The Impact of Incentive Compensation on Labor Productivity in Family and Nonfamily Firms

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(Authors: James J. Chrisman, Srikant Devaraj, and Pankaj C. Patel)

Research Applied précis prepared by Ken Moores, Moores Family Enterprise and Bond University

Introduction

Family business leaders have long been exhorted to professionalize their businesses. While what this entails has yet to be precisely determined, most would concede that professionalization entails the adoption of a range of human resource systems and practices. Within the suite of these human resource practices lies incentive compensation schemes which to date have been less enthusiastically embraced by family business leaders than their non-family counterparts.

Incentive compensation schemes, that align employee objectives with those of the owners, address agency issues of moral hazard. Moral hazard can arise in a principal-agent context, where one party, called an agent (e.g. non-family employee), acts on behalf of another party, called the principal (e.g. family business owner). The agent usually has more information about his or her actions or intentions than the principal does, because the principal usually cannot completely monitor the agent. The agent may have an incentive to act inappropriately (from the viewpoint of the principal) if the interests of the agent and the principal are not aligned. In short, moral hazard occurs when one person takes more risks because someone else bears the cost of those risks.

This concern has often been regarded as less critical for family firms and perhaps explains why incentive schemes are less prevalent in family firms. However, the agency issue of adverse selection, whereby family firms are less able to recruit, retain, and motivate the best possible workforce, is more widely acknowledged as a concern. Failure to attract and motivate the best possible employees potentially reduces labor productivity in family firms and puts them at a performance disadvantage vis-à-vis non-family firms.

Incentive compensation schemes can signal to potential employees in the labor market that performance will be rewarded and they are thus attracted to seek employment within family firms. This paper is one of the first to assess incentive compensation from a family business perspective and to explain its relevance in addressing the adverse selection problem.

The authors examine the impact of incentive compensation schemes on labor productivity in family and non-family firms. They employ three hypotheses to maintain this focus and measure the key variables as:

  • Incentive compensation as whether the firm provided employees with profit sharing and/or stock options,
  • Labor productivity as the ratio of firm revenues to number of employees,
  • Family business as whether two or more members of the same family own the majority of the business.

In addition, they controlled for a range of factors including firm size, firm age, average wages, benefits, nature of business (i.e. whether seasonal, franchise or home-based), location (i.e. state) and industry sector.

Findings

The authors use data collected by the US Census Bureau. From the initial sample of 2,165,680 firms they narrowed this down to a matched sample of 216,768 firms (108,384 family firms and 108,384 non-family firms) as the focus of their analyses.

Their results show that:

  1. Family businesses have lower labor productivity than non-family firms
  2. Incentive compensation is positively related to higher labor productivity
  3. The labor productivity differential between family and non-family is lowered when incentive compensation is used.

This suggests that in family firms, incentive compensation may not only align the interests of employees with that of their family owner-managers, but it may also reduce the adverse selection effects that can bedevil family firms.

Implications

So, what should family business owners and their advisers do because of these findings?

Certainly, there is sufficient evidence here in this carefully conducted study with robust results to suggest that when professionalizing human resources practices family firms should seriously consider the positive impact that incentive compensation can offer. Apart from aligning the interests of employees with that of family owner-managers, incentive compensation can also reduce the adverse selection that comes from labor market signals that reduce the attractiveness of family firm employment for high quality workers. In short, this evidence indicates that incentive compensation schemes can:

  • elicit value increasing behaviors from current employees, and
  • increase the odds of attracting high quality employees.

Both outcomes broadly affect the ability and effort of the workforce. Effects that will likely improve labor productivity resulting in greater efficiency and enhanced profitability of the family firm operation. Consequently, incentive compensation requires much greater attention from family firm owners as part of their professionalization agenda.

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About the contributor

Ken Moores is an FFI Fellow and recipient of the 2015 Barbara Hollander Award. He is a principal in Moores Family Enterprise in Australia and an emeritus professor at Bond University. Ken can be reached at [email protected].