Table of content
1. Introduction page
2. Performance evaluation – overview page
3. Objective performance evaluation page
3.1 Advantages page
3.2 Shortcomings page
4. Subjective performance evaluation page
4.1 Advantages page
4.2 Problems page
5. Combined evaluation tool: The Balanced Scorecard page
6. Conclusion page
7. Appendix page
8. References page
Performance evaluation is a topic of ongoing concern, interest and controversy. While the main goal of performance measurement is to provide a basis for the assessment of employee’s objective achievement it also helps to develop strategic plans and when properly designed it gives the motivation to work towards goals that are aligned with the principals residual interests (Ittner & Larcker, 1998). However, this incentive alignment is subject to major discussion. For example Josef Ackermann (2008), CEO of Deutsche Bank, admitted that one reason for the development of the sub prime crisis was the bonus system among banks. He argued that bonuses should establish the right incentives and be oriented towards medium- and long-term goals. He assessed tying bonuses to maximize profits in the short term – which encourages managers to take high risks – as the wrong approach. The question is therefore, which kind of measurement techniques can be used to reflect the subordinate’s incremental contribution to the firm value and how they can be designed to serve the principals’ goals. The paper is organized as follows. The first part provides an overview of performance evaluation in general followed by the main part about objective and subjective performance measures, their benefits and shortcomings. Before concluding, the balanced scorecard – a tool for performance evaluation that combines both financial and operational measures – is analyzed and described.
2. Performance evaluation – overview
According to agency theory, the choice of a performance measure depends on its implicit information about subordinates’ actions (Bushman et al., 1996). Another definition, which can be found in the available literature about economics-based agency theory, is that performance measures in incentive contracts should be considered as a function of the informativeness of each measure regarding the employee’s action choices (Feltham & Xie, 1994; Ittner et al., 2003; Hemmer, 1996). The information provided by the performance measures can be used for various purposes within the company. First, evaluation systems are used as basis for the assessment of an employees’ target achievement and are therefore included in the labor contract. It serves as a tool for the determination of the compensation in incentive contracts. The predominant goal of such an incentive based compensation agreement is the alignment of agent’s actions with the principals’ objectives.
Challenges can evolve when employees perform multiple tasks – which is the case for higher level personnel. In such a situation, the incentive contract has to be designed in a way that includes measures that capture all of the tasks the agent should direct his attention to (Krishnan et al., 2005). If this is not the case, the employee will focus his efforts on the measured goals because his compensation is based on them and not other activities that are important and part of his job but left unmeasured. A lot of literature provides studies on the optimal weighting of multiple performance measures. Krishnan et al. (2005) assume that weighting the used performance evaluation tools is subjectively done by non-compensation experts also based on experiences from past years or other business units. In their study on performance measure congruity and diversity Feltham & Xie (1994) find three attributes of the measure that determine the optimal weighting: the sensitivity of the measure to the agent’s actions; the precision of the measure as a function of the variability of random events not caused by the agent; and congruity related to the alignment of the agent’s actions with the principals’ interests (Krishnan et al., 2005). Banker & Datar (1989) also interpret the relative weights in terms of the sensitivity and precision. A second and straightforward objective is the use of performance evaluation for making personnel decisions. It enables supervisors to detect and select employees who outperform set targets and help supporting them for decisions concerning promotions and career advancement issues.
Having seen this general view of performance measurement, it can be distinguished between objective and subjective performance measures. Objective evaluation tools are based on accounting figures and should provide unbiased measures of agents’ actions and decisions in financial or quantitative terms. However, with the increasing shift from – broadly speaking – tangible to intangible assets, as driver of value creation, and the resulting misallocation of managerial attention (Hemmer, 1996) the demand for new evaluation measures has increased. Subjective performance measures that capture activities of the employee not reflected in traditional measures seem to be the solution in complementing the shortcomings of objective measures. Studies have addressed a multitude of aspect that arise when subjective measures are used in combination with traditional financial measures. Basis for many research studies is provided by Holmstroem and Milgrom (1991) who introduced the principal- agent framework, which was already addressed in this section. One determinant of the use of subjective measures and also the extent to which these are used is the effectiveness of financial/objective performance measures. Gibbs et al. (2004) argue that an effective performance measure should provide the supervisor with accurate, informative and timely indications about the individuals’ performance. The perspective that has to be taken is how this individual contributes to the value of the company. From this point of view one can immediately identify the problems that occur: financial measures suffer due to manipulation, incompleteness and uncontrollables (Gibbs et al., 2004). The authors therefore examine a range of hypotheses, using data from departmental managers of 250 car dealerships, leading to interesting results and implications. Arguing that objective measures lead to a short-term view of employees, they find evidence that the inclusion of subjective performance measures is positively related to the extent of long-term investments in intangibles – in this case investment in training (Gibbs et al, 2004). In the study of CEO compensation plans, Bushman et. al (1996) find that there is a “positive relation between individual performance evaluation and corporate growth opportunities…”.
3. Objective performance evaluation
Assessing the performance of an employee or a manager can be done easily by using quantitative, financial measures. Readily available through the accounting information system, objective figures like budgets, profits, accounting and stock returns (Ittner & Larcker, 1998) provide outcome-oriented measures to evaluate the performance of a subordinate. Considered as ex-post measures, goals are set and communicated before the evaluation period and compared afterwards with the achieved results. This section highlights the advantages of objective measurements and discusses their shortcomings.
Advantages of objective performance measures can be found in their source and in their explicit nature.
Source of objective measurement figures
Objective measurement tools provide evaluators with reliable guidelines in the evaluation process. Stemming from accounting data meets two requirements for making these tools credible by the subordinates and therefore effective: first, for public companies, annual and quarterly financial statements have to be independently audited and are therefore of high quality and low bias; second, being relatively easy to understand, financial performance measures can be clearly communicated to employees before the evaluation period. These two features further enable the evaluators as well as the person being evaluated to compare the performance to pervious evaluation periods, to other departments or business units and other companies/competitors. The comparison is also not only restricted to the outcome versus the previously set goal but can serve both the superior and the subordinate in continuously reviewing the performance and making the necessary adjustments. Using the accounting system as source for the performance measures leads to no additional costs. Implementing assessment methods that are not based on accounting numbers would lead to additional costs for personnel or training as well as teaching evaluators how to use these tools. For financial performance measures no additional skills are necessary on the side of the evaluator because either the measures are clearly and straightforward themselves (e.g. sales or profit) or they are implicitly given due to the nature of the job. Furthermore, given the fact that evaluators are unable to oversee the actions of their subordinates in detail, using objective measures avoids the assessment by unreasonable and unfounded opinions about their degree of goal achievement.
Using solely objective performance measures makes the compensation contract free from subjectivity. Referred to as an explicit contract, incentive plans comprised of objective performance measures have therefore the advantage that both parties – the principal and the evaluated employee – know before the evaluation period (ex ante) on which basis performance is assessed. Another feature of an explicit contract is its enforceability through labor laws. Objective measures can be clearly stated in the contract while subjective measures are hard to assess by external institutions like a court, which has no expertise in the corresponding field. Hence, the risk for the employee of facing a principal who does not honor the contract’s compensation conditions is decreased. (Baker et al., 1994)