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Incentive compensation plan at Johnson Controls Inc.

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In 1983, Johnson Controls Inc. developed a seven-year performance plan for tow of their most senior level executives. In each of the seven years, the base amount of the plan (consisting of $3000,000 and $100,000 for the two executives, respectively) is multiplied by a percentage that varies between 0% and 150%. The determination of each percentage is based upon the ratio of the average annual total shareholder return for Johnson Controls (over the 10-year period ending with the current year) to the average total shareholder return for a peer group of Fortune %00 companies over the same period. Then each of the yearly awards is invested in a hypothetical portfolio consisting of the stock of Johnson Controls. The payment of the total value of this hypothetical portfolio is deferred until the end of the seven-year performance period.

There are several interesting aspects of this performance plan. First, the term of the contract extends approximately three years beyond the retirement of the two executives. This feature appears to be an attempt to lengthen the decision making horizons of the two executives, especially in the case of those near retirement age. This contract explicitly motivates the executives to consider the impact of their decisions on the company after they leave the corporation.

Second, the scorecard for the annual changes in the value of the performance plan is formally tied to changes in shareholder wealth over the prior 10 years. This is unusual because performance plans are typically based on earnings per share or return on equity growth rates. One explanation for the choice of changes I shareholder wealth is that the board of directors is attempting to lengthen the executives decision making horizon by selecting a scorecard that has longer performance evaluation horizon than yearly accounting numbers.

Finally, the performance plan is based on relative changes in shareholder wealth. This appears to be an attempt to isolate that portions of changes in shareholder wealth that is under management's control form economy and industry wide effects. The choice of a 10-year period of assessing the performance of the company may be an attempt to wash out other random effects that affect performance in a single year.

Comment on this incentive compensation plan. Identify what you like and what you do not like about it.

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The solution analyzes the incentive compensation plan at Johnson Controls Inc.

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Comment on this incentive compensation plan. Identify what you like and what you do not like about it.

The performance plan is based on the return on the stock prices of the company. Thus the goal of the company is being identified as maximization of shareholder's wealth which is a good goal for the company to have. This aligns the interest of the managers and the shareholders and eliminates agency costs. (Sometimes the interests of the shareholders and managers may be aligned but that of the holders of debt may not be aligned but that is ...

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