pursuing a short term revenue

growth strategy of mergers and acquisitions are related to his remuneration package and as

follows:

 Benchmarking of base pay against the base pay of all the public company’s in EU

 Only two KPIs to determine the bonus and none of those takes into account constant

decline in profits.

Following are the recommendations to encourage goal congruence between shareholders and

the CEO through changes in his compensation structure:

 Benchmark against exact competitors so that the overall market fluctuation only in the

given industry sector plays a key role to determine the base salary.

 Gradually decrease the percentage of fixed salary to the total package. Remove the

50% of base salary cap in bonus and offer profit sharing so that his bonus can go as

high as 70% of the total package.

 Include indicators that are more linked with profit and overall performance of the

company. Possible options are return on net asset, relative growth in the market,

number of new products launched.

If profit sharing, as part of the bonus, option can be made such that the future wage of the

CEO will be much higher than his current wage, then he is expected to accept the offer and

take risks to maximise profit.

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Introduction

This report discusses why the current remuneration system of NewTech is fallible and needs

to be changed to align it with minority shareholders’ interest. The focus of the report is to

bring out the economic issues that explain how the CEO’s current strategy is in coherence

with his compensation structure. It, then, also recommends suitable strategy to decide the

CEO’s, package so that he focuses more on growth in profit rather than growth in revenue and

his risk taking attitude gets reinstated so that sleeping patents can be turned into potentially

profitable live products.

Issues with NewTech’s CEO’s Current Package

Wide Benchmarking

The fixed and variable component of the current remuneration package is derived from a

benchmark system that takes into account all the public companies in Europe. This means that

there could be instances when the company might do well in difficult times when all the other

companies in different industry sectors are struggling but the CEO does not get a satisfactory

pay. On the other hand he might get a handsome salary even when NewTech is performing

poorly in comparison to its competitors.

Inefficient KPIs (Key Performance Index )

The present KPIs of CEO’s salary and bonus are EPS (Earnings per share) and percentage

increase in the volume of sales.

The problem with EPS is that it, alone, can’t be a good indicator of company’s financial

performance. Since EPS does not take into account how much investment was made to

generate the earning it advocates the CEO to go for inorganic growth, which can result into

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 EOS WAC – F10137 2010

lack of organisational coherence(Appendix1), rather than leveraging the tacit knowledge of

the firm and developing a competitive advantage. This can be one reason why, since the year

2000, NewTech was involved in three acquisitions. Besides, EPS can be manipulated through

share-buy-back and in fact NewTech did repurchase 3 million shares (9.79% of the total

shares) in 2005/06.

The direct link between sales revenue and CEO’s salary is in direct conflict with the goal

congruence between shareholders and the CEO. It seriously undermines the fact that though

sales revenue has increased by 87% since 2003/04, profitability has remained almost at a

constant level of 5.5% while CEO’s package is growing at a smooth rate that fails to question

his strategy for driving growth.

The two KPIs mentioned above has changed CEO’s attitude towards risk as well. The current

remuneration structure came into effect in the year 2000. This was precisely the time since

when Michael J has become risk averse in nature. The rising number of ‘sleeping patents’ and

lack of RnD initiatives establishes the fact the company is not being able to benefit from the

economies of scope due to the risk averse attitude of its CEO.

Organisational Slack and X-inefficiency

Rising EPS and smooth dividend is an acceptable standard of performance of the CEO to

many of the non executive directors of NewTech. They are not quite concerned of the rising

costs and falling profits. This brings in an organisational slack into the company that does not

stop the current CEO to pursue his strategy of revenue growth. Besides, at least two of the

non executive directors have pursuits other than working as a voice of the minority

shareholders within the board. Their lack of motivation to monitor CEO’s performance, which

can be treated as X-inefficiency within the organisation, (Appendix2) has helped CEO to find

means to satisfy his opportunistic behaviour.

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Recommendations

From the above discussion it is quite clear that current compensation model of the CEO has to

be redesigned with following three objectives:

 Motivate the CEO towards risk taking

 Reduce the opportunistic behaviour of the CEO so that he, as an agent, focuses on the

Principal’s (Shareholders) interest

 Motivates CEO to build a competitive advantage of NewTech through exploitation of

‘Sleeping Patents’

The two main components of the CEO’s salary are the fixed( base ) and variable( bonus )

pays. Following sections discuss the proposed structures for those components in detail.

Base Pay

The benchmarking strategy to determine the base pay should consider only the firms within

the same industry sector, with similar profiles such as comparable market share and number

of employees. Besides there should be a focus on decreasing fixed pay gradually, over, say a

period of five years, to 50% of total package from current value of 70%. Sudden drop in base

pay is not recommended as it might hurt the CEO’s ego and he could resign which could be

harmful to company’s present interest.

Variable Pay

The bonus pay should take into account a number of KPIs that are linked more with

profitability of the company than with the absolute revenue. They are:

 Percentage increase in operating profit

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 Percentage increase in share price

 Return on net asset

 Dividend growth rate

 Relative growth compared to the competitors

 No. of patents converted to commercialised products

The weights of the above factors need to be decided by the remuneration committee but,

whatever the weights are, the combination of the above and potential increase in will motivate

the CEO to concentrate on both revenue and profit driving measures.

Other Considerations

The CEO’s newly developed interest in corporate social responsibility can be justified only if

NewTech is planning to achieve a sustainable growth. For that new product launch is also

crucial and if a percentage of profit coming from the new product is allowed as discretionary

expenditure(Appendix4) of the CEO towards community, the , then it might encourage

Michael J to give a green signal in commercialising the ‘sleeping patents’ and investing in

new research.

The combination of the new base and variable pay structure can be absorbed into the new

compensation structure shown in figure 1

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Pay Type Current Structure Proposed Structure

Base Pay (Fixed Salary)
 
Variable Pay (Bonus)
70% of the total package
Based on the benchmark
fixed salary of the CEO's
of public companies within
the EU
Depends on EPS and %
increase in volume of sales
Decrease it to 30% of total package by
10% annual decrement over the next 8
years
Benchmark against competitors within
the same industry
Include new performance indicators that
are better linked with profitability.

Increase it gradually to 70% and offer

profit sharing to such an extent that the
total package grows much faster than the
present rate if the profitability improves.
This will force the CEO take risks and
there is a high probability that he will
start rethinking about his attitude
  30% of the Total Package towards 'Sleeping Patents'
Figure 1

Conclusion

The decrease in fixed pay and increase in variable pay will result in a game between the

principal (Shareholders) and agent (CEO) (Appendix3). In order to ensure that both principal

and agent win this game a lucrative profit sharing (which could be stock options) has to be

offered to the CEO so that his future package looks better compared to his current

remuneration. However, a win-win solution of the game will still heavily depend on the

probability of CEO willing to take risk to innovate and launch new products. With right

amount of incentive this probability can be made close to 1. The final outcome will depend on

external factors, such as market volatility, as well. The risk of which has to be borne by the

principals.

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Appendix1

Organisational Coherence

To the extent that firms can potentially pursue more than one growth path, so there is a need

to ensure organisational coherence. This suggests growth will occur through diversification

into areas that are related in some way to the firm’s accumulated stock of knowledge. But the

idea of long–term growth, the constraints of path dependencies and organisational coherence

do not sit easily together. Sooner or later continued growth is likely to involve replacing

some existing capabilities with new capabilities.

The process of migrating to new capabilities ie, new knowledge, which the firm hopes will

add to its growth opportunities is fraught with difficulties. As diversified growth involves

some restructuring of the firm’s control and co–ordinating mechanisms at some point the

firm’s organisational coherence will start to diminish and further diversity will have a

negative impact on performance. Figure 4 shows the sources of new capabilities and three

broad growth paths.

Figure : Diversified Growth and Organisational Coherence

Inherited cumulative
organisational
resources

Purchased external Unique subset of Newly developed

resources growth opportunities internal resources

Growth
Growth Growth
opportunities for opportunities for
opportunities
related diversified unrelated
with current
diversified
operations activities
activities

Increasing need for entrepreneurial flair and

ability to maintain organisational coherence

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Appendix2

X-INEFFICIENCY

Costs

X-efficiency
B
SRAC0

A LRAC

q0 Output

Notes:

To reduce X-inefficiency you must drive SRAC down towards the LRAC

Inversely, if your SRAC increase, you encounter X-inefficiency

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Appendix3

Incentives and Risks

A. The Game Between Principal and Agent

(π-w-απ), (w+πα-e)
p

High effort by MJ

1-p
(0-w), (w-e)
MJ accepts

Low effort by MJ
Shareholders
(0-w), w

MJ declines
0, x

Adapted from Rickard, S, The Economics of Organizations and Strategy (2006), McGraw Hill Book Company, p19

At the start of the game, the principal (the shareholders) offers the agent (Michael J
McManus, MJ, i.e. the CEO) a salary plus a share of the profits, α, where 0 <α<1. If, the
share of profits, α, is given to the CEO by way of stocks, it benefits by way of increase in
share price in the long run since, the CEO will be incentivised to put in additional effort
towards value creation given that he has higher shareholding.

In the game, the CEO gets paid a base salary, w, regardless, (w being reduced from the
current fixed remuneration of say, ŵ) but the value of the profit share depends on the level of
the profits (π) the company makes. If the CEO refuses to accept the contract, the game ends
with the shareholders obtaining zero profit and the CEO earning whatever alternative
opportunity is available, say another contract with another company x.

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 EOS WAC – F10137 2010

If the CEO accepts the contract a decision has to be made as to the level of effort he or she
will expend. Low effort leads to an unsuccessful outcome, with negligible or zero profits.
The pay offs here are (0 – w) to the shareholders and w to the CEO.

If the CEO is incentivised enough to put high effort into the probability decides whether the
outcome is successful earning profits of  with a probability of p where 0 < p < 1, or
unsuccessful earning profits of zero with a probability of (1 – p). In case of an unsuccessful
project despite the higher effort the payoff to the shareholders is the same (0 – w) but the
payoff to the CEO is (w – e) where e represents the effort put in by the CEO. A successful
project triggers the profit share,, and the pay offs to the principal and agent are ( – w – )
and (w +  – e) respectively.

In this case, a successful exploitation of the ‘sleeping’ patents will result in a future
profitability and the pay-offs to the shareholders and the CEO are (π – w - απ) and (w + απ -
e) respectively.

In order to ensure that the CEO is incentivised to put the additional effort to ensure higher
profitability, the shareholders need to ensure that the CEO’s utility of the putting in additional
risky effort is higher than the utility he derives out of the fixed remuneration he currently
draw:

U (pαπ+ w –e) > U (ŵ), where 0 < απ < 1

(Adapted from Rickard, S, The Economics of Organizations and Strategy (2006), McGraw
Hill Book Company, p192-193)

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B. Profit, Managerial Bonus and External Factors.

The increase in profits is in relation to the increase in managerial effort. The agent has to be
incentivised sufficiently to maximise the effort, up to the point where the firm achieves
maximum profits. External factors may influence maximum profits E(πmax), but this is a risk
which should be borne by the principals.

E( max)

min
min Profit element
of fee
min Total Fee

Fixed element
of fee

Maximising effort

C. Risk Aversion

Pay off uncertainty is an important consideration in contractual relationships because most

people care about their exposure to risk. An individual’s risk preferences can be represented

in the shape of their utility function. An individual is said to be risk adverse if they prefer to

get a monetary payment for certain rather than a random outcome having the same expected

payment.

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 Receive €500 EOS WAC – F10137 2010

Individual
Receive €1,000
B p

(1 – p)
Receive 0

If the probability p, takes the value 0.5 then the expected value of selecting option B is the
same as option A in monetary terms. But few individuals would select option B because the
certainty of €500 delivers greater utility. That is, if U ( ) represents the individual’s utility
function then becomes U(500) > 0.5U(0) + 0.5U(1000)

This risk aversion is represented by the concave utility function shown in Figure AI.2. If an
individual prefers to get €500 for certain this is represented as delivering a higher level of
utility – point A in Figure AI.2 – than the expected outcome of a risk represented by point B.
Given the shape of the utility function illustrated, the individual would be indifferent between
receiving the payment x with certainty and the expected value 0.5U(0) – 0.5U(1000) where x
< €500. That is U(x) = 0.5U(0) + 0.5U(1000)

The more risk adverse an individual, the greater the concavity of the utility function. The
utility function for an individual who is risk neutral would lie along 45° line.

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Appendix4

The Williamson Model

 max

max Less excess staff expenditure

actual

actual Less managerial slack reported

for allocation
reported Less discretionary investment expenditure

for allocation Less total investment expenditure

for distribution

min
Profits for
distribution
as dividends
Managerial discretion

Like Baumol’s model Williamson’s model raises great difficulties when it comes to empirical

verification. It is extremely difficult for external observers to identify excess staff

expenditure, managerial slack and discretionary investment. With the possible exception of

lavish prerequisites, discretionary expenditure might be justified if the firm is attempting to

increase its scale and/or its rate of growth. The funding of a sporting or charity event may

add to senior managers’ utility, but it might also raise the company’s profile with beneficial

effects for sales. Marris, as noted in the previous chapter, has argued that three factors are

predominant in promoting firm growth: higher expenditure on advertising and other

marketing activities; higher levels of expenditure on research and development; and

diversification into new product areas. All three of these factors could be regarded as

managerial discretionary expenditure but it is far from clear that they are pursued at the cost

of maximizing the firm’s value; that is, maximizing profits over the longer run.

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An example of senior managers exercising discretion is when a firm diversifies into new

product areas. Indeed, this is an example where the firm might benefit from management

discretion as diversification into multi–products could reduce the variation in profit per

production period and increase the firm’ rate of growth. As demonstrated in Chapter 4 the

reduction in risk will only materialise if the profit streams generated by the separate products

are uncorrelated. More significantly, we observed in Chapter 5 that UK and US studies have

tended to confirm that growth rates are higher for diversified firms. In itself growth based on

diversification is likely to challenge and stimulate management efficiency. Firms that are

failing to grow, or even declining, are more likely to exhibit standardised procedures offering

managers little scope for discretion and initiative. It would be a serious oversight to seek an

explanation for diversification and firm growth rates purely in terms of the exercise of

management discretion in order to raise utility. The environment within which the firm

operates – in particular the industry and related technological developments – are likely to be

a major influence. We would expect firms operating in a new technology sector – ie, mobile

phones – to grow much faster than say, a national supermarket chain. Nevertheless a number

of studies have found that in terms of profitability, owner–controlled firms outperform

managerially controlled firms (see Leach and Leahy, 1991). Such studies do not confirm that

managerially controlled firms seek objectives other than profit maximising, but they are at

least consistent with the Baumol–Williamson type managerial theory of the firm.

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Bibliography

1. Rickard, S, The Economics of Organizations and Strategy (2006), McGraw Hill Book
Company

2. Rickard, S, Economics of Organisations and Strategy case pack notes (2010)

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