7 Promotions and Subjective Performance Evaluation

Besides direct incentives from a bonus contract, employees are also motivated by the opportunity to get a promotion. The role of promotions has not received the same level of attention as incentive contracts but we can glean some general insights within the framework that we have built up so far. This chapter will have a different flavour compared to the previous chapters. Initially, I will use the concepts from transaction cost economics, specific knowledge, and properties of performance measures to give insights in the function of promotion incentives within organisations. The second half of the chapter introduces a new story to help us understand the role of subjectivity in performance measurement and incentives. Promotion decisions are often partly based on the subjective judgment of higher-level managers and I will use this story to explain the fundamental problem with these type of evaluations. This will give us a good jumping off point to talk about subjectivity in performance evaluation in general. For a lot of non-managerial incentives, the bonus is not fully determined by objective performance which is assumed in the previous chapter but the bonus will depend on the subjective judgment of one or multiple superiors.

The Role of Promotions

In this section, we leave the territory of the simple stories from earlier chapters and we are applying the insights from those stories to look at the role of promotions in organisations. As we will see with a number of strategic management accounting tools in the second part of the book, real-life practices often have multiple functions. One role of promotions is that it is part of a career path for the employee within the organisation. Because employees who are promoted have been working in the organisation for a while, the organisation has more knowledge about their skills and abilities. Similarly, those employees will also have more knowledge about how the organisation works through experience compared to outsiders. This is straight forward application of transaction cost economics and specific knowledge. Because the employee and organisation work together for a period of time, they develop specific knowledge and become mutually dependent. The time invested together becomes an asset specific, irreversible investment ^[1]. The second role of promotions is that they can be used as a reward for employees who perform well. A promotion is often desirable and employees will be motivated to get the prize of a promotion, i.e. the promotion is the reward in an implicit incentive contract.

Mutually Beneficial Learning

One advantage of promotions is that it gives the organisation the chance to observe the employees and get experience in how they work. Internal promotions allow organisations to find out which employees have the ability and the skills to work at a higher level in the hierarchy. Upon hiring and despite the interview process, firms are still uncertain on the capabilities of their employees. While employees are working for the organisation, supervisors learn more about the employees in day-to-day interactions on the job. In other words, supervisors and co-workers gain specific knowledge about their subordinates and colleagues. They might have a better judgement about whether certain employees are able to work in a different function. The firm for which an employee is working obtains specific knowledge on their employees that is not available to other firms. Similarly, the employees learn through experience how the organisation’s processes work, and what the firm culture is. They get to know customers and suppliers of the firm. That is, the employees gains specific knowledge that is valuable for the organisation ^[2].

Baker et al. (1994) provide evidence for this idea by looking at the differences between internally promoted employees and external hires in one specific firm. They show that external hires have more experience and have a higher educational degree than promoted employees. Some of these externally hired employees rise faster in the company than the average current employee but overall more of the external hires stay at the same level or exit in the first years. These differences indicate that the career path of external hires is more uncertain than the career path of incumbents. Some of the newly hired employees are superstars who rise quickly but the majority is moving slower in the hierarchy than the incumbents. This is likely because the firm understands the capabilities of current employees better than the skill set of new hires.

This shows that there is a mutual dependence between the organisation and their employees. The organisation knows the employee better than any other potential employer and the employee has knowledge and capabilities that are specifically valuable within the organisation. Thus the organisation will be willing to pay a higher compensation to those employees or will be more ready to promote them. Baker et al. (1994) argue that in the firm they study, the internally promoted employees make up for their lack of general industry experience and education by firm specific experience.

The mutually dependent relationship between firms and employees is similar to the mutual dependence of a manufacturer making white computers and the retailers with the luxurious shops in the chapter on specific knowledge. The employee has invested time and effort in learning about the company and the company has invested time and effort in learning about the employee. Some of these investments are specific to the employee and the company, i.e. the company and the employee cannot use the knowledge respectively to another employee or in a another company.

Tournament Incentives

The second role of promotions is to provide incentives. Employees are motived to perform better if they know that their work will be rewarded with a promotion. One story to understand these incentives is to compare promotions to a tournament in sports where one competitor wins the highest price. All the employees are ranked and only one gets the promotion. The advantage of promotion based incentives is that the ranking is not affected by noise that is affecting all employees such as economic shocks or weather conditions. This is similar to the use of benchmarks as we discussed in the chapter on agency theory. Because promotions are based on the relative performance of an employee, they implicitly use peer performance as a performance measure. As a result, the tournament creates an incentive system that is less noisy than a pure bonus based incentive system.

One of the predictions of tournament theory is that the prize for winning the tournament should increase with more competitors. With more employees competing for one promotion, every employee has a lower chance that they will get the promotion. Therefore, they will need to be compensated with a higher reward for this uncertainty, i.e there is a risk premium. This is the sensitivity effect of tournament incentives. As a consequence, you would expect a higher compensation for functions in a hierarchy that are limited to a few people (e.g. the CEO) because a lot of employees are competing for a limited number of positions. Baker et al. (1994) show indeed that the compensation level increases more for promotions higher in the hierarchy.

The literature also reports a number of drawbacks from tournaments. When employees feel they can not get the promotion they will be demotivated and they will not be motivated to work harder. In agency theory terminology, the employees belief that their promotion chances are not sensitive to their effort. Other employees might take risky decisions to catch up with co-workers that are ahead of them in the ranking. Tournaments do not provide reasons to cooperate with co-workers and it might even be beneficial for an employee to sabotage co-workers if they are in a better position for the promotion. In the last two examples, the rank is an incongruent measure because it motivates the employees to take actions that are not in the best interest of the organisation. In the tournament story, promotions are an incentive contract with a performance measure, the rank of the employee, that has less noise than the employee’s performance but is also potentially less sensitive and less congruent. As we have seen so many times before, in this story promotions require a cost-benefit trade-off.

Promotions and the Hierarchical Organisation

While some elements of promotions in the tournament story are reminiscent of the blueprint of the perfect market as we encountered in the chapter on transaction cost economics, it is actually instructive to think about promotion incentives as being part of a hierarchical organisation (Baker et al., 1994). Promotions do instigate a market like competition between employees but typically that competition is limited. For instance, the organisation will limit who can apply for new position and often exclude anyone who is not already in the organisation. In the blueprint of an ideal market, there are no restrictions on who can compete. Another restriction is that the organisation typically has a stable hierarchy and the promotions follow a well known procedure and timing.

One of the reasons why promotions work in stable, hierarchical organisations is the mutual dependence that I have explained above. Organisations are the preferred blueprint when the transaction requires mutual asset specific investments. The stable structure also provides benefits from a tournament theory point of view. Employees know which opportunities are available to them further in their career and they can see how other employees have climbed the ladder. The stability makes it easier to understand what the reward is and it decreases the risk that employees might not get a reward despite working hard. Similarly, restrictions on who can apply for a promotion increase the chances of a promotion and increase the sensitivity of getting a promotion to the employee’s effort.

Finally, most promotion decisions are at least partly based on the subjective judgment of superiors. These judgments are often more informative than current performance to decide whether an employee will be successful in the higher position because the new position will require different skills and capabilities than in the employee’s previous job. Nevertheless, from the employee’s point of view subjective judgments are more noisy than an objective measure. Hierarchical organisations use formal procedures where they specify the criteria the superiors have to address so that the employee has more certainty and bears less risk.

There is a second problem with subjective performance evaluation. The superior might have incentives to not be honest in their evaluation of the employee. This is the problem I will explain in the next section of this chapter.

Subjective Performance Evaluation

Subjective evaluations by superiors are an important measure in most bonus contracts, not only for promotions. If superiors have experience in the department or the job they are evaluating, they have developed specific knowledge to determine what good performance means. Knowledgeable superiors can also take into account and adjust for unexpected events during the year. An extreme example is the impact of the pandemic in 2020 on almost every part of the economy which could not be predicted at the start of the year. Remember from the time line of the incentive contract, that these adjustments are not possible in the traditional incentive contract. The reward and the measure are set at the start of the period and are not changed ^[3]. Another advantage of subjective evaluation is that the superior can take into account factors that are harder to quantify such as the employee’s attitude or how well they collaborate with their colleagues. In other words, the benefits of subjective performance evaluation is that when it is done well the performance evaluation by an experienced superior is more congruent than any combination of objective measures such as profitability or customer satisfaction.

The Incentive Problem of Subjective Performance Evaluation

The incentive problem of subjective evaluations is that the supervisor can manipulate subjective measures of performance. If the supervisor is not willing to grant a bonus or promote the employee, they can always understate the performance of the employee. The supervisor might even have an incentive to understate the performance of the employee, if the bonus or the higher salary is paid from the supervisor’s budget. Economists consider this the fundamental difference between objective and subjective performance measures. Objective measures are performance measures that are specified at the start of the working period and the principal and agent agree on what the value of the performance measure is at the end of the period. Subjective measures are performance measures that are under control of the principal. The most straightforward example is if the measure is the opinion of the principal.

To see the problem of subjective measures imagine the following story between a principal and an agent. The principal delegates some job to the agent where the agent has to make a decision between 1 and 5. The higher the agent’s choice, the higher the cost to the agent and the higher the profit to the principal. This part of the story introduces a conflict of interest between the principal and the agent. The principal wants a high choice and the agent prefers a low choice. After the agent has made their decision, the principal will judge the outcome of the decision and decide on the compensation for the agent. The key difference with the incentive contract story is that there is no contract that guarantees the agent a bonus for a certain outcome of the performance measure ^[4]. Table 7.1 puts some numerical values on this story.

You can imagine for instance that the agent chooses 4, and the principal pays the agent 15 in compensation. In this case, the agent earns 7 = 15 – 8 and the principal earns 25 = 40 – 15. However, nothing is stopping the principal to pay a lower compensation. For instance, they could pay 8.5, which leaves the agent with 0.5. The principal does not even have to stop there. If the agent and the principal make this decision only once, the principal is best off when they just do not pay any compensation to the agent. If the agent realises that the principal can do that, they will decide that the best they can do is to choose 1 or just find a different job. The principal does not want that because their profit will go down as well.

In contrast, in the long run, when this story plays out repeatedly, the principal is motivated to establish a reputation for being a fair assessor and reward their agents with a high enough compensation. If they establish such a reputation, their employees are motivated to choose 4 or 5 because they know if they perform well they will be rewarded. On the other hand, if the principal does not have such a reputation, employees have no incentive to work hard because their performance will not affect the likelihood of earning a reward (Prendergast, 1999).

To overcome the incentive problem, the organisation needs to establish a norm or a culture where it is credible and clear that agents will do their job well and that they will be rewarded for their effort (Gibbons & Henderson, 2012). Credibility means that it is in the best interest of the agent and the principal to not defect from the established norm. Clarity means that the norm and thus the expectations of what it means to perform well in a job. In Table 7.1, the agent’s actions and the principal’s profit have numerical value and are thus easy to communicate. However, remember that this story is meant to illustrate the problem with subjective performance evaluation where the superior makes a judgment about the agent’s performance and the superior uses specific knowledge which is by definition difficult to communicate. As I will explain in the next section, the role of management accounting is to establish credibility and clarity of what the expectations are.

The Role of Management Accounting

In the first section of the chapter, we saw that promotions motivate the employees to develop specific knowledge for working in the organisation. The stable structure of the typical hierarchical organisation with a limited number of job types helps clarify what the rewards are when you get promoted and how you can get a promotion. The stable organisational structure also provides credibility. If employees see that their predecessors got fairly evaluated and received a promotion, they are more likely be motivated and work hard to receive a promotion. Especially larger organisations will have a policy with formal rules on how promotion decisions should be made. These formal rules will help supervisors to establish a reputation.

Management accounting plays an important role in setting up these formal structures and rules that support promotions. Especially budgets help define responsibilities of departments and their managers. Management accounting tools are equally an important part of subjective performance evaluation for promotions and rewards. So far, I have presented subjective performance evaluation as the extreme version where no objective measures are used by the superior. In reality, performance evaluation is a combination of objective measures such as profit, sales, customer satisfaction, and productivity measures and the subjective judgment of the superior. The superior can use their judgment to decide how important the different measures are or to exclude measures that were affected by unexpected events beyond the control of the employee. In the best case scenario, the superior can use the objective measures to set clear targets and create clarity about what their expectations are for good performance. At the same time, they can use their judgment to filter out noise from events that could not be foreseen at the start of the period ^[5]. In addition, the use of objective performance measures makes it easier for the superior to defend their decisions to top management. Top management can hold the superiors responsible when they use their discretion unfairly. If employees know that their superiors are held accountable for their evaluations, the superiors’ subjective judgment is seen as more credible.

In the chapter on specific knowledge, we saw that accounting tools like cost accounting, budgets, and balanced scorecards can help organisations to capture specific knowledge and make it easier to communicate within the firm. These same tools provide financial and non-financial performance measures to similarly help the organisation to communicate their expectations about what good performance means. The similarity in both situations is the role of accounting to quantify the specific knowledge and experience so that it is easier to communicate.

Examples of Problems with Subjective Performance Evaluation

This story of subjective measures is not only applicable to soft measures, subjective judgments, or a subjective combination of objective measures. It can also apply directly to measures of profitability. This might be somewhat counterintuitive because profit measures are often seen as the most objective measure of performance. Remember that the defining feature of the subjective performance evaluation is that the principal can decide what the value of the measure is. If the principal can change the profit measure and the agent cannot stop them, we are in the story of subjective performance evaluation.

Hollywood accounting is a an example where profit can be seen as a subjective measure of performance. If the bonus of a movie star would be dependent on the profitability of the movie, the actor or actress has to trust the profit figures that the accountants from the production company come up with. The production company has an incentive to underestimate the profitability of the movie so they can pay a lower bonus. This might backfire in negotiation with other actors for new movies because they will not trust that they will get their bonus even if the movie is a success. For an example of some creative accounting in Hollywood: Even Harry Potter Movie Makes Loss

As a result, big movie stars usually do not trust the studios’ profit calculations and they will only except incentive contracts based on gross revenues. The revenues can be verified by comparing them to independent measures of box office sales. While profit is a more congruent measure from the studios’ point of view, they cannot fully use it in contracts because actors fear that the studios will not calculate the profit fairly.

Another potential problem with subjective measures is that the employees can influence the judgement of a supervisor without improving their performance. They might sabotage others or try to present their work more favourably without doing any productive work for the company. In other words sometimes there is an incentive for employees to spend less time being productive and more time trying to influence the evaluation by a supervisor. These latter activities are sometimes called rent seeking activities and it means that the performance measure is not congruent with the interests of the firm ^[6]. Employees can influence their supervisor’s judgement without actually improving their performance.

Subjective measures are also influenced by psychological biases. Superiors sometimes put a higher weight on information that is externally generated, e.g. by customers, than internally generated information, e.g. by their own employees. Most superiors favour financial information over non-financial information and objective, quantifiable measures over subjective, qualitative judgements and they find it easier to interpret performance when they can compare it to a performance target or a benchmark.

Ittner et al. (2003) investigate these biases based on the case of a financial service provider with a balanced scorecard. The scorecard has six dimensions. The headquarter of this firm has to assess the performance of local bank managers on the six dimensions. They also have to combine all the information in the scorecard to judge the overall performance of the local bank managers. Some of the dimensions are based on financial information and others on non-financial. Some of the dimensions are based on externally generated data but other dimensions are based on internally generated data. Some measures in the scorecard are quantifiable and other information is qualitative. The researchers estimated how much a change in each dimension influences the change in the overall performance score for a local manager. Although the findings are equivocal, the authors report that the psychological biases explain a considerable amount of the variation in the judgements of the supervisors.

Conclusion

This chapter serves as a capstone chapter to the previous chapters in the sense that it brings together the different strands we have touched upon so far. In this chapter, I argue that one of the benefits of a hierarchical organisation is that organisations can develop, identify, and retain human capital through promotions and offering a career path within the organisation for their employees. Because identifying employees who would do better at higher levels in the organisation requires specific knowledge, the decision on who gets a promotion cannot be specified in a traditional agency theory contract. Especially in larger organisation, promotions are decided by a committee to include different points of view (i.e. specific knowledge) and increase the credibility of promotion decisions. These committees will partly rely on objective performance measures when making these decisions because objective measures also increase the credibility and they clarify the expectations of good performance. The bureaucracy around promotion decisions and collecting performance measures are some of the more obvious transaction costs involved in these promotion decisions. As before, organisations have to decide to trade-off the accumulation of human capital and better employees against the transaction costs of the promotions.

References

Baker, G., Gibbs, M., & Holmstrom, B. (1994). The internal economics of the firm: Evidence from personnel Data. The Quarterly Journal of Economics, 109(4), 881–919. https://doi.org/10.2307/2118351

Gibbons, R., & Henderson, R. M. (2012). Relational Contracts and Organizational Capabilities. Organization Science, 23(5), 1350–1364. https://doi.org/10.1287/orsc.1050.0136

Ittner, C. D., Larcker, D. F., & Meyer, M. W. (2003). Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard. The Accounting Review, 78(3), 725–758. https://doi.org/10.2308/accr.2003.78.3.725

Prendergast, C. (1999). The provision of incentives in firms. Journal of Economic Literature, 37(1), 7–63. https://doi.org/10.1257/jel.37.1.7