Research Paper No.

1647

Performance and the Design of Economic Incentives

in New Product Development

Tony Davila

RESEARCH PAPER SERIES

GRADUATE SCHOOL OF BUSINESS

STANFORD UNIVERSITY
 Performance and the design of economic incentives in new product development

Tony Davila
Assistant Professor
Graduate School ofBusiness
Stanford University
e-mail: adavila@stanford.edu

June, 2000

I want to thank George Foster, Robert Kaplan, Robert Simons, Clayton Christensen, V.G. Narayanan, Kentaro
Koga, Marc Wouters, Wim Van der Stede as well as Nathan Stuart for their comments. I will also like to thank
participants at Stanford University, Wharton, and University of Southern California. I also acknowledge the
financial support of the Division of Research at the Harvard Business School and Stanford Graduate School of
Business.
Performance and the design of economic incentives in new product development

June, 2000
 Abstract

This study investigates the use of variable compensation to motivate product development
managers and its impact upon the performance of product development projects. Grounded on
measurement theory, the paper presents a model to explore the question of how to combine
subjective and objective measures of performance contingent upon the uncertainty of the project.
Next, the model is used to guide the analysis of data from 56 product development projects and
understand how technology-intensive finns use variable compensation. Using a hierarchical
modeling approach, I find that higher uncertainty is associated with lower variable
compensation. Moreover, organizational structure, through its effect upon the allocation of
uncertainty among organizational participants, also affects the level of variable compensation. I
also explore whether the level of variable compensation is related to better or, alternatively,
worse project performance. While extrinsic rewards may motivate a manager to exert more
effort, they can also reduce intrinsic motivation or focus the manager’s attention away from
relevant project dimensions. I find a positive relationship between economic incentives and
project performance; however, the slope of this relationship is not linear decreases as the
percentage of variable compensation increases. Finally, the paper uncovers that European
companies are more likely to give a flat salary than their U.S. counterparts.
 1. INTRODUCTION

This study investigates the use of variable compensation to motivate new product

development managers in technology-intensive firms and its impact upon project performance.

As manufacturing innovations have spread throughout leading organizations, the success of

companies in industries with short product life cycles resides not only in manufacturing

excellence, but also in the fast development of high quality products that meet customer demands

(Wheelwright and Clark, 1992; Friar, 1995). The growing importance of new product

development and its distinctive characteristics offer a relevant and fruitful setting to further our

knowledge about this business process as well as the design and use ofvariable compensation.

The structure of managers’ compensation is an important variable in the design of

management systems. Accordingly, it has received significant attention at the top management

level (Tosi and Gomez-Mejia, 1994; Ittner et al., 1997) as well as the level of the division

(Keating, 1997) or of the sales organization (Bartol, 1999). However, compensating product

development managers presents its particular challenges. Each project is unique, involves a high

degree of creativity, goals are hard to specify ex-ante, and the organizational structure

surrounding the development effort varies across projects. Some of the project managers in the

sample received a flat salary while others had up to 33% in variable compensation. Some

divisions were starting to experiment with putting a certain percentage of project managers’

compensation “at risk” while others had recently moved back to a flat salary. This diversity not

only suggests differences across projects, but also reflects a lack of consensus on how to use

economic incentives to motivate these managers (Soderberg and O’Halloran, 1992).

Another debated issue is the relationship between variable compensation, creativity, and

performance. At the CEO level, where data is more readily available, the conclusion is that “after
 six decades of research, the failure to identify a robust relationship between top management

compensation and firm performance has led scholars into a blind alley” (Barkema and Gomez-

Mejia, 1998, page 135). At the product development level, additional issues become relevant. In

particular, extrinsic rewards may drive away intrinsic motivation (Amabile, 1996) and product

manager’s risk aversion may lead to suboptimal decisions (Kohn, 1993). According to a senior

manager in R&D, “research employees are often less excited about bonuses than about peer

recognition” (quoted in Higginbotham, 1997).

The paper addresses these two research questions from analytical and empirical perspectives.

The analytical model explores the impact of costly measures of performance and project

uncertalnty on the design of variable compensation. It reveals that as the size of the product

development effort decreases relative to the size ofthe division, measures ofproject performance

will be preferred over aggregate divisional measures. Moreover, as the uncertalnty of the project

increases, objective measures are preferred over subjective ones. Data for the empirical study

comes from 56 individual product development projects in the medical devices industry. The

main findings are: (1) product development managers receive less variable compensation when

project uncertainty is high; (2) the organizational structure around the development effort affects

how project uncertainty is allocated and, accordingly, has an impact upon the level of variable

compensation that the project manager receives; and (3) there is a positive relationship between

the level of variable compensation and project performance. However, this relationship is not

linear and its intensity (slope) decreases as the percentage of variable salary increases. (4)

Finally, European companies are less likely to use economic incentives.1

1 It may be possible that Europe is in transition and moving towards more widespread use of economic incentives
(The Economist, 1999).

2
 The following section reviews related literature and the theoretical background for the

paper. Section three presents the analytical model and the hypotheses. Section four describes the

research design. Section five discusses the results of the study. Finally, section six suggests

possible extensions of the research and concludes.

2. ECONOMIC INCENTIVES IN PRODUCT DEVELOPMENT

IL] The design ofperformance measures

Information about the effort and skills of the project manager is required to use economic

incentives2 (Holmstrom, 1979). But measuring product development performance is difficult.

Ex-ante product specifications are never complete and uncertainties get resolved as the project

progresses (Thomke and Reinersten, 1998). In many instances, judging whether the product

meets its intended objectives can only be done ex-post when the product competes in the

marketplace and all unknowns have been resolved. However, at this point the project manager’s

effort is confounded with the ability of other departments in the organization including

marketing and manufacturing.

Moreover, the success of a product in the market depends as much on designing the product

to specifications as on the ability to translate customer needs into product specifications or on the

existence of an adequate product family strategy (Meyer and Utterback, 1993). It can also be

myopic to limit the effect of the product development process to the financial returns of the

product (Meyer et al., 1997). For example, one of the project managers interviewed had spent

five years working in a product based on a totally new type of material. The knowledge that he

developed about the mechanics of this material was going to be employed in future generations

of the product and, possibly, in other products. However, these spillover effects (organizational

3
 learning) were difficult to quantify even if the fact was that this knowledge was a significant

source of competitive advantage for the division.

Measurement theory offers the concepts required to address these problems from a technical

point of view. Measuring product development performance is difficult because of limitations in

measurement technology. Even if recent advances have improved the technology avallable to

measure R&D performance (Meyer et al., 1997; Werner and Souder, 1997; Hauser, 1998),

several limitations are likely to persist. First, available measures may lack the required sensitivity

and precision (Banker and Datar, 1989). The signal-to-noise ratio combines sensitivity and

precision into one concept. It compares the sensitivity of a measure to its level of noise,; the

better this ratio, he more informative the measure is.

A second limitation is related to the multitask nature of the project manager’s job

(Holmstrom and Milgrom, 1991). Product development performance is multidimensional

(Shenhar and Dvir, 1996). It includes tasks related to the actual design of the product as well as

the development of new technology and interaction with other functions as marketing or

manufacturing. Ideally, the portfolio of performance measures has to be complete to reflect all

the tasks that the project manager influences while maintaining good signal-to-noise ratios.

A final limitation is the congruity of performance measures (Feltham and Xie, 1994).

Congruent measures weight the various objectives that the project manager pursues according to

the preferences of the organization. A consequence of using non-congruent measures is that the

project manager allocates his effort differently from what the organization would want him to do.

A potential alternative to overcome these limitations that is explored in section three is to use

subjective measures of performance. This solution allows the person assessing project

2 ~refer to economic incentives as the theoretical variable that variable compensation represents.

4
 performance to include information not foreseen ex-ante, adjust available measures to

reduce noise, and address congruity problems. But subjective measures have their own

limitations. They rely on the availability of information as well as the ability, knowledge, and

monitoring effort of the person doing the evaluation. These conditions are hard to meet for

highly uncertain projects.

1L2 Economic incentives and product developmentpeiformance

The previous discussion assumes that economic incentives should be used when the

appropriate measurement technology is available. This assumption is common to economics and

to agency theory in particular (Eisenhardt, 1989), as well as to several social psychology theories

including expectancy theory (Lawler, 1973), reinforcement theory (Komaki et al., 1996), and

goal-setting theory (Locke et. al, 1988). Existing evidence indicates that managers respond to

economic incentives (Kahn and Sherer, 1990; Zenger, 1994). However, a meta-analysis of

existing evidence relating financial incentives to performance across different organizational

levels (Jenkins et al., 1998) indicates that the relationship is positive for quantity but not for

performance quality, which is a key driver in new product development. Thus, in product

development where quality and creativity is paramount, the relationship between economic

incentives and performance is not necessarily granted and it may actually be negative. Extrinsic

motivation can drive away intrinsic motivation (Deci and Ryan, 1985; Skaggs et al., 1992) that is

argued to be more relevant in driving creativity and innovation (Amabile, 1996). Eisenhardt and

Tabrizi (1995) partially address this question and investigate whether greater variable rewards

for schedule attainment are linked to shorter development time. They conclude: “the results also

show that planning and rewarding for schedule attainment are ineffective ways of accelerating

pace” (page 84).

5
 Moreover, alternative control mechanisms inside organizations may fruitfully replace

economic incentives to address the goal divergence problem. Personnel or clan control—where

the organizational culture or professional standards aligns personal and organizational goals—is

a powerful mechanism that does not require external incentives (Merchant, 1982). Alternatively,

organizations may use non-economic extrinsic rewards to recognize the project manager’s

performance like assigning him to a more important project3 or simply peer recognition.
3. PERFORMANCE MEASURES IN NEW PRODUCT DEVELOPMENT

This section models the selection of performance measures in product development with

links to the intuition discussed in the previous section.

3.1 The model

The model is a traditional one period game with a risk-neutral principal (the division) and a

risk-averse agent (the project manager) with unobservable effort (Lambert, 2000). The particular

feature of the model is that, in order to reflect the product development setting, it combines

signal-to-noise and congruity characteristics together with the cost of gathering those signals.

Consistent with the previous section, the model includes a congruent measure that becomes more

costly to obtaln as the uncertainty of the project increases (that models the characteristics of a

subjective measure) and a non-congruent measure available at a fixed cost (that models the

characteristics of an objective measure).

The profits of the division are the principal’s objective function and they depend on the

efforts of the agent, other project managers in the division, and non-controllable factors. Project

managers affect profits through two types of effort (e

1 and e2) that capture the multi-

~Non-economic but extrinsic rewards like promotions may have an economic side to them as well as a social side
(for example, organizational power). The objective of the paper is not to disentangle these complex rewards but a
more humble one, which is to understand the use of variable pay schemes.

6
 dimensionality of product development (Feltham and Xie, 1994). The contribution of the

project manager ito the division’s profits is represented by: a11 * e1, +a2, *e2. +~, (1)

Where ah (a21) captures the impact of e1 (e2) on profits and ~, is random noise reflecting the

underlying uncertainty that exists in any product development effort.

The total profits to the division are just the sum of the profits of every project manager:

x=~Qx11 *e +a2, *e +e1) (2)

To focus on one product manager, I assume that the uncertainty associated with each project

is independent ofthe uncertainty of the other projects, cov(s,, s3) = 0 V i !=j.

Because the effort of the manager affects the profits of the division, profits can be used to

evaluate and reward the agent. Moreover, the principal knows the effort of every manager in

equilibrium and can rescale profits to remove the effects of the other agents upon profits. Once

this constant is removed, profits can be rewritten as:

x=a1 *e1 +a2 *e2 +~8~ =a1 *e1 +a2 *e2 +e~ (3). Where subscript i is omitted without

ambiguity. Notice that the existence of additional projects (or activities) in the division, typically

associated with larger organizations, affects this signal by increasing the variance of the noise

term. For simplicity, contracting on profits is costless and thus, this signal is present in every

contract and precludes flat wages.4

To model the possibility of using subjective and objective evaluation of the agent’s

performance, two new signals are introduced. The first signal captures all of the dimensions of

~‘ Allowing profit-based contracts to be costly would make flat wages a feasible solution when the three available
signals do not meet the cost-benefit trade-off (that is, they are too costly). In particular, if measuring profits has a
fixed cost, then they would only be used in small divisions with low uncertainty (low signal-to-noise ratio) projects.
Flat wages will be used in large divisions and projects with high uncertainty.

7
 effort that affect the profit function (this is e1 and e2) and thus relevant to the principal. This

signal models the characteristics of subjective evaluation in that the principal can gather

information on all the dimensions relevant to its objective function and can weight them in the

same way as they come in the profit function (and avoid congruity problems). In mathematical
6~ ~4 1
i
terms: y=,6
1*e1+/i2*e2+e~ and — = — (congruity).

Another important characteristicfi2of subjective

~2~2 ~ll evaluation is that as project uncertainty

increases, the cost to the principal increases. Because more complex projects are harder to

understand and gathering the relevant information requires more effort, the principal has to

invest more resources as uncertainty increases. The cost of subjective evaluation is modeled as a

variable cost increasing with project uncertainty: C, (var e,,) = c~ * var(e ~)

The second signal models the characteristics of an objective measure. To reflect the fact that

objective measures are typically not complete, this signal only captures one of the agent’s effort

dimensions. The mathematical formulation is as follows: z = ~ * e1 +

In contrast to the subjective signal, the cost of contracting on the objective signal is fixed:

C~=F.

The intuition behind this assumption is that the cost ofcollecting objective measures does not

significantly differ across projects (collecting time-to-market or project expenses is similar

across projects). More complex projects may require an incremental effort to collect objective

signals, but this additional effort is small compared to the case of a subjective measure.

S
 To reflect the fact that as project uncertainty increases both the subjective and the

objective signals become less informative, we assume that var y = var z. Finally, to stylize the

results, we assume that the division uses either the objective or the subjective signal, but not both

together.5
1
The rest ofthe assumptions are: (1) the agent’s cost is C(e
1 ,e2) — — * (e~ + el), (2) his utility
2

function is: u(W) = ~&rW, where r is the agent’s risk aversion and Wis his compensation minus

personal cost, and (3) only linear reward schemes are considered (Feltham and Xie, 1994).

3.2 Results
The first best is obtained from first order conditions. — and~ e
~je1 ~e, 1=a1ande2=a2.

In the second best world effort is not observable. Defining the noise-to-signal ratio of signal

x as N / s~ = r * var(x)
2
the loss in welfare with respect to the first best is:
a1

2 *(1+,12)* 1 (5).
AW~ ~ (a~ +a~)—a1 1+N/S~

aAWX
Comparative statics show that: <0. As the size of the division increases (var (x)
aN / S~

increases and the noise to signal ratio increases), the loss in welfare for the principal from

contracting only on group measures (profits) increases. Thus, individual performance measures

are more likely to be used as the size ofthe division increases.

When both signal x (profits) and signal y (subjective measure) are used to contract with the

agent, the change in welfare with respect to contracting on signal x only is:

~Relaxing this assumption modifies the solution space but not the conclusions of the model.

9
 _
*
N/Si
________________________________
AW~, _
2 (l+N/S~)[(1+N/S~)*(l+N/S~)~l] (6)

Where N/S~ is defined as NIS~ = r * fi2*(1+~2)

var(y

~AW ~AW
Comparative statics lead to ~ >0 and ~‘ <0.
~JN/S~

As division size increases (N/Sr increases), the value to the principal of using an individual

measure of performance increases. And, as the product becomes more uncertaln, the individual

performance signal becomes less informative and thus less valuable to the principal (figure 1).

If AW > C,, = (var(e,, * c,, then both signals will be used. The region where N/S will be

used is NIS,, e (0,N/S~ * jl+2 a 2) 2*(1+N/S~)) (7)

1 *r/(c *fi1
Notice that the region is non-empty (which only reflects the fact that the cost is variable with

no fixed component) (see figure 1). Also, the upper limit is increasing in N/Sr and as division

size increases, subjective evaluation becomes attractive for more uncertain projects.

The alternative to subjective evaluation is to contract on an objective measure of

performance (signal z). In this case, the change in the welfare function is:

1 ____________________

AW~~ ~....*a2*(1+fl2)* N/S2

2 (1+N/S~)[(1+ji2)*(1+N/S~)*(1+N/S~)~1] (8)

Where N/Si is defined as N / s~ = r * var(z

2
Yi

_______ ~JAWXZ
The comparative statics lead to: ~AWXZ >0 and <0. As division size increases
~N/SZ

(N/Sr increases), objective measures are used in more uncertain projects. When project

10

))
 uncertainty increases (and division size stays constant) objective measures are used less

(figure 1).

If AW~~ > C~ = F then the objective signal will be used for contracting. The region where

N/S~willbeusedis N/SZ e (0 N/S~2 *a2 + 1

‘2*F*(1+N/S~)2 (l+N/S~)*(1±p2) —1) (9)

Notice that the region may be empty and then the objective signal is not used for contracting

(figure 1). However, when such a region exists, the upper limit is increasing in N/Sr and as
6
division size increases, objective evaluation becomes attractive for more complex projects
When AW~ > C,, = (var(~,,)) * C
1,, and AW~~ > C~ = F, the principal can choose, in addition

to signal x, one of the other two signals. In particular, he will select the one that provides a larger

net welfare increase: max( AW~ — C,, ,AW~ — C). From equations 6 and 9 and the assumption

— C,, — (AWX~ — Ce)

that var y = var z, comparative statics indicate <0 (10) and
~var y

objective measures are preferred over subjective ones as uncertainty increases (figure 1).

Insert figure 1 about here

Several testable conclusions can be derived from the previous model. Comparative statics on

equation 6 and 9 indicate that individual signals (y and z) are more likely to be part of the

measurement system as division size increases. In large divisions, those projects that the

organization understands, either because it has previous experience or because they are simple to

conceptualize (the S/N ratio for signals y and z is high), are more amenable to the design of a

good measurement system. For these low uncertainty projects, subjective measures are cheaper

11
 to obtain (equation 7) while objective measures have better signal-to-noise ratio (equation

9). For large divisions and as project uncertainty increases two effects happen. First, subjective

measures are not cost effective to measure performance anymore (equation 10). As project

uncertainty keeps on increasing, objective measures are not cost effective either (equation 9). If

contracting on profits is costly, then a flat wage is used for compensation purposes.

Two sources of uncertainty are typically identified: market and technology (Shenhar and

Dvir, 1996). Market uncertainty is related to the speed of changes in customer preferences and

market forces as well as the existing stock of market knowledge that the organization has. For

example, when an organization has experience with the customers that the product is targeting

and the market is not moving fast, their needs and requirements are better understood and the

organization faces a low deficit of market information. Technology uncertainty is related to the

knowledge that the project manager and the organization have about the technology underlying

the project. The sources of product technology can range ftom existing, well-known bodies of

knowledge to unknown, yet-to-be developed technologies. Finally, the size of the project effort

(project scope) is sometimes interpreted as an additional dimension of uncertainty (Shenhar and

Dvir, 1996) and is included as a control variable.

Under the assumption maintained in the model that economic incentives have a positive

impact upon performance, low uncertainty projects are more amenable to higher levels of

economic incentives. This argument leads to the first prediction from the model tested in the

paper. The first hypothesis is:

Hi: The level of economic incentives that a project manager receives decreases as the level

of project uncertainty increases.

~ proof of this statement hinges on the fact that N/Si (N/Sr =0) <0.

12
 This hypothesis predicts a link between the level of variable incentives and project

uncertainty. Notice, however that the model additionally predicts that, as uncertainty increases,

subjective measures are dropped first out of the contract and then objective measures to end up

with a flat wage. Due to data availability only the first prediction mentioned is tested.

The previous hypothesis assumes that all project managers have the same exposure to project

uncertainty. However, exposure depends on the organizational structure of the product

development effort. In other words, organizational structure affects the allocation of uncertainty

among organizational members and therefore compensation of project managers. Because of the

importance of technology in the medical devices industry, project managers are always

responsible for the engineering aspect of product development, but their authority over

marketing decisions vary. Project managers may have no authority over marketing and then

product specifications work as the interface between the project manager and marketing. In this

case, the limitations of the measurement system to reflect market uncertainty are not relevant to

the compensation of the project manager because the design of the organizational structure

isolates him from market uncertainty. This argument leads to the following hypothesis:

H2: The level of economic incentives that a project manager receives decreases as the

organizational structure exposes him to higher levels of market uncertainty and as market

uncertainty increases.

Finally, section two presented arguments in favor and against a positive relationship between

the level of economic incentives and project performance. While the model makes the traditional

economic assumption that a positive relationship exists, the evidence available is not conclusive,

especially for new product development where quality and creativity are paramount. Economic

13
 incentives can have dysfunctional consequences because of the limitations in measurement

technology or because they reduce intrinsic motivation and, as a consequence, creativity. The

alternative argument suggests that economic incentives (extrinsic rewards) help skilled project

managers to self-select themselves and also motivate project managers to put more effort leading

to better performance. The answer to this question is an empirical one; if the latter argument is

valid then the following hypothesis holds:

H3: Higher level ofeconomic incentives is associated with betterprojectperformance.

However, if economic incentives have dysfunctional effects, then the relationship is reversed

and worse performance is expected.

5. RESEARCH DESIGN

5.1 Sample selection

The study is conducted in large medical devices companies. Product development is at the

core of the strategy of companies in this industry and consumes a significant amount of

resources. Product development processes at these organizations are well thought out including

the incentive structure of their project managers. Another attractive feature of this industry is that

technologies in different product lines are at different stages of maturity and, accordingly,

technology and market uncertainty will vary.

The sample was selected from the population of medical devices companies with sales over

$300 million both in Europe and the U.S. A letter describing the purpose and time conunitment

required was sent to the CEO of each company to solicit its participation. Ten companies

representing 22 business units and 56 individual projects participated in the study. Each company

had at least three projects in the sample. The sample represents a diverse set of products. On one

extreme of the technology uncertainty spectrum are syringes with a long history and where

14
 changes are incremental; at the other extreme, magnetic resonance scanners are rapidly

changing as new technological innovations emerge.

The unit of analysis is the individual product development project. The theory presented in

previous sections predicts that the use of economic incentives affects each project development

effort differently and that their design depends on project characteristics: technology and market

uncertainties. Even if some divisions adapt the use of variable compensation as well as its

intensity to the characteristics of each project, others do not. In particular, divisions that offer a

flat salary do so across all projects. This fact decreases the power of the research design to relate

project characteristics and economic incentives. Because these divisions (by policy) do not offer

economic incentives when theory predicts that they should (see hypothesis one and two), the

empirical tests lose power to reject the no-hypothesis. In contrast, this fact favors the power of

research design to relate project performance and economic incentives. If economic incentives

are related to better performance, then the performance of product development projects in these

divisions should suffer.

Data were collected using a questionnaire mailed to project managers that had finished the

development of a product within the last twelve months. The response rate was 77% (56 out of

73 mailed questionnaires) and was achieved following questionnaire design and administration

procedures (Dillman 1983). Each questionnaire was personally addressed to the project manager

and took between 35 and 45 minutes to respond.7

The questionnaire was made of closed-ended items. Whenever possible, the instrument was

designed to collect objective datato avoid perceptual biases as much as possible. However, recall

bias—possibly driven by ex-post rationalization—is a limitation to the research design. To

~A copy of the questionnaire is available from the author upon request.

15
 reduce this problem and enhance data accuracy, a follow up visit to thirteen divisions was

undertaken. The visits included interviews with project managers, R&D manager, marketing

manager, division manager, as well as the contact person (usually in the administration or

strategic development department). Multiple informants facilitated triangulation of the data and

confirmed that the responses to the questionnaire where not idiosyncratic to the project manager.

5.2 Measure of research variables

The dependent variables in the research are variable compensation and project performance.

Variable compensation proxies for economic incentives. It is defined as the percentage of the

project manager’s expected annual compensation that is not fixed at the beginning of the year

and depends on the performance during the year. Variable compensation captures a sizeable

piece of a project manager’s economic incentives; however alternative mechanisms may

substitute for it and decrease the power of the research design. Salary increases and promotions

are alternative ways to reward managers involving cash. However, salary increases at this level

of the organization are usually restricted and promotions are limited to the assignment of the

following project. Similarly, better-paid outside opportunities also behave as economic

incentives. Even actions that seem intrinsically motivated may be driven by economic incentives.

Product development peiformance includes multiple dimensions and thus hard to measure.

For this research, I adapted a set of questions developed by Shenhar and Dvir (1996). The

instrument consists of a set of eleven items that capture different aspects of product

development. Respondents were asked to evaluate the importance of each item and to assess the

performance of the project along each of the dimensions. This procedure has the limitations of

any self-reported measure including perceptual biases and self-presentation. On the other hand, a

16
 self-reported measure captures most of the dimensions relevant to the project and gives each

dimension its appropriate weight. For example, development time may be highly important in

time-sensitive projects but much less so for projects focused on technology. I also asked product

managers to provide an overall rating of the project performance, this item was highly correlated

(0.77) with the performance measure constructed.

The independent variables are market uncertainty and technological uncertainty. Similarly to

the performance variable, these two independent variables are multidimensional. Current market

growth is used as a proxy for market uncertainty. In addition, I use a perceptual variable of

market uncertainty that combines the familiarity of the organization with the market with the

importance of market objectives to the success of the product. The respondent was asked to

assess the familiarity of the organization with the market and customers on a 5-point Likert scale

ranging from “the organization had no experience” to “the organization had extensive

experience.” He was also asked to assess the importance of market objectives to the success of

the product in a 7-point scale ranging from “not important” to “extremely important.” The

variable is constructed as the sum of four standardized items, two capturing familiarity and

another two items related to market objectives.

Technological uncertainty is also measured using both an objective and a perceptual

measure. Percentage of new parts is used to proxy for technological uncertainty under the

assumption that higher number of new parts is associated with newer products. The perceptual

measure of technological uncertainty is constructed as the market uncertainty variable but using

four questionnaire items related to the familiarity of the organization with technology and the

importance of technology to the project.

17
 Finally, the authority of the project manager over marketing decisions may affect his

exposure to marketing uncertainty and, accordingly, his variable compensation (hypothesis two).

This variable is the first factor of a principal factor analysis on a set of questions adapted from

Keating (1997) to measure authority over various dimensions (u=0.78).

Several organizational variables that are included in the research as control variables. Cross-

functional integration has proved its relevance in previous studies (Eisenhardt and Tabrizi, 1995;

Hoopes and Postrel, 1999). The number of business functions reporting to the project manager

proxies for the degree of cross-functional integration. In addition, I control for size ofthe project

through the number ofpeople working in the project, estimated as the average number of people

working for the project weighted by their time commitment.

In many occasions, the culture of a company (Merchant, 1982) is an effective substitute for

economic incentives. I include the number of years that the project manager has been working

for the company as a proxy for how much the manager has internalized the objectives of the

organization. Similarly, the manager’s cultural background may affect how he internalizes

company objectives as well as the organization’s approach to measurement (Werner and Souder,

1997). Because the sample includes two regions in the world—United States and Europe, I

include a dummy for projects executed in Europe to reflect any differences between these two

cultures. Finally, I also examine whether prizes substitute for the use ofvariable compensation.

6. RESULTS

Table 1 presents descriptive statistics for the variables included in this research. The

percentage of new parts varies from 10% to 100% indicating that the sample ranges from

derivative products to platforms and breakthrough products (Wheelwright and Clark, 1992). Also

the number of years working for the same company varies from 2 to 30 years. The number of

18
 people working for the project ranges from nobody working full time to 106, indicating that

projects include small as well as large research efforts. Finally, the median number of functions

reporting to the project manager is one. This statistic suggests that cross-functional integration is

not as widespread as expected given its proven impact upon performance.

Insert table 1 about here

Table 2 summarizes descriptive statistics on project mangers’ compensation. The sample is

almost evenly distributed between managers with and without variable compensation.8 However,
European project managers receive a flat salary more frequently than their U.S. counterparts.

Cultural differences are the only potential explanation, although there is some anecdotal

evidence that Europe is also moving towards economic incentives (The Economist, September

18, 1999, page 7).

Insert table 2 about here

Two examples illustrate the possible variety of compensation designs. One of the companies

in the sample linked variable cash-rewards to a set of targets negotiated at the beginning of the

project including product features, timing, and product cost. In another company, project

managers were selected from different business functions like marketing or finance. Their work

included function-related assignments as well as project management. At the end of the year, the

various bosses that these managers had during the year—including function-related assignments

and product developmentprojects, gave a subjective evaluation that determined theirbonus.

8 Two managers did not disclose the composition of their compensation and were dropped from further analysis.

19
 Some companies used prizes to motivate product development teams. For example, a

project team in one ofthe companies visited got tickets to a professional hockey game when they

successfully finished a project. Prizes may behave as substitutes for variable compensation.

Table 3 describes how variable compensation is related to the use of prizes. The significance test

indicates that prizes are more likely to be used together with variable compensation. Prizes and

variable compensation behave as complements and not as substitutes, therefore reinforcing each

other. Finally, table 3 also gives evidence suggesting that U.S. companies use prizes more

aggressively than their European counterparts.

Insert table 3 about here

6.1 Multivariate results

The predicted relationships happen at the project level where project uncertainty is expected

to affect the use of variable compensation. However, project managers in the sample are grouped

as members of the various divisions and regions that participated in the research. This

characteristic may introduce correlated residuals and upward biased estimates of t-statistics if

observations from managers in the same region are correlated. To take into account the nested

nature of the data, hierarchical linear models (Bryk and Raudenbush, 1992) are used with two

levels; the first level is the project manager; the second level is the region to reflect the fact that

compensation practices are clustered around regions. Table 4 presents the results from the

hierarchical linear model. The first three models use different proxies to test the relationship

between the level of variable compensation and project uncertainty as predicted in hypothesis

one. For these three models, the level- 1 regression is:

20
 Variable _compensation = /i0 + /i1market uncertainty + /i2technology uncertainty + /33 years +
+ /J4size + /35cross functional + /J6marketing authority + e
— —

The fourth model incorporates an interaction term to test whether organizational structure of

the project has an impact over the level of variable compensation. In particular, hypothesis two

predicts that higher market uncertainty together with high authority over marketing decisions is

negatively related upon the level of variable compensation (because the project manager is p
exposed to higher market uncertainty). The expected sign of the coefficient of this interaction

term is negative. The level-l regression in this case is:

Variable_compensation = /I~ + /I1market uncertainty + /i2technologyuncertainty + /33 years + /i4size +

+ /35cross functional + /36marketing authority + /i7market uncertainty * marketing authority + e
— — —

The intercept term is allowed to change across companies and it also incorporates the fact

that European companies use variable incentives less often than U.S. companies. The level-2

expression for /I~ is ~ = ~ +~01Europe+ ~ Where j~ and ~ are fixed coefficients and c~

is an error term that is allowed to vary across companies.

Evidence in table 4 agrees with hypothesis one. Model 1 uses market growth as a proxy for

market uncertainty and percentage of new parts as the proxy for technology uncertainty.

However, only 42 managers provided information about market growth, suggesting that some

managers may be far removed from the market. Percentage of new parts and market growth are

both negative and significant (at the 5% level one-tailed).

Model 2 in table 4 uses the perceptual measure of market uncertainty and model 3 uses the

perceptual measures of technology uncertainty. Percentage of new parts is still negative and

significant in model 2 and market uncertainty is negative and significant in both models.

However, the perceptual measure for technological uncertainty is not significant (but with the

21
 predicted sign). Finally, the effect of a project manager being in Europe (a level-2 variable)

is reflected in a lower level of variable compensation. For all the models, the test of homogeneity

rejects heterogeneity problems at the level- 1 analysis, reinforcing the adequacy of the models.

Insert table 4 about here

The negative and significant coefficient for the interaction terms in model 4 of table 4

supports hypothesis two. Managers with more authority over marketing decisions and,

accordingly, more exposure to marketing uncertainty have lower level of variable compensation.

Table 5 tests the prediction of hypothesis three regarding the association between

performance and the level of variable compensation. Ordinary least squares regression is used

because the potential correlation among project managers within the same region is less of a

threat.10 Model 1 includes only a linear term on variable compensation, while model 2 includes a
quadratic term. In both cases, the linear term is positive indicating that the relationship between

performance and variable compensation is positive. However, the story is not as simple and the

negative and significant sign of the quadratic term indicates that there are decreasing returns to

using variable compensation. In other words, variable compensation is associated with better

performance, but the “benefits” decrease as the percentage of compensation “at risk” increases.

This result suggests that the design of variable compensation is not just whether it reinforces

~ Censored data regressions were also performed. This approach does not incorporate the grouping nature of the
data; on the other hand, censored data models take into account the factthat variable compensation is left-censored
at zero. The significance of the results was similar. The sample was also split into European projects and U.S.
projects to explore the significance of the European effect beyond the intercept term. For the European sample,
market uncertainty was significant while percentage of new parts was significant for the U.S. sample. These two last
results should be interpreted keeping in mind the small number of observations for these two samples.
10A hierarchical linear model was run with a structure similar to the one used in table 4—a random intercept term
with Europe as a level-2 variable (not significant). The results mapped the ones reported in table 5.

22
 extrinsic motivation or deflates intrinsic motivation, but the level of variable compensation

also has an effect on this relationship.11

Insert table 5 about here

Europe is not significant in any of the regressions in table 5. Cross-functional integration is

positively associated with performance as has been documented in previous research. Also,

authority over marketing decisions has a positive impact on performance indicating that cross-

functional integration is enhanced if it also encompasses marketing decisions rather than

integrating functions other than marketing. Finally, market uncertainty is associated with better

performance.

The model developed in section three permits a further elaboration of these results. The

positive association between performance and economic incentives may be driven by low

uncertainty projects where measures are readily available. For high uncertainty projects, where

measures are harder to obtain, the relationship may reverse. To test for this additional

explanation, I divided the sample into high and low uncertainty projects and included a dummy

variable to allow slopes to differ. I also included an interaction term between economic

incentives and uncertainty. None of these specifications identified uncertainty as a contingency

variable. However, the power associated with number of observations available may not be high

enough to capture this effect.

7. DISCUSSION AND CONCLUSIONS

~ Model 2 was also run on the European and U.S. samples. The only difference was that the quadratic term was not
significant in the European sample. Again cultural reasons may explain the difference, but also the fact that when
European firms offer variable compensation, the level is much lower and probably does not reach the decreasing

23
 The interviews conducted for this research highlighted that the compensation structure

of project managers is an unresolved issue. Some of the companies visited had introduced a

variable part into the compensation of project managers. In contrast, other companies gave a flat

salary; one European company had offered variable incentives in the past but it removed them

during a period ofpoor company performance.

The evidence in the paper indicates that the level of variable compensation that product

development managers receive is lower as the uncertainty of the project increases. This

observation is consistent with measurement theory. I also document the effect of organizational

structure upon the design of the compensation scheme. In particular, authority over marketing

decisions exposes the project manager to market uncertainty and when these two variables are

high, the level of variable compensation decreases.

These results can be extended to investigate with more detail the structure of the

compensation schemes. The model developed in section three includes predictions relating

subjective and objective measures to project uncertainty. Also, the interaction with other

potential sources of economic incentives is relevant in order to understand how organizations can

offer a better mix of the various mechanisms that they have available. Finally, relative

performance evaluation was not observed in the sample of projects available, even if it is

common at higher organizational levels.

The study finds a positive relationship between the level of variable compensation and

performance. However, this positive association decreases as the level of variable compensation

goes up. The effectiveness of variable compensation appears to be limited when used too

returns side. Also, the small sample for both of these regressions indicates that these results are to be considered
with caution.

24
 extensively, probably because it reduces intrinsic motivation or, alternatively, because of its

inherent design limitations—measurement technology.

A further investigation of this relationship could explore whether a mismatch between the

level of variable compensation and the level of project uncertainty leads to worse performance.

According to existing theory, high uncertainty should be accompanied by low variable

compensation, while low uncertainty allows for more intense use of variable compensation. Any

deviation from this structure is predicted to lead to worse performance. However, exploratory

tests in the current data set fail to find any significant relationship.

These conclusions should be interpreted with some caveats. First, variable compensation is

only one of the various ways in which organizations use economic incentives. Second, this

research assumes that project uncertainty and organizational structure are exogenous to the

design of the compensation package. This assumption seems reasonable in that projects are

decided regardless of the type of compensation that the manager will receive. But the interaction

between organizational structure and compensation package indicates that both decisions may be

taken simultaneously. Third, market and technology uncertainty are multidimensional variables.

The current proxies may be too crude to fully capture these variables.

Finally, this research unveils a large gap between practices in Europe and in the U.S. that can

only be explained relating to cultural differences. The study includes the number of years that a

project manager has worked in a company to control for the potential effect of this person being

more aligned with his company’s culture. However, it is still possible that European companies

are able to indoctrinate managers faster than U.S. firms.

BIBLIOGRAPHY

Amabile, T. M. 1996. Creativity in context. Boulder, CO: Westview Press.

25
 Banker, R. D., S. M. Datar. 1989. Sensitivity, precision, and linear aggregation of signals for
performance evaluation. Journal ofAccounting Research 27(1) 2 1-39.
Barkema, H. G. & L. R. Gomez-Mejia. 1998. Managerial compensation and firm performance: A
general research framework. Academy of ManagementJournal 41(2): 135-146.
Bartol, K. M. 1999. Reframing salesforce compensation systems: an agency theory-based
performance management perspective. Journal of Personal Selling & Sales Management 29(3)
1-16.
Bryk, A. 5, 5. W. Raudenbush. 1992. Hierarchical Linear Models. Newbury Park, Ca., Sage
Publications
Deci, E. L., R. M. Ryan. 1985. Intrinsic motivation and self-determination in human behavior.
New York: Plenum.
Dillman, D. A. 1983. Mail and other self-administered questionnaires. In P. H. Rossi, J. D.
Wright, & A. B. Anderson (Eds.), Handbook of Survey Research London: Academic Press, Inc.
Eisenhardt, K. M. 1989. Agency theory: An assessment and review. Academy of Management
Review, 14 57-74.
Eisenhardt, K.M., B. N. Tabrizi. 1995. Accelerating adaptive processes: product innovation in
the global computer industry. Administrative Science Quarterly 40 84-110.
Feltham, G. A., J. Xie. 1994. Performance measurement congruity and diversity in multi-task
principal agent relations. The Accounting Review 69 429-453.
Friar, J. H. 1995. Competitive advantage through performance innovation in a competitive
market. The Journal ofProduct Innovation Management 12 33-43.
Hauser, J. R. 1998. Research, development, and engineering metrics. Management Science
44(12) 1670-1689.
Higginbotham, J. 1997. The satisfaction equation. Research & Development 39(10).
Holmstrom, B. 1979. Moral hazard and observability. Bell Journal ofEconomics, 1074-91.
Holmstrom, B., P. Milgrom. 1991. Multitask principal-agent analyses: Incentive contracts, asset
ownership, and job design. Journal ofLaw, Economics, and Organization 724-52.
Hoopes, D.G, S. Postrel. 1999. Shared knowledge, “glitches,” and product development
performance. Strategic Management Journal 20837-865.
Ittner, C. D., D. F. Larcker, M. V. Rajan. 1997. The choice of performance measures in annual
bonus contracts. The AccountingReview 2(72) 23 1-255.
Jenkins, G. D., N. Gupta, A. Mitra, J. D. Shaw. 1998. Are financial incentives related to
performance? A meta-analytic review of empirical research. Journal of Applied Psychology
83(5) 777-787.
Kahn, L. M., P. D. Sherer. 1990. Contingent pay and managerial performance. Industrial and
Labor Relations Review (43) 107-5-120-5.
Keating, A. 5. 1997. Determinants of divisional performance evaluation practices. Journal of
Accounting & Economics, 24 (3) 243-273.

26
 Kohn, A. 1993. Why incentive plans cannot work. Harvard Business Review 7 1(5) 54-63.
Komaki, J. L., T. Coombs, S. Schepman. 1996. Motivational implications of reinforcement
theory. In R. M. Steers, L. W. Porter, & G. A. Bigley (Eds.), Motivation and leadership at work.
New York: McGraw-Hill.
Lambert, R. 2000. Contracting Theory and Accounting. Working Paper, The Wharton School,
University ofPennsylvania.
Lawler, E.E. III. 1973. Motivation in the workplace. Monterey, CA: Brooks/Cole.
Locke, E. A., G. P. Latham, M. Erez. 1988. The determinants of goal acceptance and
commitment. Academy ofManagement Review 13 23-39.
Merchant, K. A. 1982. The control function of management. Sloan Management Review
(Summer) 43-55.
Meyer, M., J. Utterback. 1993. The product family and the dynamics of core capabilities Sloan
Management Review 29-48.
Meyer, M. H., P. Tertzakian, J. M. Utterback. 1997. Metrics for managing research and
development in the context of the product family. Management Science 43(1) 88-111.
Shenhar, A.J., D. Dvir. 1996. Toward a typological theory of project management. Research
Policy, 25(4) 607-632.
Skaggs, K. J.,A. M. Dickinson, K. A. O’Connor. 1992. The use of concurrent schedules to
evaluate the effects of extrinsic rewards on “intrinsic motivation”: A replication. Journal of
Organizational BehaviorManagement 1245-83.
Soderberg, L. G., J. D. O’Halloran. 1992. “Heroic” engineering takes more than heroes. The
McKinsey Quarterly 1 3-23.
Thomke, S., D. Reinertsen. 1998. Agile product development: Managing development flexibility
in uncertain environments. California Management Review 41(1) 8-30.
The Economist. 1999. Top CEO Bonuses. September 11th•

Tosi, H. L., L. R. Gomez-Mejia. 1994. CEO compensation monitoring and firm performance.
Academy ofManagement Journal 37(4) 1002-1016.
Werner, B. M., W. E. Souder. 1997 Measuring R&D performance—state of the art. Research
TechnologyManagement 40 34-42.
Wheelwright, S. C, K. B. Clark. 1992. Revolutionizing product development: quantum leaps in
speed, efficiency, and quality. New York: Free Press.
Zenger, T. R. 1994 Explaining organizational diseconomies of scale in R&D: Agency problems
and the allocation of engineering talent, ideas, and effort by firm size. Management Science 40
708-729.

27
 Figure 1
Conclusions from the model

Project uncertainty
Objective measure’s
indifference point ~q.(9))
Large

Subjective evaluation’s
indifference point ~q.(7))

Indifference
curve

Small

Small Division size Large

The parameters used to draw the figure are Cx1= 0.5, ~ 0.1, p.= 0.4, ~0.2, r 0.2, c1~= 1, F=0.03.
For projects below the line for equation 7, subjective evaluation can be used for contracting. For
projects below the line for equation 9, the objective measure can be used in the contract. The indifference
curve is pictured when subjective evaluation and the objective measure are both possible. Below the
indifference curve, subjective evaluation is preferred.

28
 Table 1
Descriptive statistics

Project performance Importance of criteria Performance

Mean M~~jp~iim M~nimiim

Meet product specifications 5.82 7 4 5.94 7 3

Meet unit cost objectives 4.62 7 1 4.76 7 2
Meet timing goals 5.57 7 1 4.55 7 3
Meet project’s budget goals 3.32 7 1 4.24 6 1
Fulfill customers’ needs 6.05 7 3 5.67 7 3
Be a business success 5.57 7 2 4.93 7 2
Capture high market share 4.84 7 2 4.72 7 1
Create a new market 2.68 7 1 3.52 7 1
Create a new product line 3.43 7 1 4.39 7 1
Develop new technology 2.64 6 1 3.91 6 1
Enhance skills to handle new technology 2.59 7 1 4.20 7 1

V~ri~h1e Mean ~t~.~darddeviation Maximum Minimum

Variable compensation 6.8% 1.0% 8.8% 33% 0%

Performance 4.67 5.02 0.72 6.3 3.3
Market growth 32% 15% 57% 256% - 10%

Market uncertainty 0.02 -0.03 2.73 8.20 -4.38

Percentage ofnew parts 56% 60% 27% 100% 10%

Technology uncertainty 0.00 -0.33 2.65 5.85 -4.50

Number ofyears 11.4 10.0 7.3 30.0 2.0

Europe 0.62 1 0.49 1 0

People 16.8 8.7 21.4 106 0
Cross-functional team 1.27 1.00 0.94 4 0

Marketing authority 0 -0.25 0.95 2.36 -1.16

29
 Table 2
Descriptive statistics for the sample of new product development managers’ compensation
Number of project managers on a straight salary: 26
Number of project managers with variable compensation: 28

1 Enrone vs United States

- United States Europe Total
No variable compensation 2 24 26
Variable compensation 19 8 27
Total 21 32
Chi-square 21.75 (p=O.OO)
=

Mean Std. Dev. Mm Max

Variable component over total compensation (%) 13 8 1 33
Mean Std. Dev. Mm Max
Variable part contingent on individual performance (%): 62 36 0 100
Variable part contingent on group performance (%): 38 36 0 100
Variable part objectively decided (%): 63 41 0 100
Variable part subjectively decided (%): 37 41 0 100
Notes
For one manager it was not possible to identify whether (s)he was U.S. or European.
Descriptive statistics for variable compensation are based only on those managers receiving variable compensation.
Individual performance includes the performance of the project manager and the project team, while group
performance includes division or company performance. Objective evaluation means that compensation is
determined through a pre-established formula or an agreed objective. Subjective evaluation indicates that
compensation depends on the assessment of performance that somebody inside the organization made.
Table 3
Relationship between the use of economic incentives and the use~f prizes to reward project managers
Use of prizes Give Do not give
Prizes Prizes Total
No variable compensation 3 23 26
Variable compensation 12 16 28
Total 15 39
Chi-square = 6.59 (p = 0.01)
Use of prizes in Eurove and the United States
United States Europe Total
Yes 10 5 15
No 11 28 39
Total 21 33
Chi-square = 6.11 (p=O.OJ)
Note
Variable compensation is measured as the percentage of total comp~nsati n~that--the-manager-would have received if
the project had evolved as expected.

30

:
 Table 4
Relationship between variable compensation and project characteristics (hypotheses 1 and 2)
Model 1 Model 2 Model 3 Model 4
Dependent variable Variable Variable Variable Variable
Prediction compensation compensation compensation compensation
Level-i results
Market uncertainty
Market growth (Hi) (-) -0.038
-1.81 **

Market uncertainty (Hi) (-) -0.979 ~ -1.196 ~ -0.879 **

-2.47 -2.86 -2.24

Technological uncertainty
Percentage ofnew parts (Hi) (-) -0.069 ** -0.074 ** -0.092
-1.93 -2.18 -2.65
Technology uncertainty (Hi) (-) -0.042
-0.11
Control variables
Number ofyears -0.240 -0.104 -0.068 -0.128
-1.75 -0.81 -0.49 -0.97
People 0.055 0.083 0.081 0.091 *

1.18 1.84 1.77 2.14

Cross-functional integration 2.413 ** 2.154 ** 2.081 ** 2.781 **

2.27 2.38 2.07 2.89

Marketing authority 0.284 -1.823 -1.662 -1.048
-0.26 -1.75 -1.51 -0.96
Interaction term
Market uncertainty (-) -0.468 **

* marketing authority (H2) -2.04

Level-2 results
Constant 16.584 ~ 13.121 ~ 8.835 ** 13.492 ~

4.32 4.25 2.55 4.56

Europe -10.104 ** -9.344 ** -9.869 ~ -8.761
-2.81 -3.57 -4.037 -4.12
Number of observations 42 52 52 52
Variance explained
(compared to a random model) 0.44 0.54 0.51 0.59
t-statistics are reported in italics (one-tailed tests except for control variables) * significant at the 10% level, **
,

significant at the 5% level, *** significant at the 1% level. The mathematical structurefor level-i of the first three
models is:
Variable compensation = /3 + /3 market uncertainty + /3 technologyuncertainty + /3 years + /3 size +
—

o i 2 3 4
+/35cross functional+/36marketing authority+e
— —

The mathematical model for the level-i of the fourth model is:
Variable compensation = /3 + /3 market — complexity + /3 technologycomplexity + /3 years + /3 size +
—

0 1 2 3 4
+/35cross functional+/36marketing authority+/38market complexity*marketing — authority+e
— — —

2’oo + y
The structure of level-2 model for the four models is: /3~ = 01Europe +
The test of homogeneity rejects heterogeneity problems at level-i.

31
 Table 5
Project performance and compensation structure (hypothesis 3)

Dependent variable Pprfarmnnep Performance

Variable compensation
Variable compensation (H3) 0.025 * 0.108 ***

1.82 3.48
Variable compensationA2 -0.003 ***

-2.93
Control variables
Market uncertainty 0.061 * 0.058 *

1.69 1.72
Percentage ofnew parts 0.002 -0.000
0.49 -0.09
Number ofyears -0.012 -0.013
0.37 -1.08
People 0.003 0.001
0.44 0.21
Cross-functional integration 0.188 * 0.186 **

1.93 2.06
Marketing authority 0.195 * 0.214 **

1.94 2.30
Europe -0.226 -0.021
-1.02 -0.92
Constant 4.669 4.592
0.00 0.00

Number of observations 53 53
Adjusted R-squared 0.17 0.29
F-statistic 2.35 3.40

t-statistics are reported in italics (two-tailed tests).

* significant at the 10% level, ** significant at the 5% level, ~ significant at the 1% level.

The first regression is:

Performance = /30 + /31 variable compensation + /3 2 market — complexity + /33 technologycomplexity +

—

+ /3 years + /3 size + /3 cross functional + /3 marketing authority + /3 Europe + e

—
4 5 6 — 7 8

32