Managerial Incentives and Investment in R&D in Large Multiproduct Firms

Incentives for division managers in large firms affect their risk orientation and thus their decisions to invest in R&D. This paper reviews theory and hypothesizes that division managers' incentive compensation that is based on financial performance is negatively related to risk taking as measured by R&D intensity. Results of a study of 184 major U.S. firms suggest that incentives based on short-term (annual) division financial performance are negatively related to total firm R&D intensity after controlling for industry R&D intensity, firm diversification, size and group structure. Furthermore, the results suggest that an emphasis on long-term financial incentives may mitigate the negative relationship between these incentives and R&D intensity, but does not promote risk taking. The results suggest the importance of emphasizing strategic controls evaluating division managers based on operational understanding of strategies proposed (strategic criteria) as opposed to the use of financial controls evaluating division managers based on financial performance (often annual ROI). However, the use of financial controls becomes more common as firms diversify. Diversification increases the span of control of corporate executives and the diversity among divisions. In highly diversified firms, corporate executives are no longer able to fully understand the operations of the multiple and diverse divisions. Thus, they must not only decentralize operating authority to divisions, but they also cannot use strategic criteria to evaluate division managers. As a result, they begin to emphasize financial controls. The shift toward risk aversion caused by the use of incentives based on short-term financial outcomes can have important implications for long-term firm performance. The results of this study have implications for long-term competitiveness, especially for firms in R&D intensive industries where R&D expenditures may affect a firm's competitive position.