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 The Business Realist

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Four big problems with most pay-for-performance systems result in motivating employees to maximize their own compensation rather than maximizing the profitability of the company. Perhaps the most shocking is that people like to game the system.

The games people play

Posted  on 5/18/2010

More on Pay-for-Performance

People playing cards with dollars instead of cardsIn the last article, I discussed all the not-part-of-the-corporate-objectives effort required by implementing a pay-for-performance compensation system. Let's pretend for a minute that all that effort is worth it if the result is an organization aligned around achieving a high-performing company. Unfortunately, data suggests that this isn't case. Companies with complicated performance systems that reward for achieving corporate goals tend to underperform the S&P. I'm going to borrow from an article from a friend of a friend on P-for-P best practices as well as speak to my own experiences.

Problem #1: People Game the System

It's a shocker! People have a tendency to achieve the goals needed to make their target compensation.  A common tactic to meet revenue targets is to run sales promotions, offering less profitable deals to increase revenues. I know of someone who increased sales to meet end of period targets by promising his distributors that they could return it once the new period started. I also know of someone else who discounted certain responses on a customer survey in order to exceed the targeted satisfaction rate. Gregg Stocker, who writes about avoiding the corporate death spiral, cites some examples of bus drivers who skipped stops to meet on-time rates and postal workers who hid large quantities of mail to meet the mail processing times quota. Be careful what you ask for, you just might get it!  This leads me to a  second problem.....

Problem #2: Setting up Conflicting Objectives

By creating artificial incentives, management inadvertently sets up conflicting objectives. Read my article on these conflicts in the Supply Chain.  All of the examples above are the result of a conflict between an individual goal and the corporate goal. When compensation is based on sales target, keep in mind that profitability may suffer. If an employee has to choose between an action that results in long-term profitability for the company and short-term profitability for himself, he will usually look after himself. A scenario that I've often seen is when a person has a goal to implement a particular project by the year-end.  After embarking on this project, this employee learns that there are many more issues and consequences involved than originally anticipated. They have the choice of implementing something quickly that does not fully address the issues or taking more time and doing it right. With those annual goals looming large, the quick fix usually wins out. The employee meets his goals, but the business loses.

Problem #3: Measuring the Wrong Things

If a company wants to be profitable, it needs to measure profits and not revenues. From my example above, revenue targets can have the effect of decreasing profits. The same goes with costs. Focusing solely on cost containment in the hopes of increasing profits can also mean lost opportunities, like neglecting to invest in expansion or even streamlining opportunities that require an initial outlay. 

Problem #4: Too Many Measures

During the auto industry bailouts, executives at GM admitted that, in hindsight, the slew of metrics upon which they were measured meant that they couldn't focus on the few that were important. Although a balanced scorecard looks quite elegant and impressive, the point of metrics is to focus on what's important, like profitability or shareholder value. Having 10-15 metrics automatically equates to a lack of focus. Yet, if compensation is tied to this slate of measures, then the lack of focus is a sure outcome.

What's the right answer?

I don't have any data at hand (but see the article I referenced) nor do I have any first-hand experience with this, but I think the right method to compensate employees for performance is to keep it very simple. Offer a simple profit-sharing system, when the company profits so do the all the employees. Forget about determining the winners and losers in the compensation system, and reward everyone equally when the company does well.  Rely on managers to manage the performance of their employees and to penalize them through performance plans or lack of promotions or lack of salary increases. This system is fair, uncomplicated, cheap, and easy to use and allows everyone to spend their time focusing on the company's objectives and not focusing on how to maximize their own compensation.

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