Interrelated Performance Measures, Interactive Effort, and Optimal Incentives

31 Pages Posted: 6 Feb 2003 Last revised: 26 Sep 2011

See all articles by Shane S. Dikolli

Shane S. Dikolli

Darden School of Business University of Virginia

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management)

Susan Cohen Kulp

George Washington University - Department of Accountancy

Date Written: September 2008

Abstract

This study uses principal agent analysis to investigate how the principal’s use of performance measures in the agent’s compensation contract are affected by (1) links between performance measures and (2) substitute and complementary characteristics of an agent’s efforts. We show that the directional effect of changes in performance measure interrelations on linear incentive weights depends on how the agent’s tasks interact with each other (i.e., substitute or complementary interactions). For example, increases in performance measure interrelations do not necessarily require higher incentive weights on more sensitive and precise performance measures. If efforts are substitutes for each other, the costs of effort are relatively high and the principal induces lower levels of total effort by offering lower incentives. We also show that differences in the combination of performance measure interrelations and effort interactions affect profits in distinctly different ways. When efforts are substitutes for each other, increases in the sensitivities of profit to the other performance metrics (i.e., increased interrelations), and thus to effort, may actually lead to lower profits.

Keywords: Principal-agent Theory, Incentive Compensation, Balanced Scorecard

JEL Classification: D82, J33, M40, M46

Suggested Citation

Dikolli, Shane Sami and Hofmann, Christian and Kulp, Susan, Interrelated Performance Measures, Interactive Effort, and Optimal Incentives (September 2008). Harvard Business School NOM Unit Working Paper; Journal of Management Accounting Research, Vol. 21, pp. 125-149, 2009. Available at SSRN: https://ssrn.com/abstract=374240 or http://dx.doi.org/10.2139/ssrn.374240

Shane Sami Dikolli

Darden School of Business University of Virginia ( email )

P.O. Box 6550
Charlottesville, VA 22906-6550
United States
4342431018 (Phone)

Christian Hofmann

Ludwig Maximilian University of Munich (LMU) - Faculty of Business Administration (Munich School of Management) ( email )

Kaulbachstr. 45
Munich, DE 80539
Germany

Susan Kulp (Contact Author)

George Washington University - Department of Accountancy ( email )

School of Business and Public Management
Washington, DC 20052
United States
202-994-3874 (Phone)

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