MGRECON401 Economics of International Business and Multinationals LECTURE 7

1. MGRECON401Economics of International Business and MultinationalsLECTURE 7 Motivating Employees and Performance Evaluation in a Complex Organization

2. Lecture Focus • Incentive Compensation • Individual Performance Evaluation • Divisional Performance Evaluation

3. Incentive compensation • Incentive compensation is any contract that rewards good behavior • Employees do what you pay them for • Two extremes: • Flat wage: minimal incentive, low risk • Ownership: maximal incentive, high risk

4. Optimal risk sharing • Most individuals (including shareholders) are risk averse • Shareholders have diverse portfolios: less concerned about performance of any one company • Employees receive substantial income from single company

5. Effective incentive contracts • Compensation contracts have two functions • motivate employees • share risk more efficiently • Contract must balance these considerations

7. Informativeness principle • Use only/all appropriate information when evaluating performance • Make exceptions for uncontrollable factors such as market conditions • select benchmarks to support relative performance measurement

8. Individual Performance Evaluation • Objective performance benchmarks • Addresses problem of uncertain reward • Relative performance evaluation • Addresses problem of exogenous shocks • Subjective performance evaluation • Addresses problem of multi-tasking and lack of observability

9. Divisional performance evaluation • Cost or Expense centers • minimize costs for given output • Revenue centers • Maximize revenue for given budget • Profit centers • Revenue and cost responsibility

10. Transfer pricing • Perceived cost of an input generated by another part of the firm • Important for getting right decision in profit center • Choice determines both distribution of profits among units and decisions regarding overall profits

11. Profit-maximizing price

12. Decentralized firm

13. Example: Du Pont • Du Pont’s fibers optic division, 1988 • portion of pay put into “at-risk pool” • Receive multiple of pool if profit goal met • Profits tanked, discouraged workers, plan abandoned

14. Example: Allen-Edmonds • Allen-Edmonds Shoe Company • Prior to 1990 paid workers on piece-rate system • 1990 adopted fix wages to encourage team work • Productivity tanked, return to piece-rate system

15. Example: CEO Compensation • Level of CEO pay • 1980: CEO compensation 42 times average worker • 2000: CEO compensation 531 times average worker • Form of CEO pay • $1,000 rise in firm value leads to $10.57 rise in pay • Equivalent to CEO owning 1.057 percent of stock • Too small? • Stock prices rise upon announcement of increasing incentive pay for CEOs

16. Example: Briggs & Stratton • Prior to 1990s • Centralized, facing increased competition, losing money • Re-organization in 1990s • Decentralized along product lines • Adopted EVA (economic value added): after-tax operating profit minus opportunity cost of capital • Bonus tied to EVA • 40 percent tied to corporate EVA • 40 percent tied to divisional EVA • Profits rose dramatically following 1990s