Engineering firm, Tomkins, has moved away from an incentive scheme that rewards performance against budget, to one which is based on the concept of bonusable profit, says Debi O’Donovan.
It has made belts and buckles, as well as bread, guns and lawnmowers, but now Tomkins concentrates on engineering. It also concentrates on value creation.
Tomkins is a global company with about 40,000 staff around the world and sales in the region of £3.3 billion. And since 1998 it has been going through a major transition to dispose of its non-core businesses.
It was during this period Ken Lever, joined Tomkins as finance director. “One of the things that I wanted to do when I came here was to try and introduce a value culture within the organisation so that the focus was more on longer-term creation of economic value rather than short-term focus on earnings per share and profitability.”
Apparently outsiders had been crucial of the incentive schemes Tomkins had run for very senior managers because of the short term nature of the metrics that were used. These were driven by earnings per share (EPS), dividends per share and general level of profit in the company.
Another problem, in Lever’s eyes was that the firms’s incentive schemes were linked to budget. “So it was all performance by reference to a budget. That meant that you could still have somebody who was operating a business that was standing still or even possibly declining and they could still be getting an increase in bonus because each year they were successful in managing the budgeted levels profit down.”
When a new chief executive, Jim Nicol, arrived to take up his post at Tomkins in February of last year, he was very focused on rewarding people by actual performance. Nicol had come from Magna, a Canadian engineering business with $12billion turnover, and he wanted to model Tomkin’s new incentive scheme on Magna’s. It was a low salary base scheme with manager being paid a percentage of the profit from the business they ran. Nicol has a firm belief that top managers should act like owners of the business. So if the profit improved they would benefit from it. And if the profit deteriorated they would suffer, explains Lever.
The result was that Tomkins introduced an incentive scheme that is one variation of the Magna scheme. One important difference is that the Tomkins scheme uses economic profit to determine bonuses, not operating profit. This means that the operating profit will have been charged tax and an average weighted cost of capital (Tomkins uses 9%) for the capital managers use in the business.
It meant that not only were you tracking the level of profitability but you were also charging them for the capital they used to create that profitability. Anybody can increase profitability just by using more capital but they don’t necessarily improve the return on capital” says Lever.
The incentive scheme is still in its first year – Tomkins’ financial year is the same as the calendar year – and has been put in place for the top 30 executives around the world, including Japan, Mexico, US, Canada, France, Belgium and the UK.
“This first year was seen very much as a transition year. All of those people were previously on a scheme that was rewarded by reference to performance against budget. The scheme now enables them to earn a bonus based on a percentage of what we call bonusable profit. And bonusable profit is effectively the same thing as economic profit. I guess it is a sort of variant of economic value added (EVA). But it isn’t quite because we don’t make all the changes to the balance sheet that EVA requires, explains Lever.
This is then translated into numbers. For example, a manager achieves a bonusable profit equivalent to 140 then they will receive 80 in cash, 20 in shares (as of that day) and the remaining 40 in shares in three years time.
The latter is the deferred compensation component which provides the long term incentive element. For the executives to be entitled to claim the 40 in shares, they would have to hold the equivalent of one year’s total remuneration in Tomkins shares. “It’s actually your average (remuneration) for the previous three years. The intention of that is the manager will not only focus on generating bonusable profit within his business, but he will have an interest in the equity of the group. He won’t be encouraged to take short-term initiatives, he will also plan for the future development of the business.”
All the participants’ salaries have now been frozen, and in the future will only be adjusted for inflation. We had to do that because it is an international group with different people operating in different countries, sometimes experiencing different rates of inflation,” says Lever. The intention is that over time the bonus will become a bigger component of total remuneration while salary becomes less significant. “Obviously if it was a high inflation environment that process would work faster. So under low inflation it will take longer for the two to diverge.”
So coming back to the main aim of the scheme, that managers should behave like owners, Lever explains: “If your business is operating in a marketplace that is slightly cyclical, there will be times when you do well and times when you do less well. But if you owned and ran that business you can’t go along to the people who are funding you, say the bank, and say “It has been a pretty bad this year, but I have still done better that I thought I was going to do. I want to take more bonus out.”
The bonuses are being paid to executives, quarterly. The bonuses for the first quarter, which was reported in March, were paid in June, The second based on the June results, will be paid this month. These bonuses are only three quarters of the size they should be. “The reason you do that is in case you get some quarters where it does down you have got to have some sort of catch up. The March, following December year-end, is the catch up period. So March will always be the month – assuming the profits are tracking that way they should be – when you get the bigger bonus,” explains Lever. Also, only the year-end results are audited so this conservatism gives Tomkins room to adjust bonuses if any quarterly figures have to be adjusted as a result of the audit.
“One of the things people have said is that the bonus being paid quarterly really does focus the mind.”
Also, it means that the company has to be buying its own shares every quarter (this is done through an employee benefits trust). “That gets announced as a share purchase by directors which is seen as important because the directors are actually buying shares in the company. It sets the right sort of tone and sends the right signals really.”
Tomkins has encountered two difficulties with the scheme so far. Despite its aims to be very simple using just one metric – bonusable profit – it has required a lot of detailed calculation work. Secondly, it proved to be very complex to set up. “There are lots of complexities involved with being able to do something which on paper sounds extremely simple. In practice, because of varying tax regimes and legal issues and so on, just dealing with the administrative detail to address the issue of the shares (Whether shares should be bought in the trust, whether individuals can receive dividends on the shares or whatever) is quite complex.
Despite these hurdles, Tomkins plans to extend the scheme in 2004. It will be extended to more managers in the business, with the reports of the people currently in the scheme likely to be next in line.
Over time we want to involve as many people as we can who are in the position to influence the bonusable profits of the group”, says Level. “I think in time we would like to introduce something of a similar nature, not necessarily in exact same detail in terms of its design, to disseminate it to as many people as we can around the group.
Scheme design
Tomkins worked with reward specialists, PA Consulting Group, to design and implement the new incentive scheme.
Mark Thomas, head of strategy and marketing at PA Consulting Group says: “this is at the forefront of schemes in the UK. I do think it is in the direction that other schemes will be moving.”
He points that the scheme is unusual, firstly, because of the direct link between the economic profit a manager generates for a business and the size of the bonus, and that is not distorted by caps for budgets. “It is purely a slice of the value they create for shareholders.” Secondly, the scheme is designed to make managers think long term by using a portion of the bonus for shares that are restricted for several years. “They have an interest in not taking decisions that might boost short term profit that could harm the company longer term. For example they could slash research and development. For a couple of years profits would be higher, but in the long run it will almost certainly be bad for the company. “
Specialists such as PA Consulting have conducted research which has found that options which are not that good a way to interest of managers and shareholders. Thomas gives the example of a manager who has 10 million options that are slightly underwater and if he exercised them today they would be worth nothing. “They really have no interest in managing the risk that the shareholders are exposed to. It creates a temptation to go into highly speculative behaviour which isn’t really in shareholder interest.”
