Chapter 16 - Individual Performance Evaluation CHAPTER 16 INDIVIDUAL PERFORMANCE EVALUATION (CHAPTER SUMMARY This chapter is the first of two chapters on performance evaluation. It focuses on the evaluation of an individual employee's performance. To organize the discussion, the chapter uses the principal-agent mode! introduced in chapter 15. This model makes a number of simplifying assumptions that reduce the complexity of measuring individual performance. The chapter analyzes the issues that arise in relaxing these assumptions. Primary topics include estimating a performance benchmark, multiple performance measures, opportunism, measurement costs, subjective performance evaluation, government regulation of labor markets, combining objective and subjective performance measures, and evaluating teams. An appendix provides a more detailed analysis of determining the optimal weight in a relative-performance contract. (CHAPTER OUTLINE ‘Managerial Application: U.S. Health Care System Adopts Pay-for-Performance SETTING PERFORMANCE BENCHMARKS ‘Time and Motion Studies Past Performance and the Ratchet Effect MEASUREMENT Costs Academie Application: Measuring What Counts Managerial Application: Technology to Reduce Measuring Costs of Individual Performance OPPORTUNISM Gaming ‘Managerial Application: Gaming Objective Performance-Evaluation Systems Horizon Problem ‘Managerial Application: Gaming Compensation Plans, RELATIVE PERFORMANCE EVALUATION Academic Application: Relative Performance Evaluation in Banking Academic Application: Relative Performance Evaluation for CEOs Within-Firm Performance ‘Managerial Application: Potential Costs of Relative Performance Evaluations Across-Firm Performance SUBJECTIVE PERFORMANCE EVALUATION Multitasking and Unbalanced Effort 16-1Chapter 16 - Individual Performance Evaluation Subjective Evaluation Methods Managerial Application: SelfEvaluation Standard-Rating-Seale Systems Goal-Based Systems Managerial Application: 360-Degree Performance Reviews Frequency of Evaluation Problems with Subjective Performance Evaluations Shirking among Supervisors Forced Distributions Influence Costs Reneging Managerial Application: Tips on Subjective Performance Reviews COMBINING OBFECTIVE AND SUBJECTIVE PERFORMANCE MEASURES Managerial Application: Objective and Subjective Performance Evaluation at Fiat TEAM PERFORMANCE ‘Team Production Managerial Application: Peer Pressure within Teams Evaluating Teams GovERNMENT REGULATION OF LABOR MARKETS SUMMARY APPENDIX: OPTIMAL WEIGHTS IN A RELATIVE PERFORMANCE CONTRACT Expected Compensation Effort Choice Minimizing Employee Risk 16-2Chapter 16 - Individual Performance Evaluation TEACHING THE CHAPTER ‘This chapter begins to focus on the final leg of the stool, performance evaluation. In particular, this chapter focuses on individual evaluation rather than divisional evaluation within a firm, which is covered in the following chapter. This chapter is not particularly quantitative in nature so instructors should make use of the numerous Managerial and Academic Applications to highlight the key concepts and generate class discussion. These applications emphasize some of the issues that must be considered when designing an evaluation and compensation system (see “Measuring What Counts” and “Gaming Objective Performance-Evaluations Systems” as prime examples). The use of relative performance evaluation is highlighted in the applications “Relative Performance Evaluation in Banking” and “Relative Performance Evaluation for CEOs”, and its potential downsides are highlighted in “Potential Costs of Relative Performance Evaluations.” The chapter includes a section on team production and evaluation and the application “Peer Pressure within Teams” highlights some of the unique issues associated With evaluating teams. The final section of the chapter acknowledges the limits that government regulations place on the ability of employers and employees to freely negotiate employment contracts. The appendix provides extended coverage of the topic, particularly for those with an appropriate mathematical background. Although most of the chapter does not involve quantitative analysis, the Self-Evaluation Problems provide an opportunity for students to determine whether they understand the quantitative tools that are presented in the chapter. The Review Questions focus more on the core concepts There are three Analyzing Managerlat Decisions scenarios presented in the chapter. ‘The first, “Semco S.A.” asks students to evaluate the company's evaluation system, The second, “Why Teams Fail” asks students to determine why team production is nat always successful. The final scenario, “Structuring Salesforce Compensation’ is located after the appendix and is quantitative in nature. Students who have completed a statistics course should be able to complete the discussion questions even if the ‘mathematical model presented in the chapter is mote advanced. REVIEW QUESTIONS 16-1. Discuss some of the costs and benefits of 360-degree evaluation systems. Costs include: ‘© Greater influence costs as employees spend time lobbying co-employees. + Employees might not have the correct incentives to be honest in their reviews. For example, while the evaluations are “anonymous,” employees have incentives to collude to overstate evaluations. * Some employees criticize the system for not providing enough structure. Some people like being bosses and other people like having bosses tell ‘them what to do.Chapter 16 - Individual Performance Evaluation Benefits include: * As the number of evaluators with Knowledge of the employee's performance increases, the accuracy of the evaluation increases and the random error deereases. This reduces the risk borne by the evaluatee. 16-2. In 360-degree performance review programs, personnel evaluations are collected anonymously from employees knowing the manager being evaluated (superiors, subordinates, and coworkers). ‘These are tabulated and a consensus summary is provided to the manager. Each manager being evaluated also does a self- evaluation, and this is used to benchmark how closely the manager and the coworkers’ assessments match. About one-third of the managers match their coworkers, one-third have an inflated view, and one-third rate themselves lower. Those who overrate themselves tend to be judged “least effective” as perceived by their coemployees. However, these overraters are more conunon higher up in the corganization.! a. What does the breakdown of three one-thirds indicate? ‘The three equal divisions indicate that people are able to form unbiased estimates of what their coworkers think. Managers in general do not have an overly rosy view of themselves. As many overrate themselves as underrate themselves. b. Offer some plausible explanation why over-raters are higher up in the organization. ‘Some alternative explanations include: + The higher up the organization one proceeds, the less feedback they are receiving and the more distorted their views of themselves become. + Aggressive, driven managers are those who believe in themselves and they, in fact, are better than their coworkers. + Higher-level_ managers have more people below them than above them. Lower level managers who were not promoted might resent the higher-level managers and rate them lower than they really deserve; they have more enemies. + The higher up in the organization, the higher the standards people hold you to. This is a Peter Principle effect. People get Promoted to their level of incompetence. BO Reilly (1994), "360 Feedback Can Change Your Life,” Fortune (October 17). 93-100. 16-4Chapter 16 - Individual Performance Evaluation 16-3. The following quote is based on statements made by quality expert W. Edwards Deming: If by bad management the components of a company become competitive, the system is destroyed. .. 4 common example lies in the practice of ranking people, divisions, teams, comparing them, with reward at the top and punishment at the bottom. Jobs and salaries are based on comparisons. Teams naturally become competitive; divisions become competitive. Each tries to outdo the other in some competitive measure. The result is higher cosis, battle of market share. Everybody loses? Do you agree with Deming that performance evaluations based on comparative rankings always reduce company value? Explain, The Deming quote is referring to relative-performance evaluation (RPE). ‘Deming is uniformly rejecting all RPE as leading to unnecessary competition. He is describing the costs of RPE. As described in the chapter, RPE, can lead to employees sabotaging other employees or dysfunctional recruiting incentives. However, RPE has benefits that Deming does not discuss. In particular, by comparing an employee's performance to that of his/her peer group, random errors or noise that affect all the employees can be filtered out. Thus, the risk from this random variation is not borne by the employee. Therefore, risk-averse employees prefer such risk reduction and will be willing to accept lower pay. Thus, Deming ignores the risk-reduction benefits of RPE. 16-4, The United States Navy recently revamped its officer fitness report system? Under the old system, officers were ranked into one of four categories, where 4.0 was the highest grade, This old system had been used for 20 years and grade inflation had become rampant, Fighty percent of all sailors routinely were ranked a perfect 4.0. One officer remarked, “Let's face it, 85 percent of the people are 4.0 and 80 percent [of those] have every mark in 4.0." A retired admiral commented, “The old system wasn’t entirely broke, it was just deteriorating over time and became less and less useful.” The Navy decided to change the evaluation system because of the natural tendency for senior officers to promote their own subordinates over unknown sailors. Not everyone deserved a 4.0, but to get their own people promoted, senior officers had to play along because that’s what everyone else was doing. * R Aguayo (1990), Dr. Deming: The American Who Taught the Japanese About Quality (Fireside Sisnon & Schuster: New York), vii-vii. * E. Blazar (1995), “The Now Standard of Excellence.” Navy Times (Masch 20), 12-14. 16-5Chapter 16 - Individual Performance Evaluation The new system requires each officer to be rated on a 1 — 5 scale in seven areas: professional expertise, leadership. support for equal opportunity programs, military bearing and appearance, teamwork, mission accomplishment, and interpersonal skills, The total points out of 35 possible are then used to provide ‘an overall promotion recommendation’ + Clearly promote + Must promote. + Promotable ‘The number of ratings in the top two categories — “clearly promote” and “must promote” — will be severely restricted to at most 20 percent of the evaluations. If an officer is evaluating 10 junior officers, at the most only two can receive the top two ratings. ‘What are the expected consequences of this new system? What are the likely outcomes? What are the pros and cons of the new system? The new system will eliminate evaluation inflation, but it will induce other dysfunctional behavior. It will encourage more sabotage and non-cooperative efforts than the old one, Knowing there are a limited number of top evaluations, officers in the same pool have incentives to undermine their peers. Teamwork will be harder to generate. Officers will seek assignments into evaluation pools where they think they will stand out. For example, someone with three or four years of experience in a job should be able to perform the duties better tham someone with one or two years of experience and hence should be more likely to get a higher rating. If the number of officers in each pool to which the forced rankings are applied becomes too small, then evaluation errors start to get large. Suppose that all five officers in one pool are outstanding. Only one can get the top rating, Another pool of five are all mediocre, but one might be top rated. Clearly, if one pool of ten is used instead of two pools of five each, fewer classification errors are made. Thus, one of the key design elements of the ‘Navy's new evaluation system is setting pool sizes.Chapter 16 - Individual Performance Evaluation 16-5. 16-6. Evaluate the following statement: The overarching purpose of a measurement system should be to help a team, rather than senior managers, gauge its progress. A team’s ‘measurement system should primarily be a tool for telling the team when it must take corrective action.* The quote assumes that the measurement system is used primarily for decision management, not decision control. Implicit in this statement is the assumption that agency problems are mot important. There’s a view that people and teams want to do “good” and will do “good” if provided the proper information, Team members do not need performance measurements and incentive systems. All they require is the proper information. This assumption need not be correct. ‘The Green Shoe Company is considering going to a piece-rate system, where ‘manufacturing employees are paid based on their level of output, Discuss what factors the firm should consider in deciding whether or not this idea should be implemented. How should the initial piece rate be set? Under what circumstances should the company alter the piece rate once it is adopted? Piece rates encourage employees to focus on the quantity of output. For piece rates to be effective, the company must be able to monitor quality. The output of the employee should be sensitive to the employee's effort and not subject to large random fluctuations. Piece rates also do not provide incentives for teamwork, generating ideas, training new employees, and so forth. If these other attributes are important, the company should either not pay piece rates or pay additional incentives to encourage these activities. The rate should be set to reflect market-determined wage rates. The company will probably want to change the piece rate when technological innovations cause the rate of output to change. The company should realize that if it changes the piece rate because it is "overpaying employees," that employees will come to anticipate these changes and will have incentives to collude to restrict ‘output (ratchet effect). “How the Right Measures Help Teams Excel,” Harvard Business Review (May-Iune), 16-7Chapter 16 - Individual Performance Evaluation 16-7. 16-8 16-9. ‘Your company currently has a bonus plan for its sales managers. If annual sales for a manager’s unit exceed $1 million, the manager receives a $10,000 bonus. In a typical year, about 5 of the 10 managers in the firm meet the target and receive the bonus, However, the number receiving the bonus varies from year to year due to the state of the economy, which in tum has an effect on sales. The company is considering replacing the bomus plan with a plan that rewards the top-five selling managers each year with 2 $10,000 bonus. Discuss the potential benefits and costs of the new plan relative to the old plan. ‘The new plan focuses on relative performance, compared to the old plan that focuses on absolute performance. The benefit of the new plan is that it helps to shelter the sales managers from risk that is beyond their control (to the extent that the good Iuck or bad luck tends to affect the sales of all the managers). The plan, however, can encourage managers to collude and not to compete (since they get the same total bonus regardless of company sales). ‘The plan also encourages potential sabotage and noncooperation (since managers are competing against one another). Also the managers will favor hiring weak people to fill vacant manager posi Communities are frequently concerned about whether police are vigilant in carrying out their responsibilities. Several communities have experimented with incentive compensation for police. In particular, some cities have paid members of the police force based on the number of arrests that they personally make. Discuss the likely effects of this compensation policy. The number of arrests would go up. However, the plan would likely have several undesirable effects. First, it encourages the police to make arrests even if the reasons for the arrests are questionable. Second, it would encourage police to work om crimes where arrests are easy to make, rather than working on more serious crimes where it is more difficult to make numerous arrests. Third, the plan would not encourage cooperation or teamwork (since the bonus fs based on individual arrests). A consultant does not like the fact that you use subjective performance measures jin your firm. He argues that they are arbitrary and should be replaced with objective measures, He stresses that explicit measures provide a clear target for employees, but mentions none of the potential costs. What are the potential problems associated with using objective performance measures? Potential problems with objective performance measures: © Gaming: Employee might engage in nonproductive efforts to improve the evaluation,Chapter 16-10. 16 - Individual Performance Evaluation + Externalities: It is usually difficult to construct am explicit measure of how the efforts of one employee affect the productivity of other employees. © Unbalanced Effort: The employee will not allocate an optimal amount of time fo unmeasured activities, + Measurement Costs: Costs are incurred in generating the measures. + Horizon Problems: Objective measures tend to be short-term measures and often do not provide incentives for proper long-run actions. Some firms have recently adopted 360-degree performance evaluations. Under this evaluation system the employee is evaluated not only by supervisors and peers but also by employees who report to the employee being evaluated. Discuss why a firm might want to adopt 360-degree reviews. What are the likely problems with this type of performance evaluation? ‘This scheme utilizes the specific knowledge of subordinates, who work with the senior manager, and thus bases the manager's pay on more information about his/her performance than a scheme that uses the information of just the manager's superiors or peers. Thus potentially useful information about the manager's effort is not being ignored. Potential problems include: + The manager colluding with the subordinates ("You give me a good evaluation, and T'll give you a good evaluation too.") Alternatively, the subordinates may not give am honest evaluation, out of fear that the manager will retaliate. * Influence costs, with the manager being nice to the subordinates, to “buy” a good evaluation. Company efficiency and productivity could suffer as a result. Costs include: Greater influence costs as employees spend time lobbying. ‘+ Employees do not always have incentives to be honest in their reviews. For example, while the evaluations are “anonymous,” employees have incentives to collude to overstate evaluations. + Some employees criticize the system for not providing enough structure. Some people like being bosses and other people like having bosses tell ‘them what to do. Benefits include: As number of evaluators with knowledge of the employee's performance increases, the accuracy of the evaluation increases and the random error decreases. This reduces the risk borne by the evaluate. 16-9Chapter 16 - Individual Performance Evaluation 16-11, Evaluate the following quote: Teams do not spring up by magic. Nor does personal chemistry ‘matter as much as most people believe. Rather, we believe that most people can significantly enhance team performance. And focusing on performance — not chemistry or togetherness or good communications or good feelings — shapes feams more than anything else? ‘The quote correctly emphasizes the importance of performance evaluation in enhancing team production, “Chemistry” — whatever it is and however one measures it — is also probably important. However, if that is all that the team has and there is no team and individual performance measures, then the analysis in the text predicts that such teams are unlikely to be successful. 16-12. A basic principle in accounting is that of “responsibility accounting.” Under this principle, it is inappropriate to base performance evaluation on measures that are beyond the control of the employee. Do you think that you should ever include variables in a worker's compensation plan that are not under at least partial contro! of the employee? Explain. Economic theory suggests that it is sometimes optimal to include variables in an employee's compensation plan over which they have no control. Including these variables can be optimal when they provide extra information about the underlying effort of the employee. An example is a relative performance contract. For instance, a firm might want to base the CEO's pay on performance relative to a market index event though the CEO has little control over the market return. 16-13. Once again, the Eastman Kodak Company has altered the determinants of pay raises for US employees. Whereas in the past pay increases for managers, professionals, and hourly workers had been automatic, starting in 1996 the company began determining the size of an annual bors pool and then allocated Jump-sum bonuses to employees on the basis of performance. Hourly workers ‘were to be evaluated within their annual performance appraisals; professional- level employees would work with their supervisors to establish personal goals against which they would be measured. a. What problems do you foresee with the implementation of this arrangement? Be specific about who will be affected by the problems you've identified. * J. Karzeabach and D. Smith (1995). The FFisdom of Teams (Harvard Business School Press: Boston). 61. 16-10