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The Power of Business Incentives

Updated: May 15

"Show me the incentive and I'll show you the outcome." - Charlie Munger

This simple statement holds a profound truth, especially in business. Metrics and incentives can shape behavior, but when designed poorly, they can lead to unintended and sometimes disastrous consequences for businesses. In the context of business operations, metrics and incentives play a pivotal role in influencing how individuals and teams approach their tasks and objectives.

How many times have we faced incentives that influence behavior in a way that is not aligned with the corporate strategy? If that's the case, we should wonder about the nature of those, both the incentives and the corporate strategy.

Why the disconnect? Is it a miss by executives? Is it the inertia of doing the same for way too long? Is it the fear of change? There are so many right answers as wrong avenues.

Let's take this thought and elaborate more - join us in this deep dive!

Executive Incentives

Designing Metrics for Desired Outcomes

When crafted thoughtfully, metrics and incentives can align employees' efforts with strategic goals, fostering productivity, innovation, and a positive work culture. However, the flip side of this reality is that poorly designed incentives can yield unintended and detrimental outcomes for businesses. In some cases, these consequences can be severe, resulting in financial losses, reputational damage, or legal ramifications.

Incentives effectiveness hinges on careful planning and consideration. Businesses must be mindful of the potential pitfalls associated with poorly designed incentives, recognizing that the wrong incentives can lead to outcomes that run counter to their intended objectives.

Examples of When Incentives Backfire

These diverse examples illustrate the powerful impact of incentives on behavior and outcomes across various sectors and historical contexts, leading to significant and sometimes unexpected outcomes.

Banking Sector

Wells Fargo Incentives

In the early 2000s, Wells Fargo introduced aggressive sales targets and incentives to cross-sell banking products to its customers. Employees were rewarded based on the number of products sold, creating a high-pressure sales environment. However, this led to unethical behavior, as some employees resorted to opening unauthorized accounts in customers' names to meet their targets. This practice came to light in 2016, resulting in a scandal that damaged Wells Fargo's reputation and led to significant financial penalties.

Food Sector

Dominos Incentives

In a more recent example, Domino's Pizza once guaranteed a 30-minute delivery or the pizza would be free. This seemingly customer-friendly policy had unintended consequences. Delivery drivers, incentivized by the promise of free pizzas, began speeding, leading to a significant number of accidents. One such accident resulted in a $79 million lawsuit against Domino's. The company had to rethink its policy and discontinued the 30-minute guarantee.

Education Sector

School Incentives

Standardized testing is often used as a metric to assess student performance and school effectiveness. However, the emphasis on test scores as a measure of success has led to unintended consequences. Some schools have been found to focus disproportionately on "teaching to the test", narrowing their curriculum to the subjects and skills that are tested, while neglecting other important aspects of education such as critical thinking, creativity, and problem-solving. This narrow focus can limit students' overall development and create a skewed perception of educational quality based solely on test scores.

Historic Incident

British East India Company Incentives

In the 19th century, the British East India Company issued new rifle cartridges to its soldiers in India, greased with animal fat. This posed a problem for both Hindu and Muslim soldiers, as the grease reportedly used was made from the fat of cows and pigs. Hindus were forbidden from consuming beef, and Muslims were forbidden from consuming pork. The cartridges required soldiers to bite off the ends before use, an action seen as defiling their religious beliefs. This sparked a major controversy, leading to the Indian Rebellion of 1857, known as the Sepoy Mutiny. The rebellion had far-reaching consequences, leading to the dissolution of the British East India Company and the beginning of direct British rule in India under the British Crown.

Historic Curiosity

India Cobras Incentives

Authorities, concerned about the rising population of venomous cobras in colonial India, offered a bounty for every cobra head brought to them. However, this seemingly logical incentive backfired. Instead of decreasing the cobra population, it increased. Why? The locals found a lucrative opportunity in breeding cobras to claim the bounty, exacerbating the very problem the incentive was meant to solve.

These examples highlight the danger of blindly relying on externally-designed metrics and incentives without considering their potential consequences. In the pursuit of specific outcomes, businesses must be mindful of how their incentives might inadvertently lead to undesirable results.

Consider that a 1-degree error in heading means a plane will miss its destination by 1 mile for every 60 miles flown. Small errors are amplified by distance and time.

Aligning Incentives for Business Success

Aligning incentives with business goals is crucial for driving performance and achieving strategic objectives. Incentives should motivate employees to focus their efforts on activities that directly contribute to the organization's success by creating a powerful incentive framework that drives desired behaviors and outcomes.

(1) Clarity and Transparency

Ensure that incentives are clearly defined, easily understood, and transparently communicated to employees. This clarity helps employees understand how their actions contribute to the organization's goals and what they need to do to achieve the incentives.

(2) Customization and Flexibility

Tailor incentives to individual roles and performance metrics, acknowledging that different roles may require different types of incentives. Flexibility allows for adjustments based on evolving business needs and individual performance.

(3) Balanced Metrics

Use a balanced set of metrics that reflect both short-term and long-term business objectives. This approach prevents employees from focusing solely on short-term gains at the expense of long-term sustainability.

(4) Continuous Feedback

Provide regular feedback to employees on their performance relative to incentive targets. This feedback loop helps employees stay on track and make necessary adjustments to achieve their goals.

(5) Alignment with Values

Ensure that incentives align with the organization's values and desired culture. Incentives should reinforce behaviors that reflect the company's core values and contribute to a positive work environment.

Rethinking Incentive Design

Take a moment to reflect on the power of thoughtful design in shaping behavior and results. Consider the impact of incentives not only within the examples we've discussed but also in your own professional experiences.

"An incentive is a bullet, a key: an often tiny object with astonishing power to change a situation" - Steven Levitt

How have incentives influenced your decisions and actions? Are there areas where a more strategic approach to incentives could yield even greater success? As you think about these questions, remember that the true art of incentive design lies in its ability to align individual motivations with collective goals, creating a harmonious synergy that propels organizations toward their aspirations.

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Incredibly valuable post! Truly enjoying reading it!

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Thanks Manel. Please, stay tuned for our regular weekly release every Wednesday morning post 😊

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