Design criteria and choices Flashcards
What are the three fundamental steps of performance measurement?
Measurement (choosing dimensions), Targeting (setting performance standards), and Weighting (assigning importance to measures)
What are the four key dimensions in choosing performance measures?
One-dimensional vs. multi-dimensional, Individual vs. collective, Objective vs. subjective, Absolute vs. relative.
There are trade offs along all dimensions related to distortion, risk, manipulation and measurement costs. Elaborate:
Multidimensional: complexity vs. completeness
Collective: free-riding? information sharing?
Subjective: non-verifiable. Ex post correction. flexible, nuance
relative: competition, completeness
What is the principal-agent problem in performance measurement?
It arises when an agent acts on behalf of a principal but has misaligned incentives, leading to issues in coordination and motivation
How can performance measurement systems be distorted?
By failing to fully capture value-creating tasks, leading to behaviors that do not align with organizational goals.
What are the four key design criteria for performance measurement systems?
Distortion (coordination) – Incompleteness of the PMSP to coordinate how the agent should create organizational value, failures leads to distorted (4) behaviors
Risk (motivation) – is about how well the employee’s effort is reflected in the performance measure
Manipulation (motivation)– The risk of agents exploiting information asymmetry for personal gain
Measurement Costs (coordination)– The cost of designing, implementing, and maintaining the system
What is the difference between absolute and relative performance measures?
Absolute measures are set in advance (e.g., revenue targets), while relative measures compare performance across individuals or teams.
What is the balanced scorecard approach?
A multi-dimensional performance measurement framework developed by Kaplan and Norton, incorporating financial, customer, internal, and people performance.
What is manipulation in performance measurement?
When an agent exploits asymmetric information for personal gain, either through adverse selection (before contracting by hiding information) or moral hazard (after contracting by hiding action).
How can an organization reduce measurement distortion?
By adding multiple performance metrics, including behavioral and qualitative measures, to create a more complete assessment
Why is subjectivity considered an important factor in performance measurement?
Subjectivity relies on judgment-based evaluations rather than just numerical data.
It allows for contextual and behavioral assessments (e.g., rating an employee’s helpfulness or creativity).
However, it depends on trust between the principal and agent and is prone to bias.
What does the self selection effect express?
that companies with variable pay (pay-for-performance) will attract more high performers than companies with fixed pay
High performers will be able to maintain a higher salary. Low performers will be attracted to a fixed pay to avoid loss
What are the key components of an agent’s utility function?
Wages/Compensation (+) → Increases utility
Effort (-) → Decreases utility (disutility of effort)
Risk (-) → Decreases utility due to risk aversion
What is the disutility of effort?
The idea that exerting effort has a cost (e.g., fatigue, stress, opportunity cost), which reduces an agent’s overall utility.
How does an agent decide how much effort to exert?
The agent weighs the benefit of higher pay (or rewards) against the cost of exerting more effort. They will only increase effort if the marginal benefit exceeds the marginal disutility.
What does it mean for an agent to be risk-averse?
A risk-averse agent prefers certainty over uncertainty and may require higher compensation for taking on risky pay structures.
How should firms design contracts for risk-averse agents?
Fixed salaries or risk-sharing mechanisms to reduce uncertainty
Performance-based pay with guaranteed base salary
Insurance or benefits to offset risk concerns
What factors influence distortion in performance measurement?
Partial value creation/ Specification error – How well performance metrics reflect true value creation
Multi-tasking – Agents balancing multiple responsibilities. All tasks in the portfolio is not reflected.
Externalities – Effects of an agent’s actions on others
Alignment/Adaptation – How well metrics align with company goals and changing tasks
What is the key risk in performance measurement?
The risk that the measured performance does not accurately reflect the agent’s effort or contribution. This is caused by factors more or less controllable by the agent
What are the two main types of risk in performance measurement?
Controllable Risk – Risks within the agent’s control
Uncontrollable Risk – Risks due to external factors beyond the agent’s control
What is manipulation in performance measurement?
The agent’s opportunistic behavior exploiting asymmetric information, either before (ex ante) or after (ex post) the contract.
What are two key forms of manipulation?
Adverse Selection – Hidden information before the contract (ex ante)
Moral Hazard – Hidden actions after the contract (ex post) e.g. free-riding
What are measurement costs in performance evaluation?
The costs of implementing and maintaining an effective performance measurement system.
What 3 dimensions are there for target setting
Objective vs. subjective; standard vs. actual; absolute vs. relative
What 4 types of reward and punishment exist?
Direct monetary compensation (Piece-rates, linear profiles, profit sharing, bonus).
Indirect monetary compensation (promotion, salary increase).
Social reward/punishment (prestiage, or social exclusion)
psychological reward (intrinsic or extrinsic rewards)
