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Performance Evaluation: The consequences of getting what you ask for

The Plan

• Goals. !

• An exercise with goals. !

• What happens when you get what you ask for? – Are we asking for the “right” things?

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• Think about a goal. – Write it down. !

• How will you evaluate whether you have achieved the goal?

– Is your goal relative to something? – Does your goal rely on others? – Can you measure whether you have achieved your

goal? – Is there a ceiling on your goal?

Gooooooooaaaal!

The evolution of goals

Goals

• Define the goal. !

• Measure success (and failures). !

• When your goal relies on help from others must involve them in the goal. !

• How do we deal with goals in business?

Manager-Sales Team Exercise

• Open your packets. – One paper for each individual. – Identify the manager – Identify the sales team

!• The sales team must collaborate. !

• If there are two managers, you are “job sharing”, and you each retain half of the final pay.

Manager-Sales Team Exercise De-brief

Manager Type

S BB MB B&S

Manager Contract

$60,000 + $1,000/u

$60,000 + $200,000 if Sales > 250 units

$60,000 + $200,000 if Sales ~= expected

$60,000 + $750/u +$200,000 if Sales = expected

Sales Team Pay:

Salary

Commission

Bonus

Goal Congruence

A sales manager with a sales team. • What are the manager’s incentives? !

• How does the manager translate these incentives to the sales team? !

•Is it important that the firm know the budget? •How does the firm provide incentives

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Budgeting and Performance Evaluation

Two Players: Manager Sales Team !Objective: – Manager also wants to encourage sales. – Manager wants accurate forecast. !

• What type of contract should the Manager write?

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Salary

• Which would the Manager prefer? - Under what conditions?

• Which would the Sales Team prefer? – Under what conditions?

• Does this help with obtaining an actuate forecast?

Sales

Pay

Sales

Sales-Commission

Incentives to sell

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Target-based Bonus

• Does this provide incentives to sell more? • Does this provide incentives to provide an accurate

forecast? • What happens next year?

Sales

Pay

Budgeted Sales

Budgeting and Performance Evaluation

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• Want to encourage an accurate forecast and additional sales

• Reward for accuracy of forecast • Reward for additional sales !

Y = actual sales Z = forecasted sales Example: 0.05Z + 0.03(Y-Z) for Y≥Z Bonus = 0.05Z + 0.07(Y-Z) for Y≤Z

How can we solve the problem?

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Soviet Incentive Model(truth inducing bonus scheme)

6058561,2005355531,1004648501,000

1,2001,1001,000Actual Sales

(Y)

Forecasted Sales (Z)

What do we know so far?

• To gain an accurate budget while providing incentives? – Must think about the budget process. – Must think about the incentives. !!

• Does this solve the complete problem? • Of course NOT!

Help! I need somebody Help

• Almost all goals rely on others. • How can I get others to help me achieve my

goals? • Involve them in the goal setting process. • Share in the rewards (and failures). • Provide Incentives! !

• What is measurable? – Hard information – Soft information

Customer Service

A Budget as a Financial Goal

• Why budget? – Allocate resources. – Plan for opportunities (or constraints). – Evaluate performance. !

• What information is required for a budget? • Where does this information come from? • What are the implications of budgeting?

What if?

• There are multiple types of products with different margins? !

• A “sale” isn’t recognized in one period (e.g. insurance)? !

• The objective is to run a division (regional manager)?

Consequences of getting what you ask for

• Hotel incentives – RevPAR !

• “Most Improved” – The ratcheting effect

!• The Solitaire Strategy

– Joan’s ability to avoid work

!• What about reputation?

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Investor Myopia and Horizon Incentives

• Firms that go public with and without venture capital financing.

• Venture Capitalists: – Controlling investors with ability to design CEO compensation

• Own a significant portion of the firm (59%). • Sit on the board (92%) and the compensation committee (100%).

– Have short investment horizons after the IPO and want to maximize returns at exit

• Gompers and Lerner, 1998 and 1999; Field and Hanka, 2001 – A shift in governance following the IPO

• market monitoring and institutional ownership (36%)).

What happens

• CEOs of VC-backed firms receive a greater proportion of their pay in the form of equity prior to the IPO. !

• A significant portion of the equity vests soon after the IPO. !

• Market monitoring (and institutions in particular) limit VCs’ abilities to provide short-horizon incentives after the IPO. !

• and…

• Long-term performance is lower for CEOs with shorter-horizon incentives.

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Let’s Flip a coin

• $100,000 or 50% chance of $125,000 & 50% chance of $75,000? !

• $100,000 or 50% chance of $175,000 & 50% chance of $25,000? !

• Let’s link your pay to your performance. – $100,000 in salary, or $50,000 in salary and an opportunity

to earn $75,000 in bonus.

!• What if you hold 85% of your wealth in the firm.

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Effect of options on risk-takingSuppose we have two investment opportunities that would have the following effects on the stock price.

1. With equal probabilities pays $10 in the good state and $0 in the bad state.

2. With equal probabilities pays $25 in the good state and -$10 in the bad state.

Risk-neutral expected values = $5 and $7.50, respectively. !Which investment would shareholder’s prefer? Which investment would you choose? What if 50% of your wealth is in the firm? What if all of your wealth is in the firm? !If the option lies at-the-money, the risk-neutral expected values are $5 and

$12.5 respectively (the option holder is not penalized any further for declines below the exercise price).

!Which investment would you choose now? !Options encourage investment in the second investment opportunity

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• Limitations of financial performance measures – Impact of risky decisions (short-term horizon) – Ability to control financial measures – Historical – Possible lag between action and reports – Market forces that are not under the manager’s control

• Examples of non-financial measures: – Productivity – Quality – Others: customer satisfaction, market share, business related

process, etc.

• Balance Score Card – Simultaneously consider financial and non-financial measures of

performance, and how these measures relate to the organization’s goals.

Non-financial Performance Measures

Summary

• Understand and define your goals. – Can you measure whether you have achieved your

goal? – What happens when you reach your goal? !

• Think about how to employ the help of others. !

• Be careful what you ask for – You just might get it. !

• If you understand what others want, it will help you motivate them.