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Weekly UpdatesThe relative importance of alternative performance measures should be a function of their precision and sensitivity to the manager's performance. Pavlik et al. (1993) suggest that stock returns are affected by many economic factors and thus may be too "noisy" and insensitive to link to a manager's actions. Accounting measures, on the other hand, can be created and tailored to capture different aspects of a firm's circumstances and appear to capture both short-term and long-term aspects of performance not adequately captured by either general or relative measures of stock return.
Hypotheses
Performance-based compensation plans represent those plans in which an executive is granted shares or stock or stock rights in exchange for meeting certain firm performance goals. These goals are typically measured using accounting variables and can include many different types of measures including those measures related to profitability, efficiency and growth.
From an agency theory perspective, increasing firm performance should be one of the goals of a firm's management. Improved profitability is one measure of performance, and a common measure of profitability often used in evaluating compensation contracts is Return on Equity (ROE). Based on agency theory, there should be significant differences between ROE as measured before and after the adoption of a performance plan. Stated explicitly,
H1: Adoption of a performance plan has a positive impact on the profitability measure ROE.
However, the general performance variable ROE does not necessarily capture differences that arise in firms due to the nature of their industry. A more accurate measure of firm performance involves considering the manager's production environment, or industry. This implies that the performance measures need to be industry-specific. Given agency theory, if performance plans work as designed, industry-specific performance measures should indicate improvement in firm performance after the adoption of a performance plan. Thus,
H2: Adoption of a performance plan results in improvement in industry-specific performance measures.
Secondly, it is important to assess if firm performance changes were the result of the adoption of a performance plan, or whether the changes were seen industry-wide and thus were not impacted by the adoption of a performance plan. Therefore,
H3: Improvement in the profitability measure, ROE, is greater for adopters of a performance plan than for non-adopters in the same industry.
H4: Improvement in industry-specific performance measures is greater for adopters of a performance plan than for non-adopters in the same industry.
Methods
Sample
The sample period covers performance plans that were adopted by a company for the first time during the years 1972-1991. The sample also covers two broad classifications of companies, Adopting Firms and Non-adopting Firms. A list of companies adopting performance plans was obtained from two sources. Performance plan adopters from 1973-1980 were obtained from the 1992 study by Gayer et al. (1992). In addition, a list of performance plan adopters was obtained from Frederick W. Cook & Co., a compensation specialist company. Both of these data sources provided the first date that a company had adopted a performance plan as a component of CEO compensation. Therefore, these companies provide an easy measuring point for change in performance based on the starting date of this first-time adoption of a performance plan. In all cases, a performance plan consists of either the granting of stock shares or stock units based on meeting specific performance criteria outlined in the actual performance plan agreement. The fi nal adopter sample consists of 335 companies over nine industries. Non-adopter companies were companies not included in the lists of performance-plan adopters provided by the two data sources. The final non-adopter sample was found by searching on COMPUSTAT for all firms with the same three-digit SIC codes as the adopting firms. This resulted in 2,896 non-adopter companies over nine industries.
Company Classification
An adopter is defined as any company that is a first time adopter of a performance plan during the sample period. Each adopter is required to have seven consecutive years of data consisting of the two years immediately preceding the year of adoption, the year of adoption and the four years immediately following the adoption. A non-adopter is any company that meets the necessary criteria (three-digit SIC code and seven consecutive years of data) to remain in the sample, but is not included in the list of companies adopting a performance plan during the adoption period being analyzed. Similarities and differences can be seen in adopters and non-adopters when the mean and median for sales are examined for each industry group. Table 1 provides this descriptive information.
Variable Aggregation
For all firms, a general performance variable and three industry-specific performance variables were calculated. Each of these variables was initially calculated for three different measurement periods. The first measurement period is the pre-adoption period, which evaluates the variables for the two years prior to the year of adoption. The second measurement period is the short-term, post-adoption period, or the two years immediately following the year of adoption. The third measurement period is the long-term, post-adoption period or the four years after the year of adoption. Following Kumar et at., (1997), the year of adoption is excluded from the analysis. The adoption of a performance plan can take place at any time during a given year and the evaluative period typically begins with measurements being examined not in the year of adoption but the following year. This allows time for the decisions of the executive to influence the firm and therefore his/her compensation.
The two post-adoption periods were compared to the pre-adoption period. Therefore, each performance variable was tested at two levels: (1) by comparing the short-term, post-adoption period to the pre-adoption period, and (2) by comparing the long-term, post-adoption period to the pre-adoption period. This results in each variable having a designation with either a "1" (pre-adoption to short-term post comparison) or a "2" (pre-adoption to long-term post comparison). This results in a total of eight variables for each industry group -- one general variable and three industry-specific variables each measured at two levels.
An additional step was needed in calculating the variables for the non-adopter firms. For each industry group, the data were sorted by year and the average for each variable was calculated for each year. [1] This resulted in one year of data for each year 1970-1994. The data were then divided into seven-year intervals (1970-1976, 1971-1977, etc.) to match the seven-year intervals surrounding adoptions.
General Performance Variable
ROE is frequently used as one means of evaluation in compensation contracts and is used in research studies as a popular profitability measure (Lambert and Larker, 1987; Abowd, 1990; Traichal and Gallinger, 1995).
ROE is used in this study to evaluate whether general performance measures, such as ROE, provide a better indication of improved firm performance than performance measured using industry-specific measures. Because ROE is a general measure, the industry-specific measures should provide a clearer indication of changes in firm performance.
Industry-Specific Variables
Nine industry groups were utilized in the present study. These groups include: (1) Bank and Non-bank Financial, (2) Chemical Manufacturing and Distribution, (3) Consumer Products Manufacturing and Distribution, (4) Food Processing and Distribution, (5) Electrical, Electronics and Related Equipment, (6) Heavy Manufacturing, (7) Mining, Fuels and Extractive, (8) Non-financial Service, and (9) Textiles, Paper and Forest Products. [2] These groupings are some of those used by Business Week in their annual "Corporate Scoreboard" (Byrne and Hawkins, 1993) and are also similar to groupings used by S&P Industry Analyst Reports. Therefore, the groupings in this study do not always coincide directly with the categories given strictly by SIC codes. These groupings are based on the functional areas of a business, and places in the same industry firms that should have the same type of production environment. The industry-specific ratios chosen for analysis should be important performance indicators for each type of compa ny within a group and the ratios should in general move in the same direction within an industry. These ratios, detailed in Table 2, are predominately measures of efficiency and growth and may or may not be the ratios actually used in a performance contract. These ratios represent, however, the ones most highly discussed by S&P industry analysts for each of the specific industry categories as being important in evaluating the performance of a firm. Including details of why each industry-specific variable was chosen is too lengthy; however, as an example of the thought processes implemented in ratio choices, details for the ratio selection for the Consumer Products group follows.
The Consumer Products Manufacturing & Distribution category group includes companies that manufacture and distribute end-user consumer products (exclusive of food products) such as clothing, furniture, household appliances, and cosmetics. Though this may seem like an unlikely set of firms to place together, as producers/distributors of consumer products these firms have some very common goals and are affected by many of the same problems. Regardless of whether a firm is a manufacturer of household appliances or cosmetics, the whims of consumers have the largest impact on the success of each of these lines of business. The consumer product life cycle is naturally an evolutionary process and it is difficult to counteract. The key strategy is to plan more effectively to sustain profitability in different stages.
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