The Bugaboo of Executive Compensation

It never fails.  Certain people will come up with executives at various companies as a reason for worker pay not being as high as it is (look how much the CEO gets!  Of course they can afford to give workers a raise) or prices or…well, whatever economic woes they’re talking about this week.

Apparently these executive compensation packages are the result of unbridled greed.  How does that work exactly?  Greed only speaks to, can only speak to, what someone wants to get.  No amount of greed is going to get someone to offer more.  What these people need to start asking is why those kind of salaries and other components of exectutive compensation are being offered.  Why is the company willing to pay that much?

Of course, it’s economics so the answer is “supply and demand”.  But that just restates the question:  why is the demand so great as to support such a price?

Well, let’s look at an example.  Walmart.  Everyone loves to snipe at Walmart.  In 2017 Walmart had a total revenue of just over $485 billion (yes, that’s a “b”) dollars.  With a gross margin of 24.7% (I looked these numbers up) that gives us a total expenses of about $365 billion.  Now, if the decisions made by an executive at Walmart affect either of those numbers by as little as 1%, that executive can save or cost the company more than 3 and a half billion dollars in a year.   Walmart can pay $22.8 million (CEO compensation at Walmart for  to get a CEO that will be on the “plus” side of that rather than the “minus” and end up making an extra 300 times as much (+1% vs -1%) than is being spent on the executive.

Someone who can add fractions of a percent to the efficiency of a company is worth billions to a company of Walmart’s size.  Getting that someone for millions is an incredible bargain.

But what about cases where companies pay millions in severance packages to executives that are failing.  What about those “golden parachutes?

Have you ever been in a relationship that went really sour?  It started as looking like a good thing, maybe it was a good thing at the time, but things changed and it turned ugly.  And instead of a clean break (maybe there are legal contracts involved.  Maybe there are kids.  Whatever.) you end up getting in argument after argument after argument?  No?  Well, not everyone has but I’ll bet you know someone who has.  And in such a situation, wouldn’t it be great to just be able to pay the other party to. go. away?

Well, that’s what we have with these golden parachutes.  Look back up and see how much going 1% the other way could be costing the company ten million dollars a day while still in place and making those decisions that aren’t even bad, just fractionally not as good as someone else could make.  If the person fights being removed, that can cost even more.  From an economic standpoint it could be simply cheaper to pay them that severance package to get them to leave now rather than after an extended fight during which the company bleeds money or more importantly the resources that money represents.

The case of Sewell Avery and Montgomery Ward is illustrative.  At the beginning of the Great Depresssion J. P. Morgan hired Jewell to run the struggling Montgomery Ward and turn it around.  He succeeded and ran it well for some years.  Then, in the post war years the market changed with, among other things, an increasing demand for durable goods and Avery failed to adapt to the changing market.  A power struggle continued for some time with Montgomery Ward sinking further and further behind rival Sears Roebuck and Co.  When Avery finally resigned in 1954, Montgomery Ward stock rose dramatically, but the company was never again regained its former position.  Had Montgomery Ward been able to get rid of Avery cleanly and, most importantly, quickly, when it became clear his position was harming the companies position, the company could well have earned millions, if not billions, that were forever lost to it.

The people making the decision have more information to decide how much they should offer an executive to work for them, how much to offer to make him go away.  A failing executive is more willing to jump, after all, if he has a nice parachute.

People sitting on the outside, just do not have enough information to second-guess the people actually making the decision with both their own money and their own responsibility to the stockholders, at stake.  But all too often people sitting on the outside, with no idea what’s involved or what’s at stake, think they’re qualified to tell those people what they should or should not do.

And we’re back to why economics is “the dismal science.”

Advertisements

10 thoughts on “The Bugaboo of Executive Compensation”

  1. Employee compensation is mostly based on the labor market for the particular position. If there are hundreds of people applying for each opening, because the entry requirements are fairly low and there are a lot of people looking for work. then compensation will be low. It has little to do with how much profit is being made and everything to do with the local labor market for the skills in question. If the applicant pool is small then wages go up, and this can be true even for some jobs that don’t require a lot of skill if the jobs are distasteful enough even though the labor pool might appear to be pretty big. Wages generally are simply supply and demand with labor as the product. Low demand compared to high supply equals low price; high demand compared to low supply equals high price.

    1. Yes, supply and demand. However that’s a starting point, not an ending point. One has to look beyond jut the banality of “it’s supply and demand” into why that supply and that demand are what they are. The demand for someone to fill a role is very much determined by the value that role has to an enterprise. An executive making decisions that affect hundreds of millions to hundreds of billions of dollars of revenue and expenses has a very high demand indeed for someone who can do that job well. Contrariwise, the number of people who can do the job well enough to get the last few tenths of a percentage of efficiency out of the enterprise is a vanishingly small set.

      These two factors explain executive compensation.

  2. The value of the decision-maker going away posthaste is something I hadn’t really considered–and the Montgomery Ward example is fantastic. I always like the angle you bring to things. Thank you!

    1. Thanks should go to Thomas Sowell. I got the example from his book “Economics Facts and Fallacies.” Well worth reading (or listening to on audiobook as I’m doing). When I looked into it further I saw that while stocks shot up after Avery left (as Sowell mentioned), Montgomery Ward never recovered its earlier position (which Sowell did not go into although I’m quite sure he’s aware of it).

  3. Perhaps I’m just trying to make too much sense – but should it not be that if a CEO (or other C- or V-level exec) gets termed for cause, or termed for non-performance, that their “golden parachute” should fail to open?

    Why is that not put in contracts? It would be a Hell of a motivator, at least…

    1. Because then they fight getting removed, costing the company even more money. See the Montgomery Ward case for a particularly strong example of how that can play out. It may well be that it’s worth the money to get them to go away quickly.

      In any case, third parties sitting on the outside have much less information and generally far less of the relevant expertise and certain far less incentive to get it right compared to those actually making the decision within the company.

  4. “the number of people who can do the job well enough to get the last few tenths of a percentage of efficiency out of the enterprise is a vanishingly small set.” << this is true, but it does not justify most of the "top CEO" we've been seeing for the last 30 years. See the contrast with Japan's top (US Fortune 500 for example, vs Japan top 200) CEOs.

    The huge potential benefit is being used by the very small clique of mostly CEOs who are on Boards of Directors to decide the pay of other CEOs. It is more a "principal agent" problem, where the external owner is looking for an incentive to get the CEO to do the effort. There is little evidence that the CEOs which are hired are actually getting the extra performance. Unfortunately, the idea of stock options or other rewards for actual good performance hasn't resulted in any good formula for truly getting the top performance.

    They get excess pay because the decision makers want to get, or have already gotten, excess pay and none can tell them no with a clear way to determine what the pay should be. The rat race political skills seem to dominate, altho being division VP and doing well usually is quite important, too.

  5. Sometimes, just sometimes… CEOs get hired, but not supported by the Board Of Directors… THEY make the right decisions and get overruled by the BOD at every turn.
    This usually results in poor performance, loss of profits, and eventually shareholder unrest…
    At which point the BOD blames the CEO and dumps them.
    That, generally, is why CEOs won’t sign on without that Golden Parachute provision in their contracts…
    You can see examples where a successful CEO gets poached by a Big Name Company… the company fails to change their business practices, and the CEO moves on… usually to another success in running the next company.
    Dunning Kruger is applicable at all levels of responsibility and compensation

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s