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4.2. DEVELOPMENT OF THE MODEL 91
is the way in which performance standards are determined. Murphy argues that various
standard-setting processes differ in their vulnerability to opportunism. The performance
standard-setting process can assume two main forms: 1) standards can be determined by
some internal, administrative process; or 2) standards can be determined externally (Murphy
2001). The difference between these alternatives lies in the extent to which agents can
influence the target difficulty (Murphy 2001) 1 , as described earlier in this thesis. Internally
determined standards include standards based on prior-year performance and standards
derived from firm plans or budgets. Such standards are affected by managerial actions
and can have dysfunctional effects. For example, if standards are based on prior-year
performance, managers have an incentive to avoid unusually positive outcomes, because
good performance in the current period is penalized by an increased standard in the next
period (Murphy 2001). Similarly, budget-based standards provide incentives to negotiate
easy standards (Fisher, Frederickson & Peffer 2002) and disincentives to beat the budget,
especially in a regime of incremental budgeting (Murphy 2001). In contrast, externally
determined standards are less affected by managerial actions because the difficulty of the
standard is based on something outside the managerial sphere of influence (e.g. the target
is based on market conditions or peer performance). Murphy supports this theoretical
claim with empirical results. His data show more year-to-year variance in the bonus payouts
of top executives from companies using externally determined performance standards
than those of top executives from companies using budget-based and other internally determined
performance standards. This finding suggests that executives rewarded based on
internal standards are more likely to opportunistically smooth earnings than executives
rewarded based on externally determined standards (Murphy 2001:245).
RPE is an external standard-setting method (Murphy 2001:252). Under RPE, the performance
of the evaluated agent is compared with the performance of an external reference
group of agents 2 . This peer-comparison determines a (explicit or implicit) performance
standard to which the agent’s performance is benchmarked. Although the performance of
the peer group generally lies well outside the managerial sphere of influence, their performance
does constitute the evaluated agent’s performance target. This RPE-based target
is not subject to the business unit’s prior-year performance, to negotiations between the
business unit manager and the firm’s top management, or to anything else that can be manipulated
easily by the business unit manager. These considerations suggest that the room
for managerial opportunism can be delimited by incorporating the performance of a reference
group of agents into the compensation plan and that RPE can aid the standard-setting
process. As a result, RPE-based standards are less vulnerable to managerial opportunism.
1 Murphy (2001) notes that the distinction between internally and externally determined performance
standards is not dichotomous but rather one of degree. Even externally determined standards are manipulable
to some extent, especially when they are established for the first time and if major changes in the
environment force a modification (Murphy 2001:249).
2 ‘External’ means that the reference group is external to the business unit. However, the group is not
necessarily external to the firm. A reference group might consist of other business units inside the firm
that somehow face (some of) the same external conditions (e.g., they operate within the same market).