Earnings-Based Bonus Compensation

Abstract

This article studies the cost to the firm of contingent earnings-based bonus compensation that is effectively paid to its managers if the earnings of the firm exceed the threshold performance at the end of the evaluation period. We assume that the firm has normal and abnormal earnings. The normal earnings result from the normal activities of the firm and are modeled as an arithmetic Brownian motion. The abnormal earnings result from surprising activities of the firm (e.g. introduction of a new product, that is only possible due to an unexpected authorization by the authorities, that yields a sudden increase in earnings, the unexpected loss of earnings due to idiosyncratic factors to the firm like a strike, etc.) and are modeled as a compound Poisson process where the earnings jump sizes have a normal distribution. We investigate, in a simple general equilibrium model, how normal and abnormal earnings affect the cost of contingent bonus compensation to the firm.