Factors Influencing Award of Compensation Contraacts: An Analysis of Written Protocols

The view that compensation should be tied to performance is widespread throughout the organization literature. It is commonly believed that if one wants to motivate high performance, one should attach rewards to it (Eisenhardt, 1988; Fein, 1976; Lawler, 1971, 1981; Pearce et al., 1985; Rubery, 1995). While a majority of the literature generally advocates contingent pay systems, it is also recognized that under some conditions the implementation of such systems may be dysfunctional. For example, Lawler (1971, 1981) stated that performance contingent pay cannot be used when trust levels are low, when performance cannot be validly and inclusively measured, and when large pay rewards cannot be given to the best performers. Lawler (1971) also acknowledged that under certain circumstances, subjective judgments by superiors and objective performance data should be combined into a managerial performance measure on which pay could be based. The accounting literature on performance evaluation has also dealt with issues of performance evaluation styles (Hopwood, 1972, 1973; Keely, 1977) and how uncertainty in the operating environment affects performance evaluation and compensation contract decisions (Govindrajan, 1984). In fact, several researchers in accounting and marketing have used techniques such as analytic modeling (Basu et al., 1985; Lal and Srinivasan, 1988; Baiman and Rajan, 1995), field studies (Coughlan and Narasimhan, 1992; Eisenhardt, 1988; John and Weitz, 1988, 1989; Lal et al., 1990; Oliver and Weitz, 1989; Ray and Cushing, 1994), and laboratory experiments (Umanath et al., 1993) to assess the individual and proportionate effects of environmental uncertainty and level of agent (employee) effectiveness on the salary/incentive mix in employment contracts. Of these studies, however, none have analyzed the decision process resulting in the final selection. Accordingly, this study is motivated by 1) the equivocal results obtained to date regarding the effects of environmental uncertainty and agent (employee) effectiveness, and 2) the lack of any decision process-oriented studies in this field. This research also takes a unique methodological approach in accounting by analyzing the written protocols collected from subjects in a laboratory experiment to assess the impact of environmental uncertainty and agent effectiveness on compensation plan selection. Umanath et al.'s (1993) study used chosen contracts as the dependent variable of interest, thereby focusing on choice behavior. By using the written protocol data from that experiment, this study is the first to focus on the process of compensation contract selection under some controlled conditions. HYPOTHESIS DEVELOPMENT Background Basu et. al (1985) and Lal and Srinivasan (1988) both examined the issue of sales force compensation using an analytic principal-agent framework. The basic principal-agent model has a risk neutral principal and a risk averse agent. The nature of the effort-outcome relationship is stochastic, that is the outcome given high or low effort cannot be determined with certainty. The agent is effort averse and there is a condition of information asymmetry, which implies that the agent has private information about prevailing conditions surrounding his/her work environment that is not available to the principal. The principal's problem in the agency model is to maximize outcome less the compensation paid to the agent. As two extreme responses, the principal can either select a contract totally dependent on outcome or one that consists of only a fixed salary, neither of which are optimal solutions. A contract totally dependent on outcome would transfer the entire risk to the agent while a fixed salary would fail to elicit the right level of effort. One solution for the principal is to opt for a risk sharing contract which gives the agent a base (fixed) salary and an additional incentive component based on some measure of outcome that is observable. …