When Your Incentive System Backfires

How many times have you seen an incentive system produce the exact opposite of the desired behavior? Why is that? And why can't organizations see, let alone fix, the problem?

For example, I (Srikanth) went to visit a client in an Asian city. I stayed in a hotel in the middle of the city, and had to meet the client at his factory location that was quite far away. The client suggested that I catch the bus and gave me instructions. I went to the bus stop and waited. Several buses came close to the stop, but they all whizzed by without stopping. It wasn't that the buses were full. In fact there were plenty of empty seats. After half a dozen buses came tantalizingly close but without stopping to pick up passengers, I finally caught a cab. Upon my later than planned arrival at the factory, I apologized to the client and told him the cause for my delay. The client laughed and said, "The driver's bonus depends on whether or not he reaches his destination on time. So during peak traffic when they find they are running behind, they don't bother picking up passengers!"

Here was the height of insanity — an incentive system that succeeded only in defeating its original purpose. At peak time, exactly when more passengers need to be picked up, it was better for the driver to go empty. Frustrated citizens, lost revenue and increased costs all thanks to the incentive system and the driver's desire to maximize his individual gain. Further, every "man on the street" seemed to know the problem, but not the organization that ran the buses. Or, equally baffling, they knew it and chose to ignore it.

Ever since this incident, we have become more attuned to seeing the misalignment between what people do (reach destination on time) and their underlying purpose (carry passengers to their destination). It turns out this misalignment is far more wide spread than we realized:

• Bankers maximize their bonuses and forget about the health and integrity of the financial system;
• Call center employees hurry you up or transfer you so they can meet their quota of number of calls per hour;
• Sales people maximize their commissions and forget about what best meets client needs (they "upsell," "supersize," or promote what has the best commission potential), or what is best aligned with firm capabilities (they sell what doesn't quite yet exist, as has been the case with many software firms). And when it is the "C" level executive incentivized to maximize their bonus and options, the result is "channel stuffing" — overloading retailers with goods just prior to the end of reporting periods, as was the case with Sara Lee;
• Wherever production is incentivized on units produced or unit costs, organizations produce in bigger batches. As a result, there is more inventory, more cash tied up in inventory and, at the same time, there is less flexibility to cope with changing demand.

If you look around, you will realize that what we have listed here is but a tip of the iceberg; we are sure you will start noticing misalignments all around, and at every level. Steve Kerr, in one of the most popular academic articles ever published, mentions several such instances of improper incentives .

Why are organizations oblivious to these frustrating, and costly, mismatches?

Awareness of the problem can help organizations take the next step — effective measures to correct it. Once management teams understand the behaviors that are driven by their measurement and reward systems, they should calibrate to make sure they are incentivizing exactly the behaviors they want from their people. They should remind managers and employees alike of what should be measured and rewarded. They should also be on alert and watch for undesirable behaviors and trace back its connection with 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 in spite of measurement and incentive systems. Purpose has to shine through loud and clear. Narayana Hrudayalaya (NH) is one such organization where purpose shines through in everything they do: "affordable, quality cardiac care for the masses." In spite of the fact that only 40% of the patients pay the full fee and they are cheaper than comparable Indian hospitals by at least 50% (and much cheaper by international standards), they are a profitable organization. How did they do it? Because they started with the question, "How can we provide quality, affordable care to the masses?"; not with, "How do we maximize stockholder returns by designing the right incentives?". That led them to a strategy that involved attracting paying patients with its reputation for high quality and, at the same time, having a relentless focus on lowering costs; and to use the surplus gained from the paying patients to subsidize the rest. With the large volume of surgeries performed and with specialization of surgeons, their productivity was high and the quality outcomes were world class, but at a fraction of the cost. There are no incentives based on volume or revenue for the surgeons or for the employees. Purpose was the driver. Profits were the enabler of their dreams.

Clearly, there are no easy answers. On the 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 the purpose. We believe the pendulum has swung too far one way, and that balance needs to be restored.

When Your Incentive System Backfires
Vijay Govindarajan and Srikanth Srinivas