The Agency Theory & vs. the Taylorism of Merit Pay - Article Example

Human Resources Management The Agency Theory & Pay For Performance vs. The Taylorism of Merit Pay In theory, human resources management is an activity “undertaken to attract, develop, and maintain an effective workforce within an organization” (Daft & Fitzgerald: 1982). This includes the management of the three levels of human resources – from the top level, to the middle level and the bottom level of human participation in the workplace using the classical approach, human resource approach, and modern approach. The classical method of human resources management has been based on the study of Elton Mayo (the Hawthorne Studies), Maslow’s Theories of Human Needs, and McGregor’s Theory X and Theory Y. Mayo concluded in his study that employees increase their productivity if they are given better treatment. For example, new payment system, different break time at works, different length of the working day, and if they are given food or other incentive, their productivity will increase. Maslow developed his theory of human needs as motivators to improve workers productivity. Each need should be fulfilled from the bottom first before the other needs can be fulfilled. From the bottom to the top, the human needs include biological and physical needs (basic life needs), safety needs (protection, security, law, etc.), belongings and love needs (families, affection, relationship, work group, etc.), esteem needs (achievement, status, responsibilities, reputation), and self-actualization (personal growth and fulfillment). Besides the above, there is also Frederick Taylor theory of management organization that requires managers to plan, organize, control, coordinate, and lead, or that managers should develop procedures and train the workers to do the tasks, provide them with proper tool, select the right person for the right job, and if they are given incentives, their productivity will increase. And under Taylorism, incentive is embedded in the payment system. Modern method of human resources management has been based on an open system, contingency thinking, theory Z, and the most controversial one, which is the Agency Theory. As an open system, organization is divided into different independent units but each interacts with each other within and outside the environment. Driven by the US business competitiveness, this theory Z enforces mandatory retirement at age 55, employ woman as majority in the labor force, nurtures high degree of trust and loyalty, knowledge specialization is replaced by general knowledge, staffs and managers at all levels make decision, it raises collective responsibility for success and cooperation among employees. The Agency Theory, on the other hand, assumes that both employers and employees have different goals, act according to their own interest, and that each is willing to take on different risk. This Agency Theory represents principal-agent in which the agents do the work on behalf of the principal based on contract or reward, in terms of money as carrot-and-stick (McConvill: 2005). This principal-agent mode emphasizes on monetary rewards, efforts, and incentives (Cook & Morgan: 1998). It indicates that the principal is the owner or employer, who contracts the jobs to the agent, who is the management (Tosi & Gomez-Mieja: 1989). Based upon the Agency Theory, the agent does not act on behalf of the owner but the agent has the discretion to pursue its own interest (ibid). The cost of the contract is called “agency cost” because the principal and the agent don’t have to pursue the same interest. In most firms, particularly large firms, either in the United States or in the European Countries, Principal-Agent operates under owner-controlled and management-controlled. Said Tosi & Gomez-Mieja (1989), management-controlled allows the management to control the decision while owner-controlled indicates that the owner controls and has influence over the management concerning the decision. In this case, the owner, who is generally stockholders, is the same as the principal, who is also the chief executive. In the owner-controlled firms, said Tosi & Gomez-Mieja, “there was more influence over CEO pay by major stockholders and boards of directors. In management-controlled firms, the CEO pay influence was separated from major stockholders and boards” (p. 169). In large corporations, particularly in the US, there is a difference or separation between owner and management. However, the owner has more control over the business and the board of directors and has greater influence over its decision because the members are directly chosen and appointed by the chief executives. This structure gives the board of directors’ greater influence over the management while the board of directors is under direct control of the chief executives. Consequently, even though it says that management represents the stockholders, in practice, chief executive officers tend to use board of directors as a medium to pursue their interests that benefit them more than the stockholders or the owners. Management, on the other hand, may use the discretion of the board of directors to pursue their interest as well as that of the chief executive officers even though it is contrary to the interest of the stockholders. For example, the management may to encourage increasing sales, to pursue mergers and acquisitions vigorously, and to approve high pay compensation of the chief executives (ibid). Stockholders, who are actually the owners, have no much say in the corporate decisions but the chief executive officers do. Some argue that Maslow’s theory is non-applicable in current market system because it is less responsive but can only be applicable as the foundation of understanding, explaining, and handling human behavior. Others argue that McGregor’s Theory X and Theory Y is basically describes the two sides of human enterprise such as a person needs motivation to work or is self-motivated, a person is ambition to take responsibility or is creative and is up to the challenge to take responsibility and use it industriously. It also describes of the two sides of managers, either authoritarian of participative, tolerant or intolerant, can either use threat to motivate employees or use reward to motivate employees. In either the classical term or modern term, motivation has been the most phenomenon drives to improve managers and employees’ productivity as it ties to corporate efficiency. Firms are looking for methods to increase efficiency either by using rational or scientific approach to manage human resources efficiently because the environmental factors have high influence on human resources management and its application. If Mayo, Maslow and McGregor use merit system as motivation, which is as part of the payment system, the modern approach to human resources separates the pay and the motivation. Motivation, according to Maslow, has been the main drives for human efficiency. In their abstract, Kunz & Pfaff (2002) stated, “Cognitive evaluation theory and its hypothetical construct of intrinsic motivation are enjoying increasing popularity in the fields of business and economics.” Organizations across the globe, either private corporations, nonprofit organization, or the government, all adopt motivation to improve human productivity based on Maslow’s human needs theory, and hence, the more productive the employees are, the more efficient the organization be. However, under the Agency Theory of principal-agent, competitiveness is added as the driving force for efficiency. Merit pay has been the dominant type of pay for performance in business, nonprofit organization, and the government (Heneman & Young: 1991) but it has not been applied technically after the adoption of pay for performance due to lack of capacity and the absence of strategic planning. The goal of this system is to align individual goals to organizational goals (ibid) and to increase fairness in procedures and decision-making but it requires constant planning and it ties closely align individual and organizational goals (Heneman & Young: 1991). In general, merit pay has several features. (a) It is focused on the performance of the individual employee. (b) Performance is measured subjectively through a performance appraisal system. (c) The rate of its pay increase is based on past performance measurement, and (d) the pay raise is built into base pay or is received as a one-time bonus that is not built into the base pay (Heneman & Young: 1991). Merit pay has been the tradition of the public sector. It ties to executives and employees’ performance based on skills, intellectual training, experience, professionalism, and seniority as well as their attitude and behavior (Eskew, Heneman, & Fisher: 1996). In its application, merit pay is calculated, compounded, and accumulated into the earning system. Overtime, the person will have a significant change in his or her pay. Merit pay increases over time and at a modest rate (Mulcovich & Wyder: 1991) while both the executives and employees concentrate their effort on the quality of service and work (Waite & Statis-Doe: 2000). It enhances the opportunity for success both the executives or employers and the employees (Gabris & Ihoke: 2000). It is considered to be more effective because it guarantees fairness in both the procedure and the decision-making (ibid). In the hospital, merit pay increases with the size of the organization, the older is the employers or employees in the organization, the higher is their salary (Scott, Shaw, & Duffy: 2008), which has included their compensation. In the public sector, merit pay has been the core foundation of employees and executives’ compensation. Mulcovich & Wyder (1991), Peck (1986), Eskews, Heneman, & Fisher (1996) and Nadler & Wiswall (2009) concluded that merit pay is more effective, it is not individually driven, less competitive, it promotes fairness and determines the success of both the personnel and organization. Different from pay for performance that has resulted in market failure, in his study of 370 organizations, Peck stated that on average organizations that use merit pay are more successful. It gives a comparison and describes the differences between executives and personal attitudes and behaviors. It has been considered as the “best practice” because, as stated, it ties the behavior and attitude of the executives and employees to the success of the organization. It creates fairness or equity because all people in the organization experience increase in salary and wages when the firms are profitable or the organizations are prosper (Eskew, Heneman, & Fisher: 1996). Nadler & Wisswaoo (200) added that merit pay might improve outcomes or effectiveness. Without merit pay, professional staffs are demotivated and lack incentives (ibid) to perform. Professionals are more motivated through the quality of their work (Denhardt, Denhardt, & Aristigueta: 2002) than the extrinsic reward of pay for performance. In business, it indicates the success is artificial. Nadler & Wiswall (2009) argued that merit pay system is best when it come organization effectiveness because firms or organizations can design the pay and associate it with the expected outcomes as in the case of Quality Compensation for teachers program in Minnesota. Hence, both the executives and employees will put their effort to make the organizations successful. The rank and rate of pay is also designed according to the level of professionalism, intellectual training, and seniority or experience. Risk averse individuals and those who are lacking in technical capacity are more inclined to embrace pay for performance because there are too much administrative work or excessive demands on organizations (Perry: 1986) which they cannot perform. To those who are risk averse and competitive (Nadler & Wiswall: 2009), pay for performance, which separate pay system and performance under the Agency Theory, is attractive but it is a disincentive to professionals and some are concerned that it would affect their performance in terms of ethics. All across the world, firms, nonprofit organizations, even the government are adopting employees reward system that ties to their performance (Daft & Fitzgerald: 1982) contributions. Pay for performance is “a motivational compensation program that rewards employees in proportion to their performance contributions” (ibid, p. 472) but it is mainly aimed at executive compensation rather than at the employees’ enumeration. It was developed by those who dislike Taylor motivational theory because they believed that Taylorism causes employees’ “alienation, low motivation, high control costs, and poor quality” (Cook & Morgan: 1998) and is driven by the US competitive business model (Mulcovich & Wyder, 1991). Murphy and Cleveland (1995) argued that pay for performance can (a) provide incentive to executives and employees to motivate future performance; (b) help to communicate performance standards and expectations; and (c) determine the level and variations of pay for performance. It serves as an extrinsic motivator to executives even to employees to produce work at their best. This scheme causes corporate executives all over the world to be lavished with million dollars compensation as a reward for their performance. However, Bebchuck & Fried (2004) indicated that such increase is the result of motivation of chief executives, which is simply self-interest. Pay for performance can be successful but it requires a substantial amount of investment in time, money, and effort (McPhie, Sapin, Nelson, Crum, Ferentinos, & Tsugawa: 2006). And “Earlier in this decade pay for performance took center stage as a tactic for realigning payment with values” (Rosenthal: 2008). However, in recent years, it has been widely debated that the compensation of chief executive officers of the private corporations should be directly tied to maximizing organizational performance in the market because manager and owner are the same person and they bear the same risks (Kunz & Pfaff: 2002). In the health care system, pay for performance is very controversial and is hotly debated (Asworth & Jones: 2008). It is becoming the “centre stage,” particularly, in the primary care in the United Kingdom and the United States. Using performance appraisals pay for performance is attractive to the executives or serves as extrinsic motivator as it links to pay promotions and merit pay system (Murphy & Cleveland: 1995). Pay for performance comes in different forms such as gain sharing system that links pay to companies’ profit (ibid). However, management often finds it difficult to reward those who aren’t perform well (ibid). Pay for performance also comes in the form of stock options and the executives have the preferential treatment for cashing their stocks before the shareholders do, which gives an incentive to the executives to negotiate stock price in the market. Pay for performance is also based on the notion of national capitalism and it has brought harsh competition on people’s lives. Executives promise success and do a good job in return for financial reward. They promise they give cost saving and bring efficiency in terms of restructuring in return for monetary reward. Lee Iacocca had a “touch of glamour” that he could sell Ford to the Wall Street (Surowiecki, 2002). He was worshiped, idolized, and praised as the savior of the company that was at the bridge of bankruptcy. His persistent lobbied to the Reagan administration entitled him million of dollars bail out package and Ford was saved from bankruptcy. Through the media, he broadcasted the company’s success and created the illusion of the greatness of chief executives. He convinced the members of the Board of Directors, to believe that the success of the corporation rest simply on the chief executive officer. Even though such belief is unlikely true, most Board of Directors issue proxy statement that says, “We want our compensation package to be competitive with industry as a whole” (ibid). Though the strength of pay for performance is for motivation, it creates negative agents and untrustworthy managers. It creates a gap between compensation and reality. Generally, it shows less performance and less quality but the compensation. However, with market failure or massive corporate bankruptcy and millions of corporate scandals, more questions are raised about the validity of this model and the sustainability of its impact because the higher is the reward for performance, the lower is the service quality, and the lower is the quality of goods and services provided. In the business sector, pay for performance has become the underlying cause of manipulation and fraud such as aggressive change in accounting record, financial statement presentation, and inside trading by the executives (Jensen: 1994). It indicates greater “incentive for accounting manipulation and securities fraud” (ibid, p. 7) emphasized Jensen. Despite this reality, in the United States and Asia, through politics of the state, public officials have created policy to increase taxes to fund pay for performance (ibid). In England primary health care, the use of pay for performance challenged with the rationalization that (1) in the case of several quality and outcome and framework; (2) high achievement will be interpreted as targets; who are the potential targets; and (3) there is a possibility of data manipulation (ibid; Dudley & Rosenthal: 2006). In some areas, there is a gap of less pay for greater performance and in the other areas; there is less performance but greater compensation. This is particularly difficult for the public goods or services delivered by the government because many of the services provided or delivered by the government is non-quantifiable and cannot be measured in dollar values (Labonte: 2009, Baqir: 2002) but are intended to produce peace and tranquility within the nation (Massam: 2002). Therefore, there is also the possibility of manipulation as personnel or public executives would likely over value their performance to gain higher financial reward. In business, earning manipulation has been the main cause of corporate scandals across the globe. In the United States health care system, the current system of pay for performance, in which patients are billed based on diagnosis has caused high rates of underused, misused, and overused. In other word, pay for performance in health care that utilizes more homecare has resulted in higher compensation to the provider than the true value of the clinical treatment. Alternatively, there is a gap between the true performance and the payment system (Dudley and Rosenthal: 2008). The system pays more for less performance. Physicians, on the other hand, are concerned about their ability to influence the outcome that can measure the quality of their services or making decisions that affect the quality of their service because of the involvement of the patients in the decision making process, their actions and preferences (ibid). This process makes physicians and hospital management find it difficult to apply this system because there are many parties involved and it is difficult to guarantee the quality. In addition, it is likely that parties involved may manipulate data in order to receive payment and that it is difficult to identify the target individual hospitals versus hospital system (ibid) and difficult to monitor as well. Although management plays key role in determining the chief executives compensation, the chief executives have direct influence over the management from the start (Tosi & Gomez-Mieja: 1989). In practice, they are even motivated by their impractical self-interest (Palmer: 1959). Driven by self-interest, chief executives tend to use their discretionary and legitimate powers to manipulate corporate earnings in order to increase firms performance and hence their compensation. Ethics is becoming a false premise, but it is more desirable (Moon and Woolliams: 2000) and is needed more than ever because it is good practice and the right thing to do (Webley & Moore: 2001). Earnings manipulation is likely occur in a flatter structured organization (Friebel & Guriev: 2005) of the modern organizational setting. Similarly, at the public sector, which also has a flatter structured organization, with projected revenues and expenditures, executives as well are likely encourage earning management and manipulate expenditures for their benefits (Cornett, Marcus, & Tehranian: 2008). In terms of earning manipulation, a new study has been conducted by Michigan University Business School led by Professor Imhoff indicated, “Corporate boards and compensation committees are relatively ineffective safeguards against the use of manipulated earnings as a basis of CEO pay” (DeGroat: 2004). This indicates there is a strong link between executive pay for performance incentive with accounting performance measurement, which often distorts earnings with the purpose to increase chief executive officer compensation. According to Imhoff, the accounting-based performance measurement, from operating income to net income, to income before extraordinary items, annual incentive pay and to cash bonus and total incentive pay or the annual cash bonus plus stock-based incentive compensation” (DeGroat: 2004), certain percentage of these is related to chief executive officer pay for performance. Overall, Imhoff admitted that performance measurement is “the anecdotal evidence of accounting abuses from high profile cases of earning management” (ibid). For example, during Emron inquiry, accounting staffs admitted that chief executive officer and other executives required them to “cook up the book” to meet analyst’ prediction. Consequently, the company’s book kept reporting profits, the chief executive officer and other executives had their compensation increased each year, and they kept withdrawing cash while the company was indeed losing money and was heading for bankruptcy. Companies also manipulate earnings by changing auditor on the ground that (1) the auditor failed to exercise necessary prudence, (2) reporting profits in the year they change auditor. However, the profits reported are not the result of companies’ operation but mostly from assets devaluation and adjustments of non-recurring items; and (3) reporting loses in the year they change auditor (Liu & Liu: 2008). Indeed, pay for performance has become the underlying cause of manipulation and fraud such as changes in accounting record and financial presentation, and inside trading, performed by the executives (Jensen: 1994). Empirical studies have also indicated that pay for performance gives a greater “incentives for accounting manipulation and security fraud” (ibid, p. 7). Evidence of fraud showed that managerial accounting decision is mainly focused on executive compensation associated with the executives’ contract. Hence, executives often authorize the management, who in turn authorize the staffs to manipulate the information to increase their bonuses. Is pay for performance the best motivators? According to Jensen, money is not the best way to motivate people or that over time; money is no longer able to serve as motivator. Denhardt, Denhardt, & Aristigueta (2002) stated, blue collar workers, less professional and less knowledgeable people are more motivated by financial reward than the professionals and knowledgeable ones. Competition also contributes to the incidence of earning manipulation because executives across sectors are competing for the number one or the best. Earning manipulation makes corporations to become media highlight and with the news highlight, chief executing officers become celebrities. Pay for performance is not suited for best management practices. Money can make people to become greedy and people will take any measure including negative measures to fulfill their desires. It causes people to become dependent and regardless of their bad performance, they will continuously expect the reward (ibid). This expectation causes executives to allocate most of their time bargaining, negotiating, and renegotiating business including mergers and acquisitions. These many meetings are one of the main causes of business failure (Daft: 1998). Peng & Rőell (2004) proved that pay for performance has also affected executives’ behavior and it has led to massive litigation. Incentive pay, in the form of stock options, has caused, and will likely increase the probability of class action lawsuits. Stock option incentive causes executives to target and negotiate share price for short-term earnings that would give them the compensation but it will damage the firms’ economic performance in the long-term (Peng & Rőell: 2004). Indeed, they emphasized that “incentive pay has a significant impact in earnings manipulation, which in turn significantly affects the probability of litigation” (Abstract). Scholars in the health care field indicated that there is little evidence that pay-for-performance is effective but controversial (Snyder & Neubauer: 2007). It raises ethical concern of beneficence, non-malfeasance, patient autonomy, and justice (ibid). It also raises ethical concern about potential conflict of interest and unintended consequences (ibid). Many executives also feel motivated to endorse income smoothing either through stock option grants, profit sharing scheme, exercise the decision to pattern abnormal stock return, equity based compensation, timing of disclosure of stock option grants (O’Donnell & O’Brien: 1998), and other unethical behavior including ponzi scheme, fraud and embezzlement. From the employees’ point of view, pay for performance may indicate fairness (O’Donnell & O’Brien: 1998) but it may give incentives to managers to do bad things (Jensen: 1994). In the public sector, as in the Australia public service, though it claims it promotes fairness in procedure, in practice; it elevates individuality, unproductive competition, marginalization, and even petty jealousies within the workplace (O’Donnell & O’Brien: 1998) as in the private sector. Performance appraisal is so focused on short-term that employees become demotivated and produce unhealthy or unproductive competition (Gomez-Mieja: 1990). With the budget scheme, pay for performance may further the reduction of employees morale and undermine employees’ work effort (O’Donnell & O’Brien: 1998). Motivation in public sector has been for decades and since the establishment of public administration is intrinsic reward (ibid) rather than extrinsic reward. This extrinsic reward of pay for performance will eventually no longer serve as motivator. It does not create self-fulfillment of satisfaction. Despite the excitement of pay for performance, which some employees may consider it as fairness and the employers consider it as competitive factor, in practice, pay for performance has bred unethical practices among chief executive officers and other corporate executives, discrimination in terms of employees appraisal and promotion, and jealousy among employees. It is not a motivator but a hindrance to human resources effectiveness. Then we are question, which is the best practice or the best model? 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