Smeal College of Business Pennsylvania State University Managerial Accounting B A 521 Professor Huddart Incentives and Managerial Compensation 1 Overview Managers may be considered agents of the firm s owners or principals In large companies the principal agent relationships are hierarchical A CEO is employed to manage the firm in the shareholders interest The CEO is thus the shareholders agent Divisional Managers in turn are agents of the CEO the Plant Manager is an agent of the Production Division Manager and so on Each link involves a principal and an agent with the former delegating substantial authority for making decisions to the latter In every principal agent relation there may be a conflict of interest between the principal and the agent For example the owner might want the manager to work hard and avoid unnecessary expenses so that the owner s surplus or profit may be high But the manager may not want to work hard to increase the owner s surplus He may choose to use the company s money to pursue pet projects and enjoy other perquisites such as expensive office furniture and first class travel Such a conflict of interest can often be reduced with an incentive scheme which aligns the interests of principal and agent The owner for instance can base a CEO s compensation on company profit or she can offer him shares of the company The CEO can then choose an incentive scheme for every divisional manager based on company profits or performance evaluation of the division which may in turn be based on output costs divisional profits ROI etc This note is about the structure and design of incentive schemes We shall be concerned with description of incentive schemes basic principles and issues governing the design of incentive schemes Based in part on notes by Nahum Melumad and Stefan Reichelstein c Steven Huddart 1995 2009 All rights reserved www personal psu edu sjh11 B A 521 2 Incentives and Managerial Compensation Evaluation and Incentives Basic Principles Consider the manager of a factory An owner s return on investment in the factory depends on many factors For example the market price of raw materials and finished goods and the number of equipment breakdowns will affect the factory s profit and the owner s return These factors will cause the performance of the firm to be uncertain The owner s return will also depend to some extent on how hard working and or talented the manager is If the manager works hard i e if he can keep the machinery in good condition react quickly to breakdowns treat workers well and maintain discipline etc his effort will be productive in the sense that it will increase the overall probability of good performance Outstanding effort on the manager s part however will not necessarily result in good performance because factors beyond the manager s control such as external price fluctuations or deficient raw material supply may make bad performance inevitable In this situation how should the manager be paid by the owner One principle to which many firms have traditionally adhered is that the manager should be responsible only for those dimensions of performance he can control Since the firm s good performance cannot entirely be guaranteed by the manager he should not be held responsible for nor should his pay depend upon factors he cannot control We refer to this as the controllability principle 3 Huck s Problems Well then says I what s the use you learning to do right when it s troublesome to do right and ain t no trouble to do wrong and the wages is just the same I was stuck I couldn t answer that So I reckoned I wouldn t bother no more about it but after this always do whichever come handiest at the time The Adventures of Huckleberry Finn Mark Twain 1884 Beyond a certain point Huck does not like to work If every week Huck put in just forty hours did not work too hard during any one of those hours and took a reasonable paycheck home every Friday Huck would be a happy Page 2 Incentives and Managerial Compensation B A 521 guy Sadly Huck must do some things he finds unpleasant and hard in order to maintain his standard of living Huck will not do these things unless he thinks the rewards outweigh his distaste for those activities Scenario 1 Risk Aversion Huck makes widgets in Miss Watson s factory The number of widgets produced depends partly on Huck s effort and partly on random events Huck can work hard experience bad luck and widget output will be low Or Huck could shirk his duties but with good luck widget output is high Ideally Huck always works diligently On average if Huck is diligent widget output is satisfactory Page 3 B A 521 Incentives and Managerial Compensation Case 1A Miss Watson observes exactly how hard Huck works should Miss Watson compensate Huck Consider How a salary a bonus based on the effort Huck exerts a bonus based on the number of widgets produced Case 1B Miss Watson does not know exactly what Huck does She can make inferences about Huck s effort from widget output Huck is risk neutral How should Miss Watson compensate Huck Consider a salary a bonus based on the number of widgets produced What does it mean if the bonus per widget is equal to the selling price of widgets and the salary is negative Can you give a realistic example that corresponds closely to Case 1B and the salary is negative Case 1C Huck is risk averse 1 Miss Watson does not know exactly what Huck does How should Miss Watson compensate Huck Consider 1 Informal interpretation of risk aversion Holding the expected amount of pay constant Huck dislikes pay plans that have higher variances But Huck may prefer a high variance high mean pay plan to a low variance low mean pay plan Page 4 Incentives and Managerial Compensation B A 521 a salary a bonus based on the number of widgets produced Consider how output and associated risks are shared between Miss Watson and Huck in each of these examples Do pay plans exist that make Miss Watson and Huck both better off than others What is the source of such improvements in Miss Watson s and Huck s welfare Scenario 2 Controllability Informativeness Huck is risk averse Miss Watson does not know exactly what Huck does In addition to the number of widgets produced Miss Watson has some other data that is informative of Huck s effort One interpretation of this other information could be that it is an accounting report How should Miss Watson compensate Huck Consider a salary a bonus based on the number of widgets produced a bonus based on