BMGT – Management

9. Incentive compensation and Performance evaluation

Dr. Le Minh Hanh | Winter semester 2023/24

Organizational structure – to recall

Organizations are like three-legged stools

1. Decision rights assignment – who gets to make what decisions?
2. Rewards – How are people rewarded for meeting performance goals?
3. Performance evaluation – What are the key performance measures
used in the organization?

Decision Rights
Assignment Rewards Performance Evaluation

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 Outline

• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

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 Outline

• Basic incentive problems and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

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 Incentive problems

 Principal – agent issues:

 Information asymetries
 Incentive problems
 Incentive problems exist across different hierarchical levels (principal –
agent)
 Challenge in designing organization: To maximize the rationality of
decision makers with sufficient relevant information and appropriate
incentives

VGU I VIETNAMESE-GERMAN UNIVERSITY

13.11.2023
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Incentive pay

Any compensation contract that rewards employee for good performance

or punishes employee for poor performance

6 13.11.2023 VGU I VIETNAMESE-GERMAN UNIVERSITY

 Incentive program at Du Pont

• In 1988 Du Pont`s fibers division introduced for each employee a so

called „risk pool“.

• Idea: Employees place 6% of annual pay to the pool. If the business

exceeded its profit goals for the year, the employees would receive a
multiple of the at-risk amount. If not, the employees would lose the
money.

• In 1990 the program was cancelled.

• Reason:

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 Incentive Compensation Program at Safelite

• Biggest wind shield installer in the US.

• In 1994 the CEO introduced a piece rate at Safelite (before, fixed
hourly wage): Employees receive a pay according to the amount
of installed wind shields ( $ 20 per piece).
• Workers are also guaranteed to receive a fixed wage of $ 11 per
hour.
• Result: perfomance incresses on average by 44%
. Roughly half of the increased performance is explained by stronger incentives within the commpany
(overcoming moral hazard)
The other part: better employees are attracted by the company (overcoming adverse selection)

Edward Lazear: „Performance Pay and Productivity,“ American Economic Review 90, 2000,
1346-1361

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 Outline

• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

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 Basic incentive problem

• You are the owner of a company with one employee (Erwin).

• The firm`s benefit from Erwin´s effort e is
B = 100e
• Erwin`s costs of effort are
C = e2
• Erwin`s utility function with respect to income I is
U = I – e2
• Erwin's reservation utility is 1000 dollars, then the wage the firm
should pay him is: $1000 + e2

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 Verifiable effort

• Assume you can observe Erwin`s effort and you can verify it in
court.
• Because of the outside option the firm has to pay Erwin at least
1000 + e2
• An incentive compensation is not necessary, because you can
compensate directly for the effort or effort is contractible. That
means Erwin receives a fixed payment of 1000 + e2

• Question:
- Which effort should you provide in the contract?
- How should you pay Erwin?

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 Optimal effort – to maximize firm’s profit

costs/
benefits of effort
benefits
100e

5000
profit costs of effort
3500 1000 + e2
wage

1000

e*= ? e
Benefits - cost = 100e - (1000+e^2) = Max Profit
e*=50

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 Unverifiable effort

• Assume that you can not verify the effort but you pay a fixed salary
(contractually binding) of 3500.
• Is Erwin motivated to choose e* = 50 ?
• …

Reason

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 The role of ownership

• You sell the company to Erwin for 1500 Euro.

• Does Erwin have an incentive to exert optimal effortl?
• Erwin`s utility ?
 Erwins optimal effort = ?. U = (100e - 1500) - e^2
(U = п)

Result
• Ownership is the solution for the incentive problem.
• The transfer of ownership is, however, only in part possible or desirable (reason: wealth
constraints, team production, risk aversion)

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 Outline

• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

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 Incentive compensation

• Assume the output of Erwin´s work is

Q = 100e + μ
where μ is a random variable with the expected value 0 and
variance σ2.
• The output is observable and verifiable but the effort and
uncertainty are not.
• You provide the following incentive contract to Erwin

W + βQ = W + β(100e + μ)

with the fixed wage W and a proportion β (0 ≤ β ≤ 1) of the output.

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 Graphical illustration: Employee’s effort choice
W = 1000, β = 0.2

costs/
benefits
costs e2

expected compensation:
1000 + 20e
1200

1000

e*= 10 e

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 Graphical illustration:
W = 2000, β = 0.2

costs/ expected compensation:

benefits 2000 + 20e
costs e2

2000

1000

e*= 10 e

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Graphical illustration:
W = 1000, β = 0.3
expected compensation:
1000 + 30e
costs/
benefits
costs e2

1000

e e* e

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 Incentive compensation

Result
• Fixed wages that are independent of the effort do not provide
incentives to exert effort.
• If the agent receives a proportion (β) of the output, he has an
incentive to exert effort because his wage (and thus his utility)
depends on his effort.
• The stronger the dependancy, the higher the incentives and the
higher the resulting effort.
• But with the proportion of the output the agent also has to bear
part of the risk (random effect μ). Risk-averse agents do not like it
and have to be compensated for bearing so much risk.

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 Incentive compensation

Result
• The optimal incentive contract (W*, β*) is balancing the advantages
(incentive effect) and the disadvantages (wage costs, risk bearing
of the proportion of output)
• The effort level that is induced by incentive contracts is in general
lower than the effort level that would be optimal if effort is
observable and verifiable (« first best »).
• The statement, that the maximum incentives provide the best
result, is not correct.

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 Incentive compensation

Result
• Therefore: Incentives are effective, if…

1. the output of work depends strongly on the effort (productivity of

the employee).
2. the employee is not too risk-averse.
3. the risk, based on other factors, that can not be influenced by
employees, is not too high
4. the efforts of employees respond sufficiently to changes in
incentives (costs of effort ).
5. the output is well measurable.

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 Incentive compensation
Dupont?
Result
• Therefore: Incentives are effective, if…

1. the output of work depends strongly on the effort (productivity of

the employee).
2. the employee is not too risk-averse.
3. the risk, based on other factors, that can not be influenced by
employees, is not too high
4. the efforts of employees respond sufficiently to changes in
incentives (costs of effort ).
5. the output is well measurable.

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 Incentive compensation
Safelite?
Result
• Therefore: Incentives are effective, if…

1. the output of work depends strongly on the effort (productivity of

the employee).
2. the employee is not too risk-averse.
3. the risk, based on other factors, that can not be influenced by
employees, is not too high
4. the efforts of employees respond sufficiently to changes in
incentives (costs of effort ).
5. the output is well measurable.

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 Forms of incentive compensation

• In the principal-agent model the incentives result from β.

• In reality a lot of forms of incentive compensation are possible:
- Piece rate
- Commissions
- Bonus, promotion, title, bigger office, etc. as a reward for good
performance
- Tournaments (e.g. incentive travel)
- Employee share scheme
- Punishment (wage cuts, dismissal, …) for bad performance
- Deferred compensation

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 Selection effect of incentive contracts

• Starting point: Employees have diverse productivity

- Erwin‘s marginal productivity= 100  Q (E) = 100e
- Armin‘s marginal productivity= 90  Q (A) = 90e
- Both have effort costs of C = e2.
• Incentive contract W = 1000, β = 0.2

• Who will accept? Who will decline?

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 Selection effect of incentive contracts

• If both have an outside option of 1090, Erwin will take the contract
but Armin will not.

Result
• Incentive contracts attract more productive employees.
• Reason: They profit (ceteris paribus) more from the incentive
contract and therefore it is more attractive for them

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 Do incentive contracts work?

• Critics claim that incentive contracts are bad and do not work.
• Reason:

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 Issues in Developing a Pay Structure

From Noe et al. (2011)

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 Outline

• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

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 Performance evaluation methods

- Objective performance evaluation

- Relative performance evaluation

- Subjective performance evaluation

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 Objective performance evaluation

• Remember: Principal - Agent model

• Output depends on the agent`s effort and a random component.
Q = αe + μ
μ random component, α agent`s marginal productivity.
• Output is observable and verifiable while effort and random
component are not.
• Compensation contract
W + βQ = W + β(αe + μ )
fixed wage W and sensitivity of pay to performance β (0 ≤ β ≤ 1).

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 Objective performance evaluation

• Productivity is difficult to observe and therefore the principal has to

estimate it. (Problem: Output depends on e as well as on μ .)
• Two options:
- Time and motion studies
- Historical data on past performance
• Problems:

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 Ratchet effect

• If future standard of performance depends on the actual

performance, an incentive is provided that leads to a low
actual performance.
• Example:
-In an unexpected good year, sales are deferred into the next
fiscal year.
• Possible solution: Job rotation

• There is also a risk of the ratchet effect at Lincoln Electric: If high

productive employees earn a lot, the piece rate should not be
adjusted until production methods or processes are changed.
 Commitment important!

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 Measurement costs

• Basically: The stronger the incentive component, the more

important to measure output and effort as exactly as possible.
 Compensation and evaluation are two legs of the same stool!

• Sometimes output is not directly measurable

• Costs are incurred when generating performance measures
• Measured output needs to be highly correlated with firm value.
Otherwise agents have an incentive to game the system
(«gaming »)! Only because something is measureable it is not
necessarily useful! (Example: Students whose Bachelor thesis is
graded by the amount of pages)

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 Relative performance evaluation

• A possibilty to increase the exactness of a performance evaluation

is to consider the information about the other colleagues` output.
 Relative performance evaluation
• Advantage:
-Exogenous, random influences are filtered out.
-Therefore, the risk that is transferred through incentive
compensation is reduced.

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 Relative performance evaluation

• Concrete: Q is the average output of the benchmark group.

• Compensation contract
W + β(Q – λQ)
• The optimal level of λ is determined as follows.

Cov(Q, Q)
 λ* =
Var(Q)

• Example: λ* = 1, Q = 43, Q = 40  variable compensation = 3β.

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 Cov(Q, Q)
Interpretation of λ* =
Var(Q)
Cov(Q, Q)
• The output of the benchmark group Q should be considered only if
this is correlated with Q.
• The stronger the correlation, the stronger the weight of relative
performance.

Var(Q)
• If the output of the benchmark Q is noisy, it should not be
considered that strongly.
• The higher the variance Q, the weaker the weight of relative
performance.

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 Problems of relative performance evaluation

• There is not always a (useful) benchmark group.

• Differences between stores are potentially too big.
• Even if there is a statistical relation, it does not mean that a
comparison makes sense from an economic perspective.
• Resistance of employees is to be expected.
• Employees have an incentive to collude and to sanction the so
called « rate busters » who raised the average (social
pressure, sabotage, …).
• Incentive to recruit only « low performers » to have a benchmark
group that is as favorable as possible.

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 Subjective performance evaluation

• Subjective performance evaluation typically refers to „soft“ and

difficult to measure aspects of effort that are nevertheless
important.

• Standard-Rating Scale
1 2 3 4 5
„Cooperates with colleagues“
„Shows self initiative“
„Works problem oriented“

• Goal-Based System, MBO

- A set of goals for the year.
- At the end of the year the extent to which each goal has been
met is checked.
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 Problems of subjective performance evaluation

• Main problem: It is subjective.

• Frequent bias:
- Every employee is more or less evaluated equally.
 Distribution is „too compressed“
- Supervisor is too mild.
 Evaluations are „too good“
- Direct favoritism
• Solution (?): Grade to a fixed distribution
• Further (resulting from above) problems:
 Incentive for exerting influence activities.
 Uncertain career perspectives. Can employees be confident that
supervisors evaluate good performance appropriately?

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 Outline

• Basic incentive problem and the role of ownership

• Incentive contracts and principal-agent model
• Performance evaluation methods

Q&A

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