The Use of Objective and Subjective Measures: Implications for Incentive System Design

Abstract

This study examines the question, is the use of subjective measures an ex post adjustment of objective measures to take into account three types of risk: target difficulty (after controlling for budget loss), shared risk (after controlling for business unit strategy) and downside risk? We examine this question using data from a sample of 522 managers and professionals in period 0 (and 434 in period 1) from a large Australasian corporation over a two year period. Period 0 is a pre shock period and period 1 is a post shock period. We find that for the overall two years that the subjective is an upward adjustment to the objective to take into account: (1) target difficulty, the spread between upper limit and lower limit of unit performance; (2) shared risk, that is organizational interdependencies; and (3) downside risk, which is the opportunity loss function that the employees faced in not meeting the maximum bonus allowed.

However, in examining the pre shock period and post shock period, the results indicate that the subjective evaluation has been used differently for each period for two type of risk (target difficulty, shared risk). (1) With regard to target difficulty for the pre shock period, the subjective makes an upward adjustment to the objective; but for the post shock, the subjective makes a downward adjustment. One plausible explanation is that during the post shock, quite a few managers and professionals were already on the maximum of the objective measures (given that there may have been gamesmanship at setting targets and upper limits for an anticipated poor economic period). Therefore, the subjective can be a downward adjustment to reflect this gamesmanship. (2) In regard to shared risk (the percentage of transfer revenues), for the pre shock period the subjective was a downward adjustment, while for the post shock period the subjective adjustment is an upward adjustment to the objective measure. This implies that for the pre shock or times of economic stability, the subjective could be used to reduce some of the free rider challenges that face incentive systems. Conversely for the post shock period, or during times of economic instability, the subjective adjustment is to encourage resource sharing and greater coordination and communication. Overall, our results indicate that the subjective measure is used as an ex post adjustment to the objective measure. This could be in response to flaws in the objective (financial) performance measures as subjective measures as this enables other factors to be taken into account.