Foundations and Trends® in Accounting > Vol 5 > Issue 4

Discretion in Managerial Bonus Pools

Merle Ederhof, Ross School of Business, University of Michigan, USA, ederhof@umich.edu Madhav V. Rajan, Graduate School of Business, Stanford University, USA, mrajan@gsb.stanford.edu Stefan Reichelstein, Graduate School of Business, Stanford University, USA, reichelstein@stanford.edu
 
Suggested Citation
Merle Ederhof, Madhav V. Rajan and Stefan Reichelstein (2011), "Discretion in Managerial Bonus Pools", Foundations and TrendsĀ® in Accounting: Vol. 5: No. 4, pp 243-316. http://dx.doi.org/10.1561/1400000014

Published: 30 Jun 2011
© 2011 M. Ederhof, M. V. Rajan and S. Reichelstein
 
Subjects
Management control
 
Keywords
Agency theoryIncentive mechanismsBonus poolsSubjective performance indicators
 

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In this article:
1. Introduction
2. Incentive Contracting with a Single Agent
3. Incentive Contracts with Multiple Agents
4. Multiple Periods
5. Conclusion
A. Appendix
References

Abstract

It is common practice for firms in a variety of industries to specify bonus pools that are available for distribution among a group of managers. While the actual size of the bonus pool may vary with the realization of certain financial metrics, for example, earnings growth or Return-on-Investment, the essential property of bonus pools is that the firm retains discretion in how the overall pool is divided among the target group of managers. An important advantage of discretionary bonus payments is that the persons in charge of administering the bonus pool are in a position to incorporate subjective, non-verifiable indicators of individual performance that would be impossible to specify contractually as part of an explicit incentive scheme. This paper synthesizes several strands of the recent principal-agent literature that have explored the structure and the relative efficiency of discretionary bonus pools. Our analysis is framed around a number of recurring themes. These include the value of subjective performance indicators for contracting purposes, the loss associated with subjective rather than objective information, and finally, the degree to which bonus pools entail more compression in the amounts of bonuses paid to managers.

DOI:10.1561/1400000014
ISBN: 978-1-60198-454-8
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Table of contents:
1. Introduction
2. Incentive Contracting with a Single Agent
3. Incentive Contracts with Multiple Agents
4. Multiple Periods
5. Conclusion
A. Appendix
References

Discretion in Managerial Bonus Pools

Discretion in Managerial Bonus Pools synthesizes and integrates a growing literature that has emerged over the past 10-15 years on the use of both objective and subjective performance indicators in managerial incentive plans. The authors examine the structure of efficient bonus pools (fixed payment schemes) in the presence of subjective performance indicators. The analysis covers a range of scenarios including single- and multi-agent settings, the interplay of objective and subjective indicators and short-term as opposed to long-term contracting relations.

To synthesize the existing research, the authors frame their exposition around five recurring themes which collectively speak to the structure and the efficiency of incentive schemes based on subjective information i. Value of Subjective Performance Indicators. ii. Incremental Agency Cost. iii.Compression of Optimal Incentive Contracts. iv. Optimality of Proper Bonus Pools. v. Value of Multiperiod Contracting

 
ACC-014