Performance Standards in Incentive Contracts

43 Pages Posted: 26 Nov 1999

See all articles by Kevin J. Murphy

Kevin J. Murphy

University of Southern California - Marshall School of Business; USC Gould School of Law

Date Written: October 1999

Abstract

Research in incentives has focused on performance measures and pay-performance sensitivities but has largely ignored a third significant dimension: the performance standard. Performance standards generate important incentives whenever plan participants can influence the standard-setting process. I describe management bonus contracts and the role of performance standards, distinguishing between "internally determined" standards that are directly affected by management actions in the current or prior year, and "externally determined" standards that are less easily affected. I show that companies choose external standards when prior-year performance is a noisy estimate of contemporaneous performance. In addition, companies using budget-based and other internally determined performance standards have less-variable bonus payouts, and are more likely to smooth earnings from year to year, than companies using externally determined standards.

JEL Classification: J33, J44, M41, M43, G30

Suggested Citation

Murphy, Kevin J., Performance Standards in Incentive Contracts (October 1999). Available at SSRN: https://ssrn.com/abstract=189808 or http://dx.doi.org/10.2139/ssrn.189808

Kevin J. Murphy (Contact Author)

University of Southern California - Marshall School of Business ( email )

BRI 308, MC 0804
Los Angeles, CA 90089-0804
United States
213-740-6553 (Phone)
213-740-6650 (Fax)

USC Gould School of Law

699 Exposition Boulevard
Los Angeles, CA 90089
United States

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