You Get What You Pay For – Short Term Incentive Pitfalls
By Chris Blair and Mark Bussin who can be contacted
at www.21century.co.za &
1. Introduction and background
It is a widely held view that there is no one best type of incentive scheme – the scheme has to be designed to drive the behaviour you want in an organisation. Arguably the single most important step in incentive design is to identify the drivers that you want to incentivise. The link to reward then incites certain behaviours amongst articipants that should drive the appropriate drivers selected during the design process.
This link can be a tenuous one in that we are dealing with people who do not always react as we would expect or react logically. High level staff may quickly compute how to maximize the incentive for their own gain whilst general staff often follow myopic behaviours without seeing the whole picture – these behaviours can both be ultimately detrimental to the organisation. Another aspect that becomes apparent when reviewing incentive scheme outcomes is that the majority of people are motivated by money and their actions are a result of the clichéd ‘carrot’ being dangled before them.
2. Incentive pitfalls
21st Century Business and Pay Solutions has had extensive exposure to the outcomes of various incentive schemes – some more fortunate than others. Let us look at a few examples to illustrate the point.
When the super tanker "Exxon Valdez" ran aground in Alaska, fast action was required to rescue wildlife from the spreading oil. For $20 an hour, local members of an Eskimo tribe were hired to care for stranded whales, cleaning and feeding them until they could be released. When the temporary, highly paid jobs were no longer available, the Eskimos went back to their usual occupation – hunting the whales.
The point is that money matters. It matters what is paid and how it is paid.
A law firm implemented a team based short term incentive to try to contain and reduce overhead costs in the office. Participating employees were incentivised by equal sharing cost savings against budget on six overhead costs that were deemed to be in their control; namely, telephone calls, printing and stationery, office costs, casual wages, information technology and network costs, travel costs and utility costs. A short time after implementation of the scheme, one of the partners complained that office staff usually asked him to call them back after about one minute on the phone when he was out of the office. Subsequent investigation showed that the office staff had decided to keep phone calls out of the office to less than a minute and to request partners to call them back to save money on the telephone bill!
Incentivising certain behaviours may have a domino effect – be sure to try to second guess the resultant reactions created by the new force introduced through the incentive programme.
A large engineering company set about designing an incentive to improve its gross margin (sales price less discounts given). At the same time its major business strategy was to increase market share. The company figured that it would incentivise the sales growth by a typical commission structure whilst it incentivised the gross margin improvement via a sharing of improved profitablility on the sale in question. It never occurred to the company that its sales representatives would forfeit volumes of sales in favour of gross margin improvements and although the company’s gross profit improved remarkedly, the company lost market share. Adding insult to injury, the lower volumes could not cover the same fixed overheads and net profit reduced too!
Scaling of the various drivers of incentives must be closely linked to the business strategy and drivers cannot be viewed in isolation of each other.
A survey consultancy introduced a sales commission based on the number of surveys sold. The trigger for payment to the sales representative was receipt of the participants data and the sales incentive did not terminate during the employees notice period on resignation. The crafty sales representative "sold" the survey at no cost during this period provided the participant sent in the data before the end of the month. The unwitting company discovered the employee’s actions more than a month later, having paid the commission in full based on receipt of all the data, whilst incurring bad debt from all the participants who claimed that the survey was a free service!
Payout conditions and rules must be carefully constructed to protect the company’s interests under all circumstances like resignation, death, maternity leave, retrenchment, promotion, transfer, etc
A medium sized company was purchased by one of the largest players in the market and became a subsidiary of the purchaser. Once the first incentive cycle was reached after the merger was complete, the managing director of the subsidiary was paid out twice the incentive paid to the Group CEO. This was a consequence of the incentive scheme rules (designed and scaled differently) not catering for a fundamental business change like a merger, takeover, purchase, etc.
Incentive schemes should not form part of the employees’ terms and conditions of employment and should have the flexibility for the Board or Remuneration Committee to adjust/cancel after a relevant cycle.
Although these amusing examples illustrate some fundamental criteria in the design of incentives and may be easy to spot in hindsight, the effect of poor incentive design can be devastating to a company or organisation. Successful incentive scheme design follows the steps outlined in the follow figure:
Another useful aide when designing incentive schemes is to ensure that the scheme is written up using at least the following headings:
3. Measurement Criteria
4. Determining the bonus pool
5. Limits of payout (drawback clause)
6. Timing of payout
7. Scheme administration
Every organisation should follow a rather prudent approach when selecting consultants to assist in incentive design.
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