Lecture 9 - Controlling for the effects of uncontrollable factors

After measurement period - Relative performance standards

- Based on employee's performance relative to their peers - Useful when uncontrollable factor affects performance of employee - Difficult to find comparison group that performs similar task

After measurement period - Flexible performance standards

- Define performance employees are expected to achieve given actual conditions in the period - Flexible budgets based on flexible performance standards

Before measurement period - Insurance

- Low frequency events with potential for high impact - Regular premiums in exchange for high claims in times of a disaster - More man-made threats than natural in past years

Types of uncontrollable factors - Economic, competitive factors

- Many result measures affected by uncontrollable facts Example: Profit measure - Demand: Changing tastes, competitor actions, etc - Production costs: Price of RM, regulations, etc

Benefits of adjusting for uncontrollable factors

- More accurate performance evaluations - Less manager frustration, better motivation - Better decision making, less noise - Lower compensation costs

Types of uncontrollable factors - Interdependencies between units

- One unit depends on another's performance - Types 1) Pooled 2) Sequential 3) Reciprocal Pooled: Tend to be protected from cost inefficiencies of shared resources Sequential and reciprocal: Use TP system to price goods used by other entities - Look at lecture notes for diagrams

Before measurement period - Responsibility structure

- Relies on controllability principle: Hold employees accountable for performance areas that management wants them to focus on

Types of uncontrollable factors - Acts of nature

- Tend to be unexpected, one-off events (Ex. earthquake, death of key executive, etc) - What may be problematic for one company may be an opportunity for another

Total, partial or no adjustment?

- Total adjustment: Managers not involved with those decisions, no need for them to be concerned about cost related to decision - Partial adjustment: Company wants managers to respond to uncontrollable factors - No adjustment: Factors are partially controllable. Don't want an excuse culture.

After measurement period - Subjective performance standards

- Use of judgement by superiors, not entirely based on objective data Superiors may be subjected to: - Outcome bias: Knowing outcomes influences evaluation - Hindsight bias: Given knowledge of events, may perceive events are controllable - Uncertainty for employees

After measurement period - Variance Analysis

- Used to explain why actual results are different from predetermined standards - Useful in disaggregating controllable and uncontrollable factors

Types of uncontrollable factors

1) Economic, competitive factors 2) Acts of nature 3) Arising from interdependencies between organizational divisions

Controlling for effects of uncontrollable factors

2 types of controls 1) Before measurement period 2) After measurement period Before measurement period - Insurance - Responsibility structure After measurement period - Variance analysis - Flexible performance standards - Relative performance evaluations - Subjective performance evaluations

Controllability principle

Employees should be held accountable for results they can control

Why focus on controllability only?

Uncontrollable factors can: - Distort performance measures and evaluations - Create risks Managers want to be compensated for bearing risk for aspects out of their control. If not, they will engage in undesirable actions to protect themselves (Ex. Game playing) - Uncontrollable risks should be borne by owners/investors