What affects the intensity of incentives? That is, how large should the incentive component of a manager’s compensation be relative to the salary component? To answer these questions, we need to understand how much the performance measure is affected by the actions the manager takes to further the owner’s objectives.
Preferred performance measures are those that are sensitive to or that change significantly with the manager’s performance. They do not change much with changes in factors that are beyond the manager’s control. Sensitive performance measures motivate the manager and limit the manager’s exposure to risk, thereby reducing the cost of providing incentives. Less-sensitive performance measures are not affected by the manager’s performance and fail to induce the manager to exert effort. The more owners have access to sensitive performance measures, the more they can rely on incentive compensation for their managers.
The salary component of compensation dominates when performance measures that are sensitive to managers’ actions are not available. This is the case, for example, for some corporate staff and government employees. A high salary component, however, does not mean incentives are completely absent. Promotions and salary increases do depend on some overall measure of performance, but the incentives are less direct. The incentive component of compensation is high when sensitive performance measures are available and when directly monitoring the employee’s effort is difficult, such as in real estate agencies.
To evaluate Brett, Chungi uses measures from multiple perspectives of the balanced scorecard because nonfinancial measures in the scorecard—employee satisfaction and the time taken for check-in, cleaning rooms, and providing room service—are more sensitive to Brett’s actions. Financial measures such as RI are less sensitive to Brett’s actions because they are affected by external factors, such as local economic conditions, beyond Brett’s control. Residual income may capture the economic viability of the hotel, but it is only a partial measure of Brett’s performance.
In addition to considerations of sensitivity and risk, another reason for using nonfinancial measures is that these measures follow Hospitality Inns’ strategy and are drivers of future performance. Evaluating managers on these nonfinancial measures motivates them to take actions that will sustain the long-run financial performance of the firm’s hotels while meeting the company’s environmental and social goals. Therefore, evaluating performance in all four perspectives of the balanced scorecard promotes actions aimed at both the short and the long run. The relative weight placed on the various measures in the scorecard is ideally aimed at achieving congruence between the extent to which the manager is motivated to maximize each performance metric and its importance in generating the long-run objective the firm wishes to achieve. The tradeoff between considerations of sensitivity and risk, on the one hand, and the congruence of goals, on the other, determines the effective intensity of incentives placed on each measure of performance. Concepts in Action: Performance Measurement at Unilever illustrates the use of multiple measures to motivate a CEO to balance financial and nonfinancial (health and environmental sustainability) goals.