Incentive Compensation Schemes Shouldn’t Be ‘One Size Fits All’

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By Associate Professor of Management Daniel Han Ming Chng

The carrot and stick approach of tying senior executive’s compensation to their company’s financial performance has long been a way of ensuring that their interests and those of shareholders are aligned. But the findings of two new research studies co-authored by CEIBS Associate Professor of Management Daniel Han Ming Chng suggest that both the external business environment and each executive’s characteristics influence how effective incentive compensation actually is.

Both studies took their results from a specially-designed management simulation game with experienced Chinese managers enrolled in a part-time MBA programme at a major university in Northeast China. 

One study is the first to explore how incentive pay influences the time and money that senior executives are willing to spend on corporate image management when their company is facing a downturn. The results show that publicity about the company’s poor performance increases executives’ image concerns, and in turn, they will make greater investments in time and money on managing the company’s reputation; they are even more likely to do so when their compensation is tied to  the company’s performance. Conversely, executives with fixed compensation and those operating without much media attention spend less time and money on corporate image management in tough times.

Given that a senior executive’s reputation is closely tied to their company’s performance and image; those ties are amplified when their compensation is linked to the company’s performance. The findings in this study show that it may be in the executive’s own best interest to allocate more resources for corporate image management, even if other strategic activities may ultimately be more beneficial to the company and its shareholders. The researchers suggest that companies should understand the downside risks of incentive compensation and reduce leaders’ individual accountability during a downturn by specifying clear, measurable short- and long-term performance goals and appropriate corporate governance processes, including increased monitoring and managing of public relations efforts. The results of this study have been published by The Leadership Quarterly in a paper titled, “Leaders’ Impression Management during Organizational Decline: The roles of publicity, image concerns, and incentive compensation”. Read the paper here.

The second study examines the effectiveness of incentive pay from a different perspective. It looks at how a senior executive’s own career ambition and their ability to recognize and prioritize tasks involved with managing their organization’s performance affect the way they respond to incentive pay in terms of how they handle strategic risks. The researchers explore these relationships both when a company is prospering and when it is facing hard times. The results show that in a downturn, more ambitious and task-oriented executives with incentive pay packages take more strategic risks in order to try to improve the company’s performance. However, when a company is doing well, neither incentive pay nor executives’ characteristics affect their strategic risk taking.

The results of this study suggest that senior executives’ responses to incentive pay is rather muted during prosperous times, and companies should incorporate other organizational practices to motivate executives, such as fostering stronger organizational identification or developing greater managerial competencies. In contrast, during a downturn, companies should carefully design compensation packages that match the individual characteristics of the managers they employ in order to influence their managerial behaviours, or select managers with characteristics that match existing compensation schemes. Companies may also need to take an active role in keeping managers focused on the necessary tasks for turning around the company. The results of this study have been published by the Journal of Organization Behavior in a paper titled “An Experimental Study of the Interaction Effects of Incentive Compensation, Career Ambition, and Task Attention on Chinese Managers’ Strategic Risk Behaviors”.  Read the paper here.

Image courtesy of Stuart Miles at FreeDigitalPhotos.net

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