The effect of supplier industry competition on pay-for-performance incentive intensity

Abstract

We examine how supplier industry competition affects CEO incentive intensity in procuring firms. Using Bureau of Economic Analysis data to compute a weighted supplier industry competition measure, we predict and find that higher supplier competition is associated with stronger CEO pay-for-performance incentive intensity. This effect is incremental to that of the firm's own industry competition previously documented and is robust to alternative measures of supplier competition and to exogenous shocks to competition. Importantly, we show that performance risk and product margin act as mediating variables in the relation between supplier competition and CEO incentive intensity providing support for the theory underpinning our finding. We document that CEO compensation contracts are used as a mechanism to exploit the market dynamics of upstream industries to a firm's benefit. Our findings are economically important as suppliers provide, on average, 45 percent of the value delivered by procuring firms to the market (BEA, 2016).

Introduction

We examine the effect of upstream supplier competition on downstream focal firm compensation contracts. Organizational economics and strategy research suggest economic benefits to increased competition in the upstream supplier market. Supplier competition benefits downstream procuring firms by reducing the risk of supply chain disruption (Walker and Weber, 1987). Greater competition in that market also weakens supplier pricing power and drives down input prices, allowing procuring firms to enjoy greater profit margins (Porter, 1990). The question we address in our study is whether downstream procuring firms structure CEO compensation contracts in a manner that leverages the benefits of supplier market competition. As external suppliers provide, on average, 45 percent of the value delivered to the market by downstream firms (BEA, 2016), supplier market structure is likely to be an economically important determinant of the value that a firm can capture through incentive contracting, perhaps even as important as the structure of the firm's own product market. Indeed, prior studies document greater incentive intensity for CEOs as a means of capturing value from a firm's own product market (e.g. Chen et al., 2015; Karuna, 2007). However, these studies have not considered a firm's supplier market.

We predict that firms increase CEO pay-for-performance incentives on earnings as supplier industry competition increases and base our prediction on two main arguments. First, as supplier competition reduces performance risk (i.e., earnings volatility), including the risk of supply disruptions and the risk suppliers will engage in opportunistic behavior (Walker and Weber, 1987), the cost to the firm of providing greater earnings-based incentives is lower. Also, reduced volatility increases the informativeness of earnings as a measure of CEO effort (Holmstrom, 1979) and, accordingly, should be given greater incentive weight in an optimal incentive contract (Holmstrom and Milgrom, 1991). Second, supplier competition reduces supplier negotiating power, constraining their ability to raise prices in the downstream market as a means of capturing profit from the value chain (Porter, 1990). Thus, downstream firms appropriate more of the value created from their own CEOs' effort to make efficiency improvements or increase sales (Hinterecker and Kopel, 2017). Firms can motivate such actions by increasing earnings-based incentives. Taken together, theory suggests that supplier competition lowers the cost of earnings incentives (i.e., by reducing earnings volatility) and increases the benefits of earnings incentives (i.e., through greater appropriation of the CEO's value-increasing efforts). Accordingly, we expect downstream firms with more competitive supplier markets to provide greater incentives toward earnings as compared to firms with less competitive supplier markets.

To test our prediction, we construct from Compustat a sample of 2232 publicly-traded U.S. firms from 1997 to 2016 for a total of 19,494 CEO-years representing 52 industries. We complement these data with the Bureau of Economic Analysis (BEA) Input-Output data to measure the extent to which each industry supplies goods and services to every other industry in our sample. We use this information as the weights in the construction of a novel industry-year measure of weighted average domestic supplier industry competition.

Our analyses examine cash compensation, which is largely based on earnings performance (Murphy, 2000; Guay et al., 2019) and thus a natural setting to test our predictions. Cash-based incentive pay has been shown to influence CEO investment decisions (Dechow and Sloan, 1991) and provides a substantial portion of CEO financial incentives (Guay et al., 2019).¹

We find that the incentive weight on earnings in CEO cash compensation is positively associated with our measure of a firm's supplier industries' competition intensity. In terms of economic magnitude, we find that a firm with supplier competition at the 75th percentile has an incentive intensity that is 59% higher than a firm at the 25th percentile. Importantly, the effect of supplier competition on incentive intensity is incremental to, and larger in magnitude than, the effect of the focal firm's own product market competition on incentive intensity. As our theory supporting the prediction of greater pay-performance sensitivity from supplier competition is based on reduced performance risk and higher margins for the downstream firms, we examine whether these are indeed the channels through which our findings are predicated. We document that supplier competition is negatively associated with the downstream firm's one-year-ahead earnings volatility and positively associated with its one-year-ahead product margin. Further, consistent with our theoretical arguments, we find that the relation between supplier competition and pay-for-performance incentive intensity we document is partially mediated by the firm's decrease in earnings volatility and increase in product margins.

Additional cross-sectional tests further validate our results. As would be expected since our measure of supplier competition is limited to domestic suppliers in Compustat, we confirm that our finding is stronger for firms with greater dependence on domestic suppliers. We also find that our hypothesized positive relation between earnings incentive weight and supplier competition is stronger for firms whose inputs from suppliers is likely to be higher – namely, those with higher levels of cost of goods sold relative to total costs. Lastly, we find weaker effects for firms with limits in their ability to increase production, proxied by high operating leverage.

We perform several additional tests. First, we examine significant industry tariff rate changes that provide an exogenous shift in supplier industry competition as an identification strategy. Our difference-in-differences estimations shows that firms whose primary supplier industry experiences a significant tariff rate reduction, hypothesized to induce an exogenous increase in competition in that market, place greater incentive weight on earnings than in other firms, consistent with our predictions. Further, we show corroborating evidence of a positive association between supplier industry competition and cash compensation incentive intensity using two alternative measures of weighted average supplier industry competition adapted from Karuna (2007) and Li et al. (2013). Lastly, in a smaller sample of firms covered in the Incentive Lab data, we document that supplier competition is positively related to the weights on earnings-based performance measures in determining bonus compensation and the pay-for-performance sensitivity of these performance measures. In terms of economic magnitudes, there is a seven percent increase in the weight on earnings-based performance measures as well as a 26% increase in the pay-for-performance sensitivity on these earnings-based performance measures shifting from the 25th to 75th percentile of supplier competition. Overall, we find consistent evidence that firms exploit the improvement in earnings informativeness and harness the profit opportunities provided by greater supplier competition by increasing incentive intensity on earnings.

We contribute to the literature in two important ways. First, we provide evidence on how firms adapt compensation practices to attributes of their supplier markets. Previous literature examining the influence of external market structures on managerial incentives either focuses on the effect of own-firm product market competition (e.g. Chen et al., 2015; Karuna, 2007) or on how the concentration of a firm's customer base affects the provision of equity incentives in a supplying firm (Albuquerque et al., 2014). We show that firms use incentive contracts to take advantage of the structure of upstream supplier industry competition by exploiting reductions in earnings volatility and increases in product margins and setting incentive contracts to extract more value from the value chain.

Second, we provide a methodological contribution to the literature. As U.S. firms are not required to disclose supplier information, research on the effect of supply market characteristics is scarce (Chen et al., 2017). We use publicly available data from the Bureau of Economic Analysis (BEA) to construct a measure of weighted average (domestic) supplier industry competition. Our measure and, more generally our method, can be used to test other effects of supply market dynamics.

The remainder of the paper is organized as follows. In Section 2, we review the related literature and develop our hypothesis. In Section 3, we describe our data and variables. Section 4 presents the base results; in Section 5, we provide supplemental analyses. Section 6 concludes.