2. Literature review

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MANAGEMENT CONTROL IN KNOWLEDGE-BASED FIRMS

By

Mark Sips

University of Groningen Faculty of Economics and Business

January, 2011

Lauwerstraat 16 9725 HG Groningen

06 53714368 m.j.sips@student.rug.nl Student number 1761501

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1

Preface

I would like to thank the Cardas Research & Consulting Group for giving me the opportunity to conduct an internship and collect data for my research. I especially want to thank Jim Chong for showing me the insights in management practices and to let me experience the challenges of a consultancy firm. The internship in Malaysia had a great impact on my life. I can say I truly experienced the Asian life. When you live and work for six months in a foreign country you learn a lot about the habits, mentality, way of thinking and religion of other people, but in the end you may become aware and learn the most about your own culture. I want to thank all the colleagues for this wonderful experience.

Additionally, I want to thank my thesis supervisor, dr. Bo Qin for his ideas and feedback during this research. I also would like to take the opportunity to thank prof.

dr. H.J. ter Bogt for his role as a co-assessor for this research.

Last, but certainly not least, I would like to express my gratitude to my family and friends for their support throughout my entire studies.

Groningen January 2011

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2

Abstract

This thesis studies the management control system of a knowledge-based firm in practice by conducting a case study research at the Cardas Research & Consulting Group which is located in Kuala Lumpur, Malaysia. The thesis studies how a knowledge-based firm can retain high-performing employees and stimulate knowledge development within the firm. The case study showed that predetermined monetary performance-based rewards in combination with pyramid-shaped tournament career model stimulate the increase and spread of knowledge within the firm. Furthermore, this thesis sheds light on performance-based pay systems and the effects of the tournament model. This thesis also highlights the perceived trust in the performance evaluation process which is essential for the effectiveness and eventually the competiveness of knowledge-based firms.

Keywords: knowledge-based firms, tournament model, performance-based rewards, performance evaluation.

Supervisor : Dr. B. Qin

Co-Assessor : Prof. dr. H.J. ter Bogt

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1. Introduction

In Section 1 the design of this research and the used methodology will be discussed.

The goal of the research and the main research question are presented. In order to answer the main research question several sub-questions are formulated.

1.1. Research goal

Lately a trend can be spotted that the world is changing from a production-based economy to a knowledge-based one (Drucker, 1993; Powell & Snellman, 2004). The result of this major shift is that organizations become more knowledge-intensive (Alvesson, 1995). Organizations become more dependent on knowledge in creating value within the firm and therefore focus on innovative knowledge (Kim &

Mauborgne, 1997). Consulting firms are epitome of knowledge-based organization because their main assets are the expertise and competence of their personnel (Engwall & Kipping, 2002). Such firms are especially reliant on their staffs for competitive advantage through knowledge-based innovation (Anand et al., 2007).

Therefore it is essential for a knowledge-based company to retain the high-performing employees in order to “retain the knowledge in the company”. The goal of this research is to investigate how a knowledge-based firm can remunerate and evaluate the performance of the employees in order to retain high-performing employees. In addition this thesis aims to study how the management control system in a knowledge-based firm functions. A confrontation is made by studying the management control system of a knowledge-based company in practice by conducting a case study. This confrontation allows the researcher to enrich the theory and give recommendations to the management of the knowledge-based company to improve the management control system.

1.2. Research questions

In a knowledge-based company the employees are the primary assets. For the knowledge development and the continuation of the firm it is vital to retain the talented employees. The purpose of this thesis is to explore the design of the

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6 rewarding system in a knowledge-based company and the effects for the employees’

willingness to stay within the company. Furthermore, this thesis also explores the process of performance evaluation and shows how this contributes to the development of knowledge. There are several ways to control employees and to ensure they act in the interest of the organization. These systems are called management control systems. One of the most important control mechanisms available in a knowledge- based firm is the incentive mechanism or the rewarding policy. The following main research question is designed:

How can a knowledge-based firm compensate and evaluate the employees’

performance and how does this process contribute to knowledge development in the firm and the retaining of high-performing employees?

The following sub-questions are developed:

1. Why is a knowledge-based firm a distinguished type of firm and what specific challenges does it face?

2. What is the definition of a management control system and what purpose does it serve?

3. What is performance measurement and how can a knowledge-based firm evaluate their employees?

4. What influence has the rewarding policy on retaining employees?

5. How is the remuneration system related to knowledge development?

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7 FIGURE 1

Theoretical framework

Knowledge-based firms (2.1)

Management control systems (2.2)

Performance Measurement Rewarding Policy

(2.3) (2.5)

Delegation of Authority / Asset Specificity (2.6)

1.3. Thesis outline

The thesis is organized as followed. A theoretical framework in Figure 1 is presented to give theoretical guideline to the research questions. The literature review contains five sub-sections. First in Section 2.1, the thesis discusses the unique characteristics of a knowledge-based firm. Second in Section 2.2., the concept of management control is presented. Third in Section 2.3., the thesis discusses the concept of performance measurement and will shift to theory on personal performance measurement. Fourth in Section 2.4., this thesis discusses rewarding policies and uses an agency framework. Fifth in Section 2.5., the relationship between compensation and delegation is explained. After the literature review the research methodology is presented in Section 3. Then the thesis moves on to the case study in Section 4 and presents the main findings in the case company. The thesis ends with the discussion in Section 5 which will analyze the observations from the case in relation to the

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8 literature review. Finally, Section 6 will present the conclusions drawn from this research.

1.4. Main findings

Knowledge-based companies are a distinguished type of company and there are many ways to remunerate an employee active in this field. However, monetary rewards and promotions are popular among knowledge-intensive companies. This study shows that a system where employees compete for a predetermined amount of monetary rewards and promotions can stimulate the increase and spread of knowledge among coworkers. This study shows the performance evaluation process is a massive and time- consuming operation. However, since the employees are the most important assets of a knowledge-based company it seems fair to invest a significant amount of time in the evaluation process. Trust is essential in the performance evaluation process and if the process is perceived as trustful it will improve the performance of employee and stimulates the competences of the employees.

2. Literature review

The purpose of the literature review is to present a theoretical guideline in order to analyze the management control system of a knowledge-based firm. This literature review is divided in a few sections. Section 2.1. will discuss the characteristics and the dynamics of a knowledge-based firm. Section 2.2. focuses on the definition of management control and presents a detailed management control model. Section 2.3.

focuses on performance measurement and individual performance evaluation. Section 2.4. discusses different rewarding policies. Section 2.5. stresses the link between incentive compensation and the delegation of authority.

2.1. Characteristics of a knowledge-based firm

Lately a trend can be spotted that the world is changing from a production-based economy to a knowledge-based one (Drucker, 1993; Powell & Snellman, 2004). The result of this major shift is that organizations become more knowledge-intensive

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9 (Alvesson, 1995). Organizations become more dependent on knowledge in creating value within the firm and therefore focus on innovative knowledge (Kim &

Mauborgne, 1997). Scholars studying the change in knowledge-intensive firms have addressed this ambiguity by focussing on the organizational elements in which knowledge inheres, such as people, processes and systems (Anand et al., 2007).

There are several views each with a unique way to study the change in knowledge-intensive firms. The first view emphasizes on the importance of systems, such as codification routines by which innovative types of expertise can be appropriated (Morris & Empson, 1998; Werr & Stjernberg, 2003). Another view emphasizes on the importance of social processes by which knowledge is recognized as useful and valuable in an organizational context (Alvesson, 2004). The third and latest view emphasizes on the importance of individuals’ expertise and the creation of policies enabling the recruitment, development and retention of highly talented people (Starbuck, 1992). This thesis is consistent with the third view that emphasizes on recruitment, development and retention of highly talented people.

The following sub-paragraphs highlight the three major features of a knowledge-based firm. In Section 2.1.1. the demand for temporary workers will be addressed. In knowledge-based firms on the job learning is important since it is essential for the development of competences, knowledge and skills. In Section 2.1.2.

on the job learning will be highlighted. Section 2.1.3. will focus on the unique characteristics of a consultancy firms which is epitome for a knowledge-based firm.

2.1.1. Demand for temporary workers

Most consultants work under a temporary contract for a client company, although they may have a permanent work contract with their consultant company. Findings from prior research show that temporary workers (e.g. consultants) are relatively young people, unmarried and females are overrepresented (OECD, 2002). Another difference between permanent jobs and skilled temporary jobs is the level of education. Temporary workers in the consultancy sector are highly educated and have a larger salary than permanent workers. The consultancy sector shows a relatively high employee turnover; within two years 66% of the workforce has moved to another permanent job.

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10 There are numerous reasons for companies to hire skilled temporary workers.

Andersson and Wadensjö (2004) give four examples of situations where a temporary worker is a good employment choice. The first reason is focussed on flexibility. For a short period several part-time jobs can turn into a few full-time jobs. In this situation an agency with temporary workers can come in to collect all the different part-time jobs. The second reason for hiring skilled temporary workers is focussed on costs. For every organization it is costly to recruit and train new employees. It is often more cost-effective if an organization contracts highly knowledged temporary workers for a short period of time to get the job done instead of recruiting and training the employees themselves. The third reason is that an agency with temporary workers with specific knowledge, like a consultancy firm, is often better equipped to attract and recruit the right people than client companies. The fourth reason to hire temporary workers is due to restrictions in law and regulations in some countries to lay-off workers. Changes in the demand for workers can be easily substituted by temporary workers. For example, consultants can be hired to complete one specific assignment and after completion be resigned.

2.1.2. Learning on the job and knowledge development

Learning on the job is very important, because no individual can learn and develop them self from a monotone and single-handed work task. Instead assignments that allow an individual to take responsibility and which demand interaction with other individuals and give feedback regarding the end results contribute the most to the development of individual competences. It is essential for the development of competences, knowledge and skills to interact with other individuals, because interaction results in the transfer of knowledge and experiences. The most suitable organizations in this perspective are the organizations that allow individuals to work in a group which have the right to make their own decisions. An example of transferring information between individuals is the relationship between a superior and a subordinate. Superiors are capable to act as coaches or as mentors. The objective of a superior is to transfer knowledge, facilitate learning and assist in spotting the important aspects of the work tasks. A superior in the role of a coach can

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11 also assist an employee throughout their career for personal development purposes and to push their performance.

Temporary workers in the consultancy sector are highly educated which provides them valuable articulable knowledge. Articulable knowledge can be codified and thus can be written and easily transferred (Liebeskind, 1996). Professionals gain knowledge through formal education (articulable) and through learning on the job (tacit). This education and training usually provide a high level of articulable knowledge in the field of specialty (Hitt et al., 2001). Learning on the job allows an individual to gain tacit knowledge. Tacit knowledge is often embedded in uncodified routines and in a firm's social context (Liebeskind, 1996). More specifically, it is partially embedded in individual skills and partially embedded in collaborative working relationships within the firm (Nelson & Winter, 1982). According to Maister (1993), tacit knowledge is integral to professional skills. In the knowledge-intensive industry employees often start their career as juniors or associates. In these roles, they continue to learn and thus, they gain significant tacit knowledge through "learning by doing" (Pisano, 1994). Knowledge-based firms often use a partnership form of organization (Maister, 1993). In this setting, those who learn the most and who are highly effective in using or applying that knowledge are eventually rewarded with partner status, and thus own stakes in a firm (Hitt et al, 2001).

2.1.3. Consultancy: a distinguished type of business

Consulting firms are epitome of knowledge-based organization because their main asset is the expertise and competence of their personnel (Engwall & Kipping, 2002).

Consultants who develop expertise through a mix of formal and tacit knowledge execute the primary task of these firms (Maister, 1993). Such firms are especially reliant on their staffs for competitive advantage through knowledge-based innovation (Anand et al., 2007).

Knowledge-based organisations, like a consultancy firm, distinguish themselves for three reasons. First, successful innovation requires the careful negotiation of internal power relations within these firms (Anand et al., 2007). Like other professional service organizations, consulting firms are distinctive in their widespread use of the partnership form of ownership, sometimes in addition to formal

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12 incorporations (Greendwood et al., 1990). Partners serve as producer-managers, actively participating in these businesses as key production workers (Anand et al., 2007). Each partner is responsible for organizing a group of professionals who share a particular form of expertise into recognizable practice area (Greenwood et al., 1990).

Second, partners are also responsible for a firm’s overall management.

Partners’ desire for autonomy and their control of client relationships produce a dispersed distribution of power in professional firms (Hall, 1968). This dispersion limits the ability of the top management of a partnership (as opposed to that of a corporation) to exercise absolute control over the strategic initiatives that are likely to be undertaken at a relatively decentralized level by individual partners, since they are the most aware of opportunities in their client markets (Hinings, Brown, &

Greenwood, 1991). Consequently, knowledge-based innovation in consulting firms requires the judicious exercise of power and influence which may involve trading-off the interests of an individual partner against those of a firm as a whole (Heusinkveld

& Benders, 2005).

Third, consulting firms have an inherent imperative for both organic growth and diversification in the context of innovation. As Suddaby and Greenwood (2001) noted, management knowledge “commodifies” over time as consulting firms try to colonize new knowledge territories which inevitably leads to expansion in their scale and scope of activities. For a consulting firm to be viable, newly promoted partners must develop reputations in the client marketplace through which they can attract work and then deploy junior professionals to execute this work (Gilson & Mnookin, 1989). The continued profitability of a consulting firm rests on partners’ ability to leverage their reputations by deploying increasing numbers of junior staff (Maister, 1993; Sherer, 1995). Beyond this argument, consulting firms have a mandate to diversify, in order to hedge against possible shrinkage in their client markets and to exploit underutilized firm resources (Hitt et al., 2001).

2.2. Management Control

Last decades many academics studied the function of a management control system.

There are a lot of definitions on what a management control system is about. This

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13 section will present the major view towards management control and the management control model of Simons (1995).

2.2.1. Management control system

According to Merchant (1982), the management control system its primary task is to take steps to ensure that the preliminary defined strategies and plans are carried out.

Merchant (1982) also states management control is a critical part of the management and the function is to make sure lower-level employees do what they are expected to do. Another definition of management control comes from Anthony (1965).

Anthony’s (1965) definition of management control is that this is a process that managers use to ensure the required resources are obtained and used effectively and efficiently in the attainment of the objectives of the organization. Flamholtz et al.

(1985) provide a definition which is consistent with the statement of the above mentioned authors. Flamholtz et al. (1985) state: the purpose of management control is increasing the probability that the behaviour of the employees is consistent with the defined objectives of the organization. Simons (1990) said management control systems are more than devices of constraint and monitoring: management control systems are the formalized, information-based routines, procedures and systems used by managers to maintain or alter patterns in organizational activitities. Using this definition, these systems broadly include formalized procedures for such things as planning, budgeting, environmental scanning, competitor analysis, performance reporting and evaluation, resource allocation and employee rewards (Simons, 1987).

Otley and Berry (1980) have a broader definition of management control. They define management control as all the activities that the management undertakes to safeguard the continuity of the organization.

It is widely recognized that the management control system should have a contingent fit with the business environment and the goals of the organization.

Merchant (1982) states that the control systems are dynamic systems which can be modified in terms of adjusting the control function of the management with the planned strategies. Chenhall (2003) argues that the management control system changes according to the dynamic nature of the environment. To get a fit between the goals of the organization and the management control system can be challenging.

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14 Evans (1986) stated that the unpredictable influence of internal contingencies on the organization’ its targets complicates the design of an effective management control system. Management control systems differ among organizations and exist in many forms (Merchant & Van Der Stede, 2007).

Merchant (1982) argued that control would not be necessary if all individuals did what was best for the organization. These authors show that behavioural control is one of the main elements of a management control system. Malmi and Brown (2008) elaborate that all the systems are used to align the behaviour of the employee with the objectives of the organization. Management control systems provide a means for gaining cooperation among collectives, individuals or organizational units who may share only partially congruent objectives, and channelling those efforts toward a specified set of organizational goals (Ouchi, 1979; Flamholtz, 1985).

Fisher (1998) states that management control should ensure that the conditions are in place in order to motivate an organization to achieve desirable or predetermined results. A definition more focussed on the individual comes from Anderson and Oliver (1987). These authors state that a control system is a set of procedures for monitoring, directing, evaluating and compensating its employees. Merchant and Van Der Stede (2007) elaborate further on this definition by focusing on the performance measurement aspect of the management control system. They state management control are all the devices or systems that managers use to ensure that the behaviour and decisions of the employees are consistent with the organization’ objectives and strategies. They further explain that management control systems exist for three reasons: lack of direction, motivational problems and personal limitations (Merchant

& Van Der Stede, 2007).

2.2.2. Simons control levers

Simons (1995) states that organizations are complex since a control system have to stimulate the demand for creativity, flexibility, innovation and empower the employees. Simons (1995) designed four levers to attain adequate control in decentralized organizations with empowered employees. Simons (1995) states that the four levers should be used together to attain the best results. Each lever of control has

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15 a distinct purpose for managers attempting to control, to some extent, the creativity and empowerment of employees (Simons, 1995).

Simons (1995) defines the levers of control according to the goals of management control:

1. Diagnostic control lever

The diagnostic control lever is used to monitor profitability and measures the progression towards targets. This lever is focussed on the measurement of the output of quantitative targets which should be compared to predetermined standards.

Feedback will then, if necessary, lead to corrective action to increase the likeliness of achieving the desirable outputs (Simons, 1995). So, diagnostic control is applied to achieve control by monitoring critical performance variables. It is mainly applied in order to eliminate manager’s exertion of constant monitoring (Simons, 1995).

2. Belief control lever

The belief control lever contains the values and directions of employees of an organization. It is used to inspire employees by communicating the core values, purposes and mission of the organization (Simons, 1995). Belief control lever promotes commitment to the organization’s core values and inspires employees to create new opportunities. It is applied when there is uncertainty among the employees about the purpose of the organization and how they can contribute (Simons, 1995).

3. Boundary control lever

Boundary control lever is focused on the activities that are not acceptable. It will tell the employees what they are not allowed to do. It allows employees to be creative within clearly defined boundaries. The boundaries are embedded in standards of ethical behavior and codes of conduct. Employees who are not working conform these rules must be punished (Simons, 1995). This lever attempts to achieve control by avoiding and minimizing risk and is especially important in an organization in which a reputation built on trust is a key competitive asset (Simons, 1995). It is used to anticipate the inevitable temptation and pressure on employees that exist in organizations (Simons, 1995).

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16 4. Interactive control lever

Interactive control lever is used to involve managers in the activities of their subordinates (Simons, 1995). The lever focuses on the exchange of information that is strategically important between different hierarchical levels of an organization. The process is surrounded by dialogues and debates which may result in adapted or newly formulated strategies (Simons, 1995). It is of use to explore the impact of emerging threats and opportunities which are important for the continuity of the organization (Simons, 1995).

2.2.3. Management control in knowledge-based firms

The management control system of a knowledge-based firm is a distinguished type since the main asset is the expertise and competence of their personnel (Engwall &

Kipping, 2002). Consultants who develop expertise through a mix of formal and tacit knowledge execute the primary task of these firms (Maister, 1993). Such firms are especially reliant on their staffs for competitive advantage through knowledge-based innovation (Anand et al., 2007). The focus of knowledge-based firms emphasises on the importance of individuals’ expertise and the creation of policies enabling the recruitment, development and retention of highly talented people (Starbuck, 1992).

Section 2.2.1. highlighted the importance of a contingent fit between the management control system and the operating environment and strategy. The management control system of a knowledge-based firm should focus on the importance of individuals’

expertise, recruitment and retention of talented employees since the employees are the main assets. When applying the control levers of Simons (1995) to the characteristics of knowledge-based firm (Section 2.1.), the dominant control levers are the diagnostic control lever and the belief control lever.

Diagnostic control lever

Knowledge-based firms will often work on temporary assignments for a client company. The projects are all unique and in this kind of business no standard procedures can ensure the fulfilment of objectives in an effective manner (Merchant and Van Der Stede, 2007). The diagnostic control lever is used to monitor profitability and measures the progress towards targets. This lever is focussed on the measurement

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17 of the output of quantitative targets which should be compared to predetermined standards. Feedback will then, if necessary, lead to corrective action so that it is more likely the desirable outputs will be achieved (Simons, 1995). Important in this respect is the performance measurement system that creates a feedback loop which affects the development of the competences of the employees and stimulates knowledge-based innovation. The incentive system plays an essential role in the development and retaining of talented individuals. The performance measurement system and the incentive system will be further discussed in detail in Section 2.3 and 2.4.

Belief control lever

Essential is the selection and recruiting employees with the right competences and potential for a position. This is not only the result of screening or to check if the employee has the necessary educational background. More important is finding a position that has a fit with the character of the recruited person. In general good placement will increase the chance to be successful and therefore knowledge-based firms put much time and effort in the selection, recruitment and placement of the employee.

Since the employees are the most important assets of knowledge-based firms a major feature is the spread of knowledge among coworkers. Training is another mean to make sure that employees perform in the best manner. An employee can feel more motivated by understanding their jobs more thoroughly and feel more professional.

Training is knowledge-based firms is often conducted in the form of courses, mentoring or learning from co-workers.

Job design is essential to optimize the performance of the workforce. Jobs designs should stimulate and assists qualified personnel to be successful in their job.

If an assignment is too complex or the necessary resources are not in place then the employees are not in control of their jobs and, as a result, the outcome of the performance. This will negatively affect the intrinsic motivation and satisfaction of the employee.

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2.3. Performance measurement

Performance measurement is a widely discussed subject among academics. According to Neely et al. (1994) is hard to define performance measurement even though it is frequently discussed. First, Section 2.3.1. reviews performance measurement on a corporate strategic level. Second, Section 2.3.2. and beyond present an individual performance measurement model. Third, in Section 2.3.2. the concept of relative performance evaluation (RPE) is addressed which in often applied in the performance measurement process in knowledge-based firms.

2.3.1. Corporate performance measurement

Neely et al. (1994) sees performance measurement as the process of quantifying the efficiency and the effectiveness of the action. Neely (1994) states performance measurement systems are described as a set of metrics to quantify both effectiveness and efficiency of the action. The definition of Merchant and Van Der Stede (2007) is consistent with the above mentioned definition and describe the performance measurement system as the assignment of numbers to a performance. Sinclair and Zairi (2000) link the performance measurement system to the organizational goals and state that the performance measurement system must include measures that integrate the goals of everyone in an organization.

Hacker and Botherton (1998) link the performance measurement system to the organizational strategy. They state that a performance measurement system ensures that the organization follows an appropriate course towards the achievement of targets. They see the organizational vision and mission as the basis of a performance measurement system and quantitative objectives can be defined to present process.

Kaplan and Norton (1996a), Dixon et al. (1990) and Bourne et al. (2000) elaborate further on this definition by stating that there should be a clear link between the strategy of an organization and the dimensions of the performance measured. As a result, the emphasis in the performance measurement system will change over time and a regular performance measurement review is necessary. This implies that performance measurement should be linked to environmental changes (Bourne et al., 2000). Kaplan and Norton (1996a) and Sinclair and Ziari (2000) recognize the fact that performance should be measured in more than one dimension.

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19 Performance measures come in many forms. Pheasey (1991) states it is not important which measures an organization uses, but the organization must find the

“right measures”. Vavio (1999) states financial measurement should be complemented with non-financial indicators. Hayes and Abernathy (1980) claim that non-financial measures could provide more penetrating control, extending beyond only financial measures.

Traditional performance measures, developed from costing and accounting systems, have been criticised for encouraging short termism (Banks & Wheelwright, 1979; Hayes & Garvin, 1982), lacking strategic focus (Skinner, 1974), encouraging local optimisation (Hall, 1983; Fry and Cox 1989), encouraging minimisation of variance rather than continuous improvement (Johnson & Kaplan, 1987; Lynch &

Cross, 1991), not being externally focused (Kaplan & Norton, 1992) and even for destroying the competitiveness of US manufacturing industry (Hayes & Abernathy, 1980). At the time, many performance measurement systems in the UK and USA were heavily financially biased and it has been argued that systems which were specifically designed for external reporting were being inappropriately used to manage business enterprises (Hayes & Abernathy, 1980).

2.3.2 . Performance evaluation in knowledge-based firms

In a knowledge-based firm the performance measurement system focuses on the employees. Neely et al. (1994) sees performance measurement as the process of quantifying the efficiency and the effectiveness of the action. Neely (1994) states performance measurement systems are described as a set of metrics to quantify both effectiveness and efficiency of the action. In a knowledge-based firm the most important assets are the employees. The performance measurement system therefore should affect the performance of the employee in order to develop competences and to gain knowledge. Kressler (2003) states that from the employee’s point of view the evaluation process is a question of fairness and from the management’s point of view it is a question of the efficient utilization of human resources. Very common in most companies is a functional top-down method. Top-down suggests that employees at different hierarchical levels in the organization evaluate employees on a lower hierarchical level and report the results up to their superiors. The bottom-up method is

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20 different from the above mentioned method. The top-down method focuses towards performance contribution and efficiency in contrasts to the bottom-up method that primarily aims at leadership skills of an employee in charge of a group or team. In Section 2.3.2.1. one of the major personal feedback methods will be theoretically addressed. In Section 2.3.2.2. the concept of relative performance evaluation will be explained which is widely used on lower-hierarchical levels of a knowledge-based firm.

2.3.2.1. 360-degrees feedback method

The employees are the most important assets in a knowledge-based firm. One of the most well-known performance measurement tools is the 360-degrees feedback model.

Typically, the feedback survey invites individuals, peers and supervisors to provide scores against the perceptions of others. The leader (ratee) also provides “self” scores against which the perceptions of others are compared. Peiperl (2001) defines this process as “peer appraisal” which “begins with a simple premise that the people best suited to judge the performance of others are those who work most closely with them.” Peiperl (2001) studied for ten years the theory behind the 360-degree feedback model and reports, the somewhat vexed nature of its practice. As Peiperl (2001) says, performance management is not easy under any circumstances, and while “a certain clarity exists in the traditional form of performance review, when a boss evaluates a subordinate,” some paradoxes arise in “the novelty and ambiguity of peer appraisal,”

the chief one being that “people are torn between being supportive colleagues or hard- nosed judges.” A wider rater base, hence invoking wider opinion, may provide greater balance; however, views on the effectiveness of 360-degree feedback processes are far from uniform.

According to many workers in the field, 360-degree surveying importantly allows for participants to reflect on perceptions from a variety of observers of their work to improve self-monitoring (Avolio et al., 1999). An idealised goal of 360- degree feedback is that leaders who are high self-monitors can then “adjust their behaviour as they watch the impact (that their behaviour) is having on followers”

(Avolio, 2005). The study of Reilly et al. (1996) found that managers whose performance was perceived by subordinates as low improved between the first and

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21 second iteration of the program and sustained that improvement two years later. The study found that rewarding and top-down modelling of desired behaviours appeared to be the most important factor leveraging improvement. Dominick et al. (1997) agree that people will be more motivated to develop the behaviours that they believe are rewarded. In fact, Dominick et al. (1997) found that employees can change behaviour merely by becoming aware of the behaviours that are rewarded in the organisation. It follows that survey participants may take their survey results on behaviours more seriously if they perceive the relevant behaviours to be valued. Avolio et al. (1999) claims organizational leaders, from the CEO down, can empower themselves and their people to become continuous learners through use of multi-source feedback processes.

This notion is closely tied to the empowering nature of organisational support provided for the 360-degree process. Ideally, this includes top-down modelling to seek and act upon feedback, and providing institutional support for skilled debriefing of reports and follow-through (Anand et al., 1997).

Bascal (2003) highlights some aspects to use the system efficiently. Bascal (2003) elaborates the evaluee need to trust those who evaluate them as the evaluation system itself. The evaluee might in case of distrust discount the feedback. Especially in case of ulterior motives behind negative feedback, the evaluee may become irritated or feel attacked. When the level of trust is high and the evaluee perceives the feedback with the purpose of performance improvement this system can be fruitful.

Bascal (2003) states that this system reminds the evaluee that people who are performing well at the expense of their colleagues will be spotted. Furthermore, Bascal (2003) states that it is best when an employee voluntarily contributes the feedback process and because of the vast amount of inputs the 360-degrees feedback system can be time consuming compared to other methods.

2.3.2.2. Relative performance evaluation

Relative performance evaluation measures the performance of similar employees (agents) relative to each other to filter out background noise factors. An example of an exogenous factor can be the fluctuation in demand. According to Lazear and Rosen (1981) an incentive compensation scheme based on relative performance is superior to that based on individual performance when the agent is sufficiently risk averse or the

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22 common uncertainty is high. Therefore relative performance evaluation (RPE) reduces the effect of common shocks on performance and allows the risk averse employee (agent) to bear less risk and the evaluator (principal) to better evaluate and motivate the agent’s effort (Gong et al., 2010). Moreover, RPE can improve incentive contracting by providing incentives for executives to outperform their competitors (Hvide, 2002).

Despite its theoretical appeal, RPE also involves implementation costs.

Tournament theory suggests that heterogeneity among agents may dilute the benefits of RPE. Specifically, RPE contracts may induce inefficiency if agents in a tournament have unequal chances to win the prize given the same level of effort (Gong et al., 2010). Such unequal contests may induce disadvantaged agents to shirk (O’Keeffe et al., 1984) and may distort the agents’ risk choices—more capable agents become overly conservative in choosing risky investments to preserve their favourable positions, whereas less capable agents overly aggressive in pursuing risky investments (Rosen, 1988; Gong et al., 2010). The prior study of Gibbons and Murphy (1990) argues that RPE may create adverse incentives for management to sabotage the performance of peers, or create opportunities to collude with peers, and choose inappropriate peer groups. In addition, empirical evidence is consistent with competitive environments and certain executive attributes (such as self-hedging ability and outside employment opportunities) reducing the benefits of RPE in incentive contracting (Garvey & Milbourn, 2003). The theory and evidence cited above provide a potential explanation for the lack of consistent empirical evidence supporting the use of RPE in executive compensation contracts (Gibbons & Murphy, 1990).

Peer groups used in compensation can be categorized in two groups;

benchmarking peer groups and RPE peer groups. Benchmarking peer groups are used to gauge an executive’s reservation wage in the competitive labour market (Gong et al., 2010). Compensation benchmarking peer groups therefore represent a set of companies against which a firm competes for executive talent. Bizjak et al. (2008) construct compensation benchmarking peers from firms with similar size and same industry membership. They find that compensation benchmarking is an efficient mechanism to gauge the market wage necessary to retain valuable human capital.

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23 RPE peer groups are mainly used to filter out common risks and thus insulate performance evaluation from the effect of exogenous factors. Moreover, the implication of peer selection bias for peer performance is opposite for compensation benchmarking peers versus RPE peers, because better performing firms tend to pay higher compensation and thus are more likely to be selected as compensation benchmarking peers, whereas worse performing firms are more likely to be selected as RPE peers to boost firms’ relative performance and hence incentive compensation (Gong et al., 2010).

2.4. Incentive compensation

The management of a knowledge-based company has to make important decisions regarding the incentive system in order to motivate and control the behaviour of the employee in such a way that organizational goals will be achieved. This section deals with different remuneration policies and presents the theoretical foundation to give answer to the research questions. Furthermore, this section will explain how to remunerate employees after achieving a goal. According to Merchant & Van Der Stede (2007) incentive systems are an important tool for an organization in guiding their employees to the desired results and it motivates them to achieve performance- based targets. Hansson (2007) claims that the wage and reward system show the employees and the outside world what is important for a company and provide a significant aid in order to affect employees’ development, commitment and the willingness to learn.

2.4.1. Rewards & Incentives

The terms reward and incentive are closely related. To make a clear distinction between the two closely related terms a definition is needed. Armstrong (1993) made a clear distinction between reward and incentive. Armstrong (1993) states that rewards recognize the past achievements and provide remuneration and other financial and non-financial benefits in accordance with individual and team competences and contributions. According to Armstrong (1993) incentives encourage and energise people to do more and to do better in the future by offering the

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24 opportunity to earn financial and non-financial benefits. The definitions of Armstrong (1993) help to make the close relation visible. Rewards have the potential to become incentives by creating a desire for a higher level of remuneration. This implicates that the perception of the employee is important. The reward becomes an incentive if the employee perceives the reward as an incentive for a better performance.

2.4.2. Intrinsic and extrinsic motivation

There are two kinds of motivation, namely intrinsic and extrinsic motivation. Intrinsic motivation comes from within the individual. Intrinsic motivation affects satisfaction that individuals experience in their jobs. Bartol et al. (2000) defines intrinsic motivation as the pleasure of the employee that is derived from performing well compared to a standard. The management can influence intrinsic motivation of the individual. Simons (2000) states that when employees are involved in the goal-setting process they are more likely to work towards the organizational goals. Intrinsic motivation is important and affects the satisfaction of the employee which has a more long-term effect.

Extrinsic motivation relates to the use of rewards that are expected to motivate an individual for a good performance, for example increased payments, promotion or getting dismissed. The level of extrinsic motivation can be increased by linking bonuses to the achievement of a goal (Simons, 2000). Rewards that trigger the extrinsic motivation of an individual can have an intermediate and powerful effect, but it is not sure how long this will last on a long-term basis (Armstrong, 1993).

2.4.3. Pay-performance

To increase the interest of the employee towards the organizational objectives many companies use performance-based incentives. It is important that the employee knows what is important for the company and therefore rewards can assist in communicating the organizational goals. According to Merchant and Van Der Stede (2007) rewards can help to communicate the organizational strategy and serve three types of management control purposes. The first purpose is the informational benefit which focuses on informing and attracting the attention of employees on the result areas

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25 within in the organization. The second purpose is the motivational benefit; an incentive can increase the performance of the employee and motivate them to work hard. Third, the personnel-related control benefit emphasizes on the fact that performance-based rewards are often an important part of the employee’s compensation.

Incentive systems also serve a non-control purpose which means that the compensation for the performance-based incentive varies with the firm’s performance.

This implicates that when the organizational performance is low, the employee also receives a lower firm performance-based compensation. This allows companies to smoothen their earnings.

2.4.3.1. Agency theory

The agency theory can help to further analyze the performance-based incentive mechanisms. According to Sappington (1991) the "principal" is obliged to hire an

"agent" with specialized skills or knowledge to perform the task in question. The basic idea of the agency theory is that the principal delegates work to the agent. The agency theory can be applied to several relationships, for example employer-employee, lawyer-client, or buyer-supplier relationships. The central concern of the agency theory is how the principal can best motivate the agent and monitor the activities of the agent. For example, the agent may pursuit personal interests at costs of the interests of the principal, or the agent has different thoughts about the strategy of the firm than the principal.

2.4.3.2. Different lines of research

There are two streams within the agency theory, respectively the positivist and the principal-agent stream (Jensen and Meckling, 1993). Both streams see the contract between the principal and the agent as the unit of analysis. They also share common assumptions about people, organizations and information (Eisenhardt, 1989). The difference is the mathematical rigor, treatment of the dependent variable and the style.

In general positivist researchers focus on the identification of different situations in which the goals of the principal and the agent are conflicting. They aim

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26 to describe the governance mechanism that aims to limit the self-serving behaviour of the agent. Berle and Means (1932) state that positivist researchers tend to focus on the principal-agent relationship between owners and managers of a public cooperation.

Jensen and Meckling’s (1976) studied the ownership structure of firms which also includes an exploratory view of how equity ownership is used by managers to align managers’ interests with those of the owners. Fama (1980) describes the role of efficient labour and capital markets as an information mechanism that is used to control the self-serving behaviour of executives. Fama and Jensen (1983) explored the role of the board of directors and see them as an information system that stakeholders within a firm could use to monitor the opportunism of executives.

Positivist agency theory can be seen as enriching the field of economics by offering a more complex view towards organizations (Jensen, 1983). There are also critical views of authors to the positivist agency theory. Hirch et al. (1987) criticized that the agency theory is “minimal”. Jensen (1983) claims the positivist principal- agency stream is a tautological one and is lacking rigor.

2.4.3.3. Agency problems

Agency theory is concerned with resolving two problems that may occur in an agency relationship. The first problem is called the agency problem. Agency problem consists of the moral hazard and the adverse selection problem. Moral hazard refers to the lack of effort of the agent. Adverse selection refers to information asymmetry between the principal and the agent and may occur when the desires or goals of the principal and agent conflict (Eisenhardt, 1989). The agent may claim some qualifications that cannot be checked by the principal, because it is difficult or too expensive for the principal to verify what the agent is actually doing (Eisenhardt, 1989). The second agency problem affects risk sharing. The risk sharing problem occurs when the principal and the agent have different attitudes towards risk. The problem is that the principal and agent may prefer different actions because of the difference in risk preferences (Eisenhardt, 1989). The agency theory aims to explain the relationship between the principal and the agent. Therefore the agency theory makes assumptions about human behaviour in search for determination of the optimal contract. According

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27 to the agency theory people are self-interested, are bounded rational and have risk preferences.

2.4.3.4. Monitoring- and bonding mechanisms

The agency theory distinguishes two kind of mechanisms; monitoring- and bonding mechanisms. In order to alleviate the agency problems, like a conflict of interest between the agent and the principal or the pursuit of self-interests by the agent, the principal uses mechanisms to monitor and steer the behaviour the agent. The principal tries to eliminate conflicts as much a possible by bonding the goals of agent to the goals of the principal and monitoring the activities of the agent.

There are several forms of monitoring the agent, for example direct supervising or penalty and award. According to Shavell (1979) observation of an agent’s effort or outcomes that are accomplished through supervision, accounting controls and other devices, assuming that monitoring was costless, demonstrates that any monitoring will result in gains to a principal except when the actions of an agent can have no negative effects on the principal’s outcomes. Monitoring mechanisms seem not to be successful, because they fail most of the time. One fiction that has a significant contribution for this failing of monitoring mechanism is the information asymmetry friction. Information asymmetry means that one party has more relevant information than the other, for example information about an important transaction.

The agent has more relevant inside information during a decision-making phase and that why is it hard to monitor the performance of the agent by the principal. Agents in general possess more information than relative outsiders and they are expected not to share this information with outsiders.

Bonding mechanisms seem to be more effective in aligning the interests of the agent to the interests of the principal. Sappington (1991) states that in the classical agent-principal relation, the principal designs the contract specifying the payment the agent will receive depending on observed performance. The goal of the principal is to resolve the problem of motivating the agent by making the agent the residual claimant in the relationship. Examples of bonding mechanisms are profit sharing, equity grants, cash bonuses, stock compensation or option compensation. For example, the cash bonuses are annually paid and should motivate the agent to reach the bonus target for

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28 that year. The stock and option compensation should motivate the agent not only to think short-term, but align the goals also on long-term basis. By incentive schemes the principal “buys” the “franchise” in order to align the goals of the agent with the principal’s goals (Sappington 1991). Therefore, the agent always acts as the principal would if she shared the agent's superior information and expertise (Sappington, 1991).

The agency theory explains that the principal’s pay-off is a function of output, net of incentives pay to the agent. The relevant question is: how sensitive is this pay- performance relationship? When the incentive payments are linked to the firm’s performance, the agent will be encouraged to improve the firm’s performance to obtain the payment (Meckling & Jensen, 1976). According to Conyon and Peck (1998) the management effort is positive correlated with performance. This means that exceptional management efforts are more likely to be associated with high performance outcomes. Incentive schemes can be used to alleviate the agency problems as a bonding mechanism and to stimulate the pay-performance principle.

2.4.2.5. Incentive contracts

Economical models of compensation assume that a higher performance requires a greater effort which is associated with the disutility of the worker. The underlying thought of the economical models, for example the agency model, is that providing incentives the worker’s expected utility increase with the observed productivity.

Economists notice the importance of nonmonetary, but tend to focus on monetary rewards.

The study of Lawyer (1971) on the relationship between pay-performance finds that evidence of the study indicates that pay is not very closely related to performance in many organizations that claim to have merit increase salary systems.

The study suggests that many organizations do not do a very good job of tying pay to performance. This conclusion is rather surprising in the light of many companies’

frequently claiming their pay systems are based on merit salary systems.

For economist the benefits of tying pay to performance are obvious. An answer to the lack of pay-performance plans in firms can be offered by behaviourists.

Deci (1972) states monetary rewards make employees counter-productive. Deci (1972) argues that money actually lowers employee motivation by reducing the

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29 intrinsic motivation that an employee receives from the job. Similarly, Slater (1980) concludes that “getting people to chase money, produces nothing but people chasing money”. Using money as a motivator leads to a progressive degradation in the quality of everything produced. Kohn (1988) states incentives are bad for business and he gives three reasons for this assertion. First, rewards encourage people to focus narrowly on a task, to do it as quickly as possible, and to take a few risks. Second, extrinsic rewards can erode intrinsic interest. Finally, people come to see themselves as being controlled by rewards.

2.4.3. Promotion-based incentive systems

Wage level pay is often tied to the job levels and not to the individual. Most of the average increase in an employee’s compensation can be traced to promotions and not to continued service in a particular position (Baker, 1988). The study of Medoff and Abraham (1980) acknowledge that between-job-level earnings differentials are more important than within-job-level differentials. The study of Murphy (1985) also is consistent with this view and finds that corporate vice presidents receive average pay increases of 18.8% upon promotion to another vice-presidential or higher position, compared to average pay increases of only 3.3% in years when they remain in the same position. According to Baker (1988) promotions serves two unique purposes.

The first purpose is matching. Matching occurs over time through promotions as employees accumulate human capital and as more information is generated and collected about the employee’s talents and capabilities. The second purpose is to provide incentives to lower-level employees who value the pay and prestige associated with a higher rank in the organization.

When comparing promotion-based incentives versus bonus-based incentives, promotion-based incentives must be either less costly or more effective than bonus- based incentives. Lazear and Rosen (1981) single tournament promotion model argue that, under some conditions, risk-averse workers prefer tournaments to linear piece rates. According to Baker (1988) the incentives generated by promotion opportunities, for example, depend on the profitability of promotion which in turn depends on the identity and expected horizon of the incumbent superior. Baker (1988) recognizes another important problem associated with a promotion-based reward system. A

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30 promotion-based reward system may work well in a rapidly growing firm, but are likely to caused problems in a slowly growing or shrinking firm. Furthermore, Jensen (1986a) argues that, in slowly growing firms with free cash-flow, promotion-based reward systems encourage managers to spend resources on unprofitable growth rather than paying out excess cash to shareholders. The advantages of a bonus-based rewarding system may be obvious. Bonus-based rewarding systems can provide incentives for all individuals in the organization, regardless of their ability, position and promotion opportunities (Baker, 1988). A well-working bonus scheme can punish top executives for unprofitable expansion without degrading incentives for lower- level managers.

According to Baker (1988) it is often argued that promotion contests are desirable since they need only be based on rank order and thus can reduce risk or random noise common to all contestants – but bonus systems based on ranked or relative performance can easily achieve the same objectives.

Baker (1988) concludes that bonus-based incentives will be more important at higher levels in the organization since the profitability of future promotion is lower;

the CEO is not promotable and therefore his or her financial incentives must come from bonuses. Promotion-based schemes will be used more in large organizations with many hierarchical levels than smaller organizations with a fewer levels. In addition, promotion-based reward systems will be more prevalent in growing industries, while bonus-based systems will be more prevalent in declining industries.

2.4.4. Profit-sharing plans

Profit-sharing is increasingly popular in U.S. corporations. Kruse (1987) found that 20 percent of the U.S. labor force participates in over 400,000 workplace profit-sharing plans, and that the number of profit-sharing plans has increased by 19,000 per year since 1970. Ehrenberg and Milkovich (1987) argue based on their personnel economical studies that merit pay and bonuses-based on individual performance are less effective than profit-sharing, stock ownership, and team-based bonuses. A New York Stock Exchange survey report indicates that 70 percent of the firms with profit- sharing plans report that they lead to improved productivity. Economists seem to have a doubt on the effectiveness of profit-sharing plans, because of the free-rider effect.

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31 Baker (1988) state when the measures of individual performance are available, it always seems better to tie pay to individual performance rather than to overall firm performance. An argument for team-based incentives is that these policies encourage mutual monitoring.

2.4.5. Incentive compensation in knowledge-based firms

The incentive compensation system has to affect the extrinsic motivation of the employee, because this will increase the chances that organizational goals will be achieved. To increase the interest of the employee towards the organizational objectives many companies use performance-based incentives. It is important that the employee knows what is important for the company and therefore rewards can assist in communicating the organizational goals. Knowledge-based companies are a distinguished type of company and there are many ways to remunerate an employee active in this industry. However, monetary rewards and promotions are popular among knowledge-intensive companies.

Consultants with no relevant experience will start on a low hierarchical level where the individual has a lot to learn. To gain experience the consultants will often work in a team with peers on temporary assignments which allow the individual to gain experience in numerous companies especially compared to a regular job. On the lower hierarchical levels of the organization learning on the job and training are essential to develop competence, skills and knowledge. Interacting in a team with their own decision-rights will stimulate learning, because interaction results in the transfer of knowledge and experiences. To stimulate the learning on the job knowledge-based firm often apply a promotion-based incentive system where employees on the same hierarchical level compete for a limited available positions.

Consulting firm often recruit a lot of employees on the lowest-hierarchical level, but only part of this recruited group will be promoted. Therefore a consulting firm has an inherent imperative for organic growth and this is one of the major reasons why promotion-based incentive systems work well for consulting firms for this particular part of the organization.

When a consultant has gained experience and reached a higher hierarchical level the promotion incentive will be less. Consulting firms are distinctive in their

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32 widespread use of the partnership form of ownership. Baker (1988) states that bonus- based incentives will be more important at higher levels in the organization since the profitability of future promotion is lower, for example; the CEO is not promotable and therefore his or her financial incentives must come from bonuses. The incentive then must come from bonus-based incentive to align the interest of the consultant.

According to Conyon and Peck (1998) the management effort is positive correlated with performance. This means that exceptional management efforts are more likely to be associated with high performance outcomes. Incentive schemes can be used to alleviate the agency problems as a bonding mechanism and to stimulate the pay- performance principle.

2.5. Asset specificity

The management of a knowledge-based company has to make two important decisions regarding the organizational design in order to control the employee behaviour and manage the operations. The first choice affects how much authority should the management delegate to their lower-level employees. The second choice affects the use of incentive compensation to ensure that these employees do not misuse their discretion (Milgrom & Roberts, 1992). Section 2.5.1. addresses the importance of responsibility accounting. Section 2.5.2. focuses on asset specificity and the costs of transferring knowledge in a knowledge-based firm.

2.5.1. Responsibility accounting

One of the fundamental requirements of a management control system is the principle of responsibility accounting. Responsibility accounting is a system under which managers are given decisions-making authority and responsibility for each activity occurring within a specific area of the company. According to prior research responsibility accounting is established when responsibility is delegated to various levels of management. Management information and reporting system must be instituted to give adequate feedback in terms of the delegated responsibility.

Responsibility accounting stresses the importance of divisions or departments of an organization under a specified authority. This specified authority should be evaluated

2. Literature review

Preface

Abstract

Table of contents

1. Introduction

2. Literature review

2.2. Management Control

2.3. Performance measurement

2.4. Incentive compensation

2.5. Asset specificity