UMHS-LDP 1 Friday, November 14, 2003 Performance Measurement and Evaluation Questions and Answers...

UMHS-LDP1

Friday, November 14, 2003

Performance Measurement and EvaluationQuestions and Answers

How do (should?) organizations select performance measures for evaluating executives, business unit managers, other employees?

What are the comparative advantages or disadvantages of:• Financial versus non-financial measures

• Corporate or institution-wide versus localized measures

• Objective versus subjective measures

• Absolute versus relative measures

How do (should?) organizations set performance targets and benchmarks

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Choice of Performance Measures

Choice (or weight) of Performance Measures should reflect:

• “Congruence” of the measure

— Link to strategy or key success factors; the choice of a performance measure may serve as a mechanism to communicate senior management’s “business model” - Citibank

— Multi-dimensional nature of most managerial tasks implies that specific measures are often incongruent but a portfolio of measures may be more congruent.

• “Controllability” of the measure

— How much of the results reflected in the measure captures the actions or decisions of the individual (that holds decision rights) versus how much is due to other events. Look for ability to influence the measure rather than strict controllability.

• “Externalities” (positive or negative) or interdependencies amongst individuals and subunits.

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Choice of Performance MeasuresAnecdotal example of a negative externality

In 1992, Levi Strauss directed its U.S. plants to abandon the piecework system, under which

workers repeatedly performed a single, specialized task (e.g., sewing zippers) and were

paid according to the amount of work they completed.

In the new system, groups of 10 to 35 workers would share the tasks, and would be paid

according to the total number of trousers the group completed. Before becoming a

member of a team, each employee received two weeks of training in group dynamics and

a one-day seminar in “let’s-get-along sessions” with private consultants.

Source: WSJ, May 20 1998

Consequences:

Low morale, increased infighting; Supervisors spent a great deal of time intervening to prevent big fights.

Absenteeism increased.

Labor and overhead costs per pair of pants increased.

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Choice of Performance MeasuresA research study of the role of “Interdependencies”

Bushman, Indjejikian and Smith, 1995

Basic idea:• Explain the “weight” placed on “more aggregate” (e.g., corporate or institution-wide)

versus “local” performance in managerial bonus plans as a function of various proxies for “interdependence” in an organization.

Performance of Organizational Level

Manager

Corporate Group Division Plant Nonfinancial

Individualized

Corporate CEO 83.2 0.8 0.3 0 15.7

Group VP Manager 38.9 40.8 1.5 0 18.8

Division Manager 26.9 6.8 46.3 0.2 19.8

Plant Manager 25.0 5.2 23.3 21.4 25.1

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Choice of Performance MeasuresObjective versus Subjective Measures

Objective Measures:

• More reliable – subject to internal and external audit scrutiny (e.g., revenue and margin measures).

• May be highly variable (too much risk or susceptible to windfalls).

• “Gaming” (e.g., timing of revenues, expenses) and “manipulation.” – some academic evidence of “gaming” corporate earnings in response to annual bonus plans.

• “You get what you measure” phenomenon (e.g., Sears Auto Center anecdote from earlier notes).

• Horizon problems (short-run versus long-run).

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Choice of Performance MeasuresMitigating the Limitations of Objective Measures

Eliminate performance-based rewards (rely on intrinsic incentives only)

Search for better or the “best” performance measure or portfolio of measures • multiple performance measures

• “balanced scorecards” of measures as in Citibank

Subjective performance evaluation / discretionary rewards

• most workers operate in this kind of environment where salary revisions, job promotions and bonuses are at the discretion of superiors.

• Can overcome limitations of “you get what you pay for.”

• Unforeseen events and contingencies can be taken into acount.

• Problems? Biases, evaluation inflation and compression; influence activities (workers spending too much time currying favor with their bosses); superiors reneging on implicit promises.

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Choice of Performance MeasuresFinancial versus Non-financial Measures

Non-financial measures• More relevant to company strategy

• Better line-of-sight

• Lead indicators of financial performance – research evidence of a lead-lag relation between financial and non-financial performance is weak to modest.

Examples in practice Merck includes the strategic goal of “strong commitment to research” in its determination of

executive bonuses

“Quality of client service” is one of the measures used by Merrill Lynch

Lucent Technologies considers an officer’s “customer focus”

Towers Perrin 2001 Annual Incentive Plan Survey found that 56%) of surveyed companies assign some weight to a non-financial measure each year, including individual performance and other corporate non-financial measures.

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Performance Targets and Benchmarks

“Objective” Benchmarks

• Past Performance of units (beware of the “ratcheting” effect).

• Performance of “peer” units – external or internal peers.

Participative Budgeting (more subjective)

• Makes better use of local specific knowledge of managers and department heads.

• Academic research suggests significant performance benefits of “participation” - improves employee morale, better “buy-in.”

• But more costly - introduces slack, budget padding.

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Setting Performance Expectations

Based on budget

Determined by mgmt/B

oard

based on business conditions

Yr-to-yr g

rowth/improvement

Based on expectations of in

vestors

Peer group perfo

rmance

Company's cost of c

apital

Probabilit

y of achievement

Achievement of s

trategic goals

Timeless/absolute standard

Other

0%

10%

20%

30%

40%

50%

60%

70%Source: Towers Perrin’s 2001 Annual Incentive Plan Design Survey

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How achievable are Performance Targets?

• Most companies feel that managers should be able to meet their minimum thresholds in most years. The following chart presents the reported probabilities of achieving threshold, target and maximum performance (research evidence of ex-post performance consistent

with this table).

Threshold Target Maximum

90th %ile 100% 95% 50%

75th %ile 100% 80% 20%

Median 90% 60% 15%

25th %ile 80% 50% 10%

10th %ile 75% 50% 5%

Mode 100% 50% 10%

Source: Towers Perrin’s 2001 Annual Incentive Plan Design Survey

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Academic Evidence – Does Any of this Really Matter?

1) Does the introduction of “incentive pay” change incentives - lead to a change in behavior?

• Incentive Pay Changes in managerial actions and decisions

• Approach of typical study: compare behavior pre and post incentive pay plan adoption.

• Strong evidence – particularly at lower levels in organizations.

• Weak or modest evidence at senior organizational levels; few studies, experimental design problems, data limitations due to sensitive nature of data.

2) Do we see more “incentive pay” in settings where the motivation problem is thought to be more severe?

YES - cross-sectional studies; - % of compensation that is performance-based as a function of proxies for magnitude of “motivation” problem. But, numerous model specification and experimental design problems.

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Academic Evidence – Does Any of this Really Matter?

3) Does performance-based pay now affect future organizational performance.

1) Linking current pay practices to future difficult experimentally.

2) But some evidence that current incentive pay arrangements are associated with both current and future performance.

3) There is also evidence that investors believe (or behave as if they believe) that incentive pay matters.

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Concluding Remarks

• Well designed performance evaluation and reward systems contribute to value creation – despite the “negative” examples

that make good press.

• A lot of differences in pay practices across industries and firms –

most differences are economically intuitive.

• The “academic” knowledge or wisdom is relatively modest. At

this point, designing incentive pay plans is as much an art form as a science.

UMHS-LDP 1 Friday, November 14, 2003 Performance Measurement and Evaluation Questions and Answers...

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