THE JOURNAL OF INDUSTRIAL ECONOMICS
Volume LV
March 2007
0022-1821
No. 1
AUTHORITY, RISK, AND PERFORMANCE INCENTIVES:
EVIDENCE FROM DIVISION MANAGER POSITIONS
INSIDE FIRMS
Julie Wulfw
I show that performance incentives vary by decision-making authority
of division managers. For division managers with broader authority,
i.e., those designated as corporate officers, both the sensitivity of pay to
global performance measures and the relative importance of global to
local measures are larger, relative to non-officers. There is no difference
in sensitivity of pay to local measures by officer status. These results
support theories suggesting that authority over project selection
combined with incentives designed to maximize firm performance, as
well as induce effort for the division, are important in incentive design
for division managers. Consistent with earlier findings, the evidence
strongly supports one of the main predictions of the principal-agent
model, that is, a negative tradeoff between risk and incentives.
I. INTRODUCTION
ECONOMISTS HAVE LONG BEEN INTERESTED IN MANAGERIAL INCENTIVES. Most
empirical research has focused on performance pay of Chief Executive
Officers (CEOs), the executive with the highest authority in the firm. While
CEOs may have ‘formal’ authority (the right to decide), in practice, they may
exercise little ‘real’ authority (the effective control) over many decisions
within organizations (Aghion and Tirole [1997]; Baker, Gibbons and
Murphy [1999]). Consistent with this view, there are many inside-the-firm
theories of division managers making a wide-range of decisions that are
critical to firm performance. Yet, the empirical research analyzing incentives
of division managers falls behind theoretical contributions.
I would like to especially thank Charles Himmelberg, Raghuram Rajan, Scott Stern, and
Eric Van den Steen for helpful comments and Katie Donohue at Hewitt Associates for
assistance with data collection. I also would like to thank Rajesh Aggarwal, Ben Campbell,
Francine Lafontaine, Vinay Nair, Paul Oyer, Canice Prendergast, Tano Santos, Justin
Wolfers, Jan Zabojnik, the editor and two anonymous referees, and seminar participants at
Northwestern University (Kellogg), Washington University (Olin) and the Applied Econ
Summer Workshop at Wharton. I acknowledge research support from the Center for
Leadership at the Wharton School.
wAuthor’s affiliation: Wharton School, University of Pennsylvania, 2000 Steinberg-Dietrich
Hall, Philadelphia, Pennsylvania 19104-6370, U.S.A.
e-mail: wulf@wharton.upenn.edu.
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169
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JULIE WULF
In an attempt to narrow the theory-empiric gap, this paper provides
additional facts about performance incentives of division managers and
sheds light on the following questions: How sensitive is division managers’
pay to performance of their division and to performance of the firm? How
does this sensitivity vary with division and firm risk? Do these relationships
depend on division managers’ decision-making authority and involvement
in firm-wide decisions? I use a longitudinal data set of more than 10,000
division manager position-year observations from a proprietary compensation survey of more than 250 firms from 1986 to 1999. The panel nature of
the data allows this paper to move beyond cross-sectional approaches
common to several prior studies. To address the research questions, I exploit
the variation in performance incentives, firm and division risk, and divisionspecific characteristics as measures of authority across multiple division
manager positions within firms.
Consistent with earlier research, I find strong support for the predicted
tradeoff between risk and incentives for division manager positions.1 First,
the performance pay of division managers is increasing in local performance
(division sales growth) and in global performance (firm sales growth).
Second, the sensitivity of pay to division performance is decreasing in
division risk and the sensitivity of pay to firm performance is decreasing in
firm risk. The negative risk-incentive tradeoff is based on the simple intuition
that risk-averse agents require more compensation to offset the additional
risk they face thereby increasing the costs of incentives to risk-neutral firms.
This tradeoff is one of the central predictions of principal-agent models that
explore managerial incentives (e.g., Holmstrom and Milgrom [1987];
Banker and Datar, [1989]) and is the subject of more recent theoretical
research (e.g., Zabojnik [1996]; Prendergast [2002]; Baker and Jorgensen,
[2003]).
Of potentially greater interest, I find that pay-performance sensitivities
vary by decision-making authority of division managers. Since appointment
as a corporate officer is based on ‘individual authority’ and implies the
fulfillment of ‘a policy-making function’ for the firm, it is one characterization of the decision-making authority for division managers.2 I find
differences in performance incentives between division manager positions
with corporate officer status relative to division managers that are not
officers. Specifically, the sensitivity of pay to global performance measures
and the relative importance of global to local measures for division
1
Aggarwal and Samwick [1999] find support for the predictions of a two-signal principal
agent model for division managers. Refer to the text in Section 3.2 for a discussion that
compares the findings presented in this paper to those in Aggarwal and Samwick.
2
Corporate officers are registered with the SEC and are defined by title (e.g., president, CFO,
vice-president in charge of a principal business unit, division or function) or more generally as
an executive ‘who performs a policy-making function.’ See discussion in text and footnote 21
for additional details.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
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managers that are officers are more than three times larger than that of nonofficers. However, there is no significant difference between the sensitivity of
pay to local performance measures for division managers that are officers
versus those that are not. Using proximity to the CEO as an additional
measure of authority, I find no significant difference in pay-performance
sensitivities for division managers that are closer to the CEO in the
organizational hierarchy.
These findings are generally consistent with a class of models in which
performance pay is based disproportionately on firm performance relative
to division performance when managers have broader authority or greater
involvement in firm-wide decision-making (e.g., Holmstrom and Milgrom
[1991] and various multi-tasking models; Bushman, Indjejikian, and Smith
[1995]).3 More specifically, the evidence relates to theories suggesting that
authority over project selection combined with incentives designed to
maximize firm performance, as well as induce effort for the division, are
important in incentive design for division managers (e.g., Athey and Roberts
[2001]). Finally, the results are informative to the finance literature related to
optimal capital allocation across investment projects and organizational
form (e.g., Stein [2002]) and agency problems within internal capital markets
(e.g., Rajan, Servaes, and Zingales [2000]; Scharfstein and Stein [2000]; Wulf
[2002]).
The remainder of the paper is organized as follows. In Section 2, I describe
the data and define measures of incentives and risk. I present the findings on
the risk-incentive tradeoff in Section 3 and subsequently evaluate the
relation between authority, the tradeoff and performance incentives. I
conclude in Section 4.
II.
II(i).
DATA DESCRIPTION
Sample Description
The primary data set used in this study includes a panel of more than 250
publicly traded U.S. firms over the years 1986–1999, spanning a number of
industries. The survey includes a rich array of compensation data for senior
and middle management. Relative to existing research, the dataset used in
the paper has several advantages. It is comprised of longitudinal data on
both firms and multiple division manager positions within firms. It covers a
longer time period (14 years versus 5 years). The pay data are comprehensive
and the measures of performance, risk and authority are all specific to the
division.
3
The paper contributes to the growing interest in determinants, beyond risk, of incentive
provision to managers with authority or decision rights. As stated by Gibbons [1998]: ‘ . . .
recent work on incentives has moved beyond the classic focus on the tradeoff between
insurance and incentives. Risk remains an important issue, but is now recognized as one issue
among many.’
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JULIE WULF
The data are collected from a confidential compensation survey
conducted by Hewitt Associates, a leading human resources consulting
firm specializing in executive compensation and benefits. The survey is the
largest private compensation survey (as measured by the number of
participating firms) and the survey participants are typically leaders in their
sectors. More than 75% percent of the firms in the dataset are listed as
Fortune 500 firms in at least one year and more than 85% are listed as
Fortune 1000 firms. In general, Hewitt survey participants also participate in
other compensation consulting firm surveys (e.g., Hay Associates,
Mercer, Towers Perrin, to name a few) and do so primarily to receive
information about pay practices to use as a competitive benchmark in
evaluating their own compensation programs. It is important to note that
the sample includes many more firms than Hewitt’s consulting client base
with at least 50% of the firms as survey participants with no other
relationship to Hewitt. Based on several analyses described in Appendix
AI, I conclude that the survey sample is probably most representative of
Fortune 500 firms.
The survey is exceptionally broad in that it collects data on many senior
and middle management positions including both operational positions
(e.g., Chief Operations Officer and Division CEO) and staff positions (e.g.,
Chief Financial Officer and Head of Human Resources). The survey
typically covers all the positions at the top of the hierarchy and a sample of
positions lower down. In this paper, I focus on the most senior position in a
divisionFwhich I term the division manager. In the survey, a division is
defined as ‘the lowest level of profit center responsibility for a business unit
that engineers, manufactures and sells its own products.’
The data for each position include all components of compensation
including salary, bonus, restricted stock, stock options and other forms of
long-term incentives (e.g., performance units). An observation in the dataset
is a division managerial position within a firm in a year. To ensure
consistency in matching these positions across firms, the survey provides
benchmark position descriptions and collects additional data for each
position leading to a dataset rich in position characteristics. As a result, in
addition to data on all aspects of compensation for multiple division
manager positions, the dataset includes division-specific characteristics such
as: job title, the title of the position to whom the position reports (i.e., the
position’s boss), division sales, number of employees under the position’s
jurisdiction, industry of operation, geographic state of location, number of
positions between the division manager position and the CEO in the
organizational hierarchy, an indicator of the incumbent’s status as a
corporate officer and the manager’s tenure in the position.
In Appendix AII, the figure displays an (edited) example from the survey
that demonstrates a typical line of authority and the number of reporting
levels for each position. The reporting relationships are clearly illustrated
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
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with the line of authority starting with the CEO as the most senior position,
moving down to the Chief Operating Officer, Group CEO, Division CEO
and finally the Plant Manager as the most junior management position. The
definitions for each of these positions are also described.
I believe the survey data are accurate for several reasons. First, Hewitt
personnel are knowledgeable about survey participants because they are
assigned to specific participants for several years. Furthermore, while the
participating firms initially match their positions to the benchmark positions
in the survey, Hewitt personnel follow up to verify accuracy and spend an
additional 8–10 hours on each questionnaire evaluating the consistency of
responses with public data (e.g., proxy statements) and across years. Finally,
participants have an incentive to match positions correctly and provide
accurate data because they use the survey results to set pay levels and design
management compensation programs.
The above data are supplemented with financial information from
Compustat. While the Hewitt survey is conducted in April of each year and
the compensation data describe the firm in the year of survey completion,
some statistics (e.g., number of employees in the firm) represent the end of
the most recent fiscal year. To maintain consistency, I match Compustat
data using the year prior to the year of the survey.
In Table I, I present descriptive statistics for the firms and divisions
in the sample. While the dataset includes more than 250 firms, the exact
number varies over the period, as firms enter and exit as survey participants.
The firms in the sample are large, well-established and profitable with
average size of approximately 45,900 employees, sales of $8.2 billion, return
on assets of 17%, and sales growth of 6%. The average number of divisions
reported in the survey for the sample firms is approximately five. Next,
turning to division statistics, the mean size of divisions is $688 million in sales
and approximately 3,000 employees. On average, 23% of the division
managers are corporate officers and the division managers have 1.43
positions between the CEO and their position in the organizational
hierarchy (56% either report directly to the CEO or one level below).
Finally, the sample firms span many industrial sectors of the economy, with
some concentration in the food, paper, chemical, machinery, electrical,
transportation equipment, instrumentation, communications and utilities
industries.
II(ii).
Measures of Incentives
Recent research on managerial incentives focuses on stock-based incentives
of CEOs because they dwarf other components of pay (e.g. Hall and
Liebman [1998]; Aggarwal and Samwick [1999]; Core and Guay [1999];
Himmelberg and Hubbard [2000]. However, for division manager positions,
annual bonuses can be equally and, by some measures, more important
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JULIE WULF
Table I
Summary Statistics
Variable
Obs
Mean
Std. Dev.
Min
Max
FIRM
Sales ($ millions)
Employees (000s)
Assets ($ millions)
Return on Assets
Sales Growth
Average Number of Divisions per Firm
2416
2402
2417
2406
1900
2482
8162.43
45.90
9334.32
0.17
0.06
4.85
14710.43
78.02
20769.46
0.08
0.14
4.34
121.65
0.94
91.81
0.07
1.08
1.00
174694.00
825.00
279097.00
0.97
0.91
34.00
11048
10953
10005
688.23
2.96
0.23
1422.96
9.78
0.42
0.05
0.00
0.00
53000.00
611.36
1.00
11970
1.43
0.82
0.00
4.00
11970
0.56
0.50
0.00
1.00
11970
0.18
0.38
0.00
1.00
DIVISION
Sales ($ millions)
Employees (000s)
Division with Incumbent as Corporate Officer
(Officer)
Depth (# of positions between CEO &
Division Manager)
Division at High Organizational Level
(DivHigh)
Division with Incumbent as Officer at High
Orgn. Level (OffHigh)
Notes: Officer is an indicator variable equal to one if the incumbent in the division manager position is a
corporate officer of the firm and zero otherwise. See footnote in text detailing definitions of a corporate officer
used by both the Securities and Exchange Commission and the Internal Revenue Service. Depth is defined as the
number of positions between the CEO and the division manager position in the firm’s organizational hierarchy.
Refer to both Figure 1 at the end of this paper and to Rajan and Wulf (2006) for additional details. DivHigh is an
indicator variable equal to one if the division manager position reports either directly to the CEO or one level
below that and zero otherwise. OffHigh is an indicator variable equal to one if the incumbent in the division
manager position is a corporate officer of the firm and reports either directly to the CEO or one level below that
and zero otherwise.
because bonuses represent a significant fraction of pay relative to stockbased pay for division manager positions and a larger fraction of incentive
pay relative to CEOs.4 Division manager bonuses are typically linked to
local or division performance measures over which the manager has greater
control relative to firm performance measures. Also, firms use greater
discretion in determining bonuses for lower level managers in comparison to
CEOs. This allows firms to mitigate the risk and distortion associated with
available performance measures.5 The relative magnitude of bonuses
combined with the closer link to local performance measures and greater
discretion suggests that annual bonuses for division managers are an
important incentive instrument.
Importantly, there are several econometric advantages to the analysis of
bonuses relative to that of stock-based pay. Performance measures that
firms commonly use to determine bonus payouts have been documented in
4
Refer to the discussion of Table II later in this section.
Murphy and Oyer [2003] use a cross-sectional survey of 280 bonus plans and find that
discretion is less important in determining CEO annual incentive pay relative to other
executives.
5
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
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previous research, yet we know less about how firms grant options, restricted
stock or other long-term performance incentives. Moreover, the time-frame
by which performance is measured for bonuses is well-defined (i.e.,
performance over the past fiscal year), while stock and option grants do
not necessarily occur yearly and the timing of vesting schedules vary across
incentive instruments and firms.
Because of the relative magnitude of bonuses and the econometric
advantages, I focus on annual salary and bonus paid to division manager
positions. However, I also report summary statistics and estimate select
regressions using total compensation defined as the sum of salary, bonus and
long-term compensation. The value of the long-term compensation includes
restricted stock, stock options and other components of long-term
incentives and is determined by a modified version of Black-Scholes.6 Also,
while the main results are based on salary plus bonus, I also show that the
results are qualitatively similar when using the logarithm of bonus and the
logarithm of total compensation as the pay measure.
The measure of performance incentives or pay-performance sensitivity is
based on the ‘implicit’ method discussed in Murphy [1999] and similar to
that in Aggarwal and Samwick [2003] (hereafter A&S). The implicit
pay-performance sensitivity is simply the coefficient on performance
in a regression with the level of compensation as the dependent variable.
Variation in the pay-performance sensitivity can be analyzed by including interaction terms between variables of interest, such as the
variance of performance or measures of authority, with the performance
measure.
In Table II, I report means, medians, and standard deviations of several
pay measures for both CEO and division manager positions. Compensation
variables are denominated in millions of 1996 dollars. Sample averages for
CEO salary plus bonus (or cash compensation), long-term compensation
and total compensation are $1.229 million, $1.493 million and $2.719
million, respectively. Comparable sample averages for the division manager
are $0.259 million, $0.152 million and $0.411 million, respectively. To get a
sense of the relative importance of annual bonuses versus long-term
compensation for CEOs relative to division managers, I report annual bonus
and long-term compensation as a fraction of salary and bonus. Both ratios
of performance-based pay to cash compensation are common measures in
6
The value of long-term compensation is computed by Hewitt Associates. Stock options are
valued using a modified version of Black-Scholes that takes into account vesting and
termination provisions in addition to the standard variables of interest rates, stock price
volatility, and dividends. As is standard practice among compensation consulting firms, the
other components of long-term incentives (i.e., restricted stock, performance units and
performance shares) are valued using an economic valuation similar to Black-Scholes that
takes into account vesting, termination provisions, and the probability of achieving
performance goals.
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JULIE WULF
Table II
CEO and Division Manager Compensation
CEO (n 5 2482)
Division Manager (n 5 12,032)
Std.Dev.
Mean Median Std.Dev. Mean Median Std.Dev. (within firm)
Salary ($ millions)
Bonus ($ millions)
Salary Plus Bonus ($ millions)
Bonus/(Salary þ Bonus)
Long-term Compensation/
(Salary þ Bonus)
Bonus/Long-term
Compensation
Long-term Compensation
($ millions)
Total Compensation
($ millions)
0.665
0.563
1.229
0.37
1.13
0.605
0.376
0.975
0.40
0.71
0.303
0.758
0.953
0.18
7.67
0.179
0.081
0.259
0.27
0.47
0.163
0.060
0.225
0.28
0.37
0.084
0.082
0.152
0.13
0.48
0.034
0.034
0.063
0.07
0.15
0.83
0.49
1.98
1.09
0.68
2.86
0.60
1.493
0.677
2.593
0.152
0.081
0.261
0.062
2.719
1.675
3.314
0.411
0.312
0.381
0.117
Notes: Compensation variables are denominated in millions of 1996 dollars. The value of long-term
compensation is computed by Hewitt Associates. Stock options are valued using a modified version of BlackScholes that takes into account vesting and termination provisions in addition to the standard variables of
interest rates, stock price volatility, and dividends. As is standard practice among compensation consulting
firms, the other components of long-term incentives (i.e., restricted stock, performance units and performance
shares) are valued using an economic valuation similar to Black-Scholes that takes into account vesting,
termination provisions, and the probability of achieving performance goals. The standard deviation within the
firm reported in the last column is the sample average of the standard deviation of the division manager pay
measure across divisions within a firm in a given year.
the accounting literature (e.g., Baiman et al., [1995]). For the CEO position,
the sample average and median ratios of bonus to the sum of salary and
bonus are 0.37 and 0.40, while the corresponding statistics for the ratio of
long-term compensation to salary plus bonus are 1.13 and 0.71. Consistent
with the findings of the CEO literature, long-term compensation comprises a
greater proportion of CEO pay relative to annual bonuses.7
Next, let us turn to division manager compensation. The sample average
and median ratio of bonus to salary plus bonus are 0.27 and 0.28, while the
corresponding statistics for the ratio of long-term compensation to salary
plus bonus are 0.47 and 0.37. In sum, annual bonuses for division managers
represent a comparable fraction of pay relative to long-term compensation
(0.28 for short-term vs. 0.37 for long-term based on median values) and a
larger fraction of pay relative to CEOs (0.68 for division manager bonus
relative to long-term compensation vs. 0.49 for CEO based on medians).
7
This ‘flow’ measure of long-term compensation understates incentive pay for the CEO
relative to the division manager because CEOs hold a much higher percentage of a firm’s stock
in comparison to division managers. Recent research on CEO compensation accounts for the
incentives from the holding of stock and stock options (in addition to annual grants of
restricted stock and options). While Hewitt does not collect data on stock holdings for division
managers, this restriction is less of a problem at lower levels of management.
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Figure 1
Trends in CEO and Division Manager Compensation (medians)
Notes: Includes only observations that appear for two consecutive years in dataset. Refer to notes
in Table II for additional definitions.
In comparison to the CEO position, annual bonuses for division managers
are a relatively important incentive mechanism.
In Figure 1, I document changes in both the fraction of bonus and the
fraction of long-term compensation of salary plus bonus for both the CEO
and division manager positions over the period of study. The figure is based
on the sample that includes firms and divisions that appear in the dataset for
two consecutive years. By focusing on this set of observations, I minimize
biases from the exit and entry of firms. As we see, there is an upward trend
in both annual and long-term compensation as a fraction of cash
compensation for both positions over time for this sample. Also, the
increase in the ratio of long-term compensation is much greater than that of
the ratio of annual bonus, especially for the CEO. (The patterns for the
whole sample are qualitatively similar.)
III. EMPIRICAL METHODOLOGY AND RESULTS
III(i). Empirical Methodology and Performance Measures
The empirical strategy used to identify the relation between authority,
risk and performance incentives is to exploit the variation in these measures
across multiple division manager positions within a firm.8 In this paper,
I estimate firm fixed effects regressions of division manager compensation. Let us begin with the basic econometric specification based on
8
One fact that suggests this is a promising strategy is that more than half of the total variation
in the ratio of bonus to salary plus bonus across division manager positions is within firms (0.07
in last column of Table II vs. 0.13 in the second to last column in Table II).
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JULIE WULF
the ‘implicit’ method:
ð1Þ
wijt ¼b1 dijt þ b2 dijt Fðsdi Þ þ b3 Fðsdi Þ þ b4 fjt þ b5 fjt Fðsfj Þ
þ b6 Fðsfj Þ þ b7 Xjt þ b8 Dijt þ aj þ dt þ eijt
While the dependent variable wijt varies across specifications, in the
primary regression it is defined as the logarithm of the sum of salary and
bonus for the division manager position i, working at firm j, in year t.
I include two measures of performance: a local performance measure that is
specific to the division (dijt) and a global measure to represent firm
performance ( fjt). The local measure (dijt) is division sales growth defined as
the change in the logarithm of division sales at division i between t and t-1.9
The global or firm measure (fjt) is firm sales growth defined as the change in
the logarithm of total sales at firm j between t and t-1.
Also, I include measures of both division and firm risk, based on the
volatility of division and firm performance measures, and include
interaction terms between each measure of risk and the corresponding
performance measure. Following A&S [2003], I define the volatility of
division performance (sdi) and the volatility of firm performance (sfj)
as the standard deviation in division and firm sales growth, respectively,
over as much of the 1986 to 1999 period for which the firm and division
report data.10 I use the empirical cumulative distribution (CDF) of
risk measures in the reported regressions instead of the risk measure itself.
For division risk, I use the percentile of the standard deviation of
division performance in the distribution of standard deviations across all
sample divisions (represented by F(sdi). For firm risk, I use the analogous
measure based on the distribution across all sample firms (represented
by F(sfj)).
The use of the CDF allows the pay-performance sensitivities at different
points in the distribution of division and firm risk to be easily computed.
The sensitivity of a division manager’s bonus to local performance
(or pay-division performance sensitivity, PPSD) for a division manager
with a given division sales growth standard deviation is b1 þ Fðsdi Þb2 .
For a division at the median, where F(sdi) 5 0.5, the PPSD equals b1 þ 0.5b2.
Turning to global measures, the sensitivity of a division manager’s bonus
9
I winsorize the division sales growth measure (at 1%) to address concern about
measurement error in division sales.
10
This paper uses the same risk measures as A&S to be consistent with their approach and to
allow comparison. Also, since I do not observe division sales growth outside of the sample,
I cannot use a time-varying measure of risk and, because of this, choose to use an analogous
measure for firm risk. One limitation of this measure of risk is that it can be affected by the
agent’s actions. For empirical research analyzing risk-incentive tradeoffs for CEOs and the
relationship to different types of risk, refer to Jin [2002] and Shi [2003].
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to global performance (or pay-firm performance sensitivity, PPSF)
for a division manager with a given firm sales growth standard
deviation is b4 þ Fðsfj Þb5 (and for a firm at the median, PPSF equals
b4 þ 0.5b5).
Xjt and Dijt represent firm and division characteristics, respectively, e.g.,
the logarithm of firm and division sales. In all specifications, I include firm
fixed effects (aj), thereby controlling for firm-specific omitted variables that
are constant over the period, and year indicators (dt). While this addresses
concerns about unobserved firm heterogeneity in the levels of performancebased pay, it doesn’t address the problem with respect to estimates of the
pay-performance sensitivities. Since my measure of sensitivity is represented
by the coefficient on performance in equation (1), I also estimate select
specifications with interaction terms between the division measure of
performance and firm indicators (i.e., dijt aj ).11 When I turn to analyzing
the relation between authority, risk, and performance incentives, I introduce
measures of authority directly in this specification. I also include interaction
terms between authority measures and all other measures in this basic
specification. Finally, I address the lack of independence across division
manager observations within a firm and report robust standard errors
(clustering by division) in all specifications.
Since this paper primarily focuses on annual bonuses as performance
incentives, the appropriate performance measures are accounting measures,
not stock returns.12 There is extensive evidence documenting that the most
commonly used measures in determining annual bonuses are accounting
measures. For example, Murphy [2000] reports performance measures used
in 177 annual incentive plans in companies surveyed by Towers Perrin in
1996–1997. He finds that ‘almost all companies rely on some measure of
accounting performance . . . ’ and that ‘ . . . 161 of the 177 sample (91%)
explicitly use at least one measure of accounting profits in their annual bonus
plans.’13
11
This is possible with division performance, but comparable interaction terms between firm
sales growth and firm indicators are not identified due to high collinearity.
12
As stated in Murphy [1999; p. 2525]: ‘Realized bonuses are explicitly related to accounting
profitability, but only implicitly related to stock price performance.’
13
Common performance standards for accounting performance measures include ‘budget’
standards based on annual budget goals and ‘prior-year’ standards based on year-to-year
growth or improvement (such as growth in sales or EPS) [Murphy, 2000]. Keating [1997]
conducts a survey about the use of performance metrics in evaluating division managers and
finds that firm performance use increases with the manager’s ability to affect other divisions.
Bushman et.al. [1995] and Wulf [2002] document that approximately 50% (25%) of a division
manager’s annual bonus is determined by division (corporate) performance, respectively.
Chichello, Fee, Hadlock and Sonti [2005] study the relationship between division manager
turnover/promotions and division accounting performance.
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JULIE WULF
Hewitt only collects sales figures for divisions and not profitability. Due to
this data limitation, I use year-to-year sales growth of the division as the
local performance measure and, for consistency, sales growth of the firm as
the global measure.
III(ii).
Tradeoff between Risk and Incentives
Using the notation in equation (1) and informed by the empirical regularities
of earlier research, I summarize the predictions of the risk-incentive tradeoff.
First, division manager pay should be positively related to both local and
global performance measures (i.e., b3 4 0 and b6 4 0), and decreasing in the
noise of each performance measure (i.e., b4 o 0 and b7 o 0). These latter two
coefficients capture the negative tradeoff between risk and incentivesFor
how the sensitivity of pay to performance declines with increases in the
volatility or noise of the performance measure.
In the first column of Table III, I regress the logarithm of salary plus bonus
for the division manager position on division sales growth, an interaction
term between division sales growth and division risk (or the CDF of the
standard deviation of division sales growth), division risk (coefficient not
reported), firm sales growth, and an interaction term between firm sales
growth and firm risk (or the CDF of the standard deviation of firm sales
growth). I include both firm and division sales as controls because of the
argument that more talented or productive managers are selected to manage
larger units and the corresponding, well-documented relationship between
size and pay (Schaefer [1998]; Baker and Hall [2004]). Finally, all regressions
include firm and year indicators.
In column (1), I find positive and statistically significant coefficients on
both division and firm sales growth. More notably, I find negative and
significant coefficients on the interaction terms between growth and risk for
both division and firm measures. Division manager salary plus bonus is
larger in divisions and firms with faster sales growth, and the sensitivity of
pay to performance is declining in the volatility of each performance
measure. Or, in terms of equation (1), the sensitivity of pay to the local
measure is positive (i.e., b1 4 0) and declines with the volatility of the local
performance measure (i.e., b2 o 0). The same relationship holds for the
global measure (i.e., b4 4 0 and b5 o 0). These findings provide strong
support for the negative tradeoff between risk and incentives predicted by a
standard principal-agent model.
Let us now turn to interpreting the magnitudes of the coefficients. In the
panel below Table III, I report estimated pay-performance sensitivities at
both the median and 25th percentile of the distribution of division and firm
risk. The estimated pay-division performance sensitivity (PPSD) at median
standard deviation is given by b1 þ 0.5b2 and is equal to 0.101 (0.289–
0.50.377). This suggests that a one per cent increase in division sales growth
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
Table III
Division Manager Position Pay Regressions of Pay-Performance Sensitivities
Firm Fixed Effects Regressions
(1)
(2)
(3)
(4)
(5)
(6)
Log
(Salary þ Bonus)
Log
(Bonus)
Log (Total
Comp.)
Log
(Salary þ Bonus)
Log
(Bonus)
Log (Total
Comp.)
0.289
(0.049)
0.377
(0.057)
0.985
(0.114)
1.111
(0.131)
0.291
(0.062)
0.386
(0.072)
0.141
(0.061)
0.192
(0.072)
0.966
(0.267)
0.604
(0.175)
0.045
(0.080)
-0.191
(0.093)
0.540
(0.113)
0.572
(0.127)
1.538
(0.262)
1.507
(0.290)
0.696
(0.135)
0.747
(0.153)
0.573
(0.118)
0.613
(0.133)
1.549
(0.272)
1.540
(0.302)
0.779
(0.141)
0.834
(0.160)
0.044
(0.023)
0.166
(0.007)
11.387
(0.199)
No
0.059
(0.050)
0.236
(0.012)
9.624
(0.447)
No
0.068
(0.031)
0.202
(0.009)
11.526
(0.273)
No
0.035
(0.023)
0.170
(0.007)
11.280
(0.162)
Yes
0.049
(0.051)
0.240
(0.013)
8.944
(0.402)
Yes
0.054
(0.032)
0.207
(0.009)
11.299
(0.217)
Yes
6346
0.80
6346
0.77
Division sales
growth
Div sales
growthDiv
CDF
Firm sales growth
Firm sales
growthFirm
CDF
Log (firm sales)
Log (division sales)
Constant
Firm FE Div sales
growth
Observations
R-squared
6346
0.76
5866
0.65
5866
0.67
6346
0.83
Estimated Pay-Division Performance Sensitivities (PPSD) and Pay-Firm Performance Sensitivities (PPSF)
PPSD at median
Division Std. Dev.
PPSD at 25th percentile
Div. Std. Dev.
PPSF at median Firm
Std. Dev
PPSF at 25th percentile
Firm Std. Dev.
0.101
0.430
0.098
0.045
0.664
–
0.195
0.707
0.194
0.093
0.815
–
0.254
0.785
0.323
0.267
0.779
0.362
0.397
1.161
0.509
0.419
1.164
0.571
Notes: Based on sample of divisions that appear for at least 4 years in dataset. Firm Sales Growth is defined as
the difference in the logarithm of firm sales between year t and t-1 for the years that the firm is in the sample.
Division Sales Growth is defined as the difference in the logarithm of division sales between the year t and t-1 for
the years that the division is in the sample. Firm CDF is the measure of firm risk defined as the empirical
cumulative distribution function (CDF) of the standard deviation of firm sales growth for firms in the sample.
Division CDF is the measure of division risk defined as the empirical cumulative distribution function (CDF) of
the standard deviation of division sales growth for divisions in the sample. All regressions include Division
CDF. Robust standard errors clustered by division; firm and year indicators included in all specifications.
Regressions in columns (4), (5) and (6) include interaction terms between firm indicators and division sales
growth. PPSD and PPSF are defined in text.
//
represents significance at the 10%/5%/1% level, respectively.
increases salary and bonus by 10.1% at the median standard deviation. The
estimated pay-firm performance sensitivity (PPSF) at median standard
deviation is given by b4 þ 0.5b5 and is equal to 0.254 (0.540–0.50.572).14
14
The strong pay-firm performance sensitivity is consistent with the research documenting
that division manager bonuses are linked to firm performance. By contrast, relative
performance evaluation (RPE) implies a negative coefficient on firm sales growth: as other
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This suggests that a one per cent increase in firm sales growth increases salary
and bonus by 25.4% at the median standard deviation.
In the panel below Table III, we can see that pay-performance sensitivities
at median standard deviation are an order of magnitude lower than PPS
estimates at the 25th percentile standard deviation for both division and firm
performance measures. Focusing on the results in column (1), the PPSD at
median division volatility is 0.101 in comparison to 0.195 at the 25th
percentile volatility. Turning to the pay-firm performance sensitivity, the
PPSF at median firm volatility is 0.254 versus 0.397 at the 25th percentile
volatility. This is consistent with earlier research showing that increases in
volatility have negative and economically significant effects on payperformance sensitivity. Finally, one other notable observation is that the
estimated sensitivity of salary plus bonus to the global performance measure
is larger than the sensitivity to the local performance measure. For example,
in column (1) the PPSF at median volatility is more than two times PPSD
(0.254 vs. 0.101).15
Since I use logarithm of pay, I am estimating elasticities: a percentage
change in pay relative to a change in the performance measure. However,
this measure has limitations as a measure of pay for performance since
elasticities change if the fixed portion of pay changes. To isolate changes in
performance-based pay, I also re-estimate the baseline regression with the
logarithm of bonus as the dependent variable. The reported results in
column (2) are qualitatively similar but, as expected, the magnitudes of the
pay-performance sensitivities are significantly larger. In the panel below
Table III, we see that PPSD (at the median standard deviation) is 0.430, while
PPSF is 0.785.
While the focus of this paper is cash compensation, I also estimate
regressions using the log of total compensation as the pay measure. In Table
III column (3), the estimated pay-division performance sensitivity at median
standard deviation (PPSD) is 0.098, while the pay-firm performance (PPSF)
sensitivity is 0.323. Both estimates are statistically significant at the 1% level
(as are the individual coefficients on each performance measure and
associated volatility measures). The estimated pay-firm performance
sensitivity (PPSF) in this regression is more than 25% greater in comparison
to the regression with salary plus bonus as the pay measure (0.323 vs. 0.254).
divisions within the firm perform better, division managers should be paid less. However, there
is mixed evidence in the literature supporting RPE.
15
The sign and significance of coefficients in Table III are robust to defining pay in terms of
levels (or dollars). The pay-performance sensitivities of the regression in column (1) when pay is
defined in dollars are as follows: PPSD is 27,751 and PPSF is 59,903. The estimates imply that a
one per cent increase in division sales growth increases salary plus bonus by $27,752 (at the
median standard deviation) which is about 10% of the average salary plus bonus; while a one
per cent increase in firm sales growth increases salary plus bonus by $59,903 which is about 23%
of the average.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
183
This is not surprising since the difference in the pay measures is primarily
equity-based pay which is more strongly correlated with firm performance.
The specifications in columns (1) through (3) include firm indicators
thereby controlling for the effect of unobserved firm heterogeneity on the
level of division manager pay. To address how this affects the estimates of
pay-performance sensitivity, I include interaction terms between firm
indicators and division sales growth. The results are presented in Table III
columns (4) through (6). In column (4) using salary plus bonus as the pay
measure, we see that the signs and significance of the coefficients are identical
to column (1) (without the interaction terms between firm indicators and
division sales growth), however, the estimates for PPSD at the median are
about half as large (0.045 vs. 0.101). Using bonus as the pay measure in
column (5), the estimated PPSD at the median is higher in comparison to
column (2) (0.664 vs.0.430). Lastly, in the regression of total compensation,
the coefficient on division sales growth is positive, but insignificant.
At this point, let us compare these results to estimates of pay-performance
sensitivities from Aggarwal and Samwick [2003], the paper closest in spirit.
While the primary focus of A&S is to document performance incentives
across senior executive positions in different job groups (e.g., CEOs vs.
CFOs), they do test and find support for the predictions of a two-signal
principal-agent model (Banker and Datar [1989]) for division managers.
This paper’s results are generally consistent with A&S findings on division
manager performance incentives. Importantly, this paper goes beyond A&S
in analyzing how performance incentives vary by authority across division
manager positions in the same job classification.
The Hewitt dataset provides several advantages relative to ExecuComp in
analyzing division manager positions. The first is that it allows analysis of
incentives for positions further down the organizational hierarchy.16 The
lower level positions are interesting because it is this set of managers that is
more likely to have better information about certain types of decisions. The
second advantage is the reporting of multiple observations of a single job
classification: Hewitt reports five division manager positions per firm-year
on average in comparison to approximately one-half division manager
position per firm-year in ExecuComp.17 As such, the analyses in this paper
offset some of the data limitations faced by A&S that potentially lead to two
16
The ‘division managers’ analyzed in A&S receive more than double (triple) the total
compensation (long-term compensation) of Hewitt division managers during comparable time
periods, respectively: average of $1.05 million.vs. $449,000 for Hewitt for total compensation
($541,000 vs. $152,000 for long-term compensation).
17
On average, A&S observe approximately one business unit executive in a firm-year, and
can only match about half of these executives to business unit or ‘segment’ sales as reported in
Compustat’s Industry Segment database. Of approximately 6,800 firm-year observations,
A&S identify approximately 6,400 executive-years with business unit responsibility, but only
match approximately 3,300 executive-years to segments (as reported in their Table I).
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JULIE WULF
types of selection bias on their pay-performance estimates. The first is that
they only observe business unit executives that are among the top-five
highest paid managers. Second, they don’t observe sales data for all of the
business unit executives that they identify.
For business unit executives matched to segment sales, the A&S estimate
of the pay-segment performance sensitivity at median segment volatility is
0.283 (and 0.120 when segments are matched to any business unit executive)
as reported in their Table VI. While the specifications in the two papers are
not identical, the analogous pay-division performance sensitivity (PPSD)
estimate for the division managers in this sample is 0.101, which is
significantly smaller than the A&S estimate for matched executives (but
quite similar to their estimate based on any business unit executive). While
the larger estimate by A&S may be due to selection bias, another equally
plausible explanation is that division managers at lower levels have less
authority and, in turn, their pay is less sensitive to division (or segment)
performance. Based on a richer dataset than ExecuComp, the findings in this
paper confirm the robustness of the pay-division performance sensitivities
and that the risk-incentive tradeoff holds for managers further down the
hierarchy.18
To sum up, I find strong support for the negative tradeoff between risk
and incentives in analyzing division managers at lower levels than previous
research. That is, pay-performance sensitivities are positive and declining in
the volatility of the performance measure. This relationship holds for both
local and global performance measures and the results are robust to using
two additional pay measures: annual bonuses and total compensation. The
evidence contrasts with the mixed empirical support for the negative
tradeoff between risk and incentives as summarized in Prendergast [2002].
In the next section, I turn to evaluating how measures of authority are
related to performance incentives.
III(iii).
Authority and Incentives
Measures of authority within firms in large sample studies are not readily
available. I use two division-specific measures related to division manager
18
Another difference between the two papers is that I find a positive relation between the log
of salary and bonus for divisional managers and firm sales growth that is statistically and
economically significant. In contrast, A&S find a negative relation. They argue that their result
is consistent with relative performance evaluation in that business unit executives’ ‘short-term
compensation increases with divisional performance only to the extent that the growth exceeds
the growth in firm-level sales.’ One possibility is that the negative coefficient on firm sales
growth is largely explained by the inclusion of shareholder returns as a firm performance
measure in their specification. While this is an appropriate measure for analyzing equity-based
incentives, it is less so for salary and bonuses. As discussed earlier, evidence suggests that
accounting performance measures are relevant in annual bonus contracts, not stock returns
(Murphy [2000]).
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
185
authority: officer status of the division manager and the level of the position in
the hierarchy. Both constructs are related to the discussion of measurement of
real authority over investment projects in Aghion and Tirole [1997].19 My
approach is first to analyze pay-performance sensitivities for sub-samples
partitioned by each criterion, e.g., officers vs. non-officers. Next, I estimate
pooled regressions with interaction terms between measures of authority and
all variables in the partitioned regressions. And, finally I evaluate whether the
results are robust to defining pay as total compensation.20
Officer Status of Division Manager The first measure of division manager
authority is whether the incumbent in the position is a corporate officer of
the firm. Officers of the corporation are determined by both the individual’s
authority and the nature and extent of the individual’s duties. Corporate
officers are registered with the SEC and are defined by title (e.g., president,
CFO, vice-president in charge of a principal business unit, division or
function) or more generally as an executive ‘who performs a policy-making
function.’ I define Officer as an indicator variable equal to one if the division
manager is a corporate officer of the firm. Approximately 23% of division
managers in the sample are corporate officers.21
Let us turn to the question: does the sensitivity of pay to performance
among managers in the same job with similar responsibilities (i.e., profit and
loss responsibility for a division) vary by officer status of the incumbent? In
the first two columns in Table IV, I partition the sample into division
managers that are officers (column (1)) and those that are not (column (2))
and estimate the baseline regression from the first column in Table III. The
coefficients on division sales growth and the interaction between CDF and
19
Hierarchical level of the division manager position is directly related to Aghion and
Tirole’s suggestion that ‘organizational characteristics such as the span of control, the
concentration of ownership, and the number of principals and supervising layers are directly
relevant for measuring (or assessing) real authority enjoyed by subordinates within a firm.’
Corporate officer status is related to their discussion of how legal specialists are proposing that
liability rules should also accommodate organizational characteristics that affect real
authority. (pp. 26–27).
20
Other papers in the accounting literature study the relationship between authority and
incentives for a single job type, but do not analyze risk and are confined to cross-sectional
analysis (e.g., Nagar [2002], Baiman, Larcker and Rajan [1995]).
21
The term ‘officer’ is defined by both the Securities and Exchange Commission in Section
240.16 (rules governing insider trading) and the Internal Revenue Service in Section 280G. The
SEC defines an officer as ‘an issuer’s president, principal financial officer, principal accounting
officer (or, if there is no such accounting officer, the controller), any vice-president of the issuer
in charge of a principal business unit, division or function (such as sales, administration, or
finance), any other officer who performs a policy-making function.’ The IRS code states that
‘whether an individual is an officer with respect to a corporation is determined upon the basis of
all the facts and circumstances in the particular case (such as the source of the individual’s
authority, the term for which the individual is elected or appointed, and the nature and extent of
the individual’s duties).’ See Rajan and Wulf [2006] for a discussion of the increasing trend of
division managers as corporate officers.
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JULIE WULF
Table IV
Division Manager Position Pay Regressions of Pay-Performance
Sensitivities Firm Fixed Effects Regressions Division-Specific Measures of
Authority Proxied by Corporate Officer Status of Division Manager
(1)
(2)
(3)
(4)
(5)
(6)
Officer
NonOfficer
Whole
Sample
Officer
Non-Officer
Whole
Sample
Log (Total
Comp.)
Log (Total
Comp.)
Log (Total
Comp.)
0.275
(0.109)
0.361
(0.137)
1.393
(0.264)
1.406
(0.308)
0.275
(0.067)
0.370
(0.078)
0.414
(0.154)
0.428
(0.174)
0.012
(0.061)
0.179
(0.014)
12.083
(0.517)
1619
0.82
0.055
(0.031)
0.190
(0.010)
11.634
(0.278)
4727
0.81
0.287
(0.069)
0.386
(0.080)
0.494
(0.150)
0.523
(0.170)
0.053
(0.140)
0.049
(0.138)
0.027
(0.165)
0.719
(0.294)
0.802
(0.343)
F
0.095
0.090
F
F
Log
Log
Log
(Salary þ (Salary þ (Salary þ
Bonus)
Bonus)
Bonus)
0.276
0.288
0.289
(0.086)
(0.055)
(0.055)
Div sales growthDiv
0.334 0.383 0.386
(0.103)
(0.064)
(0.065)
CDF
Firm sales growth
1.136
0.281
0.386
(0.213)
(0.127)
(0.126)
Firm sales growthFirm 1.168 0.279 0.391
CDF
(0.250)
(0.143)
(0.142)
Officer
0.001
(0.106)
Division sales
0.016
growthOfficer
(0.111)
Div sales growth div
0.029
(0.132)
CDFOfficer
Firm sales growth Officer
0.575
(0.243)
Firm sales growthFirm
0.696
CDFOfficer
(0.283)
F
Log (firm sales)
0.014
0.054
(0.037)
(0.026)
Log (division sales)
0.152
0.159
F
(0.012)
(0.008)
Constant
11.935
11.322
11.407
(0.313)
(0.229)
(0.200)
Observations
1619
4727
6346
R-squared
0.77
0.78
0.77
Division sales growth
PPSD at median Div. Std.
Dev.
PPSF at median Firm Std.
Dev
0.109
0.552
0.096
F
F
0.141
0.689
0.199
F
11.554
(0.269)
6346
0.81
Notes: Based on sample of divisions that appear for at least 4 years in dataset. Officer is an indicator variable
equal to one if the incumbent in the division manager position is a corporate officer and zero otherwise. All
regressions include Division CDF. See notes in earlier tables for other definitions. Columns (3) and (6) only
report select coefficients of interest. Robust standard errors clustered by division; firm and year indicators
included in all specifications.
//
represents significance at the 10%/5%/1% level, respectively.
division sales growth are similar in magnitude for officers and non-officers
(and all coefficients are statistically significant). In contrast, coefficients on
firm sales growth (and the interaction between CDF and firm sales growth)
are much larger (smaller) for the officer sample relative to the non-officer
sample. Focusing on the relative magnitudes of the estimates of the payperformance sensitivities, PPSF at the median standard deviation of firm
sales growth for officers is approximately 0.552, while for non-officers it is
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0.141 (reported in the panel below Table IV). Both estimates are statistically
significant at the 1% level. Officer pay is almost four times more sensitive to
firm performance than non-officer pay, but sensitivity to division
performance is no different. Furthermore, the ratio of PPSF to PPSD for
officers is more than three times that for non-officers.22
To evaluate whether the differences are statistically significant, in column
(3), I return to the whole sample and include interaction terms between Officer
and all variables included in the previous regressions. I only report coefficients
for variables of interest: performance, Officer, performanceOfficer, and
performanceCDFOfficer. Notably, the coefficient on the interaction term
between firm sales growth and Officer is positive and significant, while the
coefficient on the interaction term between firm sales growth, firm CDF and
Officer is negative and significant. Thus salary plus bonus for division
managers with officer status is more sensitive to global performance and the
difference is statistically significant. When I repeat the specifications in
columns (1) through (3), but define pay as total compensation, the results are
qualitatively similar (reported in columns (4) through (6)).
Hierarchical Level of Division Manager Position. Another measure
related to authority is the position of the division manager in the
organizational hierarchy. Division managers reporting at higher levels in
the organization may have more decision-making authority relative to
division managers further down the hierarchy. A natural question is: do
division manager performance incentives vary by the organizational level of
the position in the hierarchy? 23 Depth is defined as the number of positions
between the CEO and the division manager position in the firm’s
organizational hierarchy (refer to the figure in Appendix AII at the end of
this paper and Rajan and Wulf [2006] for a more detailed definition).24
I define DivHigh as an indicator variable equal to one if Depth is less than or
22
Notice that PPSF is slightly larger than PPSD for non-officers (bottom of Table IV column
(2)). This may reflect the importance of giving broad-based incentives to division managers
even if they are not officers.
23
Variation in pay across hierarchical levels may be partially explained by career concerns in
that lower level managers can be paid less in current compensation because they enjoy greater
internal promotion opportunities relative to those at higher levels. Gibbons and Murphy [1992]
suggest that ‘pay should be most sensitive to current performance for workers . . .. with no
promotion opportunities (such as workers at the top of the corporate hierarchy . . .)(p. 470).’
Managers in lower level positions have a greater number of potential promotions to more
senior positions in the hierarchy which is consistent with lower levels of current pay.
24
See Rajan and Wulf [2006] for a discussion of the increasing trend of division managers
getting closer to the top of the organizational hierarchy (or decreasing depth). In addition to
depth, span of control is another dimension of the organizational structure that could affect the
relationship among authority, risk and incentives. Since span changes over time (see Rajan and
Wulf [2006] for evidence), this is not addressed by the inclusion of firm fixed effects. The results
are qualitatively similar when I include span of control (measured by the number of reports to
the CEO position) as a control variable.
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JULIE WULF
equal to one, i.e., the division manager either reports directly to the CEO or if
there is one position between the CEO and the division manager. Based on
this definition, approximately 56% of division managers in the sample are at
a high organizational level.
In Table V, I partition the sample into division managers at a high level in
the hierarchy (DivHigh equal to one) (column (1)) versus lower level
managers (column (2)). In comparing the two columns, coefficients on
division sales growth are larger for high-level managers (column (1)) relative
to low-level managers (column (2)), but the opposite holds for the
coefficients on firm sales growth. In turn, the PPSD is positive and significant
at the 1% level for high-level managers, while that for low-level managers is
positive, but only marginally significant (10% level). The PPSF is smaller for
high-level managers relative to low-level managers and both estimates are
significant at the 1% level. In a pooled regression of both samples with
interaction terms between Depth and all variables in the partitioned
regressions, the results suggest no statistically significant differences in payperformance sensitivities by organizational level (unreported). Thus, there
appears to be no difference in performance incentives between division
managers that are close in proximity to the CEO relative to those that are
further down the hierarchy.25
Since division managers with officer status are more likely to be positioned
at higher organization levels (i.e., correlation coefficient 5 0.16), I next
analyze partitions that combine these characteristics. In Table V column (3),
I include division managers that are officers and also positioned at high
organizational levels (OffHigh as an indicator variable equal to one). This
represents 18% of the division managers included in this analysis. The
regression in Table V column (4) is based on all other division manager
positions, i.e., those without officer status or at low organizational levels
(OffHigh equal to zero). In a comparison of the coefficients on division and
firm sales growth between columns (3) and (4), we see that salary plus bonus
for officers at high levels is more sensitive to both division and firm
performance relative to non-officers or managers at low-levels, but the
differences are most pronounced for firm performance. These results are
qualitatively similar to the partitions based on officer status.
To evaluate the statistical significance of these differences, in Table V
column (5), I return to the whole sample and include interaction terms
between the indicator representing officers at high levels (OffHigh) and all
25
There is one exception: PPSF for division managers reporting directly to the CEO
(approximately 10% of the sample) is significantly larger in comparison to all other division
managers, but only when pay is defined as total compensation. Related to this, Barron and
Waddell [2003] show that the importance of equity-based pay among the top-five highest paid
executives in different job classifications varies by rank (determined by compensation levels):
executives with higher pay receive more in equity-based incentives.
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AUTHORITY, RISK, AND PERFORMANCE INCENTIVES
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TableV
Division Manager Position Pay Regressions of Pay-Performance Sensitivities
Firm Fixed Effects Regressions
Division-Specific Measures of Authority Proxied by Organizational Level
and Corporate Officer Status of Division Manager
Division sales growth
Div sales growthDiv
CDF
Firm sales growth
Firm sales growthFirm
CDF
OffHigh
Division sales
growthOffHigh
Div sales growthdiv
CDFOffHigh
Firm sales
growthOffHigh
Firm sales growthFirm
CDFOffHigh
Log (firm sales)
Log (division sales)
Constant
Observations
R-squared
PPSD at median Div. Std.
Dev.
PPSF at median Firm Std.
Dev.
(1)
(2)
(3)
High
Level
Low
Level
(4)
Officer þ High Non-Officer
Level
or Low
(5)
(6)
Whole
Sample
Whole
Sample
Log
Log
(Salary þ (Salary þ
Bonus)
Bonus)
Log
(Salary þ
Bonus)
Log
(Salary þ
Bonus)
0.317
0.192
(0.062)
(0.069)
0.391 0.284
(0.073)
(0.080)
0.445
0.650
(0.151)
(0.162)
0.545 0.717
(0.176)
(0.175)
0.319
(0.095)
0.383
(0.114)
1.075
(0.247)
1.097
(0.280)
0.067
0.155
(0.030)
(0.041)
0.173
0.141
(0.008)
(0.010)
10.792 10.471
(0.239)
(0.384)
3728
2613
0.78
0.75
0.008
(0.067)
0.166
(0.013)
11.377
(0.517)
1136
0.81
0.273
0.278
(0.052)
(0.053)
0.361 0.370
(0.061)
(0.062)
0.397
0.441
(0.124)
(0.122)
0.411 0.463
(0.139)
(0.137)
0.013
(0.108)
0.051
(0.123)
0.014
(0.146)
0.402
(0.244)
0.543
(0.283)
0.074
F
(0.024)
0.157
F
(0.008)
11.162
11.108
(0.212)
(0.186)
5205
6341
0.76
0.77
0.121
0.173
0.050
0.291
Log
(Salary þ Log (Total
Bonus)
Comp.)
0.261
(0.066)
0.353
(0.077)
0.526
(0.142)
0.576
(0.162)
0.036
(0.146)
0.149
(0.157)
0.154
(0.189)
0.741
(0.312)
0.856
(0.357)
F
F
11.135
(0.246)
6341
0.81
0.128
0.092
F
F
F
F
0.527
0.192
Notes: Based on sample of divisions that appear for at least 4 years in dataset. OffHigh is an indicator variable
equal to one if the division manager is an officer and either reports directly to the CEO or if the no. of positions
between the division manager and the CEO is one and zero otherwise. All regressions include Division CDF. See
notes in earlier tables for other definitions. Columns (5) and (6) only report select coefficients of interest. Robust
standard errors clustered at division-level; firm and year indicators included in all specifications.
//
represents significance at the 10%/5%/1% level, respectively.
variables included in both columns in which I partition the sample.
As earlier, I only report coefficients for variables of interest: performance,
performanceOffHigh, and performanceCDFOffHigh. I repeat this
specification in column (6) using total compensation as the pay measure.
Results are now qualitatively similar to those in Table IV column (3) based
on officer status. Taken together, the evidence confirms that the division
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characteristic that is associated with differences in performance incentives is
officer status of the division manager and not position in the hierarchy. The
other result that is more difficult to interpret is the small and marginally
statistically significant estimate for PPSD for division managers further
down the hierarchy. Lower level division managers may have less authority
and a correspondingly weaker link to division performance. Another
explanation is that there is more noise in division performance measures at
lower organizational levels.
To sum up relationships between authority, risk and performance
incentives, I find no difference in pay sensitivity to local performance
measures between officers and non-officers, but statistically and economically significant differences in pay sensitivity to global performance measures.
Officer pay is almost four times more sensitive to firm performance relative
to non-officers and the ratio of PPSF to PPSD for officers is more than three
times that for non-officers. These findings are robust when defining pay as
total compensation. Notably, the negative tradeoff between risk and
incentives holds for both officers and non-officers and for both performance
measures. In contrast, I find no consistent differences in pay-performance
sensitivity for division managers that are closer to the CEO in the
organizational hierarchy.
The evidence is generally consistent with a class of models in which
performance pay is based disproportionately on firm performance relative
to division performance when managers have broader authority or greater
involvement in firm-wide decision-making. This includes multi-tasking
models (e.g., Holmstrom and Milgrom [1991]) and more recent models
that investigate the relation between authority over investment decisions
and incentive contracts. For example, Athey and Roberts [2001] argue
that project manager incentives for effort may conflict with incentives for
optimal investment decisions over which projects to pursue. Incentives to
induce effort link pay to local performance measures, while incentives
designed for optimal investment allocations or project selection link
pay to firm value or global performance measures. The relative importance
of the quality of decisions regarding which projects to pursue to that of
inducing effort should determine the relative weight on global versus
local performance measures in optimal incentive design. Furthermore, the
results are informative to the finance literature related to optimal capital
allocation across investment projects and organizational form (e.g., Stein
[2002]) and agency problems within internal capital markets (e.g., Rajan,
Servaes and Zingales [2000]; Scharfstein and Stein [2000]; Wulf
[2002]). Finally, while the presented findings do not explicitly support
Prendergast’s [2002] argument that omission of authority in regressions
leads to either a positive or insignificant relation between risk and incentives,
they do suggest that authority is important in estimating the risk-incentive
tradeoff.
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III(iv). Alternative Explanations
There are several potential alternative explanations for the differences
I observe in pay-performance sensitivities across division manager
positions. First, a plausible explanation for the evidence in favor of
the risk-incentive tradeoff is that risk-averse managers are assigned or
choose to manage divisions operating in less uncertain environments. Yet,
it seems that assigning managers to divisions based on risk preferences
would decrease the odds of finding evidence in favor of the tradeoff between
risk and incentives. The fact that I do suggests that the estimated
relationship between pay-performance sensitivities and volatility might be
a lower bound on the true relationship between risk and incentives.
Furthermore, while managers may choose certain job assignments, their
level of risk aversion is unlikely to be known by the firm, suggesting that
matching managers to divisions based on risk aversion is an uncommon
phenomenon.
Second, one might argue that the findings can be explained solely by
economic differences in division manager positions or by differences in
definitions of corporate officer or steepness of hierarchies across firms. But,
this can’t be the only reason because firm fixed effects absorb many of the
differences across firms, and, in select regressions, I show the results are
qualitatively similar when I include interaction terms between firm
indicators and division performance measures. Another, more plausible,
argument is that the results are just picking up differences in managerial
productivity across positions. Suppose more productive, talented or
experienced managers are designated as officers or placed at higher levels
in the hierarchy because their decisions affect more people at the margin
(e.g., Calvo and Wellisz [1979]; Rosen [1982]). There are two facts which
shed light on the plausibility of this explanation. The first is that by including
division sales in all regressions, I somewhat control for differences in
managerial productivity in pay levels. The large positive and significant
coefficient on division sales is consistent with the explanation that more
productive managers operate larger units and are paid more. Furthermore,
when I partition the officer sample into the largest divisions within the firm
ranked by sales versus all other officer divisions, the coefficients on both
performance measures and the interaction terms between performance
measures and risk are not significantly different between partitions. I find
similar results when I compare non-officer divisions of the largest rank
versus all other non-officer divisions (unreported).
As a proxy for managerial experience in the position, I include tenure in
position in the regressions (the survey collects tenure for 10 of the 14 years).
Tenure in position can represent either higher skill (conditional on survival)
or that the match between skills and the position is better for managers with
greater tenure. While I find a positive and significant coefficient on tenure,
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the basic results remain qualitatively unchanged. To further evaluate how
tenure is related to pay-performance sensitivities, I define an indicator
variable Tendum that equals one if the division manager tenure is above the
sample median and zero otherwise. I include interaction terms between
Tendum and measures of performance and the interaction terms between
performance measures and risk. Of notable interest, I find that the coefficient
on the interaction term between Tendumdivision sales growth is positive
and significant and that on the interaction term Tendumdivision sales
growth division CDF is negative and significant (unreported). For division
managers with longer tenure and more experience in their position, salary
plus bonus is more sensitive to local performance. This result holds in both
officer and non-officer partitions. One plausible interpretation is that
division managers with more experience in their position have greater
decision-making authority and, in turn, a stronger link between bonuses and
local performance. Another related explanation is that managers must have
enough time in position to be held accountable for local performance.
The most reasonable alternative interpretation that is more difficult to
dispute is that firms hire managers that respond well to high-powered
incentives and assign them to divisions with the most promising prospects.
While the evidence is broadly consistent with this explanation, it places steep
informational requirements on firms: they must know which individuals
respond well to strong incentives and which divisions are the most
promising.
Finally, research on authority, risk and incentives ultimately will be
limited by the strength of the proxies used to represent the theoretical
constructs. Furthermore, since compensation contracts, job design,
authority and organizational structures are endogenously determined, these
results should be interpreted as a first step in contributing to an extremely
limited empirical literature on the relation between decision-making
authority, risk and incentives.26 A related and interesting set of questions,
but beyond the scope of this paper, is whether other, potentially more
exogenous, measures of authority and monitoring cost (e.g., location of
divisions relative to headquarters) are related to the design of division
manager compensation contracts. This is a question for future research.
IV. CONCLUSION
Using a proprietary data set of compensation for lower level managers, this
paper contributes to empirical research on division managersFexactly
26
For a discussion of empirical frameworks to identify structural parameters when multiple
organizational design practices are jointly determined, see Athey and Stern [1998]. For
examples of empirical work employing these techniques, refer to Baker and Hubbard [2004],
Ichniowski, Shaw and Prennushi [1997], and Cockburn, Henderson, and Stern [2004].
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193
those managers for whom the more recent inside-the-firm theories have been
developed. Positions further down the hierarchy are interesting because it is
this set of managers that is more likely to have better information about
certain types of decisions critical to the firm and the ‘real’ authority over
those decisions. In the paper, I document the following facts: (1)
performance pay of division managers is increasing in division sales growth
and in firm sales growth; (2) the sensitivity of pay to division sales growth
(firm sales growth) is decreasing in the volatility of division sales growth
(firm sales growth), respectively; (3) the sensitivity of pay to firm sales
growth and the relative importance of firm to division measures are
significantly larger for division managers who are corporate officers relative
to non-officers; (4) there is no significant difference between the sensitivity of
pay to division sales growth for officers versus non-officers; and (5) there is
no significant difference in pay-performance sensitivities for division
managers that are closer to the CEO in the organizational hierarchy.
Consistent with earlier findings, these results strongly support the predicted
negative tradeoff between risk and incentives. Of greater potential interest,
the results are informative to theories suggesting the authority over project
selection combined with incentives designed to maximize firm performance,
as well as induce effort for the division, are important in incentive design for
division managers.
These findings support agency model predictions that optimal compensation contracts balance risk sharing against incentives for division managers
with business unit responsibility. They also demonstrate that additional
factors beyond risk–such as, decision-making authority over project
selection–are important determinants in the provision and design of
incentives and worthy of further empirical study.
APPENDIX AI
Sample Representativeness
I evaluate the representativeness of the sample by comparing key financial measures
of the survey participants to a matched sample from Compustat. I begin by matching
each firm in the Hewitt dataset to the Compustat firm that is closest in sales within its
two-digit SIC industry in the year the firm joins the sample. I then perform Wilcoxon
signed rank tests to compare the Hewitt firms with the matched firms. While the firms in
the Hewitt dataset are, on average, slightly larger in sales than the matched sample,
I found no statistically significant difference in employment and profitability (return on
sales).27 I also found no statistically significant difference in sales growth, employment
growth, or annual changes in profitability for all sample years. In sum, while the Hewitt
27
The Hewitt firms are larger in sales than the matched sample of firms because in a number
of the cases, the Hewitt firm is the largest firm in the industry thus forcing me to select a matched
firm smaller in size.
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firms are larger (measured by sales) on average than the matched sample, there is little
additional evidence that these firms are not representative of the population of
industrial firms that are leaders in their sectors.
I also calculate financial measures for the sample of Compustat firms with 10,000
employees or greater over the period from 1986 to 1999 (excluding firms operating in
financial services). I find that, on average, survey participants are more profitable, but
growing at a slower rate relative to the sample of large Compustat firms. Specifically,
the sample average return on sales for survey participants is 17.8% versus 15.7% for the
sample of large Compustat firms and the average sales growth is 5.7% vs. 7.4%. This is
consistent with the observation that the firms in the sample are likely to be industry
leaders (hence slightly more profitable) and also large (hence the slightly slower
growth). To sum up, the survey sample is probably most representative of Fortune 500
firms.
APPENDIX AII
Example of Lines of Authority, Depth of Division Manager Position, and Position
Descriptions
Manager Position
Depth of Division Manager Position
(# of positions between CEO
& Division Manager)
Chief Executive Officer (CEO)
Chief Operating Officer (COO)
2
Group CEO
Division CEO
Plant Manager
Position Descriptions
1. Chief Executive Officer (CEO). The highest executive authority in the
corporation. Reports to the Board of Directors. May also be Chairman or
President.
2. Chief Operating Officer (COO). The corporation’s second in command,
provided the person’s span of responsibility is as broad or almost as broad as
the Chief Executive’s, and provided he or she has line rather than staff or
advisory responsibility. This person may be the President if the Chief
Executive Officer is the Chairman of the Board.
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3. Group Chief Executive (or Group Manager). The highest authority in the
group. A Group is the highest level of multiple profit center linking the
Corporate Chief Executive Officer or Chief Operating Officer directly to two
or more single profit center units (divisions).
4. Division Chief Executive (or Division Manager). The highest authority in the
division. A Division is the lowest level of profit center responsibility for a
business unit that engineers, manufactures, and sells its own products.
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