Students in MBA 505 learn about pay for performance and economic profits. Yesterday's WSJ reports that economic profits (total revenue less taxes, operating costs and the cost of capital) is increasingly being used as a metric in pay-for-performance plans. In a recent PriceWaterhouseCoopers survey, 27% of the respondents said they were using economic profits, whereas only 19% were using stock prices.
Why are economic profits becoming more popular as a measure? After all stock price is what shareholders should be caring about, so stock grants and stock options would be the best way to align the interest of managers and shareholders. However, stock prices are a forward looking measure taking into account a wide range of variables, many of which are outside the realm of control for middle or even top managers. Economic profits are an indicator of cash flow, a variable that is much easier for managers to control, either through increased revenue or lower cost.
One thing Pepsi and Coke have in common is that both reward execs using economic profits as the basis for bonus calculations.
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