When your incentive system backfires

When your incentive system backfires

How many times have you seen an incentive system produce the exact opposite of the desired behaviour? Why does this happen? And why can’t organisations see, let alone fix, these problems?

Here’s one example of how incentive systems can backfire. Srikanth went to visit a client in an Asian city. He stayed in a hotel in the middle of town, and had to meet the client at a factory that was located far away. The client suggested that Srikanth catch a bus and gave him instructions on how to do so. Srikanth went to the bus stop and waited. Several buses whizzed by without stopping – even though they all had plenty of empty seats. After half a dozen buses failed to stop, Srikanth finally caught a cab.

Upon arriving late at the factory, he apologised to the client and told him the cause for his delay. The client laughed and said, “The driver’s bonus depends on whether or not he reaches his destination on time. So when drivers find that they’re running behind schedule during peak traffic hours, they don’t bother picking up passengers.”

This was the height of insanity – an incentive system that succeeded only in defeating its purpose. During rush hour, the exact time when more passengers needed to be picked up, it was better for the driver to leave them on the curb. Frustrated citizens, lost revenue and increased costs – all thanks to a misaligned incentive system. Furthermore, everyone seemed to be aware of the problem except the organisation that ran the buses. Or, equally baffling, the company knew about the issue but chose to ignore it.

Ever since this incident, we have become more attuned to seeing misalignments between a company’s purpose and what its employees actually do. And it turns out this problem is far more widespread than we realised. Here are a few common examples:

— Bankers maximise their bonuses while forgetting about the health and integrity of the financial system.

— Call centre staff hurry customers off the line or transfer them so the employees can meet their quota of calls per hour.

— Salespeople maximise their commissions and forget about what best meets the client’s needs, or what is best aligned with the firm’s capabilities. When top sales executives are incentivised to maximise their bonuses and options, the result is “channel stuffing” – overloading retailers with goods just before the end of reporting periods.

— Whenever production is incentivised in terms of the number of units produced or the cost per unit, the result is simply more inventory, more cash tied up in inventory and less flexibility in coping with changing demand.

Clearly what we’ve listed here is just the tip of the iceberg. So what can organisations do to correct these mismatches?

The first step is simply awareness. Once management teams understand the behaviours that are driven by their measurement and reward systems, they can calibrate them to make sure they’re incentivising exactly the outcomes the firm desires. Executives should remind managers and employees alike of what should be measured and rewarded. They should also be on the lookout for any undesirable behaviours to see if they can be traced back to the company’s reward systems.

But even the best designed incentive systems can only go so far. In the final analysis, it is essential that leaders have a strong inner compass to do the right thing, regardless of any measurement system. Purpose must shine through loud and clear.

Bangalore’s Narayana Hrudayalaya Hospital is one such organisation. Its vision, as articulated on its website, is “affordable, quality healthcare for the masses worldwide.” Despite the fact that it is much cheaper than comparable Indian hospitals, and only 40% of its patients pay the full fees for care, Narayana Hrudayalaya is a profitable organisation.

Why? The hospital started with the question, “How can we provide quality, affordable care to the masses?” – not with, “How do we maximise stockholder returns by designing the right incentives?” That has led to a strategy focused on both lowering costs and attracting paying patients by leveraging the hospital’s reputation for high-quality care. The surplus gained from these full-paying patients helps subsidise the cost of care for everyone else.

With the specialisation of its surgeons and the large volume of operations they perform, Narayana Hrudayalaya is able to produce world-class outcomes at a fraction of the cost at other hospitals. There are no incentives based on volume or revenue for its surgeons and other employees. Purpose is the driver; profits are the enabler.

In the end, there are no easy answers. On one hand, good measurement systems are needed to track progress, and incentive systems are needed to motivate and align people. On the other hand, it is far more important to stay true to your organisation’s purpose. We believe the pendulum has swung too far toward incentives, and that balance must be restored.

Vijay Govindarajan is a professor of international business at the Tuck School of Business at Dartmouth College. He is the co-author, with Chris Trimble, of ‘Reverse Innovation’. Srikanth Srinivas is a retired management consultant. He is the author of ‘Shocking Velocity’.

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