Smeal College of Business Managerial Accounting: B A 521Pennsylvania State University Professor HuddartIncentives and Managerial Compensation1. OverviewManagers may be considered agents of the firm’s owners (or principals).In large companies, the principal/agent relationships are hierarchical. ACEO is employed to manage the firm in the shareholders’ interest. The CEOis thus the shareholders’ agent. Divisional Managers, in turn, are agents ofthe 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 formerdelegating substantial authority for making decisions to the latter.In every principal-agent relation, there may be a conflict of interestbetween the principal and the agent. For example, the owner might want themanager to work hard, and avoid unnecessary expenses, so that the owner’ssurplus or profit may be high. But the manager may not want to work hardto increase the owner’s surplus. He may choose to use the company’s moneyto pursue pet projects and enjoy other perquisites (such as expensive officefurniture 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, canbase a CEO’s compensation on company profit, or she can offer him sharesof the company. The CEO can then choose an incentive scheme for everydivisional manager, based on company profits or performance evaluation ofthe 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. Weshall 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/sjh11B A 521 Incentives and Managerial Compensation2. Evaluation and Incentives: Basic PrinciplesConsider the manager of a factory. An owner’s return on investment inthe factory depends on many factors. For example, the market price of rawmaterials and finished goods, and the number of equipment breakdowns willaffect the factory’s profit and the owner’s return. These factors will cause theperformance of the firm to be uncertain. The owner’s return will also dependto some extent on how hard-working and/or talented the manager is. If themanager 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 overallprobability of good performance. Outstanding effort on the manager’s part,however, will not necessarily result in good performance, because factorsbeyond the manager’s control (such as external price fluctuations or deficientraw 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 themanager should be responsible only for those dimensions of performance hecan control. Since the firm’s good performance cannot entirely be guaranteedby the manager, he should not be held responsible for, nor should his paydepend upon, factors he cannot control. We refer to this as the controllabilityprinciple.3. Huck’s ProblemsWell, then, says I what’s the use you learning todo right when it’s troublesome to do right andain’t no trouble to do wrong, and the wages isjust the same? I was stuck. I couldn’t answerthat. So I reckoned I wouldn’t bother no moreabout it, but after this always do whichever comehandiest at the time.The Adventures of Huckleberry FinnMark Twain, 1884Beyond a certain point, Huck does not like to work. If every week Huckput 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 happyPage 2Incentives and Managerial Compensation B A 521guy. Sadly, Huck must do some things he finds unpleasant and hard in orderto maintain his standard of living. Huck will not do these things unless hethinks the rewards outweigh his distaste for those activities.Scenario 1: Risk-AversionHuck makes widgets in Miss Watson’s factory. The number of widgetsproduced depends partly on Huck’s effort and partly on random events. Huckcan work hard, experience bad luck and widget output will be low. Or, Huckcould shirk his duties, but with good luck, widget output is high. Ideally,Huck always works diligently. On average, if Huck is diligent, widget outputis satisfactory.Page 3B A 521 Incentives and Managerial CompensationCase 1A: Miss Watson observes exactly how hard Huck works. Howshould Miss Watson compensate Huck?Consider:• 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 canmake inferences about Huck’s effort from widget output. Huckis 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 ofwidgets and the salary is negative?Can you give a realistic example that corresponds closely to Case 1B andthe “salary” is negative?Case 1C: Huck is risk-averse.1Miss Watson does not know exactly whatHuck does. How should Miss Watson compensate Huck?Consider:1Informal interpretation of risk aversion: Holding the expected amount ofpay constant, Huck dislikes pay plans that have higher variances. But, Huck may prefera high variance/high mean pay plan to a low variance/low mean pay plan.Page 4Incentives 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 Watsonand Huck in each of these examples. Do pay plans exist that make MissWatson and Huck both better off than others? What is the source of suchimprovements in Miss Watson’s and Huck’s welfare?Scenario 2: Controllability/InformativenessHuck is risk-averse. Miss Watson does not know exactly what Huckdoes. In addition to the number of widgets produced, Miss Watson has someother data that is informative of Huck’s effort. One interpretation of thisother information could be that it is an