Firm size and executive compensation: The impact of the foreign operations on US companies

Multinational Business Review, Fall 2002 by Ramcharran, Harri

Recent studies of firm size as a determinant of executive compensation did not differentiate the impact of foreign from domestic operations despite the growing economic importance of the former. In light of the unique risk in conducting business abroad, we estimate the impact of the foreign operations of U.S.- based MNCs on the compensation of executives. The results, based on data for the period 1980-2000, indicate a significant correlation between executive compensation and the independent variables representing foreign operations, size (assets and sales) and performance (net profit). As these variables reflect the outcome of innovative strategies for profitable expansion, they are important for devising compensation packages for CEOs. This methodology is a significant improvement of the earlier models that utilize total assets, total sales, total profit etc, as explanatory variables.

Some of the recent studies of executive compensation, for example, Ciscel and Carroll, (1980) and Baker, Jensen and Murphy (1988) find that the size of firms, measured by sales or revenues, is significant. Most of these studies focus on large U.S.- based firms with extensive foreign operations of over 50% of total assets, sales and net profit (see Forbes, July 26,1999). The limitation of these studies is their failure to make a distinction between domestic and foreign operations. Ongoing cross-border mergers and acquisitions, joint ventures and foreign direct investments have increased the economic importance of multinational corporations' (MNCs') foreign operations.

This paper examines the extent to which CEOs compensation is impacted by the size of the foreign operations of US MNCs. The unique risks (exchange rate, political, tax, economic, inflation, regulatory and multicultural, (see Shapiro, 1996) associated with foreign operations require innovative policies to maximize shareholder wealth in a competitive global economy. An empirical model, using three independent variables measuring the foreign component of total assets, sales, and net income, is estimated using annual data for the period 1980-2000.

Companies with significant foreign operations are examined.

We offer the following hypotheses

H1: The higher the foreign/total sales ratio the higher will be the level of compensation.

H2: The higher the foreign/total asset ratio the higher will be the level of compensation.

H3: The higher the foreign/total profit ratio the higher will be the level of compensation.

The main reason for promoting these hypotheses is that foreign operations require greater managerial effort and /or a higher skill level, which should be highly compensated. The importance of this paper must be viewed in light of: (a) the challenging tasks faced by CEOs because of increasing transnational activities, and (b) the development of appropriate compensation packages in recognition of the foreign risks. Lambert and Larcker (1991) note that an increase in the risk exposure may cause a CEO to be conservative in his investment strategy and turn down risky projects that may promise higher expected returns to shareholders or accept "safe" projects with stable but substandard returns. McLaughlin (1991, page 22) also notes that "the tax, legal, regulatory, and economic environment in which a compensation program must function is constantly changing and this can undermine or thwart well-intentioned plans."

PREVIOUS RESEARCH

CEO compensation contracts have received considerable critical scrutiny, primarily that compensations are unrelated to firm profitability. The effect of firm size on compensation is the primary focus of the earlier studies, for example, Baumol (1959) contends that executive salaries are more correlated with the scale of a firm's operation than with its profitability, McGuire, Chiu, and Elbing (1962), find executive compensation (measured by salary plus bonus) more correlated with sales than profitability, thus lending further support to the "revenue-maximizing" theory of the firm. Baker, Jensen and Murphy (1988) also find that the compensation of CEOs varies with firm size, and strongly note that CEOs can increase their pay by increasing firm size even at the expense of a reduction in the firms' market value.

Many empirical analyses of executive compensation focus on the validity either the size or the performance hypothesis. Ciscel and Carroll (1980) argue that the two approaches could be complementary rather than substitute, and both objectives (sales and profit) can be maximized through sales growth and cost control. One of the main implications of the results is that an incentive to maximize size can be at expense of performance. The extent to which size, rather than profitability, is maximized has important implications on the interest of shareholders and the advantages/ disadvantages of the separation of ownership and control theory of corporate governance.

The empirical results of these studies are mixed. Hirschey and Pappas (1981) find CEOs compensation positively related to sales and negatively related to profitability. Ciscel and Carrol (1980) find sales more significant, and, for some years, profit negative and significant. Jensen and Murphy (1990) find accounting profit positively related to compensation, while Miller (1995) shows no significant relationship between this variable (accounting profit) and compensation.