Improvement of CEO Efficiency - Case Study Example

Is CEO Pay really inefficient? If so, propose a mechanism to improve efficiency. Introduction: The Chief Executive Officer (CEO) of a company works in a strategic position of employment. His or her main job is planning the future of the company and the main objective is the maximization of shareholder wealth. A CEO is answerable to the Shareholders as well as the non-executive directors of the company. He is not paid for manual labor performed or the paperwork compiled. A CEO’s performance is judged by his profitability to the company. The successful endeavors undertaken by the company and the increase or decrease in the company’s economic value are the clear markers of the CEO’s productivity.While it is easy to assess the profitability of a company by analyzing its ratios and comparing them to those of other similar businesses, judging the extent to which its employees are responsible for its position is much harder it judge. The inefficiency in CEO’s pay arises because it is very difficult to quantify the productivity of the company and its limit with respect to a certain individual. According to Robert (1995) “Although much of the decision-making power resides with the CEO, the research and background analysis reports are not made by him. Hence a venture that incurs losses upon the company may not have been caused due a bad decision made by the CEO but rather incomplete or inaccurate information provided to him. These are exemplary scenarios that have more theoretical than practical basis. “ (Robert A. G. Monks, Nell Minow 1995) In today’s world where most business ventures are based solely on the situation in the relevant markets, employee wages are no exception. The general pay of a CEO in competitors would play a large part in deciding the payment package of a company’s CEO.The rest of the essay will be divided into four sections the first three will discuss the various aspects of payment while the last would be the concluding statement. Section one will view the entire payment package of a CEO and its implications. These have a strong basis in market evaluation and the integration of the CEO’s position in the company. Section two will discuss the Agency theory. This theory outlines the principal-agent relationship existing between the shareholders and the CEO and its impact on efficient pay. This relationship is both contractually binding and ethical in nature where the extent of the Agent’s authority to bind the company in a contract is deduced by the power given to him by the Principal.. Section three will reflect on the opposing theories of Rent-extraction and the efficient market hypothesis, while both valid in nature, reflects two different sides of an employment contract. Section one: Most CEOs are given the title of either president or CEO. This is a very connotation in the text of CEOs. It is widely used world over. It could mean that the title holders also includes the directors which are present on the board of directors. On the other hand it could also mean the chief operating officer. When compared to the CEO, the president’s central focus is daily operations. CEO, on the other hand is more of a visionary. He projects the future of the company and determines the direction that the company takes. Thus at times, the titles of both president and CEO are used interchangeably to emphasize on the roles that both these title holders play. The increase in pay of a CEO has been six times more than the average wages paid to employees in the last thirty years. The payment package may be seen as inefficient and problematic. An internal sensitivity-analysis of firms indicates that the proportion of loss suffered by the manager when the firm suffers a loss is very small. This amount is greater for small or medium-sized firms as the size of the business increases the loss in pay of the manager decreases when the company suffers a setback. For example, it has been estimated that in a large firm a loss of $1000 by the company only passes on a loss of $1 to the manager who in fact was in charge if the decision to invest in the first place. Similarly if the firm in question is medium-sized or small the amount would approximately $3. (Walton, Sam 1993) According to Beechuk (2004) “If the profit the CEO has made for the company is equal to or greater than the cost of hiring him, the pay is efficient. This is the concept of Marginal Productivity, which by definition is the extra output produced by one more unit of input.” Profits earned by the shareholders being the output and the CEO being the extra unit of input. The sensitivity of the manager’s pay to an economic windfall is even more inefficient. In times of economic boom when the overall market is working at optimal conditions and suppliers are not being exploited, the manager’s pay will rise through no action of his own but as a consequence of the company’s increasing profitability. With an increase in the price of the company’s shares, the manager’s pay is increased. This scenario not only improves the shareholders’ wealth but also the manager’s position. Bebchuk (2004) explains how “ in a reverse scenario where the share price plummets to well below the par value, the shareholders are the only people who will suffer as a result while the manager’s pay will be secure.” (Bebchuck LA, 2004) The severance package, adopted by firms, for their managers is an incentive to perform poorly. It is for managers who have been made to leave the company due to poor performances. The severance package includes a substantial amount of money that is calculated in the basis of the years of services provided by the manager. Theoretically this amount is in lieu for dismissing an employee without due notice, but as the law requires that any employee should be notified beforehand in cases of dismissal from employment or they may sue the firm in a court of law, this payment serves an entirely different purpose. It is inefficient as it gives the manager encouragement to shun his duties as he will be paid even when he is dismissed for poor performance. The attitude of the shareholders and the manager (CEO) towards the business causes another conflict of interest. While the shareholder would in general circumstances wish to play it safe and not risk his own benefits in a highly risky venture, the manager may be of a different opinion. As the manager will receive a steady salary he is more likely to be pro-risk, where if the chances of loss are high the rate of profit is also very good. These rudimentary issues are to be taken into account when the manager’s pay is to be decided. According to Fried (2006) “ The incentive of a manager to work harder is if he will reap greater benefits for more effort. A decided salary would give the manager too much room to be careless and lax in his duties. If he believes that no matter what effort he puts into his work he will be paid the same amount he will not be inspired to work harder” . (Lucian Bebchuk and Jesse Fried, 2006) But if the manager’s pay is rated to the performance of the company under him, he will be inspired to work to improve the company’s performance. A profitable transaction made by the manager will result in a marginal increase to his salary. In addition to this the manager should also be paid a base amount which remains constant so that during an economic downturn he does not suffer as a consequence to the company’s dire position. (Eisner, Michael ,1998) Section two: Agency is the relationship where one person, the Principal, appoints another, the Agent, to bring about, modify or terminate business dealings between the Principal and a third party. Usually such a relationship would be created by mutual consent, either stated expressly or implied. Agency may also arise by operation of law and through estoppel. Where agency relationship exists, the Principal has direct rights against and liability to the third party. In this scenario the relationship of the CEO to the shareholders is that of an agent to a principal. While the former has control the latter has the ownership. This distinct break between the owner and the decision-making authority leads towards a separation of goals. While the Principal aims for wealth maximization, the Agent will also work towards the economic benefit of the company and in some instances towards personal benefit. It is improbable for the shareholders to monitor the entire performance of the officer, and have to have a certain amount of trust in his integrity and ability to work well. (Rees, R., 1985) (Sappington, David E.M 1991) Section three: The rent extraction theory suggests that the main cause of pay exploitation done by the managers is due to the shareholders’ inability to judge their performances thoroughly. The manager may demand a large amount of money which the firm will agree to pay based on the performance analysis done of his work. But it is highly improbable that the analysis is complete enough to warrant the astronomical pay package. (Low, Albert 2008.) Usually due to the high costs this might incur, a full report is not made of the manager’s efficiency in performing his duties. Hence many aspects remain unobserved, and the manager is paid his salary based on the approximate performance of the company itself. The benefit of the doubt is given to the manager, in for example his part in the current price of the company’s shares. According to Roger (1993) “This way a lot more money is paid than the manager’s performance may warrant, and gives him a sense of careless authority i.e. that he will be paid even if his efforts lessen. (Rodgers TJ 1993) The efficient market hypothesis takes a different view of this. It suggests that the duties of the manager require a different set of skills and expertise from that of an average worker. The tasks are more complicated and the risks higher, so the huge differences in pay are completely justifiable. According to Burton (1987) “The diverse nature of the work performed by the manager as well as the incomplete reporting techniques of all the duties they performed, warrant the extra payment as compensation for a job well-done, even if the actual performance is mediocre.”To support this theory it has been observed that the larger the firm hence the more extensive the manager’s job requirement, the greater is his pay package. (Burton G. Malkiel1987) Conclusion: The inefficiency of the CEO’s pay is an international issue. In market terms, the employee is exploiting the employer with a higher demand than is ethical. But as the managers seem to have autonomy over the salary they can demand, it has become the generally followed procedure. The agency theory will help understand the nature of the relationship between the authoritative figures and the true owners in a company. While this shows us the dilemma faced in the corporate boardroom it doesn’t offer a feasible solution to the problem that has arisen. The simplest approach would be to decide on a justifiable punishment when mistakes are made. If the manager senses a lax in his supervision, he will not have the incentive to work hard, or perform to the best if his abilities. To rectify this, if the company suffers losses and even obscurely the manager can be blamed for it wholly or partially he should be penalized or even put on probation. If this method is implemented the manager in fear of his finances and employment will do his very best to make sure such a circumstance does not present itself and if it does he is not to blame for it. Bibliography Lucian Bebchuk and Jesse Fried, Pay without performance: The Unfulfilled Promise of Executive Compensation (2006) Burton G. Malkiel (1987). "efficient market hypothesis," The New Palgrave: A Dictionary of Economics, v. 2, pp. 120–23. Rees, R., 1985. The Theory of Principal and Agent—Part II. Bulletin of Economic Research, 37(2), 75-9 Sappington, David E.M., “Incentives in Principal–Agent Relationships”, Journal of Economic Perspectives 5:2 (Spring 1991), 45-66 No Excuses Management Rodgers, TJ 1993 Work in Progress Eisner, Michael 1998 Sam Walton: Made in America Walton, Sam 1993 Low, Albert, 2008. "Conflict and Creativity at Work: Human Roots of Corporate Life, Sussex Academic Press Bebchuck LA. (2004). The Case for Increasing Shareholder Power. Harvard Law Review Corporate governance By Robert A. G. Monks, Nell Minow 1995 Read More