Impact of the crisis on performance measures used in CEO incentive contracts

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‘Impact of the crisis on performance

measures used in CEO incentive contracts.’

Management Accounting

Master Thesis Accountancy & Control, Control track

Name: Roseanne Visser

Student number: 10440178

Supervisor: Dr. P. Kroos

Date: 21th June 2014

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Abstract

Previous research investigated the relation between strategy and CEO incentive

compensation, however recently the society is questioning the effectiveness of the CEO incentive compensation. This study will contribute to the existing literature by examine the relation between the used performance measures within the CEO incentive compensation and the crisis, sequentially this research analysis the moderating effect of strategy on the use of a mix of financial and nonfinancial performance measures within the CEO incentive contract and the crisis. Based on the prior literature it is predicted that the change from financial performance measures to a mix of nonfinancial and financial performance measures is relating to financial bad times. This study finds evidence for the relation between the use of financial performance measures supplemented with nonfinancial performance measures and the crisis. However there is no evidence for the moderating effect of strategy between the use of a mix of financial and nonfinancial performance measures and the crisis.

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1. Introduction

1.1 Background

Recent years the discussion of executive’s compensation is growing, not only on ‘how much’ but also ‘how’ is a popular topic for management scholars and the press. (Cooper, Gulen and Rau, 2009). The research of Balsam et al. (2010) investigates the use of performance

measures in relation to firm strategy and concludes that firms consider strategy in deciding the executive compensation, however they did not investigates the relation during the crisis period. Porter (1980) state a firm is more able to compete to their competitors when the firm is following a strategy. During the crisis period the firms are in a more competitive

environment, which makes strategy important. Porter (1980) describes two different strategy types; cost leadership and differentiation strategy. Also Schuler and MacMillan (1984) argue that CEO incentive compensation systems stimulate the executives towards implementing a strategy. So when a firm selects the performance measures in relation to their strategy, the firm is able to receive the best of it. Furthermore prior literature (Balsam et al. 2010;

Govindarajan and Gupta, 1985; Otley, 1980; Simons, 1987; Veliyath et al., 1994) argues the dependency of managerial action on firm strategy, the optimal incentive contract should also depend on the strategy of the firm.

Besides the strategy, the executive compensation is considered as one of the most used mechanisms to align the interests of management and shareholders (Barkema and Gomez-Mejia, 1998). A common problem within organizations is the congruence between the principal and the managers and employees, this problem can be described as the agency problem. Jensen and Meckling (1976) describe the agency theory as follows: stakeholders and managers have different interests and objectives. Since wealth maximization is one of the interests of the shareholders, and where personal welfare are the concerns of the managers, which includes minimizing their effort and maximizing their leisure. These differences give rise to agency problems relating to incentive alignment (Jensen and Meckling, 1976). Regarding this the previous research of Core et al. (1999) demonstrate that CEO’s at firms with greater agency problems receive greater compensation and that firms with greater agency problems perform worse. So, compare to the pursuing of the firm strategy, the compensation is used to align the executives to the same interests and objectives of the stakeholders. However, when firms determine the executive compensation with performance measures in relation to the firm strategy, the agency problems will decrease. Datar et al (2001) shows that

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congruence between performance measures and the firm strategy are an important factor within the design of effective incentive compensation contracts for executives.

However, Govindarajan and Gupta (1985) argued that there is no single "best" incentive compensation system for all companies and that such systems should "fit" the requirements of corporate strategy. So firms should determine which strategy they pursuit whereby they can select the right performance measures for their situation. Balkin and Gomez-Mejia (1987) state when strategy factor of the contingency theory can be successfully developed, it should also improve the effectiveness of pay practices by incentive

compensation strategy choices made by different organizations. Whereby incentive compensation can be used to give a competitive advantage to an organization over it competitors (Schuler and MacMillan, 1984). They state also when the compensation is designed in such way, it can give the organization the possibility to gain advantages in both strategy types over their competitors. There will be cost-efficiency advantages over their competitors, but also the differentiation strategy will be stimulated by using incentive compensation policies that by rewarding over entrepreneurial behavior and innovation. The compensation policies help drive the overall business strategy. (Balkin and Gomez-Mejia, 1987)

Previous research of Kirkpatrick (2009) argues that performance should determine an executive’s remuneration, however during the crisis firms are generally underperforming. Murphy and Jensen (2011) state that CEO’s should be held accountable for factors that are beyond their control, and if they can control or affect the impact of uncontrollable factors on performance. Which means, when the performance of the CEO is worse during a crisis, the CEO can not be accountable for the uncontrollable factors of the crisis, so it will result in a different compensation structure. The study of Ladipo et al (2008) indicated that in 2006, the fixed salary accounted for 24 per cent of CEO remuneration, annual cash bonuses for 36 per cent and long-term incentive awards for 40 per cent. Likewise, Matejka et al. (2009) show that being loss-making changes the way that firms select performance measures in their CEO incentive contracts. Specifically,Wallsten (2000) concluded that in good years the executive compensation increase on average by about $151,000, but in bad years their compensation decreases by about $10,000. However a economic crisis is different from being loss-making as the reasons that respective firms are loss-making in an economic crisis are clearly not attributable to bad decisions of the involved top managers. To conclude a crisis will lead to different performance measures in the incentive compensation pay. The research of Balsam et al. (2010) investigates already the use of performance measures in relation to firm strategy

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and found out that firms consider strategy in determining executive compensation, but they analyzed the period before the crisis. However, this study will investigate the relation between the CEO incentive compensation and the firm strategy during the crisis, and taking into

account the different reactions per strategy type.

1.2 Research Question

Based on the aforementioned, the following research question is formulated: How does the economic crisis affects the use of performance measures in CEO incentive contracts? So this research investigates the changes occurred in CEO incentive contracts during crisis period, in contrast to previous research like Balsam et al. (2010) focused on the period before the crisis. During the crisis years there is a lot of debate around the CEO incentive contracts. However, this research will also take in account the strategy contingency factor, because this factor is mentioned as an important factor by selecting the performance measures within the CEO incentive contract. Subsequent to examining the research question, I will also conduct some exploratory analyses that examines to what extent the firm's choice of strategy

moderates the impact of the economic crisis on the use of performance measures in CEO incentive contracts. So, I explore the influence in the firm's strategy in the relationship between the economic crisis and the use of performance measures in CEO incentive contracts.

1.3 Motivation and Contribution

The society is questioning the effectiveness of the executive compensation, after the Enron debacle and the Global Crossing bankruptcy the concerns about the effectiveness of the high compensations that directors’ receive show up. (Brick et al., 2006: Abelson, The New York Times, December 16, 2001, and Douglas et al., Los Angeles Times, February 24, 2002). These papers agree that the high compensation of Enron’s directors may have compromised their objectivity in monitoring management on behalf of shareholders. The societal relevance of this study will be gained by analyzing the performance measures used in incentive

compensation of the CEO’s in relation to the strategy of the organization the societal need could be answered.

On scientific perspective this study will contribute to the contingency theory.

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that financially constrained firms planned to cut more investment, technology, marketing, and employment relative to financially unconstrained firms during the crisis, but they haven’t researched the compensation structure. In contrast, Finkelstein and Boyd (1998) and Gomez-Meija (1992) studied the contingency factors in compensation, however there is little research done on the contingency factor crisis.

Furthermore this study also contributes to the agency theory, Holmstrom (1979), Grossman and Hart (1983) and Jensen and Murphy (1990) argued within the academic literature on agency theory and executive compensation that CEO incentive contract should consists of performance measures which are aligned to firm performance. Wallsten (2000) concluded that the compensation of the executive’s growth in average much more in good times, and decreases a little bit in bad years. However, the executives could not always have an influence on the crisis factor, the research of Wallsten (2000) hasn’t take into account the performance measures that were aligned to the compensation payout. This research will contribute to the existing literature on compensation arrangements. Frydman (2007) did research on the historical perspective of the compensation arrangements, which often helped to create congruence between stakeholders and executives, due the executive wealth was sensitive to firm performance. The correlation between the CEO compensation and firm performance was much stronger the last thirty years. The real value of compensation was remarkable flat during the 1940s till the 1970s. A large number of studies have examined its determinants and performance effects. The most researched question in this area has been the link between executive compensation and firm performance (Barkema and Gomez-Mejia, 1998). However Ittner et al. (1997) state there is little empirical evidence that the used performance measures in executive compensation are aligned to firm strategy, so this study contribute the existing literature on performance measures in executive compensation.

1.4 Structure

Chapter 2 till chapter 5 will be structured as followed. Chapter 2, the literature review, described the prior literature and the developed hypothesis will be explained. Chapter 3 described the Methodology. Chapter 4 provides an overview of the empirical results. The last Chapter of this paper will represent the conclusion.

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2. Literature review and hypotheses

2.1 Agency theory

Jensen and Meckling (1967) state the agency theory, represents the firm as a web of two-person contracts between owner and employees, where the owner or principal uses accounting information to control the employee who acts as the owners’ agent. They argue that the

agency theory can be seen as the differences in executive compensation structures of management and owner controlled firms. The compensation is a mechanism to align the interests of the principal and employee. So the CEO who makes contributions to the

organization will receive in return payments from it (Stinchcombe, 1965). Owners are seen as principals, who has a contract with the employee (the agent) and are dependent of the actions of the employee. The term "contract" is used which means the agreement between the

principal and the agent that specifies the rights of the parties, ways of judging performance, and the payoffs for them (Fama and Jensen, 1983). The costs of this relationship are called "agency costs." These costs incorporate costs of losses to the principal because the agent does not act in the principal's interests and costs of monitoring the activities of the agent. In Fact, the agents have an advantage on the principal, because the agents control the organizational resources and know more about the tasks they perform, which leads to an information

asymmetry (Pratt and Zeckhauser, 1985). Most of the times the principal want to counter this asymmetry, so he tries to limit the agent from making decisions which are not in line with the principals interests.Marris's (1964) found evidence for the managerial capitalism hypotheses, that in management-controlled firm, CEO compensation increases in tandem with increases in firm size through mergers and acquisitions. Fama and Jansen (1983) state that such behavior is possible because the organizations allocate four steps in the decision process across agents. The steps are initiation, ratification, implementation and monitoring. The first two steps are decision management; they define rules, including two dimensions; system for monitoring the agent actions and the reward structure, which includes the degree to which managerial

incentives are aligned with the interest of owners (Fama and Jensen 1983). Incentive alignment is defined as the degree to which the reward structure is designed to induce managers to make decisions that are in the best interests of the shareholders. Shavell (1979) and Holmstrom (1979) have shown that there are potential gains to monitoring, except from the situations where the agent’s actions cannot have a negative consequence for the principal. The theory have shown that agency costs can be reduced when the CEO compensation is

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related to CEO pay and firm performance or other types of information regarding actions taken by executives. (Holmstrom, 1979).

2.2 Incentive contract

Weitzman (1983) described the incentive contract as a contract where the principal pays a fixed fee plus some proportion on the performance of the agent. To implement an appropriate incentive compensation system the firm should determine performance measures, which should focus on measuring the contribution of the executive on the firm value. Because the increase in the firm value compares to the shareholder/principal needs. Performance measurement, choosing which quantity or quantities to use in an incentive contract, is a central problem in agency theory (Baker, 2000). Each firms has their own goals according to the shareholders needs. The performance measures within the incentive contract can improve the goal congruence. Therefore, each firm should design performance measures, which take in consideration the corporate goals. By the designing process there will arise two important properties within the performance measures, noise and distortion. Baker (2000,2002) state noise is related to what extent the performance measure is influenced by factors beyond the control of the agent. Noise can reduce the efficiency of the incentive. (Holmstrom 1979; Banker and Datar 1989; Feltham and Xie 1994; Indjejikian 1999). Whereas, distortion arises when employees can take action that increase the performance measures without stimulate the corporate goals (Baker, 2000). Firms should give these performance measures a lower weight in the incentive scheme. And the performance measures, which increase the corporate goals, should get a high weight within the incentive scheme. (Hopwood 1974; Baker 2000; Bushman et al. 2000; Baker 2002). The set of performance measures a firm could use in an incentive contract, and the weights to place on them depends on how the amount of distortion and the amount of risk changes as one moves from one performance measure to another. Whereby the measure or combination of measures yields the strongest incentive and or the highest surplus (Baker, 2000). The traditional accounting research relied on financial performance measures to evaluate performance, however to nonfinancial performance measures can compensate for noise and goal incongruence of financial performance measures (Datar et al. 2001, Feltham and Xie 1994, Banker and Datar 1989).

2.3 Contingency factor strategy

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effectiveness differs according to contingency factors such as strategy, national culture, competitive environment, and employee characteristics. Therefore, Balkin and Gomez-Meija (1987); Gomez-Mejia and Balkin (1992); Schuler and Jackson (1987) argue that in order to be effective, the organization incentive policies should be consistent with the contingency

aspects, the organization needs to develop a good conceptual framework which takes into account the contingency aspects. However, Gomez-Mejia and Balkin (1992) state that there is not yet a theory of incentive compensation that takes these contingency factors into account. Since no best management system for managing the company exist, so neither to a best pay system. Considering this Tosi et al. (1984) state effectiveness is either too broadly or too narrowly. Too broadly can be understood as the effectiveness is achieved when organization has created an environment where they can serve their customers comparing to their

principals and are effective. However organizations serve on different levels. But

effectiveness can interpret to narrowly by meaning only profitability. Snow and Hrebiniak (1980); Mott (1972) and Perrow (1980) argued that such a view is to narrow because other performance criteria exists. Other performance criteria could be more appropriated than profit, such as market share, morale, growth, flexibility, efficiency and quality.

Therefore, a contingency perspective requires taking into account the theory of firm strategy by researching the executive incentive compensation. Delery and Doty (1996) state that the organizations strategy is considered to be the primary contingency factor for the compensation literature. Thus, the contingency theory distinguishes two types of strategy, namely the corporate strategy and the business strategy. Both, corporate and business, should be taken into consideration by developing the incentive compensation structure. Human resource management is one of the perspectives in corporate strategy and is involved in formulation the incentive compensation structure (Balkin and Gomez-Mejia, 1987). This strategic human resource management perspective views people, as much as capital, buildings or equipment. Whereby employees are seen as important source of strategic opportunities and constrains, by recognizing that firm’s human resources have certain strengths and weaknesses that should be factored into corporate strategies (Dyer, 1983). Balkin and Gomez-Mejia (1987) state a broader and more recent literature argued that human resource strategy, which incorporates pay policies, should be treated as integral component of corporate strategy. Besides this the organization can get a competitive advantage over its competitors by

exploiting the business strategy in order to the incentive compensation practices (Schuler and MacMillan, 1984). There are several researchers who developed business strategy types (Milles and Snow, 1978; Gupta and Govindarajan, 1984; Porter 1980). This research makes

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use of the framework for considering the nature of strategy priorities, which was developed by Porter (1980,1985). Porter (1980) argued that to compete effectively, a firm must derive this competitive advantage form product differentiation or low cost production. In order to follow the product differentiation strategy the firm should provide customer satisfaction form factors such as superior quality, product exclusivity, delivery and product design, whereby low cost production primarily focused on efficiency. In both of these situations the

compensation policies help drive the overall business strategy, which are dominated by cost-efficiency or innovation.

When the firm pursuit the low cost production they should offer the products at a lower price than the competitors. Chenhall (2003) state that there is evidence from the strategy-organizational design research suggests that strategies characterized by a cost

leadership strategy are best served by centralized control systems, specialized and formalized work, simple co-ordination mechanisms and attention directing to problem areas. Strategies characterized by a product differentiation strategy are linked to lack of standardized

procedures, decentralized and results oriented evaluation, flexible structures and processes, complex co-ordination of overlapping project teams, and attention directing to curb excess innovation (Porter, 1980). Moreover, there is a difference in management accounting practice for both, the cost leadership strategy and differentiation strategy. The formal performance measures are appropriate for firms emphasizing low cost production strategies, the major focus will be mainly on controlling costs. Thus, traditional accounting techniques, such as budgetary performance measures and variance analysis, may be particularly suitable for these companies (Johnson & Kaplan, 1987; Drucker, 1990). These traditional techniques include the

use of budgeting systems for planning and control, performance measures such as ROI, divisional profit reports, and cost-profit-volume techniques for decisions. However for companies emphasizing product differentiation strategies, traditional financial accounting performance measures are unlikely to be sufficient for assessing how production processes support a variety of customer-focused strategies (Shank, 1989; Lynch & Cross, 1992). Financial measures are too aggregate and not timely enough to provide effective feedback on how the organization is maintaining product quality and timely delivery (Davis and

Vollmann, 1990). Several frameworks have been developed to ensure that performance measurement systems provide a balanced focus on various aspects of differentiation strategies (Kaplan and Norton, 1996; Nanni et al., 1992). One of the frameworks that is developed is the Balanced score card of Kaplan and Norton (1996). This framework balanced performance measures, whereby there is a link in measuring the customer satisfaction, by such as timely

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and reliable delivery, with other measures of key production activities, such as cycle time and throughput rates, while demonstrating the implications for financial outcomes (Kaplan & Norton, 1992). So, the differentiation strategy needs a more elaborate performance measurement system, with a variety of contemporary practices include various forms of benchmarking, activity-based techniques, such as activity-based costing and activity-based management; balanced performance measures; team-based performance measures, employee-based measures; and strategic planning.

2.4 Characteristics of the crisis

Wallsten (2000) state that executive pay and performance are strongly linked when firms’s market value increases, but not when the market value decreases. The compensation pay will reduce the agency problem only when executives should be at least partially involved from the downside risk of making big decisions. The research of Wallsten (2000) mentioned the link between compensation and performance during good times, when firms doing well top executives receive relatively a large increase in compensation in contrast to the increase in firm value. To be more precise, in good years their compensation increases on average by about $151,000, but in bad years their compensation decreases by about $10,000. Also in good times, it is not always totally related to the CEO performance, similarity to the decreases in firm value. This can be linked to the change from financial performance measures within the incentive contract to nonfinancial measures. Ittner et al (1997) state that firms traditionally relied on financial performance measures, however there is an increase in the use of

nonfinancial performance measures. Prior literature shows that nonfinancial performance measures can compensate for noise and goal incongruence of financial performance measures (Matejka, Merchant and van der Stede 2009). Matejka et al. (2009) argue that loss-making firms has to increase their nonfinancial performance measures to motivate their managers on the longer-term. Their research finds support that the emphasis on nonfinancial performance measures is greater for loss-making firms than for profitable firms. Since, nonfinancial measures are uncorrelated with earnings, the loss-making firms have a weaker link between earnings and cash compensation (Matejka, Merchant and van der Stede 2009). However the crisis difference from loss-making firms, facing the crisis is an uncontrollable factor for firms. Losses, which occur during the crisis, are not specifically related to bad decision making of the executives. Campello et al. (2010) show evidence that indicates that firms facing the crisis planned deeper cuts in tech spending, employment and capital spending. Firms have to sell

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more assets to fund their operations, even they have or expect troubles by lending money form the banks. Also they find the inability to borrow externally because many firms avoid investment opportunities during the crisis. 86% of the US CEO’s saying restricted their investment projects during the credit crisis of 2008 and more than half of the respondents say they will cancel or postpone their planned investment (Campello et al (2010). Other effects of the crisis are firms dramatically reduce employment by 11%, technology spending by 22%, capital investment by 9%, marketing expenditures by 33%, and dividend payments by 14% in 2009. Kirkpatrick (2009) conclude out of the survey of KPMG, the board and/or audit

committee should improve their effectiveness during the crisis by addressing risks that may be driven by there compensation structure. He also argues that performance should determine an executive’s remuneration in terms of equity compensation. It could therefore well be that a global crisis results in a lower share of performance-dependent pay, as firm performance is worse during a crisis. Similarly, to the findings of Matejka et al. (2009) conclude, firms pay more on nonfinancial performance measures instead of financial performance measures during bad times.

Previous research of Balsam et al. (2010) investigates the relationship between firm strategy and the use of performance measures in executive compensation within the period 1992 till 2006. Their results indicate that executive incentive compensation is linked to firm strategy. Kirkpatrick (2009) argue the relationship between the performance of the CEO and the compensation. There should be goal congruence between the firm strategy and the performance of the CEO. Whereby the performance of the CEO should lead to the

compensation, when the CEO performance is worse during the crisis the compensation should be lower. However the incentives are intended to stimulate the CEO, Matejka et al. (2009) argue that firms should pay incentive compensation to motivate their managers on the longer-term. When the compensation should be motivating the managers, the incentive compensation structure has to change. The crisis will have an effect on the performance measures,

Kirkpatrick (2009) and Matejka et al. (2009) both argue the change from financial

performance measures to nonfinancial performance measures during bad times. But are these performance measures still linked to the firm strategy, since Matekja et al. (2009) state nonfinancial performance measures are less correlated to earnings but are more long term focused.

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2.5 Strategy

As mentioned before, this research will make use of the strategy theory of Porter (1980). Porter (1980) state strategy is about organizational change, firms become better than its competitors, when this competitive advantage can be sustained. He stated strategy is about choosing new games to play and playing existing games better. Porter (1980) describes two strategies, the cost leadership and differentiation strategy. Firms which pursuing cost

leadership strategy produce low cost products for a certain level of quality (Porter, 1980). These products will be sold due the low prices, the products are priced below their

competitors (Hambrick, 1983). These firms offering the high margin and are generating profits though volume. (Daly, 2001; Campbell et al., 2002; Rea and Kerzner,1997; Peng, 2008). Rea and Kerzner (1997) assert that firms pursuing a cost leadership strategy require a high market share, whereas Daly (2001) states that firms pursuing a cost leadership strategy has to be a the high volume producer.Whereas, firms following a differentiation strategy attempt to sell a special product, where they price their products above market price (Berman et al., 1999). These firms try to create value through price inelasticity, customer loyalty, and higher margins, which they will achieve via brand image, premium pricing, advertising intensity, fashion, novelty, and exclusive distribution networks (Mason et al., 1991; Chaganti et al., 1989). The differentiation strategy is associated with innovative and growth strategies, these firms rely more on long run yield results than in the short run (Galbrath and Merrill, 1991). They also state that the chance to fail is more associated with firm following the differentiation strategy. These strategies also negatively affect short-term earning and

performance measures normally used in compensation contracts (Rappaport, 1978). With this intention, the cost leaders make more use of the formal performance measures, this

performance measures are more appropriate for firms pursuing cost leadership strategy, the major focus of these companies are mainly on controlling the costs. These companies will use the traditional accounting techniques, which mainly are budgetary performance measures and variance analysis (Johnson & Kaplan, 1987; Drucker, 1990). These traditional techniques include the use of budgeting systems for planning and control, performance measures such as ROI, divisional profit reports, and cost-profit-volume techniques for decisions. Balsam et al (2010) shows that the link between CEO cash compensation and sales is stronger in firm pursuing a cost leadership strategy. They show a correlation of ROA, return and sales to cost leadership strategy. Whereas the differentiation strategy has a significant negative relation with ROA, while the other relations are not significant showing that for firms pursuing a differentiation strategy which indicates that there is less weight applied to the ROA. Ittner et

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al. (1997) find a greater use of non-financial measures in firms who are emphasizing the differentiation strategy. For these companies the traditional accounting techniques are too aggregate and not timely enough to provide effective feedback. Firms emphasizing the differentiation strategy needs a more elaborate performance measurement system, with a variety of contemporary practices include various forms of benchmarking, activity-based techniques, such as activity-based costing and activity-based management; balanced performance measures; team-based performance measures, employee-based measures; and strategic planning.

On the contrary Hayes and Schaefer (2009) state no firm wants to admit having a CEO who is below average, so each firm wants its CEO’s compensation package above the median pay level of comparable firm. As mentioned before, firms emphasizing cost leadership

normally make use of the traditional accounting techniques, which are more financial, and firms pursuing the differentiation strategy already make more use of nonfinancial measures. Accordingly, the relationship between the CEO compensation of firms pursuing cost

leadership strategy will become weaker than for firm following the differentiation strategy. As mentioned before during the crisis firms probably adopt more nonfinancial performance measures within their incentive contract. Firm pursuing the differentiation strategy used already more nonfinancial performance measures in their incentive contract.

H2: The firm's strategy is not moderating the relationship between the economic crisis and the use of performance measures in CEO incentive contracts.

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3. Methodology

3.1 Sample selection

The sample of firms used in this study are 150 random selected firms from the S&P 1500. Financial institutions and public utility firms are not eligible to be selected since these firms have deviating financial statements (Kama and Weiz, 2010; Banker et al. 2011). The

observations are based on CEO incentive contracts described in the compensation section of the SEC Proxy Statements (DEF 14a). By hand collection the firms are classified whether they use only financial performance measures or used a mix of financial and non-financial performance measures. The crisis year is classified as 2008. Therefore, for each firm that is selected in the sample, two observations are retrieved. The selected research years are respectively the calendar years 2007 and 2009. The initial obtained sample consists of 300 observations (N=300), two observations per firm.

In order to separate firms on the basis of their strategy, cost leadership and

differentiation, the following measures should be available within the dataset. By measuring the ratio net sales to capital expenditures on property, plant and equipment (SALES/CAPEX) and ratio net sales to capital expenditures on property, plant and equipment (SALES/P&E), the firm’s efficiency on utilizing capital investment will be measured (Balsam et al. 2010; David et al, 2002). While the Ratio of employees to total assets is used to measure labor (input) efficiency (EMPL/ASSETS) measures the efficiency of firm’s resources by its

employees (Balsam et al, 2010;Hambrick, 1983; Kotha and Nair, 1995). The higher measures of SALES/CAPEX, SALES/P&E and EMPL/ASSETS will indicate the cost leadership

strategy. Whereas, the ratio of selling, general and administrative expenses to net sales (SG&A/Sales) and the ratio of research and development to net sales (R&D/Sales) will

indicate firms pursuing the differentiation strategy, because these type of firms will invest in a variety of marketing activities and have a greater spending on research and product design (Balsam et al., 2010). In this research, a distinction is made between a cost leadership strategy and a differentiation strategy. These constructs are measured by means of publicly available data. Because of missing observations on these measures, two firms are removed from the sample. Therefore, the final sample has 296 observations (N=296).

As mentioned earlier, this research makes use of two types of performance measures, the financial and non-financial performance measures. The sample is classified into 2

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observations for which the CEO compensation is merely based on financial performance measures. The sub sample financial consists of 168 observations (N=168) and is derived by focusing on financial measures that are earnings-based and or revenue/cost-based, like indicators as EPS, Net income, ROA, RI, Sales and stock market performance (Hoppe and Moers, 2011). The subsample mix of financial and non-financial consists of 128 observations (N=128), by these observations the CEO receives an incentive compensation on both,

financial and non-financial. Where the financial measures are recognized with the same components, and the non-financial measures are derived by focusing on qualitative measures, like indicators as customer satisfaction, employee safety, product quality, new product

development, innovation and market share (Ittner et al. (1997), as well when firm mentioned within the statement that they used quantitative and qualitative performance measures or financial and non-financial measures the firms where classified as mix of financial and non financial (Hoppe and Moers, 2011). Appendix 1 shows some of the observations.

Table 1

Financial or mix of Financial and Non-financial

Observations 2007 2009 Financial 95 73

Mix Financial and non-financial 53 75

Total observations

148 148

3.2 Main empirical model and variable measurement

Previous research expects that the performance measures will change from only financial performance measures to financial performance measures supplemented with nonfinancial performance measures as an effect of the crisis. (Kirkpatrick 2009, Matejka et al. 2009) To define this relationship between the use of performance measures within the CEO incentive contract and the crisis this research makes use of the following regression model:

MIXPERFMEAS = β0 + β1CRISIS + β2F_SIZE + β3GROWTH_OPP + error

Where,

MIXPERFMEAS Will be measured by 1 and 0, where 1 represents the firm uses a mix of financial and nonfinancial performance measures and 0 shows that the

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firm uses only financial performance measures.

CRISIS Construct to capture the crisis, created by a dummy variable, where 0 represents the period before the crisis (2007) and 1 the period during the crisis (2009).

F_SIZE Control variable firm size (F_SIZE) measured by the naturallogarithm of net sales.

GROWTH_OPP Control variable for growth opportunity measured as the market to book value (MTB), which is the ratio of total market value to the book value.

The β1 represents the coefficient of interest, a positive and significant coefficient on β1 CRISIS implies that firms in the crisis display a greater reliance on financial measures supplemented with nonfinancial measures in the CEO incentive contract. The FIRM_SIZE is often assumed to be negatively associated with the use of nonfinancial performance measures, because the sales will decrease in times of crisis, however GROWTH_OPP is typically found to be positively associated to the level of financial performance measures supplemented with nonfinancial performance measures.

In order to find support for Hypothesis 2, to define the moderating effect of strategy in relation to the crisis within CEO incentive contracts. The following regression model is formulated:

MIXPERFMEAS = β0 + β1CRISIS + β2 DIFF_STRAT + β3 CRISIS*DIFF_STRAT + β4F_SIZE + β5 GROWTH_OPP + error

Where,

DIFF_STRAT Dummy variable to define whether a firm is pursuing the cost leadership (CL) or differentiation strategy (DIFF).

CRISIS*DIFF_STRAT Implies the impact of differentiation strategy on the relation between the crisis and the use of a mix of financial and nonfinancial performance measures.

The prior research of Balsam et al. (2010) argued that there is a link between the use of performance measures in CEO incentive contracts and the strategy a firm pursuit, As Ittner et al. (1997) state there is a greater use of non-financial measures in companies pursuing the differentiation strategy. The β1 gives the association between the crisis and the use of a mix

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of performance measures for firms that adopt cost leadership strategy, where the sum of the coefficients β1 and β3 gives the association between the crisis and the use of a mix of

performance measures for firms that adopt differentiation strategy, and β3 gives the difference between cost leadership and differentiation strategy firms on the impact of the crisis on the use of a mix of performance measures in the CEO incentive contracts. β3 is expected to be positive and significant.

3.2.1 Measurement of crisis variable

Around mid 2008 the crisis was shown up at the financial market in the US, which was having a major impact on the financial institutions around the world. The crisis intensified in the third quarter of 2008 with a number of collapses, such as the Lehman Brothers and there is a generalized loss of confidence in the financial institutions. As a result, several banks failed in Europe and the US or some others received government recapitalization towards the end of 2008 (Kirkpatrick, 2009). Based on the literature, I classify 2008 as the start of the crisis and therefore 2007 represents the period before the crisis and 2009 be representative of the crisis.

Within the empirical model the period before the crisis (2007) will be defined as a 0 within the dummy variable, where the period during the crisis (2009) is defined as a 1. The β1 CRISIS coefficient should be positive and significant to accept H1, in that case the crisis is an effect on the performance measures (MIXPERFMEAS).

3.2.2 Measurement of strategy variable

To be able to test the second hypothesis the firms should be classified on the strategy. Cost leadership can be classified as a firm that has as main priority efficiency, which can be obtained by the cost efficiency and asset parsimony (Hambrick and Macmillan, 1984). These firms improve their financial performance by utilizing their assets and inputs as efficient as possible. So cost leaders pay attention to asset use, employee productivity and discretionary expenses (Balsam et al, 2010). Therefor the firms emphasizing the cost leadership strategy could be recognized on the higher levels on SALES/CAPEX, SALES/P&E and

EMPL/ASSETS.

(1) (SALES/CAPEX) Ratio net sales to capital expenditures on property, plant and equipment. The higher ratio indicates more efficient use of assets. (Balsam et al. 2010 :

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Berman et al., 1999;Hambrick, 1983; Hambrick et al., 1982; Kotha and Nair, 1995; David et al., 2002)

(2) (SALES/P&E) Ratio of net sales to net book value of plant and equipment, also a higher ratio indicates more efficient use of assets (Balsam et al. 2010 : Hambrick, 1983; Hambrick et al., 1982; Miller and Dess, 1993; David et al., 2002)

(3) (EMPL/ASSETS) Ratio of employees to total assets in used to measure labor (input) efficiency. (Balsam et al. 2010 : Hambrick, 1983; Kotha and Nair, 1995; Nair and Filer, 2003)

Firms pursuing a differentiation strategy can be classified as firms which are creating an image on their product which indicates their products is special and so they are pricing above market prices. These firms spending money on innovation, marketing and image

management, this requires investment in research and product design. So Higher levels of SG&A/SALES, R&D/SALES, and SALES/ COGS will be consistent with a differentiation strategy.

(4) (SG&A/Sales) Ratio of selling, general and administrative expenses to net sales Balsam et al. (2010; Berman et al., 1999; David et al., 2002; Hambrick et al., 1982; Miller and Dess, 1993; Thomas et al., 1991) argue that firms who follow the differentiation strategy will invest in a variety of marketing activities, which will lead to a higher SG&A.

(5) (R&D/Sales) Ratio of research and development to net sales. The firms pursuing differentiation strategy sells high quality and innovative products or services. This type of firms will have a greater spending on research and product design. (Balsam et al 2010 : Hambrick, 1983; David et al., 2002; Ittner et al., 1997; Prescott, 1986; Thomas et al., 1991). (6) (Sales/COGS) Ratio of net sales to cost of goods sold (Sales/COGS). Balsam et al. (2010 : Kotha and Vadlamani, 1995; Porter, 1980) state the success of firms following the

differentiation strategy are the high margins.

In order to measure which of the strategy types the firms emphasize, the average of strategy variables from 2006 till 2010 is computed. The firms should be classified on whether they following the differentiation strategy or not, where not means they are following the cost leadership strategy. The dummy DIFF_STRAT is created to measure the strategy, this dummy represents the firms who are following the differentiation strategy indicated by a 1.

Which will be measured by creating per sample firm the sum of the DIFF variables and the sum of the CL variables. For both, the DIFF variable and CL variable, the median of the total

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sample is calculated, this median is used to calculate per firm the rate compared to the median of both variables. When the variable DIFF is higher than the variable CL the dummy variable is indicated by a 1 if not by a 0.

Table 2

Cost leadership vs. Differentiation

Firm sample Observations Cost leadership 67 Differentiation 81

Total firm observations 148

3.3 Measurement of control variables

The control variables used within the formula are developed to take into account that larger firms with greater growth opportunities are expected to have more developed CEO incentive contracts. Therefore, this study created control variables. The first one is firm size, as

mentioned within previous research this variable could be an important determinant of firm performance. Hoppe and Moers (2011) described that firm size can be based on the natural logarithm of firm sales measured in millions of dollars (FIRM_SIZE). The second control measure is growth options, the growth stands for the growth opportunity of the firm

(GROWTH_OPP). This is defined as the market-to-book ratio, which will be measured by the market value to the book value of the firm (Chen and Zhao, 2006).

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4. Results

4.1 Descriptive results

Panel A of table 3 provides descriptive statistics of the dependent variable, which is used performance measures within the sample. The firms merely rely on the traditional

performance measures / financial performance measures. 43,24% of the sample firms use financial performance measures supplemented with nonfinancial performance measures. Panel B of table 3 shows the descriptive statistics of the independent variables. Crisis is the created dummy variable of the crisis, the sample firms has an observation before the crisis (2007) and has an observation during the crisis (2009), so the average is exactly 0.5. Differentiation strategy is also a dummy variable, these descriptive statistics shows the average of 54,72% of the firms pursuing the differentiation strategy. The firms within the sample rely a bit more on differentiation strategy which also can be seen by the median of 1. The CL variables SALES/CAPEX, SALES/P&E and EMPL/ASSETS and the DIFF variables R&D/SALES SG&A/SALES and SALES/COGS are used to measure the strategy. On

average the firms in the sample earn on net sales 41.95 times more then they invest in capital expenditure, for property plant and equipment the firms earn on net sales 9.25 times more. On average the firms in the sample needs 0.0036 employees on 1 million USD assets. The DIFF variables show that the firms invest on average 0.047 in Research and Development and 0.227 in Selling, General and Administrative expenses of the net Sales. The net sales of the firm in the sample are on average 2.6 higher than the Cost of Goods Sold. Panel C of table 3 provides the descriptive statistics of the control variables.

Table 3 Descriptive statistics

Mean Std. Dev. 10% 25% 50% 75% 90%

Panel A: dependent variable

MIXPERFORMEAS 0.432 0.496 0.000 0.000 0.000 1.000 1.000

Panel B: independent variables

CRISIS 0.500 0.501 0.000 0.000 0.500 1.000 1.000 DIFF_STRAT 0.547 0.499 0.000 0.000 1.000 1.000 1.000 SALES/CAPEX 41.947 63.774 6.722 14.846 27.541 43.829 72.025 SALES/P&E 9.244 15.537 1.118 2.827 5.356 8.414 16.766 EMPL/ASSETS 0.004 0.005 0.000 0.001 0.002 0.004 0.007 R&D/SALES 0.047 0.079 0.000 0.000 0.010 0.058 0.156 SG&A/SALES 0.227 0.164 0.021 0.112 0.192 0.330 0.468 SALES/COGS 2.637 3.012 1.225 1.354 1.758 2.510 4.684

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Panel C: Control variables

FIRM_SIZE 9.09725 1.244277 7.636579 8.258895 8.907435 9.852353 10.85038 GROWTH_OPP 3.706786 4.485883 1.422005 2.105903 2.928097 4.353905 6.263506

The Pearson Correlation matrix of the main variables is reported in table 4. As expected both the Crisis and the adoption of a differentiation Strategy are positive and significant related with the use of MIXPERFORMEAS, financial performance measures supplemented with nonfinancial performance measures (0.15), suggesting that Crisis and strategy moving in the same direction as the mix of financial and nonfinancial performance measures used in incentive contacts of CEO’s.

On the contrary, there is no significant relation between the crisis and the adoption of a differentiation strategy, which is logical since this research makes use of strategy measures over 5 years, which means the firms pursuing in 2007 and 2009 the same strategy.

Table 4 Correlation matrix

MIXPERFORMEAS CRISIS

DIFF_

STRAT FIRM_SIZE GROWTH_OPP MIXPERFORMEAS 1.000

CRISIS 0.150* 1.000

DIFF_STRAT 0.150* -0.000 1.000

FIRM_SIZE 0.027 -0.000 -0.160* 1.000

GROWTH_OPP -0.087 -0.000 0.080 -0.177* 1.000 *Correlations are significant at a 1% significance level

The correlations of the strategy variables are reported in table 5, as expected given that the different empirical measures should proxy for the same theoretical construct, the CL variables SALES/CAPEX and SALES/P&E ratios are highly positive correlated with each other

(0.9155) and significant with a 1% significance level. The SALES/CAPEX and the

SALES/P&E are both measures of the firm’s efficiently in utilizing capital investments. The last CL variable EMPL/ASSETS does not have a significant relation with both strategy variables, which is consisted with the results of the previous research of Balsam et al. (2010). The DIFF variables R&D/SALES, SG&A/SALES and SALES/COGS are all positive and significant correlated with each other. These variables represent the degree to which a firm attempts to differentiate itself from its competitors. The variables SG&A/SALES and

R&D/SALES show the investment in marketing and research, where SALES/COGS measures its success in charging a premium price (Balsam et al., 2010).

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Table 5

Correlation matrix strategy variables

SALES/CAPEX SALES/P&E EMPL/ASSETS R&D/SALES SG&A/SALES SALES/COGS

SALES/CAPEX 1.0000 SALES/P&E 0.9155* 1.0000 EMPL/ASSETS -0.0450 -0.0643 1.0000 R&D/SALES -0.0667 -0.0401 -0.2261* 1.0000 SG&A/SALES -0.1065 -0.0607 -0.0462 0.6473* 1.0000 SALES/COGS -0.0977 -0.0357 -0.1482 0.5623* 0.6585* 1.0000 *Correlations are significant at a 1% significance level

4.2 Results of hypothesis tests

4.2.1 Relation between performance measures in CEO incentive contracts and the crisis

Table 6 presents the regression summary statistics for hypothesis 1. Based on the sample of 296 firms over a period before (2007) and during (2009) the crisis. The first hypothesis test whether the crisis has an effect on the use of performance measures in the CEO incentive contracts. More specific, it is expected that those firms will make more use of financial performance measures supplemented with nonfinancial performance measures when they faces the crisis. Thus, for H1 to be not rejected the β1 coefficient needs to be positive and significant. Consistent with the predictions, the results of the summarized regression indicate a significant relation between the crisis and the use of a mix of financial performance

measures and nonfinancial performance measures, because β1 = 0,15 (p<0,01) positive and significant.

The model as a whole is significant as shown by the F-value of 3,03 (p<0,05). The model has a R-squared of 3,01% which explains a small part of the variance in the dependent variable.

Table 6

Summarized model 1 OLS regression results

Variables

Predicted

Sign Coef. t-stat p-value β0: Intercept 0.3478576 1.57 0.118 β1: dummy CRISIS H1 + 0.1486486 2.60 0.010 CONTROL FIRM_SIZE 0.0049292 0.21 0.833 CONTROL MARKET TO BOOK -0.0093321 -1.44 0.151

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4.2.2 The moderating effect of strategy

The second hypothesis explores whether the strategy choice of the firm influences the relation between the crisis and the use of performance measures. It is set as a null hypothesis. Prior research, however, has argued that firms, which are following the differentiation strategy, change the use of financial performance measures to a mix of financial and nonfinancial more during the crisis. The 2nd regression model describes this as the β3 coefficient having to be positive and significant.

The summarized results of the regression, as reported in table 7, does not indicate a significant coefficient of all betas, β3 should be positive and significant to find proof for the hypotheses, however this is not the case. Thus it could not be statistically proven that firm following the differentiation strategy relies during the crisis more on a mix of financial and nonfinancial performance measures during the crisis.

As with model 2, this model is highly significant as shown by the F-value of 3.55 (p<0.01). The model has a R-squared of about 5,77% which explains a small part of the variance in the dependent variable, this can be explained due the small sample of 296 observations.

Table 7

Summarized model 2 OLS regression results

Variables Predicted Sign Coef. t-stat p-value

β0: 0.1950353 0.85 0.397 β1: dummy CRISIS 0.1044776 1.24 0.214 β2: dummy DIFF_STRAT 0.1221892 1.51 0.132 β3: dummy CRISIS*DIFF_STRAT 0.0807076 0.71 0.477 CONTROL FIRM_SIZE 0.0147682 0.63 0.528 CONTROL MARKET TO BOOK -0.0102923 -1.6 0.110

Number of observations 296 F-Value 3.55 P-value 0.0039 R-squared 0.0577 Adjusted R-squared 0.0415 Number of observations 296 F-Value 3.03 p-value 0.0299 R-squared 0.0301 Adjusted R-squared 0.0202

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4.3 Additional analysis

The additional analysis will determine the relation of differentiation strategy in relation to the use of financial performance measures supplemented with nonfinancial measures. Previous research of Ittner et al. (1997) argues that firms pursuing the differentiation strategy rely more on nonfinancial measures compared to firms who pursuing the cost leadership strategy. The regression model of table 8 shows the results of the OLS regression model that test the relation of strategy and the use of a mix of financial and nonfinancial performance measures.

Table 8

Summarized additional model OLS regression results

Variables

Predicted

Sign Coef. t-stat p-value β0: 0.2472741 1.08 0.279 β1: dummy DIFF_STRAT 0.162543 2.80 0.005 CONTROL FIRM_SIZE 0.0147682 0.63 0.531 CONTROL MARKET TO BOOK -0.0102923 -1.59 0.113

Number of observations 296 F-Value 3.38 p-value 0.0187 R-squared 0.0335 Adjusted R-squared 0.0236

The summarized additional model shows that the regression results from the initial sample are consisted with earlier findings from Ittner et al. (1997). The coefficient of differentiation strategy is positively (0.163) and significant (p<0.01). This indicates that firms rely more on nonfinancial performance measures instead of firm who are following the cost leadership strategy.

Table 9 shows the regression results of the summarized additional model 2, this regression model shows that the prediction of Ittner et al. (1997) still holds during the crisis. The coefficients β1 (0.149, p<0.01) and β2 (0.163, p<0.01) are both positive and significant.

However, it cannot be statistically proven that the use of a mix of financial and

nonfinancial performance measures is an effect of the crisis, which is shown in table 7. But in addition to the crisis, following the differentiation strategy is incrementally explanatory to the adoption of nonfinancial measures supplemental to financial measures in the CEO incentive contracts.

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Table 9

Summarized additional model 2 OLS regression results

Variables

Predicted

Sign Coef. t-stat p-value β0: 0.1729497 0.76 0.448 β1: dummy CRISIS 0.1486486 2.63 0.009 β2: dummy DIFF_STRAT 0.162543 2.83 0.005 CONTROL FIRM_SIZE 0.0147682 0.63 0.527 CONTROL MARKET TO BOOK -0.0102923 -1.61 0.109

Number of observations 296 F-Value 4.32 p-value 0.0021 R-squared 0.0561 Adjusted R-squared 0.04545

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5. Conclusion and Discussion

This paper examines the relationship between the use of nonfinancial measures as supplement for financial measures in the CEO incentive contract and the crisis. Sequentially this research analysis the moderating effect of strategy on the use of a mix of financial and nonfinancial performance measures within the CEO incentive contract and the crisis. Based on the prior literature it is predicted that the change from financial performance measures to a mix of nonfinancial and financial performance measures is relating to financial bad times. Previous research also states that the differentiation strategy is positively related to the use of

nonfinancial performance measures in CEO incentive contracts with the firms following the differentiation strategy.

The findings regarding the relation between the use of a mix of financial and

nonfinancial performance measures and the crisis are consistent with the predictions. Using a sample of 296 observations, with 148 firm observations before the crisis in 2007 and 148 firm observations during the crisis at 2009. These observations shows evidence that firms make more use of financial performance measures supplemented with nonfinancial performance measures during the crisis. However, there is no evidence for the moderating effect of strategy between the use of nonfinancial performance measures and the crisis. This research shows that all of the firms, cost leadership and differentiation pursuing firms, are more

supplementing their financial performance measures with nonfinancial performance measures during the crisis, there is no evidence that firms who follows the differentiation strategy are more capable of change their performance measures. Alternatively, this study conducts an additional analysis, these findings are consistent with earlier finding from Ittner et al. (1997), where the strategy type differentiation is associated with nonfinancial performance measures also during the crisis period.

The results of this study are subjected to the following limitations. First, this study made use of a sample of 296 observations, which is relatively small to represents the whole population. The small sample size is one of the factors why the second hypothesis did not show evidence. In order to measure the moderating effect of strategy between the crisis and the use of nonfinancial performance measures this research should be conducted with a bigger sample which can represents the whole population. Second, the used measures of strategy aren’t developed very elaborate, previous research of Balsam et al. (2010) conducted this measures form earlier studies. However, there exist no universal formula for measuring the strategy type per firm using the strategy types of Porter (1980). Third, currently there is limited research on the effects of the crisis. Therefore, there is limited direction of which

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control variables could influence the outcomes and which control variables should be

included in the empirical models. Further research should focus on the effects of the crisis and thereby also the relation with the strategy the firm’s emphases.

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