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THE JOURNAL OF INDUSTRIAL ECONOMICS 0022-1821
Volume LV March 2007 No. 1
Julie Wulfw
I. INTRODUCTION
I would like to especially thank Charles Himmelberg, Raghuram Rajan, Scott Stern, and
Eric Van den Steen for helpful comments and Katie Donohue at Hewitt Associates for
assistance with data collection. I also would like to thank Rajesh Aggarwal, Ben Campbell,
Francine Lafontaine, Vinay Nair, Paul Oyer, Canice Prendergast, Tano Santos, Justin
Wolfers, Jan Zabojnik, the editor and two anonymous referees, and seminar participants at
Northwestern University (Kellogg), Washington University (Olin) and the Applied Econ
Summer Workshop at Wharton. I acknowledge research support from the Center for
Leadership at the Wharton School.
169
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170 JULIE WULF
1
Aggarwal and Samwick [1999] find support for the predictions of a two-signal principal
agent model for division managers. Refer to the text in Section 3.2 for a discussion that
compares the findings presented in this paper to those in Aggarwal and Samwick.
2
Corporate officers are registered with the SEC and are defined by title (e.g., president, CFO,
vice-president in charge of a principal business unit, division or function) or more generally as
an executive ‘who performs a policy-making function.’ See discussion in text and footnote 21
for additional details.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 171
managers that are officers are more than three times larger than that of non-
officers. However, there is no significant difference between the sensitivity of
pay to local performance measures for division managers that are officers
versus those that are not. Using proximity to the CEO as an additional
measure of authority, I find no significant difference in pay-performance
sensitivities for division managers that are closer to the CEO in the
organizational hierarchy.
These findings are generally consistent with a class of models in which
performance pay is based disproportionately on firm performance relative
to division performance when managers have broader authority or greater
involvement in firm-wide decision-making (e.g., Holmstrom and Milgrom
[1991] and various multi-tasking models; Bushman, Indjejikian, and Smith
[1995]).3 More specifically, the evidence relates to theories suggesting that
authority over project selection combined with incentives designed to
maximize firm performance, as well as induce effort for the division, are
important in incentive design for division managers (e.g., Athey and Roberts
[2001]). Finally, the results are informative to the finance literature related to
optimal capital allocation across investment projects and organizational
form (e.g., Stein [2002]) and agency problems within internal capital markets
(e.g., Rajan, Servaes, and Zingales [2000]; Scharfstein and Stein [2000]; Wulf
[2002]).
The remainder of the paper is organized as follows. In Section 2, I describe
the data and define measures of incentives and risk. I present the findings on
the risk-incentive tradeoff in Section 3 and subsequently evaluate the
relation between authority, the tradeoff and performance incentives. I
conclude in Section 4.
3
The paper contributes to the growing interest in determinants, beyond risk, of incentive
provision to managers with authority or decision rights. As stated by Gibbons [1998]: ‘ . . .
recent work on incentives has moved beyond the classic focus on the tradeoff between
insurance and incentives. Risk remains an important issue, but is now recognized as one issue
among many.’
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172 JULIE WULF
Table I
Summary Statistics
Variable Obs Mean Std. Dev. Min Max
FIRM
Sales ($ millions) 2416 8162.43 14710.43 121.65 174694.00
Employees (000s) 2402 45.90 78.02 0.94 825.00
Assets ($ millions) 2417 9334.32 20769.46 91.81 279097.00
Return on Assets 2406 0.17 0.08 0.07 0.97
Sales Growth 1900 0.06 0.14 1.08 0.91
Average Number of Divisions per Firm 2482 4.85 4.34 1.00 34.00
DIVISION
Sales ($ millions) 11048 688.23 1422.96 0.05 53000.00
Employees (000s) 10953 2.96 9.78 0.00 611.36
Division with Incumbent as Corporate Officer 10005 0.23 0.42 0.00 1.00
(Officer)
Depth (# of positions between CEO & 11970 1.43 0.82 0.00 4.00
Division Manager)
Division at High Organizational Level 11970 0.56 0.50 0.00 1.00
(DivHigh)
Division with Incumbent as Officer at High 11970 0.18 0.38 0.00 1.00
Orgn. Level (OffHigh)
Notes: Officer is an indicator variable equal to one if the incumbent in the division manager position is a
corporate officer of the firm and zero otherwise. See footnote in text detailing definitions of a corporate officer
used by both the Securities and Exchange Commission and the Internal Revenue Service. Depth is defined as the
number of positions between the CEO and the division manager position in the firm’s organizational hierarchy.
Refer to both Figure 1 at the end of this paper and to Rajan and Wulf (2006) for additional details. DivHigh is an
indicator variable equal to one if the division manager position reports either directly to the CEO or one level
below that and zero otherwise. OffHigh is an indicator variable equal to one if the incumbent in the division
manager position is a corporate officer of the firm and reports either directly to the CEO or one level below that
and zero otherwise.
4
Refer to the discussion of Table II later in this section.
5
Murphy and Oyer [2003] use a cross-sectional survey of 280 bonus plans and find that
discretion is less important in determining CEO annual incentive pay relative to other
executives.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 175
previous research, yet we know less about how firms grant options, restricted
stock or other long-term performance incentives. Moreover, the time-frame
by which performance is measured for bonuses is well-defined (i.e.,
performance over the past fiscal year), while stock and option grants do
not necessarily occur yearly and the timing of vesting schedules vary across
incentive instruments and firms.
Because of the relative magnitude of bonuses and the econometric
advantages, I focus on annual salary and bonus paid to division manager
positions. However, I also report summary statistics and estimate select
regressions using total compensation defined as the sum of salary, bonus and
long-term compensation. The value of the long-term compensation includes
restricted stock, stock options and other components of long-term
incentives and is determined by a modified version of Black-Scholes.6 Also,
while the main results are based on salary plus bonus, I also show that the
results are qualitatively similar when using the logarithm of bonus and the
logarithm of total compensation as the pay measure.
The measure of performance incentives or pay-performance sensitivity is
based on the ‘implicit’ method discussed in Murphy [1999] and similar to
that in Aggarwal and Samwick [2003] (hereafter A&S). The implicit
pay-performance sensitivity is simply the coefficient on performance
in a regression with the level of compensation as the dependent variable.
Variation in the pay-performance sensitivity can be analyzed by in-
cluding interaction terms between variables of interest, such as the
variance of performance or measures of authority, with the performance
measure.
In Table II, I report means, medians, and standard deviations of several
pay measures for both CEO and division manager positions. Compensation
variables are denominated in millions of 1996 dollars. Sample averages for
CEO salary plus bonus (or cash compensation), long-term compensation
and total compensation are $1.229 million, $1.493 million and $2.719
million, respectively. Comparable sample averages for the division manager
are $0.259 million, $0.152 million and $0.411 million, respectively. To get a
sense of the relative importance of annual bonuses versus long-term
compensation for CEOs relative to division managers, I report annual bonus
and long-term compensation as a fraction of salary and bonus. Both ratios
of performance-based pay to cash compensation are common measures in
6
The value of long-term compensation is computed by Hewitt Associates. Stock options are
valued using a modified version of Black-Scholes that takes into account vesting and
termination provisions in addition to the standard variables of interest rates, stock price
volatility, and dividends. As is standard practice among compensation consulting firms, the
other components of long-term incentives (i.e., restricted stock, performance units and
performance shares) are valued using an economic valuation similar to Black-Scholes that
takes into account vesting, termination provisions, and the probability of achieving
performance goals.
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176 JULIE WULF
Table II
CEO and Division Manager Compensation
CEO (n 5 2482) Division Manager (n 5 12,032)
Std.Dev.
Mean Median Std.Dev. Mean Median Std.Dev. (within firm)
Salary ($ millions) 0.665 0.605 0.303 0.179 0.163 0.084 0.034
Bonus ($ millions) 0.563 0.376 0.758 0.081 0.060 0.082 0.034
Salary Plus Bonus ($ millions) 1.229 0.975 0.953 0.259 0.225 0.152 0.063
Bonus/(Salary þ Bonus) 0.37 0.40 0.18 0.27 0.28 0.13 0.07
Long-term Compensation/ 1.13 0.71 7.67 0.47 0.37 0.48 0.15
(Salary þ Bonus)
Bonus/Long-term 0.83 0.49 1.98 1.09 0.68 2.86 0.60
Compensation
Long-term Compensation 1.493 0.677 2.593 0.152 0.081 0.261 0.062
($ millions)
Total Compensation 2.719 1.675 3.314 0.411 0.312 0.381 0.117
($ millions)
Notes: Compensation variables are denominated in millions of 1996 dollars. The value of long-term
compensation is computed by Hewitt Associates. Stock options are valued using a modified version of Black-
Scholes that takes into account vesting and termination provisions in addition to the standard variables of
interest rates, stock price volatility, and dividends. As is standard practice among compensation consulting
firms, the other components of long-term incentives (i.e., restricted stock, performance units and performance
shares) are valued using an economic valuation similar to Black-Scholes that takes into account vesting,
termination provisions, and the probability of achieving performance goals. The standard deviation within the
firm reported in the last column is the sample average of the standard deviation of the division manager pay
measure across divisions within a firm in a given year.
the accounting literature (e.g., Baiman et al., [1995]). For the CEO position,
the sample average and median ratios of bonus to the sum of salary and
bonus are 0.37 and 0.40, while the corresponding statistics for the ratio of
long-term compensation to salary plus bonus are 1.13 and 0.71. Consistent
with the findings of the CEO literature, long-term compensation comprises a
greater proportion of CEO pay relative to annual bonuses.7
Next, let us turn to division manager compensation. The sample average
and median ratio of bonus to salary plus bonus are 0.27 and 0.28, while the
corresponding statistics for the ratio of long-term compensation to salary
plus bonus are 0.47 and 0.37. In sum, annual bonuses for division managers
represent a comparable fraction of pay relative to long-term compensation
(0.28 for short-term vs. 0.37 for long-term based on median values) and a
larger fraction of pay relative to CEOs (0.68 for division manager bonus
relative to long-term compensation vs. 0.49 for CEO based on medians).
7
This ‘flow’ measure of long-term compensation understates incentive pay for the CEO
relative to the division manager because CEOs hold a much higher percentage of a firm’s stock
in comparison to division managers. Recent research on CEO compensation accounts for the
incentives from the holding of stock and stock options (in addition to annual grants of
restricted stock and options). While Hewitt does not collect data on stock holdings for division
managers, this restriction is less of a problem at lower levels of management.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 177
Figure 1
Trends in CEO and Division Manager Compensation (medians)
Notes: Includes only observations that appear for two consecutive years in dataset. Refer to notes
in Table II for additional definitions.
8
One fact that suggests this is a promising strategy is that more than half of the total variation
in the ratio of bonus to salary plus bonus across division manager positions is within firms (0.07
in last column of Table II vs. 0.13 in the second to last column in Table II).
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178 JULIE WULF
9
I winsorize the division sales growth measure (at 1%) to address concern about
measurement error in division sales.
10
This paper uses the same risk measures as A&S to be consistent with their approach and to
allow comparison. Also, since I do not observe division sales growth outside of the sample,
I cannot use a time-varying measure of risk and, because of this, choose to use an analogous
measure for firm risk. One limitation of this measure of risk is that it can be affected by the
agent’s actions. For empirical research analyzing risk-incentive tradeoffs for CEOs and the
relationship to different types of risk, refer to Jin [2002] and Shi [2003].
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 179
to global performance (or pay-firm performance sensitivity, PPSF)
for a division manager with a given firm sales growth standard
deviation is b4 þ Fðsfj Þb5 (and for a firm at the median, PPSF equals
b4 þ 0.5b5).
Xjt and Dijt represent firm and division characteristics, respectively, e.g.,
the logarithm of firm and division sales. In all specifications, I include firm
fixed effects (aj), thereby controlling for firm-specific omitted variables that
are constant over the period, and year indicators (dt). While this addresses
concerns about unobserved firm heterogeneity in the levels of performance-
based pay, it doesn’t address the problem with respect to estimates of the
pay-performance sensitivities. Since my measure of sensitivity is represented
by the coefficient on performance in equation (1), I also estimate select
specifications with interaction terms between the division measure of
performance and firm indicators (i.e., dijt aj ).11 When I turn to analyzing
the relation between authority, risk, and performance incentives, I introduce
measures of authority directly in this specification. I also include interaction
terms between authority measures and all other measures in this basic
specification. Finally, I address the lack of independence across division
manager observations within a firm and report robust standard errors
(clustering by division) in all specifications.
Since this paper primarily focuses on annual bonuses as performance
incentives, the appropriate performance measures are accounting measures,
not stock returns.12 There is extensive evidence documenting that the most
commonly used measures in determining annual bonuses are accounting
measures. For example, Murphy [2000] reports performance measures used
in 177 annual incentive plans in companies surveyed by Towers Perrin in
1996–1997. He finds that ‘almost all companies rely on some measure of
accounting performance . . . ’ and that ‘ . . . 161 of the 177 sample (91%)
explicitly use at least one measure of accounting profits in their annual bonus
plans.’13
11
This is possible with division performance, but comparable interaction terms between firm
sales growth and firm indicators are not identified due to high collinearity.
12
As stated in Murphy [1999; p. 2525]: ‘Realized bonuses are explicitly related to accounting
profitability, but only implicitly related to stock price performance.’
13
Common performance standards for accounting performance measures include ‘budget’
standards based on annual budget goals and ‘prior-year’ standards based on year-to-year
growth or improvement (such as growth in sales or EPS) [Murphy, 2000]. Keating [1997]
conducts a survey about the use of performance metrics in evaluating division managers and
finds that firm performance use increases with the manager’s ability to affect other divisions.
Bushman et.al. [1995] and Wulf [2002] document that approximately 50% (25%) of a division
manager’s annual bonus is determined by division (corporate) performance, respectively.
Chichello, Fee, Hadlock and Sonti [2005] study the relationship between division manager
turnover/promotions and division accounting performance.
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180 JULIE WULF
Hewitt only collects sales figures for divisions and not profitability. Due to
this data limitation, I use year-to-year sales growth of the division as the
local performance measure and, for consistency, sales growth of the firm as
the global measure.
Estimated Pay-Division Performance Sensitivities (PPSD) and Pay-Firm Performance Sensitivities (PPSF)
PPSD at median 0.101 0.430 0.098 0.045 0.664 –
Division Std. Dev.
PPSD at 25th percentile 0.195 0.707 0.194 0.093 0.815 –
Div. Std. Dev.
PPSF at median Firm 0.254 0.785 0.323 0.267 0.779 0.362
Std. Dev
PPSF at 25th percentile 0.397 1.161 0.509 0.419 1.164 0.571
Firm Std. Dev.
Notes: Based on sample of divisions that appear for at least 4 years in dataset. Firm Sales Growth is defined as
the difference in the logarithm of firm sales between year t and t-1 for the years that the firm is in the sample.
Division Sales Growth is defined as the difference in the logarithm of division sales between the year t and t-1 for
the years that the division is in the sample. Firm CDF is the measure of firm risk defined as the empirical
cumulative distribution function (CDF) of the standard deviation of firm sales growth for firms in the sample.
Division CDF is the measure of division risk defined as the empirical cumulative distribution function (CDF) of
the standard deviation of division sales growth for divisions in the sample. All regressions include Division
CDF. Robust standard errors clustered by division; firm and year indicators included in all specifications.
Regressions in columns (4), (5) and (6) include interaction terms between firm indicators and division sales
growth. PPSD and PPSF are defined in text.
//
represents significance at the 10%/5%/1% level, respectively.
increases salary and bonus by 10.1% at the median standard deviation. The
estimated pay-firm performance sensitivity (PPSF) at median standard
deviation is given by b4 þ 0.5b5 and is equal to 0.254 (0.540–0.50.572).14
14
The strong pay-firm performance sensitivity is consistent with the research documenting
that division manager bonuses are linked to firm performance. By contrast, relative
performance evaluation (RPE) implies a negative coefficient on firm sales growth: as other
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182 JULIE WULF
This suggests that a one per cent increase in firm sales growth increases salary
and bonus by 25.4% at the median standard deviation.
In the panel below Table III, we can see that pay-performance sensitivities
at median standard deviation are an order of magnitude lower than PPS
estimates at the 25th percentile standard deviation for both division and firm
performance measures. Focusing on the results in column (1), the PPSD at
median division volatility is 0.101 in comparison to 0.195 at the 25th
percentile volatility. Turning to the pay-firm performance sensitivity, the
PPSF at median firm volatility is 0.254 versus 0.397 at the 25th percentile
volatility. This is consistent with earlier research showing that increases in
volatility have negative and economically significant effects on pay-
performance sensitivity. Finally, one other notable observation is that the
estimated sensitivity of salary plus bonus to the global performance measure
is larger than the sensitivity to the local performance measure. For example,
in column (1) the PPSF at median volatility is more than two times PPSD
(0.254 vs. 0.101).15
Since I use logarithm of pay, I am estimating elasticities: a percentage
change in pay relative to a change in the performance measure. However,
this measure has limitations as a measure of pay for performance since
elasticities change if the fixed portion of pay changes. To isolate changes in
performance-based pay, I also re-estimate the baseline regression with the
logarithm of bonus as the dependent variable. The reported results in
column (2) are qualitatively similar but, as expected, the magnitudes of the
pay-performance sensitivities are significantly larger. In the panel below
Table III, we see that PPSD (at the median standard deviation) is 0.430, while
PPSF is 0.785.
While the focus of this paper is cash compensation, I also estimate
regressions using the log of total compensation as the pay measure. In Table
III column (3), the estimated pay-division performance sensitivity at median
standard deviation (PPSD) is 0.098, while the pay-firm performance (PPSF)
sensitivity is 0.323. Both estimates are statistically significant at the 1% level
(as are the individual coefficients on each performance measure and
associated volatility measures). The estimated pay-firm performance
sensitivity (PPSF) in this regression is more than 25% greater in comparison
to the regression with salary plus bonus as the pay measure (0.323 vs. 0.254).
divisions within the firm perform better, division managers should be paid less. However, there
is mixed evidence in the literature supporting RPE.
15
The sign and significance of coefficients in Table III are robust to defining pay in terms of
levels (or dollars). The pay-performance sensitivities of the regression in column (1) when pay is
defined in dollars are as follows: PPSD is 27,751 and PPSF is 59,903. The estimates imply that a
one per cent increase in division sales growth increases salary plus bonus by $27,752 (at the
median standard deviation) which is about 10% of the average salary plus bonus; while a one
per cent increase in firm sales growth increases salary plus bonus by $59,903 which is about 23%
of the average.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 183
This is not surprising since the difference in the pay measures is primarily
equity-based pay which is more strongly correlated with firm performance.
The specifications in columns (1) through (3) include firm indicators
thereby controlling for the effect of unobserved firm heterogeneity on the
level of division manager pay. To address how this affects the estimates of
pay-performance sensitivity, I include interaction terms between firm
indicators and division sales growth. The results are presented in Table III
columns (4) through (6). In column (4) using salary plus bonus as the pay
measure, we see that the signs and significance of the coefficients are identical
to column (1) (without the interaction terms between firm indicators and
division sales growth), however, the estimates for PPSD at the median are
about half as large (0.045 vs. 0.101). Using bonus as the pay measure in
column (5), the estimated PPSD at the median is higher in comparison to
column (2) (0.664 vs.0.430). Lastly, in the regression of total compensation,
the coefficient on division sales growth is positive, but insignificant.
At this point, let us compare these results to estimates of pay-performance
sensitivities from Aggarwal and Samwick [2003], the paper closest in spirit.
While the primary focus of A&S is to document performance incentives
across senior executive positions in different job groups (e.g., CEOs vs.
CFOs), they do test and find support for the predictions of a two-signal
principal-agent model (Banker and Datar [1989]) for division managers.
This paper’s results are generally consistent with A&S findings on division
manager performance incentives. Importantly, this paper goes beyond A&S
in analyzing how performance incentives vary by authority across division
manager positions in the same job classification.
The Hewitt dataset provides several advantages relative to ExecuComp in
analyzing division manager positions. The first is that it allows analysis of
incentives for positions further down the organizational hierarchy.16 The
lower level positions are interesting because it is this set of managers that is
more likely to have better information about certain types of decisions. The
second advantage is the reporting of multiple observations of a single job
classification: Hewitt reports five division manager positions per firm-year
on average in comparison to approximately one-half division manager
position per firm-year in ExecuComp.17 As such, the analyses in this paper
offset some of the data limitations faced by A&S that potentially lead to two
16
The ‘division managers’ analyzed in A&S receive more than double (triple) the total
compensation (long-term compensation) of Hewitt division managers during comparable time
periods, respectively: average of $1.05 million.vs. $449,000 for Hewitt for total compensation
($541,000 vs. $152,000 for long-term compensation).
17
On average, A&S observe approximately one business unit executive in a firm-year, and
can only match about half of these executives to business unit or ‘segment’ sales as reported in
Compustat’s Industry Segment database. Of approximately 6,800 firm-year observations,
A&S identify approximately 6,400 executive-years with business unit responsibility, but only
match approximately 3,300 executive-years to segments (as reported in their Table I).
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184 JULIE WULF
18
Another difference between the two papers is that I find a positive relation between the log
of salary and bonus for divisional managers and firm sales growth that is statistically and
economically significant. In contrast, A&S find a negative relation. They argue that their result
is consistent with relative performance evaluation in that business unit executives’ ‘short-term
compensation increases with divisional performance only to the extent that the growth exceeds
the growth in firm-level sales.’ One possibility is that the negative coefficient on firm sales
growth is largely explained by the inclusion of shareholder returns as a firm performance
measure in their specification. While this is an appropriate measure for analyzing equity-based
incentives, it is less so for salary and bonuses. As discussed earlier, evidence suggests that
accounting performance measures are relevant in annual bonus contracts, not stock returns
(Murphy [2000]).
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 185
authority: officer status of the division manager and the level of the position in
the hierarchy. Both constructs are related to the discussion of measurement of
real authority over investment projects in Aghion and Tirole [1997].19 My
approach is first to analyze pay-performance sensitivities for sub-samples
partitioned by each criterion, e.g., officers vs. non-officers. Next, I estimate
pooled regressions with interaction terms between measures of authority and
all variables in the partitioned regressions. And, finally I evaluate whether the
results are robust to defining pay as total compensation.20
19
Hierarchical level of the division manager position is directly related to Aghion and
Tirole’s suggestion that ‘organizational characteristics such as the span of control, the
concentration of ownership, and the number of principals and supervising layers are directly
relevant for measuring (or assessing) real authority enjoyed by subordinates within a firm.’
Corporate officer status is related to their discussion of how legal specialists are proposing that
liability rules should also accommodate organizational characteristics that affect real
authority. (pp. 26–27).
20
Other papers in the accounting literature study the relationship between authority and
incentives for a single job type, but do not analyze risk and are confined to cross-sectional
analysis (e.g., Nagar [2002], Baiman, Larcker and Rajan [1995]).
21
The term ‘officer’ is defined by both the Securities and Exchange Commission in Section
240.16 (rules governing insider trading) and the Internal Revenue Service in Section 280G. The
SEC defines an officer as ‘an issuer’s president, principal financial officer, principal accounting
officer (or, if there is no such accounting officer, the controller), any vice-president of the issuer
in charge of a principal business unit, division or function (such as sales, administration, or
finance), any other officer who performs a policy-making function.’ The IRS code states that
‘whether an individual is an officer with respect to a corporation is determined upon the basis of
all the facts and circumstances in the particular case (such as the source of the individual’s
authority, the term for which the individual is elected or appointed, and the nature and extent of
the individual’s duties).’ See Rajan and Wulf [2006] for a discussion of the increasing trend of
division managers as corporate officers.
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186 JULIE WULF
Table IV
Division Manager Position Pay Regressions of Pay-Performance
Sensitivities Firm Fixed Effects Regressions Division-Specific Measures of
Authority Proxied by Corporate Officer Status of Division Manager
(1) (2) (3) (4) (5) (6)
Notes: Based on sample of divisions that appear for at least 4 years in dataset. Officer is an indicator variable
equal to one if the incumbent in the division manager position is a corporate officer and zero otherwise. All
regressions include Division CDF. See notes in earlier tables for other definitions. Columns (3) and (6) only
report select coefficients of interest. Robust standard errors clustered by division; firm and year indicators
included in all specifications.
//
represents significance at the 10%/5%/1% level, respectively.
division sales growth are similar in magnitude for officers and non-officers
(and all coefficients are statistically significant). In contrast, coefficients on
firm sales growth (and the interaction between CDF and firm sales growth)
are much larger (smaller) for the officer sample relative to the non-officer
sample. Focusing on the relative magnitudes of the estimates of the pay-
performance sensitivities, PPSF at the median standard deviation of firm
sales growth for officers is approximately 0.552, while for non-officers it is
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 187
0.141 (reported in the panel below Table IV). Both estimates are statistically
significant at the 1% level. Officer pay is almost four times more sensitive to
firm performance than non-officer pay, but sensitivity to division
performance is no different. Furthermore, the ratio of PPSF to PPSD for
officers is more than three times that for non-officers.22
To evaluate whether the differences are statistically significant, in column
(3), I return to the whole sample and include interaction terms between Officer
and all variables included in the previous regressions. I only report coefficients
for variables of interest: performance, Officer, performanceOfficer, and
performanceCDFOfficer. Notably, the coefficient on the interaction term
between firm sales growth and Officer is positive and significant, while the
coefficient on the interaction term between firm sales growth, firm CDF and
Officer is negative and significant. Thus salary plus bonus for division
managers with officer status is more sensitive to global performance and the
difference is statistically significant. When I repeat the specifications in
columns (1) through (3), but define pay as total compensation, the results are
qualitatively similar (reported in columns (4) through (6)).
22
Notice that PPSF is slightly larger than PPSD for non-officers (bottom of Table IV column
(2)). This may reflect the importance of giving broad-based incentives to division managers
even if they are not officers.
23
Variation in pay across hierarchical levels may be partially explained by career concerns in
that lower level managers can be paid less in current compensation because they enjoy greater
internal promotion opportunities relative to those at higher levels. Gibbons and Murphy [1992]
suggest that ‘pay should be most sensitive to current performance for workers . . .. with no
promotion opportunities (such as workers at the top of the corporate hierarchy . . .)(p. 470).’
Managers in lower level positions have a greater number of potential promotions to more
senior positions in the hierarchy which is consistent with lower levels of current pay.
24
See Rajan and Wulf [2006] for a discussion of the increasing trend of division managers
getting closer to the top of the organizational hierarchy (or decreasing depth). In addition to
depth, span of control is another dimension of the organizational structure that could affect the
relationship among authority, risk and incentives. Since span changes over time (see Rajan and
Wulf [2006] for evidence), this is not addressed by the inclusion of firm fixed effects. The results
are qualitatively similar when I include span of control (measured by the number of reports to
the CEO position) as a control variable.
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188 JULIE WULF
equal to one, i.e., the division manager either reports directly to the CEO or if
there is one position between the CEO and the division manager. Based on
this definition, approximately 56% of division managers in the sample are at
a high organizational level.
In Table V, I partition the sample into division managers at a high level in
the hierarchy (DivHigh equal to one) (column (1)) versus lower level
managers (column (2)). In comparing the two columns, coefficients on
division sales growth are larger for high-level managers (column (1)) relative
to low-level managers (column (2)), but the opposite holds for the
coefficients on firm sales growth. In turn, the PPSD is positive and significant
at the 1% level for high-level managers, while that for low-level managers is
positive, but only marginally significant (10% level). The PPSF is smaller for
high-level managers relative to low-level managers and both estimates are
significant at the 1% level. In a pooled regression of both samples with
interaction terms between Depth and all variables in the partitioned
regressions, the results suggest no statistically significant differences in pay-
performance sensitivities by organizational level (unreported). Thus, there
appears to be no difference in performance incentives between division
managers that are close in proximity to the CEO relative to those that are
further down the hierarchy.25
Since division managers with officer status are more likely to be positioned
at higher organization levels (i.e., correlation coefficient 5 0.16), I next
analyze partitions that combine these characteristics. In Table V column (3),
I include division managers that are officers and also positioned at high
organizational levels (OffHigh as an indicator variable equal to one). This
represents 18% of the division managers included in this analysis. The
regression in Table V column (4) is based on all other division manager
positions, i.e., those without officer status or at low organizational levels
(OffHigh equal to zero). In a comparison of the coefficients on division and
firm sales growth between columns (3) and (4), we see that salary plus bonus
for officers at high levels is more sensitive to both division and firm
performance relative to non-officers or managers at low-levels, but the
differences are most pronounced for firm performance. These results are
qualitatively similar to the partitions based on officer status.
To evaluate the statistical significance of these differences, in Table V
column (5), I return to the whole sample and include interaction terms
between the indicator representing officers at high levels (OffHigh) and all
25
There is one exception: PPSF for division managers reporting directly to the CEO
(approximately 10% of the sample) is significantly larger in comparison to all other division
managers, but only when pay is defined as total compensation. Related to this, Barron and
Waddell [2003] show that the importance of equity-based pay among the top-five highest paid
executives in different job classifications varies by rank (determined by compensation levels):
executives with higher pay receive more in equity-based incentives.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 189
TableV
Division Manager Position Pay Regressions of Pay-Performance Sensitivities
Firm Fixed Effects Regressions
Division-Specific Measures of Authority Proxied by Organizational Level
and Corporate Officer Status of Division Manager
(1) (2) (3) (4) (5) (6)
Notes: Based on sample of divisions that appear for at least 4 years in dataset. OffHigh is an indicator variable
equal to one if the division manager is an officer and either reports directly to the CEO or if the no. of positions
between the division manager and the CEO is one and zero otherwise. All regressions include Division CDF. See
notes in earlier tables for other definitions. Columns (5) and (6) only report select coefficients of interest. Robust
standard errors clustered at division-level; firm and year indicators included in all specifications.
//
represents significance at the 10%/5%/1% level, respectively.
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192 JULIE WULF
IV. CONCLUSION
Using a proprietary data set of compensation for lower level managers, this
paper contributes to empirical research on division managersFexactly
26
For a discussion of empirical frameworks to identify structural parameters when multiple
organizational design practices are jointly determined, see Athey and Stern [1998]. For
examples of empirical work employing these techniques, refer to Baker and Hubbard [2004],
Ichniowski, Shaw and Prennushi [1997], and Cockburn, Henderson, and Stern [2004].
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 193
those managers for whom the more recent inside-the-firm theories have been
developed. Positions further down the hierarchy are interesting because it is
this set of managers that is more likely to have better information about
certain types of decisions critical to the firm and the ‘real’ authority over
those decisions. In the paper, I document the following facts: (1)
performance pay of division managers is increasing in division sales growth
and in firm sales growth; (2) the sensitivity of pay to division sales growth
(firm sales growth) is decreasing in the volatility of division sales growth
(firm sales growth), respectively; (3) the sensitivity of pay to firm sales
growth and the relative importance of firm to division measures are
significantly larger for division managers who are corporate officers relative
to non-officers; (4) there is no significant difference between the sensitivity of
pay to division sales growth for officers versus non-officers; and (5) there is
no significant difference in pay-performance sensitivities for division
managers that are closer to the CEO in the organizational hierarchy.
Consistent with earlier findings, these results strongly support the predicted
negative tradeoff between risk and incentives. Of greater potential interest,
the results are informative to theories suggesting the authority over project
selection combined with incentives designed to maximize firm performance,
as well as induce effort for the division, are important in incentive design for
division managers.
These findings support agency model predictions that optimal compensa-
tion contracts balance risk sharing against incentives for division managers
with business unit responsibility. They also demonstrate that additional
factors beyond risk–such as, decision-making authority over project
selection–are important determinants in the provision and design of
incentives and worthy of further empirical study.
APPENDIX AI
Sample Representativeness
I evaluate the representativeness of the sample by comparing key financial measures
of the survey participants to a matched sample from Compustat. I begin by matching
each firm in the Hewitt dataset to the Compustat firm that is closest in sales within its
two-digit SIC industry in the year the firm joins the sample. I then perform Wilcoxon
signed rank tests to compare the Hewitt firms with the matched firms. While the firms in
the Hewitt dataset are, on average, slightly larger in sales than the matched sample,
I found no statistically significant difference in employment and profitability (return on
sales).27 I also found no statistically significant difference in sales growth, employment
growth, or annual changes in profitability for all sample years. In sum, while the Hewitt
27
The Hewitt firms are larger in sales than the matched sample of firms because in a number
of the cases, the Hewitt firm is the largest firm in the industry thus forcing me to select a matched
firm smaller in size.
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194 JULIE WULF
firms are larger (measured by sales) on average than the matched sample, there is little
additional evidence that these firms are not representative of the population of
industrial firms that are leaders in their sectors.
I also calculate financial measures for the sample of Compustat firms with 10,000
employees or greater over the period from 1986 to 1999 (excluding firms operating in
financial services). I find that, on average, survey participants are more profitable, but
growing at a slower rate relative to the sample of large Compustat firms. Specifically,
the sample average return on sales for survey participants is 17.8% versus 15.7% for the
sample of large Compustat firms and the average sales growth is 5.7% vs. 7.4%. This is
consistent with the observation that the firms in the sample are likely to be industry
leaders (hence slightly more profitable) and also large (hence the slightly slower
growth). To sum up, the survey sample is probably most representative of Fortune 500
firms.
APPENDIX AII
Group CEO
Division CEO
Plant Manager
Position Descriptions
1. Chief Executive Officer (CEO). The highest executive authority in the
corporation. Reports to the Board of Directors. May also be Chairman or
President.
2. Chief Operating Officer (COO). The corporation’s second in command,
provided the person’s span of responsibility is as broad or almost as broad as
the Chief Executive’s, and provided he or she has line rather than staff or
advisory responsibility. This person may be the President if the Chief
Executive Officer is the Chairman of the Board.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES 195
3. Group Chief Executive (or Group Manager). The highest authority in the
group. A Group is the highest level of multiple profit center linking the
Corporate Chief Executive Officer or Chief Operating Officer directly to two
or more single profit center units (divisions).
4. Division Chief Executive (or Division Manager). The highest authority in the
division. A Division is the lowest level of profit center responsibility for a
business unit that engineers, manufactures, and sells its own products.
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