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Article Excerpt
The topic of CEO compensation has received a great deal of attention in the literature (Coombs and Gilley, 2005; Gomez-Mejia and Wiseman, 1997). For example, Kristie (1998) reported that the average CEO pay of the top 200 corporations in 1998 was $8.3 million. As such, CEO compensation levels are often criticized for being out of control (Crystal, 1995; Moriarty, 2005). These statements are further fueled by such staggering reports of the CEOs of Oracle and JDS Uniphase earning approximately $706 million and $150 million, respectively, for 2001 (Lavelle et al., 2002).
In spite of research efforts, there is still much to be learned regarding CEO compensation (Gomez-Mejia and Wiseman, 1997). The majority of research in this area has focused on the relationship between CEO compensation and firm performance (Barkema and Gomez-Mejia, 1998; Sundaramurthy et al., 2005). However, the results of this research stream are mixed (Jensen and Murphy, 1990). One variable that has been found to have a consistent positive relationship with CEO compensation is firm size (Tosi et al., 2000). However, the theoretical development and empirical findings of this relationship have typically involved firms increasing in size. Moreover, the majority of studies examining the relationship between size and compensation have utilized cross-sectional data. Thus, the ability to infer causation is limited.
One issue not examined in other previous studies is the relationship between size and compensation for firms decreasing in size or scope. A debatable assumption here is symmetrical causation; that is, it is assumed that if a cause reverses itself, the effect is also reversed. There is reason to believe that processes and responses to growth and decline are not symmetrical (Freeman and Hannan, 1975) and therefore a positive relationship between CEO salary and size may not necessarily hold true for organizations decreasing in size. Moreover, prior research suggests that in certain situations personal interests may impact corporate strategy and thus compensations levels (Tosi et al., 2000). As such, is it possible that corporate strategies decreasing firm size lead to increases in CEO compensation?
To address the above question we examine a phenomenon common in the last twenty years--corporate downscoping (refocusing). Markides (1993) reported that at least 20% and as many as 50% of the Fortune 500 firms refocused in the period of 1981 through 1987. These numbers are in contrast to approximately 1% of the Fortune 500 organizations that refocused in the 1960s. In spite of these recent phenomena the strategic management literature has yet to examine the relationship between downscoping and CEO compensation. Previous literature suggests a positive relationship between diversification and CEO pay (Rose and Shepard, 1997; Schmidt and Fowler, 1990). However, it is yet to be determined if this relationship holds for firms downscoping.
The purpose of this study is to integrate the traditionally studied determinants of CEO pay by examining the interactive effects of organizational size and corporate strategy (e.g., downscoping or refocusing) on chief executive remuneration. A review of the academic literature reveals that no known studies to date have empirically examined the effects of corporate refocusing on CEO compensation. Thus, little is known about CEO compensation following downscoping. This study integrates both agency theory and the promising conceptual viewpoint of information-processing theory (Prahalad and Bettis, 1986; Henderson and Fredrickson, 1996) to examine the impact of downscoping on CEO compensation.
LITERATURE REVIEW
CEO Compensation
The issue of top management compensation has received attention from more than 300 studies (Gomez-Mejia and Wiseman, 1997). The vast majority of this research, guided by agency theory, has focused on the hypothesized positive relationship between CEO compensation and firm performance (Barkema and Gomez-Mejia, 1998). Agency theory serves as a useful lens when viewing the relationship between corporate-level strategy and CEO compensation. The focus of agency theory is on the contract between the principal and the agent, and the divergent interests of both. Of particular concern to agency theorists is that the agent/principal contract may favor agents, thus increasing costs to principals (Tosi et al., 1997). Moreover, it is suggested that executive compensation plans provide inadequate performance incentives for CEOs to focus on maximizing shareholder wealth (Jensen and Murphy, 1990). As such, it is argued that the personal motivations of CEOs may sometimes shape the corporate strategies of firms (Wright and Ferris, 1997).
In support of agency concerns, empirical evidence of the relationship between pay and performance has been mixed. In fact, Jensen and Murphy (1990) used a total of 10,400 years of compensation and performance data to conclude that the pay-performance sensitivity for executives is approximately $3.25 per $1,000 change in shareholder wealth (Gomez-Mejia and Wiseman, 1997). In conclusion, after 70 years it appears that research has failed to identify a robust relationship between top management compensation and firm performance.
Outside of firm performance, studies have also investigated the effects of various organizational and CEO characteristics on CEO compensation. For example, Belliveau, O'Reilly and Wade (1996) found that social capital (resources available from social networks and institutional ties) significantly impacts CEO compensation. More recently, research has examined the impact of compensation committee composition on CEO remuneration. Daily, Johnson, Ellstrand and Dalton (1998) found that compensation committee composition did not impact CEO compensation. Furthermore, Daily et al. (1998) suggest that other theories besides agency theory should be considered in future research of CEO compensation. Echoing these remarks, Barkema and Gomez-Mejia (1998) hold that greater efforts are needed to examine alternative mechanisms of how CEO compensation is set.
While research investigating the above variables is at best mixed, results from the second most studied predictor of executive compensation--firm size--are significantly positive and consistent across studies. Several explanations for the correlation between a firm's size and a CEO's pay level exist. First, it has been argued that organizations make a concerted effort to maintain appropriate pay differentials between levels of managers and these differentials tend to be established as ratios (Simon, 1957). Thus, CEO compensation is greater in large firms because they tend to have more executive levels (Gomez-Mejia et al., 1987). Second, based on human capital theory (Agarwal, 1981), it is argued that as organizational structures get larger and more complex, CEO work specifications become more difficult, and their pay increases in order to compensate them for the additional human capital their jobs demand (Gomez-Mejia et al., 1987). Empirical evidence generally supports a strong relationship between firm size and executive pay (Schmidt and Fowler, 1990). Moreover, a meta-analysis by Tosi et al. (2000) found that 40% of the variance in CEO pay is explained by firm size.
However, Gomez-Mejia and Wiseman (1997) note that the literature is lacking in measuring whether firms experience changes in size for positive or negative reasons. For example, does firm growth associated with excessive diversification result in an increase in CEO compensation? Moreover, do decreases in firm size due to corporate refocusing efforts lead to greater compensation for CEOs? Gomez-Mejia and Wiseman (1997) argue that larger firm size due to mergers and acquisitions may reduce the tightly linked relationship between size and compensation. Gomez-Mejia and Wiseman also suggest that reductions in size for positive reasons such as refocusing may result in a stronger relationship between size and compensation. Moreover, Tosi et al. (2000) suggest that...
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