I. Introduction
1.1 Definition of Compensation
Compensation refers to all forms of pay or rewards going to employees and arising from their employment and it has two main components:
· Direct financial paymentsà pay in the form of wages, salaries, incentives, commissions, and bonuses.
· Indirect financial paymentsà pay in the form of financial benefits such as insurance.
1.2 Definition of Executive Compensation
Executive compensation is total of salaries and other financial acceptance or payment that received by executives in a firm.
Although there are a lot of once difference about how practice of compensation to executive in many industry and company, most payment of ekskutif contain four especial components: fundamental salary, annual bonus which related to accounting performance, share option, long-range incentive plan ( including limited share plan and performance plan belong to accounting for some years). In addition, role of executive for board also accept special benefit, including life insurance and pension plan of executive addition. Differ from mid level management, top executive negotiation for increase of job formal contract. Formal contract usually end in five years and specify minimum salary, targeted bonus ( with or without guarantee), and plan allowance of retirement of dissociation moment or commutation in company control.
II. Organizing Dimensions for a Framework of Executive Compensation
There are three dimensions that characterize the assumption often implicit in empirical research on executive compensation, these are:
2.1 Direction of Causality
Executive compensation can be considered as a dependent variable (something to be explained) or an independent variable (for explaining something else). Scholarly and popular interest in understanding why some CEOs are paid more than others has focused on compensation as a dependent variable. Thus, the prevailing research has been on the determinants of pay. Modeling executive compensation as an independent variable directs attention not only to firm performance, but also to a potentially wide set of strategic choices, organizational characteristics, and stakeholder reactions that may be responsive to executive compensation plans.
2.2 Theoretical Perspective
Research on executive compensation has historically been driven by economic theory: for example, Berle and Means (1932), in one the earliest and still most influential published works on corporate ownership structure, documented the increasing separation of ownership and control in modern organizations. This work led other economist to focus on the consequences of this separation, including the observation that “executive salaries appear to be more closely associated with the scale of operations than with it’s, the firm’s, profitability” (Baumol 1967). Consequently, early empirical research on executive compensation was dominated by economists’ concerns about the relative importance of firm size and profitability as determinants of pay.
In spite of the prevalence of economic approaches to executive compensation, alternatives perspectives based on social-psychological and political theories of organizations are becoming more common. The social-psychology perspective argues that the setting of executive compensation is a social phenomenon (Bernard 1938; Hicks 1963) and, hence, is influenced by the actions of other individuals both within and outside of the organization. The political perspective, suggest that executive compensation and executive power are closely related (Finkelstein and Hambrick 1988). Taken together, then, scholars interested in studying executive compensation can select from economic, social-psychological, and political theoretical perspectives. In addition, research that seeks to combine theoretical perspectives may be particularly valuable because it can lead to critical tests that help distinguish the conditions under which various theories are applicable and the conditions under which they are not (Platt 1964).
2.3 Unit of Analysis
The question of unit of analysis is seldom explicitly considered in research on executive compensation. Most work focuses on either the pay of the CEO or the aggregate pay of a larger set of top managers. Less common, but potentially very informative, is research on pay patterns within top management groups, such as pay dispersion and differentials to understand both its determinants and consequences. Although research on pay at the group level is common for non-managers (Hirsch 1982), it is only in recent years that work on this topic has been directed toward senior executives.
When direction of causality, theoretical perspective, and unit of analysis are all considered together, a complex but analytically useful framework for the study of executive compensation emerges. The value of such a framework is twofold:
a. It provides a broad view of research on executive compensation that help match pieces of a complex puzzle.
b. It enables identification of research opportunities along multiple combinations of underlying dimensions.
III. A Framework to Study Executive Compensation
When all three possible dimensions are brought together in a two-by-two-by-three framework, as in Table 10.1, twelve possible conditions emerge.
Table 10.1
A Framework to Study Executive Compensation
Individual Unit of Analysis Direction of Causality Group Unit of Analysis Direction of Causality
| Perspective | Determinants | Consequences | Determinants | Consequences |
| Economic | · Managerial versus neoclassical economics · Human capital · Marginal product · Managerial labor market | · Managerial risk acceptance and acceptance of longer time horizons · Firm performance | · Tournament model and pay differentials | · Tournament model and turnover · Tournament model and firm performance |
| Social-Psychological | · Mimetic and normative isomorphism · Social comparison | · Equity and turnover | · Social comparison and pay dispersion | · Pay inequality and turnover · Pay inequality and firm performance |
| Political | · Managerial power versus board power | · Managerial manipulation of incentives systems · Unintended consequence of pay | · Distribution of power within top management teams | · Politic as a contingency between pay inequality and firm performance · Pay inequality and top management team politics · Relative managerial pay and internal labor markets |
3.1 Economic Explanation for Executive Compensation
The economic determinants of executive compensation have been a major focus of research for some times. For many years economist have been interest in the relative importance of sales and profits in explaining compensation.
3.1.1 Research from the managerialist and neoclassical Traditions
The managerialist view leads naturally to a “corporate growth hypothesis”, that firms size (sales or assets) will be positively associated with executive compensation, it also possible to argue that maximizing firms size is a worthy goal for which CEOs should be rewarded because larger firms may have greater market power and access to more resource and managerial jobs in such setting involve more complex and demanding responsibilities.
Neoclassical economist support the “Profit maximization hypothesis”, which translate compensation arena to an expectation that executive pay will be significantly related to firm profitability. According to this prospective, because corporations, through the decision of management, seek to maximize profitability, profit should have a strong and persistent to influence of executive rewards.
3.1.2 Moderator of the pay-performance relationship
Corporate Control
Research of corporate control has probably come close to developing these opposing theoretical prospective on executive compensation. This work differentiated externally controlled firms from managerial control firms. When externally control and managerially controlled firms are compared directly, the underlying logic behind the neoclassical and managerialist schools becomes clear.
In sum, Corporate control plays a key role in the setting of executive compensation, these studies make clear that differences between neoclassical and managerialist prospective on executive compensation are fundamental and can understood much more clearly when critical contingency factors such as corporate control are taken into consideration.
Table 10.2
Externally Controlled versus Managerially Controlled Firms
External Control Managerial Control
| Underlying Theories | · Neoclassical · Agency Theory | · Managerialist · Managerial hegemony theory |
| Locus of Corporate Control | · BOD | · CEO |
| Competence depends on | · Alignment of shareholder and CEO’s objectives | · Dominance of CEO’s preferences |
| Guidelines in setting Compensation | · Reward performance · Minimize CEO’s pay | · Legitimize process · Maximize CEO’s pay |
| Key Driving Force | · Profit maximization · Supply and demand · Marginal product | · Socio political force · Institutional norm · Bureaucracy |
Risk
Risk is a central component of agency theory and one that has figured prominently in studies of executive compensation. This risk problem effectively rules out any perfect solution to the divergence of interest between managers and shareholders, empirical work has focused on exploring the trade between incentives and risk sharing.
Taking this tradeoff between incentives and risk sharing as their starting point, there is three dimensions of compensation relevant to CEO risk sharing-total compensation, compensation risk, and compensation time horizon.
Managerial discretion
The work on managerial discretion, that provided evidence for its effect on overall compensation and the use of incentives compensation. Managerial discretion is a potentially powerful predictor of the extent to which pay and performance are related, stated simply, the grater the level of managerial discretion, the greater the potential impact of managers on organizational outcomes and the more important it is to ensure that their pay is tied to performance.
There are several propositions than came up in the explanation:
Proposition 1: The association between CEO compensation and firm performance is not a direct one. Rather, the nature of the pay performance relationship depend such contingency factor as corporate control, firm risk, and managerial discretion.
Proposition 2: The greater the level of external control, the stronger the relationship between CEO compensation and firm performance.
Proposition 3: The greater the level of firm risk, the weaker the relationship between CEO compensation and firm performance.
Proposition 4: The greater the level of managerial discretion, the stronger the relationship between CEO compensation and firm performance.
Human capital
Human capital derives from the experiences and background of a manager and it is important source of compensation to the extent that is recognized and value of firms, such as, managerial experience, education and tenure.
Three key factors that related to skill specificity affect compensation:
· Risk and return to human capital
· Market power
· Adverse selection
For outside CEO candidates, the lack of firm specific human capital suggest that they must be compensated for the previous employer specific human capital they give up to make the move. In all, the work on human capital has not yet produced a robust set of results, while it may be that certain human capital is advantageous in reaching the top echelons of a firm or in being selected as an outsider to run a company, theory has been little less clear on how this translates more directly into higher.
There are several new propositions on compensation belong to human capital concept such as:
Proposition 1: output function experience among executives in firms pursuing Prospector strategies is more strongly related to executives’ compensation that output function of experience among executives in firms pursuing Defender strategies.
Proposition 2: Throughput function experience among executives in firms pursuing Defender strategies is more strongly related to executive compensation than throughput function experience among executives in firms pursuing Prospector strategies
Marginal product and the managerial labor market
Beyond human capital, while it seems likely that an executive’s compensation depends in part on his or her marginal product and the workings of the managerial labor market.
The several factors that have been found to determine executive compensation:
· managerial job complexity
· degree of complexity
· degree of regulation
· firms size
· Firm performance
Proposition 10-6: The greater the marginal product of CEO, the grater his or her compensation.
The studied how market compensations affect executive compensation, if one believes in an information efficient labor market, there is no reason to expect that there will be as strong pay performance link because compensation committees must pay the going rate, because none of executives directors and compensation committee members tend to be a similar to CEOs, they will tend to be quicker to respond to situation in which their CEOs is underpaid relative to the market than to situation in which their CEO is overpaid.
3.2 Social Explanation for Executive Compensation
3.3 Political Explanation for Executive Compensation
Power an important factor in explaining behavior in top management teams, plays a central role in the strategic decision making process. Hence, it would not be surprising to find that managerial power is a critical determinant of pray.
At heart of a political model of executive compensation is the realization that the board of directors acting as monitor of managerial behavior and top management area fundamentally in conflict. Boards have a fiduciary responsibility to maximizing shareholder value, while top management area more concerned with maximizing their own utility. As a result, the setting of executive compensation brings together boards and managers with different interest that are often resolve through political means.
The consequence of conceptualizing the compensation-setting process through a political lens is that the key predictor of executive pay becomes the relative power of a manager (typically the CEO in empirical work) versus the board. An implicit assumption here is that managerial power will be associated with greater levels of compensation. Thus, a model that considers the interaction of power and preferences in the determination of pay is needed.
Proposition 10-14: CEO preferences for pay determine the amount, mix, and type of CEO compensation
Proposition 10-15: The more powerful the CEO, the stronger the relationship between CEO preferences for pay and the amount, mix, and type of CEO compensation.
A broader conceptualization of power is needed in the context of executive compensation. Power is multidimensional, complex construct (Finkelstein 1992; March 1966; Pfeffer 1981), a consequence of which is the potential instability of results across studies that use different measures of power without grounding in a clear theory of board-CEO power. Such a model would need to:
a. Develop a conceptualization of board-CEO power grounded in theory
b. Use this grounding to identify appropriate dimensions of the construct
c. Create a measurement methodology that adequately captures that multiple dimensions of board-CEO power.
4 Compensation for Business Unit General Manager: Determinants and Consequences
4.2 GM Compensation versus CEO Compensation
The administration of business unit GM compensation differs from CEO compensation in several ways. Fist, divisional GMs are generally subject to greater constraint than CEOs by virtue of being in middle management and thus having less direct influence in the setting of their pay. Nevertheless, it is incorrect to disregard the role of power in business unit GM pay because the level of compensation earned by general managers may be influenced by top managers’ perceptions of GMs upward mobility. A second, difference between business unit GM pay and CEO pay is that the letter pay is formally set by the board of director, while general manager pay is based on internal evaluation. Future work may build on this observation by modeling agency relationship within firm, with the CEO acting as principal and the business unit general manager as agent. Third, pay may be less of a motivator CEOs than for business unit GMs because CEOs generally have greater wealth and may be motivated by other factors, such as power and prestige.
4.3 The Determinants of GM Compensation
Although the work cited earlier on the determinant of divisional reward system has been informative, little research has been done on the determinants of the actual level of GM pay. In a study that relief on data collected by compensation consultant, however, Fisher Govindarajan tested a model of business unit GM pay. Their model applied finding on CEO pay to the profit center manager and found that such variable as firm size, profit center size, firm performance, and the human capital of the GM were significant predictors CEO pay may be an important driver of GM pay. As we discuss earlier, research by Graffin, Wade, Porac, and McNamee found that high status CEOs shared their good fortune with subordinate. The authors take these ideas and examine four compensation of foreign subsidiary compensation strategy:
· Headquarters senior management pay mix
· Market positioning
· Subsidiary pay mix
· Adjustment criteria
4.4 The Consequences of GM Compensation
Proposition 10-16: The more diversified the firm, the stronger the relationship between performance-contingent compensation and firm performance.
Hamrick and Snow developed a set of prescription that different between emerging and established general managers, arguing that each group has its own needs desire, and value, and, hence may respond to different reward system. Emerging GMs are “in the 35-50 age range, often have less than ten years tenure with the firm, and while part of the general management ranks, tend to preside over smaller, lower level units that their more seasoned counterparts”. Established GMs are older, have longer company tenures, and “have largely achieved the position of power and responsibility that their younger counterparts seek”.
As Table 10.4 illustrate, these differences extend to the type and amount of incentives, payment criteria, and incentive administration. Each of the cells in Table 10.4 represents hypothesis on business unit GM pay that require empirical test. Hence, firm performance should be greater to the extent that emerging and established general, managers are rewarded through the pattern of incentives, criteria for receipt, and administration described for each in Table 10.4.
Table 10.4
Incentive Systems for Different Managerial Contexts
Incentive Types and Amounts Criteria for Receipt Incentive Administration
| Emerging General Managers | · Promotion and advancement of paramount importance · Pay emphasis on cash, reliable base salary, high incentive leverage and hurdles | · Emphasis on unit performance · Emphasis on quantitative, “objective” indicators. | · Explicit and unambiguous incentives. |
| Established General Managers | · Perquisites and recognition of primary importance · Blend of cash and deferred stock compensation, competitively average base salary, moderate incentive leverage and low hurdles. | · Balanced emphasis on unit and corporate performance · Balanced emphasis on quantitative and qualitative measures. | · Somewhat implicit, flexible, and ambiguous incentives. |
CONCLUSION
Review of social and political factors strongly suggests that a prime reason for the often weak reported association between pay and performance is that the “agent” in the principal-agent framework is not necessarily a fully “rational,” risk-averse, self-interested optimizer, but rather an individual whose complex motivations and interests cannot be scripted.
The implications of these arguments are fundamental: (1) pay and performance are not always related, and (2) the relationship between pay and performance is contingency-driven, depending on an assessment of such factors as principal (board of directors) effectiveness, agent (managerial) preferences for different types and amounts of compensation, existence of alternative monitoring devices, firm risk, and the nature of top managerial work and discretion in different contexts.
A focus on social and political, as well as economic, factors is needed to not only develop more complete understanding of compensation, but also to begin to resolve such fundamental dilemmas as the pay-performance relationship. Compensation has an impact on people, and on organizations. In addition, organizations are social organisms, and executives are surrounded by other executives in a firm.
