Performance Measurement, Value-Creation and Managerial Compensation: The Missing Link

The discussion on value-based performance measures is centered around the concept of residual income. The main property of residual income is its connection to capital budgeting and the net-present-value-rule. This property is, however, not sufficient to guarantee strong goal congruence between management decisions and the firm's objectives. So far, the literature suggests compensation schemes based on modified accounting rules in order to induce the manager to make optimal investment decisions. In contrast, we show that strong goal congruence is also attainable by modifying the compensation function. We develop an incentive scheme based on a bonus bank, which can be interpreted as a nonlinear contract. Within this concept, we provide a link between the incentive system and the actual creation of value, measured by a performance measure derived from Excess Value Created.