Implicit Employment Contracts: The Limits of Management Reputation for Promoting Firm Productivity

Implicit employment contracts are a common way to motivate firm productivity but also require that employees trust management to be fair when allocating postproduction firm resources between employees and owners. We use an experiment to study the problem of motivating firm productivity, which depends on levels of owner investment and employee productive effort, when managers have an incentive to favor the owner's interests over those of the employee. Drawing on research in psychology and behavioral economics, we argue that reputation concerns can more effectively promote firm productivity when manager compensation is relatively insensitive to how much the owner is allocated after production occurs. Consistent with our predictions, we find that reputation concerns lead to greater firm productivity and higher payoffs for all firm members, but only when manager pay is relatively insensitive to the owner's ex post allocation. In addition to offering testable empirical implications, our theory and results are important because they can help explain why executive compensation is, in practice, surprisingly insensitive to owner returns.     

The bright side of the internal labor market: Evidence from the labor cost stickiness of firms affiliated with privately owned business groups in China

We examine whether having an internal labor market can help a firm affiliated with a privately owned business group (POBG) reduce labor cost stickiness. Our findings suggest that, when a POBG-affiliated firm experiences a decrease in sales, it has lower labor cost stickiness than an otherwise equivalent firm that is not affiliated with a POBG. Specifically, we find that, on average, a POBG-affiliated firm entirely mitigates labor cost stickiness when it has a decrease in sales. In addition, we document that, to adjust its labor cost downward, a POBG-affiliated firm hires fewer employees, rather than paying lower wages. We show that the lower labor cost stickiness is due to movement of employees from the focal firm to other firms within the same POBG. When sales fall, the POBG reallocates excess employees at the focal firm to other firms within the business group via an internal labor market, and the focal firm thereby increases its per capita profit. Moreover, we find that agency cost mediates the impact of a POBG on labor cost stickiness. When the external market is less effective or the POBG headquarters have strong incentives, the effect of POBG affiliation on the reduction in an affiliated firm's labor cost stickiness is more salient.     

The mediating role of happiness on the effect of locomotion and effort on salesperson’s performance and cross-selling: the case of financial insurance

In this study, the authors propose a theoretical framework and show how salespeople’s locomotion orientation and effort increase financial sales outcomes (e.g., performance and cross-selling). We propose that a salesperson’s happiness plays a mediating mechanism in these main effects. The authors collected data from two samples. In Study 1, the authors collected data from financial insurance brokers, which worked as a link between insurance companies and customers. In Study 2, the authors analyzed answers from salespeople working on home improvement and construction products and services. First, the results demonstrate that the salespersons’ locomotion (an orientation toward a behavior), effort, and happiness increased sales performance (main effects). Second, salespersons’ locomotion and effort have an indirect effect through individuals’ happiness on our dependent variables, such as sales performance, product performance and cross-selling. Firms can improve individuals’ locomotion and effort by developing goal setting and goal striving.

     

How do different performance measures affect managerial time orientation? Empirical evidence from sales managers in the oil and gas industry

This study investigates the relative effect of performance measures on managerial time orientation. We collect survey data on the actual time allocation of sales managers for tasks that affect financial performance on the short-, medium-, and long-term horizons. In addition, we obtain survey data on the specific metrics used by an oil and gas firm and classify them into three groups: traditional accounting (gross margin and budgeted costs), nonfinancial (market share and sales volume), and accounting returns (economic value added — EVA). Based on partial least-squares analysis, our results suggest that, in our setting, both nonfinancial and accounting return measures can supplement traditional accounting metrics to mitigate potential short-term orientation by inducing sales managers to consider mainly not only sales tasks but also investing tasks, which will affect the firm results more than a quarter ahead. In addition, our results imply that accounting return metrics are not better than nonfinancial measures in inducing a longer-term orientation in our research setting.     

Impact of Replacing a Defined Benefit Pension with a Defined Contribution Plan or a Cash Balance Plan

Abstract

Four pension plan conversions are examined to determine the impact on retirement benefits of workers. The study was based on interviews with top management, employee surveys, and actuarial analysis of retirement benefits under the old and new pension plans. In general, workers who leave the firm prior to the age of early retirement can expect increased benefits under the new defined contribution and cash balance plans, whereas older, more senior workers can expect to accrue smaller benefits after the plan conversions. Recognizing these potential adverse effects, the employers in our studies provided various types of transition benefits to existing workers or gave employees the choice of remaining in the old defined benefit plan. Employee surveys reveal that younger workers are more supportive of the new pension plans than are older workers. These case studies also indicate that communication by managements with their employees is very important to the successful implementation of plan conversions.     

Positive intelligence

Most of us assume that success will lead to happiness. Shawn Achor, founder of the corporate strategy firm Good Think, argues that we've got it backward; in work he's done with KPMG and Pfizer, and studies he's conducted in concert with Yale's psychology department, he has seen how happiness actually precedes success. Happy employees are more productive, more creative, and better at problem solving than their unhappy peers. In this article, Achor lays out three strategies for improving your own mental well-being at work. In tough economic times, they're essential for keeping yourself-and your team-at peak performance.     

The association between quarter length,forecast errors,and firms’ voluntary disclosures

Approximately 60 percent of adjacent fiscal quarters contain a different number of calendar days. In preliminary analyses, we find the change in quarter length is significantly associated with the changes in sales and earnings and that analysts condition on the prior quarter's results when making their forecasts. These results indicate that it is important for analysts to adjust for changes in quarter length when making forecasts. However, we find the quarterly change in days is positively associated with analysts’ sales and earnings forecasts errors, where forecast error equals the actual earnings minus the forecasted earnings. These results indicate that analysts systematically underestimate (overestimate) performance when quarter length increases (decreases). We find evidence indicating investors make similar errors as returns around earnings announcements are positively associated with the change in quarter length, but only when changes in firm performance is more sensitive to changes in quarter length. Corroborating these findings, managers are more (less) likely to discuss quarter length during conference calls when quarter length decreases (increases). These results are consistent with managers’ strategic disclosure incentives. In summary, our evidence suggests analysts and investors fail to fully take account of the quasi-mechanical effect that quarter length has on firm performance and managers strategically alter their voluntary disclosures to take advantage of these failures.     

The sales learning curve

When a company launches a new product into a new market, the temptation is to immediately ramp up sales force capacity to gain customers as quickly as possible. But hiring a full sales force too early just causes the firm to burn through cash and fail to meet revenue expectations. Before it can sell an innovative product efficiently, the entire organization needs to learn how customers will acquire and use it, a process the authors call the sales learning curve. The concept of a learning curve is well understood in manufacturing. Employees transfer knowledge and experience back and forth between the production line and purchasing, manufacturing, engineering, planning, and operations. The sales learning curve unfolds similarly through the give-and-take between the company--marketing, sales, product support, and product development--and its customers. As customers adopt the product, the firm modifies both the offering and the processes associated with making and selling it. Progress along the manufacturing curve is measured by tracking cost per unit: The more a firm learns about the manufacturing process, the more efficient it becomes, and the lower the unit cost goes. Progress along the sales learning curve is measured in an analogous way: The more a company learns about the sales process, the more efficient it becomes at selling, and the higher the sales yield. As the sales yield increases, the sales learning process unfolds in three distinct phases--initiation, transition, and execution. Each phase requires a different size--and kind--of sales force and represents a different stage in a company's production, marketing, and sales strategies. Adjusting those strategies as the firm progresses along the sales learning curve allows managers to plan resource allocation more accurately, set appropriate expectations, avoid disastrous cash shortfalls, and reduce both the time and money required to turn a profit.     

Rank and file equity compensation and earnings management: Evidence from stock options

The widespread use of rank and file equity‐based compensation suggests that executives believe that rank and file employees can affect firm outcomes, and some research supports this view. If equity‐based incentives influence rank and file employees’ productive efforts, they might also influence their earnings management decisions. We find that increases in rank and file employees’ option‐based compensation—our proxy for equity‐based compensation—are associated with increases in earnings management and that this relation is attributable to real activities (as opposed to accrual) earnings management. Cross‐sectional tests indicate that the relation is stronger when rank and file option compensation is likely to generate greater performance incentives and attenuated in the presence of more intense monitoring. Finally, we explore the role of cash constraints and overvaluation as potential alternative explanations for this relation and find that neither accounts for our results.     

THE EFFECTS OF SPIN-OFFS ON CORPORATE INVESTMENT AND PERFORMANCE

We examine characteristics of firms involved in spin-offs and test whether these spin-offs induce changes in investment incentives and economic performance. We find that firms engaging in spin-offs are larger, more highly leveraged, and have higher asset turnover and lower real asset growth than their industry rivals. We also find that spin-offs generate significant increases in real asset growth and cash flow margin on sales for combined firm measures (spun-off firm plus parent firm). The gains result from increases in real asset growth for parent and spun-off firms, and improvements in cash flow margin on sales for parents. Our evidence is consistent with models in which spin-offs create value by improving investment incentives and economic performance.     

Scale, scope, and spillovers: the determinants of research productivity in drug discovery

We examine the relationship between firm size and research productivity in the pharmaceutical industry. Using detailed internal firm data, we find that larger research efforts are more productive, not only because they enjoy economies of scale, but also because they realize economies of scope by sustaining diverse portfolios of research projects that capture internal and external knowledge spillovers. In pharmaceuticals, economies of scope in research are important in shaping the boundaries of the firm, and it may be worth tolerating the static efficiency loss attributable to the market power of large firms in exchange for their superior innovative performance.     

Share Repurchases and Pay-Performance Sensitivity of Employee Compensation Contracts

I show that share repurchases increase pay-performance sensitivity of employee compensation and lead to greater employee effort and higher stock prices. Consistent with the model, I find that after repurchases, employees and managers receive fewer stock option and equity grants, and that the market reacts favorably to repurchase announcements when employees have many unvested stock options. Managers are more likely to initiate share repurchases when employees hold a large stake in the firm. Moreover, since employees are forced to bear more risk in firms that repurchase shares, they exercise their stock options earlier and receive higher compensation.     

An equilibrium model of incentive contracts in the presence of information manipulation

This paper develops an agency model in which stock-based compensation is a double-edged sword, inducing managers to exert productive effort but also to divert valuable firm resources to misrepresent performance. We examine how the potential for manipulation affects the equilibrium level of pay-for-performance sensitivity and derive several new cross-sectional implications that are consistent with recent empirical studies. In addition, we analyze the impact of recent regulatory changes contained in the Sarbanes-Oxley Act of 2002 and show how policies intended to increase firm value by reducing misrepresentation can actually reduce firm value or increase the upward bias in manipulated disclosures.     

Multinationality and the value of green innovation

When do multinational corporations (MNCs) derive the most from internalizing the transfer of proprietary technological knowhow? We revisit this question, which lies at the core of theories on multinationality and performance, from the perspective of corporate strategy involving a mix of green versus nongreen innovation effort and foreign operations focusing on countries with high versus low environmental standards. We find that high exposure to foreign markets with more stringent environmental regulations stimulates MNCs' green patent applications. Predictably, the pursuit of green innovation is positively associated with firm value in the long run. This long-run advantage produces higher economic rents when MNCs' home countries rely on more clean energy for power generation, have a more developed economy and have a more effective government. We further show that this long-run value enhancement effect is more pronounced in Mining & Oil and energy sectors (i.e., more polluting) than sales and service sectors (i.e., less polluting). In addition, MNCs' environmental competitive advantage obtained through green innovation activities is coupled with exposure to MNCs' host countries with high long-term and femininity orientations. Overall, our study highlights that green technology development is a main source of value creation for multinationals.     

ISO certification,financial constraints,and firm performance in Latin American and Caribbean countries

We employ World Bank Enterprise Survey data collected in 2006–2010 for 21,852 firms from 31 Latin American and Caribbean countries to investigate determinants of the adoption of International Organization for Standardization (ISO) certification, the relation between ISO certification and firm financial constraints, and the effect of ISO certification on firm performance. We find that ISO accreditation is positively related to firm size and firm age. Exporters and foreign firms are more likely to adopt ISO certification. We document that ISO-certified firms exhibit significantly lower level of financial constraints and higher labor productivity and lower cost of sales than non-certified firms.     

The Influence of Culture on Pension Plans

It is widely recognized that culture is a dimension affecting a vast array of management and social choices. However, we know little about the effect of culture on choices that combine both business and social issues in an accounting setting. Employee benefit choices by managers reflect both the business choices of a firm in the selection and retention of employees and social choices in the type and extent of benefits provided to employees. The objective of this study is to investigate the extent to which culture affects employee benefits as manifested in pension plans. In a comparison of plans that differ according to the home country of the parent firm and are offered in the regulated environment of the United States, results indicate an effect of culture on pension plan choices. In particular, culture plays a role in determining the funding level percentage of the plan, employer contributions receivable, and revenues received or receivable from employers.     

Entry Mode Choice and Performance: Evidence from Taiwanese FDI in China

This paper examines entry mode choices between wholly owned subsidiaries (WOSs) and joint ventures (JVs) and the impact on performance for Taiwanese foreign direct investment in China. Taiwan and China share common cultural traits, so Taiwanese investors inherently prefer WOSs because these investors are acquainted with local conditions in China. This paper shows that even if WOSs are a natural choice, transaction cost theory is applicable in explaining the adoption of JVs by Taiwanese firms when investing in China. Firms that choose WOSs generally have higher sales growth and superior profitability. However, the smaller the subsidiary and the less experienced the firm, the more likely that JVs will have better performance.     

Cash-Balance Plan Conversions: Evidence on Excise Taxes and Implicit Contracts

Firms that wish to switch from a traditional defined‐benefit pension plan to a defined‐contribution‐type plan have a choice between converting to a cash‐balance plan or replacing the defined‐benefit plan with a full‐fledged defined‐contribution plan. According to Ippolito and Thompson's (1999; Industrial Relations, 39: 228‐245) excise tax avoidance hypothesis, a number of firms have switched to cash‐balance plans because conversion allows the firm to avoid excise taxes on its excess pension assets. In contrast to existing studies, our evidence supports the excise tax avoidance hypothesis. Cash‐balance plan conversions also have been criticized for imposing pension losses on older employees. The implicit contract theory of pensions predicts that poorly performing firms would be the ones that would impose losses on employees. However, our evidence indicates that firms converting to cash‐balance plans typically are not poor performers.     

The residual claim of rank and file employees

This paper estimates the intensity of the value-maximization incentives for average employees generated through the combination of wage, salary, and bonus mechanisms. This is accomplished through estimation of the elasticity of average employee hourly compensation with respect to changes in firm performance. This performance elasticity indicates the degree of alignment between employee and shareholder objectives, and it can also be interpreted as an incomplete residual income claim for employees. The estimated performance elasticity for the full sample of firms is not significantly different from a CEO salary-plus-bonus performance elasticity of 0.1 published in Coughlan and Schmidt [Journal of Accounting and Economics 7 (1985) 43]. Jensen and Murphy [Journal of Political Economy 98 (1990) 225] find that CEOs received approximately US$3.25 for each US$1000 increase in shareholder wealth. This translates to an elasticity of just over 57, but most of these payments come through channels other than salaries and bonuses. Jensen and Murphy report a performance sensitivity of salary and bonus payments for CEOs that is equivalent to analogous elasticities for rank and file workers reported in this paper. While the rewards CEOs receive through salary and bonus channels are larger than those of average employees in absolute terms, these rewards represent comparable fractions of income. This paper also finds differences in the pay-performance link based on firm size. The estimated performance elasticity is 0.197 in small firms and is indistinguishable from zero in large firms. The results indicate that firms use wage, salary and bonus adjustments to direct approximately 5.3% of firm value increases to employees. Although the precise link between pay and performance is not visible with this data, these results indicate that average employees benefit when the firm performs well.     

Managerial ownership and firm performance: Evidence from China's privatizations

We examine the relationship between managerial ownership and firm performance for a sample of Chinese State-owned enterprises (SOEs) privatized over the period 1992-2000. The results indicate that managerial ownership has a positive effect on firm performance. Although return on assets (ROA) and return on sales (ROS) decline post-privatization, firms with high managerial ownership and, specially, high CEO ownership, exhibit a smaller performance decline. The difference is highly significant, with or without controlling for residual state ownership and changes in the firm's operating environment. We also find that the influence on firm performance becomes less significant at higher levels of CEO ownership. In contrast, performance continues to increase with managerial ownership. This finding suggests that, beyond a certain point, the distribution of shares would be more effective if extended to the whole management team instead of being limited to the chief executive.