Do executive compensation incentives really matter?

Many companies don’t link incentives to return on investment and cash flow. Are they getting what they’re paying for?

In brief

• An EY-Parthenon analysis looked at the importance of including return on invested capital and cash flow metrics in executive compensation incentives.
• The study shows that companies get what they pay for: Those that included these measures in executive incentives outperformed those that did not.
• EY-Parthenon teams help clients identify appropriate KPIs that align financial results with strategic business objectives.

When it comes to executive incentives, the conventional wisdom is clear — if you want to improve a metric, tie compensation to it. Unfortunately, creating the right mix of incentives to influence the right combination of outcomes is tricky, and many companies fail to do this well.

Figure 1

The ROIC-CF paradox: unraveling the impact of executive compensation

While the findings reinforce the key message that both ROIC and CF are valuable components that should be considered in a well-designed compensation incentives program, the analysis also reveals an interesting nuance. Companies that eliminated ROIC from incentives experienced a larger negative impact than those that eliminated CF, while companies that added CF metrics to incentives that hadn’t previously included them saw a greater positive improvement than those that added ROIC metrics. While the underlying reasons are not entirely clear, we propose some explanatory theories.

ROIC, as a comprehensive performance measure, demands sophisticated implementation. It compels executives to consider both income statement and balance sheet dynamics simultaneously. Its complexity has benefits as well as drawbacks, however. Many organizations are still developing the capability to calculate ROIC rigorously, and, at the granular level, that is necessary to meaningfully inform value-creating decisions. Companies that eliminate ROIC metrics might be making a concerning shift toward simplistic growth metrics, prioritizing revenue or EBITDA expansion without adequate consideration of capital efficiency.

In contrast, adding CF metrics seems to offer more of a direct performance boost. CF metrics are typically easier to calculate and understand with fewer inputs than ROIC, and our data suggests they broadly drive positive performance outcomes. This comparative accessibility potentially reduces implementation risk, making CF particularly attractive for the more mature organizations in our data set that may have historically underemphasized CF management or that may need to transition to more cash-based metrics as their growth rates slow. Interestingly, when CF metrics are removed, there is less downside; organizations seem to maintain underlying cash management disciplines, suggesting that these positive practices are sticky when habituated over time.

A path forward for effective executive compensation incentives

Organizations often operate in silos, with weak or inadequate coordination among strategy, finance and HR functions. We advocate integration, where:

• Strategic initiatives align with appropriate and measurable key performance indicators (KPIs) that can drive performance improvement at a granular level.
• Accurate financial forecasting provides challenging yet achievable targets and flags issues and leading practices early.
• Compensation structures woven into middle manager ranks reinforce these objectives.

Education and awareness form the critical foundation of this integrated approach. Both knowledge and incentives must cascade from the C-suite throughout the organization, making decision rights align with strategic objectives at every level. 

A robust data and analytics infrastructure is needed to make it easier for executives to measure CF and ROIC at the desired granularity. Without effective measurement of KPIs integrated into the operating and strategic planning processes, organizations will not be able to align management behavior to focus on CF and ROIC.

One example is a global pharma and medical technology company that incentivized its management teams to focus on CF in addition to traditional P&L metrics. Finance and business teams invested in data technology to improve visibility into CF, implemented quarterly reviews of CF and balance sheet metrics, and used the insights to improve cash drivers.