May 27, 2002
Constructing Long-Term Incentive
Plans with the Balanced Scorecard Model
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
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
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
Customer, Quality, Growth, and Human Resource Scorecard
- 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.
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
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
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:
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.
- None of the units and / or individual's scorecard
measures are met = 0% stock allocation
- 20% of the scorecard measures met = 25% stock
- 40% of the scorecard measures met = 75% stock
- 80% of the scorecard measures met = 100% stock
- 100% of the scorecard measures met = 125% stock
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