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1.2. LITERATURE REVIEW 5 along two lines. First, RPE can provide the owner/top management with more complete information about the performance of the manager. This makes the performance evaluation less ‘noisy’. Second, RPE can reduce the room that the employee has to behave opportunistically. In this section, the mechanics of both the noise-reduction and opportunism-mitigating properties of RPE are introduced. Relative Performance Evaluation has been recognized in the literature primarily for its noise-reduction properties (Holmstrom 1982). Noise in the performance evaluation is caused by factors beyond the employee’s control that affect his measured performance. With noisy performance measures, factors beyond the control of the employee influence whether he reaches his performance target. This external influence reduces the quality of the performance evaluation, which aims to reward the employee for his provision of effort, not for uncontrollable events. Reasoning from an analytical agency theoretical tradition, Holmstrom (1982) proves that RPE reduces noise in the evaluation by incorporating information about peer performance into the performance contract between the owner/top management (in agency terminology, the principal) and the employee/middle manager (designated as the agent in this relationship). The performance of the reference group is informative about the quality of the agent’s performance, due to shared exposure to the uncontrollable events. Comparing the performance of the agent to the reference group partially filters out the effects of external uncontrollable factors. As a result of this noise reduction, RPE improves the quality of performance evaluation. Example Consider the hypothetical situation of a sales manager at the Japanese guitar manufacturing company ‘Ibanez Guitars’ in the early 1990s. Due to the increasing popularity of electronic dance music, playing the guitar became less popular. As a result, guitar sales dropped, and Ibanez’s previously healthy company profits slowly vanished. The external event (the changing musical preference) affected the performance evaluation of Ibanez’s sales manager, who was rewarded based on his sales revenue. The changing music scene did not only affect Ibanez’s performance. Other guitar companies suffered from dropping revenues and profits too. The performance evaluation of the manager, which compared his actual revenue to his sales budget, was noisy. This noise was due to the impact of external events over which the manager had no control. This situation was not motivating for the sales manager because his performance evaluation indicated decreasing performance every year, no matter how much effort he put in. However, if the superior of Ibanez’s sales manager had taken peer performance into account when evaluating the manager, the performance evaluation would have given a more accurate impression of the sales manager’s efforts. By judging the manager’s relative performance (i.e., his performance compared to his peers), the evaluation would be insulated from the effects of society’s eroding musical taste.
6 CHAPTER 1. GENERAL INTRODUCTION The second explanation for RPE is the opportunism-mitigation perspective. The opportunism-mitigation perspective relates to the way in which performance standards are determined. Murphy (2001) distinguishes between two main ways in which standards can be set: 1) they can be determined in an internal, administrative process; or 2) they can be externally determined. The difference between these alternatives lies in the extent to which employees can influence the target level (Murphy 2001). Internally determined standards include standards based on prior-year performance and standards derived from company plans or budgets. Such standards are affected by managers’ actions, and can have dysfunctional effects. For example, when 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 through an increased standard in the next period (Murphy 2001). In a similar vein, 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 managers’ actions because the difficulty of the standard is based on something outside the sphere of influence of the manager (e.g., it is based on market conditions or peer performance). RPE is an example of such an externally determined performance standard, because it incorporates information about the performance of an external reference group of agents. The performance of an industry peer group lies well outside the sphere of influence of the manager, yet it determines his performance target. RPE-based targets are not subject to the prior year’s performance, to negotiations between the evaluated manager and the top management of the firm, or to any other factor that the evaluated manager can easily manipulate. These considerations suggest that the room for managerial opportunistic behaviour can be delimited by incorporating the performance of a reference group of agents into the compensation plan and that RPE can aid in the standard-setting process. Throughout the thesis, I motivate and test the use of RPE with the two perspectives presented above. 1.2.2 Empirical Results on RPE Despite a promising theoretical basis, the empirical literature, focusing mainly on executive compensation praxis, provides inconclusive evidence on the empirical relevance of RPE theory. Both Jensen & Murphy (1990) and Aggarwal & Samwick (1999) find that RPE is not a prominent feature of executive compensation contracts. Antle & Smith (1986) find weak support for RPE use in the executive compensation contracts of 16 firms in a sample of 39 firms with longitudinal data from 1947 to 1977. Also Liu & Stark (2008) find mixed support for RPE amongst 169 UK non-financial listed companies. They provide evidence for the presence of RPE in the design of board compensation based on stock market returns, but they find no relation between cash compensation of the board and peer group
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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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3.4. 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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4.4. 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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