Catalytic Solutions, Inc PDF

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This course contains information about the Catalytic Solutions Case which was presented on the course....

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Catalytic Solutions, Inc Purpose Of Case The Case of Catalytic Solutions, Inc. (CSI) was written to motivate class discussion on several issues commonly associated with the design of performance measurement and incentive systems in young, growing companies. The subject company in this case is private, still in a "pre-profit" situation, and preparing for an IPO, hopefully, in the not too distant future. The case describes the company, its competitive advantages and strategies, and the elements of its employee compensation package. At least for some employees, this package includes three elements: salary, stock options, and annual bonuses. What is particularly interesting about the compensation package is that the company's annual bonus plan rewards primarily on non-financial performance. This is unlike the bonus plans used in larger and more established companies, where bonus rewards are primarily based on financial performance measures. In this case, CSI's VP-Finance & Administration is quoted as saying that he doubts that financial measures will be more important than nonfinancial measures in this plan. Thus, this case can be useful for motivating class discussions about the role of non-financial measures in incentive systems as a substitute or complement to financial measures. Possible Student Assignment As with most cases, students can be given more or less preparatory guidance in their assignments. If the instructor wants to provide relatively little guidance, we recommend these short assignments: 1. Evaluation of the CSI performance measurement and compensation system. What changes would you suggest being made to this system, if any? Explain. 2. Fast forward 10 years. Assume that CSI has succeeded. Now public companies are much bigger. It has three operating divisions (investment centres) that focus on different markets. What would you expect the CSI measurement and compensation system to look like back then? Why? Here are tasks that may take longer: 1. Evaluate the composition of the compensation package at CSI. a. What are the advantages and disadvantages of granting stock options? b. What are the advantages and disadvantages of giving bonuses? c. Does the relative importance placed on salaries, stock options, and bonus awards make sense? Why does CSI offer a mix of rewards instead of providing 100% compensation to its employees based on 100% salary? 100% annual bonus? 2. Evaluation of the specific features of the annual bonus plans in 2001 and 2002. Comments on: a. Choice of the number of actions used, the specific actions used, and Change of plans between years; b. Relative proportion of financial vs non-financial measures; c. The decision to base the award on the overall performance of the company, not the individual; d. The amount of subjectivity allowed in determining the award bonus;

e. Calibration (target difficulty) of the bonus plan. 3. As CSI grows and, perhaps, becomes a public company, how will performance measurement options and compensation package options evolve? Discussion A. Critical Success Factor One good way to discuss this case is to clarify the company situation. This can be done by assembling a list of CSI critical success factors (CSF). CSI seems to have developed a better product, a better performance catalytic converter at a lower cost. It had to maintain that competitive advantage, and CSI managers thought they could. CSI tries to sell its products to an industry, car manufacturing, which is demanding and unforgiving. There are significant barriers to entry. On the other hand, the market potential is huge. To gain market penetration, CSI managers must tell their product superiority story effectively, and they must demonstrate to manufacturers that they can deliver consistently high quality products on schedule. The CSF list, then, should include the following: • Design-product performance and cost. Maintain technological advantage. • Production capability-capacity, efficiency, quality, delivery. • Sales / marketing - tell stories effectively to gain customer commitment. The list of CSFs is complete if one can conclude that if CSI does well in all of these areas, the company will most likely succeed. If the instructor has previously taught subjects such as integrated performance measurement systems or the Balanced Scorecard (BSC), this CSF can be reorganized and upgraded into a "strategy map." If the BSC framework is used, then students must add the financial measures they want. track; They must identify the processes that will produce the desired customer value proposition; And they must demonstrate awareness of some of the learning and growth initiatives (e.g., training) that will enable the company to implement a strategy of de only success. B. Compensation Package The CSI compensation package has three elements: base salary, stock options, and annual bonuses. CSI's strategy is to pay below-market salaries and then use the other two elements to create a competitive total compensation. One decision that can be well discussed in class is the CSI manager's choice of the relative importance of the three elements of a compensation strategy. Why do companies choose to use three elements of compensation instead of just one, whether it's 100% pay or 100% equivalent performance compensation? This should lead to a discussion of the purpose of the compensation system. These goals include: 1. Attraction/retention of good people. Paying employees only guaranteeing salaries tends to attract risk-averse employees. Paying performance-dependent compensation tends to attract employees who are more risk tolerant, more aggressive, more confident in their abilities, and/or more financially independent. What kind of people do start-ups want? Possibly many more of the latter type. However, paying compensation depends on the performance of the employee who is at risk. Employees should be compensated for this by paying a risk premium, the value of which is expected to be higher than they would get from just a competitive base salary.

This costs the company money. This measure of risk premium is impossible to calculate in the case of CSI, mainly because of the difficulty of assessing the perceived value of stock options. Subjecting employees to risk also complicates the administration of compensation packages. The company must decide how to measure/assess performance and, if performance-dependent compensation is a large part of the total compensation package, how to cash in on its employees to maintain their basic cost of living even through periods of low performance. So the additional costs for the company can be significant. Stock option plans, in particular, help with employee retention. They should stay with the company until the option can be exercised. Exercise cannot happen until the option vests and until the company creates a market for the stock by going public. Thus, the choice gives the shape of a "golden handcuff". 2. Motivation. Motivation has two elements. One of them involves encouraging, making employees work hard. Others direct effort, helping employees understand what is expected of them. In the case of CSI, the induction of effort does not appear to be a problem. CSI employees seem to be working really hard. But companies need to inform and remind employees of what is important for the company to be successful. This is the main purpose of the CSI bonus system C. Stock option plan The element of CSI compensation that most students don't understand is stock options. Choices can pay off a lot for employees if the company is successful. Because the value depends on the company's performance, choices can shape the company's culture. They can help create a culture of teamwork and cross-sectoral collaboration. The options also compensate while conserving cash, which is often important in startups. CSI is not short on funds. But even so, the company's cost of capital is high, as most of the funds come from venture capitalists. The complication in this case is that CSI is a private company. What do stock options mean in private companies? There is no market for options until, and unless, the company goes public, which is expected to do in the next few years after the time of the case. There's no easy way to appreciate CSI's choices. Employees can sell their options if they can find someone (e.g., a friend) to buy them, but the company has the right of first disclaimer over all options. Meanwhile, this company gives employees all options from the moment they are hired. Initial grants range from 200-20,000 options per employee. 200 is typical for production line workers. 20,000 will be senior executives. A new engineer will be given 1,000-2,000 choices. Since mid-2001, the strike price on each option has been set at $10, based on valuations made at the time. CSI managers estimate that the value of the company may have increased by 25-50% since mid-2001. (A new valuation was being conducted in early 2003.) If one can assume that each share is worth $15 by the time 1,000 new selected employees are hired, then CSI give the employee an immediate $5,000 option, plus the value of the option. But most employees don't understand what they're providing. This limits the value of the firm's options. The problem is, CSI managers are limited in what they can tell their employees about stock options. They are reluctant to provide an "official" declaration of what options are feasible for fear of employees being disappointed if that value cannot be realized l again. In Mike Redard's words, the puzzle is, "How can we communicate the value of an option without promising it?" D. Bonus Plan

Since the focus of this case is on performance measurement, most of the class time should be spent on the bonus plan. There are many issues that could possibly be discussed. One issue is the level of measurement. Both elements of CSI's performance-dependent compensation - options and bonuses - are based on the overall performance of the company, not the performance of specific individuals. The overall measures of the company are really controlled to some extent only by a few managers at the top of the company. But, for example, manufacturing employees, about half of the CSI workforce, are rewarded for new OE commitments (about 50% of the bonus target). Similarly, R&D people receive half of their bonus for implementing existing business infrastructure and buildings over which they may have little control. In addition, while the R&D department influences the likelihood of winning a new OE commitment (reputation from working with the customer development team, determining product costs through specifications), the impact is likely to be small compared to the contribution of the executive in charge of the new contract. This makes this compensation element have a wealth-sharing feature, not a motivational one, in an attempt to make sense. Instructors can illustrate this by discussing it in a motivation theory, such as expectancy theory or goal trajectory theory. For most employees, the expectation that an individual's behavior will achieve a goal for which the reward is paid is small enough, that little or no motivation is generated. Why does CSI do this? There is some reasons. One is that the company does not have a welldeveloped system to track individual employee performance. The second is that they use incentives to communicate critical success factors to all employees, and hope to encourage teamwork through this wealth-sharing mechanism. And third, CSI managers don't really care about driving the effort; Their employees have worked hard. In 2004, CSI moved to introduce several individual performance measures in the bonus plan. Bonuses will still be based on company performance measures, but bonus payments will be conditioned by individual performance appraisals. The second important issue is that of involving heavy use of non-financial performance measures. In 2001, the bonus was based exclusively on non-financial performance measures. In 2002, financial measures were added, but their importance weights are still far below non-financial measures. (Figure TN-1 shows a summary of actions and their weighting importance in 2001 and 2002.) Why does CSI base its results on non-financial, not financial, performance measures? Most importantly, CSI managers believe that there are many ways to achieve financial results, but not all of them are desirable. Non-financial measures communicate to employees how top management wants the company to create long-term value. CSI managers find it easier to use non-financial measures because CSI is not publicly held. They don't have to try to communicate results to market investors and analysts, and they don't need to be short-term oriented, perhaps focusing on quarterly earnings per quarter. So the focus is on building their company through long-term value creation drivers. However, several summary financial performance measures were included in the 2002 bonus plan. This reflects managers' awareness that when CSI becomes a public company, these actions will gradually become more important. (They called their upcoming IPO a “liquidity event.”) The third issue is the choice of action. If CSI has chosen well, their actions should be a good representation of their critical success factors. Students may be asked to identify missing factors from the CSI list. One that could be added would be an indication of the quality of the product delivered to the customer, as indicated, perhaps, by the customer's return. Is it necessary to add to this list by adding some success drivers in this critical success area, as

the balanced scorecard advisor suggests? Mike Redard doesn't believe that this level of complexity is necessary or desirable at this stage of CSI's history, if ever. The fourth issue involves the use of subjectivity. The CSI manager requested the right to make subjective adjustments to the plan. This case provides one example where they exercised this right, in the case of the QS-9000 certification. Subjectivity is associated with a set of advantages and disadvantages, advantages and costs. The gain is subjective vitas can be used to make performance indicators and bonus rewards more reflective of controllable performance and therefore fairer to employees. On the other hand, subjectivity can be abused, and if the employer provides bonuses even when performance targets have not been met, this can create unfavorable expectations that can undermine the incentive value of the incentive rewards. The QS9000 certification example illustrates these benefits and costs. The QS-9000 bonus award was awarded in 2001 although CSI missed that target by several weeks. The danger here is precedent. Perhaps employees expect a similar dispensation when they fail to achieve other targets in the future? On the positive side, however, these subjective grants may have shielded employees from uncontrollable factors (such as problems getting appointments from the certifying agency). Subjectivity demonstrates management's affection and gives employees assurance that hard work will be rewarded. Mike Redard calls this the "spirit of appreciation." The fifth issue that can be discussed is the number of actions. Compensation consultants have a few rules of thumb for choosing the number of actions that should be included in a bonus plan. One is that no more than 5-8 sizes must be included. Five to eight measures usually capture the most important performance factors and including other measures will only detract from focus. Another rule of thumb is that each measure included in the plan should have an important weight of 5-10% of the total bonus impact. The CSI choice is consistent with these two rules of thumb. This case illustrates one example of a potentially important action that did not go according to plan. That measure is the number of patents, which is Can be a useful indicator of value for CSI. It was omitted from the bonus plan because patenting didn't happen every year, and after all, few CSI employees were responsible for new inventions that could be patented. The sixth issue is related to the calibration of bonus payments. CSI managers strive for payouts near 100% of the target bonus rate if all employees work hard and smart. CSI managers recognize that there will be some variance between good and bad years. (If this variance does not exist, the bonus award is simply a deferred salary payment.) The actual payout for 2001 was 117.9% of the target bonus. In 2002, the payout is estimated to be slightly below 100% of the target. Finally, the size of the bonus award can be discussed. CSI target bonus in the range of 5-15% of low base salary. They may not be enough to make employees work extra hard to earn bonus rewards. The incentive effect of the bonus is also weakened because there is no minimum performance threshold for awarding the bonus, so bonuses are always paid out. This reduces pressure to meet short-term targets. And, as noted earlier, the effect of extrinsic incentives weakens because of the emphasis on firm, not individual, performance measures. CSI uses bonus plans to create a sized total compensation package and communicate organizational priorities that are important to employees. E. The Future

The final assignment question asks students to think about how CSI's performance measurement and incentive system will change. CSI managers know that their strategic themes change from year to year. Here's a short list of their themes for the early years: 2001 • New customers • Build infrastructure 2002 • New customers • Perform scale-up and execution • financial discipline 2003 • Grow existing base • Run • Financial predictability Mike Redard's findings on strategic themes for 2013 are this list: • SBU focus • Customer retention/growth • New market penetration • Profit/cash flow growth So, as Mike conjectured about the bonus plan in 2013, it will be based more on the performance of the SBU than on the performance of the company. These measures will change, to focus more on customer growth and retention, rather than achieving specific new customer commitments. It will focus more on penetrating new markets outside the automotive industry. And it will have a financial performance component, although Mike still believes that financial measures will never be weighted more than 50% of the total....