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Evaluating Managerial Performance: Mitigating the "Outcome Effect"

Dipankar Ghosh; Manash R Ray

07/01/2000, Journal of Managerial Issues, Page 247-260

Copyright (c) 2000 Bell & Howell Information and Learning Company. All rights reserved. Copyright Pittsburg State University, Department of Economics Summer 2000

Evaluating performance is an important function in organizations and few decisions are made in organizations that are not subject to some sort of performance evaluation. Although it is possible in some jobs to obtain objective performance information, more typically this is not the case. Instead, organizations frequently rely upon some type of subjective evaluation of performance which, by the very nature of being subjective, is criticized for having errors, biases, and inaccuracies (Borman, 1991). One such bias commonly encountered in evaluations is the "outcome effect," which is a systematic overweighting of outcome knowledge by the evaluator in assessing a manager's performance (Hawkins and Hastie, 1990). Thus, when the outcome is positive (negative), evaluators tend to evaluate the manager positively (negatively), regardless of the actual appropriateness of the decision resulting in the outcome. Hence, organizations often end up evaluating managers based upon outcomes over which they may not have control.

This research first shows the outcome effect and also examines whether this effect can be mitigated during performance evaluation. Organizational members responsible for evaluation should be aware of the outcome effect and how to mitigate it since they influence how managers experience organizational phenomena and learn from that experience. Improper evaluation undermines its influencing and learning roles.

The remainder of this article is organized as follows. The next part discusses prior research and develops the hypotheses. The subsequent parts, in order, describe the research method, present the results, and summarize the implications of this research.

Theory and Background

Evaluation, Information Asymmetry and Cognitive Process. An evaluator cannot observe all aspects of performance of a manager/decision maker (hereafter referred to as DM) because of conflicting demands on the evaluator's attention, or simply because of physical constraints (DeNisi, 1996). Hence, there is always information asymmetry between the evaluator and DM, and when the evaluator has less information than the DM, his or her ability to evaluate the DM's performance accurately is limited (Hershey and Baron, 1992). If, however, this information asymmetry can be reduced, an evaluator can take into consideration DM's information about potential outcomes that existed at the time of the decision to evaluate it (Hershey and Baron, 1992). Three general approaches were adopted by prior research to reduce the information asymmetry between the evaluator and the DM in order to eliminate the outcome effect. However, for reasons discussed below, the applicability of these approaches in the organization remains an open question.

The first approach attempts to increase the involvement of the evaluator in the DM's decision-making process. Brown and Solomon (1987) reduced the outcome effect on performance evaluation by prior advisory involvement on the part of the evaluator. Brown and Solomon (1993), however, found that only prior involvement with an ex-ante agreement between the evaluator and DM on the course of action to be adopted by the DM reduced the outcome effect. Finally, Fisher and Selling (1993) found that an ex-ante correct outcome prediction made by the evaluator reduced the outcome effect. But in each of these cases, the evaluator is contracting on foresight or an occurrence predicted to happen. Thus, the outcome effect is reduced because the evaluator is inclined to remain committed to the initial outcome agreed upon based on the outcome predicted, an example of escalation of commitment bias (Bazerman, 1994). Research shows that subjects who choose a particular course of action subsequently filter information selectively to justify remaining committed to that course of action (Caldwell and O'Reilly, 1982).

The second approach to mitigate the outcome effect is to make the decision process of the evaluatee observable to the evaluator. Fisher and Selling's (1993) work is an illustration of this approach. However, their result may have been influenced by the strong operationalization of observability since evaluators were given a full description of the DM's decision process along with the cues used by the DM in making the final decision.

The third approach examines whether framing can mitigate the outcome effect. Lipe's (1993) experiment on outcomes and framing on the evaluations of managers responsible for the variance investigation decision showed that the evaluations were more favorable when investigations revealed problems in the production system. Further, managers received higher ratings when the initial expenditure (IE) made to investigate the variance was framed as a cost than when the IE was framed as a loss. The rationale is that investigation expenditures matched with perceived benefits are framed as costs while those without perceived benefits are framed as losses. But, a critical issue is whether framing is an appropriate mechanism for mitigating the outcome effect. Although a decision problem can be presented in a frame-- consistent format in an experiment, discerning a frame latent in the presentation of a real-world problem is difficult. Tversky and Kahneman assert that "individuals who face a decision problem . . . are normally unaware of alternative frames and of the potential effects on the relative attractiveness of options" (1981: 457). Thus, it is debatable whether evaluators would perceive an IE as a "cost" or as a "loss" and not just another item of expense unless it is labeled as such and explicitly brought to the attention of the evaluator.

In light of the limitations of the above approaches, an alternative approach to mitigate outcome effect (examined in this research in the context of cost variance investigation decisions) is to make the evaluator more aware of the nature and extent of uncertainty faced by the DM when making such decisions. Lord (1985) suggests that evaluation accuracy would always depend on the information available to the evaluator, and this first step is seen as critical to the entire appraisal process. This awareness should be relevant since the characteristics of the available information have an impact on the cognitive process of the evaluator during performance evaluation (DeNisi, 1996). This will be elaborated more at a later stage, when discussing hypothesis H2.

Since the outcome effect and how to mitigate it is examined in this research in the context of a cost variance investigation decision, a brief discussion of the formal cost/benefit rule which facilitates making such a decision is necessary at this stage. Information needs of this rule include cost of investigating the variance, cost of correcting the problem, cost of allowing an out of control production process to continue, and the state of the production process (i.e., the probability the production process is in control or out of control). In this rule, illustrated in Figure I, the expected costs of the two managerial alternatives are computed, based on the probability that the production process is in control or out of control. The alternative with the smaller expected cost is then selected (Horngren et al., 1997).

In a cost variance investigation decision, the critical part is the DM's assessment of the probabilities of the production process incurring the cost being in control or out of control. In reality, however, such probabilities can rarely be judged precisely (Dyckman, 1969; Kaplan, 1975) and the DM may at best be able to specify a range of probabilities. Moreover, in some situations there can be some reservation about the uncertainty of the production process and even when specifying the range of probabilities, the DM may be unsure of the second-order probability distributions for each point within that range. In contrast to precise uncertainty, defined as one that can be justifiably expressed either as a point probability estimate or a second-order distribution over probability values (Budescu and Wallsten, 1987), the nature of uncertainty in the variance investigation decision about the production process being out of control is best described as "ambiguous" or "vague" (Einhorn and Hogarth, 1985). If so, representing ambiguous uncertainty as a point estimate gives an unwarranted appearance of precision. Alternatively, evaluating the DM may involve communicating to the evaluator the nature and extent of uncertainty faced by the DM by representing it as a range of probability values, thus providing some insight into its qualitative characteristics. As discussed next, the evaluator's cognitive approach entails .a process called simulation heuristic, which is of fected by knowing the kind of probability data faced by the DM (Kahneman and Tversky, 1982). Thus, communicating the characteristics of the uncertainty faced by the DM may facilitate more accurate evaluation (Goguen, 1974).

Outcome Effect and Variance Investigation Decision. Since the variante investigation decision is made ex ante (i.e., before the results or outcome of the investigation is known), the DM should be evaluated based on the ex ante information assuming that information is available to the evaluator (Edwards, 1984; Hershey and Baron, 1992) . However, Lipshitz (1989) showed that those who take normatively correct actions are evaluated more favorably than others. Thus, for example, DMs who choose actions with lower expected costs are likely to be evaluated higher than those who choose actions with greater expected costs.

However, since it is difficult to ignore outcome knowledge, ex post information also affects performance evaluation of DMs (Baron and Hershey, 1988). For example, Lipshitz (1989) found that Israeli Defense Force officers evaluated a regiment commander more favorably when his decision to go to the aid of an attacked force was followed by a signif icant battle rather than a minor one. Furthermore, a commander who did not go to the attacked force's aid was viewed more favorably if this decision preceded an attack on his own sector (see also Mitchell and Kalb, 1981; Baron and Hershey, 1988). Thus, in the case of a variance investigation, it is likely that evaluators will consider the outcome of the investigation (the ex post information), as well as the ex ante expected costs. Specifically, when the investigation reveals a problem, the manager's decision will appear more appropriate and will lead to higher performance ratings than when the investigation indicates no problem with the system.

H1: The outcome of a cost variance investigation will be related to the performance rating of the DMs, such that their performance evaluation will be higher if the system was found ex host to be out of control than it was found to be in control.1

Communicating Uncertainty, Cognitive Process and Mitigating the Outcome Effect

As stated earlier, the precision of the probability information used in the variance investigation model is often low (Dyckman, 1969). Thus, the forced dichotomy between in control and out of control may be an unrealistic aggregation of reality (Kaplan, 1975). In discussing variance investigation models, Kaplan suggests:

. . expanding the number of states to allow for varying degrees of out of controlness. For example, we might allow S states (S=5 or 10, say) with state 1 representing perfectly in control, state 2 representing slight deterioration and state 5 being well out of control (1975: 323).

This solution clarifies the imprecision of uncertainty inherent in variance investigation decisions (Zebda, 1991). Most real-world decisions, including the investigation decision, depend on uncertain events whose probabilities cannot be precisely assessed (Ghosh and Ray, 1997). Thus, the imprecision of the uncertainty should be considered in the analysis and explicitly communicated to the evaluator (Wallsten, 1990) because if DMs fail to communicate the uncertainty they face when making decisions, evaluators tend to assume that the DMs' estimates require no qualifications (Fischhoff, 1994).

If many probability distributions are consistent with the evidence of the process being out of control, then selecting any one by the DM is arbitrary. Any subsequent decision, such as evaluating the DM based on arbitrary information, is likewise arbitrary (Wallsten, 1990). Thus, in situations where there are many probability distributions, the DM might communicate a more realistic assessment of uncertainty by showing it as a range (Ghosh and Crain, 1993). This allows the evaluator to consider the extent of imprecision in the investigation decision and should have a marked ef fect on the evaluator's simulation heuristic when evaluating the DM's decision.

Simulation heuristic entails a cognitive construction or imagining of outcomes of how an event will turn out or how it might have turned out under other plausible circumstances (Kahneman and Tversky, 1982), and provides an explanation of the cognition process that results in the outcome effect. Assume the evaluator is not made aware of the uncertainty faced by the DM making the variance investigation decision. The outcome knowledge then dominates the evaluator's simulation heuristic in which otherwise plausible outcomes from the investigation decision are discounted because they are less easy to imagine than the actual outcome (Ashcraft, 1994). It is this implausibility of alternate paths or outcomes that produces the outcome effect in performance evaluations. Now assume that the evaluator is made aware of the uncertainty faced by the DM making the variance investigation decision. When the evaluator thinks about the DM's investigation decision, the scenario under which that decision happened is very easy to imagine. After all, just that scenario happened. Making the evaluator aware of the nature and extent of uncertainty faced by the DM increases the range of plausible alternative scenarios and should reduce the effect of outcome knowledge on the evaluator's assessment of the DM's performance. This is consistent with the cognitive approach to an appraisal wherein evaluators attribute a performance less strongly to the ability of the ratee in the case of a more unstable environment (DeNisi, 1996).

H2: Stating the probability of the system being out of control imprecisely (precisely) when the data warrant imprecision is associated with a smaller (larger) outcome ef fect.

Method

Sixty undergraduate students enrolled in an upper-level accounting course participated in the experiment. They had just studied the normative rule used to make the cost variance investigation decision. However, to ensure that the students understood the rule, they were given the relevant data and were asked to make a variance investigation decision. The following data were provided for the decision:

Assume that you are trying to decide whether to investigate the cause of a labor efficiency variance. The following information is available to you:

Cost of investigating the cause of the variance: $500

Cost of correcting the system when it has failed: $1,000

Potential loss to the firm for not discovering an existing correctable problem now: $4,000

Probability of the system being out of control: 0.30

(a) What is the critical probability that a problem exists that must be surpassed before an investigation is justified? (b) Based on your analysis in part (a) above, would you investigate the variance? (Please state your answer as either "Yes" or "No.")

The above screening process reduced the subject pool to fifty-seven. The students were then told that the manager chose to investigate the variance and were provided with the information regarding the outcome of the investigation. Next, they were asked to evaluate the manager's performance using a rating scale. Finally, the students completed a debriefing questionnaire, which collected information regarding their age, graduating major, gender and work experience. In addition, there were questions about the experiment. The experiment took about 10 minutes to administer.

The experiment employed a 2 X 2 mixed design. The within-subjects variable was the outcome of the variance investigation decision (OUTCOME) with two levels; that is, the production process is in control or out of control. The between-subjects variable was the precision of the probability describing the production process being out of control (PRECISION). Subjects in the precise probability manipulation were presented with the following data related to a variance investigation decision:

Assume that you are a VP-Manufacturing for a medium sized firm. Your firm uses a standard costing system with currently attainable standards. You have several production managers working for you. Each one runs his/her own production plant.

Pat Smith is one of these production managers. Pat's plant had a large direct labor efficiency variance this year and he had to decide whether to investigate the variance further. Pat's staff collected all the relevant cost information and provided him only with the following summary:

Critical probability: 10%

Probability of the process being out of control cannot be determined with certainty, but was estimated to be 20%.

You, as VP-Manufacturing, received a report from Pat which included the above summary information, along with Pat's decision.

You need to evaluate Pat's performance for the period under two situations discussed below. Please give a judgment or opinion for both the situations on the scales below. Although Pat is not held accountable for direct material or overhead variances, the direct labor variances and investigation decisions are Pat's responsibility.

Situation 1: Pat made the investigation and found the process to be in control. Pat's performance for this period was (make a slash on the scale below)2:

Situation 2: Pat made the investigation and found the process to be out of control. Pat's performance for this period was (make a slash on the scale below):

Subjects in the imprecise probability manipulation had the same information as above, except that the information on the probability of the process being out of control was stated as follows:

Probability of the process being out of control cannot be determined with certainty. It ranges between 12% and 28%, and the likelihood of any of these individual probabilities occurring is equal.

The dependent variable is the performance evaluation ratings (EVALUATION) in the two situations namely, when the investigation found the production process to be in control and out of control.

Results

One of the questions posed to the students in the debriefing questionnaire was on the clarity of the instructions received for the experiment. The mean (s.d.) of the responses from the question was 9.11 (1.32). Further, the responses from the precise probability manipulation group were not significantly different from the responses in the imprecise probability manipulation group (T=0.461; p=0.8906).3 In addition, analyses of the evaluation ratings indicated that they were not affected by subjects' age, graduating major, gender, or work experience.

Hypothesis H1 documents the outcome effect by predicting that performance ratings will be higher when the variance investigation decision reveals the production process is out of control than when it is in control. Hypothesis H2 predicted that the outcome effect would be greater when the probability of the production is stated precisely than when it is stated imprecisely. Both the hypotheses were tested by using a single one-way repeated measures ANOVA model. In the model, the repeated-measures factor was the outcome of the variance investigation decision (OUTCOME) with two levels, the dependent variable was the EVALUATION associated with each of the two levels of OUTCOME, and the independent (between-subjects) variable was the precision of the probability describing the production process (PRECISION). The results are presented in Table 1.

The within-subjects analysis, (which is the only portion from part A relevant for this study) , however, indicates that all the variables were significant. Specifically, EVALUATION for the two levels of variance investigation decision OUTCOME (i.e., production process was in control or out of control) was significantly dif ferent from each other (F=139.21; p= 0.0001). Further, the interaction of OUTCOME with PRECISION was also significant (F=45.87; p=0.0001). This suggests that not only was the EVALUATION for the two OUTCOME levels different from each other but this difference was not the same when the probability describing the production process was stated precisely compared to when the probability was not stated precisely.4

To better understand the results from the within-subjects analysis, the mean ratings of EVALUATION by OUTCOME were compared separately for the two levels of PRECISION (refer to Part B of Table 1 ) . When the probability of the production process was stated precisely, mean evaluations from out of control OUTCOME was 67.17 and mean evaluations from in control OUTCOME was 53.45. In addition, these evaluations were significantly different from each other (T=6.819; p=0.0001). Similarly, when the probability was stated imprecisely, mean evaluations from out of control OUTCOME was 61.53 and mean evaluations from in control OUTCOME was 57.82. These evaluations were also significantly dif ferent from each other (T=2.875; p=0.0001). The above results document the outcome effect and provide evidence in support of hypothesis HI that ratings will be higher when the variance investigation decision reveals the production process is out of control than when it is in control.

Next, the interaction of OUTCOME and PRECISION is examined in Part C of the Table and illustrated in Figure II. When the probability describing the production process was stated precisely, DMs' EVALUATION when the production process was found to be in control averaged 53.45, which increased by 13.72 to 67.17 if the process was found to be out of control. In contrast, when the probability was stated imprecisely, DMs' average evaluation ratings were 57.82 for in control production process, which increased by only 3.71 to 61.53 for out of control production process. Furthermore, these increases (i.e., 13.72 and 3.71) were significantly different from each other (T=4.424; p=0.0001). The results show that, consistent with hypothesis Hz, the outcome effect is significantly greater when the probability of the production process is stated precisely compared to when the probability is stated imprecisely.

Summary and Discussion

The noted philosopher Karl Popper once remarked that, "it is always undesirable to make an effort to increase precision for its own sake . . one should never try to be more precise than the problem situation demands" (1974: 284). In discussing the communication function in accounting, Hayes (1983) states that too much precision does not help and, in fact, it may harm communication because excessive precision limits obtaining insight into the qualitative characteristics of the data.

Because the evaluation of the DM involves the cognitive process of imagining an alternative outcome to the decision made by the DM, the evaluator bases evaluations on the simulation heuristic, which depends on the ease with which alternatives can be constructed or imagined (Kahneman and Tversky, 1982). This is facilitated by communicating a more accurate assessment of the uncertainty facing the DM to the evaluator to alleviate the connection between the initial situation facing the DM and the final outcome decision. Consequently, the outcome effect in performance evaluation of the DM's variance investigation decision is significantly reduced. The principal conclusion of this study is that the outcome effect can be mitigated by providing the evaluator more accurate information about the nature and extent of uncertainty in the form of a range of probabilities rather than as a point or precise estimate. The results underscore an observation by DeNisi ( 1996) that since evaluation is a cognitive process, accuracy of evaluation would be dependent upon the information available to the evaluator and is a critical step in the entire appraisal process.

The results of this research have practical implications for mitigating the outcome effect. First, communicate to the evaluator the decision process and the decision outcome. For example, along with the material price variance, the assumptions that the DM had to make in order to estimate the initial budgeted price quality of raw material, consumption patterns, market demands, supply sources, etc. - should also be reported. This information would allow the evaluator to assess the validity of the critical assumptions and the uncertainty faced by the DM in budgeting material price. And second, since the outcome effect is a bias, efforts to reduce biases of supervisors in training programs should be considered. Such training sensitizes supervisors to a potential problem in evaluating subordinates and may help reduce the bias.

There also are important managerial implications for using a probability range to describe uncertainty when it is warranted. For example, reporting uncertainty range may facilitate job selection. Some selection decisions could perhaps be automatic; for example, everyone above a particular score on a test is offered a job and everyone below the score is rejected. But someone would have to make a judgment about what that score should be. Judgment is an integral part of most selection procedures. The question is not whether there is subjectivity in selection decisions but whether the subjectivity is recognized and understood. Reporting a range of acceptable scores may ameliorate this problem, thereby reducing the dependency on a single score to make selection decisions and, instead, encourage adopting additional methods (e.g., a structured interview) to augment that test score.

As with any research effort, limitations exist, and the results of the present experiment must be considered in light of those limitations. For example, the evaluators in this study were all students with, perhaps, no prior experience or formal training in doing performance ratings. Thus, experienced raters may have reacted differently to the uncertainty information compared to the subjects in the current study. Further, although generalizability is from the theory and not from the data, nevertheless, additional research needs to be done to determine whether the findings from the study would generalize to contexts other than the very specific one studied here. Also, the results are parameterized by the features of the experimental design, such as the operationalization of the nature of uncertainty about the production process. And, finally, all the cost information was arbitrary; thus, it is unknown if the competing treatments contained too little or too much information.

Future research should further examine the subtleties of the outcome effect and performance evaluations. For example, this study can be replicated using tasks where prescriptive models or policies are used, such as inventory purchase (EOM, capital budgeting decisions and buy-or-make decisions. Also, Fischhoff s ( 1994) research suggests that decisions are of fected by accountability and reputation; thus, future research on decision making could examine their role along with the nature of information provided to the evaluator. Finally, future research should study how various organizational factors (e.g., budgetary participation, technology, compensation structure) along with the nature of information might influence the level of outcome effect.

Dipankar Ghosh
Associate Professor of Accounting
University of Oklahoma

Manash R. Ray
Associate Professor of Business
Lehigh University

Footnotes:

' The comments of Margie Boldt, Steve Butler, Jim Largay, Marlys Lipe, the two anonymous reviewers and the Editor are gratefully acknowledged.

' It should be noted that a hypothesis similar to this hypothesis was also posited and supported in Lipe ( 1993). However, it is included here since it was deemed necessary to first replicate the outcome effect in the context of the current study and then demonstrate an outcome effect differential due to reasons discussed next and stated in hypothesis H2.

Half of the subjects received these questions in reverse order; statistical analysis confirmed that there were no order effects.

Part A of the Table (between-subjects analysis) also shows the PRECISION variable to be insignificant. It should be noted that for between-subjects analysis, the repeated-measures procedure averages the dependent variable (EVALUATION) across all levels of the repeated-measures factor (OUTCOME). In this study, for the two levels of OUTCOME from the investigation decision, average EVALUATION was 60.31 when the probability of the production process being out of control was stated precisely and 59.69 when the probability was stated imprecisely. The insignificance of PRECISION is not central to this study since there was no hypothesis (or theory) which suggests that average EVALUATION for the two levels of OUTCOME should be more or less when the probability describing the production process is stated precisely or imprecisely. Furthermore, since the outcome effect is measured as the difference of EVALUATION associated with the two levels of OUTCOME, averaging the EVALUATION has no meaning.

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