How Goals and Incentive Contracts Influence and Facilitate. Long-Term Manager Performance

Transcription

1 How Goals and Incentive Contracts Influence and Facilitate Long-Term Manager Performance Leslie Berger PhD Candidate School of Accountancy University of Waterloo Waterloo, Ontario N2L 3G1 Comments Welcomed July 6, 2007 I am greatly indebted to my advisor, Alan Webb, for his guidance and valuable advice on this proposal. I am also thankful to Tony Atkinson, Natalia Kotchetova, Guoping Liu, and Tom Vance for their very helpful comments and suggestions on an earlier version of this paper.

2 ABSTRACT: This study will investigate how goals and incentive contracts motivate managers to make decisions consistent with the organization s long-term objectives. In the context of a multi-period, long-term management setting, I will identify incentive contracts that can improve management decisions in an environment where forward looking and contemporaneous information is available. Using incentive and goal setting theory I hypothesize that the assignment of forward looking and contemporaneous goals, with incentives rewarded only for contemporaneous goal achievement, provide managers with the most motivation to perform in a manner consistent with the organization s long term objectives. This combination of incentives and goals is believed to overcome the challenges associated with forward looking indicator contracts, but still maintain their decision influencing qualities. In an experimental setting I will test the long-term performance of managers in four different incentive/goal setting conditions. This study contributes to the incentive contracting literature by identifying an incentive contract that incorporates the decision facilitating benefits of forward looking information, without explicitly contracting upon such information. This study also contributes to the Balanced Scorecard literature by examining how managers, with a long-term profitability horizon, respond to the decision influencing nature of goals and incentives in an effort to identify effective resource allocation strategies, and to make management decisions that meet the organization s objectives. 2

3 1. INTRODUCTION This study will investigate how goals and incentive contracts motivate managers to make decisions consistent with the organization s long-term objectives. I will consider performance in the context of a multi-period setting, where managers have a long-term profitability horizon. My primary objective is to identify goal sets and incentive contracts that can facilitate and influence management decisions in an environment where both forward looking and contemporaneous indicators are being used to manage performance. Specifically, two research questions will be addressed in this study. First, in a long term horizon how do incentive contracts, based on various combinations of forward looking and contemporaneous indicators, influence management resource allocation decisions? Second, how do forward looking and contemporaneous goal assignments influence management decisions? In this setting, I define good management decisions to be ones that result in contemporaneous performance that is consistent with the organization s long term objectives. Management accounting information is generally regarded as having one of two qualities: decision facilitating or decision influencing (Sprinkle 2003). Decision facilitating information provides information for planning and decision-making, while decision-influencing information motivates decision makers (Sprinkle 2003, Demski and Feltham 1976). One well-known example of decision facilitating information is Kaplan and Norton s Balanced Scorecard (1993, 1996). The Balanced Scorecard includes measures of forward looking information, such as current period customer satisfaction, that is expected to affect the contemporaneous results in subsequent periods, such as Net Income. This information allows managers to monitor current period investments and identify strategies to maximize future performance (Kaplan and Norton 3

4 1996, 2006). 1 Recent field and archival studies confirm the importance of forward looking information in facilitating management decisions by demonstrating a positive relationship between forward looking information and future financial performance (Ittner et al. 1998; Banker et al. 2000; Bryant et al. 2004). An unresolved issue in the performance measurement literature is whether or not to include forward looking measures in compensation contracts. There is evidence that many organizations do integrate forward looking measures into employee evaluation and compensation contracts (Ittner et al. 1997; Banker et al. 2000; Ittner et al. 2003; Bryant et al. 2004; Kaplan and Norton 2006). Further, in an experimental setting, Farrell et al. (2006) demonstrate that linking compensation to forward looking measures may provide better long-term results. However, despite its potential decision facilitating benefits, forward looking information can be difficult to effectively incorporate into incentive contracts. Indeed, some accounting researchers argue that the most effective contracts for employees with long-term commitments to the organization need not include forward looking indicators because of three issues (Dikolli 2001; Sliwka 2002; Dutta and Reichelstein 2003). First, forward looking information, although more timely, provides a noisy forecast of future returns that is less informative than awaiting actual results (Dutta and Reichelstein 2003). Second, it is difficult to identify and measure all possible forward looking information that may provide inferences about future earnings (Meyer 2002). Third, weighting various forward looking measures in an incentive contract to accurately reflect the company s business model is a difficult task that is often not done well by mangers (Krishnan, Luft and Shields 2005). Ineffective incentive contracts resulting from these issues create opportunities for employees to shift their effort amongst the indicators to maximize their own wealth, often to the 1 Kaplan and Norton s Balanced Scorecard (1993, 1996) has been widely adopted by organizations (Malina and Selto 2001; Bryant et al. 2004). 4

5 detriment of the long-term corporate results (Smith 2002; Meyer 2002). Thus, the challenges in contracting upon forward looking indicators raise concerns about the ability of this information to effectively influence the long-term decisions of management in a manner consistent with the firm s objectives. This study contributes to the debate by comparing the performance effects of contracting only on contemporaneous measures to those of contracting on both forward looking and contemporaneous measures. Another unresolved issue in the performance measurement literature is whether or not providing goals on forward looking measures results in better performance on contemporaneous measures. Psychology research suggests that forward looking goals can play a decisionfacilitating role for managers working towards contemporaneous goals (Latham and Seijts 1999; Winters and Latham 1996; Locke and Latham 2002, Farrell et al. 2006). In complex tasks where both forward looking (e.g. improve service quality) and contemporaneous goals (e.g. improve gross margin) are provided, forward looking goals generally can provide information to help managers achieve contemporaneous goals (Seijts et al 2004). However, in some circumstances, providing forward looking goals can lead to unintended results. High levels of commitment to forward looking goals can cause the forward looking goals to become decision influencing, instead of decision facilitating (Fishbach et al. 2006). Specifically, managers excessive focus on forward looking goals can lead to a suboptimal allocation of effort resulting in outcomes that are inconsistent with the long term objectives of the organization (Fishbach et al. 2006). This study will compare the performance effects of providing goals only on contemporaneous measures to those of providing goals on both forward looking and contemporaneous measures. My research will contribute to the existing literature in two ways. First, this study extends the accounting research that examines the use of forward looking and contemporaneous 5

6 indicators in corporations. Existing research has considered how companies use forward looking and contemporaneous indicators to manage their companies (Hendricks et al. 2004; Malina and Selto 2001), to establish the relationship between current forward looking indicators and future results (Bryant et al. 2004; Ittner and Larcker 1998), and to evaluate manager performance (Lipe and Salterio 2000; Libby et al. 2004; Banker et al. 2004). There has been some research examining how managers use forward looking and contemporaneous information to make decisions and manage performance (Kelly 2007b; Kelly 2007a; Webb 2004; Farrell et al. 2006). However, there has not been any research examining the effects of goal based incentive schemes in a long-term setting. This will be the first study to compare the performance effects of different combinations of forward looking and contemporaneous goals and incentives. Further, this study will also examine an important antecedent of performance in a goal setting environment goal commitment. Second, this study will contribute to the incentive contracting literature. Existing research examines how incentives affect employees in various ways. For example researchers have established the effect of incentives on employee horizon (Farrell et al. 2006), learning (Sprinkle 2000), employee effort (Hannan 2005), delegation (Nagar 2002) and performance (Fessler 2003). This paper extends the literature by examining incentive effects over the longterm. Although Farrell et al. (2006) conclude that forward looking indicators can provide information to employees with a long-term horizon, they do not consider the challenges of contracting on leading indicators, examine the impact of goals on performance, nor require participants to manage resources to achieve both forward looking and contemporaneous measures. My paper will be the first to experimentally test incentive contracts for long-term employees that incorporate forward looking information without explicitly contracting upon it. 6

7 This research also has practical significance to managers and shareholders that design and implement performance measurement systems. Specifically, this research will provides these stakeholders with a feasible method to incorporate the decision facilitating benefits of forward looking information into management decision making. In a recent survey by Deloitte (2007), senior management and board members clearly recognized the importance of forward looking indicators: 78% of those surveyed stated that contemporaneous measures alone did not adequately capture their company s results and 54% acknowledged that forward looking indicators were of greater value to management than contemporaneous indicators. However, the majority of those surveyed were not confident in their firms ability to effectively monitor and communicate forward looking results to decision makers within their firms (Deloitte 2007). Thus, while practitioners understand the decision facilitating benefits of forward looking indicators they are not sure how to incorporate them into management decision making. This paper will address this issue by identifying one method that incorporates both forward looking and contemporaneous measures into management decisions. I will address my research questions using an experiment where participants will be assigned the role of a restaurant manager. A task will be employed where participants will allocate resources between customer satisfaction and food quality activities. Four different conditions, plus one control group, will be used to compare the effects of three different incentive structures and three different goal sets on manager performance. The remainder of the paper is organized as follows. The next section defines the research setting, Section 3 reviews the literature and develops my hypotheses and Section 4 summarizes the research design, participant task information and pilot testing plans. 7

8 II. RESEARCH SETTING To examine my research questions and to develop my hypotheses, I use a setting in which current period product quality and customer services are associated with the future revenues of the organization. In this setting, customers that receive a high quality product and excellent service today are more likely to both return to the organization in the future and encourage other potential customers to frequent the organization. To maximize their personal wealth, managers in my setting must determine how to maximize his division s long-term cumulative net income (contemporaneous indicator) by allocating current period resources between quality and service (forward looking indicators). Goals and Incentives This research will examine the impact of two factors on employee performance: goals and incentives. In this context, goals and incentives could be tied to various combinations of forward looking and contemporaneous indicators. A forward looking goal is short-term in nature, designed to help focus the decision maker on tasks that contribute to the overall achievement of the contemporaneous goal. A contemporaneous goal is a long-term goal that focuses on the end result of a complex task. 2 In a fully crossed design, 9 different conditions are available (See Figure 1); however, 4 of the conditions (F, G, H and I in Figure 1) are not feasible (i.e., it is not possible to provide incentives on the attainment of a goal, if one was not assigned). Although it is possible to assign both forward looking and contemporaneous goals and only provide incentives on the forward looking indicator (Condition E in Figure 1) this condition does not appear to be an externally valid condition, as it would be unusual for an organization to 2 The literature also refers to forward-looking goals as proximal, learning, short-term and sub goals. For the purposes of this study, I will use the term forward-looking goals. Similarly, the literature also refers to contemporaneous goals as distal, performance, achievement, outcome and long-term goals. For the purposes of this study, I will use the term contemporaneous goals. 8

9 assign contemporaneous goals but not contract upon them (Kaplan and Norton 2006). Furthermore, I have not identified any theoretical reason why this incentive/goal condition would benefit organizations. Therefore conditions E, F, G, H, and I will not be examined in this study. << Insert Figure 1 here >> I focus on the remaining conditions: A, B, C and D (See Figure 1). In the first condition (Condition A), managers will only be provided goals for forward looking indicators and compensated for achieving these goals. This condition is the suggested incentive structure for short-term horizon participants (Dikolli 2001). Conditions B and C assign both forward looking and contemporaneous goals to the managers. Condition B financially rewards managers for the attainment of all goals assigned representing a type of contract often used in industry where all performance indicators are incorporated into the bonus structure (Kaplan and Norton 2006; Ittner et al. 2003; Malina and Selto 2001). Condition C only rewards managers for the attainment of contemporaneous indicator goals. Finally, in Condition D managers will only be provided and compensated for contemporaneous indicator goals. This manipulation is based on the optimal solution for a long-term horizon manager in time horizon agency models (e.g. Dikolli 2001). As outlined in the hypotheses below, I expect that condition C will result in the best long-term performance. Employee Horizons Incentive contracting research typically assumes that employees have a short-term horizon and do not have an implicit interest in future period production (Sprinkle 2000; Hannan 2005; Fisher et al. 2005; Ullrich and Tuttle 2004; Kelly 2007a). This research has resulted in a focus on the short-term effects of incentives on learning, motivation and performance. Typically, payouts are determined on a per period basis and performance evaluations in each 9

10 period are independent. By design, this research has examined performance considerations for workers that do not have long-term aspirations, or long-term commitment to the organization (Sprinkle 2000; Kelly 2007a). Another less developed stream of research in the compensation literature considers employees with a long-term horizon. A long-term horizon is defined in the agency literature to be one where the agent s horizon nears that of the principal (Dikolli 2001). For example, compensation based on stock options or other vesting equity instruments encourages employees to view their decisions under a long-term horizon (Aseff and Santos 2005; Hall and Murphy 2003). Although not all employees within an organization will have a long-term horizon, those with more seniority and responsibility may be more likely to view their work, and their lifespan at the company, from a longer term point of view. This study will extend the existing incentive contracting literature by studying the effects of various incentive contracts on manager performance. Focusing on a long-term horizon environment contributes to the literature because, unlike short-term horizon settings, managers with a long-term horizon have the opportunity to manage current resource allocations while observing (and potentially benefiting from) the consequences of prior resource allocation decisions. This environment would not be possible in an experiment limited to short-term horizon, because the optimal contract focuses manager attention on forward looking indicators, and does not incorporate contemporaneous variables in the contract (Dikolli 2001; Dutta and Riechelstein 2002). Task Complexity Much of the incentive contracting and goal setting literature in accounting (Libby 2001; Hannan 2005; Schulz et al. 2007) and psychology (Heath et al. 1999; Locke and Latham 2002; 10

11 Seijts and Latham 2005) examines participant performance using simple tasks. A simple task is one where performance is largely a function of the effort exerted. Such tasks allow researchers to examine the effects of goals and incentives on performance independent of cognitive effort and task related abilities. Complex tasks require cognitive, not physical, effort and have at least one of the following characteristics: multiple ways to arrive at the desired outcome, multiple possible outcomes, conflicting decisions, and uncertainty (Bonner and Sprinkle 2002, Campbell 1988, Wood et al. 2000). Business decisions are often complex involving uncertainty, multiple outcomes, and multiple decision paths (Campbell 1998; Seijts et al 2004). The generalizability of the results from goal-setting research using simple tasks to more complex task settings where the appropriate task strategy must be learned through experience is limited (Campbell 1988; DeShon and Alexander 1996). Indeed, contrary to the empirical results found simple task settings, participants assigned only a challenging contemporaneous goal for a complex task often perform worse than those not assigned any goals (Winters and Latham 1996; Seijts et al. 2004). In this setting, participants have difficulty monitoring performance, developing effective strategies and motivating themselves to complete goal congruent actions (Winters and Latham 1996; Latham and Seijts 1999; Heath et al. 1999). Because forward looking and contemporaneous measures are often employed in complex task settings this is the context in which the hypotheses are developed. III. THEORY AND HYPOTHESES In this section I use a combination of agency theory and goal setting theory to motivate the hypotheses about manager behaviour. As noted above, I examine manager behaviour in a long-term environment, when faced with a complex task. My objective is to identify the incentive contract and goal set that allows managers to perform in a manner most consistent with 11

12 the long-term objectives of the organization. My hypotheses are developed as follows. First, consistent with Dikolli (2001), I establish that an incentive contract based only on attaining contemporaneous goals is more decision influencing than one based only on attaining forward looking goals. 3 Next, I show that providing forward looking goals (without incentives) is decision facilitating in that it allows managers to identify appropriate resource allocation strategies that are consistent with the organization s long term objectives. 4 Finally, I establish that when incentives are provided for the attainment of contemporaneous goals, assigning forward looking goals without forward looking incentives sufficiently influence management s decisions 5. The Decision Influencing Characteristic of Contemporaneous Information First I examine manager performance, in a long term setting, where only one goal type (either contemporaneous or forward looking) is assigned and rewarded. For the remainder of this paper, I define better performance as performance that is more aligned with the organization s long term objectives (i.e., net income). Based on the theory outlined below, I expect that when assigned and rewarded for the attainment of contemporaneous goals manager performance (i.e. Condition D in Figure 1) will be better than when forward looking goals are assigned and rewarded (i.e. Condition A in Figure 1). To examine the importance of contemporaneous information in a long-term environment, I begin by comparing the performance effects of contracting only contemporaneous measures with those of contracting only forward looking measures. I use agency theory to predict that, 3 For this prediction goals are only assigned for the indicators (contemporaneous or forward looking) included in the incentive contraction (Figure 1, Condition D versus A). 4 For this prediction incentives are only provided for attainment of goals on the contemporaneous indicator (Figure 1, D versus C) 5 For this prediction incentives are provided for either contemporaneous goal attainment only, or contemporaneous and forward looking goal attainment (Figure 1, Condition B versus. C). 12

13 when managers have a long term profitability horizon, contracting only upon contemporaneous information influences management s decisions to be more congruent with the organization s objectives than contracting only upon forward looking indicators 6. In recent years, the traditional agency model has been extended to incorporate the time horizon of the agent and the principal. If the manager has a shorter time horizon than the organization, a contemporaneous measure (e.g. net income) is not an appropriate measure of performance (Sliwka 2002; Dikolli 2001; Dutta and Reichelstein 2003). Instead, forward looking indicators (e.g. product quality) direct the manager s efforts to be more congruent with the organization s strategy (Sliwka 2002; Dikolli 2001; Dutta and Reichelstein 2003). When the manager s employment horizon is long term the optimal weight placed on short-term measures in the incentive contract decreases, and the weight on the long-term measures in the incentive contract increases (Sliwka 2002; Dikolli 2001). Expanding on the multi period model, Dutta and Reichelstien (2003) specify that when the manager s horizon is long-term it is optimal to contract on the contemporaneous variable. The agency literature assumes that forward looking indicators provide a noisy measurement of the long-term outcomes of the manager s performance (Dutta and Reichelstien 2003). Recent behavioral work suggests that this assumption is valid. It may be difficult for a manager to accurately identify all of the forward looking indicators that contribute to the future success of the company (Meyer 2002). Further, even if the appropriate forward looking indicators are identified, determining the extent to which they are associated with future performance is a cognitively difficult task (Krishnan et al. 2005). Based on these observations, it may be a common occurrence for company s forward looking measures to be either noisy (high 6 In my study contracting upon a forward looking (contemporaneous) indicator requires the manager to achieve an assigned goal to receive a bonus payout. 13

14 level of variance) or insensitive (inaccurate, or weakly related) predictors of long-term performance. Contracting upon noisy, insensitive forward looking information, could create opportunities for employees to shift their effort amongst the indicators to maximize their own wealth, perhaps to the detriment of long-term corporate results (Smith 2002; Meyer 2002). Thus, the challenges in contracting upon forward looking indicators raise concerns about the ability of this information to effectively influence the long-term decisions of management in a manner consistent with the firm s objectives. Given that managers primary objective is to maximize their own wealth, when contracts are based on forward looking goal attainment, I expect them to employ effort shifting techniques to ensure that forward looking goals are met, and their own wealth is maximized, regardless of the long term effect on the company s contemporaneous results. Conversely, when managers contracts are based only on contemporaneous goal attainment, I expect them to engage in behaviour to maximize contemporaneous results, thereby maximizing their own wealth as well as that of the organization 7. Based on agency theory developed in the agency literature, I predict the following in the context of a long-term horizon: H1: Managers that are assigned an incentive contract based only on contemporaneous indicators will perform better than managers that are assigned an incentive contract based only on forward looking indicators. (Figure 1, Condition D > Condition A) The Decision Facilitating Characteristic of Forward Looking Goals In the previous section I predict that contracting on contemporaneous indicators will result in better management performance than contracting only on only forward looking 7 For H1, recall that contracting only upon forward looking (contemporaneous) indicators means goals are only assigned for those indicators. The potential benefits of assigning goals not included in the incentive contract are examined in H2 H4. 14

15 indicators. Next, I consider whether providing forward looking goals, without incentives, would improve managers performance when incentives are only provided for attaining goals on contemporaneous indicators. (i.e. Condition C versus D in Figure 1). Two factors that I expect will contribute to performance are contemporaneous goal commitment and learning effective resource allocation strategies. Therefore, in this section I consider the effects of assigning forward looking goals on performance, contemporaneous goal commitment, and resource allocation strategy identification. The agency literature, discussed above, suggests that when the manager has a long-term horizon, an incentive contract based on contemporaneous indicators will lead to better performance than an incentive contract based on forward looking indicators. In contrast, the psychology literature suggests that only assigning the manager goals on contemporaneous indicators may not enable him to perform to the best of his ability, leading to less desirable results for the organization as a whole (Winters and Latham 1996; Latham and Seijts 1999; Seijts et al 2004). Psychologists attribute this issue to the starting problem (Heath et al. 1999, pg 91). When people are far away from the goal and progress is difficult to measure and evaluate, there is low motivation to complete goal congruent actions (Heath et al. 1999). The goal setting literature points to the use of both forward looking and contemporaneous goals to overcome this problem. Evidence shows that assigning both forward looking and contemporaneous goals positively affects long term performance (Locke and Latham 1990, Latham and Seijts 1999, Morgan 1985, Bandura and Simon 1977). In the goal setting literature, the improved performance is attributed to two factors: increased levels of contemporaneous goal commitment, and an improved ability to identify effective task strategies. I discuss both factors below. 15

16 Goal commitment is defined as one s determination to reach the goal (Hollenbeck et al 1999; Locke and Latham 2002; Klein et al 2001). Commitment to a goal will be high when the combination of self-efficacy (the belief that one can meet the goal) and goal attractiveness (the desirability of meeting a goal) are high (Wood et al. 1990, Locke and Latham 1990, Klein et al. 1999, Locke and Latham 2002). In complex tasks, due to the increased levels of self-efficacy, forward looking goals can increase levels of commitment to achieving contemporaneous goals (Latham and Seijts 1999). In a meta-analysis of 74 studies over a 13 year period, Klein et al. (1999) report a positive relationship between goal commitment and performance. In addition to positive performance effects, the advantages of higher contemporaneous goal commitment include an increase in participant performance aspirations and perseverance when faced with discrepant feedback (Heath et al.1999; Latham and Seijts 1999; Earley and Lituchy 1991) and an increased likelihood of developing effective task strategies (Latham Winters and Locke 1994; Wood and Bandura 1989). Therefore, higher contemporaneous goal commitment is an important factor in achieving better management performance. In complex tasks, forward looking goals can focus the individual s attention on strategy development (Winters and Latham 1996; Latham and Seijts 1999). Forward looking goals provide feedback that allows participants to monitor their progress towards contemporaneous goals and, if need be, adjust their strategies to improve future performance (Latham and Seijts 1999; Winters and Latham 1996; Bandura and Simon 1977). The information conveyed by forward looking goals allows managers to more easily learn successful resource allocation strategies than those not provided forward looking goals (Morgan 1985; Stock and Cervone 1990). Learning successful task strategies allows one to attain forward looking and contemporaneous goals and ultimately perform better than those who do not identify successful 16

17 strategies (Latham and Seijts 1999). Therefore, managers who learn appropriate resource allocation strategies are expected to perform better. Simply providing forward looking indicators without assigning specific goals for those indicators does not appear to motivate managers to incorporate the information in their decisionmaking. The experimental accounting literature suggests that when incentives are tied only to contemporaneous goal achievement, and no goals are assigned for forward looking indicators, the decision influencing properties of the forward looking indicators are limited (Farrell et al. 2006, Kelly 2007a). The existing literature has not examined whether the use of goals will sufficiently attract management attention to incorporate the forward looking indicators in their decisions. Hence, I examine a setting where both forward looking and contemporaneous goals are provided. Although it may be that the motivational effects of goal setting (without incentives) are not sufficient to attract managers attention, I hypothesize that forward looking goals will have sufficient decision facilitating characteristics to increase contemporaneous goal commitment, improve identification of successful allocation strategies, and improve manager performance 8. In this set of hypotheses, I examine a setting where incentives are only paid for the achievement of the contemporaneous goal. Thus I predict: H2: Commitment to contemporaneous goal attainment will be higher for participants assigned goals for both contemporaneous and forward looking indicators compared to those provided only a goal for the contemporaneous indicator. (Figure 1, Condition C > Condition D) H3: Managers assigned goals on both forward looking and contemporaneous indicators will more quickly learn effective resource allocation strategies than managers that are not assigned both forward looking and contemporaneous goals. (Figure 1, Condition C > Condition D) 8 I examine the manger s commitment to the contemporaneous indicator goal to understand the antecedents of managers performance. Although attainment of forward-looking indicator goals is essential for attainment of the contemporaneous indicator goal, the hypothesis examines only commitment for the contemporaneous goal because attaining that goal meets the organization s long-term needs. 17

18 H4: Managers assigned goals on both forward looking and contemporaneous indicators will perform better than managers that are not assigned both forward looking and contemporaneous goals. (Figure 1, Condition C > Condition D) Comparing the Decision Influencing Characteristics of Incentives and Goals Based on the expectation that assigning managers both forward looking and contemporaneous goals improves long-term performance, I now examine two possible incentive structures to compensate performance when both forward looking and contemporaneous goals are assigned. I will examine contracts that reward managers for attainment of both forward looking and contemporaneous goals, and contracts that only reward managers for attainment of contemporaneous goals (i.e. Conditions B and C from Figure 1). An important assumption I make in developing predictions in this section is that the bonus pool is fixed. A fixed bonus pool sets the maximum bonus amount to be earned by managers, regardless of how it is allocated across one or more performance indicators. Recent incentive studies suggest that a fixed bonus pool is common in industry (Bailey et al. 2006). For example, a recent field study suggests that although the method used to allocate bonus money varies, the overall size of the bonus pool is fixed for about 60% of firms sampled (Murphy and Oyer 2003). Accordingly, if the total bonus pool is fixed, the more goals contracted upon, the lower the incentive amount rewarded per individual goal attainment. In the two contracts under consideration, if incentives are tied to goal attainment for both forward looking and contemporaneous indicators (Condition B), the incentive earned for the contemporaneous indicator will be less than if incentives are only tied to the contemporaneous indicator goal (Condition C). From the manger s point of view, attainment of the contemporaneous goal in Condition C leads to a larger bonus and thus will be more attractive, than the same goal in Condition B. As goal attractiveness is an antecedent of goal commitment (Locke, Latham and 18

19 Erez 1988), I expect that commitment to the contemporaneous indicator goal will be higher in Condition C than in Condition B. High levels of commitment to forward looking goals can also cause the forward looking goals to become decision influencing, instead of decision facilitating (Fishbach et al. 2006). In other words, greater management focus on attaining forward looking goals can lead to a suboptimal decision that may not result in contemporaneous goal attainment or outcomes that are consistent with the long term objectives of the organization (Fishbach et al. 2006). The existing literature has not examined whether financially rewarding forward looking goal attainment (in addition to contemporaneous goals) will affect the quality of managers decision making. Thus, I extend the existing literature by hypothesizing that financially rewarding forward looking goals (in addition to contemporaneous goals) will result in suboptimal behaviour that is not consistent with the organization s long term objectives. The incentive contract based only on contemporaneous goals is expected to create a higher level of commitment to the contemporaneous goal than the incentive contract based on both forward looking and contemporaneous goals. The incentive contract based only on contemporaneous goals is also expected to discourage the effects of relatively high levels of forward looking goal commitment. Therefore, I expect that performance in a contemporaneous incentive contract will also be better than that in a forward looking and contemporaneous incentive contract. Thus I predict that: H5: When goals for both forward looking and contemporaneous indicators are assigned, managers commitment to the contemporaneous indicator goal will be higher when contracted only on contemporaneous indicators, than when contracted on both forward looking and contemporaneous indicators. (Figure 1, Condition C > Condition B) 19

20 H6: When both contemporaneous and forward looking indicator goals are assigned, managers contracted on the contemporaneous indicator will perform better than those contracted on both contemporaneous and forward looking indicators. (Figure 1, Condition C > Condition B) IV. RESEARCH METHOD Participants and Task Overview An experiment will be used to test the hypotheses. Participants will be assigned the role of manager in a franchised restaurant. Using a computerized business simulation, participants will complete a resource allocation task, which has several characteristics that make it appropriately complex to test the above hypotheses. First, outcomes of the task require cognitive effort to identify the most effective resource allocation strategy. Second, there are many possible outcomes to the simulation, and multiple resource allocations that result in a successful outcome. Although the task is complex, undergraduate students are appropriate participants because it is relatively easy to understand the task requirements and does not require specialized industry or accounting knowledge to complete. Therefore, the complexity of the task is appropriate for the participants. The use of undergraduate students is consistent with other accounting studies where participants were required to make resource allocation decisions, quality versus quantity tradeoffs, and production decisions (Fredrickson et al. 1999; Towry 2003; Sprinkle 2000; Farrell et al. 2006; Shultz et al. 2007; Kelly 2007b). I have performed an a priori statistical power analysis to determine the number of participants required for this experiment (Cohen 1988; Cohen 1992). Assuming a medium effect size, for both the goal and incentive manipulations, it appears that 25 participants per condition will provide sufficient level of statistical power for this experiment. 9 9 Consistent with Cohen s (1988, 1992) recommendations, power of 0.80 and probability of a Type 1 error of 0.05 were used in this analysis. 20

21 Task Details Work Horizon of the Employee All participants in this experiment will have a long-term work horizon. In existing experimental research, a short term horizon is created by notifying participants that they will be working for different companies in each period (Farrell et al. 2006), or creating uncertainty as to the number of periods of play (Kelly 2007a; Kelly 2007b). To create a long-term environment in this experiment, I will employ opposite strategies to these short-term horizon manipulations. Participants will work for the same company for the entire simulation (also consistent with the long term horizon manipulation of Farrell et al. (2005)), and be informed that the simulation will last 36 periods (See Appendix 1). 10 I expect approximately 36 periods of play will be required to allow for adequate observations as discussed in the performance measurement section below. Each period will be described in the simulation as 1 month of business operations. However, the exact number of periods required in each game will need to be confirmed through pilot testing. Factors such as duration of the experiment and participant fatigue will be considered. Forward looking Performance Indicators On a monthly basis, participants will be asked to allocate current resources (to a maximum of $10,000 per month) to activities that will impact customer satisfaction and food quality (See Figure 2). In the restaurant business, a customer s satisfaction with the restaurant s 10 If participants were not informed of the simulation length, their motivation would be to maximize their own wealth immediately, in essence acting as though they had a short term profitability horizon. As participants reach the end of the simulation, their profitability horizon should become short term. I expect this shift in profitability horizon will impact their allocation decisions. I plan to remove the last period of play from my statistical analysis for this reason. 21

22 service affects future sales levels. Customers who are satisfied with their dining experience are more likely to return to the restaurant in the future, or to recommend the restaurant to others (Berry 2001; Ross 2007; O Connell 2006). Customer satisfaction can be affected by a number of things including: attentiveness of the server, time spent waiting for a table, restaurant cleanliness, etc. These factors can be influenced almost immediately with investments of cash in additional wait staff and support staff (Ross 2007; O Connell 2006). Participants will be told that: (1) customer satisfaction levels are measured using customer survey information collected at the end of their dining experience; and (2) customers rate their satisfaction with the restaurant s service using an 11-point scale, ranging from extremely dissatisfied (0 points) to extremely satisfied (10 points). <<Insert Figure 2 here>> Food Quality in the restaurant business also affects future sales levels. Customers, who are served meals of good quality, will be more likely to return to the restaurant in the future, or recommend the restaurant to others (Berry 2001; Ross 2007). Food Quality can be affected by factors such as the number of cooking staff on hand, the freshness of the ingredients, and the quality of the ingredients used in food preparation. These factors can be affected almost immediately with investments of cash (Berry 2001; Ross 2007). Participants will be told that: (1) food quality levels are measured using customer survey information collected at the end of the dining experience; and (2) customers rate their assessment of the food quality on an 11-point scale with the following attributes: extremely poor (0 points) and excellent (10 points). 22

23 Contemporaneous Performance Indicator Although the resource allocation in customer satisfaction and food quality will have a downward effect on current net income, future sales will be positively affected by such investments. Consistent with Kelly (2007a) investments in the current period (period t) will affect revenue in the future in only one period (t+3). Consistent with observations in practice (Ittner et al. 1998), the forward looking indicators in this simulation will not have a strictly linear relationship with future sales. After a certain point additional investment in customer satisfaction or food quality will positively affect future sales at a decreasing rate. As shown in Table 1, the best decision is to allocate the entire budget of $10,000 each month with $6,750 allocated to customer satisfaction and a $3,250 allocated to food quality. All other allocations will result in a lower net income. << Insert Table 1 here>> Noise between Resource allocation Decisions, Forward Looking Indicators, and Contemporaneous Indicators To observe participants responses in an environment where factors other than the identified forward looking indicators influence future net income (i.e. to increase the external validity of the design) a random noise factor will be employed. This feature of the design is intended to make the task more realistic and complex. Randomly selected noise variables will increase/decrease the investment/forward looking indicator and forward looking/contemporaneous indicator relationships. Consistent with Sprinkle (2000), a noise variable (90, 95, 100, 105, or 110 percent) will be randomly selected and multiplied by the noiseless customer satisfaction score, food quality score, and the resulting gross profits. Each period a separate noise variable will be randomly selected. As each will have an equal chance 23

24 of being selected the expected impact of noise on variables across the simulation will be 0. Thus, the internal validity of the results will not be negatively affected. Feedback on Performance Feedback for all participants will include monthly customer satisfaction levels, monthly food quality scores, and monthly net income. (See Appendix 1 for more details.) Participants will also be informed of the year to date net income each period. Consistent with Kelly (2007a), participants will be provided with a full history of their resource allocation choices, and monthly income amounts. Independent Variables Goals Employees will either be assigned a contemporaneous goal only (Figure 1, Condition D), forward looking and contemporaneous goals (Figure 1, Conditions B and C), or forward looking goal only (Figure 1, Condition A). Forward looking goals (i.e. customer satisfaction and food quality scores) will be leading, non-financial targets set for monthly performance. Contemporaneous goals will be financial targets for cumulative net income set for a 6-month period. To attain their assigned goals, participants must make resource allocation decisions. To ensure that the participants remain aware of their assigned goals, goal information will be accessible to the participants throughout the simulation. Forward looking goals will be assigned at the level of resource allocation required for the highest positive impact on future income. Specifically, the forward looking goal assigned for the customer satisfaction score will be a Satisfied ranking (obtained with a score of 7.5 out of 10 possible points) and the goal assigned for food quality will be a Good ranking (7.5 out of 10 24

25 possible points). As shown in Table 1, a resource allocation of $6,750 in Customer satisfaction and $3,250 in Food Quality allows achievement of both forward looking and contemporaneous goals. The contemporaneous goal will be based on cumulative net income for a 6-month period (i.e. 6 periods of play). I selected 6 months to allow the participants to have a sufficient longterm horizon over which to manage their resource allocation choices in an effort to meet the forward looking and contemporaneous indicator goals, while attempting to minimize the total length of the experimental task. 11 The goal assigned for cumulative 6-month net income is $582,000. To obtain this goal, participants must achieve an average net income of $97,000 per month, which can be attained by several different resource allocations. For example, a consistent resource allocation strategy of $6,000-$7,250 to customer satisfaction and $4,000 - $2,750 to food quality will result in contemporaneous goal attainment (See Table 2) 12. << Insert Table 2 here>> Incentives All participants will receive a flat wage $0.25 for each month of work. Participants will also be rewarded based on how well they perform on forward looking goals, contemporaneous goals, or both forward looking and contemporaneous goals. Incentives earned for forwardlooking indicators will be based on monthly performance versus the assigned goal. Due to the cumulative nature of the contemporaneous goal, incentives for goal attainment will be based on net income for each 6-month period. All incentives earned will be tracked on the computer screen for the duration of the 6-month period. Information regarding participants earnings 11 Six month periods were used in order to shorten the length of the task for the participants. It seems plausible to expect that the long-term effects observed in 6-month periods, will generalize to longer periods (i.e. 12 months). Therefore, this research design choice should not limit the external validity of the results. 12 This feature of the design (i.e. multiple allocation combinations that result in contemporaneous goal attainment) is an example of the multiple decision paths characteristic of complex decisions. 25

26 (current and prior periods) will be available to them throughout the simulation. Participants will be paid at the end of the experiment. Depending on the incentive condition, attainment of goals for the forward looking indicators will result in a payout of $0.33 (only forward looking indicators rewarded), $0.17 (forward looking and contemporaneous rewarded) or $0.00 (only contemporaneous indicators rewarded). Participants whose performance exceeds the assigned forward looking goals will receive additional compensation. Specifically, additional compensation will be provided when participants customer satisfaction scores are very satisfied ( points) or extremely satisfied ( points), or food quality scores are very good ( points) or excellent ( points). The details of this bonus scheme are explained in Table 3, Panel A. Similar to a budget-linear incentive scheme, this contract provides motivation for managers to meet the goal, but also rewards performance that exceeds the assigned goals (Sprinkle 2000). In an environment where the most desirable level of customer satisfaction or food quality is difficult to determine, it seems plausible that an organization would be willing to encourage and reward for performance beyond the assigned goal. This design feature provides an opportunity for participants to shift effort to maximize their earnings but at the expense of the long-term earnings of the company. When participants exceed either forward looking goal, they will have the opportunity to earn as much as $0.66 ($0.33) per period in the condition where only forward looking (forward looking and contemporaneous) performance is (are) rewarded. Thus, when only forward looking goals are rewarded (Condition A in Figure 1), maximizing performance on one of the forward looking indicators provides as much earnings for the participants as the resource allocation that has the most beneficial long-term impact on the company s income. << Insert Table 3 here>> 26