Briefly explain how the design of management compensation can affect conflicts of interest (i.e., agency problems)...

Briefly explain how the design of management compensation can affect conflicts of interest (i.e., agency problems) between managers and stockholders.

Expert Solution

Question summary : Effect of Management compensation Design on AGency problems between managers and stockholders.

Answer :

Agency problem between managers and stockholders is the problem of conflict of interest i.e. actually managers or employees of a company are supposed to act in the interest of the stockholders but most of the time they act in their own interest. This causes loss to the companies. This is agency problem

Agency problem is caused to to a FIXED COMPENSATION SYSTEM which was traditinally followed in organisations. In this case, employees are paid a fixed salary every month and they do not participate in the prosperity of the company.

Eg : Suppose the manager of a company is on fixed salary basis, he will not be interested in contacting more and more customers as this would be an extra work load for him. He may not take more orders than the targets given to him . This leads to inefficiencies and loss for the compny whereas no problems for the employee.

Agency Problem can be overcome by designing an INCENTIVE/ PERFORMACE BASED COMPENSATION SYSTEM. Here a variable portion of a manager's saalry is introduced which is directly linked to the sales or profits or the EVA of the company. If all employees are , say, being given 10% of the total profits of the company being distributed to tham as a variable part of their salary, each would feel as a part of the company and try to increase the profits of the comany. The managers' interest and the shareholders' interest become the same i.e. Goal Congruence. If each manager gets a variable portion of his compensation based on his perofrmance, each would be motivated to perform better , which is also in the interest of the company.

jeff jeffy answered 2 years ago

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