THE EFFECTS OF USING BALANCED SCORECARD MEASURES IN EXECUTIVE COMPENSATION ON ORGANIZATIONAL PERFORMANCE.

• Author: Pollanen, Raili M.
• Position: Report

INTRODUCTION

It has been argued that balanced scorecard (BSC) measures tailored to fit the organizational context can improve performance (Sila, 2007; Fisher, 1998). The proper fit, which involves reconciling various organizational characteristics and their effects (Venkatraman, 1989; Venkatraman & Camillus, 1984), has been considered as a prerequisite of organizational success (HassabElnaby, Said, & Wier, 2005). Kaplan and Norton (1996) proposed that BSC measures should be linked to executive compensation. In general, Roberts, Albright, and Hibbets (2004) found performance and incentives to be highly correlated, and Jensen and Murphy (1990) suggested that managers' and shareholders' interests could be aligned through appropriate incentives.

However, heavy reliance on financial measures in executive compensation could lead to short-term focus and behaviors (Bartlett, Johnson, & Reckers, 2014; Ittner, Larcker, & Rajan, 1997; Bushman, Indjejikian, & Smith, 1996). Nonfinancial leading indicators embedded in the BSC could re-focus attention to long-term performance (Bartlett, Johnson, & Reckers, 2014).

Little empirical evidence exists on performance impacts of BSC-based compensation plans (Ittner, Larcker, & Meyer, 2003). Although HassabElnaby, Said, and Wier (2005) studied the context and performance consequences of nonfinancial measures in compensation contracts, they did not explicitly consider the BSC. Crabtree, and DeBusk (2008) reported that organizations adopting the BSC performed significantly better than non-adopters in the same industry. Larcker (1983) found increased capital investment in organizations with incentive plans and a positive market reaction to the disclosure of such plans, while McConnell and Muscarella (1985) reported a positive association between measurement systems and share price. Yet, Gaver and Gaver (1993) found no evidence of increased capital spending after the adoption of incentive programs. Such inconsistent findings warrant further study of performance effects of BSC use in executive compensation.

This study extends prior research by investigating the performance consequences of BSC-based measures in executive compensation, including the fit between BSC use and organizational characteristics. It poses the following research questions: (a) Does BSC use in executive compensation affect organizational performance? (b) Is organizational performance affected by the fit between BSC use in executive compensation and organizational characteristics? As such, it can help link performance measurement and incentive compensation literatures. First, related literature is reviewed and the study's hypotheses developed. Next, research method is outlined, followed by the findings of the study. Finally, conclusions, limitations, and future research directions are discussed.

LITERATURE AND HYPOTHESES

Balanced Scorecard Use in Executive Compensation and Organizational Performance

Several studies have found associations between the use of financial and nonfinancial performance measures (although not necessarily termed BSC measures), and organizational performance. For example, Hoque and James (2000) found that BSC use was significantly correlated with organizational performance, and Crabtree and DeBusk (2008) demonstrated that the use of BSC improved shareholder returns. Similarly, Davis, and Albright (2004) found that bank branches using the BSC performed better than those that did not, and Ittner, Larcker, and Meyer (2003) reported that organizations using a broad set of financial and nonfinancial measures earned higher stock returns. In addition, Banker, Lee, and Potter (1996) discovered that customer satisfaction measures were significantly associated with future financial performance.

Furthermore, several studies have also argued that properly designed BSCs can link strategic goals to performance targets and help organizations evaluate managerial performance against targets (Bartlett, Johnson, & Reckers, 2014). For example, considering BSC measures in executive incentives, Budde (2007) asserted that linking BSC measures to incentive contracts can align the interests of owners and employees, and Banker, Lee, and Potter (1996) provided evidence of behavioral and performance effects of remuneration linked to nonfinancial measures. More generally, Ittner, Larcker, and Rajan (1997) concluded that any financial or nonfinancial measures that convey information about desired managerial actions should be included in incentive contracts to motivate managers to improve performance.

It has been further argued that organizational performance includes the dimensions of effectiveness and efficiency (Berry, Broadbent, & Otley, 2005; Lebas & Euske, 2002). For organizations that aim to maximize shareholder value, return on equity, dividends, and stock price can serve as indicators of long-term effectiveness (HassabElnaby, Said, & Wier, 2005; Said, HassabElnaby, & Wier, 2003; Wallace, 1997; Bushman, Indjejikian, & Smith, 1996) and revenue per employee, accounts receivable turnover, net assets turnover, and current ratio as indicators of operational efficiency (Berry, Broadbent, & Otley, 2005).

Although Pollanen et al. (2017) found both efficiency and effectiveness measures to be related to organizational performance, no consensus presently exists regarding the categorization of specific indicators as efficiency and effectiveness indicators. Nonetheless, Murphy (1985) suggested that executive compensation would best be based on both market-based and operational performance measures. Therefore, this study postulates a main relationship between BSC use and overall organizational performance (but also explores effectiveness and efficiency dimensions in additional analyses), as follows:

H1: The use of the balanced scorecard (BSC) measures in executive compensation is associated positively with organizational performance.

Balanced Scorecard Fit with Organizational Characteristics and Performance

Organizational performance can be affected by various organizational and environmental factors. For example, Said, HassabElnaby, and Wier (2003) argued that the adoption and use of performance measures is a choice, with their potential net benefit depending on contextual factors. Similarly, Ittner and Larcker (1998) suggested that the optimal choice of performance measures is a function of many factors. Jermias and Gani (2005) found that the fit between strategy and contextual variables had a positive relationship with performance, while HassabElnaby, Said, and Wier (2005) discovered that the relationship between nonfinancial measures and organizational performance is contingent on the fit of these measures and organizational characteristics. Based on prior studies, Pollanen and Xi (2015) considered six characteristics, namely, strategy, structure, ownership, industry, quality, and culture.

Strategy is seen as an important consideration in the design of performance measures and incentives. For example, Chenhall (2005) argued that the influence of strategic performance measurement systems on organizational performance is indirect through the mediating alignment of manufacturing with strategy and organizational learning, while Langfield-Smith (1997) proposed that control systems customized to fit strategy can enhance competitive advantage. Organizations with prospector strategy have been found to emphasize nonfinancial measures and those with defender strategy financial measures (Ittner, Larcker, & Rajan, 1997; Said, HassabElnaby, & Wier, 2003). Gani and Jermias (2012) discovered that prospectors used more performance-based compensation systems than the defenders and that a misfit between strategy and control systems (e.g., BSC) was associated with lower performance.

Different strategies may require different organizational structures. For example, prospectors could gain greater advantage from decentralized structure than defenders (Jermias & Gani, 2005). Greater authority and accountability are typically granted to managers of decentralized units than to managers of units in centralized organizations (Chenhall, 2003). However, if operations are diverse, for example, in organizations with multiple segments and foreign subsidiaries, control systems complexity increases (Ashbaugh-Skaife, Collins, & Kinney, 2007). Because of their greater and more complex information needs, formal control systems are thus more appropriate for decentralized...