Nov 24 Article Incentives Within Organ
9-904-043
REV: JULY 20, 2006
BRIAN J. HALL
Incentives within Organizations
Incentives are ubiquitous. Moment to moment, people take actions that provide immediate rewards and that they hope will lead to future rewards. They avoid actions that are unpleasant or that will be punished. Of course, this does not imply that all behavior is purposeful; people are sometimes illogical, misguided, or prone to bad habits. But purposeful behavior—responding to incentives—is pervasive.
Incentives are virtually always important since purposeful people care about, and therefore are motivated by, the things that companies typically must allocate, such as promotions, influence (the right to make decisions), working conditions, and money. And purposeful people are motivated by the allocation of things that companies often choose to allocate, such as recognition, pats on the back, and perquisites. Intentionally or unintentionally, by design or not, all companies allocate things that purposeful people care about. Thus, all companies have incentive systems that, depending on their design, can drive very desirable or very undesirable behavior.
An organization’s incentive system is defined as:
The system of formal and informal rules that determines how the wealth created or destroyed by an organization is divided among the organization’s members, which, in turn, affects the amount of wealth that is created or destroyed by the organization.
Thus, the key question is not whether an organization has an incentive system. Rather, it is whether the incentive system it has motivates behavior that leads to value creation or value destruction.
Defining and Locating Incentive Strategy
A firm’s strategy for success requires two substrategies. First, the organization must design a business strategy for how to compete, and whether to compete, in specific product markets. Second, the organization must develop an organizational strategy for successful execution of the business strategy. As shown in Figure A, if the firm’s business strategy concerns “where the organization wants to go,” its organizational strategy is about “how it plans to get there.”
Business Strategy
The starting point for the development of a firm’s business strategy involves its mission, which refers to an organization’s broad purpose. At the most fundamental level, businesses exist to create value. And in creating value in markets, businesses create both profits and shareholder returns. But
________________________________________________________________________________________________________________
Professor Brian J. Hall, with the assistance of Research Associate Jonathan P. Lim, wrote the original version of this note, “Incentive Strategy within Organizations,” HBS No. 902-131. Professor Brian J. Hall prepared this abridged version as the basis for class discussion.
Copyright © 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
904-043
Incentives within Organizations
value creation is too general a concept, and one of the ways great business leaders lead is by giving texture and meaning to the firm’s value-creating mission. They give speeches, create mission statements, and build cultures that communicate and reinforce the purpose of the organization. Top managers create mission statements about providing “the highest quality [health] care to individuals and to the community” and advancing “care through excellence in biomedical research.”1 They talk about their organization’s “revolution” to speed up the Internet by “bringing an end to ‘World Wide
Wait.’”2 By making the value-creating mission of an organization concrete, top managers can help create passion for the work and instill pride in their workers.
Once the broader purpose of an organization is defined, the development of a firm’s business strategy3 requires managers to analyze both the internal capabilities it possesses (or has the potential to possess) and the external competitive markets in which it operates. The firm-specific capabilities and resources determine a firm’s internal strengths and weaknesses, while the competitive market dynamics (Porter’s “Five Forces”)4 determine the firm’s external opportunities and threats.5 These internal and external factors are the critical determinants of a successful business strategy.
Figure A
Business Strategy and Organizational Strategy
Com petitive
M arket
D ynam ics
Firm -Specific
R esources and C apabilities
M ission
B usiness
Strategy
B usiness Strategy:
W here does the organization w ant to go?
O rganizational
Structure
O rganization al Strategy:
H ow can the organization get there?
A llocation of
D ecision Rights
Perform ance
G oals and O bjectives
Perform ance M easurem ent for Interactive Learning
•T he “R adar Screen”
Inform ation Focus
Perform ance M easurem ent for M otivating Behavior
•T he “Incentive System ”
M otivation Focus
Sources: The business strategy component is adapted from Simons (2000). The organizational strategy component is adapted from Jensen (1998) and Jensen and Meckling with Baker and Wruck (1999) and Simons (2000).
Organizational Strategy
Managers must then develop their organizational strategy in order to execute the business strategy. First and foremost, top managers must create an organizational structure, which involves deciding how to organize managers and workers into work units. For example, functional organizations group people according to functional expertise (e.g., marketing, finance, manufacturing), while other organizations group people according to their product market (e.g., wireless communication, electronics). Other common ways of organizing people include geographical groupings (regional businesses) and client or customer-based groupings.6
2
Incentives within Organizations
904-043
A second crucial decision managers must make regards the allocation of decision rights, that is, how the authority to make decisions is allocated among the managers and workers. The allocation of decision rights is absolutely crucial since decisions are made on so many dimensions: pricing, hiring, firing, pay, budgeting, capital spending, work hours, dress code, factory design, and virtually everything organizations do. Since good decision making is so important to organizational success, the allocation of decision-making authority is a crucial design feature of organizations. As will be explained later, it is also a foundational element of a firm’s incentive strategy.
Along with deciding on an organizational structure and allocating decision rights, a key element of organizational strategy is determining the performance goals and objectives of various units, teams, or individuals. These include both broad goals, such as increasing earnings, and narrow objectives deemed to be critical drivers of higher-level profit goals, such as cutting food costs or lowering defect rates.
Of course, an organizational strategy also requires performance measurement—the gathering of information in order to determine whether, and to what degree, various goals and objectives are being met. Indeed, organizations often put substantial resources into information gathering for the purpose of performance measurement. Performance measurement is important for two distinct reasons, which are not mutually exclusive. First, managers measure performance in order to gauge progress, find problems, and better understand which strategies are working and which are not. This type of information gathering provides managers with a “radar screen” of sorts and is a crucial element of an organization’s interactive learning. Organizations also gather information in order to provide accountabilities. That is, they measure performance in order to motivate the right behavior through incentives—rewards and punishments. These two performance-measurement channels are depicted at the bottom of Figure A. This latter channel—performance measurement attached to rewards and punishments—is at the heart of a firm’s incentive strategy.
The Allocation of Decision Rights
The crucial feature of decision-right allocation is whether authority for various decisions is high up in the organization—with the top managers—or down low—with lower-level managers and workers. Of course, in virtually all organizations, some decision rights are located toward the top of the organizational hierarchy—centralized decision rights—while others are located near the bottom of the organization—decentralized decision rights. And, of course, many are in between. When decision rights are centralized, the top managers need only to ensure that the decisions they have made are being carried out. In other words, they need systems to monitor and control. However, when important decision rights are decentralized, there is a much greater need for well-developed incentive systems to ensure that those making decisions are accountable for the decisions they make.
Maintaining alignment between accountability and authority requires pushing accountability systems deep into organizations when decision rights are pushed deep into organizations.
Should decision rights be centralized or decentralized? There are three factors that affect the location of decision rights: 1) the location of specific knowledge, 2) the intrinsic motivation of workers, and 3) the existence of influence activities. Let’s discuss each in turn.
Specific knowledge, unlike general knowledge, is knowledge that is not easily transferred up and down hierarchies. Thus, when the specific knowledge is located deep within organizations, the advantages of decentralization rise. (Conversely, when specific knowledge is located at the top of organizations, the advantages of centralized decision making rise.) Lower-level workers often have specific knowledge about how to best create value. They often best understand customer needs since they are closest to the customers. Likewise, they are close to the problems and therefore most able to
3
904-043
Incentives within Organizations
figure out solutions. In these situations, there are enormous advantages to pushing decision-making authority deep within organizations.7
Decentralization also empowers lower-level managers and workers, which spurs passion and excitement about the work. Although exceptions surely exist, few people enjoy their work when they are told exactly what to do and how to do it. When workers have little say about their work, the work becomes less interesting and more tedious. The evidence suggests that allowing workers to make decisions, even if they are sometimes poor ones, has the advantage of raising intrinsic motivation and creativity.8 It also increases the speed with which the organization responds to changed circumstance, opportunity, and diversity.
Finally, decentralization mitigates the scope for value-destroying politics or influence activities.
When decision rights are largely centralized, then the top management team has more power or influence (by definition). The exercise of power at the top invites wasteful lobbying by subordinate managers when value-creating decisions are made that threaten to redistribute power or resources within the organization. In centralized organizations, the need for lower-level managers to persuade top managers of the merits of a certain action creates incentives for lower-level managers to spend valuable time and effort manipulating information and politicking for their positions. Centralized organizations create an organizational structure more susceptible to harmful influence activities than decentralized organizations.9
The link from decision rights to rewards and punishments within organizations is depicted in
Figure B. Note that performance measurement is broader than objective performance measurement because it also includes subjective performance measurement (any measure that relies on subjective assessments). Likewise, rewards and punishments are broader than money. We will return to both of these issues in subsequent sections.
Figure B
Connecting Accountability (rewards and punishments) to Authority (decision rights)
Allocation of Decision Rights
(Authority)
• Specific Knowledge
• Intrinsic Motivation
Performance Measurement
• Objective
• Subjective
Rewards and Punishments
(Accountability/Incentives)
• Monetary
• Non-monetary
• Culture, norms, etc.
Source:
4
Adapted from Jensen (1998); see also Jensen and Meckling with Baker and Wruck (1999).
Incentives within Organizations
904-043
We are now in the position to define incentive strategy:
Incentive strategy concerns the way that organizations, operating within markets, tie rewards and punishments to individual and team performance in order to motivate value-creating behavior.
Managing Incentive Strategy
The management of incentives is generally difficult and messy. Tensions arise over the division of pay, as managers and workers routinely feel underpaid but rarely feel overpaid. The bonus plan, even when it is “working,” never seems to drive precisely the right behavior. And subjective performance evaluations—especially those tied to rewards and punishments—are a dreaded task.
They are fraught with anxiety, vulnerable to destructive politicization, and typically disliked by both those doing them and those receiving them.
Many managers wish the whole compensation and incentive issue would simply go away. And indeed, a tempting model sits before them—a purely objective, formula-based system that requires no subjectivity and takes all the messiness out of it. Since markets work so well as an incentive system, why not bring a market-like system into the firm? The messiness of managing incentive systems can be replaced by clear-cut, objective contracts.
Unfortunately, both theory and evidence provide some very bad news for managers who dislike the messiness of managing incentives and want to replace it with purely formulaic incentives that require no subjectivity: it can’t be done, and it shouldn’t be tried. Although the degree of “messiness” in managing incentives varies with many factors, the management of incentives will always require managers to make difficult trade-offs based on subjective judgment.10 In commenting on their incentive system, one manager stated: “We go back and forth between thinking that [our incentive system] will run itself—just turn it on and let it go—and realizing that it’s a tool that needs to be managed.”11 Incentive systems cannot just be turned on and let go; they need to be managed.
The Principal-Agent Problem
Every day, managers and workers within firms make enormously important decisions and take actions that either create or destroy the value of the company’s assets. But unlike “owners,” managers and workers do not pay the full consequences of their actions and decisions. This is the incentive problem, also known as the “principal-agent” or “agency” problem.12 Agency problems are pervasive in organizations because the incentives of owners, managers, and workers are virtually never perfectly aligned, creating conflicts within organizations.
Mitigating the agency problem within firms requires linking rewards to performance measurement. Specifically, solving the agency problem completely would require firms to measure precisely the value creation or destruction of each individual. But one of the core features of firms is that value is created by interdependent individuals organized into interdependent teams. For this reason, and for reasons discussed in the next section, disentangling an individual’s contribution to value creation is astoundingly difficult.
Evidence for this view is the simple fact that purely formulaic incentives within firms—contracts with no subjective component—are essentially nonexistent. The very benefits of organizing work in firms—the synergistic interdependencies that push people to create value in teams (called firms) rather than through contracts in markets—are the very things that create problems for the performance-measurement component of incentive systems. This suggests that the incentive problem is largely a performance-measurement problem. It also suggests an important principle of incentive
5
904-043
Incentives within Organizations
strategy: although it can never be done perfectly, measuring performance well is one of the keys to a successful incentive strategy.
Human Nature and Monetary Incentives
Before moving on to performance measurement and incentive design, a brief aside on human nature, money, and incentives is in order. Although much of the analysis that follows is on monetary incentives, the implicit model of human nature underlying this analysis implies neither a narrow nor a cynical view of human nature. Let’s begin with the issue of narrowness. A narrow view of human nature is that people care only about money. In fact, people care about—they value—an astounding array of things, from tangible things such as food, housing, and clothes to intangible (but no less important) things such as friendship, prestige, and justice.13 Because people care about more things than money, incentives are necessarily broader than money. Incentives are created when organizations allocate anything that people value, from promotions to influence to money. Thus, incentive strategy is about aligning performance with “the things that people value,” taking into account all of the richness and complexity of human beings.
But despite the fact that incentives are broader than money, money is a very widely used currency
(pun intended) for incentive design in organizations. And much of incentive strategy is about aligning monetary rewards with performance. Money is a widely used form of incentive for two reasons. First, money represents a very flexible claim on other valuable resources. Indeed, its flexibility is why money replaced barter (goods traded for other goods) as a way to transact. Money cannot buy love (at least, this is the view of this noncynical professor), but it does allow people to purchase an enormously broad range of things that they value. Second, money can be varied with performance easily. But varying other things that people value with performance is generally difficult, infeasible, or unwise (because it conflicts with other priorities). For example, people value not having to travel (or getting to travel to desirable places); they also value meaningful friendships within organizations. But neither is easily varied with performance.
Likewise, the underlying model does not imply the cynical view that people are purely greedy and need to be “bribed” to do a good job. Many people are passionate about their work and intrinsically motivated to succeed. Indeed, having a set of employees who are passionate about their work is one of the hallmarks of great organizations. Moreover, a crucial management skill is the ability to attract intrinsically motivated people and to foster and cultivate that intrinsic motivation. If intrinsic motivation is perfectly aligned with value creation—if people naturally enjoy and want to do the things that create the most value for the organization—then there is no incentive problem.
Unfortunately, such perfect alignment is hard to imagine in practice. Even the best jobs entail some aspects that are value creating for the organization but are taxing, unpleasant, and appropriately called “work” for the individual. In such cases, accountabilities—rewards and punishments—are crucial. Managers, therefore, are not behaving inconsistently when they attempt to cultivate intrinsic motivation for value creation while at the same time building incentive systems that reinforce valuecreating behavior. Jack Welch is perhaps the most well-known proponent of this view. He states that it is vitally important to find people “who are filled with passion, committed to making things happen . . . [and] have the ability to energize not only themselves, but everyone who comes into contact with them.” He also describes the importance of holding “management accountable” and using the “reward system: salary increases, stock options and promotions” to motivate behavior.14
His view of human nature is not cynical. He believes that passion and accountability—intrinsic motivation and extrinsic rewards—are complementary features of high-performing organizations.15
6
Incentives within Organizations
904-043
Objective Performance Measurement
As noted earlier, the incentive problem is largely a performance-measurement problem, and all objective performance measures are necessarily imperfect. Understanding the trade-offs that exist between various objective performance measures is the key to:
•
Developing the intuition and business judgment to make wise decisions about the best
(imperfect) performance measure in specific business settings
•
Managing the inevitable challenges that result from choosing a necessarily imperfect performance measure
Thankfully, despite the complexity of performance measurement, the ways in which performance measures are imperfect can be broken down and analyzed because of the limited number of imperfections. In particular, essentially all performance-measurement problems fall into one of three buckets. That is, there are three fundamental reasons why performance is hard to measure accurately.
First, it is often difficult to know whether a good (or bad) performance outcome was the result of high
(low) effort and skill or simply the result of good (bad) luck. This is sometimes called the controllability problem. Most performance measures (such as profits) are the result of factors that are both controllable (such as working harder and smarter to generate new business) and uncontrollable (such as bad weather or price changes in raw materials).
Second, most jobs require multiple tasks, some of which are easy to measure and some of which are not. Thus, narrow measurement of the performance on individual tasks is necessarily incomplete and therefore is not perfectly aligned with value creation. Put another way, individual performance measures are imperfect proxies for value creation. The use of them for incentive purposes therefore creates imperfect alignment with value creation. This is called the alignment problem.
Finally, value in organizations is typically created by interdependent groups of individuals. When a given outcome is the result of the joint performance of many, it is difficult to determine the individual contributions of each individual. This is called the interdependency problem. The three fundamental performance-measurement problems are summarized in Table A.
Table A
The Three Fundamental Objective Performance-Measurement Problems
The Controllability Problem
It is difficult to know whether an outcome was the result of controllables (effort, wise decisions) or uncontrollables (luck, chance).
The Alignment Problem
When a job requires multiple tasks, it is typically the case that performance regarding some tasks is easy to measure (e.g., on-time deliveries) relative to other tasks (e.g., courteous deliveries). Individual performance measures (e.g., on-time deliveries) are incomplete
(“distorted”) and therefore not perfectly aligned with value creation.
The Interdependency Problem
Value is often created by teams of individuals. When a given outcome is the result of the joint performance of many, it is difficult to determine the individual contributions of any team member.
Source:
Created by casewriter.
7
904-043
Incentives within Organizations
Subjective Performance Evaluation
Most of the difficult trade-offs that arise in using objective performance measures can, in theory, be overcome by the use of subjective performance evaluation. Consider again the fundamental problem that we are trying to solve: how to measure the total contribution toward value creation of an individual. Note that this is the total contribution and includes everything that an individual does in an organization that creates or destroys value. This includes not only the “hard” things such as
“making the numbers” but also the “soft”—and therefore harder-to-measure—things such as mentoring (raising the human capital of others), cooperating (helping others to make their numbers), providing leadership, and accepting unpleasant tasks. It even includes such things as “being pleasant to work with and around.” Contributing to an attractive work environment can help raise the productivity of others and help the organization attract and retain better workers.16
In many cases, the harder-to-measure contributions to value creation are no less important than the “objectively measured” contributions; they are just more difficult to measure. The great hope of subjective performance evaluations is that these softer—but no less important—factors can be appropriately considered and weighed in measuring performance. Subjective performance evaluation can then be used as a substitute for objective measures, or in addition to objective performance measures, as a way to minimize the distortions—and to complete the incompleteness— of those measures.
The key virtue of subjective performance evaluation, therefore, is that managers can flexibly measure value creation and do not have to rely on narrow measures.
Subjective performance evaluation requires substantial company resources because it is so hard to do well. Even companies that believe they do it successfully—and perhaps especially those companies—find it to be frustrating, time consuming, and rancorous.
The Achilles heel of subjective performance evaluation is that most people dislike evaluating others, especially when performance is weak. Rigorous evaluations require differentiation—claiming and supporting the view that some people are better performers than others and stating that people are differentially better (and therefore also differentially worse) in some areas than in others. If done well, such differentiation is hard work and requires the evaluator to justify and be accountable for his or her evaluation. It also leads to conflict since individuals—especially when the stakes are high but even when they are low—generally do not like being evaluated and do not respond well to negative feedback.17 Because of these forces, most evaluators find it to be easier and much more enjoyable to give virtually everyone positive evaluations.
One of the most common ways in which companies ensure differentiation is through the use of forced curves. Some managers believe that forced curves are the only dependable way to create disciplined subjective evaluations. General Electric’s well-known “vitality curve”—where all managers are asked to rank their people into one of three categories: “top 20,” “the vital 70,” and the
“bottom 10”—is at the heart of their organizational strategy. The rankings and evaluations that result from this system are used to compensate, promote, and “weed out the worst performers.”18 Former
GE CEO Welch comments: “We build great people, who then build great products.” He continues,
“For a guy who hates bureaucracy and rails against it, the rigor of our people system is what brings this whole thing to life. . . . The basic concept was we forced our business leaders to differentiate their leadership [through the vitality curve]. . . . Making these judgments is not easy, and they are not always precise. Yes, you’ll miss a few stars and a few late bloomers—but your chances of building an all-star team are improved dramatically. This is how great organizations are built.”19
8
Incentives within Organizations
904-043
Subjective evaluations also present other challenges. They can become politicized (for example, managers may give higher valuations to people with whom they worked closely), and they can lead to gaming of the system (at GE, some managers gave low rankings to employees they already knew were leaving the company, and in one case, to an employee who had recently died).20 Moreover, the conflict that is created by subjective evaluations has the potential to poison the culture of the organization. Nevertheless, despite all of these problems, and despite the overwhelming forces that top managers feel to avoid subjective evaluation—since both evaluators and evaluatees dislike them so much—many organizations fight through the mess and maintain their commitment to rigorous subjective evaluation. They use subjectivity because the alternative of relying solely on objective measures—which are often either narrow and misaligned or overly broad and uncontrollable—is simply unacceptable to them given their commitment to measuring performance well. But even managers who are fully committed to rigorous subjective evaluation recognize the profound uneasiness it creates in most normal humans.21 Welch states: “Differentiation is hard. Anybody who finds it easy doesn’t belong in the organization, and anyone who can’t do it falls in the same category.”22 9
904-043
Incentives within Organizations
Endnotes
1 See Barro, Bozic, and Zimmerman, “Performance Pay for MGOA Physicians (A),” HBS Case No. 902-159, 2002.
2 See Hall, Lane, and Lim, “Akamai’s Underwater Options (A),” HBS Case No. 902-069, 2002.
3 See Wernerfelt (1984) for a development of this view.
4 See Porter (1980) for a detailed analysis.
5 For a complete treatment of the analysis of a firm’s strengths, weaknesses, opportunities, and threats (SWOT analysis), see
Simons (2000). Note also that the analysis that connects competitive market dynamics, firm-specific resources and capabilities, mission, and business strategy is adapted from Simons (2000).
6 Unfortunately, decisions regarding organizational structure require difficult trade-offs. For example, workers and managers in functional organizations are able to specialize in their functional area, a crucial advantage. But functional organizations require coordination across functions, which can lead to cumbersome bureaucracies that are far removed from customers.
Product market organizations are closer to the customer and therefore able to be more responsive but lose the advantage of specialization. See Simons (2000), pp. 48–50.
7 See Jensen and Meckling (1994), pp. 4–19, for a detailed analysis of the allocation of decision rights and specific knowledge.
8 For evidence and analysis consistent with the view that autonomy in work leads to greater creativity and intrinsic motivation, see Amabile and Gitomer (1984), Amabile and Gryskiewicz (1987), and Hackman and Oldham (1976).
9 See Milgrom and Roberts (1988) and Milgrom (1988) and the references within for theory and evidence on this point.
10 The theory about the difficulty of bringing the market into the firm is part of a growing academic literature that includes
Baker; Gibbons and Murphy (2001); Baker, Gibbons, and Murphy (2001); Gibbons (1999); Holmstrom (1999); and Holmstrom and Milgrom (1994).
11 See Hall, Lazear, and Madigan, “Performance Pay at Safelite Autoglass (B),” HBS Case No. 800-292, 2000a, p. 4.
12 The incentive problem is called the principal-agent problem because the owners (principals) of firms hire managers and workers (agents) whose incentives are not naturally aligned with those of the principal. A seminal paper by Jensen and
Meckling (1976) was the first to develop the modern theory of the agency problem. The conflicting incentives of owners and managers was first noted 200 years earlier by Adam Smith in The Wealth of Nations (1776), the book that began the field of economics. 13 See Jensen and Meckling (1994) for discussion and analysis of this point.
14 See Welch (2001), pp. 158–160.
15 This view that intrinsic and extrinsic motivation are complements is inconsistent with some psychological models that view them as substitutes—that extrinsic motivation can drive out intrinsic motivation (Deci, 1971). But there is much evidence consistent with the view that intrinsic and extrinsic motivation can work synergistically. See Amabile, Hill, Hennessey, and
Tighe (1994) and Amabile and Gryskiewicz (1987, 1989) for examples. Much of the evidence in support of the view that extrinsic motivation can enhance intrinsic motivation suggests that worker autonomy—not requiring workers to accomplish tasks in specific and predetermined ways—is one of the crucial factors in fostering synergies between extrinsic and intrinsic motivation (Amabile, Phillips, and Collins, 1993).
16 More specifically, when an organization has an attractive work environment, it can gain a competitive edge by 1) paying slightly lower compensation relative to competitors (because the attractive work environment provides an offsetting benefit) or
2) attracting and retaining better talent, or doing a little of both. Of course, to the extent that this strategy is successful and makes everyone more productive, it can feed back into higher compensation.
17 Another reason it is hard to give negative feedback is the vast majority of individuals believe that their performance is well above average and virtually no one ranks themselves below the median. These results are robust to a variety of studies. See
Baker, Jensen, and Murphy (1988), Meyer (1975), and references therein for details.
18 See Welch (2001), p. 387.
19 See Welch (2001), pp. 156–158.
20 See Hall and Madigan, “Compensation and Performance Evaluation at Arrow Electronics,” HBS Case No. 800-290, 2000, and Welch (2001).
21 If differentiation does not lead to profound uneasiness on your part, you just have to figure out which of the qualifiers applies in your case: “most” or “normal.”
22 See Welch (2001), p. 388.
10
Incentives within Organizations
904-043
References
Amabile, T.M. and J. Gitomer. “Children’s artistic creativity: effects of choice in task materials.” Personality and Social Psychology Bulletin 10 (1984): 209–215.
Amabile, T.M. and S.S. Gryskiewicz. “Creativity in the R&D laboratory.” Technical report number 30
(Greensboro, NC: Center for Creative Leadership, 1987).
Amabile, T.M. and S.S. Gryskiewicz. “The creative environment scales: the work environment inventory.”
Amabile, T.M., K.G. Hill, B.A. Hennessey, and E. Tighe. “The work preference inventory: assessing intrinsic and extrinsic motivational orientations.” Journal of Personality and Social Psychology 66 (1994):
950–967.
Amabile, T.M., E. Phillips, and M.A. Collins. “Personality and environmental determinants of creativity in professional artists.” Unpublished manuscript, Brandeis University, Waltham, MA, 1993.
Baker, G.P., R. Gibbons, and K.J. Murphy. “Bringing the market inside the firm?” American Economic Review
91 (2001): 212–218.
Baker, G.P., R. Gibbons, and K.J. Murphy. “Relational contracts and the theory of the firm.” Quarterly
Journal of Economics (2001).
Baker, G.P., M.C. Jensen, and K.J. Murphy. “Compensation and incentives: practice vs. theory.” Journal of
Finance 43 (1988): 593–616.
Barro, J.R., K.J. Bozic, and A.M. Zimmerman. “Performance Pay for MGOA Physicians (A).” HBS Case No.
902-159 (Boston: Harvard Business School Publishing, 2002).
Deci, E.L. “Effects of externally-mediated awards on intrinsic motivation.” Journal of Personality and Social
Psychology 18 (1971): 105–115.
Gibbons, R. “Taking coase seriously.” Administrative Science Quarterly 44 (1) (1999): 145–157.
Hackman, J.R. and G.R. Oldham. “Motivation through the design of work.” Organizational Behavior and
Human Performance 16 (1976): 250–279.
Hall, B.J., H. Lane, and J.P. Lim. “Akamai’s underwater options (A).” HBS Case No. 902-069, 2002.
Hall, B.J., E. Lazear, and C. Madigan. “Performance Pay at Safelite Auto Glass (B).” HBS Case No. 800-292,
2000.
Hall, B.J., and C. Madigan. “Compensation and Performance Evaluation at Arrow Electronics.” HBS Case
No. 800-290, 2000.
Holmstrom, B. “The firm as a subeconomy.” Journal of Law, Economics and Organization 9 (1999): 74–102.
Holmstrom, B. and P. Milgrom. “The firm as an incentive system.” American Economic Review 84 (1994):
972–991.
Jensen, M.C. Foundations of organizational strategy. Cambridge, MA: Harvard University Press, 1998.
Jensen, M.C. and W.H. Meckling. “The nature of man.” Journal of Applied Corporate Finance 7 (1994): 4–19.
Jensen, M.C. and W.H. Meckling. “Theory of the firm: managerial behavior, agency costs, and ownership structure.” Journal of Financial Economics 3 (1976): 305–360.
11
904-043
Incentives within Organizations
Jensen, M.C. and W.H. Meckling with G.P. Baker and K.H. Wruck. “Coordination, control, and the management of organizations.” HBS Working Paper No. 98-908, 1999.
Meyer, H.H. “The pay-for-performance dilemma.” Organizational Dynamics 3 (1975).
Milgrom, P. “Employment contracts, influence activities, and efficient organization design.” Journal of
Political Economy 96 (1988): 42–60.
Milgrom, P. and J. Roberts. “An economic approach to influence activities in organizations.” American
Journal of Sociology 94, Supplement S154-S179 (1988).
Porter, M.E.. Competitive strategy: techniques for analyzing industries and competitors. New York, NY: Free
Press, 1980.
Simons, R. Performance measurement & control systems for implementing strategy. Upper Saddle River, NJ:
Prentice Hall, 2000.
Smith, A. Wealth of nations (1776; ed. E. Cannan, 1904). Reprint: New York, NY: Modern Library, 1937.
Welch, J.F. with J.A. Byrne. Jack: straight from the gut. New York, NY: Warner Books, 2001.
Wernerfelt, B. “A resource-based view of the firm.” Strategic Management Journal 5 (1984).
12
References: Amabile, T.M. and J. Gitomer. “Children’s artistic creativity: effects of choice in task materials.” Personality and Social Psychology Bulletin 10 (1984): 209–215. Amabile, T.M. and S.S. Gryskiewicz. “Creativity in the R&D laboratory.” Technical report number 30 (Greensboro, NC: Center for Creative Leadership, 1987). intrinsic and extrinsic motivational orientations.” Journal of Personality and Social Psychology 66 (1994): 950–967. Amabile, T.M., E. Phillips, and M.A. Collins. “Personality and environmental determinants of creativity in professional artists.” Unpublished manuscript, Brandeis University, Waltham, MA, 1993. Baker, G.P., R. Gibbons, and K.J. Murphy. “Bringing the market inside the firm?” American Economic Review 91 (2001): 212–218. Baker, G.P., R. Gibbons, and K.J. Murphy. “Relational contracts and the theory of the firm.” Quarterly Journal of Economics (2001). Baker, G.P., M.C. Jensen, and K.J. Murphy. “Compensation and incentives: practice vs. theory.” Journal of Finance 43 (1988): 593–616. 902-159 (Boston: Harvard Business School Publishing, 2002). Deci, E.L. “Effects of externally-mediated awards on intrinsic motivation.” Journal of Personality and Social Psychology 18 (1971): 105–115. Gibbons, R. “Taking coase seriously.” Administrative Science Quarterly 44 (1) (1999): 145–157. Hackman, J.R. and G.R. Oldham. “Motivation through the design of work.” Organizational Behavior and Human Performance 16 (1976): 250–279. Hall, B.J., H. Lane, and J.P. Lim. “Akamai’s underwater options (A).” HBS Case No. 902-069, 2002. Hall, B.J., E. Lazear, and C. Madigan. “Performance Pay at Safelite Auto Glass (B).” HBS Case No. 800-292, 2000. Holmstrom, B. “The firm as a subeconomy.” Journal of Law, Economics and Organization 9 (1999): 74–102. Holmstrom, B. and P. Milgrom. “The firm as an incentive system.” American Economic Review 84 (1994): 972–991. Jensen, M.C. Foundations of organizational strategy. Cambridge, MA: Harvard University Press, 1998. Jensen, M.C. and W.H. Meckling. “The nature of man.” Journal of Applied Corporate Finance 7 (1994): 4–19. Jensen, M.C. and W.H. Meckling. “Theory of the firm: managerial behavior, agency costs, and ownership structure.” Journal of Financial Economics 3 (1976): 305–360. management of organizations.” HBS Working Paper No. 98-908, 1999. Meyer, H.H. “The pay-for-performance dilemma.” Organizational Dynamics 3 (1975). Milgrom, P. “Employment contracts, influence activities, and efficient organization design.” Journal of Political Economy 96 (1988): 42–60. Milgrom, P. and J. Roberts. “An economic approach to influence activities in organizations.” American Journal of Sociology 94, Supplement S154-S179 (1988). Porter, M.E.. Competitive strategy: techniques for analyzing industries and competitors. New York, NY: Free Press, 1980. Simons, R. Performance measurement & control systems for implementing strategy. Upper Saddle River, NJ: Prentice Hall, 2000. Smith, A. Wealth of nations (1776; ed. E. Cannan, 1904). Reprint: New York, NY: Modern Library, 1937. Welch, J.F. with J.A. Byrne. Jack: straight from the gut. New York, NY: Warner Books, 2001. Wernerfelt, B. “A resource-based view of the firm.” Strategic Management Journal 5 (1984).
REV: JULY 20, 2006
BRIAN J. HALL
Incentives within Organizations
Incentives are ubiquitous. Moment to moment, people take actions that provide immediate rewards and that they hope will lead to future rewards. They avoid actions that are unpleasant or that will be punished. Of course, this does not imply that all behavior is purposeful; people are sometimes illogical, misguided, or prone to bad habits. But purposeful behavior—responding to incentives—is pervasive.
Incentives are virtually always important since purposeful people care about, and therefore are motivated by, the things that companies typically must allocate, such as promotions, influence (the right to make decisions), working conditions, and money. And purposeful people are motivated by the allocation of things that companies often choose to allocate, such as recognition, pats on the back, and perquisites. Intentionally or unintentionally, by design or not, all companies allocate things that purposeful people care about. Thus, all companies have incentive systems that, depending on their design, can drive very desirable or very undesirable behavior.
An organization’s incentive system is defined as:
The system of formal and informal rules that determines how the wealth created or destroyed by an organization is divided among the organization’s members, which, in turn, affects the amount of wealth that is created or destroyed by the organization.
Thus, the key question is not whether an organization has an incentive system. Rather, it is whether the incentive system it has motivates behavior that leads to value creation or value destruction.
Defining and Locating Incentive Strategy
A firm’s strategy for success requires two substrategies. First, the organization must design a business strategy for how to compete, and whether to compete, in specific product markets. Second, the organization must develop an organizational strategy for successful execution of the business strategy. As shown in Figure A, if the firm’s business strategy concerns “where the organization wants to go,” its organizational strategy is about “how it plans to get there.”
Business Strategy
The starting point for the development of a firm’s business strategy involves its mission, which refers to an organization’s broad purpose. At the most fundamental level, businesses exist to create value. And in creating value in markets, businesses create both profits and shareholder returns. But
________________________________________________________________________________________________________________
Professor Brian J. Hall, with the assistance of Research Associate Jonathan P. Lim, wrote the original version of this note, “Incentive Strategy within Organizations,” HBS No. 902-131. Professor Brian J. Hall prepared this abridged version as the basis for class discussion.
Copyright © 2004 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-545-7685, write Harvard Business School Publishing, Boston, MA 02163, or go to http://www.hbsp.harvard.edu. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of Harvard Business School.
904-043
Incentives within Organizations
value creation is too general a concept, and one of the ways great business leaders lead is by giving texture and meaning to the firm’s value-creating mission. They give speeches, create mission statements, and build cultures that communicate and reinforce the purpose of the organization. Top managers create mission statements about providing “the highest quality [health] care to individuals and to the community” and advancing “care through excellence in biomedical research.”1 They talk about their organization’s “revolution” to speed up the Internet by “bringing an end to ‘World Wide
Wait.’”2 By making the value-creating mission of an organization concrete, top managers can help create passion for the work and instill pride in their workers.
Once the broader purpose of an organization is defined, the development of a firm’s business strategy3 requires managers to analyze both the internal capabilities it possesses (or has the potential to possess) and the external competitive markets in which it operates. The firm-specific capabilities and resources determine a firm’s internal strengths and weaknesses, while the competitive market dynamics (Porter’s “Five Forces”)4 determine the firm’s external opportunities and threats.5 These internal and external factors are the critical determinants of a successful business strategy.
Figure A
Business Strategy and Organizational Strategy
Com petitive
M arket
D ynam ics
Firm -Specific
R esources and C apabilities
M ission
B usiness
Strategy
B usiness Strategy:
W here does the organization w ant to go?
O rganizational
Structure
O rganization al Strategy:
H ow can the organization get there?
A llocation of
D ecision Rights
Perform ance
G oals and O bjectives
Perform ance M easurem ent for Interactive Learning
•T he “R adar Screen”
Inform ation Focus
Perform ance M easurem ent for M otivating Behavior
•T he “Incentive System ”
M otivation Focus
Sources: The business strategy component is adapted from Simons (2000). The organizational strategy component is adapted from Jensen (1998) and Jensen and Meckling with Baker and Wruck (1999) and Simons (2000).
Organizational Strategy
Managers must then develop their organizational strategy in order to execute the business strategy. First and foremost, top managers must create an organizational structure, which involves deciding how to organize managers and workers into work units. For example, functional organizations group people according to functional expertise (e.g., marketing, finance, manufacturing), while other organizations group people according to their product market (e.g., wireless communication, electronics). Other common ways of organizing people include geographical groupings (regional businesses) and client or customer-based groupings.6
2
Incentives within Organizations
904-043
A second crucial decision managers must make regards the allocation of decision rights, that is, how the authority to make decisions is allocated among the managers and workers. The allocation of decision rights is absolutely crucial since decisions are made on so many dimensions: pricing, hiring, firing, pay, budgeting, capital spending, work hours, dress code, factory design, and virtually everything organizations do. Since good decision making is so important to organizational success, the allocation of decision-making authority is a crucial design feature of organizations. As will be explained later, it is also a foundational element of a firm’s incentive strategy.
Along with deciding on an organizational structure and allocating decision rights, a key element of organizational strategy is determining the performance goals and objectives of various units, teams, or individuals. These include both broad goals, such as increasing earnings, and narrow objectives deemed to be critical drivers of higher-level profit goals, such as cutting food costs or lowering defect rates.
Of course, an organizational strategy also requires performance measurement—the gathering of information in order to determine whether, and to what degree, various goals and objectives are being met. Indeed, organizations often put substantial resources into information gathering for the purpose of performance measurement. Performance measurement is important for two distinct reasons, which are not mutually exclusive. First, managers measure performance in order to gauge progress, find problems, and better understand which strategies are working and which are not. This type of information gathering provides managers with a “radar screen” of sorts and is a crucial element of an organization’s interactive learning. Organizations also gather information in order to provide accountabilities. That is, they measure performance in order to motivate the right behavior through incentives—rewards and punishments. These two performance-measurement channels are depicted at the bottom of Figure A. This latter channel—performance measurement attached to rewards and punishments—is at the heart of a firm’s incentive strategy.
The Allocation of Decision Rights
The crucial feature of decision-right allocation is whether authority for various decisions is high up in the organization—with the top managers—or down low—with lower-level managers and workers. Of course, in virtually all organizations, some decision rights are located toward the top of the organizational hierarchy—centralized decision rights—while others are located near the bottom of the organization—decentralized decision rights. And, of course, many are in between. When decision rights are centralized, the top managers need only to ensure that the decisions they have made are being carried out. In other words, they need systems to monitor and control. However, when important decision rights are decentralized, there is a much greater need for well-developed incentive systems to ensure that those making decisions are accountable for the decisions they make.
Maintaining alignment between accountability and authority requires pushing accountability systems deep into organizations when decision rights are pushed deep into organizations.
Should decision rights be centralized or decentralized? There are three factors that affect the location of decision rights: 1) the location of specific knowledge, 2) the intrinsic motivation of workers, and 3) the existence of influence activities. Let’s discuss each in turn.
Specific knowledge, unlike general knowledge, is knowledge that is not easily transferred up and down hierarchies. Thus, when the specific knowledge is located deep within organizations, the advantages of decentralization rise. (Conversely, when specific knowledge is located at the top of organizations, the advantages of centralized decision making rise.) Lower-level workers often have specific knowledge about how to best create value. They often best understand customer needs since they are closest to the customers. Likewise, they are close to the problems and therefore most able to
3
904-043
Incentives within Organizations
figure out solutions. In these situations, there are enormous advantages to pushing decision-making authority deep within organizations.7
Decentralization also empowers lower-level managers and workers, which spurs passion and excitement about the work. Although exceptions surely exist, few people enjoy their work when they are told exactly what to do and how to do it. When workers have little say about their work, the work becomes less interesting and more tedious. The evidence suggests that allowing workers to make decisions, even if they are sometimes poor ones, has the advantage of raising intrinsic motivation and creativity.8 It also increases the speed with which the organization responds to changed circumstance, opportunity, and diversity.
Finally, decentralization mitigates the scope for value-destroying politics or influence activities.
When decision rights are largely centralized, then the top management team has more power or influence (by definition). The exercise of power at the top invites wasteful lobbying by subordinate managers when value-creating decisions are made that threaten to redistribute power or resources within the organization. In centralized organizations, the need for lower-level managers to persuade top managers of the merits of a certain action creates incentives for lower-level managers to spend valuable time and effort manipulating information and politicking for their positions. Centralized organizations create an organizational structure more susceptible to harmful influence activities than decentralized organizations.9
The link from decision rights to rewards and punishments within organizations is depicted in
Figure B. Note that performance measurement is broader than objective performance measurement because it also includes subjective performance measurement (any measure that relies on subjective assessments). Likewise, rewards and punishments are broader than money. We will return to both of these issues in subsequent sections.
Figure B
Connecting Accountability (rewards and punishments) to Authority (decision rights)
Allocation of Decision Rights
(Authority)
• Specific Knowledge
• Intrinsic Motivation
Performance Measurement
• Objective
• Subjective
Rewards and Punishments
(Accountability/Incentives)
• Monetary
• Non-monetary
• Culture, norms, etc.
Source:
4
Adapted from Jensen (1998); see also Jensen and Meckling with Baker and Wruck (1999).
Incentives within Organizations
904-043
We are now in the position to define incentive strategy:
Incentive strategy concerns the way that organizations, operating within markets, tie rewards and punishments to individual and team performance in order to motivate value-creating behavior.
Managing Incentive Strategy
The management of incentives is generally difficult and messy. Tensions arise over the division of pay, as managers and workers routinely feel underpaid but rarely feel overpaid. The bonus plan, even when it is “working,” never seems to drive precisely the right behavior. And subjective performance evaluations—especially those tied to rewards and punishments—are a dreaded task.
They are fraught with anxiety, vulnerable to destructive politicization, and typically disliked by both those doing them and those receiving them.
Many managers wish the whole compensation and incentive issue would simply go away. And indeed, a tempting model sits before them—a purely objective, formula-based system that requires no subjectivity and takes all the messiness out of it. Since markets work so well as an incentive system, why not bring a market-like system into the firm? The messiness of managing incentive systems can be replaced by clear-cut, objective contracts.
Unfortunately, both theory and evidence provide some very bad news for managers who dislike the messiness of managing incentives and want to replace it with purely formulaic incentives that require no subjectivity: it can’t be done, and it shouldn’t be tried. Although the degree of “messiness” in managing incentives varies with many factors, the management of incentives will always require managers to make difficult trade-offs based on subjective judgment.10 In commenting on their incentive system, one manager stated: “We go back and forth between thinking that [our incentive system] will run itself—just turn it on and let it go—and realizing that it’s a tool that needs to be managed.”11 Incentive systems cannot just be turned on and let go; they need to be managed.
The Principal-Agent Problem
Every day, managers and workers within firms make enormously important decisions and take actions that either create or destroy the value of the company’s assets. But unlike “owners,” managers and workers do not pay the full consequences of their actions and decisions. This is the incentive problem, also known as the “principal-agent” or “agency” problem.12 Agency problems are pervasive in organizations because the incentives of owners, managers, and workers are virtually never perfectly aligned, creating conflicts within organizations.
Mitigating the agency problem within firms requires linking rewards to performance measurement. Specifically, solving the agency problem completely would require firms to measure precisely the value creation or destruction of each individual. But one of the core features of firms is that value is created by interdependent individuals organized into interdependent teams. For this reason, and for reasons discussed in the next section, disentangling an individual’s contribution to value creation is astoundingly difficult.
Evidence for this view is the simple fact that purely formulaic incentives within firms—contracts with no subjective component—are essentially nonexistent. The very benefits of organizing work in firms—the synergistic interdependencies that push people to create value in teams (called firms) rather than through contracts in markets—are the very things that create problems for the performance-measurement component of incentive systems. This suggests that the incentive problem is largely a performance-measurement problem. It also suggests an important principle of incentive
5
904-043
Incentives within Organizations
strategy: although it can never be done perfectly, measuring performance well is one of the keys to a successful incentive strategy.
Human Nature and Monetary Incentives
Before moving on to performance measurement and incentive design, a brief aside on human nature, money, and incentives is in order. Although much of the analysis that follows is on monetary incentives, the implicit model of human nature underlying this analysis implies neither a narrow nor a cynical view of human nature. Let’s begin with the issue of narrowness. A narrow view of human nature is that people care only about money. In fact, people care about—they value—an astounding array of things, from tangible things such as food, housing, and clothes to intangible (but no less important) things such as friendship, prestige, and justice.13 Because people care about more things than money, incentives are necessarily broader than money. Incentives are created when organizations allocate anything that people value, from promotions to influence to money. Thus, incentive strategy is about aligning performance with “the things that people value,” taking into account all of the richness and complexity of human beings.
But despite the fact that incentives are broader than money, money is a very widely used currency
(pun intended) for incentive design in organizations. And much of incentive strategy is about aligning monetary rewards with performance. Money is a widely used form of incentive for two reasons. First, money represents a very flexible claim on other valuable resources. Indeed, its flexibility is why money replaced barter (goods traded for other goods) as a way to transact. Money cannot buy love (at least, this is the view of this noncynical professor), but it does allow people to purchase an enormously broad range of things that they value. Second, money can be varied with performance easily. But varying other things that people value with performance is generally difficult, infeasible, or unwise (because it conflicts with other priorities). For example, people value not having to travel (or getting to travel to desirable places); they also value meaningful friendships within organizations. But neither is easily varied with performance.
Likewise, the underlying model does not imply the cynical view that people are purely greedy and need to be “bribed” to do a good job. Many people are passionate about their work and intrinsically motivated to succeed. Indeed, having a set of employees who are passionate about their work is one of the hallmarks of great organizations. Moreover, a crucial management skill is the ability to attract intrinsically motivated people and to foster and cultivate that intrinsic motivation. If intrinsic motivation is perfectly aligned with value creation—if people naturally enjoy and want to do the things that create the most value for the organization—then there is no incentive problem.
Unfortunately, such perfect alignment is hard to imagine in practice. Even the best jobs entail some aspects that are value creating for the organization but are taxing, unpleasant, and appropriately called “work” for the individual. In such cases, accountabilities—rewards and punishments—are crucial. Managers, therefore, are not behaving inconsistently when they attempt to cultivate intrinsic motivation for value creation while at the same time building incentive systems that reinforce valuecreating behavior. Jack Welch is perhaps the most well-known proponent of this view. He states that it is vitally important to find people “who are filled with passion, committed to making things happen . . . [and] have the ability to energize not only themselves, but everyone who comes into contact with them.” He also describes the importance of holding “management accountable” and using the “reward system: salary increases, stock options and promotions” to motivate behavior.14
His view of human nature is not cynical. He believes that passion and accountability—intrinsic motivation and extrinsic rewards—are complementary features of high-performing organizations.15
6
Incentives within Organizations
904-043
Objective Performance Measurement
As noted earlier, the incentive problem is largely a performance-measurement problem, and all objective performance measures are necessarily imperfect. Understanding the trade-offs that exist between various objective performance measures is the key to:
•
Developing the intuition and business judgment to make wise decisions about the best
(imperfect) performance measure in specific business settings
•
Managing the inevitable challenges that result from choosing a necessarily imperfect performance measure
Thankfully, despite the complexity of performance measurement, the ways in which performance measures are imperfect can be broken down and analyzed because of the limited number of imperfections. In particular, essentially all performance-measurement problems fall into one of three buckets. That is, there are three fundamental reasons why performance is hard to measure accurately.
First, it is often difficult to know whether a good (or bad) performance outcome was the result of high
(low) effort and skill or simply the result of good (bad) luck. This is sometimes called the controllability problem. Most performance measures (such as profits) are the result of factors that are both controllable (such as working harder and smarter to generate new business) and uncontrollable (such as bad weather or price changes in raw materials).
Second, most jobs require multiple tasks, some of which are easy to measure and some of which are not. Thus, narrow measurement of the performance on individual tasks is necessarily incomplete and therefore is not perfectly aligned with value creation. Put another way, individual performance measures are imperfect proxies for value creation. The use of them for incentive purposes therefore creates imperfect alignment with value creation. This is called the alignment problem.
Finally, value in organizations is typically created by interdependent groups of individuals. When a given outcome is the result of the joint performance of many, it is difficult to determine the individual contributions of each individual. This is called the interdependency problem. The three fundamental performance-measurement problems are summarized in Table A.
Table A
The Three Fundamental Objective Performance-Measurement Problems
The Controllability Problem
It is difficult to know whether an outcome was the result of controllables (effort, wise decisions) or uncontrollables (luck, chance).
The Alignment Problem
When a job requires multiple tasks, it is typically the case that performance regarding some tasks is easy to measure (e.g., on-time deliveries) relative to other tasks (e.g., courteous deliveries). Individual performance measures (e.g., on-time deliveries) are incomplete
(“distorted”) and therefore not perfectly aligned with value creation.
The Interdependency Problem
Value is often created by teams of individuals. When a given outcome is the result of the joint performance of many, it is difficult to determine the individual contributions of any team member.
Source:
Created by casewriter.
7
904-043
Incentives within Organizations
Subjective Performance Evaluation
Most of the difficult trade-offs that arise in using objective performance measures can, in theory, be overcome by the use of subjective performance evaluation. Consider again the fundamental problem that we are trying to solve: how to measure the total contribution toward value creation of an individual. Note that this is the total contribution and includes everything that an individual does in an organization that creates or destroys value. This includes not only the “hard” things such as
“making the numbers” but also the “soft”—and therefore harder-to-measure—things such as mentoring (raising the human capital of others), cooperating (helping others to make their numbers), providing leadership, and accepting unpleasant tasks. It even includes such things as “being pleasant to work with and around.” Contributing to an attractive work environment can help raise the productivity of others and help the organization attract and retain better workers.16
In many cases, the harder-to-measure contributions to value creation are no less important than the “objectively measured” contributions; they are just more difficult to measure. The great hope of subjective performance evaluations is that these softer—but no less important—factors can be appropriately considered and weighed in measuring performance. Subjective performance evaluation can then be used as a substitute for objective measures, or in addition to objective performance measures, as a way to minimize the distortions—and to complete the incompleteness— of those measures.
The key virtue of subjective performance evaluation, therefore, is that managers can flexibly measure value creation and do not have to rely on narrow measures.
Subjective performance evaluation requires substantial company resources because it is so hard to do well. Even companies that believe they do it successfully—and perhaps especially those companies—find it to be frustrating, time consuming, and rancorous.
The Achilles heel of subjective performance evaluation is that most people dislike evaluating others, especially when performance is weak. Rigorous evaluations require differentiation—claiming and supporting the view that some people are better performers than others and stating that people are differentially better (and therefore also differentially worse) in some areas than in others. If done well, such differentiation is hard work and requires the evaluator to justify and be accountable for his or her evaluation. It also leads to conflict since individuals—especially when the stakes are high but even when they are low—generally do not like being evaluated and do not respond well to negative feedback.17 Because of these forces, most evaluators find it to be easier and much more enjoyable to give virtually everyone positive evaluations.
One of the most common ways in which companies ensure differentiation is through the use of forced curves. Some managers believe that forced curves are the only dependable way to create disciplined subjective evaluations. General Electric’s well-known “vitality curve”—where all managers are asked to rank their people into one of three categories: “top 20,” “the vital 70,” and the
“bottom 10”—is at the heart of their organizational strategy. The rankings and evaluations that result from this system are used to compensate, promote, and “weed out the worst performers.”18 Former
GE CEO Welch comments: “We build great people, who then build great products.” He continues,
“For a guy who hates bureaucracy and rails against it, the rigor of our people system is what brings this whole thing to life. . . . The basic concept was we forced our business leaders to differentiate their leadership [through the vitality curve]. . . . Making these judgments is not easy, and they are not always precise. Yes, you’ll miss a few stars and a few late bloomers—but your chances of building an all-star team are improved dramatically. This is how great organizations are built.”19
8
Incentives within Organizations
904-043
Subjective evaluations also present other challenges. They can become politicized (for example, managers may give higher valuations to people with whom they worked closely), and they can lead to gaming of the system (at GE, some managers gave low rankings to employees they already knew were leaving the company, and in one case, to an employee who had recently died).20 Moreover, the conflict that is created by subjective evaluations has the potential to poison the culture of the organization. Nevertheless, despite all of these problems, and despite the overwhelming forces that top managers feel to avoid subjective evaluation—since both evaluators and evaluatees dislike them so much—many organizations fight through the mess and maintain their commitment to rigorous subjective evaluation. They use subjectivity because the alternative of relying solely on objective measures—which are often either narrow and misaligned or overly broad and uncontrollable—is simply unacceptable to them given their commitment to measuring performance well. But even managers who are fully committed to rigorous subjective evaluation recognize the profound uneasiness it creates in most normal humans.21 Welch states: “Differentiation is hard. Anybody who finds it easy doesn’t belong in the organization, and anyone who can’t do it falls in the same category.”22 9
904-043
Incentives within Organizations
Endnotes
1 See Barro, Bozic, and Zimmerman, “Performance Pay for MGOA Physicians (A),” HBS Case No. 902-159, 2002.
2 See Hall, Lane, and Lim, “Akamai’s Underwater Options (A),” HBS Case No. 902-069, 2002.
3 See Wernerfelt (1984) for a development of this view.
4 See Porter (1980) for a detailed analysis.
5 For a complete treatment of the analysis of a firm’s strengths, weaknesses, opportunities, and threats (SWOT analysis), see
Simons (2000). Note also that the analysis that connects competitive market dynamics, firm-specific resources and capabilities, mission, and business strategy is adapted from Simons (2000).
6 Unfortunately, decisions regarding organizational structure require difficult trade-offs. For example, workers and managers in functional organizations are able to specialize in their functional area, a crucial advantage. But functional organizations require coordination across functions, which can lead to cumbersome bureaucracies that are far removed from customers.
Product market organizations are closer to the customer and therefore able to be more responsive but lose the advantage of specialization. See Simons (2000), pp. 48–50.
7 See Jensen and Meckling (1994), pp. 4–19, for a detailed analysis of the allocation of decision rights and specific knowledge.
8 For evidence and analysis consistent with the view that autonomy in work leads to greater creativity and intrinsic motivation, see Amabile and Gitomer (1984), Amabile and Gryskiewicz (1987), and Hackman and Oldham (1976).
9 See Milgrom and Roberts (1988) and Milgrom (1988) and the references within for theory and evidence on this point.
10 The theory about the difficulty of bringing the market into the firm is part of a growing academic literature that includes
Baker; Gibbons and Murphy (2001); Baker, Gibbons, and Murphy (2001); Gibbons (1999); Holmstrom (1999); and Holmstrom and Milgrom (1994).
11 See Hall, Lazear, and Madigan, “Performance Pay at Safelite Autoglass (B),” HBS Case No. 800-292, 2000a, p. 4.
12 The incentive problem is called the principal-agent problem because the owners (principals) of firms hire managers and workers (agents) whose incentives are not naturally aligned with those of the principal. A seminal paper by Jensen and
Meckling (1976) was the first to develop the modern theory of the agency problem. The conflicting incentives of owners and managers was first noted 200 years earlier by Adam Smith in The Wealth of Nations (1776), the book that began the field of economics. 13 See Jensen and Meckling (1994) for discussion and analysis of this point.
14 See Welch (2001), pp. 158–160.
15 This view that intrinsic and extrinsic motivation are complements is inconsistent with some psychological models that view them as substitutes—that extrinsic motivation can drive out intrinsic motivation (Deci, 1971). But there is much evidence consistent with the view that intrinsic and extrinsic motivation can work synergistically. See Amabile, Hill, Hennessey, and
Tighe (1994) and Amabile and Gryskiewicz (1987, 1989) for examples. Much of the evidence in support of the view that extrinsic motivation can enhance intrinsic motivation suggests that worker autonomy—not requiring workers to accomplish tasks in specific and predetermined ways—is one of the crucial factors in fostering synergies between extrinsic and intrinsic motivation (Amabile, Phillips, and Collins, 1993).
16 More specifically, when an organization has an attractive work environment, it can gain a competitive edge by 1) paying slightly lower compensation relative to competitors (because the attractive work environment provides an offsetting benefit) or
2) attracting and retaining better talent, or doing a little of both. Of course, to the extent that this strategy is successful and makes everyone more productive, it can feed back into higher compensation.
17 Another reason it is hard to give negative feedback is the vast majority of individuals believe that their performance is well above average and virtually no one ranks themselves below the median. These results are robust to a variety of studies. See
Baker, Jensen, and Murphy (1988), Meyer (1975), and references therein for details.
18 See Welch (2001), p. 387.
19 See Welch (2001), pp. 156–158.
20 See Hall and Madigan, “Compensation and Performance Evaluation at Arrow Electronics,” HBS Case No. 800-290, 2000, and Welch (2001).
21 If differentiation does not lead to profound uneasiness on your part, you just have to figure out which of the qualifiers applies in your case: “most” or “normal.”
22 See Welch (2001), p. 388.
10
Incentives within Organizations
904-043
References
Amabile, T.M. and J. Gitomer. “Children’s artistic creativity: effects of choice in task materials.” Personality and Social Psychology Bulletin 10 (1984): 209–215.
Amabile, T.M. and S.S. Gryskiewicz. “Creativity in the R&D laboratory.” Technical report number 30
(Greensboro, NC: Center for Creative Leadership, 1987).
Amabile, T.M. and S.S. Gryskiewicz. “The creative environment scales: the work environment inventory.”
Amabile, T.M., K.G. Hill, B.A. Hennessey, and E. Tighe. “The work preference inventory: assessing intrinsic and extrinsic motivational orientations.” Journal of Personality and Social Psychology 66 (1994):
950–967.
Amabile, T.M., E. Phillips, and M.A. Collins. “Personality and environmental determinants of creativity in professional artists.” Unpublished manuscript, Brandeis University, Waltham, MA, 1993.
Baker, G.P., R. Gibbons, and K.J. Murphy. “Bringing the market inside the firm?” American Economic Review
91 (2001): 212–218.
Baker, G.P., R. Gibbons, and K.J. Murphy. “Relational contracts and the theory of the firm.” Quarterly
Journal of Economics (2001).
Baker, G.P., M.C. Jensen, and K.J. Murphy. “Compensation and incentives: practice vs. theory.” Journal of
Finance 43 (1988): 593–616.
Barro, J.R., K.J. Bozic, and A.M. Zimmerman. “Performance Pay for MGOA Physicians (A).” HBS Case No.
902-159 (Boston: Harvard Business School Publishing, 2002).
Deci, E.L. “Effects of externally-mediated awards on intrinsic motivation.” Journal of Personality and Social
Psychology 18 (1971): 105–115.
Gibbons, R. “Taking coase seriously.” Administrative Science Quarterly 44 (1) (1999): 145–157.
Hackman, J.R. and G.R. Oldham. “Motivation through the design of work.” Organizational Behavior and
Human Performance 16 (1976): 250–279.
Hall, B.J., H. Lane, and J.P. Lim. “Akamai’s underwater options (A).” HBS Case No. 902-069, 2002.
Hall, B.J., E. Lazear, and C. Madigan. “Performance Pay at Safelite Auto Glass (B).” HBS Case No. 800-292,
2000.
Hall, B.J., and C. Madigan. “Compensation and Performance Evaluation at Arrow Electronics.” HBS Case
No. 800-290, 2000.
Holmstrom, B. “The firm as a subeconomy.” Journal of Law, Economics and Organization 9 (1999): 74–102.
Holmstrom, B. and P. Milgrom. “The firm as an incentive system.” American Economic Review 84 (1994):
972–991.
Jensen, M.C. Foundations of organizational strategy. Cambridge, MA: Harvard University Press, 1998.
Jensen, M.C. and W.H. Meckling. “The nature of man.” Journal of Applied Corporate Finance 7 (1994): 4–19.
Jensen, M.C. and W.H. Meckling. “Theory of the firm: managerial behavior, agency costs, and ownership structure.” Journal of Financial Economics 3 (1976): 305–360.
11
904-043
Incentives within Organizations
Jensen, M.C. and W.H. Meckling with G.P. Baker and K.H. Wruck. “Coordination, control, and the management of organizations.” HBS Working Paper No. 98-908, 1999.
Meyer, H.H. “The pay-for-performance dilemma.” Organizational Dynamics 3 (1975).
Milgrom, P. “Employment contracts, influence activities, and efficient organization design.” Journal of
Political Economy 96 (1988): 42–60.
Milgrom, P. and J. Roberts. “An economic approach to influence activities in organizations.” American
Journal of Sociology 94, Supplement S154-S179 (1988).
Porter, M.E.. Competitive strategy: techniques for analyzing industries and competitors. New York, NY: Free
Press, 1980.
Simons, R. Performance measurement & control systems for implementing strategy. Upper Saddle River, NJ:
Prentice Hall, 2000.
Smith, A. Wealth of nations (1776; ed. E. Cannan, 1904). Reprint: New York, NY: Modern Library, 1937.
Welch, J.F. with J.A. Byrne. Jack: straight from the gut. New York, NY: Warner Books, 2001.
Wernerfelt, B. “A resource-based view of the firm.” Strategic Management Journal 5 (1984).
12
References: Amabile, T.M. and J. Gitomer. “Children’s artistic creativity: effects of choice in task materials.” Personality and Social Psychology Bulletin 10 (1984): 209–215. Amabile, T.M. and S.S. Gryskiewicz. “Creativity in the R&D laboratory.” Technical report number 30 (Greensboro, NC: Center for Creative Leadership, 1987). intrinsic and extrinsic motivational orientations.” Journal of Personality and Social Psychology 66 (1994): 950–967. Amabile, T.M., E. Phillips, and M.A. Collins. “Personality and environmental determinants of creativity in professional artists.” Unpublished manuscript, Brandeis University, Waltham, MA, 1993. Baker, G.P., R. Gibbons, and K.J. Murphy. “Bringing the market inside the firm?” American Economic Review 91 (2001): 212–218. Baker, G.P., R. Gibbons, and K.J. Murphy. “Relational contracts and the theory of the firm.” Quarterly Journal of Economics (2001). Baker, G.P., M.C. Jensen, and K.J. Murphy. “Compensation and incentives: practice vs. theory.” Journal of Finance 43 (1988): 593–616. 902-159 (Boston: Harvard Business School Publishing, 2002). Deci, E.L. “Effects of externally-mediated awards on intrinsic motivation.” Journal of Personality and Social Psychology 18 (1971): 105–115. Gibbons, R. “Taking coase seriously.” Administrative Science Quarterly 44 (1) (1999): 145–157. Hackman, J.R. and G.R. Oldham. “Motivation through the design of work.” Organizational Behavior and Human Performance 16 (1976): 250–279. Hall, B.J., H. Lane, and J.P. Lim. “Akamai’s underwater options (A).” HBS Case No. 902-069, 2002. Hall, B.J., E. Lazear, and C. Madigan. “Performance Pay at Safelite Auto Glass (B).” HBS Case No. 800-292, 2000. Holmstrom, B. “The firm as a subeconomy.” Journal of Law, Economics and Organization 9 (1999): 74–102. Holmstrom, B. and P. Milgrom. “The firm as an incentive system.” American Economic Review 84 (1994): 972–991. Jensen, M.C. Foundations of organizational strategy. Cambridge, MA: Harvard University Press, 1998. Jensen, M.C. and W.H. Meckling. “The nature of man.” Journal of Applied Corporate Finance 7 (1994): 4–19. Jensen, M.C. and W.H. Meckling. “Theory of the firm: managerial behavior, agency costs, and ownership structure.” Journal of Financial Economics 3 (1976): 305–360. management of organizations.” HBS Working Paper No. 98-908, 1999. Meyer, H.H. “The pay-for-performance dilemma.” Organizational Dynamics 3 (1975). Milgrom, P. “Employment contracts, influence activities, and efficient organization design.” Journal of Political Economy 96 (1988): 42–60. Milgrom, P. and J. Roberts. “An economic approach to influence activities in organizations.” American Journal of Sociology 94, Supplement S154-S179 (1988). Porter, M.E.. Competitive strategy: techniques for analyzing industries and competitors. New York, NY: Free Press, 1980. Simons, R. Performance measurement & control systems for implementing strategy. Upper Saddle River, NJ: Prentice Hall, 2000. Smith, A. Wealth of nations (1776; ed. E. Cannan, 1904). Reprint: New York, NY: Modern Library, 1937. Welch, J.F. with J.A. Byrne. Jack: straight from the gut. New York, NY: Warner Books, 2001. Wernerfelt, B. “A resource-based view of the firm.” Strategic Management Journal 5 (1984).
You May Also Find These Documents Helpful
-
Stillwell, L. (2002, December 16). Performance-based compensation increasingly popular. The business review, Retrieved from http://www.bizjournals.com…
- 3982 Words
- 16 Pages
Best Essays -
References: Canarella, G., & Gasparyan, A. (2008). New insights into executive compensation and firm performance. Managerial Finance, 34(8), 537.…
- 2303 Words
- 7 Pages
Powerful Essays -
Milkovich, G. T. (1987). A strategic perspective on compensation management (CAHRS Working Paper #87-01). Ithaca, NY: Cornell University, School of Industrial and Labor Relations, Center for Advanced Human Resource Studies. http://digitalcommons.ilr.cornell.edu/cahrswp/444…
- 1775 Words
- 8 Pages
Best Essays -
Milkovich, G., & Newman, J. (2004). Compensation 8e: The pay model. Retrieved January 23, 2008, from Univerity of Phoenix, eBook Collection…
- 3901 Words
- 16 Pages
Powerful Essays -
References: Badaracco, J. (2002). The Individual and the Corporation: Kathy Levinson and E*Trade. Boston: Havard Business School .…
- 1551 Words
- 7 Pages
Best Essays -
This report examines 3 different compensation systems that our company can develop and enforce within our company for our employees. Compensation is the most important and rewarding factor for employees, so a thorough and thoughtful approach should be taken as we think about changing the way in which this company rewards it's employees for the work they do for us each and every day.…
- 2313 Words
- 10 Pages
Best Essays -
References: Henderson, R. I. (1998). Compensation management: rewarding performance. ( 2nd Ed.). Reston Pub. Co.…
- 516 Words
- 3 Pages
Good Essays -
Reif, W. (1975). Intrinsic Versus Extrinsic Rewards: Resolving the Controversy. Human Resource Management, 14(2), 2-10. Retrieved from Business Source Complete database.…
- 5333 Words
- 22 Pages
Powerful Essays -
As a result, firms often use compensation plans combined fixed salaries with one or more variables based on performance. Economists have been trying hard to work out effective plans. Nevertheless, there are also doubts on whether or not incentive compensation works. Alfie Kohn has offered analysis on reasons for the failure of incentive programs. He states that incentive rewards “have failed to offer a convincing argument for behavioral manipulation”. (Kohn,…
- 310 Words
- 2 Pages
Good Essays -
Nonfinancial compensation consists of the satisfaction that a person receives from the job itself or from the psychological and/or physical environment in which the person works. This aspect of nonfinancial compensation involves both psychological and physical factors within the firm’s working environment. The various rewards described comprise a total compensation system” (p. 277) Organizations must follow certain guidelines to design a general compensation package that may be customized to each company as well as each position. Organizations must pay special attention to the indirect benefits that they can offer their employees. For example when offering incentives and bonus plans, companies must be clear and specific to avoid or minimize misunderstandings. End-of-year bonuses are usually expected as part of the employee’s salary, therefore other incentive and bonuses may be added and reserved for employees who excel in their performance and help the company attain their strategic goals. When determining the various benefit plans, an organization must conduct intensive research on the long term financial…
- 1310 Words
- 6 Pages
Better Essays -
Rousseau, D. M. and Parks, J. M. (1993) “The Contracts of Individuals and Organisations” in Cummings, L.L. and Straw, B. M. (Eds), Research in organisational Behaviour, Vol. 15, pp. 1-43.…
- 2886 Words
- 12 Pages
Best Essays -
Do you believe the incentive benefits such as those offered at Genentech and Zappos can be used in…
- 454 Words
- 2 Pages
Good Essays -
Traditionally, all incentive plans are “pay-for-performance” plans. They pay all employees based on the employee’s performance (Dessler). Compensation is a primary motivator for employees. People look for jobs that not only suit their creativity and talents, but compensate them both in terms of salary and other benefits accordingly. Compensation is also one of the fastest changing fields in Human Resources, as companies continue to investigate various ways of rewarding employees for performance. It is very important for organizations to make sure that the incentive plans are well structured to need the needs of the employee and in return make the organization profitable. Giving incentive pay to employees that has not earned them destroys the motivation and moral of employees which leads to less productivity. Thanks to public outcry, shareholder outrage, and increased government scrutiny, companies are making some adjustments to their executive incentive programs. At the very least, it gives the appearance of linking pay to performance.…
- 1107 Words
- 5 Pages
Good Essays -
The purpose of this paper is to provide an analytical overview of compensation strategies within organizations. First, an analysis of the impact of various compensation methods and benefit programs on employees and organizations will be discussed followed by how salary and benefit administration strategies relate to organizational culture and performance. What are compensation and benefit strategies? Compensation and benefit strategies are ways that organizations can use pay and benefits to recognize and reward employees’ contributions to the organization’s success. (Noe, Hollenbeck, Gerhart, and Wright, 2004) Some examples are wage and salary administration, incentive pay, insurance, vacation leave administration, retirement plans, profit sharing, and stock plans. In order to gain a better understanding of these programs and how they impact organizations, a comprehensive look at compensation methods and benefit programs is necessary.…
- 1891 Words
- 8 Pages
Better Essays -
References: Boone, L. E. & Kurtz, D. L. (2012 Update). Contemporary business (14th ed. Hoboken, NJ: John…
- 1804 Words
- 8 Pages
Better Essays