Our focus has been on how to evaluate the performance of a subunit of a company, such as a division. If the subunit performed well, does it mean the manager performed well? In this section, we argue that a company should distinguish between the performance evaluation of a manager and the performance evaluation of that manager’s subunit. For example, companies often put their most skillful manager in charge of the division producing the poorest economic return in an attempt to improve it. But turning around a subunit may take years, and the relative underperformance of the division during that time is no reflection of the performance of the manager.
As another example, consider again the Hospitality Inns Mexico City (HIMC) hotel. Suppose, despite the high inflation in Mexico, HIMC could not increase its room prices due to price-control regulations imposed by the government. HIMC’s performance in dollar terms would be poor because of the decline in the value of the peso. But should top managers conclude that the HIMC manager performed poorly? Probably not. The poor performance of HIMC is largely the result of regulatory and economic factors beyond the manager’s control.
In the following sections, we show the basic principles for evaluating the performance of an individual subunit manager. Later sections consider the principles that apply to rank-and-file employees and those that apply to top executives. We illustrate these principles using the RI performance measure.
How companies measure and evaluate the performance of managers and other employees typically affects their compensation. Compensation arrangements range from a flat salary with no performance-based incentive (or bonus), as in the case of many government employees, to rewards based solely on performance, as in the case of real estate agents who are paid only via commissions on the properties they sell. The total compensation for most managers includes some combination of salary and performance-based incentive. In designing compensation arrangements, we need to consider the tradeoff between creating incentives and imposing risk. We illustrate this tradeoff in the context of our Hospitality Inns example.
Indra Chungi owns the Hospitality Inns chain of hotels. Roger Brett manages the Hospitality Inns San Francisco (HISF) hotel. Assume Chungi uses RI to measure performance. To improve the hotel’s RI, Chungi would like Brett to increase its sales, control its costs, provide prompt and courteous customer service, and reduce the hotel’s working capital. But even if Brett did all those things, a high RI is not guaranteed. HISF’s RI is affected by many factors beyond Chungi’s and Brett’s control, such as road construction near the hotel that would make it difficult for customers to get to it or an earthquake in the San Francisco Bay Area that would make people reluctant to travel to the region.
As an entrepreneur, Chungi expects to bear risk. But Brett does not like being subjected to risk. One way of “insuring” Brett against risk is to pay him a flat salary, regardless of the actual amount of RI the San Francisco hotel earns. Chungi would then bear all of the risk. This arrangement creates a problem, however, because Brett’s effort is difficult to monitor. The absence of performance-based compensation means that Brett has no direct incentive to work harder or to undertake extra physical and mental effort beyond what is necessary to hold on to his job.
Moral hazard describes a situation in which an employee prefers to exert less effort compared with the effort the owner desires because the owner cannot accurately monitor and enforce the employee’s effort.* Moral hazard also occurs when an employee reports inaccurate or distorted information for personal benefit because the owner cannot monitor the validity of the reported information. Repetitive jobs, as in electronic assembly, are relatively straightforward to monitor and so are less subject to moral hazard. However, a manager’s job, which is to gather and interpret information and exercise judgment on the basis of the information obtained, is more difficult to monitor.
Paying no salary and rewarding Brett only on the basis of some performance measure—RI in our example—raises different concerns. In this case, Brett would be motivated to strive to increase the hotel’s RI because his rewards would increase. But compensating Brett on RI also subjects him to risk because HISF’s RI depends not only on Brett’s effort, but also on factors such as local economic conditions over which Brett has no control.
Brett does not like being subjected to risk. To compensate Brett for taking risk, Chungi must pay him extra compensation. That is, using performance-based bonuses will cost Chungi more money, on average, than paying Brett a flat salary. Why “on average”? Because Chungi’s compensation payment to Brett will vary with RI outcomes. When averaged over these outcomes, the RI-based compensation will cost Chungi more than paying Brett a flat salary. The motivation for having some salary and some performance-based compensation is to balance the benefit of incentives against the extra cost of imposing risk on a manager.