This document is a summary of everything you need to know for the course 'Incentives & Control' (6314M0401Y) at the univeristy of Amsterdam. This course is taught by Peter Kroos and is part of the master Accountancy and Control. The summary includes: a summary of the lectures, a short and concise s...
Lectures
Incentives and control → contribution of various methods and techniques to the challenge of aligning interests of
employees with the overall organization objectives in settings characterized by asymmetric information.
Assumptions of economic models:
• People are motivated by (1) greed and (2) risk-aversion.
o
• Information asymmetry/private information
o Moral hazard Hidden actions/effort
Uninformed party moves first → principal elicits high effort and desired
action choices by offering contracts contingent on performance measures
rewarding agents for productive effort
Screening/adverse Hidden characteristics
selection Uninformed party moves first → principal induces agents to truthfully
reveal their private information about its type by offering contract
beneficial for high type, but not for low type.
Signalling Hidden characteristics
Informed party moves first → agents communicate their type to principal
by taking actions less costly to the high type (relative to the low type).
In order to make a good decision you want the combination of information and decision rights. However, knowledge is
often dispersed throughout the organization. Two alternatives:
1. Moving knowledge to those with decision rights (KTC; Knowledge transfer cost)
2. Moving decision rights to those with knowledge (CC)
General knowledge is inexpensive to transmit, however specific knowledge is costly to transfer. Therefore, specific
knowledge necessitates the decentralization of decision rights. This creates 2 problems: the rights assignment
problem and the control/agency problem.
Jensen & Mechling (1992)
Alienability (= the right to sell/transfer rights and right to
pocket the proceeds) facilitates the rights assignment
problem in the outside market, as rights are now acquired
by those who value the rights the most. However,
employees within a firm cannot alienate decision rights
under their control. To what extent firms should delegate
decision rights is determined by the trade-off of the costs
associated with the rights assignment problem (costs due
to poor information) and the control problem (costs due to
, inconsistent objectives). The optimal point of lowest organization costs determines the optimal delegation.
A firm should never give away all/total decision rights to an employee; it should break it down into multiple rights
such as monitoring, executing, controlling and approving.
In the outside market the acquirer of the rights benefits from successful utilization of the acquired rights through
increasing market prices. Within firms, employees are rewarded and punished based on performance measure
outcomes. As such a firm should create an incentive system that provides measures of performance and specifies
the relationship between rewards and punishments and performance measures outcomes.
This comprehensive system is composed of:
• Result controls → define performance measures
and reward good results (and punish bad results).
o Facilitates empowerment as actions are
not constrained.
o Controllability principle → employee who is
held accountable must be able to influence
the results in a material way. If
performance measures are also affected by
external factors, risk is imposed on
employee (risk-aversion: demand risk-
premium).
o Controls ex-post
• Action controls → focus on employee behavior to
ensure that employees perform (do not perform) actions beneficial (harmful) to the organization
o Assumptions: decisions/actions are observable for superior managers and superior level knows
which actions are desirable.
o Advantages: codification of best practices, coordination incorporated in procedures.
o Disadvantages: means-end inversion, deters creativity and innovation.
• Personnel and cultural controls → based on self-control and social. E.g. the people you hire / the shared
norms and values. → known as ‘soft controls’.
o Personnel controls build on self-control, intrinsic motivation, ethics, …
o Implement personnel controls through employee selection, training and job design
o Cultural controls refers to shared norms and values, and social pressure exerted by groups on
individuals (mutual monitoring).
o Reinforced by: codes of conduct, group-based rewards, intra-organizational transfers, physical and
social arrangements, tone at the top.
Abernethy et al. (2004)
Interdependency = how much do businesses work together.
A divisional performance measure goes against cooperation.
Greater information asymmetry between the CEO and the
divisions is associated with greater delegation of decision
rights towards divisional managers.
When decision rights are delegated from the CEO to
divisional managers, a greater weight is assigned to
divisional summary measures of performance.
Campbell (2012)
The goal of the researched credit union was to build long-term relationships with members. They relied on personnel
controls (recruitment) as there is no performance measure to measure this. They found that the personnel controls
were effective as new employees made exceptions to facilitate members more often, leading to less impairments
than old employees. → getting the rights people in the organization, whose way of working align with the strategy
of the organization, works.
, Deller & Sandino (2020)
Study of employee selection as
important control mechanism to align
employees with company values and
goals. How allocation of decision
rights in hiring impacts hiring efficacy
when monitoring and rewards alone
cannot achieve goals alignment.
There is a trade-off between
centralized hiring (better alignment with corporate goals) and decentralized hiring (exploit superior information of
local managers). After the centralization the likelihood that an employee leaves is higher.
There is also the same incentive and control problems at corporate boards: presence of asymmetric information,
imperfect alignment of interests.
Jensen & Meckling (1976)
Focus on control problems due to separation of ownership and control prevalent in publicly held firms. Investors
(shareholders) delegate decision rights to corporate executives. Outside board members monitor executives on
behalf of those shareholders (‘residual claimants’). Debtholders monitor executives to assess likelihood of default.
• Agency costs of equity arise with delegation of decision rights from the shareholders towards the CEO →
if CEO owns 95% of equity then he/she will enjoy one-dollar marginal utility, but only experience a 0.95
dollar decrease in wealth for each dollar that he/she expends resources on consuming perks.
• The separation of ownership and control introduces agency problems (moral hazard) → when owner-
manager’s fraction of equity increase (i.e. a larger part of his wealth is tied to the performance measure
stock price), agent will be less inclined to consume perks.
• Agency costs of equity are defined as the sum of: monitoring the principal, bonding costs by the agent (=
trust-building of the agent with their principal), residual loss (=CEO will always be able to use value in
some extent that is only good for the CEO, not economically efficient to fully align interests). → As long as
the market anticipates the wealth effects of consumption of perks, the manager will bear the entire
effect.
• Agency cost of debt is: incentive effects associated with high leverage, monitoring costs hat follow from
incentive effects, bankruptcy costs.
o Incentive effects associated with high leverage. In a highly leveraged firm, the owner has
incentives to adopt (risky) projects with high pay-off and low likelihood of success. With diffuse
equity-ownership, creditors anticipate that managers bond with investors at the expense of the
lenders due to the different pay-off functions. Lenders will take this into account when
determining the cost of debt.
o Monitoring costs. Lenders often restrict managerial actions by including provisions into debt
covenants. Costs of writing such contracts, enforcing them, residual divergence of interests also
impounded in cost of debt.
Incentive and control systems assure a higher likelihood that organizational objectives and strategies will be
accomplished. However, with them come direct ‘out-of-pocket’ costs of bonuses paid, time allocated to execution of
control procedures, time devoted to revising the system, etc. and indirect costs associated with harmful side-effects.
You can never perfectly align all the people in the organization to work perfectly towards the goal → there is always a
residual loss.
Contingency theory = there is no universally best incentive and control system that applies to all situations and all
organizations. There are a number of situational factors (set of contingencies facing the organization) that individually
and collectively affect costs and/or effectiveness of incentive systems.
, Sandino (2007)
What kind of initial control systems (Action controls, Result controls, Personnel controls, Cultural controls) do
early-stage firms adopt? To what extent drives a specific purpose (minimize costs, enhance revenue, minimize risk)
the introduction of individual control systems? → Some controls are used by all firms and are not specifically
focused on one of those three purposes. Sandino comes up with fourth category: basic controls (= controls that all
firms have).
• Differentiation strategy firms use more revenue control systems than cost leadership strategy firm, as
consistent with contingency theory. → strategy should match with corresponding controls.
• If firm’s strategies and controls are aligned (fit) then these firms see higher performance.
Articles
Jensen & Meckling (1992)
Title Specific and General Knowledge, and Organizational Structure
Author(s) Michael C. Jensen and William H. Meckling
Keywords Decentralization, Specific Knowledge, Decision Rights, Agency Problem, Organizational Structure
The authors show that the costs associated with transferring specific knowledge lead to the decentralization of
decision rights. This decentralization creates challenges in assigning these rights (rights assignment problem) and in
ensuring that these rights are used in a manner that aligns with organizational goals (control or agency problem).
Alienability allows for the natural alignment of decision rights with individuals who value them the most, thus ensuring
efficiency. There is a lack of alienability in organizations, meaning that they must develop internal control systems,
such as job descriptions, performance measurement, evaluation, and reward mechanisms, to manage the rights
assignment and control problems, though these are less efficient than market mechanisms. Organizations survive and
compete successfully only if they provide offsetting advantages, such as economies of scale, scope, or risk-bearing,
which outweigh the inefficiencies of their internal control systems. The paper concludes by asserting that
organizations must carefully design their internal systems to overcome the inherent inefficiencies of non-alienable
decision rights.
Abernethy, Bouwens & Van Lent (2004)
Title Determinants of Control System Design in Divisionalized Firms
Author(s) Margaret A. Abernethy, Jan Bouwens, and Laurence van Lent
Keywords Decentralization, Control Systems, Divisionalized Firms, Information Asymmetry, Interdependencies
The authors aim to understand how information asymmetries between corporate and divisional managers and
interdependencies among divisions affect the control system choices between decentralization (the extent to which
decision-making authority is delegated to division managers) and the use of divisional summary performance measures
(DSMs). Complementarity Hypothesis: Decentralization and the use of DSMs are complementary choices, meaning they
are likely to be implemented together as firms decentralize decision-making and concurrently adopt DSMs to monitor
divisional performance. Information Asymmetry Hypothesis: Higher information asymmetry between corporate and
divisional managers leads to greater decentralization, as divisional managers are better informed about their specific
operational contexts. Interdependencies Hypothesis: Higher interdependencies among divisions lead to less
decentralization and reduced use of DSMs, as the performance of one division affects others, making individual
performance measures less informative. The study finds that (1) firms decentralize decision-making when divisional
managers possess specific knowledge; (2) Interdependencies among divisions are found to negatively affect the use of
DSMs, and; (3) there is non-conclusive evidence that firms tend to implement both decentralization and the use of
DSMs simultaneously. The authors conclude that both information asymmetries and interdependencies play crucial
roles in determining control system design in divisionalized firms.
Campbell (2012)
Title Employee Selection as a Control System
Author(s) Dennis Campbell
Keywords Employee selection, management control, decentralization, decision-making authority, risk
management
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