Industry attributes and their influence on managerial pay and the use of

performance measures

Christo Karuna†
December 2009

JEL classification: D4; G34; J33; L1; M40; M41; M46

Keywords: Managerial incentives; Competition; CEO compensation; Corporate governance; Performance

evaluation

I would like to thank Tony Chen, Joanna Ho, Ranjani Krishnan, Mort Pincus, Michael Raith, Siew Hong Teoh, the
workshop participants at the American Accounting Association 2006 mid-year Management Accounting Section
and 2007 Western Region conferences, University of California, Irvine, University of Sydney, Temple University,
and the principals at Towers Perrin Compensation Consultants, Chicago, for their comments and suggestions. All
errors are my own.
†
Christo Karuna, 390G Melcher Hall, C.T. Bauer College of Business, University of Houston, Houston, TX 77204-6021;
Phone: (713)743-8953; Email: ckaruna@uh.edu

Electronic copy available at: http://ssrn.com/abstract=1459101

Abstract

While most prior research has examined how firm characteristics influence the firms’ use of performance
measures to evaluate their managers, little research has been conducted on how industry characteristics affect the
weights placed on these measures. Industry factors that determine product market competition like product
substitutability, market size, and barriers to entry, as well as other factors like investment opportunities and
uncertainty/risk in the industry are shown to influence the weights placed on earnings-, stock-, and cost-based
performance measures to evaluate managers in firms. Furthermore, whether firms belong to the manufacturing or
service industrial sectors, or operate in deregulated versus regulated industries also has an impact on the weights
placed on these measures. This study contributes to the literature by providing comprehensive evidence on the
importance of considering cost-based performance measures in compensation studies and how industry attributes
play a vital role in how firms use performance measures to evaluate their managers.

Keywords: managerial incentives; competition; CEO compensation; performance evaluation

Electronic copy available at: http://ssrn.com/abstract=1459101

1. Introduction

While prior research has focused on how firm factors influence the firms’ choice of performance

measures to evaluate their managers (e.g., Lambert and Larcker 1987; Sloan 1993; Ittner, Larcker, and

Rajan 1997), several studies suggest that industry factors may also play a role in this choice. For

example, Smith and Watts (1992) show that stock-based measures are used more in innovation-based

industries such as high-tech, while Murphy (1999) finds that earnings-based measures are used more in

industries such as utilities. Furthermore, Ely (1991) finds that industry indicator variables account for a

large variation in the weights placed on these measures. More recently, Gillan, Hartzell, and Starks

(2003) provide evidence that industry factors are more important than firm factors in explaining internal

governance mechanisms in firms. In another study, Engel, Gordon, and Hayes (2002) find that Internet

firms rely on stock returns while manufacturing firms rely on earnings to evaluate managers. While these

studies collectively suggest that industry characteristics may affect the weights placed on measures to

evaluate managers, little research has explored this connection explicitly.1, 2

In examining the role of industry factors in managerial performance evaluation, one factor crucial

to a firm’s profitability and survival is product-market competition (Porter 1990). Prior studies suggest

that a firm’s optimal choice among managerial performance evaluation measures also determines its

strategy and profitability (e.g., Simons 1987; Ittner et al. 1997). For example, because stock-based

measures are forward-looking in nature, firms use such measures to encourage managers to undertake

forward-looking long-term actions. In contrast, because earnings-based measures are backward-looking

in nature, firms use such measures to motivate short-term managerial actions. This suggests that industry

product-market competition may be an important determinant of the use of stock- versus earnings-based

1
In an initial exploratory analysis, we find that industry dummy variables explain 30% of the variation in incentive
compensation across a representative sample of firms. Since prior studies that examine the relation between firm-level
variables and incentive compensation, while controlling for industry dummy variables, show that this variation ranges from
approximately 40% to 47%, the difference in results suggests that industry factors may dominate firm factors in explaining this
variation.
2
Bushman and Smith (2001) argue that more research needs to be conducted on how the external environment in which firms
operate affects the relative weights placed on these measures.
3

Electronic copy available at: http://ssrn.com/abstract=1459101

measures. However, to the best of our knowledge, no study has directly examined the relation between

competition and the tradeoff between these performance measures.

In addition to stock- and earnings-based measures, it is likely that firms may use cost-based

performance measures to evaluate their managers to encourage the managers to be more cost-sensitive.

For example, industry factors may encourage firms to motivate their managers to sustain a cost leadership

strategy. However, to the best of our knowledge, no study has empirically examined the use of such

measures to determine executive compensation.

This paper provides a direct test of how three specific determinants of industry product-market

price competition – product substitutability, market size, and entry costs – affect the weights placed on

these three measures. To define product-market price competition (hereafter “competition”), we consider

the structural aspects of the product market that affect the nature of competition. Consistent with prior

research, we define competition as the extent to which firms attempt to win business from rival firms in

the industry. Within this definition, we define product substitutability as the extent to which there are

close substitutes for a particular product in an industry, market size as the extent of demand for a

particular product in an industry, and entry costs as the costs that firms incur in entering an industry. We

denote higher substitutability, larger market size, and lower entry costs as reflecting higher competition.

To date, only a few empirical studies in the accounting literature have directly examined the

relation between competition and firms’ use of information for managerial control purposes. For

example, Karuna (2007a) provides evidence that firms in more competitive industries provide their

managers with stronger overall equity incentives. Therefore, his study is concerned with how firms

motivate their managers to work harder in general based on the nature of competition these firms face in

the industries they operate in. In contrast, our study shows how competition influences the weights

placed on stock- versus earnings-based performance measures in motivating tradeoffs between long-term

and short-term managerial actions, thus motivating the correct choice of managerial actions.

Additionally, we also examine the effect of competition on the use of cost-based performance measures.

4
In another study, Krishnan (2005) shows that the type of competition affects the demand for accounting

information. Specifically, she shows that when firms compete in price, there is a strong demand for

accounting information, whereas there is no demand for such information when they compete in quality.

Our study differs from Krishnan’s study in that while we examine how competition affects the firms’ use

of performance measures in determining managerial compensation, Krishnan examines how the type of

competition affects the firms’ use of accounting information for cost control purposes. Furthermore,

Krishnan treats competition as uni-dimensional whereas we treat it as multi-dimensional and we examine

several performance measures.

In addition to competition, we also examine if whether a firm operates in a deregulated versus a

regulated industry, whether it belongs to the manufacturing or service sector, and industry investment

opportunities and uncertainty/risk play a role in the use of these measures. To motivate our predictions on

the relations between our industry attributes and the use of the above measures, we draw upon studies in

both accounting and economics (e.g., Feltham and Xie, 1994; Prendergast 2002). To test our hypotheses,

we use data obtained from Execucomp, the Segments and Industrial databases in Compustat, CRSP, and

the Census of Manufactures report in the 1992 Economic Census compiled by the U.S. Census Bureau.

We document several interesting sets of findings. First, we show that firms in more competitive

industries place heavier reliance on stock- compared to earnings-based measures to evaluate their

managers. We also document an overall negative relation between competition and the weight placed on

earnings-based measures and a positive relation between competition and the weight placed on cost-based

measures. Second, we show that firms that operate in more regulated industries place greater weight on

stock- and earnings-based measures and less weight on cost-based measures than firms that operate in less

regulated industries.

Third, we find a more positive association between cost-based measures and managerial

compensation in the manufacturing sector compared to the service sector. We also find weak evidence

that, compared to the service sector, the manufacturing sector places a heavier weight on earnings-based

5
and less weight on stock-based measures. Fourth, we find that industry investment opportunities are

positively associated with the weights placed on earnings- and cost-based measures and negatively

associated with the weights placed on stock-based measures. Finally, industry uncertainty/risk has a

negative relation with the weight placed on stock-based measures. However, its relation with earnings-

and cost-based measures depends on the type of industry uncertainty/risk measure used. When earnings

volatility is the measure for industry uncertainty/risk, there is weak evidence of a positive weight placed

on earnings-based measures and an insignificant weight placed on cost-based measures. When stock

return volatility is the industry uncertainty/risk measure, there is weak evidence of a negative weight

placed on earnings-based measures and either a positive or a negative weight placed on cost-based

measures depending on the regression specification employed. When the volatility of cost-based

performance measures is the industry uncertainty/risk measure, there is weak evidence of negative

weights placed on both earnings- and cost-based measures.

In addition to the findings on the use of performance measures in determining managerial

compensation, we find that greater competition, deregulation, manufacturing orientation, investment

opportunities, and uncertainty/risk is positively related to the level of managerial compensation.

Collectively, these results suggest that the value of managerial effort and marginal product of managerial

labor is positively related to managerial pay and that managers are compensated for taking on additional

risk.

This study contributes to the literature in several ways. First, it provides evidence that a range of

industry characteristics are important determinants of managerial incentives. Second, it adds to our

understanding of observed heterogeneity in the use of stock- versus earnings-based managerial

performance evaluation measures across firms by showing that industry attributes play a vital role in

determining the choice between these measures across firms. Third, it is the first study to provide

evidence that firms place an important emphasis on cost-based measures to evaluate their managers in

addition to other measures. This suggests that researchers should consider cost-based measures in

6
empirical compensation and performance evaluation studies in addition to the stock- and earnings-based

measures used in prior research. Finally, we provide some evidence that refutes some findings in prior

studies and other evidence that sheds light on prior mixed findings and debates.

The rest of the paper is organized as follows. The next section provides the theoretical framework

for this study leading to the testable hypotheses. Section 3 describes the sample selection procedure and

measures used, while section 4 outlines the methodology employed. We present and discuss this study’s

results in section 5, and provide alternative explanations for the findings in section 6. Section 7

documents robustness checks and section 8 concludes this study.

2. Theoretical Framework

Much of the prior literature on the use of performance measures draws inspiration from the

informativeness criterion outlined in Holmstrom (1979). The informativeness criterion suggests that, in

evaluating their managers, firms should select performance measures that are informative of the

managers’ actions. In an accounting context, this criterion is used by Lambert and Larcker (1987) and

Banker and Datar (1989) to develop their signal-to-noise/sensitivity-precision framework. This

framework states that firms should use performance measures that are more sensitive to, or that are more

precise (with less noise) with respect to, the manager’s actions,

These early studies spawned further research in accounting that shows that both stock and earnings

measures should be used to evaluate managers (e.g., Bushman and Indjejikian 1993; Feltham and Xie

1994).3 These studies show that the stock price is a good summary measure of a complex array of

forward-looking managerial actions that map into future cash flows. In contrast, earnings are backward-

looking and are good measures of managerial actions of a short-term nature. Consequently, stock

measures can be regarded as more aggregate in nature compared to earnings measures and therefore a

3
Earnings measures are used explicitly in bonus plans. As the stock price impounds all available information based on market
efficiency, stock measures can be viewed as a proxy for other available performance measures.
7
better reflection of shareholder economic value. These studies also show that, while stock measures may

motivate managers to maximize shareholder value, the stock price is, ceteris paribus, a noisier measure,

as it is based on expectations of future earnings and hence comprises greater uncertainty compared to

current earnings. Moreover, since stock prices are affected by factors beyond management’s control, the

manager better understands the impact of her actions on current earnings compared to stock price

(Gjesdal, 1981). Consequently, firms that want their managers to undertake more complex forward-

looking activities use more stock-based measures to evaluate their managers; in contrast, firms that want

their managers to focus on short-term activities use more earnings-based measures (Feltham and Xie

1994; Ittner et al. 1997).

Although prior empirical compensation studies have not considered cost-based measures, it is

conceivable that firms will use such measures to evaluate managers to the extent that these measures are

able to motivate, or are incrementally informative with respect to, managerial actions in addition to stock-

and earnings-based measures. For example, since revenue and costs are more disaggregate than earnings,

they better map into managerial actions than earnings do.4 Furthermore, the use of earnings as

performance measures assumes that revenue and costs are equally useful (i.e., in terms of product of

sensitivity and precision with respect to managerial actions) in evaluating the manager. To the extent that

cost considerations (e.g., cost minimization) are more important than revenue considerations (e.g.,

revenue maximization), like in settings where price competition is intense, firms may supplement

earnings-based measures with cost-based measures in managerial compensation contracts. Hand (2000)

finds a negative association between earnings and market valuation in Internet firms. This finding

suggests that earnings components like costs may better map into firm value than earnings do in some

types of firms or industries. Although Hand examines earnings from a valuation perspective, it is

conceivable that from a stewardship perspective, earnings-based measures may not be as informative with

respect to certain types of managerial actions as cost-based measures are.

4
According to Banker and Datar (1989), disaggregate measures are incrementally informative and are useful in evaluating
managers provided the aggregate measures are not sufficient statistics for the disaggregate measures.
8
 To motivate our predictions on the relation between competition and the weights placed on stock-

versus earnings-based measures, and on cost-based measures, we draw from prior research in both

accounting and economics that shows that greater competition leads to a higher value placed on

managerial effort. We discuss this body of literature next.

Competition and the value of managerial effort

An increase in competition increases the value of managerial effort in two ways. First, it increases

instability and uncertainty for firms.5 This increases the need for managers to engage in more complex

forward-looking activities that use intangible assets to gain a competitive position through cost reduction

or quality improvements (Kole and Lehn 1997, 1999; Raith 2003, 2005). Consequently, increased

competition makes managerial performance less observable.6 Second, an increase in competition requires

managers with greater skills or talent (Hubbard and Palia 1995). Such managers are necessary to be able

to perform the more complex activities associated with increased competition.

According to Prendergast (2002), the skills required of managers in uncertain environments lead

firms to delegate more authority to these managers and to place a heavier reliance on more aggregate

measures (analogous to stock-based measures) and less reliance on more disaggregate measures

(analogous to earnings-based measures) even if the more aggregate measures are noisier. Prendergast

attributes this phenomenon to the firms’ decreased ability to monitor their managers due to the uncertain

environment.7 Aggregate measures provide summary information about all actions taken by the managers

and thus encourage them to make relevant tradeoffs among available options while allowing the firm to

constrain the managers’ extraction of private benefits at the expense of shareholders. Empirically, Smith

and Watts (1992) find that firms place heavier reliance on stock- compared to earnings-based measures

5
For example, an increase in competition could increase the (i) rate of firm entry and exit in an industry or (ii) level of
innovation by rival firms, both increasing instability and uncertainty for a given firm in the industry.
6
Greater instability and uncertainty associated with increased competition make it harder to distinguish the effects of
managerial decisions on firm performance from the effects of other factors.
7
Similarly, Rosen (1982) claims that leaders receive greater authority when they are required to engage in complex forward-
looking activities or have higher talent.
9
when managerial actions are less observable, and Moers (2006) finds that firms place greater weight on

more aggregate measures to evaluate managers who receive relatively greater discretion.

In another study, Christie, Joye, and Watts (2003) argue that competition generates a demand for

speed in decision making (immediacy) and thus greater specialized knowledge to make such decisions. In

these cases, firms in more competitive industries provide their leaders with greater authority and

discretion as such firms require talented leaders who need to respond quickly to competitive pressure

(Kole and Lehn 1997, 1999). Consequently, due to the increased instability, uncertainty, and managerial

discretion associated with increased competition, it becomes necessary to align managers’ pay more

closely to stock-based measures than earnings-based measures to encourage forward-looking activities

while discouraging actions that are against shareholders’ interests.

Raith (2005) makes a direct prediction regarding the relation between competition and the use of

stock- versus earnings-based measures. He analytically shows that increased competition results in

greater use of stock measures, attributing this to the need to encourage managers to use their specific

managerial knowledge when competition is greater because then the correct choice of actions is more

important than pure effort. On the other hand, when competition is lower, earnings measures are useful to

motivate managerial effort as it becomes easier to detect how managerial actions affect these measures.

The above reasoning suggests that firms in competitive industries will place less weight on cost-

based measures than firms in less competitive industries given that such measures are more disaggregate

than the other two measures. Firms in less competitive industries rely on these measures more as the

more predictable managerial actions in such industries become easier to map into these measures.

On the other hand, the need for greater speed in managerial decision-making and actions with

greater competition makes firm place greater reliance on earnings- compared to stock-based measures to

encourage their managers to focus on short-term actions. Another reasoning that leads to greater weight

on earnings- compared to stock-based measures is the higher likelihood of liquidation associated with

10
more intense competition (Schmidt, 1997), which necessitates a short-term orientation in managerial

decision-making/actions.

Similarly, the greater importance of keeping costs low due to lower profitability and the higher

threat of liquidation result in firms in more competitive industries placing heavier weight on cost-based

measures than firms in less competitive industries.

Hypotheses

We extend the preceding discussion to make predictions on the three determinants of competition

referred to above. Higher product substitutability, larger market size, and lower entry costs lead to greater

competition through lower prices. When product substitutability is high, a firm faces a greater threat of

losing its customers to rivals that have close substitutes to its product(s). Thus, competition increases

through lower prices.8 When market size increases, the demand for each firm’s product increases

proportionally. Consequently, higher expected profits from increased demand encourage market entry,

increasing competition in the industry and thus reducing prices (Sutton 1991; Mas-Collell Whinston, and

Green 1995). Finally, as entry costs decrease, the number of entrants increases, leading to increased

competition through lower prices.

Extending our discussion of competition, we predict that an increase in industry competition

through higher product substitutability, larger market size, or lower entry costs leads to a either greater or

less reliance on stock- measures versus earnings-based measures, and to a greater or less reliance on cost-

based measures, to evaluate the manager, ceteris paribus.

While there is a clear body of literature on the determinants of competition, the relation between

industry concentration and competition is far from clear, especially in cross-industry studies (Demsetz

1973; Aghion et al. 2001; Raith 2003; Karuna 2007a, 2007b). When product substitutability increases, as

does price competition, less efficient firms are forced to exit the industry or merge with more efficient

8
This intuition derives from the study of linear city/circular road models in the Industrial Organizations literature (e.g.,
Hotelling 1929; Salop 1979).
11
firms. Furthermore, this increase in competition may deter potential firms from entering the industry.

Thus, the industry ends up with fewer firms and the level of concentration increases. However, an

increase in market size or a decrease in entry costs will attract more firms, thus raising competition but

reducing concentration. This discussion suggests that market structure can be regarded as endogenous and

that high concentration could reflect either high or low competition (Raith 2003). When markets vary in

product substitutability, high concentration indicates intense competition. On the other hand, when

markets vary in size or entry costs, less concentration indicates intense competition. Due to these mixed

effects, we make no prediction on the relation between concentration and the use of performance

measures. Instead, as shown in the analysis below, we control for possible influences of concentration

and its interaction with the performance measures.

The discussion above leads to the first three hypotheses (in alternate form) for this study:

H1: Firms in industries with higher product substitutability place more (less) weight on stock- versus

earnings-based performance measures, and more (less) weight on cost-based performance measures, to

evaluate their managers, compared to firms in industries with lower product substitutability, ceteris

paribus.

H2: Firms in industries with larger market size place more (less) weight on stock- versus earnings-based

performance measures, and more (less) weight on cost-based performance measures, to evaluate their

managers, compared to firms in industries with smaller market size, ceteris paribus.

H3: Firms in industries with lower entry costs place more (less) weight on stock- versus earnings-based

performance measures, and more (less) weight on cost-based performance measures, to evaluate their

managers, compared to firms in industries with higher entry costs, ceteris paribus.

12
 To shed more light on how industry factors play a role in determining the weights on the above

three performance measures, we also examine how higher order attributes of the industrial environment

that firms operate in play a role in influencing the structure of managerial incentive contracts. Two such

features are whether firms operate in more regulated versus less regulated industries, and whether they

belong to the manufacturing or services industrial sector.

Less regulated industries generally have a wider array of products and services on offer compared

to more regulated industries. This is because the fewer restrictions in less regulated industries have

resulted in uncertainty, flexibility, innovation, and generally increased the value of managerial effort and

made it less observable (Smith and Watts, 1992; Kole and Lehn, 1997; 1999). Based on the reasoning

provided above, this suggests that firms in less regulated industries will place heavier weight on stock-

versus earnings-based measures to evaluate their managers compared to firms in more regulated

industries. Less regulation could also encourage firms to be more cost conscious to be more profitable

and to survive. Thus, it is conceivable that firms in less regulated industries may place heavier weight on

cost-based measures compared to firms in more regulated industries. Alternatively, firms in less regulated

industries may be less cost conscious than those in more regulated industries so that more innovative

activities and more complex actions could take place. To encourage managers to engage in costly

complex activities, firms in less regulated industries may place less weight on cost-based measures than

firms in more regulated industries.

The preceding discussion leads to the fourth set of hypotheses (in alternate form):

H4a: Firms in less regulated industries place greater weight on stock- versus earnings-based

performance measures to evaluate their managers compared to firms in more regulated industries, ceteris

paribus.

13
H4b: Firms in less regulated industries place greater (less) weight on cost-based performance measures

compared to firms in more regulated industries, ceteris paribus.

Although firms in both the manufacturing and services industrial sectors may have similar motives

to provide managerial incentives to enhance firm performance, it is conceivable that the differences in the

nature of the “product” pertaining to these sectors may result in different emphases on the three

performance measures discussed above. A difference between these sectors is the tangible nature of the

product in the manufacturing sector and the intangible nature of the product in the service sector. There is

more of a buffer between the product and the customer in manufacturing firms as there are quality control

mechanisms in place like product inspection that ensure that the customer receives value for what he or

she pays. In contrast, in services firms, managers have to deal with the client/customer more directly and

may need to be enterprising and more immediate in their actions as customers could easily switch to

another firm if dissatisfied with the service provided. Another difference is that in services firms a lot of

the capacity is purchased or committed upfront (e.g., consultants’ salaries) and there is less of a direct

association between the revenue generated via services and the cost of services provided. In contrast, in

manufacturing firms, it is easier to associate incremental revenue generated from selling a unit with its

incremental cost incurred in producing the unit. Third, there is more of a relationship between the

manager of a services firm and its customer than in a manufacturing firm. Customers may consume a

portfolio of services and thus maintaining the customer relationship may be more important in a services

firm.

The above discussion suggests that managers in services firms need to be provided greater

discretion to make decisions and engage in actions, and have to be more enterprising than managers in

manufacturing firms. They may also need to make tradeoffs between different decisions and actions in

providing the service and/or appeasing the customer. Therefore, based on the reasoning provided above,

due to the higher value of managerial effort, firms in services firms may place greater weight on stock-

14
versus earnings-based measures in evaluating their managers. Supporting this prediction, Engel et al.

(2002) provide weak evidence that manufacturing firms place heavier reliance on earnings-based

measures and internet firms place heavier reliance on stock-based measures.9 Alternatively, there is

greater immediacy with respect to managerial actions in services firms compared to manufacturing firms

and so it is conceivable that services firms may place less weight on stock- versus earnings-based

measures to encourage the managers to focus on short-term actions.

As for the prediction on the weight placed on cost-based measures, due to the upfront capacity

costs incurred in services firms and the less direct association between incremental revenue and

incremental costs, it may be more imperative for managers to be cost conscious and look for ways to keep

costs low and still deliver value. On the other hand, however, due to this less than direct mapping, it is

not fruitful to place reliance on such measures as they will not be informative of managerial actions. This

suggests that services firms may place greater or less weight on cost-based measures to evaluate their

managers compared to manufacturing firms.

The preceding discussion leads to the fifth hypothesis (in alternate form):

H5: Firms in manufacturing industries place greater (less) weight on stock- versus earnings-based

performance measures to evaluate their managers, and greater (less) weight on cost-based performance

measures, compared to firms in services industries, ceteris paribus.

Finally, we examine how industry investment opportunities and risk influence the weights placed

on the performance measures in this study. When an industry has abundant investment opportunities,

managers have to engage in innovative actions that are complex and long-term in nature. These actions

are hard to observe by the firms. Based on the above reasoning, firms in such industries tie the managers’

pay more to stock- versus earnings-based measures (Smith and Watts, 1992; Baber et al., 1996).

9
In contrast to Engel et al., we compare manufacturing firms with the universe of service firms available in Compustat.
15
However, it is possible that in such industries failure by managers to adopt a short-term orientation would

result in prospective firms entering the industry attracted by these investment opportunities. This could

result in incumbent firms losing market share. Prior studies that predicted a positive weight on stock-

based measures when investment opportunities are greater failed to consider how (potential) rival firms in

the industry could react to a given firm’s actions. A short-term orientation also encourages firms to

market their innovations to customers quickly. Thus, firms may place less weight on stock- versus

earnings-based measures to evaluate their managers in industries with more investment opportunities

compared to those in industries with less investment opportunities.

As far as the weights placed on cost-based measures are concerned, when investment opportunities

in an industry are greater, firms may not be as cost conscious and may prefer their managers to invest in

costly innovative actions or projects. However, it is also possible that firms may become more cost

conscious with greater investment opportunities to be able to generate the best return on investment in

innovative activities. This suggests that firms in industries with greater investment opportunities may

place greater or less weight on cost-based measures to evaluate their managers compared to firms in

industries with less investment opportunities.

These arguments lead to the sixth hypothesis (in alternate form):

H6: Firms in industries with more investment opportunities place greater (less) weight on stock- versus

earnings-based performance measures to evaluate their managers, and greater (less) weight on cost-

based performance measures, compared to firms in industries with less investment opportunities, ceteris

paribus.

Greater industry uncertainty or risk, denoted by the volatility in earnings-, stock-, or cost-based

performance measures, may result in more or less weight placed on these measures. It results in less

weight on these measures if the measures are less precise with respect to managerial actions when

16
industry uncertainty/risk is greater (Feltham and Xie, 1994). It results in more weight placed on these

measures if the measures are informative, even if they are noisier, with respect to managerial actions

when industry uncertainty/risk is greater (Prendergast, 2002). They may be more informative when

industry uncertainty/risk is greater if managers are required to expend more effort and engage in actions to

cope with the uncertainty/risk.

While it is possible that firms prefer their managers to be more cost conscious when industry

uncertainty/risk is greater so as to be profitable or to survive, it is also conceivable that they may

encourage their managers to be less cost conscious so that the managers can engage in necessary actions,

even if they are costly, to cope with the uncertainty/risk in the industry.

This leads to the seventh hypothesis (in alternate form):

H7: Firms in industries with greater risk place greater (less) weight on stock- versus earnings-based

performance measures to evaluate their managers, and greater (less) weight on cost-based performance

measures, compared to firms in industries with less risk, ceteris paribus.

We also examine how the above industry attributes influence managerial pay in firms. Consistent

with the reasoning that higher value of managerial effort or marginal product of labor is positively related

to managerial pay, we predict that firms in more competitive industries, less regulated industries, services

industries, and industries with greater investment opportunities provide their managers with higher pay.

We predict that industry uncertainty/risk could either be positively or negatively related to managerial pay

based on theoretical models in the literature that predict that compensation risk (and hence the level of

expected compensation) may either increase or decrease with firm risk (e.g., Banker and Datar, 1989).

This leads to the eighth set of hypotheses (in alternate form):

17
H8a: Firms in more competitive industries provide their managers with higher pay compared to

managers in firms in less competitive industries.

H8b: Firms in less regulated industries provide their managers with higher pay compared to managers in

firms in more regulated industries.

H8c: Firms in services industries provide their managers with higher pay compared to managers in firms

in manufacturing industries.

H8d: Firms in industries with greater investment opportunities provide their managers with higher pay

compared to managers in firms in industries with less investment opportunities.

H8e: Firms in industries with greater (less) uncertainty/risk provide their managers with higher pay

compared to managers in firms in industries with less (greater) uncertainty/risk.

The next section outlines the sample selection procedure and the measures we use in our tests.

3. Sample Selection and Measures Used

Sample

Our sample consists of 7,321 firm-years arising from 1,296 companies across 200 industries as

determined using the four-digit Standard Industrial Classification (SIC) code level for the period 1992 to

2003.10 To be included in the sample, data for a firm must be complete across the Segments, Annual

Industrial, and Execucomp databases in Compustat, and CRSP. Further, a firm must have identical four-

digit Standard Industrial Classification (SIC) Codes across all the databases for observations to be

10
Our sample period ends in the year 2003 for the main analysis due to availability of industrial segment data in Compustat. In
a later section, we include observations from 1992 to 2005 for additional tests using an alternative dataset to the segments data.
18
included in the final sample. For managerial data, we collect data on the CEO of each firm. All dollar

items are CPI-adjusted to year-2005 dollars to adjust for the effects of inflation.

Measures

Below we describe the measures we use in our study. The detailed computations for these

variables are provided in the appendix. Descriptive statistics for these variables are provided in table 1.

Managerial compensation

Using the Execucomp database, we collect data on a CEO’s salary and bonus and other annual

compensation (collectively called short-term compensation), as well as data on the values of stock option

grants, long-term incentive payouts, restricted stock grants and all other compensation (collectively called

long-term compensation). Following prior studies on executive compensation (e.g., Engel et al. 2002),

we include two versions of the compensation measure in our analyses. First, we take the sum of all

compensation data items as the compensation measure (denoted total compensation and labeled

TOTCOMP). Second, we take the sum of salary and bonus (denoted cash compensation and labeled SB).

Similar to prior studies (Clinch, 1991; Core et al., 1999; Engel et al., 2002), we use the level of

compensation as the dependent variable in our study.

Performance

For the earnings performance measure, we use the return on average assets. The return on average

assets is defined as earnings before extraordinary items divided by the average book value of total assets.

We label the earnings performance variable ROA.

Annual firm stock return is the stock-based performance measure in our study. We label this

measure RET. These two measures have been used to denote earnings- and stock-based performance,

respectively, in prior compensation research (e.g., Engel et al., 2002).

19
 For our cost-based performance measure, we use cost of goods sold. Since this measure is skewed

to the right, we log transform this variable and label it COGS. We obtain the data used to construct our

performance measures from the Annual Industrial database in Compustat and CRSP.

Competition

As discussed in sections 1 and 2 and similar to Karuna (2007), we focus on three determinants of

competition for a given level of concentration: product substitutability, market size, and entry costs. Each

of these determinants will be discussed next.

Product substitutability

Prior studies in the Industrial Organizations literature use the price-cost margin as a measure of

product substitutability. In these studies, the price-cost margin is defined as the negative reciprocal of the

price elasticity of demand (e.g., Carlton and Perloff 1994; Demsetz

1997; Besanko et al. 2000; Nevo 2001). In turn, the price elasticity of demand has a positive relation with

the extent of product substitutability (hereafter “substitutability”). This suggests that the price-cost

margin may be a suitable measure of substitutability, with low (high) levels of the price-cost margin

signifying high (low) levels of substitutability. This prediction mirrors economic intuition that the closer

to (further away from) perfect competition an industry is, the more (less) price approximates marginal

cost. Hence, higher substitutability creates greater price competition and a lower price-cost margin.

Consistent with prior studies (e.g., Domowitz, Hubbard, and Peterson 1986; Carlton and Perloff 1994;

Besanko et al. 2000; Nevo 2001; Karuna, 2007), we calculate the price-cost margin as total industry sales

divided by operating costs, all identified at the four-digit Standard Industrial Classification Code (SIC)

level. To obtain a positive association between this measure and the substitutability construct, we use the

negative value of the price-cost margin as the measure of substitutability in this study. Our measure for

substitutability is labeled SUB.

20
 In this study, price competition captures the idea that, for any given market structure and set of

long-run industry variables, the price-cost margin depends on firms’ pricing strategies, which in turn

depend on exogenous factors related to product substitutability.

Market size

Market size reflects the demand for a product in an industry. Similar to Karuna (2007), we

measure an industry’s market size by primary industry sales at the four-digit SIC code level. Larger

industry sales denote larger market size. This reflects the fact that when market demand for a product

increases at any given price, sales of that product increase proportionally, which leads to firms entering

the market and greater price competition (Sutton, 1991). For the industries in this study, market size is

highly skewed to the right. Hence, we use the log-transformed variable (labeled MKTSIZE) in

subsequent statistical analyses.

Entry costs

In this study, we define entry costs as the minimal level of investment (exogenous sunk cost) that

must be incurred by each entrant firm prior to commencing production (i.e., set-up costs). Like Karuna

(2007), we capture this level of investment by computing the weighted average gross value of the cost of

property, plant and equipment for firms for which this is the primary industry (at the four-digit SIC code

level), weighted by each firm’s market share in this industry. We compute market share by dividing the

segment sales figure for the primary industrial segment of a firm by the sum of the segment sales of all

firms that have this particular industry as their primary industry. The entry costs measure is highly

skewed; its natural log transformation is not. Therefore, we use the log-transformed entry costs measure

(labeled ENTCOST) in subsequent statistical analyses.

We collect data to compute SUB, MKTSIZE, and ENTCOST from the segments and annual

industrial databases in Compustat. Next we describe four other industry-level variables used in our study,

21
namely, regulation, manufacturing versus services orientation, investment opportunities and

uncertainty/risk.

Industry regulation

We include an indicator variable, REG, that is equal to one if the industry to which the firm

belongs to is more regulated, and zero otherwise. Similar to Smith and Watts (1992) we denote an

industry as being more regulated if it belongs to the banking (four-digit SIC code range of 6000 to 6099),

insurance (6300 to 6399), or utilities industry (4900 to 4999).

Manufacturing versus services industries

We include an indicator variable, MANUF, that is equal to one if the industry to which the firm

belongs lies within the manufacturing industrial sector with a four-digit SIC code between 2000 and 3999

inclusive, and zero otherwise. Thus we label non-manufacturing industries as belonging to the services

sector.

Industry investment opportunities

Similar to prior research (e.g., Smith and Watts, 1992), we compute the investment opportunities

in an industry by dividing industry-aggregated (at the four-digit SIC code level) values of the market

value of equity by industry-aggregated values of the book value of equity. We label our industry

investment opportunities variable INDMTB.

Industry uncertainty/risk

We compute three variables for our industry uncertainty/risk measure. One variable is the

volatility in ROA (labeled INDVOLROA), measured as the standard deviation of ROA for each firm

across our sample period and aggregated at the industry level at the four-digit SIC code level. The other

22
variable is the volatility in stock returns (labeled INDVOLRTN), measured as the standard deviation of

monthly stock returns obtained from the monthly stock files in CRSP and computed for each year. This

variable is then aggregated at the industry level at the four-digit SIC code level. Our last variable is the

volatility in cost of goods sold (labeled INDVOLCOGS) and is measured as the industry aggregate of

COGS at the four-digit SIC code level.

Control variables

To measure the level of industry concentration, we use the four-firm concentration ratio for an

industry at the four-digit SIC code level.11 This ratio measures the proportion of sales in an industry

accounted for by the four largest firms (by sales) in the industry. We label this measure CONC. 12

We also include other control variables using data from the Compustat Industrial and CRSP

databases. One control variable is firm size. Prior research has shown that firm size affects incentive

compensation (e.g., Himmelberg and Hubbard 2000; Jin 2002). We measure firm size by total firm

assets. However, as this measure is skewed, we use its natural log transformation. We label this variable

ASSETS.

A second control variable is CEO tenure. Dechow and Sloan (1991) and Gibbons and Murphy

(1992) show that a manager’s tenure in a firm affects the type of incentive provided to her. In the current

study, TENURE is the natural log of CEO tenure. CEO tenure is the number of years the executive has

held the CEO position up to the current fiscal year and is measured as the difference between the CEO’s

beginning year and the current fiscal year. Tenure is adjusted whenever a CEO commences duties in any

month other than the beginning month of her commencement fiscal year.

Another variable is VOLAT, the standard deviation of monthly firm stock returns for the year for

each firm. This measure is a proxy for both risk due to fluctuations in stock returns and monitoring

difficulty (Core and Guay, 1999). To determine VOLAT, we first collect stock returns from the monthly

11
Aggarwal and Samwick (1999) and DeFond and Park (1999) show that industry concentration affects managerial incentives.
12
Our overall results are unchanged when we use the Herfindahl-Hirschman index instead of the concentration ratio.
23
stock files in CRSP, and then calculate the annual standard deviations of these returns. MKRET, the

returns on the S&P 500 market index, is included to control for the stock market having an effect on

compensation.

We also control for growth opportunities in the firm having an influence on managerial pay. Prior

research has shown that growth opportunities in a firm result in stronger stock-based incentives (e.g.,

Smith and Watts 1992; Gaver and Gaver 1993). It has been shown to affect the level of pay (e.g., Engel

et al., 2002). In the current study, MTB is the log market-to-book ratio and is a proxy for growth

opportunities in a firm. The market-to-book ratio is calculated as the market value of equity divided by

the book value of equity. R&D, another proxy for growth opportunities, stands for the log research and

development intensity and is calculated as the natural log of annual research and development expenditure

divided by sales. Finally, similar to prior studies (e.g., Core and Guay, 1999; Engel et al., 2002), we

control for the level of managerial stock and options ownership as they could also provide managers with

incentives and because they may affect firms’ decisions to provide managerial incentives. Specifically,

we include lagged log values of stock (labeled STKHOLD) and options (labeled OPTHOLD) held by the

CEO as control variables.

Correlation matrix

Table 2 presents the Pearson correlation matrix for the independent variables of interest used in

the regression analyses in this study. The correlations show no particularly high correlations among

variables, except that between INDMTB and MTB and between INDVOLRTN and VOLAT, which are

expected, as they arise from correlations between variables being computed at the firm and industry

levels. The next section outlines the methodology we employ in the analysis.

24
4. Methodology

In our study, where the dependent variable is the level of compensation, we conduct robust

regressions for our analysis. Apart from computing robust standard errors, the robust regression weights

observations in proportion to their proximity to the mean value of the dependent variable and therefore

minimizes the impact of outliers on the results. In a separate analysis (results not reported), we also

conduct median regressions, which yield results similar to the robust regressions.13 We use the regression

specification in Clinch (1991), where the level of compensation is the dependent variable, and the level of

performance measures and the interactions between these performance measures and the independent

variables of interest are included in the regressions in addition to other control variables.14

We conduct the analysis at the firm level to account for inter-firm differences that could affect

incentives and to control for differences in the industry mix of sample firms over time (Bushman, Engel,

and Smith 2003).15 As revealed by variance inflation factors that exceed standard cutoffs in standard

collinearity diagnostics, we find that our regressions suffer from problems due to multicollinearity due to

the many interaction terms between the performance measures and the industry-level variables we include

in our regressions. We also find that including the cost-based performance measure and its interaction

with other variables also contribute to these multicollinearity problems. Therefore, we center the

industry-level variables and the cost-based performance measure by subtracting their means from their

original values before running our regressions (Aiken and West, 1991). This procedure resolves the

multicollinearity problems and we proceed with our analysis using these transformed variables.

We employ the following regression model to test the first three hypotheses for our study:

13
Median regressions minimize the sum of absolute deviations rather than sum of squared deviations (as in OLS) and are
therefore less sensitive to outliers than are the OLS regressions (Koenker and Bassett, 1982).
14
Core et al. (1999) also use the raw level of total and cash compensation as the dependent variables.
15
Consistent with prior empirical compensation research, we pool observations across firms and time, thus assuming that the
performance measures are identical across firms and time (e.g., Core, Holthausen, and Larcker 1999; Bushman et al. 2003).
When there is a change in CEO in a particular year, we include data for the incoming CEO in my analysis for that year and
exclude data for the outgoing CEO.
25
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5SUB + β6MKTSIZE + β7ENTCOST +

β8CONC + β9TENURE + β10VOLAT + β11MTB + β12MKRET + β13R&D + β14STKHOLD +

β15OPTHOLD + β16SUB*ROA + β17SUB*RET + β18MKTSIZE*ROA + β19MKTSIZE*RET +

β20ENTCOST*ROA + β21ENTCOST*RET + β22CONC*ROA + β23CONC*RET + β24SUB*COGS +

β25MKTSIZE*COGS + β26ENTCOST*COGS + β27CONC*COGS + YEAR INDICATOR + ε

(equation 1)

The definitions for the above variables are given in the appendix. Our first prediction is based on

the relation between product substitutability in the industry and the weights placed on the three

performance measures we examine to determine managerial compensation. To test this, we examine the

coefficients, β16, β17, and β24, on the interaction between SUB and ROA, between SUB and RET, and

between SUB and COGS, respectively. These coefficients show how product substitutability affects pay-

earnings, pay-stock return, and pay-cost performance sensitivities, respectively. Our second prediction is

based on the relation between market size in the industry and the weights placed on the three measures to

determine compensation. To test this, we examine the coefficients, β18, β19, and β25, on the interaction

between MKTSIZE and ROA, between MKTSIZE and RET, and between MKTSIZE and COGS,

respectively. The third prediction is based on the relation between entry costs and the measures and is

tested by observing β20, β21, and β26, which denote the relation between ENTCOST and the pay-ROA,

pay-RET, and pay-COGS sensitivities, respectively. Finally, we examine β5, β6, and β7 to test H8a.

As indicated above, we include several control variables in the regression. We also include year

indicator variables in the regressions to control for year effects but don’t report them in the tables for

brevity.

To test our fourth, fifth, and sixth sets of hypotheses separately, we run the following regression:

COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5INDUSTRY VARIABLE + β6TENURE

+ β7VOLAT + β8MTB + β9MKRET + β10R&D + β11STKHOLD + β12OPTHOLD + β13INDUSTRY

26
VARIABLE*ROA + β14 INDUSTRY VARIABLE *RET + β15 INDUSTRY VARIABLE *COGS +

YEAR INDICATOR + ε

In the above regression, we examine β13, β14, and β15 to determine how the industry variable (REG,

MANUF, or INDMTB) influences the weights placed on ROA, RET, and COGS, respectively. We also

examine β5 to test H8b, H8c, and H8d for REG, MANUF, and INDMTB, respectively.

Finally, our regression model to test our seventh hypothesis is as follows:

COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5INDVOLATROA + β6INDVOLATRTN

+ β7INDVOLCOGS + β8TENURE + β9VOLAT + β10MTB + β11MKRET + β12R&D + β13STKHOLD +

β14OPTHOLD + β15INDVOLROA*ROA + β16INDVOLROA*RET + β17INDVOLRTN*ROA +

β18INDVOLRTN*RET + β19INDVOLCOGS*ROA + β20INDVOLCOGS*RET + β21INDVOLROA

*COGS + β22INDVOLRTN *COGS + β23INDVOLCOGS*COGS + YEAR INDICATOR + ε

We examine β15, β16, and β21 to determine how INDVOLROA affects the sensitivity of managerial

compensation to ROA, RET, and COGS, respectively. We examine β17, β18, and β22 to determine how

INDVOLRTN affects the sensitivity of managerial compensation to ROA, RET, and COGS, respectively.

We also examine β19, β20, and β23 to determine how INDVOLCOGS affects the sensitivity of managerial

compensation to ROA, RET, and COGS, respectively. Finally, we examine β5, β6, and β7 to test H8e.

The next section presents and discusses the results of the tests we conduct in this section.

5. Results

The results for tests of the first three hypotheses are provided in table 3. Columns I and IV

provide results for regressions where the level of total compensation and the level of cash compensation

27
are the dependent variables, respectively, without including the industry variables. The coefficients for

the independent variables are consistent with those documented in prior research. The coefficient for

RET is negative where the level of total compensation is the dependent variable. This is not uncommon

as seen in prior studies where the level of managerial compensation is the dependent variable (e.g., Engel

et al., 2002). Introducing the industry variables in columns II and V, we observe that competition

generally has a positive relation with the level of pay. We do not include COGS and its interactions with

the industry variables in columns II and IV but include them in columns III and VI to determine the effect

of including COGS on the magnitudes, signs, and significance of the coefficients on ROA, RET, and their

interactions with the industry variables.16 Our results indicate that competition (via product

substitutability, market size, and entry costs) generally has a negative weight placed on ROA and a

positive weight placed on RET to determine compensation. These findings suggest that firms in more

competitive industries pay their managers more, generally place a negative weight on earnings-based

performance measures, and place a heavier weight on stock-based performance measures compared to

earnings-based measures to evaluate their managers than firms in less competitive industries.

Interestingly, we also find that COGS has a positive relation with the level of managerial pay

when cash compensation is the dependent variable, and firms in more competitive industries place a

heavier weight on COGS in determining managerial pay compared to firms in less competitive industries.

While the positive coefficient on COGS may be contrary to the direction we expect if we regard COGS as

a performance measure used to evaluate managers, this positive relation may be indicative of the higher

marginal product of labor associated with firms that have higher costs.17 The positive coefficient on the

interaction between competition and COGS could be due to the greater importance of minimizing costs

when price competition is more intense. These results provide important evidence that cost-based

performance measures play an important role in determining executive compensation and performance

16
We do the same for tests of the other hypotheses given below.
17
It is arguable that COGS can be regarded as a size proxy. However, we control for firm size in our regressions, and so COGS
is more likely a performance variable.
28
evaluation. Finally, we find that several coefficients change magnitude and some even become significant

when COGS and its interactions with the industry variables are introduced in columns III and VI (e.g.

interactions between CONC and both ROA and RET). This provides additional evidence that COGS may

have been an important correlated omitted variable as a managerial performance measure in prior

empirical compensation studies.

Table 4 provides results for tests of the fourth set of hypotheses. We find that greater industry

regulation is associated with lower managerial pay and stronger sensitivity of managerial pay to ROA and

RET but weaker sensitivity to COGS. Again, we note that the magnitudes of several coefficients change

in magnitude (e.g., the coefficients on the interactions between REG and both ROA and RET generally

become weaker) when COGS is introduced in the regressions in columns II and IV, indicating the

importance of COGS as an explanatory variable in empirical compensation studies.

In tables 5 and 6, we provide results for tests of the fifth and sixth hypotheses, respectively. The

results indicate that firms in the manufacturing industrial sector and those in industries with greater

investment opportunities pay their managers more; there is weak evidence of heavier reliance on earnings-

, strong evidence of heavier reliance on cost-based measures, and less reliance on stock-based measures

compared to firms in the services industrial sector and firms in industries with less investment

opportunities, respectively.

Finally, in table 7, tests of the seventh hypothesis reveal that when volatility of ROA in the

industry is the uncertainty/risk proxy, there is evidence that uncertainty/risk is positively related to

managerial pay, weak evidence of a positive weight on earnings-based measures, strong evidence of a

negative weight on stock-based measures, and insignificant weight on cost-based measures to determine

managerial pay when industry uncertainty/risk is greater.

When volatility of monthly stock returns in the industry is the uncertainty/risk proxy,

uncertainty/risk again has a positive relation with managerial compensation. Using this uncertainty/risk

measure, we find that greater industry uncertainty/risk is generally associated with less reliance on ROA

29
and RET to determine managerial compensation. However, there is mixed evidence with respect to the

weight on COGS to determine compensation. When total compensation is the dependent variable, the

weight is positive whereas it is negative when cash compensation is the dependent variable.

When volatility of COGS in the industry is the uncertainty/risk proxy, there is further evidence

that industry uncertainty/risk is positively related to managerial pay. Furthermore, there is weak evidence

that the weight on ROA is negative, strong evidence that the weight on RET is negative, and weak

evidence that the weight on COGS is negative. Overall, the results of tests of the seventh hypothesis

suggest that the relation between industry uncertainty/risk and the weights on the measures is sensitive to

the uncertainty/risk proxy used. However, we find strong evidence that industry uncertainty/risk

generally has a positive relation with managerial pay, and the weight placed on RET to determine

managerial compensation is positive irrespective of the uncertainty/risk proxy used.

In tables 5, 6, and 7, we again find that the coefficients for some variables change in magnitude

and/or significance when COGS is introduced in the regression. Therefore, overall, we find robust

evidence confirming the importance of COGS as an explanatory variable in determining managerial

compensation.

A concern with the above analyses is that there may be a simultaneous relation between the

industry-level variables and the level of compensation or pay-performance sensitivity; in particular, the

industry variable may be a function of the choice of incentive compensation. However, this study uses

yearly-adjusted measures of compensation and incentives, whereas industry factors like market entry/exit

decisions resulting in changes in the nature of competition are more long-term decisions. Further, this

study uses firm-level data, which likely would not have a major effect on industry-level factors.

Additional Tests

Random effects regression

30
 Since the sample comprises three levels of observations - industry, firm, and firm-over-time, and

the analysis involves variables measured at more than one level (Bryk and Raudenbush 1992; Singer

1998), we employ a hierarchical linear model (or multi-level model) to test our regressions more robustly.

In our sample, firms nested within industries are considered lower in the hierarchy than industries; in turn,

firm observations over time are considered lower in the hierarchy relative to firms. The multi-level model

treats industry as a cluster of firms related through similar production and investment characteristics.

Hence, it allows for the fact that firms within an industry are connected in ways that firms across

industries are not (Swamy 1970; Hsiao 1986). It also allows for an extra layer of clustering at the firm

level. This permits observations for a particular firm to be correlated over time.

Another characteristic of the random coefficients model is that the intercept can vary across

industries.18 This feature captures industry random effects and allows different compensation levels

across industries. The random-effects approach accounts for both within-industry and across-industry

variation in the data. In contrast, the fixed-effects approach, where either industry or firm is treated as a

fixed effect, accounts for only within-industry or within-firm variation. As our sample comprises panel

data with variation in all measures over time, a random-effects regression can control for unobserved

industry effects that may be constant over time but vary across industries (Wooldridge, 2002, page 169).

Failing to control for such effects could create heterogeneity bias in the pooled least-squares estimates

(Hsiao, 1986).

The results for our tests using the random coefficients model (not reported for brevity) reveal that

our overall findings generally remain. Thus our findings are generally robust to controlling for several

layers of correlation in our data and for industry unobserved effects.

18
In a separate analysis (not reported), when we allow the slopes of certain CEO- and firm-level independent variables to vary
across industries, overall findings are not affected. The PROC MIXED procedure in the SAS statistical software package
provides this flexibility (Singer 1998).
31
Alternative dataset - Economic Census Sample

One potential criticism of the Compustat sample is that it does not comprise the universe of firms

within a particular industry nor does it cover all the industries in the economy. As in Karuna (2007), to

explore whether the results are affected by potential limitations of the Compustat sample, we construct

another sample using industry-level data collected from the Census of Manufactures report in the 1992

Economic Census (at the four-digit SIC code level).19 This census provides comprehensive narrowly-

defined industry data at the plant level for the manufacturing sector (two-digit SIC codes ranging from 20

to 39) for considerably more firms per industry compared to Compustat.20 Hence, a limitation of this

sample is that it is restricted to firms in the manufacturing industrial sector only.

When we conduct regressions based on this sample to test our first three, sixth, and seventh

hypotheses (results not reported in the tables for brevity), we find that our findings generally remain.

Thus the results are robust to conducting the analysis including many more firms in an industry.

Discussion of results

We find mixed evidence with respect to the weights placed on the three performance measures we

examine in our study, thus extending prior studies and making several contributions to the literature.

First, our study is the first to show that firms in more competitive industries place less weight on earnings-

based measures, greater weight on stock- relative to earnings-based measures, and greater weight on cost-

based measures. Here, we also show the importance of considering cost-based measures in compensation

studies in addition to stock- and earnings-based measures. Thus, we make an incremental contribution to

Krishnan (2005) by showing that in addition to her finding of an increased demand for accounting

information when price competition is higher, there is also greater reliance on cost- but less reliance on

earnings-based measures for stewardship purposes when such competition is higher.

19
The 1992 Economic Census data is obtained from the U.S. Census Bureau’s website at
http://www.census.gov/epcd/www/92result.html
20
The reader is referred to Karuna (2007) for a complete description of this dataset.
32
 Focusing on one industry, Kole and Lehn (1997) show that deregulation leads to a higher level of

stock-based compensation and an insignificant effect on cash compensation. Smith and Watts (1992) find

that regulated industries have lower managerial salary and less use of both stock- and bonus-based

incentive plans. These studies don’t directly examine how pay varies with performance based on industry

regulation. Similar to these studies, we find that firms in more regulated industries provide lower

managerial pay. However, unlike Kole and Lehn, we find that this result is robust to both total

compensation and cash compensation. Thus we show that this result is generalizeable to a broad range of

industries. We also provide direct evidence on how industry regulation affects pay-performance

sensitivities. Thus, we make an incremental contribution to these prior studies by showing that firms in

more regulated industries place heavier reliance on both ROA and RET (in contrast to Smith and Watts)

in determining total and cash compensation whereas they place less reliance on cost-based measures.

Although Engel et al. (2002) don’t compare the manufacturing versus services industrial sectors,

they generally find that firms in the manufacturing sector are insignificantly related to both cash and total

compensation but positively related to stock-based compensation. They also find weak evidence of a

positive weight on ROA in determining compensation grants in the manufacturing sector and weak

evidence of a positive weight on stock returns for internet firms. Based on a direct and broad comparison

between firms in the manufacturing versus services industrial sectors, we find that firms in the

manufacturing sector pay higher total and cash compensation. Similar to Engel et al., we find weak

evidence that the weight on ROA is greater in manufacturing firms. However, we also find weak

evidence that the weight on RET is less, and strong evidence that the weight on COGS is greater, in

manufacturing industries compared to services industries. Thus, we make an incremental contribution to

the literature by providing more comprehensive evidence on how firms in manufacturing versus services

industries differ in the level of pay and the structure of incentives across different performance measures.

Similar to prior studies, we find a positive relation between investment opportunities and the level

of managerial pay (e.g., Core et al., 1999. Engel et al., 2002). The negative weight on RET when industry

33
investment opportunities are greater contrasts with the positive weight documented in prior studies (e.g.,

Smith and Watts, 1992; Baber et al., 1996). Furthermore, while Baber et al. (1996) find an insignificant

relation between investment opportunities and the weight placed on earnings-based measures to determine

compensation, we find weak evidence of a positive relation. A potential reason for these differences is

that some studies compute investment opportunities at the firm level (e.g., Baber et al., 1996) whereas

others conduct the analysis at the industry level (e.g., Smith and Watts, 1992).21 In contrast, we examine

how investment opportunities at the industry level affect incentive compensation at the firm level. It is

possible that industry-level investment opportunities could affect the weight placed on firm-level stock

returns in a different way.22 Another reason could be due to our more recent sample period.23

Core et al. (1999) find a negative relation between firm risk and the level of pay when the standard

deviation of ROA is the risk proxy and an insignificant but negative relation when the standard deviation

of stock returns is the risk proxy. In contrast, we find that although the volatility of stock returns at the

firm level has a positive relation with the level of total compensation and a negative relation with cash

compensation, risk at the industry level positively related to firm-level both total and cash compensation

irrespective of the industry risk proxy used. This positive relation is consistent with the positive relation

between stock return volatility and managerial pay documented by Cyert et al. (1997). Thus, our study

sheds some light on this mixed empirical evidence in the literature and on the mixed predictions

postulated by theoretical models (e.g., Banker and Datar, 1989). Another difference between Core et al.’s

findings and ours is that they find a negative relation between CEO stock ownership and managerial pay

whereas we generally find that CEO stock and options ownership are positively related to total

compensation and negatively related to cash compensation.

In the next section, we discuss and rule out alternative explanations for this study’s findings.

21
Smith and Watts suggest that a firm-level analysis may yield more powerful tests of their hypotheses.
22
Baber et al. (1996) find weak evidence of a positive weight on stock returns and insignificant weight on earnings-based
measures when investment opportunities are greater.
23
Smith and Watts (1992) use the 1965 to 1985 sample period and Baber et al. (1996) use only two years of data.
34
6. Alternative explanation for findings

Two potential alternative explanations that may account for this study’s findings are discussed next.

CEO power hypothesis

It is conceivable that managers with higher talent (e.g., those in more competitive industries) have

greater bargaining power with their boards of directors and, consequently, can influence their own pay

(Hermalin and Weisbach 1998). These CEOs may negotiate for more stock- relative to earnings-based

performance measures for two reasons. First, stock measures enable them to receive higher compensation

payouts when they perform well (Jensen and Murphy 1990; Hubbard and Palia 1995). Second, the risk

associated with stock measures may signal higher CEO ability to the market.

The preceding discussion suggests that CEO power, and potentially rent extraction, may provide

an alternative explanation to this study’s theoretical reasoning, which is based on optimal contracting.

However, this alternative explanation of the results can be ruled out for several reasons. First, we include

CEO tenure and lagged stock and options managerial holdings in our regressions, which are suitable

proxies for CEO entrenchment in the firm and the associated power over pay decisions.24 Second, CEO

power may arise from the CEO being the chairman of the board of directors. In a separate analysis

(results not reported), we control for this by including in the above regressions a dummy variable that

takes on a value of one when the CEO is also a chairman of the board and zero otherwise. Including this

variable does not change this study’s findings. Finally, according to Indjejikian and Cheng (2005), CEOs

with greater power may negotiate for greater emphasis on ROA as these CEOs better understand how

their actions affect earnings. Similarly, Ittner et al. (1997) find that when CEOs have greater power, firms

substitute toward financial measures in evaluating the CEOs. However, these findings are contrary to the

results in our study, which finds greater emphasis on RET compared to ROA in the presence of greater

competition.

24
Our findings are unaffected by including CEO age, another entrenchment proxy, in our regressions.
35
Relative noise in performance measures

Another potential alternative explanation for this study’s findings on how competition affects the

weights placed on stock- versus earnings-based performance measures is that competition may influence

the relative noise in these measures. As discussed above, the agency literature in accounting has shown

that when a particular performance measure is noisier relative to another performance measure, less of the

former measure should be used relative to the latter measure (e.g., Feltham and Xie 1994).

Competition may influence the relative noise in stock- and earnings-based measures through

relative performance evaluation. Greater competition leads to increased similarity among firms in the

industry based on common industry characteristics. Since firms in a particular industry face common

industry uncertainty that affects their stock prices, when there is greater similarity across firms in the

industry, this common industry uncertainty will likely be reduced or eliminated (Holmstrom 1982;

Parrino 1997). The stock performance of any rival firm in an industry provides additional information to

a given firm about its rival firm’s investors’ expectations about the rival firm’s future earnings/cash flows

that are also affected by common industry uncertainty. When there is greater similarity across firms in an

industry based on industry characteristics, the firms observe a more precise estimate of this common

uncertainty by inferring it from the independent signals about this uncertainty provided by the stock prices

of the other firms in the industry. In contrast, there is less uncertainty with respect to how current

earnings affect managerial actions as they are backward-looking in nature.

The preceding discussion suggests that less noise in stock- relative to earnings-based measures

may lead to firms in more competitive industries placing a heavier emphasis on stock measures relative to

earnings measures, compared to firms in less competitive industries. To rule out this potential

explanation for our findings, we attempt to control for the relative noise in the measures by including

some measure of the variability of these measures in the regressions. To control for potential effects of

the variability in these measures across firms and industries, we rerun the random coefficients regressions

36
discussed above, allowing the coefficients for ROA and RET to vary first across firms and then across

industries. This controls for the relative noise in the measures across firms, and also for the possibility

that industry factors like competition may influence the relative noise in the measures. This study’s

findings are generally not affected by these additional tests.25 In the next section, we conduct additional

robustness checks for the results.

7. Additional robustness checks

The overall results in this study do not change when we use the return on average equity instead of

ROA, or when we replace ASSETS with log sales or log market value of equity as proxies for size in the

regressions. Finally, although the standard errors for the regression coefficients are higher, the results

generally remain when we replace the level of managerial compensation with the first difference in

compensation as the dependent variable while including the first difference in ROA as the earnings

performance variable as in some prior studies (e.g., Sloan, 1993).

8. Conclusion

In this paper, we empirically examine the effect of several key industry factors on managerial pay

and firms’ use of three performance measures to evaluate their managers, namely stock-, earnings, and

cost-based measures. The results show that these industry factors play a crucial role in determining the

level of pay and the weights firms place on these measures. While these findings are intriguing, there are

two potential limitations to our study. First, we rely on Standard and Poor’s primary industrial segment

classification to assign firms to industries. However, the primary industry for a firm could change during

the sample period in our study. Further, it is not clear whether conglomerates provide their managers with

incentives based on the primary segment. A second potential limitation is that the use of the price-cost

margin variable assumes a one-to-one correspondence between the four-digit SIC codes and the product

25
The findings also remain when we include the ratio of the standard deviations of ROA and RET to control for exogenous
noise in these measures, as in prior research (e.g., Lambert and Larcker 1987; Ittner et al. 1997).
37
markets. However, this correspondence is not perfect, as some industries may include several products

that are not close substitutes. This aggregation tends to overstate the true substitutability for a firm’s

product. Further, some products may be in different four-digit SIC codes and yet may be close substitutes

of each other. This disaggregation tends to understate the true substitutability for a firm’s product.

However, since aggregation and disaggregation are unlikely to be systematically different across

industries, it is unlikely they would bias the empirical results in our study.

Overall, this study contributes to the accounting literature by empirically documenting the

importance of industry attributes in influencing incentive compensation. In addition, it sheds light on the

heterogeneity in the use of stock- versus earnings-based measures across firms by showing that industry

play a vital role in determining the weights placed on these measures across firms. Finally, this study also

shows the importance of including cost-based performance measures in empirical compensation studies in

addition to stock- and earnings-based measures. An extension to this study would be to examine whether

changes in the nature of these industry attributes over time affect the relative use of these measures. For

example, increases in the intensity of industry competition, the prevalence of services firms, and

deregulation in several industries may provide an explanation for the general increase in firms’ use of

stock- relative to earnings-based, and possibly indicate a trend in cost-based, managerial performance

evaluation measures over time.

38
Appendix – Definitions and computations of variables

Definitions of variables: Method of computation

COMPEN total compensation (TOTCOMP) or total compensation or cash compensation; total

log cash compensation (SB)
compensation = salary + bonus + other annual
compensation + value of stock option grants +
value of restricted stock grants + long-term
incentive payouts + other total compensation;
cash compensation = salary + bonus

ASSETS log total assets natural log of total assets

ROA return on assets earnings before extraordinary items divided by

the average book value of total assets

RET stock returns as defined

COGS Log cost of goods sold natural log of cost of goods sold

SUB extent of product substitutability in sales / operating costs, for each industrial
industry segment; operating costs include cost of goods
sold, selling, general, and administrative
(at 4-digit SIC code level)
expense, and depreciation, depletion, and
amortization

MKTSIZE level of market size in industry natural log of industry sales (industry sales is
computed as the sum of segment sales for
(at 4-digit SIC code level)
firms operating in the industry)

ENTCOST level of entry costs natural log of weighted average of gross value
of cost of property, plant and equipment for
(at 4-digit SIC code level)
firms in industry, weighted by each firm’s
market share in industry

CONC level of industry concentration proportion of industry sales accounted for by

four largest firms (by sales) in industry
(at 4-digit SIC code level)

REG industry regulation indicator variable = 1 if the industry is more

regulated; = 0 if the industry is less regulated

MANUF manufacturing or services indicator variable = 1for manufacturing; = 0

for services

INDMTB industry investment opportunities average value for log market-to-book ratio (for
computation see below under MTB)
(at 4-digit SIC code level)
aggregated at the industry level

INDVOLROA industry uncertainty/risk standard deviation of ROA over sample period

and aggregated at industry level
(at 4-digit SIC code level)

39
INDVOLRTN industry uncertainty/risk standard deviation of monthly stock returns
and aggregated at industry level
(at 4-digit SIC code level)

INDVOLCOGS Industry uncertainty/risk standard deviation of cost of goods sold and

aggregated at industry level
(at 4-digit SIC code level)
natural log of number of years CEO held that
TENURE log CEO tenure
position continuously; number of years is
calculated as the difference between the
current year and the year in the 'date became
CEO' field.

VOLAT volatility of stock returns standard deviation of monthly company stock

returns

MTB log market-to-book ratio natural log of [{number of outstanding

shares*market price at end of fiscal year}
/ {total assets - total liabilities}]

MKRET market returns return on the S&P 500 index

R&D log R & D intensity natural log of (R & D expenditure / sales);

R&D/sales set to zero when values are missing

40
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44
 Table 1--Descriptive Statistics
Descriptive Statistics on firm and industry variables for a sample of 7,321 firm-year observations. The data items are extracted from Compustat, Execucomp,
and CRSP for years 1992 to 2003. The data items are taken for CEOs only (as defined as such by Execucomp and also if the person is the CEO based on
start and end dates provided by Execucomp). All dollar values are converted to 2005 dollars. See Appendix for definitions and computations of variables.
Mean Median Min Q1 Q3 Max
Total compensation ($000s) 5,633.92 2,653.62 101.07 1,428.81 5,427.83 682,212.91
Cash compensation ($000s) 1,305.30 955.72 0.00 581.30 1,578.95 21,880.40
Log total assets (ASSETS) 7.23 7.04 1.73 6.02 8.33 13.40
Return on assets (ROA) 0.02 0.04 -5.80 0.01 0.08 0.58
Stock return (RET) 0.02 0.01 -0.23 -0.01 0.04 0.83
Log cost of goods sold (COGS) 6.48 6.45 -3.02 5.29 7.75 12.10
Extent of industry product substitutability (SUB) -1.33 -1.16 -0.52 -1.08 -1.32 -31.16
Log industry market size (MKTSIZE) 10.69 10.77 3.37 9.57 12.00 14.70
Log entry cost in industry (ENTCOST) 7.72 7.74 -7.93 6.60 9.10 11.50
Industry concentration (CONC) 0.63 0.61 0.15 0.44 0.79 1.00
Extent of industry regulation (REG) 0.10 0.00 0.00 0.00 0.00 1.00
Manufacturing or services industry (MANUF) 0.49 0.00 0.00 0.00 1.00 1.00
Monopolistic or non-monopolistic industry (MONOP) 0.02 0.00 0.00 0.00 0.00 1.00
Industry log market-to-book ratio (INDMTB) 2.00 1.68 0.47 1.29 2.37 10.15
Industry volatility of return on assets (INDVOLROA) 0.05 0.04 0.00 0.02 0.07 0.70
Industry volatility of stock returns (INDVOLRTN) 0.13 0.11 0.03 0.08 0.16 0.72
Industry volatility of cost of goods sold (INDVOLCOGS) 0.30 0.28 0.00 0.18 0.39 1.44
Log CEO tenure (TENURE) 1.44 1.61 -2.48 0.69 2.30 3.95
Standard deviation of monthly stock returns (VOLAT) 0.13 0.11 0.01 0.08 0.17 0.97
Log market-to-book ratio (MTB) 1.08 0.96 0.35 0.79 1.24 4.66
Market returns (MKRET) 0.02 0.02 -0.15 0.00 0.03 0.10
Log R&D intensity (R&D) 0.07 0.00 0.00 0.00 0.07 5.71
Lagged log CEO stock holding (STKHOLD) 8.46 8.70 -3.11 7.29 9.92 17.80
Lagged log CEO option holding (OPTHOLD) -53.08 5.30 -733.00 -27.65 8.68 15.17

45
 Table 2 – Correlation matrix comprising firm-level and industry-level variables

T S A R R C S M E C R M M I I I I T V M M R S O
O B S O T O U K N O E O A N N N N E O T K D T P
T S A N G B T T N G N N D D D D N L B R K T
C E S S C C O U M V V V U A E H H
O T I O P F T O O O R T T O O
M S Z S B L L L E L L
P E T R R C D D
O T O
A N G
S
TOTCOMP 1.00 0.30a 0.22a 0.02c 0.02b 0.15a -0.03a 0.12a 0.06a 0.02 -0.02b 0.03b -0.03a 0.08a 0.03a 0.11a 0.09a -0.01 0.08a 0.15a -0.04a -0.00 0.12a 0.02
SB 1.00 0.55a 0.11a 0.06a 0.48a -0.08a 0.14a 0.09a 0.05a -0.01 0.06a -0.04a -0.28a -0.32a -0.30a -0.04a 0.08a -0.20a -0.02b -0.00 -0.11a 0.18a -0.13a
ASSETS 1.00 0.12a -0.08a 0.83a -0.13a 0.28a 0.24a -0.03a 0.23a 0.07a -0.11a -0.04a -0.15a -0.13a -0.18a -0.01 -0.38 -0.27a -0.01 -0.27a 0.19a -0.24a
ROA 1.00 0.17a 0.14a -0.02c -0.03a -0.03a 0.01 0.02 -0.01 -0.03a -0.02b -0.20a -0.19a -0.06a 0.06a -0.32a 0.09a 0.02 -0.41a 0.08a -0.04a
RTN 1.00 -0.09a -0.02c 0.02b -0.03a -0.02b -0.02b -0.00 0.01 0.28a 0.02c 0.09a 0.08a 0.02a 0.18a 0.43a 0.07a -0.02b -0.02b 0.03b
COGS 1.00 0.03a 0.20a 0.21a 0.13a 0.11a 0.03b -0.06a -0.33a -0.32a -0.31a -0.26a -0.04a -0.39a -0.31a 0.00 -0.33a 0.18a -0.25a
SUB 1.00 -0.10a 0.12a -0.02c -0.05a 0.01 0.07a -0.00 0.06a 0.01 0.02 0.02b 0.00 0.00 0.04a 0.02 0.01 0.01
MKTSIZE 1.00 0.63a -0.48a 0.07a -0.07a -0.12a 0.04a -0.09a 0.08a -0.01 -0.01 0.09a 0.05a -0.03a 0.01 0.04a 0.00
ENTCOST 1.00 -0.14a 0.00 0.06a 0.09a -0.05a -0.07a -0.06a -0.09a -0.02c -0.02b -0.02b 0.00 0.00 -0.00 -0.08a
CONC 1.00 -0.17a 0.10a 0.20a -0.09a 0.08a 0.08a -0.05a -0.04a 0.03b -0.07a -0.05a -0.08a 0.02b -0.04a
REG 1.00 0.05a -0.32a -0.22a -0.26a -0.25a 0.01 -0.01 -0.19a -0.21a 0.03a -0.10a -0.05a -0.02b
MONOP 1.00 -0.02b -0.05a -0.07a -0.07a -0.06a -0.05a -0.06a -0.05a 0.01 -0.03a -0.02c -0.04a
MANUF 1.00 0.16a 0.25a 0.10a -0.16a 0.00 0.07a 0.12a -0.00 0.21a -0.02c -0.09a
INDMTB 1.00 0.34a 0.30a 0.31a 0.04a 0.26a 0.65a 0.05a 0.35a 0.03a 0.13a
INDVOLROA 1.00 0.51a 0.28a -0.01 0.39a 0.26a -0.04a 0.31a -0.06a 0.17a
INDVOLRTN 1.00 0.35a -0.01 0.74a 0.24a -0.21a 0.22a -0.02c 0.23a
INDVOLCOGS 1.00 0.03a 0.28a 0.24a -0.01 0.13a 0.02 0.18a
TENURE 1.00 -0.03a 0.06a 0.02 0.01 0.28a 0.05a
VOLAT 1.00 0.23a -0.17a 0.26a -0.06a 0.21a
MTB 1.00 0.03a 0.23a 0.12a 0.12a
MKRET 1.00 -0.01 -0.00 -0.05a
R&D 1.00 -0.06a 0.09a
STKHOLD 1.00 -0.02
OPTHOLD 1.00

a, b, and c denote statistical significance at the 1%, 5%, and 10% levels, respectively

46
Table 3 – Competition and weights placed on performance measures

This table presents results for a robust regression on the levels of total compensation (Columns I, II, and III) and cash compensation (Columns IV, V, and VI)
for CEOs. Data are obtained for the 1992 to 2003 period from Execucomp, Compustat and CRSP. The industry-level variables and COGS are centered at their
means. Year indicators are included in the regressions but not reported for brevity. Dollar amounts of variables (before transformation) are CPI-adjusted to
year-2005 dollar amounts. Two-tailed tests of p-values are conducted. We run the following regression:
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5SUB + β6MKTSIZE + β7ENTCOST + β8CONC + β9TENURE + β10VOLAT + β11MTB + β12MKRET +
β13R&D + β14STKHOLD + β15OPTHOLD + β16SUB*ROA + β17SUB*RET + β18MKTSIZE*ROA + β19MKTSIZE*RET + β20ENTCOST*ROA + β21ENTCOST*RET +
β22CONC*ROA + β23CONC*RET + β24SUB*COGS + β25MKTSIZE*COGS + β26ENTCOST*COGS + β27CONC*COGS + YEAR INDICATOR + ε
Dependent Variable = Dependent Variable =
Total Compensation Cash Compensation
Independent variables Prediction I II III IV V VI
Intercept ? -6,734.90*** -6,961.98*** -7,016.40*** -836.30*** -1,264.13*** -875.95***
ASSETS + 898.27*** 939.73*** 945.95*** 215.73*** 283.21*** 223.65***
ROA + 712.40*** 1,050.93*** 1,023.87*** 203.29*** 212.08*** 237.47***
RET + -289.30*** -188.39*** -165.35*** 89.78*** 97.75*** 91.53***
COGS ? 42.54** -19.32 82.40*** 64.43***
SUB ? 103.46*** 109.51*** 56.03*** 28.14***
MKTSIZE ? 113.84*** 126.23*** 38.83*** 28.34***
ENTCOST ? -81.28*** -79.52*** -22.34*** -15.26***
CONC ? 946.26*** 986.54*** 371.47*** 257.46***
TENURE ? -20.98 -20.08 -22.81 47.75*** 46.99*** 50.32***
VOLAT ? 4,334.29*** 4,297.25*** 4,278.75*** -381.37*** -450.65*** -348.25***
MTB + 1,885.36*** 1,890.29*** 1,872.81*** 270.25*** 230.92*** 248.11***
MKRET ? 3,247.36 3,461.33 3,452.33 -10.81 178.54 -8.37
R&D + 530.42*** 607.33*** 547.79*** 192.37*** 204.86*** 236.97***
STKHOLD + 32.76*** 32.54*** 30.93*** -2.66 -2.27 -3.90*
OPTHOLD + 0.15 0.13 0.07 -0.37*** -0.41*** -0.38***
SUB*ROA ? -954.79*** -953.95*** -352.84*** -217.75***
SUB*RET ? 8.09 6.73 13.45 1.56
MKTSIZE*ROA ? -234.49** -319.14*** -130.43*** -145.44***
MKTSIZE*RET ? 63.17** 85.27*** 0.39 5.13
ENTCOST*ROA ? -484.22* -409.56* 214.11*** 176.34**
ENTCOST*RET ? -202.19** -220.66** -10.20 -5.55
CONC*ROA ? -578.85 -1,228.82* -383.77** -438.00**

47
CONC*RET ? 305.48 453.84** 147.11** 166.87***
SUB*COGS ? 24.66 22.92***
MKTSIZE*COGS ? 71.66*** 8.94***
ENTCOST*COGS ? -27.76*** 2.94
CONC*COGS ? 392.11*** 43.81**
No. of Observations 6,982 6,796 6,796 6,993 6,807 6,807
Pseudo R2 0.19 0.19 0.19 0.31 0.31 0.32

48
Table 4 – Regulation and weights placed on performance measures

This table presents results for a robust regression on the levels of total compensation (Column I) and cash compensation (Column II) for CEOs. Data are
obtained for the 1992 to 2003 period from Execucomp, Compustat and CRSP. COGS is centered at its mean. Year indicators are included in the regressions
but not reported for brevity. Dollar amounts of variables (before transformation) are CPI-adjusted to year-2005 dollar amounts. Two-tailed tests of p-values are
conducted. We run the following regression:
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5REG + β6TENURE + β7VOLAT + β8MTB + β9MKRET + β10R&D + β11STKHOLD + β12OPTHOLD +
β13REG*ROA + β14REG*RET + β15REG*COGS + YEAR INDICATOR +
Dependent Variable = Dependent Variable =
Total Compensation Cash Compensation
Independent Prediction I II III IV
variables
Intercept ? -6,781.65*** -7,074.26*** -1,254.41*** -928.83***
ASSETS + 971.33*** 1,011.76*** 297.87*** 245.48***
ROA + 575.84*** 572.44*** 151.38*** 170.97***
RET + -257.89*** -261.17*** 107.02*** 99.42***
COGS ? -23.52 66.24***
REG ? -1,301.15*** -1,225.05*** -406.98*** -336.57***
TENURE ? -20.54 -22.61 43.07*** 46.86***
VOLAT ? 3,671.72*** 3,752.14*** -621.33*** -511.29***
MTB + 1,714.51*** 1,728.30*** 191.57*** 228.98***
MKRET ? 4,249.15 4,171.45 527.68 274.36
R&D + 499.70*** 501.47*** 142.03*** 186.99***
STKHOLD + 21.56** 21.02** -3.23 -5.01**
OPTHOLD + 0.27* 0.26* -0.35*** -0.33***
REG*ROA ? 5,701.59*** 4,313.95*** 1,405.07*** 1,164.94***
REG*RET ? 687.53*** 679.67*** 100.36** 101.84**
REG*COGS ? -182.65*** -50.79***
No. of 6,982 6,982 6,993 6,993
Observations
Pseudo R2 0.20 0.19 0.32 0.33

49
Table 5 – Manufacturing versus service industrial sectors and weights placed on performance measures

This table presents results for a robust regression on the levels of total compensation (Column I) and cash compensation (Column II) for CEOs. Data are
obtained for the 1992 to 2003 period from Execucomp, Compustat and CRSP. COGS is centered at its mean. Year indicators are included in the regressions
but not reported for brevity. Dollar amounts of variables (before transformation) are CPI-adjusted to year-2005 dollar amounts. Two-tailed tests of p-values are
conducted. We run the following regression:
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5MANUF + β6TENURE + β7VOLAT + β8MTB + β9MKRET + β10R&D + β11STKHOLD + β12OPTHOLD +
β13MANUF*ROA + β14MANUF*RET + β15MANUF*COGS + YEAR INDICATOR +
Dependent Variable = Total Compensation Dependent Variable = Cash Compensation
Independent Prediction I II III IV
variables
Intercept ? -7,073.46*** -6,701.98*** -1,337.92*** -850.07***
ASSETS + 940.82*** 888.30*** 285.76*** 213.68***
ROA + 555.24*** 603.38*** 138.51*** 141.47***
RET + -234.71*** -253.70*** 119.03*** 111.79***
COGS ? -9.50 62.86***
MANUF ? 81.08** 90.69** 89.07*** 84.88***
TENURE ? -23.05 -13.96 43.71*** 50.44***
VOLAT ? 4,327.31*** 4,309.81*** -474.74*** -401.58***
MTB + 1,881.63*** 1,885.79*** 229.54*** 262.89***
MKRET ? 3,485.17 3410.44 195.90 41.79
R&D + 510.62*** 639.55*** 115.47*** 217.66***
STKHOLD + 33.96*** 31.67*** -0.41 -2.96
OPTHOLD + 0.18 0.26* -0.36*** -0.29***
MANUF*ROA ? 289.08 200.31 65.31 109.39**
MANUF*RET ? -102.08 -52.64 -44.32** -33.93*
MANUF*COGS ? 129.61*** 49.84***
No. of 6,982 6,982 6,993 6,993
Observations
Pseudo R2 0.19 0.19 0.31 0.32

50
Table 6 – Industry investment opportunities and weights placed on performance measures

This table presents results for a robust regression on the levels of total compensation (Column I) and cash compensation (Column II) for CEOs. Data are
obtained for the 1992 to 2003 period from Execucomp, Compustat and CRSP. The industry-level variable, INDMTB, and COGS are centered at their means.
Year indicators are included in the regressions but not reported for brevity. Dollar amounts of variables (before transformation) are CPI-adjusted to year-2005
dollar amounts. Two-tailed tests of p-values are conducted. We run the following regression:
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5INDMTB + β6TENURE + β7VOLAT + β8MTB + β9MKRET + β10R&D + β11STKHOLD + β12OPTHOLD +
β13INDMTB *ROA + β14 INDMTB *RET + β15 INDMTB *COGS + YEAR INDICATOR +
Dependent Variable = Total Compensation Dependent Variable = Cash Compensation
Independent Prediction I II III IV
variables
Intercept ? -6,773.44*** -6,443.25*** -1,265.40*** -777.76***
ASSETS + 941.95*** 902.87*** 288.67*** 220.26***
ROA + 404.41*** 436.54*** 167.67*** 174.46***
RET + -2,454.82*** -2,461.39*** 1,234.42*** 1,221.55***
COGS ? 59.90*** 87.25***
INDMTB ? 261.19*** 326.07*** 76.64*** 110.21***
TENURE ? -23.29 -17.53 43.04*** 48.50***
VOLAT ? 4,239.87*** 4,373.79*** -362.21*** -260.82***
MTB + 1,658.87*** 1,651.25*** 185.69*** 208.11***
MKRET ? 1,636.15 868.61 223.29 -64.50
R&D + 385.48*** 496.45*** 63.18** 140.45***
STKHOLD + 32.27*** 27.71*** -0.30 -3.31
OPTHOLD + 0.07 0.07 -0.42*** -0.38***
INDMTB*ROA ? 287.87*** 191.88*** -3.76 -15.39
INDMTB*RET ? -2,655.16*** -2,335.86*** -795.32*** -709.46***
INDMTB*COGS ? 61.61*** 23.06***
No. of Observations 6,982 6,982 6,993 6,993
2
Pseudo R 0.19 0.19 0.31 0.32

51
Table 7 – Industry uncertainty/risk opportunities and weights placed on performance measures

This table presents results for a robust regression on the levels of total compensation (Column I) and cash compensation (Column II) for CEOs. Data are
obtained for the 1992 to 2003 period from Execucomp, Compustat and CRSP. The industry-level variables are and COGS are centered at their means. Year
indicators are included in the regressions but not reported for brevity. Dollar amounts of variables (before transformation) are CPI-adjusted to year-2005 dollar
amounts. Two-tailed tests of p-values are conducted. We run the following regression:
COMPEN = β0 + β1ASSETS + β2ROA + β3RET + β4COGS + β5INDVOLROA + β6INDVOLRTN + β7INDVOLCOGS + β8TENURE + β9VOLAT + β10MTB + β11MKRET +
β12R&D + β13STKHOLD + β14OPTHOLD + β15INDVOLROA*ROA + β16INDVOLROA*RET + β17INDVOLRTN*ROA + β18INDVOLRTN*RET +
β19INDVOLCOGS*ROA + β20INDVOLCOGS*RET + β21INDVOLROA*COGS + β22INDVOLRTN*COGS + β23INDVOLCOGS*COGS + YEAR INDICATOR +
Dependent Variable = Total Compensation Dependent Variable = Cash Compensation
Independent variables Prediction I II III IV
Intercept ? -6,649.71*** -6,299.59*** -1,300.54*** -807.94***
ASSETS + 957.38*** 914.61*** 286.21*** 212.71***
ROA + 568.81*** 597.12*** 570.12*** 571.50***
RET + -1,412.46** -1,340.97** 1,308.82*** 1,404.51***
COGS ? 72.61*** 85.29***
INDVOLROA ? 2,816.53*** 2,644.76*** 443.91*** 565.25***
INDVOLRTN ? 5,206.43*** 4,925.66*** 305.48** 31.51
INDVOLCOGS ? 874.35*** 143.47***
TENURE ? -28.22 -24.25 42.57*** 46.66***
VOLAT ? 1,924.49*** 1,974.79*** -478.25*** -409.39***
MTB + 1,806.47*** 1,803.49*** 215.22*** 241.72***
MKRET ? 4,466.13 3,415.77 340.06 206.49
R&D + 422.02*** 543.66*** 186.63*** 204.58***
STKHOLD + 32.47*** 27.72*** -0.38 -2.61
OPTHOLD + -0.05 -0.11 -0.43*** -0.37***
INDVOLROA*ROA ? 3,819.04** 3,295.58** -334.35 -107.70
INDVOLROA*RET ? -23,857.80** -19,007.60** -10,930.10*** -11,961.90***
INDVOLRTN*ROA ? -686.50 -2,438.49* -3,266.89*** -2,564.58***
INDVOLRTN*RET ? -24,384.30*** -13,126.90** -2,445.33* -1,759.42
INDVOLCOGS*ROA ? 1,410.10 -994.73***
INDVOLCOGS*RET ? -10,075.20*** -2,609.01***
INDVOLROA*COGS ? 195.81 -41.31
INDVOLRTN*COGS ? 1,212.82*** -232.41***
INDVOLCOGS*COGS ? -160.61** 7.18

52
No. of Observations 6,963 6,963 6,974 6,974
2
Pseudo R 0.19 0.20 0.31 0.32

53