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1.1. THE PROBLEM OF GOAL ALIGNMENT 3 individual employee. Despite the variety of performance metrics, it is often very difficult to determine a performance measurement system that is highly congruent with the owner’s goals. The second incentive system design difficulty is determining the strength of the payperformance relationship. This aspect relates to the question of how large of a reward an employee should receive if his performance metric increases. The economics literature shows that providing ‘high-powered incentives’ (or large rewards) increases the risk of incongruent behaviour if the performance metrics are not perfectly undistorted (which is almost always the case). For example, the possibility to obtain a large reward can provoke fraud with the performance metrics or other misrepresentations of performance. To avoid the risk of rewarding the wrong behaviour, the economics literature generally concludes that organizations should delimit the strength of the pay-for-performance relationship (Baker 2002). The third and final design element is the determination of the performance target level. To achieve goal alignment by using an incentive system, it is essential for organizations to make sensible choices regarding the difficulty of the performance target. In business practice, this seems to be a challenging task. Conventional wisdom suggests that, for optimum motivation, targets should be set sufficiently (but not excessively) high, so that they are more often missed than not (Merchant & Manzoni 1989:554). However, Merchant and Manzoni find empirically that, on average, organizations set their targets too low, at ‘relatively easy’ levels where they are very likely to be achieved. Setting performance targets at suboptimal levels harms the realization of organizational objectives. Relatively easy targets do not optimally motivate employees, because they do not require employees to maximize their efforts. Even with lower effort the targets can be achieved. On the other hand, overly challenging targets also do not optimally motivate the employee. Then, it becomes highly unlikely that the employee will achieve his target and receive his reward, which reduces his incentive to provide effort. This too unnecessarily limits the realization of organizational goals. Whereas the choice of performance metrics and the pay-performance sensitivity aspects of the incentive structure design are widely studied in both the economics and accounting literatures, the target-setting element is currently understudied (Ittner & Larcker 2001, Murphy 2001, Dekker et al. 2012). Consequently, we know very little about how organizations determine the difficulty of their performance targets. This is unfortunate because the performance standard choice is a consequential dimension of the incentive structure. This doctoral dissertation fills this gap by focussing on the determination of the performance standard level. According to Murphy (2001), two main ways for performance target determination can be distinguished. First, targets can be internally determined. The term ‘internally determined’ refers here to standards that are directly affected by employee actions in the current
4 CHAPTER 1. GENERAL INTRODUCTION or prior year (Murphy 2001:245). For example, next year’s revenue target can be based on last year’s sales. Another example is internal negotiations between higher and middle management about the target’s difficulty. Second, targets can be externally determined, referring to standards that are less easily affected by actions from employees who are involved in realizing the target. Externally determined targets include: timeless performance standards, companywide cost of capital, and the use of a peer group benchmark. My research project focuses on one method of ‘external’ target determination, namely Relative Performance Evaluation (or RPE). RPE is a means to determine the performance standard by using a peer group benchmark: the performance of the employee (or: manager) is compared to the performance of a reference group. This reference group typically consists of individuals facing similar tasks and circumstances. For example, a manager’s performance can be compared to the five best performing managers within the organization or to a group of important competitors operating on the same market. The idea behind this comparison is that the performance of the reference group is informative for the performance potential of the employee. The performance potential of the employee functions as an (explicit or implicit) performance target against which his actual performance is evaluated. This thesis’ overall research topic is Relative Performance Evaluation. I study the use and effectiveness of RPE at the organizational level of middle managers. Based on prior literature, I argue that RPE has a sound theoretical basis, but lacks overall conclusive empirical support. My research topic is further motivated in the remainder of this introductory chapter. First, I review the literature on RPE in section 1.2. Then, in section 1.3, I introduce the research questions of this project and discuss how these research questions contribute to the literature. Finally, section 1.4 describes the structure of the entire thesis. 1.2 Literature Review This section addresses the current theoretical and empirical literature on RPE. In section 1.2.1, I discuss two theoretical perspectives on RPE that explain why organizations might use it. Subsequently, in subsection 1.2.2, I present what the literature suggests about RPE’s empirical validity and to what extent we find empirical support for the presented theoretical explanations. 1.2.1 Theoretical Explanations for RPE Use The extant RPE literature argues that the adoption of RPE practices can be a useful endeavour for several reasons. Prior studies argue for the use and effectiveness of RPE
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2.6. CONTRACTIBILITY MIMIC MODEL (A
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2.6. CONTRACTIBILITY MIMIC MODEL (A
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2.7. ANALYSES FOR FOR-PROFIT BUS (A
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Chapter 3 Does Relative Performance
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3.1. INTRODUCTION 61 Holmstrom’s
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3.2. DEVELOPMENT OF THE MODEL 63 3.
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3.2. DEVELOPMENT OF THE MODEL 65 RP
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3.3. SAMPLE AND MEASUREMENT 67 3.3
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3.3. SAMPLE AND MEASUREMENT 69 3.3.
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3.3. SAMPLE AND MEASUREMENT 71 Tabl
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3.3. SAMPLE AND MEASUREMENT 73 Tabl
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3.4. ANALYSES 75 3.4 Analyses This
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3.4. ANALYSES 77 Table 3.9: Pearson
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3.4. ANALYSES 79 Table 3.10: Result
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3.4. ANALYSES 81 Table 3.11: Result
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3.4. ANALYSES 83 Larcker & Rusticus
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3.5. CONCLUSIONS AND DISCUSSION 85
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Chapter 4 Does Relative Performance
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4.1. INTRODUCTION 89 Moreover, chap
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4.2. DEVELOPMENT OF THE MODEL 91 is
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4.2. DEVELOPMENT OF THE MODEL 93 Sp
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4.3. SAMPLE AND MEASUREMENT 95 4.3
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4.3. SAMPLE AND MEASUREMENT 97 To i
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4.3. SAMPLE AND MEASUREMENT 99 of R
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4.3. SAMPLE AND MEASUREMENT 101 Tab
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4.4. ANALYSES 103 Table 4.8: Items
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4.4. ANALYSES 105 RPE use ✻ Posit
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4.4. ANALYSES 107 The model does sh
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4.4. ANALYSES 109 RPE and RFMO. Mor
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4.4. ANALYSES 111 room for manageri
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Chapter 5 Conclusion 5.1 Summary, C
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5.1. SUMMARY, CONCLUSIONS AND DISCU
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5.2. IMPLICATIONS FOR PRACTICE 125
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5.3. LIMITATIONS AND SUGGESTIONS FO
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Appendix Overview of Questionnaire
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Q5 How often do the following thing
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Q14 When serving your clients, how
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Q23 Please indicate whether you agr
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Noise Q34 NOISE (primary measure) P
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References 1. Abernethy, M.A., Bouw
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26. Diamantopoulos, A. & Siguaw, J.
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52. Himmelberg, C.P. & Hubbard R.G.
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83. Towry, K. 2003. ‘Control in a
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148 beïnvloeden, veroorzaken ruis
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Biography Hilco van Elten (1979) ho
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