Show Me The Money! (Part 4)

(This post is part of a multi-post thread, and is in response to Part 3.)

Show Me The Money: Value for Value Applied

Ok minions, now that we have taken that giant step back to look at the big picture lets take the knowledge that we have learned from our lessons on Corporations and Economics of Exchange and apply it to the question at hand: Why do CEO's make so much money?

Value For Value Applied: Change in the Ranks at Minions, Inc.

Lets say, theoretically, that you are a member of a board of directors for Minions, Inc. Your current CEO (Brian) is making $1 million, and is about to retire. Brian has been doing a good job around the place, in fact he regularly pulls in $9.9 million for the owners in pure profits. Now you need to pick a new CEO.

Through your recruiting efforts you have narrowed that search down to two candidates. You feel that the first, Charles, will increase your profits by $0.2 million (bringing profits to $10.1 million). The other recruit shows more promise, he is a high level executive from Followers, Inc, named Erwin. You feel that Erwin can do a better job than Brian and Charles because Erwin has been in the industry longer, he has been able to manage his employees better, and he has a stronger skill set. You feel that Erwin will increase your profits by $1.1 million (bringing profits to $11 million).

As a member of the board you need to look out for the interests of your bosses (the owners) and give them as much of a return on their money as possible. In negotiations with Erwin you offer him the same compensation as your current CEO, $1 million. But, unknown to you and the rest of the board, Erwin has been heavily recruited by other corporations who left their final offer at $1.3 million. Erwin feels that he can make the corporation at least $0.5 million more money than Brian so he says, "You know, I'd really like to work here, but I've been offered a better offer elsewhere…. If you offer me $1.4 million we'll call it a deal."

Here are the thoughts of the board: Charles would increase our profits by $0.2 million with no change in costs; Erwin would increase our profits by $1.1 million with the increase cost of only $0.4 million; the owners would see an increase in profits of $0.7 million with Erwin, while with other candidates it would only increase $0.2 million with other candidates. They perceive the value of Erwin to be greater than value of the money they need to pay him (Erwin > $).

If Erwin knew his competition (Charles) better and if he knew what the board valued his performance at ($1.1 million minus costs) he could have increased his compensation to $1.9 million and thus matched the increase in profits ($0.2 million) that the next best candidate (Charles) could have brought the firm (that’s called opportunity cost), and still would have been hired.

Value For Value Applied: Scarcity

Now tie this lesson on value-for-value to scarcity. In this case it would be the large demand of companies needing competent CEO's while being supplied with a small supply of competent CEO's. Forbes wrote an interesting article with this tag line: "What does it cost to attract first-class talent to a chief executive job? A lot. What does it cost to hire a clunker? Almost as much."

Hopefully this post wasn't to dense to be easily grasped, the next post will be shorter and make it more apparent why CEO's make so much money.