Sticky Costs and Executive Compensation

Abstract

Shareholders have recently criticized compensation committees for blindly protecting executives from earnings underperformance. We investigate this claim by considering whether compensation committees consider the sticky cost relation between sales and expenses in determining executive bonus compensation. Prior research offers two distinct, but related explanations for why costs tend to be sticky: excess capacity and expected future sales activity. Our evidence suggests that compensation committees consider the relation of sales and expenses, expected future sales and the extent of capacity utilization in determining CEO bonuses. When these factors are controlled for, our evidence suggests that the weak link between CEO bonus compensation and earnings underperformance documented in the 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 these committees take into account other non-earnings information when deciding how much weight to give to a decrease in earnings.