Performance and reward: formula sheet

Key formulas

Goal congruence test

Behaviour rewarded = Behaviour strategy needs

If the two differ, the system is not congruent. Say what behaviour the reward actually encourages.

Strategy-to-reward chain

Strategy → CSFs → KPIs → Targets → Feedback → Reward

Use it as a checklist. A break in the chain is where you criticise or recommend.

Qualities of an effective measure

Controllable, Measurable, Relevant to strategy, Understood, Timely, Fair

Use it to evaluate any proposed measure or reward basis. It is a checklist, not a fixed ACCA formula.

Agency cost (components)

Agency cost = monitoring costs + bonding costs + residual loss

Residual loss is the value lost because the agent's decisions still differ from what the principal would choose. This is a framework to list, not a calculation.

Goal congruence test

Reward is effective if agent's gain rises only when principal's wealth rises

Use this as a quick check on any reward scheme in a scenario.

Typical agency problem types

Moral hazard (hidden action) | Adverse selection (hidden information before hiring) | Information asymmetry (general gap)

Name the correct type. Do not use the terms as if they mean the same thing.

Lawler criteria (exam checklist)

Understood | Motivating | Controllable | Timely | Measurable and fair

Use as a test list. Some texts present the criteria in slightly different words, so apply the version in your study material and add cost and alignment with strategy if the case calls for it.

Pay mix

Total pay = Fixed pay + Variable pay

The balance matters. More variable pay increases focus on targets and risk transfer to the employee. More fixed pay gives security and stability.

Individual vs team reward

Individual: strong effort link, weaker cooperation. Team: stronger cooperation, free-rider risk

Choose based on whether output can be traced to one person.

Intrinsic value of a share option at exercise

Gain per option = Market price − Exercise price (if positive, otherwise 0)

The holder will not exercise if the market price is below the exercise price.

Total option gain

Total gain = Number of options × (Market price − Exercise price)

Ignores tax and any cost of financing the purchase.

Bonus as percentage of target

Bonus = Bonus rate × Measure above threshold (or a fixed sum if target met)

Use the scheme rules given in the question. Check for caps and thresholds.

Total shareholder return (TSR)

TSR = (Closing price − Opening price + Dividends) ÷ Opening price

A common LTIP condition, often compared with a peer group.

Reward-behaviour link

Measure rewarded → behaviour encouraged → effect on long-term value

Use this chain to structure every answer. Name the measure first, then the behaviour, then the harm.

Goal congruence test

Does the manager's gain from the bonus = the shareholders' gain from the action?

If not, there is an agency problem and the scheme needs redesign.

Residual income

RI = Divisional profit − (Capital employed × Cost of capital)

Often suggested to reduce under-investment seen with ROI. It is still a single-year measure, so it does not remove short-termism by itself.

Fixes checklist

Balanced measures + long-term vesting + deferral + clawback + independent oversight + disclosure

Link each fix to a specific problem. Do not just list them.

Features of a good performance measure for pay

Strategic link + Controllable + Measurable + Understandable + Timely + Hard to manipulate

Use this as a checklist when evaluating any proposed bonus measure.

Controllable profit (divisional example)

Controllable profit = Revenue − Costs the manager can influence

Exclude allocated head office costs and other items outside the manager's control. This is a common basis for judging managers rather than divisions.

Bonus calculation

Bonus = Salary × bonus % achieved, where achieved % depends on target met

Check whether the scheme has thresholds, caps and cliffs, as these drive behaviour.

Remuneration committee principle

Independent NEDs set executive pay; executives do not set their own

State this principle in plain words. Exact membership rules depend on the governance code in the scenario.

Quick revision

• Performance management systems turn strategy into measures, targets and rewards.
• An agency problem arises when managers (agents) act in their own interest rather than the owners' (principals').
• Goal congruence means managers' aims line up with those of the owners.
• Good reward schemes are linked to strategy, controllable by the manager, clear, fair and affordable.
• Bonuses reward achievement of set targets, usually over a short period such as a year.
• Share options give the right to buy shares at a set price, so value to the holder depends on share price rising.
• LTIPs reward performance over several years and help encourage long-term thinking.
• Short-termism means chasing near-term results at the cost of long-term value.
• Manipulation includes managing earnings or targets to trigger a payout.
• Deferral, clawback and multi-year measures help reduce short-termism and manipulation.
• Mix financial and non-financial measures to avoid a narrow focus.
• A remuneration committee of independent non-executive directors helps set executive pay and supports governance.

Common mistakes

• Listing theory on reward schemes without using the scenario. Fix: Quote scenario facts in every point and say what behaviour they cause.
• Ignoring the organisation's strategy when judging measures. Fix: State the strategy first, then judge each measure against it.
• Treating principal-agent theory as only a shareholder and director issue. Fix: Check the scenario. Divisional managers and head office, or government and a public body, can also be the pair.
• Using moral hazard and information asymmetry as if they mean the same thing. Fix: Information asymmetry is the knowledge gap. Moral hazard is the behaviour it allows, such as taking risk or shirking, because the agent does not bear the cost.
• Listing the Lawler criteria without applying them to the scenario. Fix: For each criterion, state whether the scheme meets it and quote the fact that proves it.
• Saying variable pay is always better because it motivates. Fix: Show the trade-off. Variable pay focuses effort but can cause short-termism, manipulation and stress. Fixed pay gives security.
• Treating options and LTIPs as the same thing. Fix: Say options depend on the share price rising above the exercise price. LTIPs depend on stated performance conditions over a period and usually vest as shares.
• Listing generic pros and cons with no scenario link. Fix: Tie every point to a fact: the target, the measure, the time period or the director's behaviour in the case.
• Listing generic problems of bonuses without using the scenario. Fix: Quote the scenario's measure, target and time frame in each point. Professional skills marks depend on applying the facts.
• Treating manipulation as the same as short-termism. Fix: Short-termism changes real decisions. Manipulation changes reported numbers. Name which one you are describing.

Exam tips

• Always open with the strategy. Markers look for the link between measures, behaviour and strategy.
• Name the behaviour a reward encourages, not just that it is good or bad.
• Use professional skills: be concise, structured and commercial. Give clear advice, not just a list.
• For recommendations, give a benefit and a limitation. This earns analysis and evaluation credit.
• Check time horizon, controllability and risk of manipulation in every reward scenario.
• Always name the principal and agent from the scenario in your first sentence. It shows application at once.
• Use the exact terms moral hazard, information asymmetry and goal congruence. Examiners look for them.
• For reward questions, give one benefit and one risk of each scheme. Balanced answers score better than one-sided ones.