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Subjective Performance Indicators and Discretionary Bonus Pools

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  • MADHAV V. RAJAN
  • STEFAN REICHELSTEIN

Abstract

Key indicators of managerial performance are frequently subjective, that is, they are difficult to specify and/or verify for contracting purposes. When a principal must rely on subjective information to create incentives for a group of agents, discretionary bonus pools are shown to be optimal mechanisms. Despite their optimality, however, discretionary bonus pools entail an additional agency cost relative to the benchmark of optimal contracts based on objective and verifiable information. Our analysis identifies circumstances under which this additional agency cost is small, for example, the subjective information signals are precise, or the number of agents participating in the bonus pool increases. When incentive schemes can be based on both objective and subjective performance indicators, the relative weights to be placed on alternative signals are shown to differ from the ones predicted by models with objective signals only. We also demonstrate that correlation in measurement errors has a different impact on the structure of optimal incentive schemes when the performance indicators are merely subjective. Copyright University of Chicago on behalf of the Institute of Professional Accounting, 2006.

Suggested Citation

  • Madhav V. Rajan & Stefan Reichelstein, 2006. "Subjective Performance Indicators and Discretionary Bonus Pools," Journal of Accounting Research, Wiley Blackwell, vol. 44(3), pages 585-618, June.
  • Handle: RePEc:bla:joares:v:44:y:2006:i:3:p:585-618
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    References listed on IDEAS

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    1. Michael E. Porter, 1992. "Capital Choices: Changing The Way America Invests In Industry," Journal of Applied Corporate Finance, Morgan Stanley, vol. 5(2), pages 4-16.
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    Cited by:

    1. Alexander K. Koch & Eloïc Peyrache, 2011. "Aligning Ambition and Incentives," Journal of Law, Economics, and Organization, Oxford University Press, vol. 27(3), pages 655-688.
    2. Imhof, Lorens & Kräkel, Matthias, 2014. "Bonus pools and the informativeness principle," European Economic Review, Elsevier, vol. 66(C), pages 180-191.
    3. Gürtler, Oliver & Kräkel, Matthias, 2010. "Optimal tournament contracts for heterogeneous workers," Journal of Economic Behavior & Organization, Elsevier, vol. 75(2), pages 180-191, August.
    4. Joyee Deb & Jin Li & Arijit Mukherjee, 2015. "Relational Contracts with Subjective Peer Evaluations," Cowles Foundation Discussion Papers 1995, Cowles Foundation for Research in Economics, Yale University.
    5. Kvaløy, Ola & Olsen, Trond E., 2016. "Teams in Relational Contracts," Discussion Papers 2016/23, Norwegian School of Economics, Department of Business and Management Science.
    6. Burney, Laurie L. & Henle, Christine A. & Widener, Sally K., 0. "A path model examining the relations among strategic performance measurement system characteristics, organizational justice, and extra- and in-role performance," Accounting, Organizations and Society, Elsevier, vol. 34(3-4), pages 305-321, April.
    7. Budde, Jörg & Hofmann, Christian, 2011. "Dynamic Bonus Pools," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 443, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
    8. Suzuki, Toru, 2012. "Competitive problem solving and the optimal prize schemes," Games and Economic Behavior, Elsevier, vol. 75(2), pages 1009-1013.
    9. Neale G. O'Connor & F. Johnny Deng & Pan Fei, 2015. "Observability and Subjective Performance Measurement," Abacus, Accounting Foundation, University of Sydney, vol. 51(2), pages 208-237, June.
    10. repec:spr:rvmgts:v:11:y:2017:i:4:d:10.1007_s11846-016-0209-9 is not listed on IDEAS
    11. Kräkel, Matthias & Schöttner, Anja, 2010. "Technology choice, relative performance pay, and worker heterogeneity," Journal of Economic Behavior & Organization, Elsevier, vol. 76(3), pages 748-758, December.
    12. Koch, Alexander K. & Peyrache, Eloic, 2005. "Tournaments, Individualized Contracts and Career Concerns," IZA Discussion Papers 1841, Institute for the Study of Labor (IZA).
    13. Oliver Gürtler, 2010. "Collusion in homogeneous and heterogeneous tournaments," Journal of Economics, Springer, vol. 100(3), pages 265-280, July.
    14. Irlenbusch, Bernd & Ruchala, Gabriele K., 2008. "Relative rewards within team-based compensation," Labour Economics, Elsevier, vol. 15(2), pages 141-167, April.
    15. Nieken, Petra & Stegh, Michael, 2010. "Incentive Effects in Asymmetric Tournaments Empirical Evidence from the German Hockey League," Discussion Paper Series of SFB/TR 15 Governance and the Efficiency of Economic Systems 305, Free University of Berlin, Humboldt University of Berlin, University of Bonn, University of Mannheim, University of Munich.
    16. Irlenbusch, Bernd & Ruchala, Gabriele K., 2006. "Relative Rewards within Team-Based Compensation," IZA Discussion Papers 2423, Institute for the Study of Labor (IZA).

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