Safelite Auto (B)
Incentive Compensation
Chapter 15
In-Class Principal-Agent Incentive Model
In-Class Student Presentations
Safelite Glass
• Did PPP succeed?
• What were the problems with PPP?
• Should management proceed with the
introduction of PPP or even a modified PPP?
• What were the consequences of the switch
from wage rates to piece rates for:
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Turnover
Recruitment
Productivity
Product Quality
Total Labor Costs
Safelite Glass
• 600 small auto-glass repair centers
• 1994 – pay for performance introduced
– Hourly wages = f(base salary, glass installed)
– Minimum base salary = $11/hr
– Must install defectives without pay
• Benefits
– 36% increase in installed glass/day
• Improved productivity per worker
• Better workers stay
– Decrease in turnover
• Costs
– Operating: 9% increase in pay/employee
– Investment: not high; info system could handle
• Net effect
– Increase in profits
• Source: E. Lazear, “Performance Pay and Productivity,” The American
Economic Review, Dec. 2000
Basic principal-agent model
• Effort not directly observable – use proxy
– “post contractual asymmetric information”
• Outside risk factor
– Could work hard but not all measured
=> Compensation contract
– tie incentive pay to proxy to motivate effort
– Include base pay to reduce risk bearing
Basic principal-agent model
Worker’s output: Q=e+, ~(0,2)
– output depends on effort and a random element
Profit=(e+)-W
– profit is output minus cost of worker
Comp. Contract: W=W0+Q, 0  1
– compensation has a fixed component and an element
linked to output
• Solution
– Firm sets Wo and b
– Worker maximizes E(U)=E(W-e2)
– Worker chooses effort
e* = ab/2
– Effort increases with b
Basic principal-agent model
Risk
If replace some base pay with variable
compensation
More variability in pay; increased risk
Must give higher expected compensation
(“compensating differential”)
Compensating Differential for Bearing
Risk: 3 Jobs
• $100,000
with 100% certainty
• 0
$200,000
50% of the time
50% of the time
• 50,000
$150,000
50% of the time
50% of the time
Specific principal-agent model
a=$100
u=+$800 with probability 0.50;
-$800 with probability 0.50;
=0.2
W0=$800
Q=e+
W=W0+Q, 0  1
Estimating unknown productivity

• Choosing incentive pay rate requires firm to
know productivity (a)
– E.g. choose b to elicit effort since e*=ab/2
• Time and motion studies
– dysfunctional behavior
• Past performance
– ratchet effect
– Lincoln Electric’s Concern about the ratchet
effect
Measurement costs
• Measurement of evaluation criteria is costly
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Accounting system
Data entry time & personnel
Supervisor observation
Record keeping
Accuracy check
Training
Opportunism
• Gaming
– Unethical efforts to alter performance
measurements (e.g. Q)
– Unintended consequences
• I.e. the typist at Lincoln Electric
• Evaluation system should be set up to detect
&/or reduce the likelihood of opportunism
Subjective performance evaluation
• Why? Some tasks difficult to measure but
should be rewarded
• Subjective evaluation methods
– Standard rating scales
– Goal-based systems
• Problems
– Supervisor shirking
– forced distribution
– influence costs
• Navy Officer Evaluation System
Relative performance evaluation
• Measures performance relative to other
employees or other firms
– E.g. 20% commission on individual sales over
average for department
– E.g. Bonus earned if market share increases are
higher than competitors’
• Benefits
– Can lower compensating differential by sifting
out outside effects (m) from effort
• Alternative: use subjective component to
adjust for outside effects
– Elicits high competitiveness
Relative performance evaluation
• Costs
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dysfunctional competitiveness
jobs not always identical
data across firms hard to obtain
group has incentive to punish “rate busters”
incentive to hire less competent workers
Combining performance measures
• Few job performance measures are purely
objective or subjective
• Both types can be inaccurate
– increasing inaccuracy of either places greater
weight on other
– inaccuracies increase employee risk
• Both can induce dysfunctional behaviors
Looking Forward
• December 6, 7, or 9: Performance Evaluation
– Chapters 16 and 17
– Prepare Arthur Anderson Case (ch. 17)
• Course Project Due
• December 13, 14, or 16: Final Exam
– Blackboard: Past Exam Exams
– Open book, open notes
– Remember to bring a calculator and all course
materials