Challenges of performance evaluation in
the modern firm
Master Thesis
Rijks Universiteit Groningen
Faculty of Economics & Business Administration Organization & Management Control (O&MC)
Preface
Abstract
Index
Abstract………... 3
1. Introduction……… 4
2. Conceptual model………... 7
3. Theoretical framework………... 8
3.1 Decision rights assignments……… 8
3.2 Compensation……….. 11
3.3 Types of performance measures……….. 18
4. Results and dilemmas from choosing organizational performance as a dependent variable…. 25 5. Results and future research………. 28
1. Introduction
Progress and modernization require from the firms and the organizations to become more complex and international. The firm stopped to be only the shell of the organization and became the organization itself. It is a complex relational system where strategy and organization represent two important elements for the firm‟s success and growth.
From this intricate organizational design I choose to analyze separately the influence of performance evaluation, compensation and decision rights assignment on the performance of the firm. The idea behind is that the right people must be attracted, motivated, retained and assigned to different tasks in order to create value for the firm (John Roberts 2007)1. I am trying to find a more effective way of decision rights assignment, and the influence of it on the performance of the firm. To attract and retain valuable employees the compensation policy and the performance measurement applied play an important role. Nevertheless decision rights assignment contributes extra to motivate the employee to perform better. I examine the interface between the employee and the with regard to all the variables mentioned before.
Additionally I choose to study incentive as a moderator between my independent and dependent
variables. Incentive is influencing the relation of each of my independent variables on the dependent variable separately. In other words the amount of incentive given to the employee affects the relation of each of my independent variables with performance. I am showing their relation in my model.
Considering all the variables mentioned before, is important because on one hand people must give the firm the capabilities it needs in order to create value; on the other hand the firm should provide effective coordination and motivation to these people.
As a research method I used the prior research made in this field. I consulted several virtual data bases, journal collections and manuals. I took also in consideration what some individuals experienced on the work floor, and the ideas they shared with me. Having in mind the problems that some of them encountered, I decided to research the literature on this subject hoping to find some solutions. While researching I was exposed to several problems, related with my dependent variable and the field researched. Literature on this subject offered some solutions
2. Conceptual model
The model that I am trying to analyze is an independent interaction model in which I am investigating how my independent variables affect performance. I choose the incentive power as a moderator in the relation between my independent and dependent variables. The amount of incentive given to the employee affects the relation of each of my independent variables with performance. In the case of the first independent variable, decision rights assignment, incentive can be defined as being the amount of decision right we should give to an employee. Depending on the incentive the employee will feel motivated to increase or not performance. In the case of my second independent variable, compensation policy, incentive can be seen as the amount of pay. I try to determine how much incentive in the form of pay one should give to an employee in order to motivate him/her to perform better. Lastly in the case of my third independent variable, type of performance measures, incentive can be achieved through the incentive plans that include nonfinancial performance measure. I showed in the following chapters how these plans can have a positive impact on performance.
Decision rights assignment ---incentive---> performance
Compensation policy ---incentive---> performance
3. Theoretical framework
Before measuring the impact of decision rights assignment, compensation systems and type of performance measures on the performance of the firm I will try to define the three independent variables before constructing my hypothesis.
3.1 Decision rights assignment
The economy as a whole consists of a decision making process. It is known that resources are scarce, so society faces a series of decisions on:
a) What to produce? b) How to produce?
c) How to share the product?
The process of decision making related with the questions above is decentralized and is linked with the way the market operates. The device through which the decision making is accomplished is the system of rights. For example under capitalism, the right to decide how some physical objects will be used is assigned to individuals through the property rights system. Not forgetting that the rights have a very important characteristic: they are alienable, can be transferred. Therefore, organizations have to design a wide variety of control mechanisms to ensure that agents exercise and transfer these rights properly.
Hypothesis I: The expectancy of a more effective decision rights assignment influences positively performance.
In this paper I try to analyze how decision rights assignments can increase performance. This analyze is made in the context of alienability of rights.
To show the connection between decision rights and performance I introduce the concept of
knowledge, namely specific knowledge. In a world where the performance of the firm depends
on the way the decision is made, the manager has two choices:
a) transferring the knowledge to the person with the decision rights
Such a decision is made having as purpose to increase the efficiency of data transfer. Efficiency in this case means lowering the data transfer costs.
The value of the firm increases by lowering the knowledge transfer costs in the first case and by lowering the control costs in the second case.
Previous research show that the transfer of knowledge to the person with then decision rights increases performance only if the knowledge resides in lower level of the firms. In this case decentralization will lead to lower knowledge costs. If on the other hand the CEO has the knowledge to be transferred to lower level the net benefit of decentralization is negative. The transfer becomes unnecessary as the CEO can take the decision himself. Moreover there are situations where the relation between decision rights assignment and performance can be negative:
a) If the decision maker doesn‟t understand the knowledge b) If the transmission of the knowledge is delayed
c) If there is a lack of common knowledge
In the case of transferring the decision rights to the person with the specific knowledge decentralization increases the control of costs because the knowledge becomes more specialized.2
Because specific knowledge is costly to transfer it is better to collocate decision rights where the specific knowledge is. Consequently we need new performance measures and new incentive systems. So the decision whether to transfer or not the decision rights relies in comparing the costs of the transfer of decision rights with the one of implementing new performance measures and new incentive systems. If the costs in the first case are lower the impact on performance will be positive.
In this sense (Wruck, K. and M. Jensen (1994) state that successful Total Quality Management relies on assigning decision rights that discourages managers to over centralize the firm but on the other side guards not to have an extreme decentralization.3
2
Christie, A., M. Joyce and R. Watts (2003), Decentralization of the firm: theory and evidence, Journal of
Corporate Finance 9(1),
Another element correlated with the delegation of decision rights is the level of incentive compensation. (Nagar, V. (2002), analyses two questions:
a) How much authority to delegate to lower level management? b) How to design incentive compensation?
He finds that managers with more authority have more incentive based pay. However if the CEO has a lot of expertise he delegates decision rights less and evaluates the divisional managers better with regard to their divisional performance. Though there is no much evidence that the extent of incentive compensation plays a significant role in explaining the extent of delegation.4 In conclusion the best way of analyzing the impact of the allocation of decision rights on performance is to find an answer to the question:
Who has the relevant knowledge?
The answer to this question proved difficult for previous research.
However we try to find an answer to this question by considering separate decision rights and by breaking up each decision in four stages:
a) initiation b) ratification c) implementation d) monitoring
I showed that the relevant knowledge is a function of decision making rights (a,c) and coordinate decision in the firm namely: control rights (b,d).
Bottom line is that decision rights have a positive influence on performance if the specialized knowledge transfer is made in the conditions of a centralized organization. But if the transfer becomes too costly the solution is to decentralize the organization and to play with the lower control costs.
A different view on the allocation of decision rights is analyzed by (Helmut Bester 2008). He shows that the most important decisions that are made in an organization affect not only the decision maker but also other members of the organization (the stakeholders). The decision maker exerts in this way externalities on other stakeholders. The party that takes the decision and hold the decision right will opportunistically consider its own interest, failing to care about the other stakeholders.
Such externalities affect the optimal allocation of decision rights in an organization having a negative impact on performance.
So the effective assignment of decision rights and of authority depends on the monetary value of the externalities generated by the decision maker.5 This means that the author tries to find an answer to the dilemma: in which sections of the organization should decision rights be
centralized or decentralized and why?
In order to bring decision rights closer to the benefits and costs of the stakeholders of the organization, authority should be assigned to the person that cares more about the decision because his preferences are better aligned with the organization‟s objectives. The framework developed in this study considers multiple decisions problems so that control rights in different areas of the organization should be assigned to different parties. Complementarities between decisions favor centralized decision rights while the absence of these complementarities favors decentralization. Thus in an organization performance gains can be obtained by a structure that defines authority separately for different decision areas. The optimal allocation of authority assigns the decision right to the party whose objective is most closely aligned with maximizing performance of the firm.6
3.2 Compensation
In markets the real use of allocating decision rights is the fact that mostly the owner of these rights is responsible for the results. The benefits and the costs resulted for the use of misuse of the decision rights come mostly into the owner‟s responsibility.
In the case of not transferable decision rights organizations use rewards and punishment systems to motivate agents to work. Having in mind the reward system, I will elaborate further on the compensation matter.
In order to design a compensation plan one has to take in consideration the three classical stages: a) the level of compensation
b) the composition of the pay package c) the shape of the pay schedule
For my research I am more interested in the composition of the pay package.
Hypothesis II: The valence attached to each component of the compensation package positively influences performance. The components analyzed are fixed pay, flexible pay and benefits.
The empirical findings suggest that there are two major strategic patterns of compensation decisions:
-mechanistic pattern -organic pattern
The mechanistic pattern pays for the job not the individual. The pay mix consists from a main part of the salary and benefits. From previous research this mechanism works the best to motivate individuals in their job. The disadvantage related with this type of compensation is that it reflects the hierarchical position in the firm and consequently there are little opportunities for employee participation.
The second strategic pattern of compensation, the organic pattern, is based on flexible pay practices. The disadvantage in this case is that a part of the pay package is at risk. To complement the salary and benefits in this case we have the pay incentives. In this way there are plenty of opportunities for the employees to participate in the pay decisions.
Many firms have patterns of compensation that are deviating from the main patterns described above. Previous research shows that the grater he deviance is from the main patterns the less effective the firm pay policies are likely to be.7 Accordingly the compensation system can be very complex and the choices made have a tremendous effect on the behavior and performance of the managers.
To show how compensation relates with performance, requires analyzing another variable, namely incentive.
I mentioned in the introduction and my model that incentive is the moderator that ties all three independent variables, one by one to performance, my dependant variable.
First I will analyze the incentive impact on compensation. To do that one must answer the question:
7 David. B. Balkin, Luis R. Gomez-Mejia (1990), Matching compensation and organizational strategies, Strategic
How much incentive we should give to people?
It is not very clear how much pay we should provide to the employee if he works harder. This problem is reflected in the pay-performance sensitivity. Having as final purpose to increase the value of the firm, respectively of the shareholders, one has to do this with mechanisms through which compensation policy can provide value increasing incentives.8 Some of the mechanisms analyzed here are:
a) performance based bonuses b) salary revisions
c) stock options
d) performance based dismissal decisions
For my research I chose to describe the impact of bonuses and stock options on performance. The results shown in the research mentioned above reflect the fact that the bonuses being a big part of the CEO‟s salary are not rewarded in ways highly sensitive to performance. Bonuses have a low variability in the CEO‟s compensation and reflect that they are not always tied to performance. The same idea of cash bonuses that have little or no effect on the overall performance appears also in (Bouwens, J. and L. van Lent (2006). The authors associate the idea of cash bonuses with the selection process rather than with performance. Even if the cash bonuses result in more intense incentives for the employee it doesn‟t have a positive guaranteed effect on the employee‟s behavior. So employees can put more effort to get the bonus, without considering the final and more important goal of increasing the value.
The conclusion of the authors is that incentive contracts affect the ability of selecting better employees. When new employees are offered higher cash bonuses, more productive employees self select into the firm. So performance based compensation plans have a larger impact on the firm performance due to the selection effort.9
With regard to the stock options previous research deals more with the impact of stock options on the CEO‟s decisions.
8
Jensen, M.C. and K.J. Murphy(1990) Performance pay and top management incentives, Journal of political Economiy 98(2)
Incentives generated by stock holdings are big even if the CEO has only a small fraction of the stock.
One solution, as shown in the agency theory as well, is to base the CEO‟s compensation
on performance measured accordingly to aggregate performance in the industry and market. Nevertheless it provides CEO‟s with incentives to increase shareholders wealth, while eliminating the risk beyond the control of the manager. The same idea is supported also by (John
Roberts 2007) who gives the example of compensating a sales person both on his overall sales
and how he has done relative to the average across then sales staff overall.10So the same compensation method works when applied, also on other categories of employees. Similarly there is some evidence that the CEO‟s compensation is not only related to their own firms‟ performance but also to how well they have done relative to comparable firms in the industry.11
The next step in this research is to find a way of linking performance to pay.
I have to find elements from the compensation package, which can improve work motivation and job satisfaction. It is proven that happy employees will perform better on the job.
(Jacques Igalens and Patrice Roussel 1999) show that only a small part of the compensation package has an impact on work motivation.
Their study examines the influence of fixed pay, flexible pay and benefits on the work motivation and job satisfaction of the employee. Their results show that only individual compensation (as a part of fixed pay+ recognition of their contribution to the company) is increasing work motivation.12
Employees that are motivated in their work will put more effort to further performance achievements. The expectancy that performance leads to obtain outcomes in terms of total compensation positively influences work motivation. The expectancy theory clearly indicates that the attitudinal factors, during the motivational process, stimulate the individual to produce effort and perform better. 13
10John Roberts, The modern Firm. Organizational design for performance and growth, Oxford University Press 2007
11 Gibbons, and Murphy,K. (1990).” Relative performance evaluation for Chief Executive Officers”Industrial and Labour Relations Review, 43:
12 Jacques Igalens and Patrice Roussel (1999) A study of the relationships between compensation package, work
motivation and job satisfaction, Journal of Organisational behaviour 20, 1003-1025
13
Benefits are also in this study negatively related with performance. They are based on the idea of individuals being part of an organization. Their main role is to tie the individual to an organization. So it has more to do with retention than with performance. In practice there is no relation between the individual‟s effort, his performance and benefits. There is however a positive relation between benefits and satisfaction as a need of comfort and security. However the variable of interest in this study is motivation. Results show that the less the employees are incited by benefits, the more they are motivated in their work. Considering flexible pay, previous research shows that it neither motivates nor increases work satisfaction. The reason behind this result is that an individual can believe that his earnings are not related to his performance in comparison with other people that he takes as reference.
In conclusion it appears that employees need security in their job (fixed pay) and incentive (rewarding individual efforts) to motivate them to enhance performance of the firm. I have to mention that most of the studies on this subject have being conducted in US ( Markham 1988, Heneman 1990) . At this point I have to take in consideration the cultural dimension of my paper.
After analyzing the compensation package, I do not have to loose sight of the fact that it is very important to attract valuable employees in the firm.
I have mentioned above how the amount of pay determines whether one will take a job or not. When designing a basic compensation plan one must take in consideration the common steps:
a) Choose a performance measure, b) Shape of pay- performance relation c) Choose the level of pay
All these elements can be found in the incentive pay compensation plan.
So the firm should give more incentive and pay when sorting for talent.
It is important to first select the talented employee. When giving more incentive one should keep in mind the final purpose of increasing the value of the firm.
Managers should give more incentive when the impact of the employee on the firm value is high, or when the employee has more specific knowledge.
For example the impact of a manager leaving can play a vital role in the future value of
the firm. The changes in value depend in this case of the ability and talent of the manager. The departure of a high ability executive results in negative abnormal returns for the firm that looses him and positive abnormal returns for the firm that rehires him. It seems to be a big correlation between the departure of the manager and his managerial ability.14
Another question that I would like to answer in this chapter is:
How to define the level of compensation in such a way, to please the organization as well as the employee?
To answer this question I have to see how the pay level is assigned to a particular job under traditional models of compensation. One would expect that the pay level is determined on the worth of the job to the organization as well as the worth of the job in the external labor market.15 As I mentioned in the case of the managers compensation, one way to define the worth of the job in the organization is to establish the level of ability required to perform the job. Previous literature shows that ability is a frequently used factor in many job evaluations plans. However pay increases should be more strongly related to effort that to ability.16 This idea is supported by the motivational theories that suggest that organizations influence more effort than ability in allocation pay incentives. A person with the abilities to do the job has to be motivated to increase effort in order to create more value for the firm. One way to do that is through the classical compensation method: an increase in the pay level.
Research on this subject tries to make a difference between the worth of the job to the organization and the personal contribution of the individual to the organization. As mentioned above, to determine the role of the job in an organization, ability plays an important part. More
14
Hayes, R. and S. Schaefer(1999), How much are differences in managerial ability worth? Journal of Accounting and Economics 27(2)
15
Debra J. Cohen and Robert L. Heneman (1994) Ability and Effort Weights in Pay Level and Pay Increase Decisions, Journal of Business and Psychology, Vol. 8, No. 3, pp. 327-343
interesting for this study is to measure and rate the personal contribution of the employee to the organization. This contribution is referred in this study as performance. Incentives using compensation plans should be related with an increase of effort.
However while a clear separation between the job and person can be made in theory, in practice the distinction is not made. In most of the cases the contribution of a person to the firm in evaluated taking in consideration factors as skills, knowledge or abilities. So ability is used in a combination with effort to determine the performance and pay incentives of the employee. To support my argument I refer once more to (Debra J. Cohen, Robert L. Heneman 1994). Their results indicate that pay level decisions are influenced primarily by ability and pay increase decisions are influenced by the interaction between ability and effort. Moreover ability had a strong impact on pay increases, contrary to both traditional models of compensation (mechanistic pattern and organic pattern).
I consider that a more effective way of compensation should take into consideration only the effort of an employee, which contributed at the increase of the performance of the firm. Organizations should relate pay increases to the effort of the individual and not to the combination of effort and ability.
Based on the arguments given above it is clear that the performance evaluation of the employees using compensation is mostly subjective. Firms do not make a differentiation between the elements that influence pay levels and those who influence pay increases. The fact that the compensation plan is mostly a function of the worth of the job and the individual contributions to the job (performance) makes decision rights assignment more difficult. The reason behind is that it is difficult to decide if compensation decisions should be made according to the job or according to the person in order to increase efficiency.
As an example of the theories analyzed above I refer to the research of (Anne T. Coughlan,
Chakravarthi Narasimhan 1992).
In their study about the impact of compensation on the sales force they find:
The ratio of salary to total pay is positively influenced by sales volume, seniority, career-path programs, educational level, and years of service.17 Or the actual measure of the effort of the sales person is shown only by the sales volume. The other elements that influence salary are
17Anne T. Coughlan and Chakravarthi Narasimhan (1992), An Empirical Analysis of Sales-Force Compensation
showing the ability of the person and have a strong impact on the pay increase of the person. Moreover the researchers show that total pay increases also with sales volume, seniority average industry pay, educational level and number of years in service.
The conclusion is that incentive pay should only be associated with the direct effort of the person in order to increase the sales performance horizon of the firm.
3.3 Type of Performance Measures
Recent developments in business practice have questioned the validity of evaluating performance on financial measures only. Calls to extend the set of performance measures have been met by introducing non-financial performance measures.
In practice there is an increasing use of non financial measures such as product quality, customer satisfaction, and market share in performance measurement and compensation systems. This tendency is explained by the fact that current nonfinancial measures are better predictors of long term financial performance than current financial measures. Nonfinancial measures try to predict the future value of the firm and help refocus managers on long term aspects of their actions. The downside of using the nonfinancial measures as a performance measurement is that I can find little empirical evidence on the relation between nonfinancial measures and financial performance. Even less evidence is found on the impact of nonfinancial measures on performance in incentive contracts.
Hypothesis III: The expectancy that the use of financial measures combined with nonfinancial measures positively influences performance.
In this study I try to find an answer using empirical evidence at two questions: -Are some non financial measures leading indicators of financial performance?
-Does the adoption of an incentive compensation plan more oriented on nonfinancial performance measures, lead to improvements in both financial and non financial performance?
following the implementation of an incentive plan that includes nonfinancial measures of performance.18
For example: traditionally firms used financial performance measures as earnings, return on
investment, or unit costs. The new trend is to use nonfinancial performance measures as customer satisfaction, productivity; product quality and market share in compensating managers. Big firms as General Motors, Ford and Chrysler Corporation pay since a long time bonuses based on quality and customer satisfaction targets.
The reason behind this trend is that nonfinancial measures are complementing short run financial figures as indicators of future value toward a firm‟s long term goals.19
From the agency theory point of view, the use of nonfinancial performance measures is consistent with the theory on compensation in agency settings. The idea behind is that nonfinancial measures add value by the long term effort of the manager, while financial measures are mostly noisy signals of managers efforts.
More evidence supporting the idea of association between nonfinancial measures and future financial performance is found in the research of (Christopher D Ittner, David F. Larckner, Taylor Randall 2003). The authors state that firms making more extensive use of a broad set of financial and especially non financial measures have higher measurement system satisfaction and stock market returns.20
However despite an increasing use of non financial measures in managerial compensation there is little empirical evidence of the performance impacts of such plans.
Incentive plans that include non financial measures can affect financial performance by
improving nonfinancial performance which impacts the financial one. So the impact on performance is indirect.21
Incentive plans are an important part of the management control field. Incentives as measures of performance are an important motivating factor especially for corporate executives. The design
18
Rajiv D Banker, Gordon Potter, Dhinu Srinivasan, An Empirical Investigation of an Incentive Plan That Includes Nonfinancial Performance, The Accounting Review, Vol. 75, No. 1 (Jan., 2000), pp. 65-92
19 Johnson, H., and R. Kaplan. 1987. Relevance Lost: The Rise and Fall of Management Accounting. Boston,
MA: Harvard Business School Press.American Accounting Association. 1971. Report of the committee on nonfinancial measures of effectiveness. The Accounting Review 46 (Supplement): 165-211.
20 Christopher D Ittner, David F. Larckner, Taylor Randall 2003, Performance Implications of strategic performance
measurement in financial services firms, Accounting Organizations and Society , volume 28, Issues 7-8
21
of a good incentive plan has been the main problem of researchers and managers for a long time. The challenge however is, to include in the incentive plan nonfinancial performance evaluation measures and to determine the impact on performance. The design of an incentive plan could be viewed as a choice of targets to motivate the manager to act in the interest of the firm. Even if the incentive plan should encourage effective planning and honest reporting of goals to achieve a better performance, in practice the system is confronted with many distortions. 22
Goal based management and planning is not uncommon in the industry. The objective is
to create an incentive plan that motivates managers to set accurate goals and motivates them to work harder to achieve a better performance.
However the inducement to work harder in order to achieve the target has to be consistent enough to avoid collusion.
One of the problems rising is that managers are tempted to perform just under the standard. The reason behind is that if you pass over the standard the standard will get higher next year, so if the reward is not big enough the manager will still down their effort to make sure that the standard will not increase next year and that he doesn‟t have to put more effort.
So the cost-benefit tradeoff is: how much money can you earn next year by going beyond the standard and how much you can earn this year by only achieving the standard.
The next logical step to avoid collusion is to use promotion as incentive device. In this way the inducement to go beyond the target will be bigger. Promotion can enhance efficiency by putting more effort at equal wage (cost). Also in this case there can be some disadvantages: -Cooperation can be harmed
-Collusion- agreement among each-other that everyone lowers the effort in some degree
Top level managers need to be paid a lot more than the level below. This pay package is the price that incentivizes everybody in the hierarchy.
What I analyzed above supports the idea of pay dispersion.23 Pay dispersion and individual incentives are positively connected with performance only when is not much work interdependency. As mentioned before pay dispersion harms cooperation and foster competition. Such an approach works only in settings where work interdependency is not high. Moreover pay
22
Rakesh K Sarin and Robert L Winkler (1980), Performance –based incentive plans, Management Science, vol. 26, No. 11
23Jason D. Shaw, Nina Gupta, John.E Delery (2002), Pay dispersion and workforce performance : moderating
dispersion should be applied only when it is due to legitimate sources. So the relation pay and performance should be legitimate. Performance is lower when pay dispersion occurs in the absence of incentives. Also here I have the risk that pay and performance are not really linked, and that dispersed wages can result from operation of favoritism or rewards from other things than performance.24
Considering that my initial purpose was to analyze the effects of nonfinancial performance measures and promotion based incentive on the performance of the firm. The conclusion that I draw is that previous research found that managers are motivated by the incentive created by the weighting of non financial performance measures in promotion decisions. Managers in locations where there is a higher probability of promotion and a higher potential reward upon promotion demonstrate significantly higher levels and rates of performance improvement in service quality.25
Promotions provide incentives when performance is rewarded by an increase in pay and consequently in rank. Most of the income increases are by promotions, not by bonuses or equity incentives.
Additionally promotions serve two roles matching and provision of incentives.
The matching role occurs when employees are sorted into the jobs where their qualities
are best suited. Managers making promotion decisions do not rely so much on nonfinancial performance measures. Prior research shows that promotion decisions are based more on subjective performance evaluation combined with observable performance measures. Managers are reluctant to use non financial performance measures because of the uncertainty about their role of showing future financial performance. Moreover also employees regard nonfinancial performance measures as unreliable for measuring their own performance.26
Considering the incentive role of promotions, prior research shows that incentive are created through the influence of nonfinancial performance measures in subjective promotion decisions. These decisions are a powerful mechanism in improving nonfinancial performance measures such as customer satisfaction, product quality or employee retention.
24
Pfeffer Jeffrey, Langton Nancy, (1993), The effect of wage dispersion on satisfaction, productivity, and working collaboratively: evidence from college and university faculty, Administrative Science Quarterly, 38(??), 382 - 407.
25
Dennis Campbell, (2008), Nonfinancial Performance Measures and Promotion –Based Incentives, Journal of Accounting Research 4692), 297-332.
26 Ittner, C.D; D.F. Larkner (1998)”Innovation in performance measurement: Trends and research Implications”
The big disadvantage of promotion based incentives is that once the promotion occurs the non promoted manager has little drive to continue the performance improvement.
Previous research found a solution to the above mentioned problem. If promotion based incentives induce learning, and then performance improvements made in prepromotion periods may persist in post promotion periods for nonpromoted managers.27
If managers expended effort to learn how to improve non financial performance for example by monitoring information and surveying customer, then the results of their efforts persist also in the post promotion period for nonpromoted managers.
In conclusion, the case discussed above shows that nonfinancial measures provide incremental information on the manager‟s expected ability to perform in a different environment. This information can be very important in combination with promotion based incentives.
Less common, but effective in many situations is to use relative performance evaluation in the incentive plan.
Relative performance evaluation consists in evaluating individual or organizational unit performance relative to the performance of others. The benefits of the method are that the higher level of common uncertainty can induce agent to exert more effort. The disadvantage of this method is that agents may reduce efforts when they perceive the competition with co agents as being unfair. Nevertheless it is proven that agents effort levels are higher with a relative performance evaluation contract that with a profit sharing contract.28
Another non financial performance evaluation method, I choose to analyze is the
subjective performance evaluation.
This method is based on judgment and not on using numbers in order to make an assumption about the performance of the managers. This method appears in the literature as being quite noisy. The reason behind is that the evaluator can be exposed to many types of errors:
Some examples of the multiple errors that can affect subjective performance evaluation are:
Appraisal errors:
-Halo- giving a good performance evaluation based on just a very good attribute of someone -Horn- giving a bad performance evaluation based on a bad attribute
27 Dennis Campbell, (2008), Nonfinancial Performance Measures and Promotion –Based Incentives, Journal of
Accounting Research 4692), 297-332.
28Matsumura, E,M. and J.Y. Shin (2006), An empirical Analysis of an Incentive Plan with Relative Performance
-First impression-matters in future performance evaluation -Recency-base your evaluation on the last impression
-Leniency-people tend to give overall a too good performance evaluation -Severity- people tend to give overall a too bad performance evaluation
-central tendency-performance evaluations that are average given to too many people -Clone- higher evaluation if the person evaluated is more like you
Errors that can occur at several stages in the appraisal process:
- Considering behavior as part of the total picture of the employee. By this stereotype we keep in mind when evaluating, the type of the individual and not the actual behavior. - Storing this information in memory we are integrating them with other information about
the individual to create a complete picture.
Process errors;
- Errors in rating process: performance is correlated with rating, but irrelevant factors influence rating. This is very risky for the person being evaluated
- Errors in observation-ratings are influenced by general appearance ( race differences, sex differences)
- Workers whose performance declines over time get lower evaluation ratings than the workers whose performance was always bad
- Workers whose performance increases over time are considered more motivated that workers with “high variance” in their performance
Errors in storage and recall:
In this case information is stored people‟s mind in „traits‟. People have the tendency to remember behavior that is consistent with trait category but need not actually to have occurred.
In conclusion regarding all these errors, it seems almost impossible to establish a formal contract between principal and agent because workers contribution is to complex to verify. However supervisors can subjectively assess the contribution of the agents in non formal contracts. To avoid abuse of the workers by the boss, the reputation effect acts as bonding when subjective performance evaluation is applied.
should establish the social identity of the individual. Evaluation of the agent should be made at the level of his inclusiveness.
When the intention is to promote people‟s effort towards a team performance one should focus on the extent to which they identify with the team not with the organization. Social identity is important to establish whether evaluation or reward structures orientates the individual through a individual or collective self orientation, whether relevant work goals apply to individuals or groups, and whether equity considerations derive from interpersonal comparisons 29or from intergroup comparisons.
So the choice of a type of performance evaluation method remains difficult. Financial performance evaluation methods tend to focus on the short term. The final purpose is to increase the future value of the firm so the measures chosen have to counterbalance the short term actions by motivating managers to undertake activities that have an effect on long run firm value. In this way accounting returns measures (return on assets, return on investments) are better in showing long run manager performance, so managers should spend more time in improving these variables. Revenue measures reinforce the emphasis of the manager on short run. Nonfinancial measures (efficiency, quality) and disaggregate measures (cost and sales measures) show managers performance one year ahead.
The idea is to combine the accounting financial performance measures and the non financial performance measures so the manager is focusing on activities that improve financial performance of the firm on long term, beyond the quarterly reporting period. This should be also the focus 30 when the firm establishes an incentive contract.
29
Naomi Elemers, Dick De Gilder, S. Alexander Haslam:”Motivating individuals and groups at work: asocial identity perspective on leadership and group performance, Academy of management Review,2004
30 Abernethy, M., J. Bouwens nad L. van Lent (2008), The role of Performance measures in the intertemporal
4. Dilemmas from choosing Organizational Performance as a dependant
variable
In this study I tried to analyze the influence of decision rights allocation, compensation policy and type of performance measure on the performance of the firm. My study was made from an economic point of view. I choose to analyze the variables from the angle of the agency theory.
I have been confronted while analyzing previous research papers on this subject, with some dilemmas and problems.
I will start with showing how difficult is to find the exact definition of my dependant variable namely the performance of the firm.
There are many studies that define performance as a dependant variable and try to identify variables that produce variations in performance. The danger arises from the fact that performance is a very complex variable and the performance advantage is competitively unstable. Moreover there is also the problem of using data based on past information, while performance should be rather related with the future value of the firm. Variables used to explain performance are sometimes assessed after the performance is known to the informants. As a result performance information will reflect subjective memories, perceptions, and weightings of possible causes of performance.
Nevertheless it is not clear if the purpose of an organization should be seen as unitary or multiple. If organizations are evaluated by their comparative organizational success and failure to fulfill their purposes then we are confronted with other inconsistencies:
Business firms are compared in terms of profits, sales, market share, productivity, debt ratios and stock prices.
Hospitals use cost recovery, mortality rates, board certification of physicians and occupancy rates.
Such comparisons are used as a basis for evaluating executives, for making decisions about allocation of human and financial resources and for writing historical reports. 31
The interest in my paper falls on the aggregate performance of the firm as for example in accounting sales, or financial reports, or socially constructed evaluations. The idea of predicting and understanding performance seems to be more difficult than expected. The problem behind is that mostly research is based on incomplete information based on historical facts. For my research a viable definition of performance can be the personal contribution of the employee to the organization.
However previous studies identify other problems in explaining organizational performance:
- Performance rankings tend to influence the actual performance of a firm.
Poor performance rankings are indications for investors that the business does not work
or the market does not exist. In this way the competitive pressure and relative performance are reduced.
Good performance rankings on the other hand stimulate admiration and encourage
imitation by other firms, stimulating competition and better performance.
- Positive and negative assessments of the firm have an impact on performance. Individuals and leaders of an organization take credit when their own performance is good and blame external factors when performance is bad. So the motivations generated by performance are likely to accelerate success rather than failure. On the other hand negative feedback creates the opposite effect. When organizational performance is below target the tendency is to increase research and decrease organizational slack and aspirations.32
- Performance in one time period is affected by performance in previous periods. Most of the variables affecting performance (investor, customer and worker confidence in the organization) are likely to be affected by past performance. So it is possible that positive experiences in an organization will contribute to future positive experiences.
- It is very difficult as we observe in previous studies, to establish a causal relation among performance variables and other variables connected with performance through the data
31 James G. March, Robert I. Sutton “ Organisational Performance as a Dependent Variable” INFORMS 1997 32Locke , P. and G. Latham (1990), A theory of goals and performance Engelwood Cliffs, NJ: Prentice Hall
5. Results and Future research
After analyzing the dilemmas of choosing as dependant variable the performance of the firm I will try to give a solution for strengthening the relation between allocation of decision rights, compensation policy, type of performance measure and performance.
Regarding my independent variables: allocation of decision rights, compensation, and performance evaluation methods, they all are influenced by several factors, and can become dependant variables. For example knowledge and transfer costs influence decision rights assignment, level of effort and ability of the employee , worth of the job have a direct influence on the compensation package and social identity , the nature of the work have a direct influence on the type of performance measure chosen. Having mentioned all these extra variables influencing the independent variables in combination with the dilemmas explained before in this chapter, research on this subject becomes very complex.
This can be one reason of the poor results obtained in proving my hypotheses.
However if the firm chooses to assign the decision right to the party whose objective is most closely aligned with maximizing performance of the firm, then my first hypothesis is verified.
Regarding the compensation policy it appears that employees need security in their job (fixed pay) and incentive (rewarding individual efforts) to motivate them to enhance performance of the firm. So there is a positive connection between fixed pay combined with incentive and performance. Neither of the variables fixed pay, flexible pay or benefits taken alone influence positive performance on their own. Previous research demonstrated also that evaluators should consider associating incentive pay only with the direct effort of the person in order to increase performance of the firm.
Some problems and questions arise:
-Why Performance Evaluation Methods do not work in practice?
Maybe because the performance evaluation method applied, didn‟t meet the individual‟s expectations. Many firms lost in this way some young talents that couldn‟t cope with a performance evaluation method that was not matching their way of working and was incapable to measure their true value. Many young and promising talents were recruited with a scope to create more value to the firm but the performance method applied proved totally ineffective. Accordingly the firm failed to motivate her employees in the right way and to add value. The young talents preferred to look for other firms that could measure their capacities in a better way. So a solution for this problem can be to tie recruitment to performance. Previous literature on this subject is scarce. The relation between human recruitment practices and performance evaluation methods has being called the “black box “of organizational management control.
Among the few studies made on this subject, some analyze the relation between HRM practices and multinational enterprise subsidiary performance by considering mechanisms through which HRM practices affect subsidiary performance.33 Although the study is focusing on the impact of HRM practices on performance in an international context, it shows that ability and motivation of the individual are important variables demonstrating how HRM practices affect MNE subsidiary performance.
For my research it is significant that previous research demonstrate that neither motivation nor ability alone is enough to achieve maximum performance. Considering the fact that we showed previously in the paper that performance evaluation practices are not so effective to increase the performance of the firm. Maybe one reason behind is that the studies researched before consider only how to motivate the employees without taking into consideration their real abilities. If the firm is able to create conditions where its employees are skilled and motivated properly, these conditions can result in a positive effect on performance. In practice this means that employees need to have both ability and motivation and use them in the interest of the firm to achieve maximum performance.
33Carl F. Fey, Sergey Morgulis-Yakushev, Hyeon Jeong Park and Ingmar Bjorkman“ Opening the black box of the
An unmotivated employee who has great abilities will not contribute much to raise the performance of the firm. Likewise an employee who is very motivated but lacks ability will try hard but the contribution to performance will be little.34
So to hire valuable employees it is necessary to find a link between HRM practices and performance evaluation.
-How to tie recruitment to performance evaluation?
In practice there is no link between recruiting and selection procedures and the performance evaluation method applied after people are hired.
Individuals are hired for their talents and capabilities to create value for the firm but they are evaluated most of the time using methods that fail to show those initial and valuable talents.
So there is a lack of convergence and communication between recruitment and performance evaluation.
In order to create value the firm has to attract, motivate and maintain the right people for the job. Previous research didn‟t find a link between recruitment and performance evaluation of the individuals.
In this way one can speak of luck if one recruits and motivates in the right way a talented individual.
Future research in the field should try to analyze and find a reliable connection between
the two fields (recruitment and performance). The purpose will be to attract talented employees in a wiser way and retain them by adapting the evaluation method to their own needs and expectations having as final goal to increase the value of the firm.
34
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