When One Size Does Not Fit All: Mitigating Heterogeneous Compensation Risk Through Subjective Evaluations
38 Pages Posted: 13 Nov 2017 Last revised: 4 Oct 2018
Date Written: September 20, 2018
Firms typically use a ‘one-size-fits-all’ (OSFA) compensation contract that specifies a common formulaic relation between performance and compensation (i.e., a performance bonus) for non-executive managers in similar jobs. However, a contract that is appropriate on average, may be suboptimal for individual managers if heterogeneity in the operating environment creates varying compensation risk. We use field data from a retail firm that introduced an OSFA bonus compensation plan for its store managers. The common bonus formula is based on a weighted sum of objective measures of sales performance (i.e., sales per hour, sales-to-goal) and a subjective rating made by supervisors. The firm intended the supervisors’ discretionary subjective rating to evaluate performance on dimensions that are difficult to measure (e.g., store appearance). We test and find that supervisors use their discretion to also address heterogeneity of compensation risk through the subjective rating. Supervisors give uniformly higher subjective ratings to managers whose objective performance measures are measured with greater noise. This result obtains after controlling for manager ability and performance, and for alternative mechanisms to mitigate differences in compensation risk (e.g., salary changes, sales target changes, and bonus adjustments). The evidence suggests that in addition to the dimensions of performance that the firm intends for subjective ratings to evaluate, supervisors use discretion in subjective ratings to provide manager-specific risk premium for non-executive managers who are subject to an OSFA contract.
Keywords: subjective evaluation, performance measurement, compensation risk
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