Causes and Effects of Subjectivity in Incentives

Abstract

This study empirically examines two basic questions. First, where and why do firms make greater or lesser use of subjectivity in the performance evaluations that lead to annual bonuses? Second, what are the effects of greater or lesser use of subjectivity on employee pay satisfaction? We examine these questions using data collected from a sample of 526 department managers in 250 automobile dealerships. Our findings suggest that subjective bonuses are used to complement perceived weaknesses in bonus awards based on quantitative performance measures. Overall, we find that the use of subjective bonuses is positively related to: (1) the extent of departmental interdependencies; (2) the department reporting a net loss; (3) the manager's tenure; and (4) the extent that the achievability of the formula-based bonus is difficult and leads to significant consequences if not achieved. We also find that the use of subjective bonuses is negatively related to the degree to which the formula bonus exhibits a short-term focus. Competition significantly influences the level of subjective bonuses but not the frequency. We also show that the incremental economic effects of these determinants are highly significant. Our results regarding the effects of the use of subjective bonuses on employee pay satisfaction, however, are inconclusive.

Keywords: Incentives; Discretionary bonus; Subjective bonus; Pay satisfaction

JEL Classification: J33, M40, M46, D23