Do incentive plans really drive performance?

Incentive plans work best only in certain contexts and cannot be a substitute for basic management processes like better reviews, hard talk, training and coaching and setting benchmarks and goals to drive performance.

In one’s early years of organisational life, one can’t be faulted for concluding that every problem can be fixed by an appropriately designed incentive plan. You were fresh out of college where you were conditioned to believe that everyone is rational and works to maximising their value and that is how a free market really works. It is only after you have been exposed to the ground reality for a sufficiently long period of time do you figure out that the reality is different from the assumptions economists made in their rather simplistic models.

Startups are more prone to failures here because they do not have sufficient experience of what does not work on the ground, and hence tend to go through the whole cycle of trial and error.

Some of these statements may sound familiar:

“Our incentive plan is not driving the right behaviours,” “Our sales staff don’t believe this incentive plan can help us meet next year’s stiff targets,” “Our delivery folks need to be incentivised for driving account growth,” “Our warehouse staff needs to be incentivised to turn up on days when there is peak demand.” Irrespective of whether the problem was with the skill set of the individual, or with the manager’s competence, or the lack of role clarity, the solution that invariably came up was an incentive plan.

There’s been substantial debate on what incentive plans really accomplish. Do they motivate? If yes, what is the causal linkage? Do incentive plans help retain talent in a competitive market? Or are they implemented to align managerial remuneration and wage bill (a significant chunk of the cost) with a company’s performance? Or are they expected to drive performance and ultimately reduce the cost-to-revenue ratio? And finally, don’t people holding public offices (or working for Japanese companies!) with no huge incentive plans deliver results?

At one level, the subject can be very complex because we are dealing with human behaviour and motives. At another level, it is fairly simple if you use past experience to determine ideas that really work, and filter out ideas that sound like as if they are from an economist’s perfect world model. It’s helpful to understand what incentive plans can achieve and what they can’t.

What are the objectives with which incentive plans are designed and implemented?

Our experience in implementing incentive plans and active involvement in the associated debates leads to some interesting conclusions:

• Most real problems cannot be solved by an incentive plan. In some situations, however, once the solution is determined and implemented, it could be cemented and accelerated by an appropriate incentive plan.
• When salaries constitute a significant chunk of total cost, it’s common to see a greater percentage of variable pay in the pay mix. This improves the operating leverage and preserves profitability in difficult times. However, even when an incentive plan is designed to improve operating leverage, it’s common to publicly posture that the incentive plan will drive and motivate performance.
• Incentives serve the purpose of rewarding “results.” Here the purpose is not to drive performance but to reward it. There is a slim chance that by rewarding performance, you can also drive it. However, the context and plan designs that reward performance are very different from contexts and plan designs that drive performance. In any case, rewarding “results” is generally considered both fair and safe. Take the case of top management whose bonuses are determined by the startup’s performance, which is an outcome of interplay between several complex factors. It’s not easy for the board to assess to what extent such performance was influenced by what the management did (or did not do) and to what extent it was influenced by factors outside the management’s control. It’s possible that poor performance was because of severe headwinds, and perhaps, no other management team may have done any better; on the other hand, when the startup has done well, a different management team may have delivered better results. Rewarding results is one of the most common objectives of an incentive plan. We don’t think there’s a very strong causal link between an incentive plan and “results” in most cases, excepting in some contexts and with special plan design. However, we have found that obtaining support for an incentive plan from a sponsor is easiest if you argue that it will motivate performance.
• In some contexts, retention of talent is the most important driver of an incentive plan. Take the case of a startup where investors want to maximise medium-term growth and value, and have identified stability in the management team as an important prerequisite. The board may suggest an attractive gain-sharing plan where a percentage of the startup’s 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 it’s really to keep a good team stable during this critical period. We believe that the primary purpose of a plan like this is retention. A poor-quality management team cannot create better value just because there is now a gain-sharing plan.
• Having said this, incentive plans can motivate when outcomes can be directly linked to an individual’s efforts. Small and self-sufficient teams with clearly defined goals, which are largely under their control, can also be motivated by incentive plans. The origins of incentive plans can actually be traced to these situations. In such cases, the incentive has to be a significant component of earnings. Therefore, it is very common to see compensation structures of sales representatives with the on-target commission (or incentive) being anywhere between 40–60 percent of total compensation. If the incentive is a miniscule part of their total compensation, it is unlikely to drive performance. Every individual makes an unconscious trade-off on the amount of incentive they would earn through extra effort and the value of leisure and relaxation (whether on the job or outside). If the incentive is a small component of the total earnings, the trade-off easily tips in favour of leisure and relaxation and hence does not drive performance.
• Another common observation is pre-sales and service delivery teams wanting some kind of commission on incremental sales they may be indirectly driving. They believe the sales personnel they support are making millions in commissions, and they aren’t, although they are instrumental in winning these deals. They don’t get the concept that a sales commission plan is designed around the basic belief that you pay for “results” not “efforts,” and you accept all the consequences of this belief. Those in other functions who crave a commission plan are unwilling to take the associated risks by accepting a lower base pay, and usually want the commission plan on top of an attractive and competitive base pay.

In conclusion

We have often seen managers trying to substitute elementary management processes with incentive plans, hoping they’d work. They don’t eventually. Oftentimes, when managers ought to be conducting better reviews, having difficult conversations, teaching their team members how to do a job better, communicating expectations, or providing direction and coaching, they suggest implementing an incentive plan. It’s not difficult to fathom why. By suggesting that an incentive plan should be put in place, they are buying time, and if things do not work, the problem was with the plan design! The subsequent discussion goes somewhat like this, “Can we try and tweak the plan? Maybe we should have a sharper payout ratio for achievement beyond the target? Or should we have a threshold up to which we do not pay an incentive?”

Well-designed incentive plans in the right context and with the right objective and expectation is a perfectly smart thing to do, but using incentive plans to solve more fundamental management failures can be setting of a culture of weak-kneed approach to dealing with problems.

(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)