Dividing the Pie: The Influence of Managerial Discretion Extent on Bonus Pool Allocation

Firms often allow managers discretion when allocating bonuses so that they can incorporate relevant noncontractible information (i.e., information that reflects employee performance but cannot be included in formal contracts because it represents unforeseen circumstances, cannot be jointly verified, or requires interpretation or judgment) into employees' compensation. However, little is known about how managers use this discretion. We investigate the effect of discretion extent - the portion of total bonus pools over which managers have allocation decision authority - on managers' bonus allocations. To examine this effect, we develop and test theory on the processes by which managers determine bonus pool allocations. Via an experiment, we find that most managers use a piecemeal approach to allocate discretionary bonus pools. That is, they consider the compensation implications of each information cue separately. We find that managers who use such an approach tend to incorporate noncontractible information to a lesser degree than managers who use a more integrative approach. However, our results also indicate that this effect is mitigated when managers have partial (as opposed to full) discretion. Specifically, when a piecemeal approach is used, managers with partial discretion incorporate noncontractible information into discretionary bonus pools to a greater degree than do managers with full discretion. Our study contributes to the growing literature on discretionary bonus pools, providing evidence on the process by which managers use their discretion. In particular, our findings highlight managers' propensity to rely on a piecemeal approach, which potentially inhibits managers' incorporation of relevant noncontractible information. Thus, the use of a piecemeal approach circumvents the very purpose for which discretion is intended.