If you pay peanuts, you’ll get monkeys

(Editor’s Note: This is an excerpt from business performance improvement expert Larry Valant’s book, Stop Breaking These Rules! 100 Hard-Hitting Truths for Business Integrity and Performance.)

RI is the superior predictor of long term company value.

The University of Chicago graduate school of business has done extensive research on residual income as a predictor of long-term company value. Its research supports the conclusion that residual income (RI) is the best predictor of long-term company value.

Because residual income reflects management strategies and the ability to execute them in absolute terms, it truly measures management effectiveness. Accordingly, RI is a wonderful tool to be used in executive compensation. Because the CEO’s primary job is growth in company value, residual income is the best measure of how well the CEO and his team are performing. Therefore, compensating the executive team based on growth in residual income is entirely appropriate.

Residual income, defined as net income after tax minus the annual cost of capital, is easily calculated. Because RI truly captures the results of management strategies and the execution of those strategies, it accurately quantifies performance.

It is therefore reasonable to conclude that a company with stable management that has shown consistent growth in residual income could be reasonably expected to continue that level of performance as long as that management team and their approach remains in place.

Obviously, this has very interesting implications for succession planning, organization planning, and management development.

One of the most volatile work issues and the one most likely to damage work relationships is compensation. That is why a key mark of management competence is the ability to create and sustain a fair compensation system.

Effective compensation recognizes the importance of those who block and tackle.

Normally when we hear about compensation, the article or review is about CEO compensation or other C-level positions. Rarely do we hear about compensation programs for those who block and tackle. However, effective compensation systems must be designed to reward people in all levels of the organization. The importance of a fair and equitable compensation system cannot be over emphasized.

Effective execution requires that all employees, from every level of the organization, agree to the objectives that are established and understand what is expected of them in quantitative terms. Once quantitative measurements have been established, each person’s contribution, no matter how high or low they are in the organization structure, can be measured, recognized, and rewarded.

To meet the revenue goals, the gross profit standards, and remain at or below budget, every person must do his or her job and deliver the results expected to standards that have been agreed upon so that an effective compensation system can then recognize and award everyone’s contribution appropriately. Then, when the CEO says the people on the loading dock (those who block and tackle) are just as important as those in the board room, his compensation strategies make his statements believable.

Those organizations that have learned to effectively measure and award performance at all levels of their organization typically have very high performance levels, very high morale, and very low turnover.

Pay peanuts — you get monkeys.

We often hear managers complaining about the lack of talent and capability of their staff. Yet, when questioned, they boast that they pay in the bottom quartile. Unfortunately, in many companies staffing is done on the cheap.

Someone told me a long time ago that you get what you pay for – in terms of quality, performance, and results. When asked to build a car designed for winning drag races replied, a mechanic replied, “It costs money to go fast, so how fast do you want to go?”

Similarly, when you want greater capability from your staff, it will cost more. A foolish economy is to nickel and dime hiring salaries and promotional rewards. At the end of the day, you will get what you pay for – the brightest and the best cost more.

It is certainly not necessary to over hire or to pay for greater skill or experience than you need, but when you are clear about the level of competence required, you can and should staff correctly and pay what is mandated by the market for the talent you need, for if you pay peanuts, you will get monkeys.