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Winter 2005 CalBusiness  
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WINTER 2005

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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<i>Sunil Dutta</i>

Sunil Dutta

Egon and Joan von Kaschnitz Distinguished Associate Professor of Accounting and International Business

Co-Chair, Haas Accounting Group

At Haas since 1996

 
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