Midterm 2 Flashcards
Contingent contracts create…
Value - align incentives and share risk
External negotiations are rough without…
Internal alignment - less time on strategy & more on interests
Owner-Manager incentive conflicts (5)
- Choice of effort
- Perquisite taking
- Differential risk exposure
- Differential horizons
- Over investment
Hierarchy in a firm
Shareholder CEO Divisional manager Plant manager Workers
Sources of conflict
- Differences in preferences for perquisites and effort
- Differences in decision horizon
- Differences in risk preferences
- Differences in investment incentives
Elements of organizational architecture
Delegated decision authority
Performance measurement
Reward system
Contracts designate…
Actions, rules, payments, expectations
Can be explicit and implicit
Contract parties voluntarily agree to….
Modify behavior for mutual benefit.
Organizational architecture
Decision rights
Reward system
Performance measurement
Benefits of decentralization
Effective use of knowledge
Conservation of management time
Training and motivation for local managers
Costs of decentralization
Potential agency problems
Coordination costs and failures (duplicate efforts)
Less effective use of central information
Revenue center
PxQ
Take derivative
Solve for Q
Optimal level of decentralization
Solve for D
Assigning decision rights to teams
Benefits: better use of member knowledge, contribution by each member, increase employee support and involvement, enhance employee buy in
Costs: slower than individual decisions, collective action problem (politics), free riders (moral hazard)
Decision process
Initiation - generate proposals
Ratification - select initiatives to be implemented
Implementation- execution of decisions
Monitoring - measurement of performance of decision makers
Why do we measure performance?
- To provide feedback on employee activities
2. To determine rewards and compensation
What determines performance?
Ability
Effort
Noise (random stuff)
Agency cost =
Monitoring costs + bonding costs + residual loss
Who pays for monitoring costs?
Principal
Who spends bonding costs?
Agent
Ex: audit fee
Residual loss represents…
Opportunity loss remaining when contracts are imperfectly enforced
Incentive contracts can improve performance because they …
Motivate employees
Attract high performers
Stretch performance
Belief that aggressive targets will motivate managers to perform at their highest levels
Minimum performance standard (MPS)
To judge managers first on if they hit an MPS
MPS should be realistic and achievable
Problem with MPS
It can be subjective
Owner incentives:
To maximize profits and have diligent employees
Employee incentives:
Maximize utility and take breaks from working
Incentive problems
Firm cannot observe employee performance costlessly
Output can be difficult to measure
If employee and owner interests align :
Incentive problem does not exist
Contracts can solve incentive problem if :
Workers actions and output are observable
Constraints for contracts
Contract must balance fixed income and performance incentives
Compensation contracts :
Motivate employees
Share risk more efficiently
Employer is risk —-
Neutral
Employee is risk —
Averse
Fixed income does not
Motivate employees to perform better - incentive coefficients do
Incentive component of pay can be made stronger if:
Employee is less risk averse
Variance of performance measurement is smaller
Employee is less effort averse
Marginal productivity of effort is higher
Ratchet effect:
Employees only have incentive to meet goal and not exceed it
Subjective performance evaluation
Can completely replace objective performance evaluation
Overcome problems with subjective performance evaluation
Forced distributions
Rotate superiors and employees more frequently
360 degree performance reviews
Relative performance evaluation
Can be used in or across firms
Upside and downside of paying for human capital
Upside :
More measurable than performance
May be better sign of long term value added
Downside:
Ability does not equal performance
Skills may erode
Upsides and downsides of seniority pay
Upside:
Long term commitment/motivation effect
Underpay in early career (firm)
Security of rising income (employees)
Downside:
Weak performance incentives/ reward
Inequity
Overpay in later career (firm)/ pension
Upside and downside of paying market wage
Upside:
Measure the market price
Equity (fair and impartial)
Downside:
Determining appropriate labor market
Upside and downside of efficiency wage
Upside:
Attract better workers
Gain in motivation and productivity
Low wages = high turnover
Downside:
More expensive to pay workers
Paying for individual performance
Reward for individual efforts
Pay for group performance
Team building system - tied to overall performance
Goals of the balanced scorecard
- Translate strategy into action
2. Communicating and linking
Decisions cannot be made based solely on…
Financial information
Much info cannot be quantified
Balanced score card balances
Current performance and long term abilities
Feedback and guidance
Financial and non financial measures
4 aspects of balanced score card
Financial
Customer
Internal business process
Innovation and learning
Financial perspective measures
Operating income
Cash flow
Revenue growth
Stock price
Customer perspective measurements
Responsiveness to customer desires
Market share
Customer satisfaction and retention
Customer perception of the company
Internal business perspective measures
Manufacturing or service excellence Backlogs Cycle time Quality New product introductions
Innovation and learning perspective measures
Technological leadership
Research and development
Employee training and satisfaction
Invest in new technologies
Designing a balanced score card steps
- develop company strategy
- determine critical success factors and goals
- determine activities that drive achievement
- determine metrics to evaluate performance
With transfer pricing no:
Cash changes hands
Seller will sell to outside if transfer price is
Below market price
Buyer will buy from outside if transfer price
Is above market price
Transfer price is calculated as:
Marginal cost per unit + opportunity cost per unit
Profit is:
Historical, backward looking, does not consider investment required, might not be comparable
ROI is:
Intuitive, measures investment usage and levels, independent of scale, does not require a cost of capital estimate
Residual income is:
Incorporate investment base, lines goals, motivates revelation of private information, conservation principal
EVA equals
Adjusted after-tax income - cost of capital x adjusted total divisional asset
EVA adjustments:
Marketing and R&D expense, depreciation expense, goodwill, restructuring costs
Challenges of EVA
Some adjustments are difficult to justify, cost of capital is difficult to measure, ignores managerial risk aversion
Informativeness principal
Compensation based on all factors of employees performance
Internal labor market
Hiring from within the firm
Two reasons why KN introduce BSC
Transfer strategy to action in communication
Downside of controllability principal
Doesn’t try to forecasting usual affects
Doesn’t cooperate with other managers
Doesn’t try to mitigate negative effects
How to determine transfer price
Market price, full cost, marginal costs, negotiation
Two types of agency problems
Adverse selection and moral hazard
ROI =
After-tax net income divided by divisional assets
Turnover ratio equals
Sales divided by divisional assets
Profit margin equals
After-tax net income divided by sales
Residual income equals
After-tax net income minus the cost of capital times total divisional assets
NPV is used for decisions…
RI is used for decisions….
Before projects
During projects for evaluation
EVA equals
Adjusted after-tax income minus the cost of capital times adjusted total divisional assets
Why are internal negotiations difficult?
1) sharing private info is uncomfortable
2) can appear as greedy - not a team player
3) info could be used against me
