It pays to perform.

As companies tighten the links between their financial results and incentive programs, financial executives will be charged with developing and applying new performance yardsticks.

Across the United States, boards of directors are tying the compensation that executives receive to the financial results of the companies they manage. Companies are adopting new incentive plans, putting a higher percentage of income at risk, extending incentive plans lower in the organization and placing greater emphasis on stock and long-term incentives. The emphasis on incentive compensation has increased the importance of the financial measures used to evaluate company, departmental and individual performance, and this in turn has increased the role of senior financial executives in developing incentive programs.

In the 1990s, the use of incentives has become almost universal for top management positions. In most industries, 90 percent or more of all major publicly traded companies provide cash incentives for top management. Even among utilities -- the last bastion of the salary-only approach among for-profit employers -- almost 90 percent have adopted annual cash incentives for management, up from 65 percent as recently as 1988. Since nearly all companies now provide incentives, there has been relatively little growth in the percentage of companies using incentives for top management, but there has been substantial growth in the size of incentive awards.

Top management compensation levels are summarized in the figure shown on page 50. Compensation varies substantially based on the size of the company, as measured by revenue in this analysis. While salaries have increased approximately 25 percent over the last five years for top management positions, bonuses have increased far more. The dollar amount of average bonuses for CEOs has increased 45 percent, while it's up 43 percent for CFOs and over 34 percent for both treasurers and controllers.

A comparison of the average bonus (as a percentage of salary) paid in 1993 and in 1988 is presented on page 49. This increase occurred despite overall levels of profitability that were good but not great in both time periods.

MORE PIECES OF A LARGER PIE

By far the most significant trend over the last five years is toward including more employees in incentive plans. Companies have achieved this both by lowering the minimum level of employees eligible to participate in the general management-incentive plan and by developing special small-group, gainsharing or similar plans designed to reward specific results or increased productivity at the department or group level.

The increase in the number of employees eligible has been dramatic. In many job categories, the eligibility has increased by 50 percent, particularly among nonsupervisory professionals like accountants, budget analysts and tax accountants. Similar increases are reflected in Mercer's "Finance, Accounting, and Legal Compensation Survey."

However, while the number of professionals eligible for incentives has increased sharply, many of the newly added plans pay relatively small incentive amounts, often as little as 5 percent of salary. Frequently, broad ranges of employees receive the same percentage of salary under these plans, in contrast to more traditional incentive plans in which the percentage of salary varies by the employee's level. As a result, the average incentive payments have actually fallen in many job families. The average incentive for senior accountants, for example, has fallen from 8.5 percent in 1988 to 7.1 percent in 1993; for accountants, it has fallen from 8.0 percent in 1988 to 6.1 percent, and for associate accountants, from 8.0 percent to 5.4 percent. Other job families have experienced similar declines in average incentive as well.

While bonuses have decreased as a percentage of salary in many job categories, the overall trend in both salaries and total cash compensation (salary and bonus) is still distinctly positive across all job families, as shown in the figure on page 50.

This increased emphasis on incentive compensation is leading to wider differences in total pay for basically the same job. While most companies have incentive plans, not all do. Approximately 15 percent of general-industry companies have elected not to use incentive plans, either out of frustration with their administration or because they feel they can get the same results through other programs. Second, among companies with incentive plans, there is greater dispersion of pay from one year to the next -- if an incentive always pays out about the same amount, it probably isn't much of an incentive. And finally, it isn't just low-salary companies that use incentives. In many cases, the employer wants to provide an above-average compensation program in every element of the total package -- salary, bonus, long-term incentives and benefits. These companies tend to pay at the 70th or 80th percentile of total compensation, or more.

As a result, companies must examine the range of total compensation rather than simply using the averages. Even if we exclude the highest-paid 25 percent and lowest-paid 25 percent of senior executives, the difference in total pay is still dramatic. The compensation for CEOs whose companies are in the $500 million to $1 billion category can range from $449,300 annually to $766,000 annually (a range of 71 percent). For CFOs in the same size companies, the middle 50 percent earn anywhere from $191,700 to $304,300. Much of this variation is attributable to incentive compensation practices among companies. The good news is it's possible to earn substantially more through incentives.

PRESSURE FOR CHANGE

Outside influences are encouraging management to refine incentive plans as well. For instance, Securities and Exchange Commission disclosure rules effective in 1993 require comparison of company stock prices over the last five years, against both the general market and a peer-group index of companies in the same industry. This has heightened interest in both annual and long-term incentives that pay off based on the company's performance compared to its peer group. In addition, the new SEC proxy rules now require employers to report salaries and bonuses separately, allowing shareholders to examine the pay/performance relationship more closely (by comparing bonus payments to profits, stock price and so forth).

In addition, tax legislation effective this year has, for the first time, imposed an upper limit of $1 million on the amount of compensation corporations can deduct with respect to any one executive. This limit does not apply, however, to compensation that is performance-related, including stock options and incentive compensation payments.

The FASB is proposing new stock-option accounting rules that will undoubtedly encourage companies to shift away from simply using stock options as the primary long-term program, toward using long-term cash incentives and other vehicles. Ironically, shareholders always benefited as well as executives with option plans, but other types of long-term programs often yield payouts whether or not the stock price has increased. And finally, both the press and the public continue to be very interested in executive compensation, placing pressure on the compensation committees to ensure a reasonable link TABULAR DATA OMITTED between pay and performance.

As a result, companies have placed greater emphasis on the performance measures and more frequently use new and/or additional performance measures to evaluate company performance. Companies are increasingly using cash flow as a way to emphasize management for total cash generation, as opposed to simply for net income. Cash flow incorporates net income, but also emphasizes inventory minimization, accounts-receivable collection and efficient use of fixed assets. Return on capital also emphasizes the importance of minimizing assets while achieving net income. Economic value added measures the adjusted after-tax operating profit after considering the cost of capital.

Each of these measures -- especially EVA -- requires substantial collaboration between the CEO and CFO in defining, tracking and setting appropriate standards for the company. These new measures tend to increase the role and responsibility of the CFO in the area of incentive compensation.

In addition, with the increased emphasis on customer and employee satisfaction and total quality, some companies are incorporating other nonfinancial factors into their incentive programs. Fully 35 percent of the 1,400 companies responding to our "1992 Current Issues in Executive Compensation Survey" indicate they have incorporated quality and customer satisfaction into at least some of their annual cash incentive plans, and 24 percent of the companies use this measure in their senior management plans.

For example, at a major East Coast utility, customer satisfaction is a major performance factor for the telephone operations service group. The group belongs to a consortium of companies that survey customers via an outside marketing service to provide a basis for comparison. Some large customers furnish additional data directly.

A large company in the Midwest has an incentive program for all employees that lays out five goals, one of which relates to customer satisfaction. The customer satisfaction target is set each year, and the company measures achievement as the average of the ratings from three customer surveys.

Since 1985, a high-tech manufacturer has used customer satisfaction in its executive compensation program. At least 25 percent of the executives' bonuses are tied to meeting quality and continuous-improvement goals.

A number of hospitals conduct patient surveys and use their level of satisfaction as a performance measure. In addition, 15 percent of the respondents to our 1992 survey use employee satisfaction or development measures, with 11 percent including these factors for management levels. One defense contractor bases 50 percent of a manager's bonus on individual performance, which includes three measures of human-resources effectiveness: dedicating resources to educating and training their units, involving employees in continuous-improvement efforts and recognizing individuals and groups that produce high-quality work and improve work processes.

A number of companies have tied executive incentives to success in reducing turnover, smooth implementation of new work methods and processes, and similar measures. A few companies ask employees to rate their supervisors on skills, such as communicating effectively, establishing clear direction, dealing with people skillfully and other qualitative yardsticks. However, most companies use these ratings to design supervisor development programs rather than to determine incentives.

Used together, financial and qualitative measures can provide a balanced, comprehensive assessment of company performance. The old management dictate says it all: "Before you motivate your people to get them going, make sure they're headed in the right direction!"

Mr. McMillan is managing director in the Houston office of William M. Mercer Inc.