Implementation of Incentive Contracts

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Topic 5

• Implementation of Incentive Contracts

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Review Incentive Contracts

• Incentive issues come from a misaligned
  objectives and asymmetric information
• Many methods of aligning incentives last
  lecture concentrated on basing pay on performance
• Need to design contracts to satisfy incentive
  constraint self enforcing contracts
• Cost of this is misallocation of risk bearing
• Have to pay agents more to satisfy participation
  constraint
• Actual loss in value means lower performance

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Design Issues

• Incentive intensity principle
• Put high incentives on performance if effort is
  important or risk costs of incentives are low
• Informativeness principle
• Use performance measures that improve your
  estimate of actual effort
• May use relative performance measures if
  uncontrolled shocks are common across agents
• Monitoring intensity principle
• Easy monitoring does not mean you dilute
  incentives makes costs of incentives lower so
  may increase them
• Equal compensation principle
• A cost of providing incentives on one dimension
  is that it may cause poor incentives elsewhere
• Either balance incentives or do not provide them
  at all

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Performance Measurement

• How to measure and evaluate performance for the
  purpose of providing incentives

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The Performance Measurement Problem

• To translate the top-level organisational
  objective into incentives (performance
  measurement systems and rewards) for lower-level
  decision-makers.
• Align individual and organisational goals

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Easy Way

• Use organisation-wide measures of performance
• Employee stock ownership plans (ESOPs)
• Profit sharing
• Make individuals have the same objective as the
  organisation

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Difficulties with Easy Way

• Free rider problems
• With many employees, each bears all their costs
  and receives a fraction of the benefits
• Problems in understanding
• Employees may not understand how their actions
  relate to firms stock price or profit
• Mitigate through learning and training programs
• Non-quantifiable organisational objectives
• Some organisations do not have profit
• Government agencies, non-profits, cooperatives

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Case Exercise

• McMullen and Worby

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How did Holly perform?

• Compare budgeted to actual
• Yearly budget 30,592K
• Actual expenditures 32,824K
• Overflow 2,232K
• But produced more,
• 50,000 12.7 per toy 639,800
• Therefore, adjusted budget is 31,231.8K
• Overflow 1,592.2

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Factors and Costs

• Special order overtime
• 50,000 toys .962 hrs/toy 4 (ot premium/hr)
  192,400
• Blizzard of 78
• No work 153,000 hrs 4/hr 612,000
• Overtime catch-up
• 241,000 ot hrs 48,100 ot hrs (special order)
• 4 (ot premium/hr) 771,600
• Innovation
• Saved ½ pound of plastic for 3rd and 4th quarters
• 414,000 in savings

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Adjusted Measures

• Adjust for Blizzard
• 1,592.2 - 192.4 - 612 - 771.6 (16.2K)
  Favourable
• Do not adjust for Blizzard
• 1,592.2 - 192.4 1,399.8K Unfavourable

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Elements of Performance Measurement

• Entity to be measured
• Divisions, teams or individuals
• Dimensions to be measured
• Which accounting numbers are important
• Weighting Scheme for measured dimensions
• How to trade-off dimensions
• Objective or subjective measures

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Dimensions

• Cost centre minimise costs is objective
• But what about quality?
• Revenue centre maximise revenues
• But what about costs?
• Profit centre maximise profits
• But what about monopoly power?
• Investment centre maximise ROI
• If it is a ratio it is wrong
• Discretionary expense centre what do you
  maximise?
• Legal or IT departments

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Weighting Dimensions

• Profit Revenue Costs
• Each has same weight equal to 1.0
• No weight for capital cost allocation
• OM Scott Measurement System
• Division managers
• .35(Corp Perf) 0.4(Div Perf) 0.25(PA)
• Corporate staff
• .5(Corp Perf) .5(PA)
• PA Personal achievement
• Corporate Performance

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Controllability, Luck and Distortion

• Basic message dangerous to insure managers
  against uncontrollables
• Examples
• plant manager who has decision rights over
  production process but no control over the
  price of raw materials. Should this price be
  removed from performance measure? If it does then
  manager has reduced incentive to alter production
  process in face of changes in price.
• Truck fleet manager whose performance measure
  does not include fuel cost has no incentive to
  economise on fuel when oil prices double
• Be careful if design performance measurement that
  gives managers blanket insurance policies. Can
  cause large distortions in incentives.

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Case

• RKO Video

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Pay for Performance
Bonus
5,000
Slope 2 on Sales Rev 6 on Rental
Rev
2,500
0
50,000
100,000
150,000
Performance
Goal
95 of Goal
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Problems with Objective Performance Measures

• Gaming
• Agents may take actions to manipulate objective
  measure
• Hard to specify all-encompassing measures
• The Ratchet Effect
• hard for principal to commit not to alter
  objective measure or targets ex post

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Gaming

• Evaluating airline pilots on number of on-time
  flights?
• Typist at Lincoln Electric evaluated on number of
  typed words?
• Government employment agency workers evaluated on
  proportion of job applicants who found jobs?
• SA Rugby Union players rewarded on number of
  tackles of Lomuh?
• Teachers evaluated on test scores?
• Academics rewarded for number of papers
  published?

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More Gaming ...

• Deciding when to close mines ...
• In this particular company, mines were shut down
  after the yield per ton or ore dropped below a
  certain level. One old marginal mine managed to
  stay open for several years because of the
  strategic behavior of its management. It happened
  that the mine contained one very rich pocket of
  ore. Instead of mining this all at once, the
  management used it as its reserve. Every time the
  yield of the ore it was mining fell below an
  acceptable level, it would mix in a little high
  grade ore so the mine would remain open.

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Comparative Performance Evaluation

• Compare the performance of individuals and reward
  on the basis of differences
• Divisional performance look at relative profits
• Sales people look at relative sales
• Useful when unmeasured factors affect individuals
  or groups in a similar manner
• E.g., weather, interest rates or probability of
  key supplier or customer going bankrupt
• Less likely to be penalised or rewarded for
  things outside of your control

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Potential Problems

• Performance measures compared should be similarly
  affect by uncontrollable environmental variables
• Regional sales managers compared but there is a
  national ad campaign that impacts differently on
  different regions
• Research teams compared on patents generated but
  some areas more patentable than others
• Potential for collusion
• Lack of incentives to help

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Costs of Comparisons ...

• Sabotage
• I was recently talking to a friend of mine who
  works at a big bank. When I asked him about his
  new promotion, he told me how he got it. He
  managed to crack the network messaging system so
  that he could monitor all the memos. He also
  sabotaged the work group software and set back
  careers of a few company-naïve souls who didnt
  realize that someone was manipulating their
  appointment calendars. They would miss important
  meetings and be sent on wild-goose chases, only
  to look like complete buffoons when they showed
  up for appointments that were never made. By the
  time any of these bumpkins knew what hit them,
  they had a new vice president. PC Magazine 1988.

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Food for Thought

• If objective, verifiable, and explicit
  performance measurement systems can effectively
  solve the problem of providing incentives to
  decentralised decision-makers within a firm,
  there is no justification for the existence of
  the firm. Parties could enter into these
  contracts through market transactions.

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Subjective Performance Measures

• Can use subjective measures that more accurately
  reflect desired goals
• Example Citibank measures performance of forex
  traders by their book values at end of each day
  complemented by subjective assessments of timing
  etc. by immediate superiors

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Potential Problems

• Evaluation inflation
• Hard to enforce these measures in a court. How to
  prevent reneging?
• Influence costs

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Evaluation Inflation
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Solution

• Forced rankings
• E.g., Merck Co., adopted a forced ranking
  system that fixed percentages for each category.
• But American Cyanamid went away from forced
  quotas because it hurt cooperation among
  co-workers.