The Impact of Executive Compensation and R&D Expenses on Firm Performance: A Comparison between Manufacturing and Services Companies in the United States
Master Thesis
The Impact of Executive Compensation and R&D Expenses on Firm Performance: A Comparison between Manufacturing and Services Companies in the United States
December 2015
Author: Nikolaos Karakatsanis
Student Number: 409742
Supervisor: Drs. Fytraki, A.T.
Second Reader: Dr. Keusch, T.
Accounting Auditing and Control
Abstract
Using a panel of U.S. manufacturing and services companies over the 2000-2014 period, this study explores the relationships between executive compensation and firm performance, as well as, the relationship between R&D (research and development) expenses and firm performance. Moreover, this study presents a comparison of these relations between manufacturing and services companies. An Ordinary Least Squares (OLS) regression model was employed to estimate these relations, with control variables of size, total executive compensation and R&D expenses. My analysis revealed that executive compensation has a significant positive impact on the performance of manufacturing companies, but do not have an effect on the performance of services companies. Additionally, R&D expenses positively affect the performance of manufacturing firms, whereas they have a negative impact on the performance of services companies.
Keywords: Executive Compensation, R&D Expenses, Firm Performance, Firm Size, Manufacturing Firms, Services Firms
Contents
1. Introduction - 4 -
1.1 Research Problem & Motivation - 4 -
1.2 Research Objectives - 5 -
1.3 Research Methodology - 7 -
2. Literature Review-Hypothesis Development - 8 -
2.1 Executive Compensation and Firm Performance - 9 -
2.2 R&D Expenses and Firm Performance - 14 -
2.3 Interaction Effects - 17 -
3. Research Design - 21 -
3.1 Variables - 21 -
3.1.1 Independent Variables - 21 -
3.1.2 Dependent Variable - 24 -
3.1.3 Control Variables - 25 -
3.2 Data Collection - 25 -
3.3 Methodology - 26 -
4. Empirical Results - 26 -
4.1 Descriptive Statistics - 27 -
4.2 Pearson Correlation Matrix - 29 -
4.3 Main Findings - 30 -
4.4 Interaction Effects - 32 -
5. Conclusion - 34 -
5.1 Limitations and Future Research - 36 -
References - 37 -
Appendix - 45 -
1. Introduction
One of the most debated issues regarding executive compensation is the one examining the relationship between CEO compensation and firm performance. For more than seven decades this particular topic continues to concern the experts in the field of management control, while the related literature consists of more than three hundred studies (Barkema and Gomez-Mejia, 1998). Many authors have identified in their works a variety of factors that regulate the pay-performance relationship. In particular, such factors are recorded firm size, firm risk, ownership structure, socio-cultural factors and demographic factors like executives’ age, tenure, education and gender. However, something that previous studies have in common and which operates as a limitation to further testing on the pay-performance sensitivity is that they focus on notable factors, whereas they ignore other unquantifiable, socio-cultural factors such as the type of services the firm provides. Therefore, this paper attempts to explain the nature of the relationship between executive pay and firm performance based on the diversity of businesses.
Furthermore, research and development expenses are an issue with great importance for the economic development of companies, hence for the development of national economies. This importance may stem from the fact that for at least a century economic growth was driven by increasingly sophisticated technologies, which were developed to a great extent through R&D expenses (Greenstone, 2011). This importance, at least for the United States, also stem from the fact that a large proportion of R&D expenses are covered by governmental funds (Greenstone, 2011).
1.1 Research Problem & Motivation
This modern era corporations have changed the way they pay their employees. Specifically, companies use more often incentives to motivate their executives and their employees than they did in the past. The reason for that is to induce them, so as to try harder in order to achieve a better performance. The basic fact that differentiates CEO and the other executives from the non-executives employees is the high of their compensation (including basic salary, bonuses and other compensation). This is happening because of the different responsibilities they have. Moreover, firms invest in innovation through R&D expenses in order to obtain an advantage over their competitors. The current study is quite relevant to the content of finance and specifically to management control which examines the numerous official mechanisms to influence the decision making process within organizations. Executive’s compensation and the decision of the amount of investments in research and development are part of such mechanisms.
It is observed by Murphy (1999) that CEOs in all countries and especially in the United States increase continuously their compensations, while worldwide economy faced many recessions and financial crisis during the second half of the past century. In many cases the performance of both services and manufacturing companies does not justify these payments. In their work, Friedman and Friedman (2010) state that the way of CEOs compensation and the conflicts of interest are the reasons of the catastrophic financial crisis after the Lehman Brothers collapse in 2008. Moreover, based on a Watson Wyatt survey, Kirkland (2006) found out that approximately 90% of institutional investors consider top executives to be dramatically overpaid for what they do. Therefore, it is praiseworthy to wonder if compensation systems work as they supposed to or not. Additionally, it would beneficiary to examine if executive compensation affects differently companies that belong in different industries. The last one could show that manufacturing and services companies might have better performance if they embrace different compensation packages for their executives.
1.2 Research Objectives
There is a plethora of past papers that state the impact of executives’ compensation and R&D expenses on firms’ performance, which are referred in details in the literature review segment. The main objective of this study is to investigate the relations between the compensation of senior business executives (such as CEOs, CFOs and COOs) and firms’ performance on the one hand and R&D expenses and firms’ performance on the other hand. This investigation focuses on firms in the United States depending on the type of services they provide. More specifically, this thesis is going to observe if there is a different impact of executive compensation and R&D expenses on the total outcome of service enterprises (including banks and other financial firms) and manufacturing companies in the United States. All these are incorporated in the following main research question:
RQ: Does executive compensation and R&D expenses have a stronger impact on the output of services firms than on manufacturing companies in the United States?
As I will elaborate below, there are past researches that show the impact of executives’ compensation and R&D expenses on the performance of both services firms and manufacturing companies in different countries. What makes my research question unique, is that aims to gather all of these information in a single work, so as to allow the comparison between these two different industries by focusing only in the United States economy.
Providing an answer to this research question is very significant. More specifically, it could modernize compensation systems, especially for the executives based in which industry each company belongs. Additionally, this could improve companies’ operations; hence it could reduce costs and increase profitability. Last but not least, the results of this paper will give American shareholders a better insight about executive compensation and R&D investments. In details, it will be a helpful tool for the policy makers regarding the design of executive compensation systems on the one hand and the release of funds in favor of research and development on the other hand.
The originality of my study lies in the fact that investigates an issue on which there is little or no relevant existing literature. Additionally, what is special about this paper is that it compares the compensation systems and R&D investments in different economic sectors to find the best possible financial mixtures that will maximize firms’ final performance.
Since the purpose of this study is to examine the impact of executives’ compensation and R&D expenses on American firms’ performance based on the type of services they provide, I split the companies into two main categories: services companies and manufacturing companies. At this point, before I continue with my research, there is an imperative need to clarify some definitions.
Firstly, by the term total output of a company I mean all goods and services that a company produces for a specific period of time. All the above contribute to form the firms’ profit. Subsequently, services companies are those companies comprising a wide variety of industries that do not produce anything but provide services and instead. Such companies are financial services firms (banks, credit card companies, insurance companies, accountancy companies, investment funds, real estate funds, etc.), retailers, accommodation industry, etc. Finally, manufacturing companies are those businesses that use raw materials to make a final product, which can be sold directly to consumers or to other manufacturing firms to make a different product, or to provide a certain service. Examples of such companies are vehicle manufacturers, construction developers, clothing companies, mining and oil-production companies, large conglomerate, etc.
Moreover, as stated previously, companies use incentives to compensate their executives. These incentives can be both monetary when they are based in equity-based compensation and non-monetary when they are based on behavioral characteristics. Examples of equity-based incentives are the total number of stock options granted, the total number of restricted shares granted, long-term incentive payouts, bonuses etc. On the other hand, examples of non-financial incentives could be the praise and commendation from immediate manager, the attention receiving from leaders and opportunities to lead projects.
Finally, some things that need to be clarified are some of my choices regarding this project. My study focuses on firms in the United States for two main reasons: firstly, because of the size of US economy and secondly, because of the role of the United States as a leading figure-country-economy of the developed world. Regarding my choice for these particular business sectors of the United States economy, is because the services and the manufacturing industry in their broader sense comprise the largest part of the largest economy in the world. In particular, the industrial sector made up 19.1 percent, while services constituted 79.7 percent of the United States GDP in 2012 (World Economy Team, 2013).
1.3 Research Methodology
As a first step towards answering my research question, a thorough existing review of the relevant literature is conducted. Firstly, I have to present the past theoretical and empirical findings about executive compensation in general and the way executives are compensated in the United States in particular. Subsequently, I will focus on the structure of this compensation; that is the basic components based on which executives are getting paid and their development through the decades. After that I will make a distinction of the previously referred subjects between different business sectors and more precisely between the services sector (including banks and other financial institutions) and the manufacturing sector, comprising mainly of companies belonging in the automotive industry, mining and aerospace companies, etc. Secondly, I have to present the existing literature that is relevant to research and development (R&D) expenses in general, their use from U.S. companies and their impact on both manufacturing and services companies. Finally, another stream of literature that I will examine is which specific metrics could act as control variables that affect the examined relations.
After that, I will collect my data which I will extract from the Wharton Research Data Services system. For my research, I will need annual data for executive compensation for companies in the United States that are available through the COMPUSTAT ExecuComp Annual Compensation database. Moreover, for the annual data about R&D expenses and ROA (firm performance) I will use the COMPUSTAT Fundamentals Annual database. The same database I will use to extract data about sales turnover which I will use to measure the control variable of firm size. Lastly, I will compare the impact of executive compensation and R&D expenses on firm performance for all the U.S. manufacturing and services companies. My sample period is from 2000 until 2014.
The main findings of my research reveal a significant positive association between executive payments and the performance of manufacturing companies. On the contrary, there is not an association between executive payments and the performance of services companies. Moreover, the analysis showed that research and development expenses have a positive impact on the performance of companies belonging to manufacturing sector. In contrast, the impact of R&D expenses on the performance of services companies is negative. Also, the impact of executive compensation on firm performance is more intense in manufacturing than in services companies. In addition, the impact of R&D expenses on firm performance is bigger in manufacturing than in services companies. Finally, the results show that the interaction effects between executive compensation and firm size and R&D expenses and firm size is positive for both manufacturing and services firms (except for the interaction of executive payments and firm size in services companies, which does not apply at all).
The paper is organized as follows. In the next section, there is a thorough presentation of the literature that is related to both the executive compensation-firm performance relation and the R&D expenses-firm performance relation. In the same section, the construction of the research hypotheses is made. This is followed by the research design that includes data collection and methodology. Then, my findings and the basic conclusions are presented, followed by the research limitations and some recommendation for further research.
2. Literature Review-Hypothesis Development
In this section there is an attempt to collect and present all the past theoretical and empirical studies which are relevant to the relationship between executive compensation and firm performance on the one hand and R&D (research and development) expenses and firm performance on the other hand. For this purpose, there has been an overview of published, working and research papers and an endeavor to be used both the market and accounting ways to measure firm performance. To choose which papers should be discussed, I used mainly those that are included in the top ten accounting journals as they ranked in both the British and the Australasian rankings. I did that because I consider it as the best way to support the ideas that my thesis promotes. Additionally, there has been an extensive use of Google Scholar, so as to find other relevant papers. Also, I choose to use papers that on average cover chronologically a period of two decades, so as to observe the changes in both practice and theory of the pay-performance sensitivity and the performance-R&D expenses relationship throughout the years.