Performance management and incentive compensation impacts directly on the behaviour and performance of people within the organisation, as well as on the organisation’s ability to attract and retain human capital.
Paul Hunter, senior manager at EOH Consulting, says that, as such, a good performance management and incentive compensation strategy should be a key element of any organisation’s business strategy.
He explains that while the concept of pay-for-performance has gained wide acceptance, the link between the incentive mechanism and superior performance is often still weak. Research indicates that the sensitivity of the average executive’s total pay with shareholder wealth creation is typically low.
Paradoxically, many traditional performance management systems actually encourage behaviour that destroys value.
Donald Roy, in a 1952 paper called Quota Restriction and Goldbricking in a Machine Shop, was one of the first people to accurately identify the source of the problem. In Roy’s machine shop, tool operators fabricated a wide variety of items at their stations, with each assigned a point value based on management’s assessment of the level of difficulty required to produce the item.
If an operator turned in 125 points in an hour, he would earn $1,25 for that hour of work. The company provided the operators with base pay of 85 cents per hour so if the points they turned in were lower than 85 they would still earn the minimum amount of 85 cents. For anything over 85 points per hour, the direct monetary incentive was that one more point generated one more cent in hourly compensation.
Roy observed that the incentives embedded in the performance management system generated behaviours that seemed to be at odds with the intended outcomes. The largest portion of work turned in (47% of total hours) was for point totals between 115 and 134. The second largest portion (24%) was between 35 and 54 points. Every other range had tiny proportions of the total hours.
What caused these two high-frequency ranges at such odd levels? It turns out that amongst the workers, jobs associated with these ranges were referred to as “gravy” and “stinker”, respectively. “Stinker jobs” were so difficult (their point totals were too low in relation to the work required) that the operator declared defeat immediately and slacked off.
But why not slack off entirely and not turn in any points? As Roy found out, any operator who turned in less than 35 to 54 points in an hour risked being fired for incompetence. So the extreme was in the range of 35 to 54 points per hour, which still netted the basic 85 cents compensation.
In contrast, “gravy jobs” were so easy in relation to their point values that the minimum could be reached with only a small amount of effort. But why stop at accumulating 134 points per hour? Roy found out (by himself hitting 150 on a gravy job and being accosted by angry co-workers) that whenever a job yielded more than about 134 points per hour, the timing department would descend on the shop and lower, often dramatically, the point value for the job. So, while the (individual) monetary incentive to keep working until accumulating 134 points was high, the (group) monetary disincentive to go even a point past 134 was even higher.
Hunter says that, ironically, the same type of incentive mechanism to that of Roy’s machine shop can be found in the vast majority of corporate performance management schemes. Goals are typically driven by annual budgets and, as such, determine what “points” are required in order to earn a bonus. The points required are, in effect, negotiated between each and every budget owner and budget approver. A threshold is then typically imposed beyond which point the relevant division starts to earn a bonus.
“Where targets are perceived as being unattainable, ‘stinker job’ behaviour is typically observed. Divisions will miss the target by a wide enough margin to avoid losing their jobs in the hopes of negotiating a better budget or lower ‘points’ the next year and still earn their annual basic salary in compensation.”
A cap is usually also built into the incentive mechanism in order to protect the company from paying out bonuses that are “too big”. Once the cap is reached, however, “gravy job” behaviour becomes the order of the day. There is no incentive to go beyond the cap as no additional bonus is earned and paradoxically, the further you go beyond the gap, the higher will be the “points value” or target for the following year.
“As such, the typical corporate incentive mechanism encourages exactly the same type of value-destroying behaviour as observed 57 years ago in Roy’s machine shop. In order to overcome this problem, companies must focus on designing performance management and incentive compensation schemes that do properly align the interests of each and every employee with the company’s strategy, business objectives, and the creation of real value for stakeholders,” Hunter concludes.