The action: Think through the unintended negative downsides of what you reward.
“Any person can invent a security system so clever that she or he can’t think of how to break it.”
The long form: The same is true of bonuses and other incentive schemes. Anyone can come up with a bonus scheme that is so watertight that the inventor can’t imagine how anyone could ever work around it. Or how your solution to the principal-agent problem can produce anything but perfect results.
Let’s say you pay a straight salary to everyone on the sales team. But now nobody has any incentive to increase their sales.
Then you start rewarding your team per number of sales. So now they start splitting major accounts into smaller sales, without increasing the revenue.
Then you start rewarding your sales people for the dollar amount of sales they bring in. Now they sell at hefty discounts because the increased quantity makes up for the lower unit price. No-one sells the most profitable products, and the best salespeople have stopped helping others on the way to more individual compensation.
And so it goes.
The problem with incentives is not that they don’t work. In most cases they do. The problem is that you get what you reward, both the good and the bad. You could almost say they work too well.
From Shane Parrish:
If you’re trying to change a behaviour, reason will take you only so far. Reflecting on another example where misaligned incentives hampered the sales of a superior product, [Charlie] Munger said:
Early in the history of Xerox, Joe Wilson […] couldn’t understand how their better, new machine was selling so poorly in relation to their older and inferior machine. Of course when he got there, he found out that the commission arrangement with the salesmen gave a tremendous incentive to the inferior machine.
I’m not arguing against the use of bonuses, rewards or even measuring performance. But euphemistic «performance management» can be blind to people gaming the system or other unintended consequences. Not because people are bad, but because «it is difficult to get a man to understand something, when his salary depends on his not understanding it,” in the words of Upton Sinclair.
There are no perfect compensation schemes, you can only try to come up with one with foreseeable and acceptable consequences. If you cannot think of any downsides, ask a friend to come up with the easiest way to get paid with your proposed scheme. Then decide whether there are better alternatives, or if this is a cost you can live with.
Well, I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.
Charlie Munger, via Shane Parrish.
Read more:
First Forty 