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The Relationship between CEO Compensation and Organizational Performance

1.0 Introduction

Apple, one of the most successful innovative companies in the whole world, announced its financial results in the first quarter in 2010. In the first quarter, 3.36 million Macintosh, 8.7 million iPhones and 21 million iPods were sold, which makes Apple receive 15.68 billion dollars sales revenue and 3.38 billion dollars net profit. At the same time, Tim Cook, CEO in Apple in the first half of 2009, was awarded 500 million dollars for one time and 75,000 shares of stock (Diaz, 2010).

On the other hand, in the economic recession in the U.S. between 2008 and 2009, the value of stock decreased substantially by 62%, the revenue dropped dramatically by 31% and companies lost $1.1 billion. Accordingly, the revenue of CEO in the companies in the U.S. went down by 11%. However, Jeff Bewkes, the CEO in Time Warner, still obtained 1 million dollars as an end-of-year bonus (Dvorak, 2009).

From these two examples, a question is needed to be taken consideration: what is the relationship between remuneration of CEO and organizational performance? Is the relationship is positive? That is, CEO only can receive handsome payment when there is a good performance in a firm. But, from the Time Warner example, the positive relationship seems wrong. Therefore, in the essay, this relationship will be discussed.

The structure of this essay is as follows: section 2 is literature review. In this section, the definition of CEO and organizational performance will be introduced first. Then, three different kinds of relationship between CEO compensation and organizational – no, weak and strong relationship – will be discussed. The conclusion in section 3 will summarize the literature mentioned and propose some factors which have influence on CEO compensation.

2.0 Literature Review

2.1 Definitions of CEO Compensation and Organizational Performance

McNamara (2008) explains that CEO (Chief Executive Officer) is a singular position in an organization. The responsibility of CEO is to set up the strategic goals, plans and policies to guide the organization into the correct direction and supervise the operations in the organization. According to the description about CEO, it is obvious that CEO plays a pivotal role in an organization. An excellent CEO has an ability to ensure the firm to obtain competitive advantage in its target market and earn a mammoth amount of profit. Conversely, an awful CEO is a nightmare of a firm, which may cause a bankruptcy of the firm.

Since CEO is vital in an organization, how to pay for CEO to encourage he/she to work effectively and efficiently? Ozkan (2009) mentions there are two types of CEO compensation. That is, monetary and non-monetary rewards. As to the monetary reward, it includes salary, bonus and stock. In non-monetary reward, a spacious office and being treated fairly belong to this category.

With respect to the definition of organization, it is a society entity which is task oriented and well structured (Samson and Daft, 2009). As to the performance of an organization, there are two kinds of criteria. The first one is financial results, such as the total profit, the price of stock and so on. This essay will focus on financial criteria to evaluate the performance of a firm. The other criterion is the influence on a society and the welfare of employees, no matter a profit or loss made by a firm.

As mentioned before, this essay will use financial result to evaluate the performance of a firm. In the financial aspect, there are several ways to calculate the financial result. For example, Finkelstein and Hambrick (1989) use return on equity (ROE) as financial index. They find that in UK the value of a company in stock market – stock market capitalization – shows stock performance of a firm. In Japan, shareholder’s return is an important signal of organizational performance (Kubo, 2001). Chalmers and his partners (2006) use annual stock market return comprising of capital revenue and dividend at the end of year to describe the performance. Jones and Kato (1996) combine return on assets and profit margin to measure firm performance.

2.2 Relationship between CEO Remuneration and Organizational Performance

Topic about relationship between CEO compensation and organizational performance is heated and controversial in both academic circles and practical exercise. Some people believe that this relationship is positive. That is, a higher payment to CEO can absolutely ensure a better performance of a firm. However, on the other hand, some people argue that this relationship is weak or there is no relationship. They insist that increase the compensation to CEO blindly will not result in an expected performance of a firm. People who hold the different opinions about the relationship between CEO compensation and organizational performance can hardly reach a consensus. In this essay, three categories of relationship – no, weak and strong – will be introduced respectively in the following section.

2.3 No Relationship between CEO Remuneration and Organizational Performance

Fleming and Stellios (2002) find there is no relationship between CEO remuneration and organizational performance. In the top 500 publicly treated firms in Australia, they apply a quota sampling method to randomly choose companies with different size – measured by market capitalization – in the population of 500 firms. They explore how firm size, firm risk and firm performance have an influence on CEO compensation. CEO compensation includes salary, bonus, stock and non-cash entitlements. After analyzing the collected data, they find there is a strong positive relationship between firm size and CEO compensation. CEO in firms with larger size can receive more revenue than that in smaller size firm. Besides that, they conclude that there is a strong positive relationship between firm risk and CEO compensation. CEO in a firm with higher risk can earn more than that in a risk-adverse firm. However, not all CEO prefer to work in a high risk firm, because the possibility of failure in this kind of is high too. Once failed, the reputation of CEO will be threatened. What’s more, Fleming and Stellios reveal that there is no relationship between CEO remuneration and organizational performance based on the analysis of collected data.

Izan, Sidhu and Taylor (1998) also discuss this relationship according to the data collected from 500 publicly treated firms in Australia. They come to the same conclusion as Fleming and Stellios (2002). That is, there is no relationship between CEO remuneration and organizational performance. In their paper, they use two different kinds of criteria to evaluate the performance of a firm. That is, accounting and marketing-based way. As to the CEO compensation, they only consider cash compensation and ignore the value of stock they receiving. They find that no matter the form of organizational performance – accounting or marketing-based way, there is no relationship between CEO compensation and organizational performance. Therefore, they point out that the compensation for CEO in Australia may be inefficient. Then, they proposed some reasons to explain why CEO compensation in Australia is inefficient. They believe the inefficiency CEO compensation is caused by the lacking of implicit arrangement and the importance of large shareholders. Besides that, they notice that neglecting deferred compensation is the other reason to explain the inefficient compensation.

2.4 Weak Relationship between CEO Remuneration and Organizational Performance

Unlike the conclusion proposed by Fleming and Stellios (2002) and Izan et al. (1998), some works show that the relationship between CEO compensation and organizational performance is weak.

Jensen and Murphy (1990) interview more than 2000 CEO during a period of five decades and find that there is a weak relationship between CEO compensation and organizational performance. Moreover, they also come to some important conclusions. The compensation of CEO will go up by 2 percent in this year and the next year if the shareholder wealth is changed every one thousand dollars. What’s more, among the incentives provided to CEO, the ownership of the firm’s stock can encourage CEO to work effectively and efficiently to the largest extent. However, the holding of stock is pretty small and it is decreasing. Furthermore, CEO compensation includes 50 percent of bonuses. Nevertheless, these bonuses have little relevance to the organizational performance.

Tosi, Werner, Katz and Gomez-Mejia (2000) take good advantage of meta-analysis, a method which is scientific rigor and little bias, to illustrate two kinds of relationships – the relationship between CEO compensation and firm size and the relationship between CEO compensation and organizational performance. In CEO compensation, salary, bonus, and value of short term and long term incentives are mentioned. As to the firm size, they use the number of employees hired, sales of products, market value and value of stock to measure the size of a firm. As to the organizational performance, stock performance and financial performance are considered. After analysis, they find that there is a strong and positive relationship between CEO compensation and firm size. Specifically speaking, the firm size can explain more than 40 percent of change in CEO compensation. However, as to the relationship between CEO compensation and organizational performance, the relationship is not significant, or weak. Organizational performance only accounts for less than 5 percent of the variance in CEO compensation.

2.5 Positively Strong Relationship between CEO Remuneration and Organizational Performance

The research mentioned above suggest that there is no or weak relationship between CEO compensation and performance of a firm. Nevertheless, Kren and Kerr (1997) find that this kind of relationship is positively strong in their research. They consider fifty transportation companies, fifty retailers, one hundred companies which provide services and five hundred companies listed on Fortune between 1987 and 1989. In their research, they use cash, stock, the value of short term and long term incentives and pension plans to evaluate CEO compensation. As to the organizational performance, two different indexes are mentioned. That is, return on assets – revenue before tax divided by the average total assets, and return on common stock – the total number of price of stock and dividends divided by the stock price in the previous year. In their conclusion, they mention that, when the outsider boards are higher and the shareholdings of boards are manifest, the relationship between CEO compensation and performance of a firm is positively strong.

3.0 Conclusion

The relationship between CEO compensation and organizational performance is controversial. Different scholars come to different conclusions. From the part of literature review, there are three main reasons to explain this difference. Firstly, different countries have different situations. Data collected from different countries may lead to the opposite result. Then, there are numerous ways to measure CEO compensation and organizational performance. The unity of measuring method may reduce this discrepancy. Lastly, in some situations, other factors may have significant influence on CEO compensation, such as firm size, CEO tenure, power determinants, and so on.


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