In a recent Harvard Business Review article, Graham Kenny posits that nonfinancial measures should be included alongside financial measures in incentive plans. He goes on to say that this is leading companies to use both hard and soft performance measures—where ‘soft’ measures can be more subjective in nature. We wholeheartedly agree with the premise—so much so that we wonder if Kenny goes far enough, particularly where subjectivity is concerned. For many, however, the element of subjectivity in this context implies an arbitrary assessment of performance against goals, based on the general sense of the board’s compensation committee. This interpretation rightly makes institutional investors and other investors uneasy. But, does this really need to be the case, especially given the abundance of data in today’s digital age?
We think there are ways to structure subjectivity such that the compensation committee’s performance assessments and incentive determinations make sense against the backdrop of company performance. Moreover, by bringing a clear structure and hard information to the more subjective elements of the incentive system, performance assessments and incentive determinations become more explainable, more powerful internally, and more defensible externally. We suggest an approach that would work as follows.
Define the performance to be measured as precisely as possible. We have used nonfinancial measures across a wide range of clients targeting a variety of strategic and operational areas. The goal in this step is to provide enough specificity at the board level so management can operationalize imperatives into specific, measurable key performance indicators (KPIs).
For example, one company was an end-to-end, integrated furniture manufacturer which covered product development, through the supply chain, manufacturing, retail sales, installation, and after-sales servicing. This company viewed the improvement of total customer experience as a critical strategic imperative in an increasingly competitive industry.
Consider potential sources of objective evidence and data. Preferably using a cross-functional team, determine KPIs to be tracked, sources of the KPI information, and favorable and unfavorable outcomes for each KPI. The KPI data could be sourced from: internal management information systems; Internet sources such as social media sites; sensors, which are becoming ever more prevalent in household goods, vehicles, industrial equipment; or tailored surveys conducted by or for the company.
For our furniture manufacturer, the board chose to use Net Promotor Score (NPS) as a key indicator. NPS could be benchmarked against key competitors and broader industry groups, and it tracked many of the key elements of total customer experience. The company then supplemented and validated this information with data collected from its own website and social media platforms as well as a few key Internet and social media sites that track customer satisfaction. It was recognized that the quality of data on these external sites can be open to question, so composite information and judgment are needed when using them. Favorable results were considered to be in the upper quartile vs. competitors, given the company’s premium pricing.
Build a scorecard. Use the evidence and data sources identified in the prior step to build a scorecard that can be measured quantitatively or with highly structured discretion. Such a scorecard is a useful tool for communicating with employee-participants, as well as external stakeholders (generally after the fact, to safeguard the company from competitive harm).
Put a range around the committee’s adjustments. Putting a fixed range around compensation adjustments makes the process more approachable and more doable versus using open-ended ranges. It also communicates to participants the importance of non-financial metrics by virtue of their potential impact on overall awards. In this case, the company allowed for a +/- 25 percent adjustment to the award.
By using this approach, executives have a better sense of focus areas and needed behaviors—as in, they know the rules of the game. And the compensation committee are more fully ‘in the seat’ when it comes time to judge performance. The committee also knows the rules of the game and, more pointedly, the committee knows the potential impact, or swing, its discretion can drive in the incentive outcome. Where discretion is left unstructured, we often see committees shying away from hard choices either out of concern for not having enough supporting information to make an informed decision or for fear of making too big an impact on the overall incentive outcome. Other important process points include: transparency, regular reporting on progress, careful consideration of unintended consequences, and openness to experimentation (e.g., implement the softer elements on a trial basis before including them in the formal incentive decision).
Consider the furniture manufacturer: the board and management built a program based on the principles outlined above that strikes the right balance of hard and soft performance measurement. And the softer, more subjective elements of the measurement system, by virtue of careful consideration and diligent information gathering, are anything but soft. Overall, the company’s incentive program is perceived as fair by employee-participants and investors, alike. And these key stakeholders also applaud how the system makes clear the company’s strategy and priorities for execution.
Barry Sullivan is a managing director at Semler Brossy. Sullivan supports boards and management teams on issues of executive pay and company performance. He may be contacted at email@example.com.
Seymour Burchman is a retired managing director at Semler Brossy. Burchman, who has been an executive compensation consultant for over 30 years, has consulted on executive pay and leadership performance for over 40 S&P 500 companies. He may be contacted at firstname.lastname@example.org.