Balanced Scorecards: A Relational Contract Approach

ABSTRACT Reward systems based on balanced scorecards often connect pay to an index, that is, a weighted sum of multiple performance measures. We show that such an index contract may indeed be optimal if performance measures are nonverifiable so that the contracting parties must rely on self‐enforcement. Under commonly invoked assumptions (including normally distributed measurements), we show that the weights in the index reflect a tradeoff between distortion and precision for the measures. The efficiency of the contract improves with higher precision of the index measure, because this strengthens incentives, and correlations between measurements may for this reason be beneficial. There is a caveat, however, because the index contract is not necessarily optimal for very precise measurements, although it is shown to be asymptotically optimal. We also consider hybrid measurements, and show that the principal may want to include verifiable performance measures in the relational index contract in order to improve incentives, and that this has noteworthy implications for the formal contract.