April 13th, 2012

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Executive salaries are again a matter of discussion in the press. A lot of people have trouble understanding why a bank president, managing directors or, as a concrete example, Dong executives, should be earning millions of kroner.

Most of us don’t see any problems with high salaries if they reflect the value of an employee’s work. But people do have trouble accepting that an executive could create so much value for a company.

That’s understandable. The fewest among us actually have an idea of what it is an executive does. We’ve never tried to manage a company that has thousands of employees. What’s more, much executive work goes on behind closed doors in order to prevent competitors from catching wind of corporate secrets.

Football stars also earn loads of money. Lionel Messi earned the equivalent of 230 million kroner in 2010. That’s far more than executives at even some of the largest companies earn. The Superliga isn’t quite as open about how much players earn, but according to insiders the highest-paid players in the domestic football league earn about 450,000 kroner a month.

Yet footballer salaries aren’t the subject of the same criticism as executive salaries. That could be because most people know significantly more about football than executive management, and that Messi and the other stars perform bathed in the spotlight and their every moves are caught on camera.

But just like the right player can be worth his weight in gold for a football club, the right executive can be worth his (or her) weight in gold for a major company.

Imagine that a board needs to hire a new managing director for a company that earns 2 billion kroner a year, and that the list of applicants has been narrowed down to two. The board’s preferred candidate is asking for 10 million kroner more than the other one. Is it really possible for one person to be worth 10 million kroner more for a company than someone else? The answer is, “yes, without a doubt”. If the preferred candidate is capable of increasing profits more than the other can, he (or she) would be worth a lot of money to  shareholders.

In fact, for every percentage point the new managing director was able to increase profitability, the company’s profits would increase by 20 million kroner.

Let’s assume that the preferred candidate, through effective leadership, could raise profitability by five percentage points to 15 percent, while the second-best candidate could only deliver a 13 percent profitability margin. Even though those two percentage points don’t seem like much, for the company they mean an extra 40 million kroner a year. Seen in that perspective, the extra 10 million kroner in salary shouldn’t be seen as unreasonable. Hiring the candidate with the lower salary requirements would, in fact, go against shareholders’ best interests, since they’d wind up losing money.

This isn’t to say that a highly paid executive is the same as a good executive. We live in a world where it’s only in hindsight that we have 20-20 vision. Mistakes are made.

Not all footballers are worth what they get paid either. Some players with big contracts never live up to expectations. Maybe they don’t get along with their coaches, or maybe they lose their drive or get hurt. One of the important factors of success in football is being able to hire the right players for the team.

Just like footballers can wind up not being worth what they get paid, executives can also fail to live up to expectations. But, that’s not the same as saying all executives get paid too much. Nor is it a reason for politicians to get involved.

The author is the president and chief executive of the Center for Political Studies (Cepos), an independent think tank promoting a society based on freedom, responsibility, private initiative and limited government.