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14 CHAPTER 2. RPE AT THE BUSINESS UNIT MANAGER LEVEL
2.1 Introduction
This chapter studies the use of RPE amongst business unit managers. RPE is a means to
determine performance targets relative to a reference group. Performance targets are an important
and consequential part of the incentive structure (Murphy 2001) and function as a
norm to which the performance of an employee is compared. According to economics-based
reasoning, setting targets at a difficult, yet attainable level helps to motivate employees in
such a way that they provide optimal and goal-congruent efforts.
However, determining the appropriate level for the performance targets can be difficult.
Factors both external and internal to the organization influence the target and its attainability.
External factors refer to events that originate from the environment of the
organization, such as rising prices or declining demand. If external events affect organizational
performance, they also affect whether an employee reaches his target. This external
influence makes the performance measures less informative about the employee’s efforts
and increases noise in the performance measurement. Noise mitigates the motivational
effects of an otherwise well functioning incentive system. Ultimately, noise harms the realization
of organizational goals. However, analytical research shows that RPE can reduce
noise and restore the relevance of the performance target (Holmstrom 1982). RPE compares
the employee’s actual performance to the performance of a reference group facing
partially the same external events. Peer performance helps to determine an explicit or
implicit performance target that is informative about the impact of external events. This
reduces noise in the performance evaluation, increasing the relevance of the performance
target and the quality of the performance evaluation (Holmstrom 1982).
Besides external events, factors that originate from within the organization can also affect
the performance target’s difficulty because of the way in which performance targets are
determined. Murphy (2001) argues that members of the organization can try to lower the
performance target if it is within their reach. Examples include negotiating easier targets,
or avoiding outperforming the target for this year to prevent more difficult targets
next year. Murphy argues that if the target-setting process does not lie within reach of
the evaluated employee, the target is better insulated against these kinds of opportunistic
behaviour. This is the case with RPE, where the performance target is based on the performance
of a peer group, external to the influence of the evaluated employee. Based on
this reasoning, Murphy claims that RPE can mitigate the room for opportunistic behaviour.
According to both of these arguments, RPE can be beneficial to the organization by improving
the relevance of the performance target. Despite this theoretical basis, the empirical
literature provides inconclusive evidence on the empirical relevance of RPE theory. For
example, both Jensen & Murphy (1990) and Aggarwal & Samwick (1999) find that RPE