Thursday, July 23, 2009

Managerial Influences Essay

Managerial Behaviour and the goals of management have long been identified by many as independent of the goals of shareholders . Two models have attempted to explain why the goals are different and how these goals are achieved; Baumol’s Theory of Revenue Maximisation and Marris’s Model of Managerial Enterprise . Initially the Two models will be briefly explained. Then, by reference to determinants of managerial remuneration, the empirical evidence of the occurrences of the determinants, the two models will be examined. This is to come to a conclusion on which model is best supported by the empirical evidence.

Marris’s model of managerial enterprise is based on the goal of the manager to increase the balanced growth of the firm . This balance is achieved by offsetting two opposite goals; Maximisation of the growth of demand for goods/services of the firm and maximisation of growth of capital. Both of these goals require opposite treatment of retained profit.

To maximise growth in capital the management must distribute as much profit as possible back to the shareholders. This keeps the shareholders content with their investment and they will not sell shares or remove the directors. It can result in rising share values and reduce the risk of the firm being taken over. This therefore appeals to the management’s main aims, job security by not being taken over or removed.

The flip side of the coin is to increase the demand customers have for the firm’s goods or services. This is achieved by using as much of the firms profits for investment and increase the firms growth. This would increase the management’s utility at the sacrifice of shareholder utility.

Marris’s model requires that these to aims be balanced to achieve the maximum use of retained profit use for investment and still keeping the shareholders content. To achieve this balance it is necessary to employ two constraints; Managerial constraint and Job security constraint.

The managerial constraint is set by the skills of the current management team or by the limit by which the management team can be increase to increase those skills. Therefore, this limit is the maximum growth achievable. R & D would also limit the growth of the firm. If new products or new designs of existing products can’t be produced, the product will only have a certain life cycle.

Job security constraint is set by the amount the manager has to do to reduce the chances of dismissal. The manager may have to distribute a certain amount of profits to share holders to keep them happy with the manager’s performance. It is also necessary to keep share prices at a high enough level to reduce the chance of take over. Reducing risky investments will have similar effects.

The effects of these constraints can be seen from figure 1 (see below) and it can be seen that a balanced growth point is where management feel the trade off between job security and maximisation of growth is most desirable. The y-axis on the graph shows the profit distributed to shareholders and the x-axis depicts the growth achievable from investment. The growth curve symbolises the managerial constraint. This is curved because the most profitable investments are undertaken first. Management can undertake a policy which would maximise growth (point B) but at the sacrifice of distributed profit which would risk job security. A more appropriate trade off may be point A where distributed profits are much higher and growth is reduced by a smaller amount.

Baumol’s Theory states that the goal of management is not profit maximisation (shareholder goal) but revenues maximisation (increased sales). Baumol gives several reasons for this belief . The reasons to focus on are to do with remuneration of management, job security and prestige (which undoubtedly can lead to increased or decreased remuneration).

Baumol feels there is evidence that directors’ salaries and slacks are more closely correlated with sales of the firm than profit. So it would follow from this that managers would maximise sales for self interest.

Job security in Baumol’s theory is shown from the desire of management to have satisfactory profits, apposed to maximised profits. Maximised profit in one year may look bad for management when in subsequent years profits are not at the same maximised level.

Prestige can come from high sales. This prestige can increase remuneration (from head hunting or shareholder retaining their services) or if bad, increase the threat of management being replaced or reduce remuneration.

To achieve sales maximisation managers have to calculate the conditions which will achieve the maximum revenue. This is not the same as profit maximisation. Point A represents profit maximisation. Point B represents the point where sales maximisation, point Z, appears on the profit ability curve. It can be seen that profit maximisation and sales maximisation are not normally the same thing. Point A is the desired position for the shareholder and point B is the desired position for, in Baumol’s theory, management.

However shareholders will require dividends to stay happy with the firm’s performance. In Baumol’s theory there an Operative profit constraint.

The operative profit restraint is the minimum amount of net profit that the shareholder will be satisfied with. If this restraint is active it may reduce the maximum sales the directors can achieve. If this operative profit constraint is active then output will be greater as a sales maximiser than a Profit maximiser. When a operative profit constraint is operative then the maximum sales drop to point Y and the intersection on the profitability falls to point C. It can be seen that management can be limited in their sales maximisation policy if operative profit is closer to the profit maximisation point.

Empirical Analysis
When discussing which model best reflect the reality of managerial behaviour it is necessary to examine what motivates managers and what determines there objectives. Focusing on remuneration as manager main motivation gives the opportunity to examine empirical evidence of what determines the amounts management receive.

Martin Conyon and Paul Gregg Examined 170 firms between 1985 and 1990 . They looked into what factors determined top directors’ pay. In conclusion of their results, it is commented that the results they received pointed to previous, earlier studies , which showed that directors’ pay had very little to do with corporate performance. Therefore, from this evidence, profit, considered a major factor in determining corporate, would not affect the directors’ pay. This would be consistent with Baumol’s model and to a certain extent Marris’s model too. Baumol’s theory identifies sales maximisation as the primary aim. Marris’s model identifies the importance of growth which is identified as a factor with similar directors’ pay correlations. Conyon and Gregg also found from there results that there seemed to definite correlation between increases in directors’ remuneration and increase in sales again consistent with Baumol’s model.

Paul Gregg, Stephen Machin and Stefan Szymanski, came to a similar conclusion in a later study (this study included the period from 1988 – 1991 when Britain was in recession). Higher sales had a direct correlation with high directors’ remuneration and identified growth as a primary salary driver.

David Shipley published a study in to pricing policies in British manufacturing firms in 1981 . Although his study was more specifically on the pricing policies his finding suggested that there was some support for profit maximisation in manufacturing firms’ management . The majority of firms in the study used multiple goals when setting pricing policies . This would not entirely be consistent with Baumol’s theory which states focus of management to maximise sales only and primarily. All other goals displayed by the study were, if not profit orientated, practiced under the premise that profit targets would be met. This is consistent with the operative profit constraint in Baumol’s theory and the job security constraint in Marris’s model. This study would point more towards Marris’s model as there is more emphasis on increasing profit if for no other reason than to improve the amount of money available to put into investment and improve growth while still satisfying shareholders.

While sales are quoted to be a major factor in managerial remuneration. It is also stated that this is not the only factor which would affect their pay. It is therefore assumed that manager’s should consider all factors that affect them. Baumol does not identify other factors which in his theory management should consider. It has been has been suggested that early studies do not reflect the current sensitivity of remuneration of management to performance of firms. This is closer to Marris’s model.

Size of firms has been identified as the most important factor in terms of remuneration. For the size of a firm to increase it must grow. Marris’s model identifies the importance of growth to management.

There have been articles and studies that point to the unreliability of empirical evidence on corporate governance and managerial remuneration factors. So many methodical issues relating to principal and agency theory have been identified as the reasons.

Only remuneration factors have been considered when examining the two models. This makes the discussion incomplete as factors such as corporate structure, managerial labour market factors and personal managerial preferences have not been discussed. There are other managerial behaviour models and theories which have not been included which may be more consistent with the empirical evidence gathered in studies referred to, such as Williamson’s model of managerial discretion. Also more detail explanations of the two models referred to may have allowed closer examination of empirical evidence. Due to these factors, the discussion is limited. However, as I feel that management has the greater ability to influence there pay and it could be argued this is the most important reward for anyone in employment; this was the most appropriate factor to use.

To generate a conclusion from the arguments in this discussion is difficult as with many studies and opinions no conclusive results have been shown. It is my opinion that although sales may be an important factor in remuneration, many other factors exist. Baumol’s theory does not allow for management to apply other factors to their management goals. Marris’s model identifies growth in general as an important factor to the agent (management) and shows the constant battle between satisfying the principal (shareholders) and achieving managements’ utility. This appears more consistent with the difficulties shareholders have in aligning their managements’ interests with there own.

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