Bonus Contracts Research Articles

The Effect of Narcissism and Contract Frame on Employee Performance in the Presence of an Ex Ante Target

ABSTRACT Incentive contracts containing ex ante targets are prevalent in organizations. Although prior research indicates that contract frame has no significant impact on employee performance when an ex ante target is assigned, we provide a more nuanced view by examining the role of narcissism in this relationship. Results indicate when an ex ante target is assigned, less narcissistic employees perform better than more narcissistic employees regardless of contract frame. In addition, target difficulty plays a role. When narcissism is lower, employees working under a less difficult target perform better than those working under a more difficult target, but there is no effect of contract frame. When narcissism is higher, we find an interaction between contract frame and target difficulty. When the target is less difficult, employees higher in narcissism perform better under the penalty than the bonus contract frame, whereas the opposite is the case when the target is more difficult. Data Availability: Data are available from the authors upon request. JEL Classifications: M41.

Overconfidence and Contract Framing

ABSTRACT Prior contract framing research finds that agents generally choose to provide greater effort under penalty contracts than under economically equivalent bonus contracts. At the same time, many individuals tend to be overconfident in their own abilities, which may alter agents’ expectancies when making effort provision decisions. In this study, we extend the contract framing literature by conducting an experiment in which participants can improve the likelihood of earning a bonus or avoiding a penalty by providing greater costly effort and by performing well on the experimental task. We find that participants who are not overconfident in their ability to perform the task well exhibit the general contract framing effect, whereas overconfident participants do not. This suggests that for work tasks where production is a function of both effort and ability, the preponderance of overconfident individuals consistent with the “better-than-average effect” mutes the effect of contract framing on effort. Data Availability: Contact the authors. JEL Classifications: M49; M12; M11.

Bonus or Penalty? Designing Service-Level Agreements for a Decentralized Supply Chain: The Implication of Return on Investment

We study the coordination of two-echelon supply chains via service level-dependent bonus and penalty contracts and assume that the manufacturer maximizes its profit while enabling the supplier to achieve its performance target. Profit and return on investment (ROI) are considered as the supplier’s performance measures. We compute optimal contract parameters and perform a numerical study. In addition, we perform a simulation-based study to analyze the profit risk of the considered parties. For supplier profit targets, bonus and penalty contracts lead to the same profit for both parties, but bonus contracts lead to lower costs, hence, a higher ROI. For supplier ROI targets, bonus contracts always lead to higher manufacturer profit, and no optimal penalty contracts exist. For every contract service level, optimal bonus contracts exist that maximize profit and ROI of the manufacturer simultaneously. Thus, we analyze the profit risk for the manufacturer and the supplier and show that it can be significantly reduced by setting an appropriate contract service level. The manufacturer usually should prefer bonus contracts. They allow to optimize profit and ROI simultaneously and even offer an additional degree of freedom to reduce the profit risk.

Contest Schemes and Dynamic Incentive Provision

Simple contest schemes, which tend to use extreme contemporaneous peer benchmarking, are generally thought to be less efficient at motivating productive and cooperative effort than explicit bonus contracts that optimally weight observed own and peer outputs. We show, however, that contest schemes can outperform explicit bonus contracts in a two-period dynamic setting if periodic output is correlated over time, and contract terms can be renegotiated. In our model, all parties update their beliefs about ex ante unknown time-invariant noise upon observing first-period outputs, and second-period wage offers are updated accordingly. This creates first-period shirking incentives for the agents. We show that relative to bonus contracts, the extreme contemporaneous peer benchmarking in contest schemes can weaken or even eliminate the adverse incentives created by prior-period benchmarking, even though the available information and the learning process are the same under both schemes. This dynamic advantage allows contest schemes to outperform repeated bonus contracts for a wide range of parameter values, despite imposing higher static efficiency losses in each period. If competing agents are assigned to sufficiently similar tasks, a contest scheme’s ability to sever the statistical link between periods can yield not only higher early productive effort compared with bonus contracts, but also less uncooperative behavior, despite putting the agents in a more contest-like situation. This paper was accepted by Brian Bushee, accounting. Supplemental Material: The online appendices are available at https://doi.org/10.1287/mnsc.2022.00035 .

Bonus incentives and losses from early debt extinguishment

An increasing number of firms repurchase debt and recognize associated accounting losses (rather than gains). However, few studies to date have examined the effect of reporting incentives on debt repurchase decisions. We examine the relation between managers' bonus incentives and the recognition of gains or losses from early debt extinguishment (EDE). Our findings indicate that managers tend to recognize disproportionately more losses from EDE when earnings before gains or losses from EDE (i.e., as-if earnings) exceed the maximum performance level set in annual bonus contracts. These results are consistent with the notion that managers' income-decreasing reporting incentives affect debt repurchases. Further analyses indicate that bonus-driven debt repurchases are associated with increases in future bonus awards, but do not significantly affect shareholder value. Overall, our results suggest that managers' bonus incentives are an important determinant of debt repurchases and the recognition of losses.

Robust incentives for risk

This paper studies a moral hazard problem wherein the principal is uncertain about the agent’s risk preferences and production technology. The principal, desiring robustness, evaluates contracts according to their worst case payoff against the set of preferences and technologies that satisfy her assumptions about the agent and his capabilities. We show that contracts which exhibit robustness to severe risk taking behavior (i) pay their smallest transfer for all outputs below some lower threshold and (ii) pay their largest transfer for all outputs above some upper threshold. In our main result, we identify a class of environments in which two-wage binary bonus contracts are robustly optimal.

Penalty contracts: is it all about paying the cash upfront?

We experimentally investigate the relevance of a cash upfront payment for the effort-enhancing effect of penalty contracts. We find that penalty contracts where participants receive the upfront payment physically before working on a real effort task induce more effort than penalty contracts where participants are only informed about the upfront payment. When comparing penalty contracts with economically-equivalent bonus contracts, we find that penalty contracts lead to higher effort provision than bonus contracts, but only if participants physically receive the upfront cash payment in advance. We suggest that the higher salience of the cash upfront payment might be a core driver of the detected framing effect. Our findings emphasize the importance of experimental design choices when studying framed incentive contracts.

Ambiguous Sticks and Carrots: The Effect of Contract Framing and Payoff Ambiguity on Employee Effort

ABSTRACT Research suggests that employees work harder under penalty contracts than under economically equivalent bonus contracts. We build on this literature by examining how the motivational advantage of penalty contracts depends on a common aspect of real-world contracts: payoff ambiguity. With payoff ambiguity, employees provide effort without knowing how much pay they will receive for a given level of performance. According to our theory, this ambiguity opens the door for employee optimism, which has contrasting effects under each contract frame. Results from an experiment support this theory, with an increase in ambiguity leading to less employee effort with penalty contracts (as employees optimistically expect small penalties) and more effort with bonus contracts (as employees optimistically expect large bonuses). We also find that these effects are stronger for more dispositionally optimistic employees. Overall, our results suggest that bonus contracts may be more motivating and penalty contracts less motivating than previously thought.

Six Impossible Things Before Breakfast

Six Impossible Things Before Breakfast

The joint effects of a manager’s level of narcissism and incentive scheme on employee effort

Narcissism has become the most heavily discussed personality trait in recent times. However, accounting research on managerial narcissism and its implications for management control system choices, such as incentive schemes, is scarce. Based on Christ and Vance’s (2018) “cascading controls” framework, we propose that employees’ work effort depends upon their manager’s level of narcissism and compensation scheme. In an experiment with 329 employees, we manipulate the description of the managers’ level of narcissism (high or low) and the framing of managers’ compensation scheme (bonus or penalty) and examine the joint effect of these two factors on employee effort to help the manager reach her or his objectives (obtain a bonus or avoid a penalty). The results show that employees invest less (more) effort to help the manager when the manager’s narcissism is high (low). This relation is partially mediated by employees’ perception of the relationship quality with their manager and negative feelings towards the narcissistic manager. Importantly, we also show that relative to a manager’s bonus contract, a penalty contract has a negative effect on employee effort when the manager’s narcissism is high. Our results underline the negative consequences of narcissism for leader-follower relations and have important implications for management compensation design in business practice.

Replacing key employee retention plans with incentive plans in bankruptcy

We examine executive bonus contracts in corporate bankruptcies. Introduced in 2005, Section 503(c)(1) of the United States' Chapter 11 corporate bankruptcy code regulates key employee retention plans (KERPs) but does not restrict performance incentive plans (PIPs). We find that, following the adoption of this reform, the likelihood of approval of KERPs and their coverage decrease, while those of PIPs increase. Unintended consequences of the reform include lower operating performance for PIPs and decreases in reorganization efficiency for bankrupt firms adopting KERPs or PIPs. Our results are consistent with the idea that KERPs were rent-extraction tools, which contrasts with prior evidence. PIP pay-performance link weakens after the reform, due to an increase in adoption of zero-performance thresholds and more discretion given to debtors over bonus pay. This suggests that watering down of PIPs' incentives may have re-introduced the rent extraction that the reform sought to eliminate. We conclude that the regulation of bonuses in bankruptcy should consider debtors’ reactions to such reforms.

How do cultural difference, cultural exposure, and CQ affect interpretations of trust from contract choices? Evidence from dyadic cross-country experiments

Global practices such as offshoring and expatriation of employees increase cross-cultural interactions within and across firms. In this paper, we use three experiments to investigate the effects of cultural differences on employees' interpretations of employers' contract choices. Applying insights from attribution theory, we predict that cultural differences will reduce the likelihood for employees to attribute employers' choice of a more-trusting contract to trust. This in turn will reduce the ability of such contracts to motivate higher employee effort. However, we also suggest that three interventions will mitigate the negative effect of cultural differences: employees' prior and primed exposure to employers' culture and employees' interactional cultural intelligence. In our labor market setting, employers chose a hiring contract for employees who, in return, indicated their effort levels. In all experiments, dyads interacted in real-time either in the same country or across two countries with high cultural difference. Consistent with our predictions, we find that the effectiveness of a bonus contract in increasing employees' effort is reduced by high cultural difference (in experiment 1). We also find that employees' exposure to employers' culture, either due to prior exposure (in experiment 2) or by priming exposure through culture-specific training (in experiment 3) has a mitigating effect. Finally, we find partial support that employees’ interactional cultural intelligence (CQ) has a mitigating effect. Implications to theory and practice are discussed.

Optimal contract under double moral hazard and limited liability

This paper investigates optimal contracts between risk-neutral parties when both exert efforts and the agent faces limited liability. We identify a sufficient and necessary condition for any contract to implement the second-best outcome, i.e., the best possible outcome in double moral hazard even when the agent faces unlimited liability. It is shown that a simple share-or-nothing with bonus contract (SonBo for short) is optimal and implements the second-best outcome when the condition holds. SonBo contracts have one degree of freedom, which is very useful in dealing with heterogeneous circumstances while still maintaining consistency in contracting. SonBo admits as special cases the option-like and step bonus contracts, which are widely used in dealing with limited liability. Nevertheless, we demonstrate that a step bonus contract is more powerful because an option-like contract can be problematic in some situations. The paper also discusses the performance of SonBo when the principal also faces liability constraint and investigates the optimal contract when the second-best outcome is not achievable.

Moral hazard with limited liability: Random-variable formulation and optimal contract structures

This paper studies the optimal contract for a risk-neutral agency with limited liability. We introduce a novel formulation of the model, in which the contract design problem reduces to a problem of constructing the distribution function of a random variable. This formulation directly balances the principal's tradeoff between incentivizing the agent to exert proper effort and minimizing the cost of the agent's compensation. We show that the optimal contract may involve one or two tiers of performance-based bonuses. We obtain new sufficient conditions for the optimality of bonus contracts and provide new insights into the choice of contract parameters.

Ambiguous Sticks and Carrots: The Effect of Contract Framing and Payoff Ambiguity on Employee Effort

Research suggests that employees work harder under penalty contracts than under economically equivalent bonus contracts. We build on this literature by examining how the motivational advantage of penalty contracts depends on a common aspect of real-world contracts: payoff ambiguity. With payoff ambiguity, employees provide effort without knowing how much pay they will receive for a given level of performance. According to our theory, this ambiguity opens the door for employee optimism, which has contrasting effects under each contract frame. Results from an experiment support this theory, with an increase in ambiguity leading to less employee effort with penalty contracts (as employees optimistically expect small penalties) and to more effort with bonus contracts (as employees optimistically expect large bonuses). We also find that these effects are stronger for more dispositionally optimistic employees. Overall, our results suggest that bonus contracts may be more motivating and penalty contracts less motivating than previously thought.

Bubbles and incentives: an experiment on asset markets

We explore the effects of competitive incentives and of their time horizon on the evolution of both asset prices and trading activity in experimental asset markets. We compare (i) a no-bonus treatment; (ii) a short-term bonus treatment in which bonuses are assigned to the best performers at the end of each trading period; (iii) a long-term bonus treatment in which bonuses are assigned to the best performers at the end of the 15 periods of the market. We find that the existence of bonus contracts does not increase the likelihood of bubbles but it affects their severity, depending on the time horizon of bonuses. Markets with long-term bonus contracts experience lower price deviations and a lower turnover of assets than markets with either no bonuses or long-term bonus contracts. Short-term bonus contracts increase price deviations but only when markets include a higher share of male traders. At the individual level, the introduction of bonus contracts increases the trading activity of males, probably due to their higher competitiveness.

Shielding the Workforce: Does Subordinate Contract Frame Induce Leniency in Superiors’ Target-Setting Decisions?

Management control systems affect employees at every level of the organizational hierarchy, so it is crucial to evaluate how controls at one hierarchical level spillover to another level. We examine how subordinates’ contract frame, an important management control, affects superiors’ target-setting decisions, another important control. Using an experiment, we predict and find that superiors set lower targets for subordinates under a penalty contract compared to a bonus contract, as superiors can project their negative perceptions of penalties onto subordinates and seek to reduce these perceived negative effects. Further, we predict and find that increasing the salience of subordinates’ contract choice to the superior mitigates the effect of subordinate contract frame on target-setting, and that these effects are stronger in low Dark Triad superiors compared to high Dark Triad superiors. Our findings add insights into the interrelationships of management controls at different hierarchical levels within the organization.

Optimal Contract Under Double Moral Hazard and Limited Liability

This paper investigates optimal contracts between risk-neutral parties when both exert efforts and the agent faces limited liability. We identify a sufficient and necessary condition for any contract to implement the second-best outcome, i.e., the best possible outcome in double moral hazard even when the agent faces unlimited liability. It is shown that a simple share-or-nothing with bonus contract (SonBo for short) is optimal and implements the second-best outcome when the condition holds. SonBo contracts have one degree of freedom, which is very useful in dealing with heterogeneous circumstances while still maintaining consistency in contracting. SonBo admits as special cases the option-like and step bonus contracts, which are widely used in dealing with limited liability. Nevertheless, we demonstrate that a step bonus contract is more powerful because an option-like contract can be problematic in some situations. The paper also discusses the performance of SonBo when the principal also faces liability constraint and investigates the optimal contract when the second-best outcome is not achievable.

Performance Incentives and Competition in Health Care Markets

Our study investigates the effects of introducing performance‐based incentives in a competitive health care market. We consider a market in which a payer applies a performance‐based compensation contract to two competing hospitals. We use G/ G/ m queuing dynamics to describe the patient care process and include information asymmetry between the payer and the hospitals regarding the hospital operating costs. Our paper is the first to study the performance‐based contracting problem in a health care market in the presence of competition on both the quality of and the access to care and the cost information asymmetry between the payer and care providers. We analyze the socially optimal and Nash equilibrium outcomes under bonus compensation where each of the competing hospitals is rewarded based on patient benefits delivered at that hospital. We show that both the stronger competition among hospitals and the introduction of bonus incentives can enhance patient benefits. Furthermore, we demonstrate that, in the presence of information asymmetry between the payer and the hospitals regarding hospitals' operating costs, the social welfare loss generated by the fee‐for‐service compensation as well as by the optimal bonus contract can be partially mitigated by increasing the degree of competition for patients. Such mitigation effect is amplified when the potential cost differential between the hospitals is sufficiently high and, simultaneously, the correlation between their cost parameters is not too negative.

Analyst Forecasts and Target Setting in Executive Annual Bonus Contracts

ABSTRACT Whereas practitioners often recommend that firms incorporate forward-looking information in setting executive performance targets, academic studies have mainly focused on past information (e.g., past performance) as information sources. Using analysts' annual earnings forecasts as the main proxy for market-based forward-looking information, we find evidence that boards of S&P 1500 firms exploit forward-looking information in setting targets for executive annual bonus contracts. Furthermore, we find that the positive association between analyst forecasts and firms' bonus target revisions is more pronounced when forecasts are more informative about future firm performance and when they are less likely to be influenced by managers. Our results are robust to a battery of sensitivity tests. Data Availability: Data are available from the public sources indicated in the text.