VI. Performance Evaluation

1. VI. Performance Evaluation �When You Cannot Measure, Your Knowledge is Meager & Unsatisfactory� (Lord Kelvin)

2. 2 1. Introduction:Why Pay for Performance? Is it all about pay? People tend to respond strongly to incentives the �fundamental attribution error� in psychology even if employees are intrinsically motivated, incentives can better align interests with the firm �Moral hazard� (incentive) principles are very general all employees many general business settings other than employment Incentives are an important way to reinforce many human resource objectives recruiting & retention training decision making motivation

3. 3 Example:Recruiting & Retention Even ignoring motivation, pay for performance can improve productivity Suppose employees differ in ability pay for performance � higher ability � higher output � higher pay thus, stronger pay for performance � better sorting e.g., Safelite Auto Glass

4. 4 The Principle-Agent Problem In economics, we usually analyze incentive problems using the �principle-agent� (agency theory) framework you�re probably seen this in Accounting, Finance, & other courses An agent works for a principle the agent�s efforts affect the principle�s objective (�firm value�, Q(e)) the efforts are personally costly to the agent (�disutility� of effort, e) the efforts are not perfectly observed by the principle w/out these two assumptions, there would be no incentive problem the goal is to align the agent�s interests with those of the principle through some kind of formal or implicit contract (incentive scheme) This is the moral hazard problem in game theory

5. 5 2. Sketch of a Model The firm�s objective is easy usually assumed risk neutral, so the objective is to maximize expected profit from the employee, output minus pay: max {Q(e) � pay} The employee�s objective is slightly more complicated cares about pay, cost of effort C = C(e), & risk model risk aversion as an additional cost to the employee, Rspay) thus, employee�s objective: max {pay � C(e) � Rs)} Finally, the firm is constrained it must pay the employee�s market value in total pay total pay must compensate for effort cost C, & provide a risk premium Rs

6. 6 More Sketch of a Model The firm cannot measure performance perfectly, but uses a performance measure PM(e) tied to pay, Pay = Pay(PM) Thus, the worker�s incentive depends on marginal cost of working harder, DC/De marginal benefit of working harder,

7. 7 Conflict of Interest � the Incentive Problem The firm must compensate the worker for extra effort & risk, so its marginal cost of extra effort is exactly the same as the worker�s The conflict of interest arises because the marginal benefit of extra effort is not the same firm�s marginal benefit = DQ(e)/De worker�s benefit =

8. 8 Two Key Pieces of an Incentive Plan Thus, we want to design our incentive plan so that as closely as possible, they have the same interests: You always need to think about two broad issues how well does the performance measure approximate employee contribution to firm value? how should we tie the measure to pay?

9. 9 3. Quantitative Performance Measurement The first approach to evaluation: numeric measures are these �objective�? An ideal performance measure: reflects employee�s total impact on firm value Q, & nothing else �controllables� � effects of efforts on firm value qi improves alignment between employee & firm �uncontrollables� � effects of other factors measurement error, effects of other employees on firm value, or effects of external events on firm value exposes employee to risk example: stock price as a performance measure for a CEO or a janitor

10. 10 Scope of a Performance Measure �Narrower measures� are those that tend to focus on fewer aspects of performance, or on inputs Narrower measures tend to reduce risk, but also to distort incentives more the greater the distortions, the weaker should the incentives be measures may be broader/ narrower or narrower on several dimensions broader job designs tend to imply broader performance measures

11. 11 Scope & Distortions Measures trade off risk v. distortions � are narrower or broader � along several dimensions 1. how many tasks to include? e.g., quantity v. quality 2. should intangibles or difficult-to-measure effects be included? e.g., opportunity costs Reading: �Folly of Reward A While Hoping for B� 3. how large a unit should be measured? e.g., individual v. team v. unit v. division v. corporate 4. what time horizon? e.g., sales v. customer retention / growth Accounting #s often have some of all 4 problems

12. 12 Performance Measure Scope & Job Design

13. 13 Manipulation Related to distortion is the problem of gaming or manipulation of performance measures the employee might use their specific knowledge to maximize the measure, at the expense of true firm value gaming may also arise if pay is not tied to the measure smoothly (next lecture) If manipulable, the measure may degrade after an incentive is put on it that is, its correlation with firm value may decline thus, a measure may gradually become less valuable for incentives, & the firm may need to change measures occasionally also, tying a measure to a stronger incentive is likely to increase the mean & variance of the measure

14. 14 Summary Properties of performance measures to think about how aligned with firm value (how distorted)? can distortions be reduced by adding an incentive on a second measure? how risky for the employee? should the firm incur greater costs to measure more accurately? how manipulable? & could this degrade the value of the measure?

15. 15 4. Subjective Evaluation The second approach to evaluation: judgment Typical problems inflation & compression reluctance for negative feedback de-motivating effects? low trust of evaluator favoritism problems are more significant when promotion stakes are higher �-life of appraisal systems ? 5 yrs

16. 16 Explanations for Typical Problems 1. Influence costs 2. Evaluator incentives 3. Conflict with other incentives discussion of promotion incentives in next lecture #1-2 � forced curve might help; #3 � opposite

17. 17 Example: TopGrading Pioneered at GE, tried by many other firms some form of forced curve GE: top 20%; middle 70%; bottom 10% those w/ consistently low ratings typically forced out Where does it work best? larger workgroups teamwork is less important culture is more aggressive / Darwinian extensive attention is paid to coaching & development employees are given clear expectations about weeding out potential legal liabilities are monitored carefully great care is taken to make sure evaluations are based on performance

18. 18 Ways to Mitigate Problems w/ Appraisals Reduce the stakes pay compression, weaker incentive intensities Evaluator Incentives pay for performance constraints & monitoring multiple evaluators; review of evaluations; grievance procedures Culture of constructive feedback Avoid conflicts between evaluation & coaching goals Other approaches: 360�, MBO Employees hate subjective evaluations, but virtually all jobs use them. Why?

19. 19 5. A Random Event Occurs � Holly Frost was plant manager for her firm�s primary plant, outside Boston the plant was a profit center One Friday afternoon, a heavy snowstorm began the 40-year old plant had a flat roof late Saturday afternoon, the roof collapsed, with major damage to the plant How do you evaluate Holly�s performance? what does your answer depend on? what do you need to know? is profit center the right performance measure in this case?

20. 20 Why Use Subjective Evaluations? Good evaluation requires judgment because of imperfections in quantitative evaluations Subjectivity, if done well, can improve incentive systems in many ways reduce risk, distortions, & manipulation what is �uncontrollable�? improve risk taking give the incentive system flexibility improve decision making encourage effective reaction encourage pro-active preparation expand communication between manager & employee facilitate training

21. 21 Conducting a Subjective Evaluation Thinking retrospectively �what did he know, & when did he know it?� (�reasonable person� standard) given what was known, were correct decisions made? avoid hindsight bias if not foreseeable, were responses appropriate? did employee try to �pass the buck� or take responsibility? � reward performance, clarify future evaluation criteria Thinking prospectively what can be improved? what needs to be clarified? � clarify responsibilities, terms of ongoing relationship �What did he know, & when did he know it?� what was foreseeable? what was known at the time? -----------?avoid hindsight bias what options was the CEO aware of? �Reasonable Person� standard given what was known, were correct decisions made? if not foreseeable, were responses appropriate? to mitigate damages to exploit opportunities Retrospective analysis � input into rewards �What did he know, & when did he know it?� what was foreseeable? what was known at the time? -----------?avoid hindsight bias what options was the CEO aware of? �Reasonable Person� standard given what was known, were correct decisions made? if not foreseeable, were responses appropriate? to mitigate damages to exploit opportunities Retrospective analysis � input into rewards

22. 22 The Appraisal Process Strive for day-to-day coaching, rather than a comprehensive annual appraisal reduces defensiveness to criticism more closely tied to events Focus on goal setting rather than criticism constructive mutual goal setting but fight the tendency to avoid tough feedback Consider separate appraisals for separate purposes evaluation for salary & promotion coaching & development

23. 23 Receiving an Appraisal Ask for feedback, regularly Avoid defensiveness / check emotions take responsibility for mistakes don�t politicize / lobby Focus on constructive suggestions set goals discuss priorities Identify what you need new skills information resources

24. 24 Example:CEO Evaluation Process at Dayton-Hudson Set objectives include financial & non-financial use CEO input specify how will be linked to rewards Mid-course correction Final review Directors (& CEO?) fill out appraisals 3rd party combines appraisals into report outside Directors review; give feedback committee chair presents to CEO; CEO gives comments Use evaluation data rewards next year (Handout: CEO evaluation form for Fortune 500 firm)

25. 25 6. Economic Ideas Agency problems effort & risk aversion by employees Controllables & uncontrollables in evaluations Scope of quantitative measures & distortions Manipulation of quantitative measures Subjectivity as an alternative (or complementary) approach to evaluations

26. 26 Other Points Performance evaluation & incentives good examples of the importance of Internet Fit between policies job design drives intrinsic motivation choose rewards to balance, but not destroy, intrinsic motivation use stronger incentives more when intrinsic motivation is weaker use stronger incentives when decentralizing match measures (scope) & subjective evaluations to decision rights complex job � pay more attention to measurement Let them do their work

27. 27 Other Points Simply measuring performance can have a powerful effect on productivity even if not tied to rewards more information can lead to better decision making signals what management is interested in Every job has subjective evaluations requires trust, so pay attention to the implicit contracting Think of evaluation as a process, not a policy start gradually & aim for habit formation make evaluation a regular, scheduled part of annual cycle (e.g., MBO)

28. 28 Dirty Little Secret in Business Lack of candor � Very few workers get real evaluations that allow them to see what they need to improve. Candor yields speed Candor reduces cost Why isn�t candor used? Socialized to �make nice� More popular Easier �not to talk about it� Real reason: self-interest rather than interest in other person

29. 29 Candor/Differentiation Very difficult to instill: Took GE nearly 20 years GE: 20/70/10 Criticisms: Unfair Undermines team Mean/immoral Only possible in the US Biggest Problem: Top of 70 not much different from Top 20. Less problem of bottom 10 not much different from bottom of 70