Managerial control versus performance pay

By Paul Walker 08/12/2013

One of the most obvious problems in any employment relationship is moral hazard. What the boss wants workers to do and what the workers actually do can be two very different things. Two of the most common methods firms utilise to try to deal with this problem are the use of performance pay and managerial control. In the empirical literature the performance pay aspect of this solution has received much greater attention than has the managerial control aspect.

In a recent NBER working paper Kirabo Jackson and Henry Schneider examine how an experiment in managerial control affected revenue at an auto repair firm. When the firm provided detailed checklists to mechanics, and managers monitored their use, revenue was 20 percent higher under the experiment. They compare this effect to that of quasi-experimental increases in mechanic commission rates. The managerial-control effect is equivalent to that of a 10 percent commission increase.

These results suggest that managerial control can be a viable alternative to performance pay for the mitigation of the effects of moral hazard. Furthermore, the managerial-control treatment was larger for mechanics that had higher commission rates, suggesting that in this context managerial control and performance pay are complements. The results also support the theoretical prediction that the optimal incentive contract depends on the level and quality of monitoring.

When they investigated the forces underlying the results, Jackson and Schneider find that the mechanics under the managerial-control treatment increase revenue through doing more repairs on each car and working more hours each week. In contrast, mechanics that received commission increases, increased revenue by substituting away from low-revenue repairs toward high-revenue repairs and getting customers to consent to higher price repairs, with no increase in time on the job or number of repairs conducted. Because this shifting toward more expensive repairs may reflect mechanics exploiting their informational advantage over customers, the result underscore the possibility that pay-for-performance may encourage undesirable worker actions.

Also the behaviour of the mechanics is adversely affected because as they only receive a fraction of the firm’s revenue, the additional compensation for mechanics for conducting a more thorough inspection of a car is insufficient to offset the associated effort and time costs. Jackson and Schneider’s calculations based on their results indicate that a modest transfer of the profits due to checklist use from firm to mechanic could compensate mechanics for their additional costs and achieve a sizable Pareto improvement.

The Jackson and Schneider study shows that increased managerial control can reduce moral hazard, something that has not often been tested empirically. Evidence is also provided that shows that increased managerial control can generate complementarities with performance pay, most likely in settings with multiple complementary tasks. Given the widespread emphasis on performance pay as an incentivising tool, their results suggest that managerial control may be an additional important tool for designing compensation schemes.

0 Responses to “Managerial control versus performance pay”

  • “Given the widespread emphasis on performance pay as an incentivising tool, their results suggest that managerial control may be an additional important tool for designing compensation schemes.”

    And you are surprised at this revelation?

    The amount of gaming that goes on inside any institution (private or Govt) because of “performance pay” or “retained salary” or “bonus” or “incentives” has never been a surprise to me and no doubt others. My experience of watching “Sales” screw “Service” within a scientific instrument supplier and watching managers and teams within a CRI gaming the year’s “bonus” and “profit sharing” reinforces the view that any incentive scheme – call anything like it what you will – will ultimately fail.

    Edward Demming had a few clues when he pronounced he would not work with ANY company or organisation that had ANY sort of incentive scheme.

    Any decent manager will make sure their underlings are doing the job they are hired to do. It’s how that happens which decides which manager is doing a good job. It appears, from what you have said, that someone is supplying checklists for the mechanics to fill out. One might read that as possibly encouragement and assistance in helping the mechanic to “do the right thing” for the customer. Nothing like a document that outlines the job. Any well run organisation will have well written procedures lying around. Whereas, leaving it to the mechanic to “achieve” ensured the mechanic’s departure from – one hopes anyway – the aims of the repair shop, a happy customer AND a profit.

    I “proudly” display on my wall a laminated letter from my CRI employer congratulating me on my efforts. It informed me that in 2001 I was awarded the princely sum of $74.39 as my share of the years profits. I personally could have done nothing to improve that figure, I was at the mercy of others. The year before “more” others were awarded bonuses of upwards of $10,000 (I kid you not) for a random million dollar contract signing. Management thought that the previous years results were wonderful and extended it to the rest of the organisation.

    They stopped it the year after. It failed to achieve the expected return.