Descriptive statistics are summarized in TABLE 1. The average of BONUS is $39,524 (note: the average bonus ratio - bonus to total compensation - is 69.7 percent, results
reflecting our earlier discussion of the importance management attaches to bonus as an incentive for branch managers). The mean (standard deviation) of RAISE is $3048 ($1,050);
almost one-fourth of managers did not get a raise. It is obvious that the influence of BONUS on manager’s compensation is larger than that of RAISE - the compensation policy reflects the annual fluctuation and competition of car dealership environment.
The branch managers have worked for the company, on an average, for 16.9 years, with 9.7 years and 27.3 years being the minimum and maximum, respectively. And the survey showed that managers plan to work on an average, for 8.9 years, with 4.6 years and
‘greater than 13 years’ being the minimum and maximum, respectively12. In essence, they are all long-horizon employees, both from a perspective of having worked for the company and with the intention of staying with this organization for a number of years.
12 The survey was sent to all the ninety branch managers. Forty-two of the managers returned the confidential survey; however, four of them had manager-specific missing data (from the organization’s data base). Thus, for analyses purposes, we had thirty-eight response responses (or a 42% response rate).
The mean and standard deviation of increase in net income before taxes (INCRNIBT) are $10,544 and $249,195, respectively. The large standard deviation in INCRNIBT implies that branches vary significantly in terms of profitability, partially a function of branch size (thus, justifying the use of SALES as a proxy for size).
--- Insert TABLE 1 ---
Panel A, Table 2 provides details on Person and Spearmen correlations among the research variables for the concurrent year (year t versus year t+1), while Panel B presents correlation matrix among the same variables for the non-concurrent year (year t versus year t-1). The correlation between RATING and SALES (0.5133) is higher than the correlation between RATING and INCRNIBT (0.0573). The magnitudes are generally small, creating no serious problems with multicollinearity in subsequent tests. Nevertheless, in order to control potential multicollinearity problems, we also use variance inflation factor (VIF) to test regression models (Maddala 1992; Hair et al. 1998).
--- Insert TABLE 2 --- Models for Analyses
For the data obtained from the HR department, the following models are used to test the research hypotheses using pooled time-series data for 90 branch managers over six years.
it
Bonusi,t = Manager i’s bonus (in constant dollars) in time-period t,
Raisei,t = Manager i’s annual raise (in constant dollars) in time-period t,
Promotioni,t and t-1 = the different levels of manager i’s employment between two consecutive years, t and (t-1)
INCRNIBTi,t = Increase in net income before taxes if the manager works in branch i in year t,
Ratingi,t = Manager i’s subjective annual rating in year t,
SALESi,t = Branches’ sales if the manager works in branch i in year t, INCRNIBTi, t-1 = Increase in net income before taxes if the manager works in
branch i in year t-1,
Ratingi, t-1 = Manager i’s subjective annual rating in year t-1,
SALESi, t-1 = Branches’ sales if the manager works in branch i in year t-1,
εit = Random error term.
For Model (1) through Model (3), we use RATING as a forward-looking measure and INCRNIBT, defined as increase in net income before taxes, as a contemporaneous measure.
Models (1) and (2) are OLS regression models, where the dependent variables are bonus and annual raise, respectively. Model (3) is a binary logistic model to test the impact of contemporaneous and forward-looking measures on promotion probability, where promotion is equal to one if the manager is promoted in year t. In order to exclude the size effect and the impact of economic fluctuation on branch performance, we also include SALES in all the models. Models (2) and (3) repeat Model (1) except for replacing the current year independent variables with the prior year independent variables. It is a common practice in this organization to announce the new base salary incorporating merit raises or promotions at the beginning of the calendar year. Thus, there is a one year lag between performance and incentives when there are raises or promotions (note: the results reported later do not change materially for promotions if we use an average of year t-1 and t-2 data). Hence, it is more appropriate to test the annual raise and promotion regression using the prior year t-1 rather than the current year t. The analysis for the survey was similar as above except it was done only for the thirty-eight usable responses from managers.
Hypotheses Testing
Hypothesis H1: Our first hypothesis states incentive contracts for long-term
employees will have significant weights for forward-looking measures. In models (1), (2), and (3), we use RATING as a proxy for forward-looking measure and INCRNIBT as a proxy for contemporaneous to test H1 for three forms of incentives: bonus, raise, and promotion. In the model, if the β1 coefficient for RATING is positive and significant, then H1 is supported.
i. Long-horizon employees as the number of years worked: Tables 3 - 5, Panels A present
the statistical results of testing H1. Separate overall regressions for models (1), (2) and (3) show that coefficients of β1 for bonus (Table 3, Panel A[1]), merit raise (Table 4, Panel A[1]) and promotions (Table 5, Panel A[1]) are all positive and significant.13
In addition, separate forward step-wise regressions were done following the above overall regressions for each of the incentives. For bonus (Table 3, Panel A[2]) and raise (Table 4, Panel A[2]), the forward-looking, RATINGS variable entered the first model ahead of the contemporaneous measure, INCRNIBT. For promotions, (Table 5, Panel A[2], the RATING variable was the only variable to enter the step-wise model.
ii. Long-horizon employees as the number of years managers plan to work: Tables 3 - 5,
Panels B show the statistical results. Overall, the results are consistent with (i) above; that is, when long-term employees was measured via the number of years actually worked. More specifically, separate regressions for models (1), (2) and (3) show that coefficients of β1 for bonus (Table 3, Panel B[1]), raise (Table 4, Panel B[1]) and promotions (Table 5, Panel B[1]) are all positive and significant.14
13 We compute inflation factors (VIF) to investigate potential multi-collinearity problems. As shown on Table 3, panel A-1 and Table 4, panel A-1, the largest variance inflation factors are 2.64 and 2.51, respectively, which are smaller than the threshold of ten in the econometrics literature (Kennedy 1992).
14 Variance inflation factors (VIF), to investigate potential multi-collinearity problems (Table 3, panel B-1 and Table 4, panel B-1, the largest variance inflation factors are 2.52 and 3.97) show they are smaller than the threshold of ten in the econometrics literature (Kennedy 1992).
As before, separate forward step-wise regressions done following the above overall regressions for each of the incentives. For bonus (Table 3, Panel A[2]) and raise (Table 4, Panel A[2]), the forward-looking, RATINGS variable entered the first model ahead of the contemporaneous measure, INCRNIBT. For promotions, (Table 5, Panel A[2], the RATING variable was the only variable to enter the step-wise model.
Taken together, the above results are consistent with the expectations of H1; long-horizon managers’ bonus, raises and promotions are all significantly affected by forward-looking measures for long-term employees.
Hypothesis H2: The second hypothesis predicts that the weights on forward-looking measures compared to contemporaneous measures in incentive contracts will increase as the implications of the time horizon and scope of the incentives also increase. To test the hypothesis, we refer to the separate forward step-wise regression for Models (1), (2), and (3) with forward-looking (i.e., RATING) and contemporaneous (INCRNIBT) measures discussed above, and use the partial R2 of the two measures to test H2.
For bonus, when long-term employment was measured as the number of years worked (see Table 3, Part A2) the partial R2 of RATINGi,t is 0.2692 and partial R2 of INCRNIBTi,t is 0.0521. Thus, the ratio of explanatory power of RATINGi,t is 5.17 times the explanatory power of INCRNIBTi,t. Similarly, when long-term employment was measured as the number of years managers plan to work (see Table 3, Part B2) the partial R2 of RATINGi,t is 0.2034 and partial R2 of INCRNIBTi,t is 0.0447. In this case, the explanatory power of RATINGi,t is 4.55 times the explanatory power of INCRNIBTi,t.
For raises, Table 4, Part A2 show the partial R2 of RATINGi,t-1 is 0.0833 and partial R2 of Increase in INCRNIBTi,t-1 is 0.0102 when long-term employment was measured as the number of years worked. Hence, for raise, the ratio of explanatory power of RATINGi,t-1
compared to explanatory power of INCRNIBTi,t-1 is 8.17. And, when long-term employment
was measured as the number of years managers plan to work, the partial R2 of RATINGi,t-1 is 0.1086 and partial R2 of INCRNIBTi,t-1 is 0.0142; that is, the explanatory power of RATINGi,t-1
is 7.65 times more than INCRNIBTi,t-1.
Finally, for promotions, only RATINGi,t-1 was significant both when long-term
employment was measured either as the number of years worked (Table 5, Past A1) or the number of years managers plan to work (Table 5, Part B1). Hence, RATINGi,t-1 was the only variable that was included the step-wise forward regression model; INCRNIBTi,t-1 did not enter the model at all (Table, Part A2 and B2).
The above analyses show that the explanatory power of the forward-looking measure compared to contemporaneous measure is greater for annual raise than for bonus (recall that the organization’s compensation policy strongly prefers bonus to merit raise). And for promotions, compared to contemporaneous measures, the explanatory power of forward-looking measure is even greater since that is the only significant variable. Thus, the results are consistent with the predictions of H2 that weights on forward-looking performance measures compared to contemporaneous measures in incentive contracts increases in time horizon and scope of the incentives (i.e., go from bonus to annual raise to promotion).
--- Insert TABLE 3 ---
5. Conclusion
To understand an organization’s incentive design and evaluation criteria, research should collectively examine all forms of incentives, namely, bonuses, merit raise and promotion (Baron and Kreps 1999) since they are considered simultaneously during
incentive design (see Gibbs 2008). The current study, therefore, examines the relevance of forward-looking and contemporaneous measures for incentive structures for
pay-for-performance encompassing bonus, annual merit raise and promotions for long-horizon
employees. The contracting literature assumes that the goals of employees and the goals of the firm's owners are misaligned: employees want to maximize short-term compensation, even at the cost of long-term firm performance, while firm owners want to maximize the firm’s long-term performance. Economic models suggest that contracts that incorporate forward-looking measures of firm performance mitigates the shortsighted efforts of employees whose employment horizons are not aligned with the firm’s profitability horizon, but forward-looking measures do not have much influence on effort choices as employment horizons approach the firm's long-term profitability horizon. However, incorporating forward-looking measures in incentive contracts influences employee effort allocation even for employees with long-term horizon because these measures have both decision-influencing and decision-facilitating benefits (see Sprinkle 2003). Further, as the motivational scope and time implications of the incentive structure increase, so will the importance of the forward-looking measures.
Using BSC data from a car-dealership organization, we find evidence consistent with our hypothesis that incentive contracts for long-term employees not only have significant weights for forward-looking measures, but also assign greater weights to them than to contemporaneous measures. Further, as predicted, the weights on forward-looking performance measures compared to contemporaneous measures in incentive contracts increases as the implications of the time horizon of the incentives increase; that is, as we go from bonuses to annual raises to promotions.
Our results come with some caveats. Although we had considerable access to the internal records of the organization, we were unable to obtain all of the background and discussion materials that went into determining each manager’s subjective annual ratings. In contrast, the contemporaneous measures were transparent and quite easily determined.
Second, we assumed that someone who is working for an organization for a long time (and plan to stay with the organization for many years) is automatically a long-horizon employee.
However, given that bonus is an annual fixture, large bonuses of the level given out by this organization may make even long-term employees behave like short-time employees. Finally, the performance measures may have an interactive effect on incentives. We did not examine this in the current study since the existing theory is either non-existent or, at best, quite simplistic on how such interactions may affect incentive structures.
Future research should examine the role of term incentive contracts and long-horizon employees. When the principal does not or cannot commit to a long term contract, but offers a sequence of one-period contracts, forward-looking indicators are important for performance evaluation purposes (Dutta and Reichelstein 2003). However, if both employers’ and employees’ time horizon are long and they can enter into long-term contractual commitments, will the need for forward-looking measures reduce since the employer can observe contemporaneous measures over multiple periods and design an incentive structure that maximizes the net present value of all such measures? While the use of forward-looking measures is wide-spread, their qualitative aspects in evaluations have behavioral connotations, such as trust and fairness. Perhaps an examination of the time horizons and contract lengths may better help understand the role of forward-looking and contemporaneous measures.
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TABLE 1
Bonus = Manager’s bonus (in constant dollars), Raise = Manager’s annual raise (in constant dollars),
Promotiont = the different levels of manager’s employment between two consecutive years
INCRNIBT = Increase in net income before taxes Rating = Manager’s subjective annual rating SALES = Sales of each dealership
ROS = Branch’s return on sales where return is income before taxes Long-term
Employment Horizon
= Experience of manager in years: have worked and plan to work (the latter is based on survey done in 2004)
TABLE 2
Panel A: Correlation coefficient (p-value) among variables for the concurrent period (Note: Spearman coefficients in the upper triangle; Person coefficients in the lower triangle)
INCRNIBT 0.1563 0.0048 1.0000 0.0144
(0.0004) (0.9163) (0.7469)
SALES 0.6038 0.5190 0.0971 1.0000
(0.0001) (0.0001) (0.0292)
Panel B: Correlation coefficient (p-value) among variables for the preceding period (Note: Spearman coefficients in the upper triangle; Person coefficients in the lower triangle)
________________________________________________________________________
Promotion Raise Ratingt-1 INCRNIBTt-1 SALESt-1
Promotion 1.0000 0.4808 0.1427 0.0478 -0.0560
(0.0001) (0.0009) (0.3851) (0.1946)
For definition of variables, see Table 1.