The link between performance and reward - promotion as incentives Flashcards
What is a budget and what is it used for?
A formal quantification of the operations in a future period. It is an aggregate forecast of all transactions expected to occur. Budgets are a part of extrinsic motivation and can be used for compensation incentive systems
What is Jensen’s critique of budget targets?
Jensen argues that tying compensation to budget targets leads to manipulation, as employees distort forecasts to meet goals.
How do budgets contribute to organizational architecture?
Budgets serve as a performance measurement system (compare to budget), linking evaluation with rewards and punishments, defining roles, and delegate decision rights (“act within budget”)
What role do budgets play in delegation of decision rights?
Budgets set expectations for costs and sales, delegating decision authority to those with the most knowledge, such as salespeople for discounts
What are the key dysfunctional consequences of budgets?
Manipulation problems, such as adverse selection (underestimating targets) and moral hazard (shifting sales), undermine budget integrity.
This is possible due to the asymmetric information and delegation of rights to the sales rep.
What is adverse selection in budgeting?
Budget planning. Hidden information before contracting—agents exploit private knowledge by setting conservative budgets to ensure easy achievement
How can adverse selection in budgeting be addressed?
Solutions include thorough investigations and high penalties, though enforcement is challenging.
What is moral hazard in budgeting?
Hidden actions after contracting—agents shift (postpone) sales between periods or reduce effort when performance is hard to monitor.
o Bonus phase (during period): moral hazard -> the agent would e.g. move the sale to next period to make sure they will reach the budget
o Cap phase (in period): moral hazard -> effort adverse agents will stop working as hard once cap is met
How can moral hazard in budgeting be mitigated?
Solutions include inspection, monitoring, and transparent performance evaluations
How does a kinked compensation profile affect sales incentives?
Salespeople delay sales to the next year once they reach the cap, as exceeding it does not yield additional rewards.
What are the benefits of a linear compensation profile?
It eliminates incentives for manipulation, ensuring direct correlation between performance and reward.
What are the challenges of removing budget targets as seen in a linear compensation profile?
- When there is no link between budget target and reward, which can also mean externalities will cause high/low payouts, which is not correlated to a coresponding performance.
- According to self-selection effect: high or low performers will be attracted
- Requires training and organization being onboard
- Market changes has to be reflected in changing the slope of the curve. leading to reduced effort due to expectations of future reductions (ratchet effect)
What is the ratchet effect? give example
the tendency of performance standards in an incentive system to be adjusted upwards after a particularly good performance, thereby penalizing good current performance by making it harder to earn future incentive bonuses.
The employees get fired when productivity increase.
Budgets are reduced when we implement cutbacks.
What is the self-selection effect in compensation?
High performers benefit more from performance-based pay, while lower performers prefer fixed salaries
in context of the ratchet effect, what does the pal effect refer to? Give an example
This triggers a pal effect, referring to a situation where you cannot go back once it has occurred.
If you don’t spend the budget fully, you will probably receive less money next year
Reflect on the balance between base salary and incentive intensity in rewarding.
The more weight you put on the compensation coefficient, the more sensitive you are to risk, moral hazards and adverse selection. On the other hand, it should be highly motivating. When salespeople are risk adverse (sensitive to external risk) it should rely more on base salary.
When should you use strong incentives?
Distortion is low.
Uncontrollable risk is low.
Controllable risk is high.
Measures are hard to manipulate.
The agent is less risk averse.
Weak intrinsic motivation.
Self-selection is more important: high compensation packages attract certain people.
Remember to safeguard with a cap, to reduce gaming (but keep in mind consequences on recruitment)
How does promotion function as an incentive?
Many firms use promotion rather than direct performance pay, making career progression a motivational tool. This is preferred also when in jobs where impact of your tasks are hard to track.
What are the two purposes of promotion
o Matching (or sorting): finding the right people for the right jobs (coordination)
o Incentivizing (motivation)
What is the Peter Principle and how is it related to promotion?
The peter principle expresses a real risk when promotion is used as a reward. Employees get promoted until they reach a level of incompetence, reducing overall efficiency
What is the “up-or-out” promotion principle? List advantages and disadvantages.
It is a promotion system where employees are promoted if they meet all specified performance standards. It ensures better control over the quality of promoted employees. The number of promotions is variable and may fluctuate.
What is a tournament-based promotion system? Advantages and disadvantages.
It is a system where a fixed number of the best employees are promoted, regardless of absolute performance. This is a relative performance measurement.
advantage: the number of promotions is strictly controlled.
cons: The quality of promoted employees may vary, as even low performers could be promoted if they are the best among a weak group.
What is the idea behind a parallel career path?
Career stages should contain the same types of tasks to maintain efficiency in promotions. Allowing employees to advance within their expertise and avoids the peter principle
How is promotion impact by externalities (the external job market)
first, companies might use promotions to spot talents in other firms. This will in turn motivate the company to under-promote certain employees to hide them from others. Additionally, employees can use their promotion for external job opportunities
