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Do incentive plans really drive performance?

During the early years of ones organisational life, it is but natural to assume that every problem can be fixed by an appropriately designed incentive plan.

Some of these statements may seem familiar:

We need to incent the right behaviors”, Our incentive plan is not driving the right behaviors”, Our sales staff don’t believe this incentive plan can help us meet next years stiff targets”, Our delivery folks need to be incented for driving account growth”, As we look at the year ahead, we should create the right incentive structure for our managers to achieve their goals”.

There has been a lot of debate on what incentive plans help accomplish. Do they motivate? If yes, what is the causal linkage? Don’t people holding public offices, that do not have huge incentive plans, deliver results? Don’t managers in say Japanese companies, where there is not much emphasis on individual incentive plans, feel motivated to perform? Or, do incentive plans really help retain talent in a competitive market? Or, is the real purpose of incentive plans to simply align managerial remuneration with company performance (even if there is a very limited causal relationship between company performance and associated incentives)? Or is the primary purpose of incentive plans to preserve profitability in difficult times?

At one level the subject is complex. At another level, it is fairly simple if you limit yourself to getting a pragmatic understanding of the subject. It is helpful to understand what incentive plans can achieve, and more importantly, what they cannot achieve.

Based on our experience in designing and implementing incentive plans and active involvement in the associated debates, we reached some interesting conclusions:

– Most managers don’t realise that the right incentives merely reward and motivate certain outcomes. They dont directly drive outcomes. And this is a very fundamental difference. It is important to reward the right outcomes through incentives, but it works only if you have the right person in the job and there is an ecosystem that supports the achievement of desired outcomes. If you have the wrong person in the job and the ecosystem doesnt exist, all incentives are irrelevant. Therefore, a managers primary role is to ensure that she picks the right person for the job and fosters the right ecosystem, which is the difficult part. As a result, most managers end up doing the easier part which is putting an incentive plan in place that is tied to predefined outcomes, and hoping that somehow magically the outcomes would be achieved.

– No real problem can be fixed by an incentive plan. However, in some situations, once you determine what the fix to a problem is, it could be cemented and accelerated by an appropriate incentive plan (especially if it is culturally acceptable to incent desired behavior with money).

– A greater percentage of variable pay in the pay structure is a common trend where the salaries constitute a significant chunk of the total cost. This helps limit payouts in difficult times and preserve profitability. Even when the underlying idea behind a variable pay plan is really about linking costs to profitability more directly, it is common to publicly state that ‘incenting performance is the purpose. For several reasons, there is a tremendous reluctance to acknowledge anything other than the motivational aspect of an incentive plan as the reason for its creation.

– Rewarding for ‘results is generally considered fair and safe. Take the case of top management whose bonuses are determined by firm performance. Performance of a firm is really an outcome of interplay between several complex factors. It is extremely difficult for the Board to assess to what extent the performance was influenced by what the management did (or did not do) and to what extent it was influenced by factors totally outside managements control. Since the actions of the Board are subject to scrutiny, the safest bet would be to attribute results (whatever they may be) to what the management did or did not do. No Board will be blamed for slashing bonuses of top management when a firm performs poorly, and by the same token, paying disproportionate bonuses when it does well. It is possible that when a firm has not done well, it was because of unforeseen headwinds, and perhaps no other management team could have done any better; or for that matter, when a firm has done well, maybe a different management team could have delivered far better results. However, this would be very complex to assess and it would be even more complex to defend such an assessment. So, sharing in the fruits of your effort is considered a fair (and safe from a Boards perspective) principle to apply.

– In our opinion, retention of talent is the most important driver of incentive plans (cash or stock). Take the case of a firm that is in between an early stage start up and a mature firm. The investors would like to maximise growth and valuation. This cannot be done if there is instability and churn at the senior management level. So the Board may come up with an attractive gain-sharing plan where a percentage of the firms valuation on exit is shared with the management team. One can argue whether the purpose of this plan is to motivate the management team to create value or whether the purpose is to really keep a good team stable during this critical period. Our belief is that the primary purpose of a plan like this is retention. Therefore, if you have a wrong set of individuals or a wrong individual as a part of the senior management team, this cannot be fixed through an incentive plan like this. You cannot substitute the quality of the talent and the rigor of the management processes with an incentive plan. If someone is not a right fit for the role, there is no choice but to let the individual go.

– High incentives (whether in cash or stock) are considered a reward for risk. An early stage firm may find it difficult to pay market compensation but could attract risk takers when there is a credible chance of disproportionate wealth if the firm strikes gold. The upside has to be so significant that risk takers can be lured by the possibility of a pot of gold at the end of the journey. Here the primary purpose of the incentive plan is to attract (and to some extent retain) a team.

– We don’t think there is a very strong causal link between an incentive plan and results. Therefore the motivation to perform” argument for an incentive plan is at best weak. However, we have found that getting support for an incentive plan (or arguments in favor of an incentive plan) is easiest if you argue that it would motivate performance. There is at best a very small element of a motivation angle to incentive plans, but that is not significant. Imagine a firm going through a tough time – the market is collapsing or new buying patterns and competitors are emerging. The management team does not need the motivation of a variable pay to fight and emerge a winner. If a team cannot manage these conditions, it will be because of more serious capability issues and not the lack of motivation. So, when it really matters, the motivation of an incentive plan is likely to be the least important determinant of success.

– Having said this, incentive plans can motivate when outcomes can be directly linked to an individuals efforts. Small and self-sufficient teams with clearly defined goals that are largely under the control of the team can also be motivated by incentive plans. Historically too, incentive plans have their origins in these situations. The motivational power drops off exponentially when there are complex dependencies with what other people do, especially if they are from other functions. People are willing to accept the vagaries and uncertainties of markets and customer behavior, and how it impacts the results and their bonuses, but somehow find it difficult to accept vagaries of complex linkages with other peoples efforts. Even when there is acceptance of an incentive plan in these situations, the motivational element is very limited. The incentive plan simply ends up aligning total payout (and therefore cost) to firm performance, which in itself is not a bad objective to achieve. As long as this is recognised and acknowledged, it should be fine.

In summary

We have often seen managers trying to substitute elementary management processes with incentive plans, hoping they work. They don’t eventually. Often when managers ought to be conducting better reviews, or having difficult conversations, or providing direction and coaching, they would come up with the idea of implementing an incentive plan. It is not difficult to fathom why. If something does not work you can blame the incentive plan and get away for something you should have been doing.

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