Week 3 - Delegation Flashcards
- Primary benefit & cost of delegation
- Trade-off (Moers)
+ Employee has knowledge -> delegation AVOIDS KNOWLEDGE COSTS (=costs of transmitting knowledge)
- AGENCY COSTS (misuse of authority)
» difficult to check if employees are indeed making the right decisions
- Trade-off between agency and knowledge costs
- agency costs INCREASE in delegation
ie. the more you delegate, the greater the risk that employees “abuse” their decision rights
- knowledge costs DECREASE in delegation
ie. the more you delegate, the better you exploit available information
-> if we can REDUCE agency costs due to BETTER RESULTS CONTROLS (shift the agency cost function to the right), we expect MORE delegation
- Under what circumstances is there more delegation?
- In turn, more delegation implies more __ controls?
- When EMPLOYEE KNOWLEDGE is vital
- and/or more difficult to transmit to MANAGEMENT {delegation allows quicker decision-making since no need to go through all the top levels}
eg. dispersed, high-growth, volatile, innovative firms - RESULTS CONTROLS!
eg. more incentive-based pay
» b/c cannot rely on action controls
3 steps for designing Result controls
- REWARD employees for good results (or punish for poor results, usually for high-level executives like CEOs)
- INFLUENCES ACTIONS b/c employees care about the consequences of their actions
- Define performance dimensions
- Set performance targets
- Measure performance & pay rewards
Defining performance dimensions
1. Responsibility center
2. 4 types of Financial responsibility center
RESPONSIBILITY CENTER
- which inputs/outputs are employees responsible for? {ie. what can employees IMPACT}
FINANCIAL RESPONSIBILITY CENTER
1. Revenue centers
- responsible for generating revenues, eg. sales dept
- inputs (eg. costs) are not related to outputs
- tradeoff between easy and profitable sales {tradeoff between what co.s want & what employees are able to influence and be evaluated on}
-
Cost centers
- responsible for costs
- outputs (eg. sales) are not related to inputs
- control achieved through BUDGET COMPARISONS -
Profit centers
- responsible for profits (= SALES - COSTS)
» natural tradeoff that leads to taking BEST ACTIONS that are ultimately best for company
- outputs (eg. sales) ARE related to inputs (eg. costs) -
Investment centers
- responsible for returns on capital
» majority of employees don’t have this responsibility
- invest only when investments produce adequate returns, ie. absolute profits are not the objective but returns
CONTROLLABILITY principle + why it is important
= employees should be held ACCOUNTABLE only for what they can CONTROL
Important b/c…
- results controls are useful only to the extent that they provide INFORMATION about the desirability of the ACTIONS that were taken
- if results are uncontrollable (or random), they tell nothing about the ACTIONS that were taken
{the whole reason we use results controls for employees in the 1st place is b/c we don’t know what actions they should be taking}
- thus b/c more delegation implies more results controls, the CHOICE to delegate should also depend on the firm’s ability to construct appropriate results controls
ie. don’t delegate if you know you cannot resolve the subsequent incentive problem
3 “factors” of “good” results controls (Moers)
- PRECISION
- is the measure impacted by OUTSIDE FACTORS?
ie. to what extent does it introduce NOISE in the evaluation - SENSITIVITY
- is the measure impacted by the EMPLOYEE?
ie. does it separate hard-working employees from less hard-working? - CONGRUENCE
- does the measure ALIGN with the FIRM’S GOALS?
ie. does it incentivise behaviour that is first priority in the firm?
The learning effects of monitoring (Campbell et al., 2011)
Delegation can lead to more learning b/c of more experimentation
Delegation & (transfer) pricing issues
ref. to slides example with Manufacturing (M) + Selling (S) departments that sell to each other internally as well as selling to outside customers/suppliers
- 2 scenarios with decisions on selling price & quantity to produce
Conclusion: S has the decision power because M is “maxed out” externally. Scenario 2 is best for the firm, but worst for division S.
->should management intervene, ie. take away delegation rights? what are the tradeoffs?
> > if mgmt intervenes, this DEFEATS the PURPOSE of the delegation system b/c mgmt will always end up making decisions when a similar problem arises in the future
-> hence, cannot centralise decisions
Kranworth Chair Corporation case
1. Should R&D be decentralised too?
2. Does R&D really distort incentives
- better to keep R&D CENTRALISED b/c delegating to profit center managers creates incentives to MYOPICALLY CUT R&D to earn bonuses under the incentive scheme
-> will have long-term implications - R&D will probably not distort incentives
- the ex ante targets and/or ex post performance can be easily adjusted for if it really cause problems
- b/c 1) R&D expenditures are likely predictable at the corporate-level…
- …2) the allocation rule is known in advance
Kranworth Chair Corporation case
5 key points to note
incl.
objective bonus = f(75% × division + 25% × corporate) and max 30% of salary
Argument for & against the objective bonus
- See week 2 deck for pros and cons of dencentralisation
- 2 components of a bonus system: performance measurement + incentive system
- Are all controllable assets “CONTROLLABLE”?
- overall, “controllable returns” = operating income/controllable assets are a GOOD MEASURE - SUBJECTIVE BONUS provides incentives to go beyond target, but opens firm up to BIASES, eg. favouritism, since not tied to targets
Against
5. OBJECTIVE BONUS explicitly introduces UNCONTROLLABILITY (in this KCC case where it’s 25% of corporate performance) b/c DEPENDENT on OTHER dept.s
For
- but wants divisions to also focus on the CONGRUENT corporate goals
Kranworth Chair Corporation case
Incentive system (for division manager) has a **non-linear (convex) relationship - What does this mean?
Related to Week 4 Target setting - linear (continuous) contracts work better than ^ so that there is always an incentive to keep going forward (see slides)
- Only get a bonus if reach 100% of target.
- Therefore the incentive system will only have an impact on performance when employees are very near the target
- ALL-OR-NOTHING CONTRACT! very convex
