MGRECON401 Economics of International Business and Multinationals LECTURE 7 Motivating Employees and Performance Evaluation in a Complex Organization

12-2 Lecture Focus Incentive Compensation Individual Performance Evaluation Divisional Performance Evaluation

12-3 Incentive compensation Incentive compensation is any contract that rewards good behavior Employees do what you pay them for Two extremes: Flat wage: minimal incentive, low risk Ownership: maximal incentive, high risk

12-4 Optimal risk sharing Most individuals (including shareholders) are risk averse Shareholders have diverse portfolios: less concerned about performance of any one company Employees receive substantial income from single company

12-5 Effective incentive contracts Compensation contracts have two functions motivate employees share risk more efficiently Contract must balance these considerations

12-6

12-7 Informativeness principle Use only/all appropriate information when evaluating performance Make exceptions for uncontrollable factors such as market conditions select benchmarks to support relative performance measurement

12-8 Individual Performance Evaluation Objective performance benchmarks Addresses problem of uncertain reward Relative performance evaluation Addresses problem of exogenous shocks Subjective performance evaluation Addresses problem of multi-tasking and lack of observability

12-9 Divisional performance evaluation Cost or Expense centers minimize costs for given output Revenue centers Maximize revenue for given budget Profit centers Revenue and cost responsibility

12-10 Transfer pricing Perceived cost of an input generated by another part of the firm Important for getting right decision in profit center Choice determines both distribution of profits among units and decisions regarding overall profits

12-11 Profit-maximizing price

12-12 Decentralized firm

12-13 Example: Du Pont Du Pont’s fibers optic division, 1988 portion of pay put into “at-risk pool” Receive multiple of pool if profit goal met Profits tanked, discouraged workers, plan abandoned

12-14 Example: Allen-Edmonds Allen-Edmonds Shoe Company Prior to 1990 paid workers on piece-rate system 1990 adopted fix wages to encourage team work Productivity tanked, return to piece-rate system

12-15 Example: CEO Compensation Level of CEO pay 1980: CEO compensation 42 times average worker 2000: CEO compensation 531 times average worker Form of CEO pay $1,000 rise in firm value leads to $10.57 rise in pay Equivalent to CEO owning percent of stock Too small? Stock prices rise upon announcement of increasing incentive pay for CEOs

12-16 Example: Briggs & Stratton Prior to 1990s Centralized, facing increased competition, losing money Re-organization in 1990s Decentralized along product lines Adopted EVA (economic value added): after-tax operating profit minus opportunity cost of capital Bonus tied to EVA 40 percent tied to corporate EVA 40 percent tied to divisional EVA Profits rose dramatically following 1990s