Cost Behavior and Executive Compensation

Abstract

Prior literature provides compelling evidence of an asymmetric relation between executive bonus compensation and earnings performance. In particular, this literature reports that compensation committees assign greater weight to good (positive) earnings performance than poor (negative) earnings performance. Taken together, the prior literature provides strong support for critics who claim that compensation committees blindly protect executives from earnings underperformance. We further examine this issue by investigating whether a firm’s cost behavior (i.e., the relation between expenses and sales) provides an explanation for the apparent inefficiency in executive compensation contracts. Our evidence suggests that executives are rewarded more for increases in ROA that arise from normal cost behavior than other increases in ROA consistent with these increases being perceived as more persistent. In contrast, we do not find such a relationship for decreases in ROA which suggests that executives are largely shielded from decreases in ROA that follow normal cost behavior. We examine two factors suggested by the prior literature, expected future sales and the extent of capacity utilization, which may provide an explanation for why executives are shielded from normal cost behavior decreases in ROA. When these additional factors are included in our empirical models, our evidence suggests that the asymmetric relation between changes in CEO bonus compensation and increases and decreases in earnings performance documented in prior literature goes away. That is, our results suggest that compensation committees do not blindly protect executives for earnings underperformance. On the contrary, our evidence suggests that these committees take into account other non-earnings information when deciding how much weight to give to a decrease in earnings and that executive compensation may not be as inefficient as suggested by prior research.