Selecting Performance Measures: Managing Trade-offs between Costs • 417
is another. Disagreements over such charges grew heated, and much of top management’s time was consumed in mediating these disputes. Some divisions also began engaging in “channel stuffing”—a practice in which orders from other parts of the company were rushed to be filled at the end of each month. This allowed the division filling the order to recognize the revenue from this sale (and thus increase profits), but it led to problems with excess inventory. Internal strife became so severe that the firm eventually elected to discontinue the division-based bonuses and instead make profitsharing payments based on the performance of the entire firm.
A manager designing pay plans should identify the activities an employee can undertake to improve measured performance and then ask how well this set of activities overlaps with those the firm would like the employee to pursue. Are there activities important to the firm that are not reflected in measured performance? Are there activities that improve measured performance that the firm does not want employees to pursue? The larger these sets of activities, the lower the efficacy of pay-for-performance based on the measure in question.
Organizations may respond to this problem in a number of ways. First, they may elect not to use any pay-for-performance incentives. If the performance measures are of poor quality, the firm may be better off paying fixed salaries and instructing employees in how to allocate their efforts toward various activities. While this approach does not motivate employees to exert extra effort on the job, it has the virtue of not motivating them to ignore tasks that are important but difficult to measure. Most U.S. public schools offer little or no compensation based on teacher performance. The problems of identifying good performance measures may be so severe that the best outcome may be to rely on teachers’ inherent concern for students’ educational progress.
Firms may also deal with limitations in measurement through careful job design. Grouping tasks according to ease of measurement can mitigate the multitasking problem. Suppose, for example, that activities A and B are easy to measure but activities C and D are hard to measure. If, on one hand, tasks A and C are assigned to one employee and B and D are assigned to another, the firm faces the multitask problems identified earlier. If, on the other hand, the firm assigns tasks A and B to one employee and C and D to the other, it can provide strong incentives for tasks A and B without pulling focus away from C and D.
Finally, firms can augment explicit incentive contracts with direct monitoring and subjective performance evaluation. Recalling the Lantech example, it may be difficult to base an explicit contract on whether a manager is fighting “too hard” to allocate overhead to another division. But it may be relatively easy for a CEO or other top manager to subjectively assess whether this is going on. If such assessments can be incorporated into the determination of overall compensation, subjective evaluations of performance can mitigate the problems we have described. Critics of U.S. public schools contend that the tenure system and rigid pay and promotion criteria limit the ability of school administrators to reward teachers based on subjective evaluations.
SELECTING PERFORMANCE MEASURES:
MANAGING TRADE-OFFS BETWEEN COSTS
The foregoing discussion identifies three features of a good performance measure:
•A performance measure that is less affected by random factors will allow the firm to tie pay closely to performance without introducing much variability into the employee’s pay.
418 • Chapter 12 • Performance Measurement and Incentives
TABLE 12.3
Jobs with Varying Ease of Performance Measurement
Job for Which Performance Is Relatively Easy to Measure
Job for Which Performance Is Relatively Difficult to Measure
Harvesting grapes |
Vintner |
Bicycle messenger |
Flight attendant |
Pharmaceutical sales representative |
Pharmaceutical research scientist |
Manager of advertising campaign |
Manager of customer service center |
|
|
•A measure that reflects all the activities the firm wants undertaken will allow the firm to use strong incentives without pulling the employee’s attention away from important tasks.
•A performance measure that cannot be improved by actions the firm does not want undertaken will allow the firm to offer strong incentives without also motivating counterproductive actions.
Unfortunately, performance measures meeting all three of these criteria are rare. In Table 12.3, we highlight a selection of jobs for which performance is relatively easy to measure, and compare this to another selection for which performance is relatively more difficult to measure. In Table 12.4, we list performance measures that might be used for various jobs, and identify some problems associated with each.
A firm’s search for the best performance measure involves trade-offs among the costs identified earlier. Consider the question of whether to use “absolute” or “relative” measures of an employee’s performance. A relative measure is constructed by comparing one employee’s performance to another’s. If the sources of randomness affecting the two employees’ individual performance exhibit a positive correlation, basing each employee’s pay on the difference between the individual performance measures will shield employees from risk.17 Hence, a firm using relative performance measures may be able to pay a smaller risk premium and therefore use stronger incentives. But relative measures can exacerbate multitask problems. Consider the possibility that one employee might be able to take actions that reduce the productivity of another employee. Clearly, the firm does not want to encourage this activity; however, relative performance evaluation directly rewards it. In determining whether to use relative rather than absolute performance measures, firms must weigh the possible reductions in risk against potential increases in the incentive to undertake counterproductive actions.
In a well-known application of this idea, the fictional real estate salesmen in the play Glengarry Glen Ross were compensated based on relative performance. Their boss announced that the first prize in a sales contest was a Cadillac El Dorado. Second prize was a set of steak knives. Third prize was “you’re fired.” This scheme was excessively harsh, but it did reward hard work and ability and shielded the salesmen from correlated risks (such as macroeconomic fluctuations). It also led one salesman to do something entirely counterproductive—he stole the list of promising leads.
Similar considerations enter into the choice between narrow or broad performance measures. An example of a narrow measure might be the number of pieces of output produced by an individual employee. A broad measure might be the accounting profits of the plant where the employee works. The broad measure has the advantage of rewarding the employee for helping coworkers or for making suggestions that
Selecting Performance Measures: Managing Trade-offs between Costs • 419
TABLE 12.4
Performance Measures of Varying Quality for Different Jobs
Job Description |
Performance Measure |
Discussion |
Baseball pitcher |
Number of games won |
Depends on how team’s batters |
|
|
perform when pitcher is pitching; |
|
|
this measure is therefore affected |
|
|
by random factors beyond the |
|
|
pitcher’s control. |
|
Opponents’ batting |
May motivate pitcher to pitch too |
|
average |
cautiously. Pitcher would rather |
|
|
issue a walk (which does not count |
|
|
against batting average) than |
|
|
possibly surrender a hit. |
|
Earned run average |
Less noisy than number of wins, and |
|
|
motivates pitcher to take any action |
|
|
that will prevent other team from |
|
|
scoring runs. |
Police officer |
Crime rate on beat |
Crime rates vary considerably by |
|
|
neighborhood; this measure |
|
|
therefore depends on factors |
|
|
beyond the police officer’s control. |
|
Number of arrests |
Officer can make an arrest only if a |
|
|
crime has been committed; this |
|
|
measure therefore limits incentive |
|
|
to prevent crimes from being |
|
|
committed. |
|
Change in crime rate |
Less noisy than the level of crime, |
|
|
and motivates officer to take |
|
|
actions that reduce crime even if |
|
|
no arrest results. |
Local TV news |
Profits of station |
Profits depend crucially on the |
producer |
|
quality of network programming |
|
|
shown on the station; this measure |
|
|
may therefore be noisy. |
|
Number of journalism |
May motivate producer to overspend |
|
awards won |
on high-profile stories. |
|
Share of viewing |
Motivates actions that retain the |
|
audience retained |
potential audience; less noisy than |
|
when news comes on |
profits. |
|
|
|
improve the plant’s overall efficiency. However, the broad measure is also likely to be subject to more random factors. The broad measure depends on the actions of many workers and many sources of randomness; hence, linking an individual employee’s pay to this measure exposes that employee to considerable risk. A firm may therefore find it very costly (in terms of employee risk premiums) to use high-powered incentives based on broad measures. In determining whether to use the broad measure or the narrow one, the firm must weigh the benefit associated with “help” activities and extra suggestions against the cost of weaker incentives for individual effort. The firm
420 • Chapter 12 • Performance Measurement and Incentives
EXAMPLE 12.4 HERDING, RPE AND THE 2007–2008
CREDIT CRISIS
One of the clearest examples of how random factors can affect measured performance comes from the very top of most organizations. Pay for top executives like chief executive officers, chief operating officers, and chief financial officers is frequently tied directly to the price of the firm’s stock through grants of equity or equity-based instruments such as stock options.
The theory of financial markets suggests that the price of a firm’s stock will move up or down for a variety of reasons. Share prices are clearly affected by any news bearing directly on the firm’s future cash flow, but they are also affected by overall movements in the market. For example, during the late 1990s a major bull market pulled all U.S. share prices up by 25 percent or more annually. Even mediocre firms saw great gains in their share prices over this period. Similarly, the declining stock market during 2001 to 2002 saw nearly all firms’ share prices fall—even those of firms with good operating performance over the period. As a result, some analysts believe that a better performance measure might be the firm’s performance relative to competitors or market indices.
Jeff Zwiebel argues that while relative performance evaluation has some benefits, substantial costs are present as well.18 Zwiebel notes that relative performance evaluation could encourage “herding.” Herding is a phenomenon whereby individuals ignore their own information about the best course of action and instead simply do what everyone else is doing.
Zwiebel’s argument is this: Suppose a manager is likely to be fired when her firm’s performance is poor relative to industry rivals but will keep her job otherwise. Suppose also that the manager faces the following strategic choice: she can “follow the herd” by making strategic choices that are similar to those made by competitors, or she can adopt a new, promising, but untested strategy. Following the
herd means the manager’s performance is unlikely to be much different from that of rivals, and so she is unlikely to be fired. The contrarian strategy has a higher expected payoff than the herd strategy, but its newness means that there is at least some chance it will fail. If the contrarian strategy fails, the firm’s performance will lag the industry, and the manager will be fired. Under these conditions, the manager may well stick with the herd, even if she knows the potential returns to the contrarian strategy are high. As we noted at the start of this chapter, Merrill Lynch CEO O’Neal seems to have been comparing his firm’s trading performance to that of rivals. One reason for his insistence on matching Goldman may have been that his continued job security depended on achieving earnings similar to Goldman’s. Could this form of relative performance evaluation have led to herding on Wall Street? It is difficult to say for sure, but it is clearly the case that many, many financial institutions were actively involved in financing risky subprime mortgages. As housing prices rose through the late 1990s and early 2000s, mortgage default rates stayed low and these risky investments paid off handsomely. Any firm choosing not to play this risky game would show poor relative performance. Managers of such firms might begin to feel the heat from shareholders, as Zwiebel suggests.
Any manager with the contrarian strategy— taking, say, a short position in the subprime mortgage securities, betting that default rates will rise—would have incurred losses through the 2000 to 2006 period. But this strategy would have earned huge profits as house prices fell and the subprime mortgage market imploded in 2007. Would a contrarian manager have kept her job long enough to earn those profits? Or would the poor relative performance between 2000 and 2006 have led to that manager’s firing?
