Managerial Control, Performance, and Executive Compensation

Author(s): Luis R. Gomez-Mejia, Henry Tosi and Timothy Hinkin

Source: The Academy of Management Journal, Vol. 30, No. 1 (Mar., 1987), pp. 51-70
Published by: Academy of Management
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?Academy of Management Journal
1987, Vol. 30, No. 1, 51-70.

MANAGERIAL CONTROL, PERFORMANCE, AND

EXECUTIVE COMPENSATION
LUIS R. GOMEZ-MEJIA
University of Colorado at Boulder
HENRY TOSI
University of Florida
TIMOTHY HINKIN
University of Virginia
Using a sample of 71 very large manufacturers, this study demonstrated
that executives in externally controlled firms receive more compensa-
tion for performance and less for scale of operation than their counter-
parts in firms without dominant stockholders. This finding held true for
both compensation level and its rate of change over time. Our main
conclusion is that outside dominant stockholders view firms primarily
as investments and have the power and the incentive to align the com-
pensation of hired CEOs with performance of firms.

Both a popular and an academic literature point out that the pay of chief
executive officers (CEOs) is not systematically related to the performance of
firms (Deckop, 1987; Lawler, 1971; Redling, 1981; Rich & Larson, 1984;
Roberts, 1959). Although profitability does show up as an important predic-
tor of CEOs' compensation in some studies (Agarwal, 1981; Lewellen &
Huntsman, 1970), a long stream of research has shown that a company's size
is the main predictor of executives' pay (e.g., Baumol, 1959; Dyl, 1985; Fox,
1980; McGuire, Chiu, & Elbing, 1962; Rich & Larson, 1984). The findings
reported in most of this research also show that, with size controlled, the
performance of firms has little or no bearing on executives' compensation.
This study addressed the differential effects of company size and perfor-
mance on executives' compensation in owner-controlled and management-
controlled firms. Its central argument is that CEOs' pay is more responsive to
performance in owner-controlled firms with dominant stockholders.
COMPANY SIZE AND EXECUTIVE COMPENSATION
The correlation between a firm's size and a CEO's pay level is not surpris-
ing and has several logical explanations. Simon (1957) argued that organiza-
tions attempt to maintain appropriate salary differentials between manage-
ment levels and establish these pay differentials not in absolute terms, but as
ratios. Consequently, the compensation of chief executive officers should be
greater in large firms because they tend to have more executive levels. In this
vein, Mahoney (1979) studied pay differentials between executive grades
and concluded that a difference between two levels is normally equivalent to
a 30 to 40 percent difference in compensation. Thus, many organizational
levels implies high pay at the top. The assumption that large firms will have
51

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52 Academy of Management Journal March

more executive levels than small firms is not an unfounded assumption; it is

consistent both with span-of-control theory and with the findings of Blau
(1970) and Child (1973) that firm size and number of levels are highly
correlated.
Economic theory also suggests that executive pay and company size
should be related (Roberts, 1959). An executive's marginal revenue product
is the excess of a firm's total profit under that person's direction over what it
would be under the direction of the best alternative executive, plus the
amount that would have to be paid to secure the latter's services. This total
amount represents the upper limit the firm would be willing to pay the
executive. The lower limit of the executive's compensation would be the
sum that this individual could command in the next best employment
opportunity. Assuming (1) perfect information and mobility, and (2) con-
tinua of alternative jobs open to executives and executives available to firms,
the upper and lower limits will converge, and executives will receive
compensation equal to their marginal revenue products. Without these
assumptions, the limits would not converge, and the executives' compensa-
tion levels would be indeterminate between them. In the second, more
realistic, case, the range of indeterminacy can be quite wide. Because a small
firm sells relatively few units, even a substantial difference in efficiency-as
reflected in profit per unit-that one executive achieves and another might
not cannot yield a large difference in total profit. In a large firm, however, the
large number of units sold can convert even a modest marginal difference in
profit per unit into a dramatic increase in total profit. By the same token, a
firm's ability to pay a CEO should be greater in large firms because CEOs'
compensation levels relative to total revenues tend to be inversely related to
company size.
The other component of compensation, the price of the best alternative
executive, should also be related to firm size. Large firms are likely to fill
vacancies by hiring replacement CEOs from other large firms. If there is a
shortage of executive talent, firms must pay competitively in order to attract
and retain executives (Roberts, 1959). In Dunlop's terminology, firms of
various sizes face their own unique "wage contours" (1975: 127) in the
managerial and executive markets.
A closely related economic argument is based on human capital theory
(Agarwal, 1981; Becker, 1964). To the extent that a company's size is associ-
ated with job complexity for its top executive, a close relationship should
exist between organizational size and CEO's compensation. Job complexity
refers to the nature and magnitude of responsibility vested in a job; it is a
structural concept relating to what a job is, rather than how well it is
performed. As organizational structures become larger and more complex,
and CEOs' work specifications get tougher, their pay should also increase to
compensate them for the additional human capital requirements their jobs
demand.
The above explanations for the relationships between firm size and CEOs'
pay do not imply, though, that increases in size, efficiency, and profitability

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1987 Gomez-Mejia, Tosi, and Hinkin 53

go hand in hand (Roberts, 1959). Neither do they mean that maximizing a

firm's size leads to maximizing its stock price (Brigham, 1985). The range of
indeterminacy in CEOs' pay may be quite wide, even for firms of similar
sizes (Roberts, 1959). Among the largest firms, even small improvements in
efficiency may yield larger increases in total company profits than the firms
would obtain through further increases in size (McEachern, 1975). Therefore,
company size should not be more important than performance as a determi-
nant of CEOs' pay for the largest firms (McEachern, 1975).
Empirical evidence for these explanations in terms of human capital and
the external labor market is rather limited and somewhat mixed. This proba-
bly reflects the difficulties involved in operationally defining some of these
concepts. Agarwal (1981), using a sample of insurance firm CEOs, tested for
close relationships between CEOs' job complexity, measured as firm size;
the executives' human capital, measured by previous work experience, edu-
cational level, and type of degree; and level of compensation. Although firm
size and CEOs' compensation were highly related (r = .78), the human capital
variables accounted for very little variance in CEOs' pay. Likewise, Dyl
(1985) examined the relationship between several demographic characteris-
tics of CEOs normally used as proxies for human capital and CEOs' pay
among a sample of 271 Fortune 500 firms; he concluded that "none of these
demographic variables were statistically related to the level of compensation"
(1985: 5). McCann and Hinkin (1984), who analyzed 812 executive transi-
tions during 1980 through 1983, found that most executive replacements
came from similar firms within the same industries as the hiring firms. This
suggests that the executive labor market is rather segmented and that a going
market rate for executives may very well exist within each segment.
Performance, Managerial Control, and Executive Compensation
What is most intriguing in the literature investigating executive comperl
sation is that, after controlling for size, researchers have not found the rela-
tionship between CEOs' pay and company performance to be as strong or
consistent as the classic economic and behavioral theories would imply.
After all, a fundamental premise of a market system is that the best perform-
ers should receive the highest rewards. Yet practicing compensation special-
ists point out that "there is little evidence of a direct pay-for-performance
relationship between top executives' compensation and corporate perfor-
mance" (Redling, 1981: 15) and that companies with long-term incentives
for chief executives were giving "stockholders an annual return no better
than the return in companies without such incentives" (Rich & Larson, 1984:
20).
There is a line of theoretical reasoning that provides some basis for
reconciling these divergent findings. Perhaps it is not reasonable to assume
that managers seek to maximize profits in the sense of classic economics. In
the conventional profit-maximizing model, a manager acts as a surrogate for
an owner and-since it is the owner's goal to maximize profits-the manager's
behavior reflects this. Lacking equity interests in their firms and thus insu-

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54 Academy of Management Journal March

lated from "both product-market and stockholder constraints" (McEachern,

1975: 41), managers' motivations might differ, and their actions might be
likely to deviate from profit-maximization behaviors. Insulation from the
ownership side can occur quite easily when shareholdings are spread across
such a large number of stockholders that the owners' power to affect a firm is
diluted. Berle and Means (1968), Galbraith (1976), and others have advanced
this thesis.
This stream of research has implications for economic theory and policy
because it examines a fundamental premise of classic economic theory, that
the management of a firm does and should reflect the interests of its owners.
If we assume a difference between the interests of owners and management,
it follows logically that with great separation of control, the making of poli-
cies and decisions will not adequately reflect the interests of the owners. An
important early study by Berle (1959) concluded that shareholders controlled
only 34 percent of the 200 largest nonfinancial corporations. Larner (1970)
reported that this figure had dropped to 12 percent. Such a finding strikes at
a core idea of classic economics because owners, interested in profitability,
may lose control of their assets to managers who may have different intentions.
A number of empirical studies have examined whether or not type of
control makes any difference in the behavior of firms, and some systematic
differences between owner- and management-controlled firms has emerged.
Owner-controlled firms tend to have higher profitability (McEachern, 1975),
and they replace executives more frequently when performance declines
(Salancik & Pfeffer, 1980). Management-controlled firms tend to over-report
earnings (Saloman & Smith, 1979), are more risk-averse (Palmer, 1973), and
are more likely to engage in activities that may violate antitrust laws (Blair &
Kaserman, 1983).
If these differences exist between management- and owner-controlled
firms, it follows that type of control could be a key determinant of the pay
levels of chief executives. Managers setting their pay levels relatively free of
the influence of owners are, as Baumol (1959) noted, more likely to place
their interests above those of the owners, who impose little penalty. Manag-
ers will seek to maximize sales and use this, rather than performance, as a
basis for pay for three reasons: (1) As we discussed, large size may be used to
justify high pay. (2) Executives may have a double standard about how pay
levels should be determined. Dyer, Schwab, and Theriault (1976) found that
managers believe that performance should be the basis of their subordinates'
pay and that seniority, cost of living, education, and the like should not be
major determinants of pay increases. They have different criteria for
themselves, however, believing that their pay should be performance-based,
but that cost of living, seniority, and the like should also be important
considerations. Therefore, it should not be surprising that when executives
control a firm, performance is not likely to be the basis of their pay, and other
factors will weigh heavily in the calculation. But, if owners' orientations to
the pay of those they hire-the managers- resemble managers' orientations
toward their subordinates' pay, owner-controlled firms should base execu-

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1987 Gomez-Mejia, Tosi, and Hinkin 55

tives' pay more heavily on performance than will management-controlled

firms. (3) Size is a less risky basis for setting executives' pay than performance,
which is subject to many uncontrollable forces outside the managerial sphere
of influence.
Hypotheses
Previous research on the relationship between compensation to CEOs
and factors like size and performance has produced weak relationships with
company performance. Research focusing on distribution of ownership,
however, provides a potentially useful theoretical point of departure. Draw-
ing on it, we framed hypotheses concerning the effects of type of control on
executive pay that specify correlates of the components of pay structures, the
level of pay of each component, and changes in each component of pay.
It follows from our arguments that owner-controlled firms will reward
executives for the outcomes that owners prefer; thus, performance will most
affect CEOs' pay. Likewise, CEOs in management-controlled firms will pre-
fer to avoid the risk of tying pay to performance; therefore, firm size, which
is likely to vary less than performance, will most affect pay (McEachern,
1975).
Hypothesis 1: Performance, rather than scale, will be the
most important determinant of compensation level for all
components of executive pay in owner-controlled firms.
Hypothesis 2: Performance, rather than scale, will be the
most important predictor of changes in all components of
executive compensation in owner-controlled firms.
Hypothesis 3: Scale, rather than performance, will be the
most important determinant of compensation level for all
components of executive compensation in manager-con-
trolled firms.
Hypothesis 4: Scale, rather than performance, will be the
most important predictor of changes in all components of
executive compensation in manager-controlled firms.
A fifth hypothesis concerns the mix of elements in compensation
structures. Again, we assume that CEOs will act in their own best interests,
and owners will act in theirs. All else being equal, owner-controlled firms
should make a larger share of compensation contingent on performance than
will management-controlled firms. Theoretically, bonuses and long-term in-
centives are more contingent on performance than is base salary. Therefore,
owner-controlled firms are more likely to develop pay packages for CEOs
favoring bonuses and long-term income rather than base salary. On the other
hand, executives in management-controlled firms would prefer just the oppo-
site type of compensation structure in order to minimize personal risks. By
implication, we expected to find a higher correlation between performance
and bonuses and long-term income as proportions of total income in owner-
controlled firms.

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56 Academy of Management Journal March

Hypothesis 5a: Bonuses and long-term income will be

greater proportions of total CEO compensation in owner-
controlled firms than in management-controlled firms.
Hypothesis 5b: Bonuses and long-term income as propor-
tions of total CEO compensation will be more highly re-
lated to performance in owner-controlled firms than in
management-controlled firms.

METHODS
Sample
In its annual survey of executive compensation for the years 1979 through
1982, Business Week (1980-83) published a list of 71 companies that an
executive firm randomly selected from the 400 manufacturing firms listed in
Standard & Poor's COMPUSTAT? tapes as largest in terms of sales. This list
of companies, which appears in Table 1, provided our sample. All 71 corpo-
rations are classified as manufacturers1 on the basis of corresponding three-
digit Standard Industrial Classification codes. We gathered statistical data
for each firm, including CEOs and their compensation, from Standard &
Poor's Directory, Business Week, and corporate annual reports, for 1979
through 1982. A four-year period is long enough to limit the influence of
short-term irregularities, but short enough that management's philosophy
and structure can be thought of as continuous (McEachern, 1975). Of the 71
organizations studied, 68 percent had annual sales exceeding $1 billion
dollars.
Measures
Ownership. Although the precise functional relationship between con-
centration of ownership and control is unknown, research spanning more
than 50 years suggests that the proportion of stock required to exercise signifi-
cant control in large firms may be quite small. A study conducted by the
Securities and Exchange Commission in 1937 argued that 10 percent stock
ownership was sufficient to allow exercise of substantial influence over a
firm. By the early 1960s, researchers were applying a lower cutoff point-5
percent stock ownership-to distinguish between owner- and management-
controlled firms. They argued that as firms grew and stocks became more
widely distributed, the fraction needed to exercise control would shrink.
Using this 5 percent ownership convention, researchers have demonstrated
significant differences between owner- and management-controlled firms on

1 Previous surveys have shown minor differences in CEOs' pay for firms of similar size
within manufacturing subsectors-durable compared to nondurable, for example-but these are
not of great magnitude, as would be the case for comparisons of CEOs' pay across diverse
industries like banking, manufacturing, and agriculture (Smart, 1985). We found no significant
differences in executives' compensation by product line in the sample of firms used in this
study.

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1987 Gomez-Mejia, Tosi. and Hinkin 57

TABLE 1
Firms in Samplea

American Can Company International Harvester Company

American Home Products Corporation International Paper Company
American International Group, Inc. Johnson Controls, Inc.
American Motors Corporation Kimberly-Clark Corporation
Armco Inc. Eli Lilly & Company
Atlantic Richfield Company (ARCO) The Mead Corporation
Baker International Corporation Merck & Company, Inc.
Boeing Company Mobil Corporation
Burroughs Corporation Monsanto Company
Caterpillar Tractor Company NCR Corporation
Clark Equipment Company NL Industries, Inc.
Colgate-Palmolive Company National Can Corporation
Cone Mills Corporation National Distillers & Chemical Corporation
Continental Group, Inc. Philip Morris Company, Inc.
Control Data Corporation Phillips Petroleum Company
Cooper Industries, Inc. Procter & Gamble Company
Dana Corporation R. J. Reynolds Industries
Dresser Industries, Inc. Schering-Plough Corporation
Exxon Corporation Shell Oil Company
Faberge, Inc. SmithKline Beckman Corporation
Firestone Tire & Rubber Company Standard Oil Company of California
Ford Motor Company Standard Oil Company of Indiana
General Dynamics Corporation Standard Oil Company of Ohio
General Motors Corporation Stauffer Chemical
General Signal Manufacturing Corporation J. P. Stevens & Company, Inc.
Gillette Company St. Regis Paper Company
The B. F. Goodrich Company Teledyne, Inc.
The Goodyear Tire & Rubber Company Texaco, Inc.
Gulf Oil Corporation Union Oil of California
Harris Corporation Uniroyal, Inc.
Hoover Company United States Steel Corporation
Hughes Tool Company Warner-Lambert Company
ITT Corporation Westinghouse Electric Corporation
International Business Machines Corporation Wheeling-Pittsburgh Steel Corporation
Ingersoll-Rand Company Whirlpool Corporation
Inland Steel Company

aN = 71.

a variety of measures, including rates of return on investment (Boudreaux,

1973), risk aversion (Palmer, 1973), performance (Glassman & Rhoades,
1980; McEachern, 1975; Sorenson, 1971, 1974), executive transitions (Salancik
& Pfeffer, 1980), and antitrust activities (Blair & Kaserman, 1983; Chevalier,
1969).
In this study, we designated a firm as owner-controlled if at least 5
percent of its outstanding stock was in the hands of one individual or organi-
zation that was not involved in actual management of the company. A firm
was management-controlled when no individual or organization controlled
5 percent or more of its stock. We used a dummy variable, with owner-

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58 Academy of Management Journal March

controlled firms coded as 1 and management-controlled firms coded as 0; 19

firms were owner-controlled, and 52 were management-controlled. No firm
in the sample was owner-managed, with a dominant stockholder who was
also the CEO.
Performance and scale indicators. A firm's performance was defined as
a composite of its financial success and the extent to which it maximized the
welfare of its stockholders. The use of profitability can be criticized: it may
not reflect a firm's true underlying value or performance because executives
can manipulate indicators to make themselves look good. Depreciation
policies, accelerated versus straightline; inventory procedures, FIFO versus
LIFO;2 use of short-term, noncapitalized leases to obtain productive equip-
ment; and window dressing techniques, such as holding borrowed money as
cash until the end of the year so a balance sheet looks good, are all potential
problems when interpreting accounting data.
Although some firmly believe that not profitability, but stockholders'
welfare-in the form of increases in stock prices or dividends paid-should
dictate executives' pay (Poster, 1985; Rappaport, 1978), others have ques-
tioned these measures as well. Paying out cash dividends will tend to raise a
stock's price. However, raising cash dividends decreases funds available for
reinvestment and R&D, which lowers expected growth rate and depresses
the price of a stock in the long run-with effects perhaps occurring at a time
when another executive will bear the brunt of the problem (Brigham, 1985).
Stock prices are also very sensitive to external events that may have little to
do with how efficiently a firm is run and that are totally beyond management's
control (Deckop, 1987). Because of these concerns, compensation consul-
tants such as Bickford (1981), Ellig (1984), and Rich and Larson (1984) have
frowned on the use of stock price data as the primary basis for establishing
CEOs' pay and have instead suggested use of profitability measures as prox-
ies for performance, or use of a combination of stock price and profitability
data.
Using multiple indices is more important than the specific measure of
firm performance chosen because any single measure may arouse criticism
(Weiner & Mahoney, 1981). Pooling performance data into a four- or five-
year average also provides a better long-term indicator and a more reliable
and valid measure of firm performance than annual measures (Brigham,
1985; McEachern, 1975). We calculated several average measures for each
firm in the sample with the goal of developing reasonably independent
parameters for scale and performance during the four years from 1979 through
1982. These measures include: (1) annual sales volume; (2) annual total
profits; (3) annual percent change in sales; (4) annual percent change in
reported profits; (5) annual return on equity (ROE); (6) annual earnings per
share (EPS); (7) annual percent change in dividend yield to investors on a
company's stock; (8) year-end market value of a firm; and (9) annual percent
2
FIFOstands for "first in, first out"; LIFOstands for "last in, first out."

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1987 Gomez-Mejia, Tosi, and Hinkin 59

change in a firm's market value, computed by multiplying stock price times

number of shares.
Sales volume and total profit reflect absolute dollar values in the scale of
firms (Lewellen & Huntsman, 1970). Measures 3 and 4 indicate the magni-
tude of the rate of change for sales and profits for the period. The profitabil-
ity ratios are the two "bottom-line" standardized financial indicators that
firms most commonly use (Brigham, 1985; Woelfel, 1980). Measure 5, ROE,
is based on net income relative to common equity, and measure 6, EPS, is
based on net income relative to shares outstanding. The last three measures
are indicators of stockholder's welfare (McEachern, 1975). Dividend yield
reflects managers' decisions on allocating net income to common stock-
holders, as dividends per share, or to corporate savings, as retained earnings.
Finally, the stock price measures indicate what investors think of a company's
past performance and future prospects (Brigham, 1985).
These nine measures were factor-analyzed by the principal axis method
with the squared multiple correlation as the estimate of communality. A plot
of eigenvalues indicated that only two factors reached the standard criterion
of 1.0. Table 2 shows the rotated varimax solution for all measures. Two
distinct factors emerged: scale, composed of sales volume and total dollar
profits, and performance, composed of the four-year rates of change in prof-
its and sales, return on equity, earnings per share, stock price, dividend
yield, and annual percent change in market value.
It is not surprising that the performance measures loaded on a single
factor. Changes in levels of sales affect net income, the common denomina-
tor of the ROE and EPS ratios. A firm's ability to pay dividends depends on
its earnings. In financial markets, investors and credit analysts use the infor-
mation contained in annual reports to form expectations about future earnings,
thereby affecting stock prices. Changes in stock prices tend to follow the

TABLE 2
Results of Principal-Axis Factor Analysis with Varimax Rotation:
Scale and Performance Indicators
Factor 1 Factor 2
Financial Items Scale Performance
Dollar sales .921 .005
Dollar profits .927 .306
Percent change in sales .048 .662
Percent change in profits .007 .723
Percent change in dividends .115 .652
Common market value .118 .622
Return on equity .035 .878
Earnings per share .229 .767
Percent change in stock price x shares .063 .420
Eigenvalues 4.810 2.426
Percent of variance 59.7 40.3

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60 Academy of Management Journal March

announcement of EPS, ROE, and dividend actions, indicating that these

reports have important signaling effects (Fama & Miller, 1984). If the profit-
ability ratios are all good, a stock price will probably be as high as is possible
(Brigham, 1985).
Because using each separate item as an independent variable would
have created a severe multicollinearity problem, we instead used these two
composites. We calculated each of the factor scores by adding the standard-
ized value of each variable weighted by its factor loading and then standard-
ized the composite factor scores. As Table 3 shows, the resulting two factor
scores are not highly correlated (r = .307).
CEOs' compensation. Compensation has three distinct components:
salary, bonuses, and long-term income. The last includes a wide array of
deferred compensation benefits like pensions, profit sharing, stock options,
IRAs, and bonus deferrals. Constructing three different compensation mea-
sures for each executive in the sample, we computed (1) the mean absolute
dollar amounts received from 1979 through 1982 for salary, bonuses, and
long-term income, (2) the mean annual percent change over the period for
each of these components, and (3) the relative weight of each component in
the earnings mix, calculated as an average ratio of the value of a particular
component to total compensation received during this period.
External hires. Attracting an executive from another organization may
have a separate effect on compensation level. We recorded CEOs who had
been hired from outside their companies in this period as externals, with
0 = no outside hire and 1 = outside hire, and entered this information as a con-
trol variable in the regression equations. Table 3 presents the relationship
between external hires and the other measures of the study. We did not
consider executives who had been promoted from within during this period
as a separate category since there were no significant differences between the
earnings of this group and those of incumbents.
Analysis
Hypotheses 1-4 and 5b were tested by regression analysis. We calculated
separate stepwise regression equations for the owner- and management-
controlled groups, with scale, performance, and external hires entered as
predictors and the three components of CEOs' compensation as dependent
variables. Using the Chow test (Chow, 1960), we tested the statistical signifi-
cance of the differences in the regression slopes between the two types of
firms. In all the regression procedures, we entered scale into the equations
first for two reasons. This factor has the highest bivariate correlation with the
level of CEOs' earnings (Table 3). Moreover, entering scale first was the more
conservative approach. This procedure gives the scale coefficients the maxi-
mum benefit of the doubt and underestimates the contribution of perfor-
mance in terms of explained variance.
For Hypothesis 5a, we used a test of proportion (McNemar, 1967) to
determine whether bonuses and long-term income were greater proportions
of total compensation in owner-controlled firms than in management-
controlled firms.

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 TABLE 3
Intercorrelation Matrix for Predictors and Compensation Me
Variablesb Means s.d. 1 2 3 4 5 6 7
1. Scale 0.00 1.00 -
2. Performance 0.00 1.00 31 -
3. External hires 0.28 0.06 -08 -18 -
4. Salary 214.26 145.07 36 21 -12
5. Bonuses 166.74 138.72 21 21 17 72
6. Long-term income 171.12 82.40 29 32 -09 35 28
7. Percent change in salary 27.83 16.31 11 20 -01 19 08 24
8. Percent change in bonus 23.12 19.94 27 21 34 26 36 18 30
9. Percent change in
long-term income 10.71 6.23 08 22 -07 15 -07 23 15 -
10. Salary / total 0.43 0.15 -15 -11 -05 -01 -16 -08 31 -
11. Bonus / total 0.34 0.13 00 -22 10 04 -03 08 00
12. Long-term income / total 0.23 0.14 16 26 -09 22 30 -62 -13
13. Owner control 0.27 0.44 -19 -24 09 -19 -26 -03 -24 -
a Decimal points are deleted; r > 15, significant at p < .05; r > 20, significant at p < .01; r > 28, sign
b The scale and performance measures are calculated in standardized scores; salary, bonuses, and long-t
of dollars.

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62 Academy of Management Journal March

RESULTS
Table 4 shows the separate regression results for the management- and
owner-controlled firms. As the first three columns show, only performance
reaches statistical significance as a predictor for each of the absolute
compensation measures in the owner-controlled group. In the management-
controlled firms, on the other hand, scale is the only predictor of base salary
and the main predictor of bonuses and total compensation, although perfor-
mance does have a major effect on long-term income.
Table 4 also shows that performance explains seven times the amount of
variance in the percent change in total compensation for the owner-controlled
group relative to the management-controlled group (AR2 = .231 versus AR2 =
.038). The performance factor reached statistical significance at the .01 level
only in the owner-controlled firms for percent changes in salary, bonuses,
and long-term income.
For the measures of compensation mix, shown in the last three columns
of Table 4, the owner- and management-controlled groups behaved similarly.
Performance is negatively related to base salary and bonuses as percentages
of total compensation and positively related to long-term income as a per-
centage of total compensation. However, a test of proportion showed that the
differences between the owner- and management-controlled groups on the
fractions of compensation devoted to salary (46.14% vs. 42.04%), bonuses
(33.4% vs. 34.2%), and long-term income (20.5% vs. 23.7%) did not reach
statistical significance, thereby failing to support Hypothesis 5a.
The Chow tests indicate that, with the exception of absolute long-term
income (p < .10) and the compensation mix equations (n.s.), there are signifi-
cant differences in the slopes of the regression equations between owner-
and management-controlled firms, providing general support for Hypothesis
1-4 but not for Hypothesis 5b. Table 5 summarizes the regression results in
terms of the hypothesized relationships, again illustrating support for all but
the hypotheses concerning compensation mix.

DISCUSSION
A firm's type of ownership significantly affects its CEO's pay. When
there are dominant stockholders, CEOs' compensation levels primarily re-
flect their firms' performance levels-these executives are paid more for per-
formance and less for the scale of operation than CEOs in firms without
dominant stockholders. We found this to be true for both pay level and its
rate of change over time.
Compensation mix does not differ for the two types of firms, and long-
term income, as a proportion of total compensation, appears to be closely
associated with performance in both owner- and management-controlled
firms. The U.S. tax system may promote this similarity. The value of any
financial reward depends on the stream of income after taxes. When federal
and state income taxes are included, the marginal tax rate for an executive in
a large corporation could approach 70 percent during the period of this

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 TABLE 4
Determinants of Executive Compensation
Absolute Amounts Yearly Percent Change
ement-
ManagemeManag anagement- Owner-
controlled controlled c l controll ed contr
Compensation Items Chow Test Chow Test
and Predictors b R2 b R2 F-Value b R2 b R2 F-Value
Salary 4.02** 2.97*
Scale 30.19*** .145 -4.71 .010 2.52 .001 10.23 .054
Organizational
performance 17.70 .168 1.48** .052 5.19 .056 6.75** .118
External hires -68.84 .172 -118.33 .054 11.05 .061 16.85 .122
Bonuses 2.68* 4.13**
Scale 13.53*** .035 -10.37 .017 12.92*** .069 -7.45 .003
Organizational
performance 17.84* .074 1.59* .054 2.27 .079 5.78** .200
External hires 354.72*** .076 -57.68 .056 293.31*** .342 18.04 .215
Long-term income 2.44 3.63**
Scale 39.80* .091 8.67 .017 1.41 .002 8.13 .060
Organizational
performance 54.46** .178 34.16* .096 0.43 .002 14.75** .245
External hires -179.78 .186 71.99 .097 -44.85 .002 65.35 .277
Total compensation 3.01* 3.44**
Scale 83.53*** .154 -6.41 .005 16.85* .034 10.92 .034
Organizational
performance 90.00* .229 31.08* .058 7.89* .072 27.29** .265
External hires 106.11 .230 -174.02 .067 259.52** .155 100.24 .289
* p < .05
** p < .01
*** p < .001

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 TABLE 5
Summary Matrix Showing Significant Determinants
of Executive Compensation by Ownership Category

Owner-controlled M
Yearly As Percent of
Compensation Items Absolute Percent Change Total Packageb Absolute
Base salary Performance Performance Performance Scale

Bonuses Performance Performance Performance Scale and

- performance
Long-term income Performance Performance Scale and Scale and
performance performance

Total compensation Performance Performance N.A. Scale and

performance
a N = 19 for owner-controlled firms; N = 52 for management-controlled firms.
b A minus sign indicates a significant negative relationship with that aspect of the compensation mix; a
relationship.

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1987 Gomez-Mejia, Tosi, and Hinkin 65

study (Brigham, 1985). But the Internal Revenue Service defines most long-
term income like stocks, bonds, and performance shares as capital assets that
are generally nontaxable until converted into cash, when they are taxed at
the rate that applies to ordinary income like salary and bonuses. Because tax
regulations apply equally to all executives, they induce both owner- and
management-controlled firms to distribute CEO compensation into the same
categories.
This study also showed that performance does have a significant effect
on executives' compensation in both owner- and management-controlled
firms; however, it is a much weaker predictor of executives' compensation in
the second. These findings may help explain the inconsistent results of
previous studies that did not control for type of ownership. If a population
consists mostly of management-controlled firms, scale is likely to be the
main predictor of executives' compensation. In an owner-controlled popula-
tion, on the other hand, performance is the most likely determinant of
executives' compensation, with scale playing a secondary role.
Some Social Implications
Currently, executive compensation is attracting extensive critical com-
ment-not surprising, since over the past ten years the salaries and bonuses of
CEOs have increased about 40 percent faster than the average hourly earn-
ings for nonfarm workers (Sibson & Co., 1985). CEOs' ability to influence
their own pay levels, subject to few constraints, may in part explain this
trend. Williams pointed out that:
In practice, contrary to the basic tenets of the [compensation]
model procedure, the chief executive often has his hand in the
pay setting process almost from the first step. He generally
approves, or at least knows about, the recommendation of his
personnelexecutive beforeit goes to the compensationcommittee,
and may take a pregame pass at the consultant's recommenda-
tion too. Both (personnel executives and consultants) rely upon
the good graces of the chief executive for their livelihood. The
consultantin particular-who is typically hiredby management-
would like to be invited for a return engagement. The board's
compensation committee doesn't operate independently of the
chief executive either (1985: 66-67).
This study also has implications for compensation's role in motivating
executives. Management-controlled firms clearly design compensation sys-
tems to avoid the vagaries of fluctuating performance and to take advantage
of a more stable factor, size. At the same time, executives in management-
controlled firms, who apparently do take advantage of performance with
respect to long-term income, appeared to have the best of both worlds. Their
basic salaries were functions of firm size, a relatively stable factor, their
long-term incomes were greater when performance was good, and the scale
of their organizations provided a downside hedge against poor performance.
The managers in the owner-controlled firms were in riskier positions-they

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66 Academy of Management Journal March

were primarily rewarded for performance, a more variable and risky factor,
in all components of compensation.
The compensation structures of management-controlled firms are not
designed well enough to maximize economic efficiency and profitability. A
significant literature shows that management-controlled firms tend to be
risk-averse, to overstate profits, to engage in activities designed to increase
size, and to engage in merger and acquisition activity (Blair & Kaserman,
1983) that may be economically inefficient (Hayes & Abernathy, 1980). Per-
haps very little can be done to change this situation; the individual stock-
holders of management-controlled firms cannot sufficiently influence these
operations, given the broad spread of ownership. Stockholders may find it
difficult to form coalitions because they usually must communicate through
a firm's management, which may not view such owner coalitions as in its
best interests. Neither can large institutional investors be expected to join
together to pressure executives in management-controlled firms to change
their approach, for to a large extent, the behavior of management-controlled
firms is attractive to them. Such firms typically avoid risk and protect and
build assets through growth. Institutional investors may find these accept-
able tradeoffs against higher profitability with more risk.
These findings raise some important normative issues about managerial
accountability and power relative to owners. In .an owner-controlled firm,
the dominant stockholder may have the power and the incentive to align the
compensation of a hired CEO with the firm's performance. Executives in
management-controlled firms, on the other hand, recognize their positions
as sources of discretion and may use this power to further their own interests.
Such strategies, however, may not go unnoticed by investors, who discount
the value of equity in those firms (Beaver & Dukes, 1973). Whether this is
normatively good or bad depends on the perspective taken on the proper
relationship between owners and managers. To someone who believes that
owners are entitled to receive the best possible return on their investment
and that they hire managers to strive for this, this situation is certainly less
than desirable.
Perhaps legislation or other regulation may shift the balance of power
toward equity holders and help resolve these conflicts. Tax laws may help
align managers' interests with those of stockholders with respect to long-
term income (Baumol, 1959; Marris, 1967); the little empirical evidence on
this point is supportive. Lewellen (1968, 1969) found that deferred executive
compensation increased dramatically during the 1950s and 1960s as a result
of tax legislation favoring such postponement and concluded that so much
of CEOs' yearly compensation in large firms was traceable to long-term in-
come that the interests of managers and stockholders could not be easily
differentiated.
Some Implications for Research and Theory
A number of interesting empirical and theoretical issues warrant
consideration. For example, the small number of variables we studied im-

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1987 Gomez-Mejia, Tosi, and Hinkin 67

plies that other, excluded factors may have strong effects on the observed
relationships. Differences in organizational complexity, executives' ages and
tenure, customary practices, and even geographical location may affect
executives' compensation.
Another issue is the impossibility of knowing the various performance
outcomes under alternative stewardships. What would a firm's performance
be without a particular executive? If a replacement would not do much
better than an incumbent, the latter's high pay may be justified, perhaps
even as compensation for the high risk of working for a company that is
performing poorly.
Since the firms used in this study were among the largest U.S. corpora-
tions, there is also a question of generalizability. If we had included smaller
firms, size's effects on CEOs' pay may have been more dramatic for a variety
of reasons. First, the executive market is much more competitive for small
firms, so replacements are easier to find and the market rate of pay for
executives is lower (McCann & Hinkin, 1984; Smart, 1985). Second, because
executive compensation as a proportion of total operating costs tends to be
inversely related to company size, ownership's effect on CEOs' compensa-
tion should be even stronger in small firms. Finally, the consequences of
poor performance by a CEO are more disastrous in small firms, since
largeness and diversification tend to minimize any single individual's influ-
ence on an organization (Hall, 1977). Other evidence suggests that changing
top management has less effect on organizational performance in large orga-
nizations (Grusky, 1963; Kriesberg, 1962).
Compensation mix tends to be similar for management- and owner-
controlled firms. For future research, it would be interesting to determine if
there are differential patterns in the structure of long-term income used in
both types of firms. Many such programs are available-incentive stock
options, stock option multiples, stock purchase plans, junior stocks, convert-
ible debentures, performance shares, performance unit plans, and phantom
stocks, to name a few. These differ significantly in terms of downside risks,
orientation toward goal achievement, investment required from executives
financing, time horizons, provisions for discretionary adjustments, restric-
tions in transfers or sales, and criteria used to determine payment (Ellig,
1984; Rich & Larson, 1984). Unfortunately, most of this information is un-
available in published sources, and much of its is proprietary.
Finally, the results reported here and previous research on managers'
behavior in these two different types of firms suggest that type of control
may be a vital concept for organizational theorists to consider. McEachern
(1975) and this study have shown that these two types of firms approach
paying top executives differently. Other studies have demonstrated differ-
ences in accounting practices, risk aversion, profitability, and propensity to
engage in growth-oriented activities like mergers. If all these actions are
components of the strategies of firms, type of control may be usefully inte-
grated into the literature about organizational strategy and environmental
adaptation. For instance, although Snow and Hrebiniak (1980) did not find

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68 Academy of Management Journal March

differences in strategic approaches as a function of environmental uncertainty,

it is quite possible that strategic approaches differ by type of control. For
example, management-controlled firms may tend toward defensive and reac-
tive strategies, and owner-controlled firms may be analytical and entrepre-
neurial. Although these points are conjectural, the evidence that type of
control has important effects seems very clear, and it is especially strong
with respect to CEOs' pay.

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Luis R. Gomez-Mejia earned his Ph.D. degree in industrial relations from the University
of Minnesota. He is now an associate professor of management at the University of
Colorado, Boulder.
Henry Tosi earned his Ph.D. degree in management from Ohio State University. He is
now a professor of management at the University of Florida.
Timothy R. Hinkin earned his Ph.D. degree at the University of Florida. He is now an
assistant professor of management at the McIntire School of Commerce, University of
Virginia. His current research interests include power and influence in organizations.

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